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Learn How to Sell Options on Futures Contracts

 

The No Nonsense Guide to Buying and Selling Options

 

*The information contained within this webpage comes from sources believed to be reliable. No guarantees are being made to the content's accuracy or completeness.

 

You have probably heard that approximately 80% of all options purchased expire worthless when held until expiration. Based on the research of the Chicago Mercantile Exchange this statistic is true. This means that the sellers of those options get to keep the option premiums that were paid to them by the option purchasers. This fact leads to an inevitable question.

 

Why would anyone ever purchase an option when the probabilities are so overwhelmingly in the favor of the option sellers?

The most enticing aspect of buying options on futures contracts is the risk to reward profile. The purchaser of an option has limited risk and theoretically unlimited profit potential. For smaller investors who do not have enough risk capital or risk tolerance to withstand a potential margin call, purchasing options may be the best way to take part in the commodity markets. However, the odds are certainly in the favor of the option sellers but the risk potential is unlimited and the profit potential is limited.

If you are one of those investors who has repeatedly lost money buying options or trading futures, then maybe it is time to add option selling strategies to your investment portfolio.

 

Why do the majority of all options purchased expire worthless when held until expiration?

Consider this example. You just purchased a December $90 crude oil call option for $700. This includes the option premium plus the commissions and fees. The option expires in 105 days and the December crude oil futures price is at $80 per barrel.

Here are 3 potential scenarios that will cause you to lose money:

1) The price of crude oil can trade lower.

2) The price of crude oil can trade sideways.

3) The price of crude oil can trade higher but not by enough to overcome the transaction costs and time decay of your option by expiration.

To profit from this option purchase, the crude oil market must move higher by enough to overcome the commission and fees paid and the time decay of the option within the 105 day time period. You must not only choose the direction of the market correctly but also the approximate distance crude oil prices will move and the correct time frame the price movement will occur within.

Conversely, the person who sold you the option is not trying to figure out where the crude oil prices will be by a certain time. They are trying to figure out where the crude oil prices will not be by a certain time. This allows the option seller a lot more room for error.

 

What is time decay?

Options are by definition a wasting asset because each and every day the option's premium is being eroded by time. This erosion of premium accelerates throughout the lifespan of the option. Time decay is the best friend of option sellers and the worst enemy of option purchasers. The value of out-of-the-money options is composed almost entirely of time value. The chart below depicts the acceleration of the time decay of an option with a 9 month lifespan from its inception to its expiration.

 

 

If the probabilities are so disproportionately in favor of option sellers, then why don't my investment advisors suggest this strategy to me?

Commodity option selling strategies are not suggested by brokers and advisors to their clients very often. In my opinion there are two reasons for this:

1) Most financial advisors are not properly licensed to suggest selling options on commodity futures contracts to their clients. That requires a Series 3 license. They have no financial incentive to suggest moving assets out of the portfolios that they manage and into another account somewhere else. Therefore, the potential merits of selling options on futures contracts are never mentioned.

2) If they are Series 3 licensed they often find that the generic risk to reward profile is hard to sell to their clients. The risk is theoretically unlimited and the profit potential is limited to the premium you receive from the sale of the option after commission and fees.

It's much easier for an advisor/broker to sell an idea of a small capital investment potentially bringing back large quick profits. It's harder to sell the idea of using a large capital investment to potentially bring back small profits over a long period of time.

Option sellers are reminiscent of insurance company owners. Their business plan is to collect a lot of small premiums year in and year out knowing that the odds of having to pay out more than they take in are disproportionately skewed in their favor.

Do you remember Aesop's fable about the tortoise and the hare? The moral of the story was slow and steady wins the race. There are no exciting pie in the sky winners or home run trades. If you are seeking huge profits in a short period of time, then selling commodity options is not for you.

This information should not be considered a guarantee that option sellers always win. Past performance is not indicative of future results. There is always risk of loss. Active risk management is a must if you intend to sell options on futures contracts.

 

How do you manage the extra risks involved in selling options on commodity futures?

1) The first thing an option seller should commit to is not using more than 50% of the available margin in their account. (ie. If you have $100,000 in your account you will stop selling options once the initial margin requirement reaches the $50,000 level.) This money management technique can help you keep out of margin call trouble.

2) The second way for a call or put option seller to manage their risk might be to focus on selling deep-out-of-the-money options. It is this trader's opinion that options should be sold at least 25% away from the actual futures price of the underlying commodity to be considered deep-out-of-the-money. (An example would be selling a November $12.50 soybean call when the underlying futures contract is at $10.00.)

3) Another way of managing the risks involved in selling options is to buy back the options that you sold if they move against you. As an option seller, you can expect to buy back (cut losses) on approximately 2 out of every 10 options that you sell.

Many option sellers buy back options that have doubled in value. (ie. If $700 in premium was collected by selling the option and now the option is worth $1,400, the option seller will buy the option back and take the $700 loss.) Active risk management is the key to having an effective option selling portfolio.

4) It also makes sense to diversify your short option strategies between multiple commodity sectors that have a low correlation to each other. This can help insulate you from a large premium expansion caused by a volatility spike within a particular sector of the commodity markets.

For instance you may want to spread out your commodity option selling portfolio between grains, meats, metals, energies and exotics. Your portfolio is not diversified very well if you sold calls in WTI crude oil, RBOB unleaded gas and ULSD heating oil because they are very highly correlated to each other. A volatility spike in crude oil will most likely affect all three contracts simultaneously.

 

How does the margin work for selling options on a futures contract?

The exchanges use SPAN margin software to calculate how much capital will be necessary for margin on options sold in a portfolio. It uses an extremely complicated algorithm that is irrelevant to this example. As a general rule of thumb the margin requirement is approximately 150-200% of the premium collected.  (ie. You sold a put and collected $600 in premium and your margin requirement is $1,400. Take $1,400 minus $600 and this equals $800. You will need at least $800 extra cash to be in your account to meet the initial margin requirements for the put that you sold.) *This depends on the underlying futures market.

 

How can a portfolio based on selling options on futures compliment my traditional stock, bond and real estate portfolio?

Alternative investments like options on futures contracts can be used to diversify and reduce the overall volatility in a traditional portfolio because they exhibit a low correlation to stocks, bonds and real estate.

Options on futures investments also have tax advantages. Any gains from your option selling trades are taxed as 60% long term and 40% short term regardless of the time frame those investments were held.

 

 

 

 

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Futures and options investing carries significant risk of loss and is not suitable for some investors. Past performance is not indicative of future results. Use only risk capital for futures and options investments.

 

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The information presented in this commodity futures and options site is not investment advice and is for informational purposes only. No guarantees are being made to its accuracy or completeness. This information can be considered a solicitation to enter into a derivatives trade. Investing in futures and options carries substantial risk of loss and is not suitable for some people. Past or simulated performance is not indicative to future results.