Short option trading in the commodity markets is sometimes touted as an easy money strategy, but the truth is there is no such thing as easy money in the commodity markets. Nevertheless, there are some compelling arguments to suggest that option sellers face favorable odds of success over option buyers, or outright futures traders. But, even putting the odds in your favor doesn’t guarantee a favorable outcome. Here are some aspects of option selling that should be considered before employing a premium collection strategy.
1. It takes money to make money
Short option traders must be properly funded to be capable of riding out any storm that might materialize. During times of excessive commodity market volatility, many traders turn to the limited risk of option buying. This has a tendency to artificially inflate commodity option prices, due to the increase in demand for the securities. Also, in a more volatile market environment, commodity traders often believe it is more likely that a long option strategy will have an opportunity to pay off. I argue this is a false perception because options on futures buyers must overcome their cost of entry before turning a profit; the higher the price of the option on the way in, the bigger the obstacle to being profitable will be. Nevertheless, in all of the excitement traders often behave emotionally rather than logically; as a result, they exuberantly bid up the prices of low probability options to shocking levels.
In most options and futures markets, you would want about $10,000 in a trading
account for one, or two, commodity options sold. In some of the higher margined markets such as gold, it would likely be in your best interest to have much more. Another way to determine the appropriate account and position size is excess margin. Generally speaking, it is a good idea to utilize 50% of less of your account when trading short options. Simply put, if your account size is $10,000 you should aim for trades that will require a margin of $3,000 to $5,000. On the flip side, the excess margin listed on the bottom of your statement should be between $7,000 and $5,000.
Some might look at the funds not being used toward margin as a missed opportunity, or a waste of risk capital. However, nothing could be further from the truth. Undercapitalized commodity option sellers will almost undoubtedly get into trouble. Without plenty of excess margin in a commodity trading account, it can be difficult to survive the normal ebb and flow of the futures markets. In addition, a lack of capital dramatically increases the odds of a margin call, which can result in pre-mature liquidation of an option trade. If the situation is dire enough, the liquidation might be at the hand of your commodity broker; which is an unpleasant experience for all parties. With that said, not all commodity option brokers are created equal (see the next talking point).
2. The commodity options broker you choose DOES matter!
Unfortunately, many beginning option sellers overlook the impact their choice of commodity broker has on the bottom line of a trading account. Even worse, they assume the only affect their option broker will have on their trading results is the per contract commission charge. As a long-time futures broker I can assure you, there is much more to the relationship between a trader and his commodity brokerage than transaction costs.
Regardless of whether a commodity option trader is placing orders online though a futures trading platform, or by phone or email with a broker, the choice of a brokerage firm will eventually play a big part in the success or failure of a commodity option trading strategy. This is because many futures brokers are averse to allowing their clients sell options on futures; even those brokers that allow it often take other actions to reduce risk exposure to the brokerage such as restricting the commodity option contracts available to trade, increasing short option margin requirements (above and beyond the exchange minimum SPAN margin), and even force liquidating client positions at the first sign of trouble. Futures brokers with heavy handed risk managers can wreak havoc on an option selling account. Imagine your option broker liquidating your trades at a highly inopportune time, before a margin call is triggered, and without notifying you. Such an event can be a costly and frustrating experience; but it can also be avoided by ensuring your commodity option broker is willing and capable of servicing your account type. My commodity brokerage service, DeCarley Trading, specializes in handling option selling accounts.
3. Most traders lose money, so don’t follow the masses!
Whether trading futures or options, a common mistake commodity traders make is to blindly follow the lead of random trading books, business news stations, popular financial newspapers, and magazines. The ugly truth is most commodity traders lose money. Knowing this, why in the world would you want to do what "everyone else" is doing? In light of the success rate of the masses, you probably don’t want to join them. Most traders are buying options, and or employing futures trading strategies; a much smaller percentage of traders are selling commodity options. Perhaps option selling is the prime “contrarian” strategy, and should be considered by all market participants for the simple reason that it is unpopular…and historically speaking, unpopular ideas in trading sometimes turn out to be the gems.
4. Sell Options Against the Trend?
As opposed to simple premium collection without a purpose, such as carelessly selling calls and hoping nothing happens, I feel like the best odds of success is to patiently wait for market panic or excitement of the masses and to play the other side of the trade. Warren Buffet said it simply, "Be fearful when others are greedy, and greedy when others are fearful"; he wasn’t referring to option trading but the concept can certainly be applied. For instance, some of the best option selling opportunities occur following massive price spikes in a particular direction. When such a price extension occurs most speculators are busy buying options in the direction of the trend at obscenely high prices, when the best trade is often to be a seller of those over-priced options. Of course, this type of approach is equivalent to catching the proverbial “falling knife”. If what you believe to be the exhaustion of a trend, turns out to be the early stages of a much larger move the trade could be in danger of substantial losses.
Selling options as a contrarian isn't easy money, but I do believe it might be advantageous from an odds perspective. After all, times of directional volatility and emotion often involve excessive option premium and this makes it a great time to be an options on futures seller. If you were a store owner, you would prefer to sell hot products at high prices, as opposed to items on the discount rack. Option selling is no different.
Of course, the trick is to be patient enough to improve the probability of your entry being at the peak of volatility; this is easier said than done. However, completely disregarding commodity market volatility when implementing a short option strategy could lead to painfully large losses regardless of whether the futures price ever touches the strike price of the short option.
5. Are you an option selling candidate?
Before choosing to implement an option selling strategy in the futures markets, you must first honestly assess your ability to accept the prospects of unlimited risk and margin calls. Not everyone is capable of managing the emotions that come with these two characteristics of the strategy; and even those who are, will have moments of weakness. As a seasoned commodity option broker, I can attest the markets are capable of making a grown man cry. Failure to keep trading emotions in check could mean letting losers get out of hand, or panicked liquidation at unfortunate prices. Either scenario could be psychologically and financially devastating to an option selling strategy.
*There is substantial risk of loss in trading futures and options. There is unlimited risk in option selling!
Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. Her books, "A Trader's First Book on Commodities," "Currency Trading in the FOREX and Futures Markets," and "Commodity Options," were published by FT Press.