What You Really Need To Know About Option Selling

Commodity Option Selling: Is it as bad as your futures broker says it is?

The practice of option selling is a controversial strategy for commodity option traders to partake in.  Many brokerage firms outright forbid the practice; others allow it, but there are often strings attached.  However, there are a limited number of brokerage services that recognize despite the challenges of option selling, it likely offers the highest long-term prospects for successful trading.  Accordingly, such brokers give their clients the freedom to implement a short option strategy.  We are a part of the minority commodity brokers that believe our clients should be given the opportunity to sell options without hassle.   Nevertheless, option selling is far from an “easy-money” venture; there is a reason many brokerage firms shy away from option selling.

What is Commodity Option Selling?

Option sellers are in the business of collecting premium, much like an insurance company, under the assertion that in the long run the premium collected should outweigh any potential payouts.  In a nutshell, an option seller is accepting the risk of the futures market trading beyond the strike price of an option, in exchange for income.  For instance, a trader selling a $60 crude call for $500 is collecting $500 with the expectation that the price of oil will be below $60 at option expiration.  If oil is above $60, the trader is exposed to risk similar to being short a futures contract from $60.00. 

The premise of option selling is based on the assumption that more options than not expire worthless, which has been suggested by several studies including one conducted by the Chicago Mercantile Exchange.  Unfortunately, similar to insurance companies who are sometimes forced to honor their policies on excessive claims, commodity option sellers are vulnerable to monster market moves than can be potentially account threatening.  Preventing such disasters ultimately come down to timing of entry along with a good understanding of futures market volatility, market sentiment, and market knowledge.  Additionally, experience, instinct and, of course, luck will also come into play.  Yet, in my judgment option selling is a superior strategy in the long run.

Why do some futures brokers discourage or forbid short option trading?

Selling naked options leaves traders exposed to theoretically unlimited risk, while accepting the potential of a limited reward.  In other words, it is the exact opposite payout diagram an option buyer faces (which is limited risk but unlimited profit potential).  To the green trader, the prospects of being an option buyer is habitually more appealing.  After all, who wouldn’t want the possibility of windfall profits with a finite risk?  Notwithstanding the appeal, option buyers face a dismal likelihood of success.  In other words, if the probability of bonanza style profits are slim then perhaps option buying is nothing more than the equivalent to buying a lottery ticket.  The risk of loss is limited and maybe even small, but the odds of a return on the investment are also trivial.

The concern that most brokerage firms have with option sellers, isn’t that traders face unlimited risk.  If that was the issue, they wouldn’t allow futures trading either (futures traders also face theoretically unlimited risk).  The primary apprehension brokers have with short option trading is option market liquidity during highly volatile market conditions.  The option market is not nearly as liquid as the underlying futures market, because of this it can sometimes be difficult to accurately value positions and account balances of option trading clients. 

In other words, if a brokerage firm has a client trading futures in danger of losing more money than is on deposit in their trading account, the risk managers can easily assess the situation to determine if forced liquidation of positions is necessary.  This is because they can see the exact price of the futures contracts and conclude the client’s account balance quickly and precisely.  Ideally, any necessary forced liquidation would occur before the account balance falls into negative territory, but that isn’t a guarantee.  

In a similar scenario with an option selling client, the risk manager might not have access to reasonable valuation or pricing.  Not only does the lack of clear position valuation pose risk to the client and broker, it also requires more brokerage firm manpower and experience to manage the risk than futures trading account would. We saw an extreme case of this during the August 2015 downturn in the e-mini S&P 500 futures options (ES).  Toward the end of a precipitous four-day decline, the bid/ask spread in most of the ES options was 10.00 points, or $500, in contrast to .50 in normal market conditions.  In addition, option prices were increasing exponentially without reasonable limits.  Those clients trading short options in high quantities could have easily seen tens of thousands of dollars vanish in an instant.  Because the possibility of the spreads and option premiums “blowing up”, as it did in this scenario, housing short option trading clients requires far more brokerage firm risk management resources.  As a result, traders should expect to pay more in commission for their option trades than they do futures trades.

Also complicating the issue, but for good reason, commodity exchanges don’t accept stop loss orders on options as they do futures.  Thus, pre-emptive risk management isn’t a possibility.    Stop orders are not possible on options because they are subject to widening bid/ask spreads, which in turn can trigger a stop loss order prematurely (stop orders are elected as soon as the market price reaches either the bid or the ask); it isn’t necessary for a trader to actually take place at the stop price to elect the order.

Deep discount commodity brokers cannot afford to let clients sell options freely because their profit margin is so tight.  At a potential gross profit of pennies per trade, the extra work and potential debit account risk of allowing clients to sell options doesn’t make sense for their business model.  Thus, if you are trading with a discount broker that is letting you sell options, you had better be aware of the fact that your positions are prone to heavy handed forced liquidation at the first sign of trouble.  This is a massive disadvantage to an option seller; in my opinion it reduces the strategy to a sure fire way to lose money.  Accordingly, be aware of your broker’s policy and “friendliness” to option selling before getting started.

Now that we’ve discussed some of the risks and challenges of option selling, we’ll shift to the brighter side of the strategy. In next month’s column, we’ll discuss ways to increase your odds of trading success as an option seller.

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.