Selling options is something many traders shy away from, but if you take the time to educate yourself, it can be a rewarding strategy. This article is meant to stimulate your thinking about different ways to participate in the futures markets, even if you decide option selling isn’t necessarily right for you. If you are comfortable buying options, you might want to think about the sell side. Option selling involves a higher level of risk than buying options, but there are a few key rules I believe can help you be more successful.
This article assumes you have a basic understanding of options. If you are new to options trading, you can read about the mechanics of buying and selling in this article on the Lind-Waldock Web site, “What are Options.”
Why Sell Options?
You’ve probably heard about or read studies that show the vast majority of options bought expire worthless. You might have even found yourself in this position as an option buyer. You might have even been right about the market’s direction, but still lost money on your option due to time decay.
Options selling (also known as options writing) can be an attractive approach to solve this issue. When you buy an option, you pay a premium, and that is the most you can lose on your trade. Your gain as a buyer of a call is unlimited as the market can theoretically rise indefinitely. As a buyer of a put, your risk is the same as a buyer of the call, but your profit potential is the largest possible decline in the asset—to zero. Remember, when you buy an option, you have the right, but not the obligation, to exercise your option and take a position in the underlying.
As the seller, you collect the premium from the buyer in exchange for bearing the risk of being forced to either buy or sell the underlying commodity if that option expires in-the-money. You could be assigned a position in the futures market, and your risk profile becomes that of any futures position holder—unlimited. If you actually want a position in the underlying market, this probably won’t bother you. And, whether you buy or sell options, you can trade out of your position before expiration, and take a profit or loss based on its premium value at that point in time.
Over time, when you buy an option, your premium will decay to zero, and your investment will be worthless. Remember, options value is derived from three factors: volatility, time to expiration, and how close the strike price is to the underlying market price.
Let’s look at an example of how these concepts could have played out in silver. In March and April, silver was looking bullish, so say you had bought $19 calls during this time. Silver saw a nice run higher and did touch $19 per ounce, but the move wasn’t straight up; there were a few sell-offs along the way. And, at expiration the call was out-of-the money, expiring worthless.
Selling a call option bears the risk of the underlying market climbing sky-high—which is why your risk is unlimited. You must determine the point at which you will chose to buy back that contract, take your hit, and move on. Selling puts bears the risk of the underlying contract falling, but the most any asset can fall is to zero, so in that sense, there is a floor. You still get to keep the premium you collected from the buyer in either case, which can cushion your losses.
If we know that typically three out of four options bought expire worthless, then option buying requires that one winner to be large enough to cover all your losses from the other three trades. That can be challenging.
So look at the inverse. If the buyer is likely to lose three of four trades, then the seller would profit in three of four trades. As we know, that one losing trade could subject the seller to unlimited risk with the assignment of a futures position. The key is to have a plan in place to manage your risk in the event that does happen.
So why don’t more people sell options? I think it’s because most individual investors just don’t have the knowledge or understanding of how to develop an appropriate strategy. If you don’t, you can work with a professional who can help. On that silver example, the person who sold the call was essentially wrong about the market’s direction, but as it rallied, time decay saved them.
As a seller, you don’t have to be right about the market’s direction. You can look at probabilities. Statistics are in your favor. It’s like hitting a baseball–think about its likely trajectory, and where the ball is likely to go. Sell those options where the ball isn’t likely to go.
Sell Deep Out-of-the-Money Options
A common misconception about selling options is that you should only consider options that are within 30 days to expiration. I think that can be a mistake. The rate of time decay is actually at its greatest slope during that time, but it’s still there even farther out in time, just to a smaller degree.
Selling options with only 30 days or less until expiration left is an aggressive approach, and requires constant monitoring. Any small hiccup in the market can dramatically change your option’s value. In early May, when the Dow Jones Industrial Average suddenly plunged 1,000 points, it created a 10 percent move against those selling options closest to expiration because their strike prices were so close to the market. Sellers of options with 60, 90, or 120 days to expiration saw their options move very little. The distance between the underlying future and those strike prices was much greater, and not threatening to go in-the-money. The sellers still had time premium on their side.
Let’s look at another example. That same day the stock market plunged, we saw the Japanese yen spike. It had been in a downtrend, and people had been looking to sell calls in the yen in the range highlighted by the red horizontal line drawn on the chart below—1.0934 – 1.0939. Then the market spiked and these options are facing the possibility of expiring in-the-money. As a seller, you have to decide to make adjustments, and possibly get out of the trade with a loss. But then the market fell back, and volatility did too. If you went out 7-9 months and sold options with a much higher or lower strike price, this wouldn’t be a factor. Short-term volatility swings can threaten your options’ value. The bottom line is that you don’t have to sell options within 30 days of expiration. It is possible to sell an option much farther out in terms of strike price and time.
Don’t Over-Position Your Account
Because options margin requirements are significantly lower than for futures, traders can easily get themselves into trouble by holding too many positions. They will buy or sell 5-10 options, reasoning that the margin required for the position is equivalent to one or two futures contracts. You can really get yourself in trouble that way.
Remember, as a seller, you face the risk of being assigned those futures positions. Don’t sell more options than you would want futures in your account. I also recommend traders don’t margin more than 50 percent of their account in short options. As selling options is a sophisticated approach, I recommend at least $100,000 in capital, with $50,000 in reserves in case one or more of your trades goes against you. That’s not to say you can’t sell options with less capital, but a higher level gives you more of a cushion if the option winds up in the money and you are assigned a futures position.
Manage Your Risk
I’ve talked about the potential risks involved in selling options, but how do you manage it? The first rule in managing your risk: don’t let your short options go in-the-money. You are probably thinking, “That’s easier said than done.” However, if you look for options very far from the underlying futures price and/or far out in time, a small move won’t cause your option to be in-the-money.
If rule number one fails, that leads us to rule two: Exit the short option position when the position premium doubles. Don’t let a small loss turn into a huge headache later on.
Finally, there is a third rule: Take your profits early. If you sell an option and it starts to decay, don’t let it sit. Buy it back. Don’t be greedy. Don’t allow the market to move against you. Why have the exposure, and tie up the margin?
These are just a few things to keep in mind when considering selling options. Please feel free to contact me with any questions you have about this topic or with any other market-related questions you might have.
Phil Streible is a Senior Market Strategist with Lind-Waldock. He can be reached at or 800-803-8037 via email at pstreible@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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