The FUDOM Method of Selling Options

The FUDOM Method of Selling Options
Jun

17

2016

The FUDOM Method of Selling Options

How to sell options with the highest odds of Expiring Worthless

An email appeared in my inbox a few weeks back from a confused option trader. “What is FUDOM?” he asked. “I’ve never seen it mentioned in any other option literature. Is that something you invented?”

I wouldn’t say its something I invented. Rather, something I discovered. I’m sure others have used the approach. I just gave it a name.

That being said, after years of years testing different option selling approaches, our conclusion is that the FUDOM method is the most efficient and most beneficial to your bottom line as an option seller. Not only should it keep you in options with high odds of expiring worthless, it can do so in a manner that allows you to sleep well at night.

What is FUDOM?

FUDOM is an acronym for FUndamentals combined with Deep Out of the Money options. FUDOM values fundamentals of the underlying market over other factors

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Selling deep out of the money options against those fundamentals is the essence of FUDOM and the entire basis of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).

For example, an investor who is bearish wheat based on a record crop and resulting supply glut might sell deep out of the money call options prior to harvest. This would force the market to make a substantial move against it’s core fundamentals for the investor to lose on the trade. (While this can happen, of course, it is our opinion that it is more difficult for the market to do)

FUDOM is about selecting options with a high probability of staying out of the money and expiring worthless, then having the patience to wait a few months for them to do so.

Opposite of what Most Option Books Teach

While most option books devote little time to discussion of the sell side at all, those that do tend to focus on factors such as volatility, momentum and selling options with short time value – often 30-45 days or less. The rational for this is that as options experience the fastest rate of decay in the final 30 days prior to expiration; it makes sense that the highest probability option sales are to be made during or immediately preceding this time period.

Our experience has been that this is not the case.

In fact, FUDOM is the opposite of this approach.

Example: FUDOM vs. “Book Knowledge” Option Selling

For example, lets go back to late April of 2014. An investor, (we’ll call him Dr. John) is looking at the Coffee market because his software has noted that volatility has surged, making it a good market for “selling volatility.”

Following what his textbook teaches, Dr. John “sells the volatility” by selling a put and a call. As July is the next month offering options, he sells July Coffee options which expire in early June (giving him about 45 days until option expiration.

With Coffee trading near $2.00 per pound, he sells a July 2.15 call for a $500 premium and a July 1.80 put for a $500 premium. To get any premium, with only 45 days left until expiration, he has to sell this close to the money.

That’s OK. Dr. John’s textbook is telling him this is the way to option selling riches. Sell volatility. Sell short time value.

JULY 2014 COFFEE

graph-july-coffee2014

  Dr. John sells a July Coffee 2.15 call and 1.80 put – it’s how he was “taught” to sell options.

The Problem

The problem with selling this close to the money is that any type of market hiccup can put Dr. John’s options “in the money” pretty quick. As an option seller, that’s not where you (or he) want to be.

The example below illustrates what happens all too often to traders using the “textbook” approach.

JULY 2014 COFFEE

graph-july-coffee2014

  Coffee rallies then falls. Both of Dr. John’s options go in the money, likely forcing stops (and losses) on both sides.

Although Dr. Johns options only have 45 days until expiration, he had to sell them fairly close to the money to get any premium. Immediately following the sale of his options, the market rallied, putting his call in the money and likely stopping him out at a loss. Then, the market immediately reversed, putting his put option in the money prior to expiration, likely triggering his stop and bringing losses on that side as well.

While this is only a hypothetical example, it illustrates the danger and potential pitfall of using “textbook” option selling knowledge when taking premium in commodities.

The Solution: FUDOM

Now lets take the same market and apply the FUDOM method.

It’s April 2014 again and YOU are the investor. Rather than trying to apply the same old option selling “logic” and sell 30-45 day options, you are now using the FUDOM method.

With Coffee prices rallying, you research the fundamentals behind the rally. It seems that prices are climbing because of anxiety over wet weather during the Brazilian Coffee bean harvest.

Speculators are watching weather reports and feeling nervous. But your research from the USDA and Ag Attaches in Brazil tell you that there appears to be little affect on the crop as of yet. In addition, you know that autumn is typically wet in Brazil – a pattern that will likely end in the next few weeks. In addition, not only is this year’s crop fairly sizable, but next year’s coffee crop could potentially be a record. Feeling that market anxiety will soon begin to pass and that the market will begin to price next year’s mammoth crop, you feel the risk of a bigger move is to the downside.

Therefore you elect to sell calls, and skip the puts.

You have just employed the FU in the FUDOM method. Fundamentals can tell you which side of the market to sell.


FUDOM puts you in a position to take advantage of the ultimate fundamental bias in the market, even if the market chooses to move against you a certain degree in the near term.

The second part of FUDOM is Deep Out of the Money. Instead of going 45 days out and selling the July Calls, you want to give yourself a chance to profit even if your timing is off. If this market still has room to rally, you want to put yourself in a position to profit for what you feel will be an eventual decline.

Markets do not always immediately obey fundamentals. Fundamentals are more like a weight that eventually pulls the market one way or the other. However, other forces can temporality push markets away from fundamentals. This is where the advantage of using FUDOM comes in.

FUDOM puts you in a position to take advantage of the ultimate fundamental bias in the market, even if the market chooses to move against you a certain degree in the near term.

Electing to employ FUDOM, you Skip over the July options and go out to September. By going out further in time you allow yourself to sell Deeper out of the money options. Thus, instead of selling a July 2.15 call, you sell a September 2.60 call. This would force the market to rally an additional 30% before your options would be in the money.

SEPTEMBER 2014 COFFEE

September 2014 Coffee

  Using FUDOM, you sell a September 2.60 Coffee Call – deep out of the money.

While you have to sell 105 days of time value, doing so would have put your option deeply out of the money, well above the frey our textbook trader had to endure.

The Fundamentals told you to sell calls, not puts – avoiding a loss on the put side.

Selling Deep out of the Money put your position well above the short term price rally that stopped out Dr. John on his call.

And because of the steep market decline during June and July, you likely could have bought your option back at nearly full profit well before expiration (thank you again fundamentals).

Should You Use FUDOM?

If you like day trading in and out of options, feed on action, love the daily excitement, then FUDOM is likely not for you.

If you are a serious investor who prefers a more passive but high odds approach, I wholeheartedly recommend it to you.


FUDOM can offer an investor some substantial advantages, including:

  1. It’s a strategy almost custom tailored for commodities where knowing the supply/demand fundamentals of a market is of utmost importance. FUDOM allows you to put your fundamental knowledge to use without having to have perfect timing – the pitfall of many commodities traders.
  2. It can allow you to profit even if your fundamental diagnosis is somewhat wrong. FUDOM is a very forgiving strategy
  3. Using FUDOM, the market can do many things and you can still make money. There is only one thing it can do for you to lose money.
  4. It is an excellent approach to combine with Staggering (covered in the Last Lesson) to build a long term, high yielding option writing portfolio.

Drawbacks

FUDOM, like any investment approach, is not perfect and not without risk.

Drawbacks include having to wait longer for your options to decay. Some argue, with some merit, that this gives the market “more time to move against you.” This is true, although accurate fundamental forecasting can go a long way toward mitigating this risk.

Another drawback is that a sudden surge in volatility can stop you out of your options well before they go in the money. While this is certainly true, I would still rather be getting stopped out of an out of the money option, than having my option go in the money (as in the “textbook” example, where losses can pile up quickly.


Conclusion

FUDOM of course is not bulletproof. You can still take losses using this approach and I recommend being comfortable with any option risk before delving into the market.

That being said, in 15 years of selling options for high net worth investors, I have found no other approach that gives such an optimum balance of high odds, low stress and potential for solid return than FUDOM.

Use it as you see fit.

Learn More

Option Seller Discovery Pack

Investor Discovery Pack

To learn more about selling options using the FUDOM method, get your copy of McGraw-Hills The Complete Guide to Option Selling today. Alternatively, if you are a high net worth investor interested in working directly with James Cordier, request your Investor Discovery Pack at www.OptionSellers.com/Discovery ($250,000 minimum investment). FUDOM is covered extensively in this information pack.

Learn More about the Pack

James Cordier is the founder of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors seeking outsized returns. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC. Michael Gross is an analyst with OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now. For more information on managed option selling accounts visit www.OptionSellers.com/Accounts ($250,000 minimum investment)


Price Chart Courtesy of CQG, Inc.


***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

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