The 3 Critical Steps to Picking the Right Option to Sell

The 3 Critical Steps to Picking the Right Option to Sell
Sep

6

2016

The 3 Critical Steps to Picking the Right Option to Sell

Taking the right premiums can have a big impact on your bottom line. Here is how to select your strikes like a Pro.

Deciding to allocate capital to an option selling portfolio can create a maze of questions. When you are initially learning about selling options, especially if you are considering going it on your own, one of the first questions that probably enters your mind is “How do I know the best options to sell?”

Even if you have a managed account, where professionals select the options for you, you still might benefit from knowing the criteria they are using to take premium on your behalf.

While option selection for a diversified portfolio is a broad subject, this month’s Institute column will give you three main guidelines to follow that will help keep you out of the red, and hopefully power up your bottom line.

The Truth about Picking the “Best” Option

Mathematicians and quants might obsess over their calculators and software programs in an attempt to select the “perfect” option for any situation. But the truth is, there is no perfect option to sell. There is no “best” option to sell. Option selling isn’t graded on the A B C D F scale. It’s pass/fail. If it expires before hitting your risk parameter, you sold the right option. Pass. You win. If it hits your risk parameter, fail, you lose. Therefore, any series of options could be the “right” one.

One of the big attractions to selling premium is you don’t have to be perfect. Being good enough wins in the option selling game. That being said, there are some things you can do to ramp up your odds and hopefully give you a smoother ride to where you want to be.

Your Objective

Ideally, you want to pick options that not only expire worthless, but quietly decay to zero – preferably well before expiration. At least, that is the objective of the premium collection program that we recommend for investors. Some options that eventually expire worthless can also have “interesting” swings in premium value prior to expiration. While these may ultimately provide profits, they don’t work so well for your state of mind! Your objective is to select the former, avoid the latter.

Therefore, while there are no hard and fast rules for selecting the “best” options to write for your commodities portfolio, here are presented some general guidelines that may help you.

The recommendations below are recommendations based on our 45+ years of combined experience as to what makes money consistently, and what doesn’t.


Three Guidelines for Successfully Selling Commodity Options Consistently

1. Know your Fundamentals.

Unlike equities, commodities are almost always dependant on their physical supply/demand fundamentals for their ultimate price direction. While institutional money or public sentiment can still play a role in commodities in the short term, a massive list of commercial players are buying and selling the futures contracts to hedge actual usage or production of the commodity.

blog-grain-truck

These commercial traders are keenly aware of the actual supply and demand for these products. You should be too.

Fundamentals can give you a fairly clear idea of where prices will not go and provide you with an advantage over the average commodity investor who is simply following a chart. Combining this knowledge with a high percentage strategy such as option selling can be a potent combination. There are many good sources of fundamental data for investors such as the USDA, the EIA, news wire services or private subscription sources. We get our data and information from a variety of sources. However, if you have the time to do your own research, one or two good sources of fundamental info should be all you need.

2. Sell Deep out of the Money.

Select markets where premium is available deep out of the money. 30, 40, 50 sometimes even 100% out of the money. Rarely possible in stocks. Quite feasible in commodities. This forces the market to make an extreme move against your position to put the option in the money. It also allows you to manage your risk based on the option value – not on the price of the underlying or it’s proximity to your strike.

June 2015 Gold

June 2015 Gold

  As gold prices surged in early 2015, call strikes were available at 50% out of the money and more. The chart above illustrates selling a June Gold 2000 call in January, with gold prices hovering near $1300 per ounce

3. Trade Time for Distance:

This is the cornerstone of the entire investment plan we recommend for high net worth individuals. Many books and courses that address selling options will advise selling options within 30 days of expiration to gain the fastest time decay. While this may make sense for option sellers collecting premium on open stock positions, I couldn’t disagree more when it comes to pure premium collection in commodities.

Getting any significant premium with this little time means selling close to the money – too close for a person that enjoys their sleep as much as I do. Close to the money strikes may decay quickly if you are right the market. But even a temporary fluctuation can put your option in the money. Guessing short term market direction is exactly what you are trying to avoid by selling options. Be willing to sell options with more time (3-5 months) and much further out of the money. If your fundamental synopsis is even close to being right, these trades should work well for you.

Of course, selecting the right strategy, managing risk and structuring your portfolio are all important too. But selecting the right options to sell is where you start. Whether you sell commodities options yourself or have a professional doing it for you, knowing how options are selected can make you a more effective trader, or a better informed investor – whichever you choose to be.

Resource: For more information on selecting the right options to sell for your portfolio, see chapters 7, 11 and 13 of The Complete Guide to Option Selling, New 3rd Edition


If you are a high net worth investor interested in selling options in commodities, you may qualify for a managed option selling account with OptionSellers.com. To learn more, request your Free Investor Discovery Kit at www.OptionSellers.com/Discovery ($250,000 minimum investment.)

James Cordier is the author of McGraw-Hills The Complete Guide to Option Selling, 1st, 2nd and 3rd Editions. He is also founder and president of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television, Fox News and CNBC. Michael Gross is director of Research at OptionSellers.com. His published research articles have appeared on Forbes.com, MarketWatch, Optionetics.com, Businessweek.com and Yahoo Finance.


*Price Chart Courtesy of CQG, Inc.
Fundamental Charts courtesy of The Hightower Report
Seasonal Chart courtesy of Moore Research, Inc

  1. Thanks for another insightful article. I had a comment on the recent September Newsletter where Mr. Cordier refers to the May recommendation to sell Soybean Calls. I was actually already in this same position, short Soybean calls in early May based on my reading of the fundamentals — with record ending stocks and predictions for another huge harvest. My question is that despite me being correct about the fundamentals and even adding to the position as soybean prices kept going higher, I had to take a fairly large loss because the position hit my risk parameter exit of 250%. Looking back at the trade now, it would have been profitable had I held on, but how is one to know this? I feel as if I had simply traded based on the charts and momentum/technical analysis that I would have been able to sell a DOTM Put and ade a nice quick profit because of the sustained up move. I’ve noticed this occur on a number of other occasions as well. The fundamentals don’t necessarily play out in the timeframe I need them to, or the price reaches such an extreme that my stop-loss is hit. How does one protect against this? Did you also take a loss on the Soybean recommendation, because I can guarantee the call premiums more than doubled? Or perhaps did you re-enter the position when you saw prices peak at $12+ and then pullback? I was too gunshy on beans at that point because of the losses I already took and was focusing on selling calls in crude oil instead… Thanks in advance!

    • Michael Gross Says:
      September 8, 2016 at 2:57 pm

      Dear Tom,

      Thank you for this question as it is one we get often. “I sold an option, it moved against me, now what do I do?”

      You did the right thing by setting a risk parameter and sticking to it. The soybean move this spring was on a speculative weather “scare” which should not be underestimated at the beginning of growing season. Our entry was admittedly a bit early. However, the point of the article was that fundamentals will always come home to roost. In regard to your trade, there were a number of actions you could have taken: Simply take your loss and move on (yes, you do take losses with option selling sometimes), close your position and “roll up” – a strategy discussed in our online seminar videos, convert the position to a credit spread, or disburse into other options positions that are working. A key factor to remember here is that trades cannot be considered in a vacuum. Option sales can be balanced by other option sales, risk curtailed by offsetting this position with another position that may move in contrast to it. Thus the critical and often overlooked step of structuring your portfolio – another subject covered in our videos. We used a combination of the strategies discussed above to manage the soybean position – but the structure of the portfolio mitigated its impact. That is the specific answer to your question. However a more general answer was provided in our August newsletter – which answered a reader with a similar question in the natural gas market. I’ve provided it below for you as it also applies directly to your soybean question. Thank you and I hope this helps you.

      -James

      Dear James,

      I was watching your recommendation on selling Natural Gas calls last month. I noticed the market spiked upwards after your recommendation. What do you do in a case like that?

      Thanks,
      Mark Brennan
      Niagara Falls, NY

      Dear Mark,
      Thank you for your question and for keeping us honest. First, I want to point out that the suggestions you read here in our newsletter and in our other forums are just that: Situations to look into on your own and trade if you feel as we do. We do not make “recommendations” per se, to investors outside of our client base. Our portfolios are managed with a variety of short options – some positions balancing and counter-balancing others. Employing one trade in a vacuum is not the way to sell options for a serious investor.
      The suggestions in our newsletters and other places are ways to give non-clients a look “through the window” so to speak, of what one position inside a portfolio might look like. These are more examples of the type of logic we base a trade on, and what kind of strikes we might look for. The positions inside an actual portfolio could be offset with other markets, long options or a variety of other vehicles.
      That being said, I realize some non-clients take these suggestions and trade on them, based on our research. So I won’t back away from the trade either – as this is a perfect opportunity to make a very key point about selling commodities options.
      The Natural Gas piece to which you are referring (www.OptionSellers.com/NatJune was published on June 10, 2016. On that day, Natural Gas prices closed near $2.55 per million btu. We suggested selling the deep out of the money December $4.50 Call. Why do we suggest selling that far out? Because we are not trying to pick a top in the market. In fact we have NO IDEA where the top will be (nor does anyone else, regardless of what they tell you.) We only pointed out that the fundamentals do not support a longer term rally.
      Now, does that mean that prices can’t still trek higher in the short term? No, it doesn’t. You sell the $4.50 call so you can benefit from an eventual stabilization or reversal in Natural Gas prices while being able to ride out short term swings against your position. This is the Whole Rational for selling options in the first place – trying to time the market’s daily moves is a fools errand.
      Natural Gas prices did rally about 45 cents more before pulling back in July. But at the high (just over $3.00 per mbtu) the $4.50 strike was still $1.50 (50%) out of the money and in no danger of holding any intrinsic value.
      Markets will always eventually have to obey their fundamentals. Your job (or our job) is only to pick where it’s not going.
      That doesn’t mean every trade will always be a winner. But it does mean there can be a large margin for error.
      Good luck in your trading.
      -James

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