Option Selling as a Business
Hi everybody, this is Michael Gross of OptionSellers.com. I’m here with your video option seller seminar. The topic of this week’s seminar is Option Selling as a Business. What we’re going to learn this week is going to tie in some of the other lessons we’ve had over the last several months and kind of put them more in a format that you may be able to better implement them when you start to sell options or consider an option selling investment. Before we do that, I would like to bring up that if you would like to learn the full system for selling commodities options as an investment, I do recommend our latest book, The Complete Guide to Option Selling: Third Edition. You can get this on our website at a discount from bookstores or Amazon. You can get that at OptionSellers.com/Book. Let’s go ahead and jump into this option selling as a business.
If you’ve ever tried to explain option selling to someone else or even in understanding it yourself, it’s difficult to get your arms around at first. A lot of times when I’m talking to people and you’re trying to explain option selling to somebody that has never done it before, they’ll ask questions like, “Well, how do I sell something I don’t own? What are we buying? What market do we want to go up?” If you’re an option seller, you have to come at it from a different angle. You’re using the market not necessarily to invest how most people view investing because an investment is typically something that you buy in hopes that the price of that asset is going to appreciate. That’s how most people think of investing in anything, whether you’re investing in stocks or bonds or automobiles or art or whatever you’re purchasing. When you sell options, you’re taking money out of the market by a completely different method, so people find it hard to understand when you describe it as an investment. One way that you can think about this, or if you’re trying to explain it to somebody else, is you don’t explain it as an investment but you explain it as a business because selling options operates more on a business model than it does on an investment model.
If you’ve ever read the book Rich Dad Poor Dad or any of the subsequent books by Robert Kiyosaki, which we do refer to often, you’re going to learn a concept of how Robert describes an asset. How he describes an asset is an asset is something that puts cash in your pocket, it doesn’t take it out. One of the primary assets he recommends to investors for building wealth is owning some type of business. Well, when you sell options it operates on that exact model. It is a type of business, so that’s how we’re going to approach it. If you approach your option selling in that manner you can get a lot better results if you’re thinking about it in that way, and we’re going to talk about how you can do that today.
Warren Buffett says the world’s most profitable business is what? The most profitable business, according to Buffett, is the insurance business. Insurance companies make their money by selling policies. This is your insurance company. They’re going to sell insurance policies to people all over the place and collect money for doing so. What’s the money called? It’s called a premium, insurance premiums. So, insurance companies make their money by collecting money from all these different people and most of the time what happens? Nothing happens, so most of the money they collect they keep. Now, every once in a while one of these policies will file a claim and they’ll have to pay out on it. That’s okay. They’re collecting so many other policies that expire so that’s okay. They pay this one from the profits from these and they keep the rest. That’s how an insurance company operates, that’s exactly how a successful option selling portfolio operates… as an insurance business. If you think of it in that manner, you can implement a lot of these types of lessons that we’re talking about to help you improve your selection of your policies. A company like Allstate or Geico, they’re not just going out and selling policies to anyone. They’re screening people. They want to know who they’re selling the policies to. They want to know what the odds are of having to pay out. They have teams and teams of people that everything they do is studying what the odds are that they’ll ever have to pay out on that policy. So, they sell policies that have the lowest odds of ever paying out. If they have higher odds of them having to pay out then they get a higher premium. That’s how that business structure is. It’s a very profitable business. Your option selling business can be just as profitable if you implement it correctly and follow some of the same rules or systems that an insurance company follows.
What we’re going to talk about today is three systems you implement, just like an insurance company, to help ensure, in your option selling portfolio, you’re getting the type of odds that they get and you’re getting the type of results that they get. So, let’s talk about those. As we discussed, an insurance business, or any business for that matter, gains success from having systems in place to handle different aspects of that business. If you jump into an option selling portfolio, a lot of people jump into it just to dabble, “Eh, I’m going to try it out and see how it goes. We’ll try this and we’ll try that.” If you’re getting into this seriously where you’re making a serious investment of $1 million or more, you want to make sure you have some systems in place. One, to protect your capital but, two, to make sure you’re getting a steady cash flow. You’re investment $1 million to $5 million, you want to see some profits from that. If you want to see some profits, you better have proven systems in place that can bring you those profits and protect your downside.
We’re going to talk about three today, so if you’re starting option selling as a core investment strategy in your portfolio, the first system you want to look at, in our opinion, is a system for structuring your portfolio. Now, most people when you say structure that’s something they don’t think about in an option writing portfolio. They want to talk about, “Well, which option is the best for me to sell? How do I manage my risk?” Those are important, but probably the most overlooked and possibly most important system you can have is how your portfolio is going to be structured in the first place, because everything else is going to be based on that. Most investors don’t have a clue how that’s done, especially when you’re writing a leveraged option like in commodities where your profit potential can be much higher but you have to approach that leverage correctly to get the most out of it. So, a system for structuring your portfolio will be paramount. We’re going to recommend one here to you today. It’s one we use in our managed portfolios, but you’re welcome to use it if you like or you’re welcome to come up with your own, but the point is to know that your first step is you want to make sure you know what the structure of your portfolio is going to be.
Our structure that we recommend, and if you’ve watched some of our other videos you may know this structure, we call is the submarine system for structuring your portfolio. I’m just going to cover it quickly here. If you want to learn all about it, you can go to our other video on this about the submarine system for structuring portfolio and managing your risk. Just briefly, because of the leverage in commodities you want to make sure you want to have a lot of backup cash. It’s the number one mistake people make is they get into trouble with the leverage in commodities. If you do it correctly, leverage can be a tremendous benefit to you in your portfolio, the problem is most people don’t know how to approach it correctly. This is a correct way to structure a commodities option selling portfolio… you keep 50% of your portfolio in cash at any given time and the other 50% is diversified over 6-10 uncorrelated commodities. We call this the submarine system.
We use an example, if you read any of our seminar systems, we refer to the movie Crimson Tide with Gene Hackman, where they’re on the nuclear submarine, the submarine takes a hit and springs a leak, and they survive by sealing that compartment that took the hit because the submarine is divided into a bunch of different sections that can be sealed off from the rest of the ship at any given time. That’s how they contain damage. That’s exactly how an option selling portfolio should be structured because if you’re in 6-10 different uncorrelated commodities and maybe here we sold soybean calls, maybe here we sold crude oil puts, and here we sold orange juice calls, here we sold silver puts, and here we sold a strangle on coffee, and here we sold a ratio spread on cocoa. That’s pretty diversified. It’s unlike people think about commodities, “Well, I’m already in commodities. I’m in a commodities fund.” Well, you’re just buying everything and hoping it goes up. That’s not diversified. This portfolio, not only allows you to benefit with some going up and some going down, they’re pretty much diversified from each other, so what happens is if you get one of these wrong and one of those policies you have to pay a claim on, as we discussed, it represents only a small little piece of the pie of your entire portfolio. So, maybe it takes the profit from this one and even if it take the profit from this one, you still have all these as your bottom line profit. That’s how an insurance company operates. That’s how an insurance company’s structured. That’s how your portfolio should be structured.
Let’s move on to the next system. System two is a system you should have in place for you selection of options. It’s your criteria… what are you looking for? This is what big insurance companies have in place, believe me, have in place for selecting policies they won’t underwrite. So, they have a certain criteria and if you don’t meet that criteria then you don’t get a policy or you pay a great big premium, one or the other. As an option seller, you want to select options with the lowest probability of ever going in the money and the highest probability of expiring worthless, preferably giving you a very smooth ride to worthless. We don’t want a lot of volatility, a lot of in and out, big swings in the value of your option. One, we want it to expire worthless, two, we want a smooth non-dramatic expiration down to zero. To do that, we have to put a system in place for selecting options.
The system we recommend for that, and you can choose to use it or come up with your own system, it’s up to you, our system is called the FUDOM method. FUDOM is an acronym. It stands for FUndamental Deep Out of the Money options. So, what the FUDOM system does is we’re looking at a commodity like corn, soybeans, coffee, oil, we’re looking at the core supply-demand fundamentals. Now, is that going to tell you what price is going to do? No, it doesn’t, but if you get an idea of what the supply-demand fundamentals are, what the seasonal tendencies are, commodities ultimately have to obey what their supply-demand fundamentals are. So, it won’t tell you exactly what price is going to do but it can give you a pretty good idea of what prices probably will not do over the long-term. As an option seller that’s all you need to know.
Let’s say you’re trading soybeans and soybean prices have been going steady to higher, but you look at a seasonal tendency and you see the tendency that soybean prices tend to decline into harvest because that’s when supplies are at the highest. If you know that, do you make a bet that soybean prices are going to go down here to $5 a bushel? No, because you don’t know that. Maybe they won’t go down here, but you can make a bet up here that prices are here, they tend to go down as supplies rise into harvest, harvest looks right on schedule this year, supplies are supposed to be big, it’s a pretty logical assumption to make that you’re not going to get a crazy rally up to here in soybeans right when the bulk of harvest is coming in. Pretty safe bet to make. Now, anything can happen, nothing is guaranteed, but as an option seller that’s what you’re doing. You’re selling deep out-of-the-money call here, you don’t care if prices go down, like the seasonal is telling you they have in the past, or maybe they just level out, maybe they just keep going up. As long as they don’t get here, that’s going to be a profitable policy for you to write because eventually it’s going to expire worthless. It’s why we called it FUDOM. It combines fundamentals with deep out-of-the-money. It’s the system we recommend for trade selection. If you’d like to learn more about it of course our book, which we already talked about, or we already have videos specifically about FUDOM that you can watch, as well.
Let’s move on to the third system. The third system is the all too important risk management. If your option selling business is run like an insurance business, you have an advantage over insurance companies. Insurance companies, if they get a claim they look into it, if it’s legit they have to pay it. As an option seller, if an option is not behaving the way you want it to, something has changed in the underlying market, your advantage over an insurance company is you can get out of it at any time. You don’t have to wait and see how big the claim is and then pay the claim. If it’s not going right, you can just close it out and pay whatever it is at that point. A system for managing risk will be one of your three critical systems, obviously, that you need. As an option seller, if you sell options in the way we’ve described here you’ll probably get 80%-90% of your options that expire worthless, maybe even more if you hold them a little longer. It’s how you manage that other 10% or so that’s really going to have a big impact on what your results are at the end of the year.
Risk management is critical. If you have read our book you know we describe several ways you can choose to manage risk. There are some more advanced ways to manage risk that we talk about in the book and in some of our other lessons; however, for today, we’re going to go with our core system that you can implement. It’s simple, it’s effective, it’s something we recommend for investors that are managing their own accounts, primarily because you don’t have to think about it a lot. It’s simple to put in place, it’s simple to implement. That system is called the 200% system or the 200% rule. What it is, it’s based on the premium of the option. If you sell an option and the option doubles, you exit the position. It’s pretty simple to implement. You sell a silver call for $800 and the price of silver rallies and 4 weeks later that option is worth $1,600, you exit at $1,600 no questions asked. This system, while simple and you won’t like it right when you have to do it, it’s going to keep you out of trouble. That’s the purpose of a risk management system, after all. Now, are there other ways to manage risk? Yes. Are there ways you can possibly increase your odds by staying in a trade longer and make it ultimately profitable? Yes, there are, but if you’re starting out and you want just a basic system that will be effective, I recommend this to beginners or even more advanced traders. The 200% rule is going to keep you out of trouble, it’s going to let the rest of your policies work, bring those premiums in to you, that’s the purpose of a system, and that’s what this will do for you.
Those are the three critical systems any option seller should have if you’re putting together a serious option writing portfolio. Now, there’s one more thing you may want to consider if you’re putting a substantial amount of capital into an option writing portfolio. That is if you’re the owner of a business, you’re the owner of this insurance business, this option selling business, just because you’re the owner doesn’t mean you have to be the guy showing up for work every day sitting in the chair and calling all the shots. Robert Kiyosaki talks about this in a lot of his teachings, as well, is if a business is an asset that’s responsible for passive cash flow, if you’re working in that business well it’s not passive, it’s active. The way you accumulate wealth is having many different passive income structures bringing you income. If you want to start an option selling business, often times it can make sense both from that aspect and from an expertise and time aspect to improve your results by bringing in a pro, to being the general manager of your business. So, you’re the owner, you bring in somebody experienced in managing this type of business, manage it on your behalf and report to you, but he’s doing the work and you’re simply owning the business.
This is a structure that’s followed in many successful businesses. To use a contemporary example, whether you love or hate the New England Patriots, one of the best most successful football teams that’s every played, you have an owner of the team, Robert Kraft, who obviously enjoys the profits that franchise generates, but is Robert Kraft the one out there on the field coaching the team? No. Is Robert Kraft the one getting up under center taking the snaps? No. For that, he hires guys like Bill Belichick and Tom Brady to do that work for him. Those are the pros that are skilled in those particular job duties. As an option seller you can do the same thing. You own your option selling business, you can hire a pro to be your general manager, quarterback, however you want to think of it, that’s implementing those systems we just talked about and that’s experienced in implementing those systems we’ve talked about on your behalf. Something Kiyosaki recommends, one of the key differences between high net-worth investors and less capitalized investors or people in general is the high net-worth community can afford to higher expertise, the best expertise they can higher, to do everything for them, whether it be law, whether it be medical, whether it be their investments. It’s an advantage that you have. Why not utilize that by seeking out a professional, any professional, that has those skills for you.
That’s option selling as a business. I hope you’ve enjoyed it. I hope you’ve learned something here today about implementing systems in your option writing portfolio. If you would like to learn more about working with a professional with a managed account, you can certainly request our OptionSellers.com Discovery Pack. It is available on our website… www.OptionSellers.com/Discovery . I hope you’ve enjoyed this week’s lesson and we’ll talk to you later this month.