Selling Deep out of the Money Options to Drive Up your Odds of Success

Selling Deep out of the Money Options to Drive Up your Odds of Success
Jan

15

2018

Selling Deep out of the Money Options to Drive Up your Odds of Success

Forget the 30 day options. The higher odds, “sleep at night” trade takes a little more time – and takes place far away from the underlying’s price action.


Deep out of the money options tend to stay out of the money, if not deep out of the money. – Investorglossary.com

Picture yourself driving a car.

If you drive down the highway at 95 miles an hour, you are going to get to your destination in a hurry. However, there are two major drawbacks: 1. There is a higher chance that you will be in an accident and 2. If you do have an accident, there is a higher chance you will get hurt.

If you drive down the highway at 40 miles an hour, you will have to wait longer to arrive at your destination. However, there is less of a chance of an accident and if you do have an accident, it will probably involve less damage to yourself or your vehicle than if you were traveling at 95 miles per hour.

The same holds true for selling options.

It is a common fallacy among option traders that in selling options, one must concentrate on options with 30 days or less remaining until expiration. The logic goes that as this is when options experience the fastest rate of time decay, why not only sell “short time” options and get the fastest time decay (and thus profits) possible?

Time Decay Chart on Option Selling

Options are known as “wasting assets” and their value gradually decays as they approach expiration. If they expire out of the money, the option goes off the board worthless, meaning the seller keeps any premium he collected as profits. The chart above shows the rate of time decay of an option as it nears expiration. Note that the rate of decay accelerates as the option approaches expiration.


I know of some traders that do utilize this strategy and hats off to them. However, I would consider this a very aggressive, almost day trading approach to option selling. The investors I work with tend to be looking for steady, consistent growth and income, not high speed thrills. If you fall into the latter category, you may want to consider selling options with more time left on them in order to get more distant strikes. Here is why.

The value of an option is made up of three main components

  1. Volatility
  2. Time remaining until expiration
  3. How close the strike is to the price of the underlying market

You can sell an option with 3-6 months (or more) left until expiration that is deep, deep out of the money, and collect a solid premium in many of the most actively traded contracts. Now you can get that same premium for a 30 day option in that same market. The upside is that you only have to wait 30 days to expiry and, it the market behaves favorably, you will get very rapid time decay.

The trade off is, to get this premium, you will have to sell very close to the money. This means that even a small “hiccup” in the underlying market and your option could be in the money. This could happen rapidly and you could lose funds in a hurry (one reason, incidentally, that option selling gets a bad rap in some “less enlightened” circles.)

For instance, in the example below, trader John is neutral to bearish the coffee market. In September, with coffee trading near $1.33 per pound, he could sell a September Coffee 1.40 call, or he could sell a March Coffee 2.00 call. Which one looks more comfortable to you? Suppose trader John is wrong and coffee goes to $1.50? How about $1.70? If this happened, which option do you think John would rather be holding – One that is $.30 cents in the money, or one that is still $.30 cents out of the money?

Figure 1 – John Sells a September Coffee 1.40 Call

“GRAPH:"


Figure 2 – John Sells a March Coffee 2.00 Call

“GRAPH:"


Sure, you can buy out of either one any time you want. But would you rather be buying back an out of the money call or an in the money call? If you haven’t traded options before, you’ll want to note that in the money options tend to get expensive fast. Out of the money options, as a whole, tend to appreciate at a slower rate in the event of an adverse move.

Now, I am not proposing that you cannot lose money by selling deep out of the money options. What I am saying is that the market has to move quite a bit further to put your option in the money. Remember that as an option seller, you want your option to expire out of the money. It doesn’t matter where, as long as it is out of the money. By selling with more time, you can sell further out of the money. In my experience, this has been an advantage, especially if you are familiar with the fundamental factors driving the underlying contract’s price.

Long term, sustained moves tend to require some kind of fundamental rational. One major advantage to selling options is that it puts your position high above or far below the market in order to ride out short term swings in the underlying caused by rumors, sensational news events or short term technical breakouts. Close to the money options are more vulnerable to these types of events. Deep out of the money options are more insulated.

The ability to sell options this way is one of the advantages of selling commodities options over stock options. This advantage should be maximized to its fullest.

True, there will be some speed demons out there that will argue that shorter is still better, that long term options “give the market too much time” to move against you. In selling options on fundamentally based commodities markets, that argument seems nonsensical to me. However, to each his own.

I’ll take the slow road, even if it means waiting longer to reach my destination. I’d rather increase the chances I get where I’m going than end up in a ditch trying to get there quickly. If you are the type of investor that prefers consistency over adrenaline, going deep could be the right strategy for you.

-MG


(If you are a high net worth investor and would like to learn more about selling deep out of the money options as a portfolio strategy, you do not want to miss a Free Report we have created just for you. The Option Selling Solution: How to Sell Options to Target Outsized Returns, Gain Real Diversification and Achieve Peace of Mind is a 30 page, comprehensive primer on getting started in option selling. If you currently sell options or are only interested in exploring the strategy, this starter guide is a MUST HAVE. Get your complimentary copy now by visiting www.OptionSellers.com/Solution.)

  1. Per Barchart Coffee Sep ’18 (KCU18) closed on January 17 at 130.30s +2.55 or $1.3030 per pound.

    It has 205 Days to expiration on 08/10/18 and an Implied Volatility of 21.86%.

    The 200 Call option closed at 0.51s or $.0051 per pound.

    Would you recommend selling this option? Why or why not?

    Thanks

    https://www.barchart.com/futures/quotes/KCU18/options/sep-18?moneyness=allRows&futuresOptionsView=split

    • Michael Gross Says:
      January 18, 2018 at 3:11 pm

      Hello Paul,

      Thank you for your comment. We are not in the business of making specific trading recommendations to the general public. However, I would say you are on the right track.

      Regards,
      Michael Gross

  2. Good read gents, it never hurts to read the basics as a review. I am big fan of 6 months out at .10 delta

  3. Would appreciate your thoughts on what out of the money percentages you would consider to be deep out of the money? Does 20%, 25%, 30%, etc. fit into the category of what you consider to be deep out of the money AND what do you consider to be a reasonable dollar value premium to receive per unit before you will enter into a contract?

    Thank you. Alan

    • Michael Gross Says:
      January 17, 2018 at 4:21 pm

      Alan,

      It all depends on the commodity and the underlying fundamentals. In some markets, you can write 50 even 100% out of the money. Others, to get any premium means going only 20-30% out of the money. That doesn’t mean its necessarily a bad trade. For our portfolios, we typically target $600-$800 per option. However, you can take lower premiums than that, as long as you’re comfortable with the margin/premium ratio and weigh the potential profit against the risk.

      Thanks
      Michael

      • I have never had a premium as high as $600 to $800, although I have come close to $600. Reason probably being I have never executed a commodity option for a period longer than 5 – 6 months and I would say my average average investment length has been about 3 – 4 months out. Most of my options have generally been OOM by an average of appx 20% (my minimum) with highs up to 70% (on a few rare occasions). After reviewing your comments a number of times, and reading the 3rd Edition a number of times, it looks like I should be looking for periods of say 4 months out minimum and up to a 7 month range with OOM percentages say minimally 30% or so. Do you think this is a fair method both to reap a reasonable proportion of risk management and financial acceptability provided the technical info is in a favorable supply and demand cycle? Thanks – I am always trying to improve and appreciate opinions and comments. Alan

      • Michael Gross Says:
        January 18, 2018 at 3:09 pm

        Alan,

        I would say you are taking a reasonable approach, yes.

        Best of luck in your trading!

        Michael

  4. You frequently refer to ‘deep out of the money’ options in your bi monthly video sessions and in your 3rd Edition tutorial book (which by the way I think is a great book). However the question that comes to mind is what do you consider to be ‘deep out of the money’?.

    Do you have a guideline on this? In my mind deep should be anywhere from 25% out of the money and up; I have however, from time to time have done trades with the SP vs. Market Value being as low as 12 1/2%.

    Natural Gas & Crude are generally the few commodities where I see respectable premiums with OOMs above 40% as they can be so volatile. Usually Corn, Soybeans and Wheat can command much lower premiums due to their less volatility. Your thoughts as to respectible ‘deep out of the money percentages’ would be much appreciated, AND what do you consider a respectible premium to accept (a minimum dollar value) before you will enter into a contract. Thank you for your insight which I find always to be relative and important.

    • Michael Gross Says:
      January 17, 2018 at 4:23 pm

      Alan,

      Please see my response above. On another note, while corn and soybean market volatility is low now, they can and will increase at some point. These can be great markets for writing premium.

      Regards,
      Michael

  5. Do you have a video or document where you explain step by step how to choose the strike price on any of the platforms you are using?

    I have been trying on Think or Swim and interactive brokers and I just can’t see that kind of return in such deep out of the money options. Or maybe a current example of a commodity right now so I can check and see. Thanks a lot for your support. Happy we year

    • Michael Gross Says:
      January 17, 2018 at 4:26 pm

      Hello John,

      I have heard mixed reviews on Interactive Brokers. You might try working directly with a futures clearing merchant such as RJ O’Brien or FC Stone. We use a CQG system for quotes and place orders directly through a professional order desk at FC Stone. For options offering the kind of premium discussed in the video, I suggest looking at the Natural Gas or Coffee market right now. Remember to look 6-12 months out in time.

      Regards,
      Michael

  6. Luis Moran Says:
    January 16, 2018 at 10:20 pm

    Sometimes is hard to find deep out of the money good Premiums opportunities

    is there a list of commodities that could be sorted by season or by high/low margins, or by Premiums or suggested best times to invest into??

    just asking

    as always enjoy your teachings Luis

    • Michael Gross Says:
      January 17, 2018 at 4:28 pm

      Luis,

      Yes. I suggest reading our book, The Complete Guide to Option Selling, 3rd Edition. You will find this exact information there.

      Thank you and best of luck in your trading.

      Regards,
      Michael Gross

  7. For Crude Oil options, which trading platform allows for 4 months or more from expiration option selling? I am using TDameritrade, the furthest I may trade is 90 days only..

    • Michael Gross Says:
      July 26, 2017 at 3:28 pm

      Kenny,

      I’d suggest looking into Interactive Brokers.

      Thanks
      MG

      • Todd Christie Says:
        January 21, 2018 at 10:09 pm

        I used Interactive Brokers for a while, but they use their own risk parameters to calculate margin requirements that end up being much higher than SPAN margin requirements. Higher margin obviously equals lower ROI, making most deep OTM trades just not worth it.

        I use Tradestation now, which uses SPAN margin, but their trading platform has very limited functionality, and it’s somehow gotten worse over the past month. Do you know of other online brokerages where I can trade with SPAN margin? I saw your comment on RJO above, but that doesn’t look like a regular online brokerage like Interactive Brokers or Tradestation.

      • Michael Gross Says:
        January 22, 2018 at 3:46 pm

        Todd,

        I’ve heard alot of complaints about both Interactive Brokers and Tradestation lately. If you really want to do this on you own, I’d recommend contacting CQG for your data. They also have a trading platform although I’m not sure what clearing firm(s) they offer. Other good bets are going directly to some of the direct commodity clearing firms and opening accounts with them. While these are not “regular” online brokerages, they are commodities firms. Many have good online commodity platforms. Or, you can simply go managed.

        Regards,
        Michael

      • In reply to Todd’s criticism of Interactive Brokers, I have a different perspective:

        Yes, IB does have their own method of computing margin that is greater than SPAN in many, if not all, cases.

        However, that does NOT at all mean that trades “are not worth it.” In fact, that is a silly assumption to make.

        Since most of us should be keeping a 30-50% cash buffer while selling futures options anyway, one can easily use IB and just leave a smaller cash cushion. For example, if you wanted to keep 50% in cash, if you instead decided to keep 40% in cash that very well may make up for the extra margin IB requires.

        If anything, for anyone other than extremely aggressive premium sellers, one could look at IB’s extra margin as extra protection for both YOU and for IB. It automatically causes you to be LESS aggressive in that you require more cash per position, and that is NOT a bad thing since most people over-position themselves anyway.

        I have used Interactive Brokers for well over a decade in both IRAs and regular accounts. I have been able to make a respectable return in selling futures options while keeping my cash cushion at around 50%, so the opportunities are there.

        As Gross/Cordier say, trade time for distance. And diversify across at least 6 markets in different sectors. And finally, follow your risk management exits even when you don’t really want to.

        Good chance, you’ll do okay.

Share This

Share This

Share this post with your friends!