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.
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.
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
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