The 5 Advantages of Commodities Options over Stock Options


Jul

9

2018

The 5 Advantages of Commodities Options over Stock Options

Michael Gross explains how to discover the hidden benefits of applying stock option selling strategies to the uncorrelated commodities markets in this week’s Option Selling Video Lesson.
Click To Read Video Transcript

(Video Transcript)

Hi, this is Michael Gross of OptionSellers.com. I’m here with your bi-monthly option seller email seminar. The title of this week’s seminar is the 5 Advantages of Selling Commodities Options Over Stock Options. Now, this is an interesting subject this week because I know there’s a lot of stock option sellers out there and their question is, “Well, why should I sell commodities options? Why shouldn’t I just keep doing what I’m doing? I’m doing fine selling stock options. What’s the need to learn something new?” Well, there’s 5 big reasons and if you are a stock option seller I think these are going to be helpful to you. It might open your eyes to a way you never thought possible for earning returns.

To get into the subject matter of what we’re going to talk about today, I think first we need to talk about stock options. Most of our clients and most of the people out there, if they don’t sell stock options now, you’ve probably already at least heard of it or maybe you’ve done it in the past. If you’re a stock option seller, chances are you already know the advantages of selling options. The odds are with you, you’re trading with time in your favor, you don’t have to pick market direction, to a certain extent. The most complaints I often hear from stock option sellers are three-fold. One, when you sell a stock option, you have to put down a very high margin requirement. What that means is, say you want to sell a share on Exxon, maybe not a good stock to be trading right now with the price of oil, but nonetheless, say you want to sell an option on Exxon. You sell the option, you sell a put on Exxon and you take in $200 for the put. The margin you put up, and there’s a lot of factors it’s dependent on, but let’s say, for example, the margin you put up is $2,500, maybe $3,000… something in that range. As far as the return you’re getting for your capital invested, you may only be getting a 2%, 3%, 4%, 5% return. A lot of times in selling equity options it might only be a 1% or 2% return. Granted, that’s not bad if you’re selling an option 30, 60, 90 days out, but it’s not spectacular either. That’s one drawback to selling the equity options is your margins can be very high.

The second drawback to selling equity options is your premiums can be low. Most equity options, even on higher valued stocks, unless you’re trading something like Google that’s trading for $500-$600 a share, most equity options you’re taking in $100-$200 on an option. A lot of times it’s less than that, so the premiums aren’t real big and if you want to generate any real money you typically have to sell a lot of options. That gives you sometimes more exposure than you may want, so that’s something to think about, as well. As far as these two things, there is one more drawback that, as an equity option seller, you have to consider. That is if you’re selling equity options, I know stock traders like to think that all their eggs aren’t in one basket but they are in one basket. They are in the basket of stocks. Stocks are an asset class. Asset class can move up or move down. If you have a stock option portfolio you can have a collection of options sold in different stocks but they’re all in stocks. If the market tanks or if you’re in calls and the market goes shooting up, either way, chances are your portfolio is going to be drastically affected. Granted, if it moves the right way you’re going to make a lot of money at once but, if it doesn’t, all the money you worked for all year long taking in each premium is going to be gone. A stock option portfolio is, if those indexes move one way or the other, it’s not really that diversified. It is something to think about as an equity option seller.

Now, for investors that have graduated to commodity options, which you may like to do one day, there are 5 key advantages… that of course is the subject of this video. Let’s talk about the first one right now. First big advantage of commodity options is larger premium. For those uninitiated to commodities or commodity options, commodities have leverage built into the product itself. The reason most people are often shy away from commodities or say I want to stay with stocks or they don’t bother to learn commodities, the leverage scares them away, they don’t know how to use it. Leverage isn’t something to be scared of. If you learn how to use it, it can be a valuable tool, it can increase your returns, granted, you have to respect it because losses can be larger as well using leverage, but as far as adding an extra punch to your portfolio, if you know how to use leverage properly you can really turn it to your advantage. In commodity options, the leverage allows you to take much larger premiums for options that are much further out-of-the-money. I’m kind of combining two of the advantages there but that’s one of the biggest advantages of selling commodity options.

You get larger premiums and most of the options we sell for our clients you’re taking in between $500-$800 an option. So, you’re getting larger premiums, you’re selling deeper out-of-the-money options, and, even more important, your margin requirement for those is substantially lower on a percentage basis than it’s going to be for your stock options. So, there’s three big advantages there… three of the five I covered in one shot. Let’s do a little example here so you understand what I’m talking about.

Rather than sell your shares on Exxon, or maybe in addition to selling your shares on Exxon, you decide, “Well, I want to maybe give some extra horsepower to my portfolio here and start selling commodities options. I’m willing to take a little bit bigger risk to get the bigger return.” Let’s take a look at things here. Let’s say you like the corn market. Here’s the chart for corn, and I know my charts look the same every week, very high tech here. I’m bearish corn, I don’t know how far it’s going to go up but I don’t think it’s going to go very far, I think its bias is to the downside. So, you decide you’re going to sell a call. So, you sell a call above the market. Now, if you do that in stocks you’re going to take in, depending on your share, you might take in $100, $150, $200, you know the drill if you sell stock options. Well, my corn call, I sell one and lets say I take in $600. That’s not uncommon for a commodities option depending on the size of the contract, corn is a smaller contract, the premiums will be a little bit lower. If you get into larger contracts, like crude oil or natural gas, you’re getting bigger premiums for them. For this example, you sell a call and you take in $600. Your margin requirement for that call is based on something called SPAN. SPAN system is used in the commodities industry to determine margin. I can’t give you a formula for SPAN. We talk about it in our book, The Complete Guide to Option Selling, and how you can use it. I recommend reading that if you want to learn more about SPAN. Based on this $600 premium I’m going to estimate that your margin to hold that position is probably about $900. So, you’re putting up $900 of your money to take in $600. We’re going to assume the thing expires in 120 days. Now, you’re taking in $600, you’re putting in $900 of your own money to make $600. If I’m doing my math right, that’s about a 66% return if the thing expires in 120 days, but we’re assuming successful trade here.

The third point I want to make here, yes you’re getting a higher ROI if successful, but if you’re selling a stock option… this is a major point if you’re a stock option seller. Here’s your Exxon chart, it looks like this right now. You want to sell a put, for example purposes, say we’re here… this is today. You want to sell a put on the Exxon, you typically have to sell it here, here, here, and you typically have to sell it 1, 2, 3 strikes. Even if you’re going 60-90 days out you’re typically having to sell pretty close to the money to get any decent premium. In commodities, because of the leverage, we don’t have any interest in selling here. If I’m going to sell a put I’m going to sell it down here and if I’m going to sell a call I’m going to sell it up here. It’s way out-of-the-money. We’re picking price levels that we think the market can never attain, not something that it might attain in a couple days if you’re wrong. The point of the whole thing is to pick price levels the market won’t go to and in commodities, the way it’s structured, it allows you to do that. So, that’s a major advantage you might want to consider.

Two more advantages to selling commodities, and they go hand in hand. One, we already addressed, the problem with selling stock options up front. In commodities options, you have real diversification. What do I mean by that? Well, one, you’re dealing in a different asset class. At times, there is some correlation between commodities as a whole to the equities market. Most times, they’re not coordinated, but that doesn’t matter to you because you’re an option seller. You can sell options, if this is the commodities market, you can sell options above the market, you can sell below, you can sell both of them, so it doesn’t really matter which way the market’s moving outright. That is no concern to you. You’re completely uncorrelated with the equities market, one, but, two, your positions in a commodities portfolio, unlike stocks, they’re not correlated to each other. The price of silver has very little to do with the price of corn, the price of natural gas has very little to do with the price of coffee, so you have markets that are quite a bit less correlated to each other than a share of Exxon to a share of Apple. If the index goes down chances are they’re all going down. In commodities, it’s not so much the case and it’s a big advantage you can take and put to work in your portfolio.

The last thing I want to talk about as far as 5 big advantages… in commodities, and we’ve discussed this in other lessons, also discuss it quite a bit in the book if you’ve read the book, one of the biggest advantages that we feel is an advantage is a fundamental bias. What that means is in commodity markets, if you know your supply-demand figures, commodities is economics 101… it’s supply and demand. If you know both sides of that equation, it’s not necessarily going to tell you what price is going to do tomorrow, but it can give you a pretty good idea of what price is not going to do and that’s exactly what we need when we’re talking about selling options. That’s all we want to know, what’s price not going to do. If we know that we can go to those far out levels and simply take premium there and not worry about what the market’s doing today or what it’s going to do next week or what the news says today. We’re far above and below that and that’s where you want to be as an option seller in commodities.

If you’re a stock option seller, I hope you found this helpful. Obviously if you want to learn more about selling commodities options, our book, The Complete Guide to Option Selling, is out in its Third Edition. I strongly recommend that to you, but there’s also a free resource you can get right now that we do recommend. That resource is The Option Selling Solution. It’s our free booklet we publish. We do cover selling commodity options versus stock options in that booklet. I would recommend that to you. If you’ve already got the booklet, obviously our Discovery Pack is for somebody who’s interested in learning how to work with us and that’s also available on our website. I hope you found this month’s lesson helpful. This is Michael Gross of OptionSellers.com.

  1. Dear Michael: Just love your book, your webinars and monthly newsletter. I’ve been trading commodities options now for over 2 years and find it is a forever learning process, and one which can produce great rewards. Thanks to you and James, I have gained knowledge, patience and ability in this ‘new trading’ world. I previously had only been involved in equity options but have since switched most activity to commodity options. I do use equity calls to generate income on my stock investments and write puts but only on equities I want to hold; but zilch for ‘equity speculation’. I am building up to be able to join you as a client, but still have a ways to go to meet your requirements. Thank you both for being here and sharing your wealth of knowledge.

    • Michael Gross Says:
      July 11, 2018 at 1:59 pm

      Alan,

      Thank you for your letter and positive feedback! I’m glad you’re finding everything helpful.

      Best of luck in all your trading!

      Regards,
      Michael

  2. You’re apparently comparing writing an option on 100 shares of Exxon, worth about $8,300, with an option on 5,000 bushels of corn, worth about $17,500.

    Thanks for video.

    • Michael Gross Says:
      December 14, 2017 at 3:55 pm

      Paul,

      That is correct. Not sure if there is an implied question here. However, the advantages apply regardless.

      M. Gross

  3. Hi Michael, I’m sure you get asked this all the time. How would a newbie get their head around some of the commodity demand/supply dynamics. Is there a resource you could recommend? Thanks.

    • Michael Gross Says:
      December 13, 2017 at 4:08 pm

      Hi Steve,

      Great question. I’d recommend subscribing to a private research newsletter such as The Hightower Report to start. I would also subscribe to the CRB yearbook. Finally, you should consider subscribing to several of the commodities newswires such as Bloomberg, Reuters or Dow Jones News. And finally, regular visits to the websites of the USDA, the DOE and the commodities exchanges themselves is strongly recommended to stay on top of market fundamentals.

      Its not an easy climb but well worth the digging. There can be gold in going where few others are willing to go.

      Thanks and good luck.

      Regards,
      Michael Gross

  4. Thank you always for your great video, Michael!

    I am learning so much from your videos and your book as well. You book is so great that I’ve just left an Amazon.com review with 5 stars! (FYI, I rarely leave any Amazon.com review). I am looking forward to working with you at some point.

    To try what I have learned from you, I sold a few commodities options on InteractiveBrokers. But the margin requirements on InteractiveBrokers seemed higher than those numbers suggested in some of your blog articles.

    The margin requirement for options on natural is in line with what you have just described in your video. BUT, for example, the premium for April 18 $70 call option on crude oil (CL) is about $95 but the margin requirement is $2,391 as of today (12/12/2017). The premium for April 18 $65 call option on crude oil (CL) is about $300 and the margin requirement is $3,097. The margin requirement for options on gold is extremely high, too. The margin requirements for options on crude oil or gold do not seem to be a lot different than the margin requirements for the stock options.

    So I asked a representative of InteractiveBrokers and have just confirmed that their margin requirement is usually higher than the minimum SPAN margin!

    Am I doing something wrong here? I want to know the true benefit of the SPAN margin. Can you recommend me a brokerage firm or any other way that allows me to use the minimum SPAN margin?

    Thanks

    Jeff

    • Michael Gross Says:
      December 13, 2017 at 4:14 pm

      Hello Jeff,

      Most of the big players in online options trading aren’t going to offer you absolute minimum SPAN margin. Thats OK. Even at slightly higher than minimum, there is still good potential ROI on commodity short options.

      That being said, to get minimum SPAN margin, you either have to work with some kind of managed option specialist, or – perhaps go directly to some of the “old school” commodities brokerages such as as RJ O’Brien, Iowa Grain or FC Stone. Even if these houses don’t offer minimum SPAN up front, they can sometimes be willing to negotiate it with qualified option traders.

      Thanks and I hope that helps.

      Regards,
      Michael

    • Jeff, I’ve been with IB for about 15 years and yes, their futures options margins are A) quite a bit higher than SPAN, and B) impossible to make sense of.

      That being said, while it is an impediment, it is still workable. Basically, you just won’t be able to put on as many positions as you could somewhere else. Since you’re new at this, that’s not a bad thing. You should still be able to work with IB for a year or two and see whether or not you can succeed at your strategy. If you can and you find that you would really like to put on more positions than IBs margin allows, then there are other places to go where the margin requirements are lower (but commissions will be higher).

      In the meantime, at IB, you can still make a reasonable return from selling options while keeping your margin usage at 50% (even at IB’s increased levels). I’ve done it for years. Another thing that IB’s higher margins does is it encourages you to close out “winners” early rather than waiting for expiration because you will see, for example, that you can have a short option that is only worth $20 but it is tying up $5000 in margin!

      In a case like that, you’re much better off covering your short and re-investing that margin into a new position, which is also something that Mr. Cordier / Mr. Gross encourage.

  5. Kenneth Says:
    June 29, 2017 at 1:20 pm

    Thanks for the great video once again, Michael!

    After reading your book, I’m quite sold to the advantages of selling commodities options and I have started to explore doing so. There’s just one thing that I can’t seem to wrap my head around – with so many advantages of selling commodities options, why are there still so few people doing it?

    • Michael Gross Says:
      June 29, 2017 at 2:37 pm

      Kenneth,

      Good question! Probably a number of reasons, first and foremost being lack of awareness – both on the public and even professional level. Its a very specialized field and thus, not many firms offer it. Therefore, there is little incentive to promote or discuss of it in the mainstream investment world. The media has little interest in addressing it (they want to hit the widest audience possible.) Also, there is the widespread belief (oft promoted by equities firms and media) that commodities are “too risky” or “too complicated” for individual investors. The solution to both of these concerns, of course, is education – something we try hard here to provide.

      Thanks for your positive feedback and best of luck in your trading!

      Regards,
      Michael

  6. Lyle Stein Says:
    June 28, 2017 at 1:33 am

    Love these comments on stock vs commodities option selling I have been selling stock options for a while. Looking forward getting started selling comm options. Your bi- monthly videos are most helpful. Looking forward getting your new book and putting it to work.

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