The 5 Advantages of Commodities Options over Stock Options
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.