Interview: The Sell Side with James Cordier
By Jayanthi Gopalakrishnan (Published in Stock & Commodities Magazine – February 2015 Issue)
The Road Less Traveled
James Cordier is the founder of OptionSellers.com, an investment firm specializing exclusively in selling options. He is also the author of The Complete Guide To Option Selling, which was recently published in its third edition. Cordier’s market comments are regularly published by international financial publications and worldwide news services including CNBC, The Wall Street Journal, Fox Business, Reuters World News, Bloomberg Television, and MarketWatch.
Stocks & Commodities Editor Jayanthi Gopalakrishnan spoke with ames Cordier on December 3, 2014 about the nuts & bolts of being on the sell side of trading options.
James, please tell us a little about yourself and how you got interested in trading options.
I spent almost three decades trading commodities. Like most people, I was trading futures and buying or selling corn, pork bellies, or cocoa based on what I thought the market was going to do. Of course, when you’re trading futures, your timing needs to be impeccable.
Since the leverage in commodity futures is something like 20-to-1, you really need to have a rabbit’s foot in your pocket, because the day you buy, if you’re off by a few days, you’ll probably be stopped out, or you wish you had stopped yourself out. I’ve been trading commodities since 1984 and learned a lot about the fundamentals of different markets such as crude oil, gold, cocoa, and soybeans. But the entire time, in the back of my mind I was thinking, “There’s got to be an easier way to do this.” Not everyone can pick the time to get in and the time to get out. It’s so difficult because of the leverage.
About 10 or 15 years ago, I thought I should discover the wonderful world of options. If you buy an option that’s 90 days, or 120 days, you may or may not make any money. But at least you’re going to be in this trade for 120 days, instead of getting stopped out in a moment’s notice. What I found was, if I am bullish on the price of gold, or crude oil, or what have you, you buy an option 90 days out. You pay a great deal of money for that call option and lo and behold, the market goes up. It did what you thought. It took several weeks to get there, but you didn’t make any money. Gold rallied $100 but my call option was $150 above the market. So what happens? I’m right at the market and I lose.
I was buying options for a period of time, which is what lots of traders do. This led me to thinking, “Who’s on the other side of these? Who am I buying these from?” The reason behind that thinking was that when I bought an option and I was wrong in the market, I lost. When I bought an option and the market went sideways, I lost. And even when I bought an option and was right in the market, I lost. So who is on the other side of these trades?
That gave birth to the idea behind being an option seller instead of an option buyer. And it worked in my favor right away. I just happened to be selling options in commodities that previously made large moves, which means that the volatility and premiums were quite high. The price of a handful of commodities had just come off of a very volatile year, and there were call options trading 100% out-of-the-money. Traders were buying these options for six, seven, eight, nine hundred dollars apiece. The light bulb was reinvented.
It sounds like it. But most people think of selling options as being extremely risky. How do you manage your risks?
You have to manage the risk just like when you buy a piece of property, or a stock. You can’t go to Bora Bora for six months and come back and expect everything to be fine. You do have to manage the risk.
However, shorting options, or selling premium that is 30–50% out-of-the- money, slows down your investment dramatically. The reason it does so is because the options that are 40% out-of- the-money are moving very slowly.
The price of crude oil is moving 50 cents every half hour right now. The gold market is moving $10 up and $10 down. If you trade futures, then you know those are pretty large moves taking place in a short period of time. Whether you’re bullish or bearish on gold, crude oil, or what have you, if you take a position in an option that’s 30% or 40% out-of-the- money, it’s barely moving.
I am familiar with the saying that selling options is risky. Everything is risky, but being short an option versus taking a futures position, in my opinion, carries only a small fraction of the risk.
Can you give us an example?
I’ll pick crude oil because a lot of people are following crude oil right now, though it could be any commodity. First, let’s look at the history of crude oil. This past summer, crude oil was up at $100 a barrel. There were skirmishes all around the Middle East, Ukraine was being invaded, and so on.
Oil was at $100–105, and everybody was bullish. However, the market usually makes its high in summer and usually falls into winter. The October–November time frame for crude oil is the smallest demand period of the year. That’s because driving season is over and it’s not quite the heating season yet. So crude oil usually comes down in September, October, November, December, and then everyone is bearish and they all get out, which is what is happening now.
Say crude oil right now is at $67 a barrel. You have two ways to go long. First, you can buy 10 contracts of crude oil futures at $67. That is one way of being bullish on crude oil for someone thinking this is just a seasonal thing and the market will go up next year. So let’s say we do a paper trade and buy 10 June crude oil for next year at $67. The other thing you can do is sell 10 June crude oil $50 puts.
So those are your two options of getting long in crude oil for next summer. Let’s face it. The price of gas is going to go up next summer. It always does, and it’s going to come up from a very low level.
Consider your futures position—you bought 10 at $67. You are now control- ling futures contracts, and every dollar down is a $10,000 loss. Conversely, every dollar up is a $10,000 gain.
Now, let’s say you instead sold 10 June crude oil $50 puts. That gives you $17 of leeway. So what is more risky? Buying at $67 or selling puts at $50?
Buying the $67 crude oil contracts.
The risk is immeasurable but it doesn’t mean you’re going to make money on those puts. The market might just keep stalling. However, you would be losing a tiny fraction of what you did if you had bought futures at $67. On the other hand, if the market rallies, you don’t make as much.
Now let’s say you sold those $50 puts for $800 or $900 each. That’s all you can make. But as you can see, there are three ways for that position to make money. Crude oil can go up and your puts expire worthless, crude oil can stay the same and your puts expire worthless (which is what you want), or crude oil can fall $17, which means your puts expire worthless and you keep the premium you sold them for. Therein is the beauty of selling options.
I’ve broken it down and given you the basics, that is, “option selling 101.” You can make this as complicated as you want.
One way to sell options is to sell more time. But when there is more time, anything could happen between now and the expiration of the option. In your book you mention that you need to keep a close watch on fundamentals. What type of fundamentals would you keep an eye on, and are they different for commodities versus equities?
The fundamentals would be the same. For example, if you’re buying shares of Apple, Inc. (AAPL) and they launch a new phone, you want to see how many of those phones were sold. If you buy AAPL, you want to know how the economy is doing. Is there spendable money right now? Is consumer spending high? Those are the types of fundamental data you’d look at if you are interested in buying AAPL.
If you were buying coffee futures, or being bullish coffee prices, you want to know what the weather is in Brazil. Coffee trees flower during October– November. The flowers turn into cherries, which are then roasted into coffee beans. You need to watch the weather in Brazil and make sure they’re getting the rain as they are supposed to during that time of the year.
Then you watch the coffee consumption trends. Are people still drinking coffee? Heck, yeah. Are they drinking more than ever? Yes, they are. There are fundamentals following AAPL. There are fundamentals following the price of coffee. And that is what we keep an eye on.
And what if the fundamentals change after you put on your position?
If the fundamentals change, then you have to make a decision. You’ll have to determine how much they have changed. If they have changed a little, can you still keep your position? If they have changed a lot, then you may have to exit your position. Just as with futures, you can get out of your crude oil puts at a moment’s notice.
It is like any other investment. You need to know what you’re doing, why you’re doing it, and if something changes, you have the maneuverability to exit the trade. It is like anything else, but what we’re doing is putting the odds in our favor, as opposed to investing in a game where the odds are really difficult. Trading futures on commodities is, as I mentioned earlier, very difficult. Your timing needs to be perfect.
When you’re selling options, you don’t need perfect timing. You can take a position, and you can be off by days, weeks, or sometimes months.
So it’s more forgiving?
It’s very forgiving, but that doesn’t mean it’s foolproof. But you do have so much leeway as compared to trading futures contracts.
I would have never thought that. One thing you mentioned is volatility spikes being a situation that option sellers should take advantage of. Why is that?
Generally, when commodity prices go up, they will cause a spike in volatility. Sometimes volatility increases when the markets are going down. Recently, the volatility in precious metals and gold just increased on a short down move. But what that does is create volatility and implied volatility in the options. You want to sell those when volatility is high rather than when volatility is low. It allows you to sell options further out-of-the-money.
The further out in price that you can sell an option, the more leeway you have or the more forgiving the position is. When options have large premiums from high volatility, I refer to it as low-hanging fruit, and that is when you want to be a seller of the option.
Another strategy that you like is to sell strangles. Can you tell us how that increases premiums?
Selling strangles is one of our favorite strategies for selling options. You implement a strangle only when you think a market is fairly valued. You don’t implement a strangle when the market is extremely high and you don’t implement a strangle when a market is extremely low.
Going back to the crude oil example, let’s say crude oil is fairly priced and you think it’s going to go up a little bit. Let’s stay with our $50 put. You don’t think the market is going to drop to that level. But you also don’t think crude oil is going to go up to $100. You think that crude oil is perhaps a little bit underpriced and that it can rally a little bit, but for the most part, you think it will be stable and probably just go up a little. So you sell the $50 put and the $100 call at the same time. That’s a $50 window for crude oil to stay within! Because of this, if you are viewing the market as being fairly priced, the strangle is a strategy that works incredibly well.
Think of what is happening. When the market falls slightly, your put is increasing just a little bit, which you don’t want it to do. But your call is decreasing in value, which is almost babysitting—it is almost monitoring your put. When the market rallies, and the call goes up just a little bit, your put is decreasing and going in your favor. It’s a beautiful thing! I’m not saying this is foolproof, and I’m not saying it works all the time. It doesn’t. But it puts the odds of the market in your favor, and it just gives you a great deal of leeway.
In other words, you wouldn’t be using this strategy when a market is trending. You would be using a strangle when a market is moving sideways, correct?
Yes, and what’s interesting is that most commodity prices, whether it be soybeans, cocoa, or gold, usually are fairly priced. You can buy or sell gold, and if gold is at an all-time high, you’re not going to put on a strangle. Conversely, if gold just fell 15%, you may not put on a strangle. But let’s say gold has made a decent move up or a decent move down, and has retraced somewhere in the middle of its trading range. Chances are that’s about what it’s worth. It didn’t just have massive liquidation. It fell and rose and now it is consolidating in the middle. More often than not, commodities are just about fairly priced. If they weren’t, they would move. If something was too cheap, it goes up. If something is too expensive, it comes down. More times than not, the investors have it about right. Putting a strangle around markets like that can work extremely well.
We have introduced the thought process or idea as an option for those who are considering alternative investing. But it isn’t for everybody and most people would probably not want to do this on their own. But by being introduced to the idea, a lot of people will start thinking in terms of the possibility of selling gold options at $2,000 when it is trading at around $1,300–1,400. The first question they should ask is, “Who is buying these things?”
We trade options that are 40–60% out- of-the-money, and the market usually doesn’t move. The financial television commentators may say that the price of gold went up by 1.5%, but that’s nothing when the option you sold is 40% out-of- the-money. While everyone is scurrying and scrambling to contemplate what just happened, your option didn’t budge. It is a new vehicle for investors to trade commodities.
You can trade similar strategies with stocks, but what I have found is that premiums on individual stocks trade much closer to the money. If you wanted to implement this strategy on options in stocks, you can, but instead of selling options 30, 40, or 50% out-of-the-money, you’d be selling options 5–10% out- of-the-money. The way I see it, selling options on commodities is much more attractive than selling options on stocks, because in most cases, you can sell options much further out-of-the-money.
When it comes to risk management in options, how similar or different is it to trading equities?
It’s similar to trading equities. Option prices move much slower, and futures contracts move a little bit each day and have a settlement price. This allows you to have a predetermined risk.
Going back to the example of crude oil, if you sold the puts that you were considering selling for, say, $800, you should know that they are going to have a different settlement price every day. The day after you sell them they might settle at $820. A week later they might settle at $780. They are near the price you sold them at. You can have a predetermined risk. You can say to yourself, “If this option doubles in price and closes at $1,600, I’ll exit the trade, and maybe reenter at a different level.” If that is in fact the way you want to trade, you want a predetermined risk.
This is one simple way, but there are several ways to manage risk when selling options. A lot of traders who sell options are of the thought that if the option doubles, they’ll exit the trade. Another is if the option increases by 1.5%, then they’ll exit the trade. There are different formulas to do that and the trader or broker can predetermine that.
As with anything else, risk management is everything and you definitely want to do that with options. In my opinion, it’s much easier to determine the risk on a short option than it is on a futures contract. Futures just move very fast.
Say crude oil moves up by $1 and you think it’s time to buy it, but if in afternoon trading it goes down 50 cents, there’s a good chance you’ll be out of the trade. That’s a $1,500 move. Let’s say that in the morning, oil was up $1 and you decided to go long and you sold the puts. At the end of the day, you might only be down about $50 on your puts instead of $1,500.
You’re a portfolio manager, but when it comes to the retail trader, what are some of the mistakes you often see t hem make?
Most often, the option retail trader is under the assumption that if you buy options, that is, if you buy a call or you buy a put, you have limited downside risk. The price of the premium is all you can lose.
Unfortunately, that is usually how the trade turns out. The premium that you paid for the option is what you wind up losing.
Options expire worthless about 80–82% of the time, which are not good odds. Not understanding that is the biggest mistake retail traders or investors make when they buy options. They are creating a difficult platform for them- selves to try to be successful trading commodities. A lot of new investors are drawn to options because by using them, they know exactly how much they can lose. For example, if they buy an option for $1,000, no matter what hap- pens, that will be their downside risk. Unfortunately, that is exactly what they usually wind up losing.
Thank you so much for speaking with me, James.
My pleasure! Selling options is an interesting concept and selling them on commodities isn’t for everyone, but it’s an alternative way to buy commodities.