If you currently limit your asset mix to traditional investments, even if you write stock options, you’re missing out on what could be a powerful tool for growing and protecting your net worth.
…selling options was, in my opinion and not without risk, the single most productive approach I’d ever found to build equity in an account.
A commodity option selling portfolio offers a true diversifier – a freedom that is rare in the financial markets. Option Selling can be the key to the chains that bind you to your overweighted stock portfolio. Now you may argue that either
Both of these statements could be true. And they would also both be irrelevant. For a commodities option selling portfolio can be totally uncorrolated to anything else, even the commodity indexes themselves. Why?
If you are purely seeking an investment with some horsepower, this could be reason #1 for you. For while option selling can be “slow and boring” for the action oriented trader, the accumulated premiums and leverage of the futures markets can make them anything but. Stock option sellers take note: This ain’t selling covered calls on your Microsoft. This is option selling on steroids. If you sell a stock option and take a $200 premium, you are generally paying 10 to 20 times that amount in margin to hold that position. In commodities options, you can sell options for
Thus a margin for a $500 option premium may only require a $750 to $1,000 margin requirement from you. We’ll let you do the math.
Suffice to say, if you get satisfaction from targeting potentially high ROI on your investments and are comfortable with a certain degree of risk, option selling on commodities could be a good choice for you.
A major benefit of option selling (and one that makes if a favorite of the high net worth crowd) is that it can be effective in nearly any kind of market conditions. As covered above, this is especially true in commodities, where individual markets tend to move somewhat independently of each other.
If you have a big chunk of your cash in stocks, it’s all good until you hit a market correction, a wave of volatility on some economic or geopolitical event, or an outright bear market.
As an option seller, especially a commodities option seller, you have the ability to be successful in these kinds of markets.Option writing can be profitable in bull, bear or listless markets. Market volatility? Great! Volatile markets are the BEST markets in which to be an option writer. It was Buffet who said to be greedy when others are fearful. While your golf buddies are complaining about the “rough waters” the market is in, you can (potentially) be sailing in a cool breeze. Remember, you’re deep out of the money – way over or way under the market. While this doesn’t make you bulletproof to all market events, it does give you a great deal of flexibility and diversity to deal with what may come along. The end result for you is the peace of mindof knowing your portfolio has the potential to produce no matter what is happening in the financial markets.
This is one of the biggest advantages of selling options. As Alan Greenspan once said: “Amateurs want to be right. Professionals want to make money.” Option sellers don’t have to be right to make money. In option selling, you give up your chance to hit “home runs” in exchange for the consistency of hitting “singles” – over and over and over again. It is estimated that 75-85% of all options held at expiration will expire worthless. By using a few simple tools – you can select options with even higher odds than this of expiring worthless. If buying options is like going to the casino, selling options is like being the casino- where the odds are tilted in your favor.
A black jack dealer in Vegas only has a tiny edge over any particular player at his table. Yet if players sit there long enough, the dealer will eventually get all of their money. This exemplifies the power of using applied odds over time.
The fact of the matter is, you can choose options with a 90, 95 even 99% chance of expiring worthless. When is the last time you got those kinds of odds buying a stock? While risk of loss is always present, as an option seller, you gain the confidence of knowing you are now trading with the percentages.
“The strategy of selling options is, at its core, a strategy of using applied odds over time.”
The 80% figure (rightly) grabs people’s attention. Chat room “option geniuses” may argue this figure’s relevance. But few will argue an option sellers advantage over an option buyer. The fact that most investors don’t know how to harness these odds is not your problem. Let it be theirs.
This consistency – having the majority of your trades as winners instead of losers- can be not only psychologically beneficial to you, the trader, but give you more focus to act when there is a risk measure to be employed or a new opportunity to capture.
When selling (or writing) an option, time value works for you instead of against you. That means that whatever else is going on in the underlying market, you enjoy the comfort of knowing that the unwavering hands of Father Time are always working in your favor.
When you sell an option, the buyer of the option pays you a premium for that option. If you sell an out of the money option, the entire value of that option is in time value. As time passes, all other things remaining constant, the option will gradually lose its value. This is called Time Decay and it’s one of the main reasons selling options can be so effective. It is for this reason that OptionSellers.com pursues a strategy of selling deep out of the money options in client portfolios.
The closer an option gets to expiration, the faster its rate of time decay.
The graph above illustrates the principle of time decay and its acceleration as expiration draws near. An option is considered a “wasting asset.” Time value erodes as each day passes, accelerating as the option’s expiration nears. This is referred to as time-decay. If the underlying contract’s price does not move to the option’s strike price by expiration, the option will have no value left and expire worthless and the option seller will keep the premium. Of course, as in any trading, a large move in the underlying may result in a loss. This is the concept on which our entire portfolio strategy is based. Notice that the value decays the fastest during the last 30-60 days of the option’s life.
You have a profit on your trade? Now what? Do you take the money off the table now and risk that your about to miss out on an even bigger move? Or do you “let it ride” and risk the profit you’ve already made?
One of the hardest parts of futures or any trading is deciding when to take profits. With option selling, if the market behaves favorably towards your position, you are relieved from the responsibility of making this decision. As time value decays your option, the market will gradually take profits for you.
Upon expiration, if the option is still out of the money (has not reached your strike price), the entire premium for which you sold the option will be in your account. At this time, your position automatically closes out.
However, you reserve the right to close out your short option position at any time prior to expiration as well – either as a loss limiting measure, or as a profit taking move. It’s a personal choice. In regard to taking a profit, some of the investors we’ve worked with find that it can be easier and require less effort to simply let the market “do it for them.”
Of course no “safe” trading system has ever been devised and no one can guarantee profits or freedom from loss.
Deep out of the money options tend to move slowly and do not require minute by minute maintenance. That being said, this isn’t a sell it and forget it strategy either. Your positions will need some adjustments from time to time. Many high net worth investors choose to remove themselves from the trading equation entirely, instead hiring a professional to handle the day to day trading and position management for them. Now that’s low maintenance!
2008 may seem like a long time ago. But investors that watched their net worth melt away through that market collapse took a key lesson away from it – At the end of the day, shares of stock are merely a piece of paper. If you really want to drive that lesson home, look up a little blip in the stock market that took place in 1929.
We all remember 9/11. Remember Lehman Brothers or Bear Stearns? How about Enron? On the days and weeks any of those events occurred, when companies and paper became worthless, (or perceived to be worthless), people still woke up and ate their corn flakes and drank their orange juice. They still put gasoline in their cars and drove to work, where they drank their coffee and ate their chocolate doughnut made with wheat, sugar and cocoa. And to comfort themselves, they went home to their nice warm natural gas heated home, got out a pound of ground beef (raised on USDA approved soybean meal) for dinner and retired to their den. Here they retrieved their gold and silver coins they had hidden in the safe and counted them to comfort themselves in the moment. Why? Because they had value. And they feared when they turned on their computer screen tomorrow, all of that paper they had their money in would not.
“Sugar can’t go bankrupt. Soybeans can’t go out of business.”
Does this mean the commodities are always a better investment than stocks? Not at all. One is not necessarily superior to the other. Are we suggesting that stocks are more dangerous or “risky” than commodities? Of course not.
What it does mean is that no matter what goes on in the world, commodities, such as the ones listed above, will always have some kind of demand. And where there is demand there will always be value. It may not always be the same value. But a value nonetheless. A pound of sugar will always be worth something to someone. Same for a barrel of oil or a bushel of wheat.
As a high net worth investor, you are likely already aware of the crucial practice of diversifying your assets. With commodities, you gain an extra feeling of security in knowing you have a component of your assets in investments you can hold in your hand –a lump of silver, a gallon of gas, a bushel of corn – things you can touch, feel, use. No matter what happens in the world, it remains likely that Americans are still going to want breakfast in the morning and dinner at night, fill up the gas tank, stay warm or cool, and feel “safe” with some precious metal in the closet. The same cannot be said for pieces of paper that have names like “Enron” or “Lehman” printed on them.
“Sugar can’t go bankrupt. Soybeans can’t go out of business. Commodities will always have a value.”
No matter what they say, nobody knows what any market is going to do, especially on a short-term basis. However, do enough homework, and it is sometimes possible to make a fairly accurate projection of where prices will not go on a longer term basis. By selling deep out of the money options, you avoid the game of trying to predict where prices will go today, tomorrow or next week. Instead you are only projecting where you think prices won’t go. For instance, if you are bullish the natural gas market, you might sell a deep out of the money put option. In this case, the market can move up, stay the same or even move down, as long as it is above your strike price upon expiration, you will still take your full profit.
As an Option Seller, you accept the fact that you cannot predict the future. You free yourself from the “need” for the market to move in a particular direction. You are satisfied to simply “bet” against the unlikely events and then take a payment for your efforts – over and over again. While there is still risk in this strategy, you have the ability to profit regardless of which direction the market is moving, or even if it does not move at all. And you relieve yourself of the stress that comes from trying to accomplish the nearly impossible.
At the same time, you’ll also free yourself from the requirement of having perfect timing. When buying a stock or futures contract, when you enter your position is just as important as what you are buying. In selling deep out of the money options, the option values typically aren’t moving as quickly as the underlying stock or commodity. The fact that they are deep out of the money can mean that daily fluctuations in the underlying market may not have a large impact on the price of the option. Thus your timing becomes less important.
Although all futures trading carries some degree of risk, done correctly, option selling can place your position in the market far enough away that short term swings in the market may not dramatically affect your position. This not only gives you staying power but allows you to focus on longer term market fundamentals. Relief from this decision means lower stress for you.
“Avoid the game of trying to predict where prices will go today, tomorrow or next week. The purpose of analyzing a market now simply becomes a practice of picking a far away point where it won’t go.”
If you think you pay your “fair share” and then some, commodity option selling could be the right strategy for you. Profits on option selling are taxed on the “60/40” rule – 40% as short term capital gains but 60% at the same rate as dividends. This makes them a favorable investment for those in high tax brackets.
In addition, your end of year taxes on your commodity option selling account are surprisingly simple. You get a straight 1099 (profit/loss) statement and you pay your taxes based on that one figure. No more reconciling each and every trade for the year.
This aspect makes the investment both simple to account for and tax efficient.
There is, of course, no perfect investment. Like any other form of wealth generation, option selling has its risks and drawbacks. The two main ones are these:
That being said, in my 30+ years of professional trading experience, selling options is, in my opinion and not without risk, the single most productive approach I’ve ever found to growing long term equity in an account.
If you are an intelligent, rational, high net worth individual who is looking for an investment approach that targets high returns with reasonable risks, has relatively high odds of success on each individual trade and requires a semi passive, lower stress type of management style, option selling could be right for you. To learn the complete strategy of option selling and how to use it in your portfolio – I recommend our third book The Complete Guide to Option Selling, 3rd Edition (McGraw Hill 2014). For a more introductory outline of the strategy, our free no obligation booklet – The Option Selling Solution will do the trick for you. If you’d like to learn more about how we can manage an option selling account for you, you’ll want to get our comprehensive Investor Discovery Pack.
While only you can decide if this type of investing is right for you and your wealth management goals, I recommend any high net worth investor consider it as a crucial component of an overall asset mix.