James Cordier and Michael Gross of OptionSellers.com highlight five critical differences between selling commodity options over stock options, weigh both sides of the equation, and cite a hypothetical example of selling a futures option for support.
"The price of a commodity will never go to zero. When you invest in commodities futures, you're not buying a piece of paper that says you own an intangible piece of company that can go bankrupt." – Jim Rogers
About 80% of the new clients I speak with have some type of experience with stock options. Most of them, when prodded, express a desire to ‘get properly diversified’ as one of their chief reasons for taking the next step to commodities. What intrigues me is that few have a firm grasp of the real advantages that commodity options can offer, especially if they are accustomed to the constraints that stock option selling can place on an investor.
Don't get me wrong…selling equity options can be a lucrative strategy in the right hands. However, if you are one of the tens of thousands of investors that sells equity options to enhance your stock portfolio performance, you may be surprised to discover the horsepower you can get by harnessing this same strategy in the commodities arena.
In this day and age, diversification is more important than ever. But the advantages don't end there.
5 Key Differences Between Stock and Futures Options
Selling (also known as writing) options can offer benefits to investors in equities or commodities. However, there are substantial differences between writing stock options and writing futures options. What it generally boils down to is leverage. Futures options offer more leverage and therefore can offer greater risk, but also greater potential rewards. But this same leverage opens up several other key advantages you may have never heard of. If you’ve only ever sold equity options, this seminar will be an eye opener for you.
While this subject is covered extensively in The Complete Guide to Option Selling, the following will give you a quick outline of the advantages that await option sellers in the commodities arena.
In selling equity options, one does not have to guess short-term market direction to profit. The same remains true in futures, with a few key differences.
- Lower Margins (Higher ROI): A key factor that attracts many stock option traders to futures. Margins posted to hold short stock options can be 10 to 20 times the premium collected for the option. With the standardized portfolio analysis of risk (SPAN) margin system used in futures, options can be sold with out of pocket margin requirements* for as little as 1 to 1 ½ times premium collected. For instance, you might sell an option for $600 and post a margin of only $700. (Total margin requirement minus premium collected.) What does this mean for you? The potential for a large return on your invested capital. (Of course, corresponding risk applies to this as well.)
- Big Premiums: Attractive premiums can be collected for Deep out-of-the-money strikes. Unlike equities, where to collect any worthwhile premium, options must be sold 1-3 strike prices out-of-the-money, futures options can often be sold at strike prices far out-of-the-money. At such distant levels, short-term market moves will typically not have a big impact on your option's value. Therefore, time value erosion may be allowed to work less impeded by short-term volatility.
- Liquidity: Many equity option traders complain of poor liquidity hampering their efforts to enter or liquidate positions. While some futures contracts have higher open interest than others, most of the major contracts like Financials, Sugar, Grains, Gold, Natural Gas, Crude Oil, have substantial volume and open interest offering several thousand open contracts per strike price.
- Real Diversification: In the current state of financial markets, many high net worth investors are seeking precious diversification away from equities. By expanding into commodities options, you not only gain an investment that is 100% uncorrelated to equities, your option positions can also be uncorrelated to each other. In stocks, most of the time, your individual stock (option) will be largely at the mercy of the index as a whole. If Microsoft is falling, chances are, your Exxon and Coca Cola are falling too. In commodities, the price of Natural Gas has little to do with the price of Wheat or Silver. This can be a major benefit in diluting risk.
- Fundamental Bias: When selling a stock option, the price of that stock is dependent on many, many factors, not the least of which is corporate earnings, comments by CEO/Board, legal actions, Fed Decisions, or direction of the overall index. Soybeans however, can’t cook their books. Silver can’t be declared too big to fail.
Knowing the fundamentals of a commodity, such as crop sizes and demand cycles, can be of a great value when selling commodities options.
In commodities, it is most often old fashioned supply and demand fundamentals that ultimately dictates price. Knowing these fundamentals can give you an advantage in deciding what options to sell.
NEXT PAGE: Key Concepts of Selling a Futures Option in Action
|pagebreak|Commodities Option Selling—An Example
The example below illustrates these key concepts of selling a futures option. This is for example purposes only and assumes the seller is neutral to bearish crude oil prices. Note particularly the distance of the strike from the underlying trading price as well as the margin vs. premium collected. Then compare these to their counterparts in selling a call in Exxon or Chevron.
Also Important to Note: We are not selling a covered position or looking to buy crude futures at a discount. This is pure premium collection. No purchase of the underlying required (or desired).
Selling a Call Option in December Crude Oil
* Price Chart Courtesy of CQG, Inc.
Click to Enlarge
Date: July 20, 2014
Scenario: An investor is neutral to bearish on crude oil prices and wishes to collect premium above the market.
Trade: Sells December Crude Oil $130.00 call option
Premium Collected: $800
Margin Requirement: $2200
Expiration Date: November 14, 2014
Summary: If December Crude Oil Futures are anywhere below $130 per barrel at option expiration, the option expires worthless and the investor keeps the full premium collected as profit. Notice that the call can be sold at a level over 30% out-of-the-money (Crude oil prices would have to rise by 30% prior to option expiration to go in the money). The option could also be bought back at any time prior to expiration at a varying level of profit or loss. Bullish oil traders could use the same strategy by selling put options far beneath the market (although in hindsight, this would not have been advisable. Thus the importance of market fundamentals).
Risk: The risk to the put seller is that crude prices move substantially higher. If the option goes in-the-money, it could be worth more than he sold it for at expiration. At that point, he would have to buy it back at a loss. He could also choose to buy it back at any time prior to expiration, even if it was not in-the-money. This can be an excellent risk management strategy.
Note: The margin requirement vs. premium collected is a 36.3% return on capital in 120 days if the option expires worthless. Compare that to a successful sale of a stock option, where the return on equity is generally 1% to 2% per option, even on options with time values similar to this.
Drawbacks of Commodities Options
Of course, no perfect trading strategy has ever been devised and commodities option selling does have its drawbacks. Leverage can be a double-edged sword. Thus, while potential profits can be larger, potential downside can be as well. An effective risk management plan is essential for any option seller seeking consistent success. In addition, commodities prices answer to a different master than stocks, making them more challenging to analyze for the neophyte accustomed to stock analysis. This can make working with a commodities professional a sensible choice for many, if not a necessity.
Conclusion
As a stock option seller, you cannot hope to learn all of the details of commodities options in one article. However, if you are a high net worth investor seeking a true alternative with the potential for outsized returns, the higher premiums and lower margins of commodities options can open a new world of investing for you. It can also give you a tax friendly, diversified portfolio that is completely uncorrelated to equity market performance.
***The information in this article has been carefully compiled from sources believed to be reliable, but it's accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
By James Cordier and Michael Gross of OptionSellers.com
