As we approach the fourth quarter of what has been an active year in commodities options, we find ourselves with a textbook opportunity to demonstrate the primary benefit and logic of selling options.
Ironically, this opportunity presents itself in the form of the authors being wrong in their projection of market direction. If you read our August columns in crude oil and natural gas (available under the newsletter archive at www.OptionSellers.com), you know we felt both markets were nearing value levels and that we expected prices to begin to gravitate higher through the September/October time frame. While this may yet happen, price direction in the meantime has continued to trend decidedly lower.
That is fine with us. We do not pretend to be market psychics that can peer into a crystal ball and predict what the market will do next week or next month. As analysts, we make the best projections we can based on the information available to us. But in the end, nobody, and I do mean nobody, knows where the market will go. And that is exactly why we sell options.
In other words, we would rather make money than be right.
In the articles, we recommended selling December crude puts below the $80 level and December natural gas puts below the $6.80 level. While both markets have since declined in price, the option values have moved only nominally. December crude $75 are about 20% more expensive now than they were at the time of the recommendation. December natural gas $6.70 calls are about 40% more expensive. To date, both strikes remain well out of the money. Therefore, while our projection for the futures price has been off thus far, sellers of these options are still holding what will very possibly become winning trades. While the trades could still end up losing money in the end, the energy markets will have to experience substantially more selling to make them losers. Selling puts or calls is the only strategy that I know of where one can be wrong the market direction and still be profitable. Try doing that with buying a futures contract or even buying an outright stock.
Our job as portfolio managers and your job as an option seller is not necessarily to be right the market. Your job is to pick options that will expire worthless. Selling options at very distant strikes is a good first step in achieving that end.
The current state of the commodities markets and why the latest volatility is good for option sellers
Fannie, Freddie, Lehman Brothers, the Fed. There has been much in the news lately to make even the most seasoned investor squeamish. Systematic risk is taking many investors, especially equity investors to the sidelines or to fixed income instruments to ride out the storm.
As an option seller, however, these can be the best of times. As a seasoned surfer knows, the surfing is best when the waves are highest. Volatility can make the most distant of strikes appear tempting to some buyers – meaning that there is premium available at the most distant levels – even in options favoring the trends.
Commodities as a whole have been in a vicious downtrend since mid July. While commodities indexes track a group of commodities, having many move together in tandem is somewhat uncommon. Commodities such as coffee, silver or natural gas do not have much in common fundamentally and tend to move their own directions based on their individual fundamentals. However, the extreme move in the U.S. dollar over the past eight weeks has affected all commodities to one degree or another. A surging U.S. dollar makes commodities cheaper. With global economic slowing also crimping demand, commodities have responded to this “one-two” punch with rapidly deflating prices.
The good news for option sellers is that while prices were deflating, the volatility in the markets has left call options far above the market holding attractive values. Commodity bears that sold call options over the past several weeks are no doubt reaping profits now. The point is that although the media continues to report the doom and gloom in the stock market, real estate market and now even the commodities market, if you sell options, there continue to be (and always will be) opportunities for generating returns. Selling options means you are not dependant on market direction. You are free to trade the market from the long side, short side, or even both sides. Volatility is your only requirement, and we have plenty of that.
If the dollar continues on its recent uptrend, it should pressure many commodities. Fundamentals, however, still play an important role. If dollar strength continues, markets that are fundamentally weak should be shorted, meaning you should sell calls. Markets with more supportive fundamentals become candidates for strangles.
Our gut feel is that the dollar is overbought and due for a correction and that commodities are oversold and due for a bounce – in the short term. However, the devaluation of international currencies in relation to the dollar should continue in the longer term as economic slowdowns overseas play catch up with the U.S. malaise. This should help to support the dollar into the fourth quarter and hinder rallies in commodities.
We like call sales in gold and silver on a rally over the next two weeks as these markets are most directly linked to fluctuations in the dollar. Even without a rally, there are calls currently for sale in silver at strike prices over double the current value of the underlying.
Volatility at its best, indeed.
James Cordier and Michael GrossLiberty Trading Groupwww.optionsellers.com
The information in this article has been compiled carefully from sources believed to be reliable, but its 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.
James Cordier is president and head portfolio manager of Liberty Trading Group/OptionSellers.com – one of the first brokerage firms in the U.S. to specialize exclusively in selling options. James’ commodity market analysis is published by several international financial publications and he appears regularly on CNBC, Bloomberg Television, and Fox Business. Michael Gross is an options analyst with Liberty Trading Group/OptionSellers.com, whose published articles on option investments have appeared in Futures Magazine, FOW London and Yahoo Finance. Mr. Cordier and Mr. Gross’ first book, The Complete Guide to Option Selling is available at bookstores and online retailers now. Cordier and Gross work personally with all Liberty Trading Clients.
