From the October 01, 2011 issue of Futures Magazine • Subscribe!

Double your option premium, balance your risk

A critical component of successful option selling is pairing the logic of selling option premium with the long-term fundamentals of a particular market. While this is a winning formula for extended success in the commodities option market, it certainly is not the only formula. At certain times, there may be other opportunities outside of your core fundamental holdings that may offer profitable opportunities for selling options — without necessarily forming a fundamental bias.

A variety of economic conditions, in the United States and abroad, have created an elevated level of volatility in a variety of markets. The U.S. dollar, coffee, sugar, soybeans, crude oil and gold all have seen their share of extreme price moves in the last six months. It was enough to have futures traders pulling their hair out trying to time the tops and bottoms.

For option sellers, however, these are the best of times; option sellers want and need volatility. The amount present in today’s markets has many eagerly rubbing their hands together, especially with commodity markets seemingly returning to more fundamentally driven price movements. High volatility makes it profitable to sell strikes so far out-of-the-money that they have little hope of ever being exercised.

Way out-of-the-money

While commodity markets appear to be returning to more traditional, fundamentally based price patterns of late, the volatility of the past 12 months remains present in many option values.

In leveraged commodities contracts, this means options available at 50%, 60% even 70% out of the money for option sellers to collect premium. By definition, there is little chance any of these options will ever go in the money. One of the seven secrets of successfully selling options is selling deep out of the money.

But that doesn’t mean that option buyers don’t think they can turn a buck by buying these kinds of options. While there is slim chance these types of options will ever go in the money, there is a chance that they could increase in value in the meantime, meaning the buyer of the option could potentially buy high and sell higher, turning an explosive profit. In addition, volatility and crowd psychology have a way of whipping speculators into a frenzy and ultimately making them do foolish things. Sometimes, this involves buying ridiculously priced options in hopes of securing big gains on the next leg.

The odds, however, are overwhelmingly in favor of the option seller who sells and holds on to these options through expiration. In most cases, time eventually will catch up with the option values and barring some cataclysmic event, erode them to zero, meaning eventual profits to the seller.

The primary risk to the far-out-of-the-money option seller then, is increased values and margin necessary to hold a position prior to expiration. Thus, it may serve an option seller well to use a strategy that could help to offset short-term increases in the value of an option while waiting for it to expire.

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