Based on experience with new commodity traders, we’ve found about 80% of them have a history with stock options. Most of these traders, when pressed, express a vague desire to diversify as one of their chief reasons for taking the next step to commodities. However, it’s intriguing 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 misunderstand: Selling equity options can be a lucrative strategy in the right hands. However, if you are one of the tens of thousands of investors who sell 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 commodities.
In an era when sudden and excessive volatility is common, diversification is more important than ever. But the advantages don’t end there.
Selling (also known as writing) options can offer benefits to investors in both equities and commodities. However, there are substantial differences between writing stock options and writing options on futures. What it generally boils down to is leverage. Futures options offer more leverage and, therefore, can deliver greater potential rewards (in addition to greater risk).
In selling equity options, you do not have to guess short-term market direction to profit. The same remains true in futures, with a few key differences:
- Lower margin requirement (that is, a higher return on investment). This is 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 futures industry’s margin calculation system, however, options can be sold with out-of-pocket margin requirements for as little as one to one-and-a-half 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). This can translate into substantially higher return on your working capital.
- Attractive premiums can be collected for deep out-of-the-money strikes. Unlike equities — where to collect any worthwhile premium, options must be sold one to three strike prices out of the money — futures options often can be sold at strike prices far out of the money. At such distant levels, short-term market moves typically will 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 efforts to enter or exit positions. While some futures contracts have higher open interest than others, most of the major contracts, such as financials, sugar, grains, gold, natural gas and crude oil, have substantial volume and open interest, offering several thousand open contracts per strike price.
- Diversification. In the current state of financial markets, many investors are seeking precious diversification away from equities. By expanding into commodity options, you not only gain an investment that is not correlated to equities, option positions also can be uncorrelated to each other. In stocks, most individual stocks, and their options, will move at the mercy of the index as a whole. If Microsoft is falling, chances are your Exxon and Coca Cola holdings are falling as well. 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 factors, not the least of which are corporate earnings, comments by the CEO or board members, legal actions, regulatory decisions or broader market direction. Soybeans, however, can’t cook their books, and copper can’t be declared too big to fail.
The supply/demand picture of commodities is analytically cleaner. Knowing the fundamentals of a commodity, such as crop sizes and demand cycles, can be of great value when selling commodity options. In commodities, it is most often old-fashioned supply and demand fundamentals that ultimately dictate price, not the actions of a badly behaving CEO. Knowing these fundamentals can give you an advantage in deciding what options to sell.
A trade example can demonstrate the mechanics of selling commodity options. This example will assume that the seller is neutral to bullish crude oil prices. Note particularly the distance of the strike from the underlying trading price as well as the margin vs. premium collected (see “High flyer,” below). Then compare these to their counterparts in selling a put in Exxon or Chevron.
May crude oil: Selling a put option
Date: February 2, 2012
Scenario: An investor is neutral to bullish on crude oil prices and wishes to collect premium above the market.
Trade: Sell June crude oil $68 put option
Premium collected: $500
Margin requirement: $1,100
Expiration date: May 17, 2012
Risk: The risk to the put seller is that crude prices move substantially lower. If the option goes in-the-money, it could be worth more at expiration than what it sold for. At that point, the seller would have to buy it back at a loss. The trader also could 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.
Summary: If May crude oil futures are anywhere above $68 per barrel at option expiration, the option expires worthless and the investor keeps the full premium collected as profit. Notice that the put can be sold at a level 32% out of the money. (Crude oil prices would have to fall by 32% prior to option expiration to move in-the-money.) The option also could be bought back at any time prior to expiration at a varying level of profit or loss. Bearish oil traders could use the same strategy by selling call options far above the market. Note the margin requirement vs. premium collected is a 45% return on capital if the option expires worthless.
Stock option sellers cannot hope to learn all of the details of commodity options in one article. However, this strategy stands as a true alternative investment that is highly uncorrelated to any equities portfolio, offers high premiums for sellers, lower margins and potentially greater rewards.
James Cordier & Michael Gross are authors of “The Complete Guide to Option Selling” 2nd Edition (McGraw-Hill 2009). They are co-portfolio managers of OptionSellers.com, an investment firm that offers managed option selling portfolios.