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.