Most equities traders understand stock options. The desire to diversify has led them to commodities, but few look at options on commodites. However, options on commodity futures offer unique opportunities. This is especially the case if they are accustomed to the constraints of selling stock options.
Don’t misunderstand: Selling equity options can be a lucrative strategy. However, the many investors who sell equity options to enhance stock portfolio performance often are surprised to discover the horsepower they can get by harnessing this strategy in commodities.
Selling (also known as writing) options can offer benefits to equity and commodity investors. However, there are substantial differences between writing stock options and writing options on futures.
In broad terms, it boils down to leverage. Options on futures offer more leverage, which means greater rewards but also greater risk.
Here is a quick outline of the advantages that the commodities arena offers option sellers. In selling equity options, traders don’t have to guess short-term market direction to profit. The same remains true in futures, with a few key differences.
- Lower margins (higher return on investment): Margins posted to hold short stock options can be 10- to 20- times the premium collected for the option. With the Standard Portfolio Analysis of Risk (SPAN) margin system used in futures, 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 (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 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 effect 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 that poor liquidity hampers their 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.
- Real diversification: By expanding into commodities options, you not only gain an investment that is 100% uncorrelated to equities, your option positions also can be uncorrelated to each other. In stocks, most of the time your individual stock (option) will be at the mercy of the index as a whole. If Microsoft is falling, chances are 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. Also, seasonality in certain commodities provides periods of enhanced premium value that you are able to exploit in writing options.
- Fundamental bias: When selling a stock option, the price is dependent on corporate earnings, comments by the CEO or board, legal actions, industry technology trends or direction of the overall index. Soybeans, however, can’t “cook their books.” Silver can’t be declared “too big to fail.” In commodities, it is most often old-fashioned supply and demand fundamentals that ultimately dictate price. Knowing these fundamentals can give you an advantage in deciding what options to sell.