Sell Options on Futures for a Higher Probability Trading Strategy

Introduction to Commodity Option Selling

The premise of commodity option selling is to collect premium through the sale of options on futures in hopes that the time erosion and volatility option selling commoditiesdecay of a particular short option will overcome any increase in option value due to adverse price movement in the underlying futures market. An option selling strategy offers unlimited risk and limited reward, which is opposite of what many might consider rational. Nonetheless, the odds of success on any given short option trade are arguably in favor of the seller over the buyer.

 

The concept of an option is nearly identical to that of an insurance policy. The buyer purchased the instrument to receive a payout should a substantial event occur. The seller of the instrument, is collecting a payment in hopes of the “policy” expiring worthless. Accordingly, the practice of commodity option selling is similar to the business of selling insurance policies.


Most of the time, premium is collected by the insurance company and kept as a profit, but there will be times in which unexpected circumstances arise and trigger "claims" against the policy, or in the case of option trading a large drawdown at the hands of an increasing option value. In other words, like that of insurance policies, the odds of success on each individual option selling venture is high, but the challenge is to keep the magnitude of the losing option selling positions to a level in which it is possible to be profitable in the long run.

 


 

Types of short options on futures

 

option strategy diagram

Short Call – Bearish Option Strategy

Call option “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to buy the futures contract at the strike price. A short call is an eroding asset to the buyer and an eroding liability to the seller.

The buyer has the right, but not the obligation to take delivery of the underlying futures contract at the stated strike price but the seller is obligated to accept the assignment of a short futures contract at the strike if the option is exercised. The seller's risk of being forced to honor the buyer’s rights diminishes with time; all else being equal the value of the option will erode.
In a nutshell, the seller of a call option keeps the premium collect if the trade is held to expiration and the futures price at that time is below the strike price of the call option.


Short Put – Bullish Option Strategy

Put “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to sell the futures contract at the strike price. If exercised, the option buyer has opted to exercise the right to go short a futures contract at the strike price and the put seller is obligated to buy the futures at the same price. Identical to a short call, a short put is an eroding asset to the buyer and an eroding liability to the seller. Also, the seller's risk of being forced to honor the buyer's rights diminishes with time and volatility.


To summarize, if held to expiration, the seller of a put option keeps the entire premium collected if the futures market is trading above the strike price of the put. We’ll go over an example of a short put to give you a clearer picture of how a short option trade works.


Short Strangle – Neutral Option Strategy

Some option sellers practice what is known as a delta neutral strategy in which both call options and put options are sold simultaneously to create a trade without any directional bias. In its simplest form, a short commodity option strangle seller sells a call for every put sold; generally the strike prices are equidistant to the current futures price.


The advantage of selling an options strangle in the futures market, as opposed to selling only one side of the trade (a call or a put), is increased profit potential and more room for error. Obviously, by selling both a call and a put, the trader has automatically doubled the potential gain on the trade. Further, the sale of both calls and puts along with the additional premium collected, provides a bigger buffer to cushion losses should the futures price trade beyond the strike price of either commodity option. Accordingly, many believe this to be a lower risk strategy relative to selling calls or puts outright on a directional basis.


Selling a Commodity Put Example (Crude Oil)

In the example portrayed in the displayed chart, it might have been possible to sell a September $62 crude oil put for 53 cents, or $530, at a time in which crude oil was valued near $80. The same option was worth only 17 cents ($170) just two days earlier prior to a multi-day plunge. Options that have tripled in value, as such, often have a tendency to see sharp premium erosion should the futures market stabilize. Accordingly, these types of spikes in option premium are attractive to option sellers.

commodity option selling example: crude oil short option


On the contrary, those that were already the 62 put prior to the two-day sell-off would be an unpleasant situation. This just goes to show you how important timing and volatility can be, even in a so-called passive strategy such as option selling. Simply put, making money by selling commodity options isn’t as easy as selling calls or puts and hoping for the best. Traders must be patient in order to be in a position to capitalize on an increase in volatility, as opposed to getting run over by it.


The maximum profit of this particular short option trading example, is $530 minus transaction cost. The max payout occurs if the option is held to expiration and the futures price is above the strike price of $64. However, even if the price is a little below $64, all is not lost; this short option position pays off at expiration with the price of crude anywhere above $63.47. This is because the premium collected of 53 cents, or $530, acts as a buffer to the risk of being assigned a futures contract at the strike price of $64.


Should the price of crude be trading below $64 at expiration, the risk is similar to that of being long a futures contract. The option value will fluctuate quickly and the trade faces theoretically unlimited risk.


As you can see from the chart , it is possible for this trader to be profitable whether the market goes up, down, or sideways; the only risk is in a massive price collapse (in this case below $64). If the price of crude is above $64 at expiration ($64 to infinity), the max payout is received by the option seller. In other words, the profit zone is large and likely, while the loss zone is far less likely to be seen.


 

The Key to Option Selling is Premium Erosion


Short Option Premium Erosion

Similar to buying a car and watching its value drop as you drive it off the lot, (all else being equal) options on futures lose value with every minute that passes. This is because as time passes, the odds of an extreme event diminish.  Assuming the futures price doesn’t increase in volatility, and more importantly do so in an adverse direction of the short option, time is money to an option seller.  On the other hand, option buyers often suffer slow and painful losses in the absence of a dramatic price change. In fact, some studies have suggested that somewhere between 70% to 90% of all futures options expire worthless.

Because of these characteristics, option selling is the only strategy in which a trader can be wrong and still make money!  For example, a trader going short a call option is accepting the risk of the futures price going above the strike price of the short call. However, the futures price can go up, down, or sideways and still produce a profit to the option seller as long as the futures price doesn’t exceed the strike price of the commodity option.


The most common turn-offs to options on futures selling are fears of margin calls, stories of account threatening losses but the truth is trading of any futures or options strategy involves substantial risk. At least commodity option sellers are putting the odds in their favor. On the contrary, option buyers are in essence purchasing lottery tickets in which their risk is limited, but the odds of success are unattractive.  In other words, although option buyers face limited price risk, they are more likely to incur a high percentage of losing trades.

 

Trading Success and FailureThe bottom line on option selling strategies


Selling options can be a high probability trading strategy, but it doesn't come without stress and risk. Although option sellers are betting against extreme price moves, it is critical that traders attempt to time their entry in regard to market analysis, sentiment and, most importantly volatility. Failure to do this will increase the odds of panicked premature liquidation, large draw-downs, or worse. Be selective and remember, it is better to miss a trade than to impatiently enter a market only to suffer the consequences of exploding market volatility, and therefore option values.

 

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