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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