Why Shorting Options Makes the Most Sense
90% Wins Are Possible
I recently heard that 90% of options expire worthless and about that same
percentage of option buyers also lose money. This coincidentally corresponds
to the roughly 90% of commodities traders who also lose money. I feel
that the easiest way for the average trader to join the ranks of the winners
is to sell options, to short puts and calls.
If 90% of options end-up worthless, one would expect that if options
are sold, and the short option positions are held until near expiration,
one would collect virtually the entire premium on about 90% of the trades.
Well, those are phenomenal statistics. But based on my personal experience,
it is now rare that I ever take a loss on out-of-the money options I sell.
There are never any "sure things" but utilizing a carefully
planned strategy which accounts for virtually any contingency, I think
there is a way to come up with an option selling plan, that if properly
implemented, will bring results much better than 90% winning trades. I
am working hard to try and refine my trading methods to try and accomplish
this.
Let me share some background information and then describe what I see
as a golden options trading opportunity now unfolding. The background information is very
important as there are many pitfalls that must be avoided in order to
be successful.
I keep adding to my knowledge every time I put on a trade. I write
so like-minded traders can learn with me.
A few years ago, I only had to look at my own trading account to conclude
that trying to make a profit from buying commodity options was a rough
road to travel. I was consistently losing. It was then that I reasoned
that I should do "naked" call and put selling. I decided to
try a new approach.
Now, every time I felt I should buy a call because I thought the market
was going to go up, instead I would sell a put. Instead of buying a put
when I felt the market was going down, I would sell a call. My results
instantly and quite dramatically improved.
I had a lot to learn though, and continued to lose money because I combined
futures contracts to do covered writing when the market would go against
me. Whenever I covered a call by going long the underlying futures contract,
often the market would immediately turn lower and the loss on the futures
contract exceeded the gain from the decay of option premium.
I was an overall winner on the options I sold, but lost a great deal
of money on the futures contracts I purchased as a defensive measure to
protect the options which seldom needed protecting.
Today I only combine futures contracts with my option writing, in very
limited, special circumstances, and I near totally balance the number
of contracts to become what they call 'delta neutral'.
One of the trade secrets I have found is to sell options that are "less
rich" meaning further out of the money. Well, I went to the library
a few years back and started doing research, manually back-testing several
strategies. I immediately recognized that there was definitely something
there. But doing the testing by hand became so tedious and hypothetical
I gave it up and went back to day-trading.
A year ago I began intensively studying the markets to try and find a
winning strategy. My study revealed that selling options had several advantages.
I just love getting paid up front with an immediate profit the day I sell
an option, and then my task is to try and keep as much of the money as
possible.
Also, option selling allows one to do more long-range planning and does
not require near as much scrutiny and close attention as buying and selling
futures positions. And option trading is much more forgiving. I have done
the most stupid mistakes when employing my option strategies and somehow
was able to make a net profit.
Believe me, if I can't make money selling options with the time decay
working in my favor, the guy trying to buy options and fight the time
decay is in real trouble. The option seller is like the gambling house.
One has to be well capitalized and willing to make small, slow profits.
But those gains will definitely add up.
In search of a perfect strategy, I started from a premise that I wanted
a market that spent a lot of time going sideways. I like trading Live
Cattle options because when the market sells off, it usually springs back.
There is good underlying support from traders to always go long cattle,
taking advantage of the backwardation that is often present in this market
and the generally upward bias of cattle prices. Up moves are seldom straight
up with ample backing and filling of prices. There are rhythms and cycles
present and the support and resistance levels are clearly defined. There
are few false break-outs as there is usually follow-through when a support
or resistance level is breached.
The following relates to Live Cattle options but the information is generally
applicable to other markets as well:
Let me begin by setting up the conditions of my personal method for option
trading. You might be able to learn something from this that will make
you a better trader. I would love to hear some suggestions which might
help me improve my methods, heaven knows there is plenty of room for improvement.
When I originally sold uncovered calls and puts, I began by selling a
call and a put at the same strike price, known as a short straddle position.
I was taking the opposite side of the trades of persons who were buying
a put and a call, waiting for a violent reaction. I was hoping the market
went to sleep. To help expedite this, I decided to sell sleeping markets
that were going nowhere.
What I didn't realize was that with a dead market, the volatility was
low and thus the premiums I got from selling were at reduced prices. When
the market finally erupted, the values of both the puts and calls increased.
That increase in volatility killed me when I was shorting volatility
at the bottom when there was no room to diminish further. Therefore, to
do well selling options which always involves shorting volatility, it
is important to sell right after a strong move has occurred.
After the market advances a few days, the call premiums expand and that
is an excellent time to sell. I like to sell right into that strength.
When the markets decline I like to sell puts, selling right into that
strength of increasing put premium, as well.
Suppose December Live Cattle is in a trading range from $72.00 to $78.00.
Then suppose that the market is in the middle, say at $75.00. If the market
rallies to the top end of the trading range and then one sells out-of-the-money
calls, and then the market retreats to the bottom of the range and one
sells out-of-the-money puts, if the market returns to the middle, one
can have an extremely wide range of prices where a profit is assured.
I like to sell calls first because I find selling puts more tricky. This
is due to the fact that markets drop much faster than they go up, about
3 times faster I think.
By waiting for a rally before I sell calls, I get the benefit of the
fact there are more buyers of calls when the market is rising than when
it is falling. Selling into strength allows one to sell to traders rather
than local market makers, who virtually control the pits when liquidity
is low.
You also want to sell into strength because when the market turns at
a top, the premium usually diminishes very fast, because the call buyers are trying
to quickly take profits the same time you are trying to initiate your
short trade. There is an order imbalance and only a market order is filled
and that can be several minutes later at a very unfavorable price. It
is better to sell a little early rather than late.
The same holds true with puts, you want to sell into price weakness when
the put premiums are the highest. This goes back to being short volatility.
You want to be a lion tamer, putting your hands around the jaws of a wild,
ferocious lion, selling options when you can still hear the roar. When
things are quiet premiums disappear.
I call these options 'sleeping bears'. Let sleeping bears sleep. If you
should awaken them they will rip you apart from both ends as the puts
and calls both gain premium. When a market is limit up (down) is the best
time to sell calls (puts), as the premium of the option continues to rise.
The next day the option premium shrinks down, virtually guaranteeing
a profit. Often the panic buying of options causes a high during the day
of the locked limit move and if you time it right, you are making a nice
profit even that first day with the market still locked limit.
I have found that selling an option in the last hour of the day works
out best for me. Option traders, the next day wait around trying to figure
out which way the market is going and often don't trade for several minutes
after the market opens. Price fills are usually very poor.
They also often lag the market which gives them an excuse to either fill
you at a lower price than you theoretically deserve or not at all. On
the other hand, during the close I believe that someone is there to try
and keep the markets orderly so there is more credibility in option fills
by the locals at the end of the day because prices are going to be printed
in the newspapers and the trading prices have to roughly correspond to
the estimated values of the options.
The fills have to be in the ball park at the end of the day, whereas
during the day the options market is free to trade about anywhere. That
is just my theory.
I like selling options 7 to 8 weeks before expiration to maximize the
time decay of premium and try to get out about 1 to 2 weeks before expiration.
Since the options expiration of the meat and livestock options often correspond
to a meat report date, I never like to be in at the end when someone gets
to find out the results of the report and then decide at the end of the
day whether or not to exercise the option if it is in or very near the
money.
Near expiration, volatility can actually increase rather than decrease.
When I have recouped about 2/3rds of the option premium I look for a place
to take profits. Many times this has made the difference between a winning
and losing trade.
Numerous times the market rallies and the puts are almost worthless.
I take my profits and then the market tumbles a couple limits down and
those puts are now worth as much or more than I paid for them. But I don't
need to worry, as I already took profits.
I have predicted the wrong trend direction many times but because I was
able to take profits or a small loss during a correction, I am able to
get out of the losing positions in good shape and the winning options
more than make up for the losses.
As I described briefly above, I like to sell calls and puts at different
strike prices. This is called a 'short strangle'. I leg the position on
by doing one side or the other, depending on market conditions, my bias
of where I think the market is headed, and several other factors I consider.
I already mentioned how I usually like selling the calls after a counter-trending
rally and then later selling the puts. If on the other hand you think
cattle is going to trend up shortly and you don't mind getting long the
market, you can sell puts and effectively get a lower price than you would
have gotten equal to the premium amount received.
That would occur if the market trended strongly lower and the put was
exercised. If however the market reversed and went up, the put will lose
value and although you did not get exercised, you make money that way
and that is all that matters.
This time of year (Fall) is a good time to sell April puts on any weakness
as I wouldn't mind getting long the April contract if the market trends
lower and the option is exercised. On the other hand, the downside is
limited on the April contract due to the fact seasonally April cattle
has in recent years rallied to $80.00 or more during the January through
March or April rally. You win either way.
Today as I write this, December Live Cattle options have 7 weeks to expiration.
Cattle has just rallied from lows and a very oversold condition. Today,
December cattle closed at 74.70, very near the last swing high just around
75.20. The contract should begin to run into some resistance.
With the couple dollar premium that December is trading over October,
when October goes off the board next week and December takes over, it
is already a couple extra dollars higher than cash. Either cash has to
rally to the futures or the futures will need to come down. I believe
the futures will come down.
Feeder Cattle has a lot of problems in the cash market which should also
negatively impact on cattle prices. I am looking for sideways to possibly
higher prices near-term with a final break into December when cattle has
to compete with turkey for Thanksgiving and Christmas.
This slackness in demand comes at one of the worst times, when seasonal
slaughter numbers are up. Although I will be selling calls lightly at
this time to initiate the position. If we bottom early, I will be a very
aggressive seller of December and later February puts should the market
retest the bottom soon as I expect it to. I want to be effectively long
the market by January 1, so I can take advantage of the first quarter
rally.
I am experimenting with some different strategies right now, so I am
not strictly following my basic scenario. But for the readers I will go
through a dry run of what I anticipate will happen in the coming weeks.
I will keep the numbers in single units, but a person with sufficient
capital can double or triple these numbers while more conservative traders
could cut these positions in half.
Since Dec Cattle broke above the resistance today at 74.20, the next
resistance is around 75.20 and it is likely we will see that price on
Monday. However, there is a down-trending line which could contain the
contract right at today's closing price of 74.70.
So what I would do is to sell a set of two 76.00 Dec Live Cattle calls
into today's close, placing a limit order during the last hour of trading
with a cancel replace at the market if I am not sure I got filled, about
15 minutes before today's strong close.
One should have been able to do this at a premium of about 75 cents or
more today. As long as Dec Cattle does not go off the boards above 76.75,
I will be in a profit situation, less the commission of course.
However, this would require that December makes a new high which is of
course possible, but it is unlikely that it will happen immediately with
a move straight up with no correction.
Upper resistance will begin to mount above 75.00. If the market can close
at 75.20 or higher, I would sell an additional set of 2 Dec. 76 calls
at a premium of $1.00 or more. If the market never reaches 76.00 I pay
absolutely no attention to the premium I may be losing on paper, as my
account is well margined.
I do not get concerned until the options begin going into the money as
I intend to keep these options close to the time of their expiration.
When the market reaches 76.00 which I doubt will happen, but if it did,
I could double my original position. Since I have already sold 4 options
with a 76.00 strike price, I would now sell 4 77.00 calls and 4 78 calls.
If the market appears that it is going to close at a price of 76.00,
I am concerned only about the 4 original 76 strike calls as they are the
only ones going into the money. To balance out 4 calls one would roughly
buy 2 futures contracts based on a delta of about .50, meaning the option
premium of the calls rise 50 cents when the futures price rises a dollar.
However, I have gotten burned so many times buying 2 futures contracts
to balance this and gotten stung, that I will only buy one now, leaving
myself only half balanced. I have somewhat cured this problem by buying
earlier on a stop, say at 75.25 or 75.30 stop. Then by the time the market
reaches 76.00 I can stop myself out of the 75.30 futures contract if the
market takes a dive.
I don't want too many futures contracts going long, as I want to be able
to still improve my position if the market retreats. What I would do if
the market started rallying past 76.90, the approximate break-even for
the two 76 calls sold for 75 cents, and the two 76 calls sold for over
a dollar. That is not an easy question to answer. I guess I would have
to hang tough and maybe say a little prayer.
If sufficient time passes, before we hit these prices, I will have the
time to remove some options at little or no loss, reducing my exposure
and allowing me to sell ever higher priced calls.
If we reach these price levels very near expiration, the time premiums are
greatly reduced and the 77 calls will be making money and the 76 calls
sold for over a dollar will be making money so I will still net a profit
even when I was selling calls and the market kept going up.
A move into new market highs in the December Cattle contract would just
be a tough break. I would call it a worse case scenario. I believe the
market will find resistance at today's close, or somewhere above 75.20
and it will quickly begin dropping, putting me in great shape. Then as
the market tests the lows, I would sell puts.
If the market goes sideways, and the chances of the 76 or 77 calls getting
into the money, becomes very remote, I would sell more 76 or 77 calls,
making sure I get at least 50 cents premium, and hopefully 70 cents or
more premium for any options sold.
If the market drops, I would more aggressively sell puts as I want to
be long the market going into the new year. I want to be long cattle going
into February so in late November or early December, I will begin selling
February puts on any weakness.
It may ultimately turn out that I will have to move up a strike price,
and be further out of the money as I may be selling options that are too
close to the money. Some readers may not be aware that in the nearby option
month, the odd priced cents options trade so there is an option strike
every dollar rather than $2.
I believe the Wall Street Journal still prints only the even numbered
strikes, causing many traders to ignore the odd numbered strikes and greatly
reducing the volume, open interest and liquidity in these odd numbered
strike options.
How it will come out, only time will tell. As I'm still trying to figure
this out, I would gladly accept any options-trading suggestions readers may have about
this trading strategy as well as hearing about an options selling method
that someone else has found successful.
Trading Paradoxes
If you want to trade commodities you should know about the following
discoveries I have made:
1. Brokers will never fill you long, if prices come down and touch your
entry price and then go up.
2. Brokers will always fill you short, if prices come down and touch
your entry price and then go up.
3. Brokers will never fill you short, if prices come back up and touch
your entry price and then go down.
4. Brokers will always fill your long, if prices come back up and touch
your entry price and then go down.
5. In T-Bonds, in the first 10 minutes after the release of any report
at 8:30 am New York time, even if prices go through your entry point,
they will deny you a fill if there is profit after that fill.
6. However, Brokers will always fill you if there was a loss after that
fill!
Where is the FBI when all this is going on? Brokers don't prevent this
rape, all they do is come after the rape has taken place and harass you
to go over the whole thing again and again, and torture your agony.
The Viewpoint of a Commodity Trade
The Right Stuff - Contrary to popular opinion, the most important factor
in trading profitably is not "knowing" where the market is going.
Nobody knows for sure exactly what a given market will do next! The most
important thing is to have a plan of attack that will allow you to successfully
cope with the uncertainty that is an inherent part of trading or investing
in anything.
It is a well-documented fact that the world's most consistently successful
investors and traders in any market, including stocks, bonds, commodities,
etc, do not have any inside information and do not know what will happen
next.
What they do know is that they have an excellent chance for success in
the long run if they can develop the discipline to stick to their plan.
Their "secret weapon" is that they have survived their mistakes
long enough to develop a good clear common-sense trading plan. Any they
survived long enough to learn that even though their plan isn't perfect,
it is more profitable to exercise the discipline to stick to the plan
through thick and thin, than to deviate from it after some losses.
So you see, this discipline to follow a plan even when the chips are
down, so crucial to success, comes from the confidence that comes from
experience. If you do not have the time and/or inclination to develop
your own trading plan, develop supreme confidence in that trading plan
and the discipline to stick to that trading plan, then the odds will be
stacked against you. That is, unless you can join forces with someone
who does have the time, inclination, plan, experience and discipline to
trade successfully.
"There are those who sit and wait for the world to change for them.
Some few guess correctly that they are the ones who must change. In commodity
trading, one usually gains by yielding, by admitting that he needs help,
that here is a better way."
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