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Why Selling Options Makes the Most Sense 90% Wins
I recently read that 90% of options expire
worthless and about that same percentage of option buyers 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 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 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 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 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 suggestions readers may have about this trading strategy as well as
hearing about an options selling method that someone else has found successful.
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