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Selling Options Profit from a Bad Economy

Another past article on selling option worth thinking about. They say option buyers loses about 90% of the time well what does that do for the option seller + $$$$

Clink on link below to vies the chart.
on Gold.


Commodities Roundup: Selling Options to Profit from a Bad Economy

James Cordier & Michael Gross, Optionetics.com
September 27, 2010

In case you didn’t hear the good news, the recession is over. The official announcement came this week. Yes, indeed, it ended last year. So we can all quit our belly aching and get back to what we were doing. Whew – Glad that’s over. It's curious that this profound announcement comes 45 days prior to an election.

Regardless, many high net worth investors are not feeling the love. Bad enough are impending tax hikes and suffering practices and businesses. But throw in the fact that most asset-based investments (other than gold) have been lackluster at best and you have a class of investors that is probably not yet ready to rejoice in the “slow but steady” growth.

Many investors believe that because their stocks, real estate and other assets are performing poorly, an option writing portfolio would have to suffer the same fate. These investors would be wrong.

As an option writer, you have the ability to adapt your portfolio to any market or economic condition – bullish or bearish. Do it right and you can not only beat your other investments, you can thrive in an otherwise unfriendly economic climate.

The Economy, The Fed and Commodities

Much of what we at Liberty Trading preach to new commodity investors is the importance of knowing the fundamentals of each commodity. Supply and Demand plays a major role in dictating price direction of any commodity such as Crude Oil, Corn or Silver. In my opinion, there are many less factors to consider when analyzing a commodity than there are when analyzing a stock. That’s a big reason why I don’t sell stock options (although I don’t dismiss it as a valid strategy).

While fundamentals are unquestionably important in commodities, there are times when the Macro-economic conditions take center stage and must be given their due weight. Late 2010 appears to be one of those times.

The “recovery” is not taking place as quickly as many would like and there is the real fear that a double dip recession could occur. Even optimistic forecasts have the US economy growing at only 2.5 – 3.0% next year. This has the Fed leaving the window open for further “quantitative easing” which is Fed lingo for “we’re going to expand the money supply.” All this in an effort to further stimulate the economy (further lower mortgage rates) and at the same time stave off deflation.

Yesterday’s announcement by the Fed that quantitative easing was a possibility down the road torpedoed the dollar and further spurred gold prices to new record highs. A dollar worth less means an ounce of gold would take more dollars to buy. Therefore, gold prices tend to rise when the dollar falls.

As long as the spector of quantitative easing looms in the background, upside action in the US dollar will most likely remain limited. And a weaker dollar is often a supportive factor to commodities.

One must be careful however, not to position a full option selling portfolio based on one single factor. A weaker dollar does not always mean a bull market in all commodities. Individual fundamentals of a commodity can offset or even trump the value of a weaker US dollar. Each must continue to be judged on it’s own merits. For instance, a weaker economy could mean less demand for certain products, pressuring prices to the downside.

Gold as the Exception

Gold, however, is much less subjected to supply/demand fundamentals in its price discovery process. Economic factors along with investor and fund interest are what typically drive gold prices. Soros may be right that gold is a “bubble.” But that bubble might not burst for years. Yes, it’s overbought. Yes, it has a huge speculative position making it vulnerable to corrections. But yesterday’s Fed comment should keep most of them from running to the doors for the time being.

I personally believe there are many ways to play the gold market right now and have recently even suggested selling call options simply because they are available so far out of the money.

While I still believe that to be a valid strategy, new futures option sellers that believe the value of the dollar will continue to decline over the next 3-6 months can enter a simple trade and feel good about it.

They can sell gold puts. For dollar bears, this is as pure of a play as it gets. The example below illustrates how.

Review of Selling a Futures Put Option

Chart 1: April 2011 GOLD FUTURES

The Trade:
An investor who is neutral to bullish gold prices sells an April Gold put option with a strike price of $975. Upon doing this, he receives a premium from a buyer on the other side of the market. In this example, we will assume he collects a premium of $500.

Condition for Profit:
As long as Gold Futures prices are ANYWHERE ABOVE $975 per ounce (the strike price) when this option expires in April, the investor keeps the $500 as his profit.

What is the cost?
There is no cost per as he is not buying anything. However, he must put up a deposit to hold this option until it expires. In futures language, this deposit is called a margin requirement. In this case, the margin requirement to hold the trade is about $1000.

What is the risk?
The Risk is that April Gold futures fall below $975 per ounce (the strike price) in which case the investor could incur a loss. However, he can exit this option at any time prior to expiration.

Selling gold puts is not a method to hit the “home run” if gold prices soar this winter. However, it can be an excellent choice for investors that look for high percentage plays to take more modest but steadier profits throughout the year.

That’s why selling deep out-of-the-money gold puts seems to make so much sense. You’re not going to hit the highs or the lows on the head. But get the long term direction right (or at least don’t get it too wrong), and you can do very well. Notice that even in the case of a moderate correction in gold prices, this strike sits far enough below the market to remain out of the money.

We at Liberty Trading don’t see gold prices dropping below $1,000 an ounce in the near future. As a (put) option seller, that’s all the analysis you need to do. In this case, you profit as long as gold prices do not collapse.

It’s one way to beat the “bad economy” blues.

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.

James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group/Optionsellers.com
Optionetics.com ~ Your Options Education Site

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Selling Options Profit from a Bad Economy