James Cordier, OptionSellers.com
March 28, 2011
Deciding to allocate capital to an option selling portfolio can create a maze of questions. When you are initially learning about selling options, especially if you are considering going it on your own, one of the first questions that probably enters your mind is "How do I know the best options to sell?"
This is a broad subject simply too complex to answer completely in a single email seminar. In reality, there probably isn't any one "best" option to sell. If it expires before hitting your risk parameter, you sold the right option. However, there are a few guidelines you can gain here that will get you started in the right direction.
One of the first questions on any new option seller's mind is "How do I know the best options to sell?"
Ideally, you want to pick options that not only expire worthless, but quietly decay to zero – preferably well before expiration. At least, that is the objective of the premium collection program that I recommend. Some options that expire worthless can also have "interesting" swings in value prior to expiration. While these can ultimately provide profits, they don't work so well for the investor's state of mind! Your objective is to select the former, avoid the latter.
Therefore, while there are no hard and fast rules for selecting the "best" options to write for your commodities portfolio, here are presented some general guidelines that may help you. These are the same guidelines discussed in more detail in The Complete Guide to Option Selling.
The recommendations below are recommendations based on my 25+ years of experience as to what makes money consistently, and what doesn't. Before the option geniuses out there write in to argue with me, let me preface these suggestions again. There are many ways to trade options. The suggestions below are simply what I have found to produce most consistently (and with the least trading "excitement") in the portfolios I manage.
Three Guidelines for Successfully Selling Commodity Options Consistently
1.Know your Fundamentals. Unlike equities, commodities are almost always dependant on their physical supply/demand fundamentals for their ultimate price direction. While institutional money or public sentiment can still play a role in commodities in the short term, a massive list of commercial players are buying and selling the futures contracts to hedge actual usage or production of the commodity. Supply/Demand fundamentals play a sizable role in determining future commodity prices
These commercial traders are keenly aware of the actual supply and demand for these products. You should be too. Fundamentals can give you a fairly clear idea of where prices will not go and provide you with an advantage over the average commodity investor who is simply following a chart. Combining this knowledge with a high percentage strategy such as option selling can be a potent combination. There are many good sources of fundamental data for investors such as the USDA, the EIA, news wire services or private sources such as The Option Seller Newsletter.
2.Sell Deep out of the Money. Select markets where premium is available 50-100% out of the money. Rarely possible in stocks. Quite feasible in commodities. This forces the market to make an extreme move against your position to put the option in the money. It also allows you to manage your risk based on the option value – not on the price of the underlying or it's proximity to your strike.
Chart: Selling Deep out of the money means seeking strike prices 50-100% away from the current price of the commodity
3.Trade Time for Distance: This is the cornerstone of the entire investment plan we recommend for high net worth individuals. Many books and courses that address selling options will advise selling options within 30 days of expiration to gain the fastest time decay. While this may make sense for option sellers collecting premium on open stock positions, I couldn't disagree more when it comes to pure premium collection in commodities. Getting any significant premium with this little time means selling close to the money – too close for a person that enjoys their sleep as much as I do. Close to the money strikes may decay quickly if you are right the market. But even a temporary fluctuation can put your option in the money. Guessing short term market direction is exactly what we are trying to avoid by selling options. Be willing to sell options with more time (3-5 months) and much further out of the money. If you fundamental synopsis is even close to being right, these trades should work well for you.
Of course, selecting the right strategy, managing risk and structuring your portfolio are all important too. But selecting the right options to sell is where you start. Getting that part right makes the rest of managing a portfolio quite a bit easier.
