Commodities Roundup: 7 Ways to Collect Higher Option Premiums
James Cordier, Michael Gross, OptionSellers.com
April 18, 2011
As a group, Option Sellers tend to be efficiency oriented. Always attuned to maximizing odds, sellers key towards being efficient. And efficiency can often mean getting the most “bang for your buck.”
To option sellers, that means collecting big premiums.
There are many ways to bring in higher premiums for the options you sell. Leaning towards a more risk averse stance, we do not recommend all of them at all times. However, taken as a whole, the list below will give you a solid primer on putting the maximum amount of premium in your account when you write options.
1.Sell Naked : Spreading has it’s merits. But for pure premium collection, there is no way to get bigger premiums and realize them faster than selling naked. While the word conjures up images of being “exposed” and thus discourages many investors from exploring it, naked option selling can be done responsibly and effectively. It’s the cornerstone of our philosophy, our portfolio strategy and our book. While risk must sometimes be managed a bit more closely than “covered” risk, you are doing yourself and your portfolio a disservice if you do not consider selling naked in at least some situations. It’s the power play, the strong side sweep, the right hook in an option seller’s arsenal.
2.Sell Strangles: Selling strangles is possibly our all time favorite option selling strategy. While not ideal for hard trending markets or breakout moves, selling strangles (selling a put and a call in the same market) can be an amazingly versatile strategy. It can be deployed in a wide variety of market conditions and has a magical effect on boosting your premium: Doubling your premium collected while reducing your margin requirement (as a percentage of premium).
For instance, selling the put may bring in $500 premium and carry a $1,000 margin requirement. Selling the call may do the same. But selling them at the same time brings in the same premium but lowers the margin requirement. Thus, selling the put and call together brings a greater return on invested capital. As a bonus, selling a strangle also comes with some built in risk temperance. A move against your call is at least partially offset by gains in your put (and vice versa). Thus a strangle can be a flexible way to build account premium quickly. Strangles can be effective even in directional markets. In a recent Option Seller Newsletter, we outlined a corn strangle for clients, even though we expected a more directional trade.
1.Sell Closer to the Money: While not our first choice for collecting higher premium, selling closer to the money will increase the premiums you collect. For the risk adverse, it may not be your first choice either. The closer you sell to the money, the better chance for your options to go in the money – a place no option seller wants to be. At the same time, moving a strike or two closer can sometimes make a big difference in the premium you bring in. Especially in markets where deep out of the money strikes are available and fundamentals support your position. For instance, if Coffee is at 1.50 per pound, it probably isn’t going to make a big difference from a risk standpoint if you sell a 2.90, 2.80 or 2.70 call. But it could make a noticeable difference in the premium you collect. In this type of situation (all strikes are deep out of the money,) selling the closer strike can make sense.
2.Sell more time: In our opinion, this is a more conservative method of collecting higher premiums than #3. But effective. So effective, in fact, that we rank it near the top of the list in The 7 Best Kept Secrets booklet. It’s a fact that the more time left on your option, the higher premium you can collect. The tradeoff is that you have to wait longer for the option to expire. Many traders do not have the patience for this. Others feel that selling more time allows a greater window for something to “happen” in the markets. If you want to reduce the chances of something “happening” to your position, know your fundamentals. This concept is the basis for our strategy when positioning managed portfolios. Sharp moves can happen in any market. However, they are less likely to happen in markets where fundamentals do not support them. Selling more time can be a slow path to higher returns.
3.Sell Volatility - Fade the News: Its not secret to most any option seller that higher volatility means higher premiums. Volatile markets bring in more speculators who not only drive prices in the underlying, they buy options. This means demand and thus premium for the options goes up. Typically, as an option seller, this will mean opportunities for you. This is not to suggest you should sell in front of runaway, breakout moves. However, a spike in volatility often makes the “ridiculous” strike prices that we refer to in The Complete Guide to Option Selling, temporarily available to option sellers. People (investors are people), tend to get carried away or lose their heads in the excitement of fast moving markets. As an option seller, you can use these situations to your great advantage. After a spike in volatility can often be a great time to sell options. A good example is after a surprise report. An unexpected number comes out and prices of the commodity in question must adjust to reflect the new numbers. This is often (though not always) done quickly – over a period of 1 to 3 trading sessions. After that, the market has priced the new number and trading resumes as normal. It is even common for the options to “price in” the most extreme possibility in the first day and then adjust its value lower – even as the price of the underlying continues to move towards it. These can be ideal conditions for collected fat premiums – again, however, only if you know the fundamentals. Other types of volatility surges, such as weather events are more fluid and require more caution. Reports are solid and the market can adjust to them quickly. Weather is constantly changing and thus, selling options in weather markets can get dicey, especially for beginners.
Selling premium against news events can be a good way to collect large premiums. The market often (but not always) prices the effects of an event within the first few days of it’s occurance. Options can sometimes far overprice the effects of an event.
Many old time traders favor the “Wall Street Journal Rule.” If a commodities story makes the front page of the Wall Street Journal, it’s time to fade the story. It’s not a guaranteed strategy, of course. As a rule, however, fade the news. Selling options against the hype can be a good way to get big premiums.
1.Leg out of Credit Spreads: Since the title of this column is not “How to run the most effective, risk adverse option portfolio” we will refrain from preaching the merits of credit spreads and instead offer just a brief tip for increasing your premium from them. A credit spread involves selling an option (or group of options) and then buying another option of lesser value to protect or “cover” your short option. Many sellers of credit spreads simply put them on and let them expire, keeping the “credit” (the difference between the two options) as profit. There is nothing wrong with this and it can be a conservative way to build a portfolio. However, to squeeze a bit more profit out of your credit spread – try this: Sell your protection early. Once the short options in your credit spread have decayed by 70-80-90%, the risk in them drops accordingly. This can be a good time to sell your protective option(s) back to the market. Obviously, they will have decayed as well. However, you will recapture some of the premium you paid for them. This can boost your overall return on the spread.
2.Use a Pro Floor Trader: Option trading on commodities is one investment vehicle where using a floor trader in the pit can still offer you an advantage. Limit orders placed on commodities options through electronic markets can often sit unless a trade actually takes place that “triggers” a fill. In other words, it has to be filled. Floor orders are actively worked by brokers. And if your limit order does not get filled, a floor broker can give you an “active” bid/ask – something that does not always show up on an electronic screen. This is especially true in placing larger orders which floor brokers are very motivated to fill. A good floor broker can sometimes work the order for a better fill. More importantly, they can sometimes get filled on a ticket that might be overlooked in the electronic market.
A final word: Collecting the biggest premiums is not necessarily always congruent with having the best return at year’s end. To successfully manage your option selling portfolio, you must balance premium collection with responsible risk management. Each of the items listed above can indeed boost your premiums. However each also comes with it’s own unique risk of implementing it. Any one of these methods will not be right for every situation. These are a list of strategies and tools you can use. How you apply them will determine your ultimate performance.
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