Selling Options - The Real Story

There are old sayings in the futures industry that go something like this: “Eighty percent of all options on futures expire worthless.” And, “The only way to make money trading options on futures is to sell them--not buy them.” Neither one of these statements is accurate. This educational feature will focus on the advantages and disadvantages of selling (also called “writing”) options on futures.

But before I discuss writing options on futures, let me first elaborate on the first “old saying” that 80% of options on futures expire worthless. While I have heard the saying many times through the years, I have never seen credible statistics on the percentage of futures options “that expire worthless.” Maybe it’s because such a statistic cannot be compiled.
Consider this: If a trader hedges his straight futures positions with options purchases, and those options do perform their function of limiting risk for a period of time, then those options have performed their intended function--even though they may expire “worthless.” Also, most speculative options buyers who make profits on trades do sell their options before they ever expire. Thus, I expect it would be very difficult, if not impossible, to have any accurate statistics on the number of futures options that are bought and sold that did not successfully fulfill their intended purpose.

A major appealing factor for speculative traders to sell (or write) options, as opposed to purchasing options, is that the odds are more favorable for producing a winning trade. Reason: If a trader is writing options, generally the market can move “against” the trader by a certain amount before the trader sees his option’s strike price hit and he starts to lose money. Also, the option writer has “time decay” working in his favor—meaning that the day the option is sold, its time premium starts to decay as the option moves toward expiration.

Now you might be thinking this options-writing stuff all sounds pretty easy, huh? Well, hold on just a minute! Remember that there are trade-offs in every aspect of trading futures. Here’s the “rub” with selling options:


--First, the premium traders collect for writing options is generally not nearly as much as the profits a trader would collect on a straight futures trade or a winning options purchase trade. For example, if a trader sells a call option on corn futures for 10 cents, that is his profit. But then he has to wait (or “squirm” might be a better way to put it) until the option expires to secure his profit. For many traders, pocketing just 10 cents profit on one corn contract is not much, so they may sell several contracts to make a bigger overall profit. Read on…

--Second, when writing options (just like in straight futures trading) you cannot absolutely limit your risk of loss. Margin money is required by the broker.

-- Finally, there is one more “old saying” regarding writing options on futures. It goes something like this: “A trader will make money and make money and make money writing options…until that one time when an option sale will go against the seller. And that one options sale will then take back all the profits that were made on the previous winning options sales—and then some.”
do want to be clear on one point. There are very good and successful traders who do employ options-writing strategies. I have another “old saying” that I use frequently when discussing a trader’s methodology. “If it ain’t broke, don’t fix it.” If there are options writers reading this educational feature and you are having and have had consistent success—more power to you! The main point I want to make in this feature is that there is generally more risk and generally less reward involved in writing options than in purchasing options on futures. The one big advantage of buying options on futures is that the price you pay for the option is the most you will ever lose on that trade. Also, there is no margin required. That’s very good money management.

We’re sure you’ve heard of exchange traded funds (“ETFs”). Even though ETFs have only been around 15 years (starting with Standard & Poor’s SPDR back in 1993), it seems ETFs have gone mainstream and become the new “in” investment, much like mutual funds in the ‘90s.

But few mainstream investors take advantage of currency investing with ETFs – considering these special currency ETFs have only been available since 2006.

The official name for the currency ETFs is “Currency Trusts.” At last count, you can buy nine currency ETFs through any normal stock broker. You can buy all right on the New York Stock Exchange, except for the PowerShares DB G10 Currency Fund (DBV) which trades on the AMEX.

These ETFs mimic the spot price of the underlying currency they target – they hold actual currencies rather than futures contracts. A single share of each ETF represents 100 units of the base currency.

Here are some of the major benefits of this product:

Liquid at all times

Trade them as often as you'd like, at anytime during regular market hours
No minimum investment
You can short-sell
You can use margin and enhance your leverage
Price is tied closely to the underlying currency
Hold them as long as you like – no time premium or expiration – so you can ride the long-term trend

Google for more info

I know that many beginning (and even veteran) traders think options trading is too complicated, and they don't have a clue about the vega, theta, delta and gamma pricing formulas--or the strangles, straddles, butterflies and other such options trading methods. Well, don't worry. I'm not going to get into those strategies in this thread.

Entire books have been written on options and options-trading strategies, but I will only focus on a few basic, low-risk and limited-risk trading strategies for beginning traders (and veterans, too). I'll also briefly talk about using options to "hedge" winning trading positions in volatile markets. I do suggest that if you are interested in trading options, you should read a book or two on options trading. Again, you don't have to be a rocket scientist to employ simple options-trading strategies.

First, I am going to assume readers know the definition of an option on a futures contract, and also the difference between a put option and a call option and "in the money" and "out of the money." (If you don't know the meaning of these terms, that's okay. Just go to one of the big futures exchange websites, and you can find a glossary of trading terms, digest the options terms and then read this article.)

A while back there was a big runup in the price of crude oil. It certainly was tempting for many traders to want to short that market at those sharply higher price levels. However, remember that to successfully trade futures you not only have to be right on market direction, you also have to be correct on the timing of the market move. Furthermore, you can be right on market direction and very close to being right on timing the trade, but still lose your trading assets because of market volatility. In crude oil, for example, a trader could have established a short position two days before the top in the market was in, and still be stopped out and lose his trading assets because of the high volatility.

Purchasing options allows you to limit your financial risk and let's you ride out volatile market swings without the worry of increased margin calls.

Buying a put or a call that is "out-of-the-money" is a relatively inexpensive way to wade into futures trading. The money the trader lays out to his broker for the option purchase is all the trader has to worry about losing. No margin money. No margin calls. He can sleep well at night. And he is still trading futures, learning the business, honing his trading skills.

Here's another trading tactic to think about regarding purchasing options in volatile markets. Just because you have a protective buy stop or sell stop in place when trading straight futures contracts, that does not guarantee you will get out of the market (filled) close to your stop. For example, weather markets in the grains and soybean complex futures can produce limit price moves--sometimes for two or more sessions in a row. If you have a straight trading position on in soybeans and the market moves against you by the limit, or multiple limits, your protective stop is virtually worthless. But if you had hedged your straight futures position with a cheap out-of­the-money option purchase, you have limited risk in a volatile market.

Let's say you are long soybeans at $5.00 in a highly volatile market. You initiated that trade on the long side, but then decided to purchase a $4.50 put option that limits your trading risk to 50 cents a bushel ($2,500 per contract), plus the price of the put option purchase. The trade-off here is that you are gaining peace of mind and losing some profit potential. But for many traders, that's well worth it. You can stay in the game to trade again another day, and won't get wiped out by a limit price move.

There are trade-offs in purchasing and trading options on futures, as opposed to trading straight futures. If you purchase "out-of-the-money" options, the market has to move in your favor for a period of time before your option becomes "in-the-money." During periods of high market volatility, the prices of options can and usually do increase substantially.

One more thing: Anyone considering trading options on futures needs to check the open interest level on the particular "strike price" they are contemplating trading. Just like in straight futures trading, the more liquid (higher open interest) strike prices and options markets are usually more desirable to trade.