Option Strategies

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Option Selling or "Writing"

Many traders opt to buy options in an effort to maximize gains and limit losses to the purchase price of the option. On the surface this seems ideal, except for one major flaw: time decay. The Chicago Mercantile Exchange estimates that over 80% of all options expire worthless. Those who sell these options to the buyers are known as option writers or sellers. Their objective is to collect the premium paid by the option buyer. Option writing can also be used for hedging purposes and reducing risk. The writer has unlimited risk and a limited profit potential: the premium of the option minus commissions. In appropriate situations you should consider selling out-of-the-money options instead of buying them. Here are some reasons why: top

Benefits of Option Selling

• Time Value: When selling out-of-the-money options, time value works for you instead of against you. The buyer of the option pays you a premium for that option. The longer the buyer holds the option, the more time decay works against him, especially as the option nears expiration. As time passes, the option will lose 100% of its time value.
  
  
• Overvaluation: Besides time decay, another reason we have found option selling so attractive is that small traders most often purchase options. Historically, small traders, as opposed to the large commercial or fund traders, are almost always on the losing side of the trade. Statistics bear out that the small trader tends to buy options, especially call options. Often these options get bid up at exaggerated, overbought prices and when the rally ends the option buyer is often left holding a deteriorating asset which was gladly sold to him or her by the professional trader.
  
  
• Three Ways To Win: There are three ways to win as an option writer: The market can move in the opposite direction from the option sold, it can trade sideways, or it can even go against you but not through your strike price. The advantage is time decay.
   
  
• Taking Profits: One of the hardest parts of futures trading is deciding when to take profits. With option selling, if the market behaves favorably towards your position, you won't need to make this decision. As time value decays your option, the market will gradually take profits for you. Upon expiration, if the option still has not reached your strike price, the entire premium for which you sold the option will be in your account. At this time, your position automatically closes out.
  
  
• Less Stressful Trading: Selling out-of -the money options removes much of the stress and emotional decision-making that is common in futures trading. Option selling usually places your position in the market far enough away that short term swings in the market may not dramatically affect your position.
  
  
• You Don’t Have To Predict Prices: Instead of trying to predict where prices will go, you are projecting where you think prices won't go. We have found that most of the time prices tend to stay in a trading range.
  
  
• Favorable Statistics: The fair market value of an option is a statistical value based on the volatility of the underlying asset and is calculated to give the seller of the option approximately an 85% chance of making consistent gains. This means that a buyer of an option has an 85% chance of experiencing consistent losses over the life of the option. top
  

The Option Selling Strategy

As an option seller, you do not have to be concerned so much as to where the price will go, but more importantly where the price will not go. The objective is to select options with the highest probability of expiring worthless. Heritage West uses both fundamental and technical analysis to project the general direction of the underlying futures market on which options will be sold. Then, far out of the money options with 1-1/2 to 4 months time remaining until expiration are selected for consideration. Strike prices are selected that could only be achieved through a dramatic change in the fundamentals of the market.

This gives the market plenty of room to make short-term moves against your positions, thus avoiding the "noise" that forces futures traders to be stopped out of the market.

Time Value

An option's value is made up of intrinsic value and extrinsic, or time, value. The intrinsic value is how far the option is “in the money.” For example, if July silver were at 5.50, the July silver 5.25 call option would have 25 cents of intrinsic value. The balance of the option’s value would consist of time value - how much time remained until the option’s expiration. If a trader sold a July silver 6.00 call option, that option would be 50 cents out of the money and therefore have no intrinsic value. The full value of the option would consist of solely time value. July silver would have to move a full 50 cents before the option would be in the money and have any intrinsic value at all.

As a seller of options, you are selling time value. As long as July silver stays below 6.00, the option will have no intrinsic value. Its only value is time value; as time passes, the option's time value will erode, slowly at first, then accelerating towards the end. The movement in the futures market can temporarily affect the value of the option as well. A move higher can temporarily propel the value of the option higher, but it will still have no intrinsic value if the futures price is below 6.00. Futures prices moving lower will accelerate the deterioration of the option.

In conclusion, if you are bearish silver and you sell a July 6.00 call, the market can move lower as you predicted, stay the same, or even move higher. As long as the price is below 6.00 at expiration, the option will have no intrinsic value and expire worthless, allowing you, the seller, to keep all premium collected as profit. top

The graph below illustrates an option’s eroding time value.

Volatility

Volatility is the most important factor when determining which options to write. Volatility is the measure of the rate and magnitude of change in the price of an option in relation to the change of the underlying futures contract. If volatility is high, the premium on the option will be relatively high, and vice versa. Many option traders fail to understand how volatility affects the price of options and how to utilize volatility to capture profits. 

Sell Overvalued Options; Buy Undervalued Options

The following graph shows the volatility levels of soybeans options over a six-year period. Notice the consistent pattern. Volatility is lowest in the inactive post-harvest to pre-planting period November to May. As the growing season gets underway volatility increases, usually peaking in July when extreme summer temperatures pose the greatest threat to soybean yields. Taking into account fundamental and technical criteria, you would look to buy options when they are undervalued (cheap), and sell them when overvalued (expensive).

A Word About Risk

Heritage West Financial believes in the prudent writing of options as part of a disciplined overall futures and options trading program. However, we advise against selling options without the advice and expertise of a knowledgeable specialist. Remember, writing options carries the same risks as trading futures, and although the percentages are in your favor, these risks should be treated with the same respect. In addition, if the market moves against your short option position, your margin requirements may increase as well. We also believe in using stops based on the underlying futures price, not on the value of the option. Once a market trades through an area perceived as strong support or resistance we recommend exiting positions. At Heritage West, your broker will work with you in analyzing the risk parameters of each trade and which positions may be suitable for you.

Option Buying & Spreads

Most options expire out of the money and worthless; therefore most traders lose when buying options. Heritage West still believes there is opportunity in buying options; however, you must be very selective. We don’t believe in buying options just because a market is extremely high or low. One must consider the fundamental and technical conditions of the market, along with historic and statistical option volatility and all other significant trading factors. Remember, though, the key factor is still going to be picking the correct market direction. There are usually several different trading scenarios and strategies to take advantage of an emerging profit opportunity. We will help you implement the correct strategies to suit your objectives and risk parameters. There are strategies that combine both futures and options designed to mitigate risk while still providing significant profit potential. top

Here are a few examples often used:

Bull call or bear put spreads involve the writing and buying of options at the same time. If corn were trading at 240, we could buy one corn 240 call and write one 280 call with the anticipation of corn trending higher. The 280 call sold would subsidize the 240 call, and likely produce a much better risk to reward ratio. The profit is limited to the difference between the 240 and 280 strike prices, less the net premium debit.

Ratio spreads involve buying calls or puts and writing multiple calls or puts that subsidize or even pay in full for the options purchased. If corn were trading at 240, we could buy one corn 240 call and write two 280 calls with the same expiration date. This would be in anticipation of corn trending higher, but not above 280 before option expiration. We'd be collecting the same amount of premium as the option purchased, so even if corn continued lower we'd lose nothing. Our highest profit would be attained at 280 based on option expiration. We would have 40 cents or $2,000 gross profit on the one 240 corn call we purchased and the two 280 calls sold would expire worthless. Above 240 we would give back our profit penny for penny up to 320, our break-even point based on option expiration. There is risk on the one uncovered 280 call above 320, based on expiration. Above that point we would lose penny for penny.

The Option Greeks

Gamma

Gamma, measures the rate of change of Delta. When call options are deep out of the money, they generally have a small Delta. This is because changes in the underlying bring about only tiny changes in the price of the option. But as the call option gets closer to the money, resulting from a continued rise in the price of the underlying, the Delta gets larger.

Gamma is the change in an option’s delta for unit change in the value of the underlying asset. The gamma of a long option position (both calls and puts) is always positive. At-the-money options have the largest gamma. The further an option goes "in-the-money" or, "out-of-the-money" the smaller is gamma.

• If you are long gamma you expect the underlying to make large moves. Traders with long positions expect positive gamma
  
• If you are short gamma you expect the underlying to remain relatively inactive. Traders with short positions expect negative gamma
  
• Gamma is a useful indication of the risk associated with a futures position. A large gamma number, whether positive or negative indicates a high degree of risk and a low gamma number indicates a low degree of risk. top

Delta

Delta is the amount by which the option changes compared to the underlying asset. It is a measure of the probability that an option will expire in the money. Call deltas can be interpreted as the probability that the option will finish in the money. Put deltas can be interpreted as -1 times the probability that the option will finish in the money.

An at-the-money option, which has a delta of approximately 0.5, has roughly a 50/50 chance of ending up "in-the-money". For example, if an at-the-money wheat call option has a Delta of .5, and if wheat makes a 10-cent move higher, the premium on the option will increase approximately by 5 cents (.5 x 10 = 5), or $250 (each cent in premium is worth $50). The interpretation of Delta values is as under:

• Call options: 0 to 1
• Put options: -1 to 0
• In-the-money options: Delta approaches 1 (call: +1, put: -1)
• At-the-money options: Delta is about 0.5 (call: +0.5, put: -0.5)
• Out-of-the-money options: Delta approaches 0
• Long Calls have a positive delta -You want the market to go up
• Short Calls have a negative delta -You want the market to go down
• Long Puts have a negative delta -You want the market to go down
• Short Puts have a positive delta -You want the market to go up

Delta is useful as a hedge ratio. A futures option with a delta of 0.5 means that the option price increases 0.5 for every 1 point increase in the futures price. For small changes in the futures price therefore, the option behaves like one-half of a futures contract. Constructing a delta hedge for a long position in 10 calls, each with a delta of 0.5 would require you to sell 5 futures contracts.

As time passes, the delta of in-the-money options increases and the delta of out-of-the-money options decreases.

Theta

Theta is defined as the change in the price of an option for a 1-day decrease in the time left for expiration. At-the-money options have the greatest time value and the greatest rate of time decay (theta). The further an option goes "in-the-money" or "out-of-the-money", the smaller is theta. As volatility falls, the time value declines and hence theta also declines.

• Theta is the rate at which an option loses its value as each day passes.
• The inherent assumption is that the options are a "wasting asset."
• Long options have negative theta
• Short options have positive theta

As time passes, the theta of at-the-money options increases, the theta of deep in-the-money and out-of-the-money options decreases.

Theta has the exact opposite characteristics of gamma. Thus the size of a gamma position correlates to the size of the theta position. A large positive gamma position goes in hand with a large negative theta position, while a large negative gamma position goes hand in hand with a large positive theta position. What this means is that every option position is a tradeoff between market movement and time decay.

Theta is not used much by traders, but it is an important conceptual dimension. Theta measures the rate of decline of time-premium resulting from the passage of time. In other words, an option premium that is not intrinsic value will decline at an increasing rate as expiration nears.

Vega

Vega is the change in the value of an option for a 1-percentage point increase in implied volatility of the underlying asset price. Implied volatility is measured as the annualized standard deviation of an asset’s daily price changes. The Vega of a long option position (both calls and puts) is always positive.

At-the-money options have the greatest Vega. The further an option goes "in-the-money" or "out-of-the-money", the smaller is the Vega. As time passes, Vega decreases. Time amplifies the effect of volatility changes. As a result, Vega is greater for long-dated options than for short dated options.

• As volatility falls, Vega decreases for in-the-money and out-of-the-money options; Vega is unchanged for at-the-money options.
  
• Vega is the option’s change in theoretical value with a change in volatility.
  
• Most options have a positive Vega because they gain value with rising volatility and lose with falling volatility

Vega of most options decline as time to expiration grows shorter. Vega tells us approximately how much an option price will increase or decrease given an increase or decrease in the level of implied volatility. Option sellers’ benefit from a fall in implied volatility, and it’s just the reverse for option buyers. Vega can increase or decrease even without price changes of the underlying because implied volatility is the level of expected volatility

If you would like to discuss these methods of option buying and selling, or assembling an option portfolio, please feel free to call us at 800-263-3004.

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