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:
Benefits of Option Selling
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.
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.
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.
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.
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.
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.
The graph below illustrates an option’s eroding time value.
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.