The Risks and Rewards of Selling Commodity Futures Options
When it comes to trading and investing, most market participants are more comfortable buying and going long rather than selling and going short. There is something in the human psyche that makes it easier to be positive than negative -- therefore most market participants are optimists rather than pessimists. When it comes to the world of options, the same holds true. Many investors are afraid of selling options.
This is understandable because when one buys an option all that is at risk is the premium for the instrument. In other words, a long option yields unlimited profit potential while limiting loss to the premium paid. Therefore, options are insurance contracts on price.
The concept of price insurance is at the very heart of option trading and investing. When it comes to the insurance business, there are the insurance companies and the insured. The insured pay premiums and the insurance company collects them. So long as the insurance companies collect more premium than they pay out in claims, they are profitable. As we all know, insurance companies tend to make a lot of money. The reason I am drawing this analogy between options trading and investing and the insurance business is that the result in both is the same. In the world of options trading and investing, it is the granters or sellers of options that tend to be more successful over time than the buyers.
A vast majority of options are worthless at expiration. Options premiums have two components, intrinsic and time value. Intrinsic value is the in-the-money portion of the option. A put option to sell gold at $1200 that expires when the gold price is $1000 has $200 of intrinsic value. Time value of an option is totally a reflection of the time left until expiration.
Therefore, at expiration all options, whether they are in the money or not, have absolutely no time value. After all, time has expired at expiration. As you can see, when it comes to the two important components for the price and value of options, one of those components always goes to zero at expiration. Therefore, the seller or granter of option has a distinct advantage over the buyer. The seller compensates the buyer by granting the leverage that long options afford. This is why most professional traders are more likely to sell options than to buy them. There are times where selling options is appropriate even for the beginner.
Buying an asset not yet held below the current market price: If you wish to buy an asset and the price is too high, selling a put option will provide immediate premium. If the price drops to or below the target buy price (the strike price) at expiration, you will buy the asset at that price. Your net price will be the target price minus the premium received. If the price does not drop and the option expires, you simply pocket the premium for selling the put option. The sale of the put becomes a profitable trade in itself.
Selling an asset at a price higher than the current market price: Let us consider the case where you are holding an asset that you may wish to sell if the price moves higher.
Selling a call option at that price target (the strike price) will provide immediate income against the long position you hold. If the price moves above the target price at expiration, you will sell the asset at that price. Your net price will be the target or strike price plus the premium received for selling or granting the option. If the price does not reach the target by expiration, you simply pocket the premium and can do it once again for a future period. In this case, the sale of a call option against an existing position will provide a new way to earn income against that long position.
For a trader or investor holding a short position, the sale of a put option will work in a similar fashion. The sale of the put in this case, creates income against that short position.
Expectations of a flat and static market in terms of price: In an earlier article, I described how the use of short options could take advantage of markets that have very low volatility, or do not move at all.
Spreading against other long options to limit premium expenditure: In some cases, the sale of one option against another will decrease the total premium spent and overall risk of an options position. A position where one buys an option and sells another option against it is a spread position.
Selling options have distinct risk-reward characteristics. All an investor or trader can earn is the premium received when selling an option. There are times when options are expensive and times when they are cheap. The value of an option depends on the volatility of the underlying market. The more volatile an asset, the more expensive option premiums become. Monitoring and analyzing option premiums over time will uncover opportunities when the market environment favors buying options and other times when it favors selling options. The old saying, a bird in the hand is worth two in the bush reflects the attitude of many professionals and investors who sell options. When you sell an option, the buyer pays the premium up front. Acting as the insurance company for price has its advantages at times.