Selling options can be an excellent trading strategy to help put the odds in your favor—if it's done correctly. If you don’t manage your risk when you're selling options, things can go bad in a hurry.
The Benefits of Option Selling
The most important benefit is that time is on your side.
Options have a limited life. That life ticks by every day and it means that options are always losing time value. Options buyers certainly know that dilemma. It's a bad feeling when you pick the right market direction but you still have a losing trade due to the evaporation of time value on your options.
When you sell options, time decay allows you to make money on the trade even if the underlying market stays the same. You can also make money on a trade if the futures market moves against you because the option might not move enough to make up for the loss in time value.
Odds in Your Favor
It's no secret that a majority of options expire worthlessly. That's a simple fact, but it can help move the odds of trading in your favor and make your commodity trading a profitable experience. You can almost throw darts at a list of out-of-the-money futures options to pick your trades. Most of them will likely expire worthlessly, and that's a 100% profit before commissions and fees when you sell them.
Unlimited Risk With Selling Options
Every trading strategy in commodities, futures, and options has its downside. An option-selling strategy entails virtually unlimited risk. If you sell a naked option—not covered or hedged—you run the risk of taking a huge loss. Options sellers often win on a high percentage of their trades, but they have a couple of losers now and again that are greater than all their wins. That's why it's so important to control your risk when you're selling.
A trend-following trading system operates on a similar principle. Most of the profits for the year are made on one or two trades when the commodities make major moves. Most of the other trades are losses. Traders who use a system like this rely on a couple of trades to make their profits for the year. When you sell options, you want to make sure those couple of trades don’t turn into your big losses. You can generally do well in the commodities and futures markets by selling options if you're able to manage your risk and sell out-of-the-money options without letting a few bad trades destroy your account.
Profit Potential vs. Risk
Options buyers have the luxury of unlimited profit potential. Options sellers can only make a 100% profit or the amount of the premium they receive minus commissions and fees. Many commodity traders like the benefit of unlimited profits. Most traders don’t have many trades where they make more than 100% anyway because they're too quick to take profits. So, if you don’t make 100% plus returns on trades, and if you have a lower percentage of winners when you buy options, why wouldn’t you want to sell options rather than buy them?
Selling options is simply a matter of putting time and the odds in your favor. It's up to you to avoid risking too much of your account on any one trade. You must cut your losses if the trades move too far against you. Just assume that two out of every three options you sell will expire worthlessly. You'll keep your risk to 100% of the option premium on the losing trades. In the end, you should still come away profitable even if two out of three of your options expire worthless—which is about the industry average.