Here’s a Different Way of Looking at Options

For most traders and/or investors, the hardest part of trading is trying to
determine where the market is going to move, and when.

But what if a trader did not have to decide? What if he did not have to
determine which way the market was going to move? What if, in exchange for
giving up his chance to make a large windfall with one big move, one could free
himself from the daily whims of the market and settle for making smaller, yet
surprisingly consistent gains over and over? In this situation, your profits
would be limited on each individual trade but your probabilities of success on
each individual trade would be high.

If this type of investing sounds interesting, then the strategy of selling
options might be for you.

In selling (or writing as it is sometimes called) options, one does not have to
decide where the market is going to go. One simply has to decide where the
market is not going to go. He selects a price level above or below the market
that he believes the market will not reach within a certain time period (for our
purposes, generally 30-90 days). He then sells an option at this price level and
collects a premium for doing so. If the time period elapses and the market has
not attained this price, the option expires and the investor who sold it keeps
the premium he collected as a profit.

The approach, in and of itself, is similar to the one used by insurance
companies across the globe.

Is there risk in this strategy? Yes, of course. But no more risk than in buying
or selling a futures contract. And, in most cases much less. Just like an
insurance company, you will have to pay out from time to time. But remember,
insurance companies make hefty profits by collecting many premiums, but only
paying out on a few. If you begin selling options, you would be operating this
way too. This does not mean that one is immune from large drawdowns when
utilizing option selling. It does mean that, statistically, the majority of your
trades should be winners. Managing the risk on the losers, then, becomes of
paramount importance in option selling.

There are many complexities to this strategy in which one can increase ones odds
even further. There are just as many strategies available to control risk. Of
course, the strategy of option selling is far to complex to condense into a
single article. There are so many intricacies to the approach that we’ve written
an entire book on the subject (see
www.optionsellers.com). However, the short explanation above is enough to
grasp the general concept.

For those unfamiliar with options, an option is a contract that gives the owner
the right, but not the obligation, to buy or sell a specific commodity or
security at a specified price. However, the buying or selling of these options
is a market in and of itself. Many traders like to buy options because, for a
small premium, they can gamble that the price of a specific commodity or equity
will make a large move in their favor. In most cases, the market will have to
move quickly and dramatically in favor of the option buyer for him to make
money.

Buying options is generally a favorite strategy of small, individual investors
trying to take a small amount of capital and turn it into a large payload. The
statistic that these speculators ignore is that it has been estimated that
options will expire worthless 80-90% of the time if held to expiration. This
means that the premiums buyers pay to purchase these options will be lost
approximately 8 out of 10 times if the option is held through expiration.

But where do these premiums go? To the sellers, of course! Selling options has
been a base strategy of professional traders and commercial hedgers for years.
They sell options, and small, generally lesser-capitalized investors buy them.
Most of the time, the options expire worthless and the professionals and
commercials take the money. This is why we recommend the strategy of selling
options to our clients. In our opinion, selling options is a strategy for
serious, sophisticated investors. Buying options is for amateurs.

Options are traded on the open market, just like futures contracts or stocks.
They can be bought and sold just as easily as buying or selling a futures
contract or a share of stock. Most major futures markets also offer a
corresponding option market for each contract. For instance, if one wanted to
trade gold, one could buy or sell a gold futures contract, or one could choose
instead to buy or sell gold options. The options, of course, are based on their
corresponding or underlying market. Therefore, if one bought or sold a February
Gold option, it would be based on the February Gold futures contract.

There are two types of options, puts and calls. At the risk of oversimplifying
the difference, buyers of calls want the market to move up, buyers of puts want
the market to move down. These option buyers generally believe the market is
going to move towards or eclipse a specific price level. With options, this
specific price level is referred to as the strike price. An option will
generally show it’s greatest increase in value after the market has moved beyond
its strike price. It is for this reason that buyers of options generally need
the market to make a moderate to large-scale move in order to show a profit.
Most of the time, this will not happen. However, occasionally, a market will
make a considerable move in favor of the investor in which case his small
investment in the option can show a substantial profit. This is what attracts
small speculators to option buying.

Sellers of options, however, do not require the market to make a big move in
order to profit. An option seller wants the options to expire worthless — for
in that circumstance, he makes his profit. And the option will expire worthless,
as long as the strike price has not been reached. Therefore, unlike the option
buyer, he can profit if the underlying market moves in his favor (away from the
strike price), remains steady, or even if the market moves moderately against
his position. As the option nears expiration, it becomes more difficult for the
option to gain in value, thus benefiting the option seller. The risk to the
seller is that the underlying market price moves beyond the strike price of the
option. There are many ways to manage this risk. However, that will be discussed
in an upcoming article.

For the purposes of this segment, the example below illustrates the concept of
selling an option. For this example, we are supposing that an investor is
neutral to bearish the silver market.

JULY 06 SILVER (COMEX)

Price Chart courtesy of CQG.

In early May 2006, the investor is neutral to bearish the silver market over the
long term. However, he is uncertain about the short-term direction of the
market. Rather than trying to outguess the futures market in the short term or
buy a put option below the market and hope it moves down quickly, this investor
chooses to sell a July Silver 22.00 call option. He places an order to sell the
option in the open market at the New York Commodities Exchange (COMEX). For this
example, we will assume he receives a premium of $500. He will have to put up a
portion of his own money to hold this position. This is called margin. For this
example, the margin the trader would have to utilize would be about $1,300.

Every option has a set expiration date. July Silver options expire on June 27,
2006. If July Silver is anywhere below 22.00 at option expiration, the seller of
the 22.00 call would keep the $500 premium collected as profit. He would, of
course, keep his margin deposit as well.

Conversely, for the buyer of the 22.00 call to show a profit at expiration, July
Silver would have to be trading somewhere above 22.00 on expiration day.

Professional traders generally consider buying options to be a legitimized form
of gambling in which the option buyer will probably lose his investment, sooner
or later. The professional knows that by utilizing some basic fundamental
research, he can potentially profit 80-90% of the time by selling options.

Of course, one should do a careful undertaking of the risks involved in option
selling before deciding if the strategy is right for him. However, professionals
know that that by managing their risk correctly, they can avoid loss much of the
time and keep a large percentage of their premiums as profit.

Professionals play the percentages. By selling options in your portfolio, you
can too.

If you would like to learn more about selling options in a diversified
portfolio, visit us on the web at
www.libertytradinggroup.com. You can also order your copy of "The
Complete Guide to Option Selling" by James Cordier and Michael Gross online
at www.optionsellingguide.com.

James Cordier is head trader and Michael Gross is director of
research at Liberty Trading Group,
a full service futures brokerage specializing in option selling. Mr. Cordier’s
and Mr. Gross’s book, "The
Complete Guide to Option Selling" (McGraw Hill 2005) is available at
bookstores and online retailers.