About 80% of the new clients I speak with have some type of experience with stock options. Most of them, when prodded, express a vague desire to diversify as one of their chief reasons for taking the next step to commodities. What intrigues me is that few have a firm grasp of the real advantages that commodities options can offer -- especially if they are accustomed to the constraints that stock option selling can place on an investor.
Don't get me wrong -- selling equity options can be a lucrative strategy in the right hands. However, if you are one of the tens of thousands of investors who sells equity options to enhance your stock portfolio performance, you may be surprised to discover the horsepower you can get by harnessing this same strategy in the commodities arena.
In this day and age, diversification is more important than ever. But the advantages don't end there.
Five Key Differences Between Stock and Futures Options
Selling (also known as writing) options can offer benefits to investors in equities or commodities. However, there are substantial differences between writing stock options and writing futures options. What it generally boils down to is leverage. Futures options offer more leverage and therefore can offer greater risk, but also greater potential rewards.
In selling equity options, one does not have to guess short term market direction to profit. The same remains true in futures, with a few key differences.
- Lower Margins (Higher ROI): A key factor that attracts many stock option traders to futures. Margins posted to hold short stock options can be 10 to 20 times the premium collected for the option. With the SPAN margin system used in futures, options can be sold with out of pocket margin requirements for as little as 1 to 1 ½ times premium collected. For instance, you might sell an option for $600 and post a margin of only $700 (total margin requirement minus premium collected). This can translate into substantially higher ROI on your working capital.
- Attractive premiums can be collected for deep out of the money strikes. Unlike equities, where to collect any worthwhile premium, options must be sold 1-3 strike prices out of the money, futures options can often be sold at strike prices far out of the money. At such distant levels, short term market moves will typically not have a big impact on your option's value. Therefore, time value erosion may be allowed to work less impeded by short term volatility.
- Liquidity: Many equity option traders complain of poor liquidity hampering their efforts to enter or liquidate positions. While some futures contracts have higher open interest than others, most of the major contracts like Financials, Sugar, Grains, Gold, Natural Gas, and Crude Oil have substantial volume and open interest offering several thousand open contracts per strike price.
- Diversification: In the current state of financial markets, many high net worth investors are seeking precious diversification away from equities. By expanding into commodities options, you not only gain an investment that is 100% uncorrolated to equities, your option positions can also be uncorrelated to each other. In stocks, most of the time, your individual stock (option) will be largely at the mercy of the index as a whole. If Microsoft (NASDAQ:MSFT) is falling, chances are, your Exxon (NYSE:XOM) and Coca Cola (NYSE:KO) are falling too. In commodities, the price of Natural Gas has little to do with the price of Wheat or Silver. This can be a major benefit in diluting risk.
- Fundamental Bias: When selling a stock option, the price of that stock is dependent on many, many factors -- not the least of which is corporate earnings, comments by CEO/board, legal actions, Fed decisions, or direction of the overall index. Soybeans however, can’t “cook their books.” Silver can’t be declared “too big to fail.”
Knowing the fundamentals of a commodity, such as crop sizes and demand cycles, can be of great value when selling commodities options.
In commodities, it is most often old fashioned supply and demand fundamentals that ultimately dictates price. Knowing these fundamentals can give you an advantage in deciding what options to sell.
Commodities Option Selling: An Example
The example below illustrates these key concepts of selling a futures option. This is for example purposes only and assumes the seller is neutral-to-bullish crude oil prices. Note particularly the distance of the strike from the underlying trading price as well as the margin vs. premium collected. Then compare these to their counterparts in selling a put in Exxon or Chevron (NYSE:CVX).
Selling a Put Option in December Crude Oil
[Click all to enlarge]
Scenario: An investor is neutral-to-bullish on crude oil prices and wishes to collect premium above the market.
Trade: Sells December Crude Oil $60.00 put option.
Premium Collected: $600
Margin Requirement: $1,300
Expiration Date: November 15, 2011
Risk: The risk to the put seller is that crude prices move substantially lower. If the option goes in the money, it could be worth more than he sold it for at expiration. At that point, he would have to buy it back at a loss. He could also choose to buy it back at any time prior to expiration, even if it was not in the money. This can be an excellent risk management strategy.
Summary: If September Crude Oil Futures are anywhere above $60 per barrel at option expiration, the option expires worthless and the investor keeps the full premium collected as profit. Notice that the put can be sold at a level over 40% out of the money (crude oil prices would have to fall by 42% prior to option expiration to go in the money.) The option could also be bought back at any time prior to expiration at a varying level of profit or loss. Bearish oil traders could use the same strategy by selling call options far above the market. Note the margin requirement vs. premium collected is a 46% return on capital if the option expires worthless.
As a stock option seller, you cannot hope to learn all of the details of commodities options in one article. However, if you are seeking a true alternative investment that is 100% uncorrelated to your equities portfolio, the higher premiums and lower margins of commodities options can open a new world of investing for you.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.