Turning A Losing Option Sale Into A Winner

by: James Cordier

Michael : Hello everybody. This is Michael Gross of OptionSellers.com. I'm here with head trader James Cordier. We are here for your monthly May video podcast from OptionSellers.com. James, welcome to the monthly show.

James : Thank you, Michael. Can you believe we're going into May already?

Michael : It sure went fast. This last month here we saw some key developments in the markets. We have a lot of tensions between China and the U.S. over trade, and then we're, lately, looking at 10-year treasuries going over 3%. A lot of people are wondering how this may affect commodities. What's your take on that?

James : Well, the trade wars that are supposedly about to take place, I think, are simply negotiation. President Trump mentioned many times going into the election that he was going to do "the art of the deal" and get us some more fair playing field, especially with China. Certainly the deficit that many goes out to China and doesn't come back is something that he's going to work on and, I believe, it's more negotiating than it's actually going to be major changes, as far as trade tariffs and such. Will some be put in place and some enacted? Probably so, but I know Mr. Mnuchin is going to China I believe in the next week or two, and he's going to have probably the checkbook ready so he can basically get an olive branch going out. Needless to say, everybody wants a strong economic global growth and a trade war is not going to help that; however, getting a more fair and balanced trade, especially with China, I think is a really good idea and I think that's what we're going to get over the next month or two. All the discussion about it, I think, is going to be more of just that: just discussion.

Michael : So, you don't see any major changes in any commodities in the immediate term? Any immediate strategies people should be doing right now or as a result of that or, primarily, do you just see things leveling out here?

James : Michael, the discussion of a trade war, like in soybeans or something that's going to affect the demand for oil, I think a person or an investor should use that to look at the idea that it's going to be settled. It's not going to be a large disruption to production or demand in any of these commodities. When the price of a commodity is affected by discussion of it, I think you should take advantage of that. 3-6 months later, the fundamentals that we see now are going to be in place then, and basically it was hype that was going on and I think it's going to offer opportunities. For markets that you're following, if there's trade discussion that's going to move up or down the market that you were hoping to sell either puts or calls on, I think that's going to be great picking in order to do that.

Michael : Okay. Well, for those of you watching, we have an exciting show for you ahead this month. We're going to be addressing a very common question we get. A lot of times, people sell an option, they get into the trade, the option moves a little bit against them, and then the question is "Well, what do I do now? Do I adjust the trade? Do I get out of it? If so, where do I get out of it?" What we're going to do this month is we're actually going to take you into some of our real trades we are doing in portfolios. Some of these, you've probably seen us talk about before. Pull back the curtain a little bit and show you a risk-parameter we might use and then recommend something you can use at home, as well, if you're trading on your own or just get a little bit better insight into how we might do it professionally. A good analogy, and, James, I know you can comment on this, is we all saw the incident with Southwest Airlines this month where they had the problem with the engine. Certainly a tragedy for the people involved that it effected; however, one thing that really stuck out to me is the pilots that landed that plane and saved all those people. Have you heard the transcripts? They're just cool as a cucumber. They knew exactly what to do, they had processes in place for every situation or condition, and you pilots out there that are clients, you know exactly what I'm talking about. When people are trading, and you know this more than anyone, James, you should have a contingency. Anything that happens, you should have a plan for that happening and have that type of control. That's how you avoid that "what should I do" when you get into certain situations. When you're trading, you deal with the same thing, James, am I right?

James : I certainly do, nothing like that pilot was facing this past week, but in a similar note, you do have a plan. We are generally positioned in anywhere from 8-10 commodities and when one is causing the plane or the bow to veer right or veer left you simply need to make the adjustment. It shouldn't be a huge deal to your portfolio. You should really be able to make a minor adjustment. If you're in 10 commodities and 1 is going really in a direction you weren't thinking, you should have a plan for that. It shouldn't be a panic. It shouldn't be large turns like this. You should just be turning the wheel like this and we've got an adjustment that needs to be made, the cocoa market or the coffee market or the silver market, and you just steer the plane and get it flying level again. Your portfolio, whether you're having a portfolio with us or you're investing with one on your own, you should never have a position that makes that much variance to your account. If you have 1 position in your account, name the commodity- it doesn't really matter, and if it moves 5-10% in a short period of time, if that makes your account move larger than it really should be, it shouldn't have a large variance because the market moved 5% or 10%. If it is doing that, you're simply not positioned correctly. Always have in your portfolio 8-10 commodities and if 1 is making the plane go like this then you just pull it back like that. You should never have a position on your account that you can't, in order to make the plane fly smoothly again, if you would. It happens all the time. We're not right all the time. We'll have 8-10 commodities in a portfolio and by-goodness, 1 is going to be causing this to happen and you just straighten the plane. Just like that brave pilot did, he knew exactly what to do. My goodness, 1 engine went out and he was able to do that. We have 10 engines on our plane. We should never have one commodity or another commodity make the plane go like this. It really shouldn't happen. For your investors at home, if that's happening to your portfolio you don't have a diversified portfolio, and that is something that we at OptionSellers.com always strive to have so that when something happens that was unexpected, there's a big headline in a certain commodity, you just straighten the plane and that's what we do.

Michael : That's what we're going to talk about today. If you're trading at home or you're checking out this strategy, one of the biggest advantages you have as an option seller is that flexibility James was talking about where if you're trading, and say you are worried about a Chinese trade war or this or that, you have the ability to build out a strategy that can benefit from nearly any type of economic condition. It's one you should use if you're an option seller. We're going to address and use a specific example this month from a market we talked about. We'll show you how to adjust a trade if you do get into those type of situations where it's not working exactly the way you hoped it would, and we're going to give you a couple examples here of how to do just that. James, why don't we move into the trading room and we'll talk about our markets this month.

James : Sounds good.

Michael: Welcome to the markets segment of the OptionSellers.com May Podcast. We are going to talk about a market this month that we featured in last month's podcast and that we've got a lot of questions on over the past month so we're going to talk a little bit about it. This does go into the topic of this month's podcast, which is how to turn a losing trade into a winning trade. So, first let's talk about the market… this is the cocoa market. You saw us feature this market in last month's podcast. Cocoa we talked about selling the 32 December call options. The markets rallied a little bit since then, did not threaten a strike, but it's up a little bit. James, do you want to tell us what's going on with this trade and this market?

James : Michael, what's going on with cocoa right now is the last several years we've had a production surplus worldwide. In 2018 and 2019, some of the largest cocoa analysis around the country is predicting the first deficit in quite some time for world production. Basically, high prices cure high prices and low prices cure low prices. The initial trade is that we're going to have a production deficit this coming year and then the market must go much higher because we're running out of cocoa, but in all actuality what happens when the price of something is rising that is dampening down demand. So, for example, when cocoa was trading around $2,000 and $2,100 a ton, chocolate manufacturers were purchasing cocoa. As it rallies, they purchase less and less and less, and the demand has already taken place. So, when we do get an announcement of a production deficit, that usually gets the last of the buyers, the headline traders, to get involved with the market. We saw a spike here recently in the last day or two where cocoa was threatening $2,900 a ton. Keep in mind that's up almost 50% in price over the last few months. Basically what that does is commercial demand then starts to fall and then basically it's a speculatively driven market. Usually a market that has moved 50%, we have just a couple percent difference in production, 2-3 years ago up until now, and yet we've had a 50% increase in price; thus, we think that's a temporary move in the market. While we were suggesting selling the $3,200 calls last month, the market did not get anywhere near that level but, as some of the viewers and readers have mentioned, the price of those options are up slightly from, maybe, when we discussed selling them.

Michael : Sure. I think that goes back to a good point is, we always say this, we don't know where the top or bottom of a market's going to be. That's why we are selling options in the first place. We're not trying to pick that anymore. You don't have to pick that either as an option seller. It's an important point to make as an option seller… you're not trying to call the market, you're just picking a window where you think prices should remain and then selling options outside that range.

James : Exactly right. Fundamentally, the price of cocoa over the next 3-6 months should be at this level. The price of coffee or crude oil based on fundamentals will be at a certain level, as well. Basically, you're selling option premium that puts you out-of-the-money sometimes 40-50-60%, and some 8 times out of 10, that leeway is all you'll ever need. As a matter of fact, anyone listening to us right now and, of course, our clients are long-term investors. So, if you are, like we discussed just recently, you are flying a plane and you want it to have several engines, okay? Your portfolio should have several commodities; however, when one does exceed a level that you thought it would, you can roll up your position. For example, each day that cocoa gets more and more expensive, the likelihood of it staying above its fundamental value diminishes. So, if you did short cocoa prices at, for example, $3,200 a ton by selling the $3,200 call, you may choose to roll it up to the $3,400 or the $3,500 if in fact it's something that if you want to stay with the market or you want to stay with your position, but speculatively the market is driven higher than we thought it would do. That is certainly one approach that we often take and someone who maybe has that position on right now might want to take that, as well.

Michael : So, what you've just explained is how to turn a losing trade into a winning trade, the title of our podcast here today. Let's go back and just explore that briefly. When we talked about selling the call here, we talked about selling it and we were right about here, now the market has rallied a little bit. As you said earlier, it really hasn't threatened the original strike. In fact, I don't even think the original premium has doubled yet.

James : No, they hadn't.

Michael : Yet, we got a handful of people writing, "Ah, I sold a cocoa call. What do I do now?" Well, there's 2 points to that. One, we're not really an advisory service, we are managed fund here, so we can't really instruct you all the way through the trade. The bigger point here is when we went back to the beginning of the podcast that James just referred to, we talk about the pilot steering the plane. If you're putting a trade like this on, you better have a plan for what you're going to do for when you go into that trade if it doesn't move the way you think. Now, the movement in cocoa right now, it hasn't really been extreme, it is pressuring the strike price a little bit. James feels it's still fundamentally justified trade, but if you're getting uncomfortable or it keeps rallying or starts pressuring that, he's talking about rolling the positions up. James, do you want to explain the mechanics of that if you were, or if somebody was holding a 32 call what they would do to recapture that premium?

James : Okay, so let's say you sold 10 contracts of the 3,200 December call strike and the price is now exceeding your risk tolerance. Let's say you sold them for $500 or $600. Let's say you have the 100% rule for your portfolio, so the option has now doubled to approximately $1,000-$1,200. Now what I would do, if you were considering staying with a fundamental trade, which I think cocoa will probably be in the high 20's at the end of the year and nowhere near 3,200; however, you buy back your $3,200 call and you can sell 20 now of the $3,400-$3,500 call. Eventually, the fundamental factors are going to slow this market down and we think that come November, when the December contracts expire, we'll probably be in the high 20's… like 2,800-2,900 at the most. So, if we do exceed 3,000 for a brief period, I would use that certainly as an option selling opportunity in cocoa calls. 3,400-3,500, I think, the market will not exceed that level in our opinion. We'll have to wait and find out, but come November I think the market will be much below that.

Michael : So, you're doubling up on those strikes. So, you sold 10 and then when you roll you're selling 20. That allows you to, one, get back your original premium, but it also allows you to recover the loss.

James : That's exactly right. Keep in mind as we discuss this, we always want to be in 8-10 commodities. We are selling options sometimes 40%, 50%, 60% out-of-the-money. You can't, or you probably don't want to, base your entire investment and the viability of this type of investment for you based on the idea that you sold 10 contracts of cocoa. Okay? We are selling commodity options in approximately 8-10 different sectors and, over the long-term, selling options 40%, 50%, 60% out-of-the-money is going to work out quite well, but, by all means, we stub our toe. We get kicked in the shin once in a while, but if you're a long-term investor, and everyone should be, whether you're long stocks or the real estate market or you're selling options as an investment portfolio, you just know that 1 or 2 may not go your way and you definitely need to manage your portfolio. This is one way to do it. Another idea is, you know, taking a losing trade. If the investment idea wasn't correct, we'll take a look at it again. Let's see if the market continues to rally, we'll sell options on another day, or we'll come and visit cocoa again next year. Have that ability to do that.

Michael : That's an excellent point. If you're watching some of the things we do and you're trying to trade just at home online saying "Oh I like that trade. I'll sell this and see how it goes", that's really not how these are meant to go. When we are putting trades on a portfolio, we are putting them on as part of an overall portfolio of, as you said, 6, 8, 10 different positions. Sometimes they're hedged on the other side of the market, sometimes they're balanced by a long or short position somewhere else. So, these are incorporated into a much bigger scheme. If you're just taking them and you're really selling them out of context, so if something like this does move against you it's a big deal for your portfolio, where for us is just like the captain of the plane. It's a flip of a switch, just something different you need to do to adjust the position.

James : Exactly, Michael. You should always be able to have both hands on the wheel and just make small adjustments. If you sold cocoa calls recently, your positioning should only be going like this and you shouldn't be turning the wheel like this. If you're doing that with your portfolio, you're not doing it right.

Michael : And as we talked about earlier for managed clients, we are going to be taking a closer look at this market this month. It is starting to get interesting and maybe look to see what we can do there in the coming weeks here. Let's talk about another market here for our second part of the podcast this month. That will be the crude oil market. If you want a market that has been in the news lately, one that has been in the headlines has been the crude oil market. We've been closing in on the $70 mark for the first time in 2014. It's been one of the strongest commodities on the board since last fall. James, you want to tell us what's going on here? What's behind this rally? What's been pushing prices higher?

James : Michael, Saudi Arabia has done just an incredible job leading the OPEC nations, as well as Russian production. Someone sat down with members of OPEC and said, "Listen. We cut production by 2-3%, we're looking at the possibility of a 20%, 30%, or 40% gain in crude oil prices." Lo and behold, that math sounded good to the OPEC producers, they did start cutting production, not a great deal, just a couple percent. Basically, we were looking at a 300-400 million barrel of surplus floating around the world, both in tankers and at storage facilities in some of the OPEC nations. After some 18 months of oil production cuts by OPEC and along with Russia, that 300-400 million barrel surplus is down to some 30 or 40 million barrels… just a huge gain for OPEC. Their ability to cut production has just paid off in spades. We have approximately 35-40% increase in oil prices. OPEC is very cohesive right now, something that a lot of analysts are quite surprised at and we are surprised at it, as well. The ability to keep that production offline when prices are going up, my hats off to OPEC, they've done a very nice job in order to do this. The market is now balanced. Basically, for every barrel that is being produced there is a consumer right now. We have a very balanced market and, as you can see, it's up some $20-$25 from where we were just not that long ago.

Michael : Yeah, compliance has been surprising, too. I read somewhere that they're at like 138% compliance. Before, they used to have trouble even getting half the members to hit their quotas, now they're above 100%.

James : Someone did the math for the OPEC producers and said a small 2-3% cut can possibly increase the prices 20-30%. They nailed it. Here are the final results.

Michael : As you mentioned, that's taking quite a bit of oil off the market. OPEC production down 11.4% since these started in January 2017. So, that's a pretty good drawdown. That's really, what James is saying, is behind this rally right now. That and we have a pretty good seasonal in effect that's helping drive prices now, as well.

James : Basically, as we get into driving season in the U.S., the largest consumer of oil and gasoline in the world, you have a ramp-up of production where you're cracking oil into gasoline and, generally, that happens between the months of March, April, and May getting ready for summer driving season. So, that cracking of oil takes oil production and supply off the market, turns it into gasoline, so you have, once again, a temporary shortage of oil as not only OPEC taking barrels off the market but also you have the largest refining season coming up going into driving times of June, July, and August here in the United States. This takes barrels of oil off the market, they are cracked into gasoline, and that's why you usually have this seasonal rally going into May and June.

Michael : Which seems to be following it very closely this year, the seasonal tendency. Now, one thing we're seeing this year, and you and I were talking about this earlier, is refineries are operating at a torrid pace right now. They're really hitting it pretty hard as far as production goes. Right now, gasoline production running about 4.2% ahead of pace for where it normally is. So, you're thinking that they may hit those levels earlier this year and we may see a topping action in crude a little bit earlier this year?

James : You know, consumption for gasoline in the United States peaks in June and July right around the 4th of July, or so it seems, but the price of crude oil will often top before then. Crude oil is clearly where gasoline comes from, and as those barrels come offline, in other words, they're cracked into gasoline, the price of oil will often top before gasoline does. So, the demand is still there but it has already been produced. So, while the greatest demand in the United States is around the middle of the summer holidays, the demand for oil to produce that gasoline has already taken place and thus the seasonal comes down sooner than you would think.

Michael : Sure, and this chart's showing you can see a top in crude any time between mid-May to early-July, as you said; however, if refineries are hitting those levels where they deem supply adequate, they're going to cut back production sooner and that will hurt demand for crude.

James : And then the crude barrels start to accumulate more.

Michael : Okay. So, we have that and then also, on the other side of the coin, what we have coming up or what's even surprised OPEC is the level at which the United States has been able to ramp up production. They're taking advantage of these higher prices and you referred to high prices carrying high prices earlier. We're seeing U.S. production just blowing up, going up about 10.5 million barrels a day. Is this having an affect right now on the supply?

James : Well, basically it's balancing… the additional barrels coming from the United States is balancing what OPEC's not producing. The fact that production in the United States is going to probably exceed 11 million barrels a day coming up in 2019 and 2020. We do see this plateauing and the excitement in oil right now is probably going to be rolling over. If the United States wasn't the largest consumer, let's say all these barrels were being produced on the opposite side of the globe, getting them to the United States would be difficult and then maybe the largest producer, now the United States, wouldn't be such a big deal, but the fact that we're producing it exactly where we need it, here in the United States, that will offset some of the global demand and price shock around the world. Everyone always talked about, "The United States is susceptible to what OPEC does"… well, we're producing all the oil we need now, so the fact that oil is approaching $70 and here in the United States we can produce it for between $35-$45, how long is it going to stay above $70? It can only exceed it by a certain amount of dollars per barrel and for a certain period of time. If this level gets to 11 million barrels a day or 11.5 million barrels a day, oil will be coming back down into the low-mid 60's at the very least, and probably setting up a sale here that's looking like in May or June for option sellers.

Michael : Okay. So, your outlook for the intermediate turn, obviously we talked earlier and we're not trying to predict what prices are going to do, only what they're not going to do, but do you see a little more strength coming in and then weakening, or what's just the general outlook for that window?

James : What's so interesting right now is in some global economies, especially throughout Europe, they are going to feel this large gain in the price of oil. Japan is going to start feeling this large gain in the price of oil. Basically, they are 100% consumers and produce nothing, so oil going from $45 up to $70 will start slowing demand from these major consuming nations. At the same time, when the United States is now producing the most they ever have and now the largest producer in the world, we see oil kind of plateauing here this summer right around maybe June or July, but not falling a whole lot. The fact that we had a 400 million barrel world surplus and it's not approximately 40 million barrels, the market's extremely well balanced right now. So, we see some of the excitement that's going on now in crude oil plateauing somewhat, maybe coming down some $3-$5, but not falling through the floor by any means. Oil production right now is down with OPEC. They have been rewarded for keeping barrels off the market, and I don't think they're going to forget that any time soon. I don't see them going back and ramping up production. They've been rewarded so well, they've learned a great lesson by keeping, at first, some 3% oil barrels off the market, now it's up to some 9%, 10%, or 11% of barrels off the market. They've learned a great lesson and they're being rewarded for it, so we don't see production swamping this market. We see oil possibly trading at about a $10 trading range from where it is now throughout the end of the year.

Michael : All that media coverage and, of course, the price rally has increased the volatility, which is what we like to see as option sellers. Taking a look at a trading strategy, how to trade that exact scenario you just described, you're looking at one of your favorite strategies, a strangle.

James : It certainly is. You discussed, just now, headlines and OPEC and trade wars with China and the value of a dollar. All of this really has the volatility of petroleum, especially crude oil, at record levels that I haven't seen almost since I've been investing in commodities, but right now you have put premium extremely high, even with a bullish fundamentals, and you have call premium through the roof right now. My favorite position in crude oil for the rest of the year is practically a $45-$50 strangle around the price of oil. So, in other words, we would be selling calls at the $90 level and selling puts at the $45 level. We think that the idea that strong fundamentals right now will keep the market from falling, but yet the fact that prices are high right now and that's going to start curtailing demand. My prediction for the rest of the year is about a $10-$12 trade range for crude oil and here we have one of the best opportunities I've seen to position in crude oil in a long time. That's putting a $45-$50 strangle around oil. We're not right all the time and every once in a while we don't get it right, but for oil to stay between 45 and 90 through the end of the year, I think, is an incredibly high probability position and that's something that we're taking advantage of, as you know, Michael, right now.

Michael : You couldn't do that a year ago. You didn't get that wide of window, and now we have it, it's on the table, and you want to take it.

James : Michael, that volatility is your friend. I know when it first happens and you already have positions on, "Oh, it's too volatile for us"… that's what you like. A year ago, 2 years ago, 3 years ago, the widest strangle you would write on crude oil was approximately $15-$20 and now you're writing a $45 strangle. We, as well, are going out slightly further in writing and $50 strangle around crude oil. We're pretty confident it's going to stay inside that window. We'll have to wait and see.

Michael : And again, watching this at home, this is an example. We are not recommending this to you personally as the perfect trade. In our portfolios, we are diversified over December, January, February, and March. Different strategies and different risk management techniques, but in going out to a month like February, a lot of people think that's a long time out. We're about 9 months out, but your plan isn't to necessarily hold these until February or March or whatever you're writing out there. Often times, with the right decay, you can be getting out of these a few months early.

James : Michael, as we discuss with our clients when they first become clients, we will sell options 6 months, 9 months, 12 months out into the future, but not with the idea that we're going to stay into that position until the very last day and try and collect the very last dollar. It's really not important to do that. If we select options fairly well, for example, on the position that we're looking at right here, after maybe let's say you sell options 9 months out, if you selected them fairly well, 5-6 months later you should have collected about 85-90% of the potential premium. That is a great place to ring the register and lower your risk and be happy with the position and get out of the trade and buy it back early. Often, we look at February or March or April when we're talking about selling options. Basically, you're Tom Brady and you're throwing it to where the market is not going to be. That is what we're doing. So, when Michael discusses layering different months and different commodities that's what we're doing. To own a portfolio like that, it looks like a great deal of layering in the market and that is what it is and it allows you to have 10 engines on your plane so that when one goes a little bit awry you have other positions to make sure that 80% of your portfolio is going the right direction. This is a great example of doing that.

Michael : Great advice. If you would like to read more about the crude oil market, what we're recommending there this month, or going into our managed portfolios, you will want to read this month's newsletter… that's the May edition of the OptionSellers Newsletter. That comes out May 1st. It should be in your e-mail box or showing up in your hard copy mailbox a couple days after that. Of course, if you want to learn more about the strategies we discussed here or the rolling or strangle or some of the other concepts James mentioned, if you don't have it yet,The Complete Guide to Option Selling: Third Edition, you can get it on our website at a discount, on Amazon, or the bookstore. Let's move into our closing section for this month.

Michael : Thank you for watching this month's edition of OptionSellers TV. James, thank you for those insights on the cocoa and the oil markets. You have any predictions for the upcoming month?

James : The month of May 2018, Michael, I think is going to be the realization that the U.S. dollar is not the weakest currency in the world. The U.S. is looking at probably 2 or 3 rate hikes this year. The U.S. economy is still doing quite well and its counterparts, especially in Europe, the economies in Germany, Italy, France, and England have been doing pretty well over the last 12-18 months, but the expansion in countries like Germany especially, the major driver of the European economy, is showing signs that it may be peaking already. Consumer Confidence in Germany is down, a lot of the sales in Germany is down right now, and not that it's going into recession, if it does that would be the shortest-lived recovery ever, now don't see that happening, but the U.S. economy still is on this footing and the European economy is fluttering already. That is going to make the U.S. dollar more buoyant than a lot of investors thought it would be and that is going to stabilize a lot of the commodities. So, getting into short options right now, whether it be puts or calls on precious metals, energies especially, and some of the foods, I think it will be a great calming effect in the 3rd or 4th quarter of this year. So, any discussion about the U.S. dollar isn't doing so good, any discussion about inflation, I would fade those ideas and sell options on those ideas and, I think, later on this year you'll be well rewarded.

Michael : Sounds like a good outlook. We'll have to keep an eye out for that. Also, May is a very active month in the grain markets. We have corn and soybean plantings going on here in the United States, so that can often create opportunities there, as well, for option sellers, sometimes on both sides of the market.

James : Practically every year we have large influx of volatility in corn, wheat, and soybeans and we are ready and waiting for that to happen.

Michael : James, again thank you for your insights this month.

James : My pleasure, Michael. It's always great to give our wisdoms and our insight. We're not right all the time, but I do like the landscape for selling options here in May and June.

Michael : Perfect. We'll look forward to the month of May and we'll talk to all of you again in 30 days. Thank you.