Selling Options Buying
Options Option Greeks
Many traders opt to buy options in an effort to maximize gains and limit
losses to the purchase price of the option. On the surface this seems ideal,
except for one major flaw: time decay. The Chicago Mercantile Exchange estimates
that over 80% of all options expire worthless. Those who sell these options
to the buyers are known as option writers or sellers. Their objective is to
collect the premium paid by the option buyer. Option writing can also be used
for hedging purposes and reducing risk. The writer has unlimited risk and
a limited profit potential: the premium of the option minus commissions. In
appropriate situations you should consider selling out-of-the-money options
instead of buying them. Here are some reasons why:
As an option seller, you do not have to be concerned so much as to where
the price will go, but more importantly where the price will not go. The objective
is to select options with the highest probability of expiring worthless. Heritage
West uses both fundamental and technical analysis to project the general direction
of the underlying futures market on which options will be sold. Then, far
out of the money options with 1-1/2 to 4 months time remaining until expiration
are selected for consideration. Strike prices are selected that could only
be achieved through a dramatic change in the fundamentals of the market.
This gives the market plenty of room to make short-term moves against your
positions, thus avoiding the "noise" that forces futures traders
to be stopped out of the market.
An option's value is made up of intrinsic value and extrinsic, or time,
value. The intrinsic value is how far the option is “in the money.”
For example, if July silver were at 5.50, the July silver 5.25 call option
would have 25 cents of intrinsic value. The balance of the option’s value
would consist of time value - how much time remained until the option’s
expiration. If a trader sold a July silver 6.00 call option, that option would
be 50 cents out of the money and therefore have no intrinsic value. The full
value of the option would consist of solely time value. July silver would
have to move a full 50 cents before the option would be in the money and have
any intrinsic value at all.
As a seller of options, you are selling time value. As long as July silver
stays below 6.00, the option will have no intrinsic value. Its only value
is time value; as time passes, the option's time value will erode, slowly
at first, then accelerating towards the end. The movement in the futures market
can temporarily affect the value of the option as well. A move higher can
temporarily propel the value of the option higher, but it will still have
no intrinsic value if the futures price is below 6.00. Futures prices moving
lower will accelerate the deterioration of the option.
In conclusion, if you are bearish silver and you sell a July 6.00 call,
the market can move lower as you predicted, stay the same, or even move higher.
As long as the price is below 6.00 at expiration, the option will have no
intrinsic value and expire worthless, allowing you, the seller, to keep all
premium collected as profit.
The graph below illustrates an option’s eroding time value.
Volatility is the most important factor when determining which options to
write. Volatility is the measure of the rate and magnitude of change in the
price of an option in relation to the change of the underlying futures contract.
If volatility is high, the premium on the option will be relatively high,
and vice versa. Many option traders fail to understand how volatility affects
the price of options and how to utilize volatility to capture profits.
The following graph shows the volatility levels of soybeans options over
a six-year period. Notice the consistent pattern. Volatility is lowest in
the inactive post-harvest to pre-planting period November to May. As the growing
season gets underway volatility increases, usually peaking in July when extreme
summer temperatures pose the greatest threat to soybean yields. Taking into
account fundamental and technical criteria, you would look to buy options
when they are undervalued (cheap), and sell them when overvalued (expensive).
Heritage West Financial believes in the prudent writing of options as part
of a disciplined overall futures and options trading program. However, we
advise against selling options without the advice and expertise of a knowledgeable
specialist. Remember, writing options carries the same risks as trading futures,
and although the percentages are in your favor, these risks should be treated
with the same respect. In addition, if the market moves against your short
option position, your margin requirements may increase as well. We also believe
in using stops based on the underlying futures price, not on the value of
the option. Once a market trades through an area perceived as strong support
or resistance we recommend exiting positions. At Heritage West, your broker
will work with you in analyzing the risk parameters of each trade and which
positions may be suitable for you.
Questions? Speak with a Heritage West Professional
Heritage West Financial, Inc.
8775 Aero Dr., Suite 302
San Diego, CA 92123
Local: (858) 560-2646
Toll Free: (800) 263-3004
TRADING FUTURES AND OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.