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Option Selling Strategy

 By James Cordier, Liberty Trading Group

 

There are as many different option strategies today as there are traders. Vertical spreads, covered calls, ratio spreads, double ratio backspreads, the infamous butterfly spread. Complex computer programs analyze mountains of data for traders to select the precise option or combination of options for traders to sell. Unfortunately, these computers still can't tell you which way the market is going to go.

There is an approach to the market is amazingly simple. If a market is identified as having only the very clearest of long term fundamentals, be it bullish or bearish, options can be sold in the opposite direction. When selling an option, an investor statistically has an approximate 80% chance of the option expiring worthless. This is before he even selects a market or strike price to sell. Thus, if bearish a market, a trader would sell calls. If bullish, he would sell puts. He sells strike prices either far above or far below the current price of the futures market. He places a stop (I recommend 200% of the current value of the option). And then he sits back and watches.

While multiple option combinations all have their merit in the right situation, a pure option selling program can be successful based on it's sheer simplicity. The benefit of always having time value working in your favor (eroding the option on a daily basis) can be a tremendous advantage. The huge margin for error, whether it be mistiming an entry or being outright wrong the market, can allow an investor to profit in a short option trade where a long option or futures trade would have resulted in a loss.

Patience - The Underrated Virtue

In John Walsh's book, How to Trade Futures, he interviews several professional traders on the subject of trading. One particular quote struck me as extremely relevant. It is from a professional trader who has been successful over the years:

Patience is a common attribute of many experienced, successful traders. Beginners are almost never patient. They want to "do something." Often they are proactive in their business and personal lives and want to trade the same way. In futures, riches often come to those who have the discipline to wait…"


No where is patience more important than in an option writing investment portfolio. Lack of patience can result in the option seller overtrading his option portfolio, over exposing himself by putting on too many positions, over weighting his portfolio in one position, or "reaching" for a new position instead of waiting for an opportunity to arise.

While many novice traders shun option selling for fear and misunderstanding of the risks, in reality, option selling can be a consistent, relatively conservative approach to the market. Percentages and time will be on your side, but if you trade for action and excitement, option selling may not be for you.

Traders adopting a longer term strategy such as this can avoid all the daily decision making such as resetting stops, taking profits, trying to outguess the market (and the pros) can watch the market from more of an objective distance.

Most investment managers recommend that you work with an experienced professional if you wish to try your hand at option writing. I tend to agree with this view. While if utilized correctly, option writing can be an extremely effective tool for strong portfolio returns, one must not get lured into a "can't lose" mentality. This is still futures trading and there are still risks involved. Right when you start to believe you can't lose, you will.

Look to sell far out of the money options in markets with clear long term fundamentals and be aware of seasonal tendencies. Don't second guess yourself or the trade. If your risk parameter is hit, exit the position. If it is not, leave it alone. Remember that, unless the market is moving sharply against your position, time value will eventually make you a winner.

Keep it simple. Cultivate your patience.

About The Author

James Cordier is head trader and president of Liberty Trading Group, a brokerage firm specializing in option writing on commodities. James' market comments are published by several national financial publications and worldwide news services. For more research visit Liberty Trading Group

 

 

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