Short option advantage: Commodities versus stocks
Commodities option selling
We’ll use crude oil’s price moves from 2014 as an example to illustrate these key concepts of selling options on futures. This is for example purposes only and assumes the seller is neutral to bearish crude oil. You will note particularly the distance of the strike from the underlying trading price as well as the margin versus premium collected. Then compare these to their counterparts in selling a call in Exxon or Chevron.
Also, we are not selling a “covered” position or looking to buy crude futures at a discount. This is pure premium collection. No purchase of the underlying is required (or desired).
Scenario: On July 20, 2014 crude opens at $103.72. An investor who is neutral-to-bearish on crude oil sells a December $130 call, collecting $800 in premium. The expiration is Nov. 14 and requires $2,200 in margin.
In our example, if December 2014 crude futures were anywhere below $130 per barrel at option expiration, the option would expire worthless and the investor would keep the full premium collected as profit (see “Room to move,” below).
In this case, the call was sold roughly 30% out-of-the-money. Crude prices would have to rise by 30% 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.
The risk to the call seller is that crude prices move substantially higher. If the option goes in-the-money, it could be worth more than it was sold for at expiration. At that point, the seller would have to buy it back at a loss. The seller could also choose to buy it back at any time prior to expiration, even if it were not in-the-money. This can be an excellent risk-management strategy. And, in this case, because of the favorable move, the seller could have collected most of the premium well before expiration and used his margin for another opportunity.
The margin requirement versus premium collected has a 36.3% return on capital in 120 days, assuming the option expires worthless. A successful stock option sale generally returns 1% to 2% per option with time values similar to this.
Commodities option selling has its drawbacks. Leverage is a double-edged sword. While potential profits can be larger, the potential downside can be as well. An effective risk-management plan is essential for any option seller seeking consistent success.
In addition, commodities prices answer to a different master than stocks, making them more challenging to analyze for the neophyte or those accustomed to stock analysis. This can make working with a commodities professional a sensible choice for many, if not a necessity.
As a stock option seller, you cannot hope to learn all of the details of commodities options in one article. However, for high net worth investors with the wherewithal to explore new financial opportunities who are seeking a true alternative with the potential for outsized returns, the higher premiums and lower margins of commodities options can open a viable new world of investing. They also can give you a tax-friendly, diversified portfolio that is uncorrelated to equity market performance.
Option writing can seem easy at first—perhaps too easy. It is a viable strategy, but it is important to know your risk tolerance and have a plan for when the market turns against you.