Tips For Selling Options on Futures Contracts Successfully
This article assumes you understand what put and call options are, and that you know what long and short means with respect to a trade. You may have difficulty understanding me without this prerequisite.
Options trading, either with stocks or with futures, put the odds in your favor when you sell short. This is because options lose value as they reach expiration. This is known as time decay.
When you’re short you reap the rewards because you can buy them back at a lower price than you sold them, or let them expire and keep 100% of the funds received. Less commission, of course.
Uneducated traders only think of buying options (going long), and they lose most of the time. The person buying options needs to be right with his or her assumption of the direction the underlying instrument will take.
When you are short, you have time decay on your side. Even if you’re wrong (but just a little wrong) you can still make a profit.
One of the best things about trading options on futures is that IRS Section 1256 allows you to take 60% of the gains as Long Term. This is true no matter how short a time you held the trade. This is true for futures as well as the options on futures. With regular stocks you need to hold over a year.
There are other advantages with futures options, but that’s not the subject of this article. You’re here for some tips, so here they are:
Sell Premium When Volatility is High
Selling options is known as selling premium, but you want that premium to be as high as possible so you increase the chances of it eroding in value quickly. Remember that term, Time Decay?
In order to know that you are getting a decent premium, the best indicator is the volatility. Every commodity has a different volatility indicator.
For example, I sell premium on the E-mini S&P Futures options. I keep an eye on the VIX. That’s the implied volatility of the S&P 500 index options.
The Chicago Board Options Exchange (CBOE) calculates the VIX on a continuous bases while the futures are trading.
When the VIX is historically low, I wouldn’t think of selling short. However, when I see an opportunity because the S&P suddenly shot up or down, I check the VIX. If it also moved up, I might consider selling a put or a call option, depending on which way the market moved.
When you expect the market (or commodity) to go up, sell a put. That means you’re long the market. A put option will lose value when the market goes up. It will also lose value if the market doesn’t move at all. This is due to that wonderful time decay again.
Reversely, if you expect the market to drop, sell a call. That means you’re short the market. A call option will lose value when the market goes down or stays the same.
Define Your Risk to Limit Losses
When you buy a stock you risk all the money you invested. With options you have more control over your risk, as long as you include the following method with all your trades. This works for stock options as well as options on futures.
How does it work? I like to explain it with an insurance analogy. You sell short and you buy insurance to lock yourself into a max loss. The insurance is actually a long option that you buy real cheap.
Here’s a simple example to show how this works:
In the last section I spoke about selling either a put or a call. Remember, when you sell short, you collect the premium for that sale. This is also known as selling naked.You’re not protected if things go wrong, as I’ll explain.
If it looses value, which is what you want, you can buy it back at the lower price and keep the difference as your profit. In some cases, you may just let it expire worthless and you keep everything, less commission from the initial sale.
However, if the underlying future commodity does not go the way you thought it would, the option can grow in value. If that happens, you can lose on that trade because you would have to buy it back at a higher price.
The difference is a loss in that case. Time decay may help a little, but only if it doesn’t move to extremes. If things really get bad, that option can grow tremendously and you can lose a lot.
However, here’s where defining your risk becomes beneficial. If you buy another option way out of the money at the same time when you sell short, you lock yourself into a fixed max loss.
Here’s a quick example without getting into particulars, and ignoring commissions:
Say the S&P is trading at 2100. You think it won’t go below 2000 in the next 30 days.
You sell a put option to expire in 30 days at a strike of 2000 and receive a premium of $8. Each E-mini S&P option is for 1 S&P contract, and each contract has a $50 multiplier, so you receive $400. (The multiplier defines the actual value of each futures contract, known as the notional value).
At the same time you buy a put option at a strike of 1900 and you pay $2.90 (option price) multiplied by the $50 S&P multiplier, which is $145.
Therefore, you receive $400 less $145, or $255 for the trade. Sure, you get less than the full $400, but that long option locks you into a defined risk of $5,000.
How did I arrive at that risk figure? You sold an option at a strike of 2000 and bought one at a strike of 1900. That’s a 100-point difference, also known as the spread. Multiply that by $50 (the S&P multiplier). 100 x 50 = $5,000.
Actually your true risk is even lower. It’s $4,745. That’s because you received $255 for the trade ($5,000 – $255 = $4,745).
Sell E-mini S&P PUT
Buy E-mini S&P PUT
If you didn’t buy that long option and the market kept going the wrong way, you could lose endlessly, up to infinity. Of course your broker would give you a margin call and pull you out before that happens, but at a tremendous loss, nevertheless.
When you define your risk, you’ll never get a margin call. No matter how bad things get, you can’t lose more than the amount you defined as your risk – $5,000 in this example.
You can make that risk larger or smaller, depending on your risk tolerance, simply by making the spread larger or smaller.
In case you’re wondering what the percentage gain is if the option expires worthless, divide the amount you received ($255) by the risk ($5,000). That’s a 5% profit in 30 days. Keep repeating that and you’re making 60% per year on a $5,000 investment. However, I don’t recommend being greedy.
Take Profits Early
Greed is our enemy. Even though it’s true that options tend to lose value over time, due to time decay, many people hope to wait and just let the trade expire worthless.
They save on the commission since they don’t have to buy it back, but this strategy is impractical for two reasons:
First: Markets and commodities can turn around any time and move quickly in the wrong direction. Therefore it works best to take profits when you have a 50% gain on the options trade. There is no need to wait for expiration. A gain can be lost if the markets turns on you.
Of course you can always roll down, but rolling takes extra resources and you might just be priced out of the market if you need to keep rolling month after month.
This is why you should close the trade when you have a 50% gain.
Second: The second reason why waiting to expiration is impractical is that you are tying up your money for the entire time of the trade. If you already have a 50% profit within a month, take it.
This will also free up your resources so you can enter a new trade when the opportunity presents itself. You might find yourself repeating several trades in a month to make much more without using extra resources. Isn’t that better than waiting for that single trade to expire?
There you have it. Remember to use your due diligence when you enter a trade. Never be greedy and take your profits early. That’s the best strategy.
Which approach do you think is best suited for you?
The strategy I discuss here is for educational purposes only. You should consult a professional to help you with your investment strategies, and you are solely responsible for your own investment decisions.
Questions & Answers
I trade ES. What is the best way to protect my account balance from flash crashes?
As with any trade, put a protective stop order on it. Make sure it’s GTC.
I always choose the max loss I’m willing to risk, and I put a stop at that price. Don’t make it too close or you will be stopped out prematurely.
You can even use a trailing stop so your profit growth is locked in as the price rises.
If your broker doesn’t support stop orders on Futures, get another broker.
© 2016 Glenn Stok