Our resident options experts, James Cordier and Michael Gross, answer readers’ questions.

Q: My broker told me that with the current volatility in the market, it was not a good idea to sell options in crude oil. Would you agree with this conclusion?

We've seen our share of market-moving news events thus far in 2011. Such events, and their resulting price movements, can bring opportunity to investors. Unfortunately, when the best opportunities are available many investors cannot see the forest for the trees.

I’ve heard it from dozens of otherwise rational investors over the years:
“Put me in anything but oil.”
“Keep me out of metals.”
“I want to stay out of coffee for a while.”
“Soybeans are just too scary for me this time of year.”

It’s the classic psychological trap of cutting off the arm to spite the hand. The tough kid on the playground took your lunch money so you’re going to have him kicked off your football team. It might make you feel better. But it’s probably not what’s best for your team.

Investors do the same thing in stocks, and most definitely in commodities. You sold some calls in oil and oil spiked. You got out, lost money. Now oil is a ‘bad’ market, at least, in your mind. There is no such thing as a ‘good’ or ‘bad’ market for selling options. The markets are neutral.

I once had an investor tell me, with a straight face, that he wanted to trade only in the ‘good’ markets. He then proceeded to instruct me on which commodities were ‘good’ markets and which ones were ‘bad’. “Oh,” I kidded, “so you only want the trades guaranteed to make money?” “Yes,” he said. Dead serious.

It sounds, and is, ridiculous. But traders and investors are doing exactly the same thing when they decide to single out a certain market or sector from their portfolios because of a bad experience in the past. “No more oil for me. That market is too volatile.” That is like saying: “No more golf for me. The fairways are too green.”

When trading your own money, pulling the trigger on a trade is as much a psychological battle with yourself as it is with the market. Your personal biases are going to come into play – and not always for the better. The markets are neutral. It’s all about how you are positioned. If you sold calls on a market and lost money, especially if it happened on more than one occasion, you may begin to develop a bias against selling premium in that particular market or sector. Yet the guy who sold puts on that same market may think it’s a great market in which to sell options. It has nothing to do with the market. It has everything to do with you being on the wrong side of it.

I’ve seen traders even develop biases against selling puts or calls. “Calls are too risky. I prefer puts.” That makes no sense and has no basis in reality.

Deeming a market to be ‘bad’ can be detrimental to your commodities portfolio over the longer term. Not only will you be dismissing outright future opportunities in that market, but you are also removing an important source of diversification in your portfolio. In a portfolio structure such as the one we suggest to clients removing diversification can increase your risk over the long term.

“I don’t want to trade metals” means your portfolio will be minus one key sector of the commodities spectrum. The funds not working here will be distributed amongst other sectors, meaning increased exposure in fewer sectors. Result: a less diversified portfolio with greater risk concentrated in fewer markets. By eliminating a market from your pool of considerations, you do not reduce your risk. You accomplish just the opposite.

You lost money in cocoa last year so it’s a ‘bad’ market. You lost money in natural gas in 2007 then again in 2008. No more gas. Pretty soon, you’re down to only one or two ‘good’ markets – the ones you never lost money in. What will happen when these markets have a volatility surge and all your money is concentrated in them?

Selling options successfully is a numbers game. Over the course of a year, the goal is to have the profits from the vast majority of your worthless options outweigh the loss you had on the handful of options that stopped you out. The best way to do this is to be diversified across many sectors – none of which are good or bad. Managing a consistently profitable option-selling portfolio means being open to opportunities in all markets at all times. The hard part is that the best opportunities often come at a time when you may be least willing to take advantage of them.

Q: Are you saying that I should keep rolling up or down, as long as the volatility is high?

Not necessarily. I'm saying, don't rule out any market just because you lost money in it. There could be good reasons to be out of it. However, traders are often guilty of ‘market discrimination’ in the immediate aftermath of a volatile, losing move in one direction or the other. Rather than taking his marbles and going home, the seasoned option seller will often go looking for new premium in that very same market. Why? Because high volatility favours option sellers. The same volatility that forced you out of your old position may very well be presenting you with a stellar opportunity to sell options much deeper out of the money at attractively high premiums.

Headline news events can pump volatility into option values. It is often the case that volatility is at its peak within the first few days of a news event. That is especially true in event- or headline-related moves that tend to take place over the course of a few days. For instance, take the recent violence in Libya or the terrible earthquake in Japan. The initial surge up or down in prices causes a spike in volatility. As we’ve noted before, event-related moves tend to see the options of the underlying contract fall in price in a worst-case scenario within the first few days. Volatility measures fear, and fear is often highest during the first few trading sessions after an event when the story is still evolving and uncertainty reigns.

Often, once the full story plays out, bullish or bearish, volatility drops in all the options. Thus, if we assume that markets tend to price in the most extreme scenario within the first few days of an event and then work backwards towards reality, there would seem to be much lower risk in selling an option whose volatility has just spiked, as the chances of it spiking again are lower. Many investors, however, tend to do just the opposite.

As an option seller, you want the volatility. That is what makes options ‘overpriced’. Many professional option-selling programs focus solely on selling options that have recently spiked in volatility. There is a reason for this.

You may want to consider this the next time you get stopped out on a spike in volatility. It wasn’t because of a ‘bad’ market. Before you go looking for greener pastures to recapture your premium, you may want to look in the one that just stopped you out. It could be offering you a gift to recoup your loss and much more. That just might get it back on your ‘good’ list.

Q: What is your philosophy on building and growing long-term wealth through option selling?

My philosophy is that high-net-worth investors should be diversified over different asset classes – not just over different sectors all within one big equities pie. Too many investors diversify by buying tech stocks, manufacturing stocks, oil stocks, foreign stocks and of course, commodity stocks. And let’s face it, that is how the mainstream financial media teach you to diversify.

The problem is, no matter how many different stocks you're in, you are still in stocks – one asset class. This can be dangerous and irresponsible in protecting your net worth. If stocks sell off, chances are, they are going to take most of your holdings with them. Sophisticated investors tend to be diversified across many asset classes including equities, bonds, real estate, hedge funds, and yes, commodities. Equally important, they know there is a time to be short markets and know how to get that way. One of the most common things that new clients of my firm tell me is that they not only want to be diversified, but they want to know they can play some markets from the short side. Selling options allows you to do both.

James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling commodities options. James’ market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC.

Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, ‘The Complete Guide to Option Selling,’ 2nd edition (McGraw-Hill, 2009) is available at bookstores and online retailers. They can be reached through their website at www.OptionSellers.com.

Do you have a question for Michael or James? Email This e-mail address is being protected from spambots. You need JavaScript enabled to view it

This article was originally published in the May/Jun 2011 issue of YourTradingEdge magazine. All rights reserved. © Copyright 2011, Your Media Edge Pty Ltd.
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