Copyright©2015byMcGraw-HillEducation.Allrightsreserved.ExceptaspermittedundertheUnitedStatesCopyrightActof1976,nopartofthispublicationmaybereproducedordistributedinanyformorbyanymeans,orstoredinadatabaseorretrievalsystem,withoutthepriorwrittenpermissionofthepublisher.

ISBN:978-0-07-183763-7

MHID:0-07-183763-9

ThematerialinthiseBookalsoappearsintheprintversionofthistitle:ISBN:978-0-07-183762-0,MHID:0-07-183762-0.

eBookconversionbycodeMantraVersion1.0

Alltrademarksaretrademarksoftheirrespective

owners.Ratherthanputatrademarksymbolaftereveryoccurrenceofatrademarkedname,weusenamesinaneditorialfashiononly,andtothebenefitofthetrademarkowner,withnointentionofinfringementofthetrademark.Wheresuchdesignationsappearinthisbook,theyhavebeenprintedwithinitialcaps.

McGraw-HillEducation

eBooksareavailableatspecialquantitydiscountstouseaspremiumsandsalespromotions,orforuseincorporatetrainingprograms.TocontactarepresentativepleasevisittheContactUspageatwww.mhprofessional.com.

TERMSOFUSE

ThisisacopyrightedworkandMcGraw-HillEducation

anditslicensorsreserveallrightsinandtothework.Useofthisworkissubjecttotheseterms.ExceptaspermittedundertheCopyrightActof1976andtherighttostoreandretrieveonecopyofthework,youmaynotdecompile,disassemble,reverseengineer,reproduce,modify,createderivativeworksbasedupon,transmit,distribute,disseminate,sell,publishor

sublicensetheworkoranypartofitwithoutMcGraw-HillEducation’spriorconsent.Youmayusetheworkforyourownnoncommercialandpersonaluse;anyotheruseoftheworkisstrictlyprohibited.Yourrighttousetheworkmaybeterminatedifyoufailtocomplywiththeseterms.

THEWORKISPROVIDED“ASIS.”McGRAW-HILL

EDUCATIONANDITSLICENSORSMAKENOGUARANTEESORWARRANTIESASTOTHEACCURACY,ADEQUACYORCOMPLETENESSOFORRESULTSTOBEOBTAINEDFROMUSINGTHEWORK,INCLUDINGANYINFORMATIONTHATCANBEACCESSEDTHROUGHTHEWORKVIAHYPERLINKOROTHERWISE,AND

EXPRESSLYDISCLAIMANYWARRANTY,EXPRESSORIMPLIED,INCLUDINGBUTNOTLIMITEDTOIMPLIEDWARRANTIESOFMERCHANTABILITYORFITNESSFORAPARTICULARPURPOSE.McGraw-HillEducationanditslicensorsdonotwarrantorguaranteethatthefunctionscontainedintheworkwillmeetyourrequirementsor

thatitsoperationwillbeuninterruptedorerrorfree.NeitherMcGraw-HillEducationnoritslicensorsshallbeliabletoyouoranyoneelseforanyinaccuracy,errororomission,regardlessofcause,intheworkorforanydamagesresultingtherefrom.McGraw-HillEducationhasnoresponsibilityforthecontentofanyinformationaccessedthroughthework.Underno

circumstancesshallMcGraw-HillEducationand/oritslicensorsbeliableforanyindirect,incidental,special,punitive,consequentialorsimilardamagesthatresultfromtheuseoforinabilitytousethework,evenifanyofthemhasbeenadvisedofthepossibilityofsuchdamages.Thislimitationofliabilityshallapplytoanyclaimorcausewhatsoeverwhethersuchclaimorcausearisesin

contract,tortorotherwise.

CONTENTS

AcknowledgementsIntroduction

PartI:SellingOptions:Whyand

HowitWorks1.TheOptionSeller’sSecret:ExcellingintheWorld’sMostUnderrated(andUndiscovered)InvestmentStrategy

2.The“Who”ofSellingOptions:InsightsFrom30YearsintheOptionsMarket

3.WhyAren’tYouSellingOptions?TheKeyAdvantagesofOptionSelling

4.BuyingOptionsVersusSellingOptions:WhoWins?

5.OptionSellingonSteroids:AnIntroductiontoFuturesOptions

6.SPANMargin:YourKeytoHighReturns

PartII:OptionSellingStrategyandRiskControl7.HowtoPicktheRightOptiontoSell:LessonsLearnedfromThreeDecadesintheField

8.TheUseandAbuseof

Spreads:HowtoKeepThemfromTakingYourMoney

9.RecommendedSpreads:TheFewandtheProud:SpreadStrategiesThatReallyWorkfortheIndividualInvestor

10.TheBestOption-SellingStrategyEver:TheRatioCreditSpread

11.Option-SellingMechanics:QuickTipsonLiquidity,Timing,OrderPlacement,Assignment,LimitMoves,andMore

12.ManagingYourOption-SellingRisk:DefenseWinsChampionships

PartIII:MarketAnalysisandOption

Selling13.Fundamentals:The

DirtyLittleSecretAbouthowMoneyReallyGetsMadeinCommodities

14.KeyFundamentalsofSelectMarkets:WhattoWatch,WheretoFindThem

15.SeasonalTendenciesin

OptionSelling:AMostPotentProfitFormula

16.TheBestMarketsforSeasonalOptionSales:APrimerforSeasonalNeophytes

17.VolatilitySimplified:AllYouNeedtoKnowAbouttheMostMisunderstoodOptionComponent

18.HowtoStructureYourOption-SellingPortfolio:TipsonBuildingYourPremiumLadder

PartIV:GettingStarted19.HowtoAvoidthe

MistakesNewOptionSellersMake:LearnThemHereandSave

YourselfTime,Money,andHeadaches

20.FindingaGoodBrokerorMoneyManager:TheBestTradingDecisionYou’llEverMakeisChoosingtheRightProfessional

21.OptionSellingasanInvestment:FrequentlyAskedQuestions

22.PullingItAllTogether:AQuickReviewofWhatYouHaveLearned

ReferencesandResources

Index

AbouttheAuthors

ACKNOWLEDGEMENTS

Specialthankstoourfriendsat Moore Research Center,ivolatility.com, TheHightower Report and CQG,Inc. for their contributionsofcharts,graphsanddatatothis

book. You guys are the bestinthebusiness.

Also a special thanks toour associate, DavidMevoli,for his help in finding,assembling and researchingfacts, charts, graphs andwhatever else we asked himtodo.YouareatruePro.

Mostofall,wethankourclients, past, present andfuture, without whom all ofthis would not be possible.

You are the sharpest, mostelite investors in the worldand we are honored to serveyou.

INTRODUCTION

Congratulations. You havejust purchased a book thatwill fundamentally changethe way you view investingfortherestofyourlife.Manybooks promise this, but few

deliver. You will find thatthisonedoes.

Making money work foryou has become increasinglycomplex and difficult in thepastseveralyears.Theworldas we knew it for manydecadesisevolvingrapidly—insomecases,toorapidlyforour liking. Traditionalvehicles such as stocks,bonds, and real estate eithergostagnantordiveandclimb

with the rate and speed of acrashing fighter jet.Politicians and bureaucratsnow meddle and attempt toinfluencewhatshouldbeandonce were free markets. Theeconomy lurches and stallsunder the same burdens.Much of what markets doseems artificial. For marketnews, we watch C-Span (forgovernmentdebates)asmuchasCNBC.

You, the investor, thepersonwhoworkedhardandnow wants your money towork hard for you, is caughtinthecrossfire.Eveningoodtimes, investors are wary ofwhatcomesnext.Thereisnoconsistency. Nothing to grabonto. Nothing to make youfeel confident abouttomorrow. The only constantischange.

Many investors I know

arehappytomakeanyreturn,letalonedouble-digitreturns.And 20%, 30%, 40%, even50% returns on a consistentannual basis? That soundslike fantasy to most. Does ittoyou?

Are you exhausted fromthe “buy and hope” style ofmodern investing? Are youtired of your money beingheld hostage to the pricedirection of stocks or other

assets?Doyoufeelpowerlessto the forces of government,the media, the economy, orgeopolitics?

Wouldn’t it feel likefreedom and self-sufficiencyto have something that canwork year in and year outregardlessofwhatisgoingonin the world, the stockmarket, government, or thecentral bank? How would itfeeltohavetheconfidenceof

knowingyourinvestmentcanexcel innearly everykindofmarketscenario?

If you are serious aboutmakingyourmoneyworkforyou, about making realreturns in a consistentmanner, regardless of whatdirectionmarketsaremoving,you are about to get somegoodnews.

There is a way to win.Casinos and insurance

companies know the secretanduseittomakebillionsofdollarseverysingleyear.Onehosts blackjack games andone trades policies forpremiums. But both areplayingthesamegame.Theyare playing and profitingfrom odds—odds that aretilteddeeplyintheirfavor.

You can use the verysame strategy as thatemployed by these two

staggeringly profitableindustries.Youcandoitwiththe little-known and widelyunpublicized strategy ofsellingoptions.

Done correctly, themarketcondition,thepoliticalclimate, or the time of yeardoesn’t matter. It’scompletely independent ofstocks,bonds,orrealestate.

And the best part? Evenforthosefamiliarwithbuying

or selling options, very fewindividualinvestorsknowtheconcept described in thefollowingpages—theconceptyouareabouttolearn.

Warning:Thisbookmightnot be for you. If you arelooking to get rich overnightby turning a small chunk ofchange into a fortune, moveontothenextoptionbook.Ifyou are looking for 1001ways to “trade options”

written in a textbook format,please move along. If youlike to listen to flashyTVorInternet option gurus (whohave never managed moneyin their lives), who will tellyou all of the easy riches tobe had if only you had their“option knowledge”—wrongplace.

Thisbookfocusesononesimple strategy applied to anunderutilizedassetclass.And

it can be strikingly effective,if you know the rules (hint:mostdonot).

Gurus,books,andcoursesthat promise to teach you“everythingthereistoknow”aboutoptionsare franklyfullof BS. I have been tradingoptionsfor30yearsandIcanassure you, I still have onlyscratched the surface of“everythingthereistoknow.”Mostoptionbooksmake this

huge promise only to rehashthe same basic commoninformation—they show youwhat to do, they just don’tshowyouhowtodoit.

That is because most oftheguyswriting thesebooks,courses, and hosting TVshows are not professionalmoneymanagers.Hard truth:iftheyweresuchoutstandingoption traders, theywouldbetradingprofessionally.Thatis

where the money is and thatis where the cream rises to.Thebestoptiontradersintheworld are likely guys whosenamesyouhaveneverheard.

I make no secret of thefact that Imanagemoneyfora living and that I am wellpaidforthattask.Ialsomakeno secret that part of themotivation for writing thisbook is to attract newinvestors/clients to my

practice. That being said,mostpeoplereadingthisbookwill not become my client.First and foremost, mostdon’t have enough capitaland/or will otherwise notqualify tobecomea clientofmy firm. More so, however,therearethosewhohavelesscapital,thosewhowanttodothings for themselves, orthosewhosimplywantapart-time semi-passive method ofgeneratingincomeorgrowing

wealth. If this is you, thisbook is very much for you,too. This knowledge shouldnot be reserved simply forinvestors ofmeans. It causesme no harm to share it withyou. In fact, I consider it anobligation.

With the popularity ofoptions soaring amongmainstream investors since2009, there seems to be awealth of option information

floodingthemarket.Someofitisgood.Mostofitisutterlyuseless to the individualinvestortryingtoincreasehisorhernetworth.

Youplunkedyourmoneydown for this book, youdeservetogetsomethingyoucan really use to makemoney. If we never crosspaths again, it is my sincerehope that you can say thatthisbookmadeyoumoney—

hopefullyalotofit.It is also my hope that

you keep it in a separateplace, away from your otheroption books, so as not tocontaminateit.

Unlikemost of the gurusyou see advertising theiroption knowledge, I have nocourse, seminar, or CDcollection to sell you. Youcan rest assured that theknowledge you are obtaining

here comes from a real-lifeportfolio manager who hasexecuted the strategiesexplainedthousandsoftimes.This is the real stuff—notalways as neat and pretty asin the textbooks, but blunt,unpolished, and effective.You can take the knowledgeyougain from this textaloneand begin implementing it ina portfolio. No 1001 waysneeded when you find onethatworksconsistently.

Most investment ortrading books aspire to teachyou how to do somethingbetter (buy the right stocks,time trades better, see adifferent pattern, etc.). Thisbookwillintroduceyoutoanaltogether different way ofgenerating capital that hasexisted only in a parallelshadow world of themainstream investmentlandscape. As you will find,its participants skew to high-

net-worth investors, hedgefund managers, and privatemoney.

We thought it time thatsomeone brought it to yourattention.

How do we know?Because we’ve workedalongside peopleimplementingthisstrategyforthe last 15 years. WhenMcGraw-Hillaskedustodoathirdeditionof thisbook,we

could not pass up theopportunity to sharewith thegeneral investmentcommunity something theycould be doing to reallyempowerthemselves.

Be warned: In this book,youaregoing toventure intoan asset class that mightinitially make you feeluncomfortable.Bearwithit.Ipromise you it is not asdifficultor as intimidatingas

youmightthink.Ithassimplynever been explained to youproperlybefore.

If you are a stock optionguy who thinks you areinterested only in sellingoptionsonshares, Iurgeyounottoputthisbookdownyet.You are going to learnsomethingherethatwillopenawhole newworld to you. Ipromised to change the wayyou look at investing for the

restofyourlife,andImeanitforthestockoptionguys,too.

You will find this bookavoidsthesame,tiredtradingphilosophies, complexnumber crunching, andpainful Greek alphabet soupthat plagues most booksabout options. Quite thecontrary. Selling optionsdoesn’t have to be difficult.You will find this booksimple and surprisingly easy

tofollow.Commonsense,nota fancy Greek calculator, isallthatisrequired.

In addition, the lessonsand concepts revealed herehave not been “theorized”and calculated from thecomfortable confines of aclassroom or universitylibrary. This is hard-wonknowledge,honedintheopenwarfare of market trenches.Combined, its authors have

more than 46 years ofexperience in the futures andoptions industry. We havereadalltheoldoptionbooks,too.What we found is whenyou go to apply them in thereal world, much of theinformation is impractical ifnotutterlyuseless.Whatyouread here is what reallyworks,what reallymatters—a library of book knowledgeand a lifetime of real-worldknowledge, relentlessly

culled and distilled into aconcentrated potion. Theresult is a simple text thatgives you only and exactlywhatyouneedtosucceed.Nowastedtimeorpagesonwhatyoudon’tneed.

Who reallymakesmoneyin the options business, wholoses it, and why? Whodoesn’t want you to knowabout it?How do they do it,exactly? Most importantly,

thisisatransferofknowledge—how you can do it now—simplyandeffectively.

Though completelyupdated and adapted tomeetmodern market conditions,the core lessons of this thirdedition remain intact. Thestrategy that is about to berevealed to you works. Thatis not going to change.Therefore, whether you arereading this book in 2015 or

2030, the lessons areevergreen and will benefityoufordecadestocome.

It is not our intention inwriting thisbook toput forththe proposition that sellingoptions is the only way toinvest. Nor do we proposethat option selling isappropriate for everyinvestor. It is also not ourintention to mislead readersinto believing that losses

cannot result from sellingoptions.Itissimplyourbeliefthat after all our years in theindustry,alltheoptiongurus,market prophets, backwardsdouble-butterfly spreads,market crashes, wars, QEs,credit crunches, governmentshutdowns, and currencymanipulations,thisistheonlyway we’ve found to profitconsistently in today’sunstable, unpredictable,illogicalmarkets.Webelieve

itisourdutytoshareit.We originally wrote this

book to help you to makemoney. This revised, fullyupdated, modern edition ispublished to help you makemoreofit.Wewillconsiderita success if it achieves thatend.

JamesCordierMichaelGrossNovember2014

PART I

SELLINGOPTIONS:WHYANDHOWITWORKS

1

TheOptionSeller’sSecretExcellingintheWorld’sMostUnderrated(and

Undiscovered)InvestmentStrategy

Forallofyouoptionbuyersouttherethatarequestioningwhethertotakethesellsideofthetrade,letmeaskyouthis:Howmany

timeshaveyouboughtanoptionandhaditexpireworthless?Ifyoucouldturneveryoptionyoueverboughtintoasellinstead,wouldyoubebetterofffinanciallytodaythanyouarenow?”(Lowrumbleof

laughterandnoddingheads).Thenwhatisthequestion?JAMESCORDIER,LASVEGASTRADERSEXPO,2006

Have you ever heard it saidthat the vast majority ofoptionsexpireworthless?Itisestimatedthatanywherefrom75% to 80% of all options

held through expiration willindeed expire worthless.Furthermore,expertsestimatethat only 10% or less of alloptions will ever beexercised. This being thecase, why aren’t moreinvestors takingadvantageofthisphenomenalstatistic?

Why are most investorsstuck in traditionalinvestments—heldhostage toprice movement based on

worldly factors far out oftheir control? Why are theysettling for what they havebeen told are “normal”returns?

Why are the average sit-at-home investors notanalyzing strike prices?Whyaretheynotseekingthemostglowing opportunities fordeterioration instead ofreviewing endless tables ofmutual fund performance or

stock price–earnings (P/E)ratios?Why are they willingtobetrappedbyanassettheypurchased, hoping andpraying that it appreciates invalue?Why are the majorityof nonprofessional traderslosingmoneyyearafteryear,trying to pick the perfect topor bottom by buying orselling a stock or futurescontract?

Worst of all, why do

some “investors” buy out-of-the-money puts or calls thathaveonlyaremotechanceofever showing any kind ofprofit,letaloneawindfall?

Why aren’t all of thesepeople selling options? Theanswer is, either they don’tknow about it, they don’tunderstand it, theyarescaredof it, or they just plain don’tcare. It has been myexperience that those who

consider themselves in thelatter two categories areactually in one of the firsttwo.

Ifthisisyou,it’snotyourfault. The concept of sellingoptions goes against whatmostofushave alwaysbeentaughtaboutinvesting.

TheMythoftheMainstream

InvestmentIndustry

We’ve all had investment“common knowledge”pounded intoourheadssincewe picked up our firstinvestment book: Buy low,sellhigh.Buy thispercentofstocks, thispercentofbonds.Buy and hold. Themainstreaminvestmentmediareinforces these themes daily—primarily because they are

constantlybeingdrivenhomeby the multitrillion-dollarinvestment industry: mutualfunds, stock brokerages, thefinancial planning industry,IRAs, 401Ks, advisors,authors,younameit.

These investments, ofcourse, have their place.However, they share onebasicdrawback:Theyallrelyon you to purchase an assetand then hope that asset

appreciates in value. Thisleavesyouwithonlyonewaytomakemoney:Thepricehastogoup.Andithastogoupafter you bought it…fromsomeone who thought theprice was going down. Soyou have to be smarter orknow something the sellerdidn’t.

But what if the pricedoesn’tmoveor,evenworse,goes lower? You are out of

luck.Thereisnowayforyoutotakeadvantageofthat.Youareheldhostagetothewhimsofyourassetprice.

Oh,youmaytellyourselfthat “over the long term” thething is sure to appreciate.Butifyouaretalkingaboutastock,thereareaheckofalotof factors that can move theprice of it—and they mayhave nothing to do with thecompany itself.Youbuy and

hopethevaluegoesup.Whatare the odds of thathappening, and how longmight that take? Well,nobodyreallyknows.

Nonetheless, the industryhas done an outstanding jobof convincing the public thatbuying an asset forappreciation is the best oronly way to invest. Theproblem?It’snottrue.

TheHaplessGameofOptionBuyers

Most traders and investors,especiallyinthecommoditiesarena,havebeen taught fromtheir first trading lesson thatto turn a profit, a series ofsmalllossesmustbeacceptedtomake that one big gain. Itis the potential for this onebig gain that keeps tradersand gamblers alike coming

back time after time andlosingmoneytimeaftertime.Taking many losses to makeonebiggainisverydifficult,evenforthemostexperiencedinvestor. Why? Because itgoes against human nature.Humans are cursed with thefeeling of hope wheninvolved in an investmentsituation.Wehopeourlosseswill turn around for us andlookforexcusestostayinourposition for one more day.

Yet, when faced with awinning trade, the anxiety ofremaining in the position isalmostunbearable.

Many traders’ firstexperience with futures is inbuying options. This isbecause their brokers toldthem that thiswas the “safe”way to trade. “Limited risk”is what they are promised.Indeed, the purchase ofoptionsdoeslimityourriskto

theamountofmoneythatyouinvest in these options.Unfortunately, most of thetime, the amount that youinvestwillbetheamountthatyou lose if you use optionbuying.Theoddsarestackedtremendously against you.There is a very good chancethat your options will expireworthless.

Maybe one of yourpositions made money. You

take what is left from thatprofit and reinvest in buyingmoreoptions.Now there isagood chance that thoseoptionswillexpireworthless.Even ifyoumanage toprofitfrom a few, eventually thechances are that your luckwill run out. When theseoptions are all expired, youhave lost your money.However, somebody elsemademoneyonthoseoptions(besides your broker).

Somebody took yourpremium and put it in his orheraccount.

ProfessionalsPlaytheOdds

Did you ever watch theProfessional Poker Playerstour on ESPN? Hundreds oreven thousands of peopleenter these tournaments. Yet

thesamesmallbunchofguystend to end up in the finalgames, on a consistent basis.Why?

Althoughmanythinkthatpoker is a game of chance,this observation wouldsuggest otherwise. Theseguys get there because theydon’t play poker like mostpeople play poker. They areonly playing odds, on eachhand,oneachdrawofacard,

on each bet. They areapproachingthegamefromacompletely differentperspective thanmost peopledo.

Unlike the investingpublic (buyers of assets oroptions on those assets),professionals andWallStreetinsiders have often movedbeyond thegameof trying toguess which way the marketis going to move.

Professionals are moreinterestedinplayingodds.

When I first bought mysummer place in Chicago, Iarranged for my boat to betransferred up from Floridaforthewarmweathermonths.Onmyseconddayattheboatdock, the man docking nextto me asked me about thename of my boat—TheOption Sailor. When Iexplained to him my

occupation, he invited me tolunch at his house. It turnedoutthatmynewfriend“Stan”wasaprofessional trader.Hetook me into his tradingroom.TosayIwasimpressedwas an understatement. Theamount of equipment in thisroomwasstaggering,eventome—a portfolio manager. Icould not imagine it was allnecessary for an individualtrader.

Stan traded in vehiclesthat I did not, so we hadmuch to share with eachother. When it was time toleave,Iturnedtoaskhimonemore question: “Do youreallyfeelallofthesescreensand programs give you anedge?”

“Only about 1%,” hequipped.

“Youuseall of this for a1% advantage?” I asked

incredulously.He smiled. “That’s all I

need.”

TheOptionSeller’sSecret

Although Stan’s approach togaining an edge may havebeen, inmyopinion, a bit ofoverkill, the story illustratesan important concept. Real

professionals, the guys whomake their livings fromtrading,aremoreinterestedinplaying the odds. Withoutdescribing his tradingprogramhere,sufficeittosayStan’s equipment was theremore or less to calculateodds.

If you remember the1980smovieWallStreet, thecharacter Gordon Gecko betonly on “sure things.”

Thoughtheremaybenosuchthing in legitimate investing,professionals are looking tostackthehighestoddsintheirfavorbeforeputtingmoneyatrisk.Using strategies such asspreads,swaps,andarbitrage,pros can increase odds ofsuccess without betting onoutrightmarketdirection.

Many of theseinstitutionalstrategies requireeconomy of scale (i.e.,

billions inequity), aphysicalpresenceonthetradingfloor,hundreds of thousands ofdollars in “quant” software,or a team of highly skilledemployees to executeeffectively.

TheProStrategyThatIndividualInvestorsCanUse

There is one strategy,however, favored byprofessionals, which can belearned relatively quickly bythe individual investor.Moreimportantly, it can beimplementedfairlyeasilyandefficiently by the personalinvestor.

The strategy is sellingoptions.

Theoptionseller’ssecret,theaceinthehole,isodds.If

youknewthat theoddsfavorany option expiringworthless, would you nothaveanadvantagebeforeyouever do one lick of researchonstrikes,time,orunderlyingmarket?Further,doyouthinkdoing just a little bit of suchresearch can improve thoseoddsevenmore?

If you have ever lostmoney buying options,imagine thatyouhadmadea

premiumforeveryoptionyouheld that expired worthless.Would you be ahead rightnow?

The option seller alsoenjoysthebenefitofmultipleprofitscenarios.Ifyoubuyanasset, the price has to moveup for you to make money.Andifyoubuyanoption,theprice has to move in yourdirection quickly for you tomake money. In either

situation, there is only onewaytoprofit.

If you sell an option, themarket can move in yourfavor, it can remainstationary, it can even movemoderately against yourposition. In any of thesescenarios, it still expiresworthless. You still makemoney.

Of course you can alsolose money selling options.

Thereisnofreelunch.Butinoption selling, there aremultiple ways you canmakemoneybutonlyonewayyoucan lose it. I like thoseodds.And I like them a lot betterthanStan’s1%.

WhatThisBookWillDoforYou

Thepurposeofthisbookisto

introduce the concept ofoption selling (or writing) toyou, the nonprofessionalindividual investor. It is ourbelief that the individualinvestorhasbeendeprivedofnotonlyaqualityresourceonthe subject of pure optionwriting but also a concreteblueprint for how to selloptions successfully. Sellingoptionsforpremiumhasbeena favorite strategy ofprofessional and commercial

traders for years. After all,somebodyhastobesellingallthose options to the generalpublic,who seem to have aninsatiable appetite forbuyingoptions all the time. Moreoften than not, these are thepeople making the realmoneyinthisbusiness.

Youwill learnhow todothis for yourself. Simpleconcepts for selling optionsfor premium and controlling

risk will be explained not intechnicaljargonbutinsimpleterms. Our intention is todemystify option selling forthe individual investor. Thegrowing popularity of sellingoptions is undeniable. Yet itremains one of the leastunderstood concepts in thetrading world. Themisunderstood concept ofunlimited risk—which seemsto frighten some investors—will be broken down and

explained.After knowing thefacts, unlimited riskmay notbe as intimidating as itsounds.

When you finish thisbook,youwillnotonlyknowabout selling options, youwill both understand theprocess and, hopefully, beable to use it to generatestellar returns for years tocome. This will hold true inbullorbearmarkets,goodor

bad economies, quiet orvolatile price moves, trendsornotrends.

The concepts you willlearn here can be applied toboth stock and futuresoptions. However, you willfind that the focus of thisbook remains firmly onfutures options. There aresome very good reasons forthis—especially if you areinterested in making larger

sumsofmoney.Thesewillbeexplained later. In themeantime, if you think thatyou are interested in sellingonlystockoptions,Iurgeyounottoputthisbookdownyet;you may be pleasantlysurprisedatwhatyoulearn.

More importantly, youwill join a very small groupofeliteswhoknowtheoptionseller’s secret. This group ismade up primarily of fund

managers, people who maketheir living trading and havehigh net worth, and/orsophisticated investors whospend a lot of time andmoney acquiring suchknowledge. This group doesnotmind,infact,mayprefer,that option selling remain“off the radar screen” of themainstream investmentcommunity.

Butwe’re happy to bring

ittoyours.Welcometotheclub.

PersonalRevelationfromtheAuthor

HowIDiscoveredSellingOptionsBYJAMESCORDIER

I never claim to haveinvented the concept ofselling options. Rather, Iacquired the knowledgemore or less by stumblingupon it. I discoveredcommodities when I was14 years old. I had a coincollection and kept itmeticulously organized bydate, type, etc.. One day Iboughtasetofsilvercoinsandkeptthemtogetherasaset.Whilemy brotherwas

playing baseball, I wasfollowing the price ofsilver in The Wall StreetJournal. A few monthslater, I noticed that silverprices had risen to over$6.00 an ounce. It wasabout$4.00anouncewhenI bought the coins. I tookthem down to my localmetals dealer and askedwhathewouldofferformycoinset.Tomysurprise,heofferedme$60for theset,

a120%profitfromthe$25I had paid for it.Asmuchas I liked my coin set, Itook the money. I couldbuymorecoins.Heboughtthem for the silver valuealone.

When I got home Ithought “That was prettyneat.” I was hooked. Tenyears later, I became acommodities broker. Oneof my first duties was

helping my clients to buyoptions. It took me fiveyears to figure out thatbuying options is a toughway to make money. Icould study every tinydetail about soybeans,coffee,oil,orgold,get themarket direction right, butwewould still losemoneybecause we bought anoption.

And then I read a

statistic that said 80% ofoptions expire worthless.So I started the study ofoption selling. I talked afew of my clients intogivingthestrategyatry.Itworked—extremely well.There was only oneproblem. These guys weregamblers. They werefutures traders. They werein it for the thrill.Making20%, 30%, even 40% ayear was not enough for

them. They wanted theaction.Sellingoptionswasalittleslowfortheirtastes.I discovered they wouldsell options for thepremium and then use thepremiumstomakebigbetson fast-moving futurescontracts. Although someactually caught a few bigmoves and cleaned up,most of them didn’t.Anything they couldgenerate from selling

optionswaseventuallylosttryingtotimemovesinthefuturesmarket.

That’s when I realizedthe difference betweeninvestors and gamblers.And so, in 1999, I startedmy own firm, specializingexclusively in sellingoptions. My firm was forinvestors.

At that time, manyinvestorswerenotreadyto

accept this “new”investment strategy. Theyhad never heard of it(despite the fact that fundshad been quietly using itforyears).Westartedslow,writinga fewarticles.Andclients started coming.People started to get it.Then we started to getsomebuzz,andprettysoonthereafter McGraw-Hillcame knocking. Theythought we had a pretty

good concept and wantedustowriteabook.Wedid.The first edition of TheComplete Guide to OptionSelling was published in2004. Then CNBC, TheWall Street Journal, andBarron’s started calling.Investors from around theworld started calling. Andwerealizedtherewereveryfew firms out thereoffering this. To say itsnowballed from there

would be anunderstatement. But it’sbeenagreat ride.Weverymuch enjoy being “theoptionsellerguys.”

AuthorRevelation

HowIDiscoveredSellingOptionsBYMICHAELGROSS

In 1996, I began mytrading career as a retailcommodities broker at amedium-sized investmentfirm. Eager and fresh outof training, my job at thetime was to advise clientson the firm’s research andrecommendations. Whennew trades wererecommended,Iwouldcallclients and inform them.Most of the time, at thepreference of the

company’s leadership,these trades involvedbuyingoptions.Beingnewtothebusiness,Iembracedthe strategy and dutifullycalled our clients with thetrades. It did not take melong tonotice thatmostofthese options eventuallyexpired worthless.When Iasked my manager aboutthis, he informed me thatmost futures traders wantto “swing for the fence”

and that we were justhelpingthemgetwhattheywanted in the most cost-effectivewaypossible.Thefact thatmostof them lostmoney sooner or later(mostly sooner) seemed oflittleconcerntohim.

Butitnaggedatme.One day, I was on the

phone with a new clientnamed Art. He was anoldermaninhismid-70sor

so. His account profilelisted his profession as“investor” and he held aconsiderable net worth—higherthanmostanyoftheother clients with whom Ihad worked at the time. Iwas explaining to him themeritsofourlatesttrade—buying soybean calls inexpectationofdrought.

“Son,I’vebeentradingcommoditiesfuturesfor40

years.How long have youbeeninthisbusiness?”

“About 6 months,” Iadmittedsheepishly.

“And that isallyoudoisbuyoptions?”

“Primarily…yessir.”“Well you better learn

to sell them or you’re notgoingtobearoundlong.”

It turned out that thisguymadehislivingsellingoptions. Why he had an

account with us, I do notknow. Perhaps to take theothersideofourtrades.

What followed was alife-changing, albeithumbling, conversation.Here was a man who wasworthmorethanhalfofmyclientsputtogether,andhewas making a living—apparently a very nice one—doing exactly theopposite of what we were

recommending.What was astonishing

to me was that he did notconsider himself a trader.He considered himself abusinessman/investor whosimply took advantage ofopportunities when theoddswereoverwhelminglyinhis favor.Hedidnotsitaroundandwatcha screenallday.Infact,heconfidedthat he spent most of his

time playing golf, runninghis grandkids around, andshoppingwithhiswife.Hescanned his trading screenabout 30 minutes eachweekday morning, enteredany order he wanted toplace, if any, and thatwasit.Donefortheday.

That day, a lightbulbnot only clicked on in myhead, it exploded. It madesomuch sense.Everybody

was buying options,swinging for the fence,hoping their lottery ticketwould hit. But the onlyones making any realmoneywerethoseactingasthe casino. They were theones selling all of theseoptions we were buying.Theywerewillingtomakea premium on each tradeand thatwas it.Butunlikethe buyers, the odds werestackedoverwhelmingly in

theirfavor.InArt’scase,hehadno

interest in gambling orswinging for fences. Thiswasapurebusinesstohim.He simply entered aninvestment arena full ofgamblers and wishfulthinkers and sold themtheir pixie dust, over andoverandoveragain.

Traderscameandwent,year after year, washing

out, closing up shop. ButArtjuststuckaroundlikeafeatureofthelandscape.

For the 12 monthsfollowing thatconversation, I studiedoption selling with apassionIhadneverknown.I pleaded with mysupervisor and eventuallywenttothepresidentofthecompany,asking if Icouldstartsellingoptionsformy

clients. Repeatedly, I wasdenied.

“It’s too much risk….That’s only forprofessionals…. Theywon’t understand it….Nobody will want to doit…. It’s not excitingenough for them….” werethereasonsIwasgiven.

Apparently, makingmoneyforthemwasnotonthemissionsheet.

Eventually, I wasgranted permission to takea small group of clientswhohadexpressed interestin the strategy and beginselling options. The earlyresults were soencouraging that I beganentertaining thoughts ofstartingmyownfirm.

When I met JamesCordiershortlyafter that,Icould not believe my luck

that he was actuallyworking with some of hisclients in selling options.We knew right then andthere that we could worktogether. We knew wecould take this to thepublic.

2

The“Who”ofSellingOptionsInsightsFrom30YearsintheOptionsMarket

Are you the type of investorwhohastherightconsistencyandobjectivestobeanoptionseller? Or are you not? Thischapter was meant to helpyoudecidethatbasedonwhothetypicaloptionselleris(inourexperience).

TheFiveQuestionsYouShouldAsk

This chapter is divided intothefollowingfivesections:

1.Whyshouldyoulistentous?

2.Whodoesn’twantyoutoselloptions?

3.Whodoesn’ttradeoptionsatall?

4.Whoisbuyingoptions?5.Whoissellingoptions?

The chapter’s purpose is to

giveyouafeelforthetypeofinvestor who sells optionsand to help you betterunderstand if the strategy isrightforyou.Doesthetypicaloption seller sound like you?Orareyoumoresuited tobean option buyer? Or are youtypically better off notinvestinginoptionsatall?Ofcourse, these are onlygeneralizations and nobodyfits neatly into a narrowcategory. The option selling

alternative is open toeveryone, but only you canknow if writing premium isthepathyouwanttotake!

WhyShouldYouListentoUs?

Firstofall,youdon’thavetolisten to either of us.However,Ihavebeendealingwith option traders since

1984. Since 2000, I haveworked almost exclusivelywithhigh-net-worth investorsin the strategy of sellingoptions. I have workedalongside investors ofdifferent nationalities, ages,professions, net worth,investment objectives, andrisk tolerances. Iestimate thetotal is over 1,500individuals.Inadditiontothisbook and its twopredecessors, I have

published more than 150articles on selling options,manyofwhichhaveappearedon Yahoo! Finance,Businessweek.com, orFortune.com, to name a few.You may have seen mediscussing our work duringour many appearances onCNBC, Bloomberg News,FoxBusinessNews, theNeilCavuto show, orLarryKing.My market insights arefeaturedregularlyinTheWall

Street Journal, Barron’s,InvestorsBusinessDaily,andForbes.

Although mostobservations here are notscientific and are based onourpersonalobservationsandexperience in the industry,someofthemarebasedonanactual study done on ourclient base in 2012.Nonetheless, this is notscientific data, so don’t call

meupandaskmetodefenditinawhitepaper.

With all of that said, thisiswhatIhavefoundtobethetendencies.

WhoDoesn’tWantYoutoSellOptions?

1.Yourbroker.(Surprise!)Itmayseemcounterintuitiveto

thinkthatyourbrokerdoesn’twantyoutoselloptions.Thinkagain.Obviously,yourstockbrokerdoesnotwantyoutosellcommoditiesoptionsasthatcanmeanmoneymovedawayfromhimorher.Butitgoesdeeperthanthat,evenifyoualreadydealwithacommoditiesbroker.Formostmainstream

brokerages,sellingoptionsisahassle.Ispeakprimarilyofthecommoditiesindustry,butIknowforafactthiscarriesoverintotheequitiessideofthingsaswell.

Buyingoptionsisaloteasierforabrokertodo.Thebrokerdoesn’thavetowatchthetransactionas

closely(theriskislimitedtothepremium).Themarginismuchlowersohecanbuyalotmoreoptionsthanhecansell.Buyingoptionsmeanstradinginandoutmuchmoreastheoptionslosevalueandheseeks“betteropportunities.”Sellingoptionsisusuallyonesaleandthenaslow

waittoexpiration.Somebrokersdon’tlikethat.

Perhapsmostimportantly,however,isthatitislikelythebrokerdoesn’tunderstandmuchaboutsellingoptions,andhissupervisorisdiscouraginghimfromdoingitorpromotingit.Orifhedoes

understandit,hedoesn’twanttoexplainor“teach”ittoyouwhenitismucheasierforhimtobuythem.Wearenotputtingdownbrokershere(webothstartedoutasbrokers)—justpointingoutthatsomehavetheirbestinterestsatheart—notyours.Evenonlinebrokersmakeithardertoselloptions

thantobuythem,makingyouqualifyfordifferent“levels,”andcharginghigherthanminimumexchangemargins.Ifyouwanttoselloptions,youarebestservedfindingabrokerthatspecializesinthisonestrategy.

2.Yourfinancialplanner.IhaveafinancialplannerandI

lovehim.Butifhedidn’tknowmeandItoldhimIwantedtoselloptions,hewouldtryeverywhichwaybutSundaytotalkmeoutofit.Why?EventhoughItrulybelievehecaresaboutmybestinterest,hedoesn’tknowanythingaboutsellingoptions(especially,eek!commoditiesoptions).

Nordoeshecaretolearnanythingaboutthem.Moreimportantly,perhaps,hedoesn’tofferany“products”thatpayhimacommissionforsellingoptions.Thus,hedeemsit“toorisky”andsomethingbetterleftunexplored.Thereisaplaceforfinancialplanners,ofcourse.Buttheyaretrainedtosella

selectionofproductsthattheyortheirfirmoffers.Theydonotoffer,noraretheylicensedtooffer,commoditiesoptions(nordoIknowofanythatdealinstockoptions).Ifyouwanttoselloptions,you’regoingtohavetolearnityourselforworkwithsomeonewhoknowswhattheyaredoing.

3.Yourbuddiesattheclub,themarina,theoffice,etc.(OK,thecoolonesmight,buttheothers,don’t.)Why?Becausetheydon’tunderstandsellingoptionseither.Or,theymightunderstandsomethingaboutstockoptions,butthey’veheardcommoditiesare“risky.”Everybodyhas

astoryaboutUncleLesterwholosthisshirttradingporkbellies,right?Nowyouwanttomesswithoptionsonthesethings?Everyonehastherighttobeuninformed:Thatdoesn’tmeanyouhavetobe.

WhoDoesn’tTrade

OptionsatAll?

This question should beaccompanied by a sisterquestion,whoshouldn’t tradeoptions at all? In general, ifyou count your pennies andonly have two dimes to rubtogether, you shouldn’t beinvesting one of them in anoptionaccount. Ifyouareona low or fixed income, havelittle or no liquid net worth

and your lifestyle would beaffectedby losing themoneyin your option account, youshouldnotbe tradingoptions—buying or selling.Fortunately,mostpeoplewhoshouldn’t trade options,aren’ttradingoptions.

As for the people whocould be trading options butdon’t? Those would includepeople who are happy withtheir current investment

performance with no interestin potentially improving it.Peoplewithanextremelylowtolerance for risk.Or, peoplewho simply have no interestinlearningnewthingsornewwaysofdoingthings.

WhoIsBuyingOptions?

Inmyexperience, and this is

a general statement, optionbuyers tend to be lesscapitalized and lessexperienced traders and/orinvestors.Althoughitisnotahard-and-fast rule, it is myopinion formed from nearlythreedecadesinthebusiness.The option buyers I haveknownandworkedwith(andtherehavebeenmany)tendtoskew toward those trying toturnasmallamountofmoneyintoalargewindfall.Justlike

at the casino, this is mostoftenalosers’game.Wewillexplore this more in laterchapters, but suffice to say,with the majority of optionsexpiring worthless, buyingthem can be compared tobuyingalotteryticket.Attheendof theday,mostof themareinthetrash,worthless.

Buying options is oftenthe preferred strategy ofbeginners—at least as it

applies to commodities. Itslimited risk aspect allowsthem to “learn” aboutcommodities with a defineddownside.Atleastthat’showthepitchgoes.Inmyopinion,the only thing they learn ishowtolosemoney.

I must also preface thatstatementwith the fact that Iamreferringtotheindividualinvestor only—one who isseeking to profit solely

through thebuyingor sellingofanoption.Therearehedgefunds, private equity funds,commercial hedgers, largetraders, and others who buyoptions for a myriad ofreasons. These could includerisk protection, hedgingpositions, complex spreads,andmore.Very few of theseentities are likely to bebuying options as a singularstrategy inapurespeculativeplay.Theseinvestorsarepros

and they know the odds.Buttheirparticipationiswhereallof the liquidity comes from.Begratefulforthem.

WhoIsSellingOptions?

First of all, hedge funds andprivate money managers sella ton of options. Why andhowtheydoitisasubjectfor

later chapters. This chapterfocuses on the individualinvestor.Overthepastfivetoseven years, we have begunto limit the number of newinvestorsweacceptasclients.One way of doing this is togradually increase theminimum investmentaccepted. However, what wediscovered was that thehigher up the net-worthladder we skewed, the moreacute the tendencies listed

belowbecame.Thus, the characteristics

listed below are derivedprimarily from our firm’sclient base frommore than adecade.Thismeansthattheseobservations are basedprimarily on high-net-worthindividuals. The informationwas obtained through bothaccountinformationandnew-client interviews, which werequire for anyone applying

formembership.Thisiswhatwe found. The commodityoption sellerswithwhomweworked tended to be thefollowing:

•Successfulintheircareersorbusinesses.

•Self-describedas“somewhat”to“veryexperienced”investors,butfewdescribedthemselvesas“traders.”

•Worthbetween$1and$5million.(Otherswereabovethatlevel.)

•Seekinghighreturns—atleastonsomeportionsoftheiroverallassets,andareopentoalternativeinvestments.

•Self-taughtinhowtotradeorinvest“thehardway”or“fromtheschoolofhardknocks.”

•Overwhelminglymale.

•Independentthinkerswhoarenoteasilyswayedbyothers’opinions.

•Typicallyexpertinatleastonecategoryordiscipline,toappreciatethevalueofexpertise,andtobelieveinhiringotherexpertstomanageorhelpthemmanagetheirassets.

•Experienced(usuallya

badexperience)inbuyingoptions(stockorfutures).

•Self-describedasneitherriskaversenorasa“risktaker.”

•Willingtotakecalculatedriskstoobtainoutsizedobjectives,bothininvestmentsandinlife.

•Marriedwithfamilies(childrenor

grandchildren).•Seekingdiversityfromequities,bonds,andothermainstreaminvestments.

Surprisingly, most of ourclients saw sellingcommoditiesoptionsasawaytotargethighreturnsontheirinvested capital or to growtheir net worth—as opposedto generate income. Otherstatisticswegatheredinclude:

•Agesrangedfrom35to75yearsoldwiththeconcentrationskewingtowardtheuppermiddlerange.

•Nearly40%wereretired.

•Professionsrangedfromphysicians,attorneys,pilots,accountants,realestateprofessionaltoself-employed,

entrepreneurs,investors,orgeneralbusinesspersons.

•About20%areclassifiedas“other.”

•31%neversoldanykindofoptionsbefore.

•84%nevertradedcommoditiesoptionsbefore.

It is not my intention tojudge or interpret these

observations but rather toallow you to do that foryourself.Doesthissoundlikeyou? Does this sound like aclub youwould like to join?Doesitsoundlikeyouareatleastintherightplace?

Ifso,readonandyouwilllearn why people like this,perhaps people like you,choosetodumpthe“buyandhope” route to investing infavor of (or at least in

addition to) an enlightenedapproach—one few take thetimetolearn.

If you do, I can promisethat you will never look atinvesting in the same wayagain.

3

WhyAren’tYouSellingOptions?TheKeyAdvantagesofOptionSelling

As enlightened as a seller ofpremium may be, our littlecorner of investing is stillinvesting. Losses can stillhappen: It’s thenatureof thebeast.

Thatbeingsaid,thenameofthisgameistomakemoremoney thanyou lose.That isyour mission in anyinvestment.Sellingoptionsissimply a different way toaccomplish this mission. It

just so happens that it offerscertainadvantagesthat,inouropinion,make this featmuchsimpler, and maybe eveneasier, to accomplish. In thedifficult game of makingmoney in the markets,simplerandeasierisbest.

In our many years ofprofessional investing, we’vetried dozens of approachesand strategies in our searchfor the investmentholygrail.

Although option selling maynot be the holy grail, we’vefound nothing to match itsconsistency. The potentialreturns to be gained fromsuch consistency are whathave kept us with it for solong. The reason for thisconsistency is that optionselling offers advantagessimply not found anywhereelseintheinvestmentworld.

Few in the general

investment community areaware of these advantages.Fewerstillareemployingthestrategy of selling premium.Most are deterred by theterms limited profit andunlimited risk. This is goodbecause as an option seller,you need plenty of tradersbuying options to help fundyourretirement!

This chapter covers theadvantagesofsellingoptions.

Before you learn the how,youmustunderstandthewhy.For a complete comparison,however, you will also findthe drawbacks to sellingoptions in this chapter. Andthere are some—no strategyis perfect. We didn’t writethisbooktoputoutone-sidedpropaganda but to give youtherealstoryso thatyoucanmakeyourowndecisions.

Advantage1:TheOddsAreAlwaysinYourFavor

Let’s start with the biggestandmost obvious advantage.The fact is thatmost optionsdoexpireworthless.Thisisafact:Ithasbeenconfirmedbystatistics. However, let’sclarify this statistic. Theactual figure is that mostoptions (north or south of

80% based on whose figuresyou are watching) held toexpiration expire worthless.Therefore, when we refer topercentages of optionsexpiring worthless, we arereferringtotheoptionsontheboard at expiration. Somestudies suggest that up to60%ofalloptionsareclosedout prior to expiration.However, these same studiesindicate that only about 10%of all options ever get

exercised.Whatthismeanstoyou as a trader is that thelonger you hold your shortoption, the better are youroddsofsuccess.

Options are a wastingasset. This means as timepasses,thevalueoftheoptionerodes. It therefore takes aprogressively larger move tomake theoptionprofitable tothebuyer.Thisiswhysuchalarge percentage of options

are closed out prior toexpiration. Buyers know thatthe longer they hold theiroptions, thebetter thechancethatthevalueofthoseoptionswill decay to zero. Inaddition, thecloseranoptionis to expiration, the moredifficult it becomes for thatoptiontoincreaseinpriceandproduce or increase a profitforthebuyer.Whethertakingprofitsorcuttinglosses,manypeople will rush to the exits

before expiration day comes.As a seller, you have theluxury of just waiting it out,welcoming the inevitable.Some very inventive tradingtechniques have been createdover the years, but nobodyyet has come upwith a wayto stop the steady march oftime.

TheOption

ExpirationStudy

Futuresmagazinepublishedastudyin2003(Summa,2003)regarding percentages ofoptions expiring worthless.The study tracked options infive major futures contracts:theStandard&Poor’s(S&P)500, the Nasdaq 100,Eurodollars, Japanese yen,and live cattle. It wasconducted over a three-year

period from 1997 to 1999.The research came to threemajorconclusions:

1.Onaverage,threeofeveryfouroptionsheldtoexpirationexpireworthless(theexactpercentagewas76.5%).

2.Theshareofputsandcallsthatexpiredworthlessisinfluencedbytheprimarytrendoftheunderlyingmarket.

3.Optionsellersstillcomeoutaheadevenwhentheygoagainstthetrend.

Intermsofthefirstpoint,theresults of this study confirmourexperience in themarket.However, putting some databehind our experiencemakesthe point even moresubstantial. Consider that76.5% of all options doexpire worthless. (We

contacted the ChicagoMercantileExchange in2001and asked exactly whatamount of options itestimated expired worthlessbasedonitsyearsofrecordeddata. After several weeks oftalking to several sourcesinside the exchange, wefinally had somebody quotethat the exchange’s estimatewas that about 74% ofoptionsexpiredworthless.)Inourpersonal,notsoscientific

experience, we fixed thefigure closer to 82%.Therefore, there is no exact,nondebatable figure for thenumberofoptionsthatexpireworthless.Onemust assume,however, that the actualnumber is somewhere in theneighborhood of thesefigures. This means that atleast three of every four andpossibly four of every fiveoptionsheldtoexpirationwillexpire worthless. And this is

shooting in the blind,throwingadart at aboardasyour option pickingprocedure.

The second conclusionwas that the amount of putsand calls expiring worthlessis influenced by the primarytrend of the underlyingmarket. In some of thestudies,up to96%ofputsorcallsexpiredworthlessiftheywere written favoring the

trend. This sounds likecommon sense, but youwould be surprised at thenumberof traderswho try tobet against a trend. When itcomes to option writing, theold adage most definitelyholds true:The trend is yourfriend. Write options thatfavorthetrendandyoucouldsubstantially boost your oddsthat the options will expireworthless.

The thirdconclusionmaybe even more significant.Option sellers still come outahead even when they aregoing against the trend. Thefindings were that, even inbull markets, most callsexpired worthless (althoughthese figures were muchlower than the 76.5% of alloptions that expiredworthless),andmostputsstillexpired worthless in a bearmarket. This means that you

couldbedeadwrong inyouranalysis of the underlyingmarketandstillhaveabetter-than-even chance at makingmoneyon the trade. If this iscorrect,youcouldberight inyour analysis of the marketonly half the time and stillhave a little better than 75%of your options eventuallyexpire worthless. If you’reany good at forecastingmarket direction at all, youmay be able to bump your

averages a little to a lothigher.

David Caplan, in hisexcellent book The NewOptions Advantage, statesthat to profit consistently infutures and option trading,traders must give themselvessomekindof“edge”ineverytrade they enter. By using astrategy that eventually winsabout80%ofthetimebeforeyou even do any market

research, you begin everysingletradewithasignificantedge.

Advantage2:YouDon’tHavetoPickMarketDirectionAnymore

One of the hardest parts oftrading stocks or futures istrying to decide where the

market is going to go next.Option buyers have it eventougher. They not only havetogetthedirectionright,theyhave to predict when themove will occur. But isn’tthat the whole concept ofinvesting? You must decidewhereyouthinkyourstockorcommodity price is headedandbetaccordingly,right?

Not if you’re an optionseller.

At any given time themarket reflects the exactvalue of a given commodityonthatparticulardayforthatparticular delivery month.Traders speculating on pricemovesmustforecastnotonlycurrent and futurefundamentals but also howthetradingworldwillreacttothose fundamentals. Onemustbeablenotonlytostudypast supply-and-demandfiguresandhowtheyaffected

pricebutalsotoknowalittleabout crowd psychology.Predicting where prices willgoisliketryingtopredictthedirectionofahurricane.Eventhe experts can make onlyvague projections until thestormmakeslandfall.

Projectingwhere itwon’tgo, however, can be anothermatter. If strong windcurrents are blowing itnortheast, and these wind

currents are expected tocontinue, one assumes thatthehurricanewillhitinsomedestination in a northeasterlydirection. Therefore, thehurricane could veer off tothe north or the east, maybeeven way off from thedirection of the wind, but itwould be unlikely (althoughnot impossible) for the stormtomake a 180-degree about-faceandheaddirectlyintothewind in a southwesterly

direction.Knowledgeable option

sellersbet that thestormwillnot make a 180-degreeturnaround into the wind.That’s all. They don’t playthe game of guessing wherethe storm will hit. That’s alow-odds game. Guessingwhere itwill not hit ismucheasier.

When you sell options inthewayyouwilllearninthis

book, this is how you willplay the market. You nolongerhavetotrytooutguessthe pros as to where themarketwill go.All youhaveto determine is a price levelto which you believe themarketwillnotgo.Whenyoubecome more skilled atselling options, you will beabletoidentifyoptionsellingat ridiculous strike prices, inwhichyouwillbeabletotakeadvantage of traders willing

tobetonthemarketgoingtothese levels. A littlefundamental knowledge cangoalongwayinthisregard.

The following is anexcerpt from an option sellerarticle that we produced forpublication several yearsback.Withanever-increasingflow of traders entering thefutures and derivativesmarkets, the lesson is evenmorerelevanttoday.

OptionSelling101:ThinkLikeanOptionSellerBYJAMESCORDIER,PRESIDENT,LIBERTYTRADINGGROUP

Youmaynotice thatmany articles that

appearinourcolumnhave a longer-termoutlook for price.Unlike manyanalysts and traders,wedonotattempttoguess what marketpriceswilldo today,tomorrow, or nextweek. I recommend

approaching themarket this way forseveralreasons.

1.Short-termtradingisjusttoodifficult.I’msuretherearesomeconsistentlysuccessfuldaytradersoutthere.Thatbeingsaid,I’venevermet

any!2.Marketscanmoveverysporadicallyovershort-termperiodsbutoverthelongtermwillalwayshavetoadjusttoreflectfundamentals.

3.Asanintermediate-termoptionwriter,short-termmarket

gyrationdoesnotconcernyou.Youareconcernedaboutlonger-termmarketdirectionand,moreimportant,wherepriceswon’tgo.

It is for these reasons thatour articles focus on long-term fundamentals and donot generally attempt topredictwhatpriceswilldo

but ratherwhat priceswillnotdo.Webelievethatthemost successful traderskeepthingsverysimple.

This is the approachthat we suggest: I do notknow what price is goingto do. Based on theexisting fundamentals,however, and what priceshave done in past yearswhen supply-and-demandfactors were similar to

those of this year, I feelthatpriceswillhaveaverydifficult time attaining acertain price level.Therefore, I will sell calls(orputs)at thatprice leveland not concern myselfwith short-term technicaltrading.Evenifmymarketanalysis or timing is off abit, time value is stillworking for me, and Iallow themarket plenty ofroom to fluctuate in the

meantime.Remember,ifyouarea

sellerof acall, themarketcan move lower, stay thesame, or even movesomewhat higher. As longas the futures price isanywhere below your calloption’s strike price atexpiration, the optionexpires worthless. If theoption expires worthless,you, as the seller, keep all

premiums collected asprofit. As the seller of aput, you want the price tostay above a particularpricelevel(strikeprice).

Although this type ofthinkingcanbedifficult atfirst for the futures traderusedtodailyaction(itwasfor me), I’ve found thatthisapproachhasimprovedmy overall trading resultstremendously.

Rememberthisthenexttime you are tempted tobite on the latest marketthat is about to“skyrocket.” Time, value,and patience are yourfriends. Think like theoptionseller!

Thepointisthatyoucanstillhave your hunches as towhere the market might go;you just position yourself

differently. In this way, ifyourpriceprojectionisright,you profit. If it is onlypartially right, you profit. Ifyouarewrong,thereisstillagood chance that you willprofit. Themarket canmoveinthedirectionyouprojected,consolidate sidewayswithnocleardirection,orevenmovein the opposite direction towhat you projected. As longas you are not absolutely100% wrong and the market

makes a rapid and/orsustained move in the exactopposite direction fromwhatyoupredicted,youwillprofitonthisposition.Youcanusethis strategy to excel in bull,bear,orstagnantmarkets.

This is why so manyoption sellers enjoyempowerment whereas somany mainstream investorsfeelhelpless—heldhostagetomarket whims, interest rate

fluctuations, economicdistressorthedirectionoftheS&P 500. Option sellers aresecureintheirknowledgethatthey have the ability togenerate returns in most anymarket condition. They canposition for higher prices,lower prices or stagnantpricesandprofit even if theyare marginally wrong. Theyknowanalternativedefinitionofthetermfinancialsecurity.

Advantage3:AccruedProfitsCanBeSubstantial

Let’sfaceit.We’renotinthisgame for paltry returns. Ourfinancial planners can likelygetusthat—inagoodyear.Ifyou are taking the time tolearn an alternative strategyand then allocating riskcapital toward it, you likelyareafterabiggerpayoff.

Let me assure you thatoption selling has thehorsepower to deliver in thisarea.

If your goal is to makeconsistent25%,40%,oreven50% annual returns in aresponsible manner, optionselling, especially futuresoption selling, may be foryou.

AdrenalineJunkiesBeware

That being said, if your goalis to make 200%, 300%, or500%returns,likeyouseeinall the hyped-up advertisingfor trading systems or“training seminars,” put thisbook down and go investyour money in some lotterytickets or head to Vegas.Overthelonghaul,yourodds

willbeaboutthesame.Theuninitiatedoftensight

lowdollaramountsandhigh-margin requirements asdeterrents to selling options.“It’s just a few dollars.Whybother?” is their argument.But these are typically theadrenalinejunkiesorthelow-cap traders looking to hit ahomerunwithasmallequitybase. The get-rich quickcrowd.

StayingOutsideofthe“BoxingRing”

Think of the investmentworld as a huge boxing ringwith complete pandemoniumgoing on inside. Bulls andbears (if youwill) battling itoutinthemiddle.Dollarsandcents flying everywhere.Yourgoalisnottogetintheringandmixitupwiththem.They are either bigger or

stronger or smarter than you(orme,forthatmatter)orjustplain crazy. This is themistakeMr.LowCapmakes.

Instead, you sit outsidethe ring with a couple ofbuckets in front of you. Asexcess dollars and centsbounce,fly,andtrickleoutofthering,yousimplycollectitallinyourbucket.Maybeyoudon’thavehugegains inanygiven week or month. But

you do this every month ofthe year. At the end of eachmonth, you empty yourbucket into a tub and startover.

At the end of the year,youcheckyour tub.After12months, that tub can getmighty full—oftentimes,muchfullerthanitevercouldhavegottenbymixingitupinthering.

Successful option sellers

think of their portfolio as abusiness. They are notgambling.Theytakeonlythehigh odds plays, over andover and over again. All thewaytothebank.

When you learn to selloptions on commodities,you’ll learn how tosuperchargethisformulawiththepowerofleverage.

Advantage4:TimeIsonYourSide

Sing it likeMick Jagger. Asanoptionseller,youcan.Nomatter what the market isdoing, time is constantly,albeit slowly, eroding thevalueoftheoption.Whiletheoption can gain value frommarket movement, time willalways be in your corner,working for you. It is also

working against the personwho bought the option. Wehave an example that mayhelp to illustrate the conceptmore clearly, especially forfootballfans.

As a seller of an option,youcouldbecomparedwithafootball team that playsdefense for an entire game.How much time is on theclock when you start thegame is up to you.You start

thegamebygivingyourselfapredetermined point lead andgiving your opponent somuch time to beat you. Forexample, you can giveyourself a 50-point lead andgive your opponent twoquarters to beat you (sellingfar-out-of-the-money optionswithmoretimevalue),oryoucan give your opponent a 7-pointleadandtwominutestobeatyou(sellingclose-to-the-moneyoptionswithlittletime

value). No matter what youchoose, theclockalwayswillbe running against youropponent. As time goes on,your opponent’s chances ofwinning the game begin todecrease(andyoursincrease).The opponent can’t step outof boundsor call timeout tostop the clock. The best partis, if you begin to feeluncomfortableatanypointinthe game, you can simplyquit.

There are many funcomparisons to draw fromthisanalogy.Thepointisthatan option buyer is workingagainst the market and time,just as a football offensetrailinginagamehastoworkagainst the defense and thetimeleftontheclock.

As an option seller, thepassage of time is yourgreatestally(seeFigure3.1).

FIGURE3.1TimeDecay

ChartThecloseranoptiongetstoexpiration,thefasteritsrateoftimedecay.

Advantage5:TakingProfitsBecomesSimple

Almost every book oreducational pamphlet ontrading at one point oranother refers to a centraltheme that has become themantra for traders the worldover: “Cut your losses short,

andletyourprofitsrun.”Thiscommon knowledge isespecially expounded amongcommodity traders. Tradershave been drilled andinstructed continuously thatto make any money in themarket, one must accept alarge percentage of smalllosers while waiting for oneortwolargewinningtradestonotonlyrecoupall thelossesbutalsotoprovideanoverallprofit.

Although we have toagree with this concept in ageneralsense,applyingittoareal-life trading account isextremely difficult, if notimpossible, for mostindividual investors. Stopscan be placed to limit lossesonfuturespositions,butfloortraderstendtohaveafeelforwherelargeconcentrationsofstop orders may be sitting.We are not suggesting thatthese floor traderswould run

these stops deliberately (ofcourse not, floor traders andprofessionals care about youandwouldneverdothat),butit is very curious how amarketwilloftencrackakeypointofsupportor resistanceonlytoturnaroundandmakea largemove in the oppositedirection.

Whenyouarelookingataprice chart, countless othertraders are looking at the

same chart. They all see thesame points of support andresistance at which to placetheir stops. This is why youwilloftenseeamarket toucha critical point of support orresistance and then make arapid move through thecritical level during a singletradingsession.Allthosebuyor sellordersare triggeredatonce,causingarapidmoveinthe market and stoppingfutures traders out of their

positions. There is nothingmore frustrating to tradersthan having this happen andthen to see the market makean immediate reversal andbegin a large move in theopposite direction. Suchtraders were in the rightmarket; they just couldn’tstayinitlongenough!

This is assuming, ofcourse, that such traders hadthedisciplinetoplacestopsto

beginwith.Cuttinglossesandletting profits run soundsgood on paper, but thepsychologyof itgoesagainsthumannature.Emotionsareacriticalenemyof traders,andofallemotions, thereisnonesodamagingtoaportfolioasthe feeling of hope. Hope iswonderful when applied tolifeoutsidethetradingworld.In the realm of trading,though, especially futurestrading,itcanrobyouofyour

moneyandwreckanaccount.Traders don’t want to cut aloss because they havebecome emotionally attachedtoaposition.They’llwatchitgoingagainstthemonadailybasis and hope that it turnsaround. Books on tradinganswerthisbytellingyounotto be emotional about yourtrading.How can you not beemotionalaboutyourtrading?Thisisyourmoneythatwe’retalking about! You’re going

to be emotional about it nomatterwhatyoutellyourself.

What about decidingwhen to take profits?Lettinga winner run can be evenmore psychologicallydifficult than cutting a lossshort. A trader is so excitedaboutseeingthemarketmovein her direction that shebecomes terrified that it willreverse and take back theprofits it sowillinglygranted

her.We’veseenmoretradersgo bust by not knowingwhere to take profits thanwe’ve seen traders who getburiedwith one or two largelosses.The result of this fearis that most traders takeprofits way too soon, evenwhentheyhaveanicewinnergoing.Therearenohard-and-fast rules as to when to takeprofits.Nobody knows if themarketisreversingonagivenday or only experiencing a

short-term trend correction.This is one of the manyreasonswhyfuturestradingissodifficult

OptionSellingIsaClearAntidotetoThisDilemma

Whenone sells an option, asopposed to trading theoutright futures contract, the

decision of when to takeprofitsgenerallybecomesonethat you no longer have tomake. The market makes itfor you. As long as youroption is not in the money,the value of your optionwilleventually deteriorate to zeroat expiration. At this point,the position automaticallycloses out. You achieve fullprofit without ever having todecide if the market iscorrecting,goingupordown

tomorrow on the open, orhaving to decide whether to“hang in there” to wring afew more dollars out of thetrade.Themostyoucanmakeis the premium that youcollect. In most cases, thiswill beyourobjectiveon thetrade. In other words, youhave a very clear profitobjective and a very clearmethod of taking that profit.What is your profit-takingstrategy in a winning trade?

Do nothing. Simply let itexpire.

This aspect of writingpremiumalonecanbeaboonto traders who have sufferedlosses because they are tooquick to exit awinning tradeorhaveahabitofholdingthetradetoolong.

Advantage6:PerfectTimingIsNoLonger

Necessary

One aspect critical forsuccess in futures trading isbeingabletotimethemarket.Because of the leverageinvolved in trading futures,mistiming the marketprobably costs traders morelosses than incorrectlypicking theultimatedirectionof prices. Although sometraders can gain a fairly

decent insight into the long-term direction of price, it iswhat the price does in themeantimethatcausesthemsomuchtrouble.

A market moving in anoverall trend upward owingto a long-term fundamentalfactorstillwillhavemoderateto severe correctionsperiodically. This can resultfor a number of reasons,including profit taking by

large funds or smallspeculatorsorasuddennewsstory that may cause sometemporary sensation in themarketbutinrealityhaslittleeffect on the long-termfundamentalsofthemarket.

Atradermayseethetrendand decide to “get in on theaction” and look for a placeto buy.Whereas buying intoan existing trend usually isnot a bad way to go, timing

will determine the odds ofsuccess or failure on thistrade.Ifallyouhadtodowasplaythetrend,futurestradingwould be easy, andeverybody would makemoney. This is even moredifficult in volatile markets.Traders, especially smallspeculators, will buy thefuturesandthenplaceastop.Moreoftenthannottheywillplace tight stops, giving themarketlittleroomtofluctuate

against them. This is whatthey have been taught, andthis is why most of theirtradeswilllose.Theyhavetoprotect capital at all costs.Unfortunately, protectingcapital does not allow muchmovement in a market thatcan and often does movesharply and rapidly in eitherdirection for no apparentreason at all. Many, if notmost, traderswill be stoppedout before themarket begins

movinginthedirectionofthetrendagain(seeFigure3.2).

FIGURE3.2PriceChartContrastingBuyandSellAreaswithOptionSale(June2014EMiniS&P)Arrowsshowpossibleentryandstoppointsforfuturestraders.

Selling options avoids allthis senselessness. In a bulltrend,asellersimplycanselloptions far beneath themarket, allowing wide pricefluctuations within the trendthat will not dramaticallyaffect her position. In thisway, she can sell options onan up or down day withoutthe need for perfect timing.Even if she catches themarket in a correctionmode,

the fluctuation in her optionprice generally will besubstantially less than if shewere in a futures position.Thus, the trader hassignificant staying power inthemarketandisabletorideout short-term marketfluctuations, unlike herfutures-trading counterpart.(This generalizes futurestraders as the averageindividual speculator. Thereare, of course, some well-

capitalized traders who arewilling to commit largechunks of margin capital toride out an adversemove. Inadditiontoalargecushionofexcessmarginfunds,thisalsorequires a strong convictionin the market, as well asnervesofsteel.)

Eventhefewtradersgoodat timing the market can getbounced out of a good trendonrandomnewsevents.

For instance, in 2013,coffeepriceswereinasteadydowntrend. Expectationswere for an ample 2013Brazilian coffee harvest andthe market was alreadypricing the new supply. Inboth May and July of 2013,weather reports out of Brazilindicated cold fronts movingthrough Brazilian growingregions (NorthernHemisphere summer isSouthernHemispherewinter).

Newsmediacoversit.Coffeetradersshortfuturescontractscover their positions. Theydon’t askquestions, they justcover.Thismaybe smart forthem, even though it is onlyprecautionary.

For the option seller,however,shortcallsat$1.85,thereisnoneedtocoveronasimplecoldfront.Coldfrontsare one thing. A real crop-damaging freeze is another

(theyareextremelyrare),andit would likely be monthsbefore the effects of onewould even be known.Precautionary short coveringtakesthefuturestraderoutofhis position. The call sellerremainssafelyabovethefray,able to continue in hisposition once the marketresumes its downtrend (afterthefrontpasses). (SeeFigure3.3.)

FIGURE3.3CoffeeChartShowingWeatherRalliesin2013Coffeepricesexperienceshortcoveringbutdoesnotaffectcallsellersposition.

Advantage7:MultipleMethodsofRiskControl

Regardless of the label ofunlimitedriskinsellingshortoptions, option selling riskcan be just as definable andcontrolled as any other typeof futures or stock tradingrisk. And there are multiple

ways to manage risk,depending on the investor’srisk tolerance. This ismentioned here as anadvantage only so you willknow that you can controloption selling risks and haveseveral methods available toyou. The subject of risk,however, is significant andtherefore will be covered inits own full chapter (Chapter12).

DrawbacksofSellingOptions

Now that we have coveredthe many benefits of optionselling, a potential optionseller must also be familiarwiththedrawbacksofsellingpremium.Theyarepresentedhere, warts and all, for yourreview.Theyareheresothatyou can draw a balanced,informedconclusion.

1.Unlimitedrisk.Hereistheelephantintheroom.Icancompareteachingoptionsellingtotheuninitiated(notyou)togivingfiretocavemen.Intherighthands,itcanprovidelightandwarmthforalifetime.Inthewronghands,itcanburnfingers.Thosewithburntfingersaretypicallytheones

shoutingthe“unlimitedrisk”mantrafromtherooftops.However,theterminandofitself,whiletechnicallyaccurate,ismisleadingandhorrendouslymisunderstood.Noviceswhohear“unlimitedrisk”picturethugsinsuitscomingtoconfiscatetheirhouseandimprisontheirfamilies.Allbecause

theyweren’twatchingthatcornputtheysoldlastweek.

Let’sbeclear.Anyoneconsideringsellingoptionpremiuminaportfolio,especiallyafuturesportfolio,shouldbeawarethattherealwaysexiststhepotentialforamoveagainstone’spositionthatcould

causetheinvestortoexperiencealoss.Justasifyoubuyastock,youhaveunlimitedupside.Ifthestockkeepsgoingupforever,you’llmakemoneyforever.Unlimitedriskisthesameconcept.Ifyouletitgo,itcankeepgoing.Ifitkeepsmovingagainstyouforever,youwillkeeplosingmoneyforever.

Butthereisawaytolimityourrisk,calledclosingyourposition,whichyoucandoatanytime.

Therearemanyexcellentwaystolimitandmanageyourriskinoptionselling,includingtheuseofstopsor“covered”spreads,whichwewillcoverlater.Selling

optionsonfutures,evennaked,entailsnomoreriskthantradingthefuturescontractitself,nordoessellingoptionsonstockscontainanymoreexposurethandoestradingtheunderlyingequity.Nonetheless,onemustbeawarethatthereisnofreelunch.Riskoflossisalwayspresentandmustbe

managed.Theunlimitedaspect,ifyouwill,meansyoudon’thaveabuilt-inlimit,asyoudowhenyoubuyanoption.Unlimitedmeansyouhavetotaketheextrastepofputtinginriskcontrolsyourself.

2.Limitedprofitpotentialonindividualtrades.In

sellingoptionpremium,yourprofitpotentialislimitedtothepremiumyoucollectwhenyouselltheoption.Nomatterhowfarthemarketmovesinyourfavor(awayfromyourstrikeprice),yourpotentialprofitremainsthesame.Itisforthisreasonthattraderschasingthe“bigscore”andtradingthemarket

fortheadrenalinerush(aconsiderablepercentageofsmallspeculators)generallyarenotattractedtotheconceptofoptionwriting.Touseabaseballanalogy,anoptionwriterisaninvestorwhoiswillingtogiveuphischanceofhittingahomeruninfavorofconsistentlyhittingsinglesoverand

overagain.3.Potentialscornorignoranceofbrokersorinvestmentadvisors.Asstatedpreviously,manybrokers,advisors,andentirefirmsareeitherhesitanttowriteoptionpremiumforfearofrisk,agenerallackofunderstandingofhowtoemployanoption

sellingstrategyeffectively,orboth.Thissometimescanmeanhighermarginoraccountrequirementsforinvestorswantingtoselloptionsintheiraccounts.Youmayhavetodoalittleworkbeforefindingagoodbrokerormoneymanagerwhoisqualifiedtoassistyouinsellingoptions

properly.Webelievethisissoimportantthatthereisanentirechapterdedicatedtothesubject(seeChapter15).Inthemeantime,justrememberthatpooradviceisoftenworsethannoadviceatall.

SellingOptionsandCatchingCatfish:

TheLogicofSellingOptions

Let’s assume that roughly80% of options expireworthless for examplepurposes. What does thismean to a trader? SupposethatyouandIwentdowntoafishingholefilledwithcatfishand bass. We toss a fishingline in thewater.Thehole isprimarily a catfish haven,

with 80% catfish and 20%bass.Ioffertopayyou$1forevery bass you pull up,whereasyoumustpayme$1foreverycatfishyoupullup.There are even a few trophybassintheholethat,basedontheir weight, I will pay you$2,$3,oreven$4forhaulingin. However, these are veryfew and far between, and Iammore thanwilling to take$1foreachcatfishwhileyoutry and catch a trophy.

Chancesarethatyouwillpullupeightcatfishandtwobass.You’ll pay me $8, and I’llgive you $2 back for yourbass. I will end up netting ahefty $6 profit. You soonrealizetheerrorofyourways,and we decide to go intobusiness with our littlefishinghole.

Soonmanynoviceanglershearabout the trophybass inthe fishing hole, paying high

prizes for anglers luckyenoughtocatchone.Theyareespecially interested in thehighlytouted“monster”bass,oneofwhichlurksinthedarkwaterbelowandpaysaprizeof $10 to the angler whohooksit.

Theanglerslineupatourhole to pay us $1 for everycatfish they catch. Wegenerallyhavetopaythem$2out of every $8 they pay us.

Sometimes we only have topay back $1. Sometimes, ifsomebodyhasa“hotstreak,”wemayhave topayback$3or $4. However, we almostalwayscomeoutaheadattheendoftheday.

Further, we don’t requirethem to cast 10 times. Somemay come with only a fewdollars and take a few casts.Somewill fish all day.Mostfish until they run out of

money.Occasionally, someone

will catch a trophy bass. Inthiscase,wehavetopayback$3 or $4 against our $1 bet.Thetrophybasscausesmuchexcitement. The newspapercomes and snaps pictures.More novice anglers andsomepeoplewhohaveneverfished before see the pictureinthepaper,getveryexcited,and stuff their pockets with

dollars and come runningdown to our hole to pursuethe elusive trophy fish. Thisbringsusevenmorebusinessandmakesushappy,foralas,most of them catch catfishandputdollarsinourpocket.

Pretty soon a few savvyanglerscatchon toourgameanddecidetostophandingusdollars.Theysetuptheirownlittlestandonthefishingholeand begin collecting dollars

for catfish. Fortunately, therearemanynewanglerscomingtotheholenow,tryingto“hitit big” with a trophy bass.Many get frustrated withcatching catfish and losingtheirmoney and come to theconclusion that “fishing isbad.” They quit altogether.However, many new, younghopefuls appear to take theirplace.

Soon another group of

entrepreneurs springs up.Their purpose is to take theanglers’moneyandgiveittous and take any money weowetheanglersandgiveittothem. Some will even helpyou bait your hook and tellyouwheretothrowyourline.For this, they charge a fee.This now means that theanglersandyouandIhavetopaya feeoneachfish that iscaught, catfish or bass.Mostof these middlemen like to

talk about the big bass andget anglers excited about the“monster” bass that lurksbelow.“Ofcourse,youcouldloseyourdollars,”theywarn,“butthinkofthepayoffifyoucatchthemonster!”Thisgetsanglers even more excited.Some take a middleman’sadviceandcast to thespot towhich he points. This, ofcourse, costs the angler aslightly higher fee, for themiddlemanmust spendmore

timewithhim.Theangler,ofcourse, still catches mostlycatfish.

Others anglers study thefishing hole for hours andlook at depth charts at hometo see where the giant fishmaymake its lair.Then theycome to the hole withsophisticated computers andtop-of-the-line fishing gear.Most fare little better thantheir unsophisticated

counterparts. The reason isthattheyarefightingalosingbattle. Even though the largebass are swimming in thehole, the hole is still 80%catfish,andthe$1theanglersmust pay for each catfisheventuallyisgoingtoexhausttheir money supply, even ifthey catch a few bass alongtheway.

Although most of themiddlemendosincerelyhope

that the anglers catch a bigbass and try their hardest tohelp them to do so, they,along with their anglerclients, fail to realize that thepersonmakingall themoneyis the one betting on catfish.Certainly, it lacks theglamour and excitement ofpursuing a “monster” bassand the big prize it bringswith it.However, formakingmoneyat the endof theday,itisdevastatinglyeffective.

A few of thesemiddlemen become wise tothe catfish betting strategyandencouragetheirclientstobegin betting on the catfishbecause there are manyanglers willing to take achance on catching a bigbass.However,most shudderat the thought. “Bet on thecatfish?” they askincredulously. “Why wouldyouwant to do that? It’s toorisky.Whatifsomebodypulls

up that monster bass? Whatwillyoudothen?Youbet$1andyou lost $10.That couldwipeyouout!Youmayevenhave to run home and getmoremoney so that you canpay that angler the $10 youowe him. Is that what youwant?”

“No, no” the ambitiousangler fearfully replies. Andso they go back to trying tocatchthe“monster”bass,and

eventuallytheanglerrunsoutofmoney.

In case you haven’tguessed,thisisananalogyofthe strategy of option sellingand how most brokers andtraders (especially novicetraders) view it. The anglerschasing the “monster” bassare option buyers. Lured bybig gains, they throw theirlineinthewater(enteralongoptiontrade)withonlya20%

chance of catching a bass(having a winning trade).Their chances of catching abass that pays anythingsignificant is even less. Thisis before they study theweather, select bait, andchoosetheareaoftheholetowhich theywillcast (analyzemarket conditions and strikeprices). The fishing hole istheexchange.Themiddlemanis,ofcourse,thebroker.

Chances are very goodthat the person getting paid$1 for each catfish caught(the option seller) will havemost of the money beforelong. But most anglers willnot bet on the catfish. Mostdon’t want to bet on catfish.Most want the chance tocatch the big or “monster”fish and bet $1 to make $3,$4,oreven$5.

There are two caveats to

betting on catfish (or sellingoptions).Oneisthatyouhaveto come to the fishing holewith enough dollars in yourpocket topayup ifananglercatchesabigbassonherfirstoneor twocasts.Thesecondis that from time to timeyouhavetoexpectthatsomebodyis going to catch a bass. Inmany cases you will alreadyhave more than enoughprofits in your pocket tocomfortably pay the lucky

winner. However, when youmake your first trip to thefishinghole,betonacatfish,andsomebodypullsoutabigbass on the first cast, youhavetohavethegumptiontopay the prize and go back toyourcatfishbet.Althoughtheodds of this happening arelow, it certainly can happen.Youcanseehow itmightbeunwise for a catfish better toassumeafterthisincidentthat“catfish betting is bad.”

Unfortunately, many optionsellers make exactly thismistakeand then tell allwhowilllistenoftheirmisfortune,especially if they had $5 intheir pocket and the angler,against all odds, pulled out a$5 fish. This furtherperpetuates themisconception that optionwritingisarecklessapproachtoinvesting.

Now that you understand

the basic concept, there ismuchyou can do to increasethe odds that anglers willcatch fewer bass andespecially keep them fromcatching the “monster” bassand keep reeling in thosecatfish.

Conclusion

You have now learned theseven advantages that option

selling has over most anyother kind of investing. Youhave also learned thedisadvantages of optionselling. We’ll let you weighthembothforyourself.

Revisit the title of thischapter: “Why Aren’t YouSelling Options?” Are youasking yourself that questionyet?

The next chapter iswritten especially for the

option buyers (or formerbuyers) reading this book. Itis also for the optionintellectuals who will arguethat the 80% figure is“misleading.” You areprobably not in this group.But you will likely find itinteresting nonetheless—especially if you ever findyourself in a discussion withoneofthesepeople.

4

BuyingOptionsVersusSellingOptions

WhoWins?

Haveyouheard any of thesecommonbitsof“knowledge”aboutoptions?

•Buyingoptionsallowsyoutotakepartinbigmoveswithlimitedrisk.

•Eightypercentofoptionsexpire

worthless.•Volatilityisthesinglemostimportantfactorforanyoptiontrader.

•Ifyousellanoptionanditmovesagainstyou,youarestuckuntilitexpires.

In the debate betweenbuyersandsellersofoptions,opinions can be representedas fact and fact can be

distorted into misconception.This chapter is to give yousome insights into some ofthe most common facts,myths, and misconceptionsabout buying and sellingoptions.Itwillhelptoclarify,confirm, or completelydiscredit some of this“commonknowledge.”

It should also settle theargument once and for allaboutwhatsideof theoption

buy/sell equation you shouldbeon.(Canyouguess?)

BasicTraining

Although this book is notmeanttobea“howto”guidetomarketpriceforecastingor“101 option strategies youcanuseathome,”webelievethatabasicreviewofoptionsand the differences betweenbuying and selling may be

helpful to novice readersexploring the subject for thefirsttime.

We have presented theinformation in the format ofmetaphors and stories asoften as possible so readerscanreadilycomprehendwhatcan be a complex subject.Nonetheless, certain aspectsof options and option sellingdemand some technicalexplanations and definitions.

If you are already familiarwiththebasicsofoptionsandhow they work, you maywant to skip this chapter.However, if you are abeginner or are onlymoderately experienced andwant to brush up on thefundamentals of options, thischapter could be a helpfulprimer.

To that end, let’s startfrom the beginning—some

“basictraining”ifyouwill.

WhatIsanOption?

Thestandarddefinitionofanoptionistheright,butnottheobligation, to buy or sell aparticularstockorcommodityat a specified price. A calloption is the right to buy astock or commodity; a putoption is the right to sell it.Whenbuyingorsellingaput

oracalloptioninstocks,onecallorput is theright tobuyor sell 100 shares of thatparticularstock.Inthecaseoffutures,oneoptionistherighttobuyorsellonecontractforthat particular commodity(seeTable4.1).

TABLE4.1UnderlyingAssetofOneOption

BuyingOptions

Before we can beginexploring the concept ofsellingorwritinganoption,itwill be useful to discuss thesubject of buying options

because this is the strategywith which most optiontraders are familiar. Thesubject of buying an option,as well as some keydefinitions regarding optiontrading, are illustrated in thefollowingexample.

WeareusingtheStandard& Poor’s (S&P) futurescontract in both examples inthis chapter because it is amarket to which both stock

andfuturestraderscanrelate.However, this is the generalconceptofhowanybuyingorselling of options can beperformedineitherindividualstocks or any commoditiesmarkets.

Example:BuyingaCallOptiononS&P500Futures

What is buying an option?Whatdoesitentail?Whatarethe potential rewards andrisks? To illustrate, let’sconsideraquickexample.

If, inDecember, you buyacalloptionontheS&P500at a1900 strikeprice for themonth of March, you havethe right (or option) to buyone contract of the MarchS&P500atthepriceof1900atany timeduring the lifeof

theoption.Youmayexercisethis right at any time youchoose, before expiration inMarch. As this is a Marchoption, this means that yourright to buy the S&P 500contract at this price willcease,orexpire, inMarch. Ifthiswere a July option, yourright to purchase a futurescontract on the S&P 500wouldend in July.Theexactdate this option expires willvary depending on the stock

or commodity you aretrading. Therefore, if youwant to exercise this right tobuytheS&P500at1900,youwillhavetodoitbeforeyourtimerunsout(seeFigure4.1).

FIGURE4.1S&P500PriceChartShowingStrikePriceBuyingaMarchS&P1900CallOption

The right or option topurchase an S&P 500contract at 1900 has a valueto it. In otherwords, the calloptionyouarepurchasinghasa value in and of itself,regardless of the price of theS&P500. IfMarchS&P500futures are trading at 1950,your right (or option) topurchase a March S&P 500contract at 1900 would beworthmore than itwould be

if the June S&P 500 weretradingonlyat1850.

But who would want tobuyaMarchS&P500futurescontractat1950ifthemarketprice were only 1900?Nobody.

However, a person whothought the S&P 500 weregoing to move to 1950 byMarch might very well wanttopurchasetherighttobuyitat 1900, especially when he

can purchase this right for afraction of the cost it wouldrun him to buy the futurescontractitself.Inaddition,hecanavoidtheriskoftheS&P500 decreasing in price andlosing a large amount on hisfutures trade.Theonly fundshewould have at risk wouldbe the price, or premium, hepaid for his option. If thepriceoftheS&P500doesnotreach 1900 (the option’sstrike price) by the time the

option expires in March, itwillexpireworthless,andthetradeisover.

Real-LifeExample:TraderMary’sExperience

Let’s review this concept inanother example. TraderMary just read an articleabout the U.S. economy that

was very bullish on theU.S.stock market. Thefundamental outlook forequities looks verypromising.Thereis,however,one point of concern: At thetimethatMaryisconsideringthetrade,theFederalReserve(Fed) could be getting readyto raise interest rates. Thismay or may not take place.However,ifitdoes,thereisachance that the S&P 500couldfallsubstantially.

Mary is eager to positionherself to take advantage ofthe situation if the S&P 500soars, as she is expecting.However, the risk of anadverse move to thedownside has her concernedenoughthatshedoesnotwantto purchase the futurescontractoutright.She insteadsees that she can purchase aMarch 1900 call option forthe price (premium) of$2,000.SincetheMarchS&P

500 contract currently istradingatabout1840anditisonly December, Mary seesthis as a good bet,considering that she feels theprice could go as high as1950. If it does, Mary canexercise her option, buy acontract for the March S&P500 at 1900, and thenimmediately sell it at 1950,making herself a gross profitof $12,500 on the futurescontract.Thisiscalculatedin

Table4.2.

TABLE4.2CalculatingTargetValueonMary’sLongS&POption

Ofcourse,Marywillhaveto subtract the premium shepaid for her option plustransaction costs to give her

the net profit, calculated inTable4.3.

TABLE4.3CalculatingNetProfitonMary’sLongOption

If the March S&P 500contract does not reach 1900(her option’s strike price) oreven falls substantially, themost Mary can lose is the$2,000 she invested topurchasethecalloption.

Are these the only twooutcomes that Mary canexperience?No.Theyarenot.

MaryLearnsthe

HardLessonofOptionBuying:TimeDecay

Let’ssay that twomonthsgoby. It isnowFebruary.Maryissittinginherofficeonedaywatching the snow falloutside and decides to checkheroptionprice.SheseestheMarchS&P500hastradedashigh as 1847 and as low as1734but is back to hovering

close to 1840 at the presenttime.Marychecksheroptionprice and sees that it is nowworth only $1,000. In otherwords,ifsheboughttheexactsame option today, it wouldcost her only half of what itdid two months ago. Themarketisinthesameplaceitwas when she bought heroption. YetMary’s option isnow at a $1,000 loss (seeFigure4.2).

FIGURE4.2S&P500PriceChartShowingPriceMovementTheValueofTimeDecay:60daysaftertheoptionpurchase,theunderlyingisatthesameprice.Buttheoptionisworth$1,000less

Buthowcanthisbe?Thefutures contract is trading atthe exact same price that itwas two months ago!However, the right to buyMarch S&P 500 futures willnow expire in one monthinstead of three months.Therefore,theoptionhaslesstime remaining and is worthless. This is known as timedecay.All other thingsbeingthe same, time decay will

always slightly erode thevalueof theoptionwitheachday that passes. Hence, evenif Mary is correct in hermarket analysis, time willalwaysbeherenemyas longassheisbuyingoptions.

Howisthisrelevant?Isn’tall thatMary cares about, asanoptionbuyer,isiftheJuneS&P 500 goes above 1250?No. It is not. This is themistake many novice option

traders make. Most optionsneverget exercised.Muchofthetime,theoptionpositions,even profitable ones, areoffsetsimplybyselling thembacktothemarket.Why?

It is at this point thatwemust delve into a few moredefinitions. IfMarybought acalloptionontheMarchS&P500 with a strike price of1900 and the price ofMarchS&P 500 futures is currently

under1900,thentheoptionissaidtobeoutofthemoney.Ifthepriceof thecontract isat1900, theoptionissaidtobeat themoney. If the price ofMarchS&P500isover1900,theoptionissaidtobein themoney(seeFigure4.3).

FIGURE4.3S&P500PriceChartShowingOptionsInandOutoftheMoney

IntrinsicValue

The value of an option ismade up of time value,intrinsicvalue, andvolatility.Time value has beendiscussed already. Volatilitywill be discussed later.However, option buyers tendtofocusonpotentialintrinsicvalue.

Anoption is said tohave

intrinsic value if it is in themoney.

•Ifitisnotinthemoney,itcannot,bydefinition,haveanyintrinsicvalue.

Forexample, if thestrikepriceof thecall is1900,andthe price ofMarch S&P 500is 1950, then the option issaid to have 50 points ofintrinsic value. If the option

were exercised at this pointand the futures positionclosed out immediately, itwould yield a profit of$12,500.However,theoptionitself, in addition to itsintrinsic value, also wouldhave some time valueremaining. The option itselfwould be worth more than$12,500. Therefore, sellingtheoptionbacktothemarketwould be worth more to theowner of the call than

exercisingit.The exception to this

would be if the option isexpiringandtheownerofthecall wishes to own the stockorcommodityatthespecifiedstrikeprice.

For this reason, whensomebody refers to tradingoptions, they are generallyreferring to the buying andselling of the optionsthemselves.Theyareactually

speculating on the optionprices and not on theunderlying stock orcommodity, although theprice of the underlying stockor commodity will have alargebearingon thevalueoftheoption.

ProfitingontheLongOptionwithNoIntrinsicValue

In the preceding example,because theMarch S&P 500was trading at 1840 whenMary bought her 1900 call,Mary bought an out-of-the-money option with nointrinsic value. This is whyMary was able to purchasethe option fairlyinexpensively. Can Marymake money even if theoption never goes in themoney? Yes. If the price oftheMarchS&P500beginsto

move toward1900, thevalueof the option may start toincrease. This is especiallytrue if the price of the S&Pmoves rapidly, with a greatdegreeofvolatility.Althoughthe option still has nointrinsicvalue,thechancesofthe option gaining intrinsicvalue begin to increase,thereby increasing the valueof the option. If this value isincreasingfasterthanthetimevalueiserodingthepremium,

the option may temporarilyshowagain, even if it isoutofthemoney.

In other words, if Maryboughtheroptionfor$2,000,andtheMarchS&P500pricemoved higher immediately,but not in the money, theprice of Mary’s option stillmay increase to, say,$2,500.Inthiscase,Marycouldclosethe position out for a $500profitwithouteverexercising

heroption.Of course, to collect this

gain, Mary will have to sellheroptionbacktothemarketbefore thevaluedrops again.IfthepriceoftheMarchS&P500 has not moved above1900 by the time the optionexpires, time valuewill haveeroded all the option’s valueand it will expire worthless.Mary will lose the premiumshepaidbutnothingmore.

The main drawback toMary’s position is this:Although she has absolutelimited risk in that only thepremiumshepaidcanbelost,there is a high probabilitythat she will indeed lose onthetrade.TheonlywayMarycan make money is if thefutures contract makes asharp and immediate movehigher. Anything less, andtime value eventually willdecay thevalueof theoption

awaytonothing.

BuyingOptions:Summation

In summation, the threefactorsthatmakeupthevalueof an option are intrinsicvalue, time value, andvolatility. If you are buyingan option that is out of themoney, it will have no

intrinsicvalue.Onlytimeandvolatility will make up thepriceofthatoption.

The key advantages anddisadvantages of buying anoptionarelistedinTable4.4.

TABLE4.4AdvantagesandDisadvantagesofBuyinganOption

TheSelling(orWriting)ofOptions

Nowthatwearefamiliarwithsome general definitionsregarding options and thestrategy of buying options,we can make our first probeinto the core subject of thisbook, which is sellingoptions.

In keeping with ourexample, let’s say that traderMary is still somewhatbullish on the March S&P500. If she buys her 1900

call,theMarchS&P500willhavetomakealargemovetothe upside for Mary to haveany hope of a profit.However,insteadofbuyingacall, as in the precedingexample, Mary decidesinstead to use the strategy ofselling a put. But how canMary sell this option whenshedoesn’townit?

The terms buying andselling,whenusedinrelation

to options, are really justtermsused todescribewhichside of an option trade atrader is positioned. When atrader buys an option, he isbuyingtherighttobuyorsella stock or commodity at aspecifiedprice.Whenatradersells an option, he is sellingthe buyer that right andtherefore assuming theobligation to take the othersideof themarketshould thebuyer of the option exercise

theoption.Inotherwords,he“grants” theoptionbuyer theright to buy or sell theunderlying market at thespecified price (strike price).This iswhy option selling isalso known as optiongrantingoroptionwriting.

In options, theremust beabuyerforeverysellerandaseller for every buyer.However, thisdoesnotmeanthat if you are holding an

open option position, youmust buy or sell your optionback to the same individualwhoboughtitfromorsoldittoyou.Youwill neverknowwho is on the other side ofyour trade. You simply willbuyorselltheoptionbackintheopenmarkettocloseyourposition.

Many new investors alsomakethemistakeofbelievingthat buying options is a

bullish strategy and sellingoptions is bearish. This is amistake. Buying a call is forbulls. Buying a put is forbears. When selling options,theopposite is true.Sellingaput is a bullish strategy.Selling a call is a bearishstrategy. Table 4.5 illustratesthisconcept.

TABLE4.5BullishandBearishOptionStrategies

Let’s go back to ourexample. Mary decides thatshe will use a put sellingstrategy to take advantage ofthe bullish fundamentals shesees for theS&P500.At the

timeofhertrade,MarchS&P500 futures are trading at1840. Rather than buy thefutures contract outright, orbuy the call, Mary decidesthatshewillsellaputoption.Shelooksattheoptionquotesand sees that a March 1650putoptionontheS&P500iscurrently at a premium of$700. She calls her brokerand places an order to sellone.Thisiscalledsellingtheput naked, and it means that

she is not selling it inconjunction with otheroptionsorthefuturescontractitself but rather is simplyselling it by itself. Coveredand spread strategies will bediscussed later.However,webelieve that it is important tounderstand the naked optionwrite before exploring morecomplexstrategies.

What happens to Mary’saccount when she sells the

option? Her account iscreditedimmediatelywiththe$700 premium becausesomebodyontheothersideofthe market just bought theMarch 1650 put option andpaidMary $700 for the rightto sell the March S&P 500futures at 1650. This meansthat Mary has committedherselftobuyonecontractofMarch S&P 500 futures at1650shouldthebuyerofthisoption decide to exercise it.

Most likely theonlyway thebuyerof theoptionwillwantto exercise this optionwouldbe if the price of the MarchS&P500fellbelow1650(seeFigure4.4).

FIGURE4.4S&P500PriceChartShowing1650PutOptionMarySellsaMarchS&P1650PutOption

To hold this position,Mary will have to put up amargin deposit. This is thesame concept used to tradefutures contracts, exceptmargin requirements to holdshort options generally aremuch less than they are tohold the outright contract.Margin is discussed in detailinChapter6.

If the price of theMarchS&P 500 is anywhere above

1650atoptionexpiration,theoption will expire worthless,andMarywillkeep the$700premium as her profit. Thus,$700 is the most Mary canmake. She gives up herchance to make a large gainonabigmoveupward in thefuturesmarket.However,sheincreases her chancesdramatically tomakeaprofiton the trade. At a currentpriceof1840,thepriceoftheMarch S&P 500 can move

up, remain the same,orevenfall almost 300 points, andMarywillstillmakethesameprofiton the trade.Shegivesherselfahugeprofitzoneandcanmakemoney inavarietyofmarketscenarios.

Mary’sRiskinSellinganOption

ButwhatisMary’sexposure?

Mary’sriskis that theMarchS&P 500 falls below 1650and remains there throughoption expiration. At thatpoint, Mary would beassigned one contract of theMarch S&P 500, long from1650. She could choose toliquidate the positionimmediately and acceptwhatever loss it would entail(if any), or if she wanted tobe long the S&P 500 from1650, she could simply hold

the position. Therefore,Mary’s risk is that she willhave to buy the March S&P500 futures at 1650. In theremote possibility that thistook place andMary electedtoremaininherposition,shewould need some additionalcapital to purchase the S&P500 contract. Regardless, the$700 premium remainsMary’stokeep.

FIGURE4.5S&P500Chart

ShowingProfitZoneofSelling1650PutOptionProfitZone:AsLongastheMarchS&PFuturesisAnywhereabove1650atexpiration,the1650putexpiresworthless.Marythenkeepsallpremiumasprofit

Although having theoption exercised is not thedesired outcome for thistrade,youcanseethatsellinga put option carries no morerisk,andinthisexample,lessrisk, than buying the futuresoutright.

By selling the option,however,Mary’sotherriskisthat the value of her optioncould increaseduring the lifeof the option, thereby

increasing her marginrequirement to remain in thetrade.Marycouldelecttoexitthe trade (buy the optionback) for the going marketprice and take a loss, or shecould put up the additionalmarginandholdtheposition.This is why Mary wants toselect an option with a lowdelta.DeltaistheonlyGreeksymbolwewilldiscussinthisbook. It is simple and usefuland will be explained more

fully in a later chapter. Tosimplifyhere,Marywants tosell an option that is farenoughoutof themoneyandwith low enough volatilitythat the market can move along way without greatlyaffecting the price ormarginrequirement of her option.Therefore, a market movethat is large enough to stopoutafuturestradermaymeanonlyaminorpriceadjustmenttoMary’sputoption.

Nonetheless, it is thispotentialforincreasedmarginrequirementsthatoftenscarestraders away from sellingoptions. Yet losses in afutures position, and thusmargin requirements, canboth accumulate much morequicklythaninashortoption.Remember, you’re sellingoptions because you want tostay away from the market’supanddownwhipsawmoves.Done correctly, selling

options should be a veryslow-movinginvestment.

Volatility:HowImportantIsIt?

One of the three mainfactors affecting the valueof an option, as wementioned previously, is

volatility. Volatilitymeasureshowfastandhowmuch the option value ismoving in relation to theunderlying stock orcommodity. Generally,underlyingmarketsthataremaking largemoves to theupside or downside or areexperiencing largeor rapiddailypricefluctuationswillproduce options withhigher volatility and thushigher-priced options.

Slowly moving or quietmarkets generally willproduce lower-valuedoptions. Volatility ismeasured by a figureknown as the option’sdelta.

Many books, seminars,and computer programshavebeendesignedaroundcalculating, analyzing, andcapitalizing on thedifferences between an

option’s delta andvolatility. Much time,effort, and money havebeen dedicated todesigning complexmathematical formulas fortrading volatility, deltas,and other Greek symbolssuchasgammasandvegasthat take othermeasurements of optionvolatility.Whereasitisnotour intention to downplaythe importance of option

volatility, we believe thatthese studies areresponsibleformuchoftheconfusion and intimidationof option trading. Thestudy of volatility hasbecome so complex that itis all but impractical foruse by the averageindividualinvestor.

Contrary to what theindustry will have youbelieve,youdonotneeda

complex computerprogram to trade optionseffectively. Just rememberthis general rule of thumbpertaining to volatility andyou should be fine: Ifvolatility is high,conditions may favoroptionsellersbecause theycan get more premium forthe options they want tosell. If volatility is low, itmay favor option buyersbecause they have to pay

less to purchase theiroptions.

Thisdoesnotmeanthatwe recommend sellingoptions with high deltas.We generally recommendselling options with lowdeltas in slightly volatilemarkets.Thisallowsonetosell very far out-of-the-money strikes with littlechance of going in themoney.Therefore,thedelta

is not low because themarket isnotmoving:Thedelta is low because theoption is so far out of themoney.

Howdoesoneknow ifvolatility is high or low?The number crunchers outtheremay cringe, but howabout simply looking at aprice chart of theunderlying market? If themarket has been making

rapid, sporadic moves,chances are that thevolatility is high in theoptions. If the market ismoving slowly or in afairly defined price range,chances are that volatilityislow.

For thosewho prefer amore scientific approach,there are many websitesand software that measurethe volatility of options.

Yourbrokershouldbeabletogiveyouthevolatilityofanoptionaswell.

In our opinion, if youcan use a little knowledgeandalotofcommonsensesimplytopickapricelevelof where the market willnot go, volatility becomeslessimportant.Wearenot,however, suggesting thatyou disregard optionvolatility completely.

Options with historicallylow volatility often can bean indicator that prices inthe underlying futurescontract are very calm ortrading in a narrow range.However, italsocanbeanindicator that a market isready to break out of itstrading range and make asizable move in onedirection. It therefore maynot be a good idea to selloptions with very low

historicalvolatilities.Many technicians

spendaninordinateamountof time studying the mostminute details andcomparisons betweenvolatilities of options. Butwearegoing togoagainstthegrainandtellyourighthere and now that it isprobably not necessary foryou to do this to selloptionseffectively.

Many pundits willargue that volatility is thekey to picking winningoptiontradesandwilltradebased solely on volatilitymeasurements. We cannotand do not agreewith thisphilosophy. Just becausean option has highvolatility does not meanthat it is a good option tosell. And just because anoptionhaslowvolatility,itdoes not mean that it is a

pooroptiontosell.We do give volatility

its due in Chapter 17.However, traders do notneed togetallwrappedupin volatility to besuccessfuloptionsellers.

Mary’sTrumpCard:TheBuyBack

Of course, Mary does not

have to hold this optionthroughexpirationifshedoesnotwant to.As in theoptionbuying example alreadypresented, the value of theoptioncanmoveupordownduring its life depending ontime value, intrinsic value,andvolatility.Marymayelectto liquidate her position atany time prior to expirationsimply by buying back heroption at the going marketprice. This could result in a

loss or a profit. However,Mary controls it. She cancloseherpositionatanytimefor any reason. If she isgetting uncomfortable, if sheheardanewsreportshedidn’tlike, if the marketfundamentals changed, shecanpulltheplugonhertradeand move on. That is howyou handle risk in optionselling.

There are several very

effective techniques formanaging risk in shortoptions, and these will bediscussed in Chapter 9. Fornow, the point is that mostoption selling trades donewiththemethodsproposedinthis book will, hopefully,rarely require you to employone.Themost importantpartof your risk management issellingtherightoptionsinthefirstplace.

Although there are manymore intricacies to sellingoptionsthatwillbediscussedin thefollowingchapters, thepreceding example illustratesthe basic concept of theapproach.

Making $700 on a trademay not sound very excitingat this point. But read on.Whatifyoucouldsellgroupsof options, over and over,consistently having them

expire in your favor whilehaving a reliable riskmanagement plan in place tolimit your downside on thefew that move against you?What if you could sell theseoptions at very low marginrequirements—sometimes aslow as the premiumscollected?

John Summa’s study(citedinChapter3)estimatesthat threeoutof fouroptions

held through expirationexpire worthless. Again,consider those percentages.Option sellers make moneywhen options expireworthless, and option buyerslose money when optionsexpire worthless. Now,setting aside all other prosandconsofoptionsellingfornow, if your goal in aparticular trade is simply tomake a profit, not to hit a“home run” but to make a

profit, wouldn’t this be agoodway to go into a trade,anytrade,inanymarket,withthis statistic behind you?Before you do a lick ofresearchorpick anyentryorexit points, you know that ifyou stick with your trade,you’ll have odds and timebothworkinginyourfavor?

In addition to odds andtime, a seller of out-of-the-money options generally

doesn’t have to pick marketdirection and generallydoesn’thave todecidewheretotakeprofits.Heavoidstwoof the hardest decisions ininvesting.

This gets even moreexciting when you considerthe extrawrinkle of leveragethatappliestosellingoptionson futures contracts. Theadvantagesanddisadvantagesof selling options is

illustratedinTable4.6.

TABLE4.6AdvantagesandDisadvantagesofSellinganOption

IstheEightyPercentFigurea

Myth?

The second edition of thisbook and subsequentarticles and televisionappearances that itspawned provoked outrageamong the option buying

community—especiallythose who make theirlivings convincing otherstobuyoptions(i.e.,brokersandsellersof“educational”materials that promotebuying options to “getrich”). “It’s a myth!” theyshouted in their onlineforumsandstilldotoday.

Imanageportfolios foralivingandthereforehavelittle time or interest in

beginning some kind ofonline debate with these“chat room”people.Thesepeople may be investorswho write option-buyingblogs and are looking toget some traffic.However,some of our readersactually look at this stuff,and so we believe it isimportant to address it inthecurrentedition.

Their main point of

contention is that a largepercentage of options getclosed out prior toexpirationandthus80%ofALLoptionsdonotexpireworthless.

Thisistrue.However, our

contention is thatapproximately 80% ofoptions held throughexpiration will expireworthless. Some even

challenge this figure.Othersexpoundthatoptionexpirations are simply toonumerousandcomplexandsimply “cannot becalculated.” Others,lookingtocapitalizeonourconcept, took our figuresand presented them out ofcontextforpersonalgain—further enflaming the “buyguys.”

You should first

remember that there are aheck of a lot more(individual,nonprofessional traders)option buyers than optionsellers.Thereasonsforthisare explained in priorchapters. And they do notlike people who tell themtheir strategy is a losinggame. For the sake ofamusementandcuriosity,Iread some of their onlinerants. I am interested to

know how many of thesefolksmanageportfoliosforaliving.

The fact is there is notonesinglestudythatstatesthe figure to be exactly80%.We use that numberas an estimated numberbased on different studies.We stand by it, firmly.Summa’sstudy(featuredinChapter3)isoftencitedinthe futures industry and is

one I would match upagainst any buyer lobbyistargument. My experiencein this industry hasconfirmed to me that hisfigures are quite accurate.Other studies have statedthat up to 85% of calloptions will expireworthless(atexpiration).

The irony is that thepercentage of ALL optionsthatexpireworthlessreally

has no relevance to you,the individualinvestor/option seller. Weuse this figure (whatevertheexactfiguremaybe)toillustrate a concept—tomakeapoint.Astudy thatwould matter more to youandmewouldcalculatethenumberofdeepout-of-the-money options that expireworthless.Myguessisthatthis figure would beastronomically higher.

When one refers to alloptions, as ours does, thefigureincludesoptionsthatarecloseto,at,andeveninthe money. These optionswould have much higherchances of expiring withsome value left on them.Furthermore, the optionswith the most volume andopeninteresttendtobetheones thatareclosest to themoney.

You cannot take a dartand throw it at a board ofany and all optionsavailable, sell the one youhit, and think that’s theway to consistent, highreturns. However, if I didhave to do that as mystrategy, I would muchratherbethesellerthanthebuyer. I contend that overthe long haul, the optionseller would still makemoneythisway.

But that is not howastute investors generatehigh odds returns. If yousell with the trend, if youselldeepoutofthemoney,ifyousellwith littleornotime, all of those factorsaffect the chances of theoptiongoinginthemoney.

The concept of thisbook teaches to sell deepout-of-the-money options.A simple look at the delta

(explained later) can tellyou each individualoption’schanceofexpiringworthless. A delta of .10meansthethinghasa10%chance of going in themoney.Sellthatoptionandit has a 90% chance ofexpiringworthless.That ismathematical fact thatcannotbedisputed.

The 80% figure is oftcited, and we use it to

make a point.However, atthe end of the day, it isirrelevant to you.You cansell options that have a90%, 95%, or even 98%chance of expiringworthless. The 80% figuredoesn’t really matter then,doesit?Letallofthe“chatroom professors” arguethatoneforawhile.

Should you wish tosilence them, I suggest

simply requesting to seetheir account statements.I’ve yet to meet a richoptionbuyer.

Conclusion

The contest between buyersandsellers is, inouropinion,no contest at all. The optionsellerwins.Theoptionbuyerhas a good pitch on the

surface.But ifyoudig just ascrapebelow the surface, thefacts tend to speak forthemselves.

Although there are nodoubtcountlessoptionbuyersjumping up and down,screaming about misleadingstatisticsatthispoint(seeboxabove, we intend to showthem the error of theirways.The concept of selling timepremium has been used by

professional and commercialtraders since the inception ofderivatives. It has been onlyrecently that the individualinvestment community hasstarted catching on. Unlessyou love to gamble, buyingoptions is a losingproposition.

I have a daughter(Michael speaking) who isnow 26. She loves to buylottery tickets—lotto, scratch

off, youname it.Despitemynumerous lectures on thefutility of such a hobby, shecontinues to purchase herticketsonaregularbasis.It’snot about themoney, it’s fortherush.Shelovestotellmeabout it every time she“wins.”Yetnotoncehas sheshared with me all of themoney she “invested” to getthatwin.Soundlikeanybodyyou know, maybe, fromearlierinthischapter?

Theallureofabigpayofffor a small investment isinnate to human nature. Thatis why there will always beplenty of buyers out there topurchase the options youwish to sell. And it is alsowhy there are plenty ofbrokers and seminarsalespeople willing to obligethem.Begratefulforthem.

Selling options goesagainst a genetically

programmedhumantrait.Itiscounterintuitive.Themajoritywill resist when you try toexplain it to them. This istypically a good tip-off thatyouareontherighttrack.

Option sellers aren’t in itfortherush.Theyareusuallyserious investors seeking asteadysourceofprofits.Theyhave no interest in trying tobe home run hitters. TheyplayMoneyball.

Unfortunately, the onlyway most investorseventually find their way tooption selling is by havingfailedateveryotherapproachfirst. Ionceaskedapotentialclient why he decided onselling option premium as ameansofinvesting.“BecauseI’m not a very good trader,”hesaid,“andoptionsellingistheonlywayIcanmakeanymoneyinthemarket.”

Indeed.

5

OptionSellingonSteroidsAnIntroductiontoFuturesOptions

After decades of being theneglected stepchild of theinvestment world,commodities have finallybegun to catch on withmainstream investors.Perhaps it is the expandingneed to diversify that isdrivingthistrend.Oritcouldbe that after the varyingdegrees of financial traumathroughout the first decadeandahalfofthe21stcentury,futuresmaynot lookquiteas

risky or as intimidating asthey used to, at least inrelation to everything else.Investors,especiallyhigh-net-worth investors, are nowwilling—and almost have tobe willing—to explorealternatives.

Unlike stock incompanies such as Enron,AIG, or Bear Stearns,commodities are physicalproducts that people use

everyday.Regardlessofwhatishappeningincreditmarketsor corporate boardrooms,peoplewill still drink coffee,eat wheat, and fill their carswith gas. These assets willalways have a value. In thisday and age where anythinggoesintheinvestmentworld,thatfactisbeginningtocarryalotofweightwithinvestors.

•Sugarcannotbeconsidered“toobigto

fail.”Silvercannotgobankrupt.TheCEOofSoybeanscannotembezzlemoneyfromshareholders.

Weuse the terms futuresand commoditiesinterchangeably in thisbook.However, there are manykindsof futures contracts. Inaddition to the actualcommodities futures such ascorn, sugar, oil, or cattle,

there are financial futures.Financial futures contractsinclude T-bonds, Treasurynotes, index futures (such asthe S&P 500), and currencyfutures. It is ironic to notethat most stock traders’introduction to futures isthroughtheS&P500contract—the biggest, baddestcontract on the board. Thesesametradersoftenshudderattrading a soybean or coffeecontract. To us, old-school

commodity traders, soybeansand coffee are not onlysmaller contracts with lowerrisk,theyare(inouropinion)morepredictablemarkets.

Stock option traders whooverlook commoditiesoptions aremissing the boat.Here’s why every optiontradershouldconsiderthem.

AThrivingIndustry

New volume records havebeenset in the last twoyearson many contracts at theChicago MercantileExchange and the ChicagoBoard of Trade. Newproducts and the continuedexpansion of electronicexchanges continue to pointto a thriving, growing assetclass that is nowavailable tomostalltypesofinvestors.

Yet, despite the

popularity of futures trading,the odds remain stackedagainstindividualinvestorsinthefuturesarena.

Studiesconfirmthatabout76%ofallfuturestradersendup losingmoney (there is nodoubt that most of these aresmall speculators). It is nomystery why. It is amateursagainsttheprosinfutures.Nomatter how hard smallinvestors try, the pros are

usuallyonestepahead.Ifyouread something on yourscreen, they probably knewaboutityesterday.Ifyoureadsomething in the newspaper,they probably knew about itlastweek.Bythetimeyougototradeit,ithasalreadybeenpricedintothemarket.

Itisnotthefactthatsmallspeculators don’t have thetime, nerves, resources,capital, or knowledge to

compete. It is the fact thatthey are amateurs competingagainstprofessionals,andthisistherealreasonmostfuturestraderslosemoney.Luckyforyou,youdon’thavetobepartofthisgroup.Youdon’thaveto go toe to toe with theseheavyweights on their turfanymore.Youcansimplyselloptions.

CommoditiesOptionsforthe

StockOptionSeller

If you currentlywrite, or areconsidering writingoptions on equities,

you are doingyourself a greatdisservice if you donot at least considerwriting options onfutures as well. Theportfolios werecommend toclients are focusedexclusively on

futuresoptions.Hereiswhy.

Key Advantages ofFutures OptionsOverStockOptions

1.SubstantiallyLowerMargins(PotentialforHigherReturns).Thisisoneofthe

topreasonssomanystockoptionsellersconverttofutures.Marginspostedtoholdshortstockoptionscanbe10to20timesthepremiumcollected.WiththeSPANmarginsystemusedinthefuturesindustry,optionscanbesoldformargin

requirementsaslittleas1to1½timespremiumcollected.Forinstance,youmightsellacornoptionfor$600andpostanout-of-pocketmarginrequirementofonly$700.

2.HighPremiumsforDeepOutof

theMoneyStrikes.Unlikeequities,wheretocollectanyworthwhilepremium,optionsmustbesold1to3strikepricesoutofthemoney,futuresoptionscanoftenbesoldatstrikesdeepoutofthemoney.Thisallowsyouto

targetpricelevelswhereshort-termmarketfluctuationswillnotadverselyaffecttheposition.Inaddition,timevalueerosionmaybeallowedtoworklessimpededbyshort-termvolatility.

3.Liquidity.Manyequityoption

traderscomplainofpoorliquidityhamperingtheireffortstoenterorliquidatepositions.Althoughsomefuturescontractshavehigheropeninterestthanothers,mostofthemajorcontractssuchasFinancials,Sugar,Grains,Gold,NaturalGas,

CrudeOil,andmorehavesubstantialvolumeandopeninterestofferingseveralthousandopencontractsperstrikeprice.

4.Diversification.Inthecurrentstateoffinancialmarkets,manyhigh-net-worthinvestorsare

seekingpreciousdiversificationawayfromequities.Inequities,bearmarketscanwreckaportfolioandbullmarketsalwaysseemripeforcorrection.Byexpandingintocommoditiesoptions,younotonlygainan

investmentthatis100%uncorrelatedtoequities,youroptionpositionscanalsobeuncorrelatedtoeachother.Instocks,mostofthetime,yourindividualstock(option)willbelargelyatthemercyoftheindexasawhole.If

Microsoftisfalling,chancesare,yourExxonandCoca-Colaarefalling,too.Incommodities,thepriceofnaturalgashaslittletodowiththepriceofwheatorsilver.Thiscanbeamajorbenefitinmanagingrisk.

5.Fundamental

Bias.Whensellingastockoption,thepriceofthatstockisdependentonmany,manyfactors—nottheleastofwhichiscorporateearnings,commentsbytheCEO/Board,legalactions,Feddecisions,ordirectionoftheoverallindex.

Soybeans,however,can’t“cooktheirbooks.”Silvercan’tgetsued.

6.SupplyandDemand.Incommodities,itismostoftenold-fashionedsupplyanddemandthatultimatelydictatesprice.Knowing

thesefundamentalscangiveyouanadvantageindecidingwhatoptionstosell.

FuturesContracts:WhatAreThey?

Before one can understandhow to sell options onfutures, one must understand

what futures are. Farmersoriginated the buying andsellingoffuturescontractsasawaytoofferahedgeagainstpricechangesintheircrops.

It works like this: Afarmer has a crop of cottongrowinginhisfield.Helikesthecurrentpricethatcottonisfetching at the market andwould be very happy if hecould sell his crop at thisprice.However,hiscropwill

not be ready to sell for threemonths. By selling a cottonfuturescontract(ornumberofcontracts) equal to theamount of cotton he hasgrowing in his field, he caneffectively “lock in” thecurrentpriceofcotton.

How does this work? Asan example, let’s say thefarmerestimatesthathiscropwill produce 50,000 poundsof cotton this year. The

futures contract for cotton isfor50,000pounds.Therefore,the farmer can sell onefutures contract of cotton attoday’spriceforthemonthheexpectshiscottontobereadyfordelivery.Nowifthepriceof cotton falls between nowand the time his cotton isreadytosell,hewillmakeupthedifferenceinprofitsonhisfutures contract. If the priceofcottonrises,hewillloseonhis futures contract, but he

will make up the differenceon the sale of his physicalcotton. It is a way for thefarmer to avoid the risk ofprices moving below a pointat which he would besatisfied. This is calledhedging, and it is still theprimary purpose of thefuturesmarketstoday.

Large institutional farmsand agricultural producershedge their products in

everything from cocoa tocattletosoybeans.Banksandgovernment institutionshedge their exposure tocurrency fluctuations andinterest rates. Worldwidebrokerage houses hedge theirexposure to the stockmarketwithindexfuturescontracts.

Hedgersalsocanbeusersof the actual products theywanttoprotectagainstpricesmoving higher. A company

suchasPillsbury,whichusesthousandsoftonsofflourinayear, may want to protectagainst higher wheat pricesand hedge by buying wheatfutures. Financial institutionsuse futures to hedge in thismanneraswell.

Pure hedgers make noactualnetprofit from tradingfutures.Itisonlyatooltocutriskandmanagepriceswingsin a product that their

business either produces orusesinsomeregard.Notonlyare these traders very wellversed in their industry, butgenerally they also work forlarge organizations and havethousandsorevenmillionsofdollars in technical andhuman resources available tothem to determine pricedirections and risk arrays ofthe commodities or financialinstruments with which theyaredealing.Thesetradersare

known as commercialtraders, or commercials forshort.

TheRoleoftheSpeculator

To hedge their risk, hedgershave to have somebodyassumetheirrisk.Speculatorsfill this role. Speculators donot trade futures to manage

riskorlockinprices.Usually,they are not even in thephysical commoditiesbusiness.Theyaretradingthecontracts purely for profit.They are willing to assumethe riskof thehedgers in thehope that a price move willproduce profits for them.They do not deliver thegoods, nor do they takedelivery. They simply buyandsellthecontractsandexitbeforedeliverycomesdue.

The Commodity FuturesTradingCommission(CFTC)divides speculators into twogroups: large and smallspeculators. If a trader has acertainnumberofcontractsinonecommodity,usually50or100,sheisconsideredtobealarge speculator in thatparticular commodity.Although many individualinvestors can easily hold thismany contracts at a time,large speculators generally

arethoughtofasprofessionalmoney managers or funds.Large investment houses orindependent operators cantradecommodityfunds,madeup of capital from manyinvestors(similartoamutualfund in equities). Ironically,some of these are known ashedge funds, supposedlybecause these funds can besomewhat of a hedge againstadverse moves in the stockmarket.However,thepurpose

ofthesefundsistoproduceaprofit.

Fund managers tradebillions of dollars and trademany thousands of contractsin a day. They have theability tomove themarket toa certain degree when theydecide to enter or exitpositions. Like commercialtraders, most have hugeamounts of resourcesavailable to them, industry

contacts, and a wealth ofpersonal or companyexperienceonwhichtodraw.

Thereisonecategoryleft.This is the small speculator.Small speculators areindividualinvestors.Theyarethe tiny capitalists trying toenter the race between thetwo titans. As we discussed,this group faces a decideddisadvantage when tradingactual futures contracts.

Selling options on thosecontracts, however, can be awaytoleveltheplayingfieldwiththepros.

ContractsandContractMonths

A futures contract is anagreement to buy or sell aspecified commodity in aspecified amount at a

specifieddate.Everycontractis for a specified amount ofthat particular commodity,currency, or financialproduct. Most commoditieshave different contract sizesdepending on the unit that isused to measure it. Forinstance,acontractforcornisfor 5,000 bushels of corn. Acontract for crude oil is for1,000barrelsofcrude.

Unlike stocks,

commodities trade indifferent contract months.Cornfordelivery inJuly isadifferent contract at adifferentpricefromacontractfor corn for delivery inSeptember. As a speculator,you will want to close outyour positions before thesecontracts come due fordelivery.

Some investors new tofutures express the fear that

theywillmakeamistakeandthat a contract for acommodity will be deliveredto their door. This is simplyunrealistic. There are severallayers of people whoseresponsibility it is to makesure this does not happen.You would be contacted byseveral of them (first andforemost, your broker) toinform you that it is time toexit your position, and ifnecessary, they probably

would do so on your behalf.Evenifyoudidintendtotakedelivery, there is muchpaperwork and arrangementsto bemade before this couldtakeplace.

Option traders generallydo not have to worry aboutthis at all. Even when anentitywants to takedelivery,they must possess a futurescontract,notanoption.

ContractSizesandPointValues

Another difference betweenfutures and stocks is howpricemovesarecalculated.Ina stock, you can buy 100shares of stock, and if theprice moves up $1 a share,you make $100. Becausecommodity contracts vary insize and units ofmeasurement (i.e., barrels,

bushels, or pounds), eachcommodity has a differentpointvalue.

Forexample,thesizeofacrude oil contract is 1,000barrels.Thepriceinthecrudeoil contract is quoted at aprice per barrel. Pricechanges incrudeoilmove in1-cent increments.Therefore,a1-centmove in thepriceofcrudeoilequates toagainorlossof$10foreverycontract

atraderholds(0.01×1,000=$10). If a trader bought onecontract forMaycrudeoil at$98.00 per barrel, and theprice increased to $98.50perbarrel, the traderwould havemadea$500profit(50×$10=$500).

Contract sizes and pointvalues for differentcommodities and futurescontracts are listed in Figure5.1.

FIGURE5.1FuturesContractSpecifications

MarginsonFutures

The term margin has acompletelydifferentmeaningin the futures world than itdoesintheworldofequities.In stocks, one often can“borrow” money from thebrokerage house to purchasestocks, at least a certainpercentage of stock. This isknown asbuying on margin.

The investor then has to payinterest on the money sheborrowed and hope that thegain fromher stockpurchaseis enough to pay her interestcharge and commission andstill show a profit. This is awayofincreasingleverage.

In futures, buying orsellingonmarginisabuilt-infeature.Touse theprecedingexample, a crudeoil contracttrading at $98per barrel at a

contract size of 1,000barrelswould mean that the totalvalue of the contract is$98,000. Yet a trader canpurchase (or sell) thatcontract for a small margindeposit, usually about 5% to10% of the value of thecontract. In the traditionalway of buying stocks, topurchase $98,000 worth ofstockswouldrequire$98,000worth of cash. However, topurchase $98,000 worth of

crude oil, one only needs toput down the marginrequirement, maybe $6,000.The exchange will front youtherest.

Thisiswheretheleveragecomes from in futurescontracts. A small move inthe value of the unleveragedstock produces a small gainor loss.A smallmove in thevalue of the commodity canresult in a large gain or loss.

For instance, if youpurchase1,000sharesofstockat$98ashare, you plunk down$98,000. If the stock movesup to $102 per share, youmake $4,000, orapproximately 4% return onyour investment(4,000/98,000=0.0408).

Ifyoupurchaseacontractfor crude oil at $98, you putdown your $6,000 marginrequirement, and when it

movesup to$102,youmakethe same $4,000, yet yourreturnoninvestmentis66.7%(4,000/6,000 = 0.667). Thisaspect of leverage is whyfutures generally areconsidered an aggressiveinvestmentbythemainstreaminvestment media. Themisunderstanding of thisleverage by new futurestraders is where many maketheir mistake in futures.Properly understanding and

using this leverage can giveyouadecidedadvantageovermany of your futures tradingpeers.

Figure 5.2 presents anexample of what a marginsheet looks like.This is onlyasample.Marginschangeallthe time, and you should askyour broker for an updatedmargin sheet if you want tosee a current margins forfuturescontracts.

FIGURE5.2SampleMarginSheet:ListingofMarginRequirementsforFuturesContracts

Margin requirements forindividualcontractsaresetbythe exchanges and can bechanged based on thevolatility of the contract.These are called minimumexchangemargins.

Individual clearing firmscan add their own additionalmargin on top of theexchangemarginsandreservethe right to increase thesemargins without notice.

Serious traders usually lookfor a brokerage that offersminimumexchangemargins.

You must distinguishbetween margin requirementfor the futures contracts, andmargin requirement for anoption on that futurescontract. These are twodifferentthings.Asanoptionseller,youwillrarely,ifever,need to know futuresmargins. They are presented

hereforeducationalpurposesonly. As a future optionseller,yourmainconcernwillbethemarginonyouroption.In the futures business, asystem call SPAN is used todetermine futures optionmargin requirements. SPANmarginisakeytogeneratinghigh returns. It is importantenough to warrant its ownchapter(Chapter6).

HowtoBuyaStock,Commodity,

orBoatataSyntheticPrice

Haveyouevernoticedhoweasy it is to enter a trade?Whether it’s a highlyrecommended company orthe next hot commodity,

the day you buy it can bethe easiest (and happiest)dayofthetrade.

A wise man once toldme that the happiest daysof a boat owner’s life arethe day he buys it and theday he sells it. You don’twantthedayyoubuyyournewinvestmenttoturnoutlike the day you boughtyournewboat.

After many years of

tradingexperience,theonething I’ve discovered isthat it is of utmostimportance to give yournew investment time towork as planned. At thevery least, allow it theopportunity to work asplanned.

All too often, pricevolatility and noise fromthe business world willcause many investors to

rethinktheirposition,closeoutwhatcouldhavebeenagoodinvestment,andcallitaboat.

What do I mean bythis? Let’s consider anexample.

TheTeriflyTrade

One day while sitting atyourdesk,apromisingnewcompany comes across

your radar screen.Aswithall investments, you doyour homework.Everything you knowabout valuations, trendfollowing, and economicshave you convinced thiscompanyisagoodbuy.Soyoujumpin.

Shortly thereafter, thestock you bought at 50 issuddenly tradingat45andyou ask, “what’s the

matter?”Initiallyyourplanwastoholdfor12months,but you are alreadyquestioning your buy andholdstrategy.

Forthenextfewweeksthe price is more stable.Your confidence returns.This stock, we’ll callTerifly, now becomes partof your portfolio.While itwas smack dab in themiddleofyourradarscreen

atfirst,itnowhastakenitsplace with several otherideas. Some have gains;othersdon’t.

After several moreweeks,Teriflycontinuestotradeinthemid-40sanditsquarterly earnings are dueoutonThursday,justafewdaysfromnow.Withsomeanticipation you’rethinking, “if my researchwas correct, I will soon

havevindication.”Thursday afternoon

arrives, and how aboutthat? Terifly beats thestreet,andthestockisupawhopping 10% in after-hours trading! Yes! OnFridaysomeanalystsplaceupgrades on your newfavorite company, andyougointotheweekendwithawinner:$52pershare.

Terifly is nowback on

theradarscreen.“Let’sseeif it has any follow-through,” you think withgiddyanticipation.

Over the next severaldaysthestockcontinuestotrend higher, enjoyingleftover buying from itsgreat quarterly results.Beforeyouknowit,Teriflyis trading at just over $55andalliswell.

As the proud owner of

a company with a 10%profit, you find yourselffaced with a decision. “Isthis trade the winner I’msupposedtoletrun,ordoItake the money and run?Afterall,ifmyinvestmentsduring the year all paid10%, I could beat thestreet,bigtime.”

Youconsidertheinitialgame plan and make thedecision to hold the stock.

“I’ve owned the companyjust a fewmonths, and theplan was to stay in for atleastoneyear,”youreason.

During the next fewweeks trading in Teriflyslows somewhat, and theupward momentum beginstofade.Afterhittingahighof $57 the stock is nowtrading in the low $50s.While its price is nothingto panic about, a thought

crossesyourmind.“MaybeIshouldhavecashedout.”

Terifly is no longer onthe radar screen but istucked back into theportfolio. It has now beennearly four months, andsure enough your stockclosesat$49.50toendtheweek. Ouch. We’veofficially turned a winnerintoa loser.Teriflyisnowback on the radar screen,

but not for the reason itonce was. Now it’ssuddenly on your “watch”list. You think back tootherholdingsthatbehavedlike this. Often, they didnotendwell.

A fewweekspass, anditseemsTeriflycan’tgetahigherweeklyclosetosaveits life. 48, 47, 46.Suddenly the idea ofholdingtightfor12months

has gone out the window.Whichmeansbuyandholdhas now been replacedwith “moneymanagement.”

Overanalyzinghasnowtakenover this investment.Itsdaysarenumbered.

Flash forward. It hasnow been almost sixmonths of watchingTerifly, and it hastransformed from an

investment into a JOB. Itsprevious low for the yearhad been $43, a level itapproached shortly afteryourinitialpurchase.

Youmake the decisionto place a sell stop ifTerifly trades below the$43 price level. It seemsalmost magical how yoursellstophasnowbecomeamagnet, as the pricecontinues to ease. Just one

week later the stop is hit.Terifly is no longer in theportfolio.AndTeriflyisnolonger your problem….Just like the day you soldyourboat.

Naturally, after oneyear, you look up its priceto see where it’s trading.What do you know?Teriflyistradingat$60pershare.Turnsoutitwasn’ta“dogwithfleas”afterall.If

only it was given anopportunity.

Investing the old-fashioned way isn’t easy.Evenindividualswhohavereached the pinnacles oftheir respective field orindustrycanfinditdifficultknowingwhentohold’emwhenitcomestoinvesting.

Trying to trade thetraditional way can turnyou into a sheep, and, as

Gordon Gekko soeloquently stated, “Sheepgetslaughtered.”

In order to stop beingthesheep,youwillneedtostop buying stocks orcommodities at the samepriceeveryoneelsedoes.

BuyingtheAssetata“Synthetic”Price

From now on, the next

time you choose to take aposition, long or short,Exxon or Copper, tryenteringthemarketusinga“synthetic” price. Bysellingfaroutofthemoneyputs, you prevent, or atleast drastically reduce,your chances of becomingoneofthemanysheep.

How about, instead ofbuying Terifly at 50, yousold the 12-month 40 puts

at$5?Yoursyntheticpricebecomes $35 per share.Your analysis is the same.Yourinvestmentplanisthesame. Only this time youdon’tgetslaughtered.

If Terifly stays above$35 per share, you simplymake $5 per share onTerifly.Ifthepricefallstoor below $35, you buyTerifly at $35—substantially below where

youwouldhave($50),andyou still keep the $5 pershare.

Some will argue thatthisstrategycapsyourgainat only $5.00. Or that it’sdifficult to calculate therequiredmargin.Anddon’tforget the margin to holdtheseputscouldincrease!

Noneof theseareyourproblem. They are issuesfor the small,

undercapitalizedtrader(theoptionbuyer).

Buying at a syntheticprice is one way thatselling options can beemployedwhether you aretrading stocks orcommodities (although incommodities,wewouldbeinterested purely in takingthe premium). However,this storywaspresented tomakeapoint.

Whenbuildingahome,the materials can often bebought at vastly differentprices. How is it that thewell-capitalized developerpays much less for thesame materials as anindividual interested inbuilding just one home?Easy answer. Because hecan.

And how is it that thewell-capitalized investor

pays much less for thesamestockasanindividualwhowants tobuy just oneshare? Easy answer again.Becausehecan.Heknowshowtobuyatthesyntheticprice.

Then he can buy theboathewantstokeep!

ACrucialWordonDiversification

One reason that commoditiesarebecomingmorepopularisthattheyofferagreatamountof diversity to a portfolio.Most investorshavemuchoftheir capital tied up in thestock market. If the stockmarket goes down, they losemoney. Investors who tradeindividual stocks experiencemuch frustration when theyspendtheirtimetryingtopickthebest-qualitystocksonlytolose because themarket as a

wholefalls.Theycanpickthehighest-quality companies onthe board and still losebecause of macroeconomicfactors that take the wholestockmarketdown.

Commodities, currencies,and other financial contractsare not necessarily affectedby the stock market or thefactors that affect itsmovement.Inmostcasestheymove completely

independently of equities—sometimes perhaps even inopposite directions. Forinstance,talkofinflationmayhurt stock prices but actuallymay benefit commodityprices.Inaddition,eveniftheprices of commodities aremoving down, it is just aseasy to go short incommoditiesastogolong.

Another reason thatcommodities are excellent

diversifiers is that although,as a whole, prices can movein a long-term generaldirection, they are not asaffectedbythecomplex,asawhole, asmuch as stocks. Inother words, Pfizer andWalmart may move lowertogether because the wholestock market in general isdown. However, the price ofsoybeans is fairlyindependent of the price oforange juice or natural gas.

There are many moreopportunities to diversifywithinthediversifier.

ManagedFutures

Nonetheless, tradingcommodity futures remains alosing game for mostinvestors. For the reasonsalready mentioned, for mostpeople it is simply toodifficult to learn to manage

the leverage and analyticskills, and to acquire theresources necessary to beconsistentlysuccessful.

So how does the averageindividual investor gainexposure to these potentiallylucrative markets withoutlosing his shirt? Manyinvestors today are adoptingtheslogan,“Ifyoucan’tbeat‘em, join ‘em.” Growth ofmanagedfundsinfutureshas

exploded in the last fiveyears.

Instead of trying tocompete against theprofessionals, these investorsare simply hiring aprofessionaltotradeforthem.Although this does notguarantee a profit, mostinvestors will fare muchbetter over the long runhaving their funds managedprofessionally. Much of this

willdepend,ofcourse,onthetraderwho ismanaging yourmoney.Thereismoreonthisin the chapter on hiringbrokers andmoneymanagers(see Chapter 15). The otherchoice, of course, is to learntoselloptions.

Some investors evenmaywant to combine these twoapproaches and hire aprofessional money managerwho sells options to trade

theiraccount.This,ofcourse,is a choice youmaywant toconsider down the road aswell.

Conclusion

If you have, up until now,only traded stocks or stockoptions, you may want toseriously considerincorporating commoditiesoption selling into your

portfolio.Takingpremium incommodities involves higherleverage, which can meanhigherrisks.However,sellingcommodities options canoffer many advantages to aninvestor—not the least ofwhich are much higherpotential returns, highpremiums,andavailabilityofdeep out-of-the-moneystrikes.

Selling commodities

options for the first time canbe like option selling onsteroids to the stock optionseller.

Although not appropriatefor every investor, thecommodity futures marketsare a thriving and growingassetclassthathascomeintoits own within the last 15years—especially among thehigh-net-worth set. They canoffer both valuable

diversification and potentialforoutsizeprofits.Becauseofthe leverage involved, manyinvestors, even sophisticatedinvestors, enlist thehelpof amarket professional when itcomestocommodities.

Regardless, sellingoptions, whether done byyourself or by your moneymanager, automaticallyrelieves you of many of theburdens and pitfalls that

befallnotonlyfuturestradersbut also traders who buyoptions. Selling options canputyouabovethecrowdatapointwhereyoudon’thavetocompete with theprofessionals in the futurespits—at least not directly.Achieving substantial returnsin the futures market,consistently, can become areality without takingoutrageous risks. Only you,however, can decide if

commodity options are rightforyourportfolio.Ifyouhaveaquestionaboutthis,Iwouldrefer you back to Chapter 2,“The ‘Who’ of SellingOptions.”

The next chapter willexplain to you a crucialcomponent of selling futuresoptions. It is the key to whyfutures options offer suchhigh potential returns. It iscalledtheSPANmargin.

6

SPANMarginYourKeytoHighReturns

Istillrememberthefirsttime

I sold a stock option. I wascollecting a $150 putpremiumona$60stock.Thething looked like a lock. Icouldn’t believemore peopleweren’t selling these things.What was I missing? Then Ifound out. The marginrequirementwas over $5,000to hold the thing. Let’s see,put up $5,000 to make $150in 60 days: 3% in 2months.Maybethat’snotbadtomostpeople. But to a person used

tosellingfuturesoptions, it’s“notwhatwe’relookingfor,”to say the least. I’m used toputting up $5,000 to make$3,500 in 60 days. That’swhat a futures option sellercalls return. And it’s whatyoucantarget,too,ifyouareusingSPANmargin.

Sellingoptions,especiallyfutures options, entails acertaintoleranceforrisk.Thestrangeness of it, or even the

potential returns, can seemscarywhenyousee it for thefirst time.TheSPANmarginsystem gives you the abilityto calculate futures optionmargin and is one of yourbiggest advantages in optionselling.Useit.

WhatIsMargin?

If you have tradedcommodities in the past, you

are already familiar with theconcept ofmargin.However,traders who have thus farlimitedthemselvestoequitiesmaynotbefamiliarwithit.

Vastly different marginrequirements are one of thekeydifferencesbetweenstockand futures options. If youbuy an option, you simplypaythepremiumandowntheoption. That’s it. That’s thedeal.Nomargin.

When you sell an option,youcollectthatpremium,butyou now hold an openposition with potential forloss. For this reason, theseller of a put or call isrequired to put up somecollateraltoholdtheposition.Thiscollateralisnotacost.Itis simply a “deposit” madewith funds fromyour tradingaccount. This deposit isknown as your marginrequirement.Inthisbook,we

use the terms margin andmargin requirementinterchangeably.

FuturesMarginvs.BuyingonMargin

It is important not toconfusethistypeofmarginwith theconceptofbuying

onmargininstocks.Inthelatter, an investor borrowsmoney from the brokeragetopurchasemoresharesofstock. Futures margin is acompletely differentapplication of the wordmargin and has nothing todo with borrowing moneyfromyourbroker.

MarginonStock

Options

Whether you sell a stockoption or a commoditiesoption, you will have amargin requirement. Thebiggestdifferenceiswhatthatmargin requirement will beversus the premium youcollect. Let’s first explorehowstockoptionmarginsarecalculated.

In the first editionof this

book, we gave a simpleformula for calculating stockoption margin. But stockoption margin calculationshave grown a bit morecomplexsincethen.

It is fair tosay thatmanybrokeragehousesnowchargewhat is known as “full cashmargin.” This simply meansthatyoupaythefullvalueoftheunderlyingsharesofstockfor yourmargin requirement.

Therefore, if you sell a $150put option on a stock andyour strikeprice is$50,yourmargin requirement is thevalue of 100 shares of thatstock ($5,000) minus thepremium collected. That isforanaked,uncoveredoption(i.e., you don’t already owntheshares.)

Some, more option-friendly houses offer certainlevels of “clearance.” This

denotes you as a moresophisticated investor,therefore deserving of lowermargin requirements. In lightof new financial regulations,however,clearanceforsellingnaked stock options isbecoming more difficult toobtain.

Stock option margin forthese investors is calculatedby a formula that can varyfrombrokerage tobrokerage.

However, the formulafeaturedbelowseems tobeacommon one for stockoptions. Thus, it shouldillustrate the concept for ourpurposes.

Suppose you elect to sellanakedputorcallonastock.Assuming you had properclearancetodothisfromyourbroker, you would likely beusingaformulasimilartotheonebelow:

•25%oftheunderlyingstock’smarketvalue(100shares)+theoptionaskprice–anyout-of-the-moneyamount

Let’s illustrate thisconceptinanexample.

Example:DonSellsaCallonXYZStock

Trader Don is bearish onXYZ stock. However, sinceDon does not want to tie upthe capital necessary to shortthe stock, nor does he thinkthat the stock will falldrastically, he believes thathisbestalternativeistosellacall. Don has obtained acertain-level“clearance”withhis stock broker to obtainfavorable marginrequirements. With XYZstockcurrentlytradingat$70

ashare,DondecidestosellaMarch$72callfor$150.Hismargin requirement iscalculatedinTable6.1.

TABLE6.1MarginRequirementforMary’sStockOption

Assuming the optionexpired with XYZ stockbelow $72 per share, Donwould have kept the fullpremium of $150. Assuming

hesoldthecall60dayspriortoexpiry,Don’srateofreturnwouldbeasfollows:

$150/1,700=8.8%returnin60days

Notbad.ButthisassumesthatDonwas able to find anoption-friendly broker whoallowed him the properclearance and operated underthisliberalmarginformula.Inaddition, it does not include

transactioncosts.Let’s recalculate Don’s

return using the full cashmargin formula that manystock brokerages are nowcharging:

$150/(7000–150)=2%returnin60days

Not as good, but stillnothingtosneezeat.

Nonetheless, let’s seewhatDon could dowith that

samecapital sellinga futuresoption using the SPANsystem.

Example:DonSellsaSoybeanPutOption

This is a hypotheticalexample, but the marginrequirement is based on thatof a recent similar trade Imade.Asallofourtradesuse

SPAN margin, I believe itrepresents a typicalpremium/margin ratio in afutures option sale. In thisexample, trader Don, ouroption trader from theprevious example, is bullishon soybeans. He sells asoybean put option andcollects a premium of $700.He is now short the soybeanput.

Toholdthisposition,Don

must put up some marginmoney. In this case, theSPAN margin requirementfor this particular option is$1,720. This simply meansthat Don must provide a$1,720margindeposittoholdthisposition.

But where does thismoney go? Who holds thedeposit? Don does! Themoneynevercomesoutofhisaccount. Instead, it is set

asideinescrow,meaningthathecannotuseittoparticipatein other trades. However, itremains in his account.Therefore,$1,720issetasideinescrowinDon’saccounttohold this position. However,didn’t Don just collect $700fromsellingtheoption?

Yes,hedid.UsingSPANmargin,Don

can apply the $700 hecollectedfromsellingtheput

to cover part of his marginrequirement.This leaves himwithonly$1,020thathemustcover from his own funds.This is illustrated in Table6.2.

TABLE6.2Example:DonSellsSoybeanPutUsingSPANMargin

Assuming that Donstarted with a $100,000account, Table 6.3 showswhat Don’s account wouldlook like after he sold theoption.

TABLE6.3Don’sAccountSnapshotAfterSellingSoybeanPutOption

This example does notinclude transaction costs,which, of course, would besubtracted from the bottomline. However, it illustratesthegeneralidea.

The available balance istheamountDonhasavailabletoinvestinotherpositions.Infutures trading, this is alsoknown as margin excess,because buying and sellingfuturescontractsalsooperates

onthemarginprinciple.The amount in escrow is

the margin requirement thatDon posted to hold hissoybeanputoptiontrade.

The total equity is thevalueofDon’saccount ifhisoption expires worthless andDon keeps the premiumcollected as profit. At thattime, he would have his$1,020 margin deposit backalongwiththe$700premium

(profit) as part of hisavailablebalance.

This example of marginrequirement is not unrealisticfor futures options. In doingthe math, one can see thatsellingtheoptioncanprovidea very attractive return onfundsinvested.

If the option expiresworthless, Don’s return oncapital invested would be asshowninTable6.4.

TABLE6.4Don’sReturnonCapitalInvested

AnnualizingDon’sRateofReturn

One also must consider thatthe lifeof theaverageoptiontrade that we wouldrecommend is about three tofour months. Assuming thatDon were to do thissuccessfully two more timesduringtheyear,itwouldgivehim a 205.8% annual returnon his original $1,020

investment. As long assoybeansdidnotcrashduringthis time, this would berealistic.

However, this examplemakessomeassumptionsanddoes not take into accountother factors, such as riskparameters, increasedvolatility, early profit taking,and other considerations thatwill be discussed inforthcoming chapters. It also

doesnottakeintoaccountthepossibility that the marginrequirement could fluctuate,which it can and does do.Thiswillbediscussedlaterinthischapter.Thepointisthatalthoughsomeundereducatedinvestorsseeoptionsellingas“slow and boring,” thepreceding numbers illustratewhy many enlightenedinvestorsarenowflocking tooption writing as theirstrategyofchoice.

WhatIsSPANMargin?

The exchanges set marginrequirements for eachunderlyingfuturescontract.But for futures options,margin is determined by apreset formula. Thisformula in the Futures

industry is known as theSPANsystem.

SPAN stands forStandard PortfolioANalysis of risk. TheSPAN margin system iscalculated by a softwareprogram at the ChicagoMercantile Exchange(CME). I have never metanyone who could explainexactly how it iscalculated! SPAN is based

onfactorssuchasthetimevalueleftontheoption,theamount by which theoption is in or out of themoney,andthevolatilityofthe underlying contract.Most clearing firms havethesoftwarethatcalculatesSPAN margin for everyoption. However,attempting to explain theexact calculations for howit is determined, we feel,wouldbefruitless.

Suffice it tosay that tofind out the marginrequirement for a futuresoption before entering theposition, we wouldrecommend calling yourbroker. Most brokers andbrokerages that areoption-sellingfriendlywillbeabletoprovideyouwith thisatyour request. After a fewmonths of selling options,you should be able toestimate the approximate

marginofsellingoptionsinthe futures contracts withwhichyouare familiar.Ofcourse,youwillbeable toseetheexactfigureonyourstatement once yourpositionisestablished.

However, for thosedo-it-yourselfersoutthere,theChicago MercantileExchange (CME) doesprovide a version of theSPAN software for

individualstouse.Thecostat this time is about $500,and the reviews we’veheardaremixed.However,ifyouwouldliketoobtainacopyof thesoftwareyoucan contact the CME orvisit its website atwww.cme.com.

Like many stockbrokerages these days,therearenowmanyfuturesbrokerageswhodonotuse

SPAN margin (or at leastexchange minimum SPANmargin) unless accountsare owned or beingmanaged by professionaltraders. Instead, manycharge the full marginrequirement for a futurescontract to sell an optionon that contract.With thissystem,theleverageisstillbetter than that of stockoptions.

SPAN margin,however,allows individualinvestorstoobtainahigherrate of return on investedcapital than if they had toprovide a full futurescontract margin to sell anoption. If youaregoing tosell futures options, find abroker or portfoliomanagerwhooffersit.Theexchange offers it toeveryone touse.Yetmanybrokerageswillnotofferit

to you and, in fact, don’toffer it. This is a bigbenefitoftheprosandonethat many individualtraders don’t know about(nor aremost in the knoweager to share with you).You learned it here.Don’tsell option premium infutureswithoutSPAN!

TheEver-Fluctuating

Margin

One of the biggest fears Ihave found in new futuresoption traders is fear of amargin call. They picturethemselves getting one. “MyGod, a Margin Call! I’mruined!”

You are not ruined. Youdo not have to fear margincalls. Ifyou’redoing it right,you should never get a

margincall.Andifyoudogetamargincall, there is averysimplewaytogetridofitthatrequires no additionalmoneyfromyou.

All of that, however, intime.

Understanding how themargin requirement canchangeonyouroptiongoesalong way toward makingpositioningdecisionsthatwillkeep you far away from any

talk of margin calls. That iswhatthissectionisabout.

The margin requirementfor any option you sell ischanging and beingreadjustedconstantly,literallyon a daily basis. Often thesechanges are slight or evenunnoticeable. But changetheydo.

As a general rule, if thevalue of your option iseroding, so is the margin

requirement. If the value ofthe option is increasing, themargin requirement willtypically increase as well, instep with the option value.Let’sviewanexampletoseehowthismightwork.

Example:TraderMarySellsaCrudeOilPut

Trader Mary is bullish oncrude oil. She knows themarket can make sharpswings downward, however,and therefore decides thatinstead of buying the futurescontract, she can sell a putseveral dollars below themarket.Marycallsherbrokerand asks the SPAN marginrequirement for selling aSeptember $74 crude oil putoption. Her broker calls herbacka fewminutes later and

tellsher that the totalmarginrequirement is $1,900. WithSeptember crude oil tradingat $94 a barrel,Mary sells a$74 September put for $700.Her out-of-pocket marginrequirement is calculated inTable6.5.

TABLE6.5CrudeOilMarginCalculation

Mary put up an initialmargin requirement to enterthetrade.Nowthatshehasanopen position, that marginrequirement can adjust. Thesame factors that affect thevalueoftheoptioncanaffect

itsmarginrequirement.Let’s assume that after

Mary sells her option,September crude oil futuresdrop to $84. If this happens,chances are that Mary’smargin requirement willincrease. How much cannotbe calculated preciselybecauseotherfactors,suchastime remaining untilexpiration, volatility, and theoptionsvalue,will come into

theSPANcalculation.Sufficeit to say that the marginrequirement will correlatelooselywith the value of theoption. If the value of theoption increases by $200,chances are that the marginrequirement will increase byan amount close to $200 ormore. This is anapproximation and can varydependingoncircumstance.

It is also possible for a

margin requirement on anoption to change if theexchange decides to raiseminimum marginrequirements for theunderlying contract itself. Inthis case, themargin to holdthe optionwould increase bya corresponding percentage.In other words, if theexchange raised marginrequirements for crude oilfutures by 10%, the marginrequirement for Mary’s

optionalsowouldincreaseby10%. This is rare andtypically happens only if theunderlying futures price isbecomingvolatile.

BackUpCash:YourSolutiontoMarginFluctuation

The point is that marginrequirements can fluctuate

throughout the life of thetrade.Itisforthisreasonthattraders selling optionpremium should keep acertain amount of backupcapitalintheiraccountstobeprepared for these marginfluctuations. We generallyrecommend that new orconservative traders keep upto50percentoftheiraccountavailable as backup capital.This will be covered morespecificallyinlaterchapters.

TheUpsideofMarginFluctuation

The upside of all this comeswhen the option deterioratesinvalue.Thiscanhappenasaresult of either a favorablemarket move or time decay.Whentheoptionvaluebeginsto decrease, the marginrequirement for that optiondecreases aswell. This is, infact, the “natural” direction

for a margin requirement tomove as time erodes theoption’s value. Despite anoption buyer’s claims, thiswill happen the majority ofthe time if you are sellingoptionscorrectly.

When this happens, thesemargin funds are releasedfrom escrow and into youravailable funds for use inothertrades.Yourescrowandavailable funds balance are

updated on a daily basis toreflect the daily changes inmarginrequirements.Inotherwords, if the value of theoption is deteriorating, youdo not necessarily have towait until expiration to usethe premium you collectedfrom your option sale. Whatthis means is that you canoftenuseyourprofits fromashort option sale to financeothertrades,evenifyouhavenot closed your original

positionyet.Your margin funds

graduallybecomeavailabletoyouastheoptiondeteriorates.This is one feature thatfutures option traders inparticular find very attractiveinincreasingtheirleverageinaccumulatingpositions.

Conclusion

SPAN margin is the system

used to calculate margin onfutures options.The leverageSPAN provides means thatoptions sold on futures canprovideasubstantiallyhigherROIoverequityoptions.

With the manyadvantagesthatoptionsellingoffers to a trader, sellingpremium can be a profitableexperience in stocks orcommodities—for a certainportion of your overall

portfolio. If you have tradedonlystockoptionsinthepast,thebenefitsofemployingthesamestrategyinfuturescouldgreatly expand yourinvestment horizons, if notyourbottom line.Wearenotbashingequityoptions.Quitethe contrary. Many investorshave achieved substantialreturns with a properlymanaged option-sellingapproach in equities. Ourpoint is to make equity

traders aware that there isanother vehicle with similar(in some cases, moredesirable) properties that isavailable for diversificationand potentially higherrewards.

PART II

OPTIONSELLINGSTRATEGYANDRISKCONTROL

7

HowtoPicktheRightOptiontoSellLessonsLearnedfromThreeDecadesinthe

Field

In Part I, you learned whatoptions are, why you mightwant to sell them, and whoelseisalreadysellingthem.

In this section, beginningwith this chapter, you aregoing to learn how to selloptions. Obviously, I cannothopetoconveyall30yearsof

knowledge and experienceswithoptionsintoafewpagesof a book.What I can do isgive you a framework, orformula if you will, to workfrom.And Iwill bring all ofthe knowledge, insights, andexperiencesofthose30yearstobearinconveyingthemostimportantpointstomakeyousuccessful. By ingesting thishard-earned knowledge andlearning from my mistakes,you will save yourself

countless hours, months, oreven years (not to mentioncapital)lost in learning themforyourself.

Myapologiesifthisbookdoes not contain thespreadsheets, greeks, andgraphs favored by so manyoption “authors.” But Ipromised you this wouldcontain real-life tips andexperiences and that is whatyouaregetting.

Think of me as that guysittingbesideyouatthehotelbar, having a beer with youand—after looking around tobe sure no one else islistening—giving you the“real story” in a low voice.That is the spirit of thischapter.

FormulaforSelectingtheRight

OptiontoSell

RightMarket+RightStrike+RightMonth

There are three mainthingstolearnaboutselectingthe right option to sell. Youwanttolearnhowtopicktherightmarket, the right strike,

and the right month. Thefollowing several chapterswill show you how to do allthree.

GoalsoftheOptionSeller

The first step is outliningwhat the goal of a properoptionsellingprogramshouldbe. Below, I have listed the

three main goals of most oftheoption sellerswithwhomIhaveworked.Thestrategiesandpointsdescribedtoyouinthis book are designed andtested to meet the followingthreemaingoals:

•Highestpossiblereturn•Lowstress•Lowmaintenance

Goal1:HighestPossibleReturn

Your first goal as an optionseller is to have as many ofyouroptionsexpireworthlessaspossible,therebyachievingthe highest potential return.But there are many ways toget there. You can go cross-country four wheeling,speeding over potentiallyframe-crushing canyons,

hitting your head on theceiling all the way—andarriving sooner, perhaps, butbumped,bruised,bloody,anddirty. Or, you could simplytake your air-conditionedMercedesdowntheinterstate.At this point in my life, Idon’t have a need forexcitementandadventure—atleast in my investments. Ichoose the latter.This bringsustoGoal2.

Goal2:LowStress

By employing the strategiesdiscussedinthischapter,younot only can potentiallyincrease the percentages ofyour options expiringworthless,youcanalsobetteryour odds that your winnersdo not move sharply againstyou in the meantime. Thiscauses stress.Andoneof thethingsweare trying to avoid

by sellingoptions in the firstplaceisstress.Wewanttobeoutside of the boxing ring,remember? Proper optionselection can help you feelmore confident that yourlosses on nonwinning tradeswill be smaller and easier tocontrol.

The goal of selecting theright market, the right strikeprice, and the right monthshouldbetopickoptionsthat

willprovideasmooth,steadyride to zero at optionexpiration without thedramaticsinthemeantime.Aproperly managed option-writingportfolioshouldallowits owner to sleep well atnight, should be lowmaintenance, and should bepredominantly absent ofheart-pounding, gut-wrenchingdecisions.

Many new traders

erroneously believe that thiscan be accomplished onlythrough writing coveredspreads.Asyouwillsee, thisis not true. Although I findcovered positions arepreferable inmany instances,writing naked positions canbe a great strategy forboosting returns in somesituations. While this maysound aggressive to some, itdoes not have to be; if donecorrectly, you shouldbe able

tosleepwellatnight.

Goal3:LowMaintenance

Many novice traders believethat selling optionssuccessfully means sitting infront of a screen all day,analyzing charts and quotes.Nothing could be furtherfrom the truth.Althoughyou

certainly can do this if youwant to, a big reason forsellingoptionsthewaywedois the low-maintenanceaspect. A key benefit yougain as an option seller isfreedom.Freedomfromstockprices,freedomfrompolitics,and freedom fromdependence on assetappreciation. Should not thisalso include freedom from acomputerscreen?

An option seller has noneedtositinfrontofascreenall day. In fact, manysuccessfulsellersofpremiumwith whom we have workedmayonlycheckoptionpricesonce a day, once a week, oreven once or twice amonth.If you are trading optionscompletely on your own,checkingyourpositionsdailyis probably something youwant to do. If you areworking with somebody you

trust to monitor yourpositions, you may not needtocheckasoften.

TheInsuranceCompanyModelofSellingOptions

It has often been said that

sellingoptionsissimilartooperating an insurancecompany. Buyers of carinsurance pay insurancepremiums to an insurancecompany to insure theirvehicles. They pay thesepremiums month aftermonth. In most cases, thedriver never has anaccident,andtheinsurancecompany keeps thepremiums as profit. If adriverdoeshappentohave

an accident, the insurancecompanymustpayup.

An insurance companytries to weed out driversthatitdeemstobepronetoaccidents. Some of thesemay get insured at higherpremiums (to account forthe higher risk theinsurance company istakingon them), and somemaynotgetinsuredatall.

Your job as an option

seller is to go through thisvery same process. Just asmost drivers do not haveaccidents, most of youroptionswillnevergointhemoney. However, as ininsurance, a few badaccidents can be bad forthe bottom line. Aninsurance company,therefore, tries to reducethe chances that one of itsdrivers will have anaccident by checking a

number of factors such asdriving record, age of thedriver, type of car, andother factors.Asanoptionseller, youwill go throughthis same process except,insteadofdrivers,youwillbe studying a market’s“driving record,” historicaltendencies, current andfuture fundamentals, andotherfactors.Aninsurancecompany can in no wayguaranteethatthedriversit

selects will not haveaccidents, but it certainlycan help its business byselecting only drivers whohave what it considers alow chance of being in anaccident.Thus,itcanlowerits risk and increase itsprofitability.Youcantoo.

As an option seller orinsurance company, youwill have to “paya claim”from time to time. The

secret is not only inkeeping these “claims”small, but in generatingnew premiums coming ineach month, enough tocover any such claim,manytimesover.Youseekto do this month aftermonthaftermonth.

TheNakedOptionSale—ASuggested

ApproachtoGettingStarted

You are about to learn astrategy to follow in sellingoptionsinthefuturesmarket.Bysuggestingthis,wearebynomeanssuggestingthatthisistheonlywaytoselloptionssuccessfully. There are asmanyoptionstrategiesaroundas there are traders. We aremerely suggesting this

approachbecauseitistheonethat has performed mostconsistently for us and ourclients over the years, basedon our years of futures andoption trading experience. Inthat time, we havemanaged,either in personal or clientaccounts, to employ justabout every kind of optionstrategy you can imagine.Through it all, there was asingle strategy that emergedthat, although not without

risk, showed over and overagain that it can profitconsistently in a variety ofmarkets. Therefore, we arenotgoingtodiscussthemanywaysatradercanselloptions.We are going to skip all thefancy delta-neutral, standarddeviation, backward triplebutterfly spread discussionsand concentrate on a singlestrategy that we believe theaverage individual investorcan understand and begin to

implement almostimmediately.Eventhoughweare going to reviewrecommended option spreadstrategies in a later chapter,this strategy will be all youneed to get started in sellingoptionseffectively.

Based on experience, adesire for simplicity, andsteady and consistent profits,wearegoingtorecommendamethod of naked option

sellingasaninitialstrategytolearn. Before you jump inalarmat the thoughtofbeing“exposed” to the market byholding naked short options,relax.Justbecauseyousellitnakeddoesnotmeanthatyouhave to hold it naked.Although this can be aproductiveapproach,wealsowill discuss how moreconservative traders can turntheirnakedoptionsale intoacoveredpositioninChapter9.

But we will treat a coveredposition as a risk-controlmethod and discuss it atlength under that heading.This chapter is about theselection and selling of theright options, regardless ofwhether they are naked orcovered.

Justtobeclear,thisisnottobe takenas theHolyGrailofoptiontrading.Itissimplyan approach that has worked

well for both of us over theyears and, if employedcorrectly,hopefullywillworkwellforyou.Thestrategyhasa very high probability ofsuccess and carries no morerisk than trading futurescontracts. If managedcorrectly, many of the riskscanbeeffectivelyminimized.

YourCoreStrategy

forSellingNakedOptions

In a nutshell, an outline forthis simple strategy is asfollows:

1.Selectmarketswithveryclearlong-termbearishorbullishfundamentals(and/orseasonaltendencies).

2.Selloptionswithdeep

out-of-the-moneystrikepricesinfavorofthosefundamentals(orseasonaltendencies).

3.Chooseexpirationmonthsinthe“sweetspot”oftimedecay.

4.Setariskparameteroneachoptionthatyousellandsitbackandwait.

Itsoundssimple,anditis.

This is one of the primarybenefits. However, simpledoes not mean easy. Thereare a number of factors tostudy and consider to giveyourself the greatest odds ofsuccess. These will be thebasis for this chapter. Let’srevieweachindetail.

Step1:Fundamentals—The

KeytoChoosingtheRightMarket

In beginning your search forthe best options to write foryour portfolio, you mustbegin to familiarize yourselfwith the key fundamentalsthat affect each market or atleast the markets in whichyou wish to trade. Technicaltradersmay argue this point,but consider the logic. As

we’ve already discussed,technical factors can and domove the market on a short-term basis. However, long-term and sustained pricemovementsarecausedbytheunderlyingbasefundamentalsof a particular commodity.And whereas technicalindicators may reflect thesefundamentals, they do notdetermine the ultimatedirectionofthemarket.

We pride ourselves onbeing excellent technicians.But we learned early that incommodities, fundamentalsare king. This is particularlytrueforoptionsellerswhoaremore concerned with longer-term overall direction thanshort-term swings.Fundamental knowledge canmake (or save) you a lot ofmoney as a commodityoption seller and we cannotoverstressitsimportance.

Nonetheless, short-termtechnical moves will oftenoccur in outrightcontradictiontothelong-termfundamentals. This is why(non-option selling)individual traders sometimeshave a hard time trying totradepurelyonfundamentals,atleastonashort-termbasis.Why?Becausetheprosknowthe fundamentals, too. Andthey are willing to be verypatient.

How many individualtraders are ultimately rightabout long-term marketdirection and still losemoney?Many.It’spartofthereputationoffuturestrading.

The fictitious interviewthat follows reflects thefrustration of many futurestraders. Although this briefinterview reflects no specificconversation, we’ve heard ithundreds of times with

potential clients, and italways has the same basictheme.

JohnTriestoBeatthePros:ABrief

Excerpt

TraderJohn:Iknewthe

marketwasheadinghigher.Weallknewitwasgoinghigher.Therewas[cropdamage,asupplyshortage,animpendingwar,etc.],andIfeltprettyconfidentthatthepricewasgoingup.

Broker:Sowhatdidyoudo,John?

TraderJohn:Ibought.I

bought[addnumber]contractsof[soybeans,orangejuice,crudeoil,etc.].

Broker:Whathappened?TraderJohn:Themarket

wentup,wayup!Broker:And?TraderJohn:Ilost.Ilosta

littlemoney.[Inreality,Johnprobablylostalotofmoney.Butwe’lllet

himoffthehookhere.]

Broker:Why?TraderJohn:Becausethe

marketwentdownandstoppedmeoutfirst.Thenitwentup.

SotheygotJohn’smoneyand his soybeans (orwhatever commodity he wastrading). Who got John’s

money? Most likely eitherprofessional or commercialtraders. They probably werewatching the samefundamentals and technicalsas was John and were eitherbetter at timing it or had theresources to ride out theshort-termmoveagainst theirposition. They ultimatelyhavemoreresourcesavailabletothemthanJohndoes.Theydo this for a living, all daylong,everyday.Johnmaybe

very good at what he doesand may be very intelligentand very dedicated to histrading. It doesn’t matter.When push comes to shove,John stands little chancetrading from his computer inhis spare bedroom with thefew spare hours he has eachweek.Even if John is retiredand has all the time andmoneyintheworld,unlessheis willing to dedicate hisentire life to trading, spend

years and countless dollarsand resourcesonbecomingaprofessional trader, hischances of success againstthese heavyweights over thelongtermareveryslim.

LevelingthePlayingField

But what if John could levelthe playing field? What if,

insteadofbeatingthem,Johnjoinedthem?Johncouldgiveup trying to duke it outwiththeprosinthefuturespitandtake a big step out of thechaos and into a favoritestrategy of the very traderswith whom he wascompeting. Although we arenot saying that professionaltradersneverbuyoptionsandalways sell options, it is ourcontention that it is thesmallspeculator who will tend to

holdsimple longcallor longput options to try to profitfromsomefuturemove.Prosand commercials often dohold long option positions,but this is often part of alarger combination of optionand/or futures positions orsome sort of hedgingsituation. Very few pros orcommercials will try tocapitalize on a move simplyby buying calls or puts. Theoddsaretoolow.

We believe that marketscan and do move somewhatrandomly on a short-termbasis.However, as anoptionseller, longer-termfundamentaltradingisalmostcustomfit foryourapproach.Thisiswhyyouwillselltwoto six months out. Sellingwiththismuchtimevalueonyouroptionswillallowyoutosellatstrikepricesfarenoughout of the money that yourposition may not be greatly

affected by short-termaberrationsinamarket.

If John had used thisapproach, he probablywouldn’thavemadeasmuchmoneyashewouldhaveifhehadcapturedthewholemovein a futures position. (Whodoes?) But he would havemade money, probably goodmoney, based on his initialinsight.The short-termmovedownwouldnothavestopped

him out, nor would it havescaredhimoutofhispositionif proper risk-managementruleswerefollowed.

Example:JohnLearnstoSellNakedPutsInsteadofGoingLongtheMarket

Let’s lookatFigures7.1 and7.2.Figure7.1 shows a right

market analysis and a wrongtrading method. Figure 7.2showsthatJohnsellsaput(s)andprofitsfrombeingright.

FIGURE7.1March2007SoybeanChartShowingBuyandStopOutPointsJohngetssoybeanfundamentalsrightbutgetsstoppedoutpriortorally.

FIGURE7.2March2007ChartShowingSaleof$5.80PutsInNovember,Johnsells$5.80soybeanputsfor$600eachforlessmarginthanhewouldhavedepositedforafuturescontract.Themarketmaymovelowershorttermandthenproceedhigher.Johnremainsinthemarket,andtheoptionseventuallyexpire,providingJohnwithagood

profit.

John learned to stoptrying to outguess what themarketisgoingtodoovertheshort term. Nobody can dothisconsistently,noteventhepros.Itisjusttoodifficult.Asstated earlier, markets canmove at random over theshort term. There are toomanyvariablesthatcanswaydailyprices,suchasbreakinggeopoliticalorfinancialnewsstories, fund accumulation or

liquidation, or simply thegeneralmoodof traderson agivendayorweek.

The option seller is freedfrom these short-termconcerns and can focuswholly on the bigger pictureofsupply,demand,andlong-term price trends. In otherwords, such an investor canfocusonthefundamentals.

WhatAretheFundamentals?

But what are fundamentals,and how does one trackthem? Fundamentals are theoverall factors of supply anddemand that affect the priceofagivencommodity.Ifyouwanttolearnwhatmovestheprice of soybeanswillmake,learn where they are grown.Learn when their growing

seasons are. Learn who thelargest producers are so thatyoucanpayattentiontotheircrops and supply situationsand not be distracted bymedia reports from smallerproducers. Learn whatcountries import thesecommodities and how muchthey use. Focus on keyimporters and overall worldnumbers.

The important part is

selecting the right market inwhich to trade in the firstplace. This is accomplishedby knowing thefundamentals.

I have found this to beparticularly true in the realcommodities contracts suchas wheat, coffee, and naturalgas as opposed to financialmarkets such as Bonds orCurrency futures. In fact, Ibelieveittobeaconsiderable

advantage that traders ofphysical commodities haveover stock index or financialfutures traders, or evenmoreso, stock traders. Everyoneknows how to look up a P/Eratio or last quarters’earnings. But how manypeople can look at a USDAmonthly Cattle on FeedReport and tell you howmanycattlearelikelycomingto market in 90 days?Answer, very few—even

among the supposed“investors” who trade cattlefutures. As a seller ofcommodities options,learningtousethisadvantagecanbeverybeneficialtoyourbankaccount.

HowdoYougetthisFundamentalInformation?

Forthosewishingtostudythefundamentals, thefirststepistoknowwheretolookfortheright information. How doyou acquire the facts andfigures that combine to formthe big picture offundamental knowledge? Agood place to start is theUnited States Department ofAgriculture (USDA)website,whichisthelargestsourceofinformation for agriculturalcommodities.Takesometime

to explore www.usda.gov.The Department of Energy(DOE) is another good placeto mine data for energytraders, and its website iswww.doe.gov.Theexchangesalso offer a wealth offundamental information.Their websites can be foundin the References andResources section at the endof this book. News servicessuch as Reuters, Bloomberg,and Oster Dow Jones offer

subscription-based financialnews that includes dailyupdated fundamentalinformation.

Good brokers can be atremendous benefit toinvestors in the area ofprovidingtimelyandrelevantmarket fundamentals. Ofcourse, it is always a goodidea to have some basicunderstanding of the marketinwhichyouare trading,but

goodbrokersspendtheirtimeresearching these data andmining this information foryou. Knowledgeable brokersshouldbeabletoguideyouindetermining whichfundamentaldataarerelevantto the market and how theycould affect price andcondense all the informationfor you in a short summaryand/or a few basic charts foryour review.Especiallygoodbrokers will not only save

you a great deal of time butmay be able to make arecommendation based onthese data that actually willmakeyousomemoney.

If your goal is to be asuccessful self-directed sellerofoptionpremium,wewouldrecommend finding a brokerwith extensive knowledge inthe fundamentals of themarketsinwhichyouwishtotrade. This will save you

countless hours of researchand years of study and canmake your option sellingdecisionsmucheasier.

However, good brokersare not necessarily goodtraders, and vice versa. Youwill learnmore about this inChapter20.

Professional portfoliomanagers who trade youraccount can do this as well,butprovidedifferentlevelsof

service. A good portfoliomanager will not only tradeyour account on your behalfbut will also provide youregular commentary on themarketsinwhichheorsheistrading, keeping you updatedonthefundamentalsaffectingthosemarkets.

But you can learn themyourself.

We have devotedChapters 13 and 14

exclusively to the basicfundamentalsofcommoditiesandhowyoucanusethemtoyouradvantage.

In the meantime, thelesson is as follows: Inpickingoptions to sell, selectthe market in which you aregoing to trade first andmakesure you are somewhatfamiliar with the long-term(bullish or bearish)fundamentals of that market.

If a friend or relative askswhy you are in that market,you should be able to give atwo- to three-sentencesummary that explains yourrationale for being in thetrade (not that it is any oftheirbusiness).

While selling options inany market gives youfavorable odds, selecting therightmarketsinwhichtosellpremiumcanboostyourodds

and your returnssubstantially. If you canselect favorable markets inwhich to write yourpremiums, you’re alreadyhalfwaythere.

SeasonalTendencies:TheOptionSeller’sSecretWeapon

If you take only one pieceof knowledge from thisbook and discard the restfrom your mind forever, Irecommend you take theconcept of combiningseasonal tendencies andoption selling. Fewmainstream investors haveeverevenheardofseasonaltendencies. And of thecommodities traders whohave,fewknowhowtousethem correctly. Learning

thisconceptaloneisworththe time and money youhave invested in thisbook.For I am convinced that atrader who learned toproperly apply seasonalanalysis to option sellingcouldfundaretirementforaslongashecouldpuncha“sell” button. Notice herethat I used the words“properlyapply.”NotealsothatIusedtheterm“optionselling” and not futures

trading.Seasonal analysis is

one of themostmaligned,misunderstood practices inthe trading industry.Asanoptionseller,itisalsoyoursecretweapon—one of themost powerful arrows inyour quill. We talk muchabout giving yourself anedge. Properly usingseasonals can give you atremendous edge. There is

a very good source ofseasonal data available toeveryone. The problem isthat there are very fewresourcesthatshowanyonehow to use them properlyina tradingprogram.Veryfew traders know how touse seasonals correctly.Youaregoingtolearnhowto do this here. And thestrategy you will learn(combining seasonals andoption selling) is featured

nowhereelseintheworld.Seasonal tendencies,or

seasonals for short, usehistorical records to graphthe tendency for certainmarkets tomove incertaindirections at certain timesof theyear.Whereas thesetendencies are often veryreliable, their exact timingand magnitude ofmovement are an inexactscience at best. Seasonal

tendencies are mostly theresult of certainfundamentals that takeplaceinaparticularmarketduring a given periodduringayear (e.g.,harvestand planting cycles,inventory accumulationperiods, etc.).Weconsiderseasonal tendencies afundamental. But they areactuallysimplyareflectionin price of regularlyoccurringfundamentals.

Seasonals and how tousethemeffectivelyaresoimportant thatwedevoteafull chapter to the subject(Chapter 15) and a secondfullchapteronsomeofthebest seasonal tendenciesyou can use right now(Chapter16).

For now, make a notetobeawareoftheseasonaltendencies of a market inwhich you are considering

selling options. Know thefundamentals behind theseasonal tendency, andanalyze how they couldaffect prices of thatcommodity this year.Knowing the seasonaltendency can be anexcellent place to start inselecting the right markettoselloptions.

Step2:WriteOutoftheMoney—DeepDeepOutoftheMoney

Once you have formed yourbasic fundamental convictionin a particular market, it’stime to start lookingat strikeprices. As we mentionedearlier, one of the mainknocks on option selling is

the unlimited risk factor. Ifyou are selling at-the-moneyor close-to-the-moneyoptions, this risk is muchcloser and is much moreimmediate than it is if yourstrikes are considerablyfarther away from where themarketistrading.

Sellingthe“Ridiculous”Option

In the summer of 2008, thepress was playing up the“severe shortages” of naturalgas in the marketplace. Thefinancial media was in afrenzy over energy prices ingeneral during this timeperiod. But natural gasenjoyed a fundamental thatplayed well in the press—asupply shortfall that lookedgood on paper and gave thepublic a reason why priceswere rising. Small specs

rushed into the market andbought call options (theirfavorite gambling method ofchoice)totrytostrikeitrich.

Unfortunately, by thetimethemediahadcaughtonto the story, the market hadlongsincepricedinthelowersupplies. Whereas long-termfundamentals were shifting,the media sensation ofshortages whipped fortune-seekers into a frenzy.By the

time peak usage seasonarrived in mid-summer, themarkethadalreadytoppedashigher prices began tosubstantially crimpconsumption and distributorsbegan to anticipate the slackautumn demand season. Ascommercial traders began to“lock in” the higher pricesthrough hedging, commodityfunds began to dump longpositions aggressively. Themarket had to answer to its

true fundamentals. Figures7.3 and 7.4 illustrate how atrader could have takenadvantage of the speculator-buying frenzy by sellingoutrageously priced calloptions.

FIGURE7.3November2008NaturalGasChartNaturalgasralliesonmediacoverage.

FIGURE7.4November2008NaturalGasChartShowing$35StrikePriceAttheheightofthenaturalgasspecbuyingfrenzyinJuly2008,calloptionswithstrikesashighas2½timesthecurrentvalueofnaturalgasweresellingforpremiumsof$400ormore.Traderswillingtoselloptionstothisbull-happycrowdcouldhavesoldNovember

35.00calloptionsforpremiumsof$400.Thisiswhatwemeanby“ridiculous”pricelevels.

In short, know yourfundamentals.Agoodruleofthumbtofollowistofadethemedia and, more important,fade public opinion. In otherwords, do the opposite. Ifyou’re watching a report onthe evening news aboutshortages in coffee, don’t beone of the treasure chaserswho calls their broker thenext day to buy coffee.Chances are that it’s already

pricedin.Ifyourfundamentalanalysis brings you to theconclusion that the marketcould continue to movehigher,selltheputsandallowfor sharp corrections (whenthe specs get stopped out).The more conservativeinvestor can wait for thecorrectionsandthensellputs.If the market looks like itmay be overdone and thereare “ridiculous” call strikesavailable, sell those calls.

Selling premium in volatilemarkets is an aggressivestrategy, and you may be inforalittlemore“fluctuation”in your option values in theshort term, especially ifyou’re a few days early inyourpositionentry.However,it will be a whole lot lessfluctuation than if youshorted the futures and werewrongintheshortterm.

Remember the preceding

example. If you thought thatnaturalgaswasoverdoneandfaded the public by shortingthe futures at 12.00 and youwere early and the marketwent to 14.00, youwould besmarting pretty badly andmaybe even stopped out. If,however, you’re short from35.00, it doesn’t hurt nearlyasbad.

Step3:Select

ExpirationMonthsinthe“SweetSpot”ofTimeDecay

Thirty-DayOptions:TheBigLie

Many option traders aretempted to sell only optionswith fewer than 30 days leftuntil expiration.Theydo thisbecause, all other things

being equal, an option willshow its maximum timedeterioration within the last30 days of its working life.Thisistrue.

However, many optionsellerstakeitforgrantedthatthis means: “To get thebiggest bang for your buck,sell options with 30 days orless time value remaining.”They know this to be true,because it has been drilled

into their heads by countlessoption books and Internetgurus who consider it“common knowledge” foranyoptionseller.

Although this may readgreat in the $600 optioncourse, real-life experiencetaught me long ago this wasfool’s gold—at least as itapplies to commodities. (Ifyou are trying to getexercisedtogetinoroutofa

stock, then it can be a goodstrategy.Butthatisnotwhereweare.)

What they don’t tell youis that to collect anyworthwhile premium, thetrader must sell at strikeprices perilously close to oreven at the money. Whatdoesthismean?Itmeansthateven a small market hiccupcan put the option in themoney and either force the

trader out of his position or,worse yet, subject him toever-increasinglosses.

Aslong-termfundamentaltraders who want to makemoneyandsleepatnight,thisisexactlywhatwe are tryingto avoid. Would you notrather sell options far out ofthe money and collect thesamepremium?Iwould.Andsocanyou.

Sellinginthe“SweetSpot”

In commodities, you can selldeep out-of-the-moneyoptions and collect largepremiums. The catch is, youmust sell options with moretime value than your quick-trade counterpart. In myexperience,thismeanssellingoptions with two to sixmonths in time value, with

mypreferenceskewingtothemiddleofthatrange.

Why? Because I havefound that this rangeoffersa“sweet spot” in the timedecay versus distance fromthe money ratio. On the onehand,youcansellfarenoughaway from the market toavoidmostshort-termmarketswings. On the other, youcollect the premium rightbeforetimedecayreallystarts

to kick in around the 90-daymark.

This allows the marketplenty of room to move andallowsyouplentyof roomtobe wrong—and still makemoney. In essence, you canoften ride out the short-termplays and technical movesagainst your long-term viewofthemarket.

You force the market tomake a long-term, sustained

move against its corefundamentals in order tomakeyoualoser.

RiskBenefitsBakedIn

Inaddition toemploying this“distanced” view of themarket, this approach hasbuilt-in benefits from a riskstandpoint.Let’s assume that

your long-term fundamentalanalysis of the market iswrong.Youstillstandagoodchance of making money.Remember, the market doesnot have to move in thedirection that most favorsyou.Itcanmovesidewaysorevenagainstyou forawhile.The option will still expireworthless if the market doesnotreachyourstrike.

By selling deep out-of-

the-money strikes, you onlyhavetopickwherethemarketwon’t go, not where it’sgoing.Inmyopinion,thatisaheck of a lot easier thantryingtoguessexactlywhereit is going to go—tomorrowornextweek.

OnSellingAheadofthe“SweetSpot”Curve

Almostanyoneevenremotelyfamiliarwithoptionshasseenthe curve in Figure 7.5illustratingthespeedatwhichoptionsdeteriorate.

FIGURE7.5TimeDecayGraph

Many option traders lookat thechart in this figureanddeduce that the fastestdeteriorationisinthefinal30days and therefore that it isbest to selloptionswithonly30 days remaining untilexpiration. Although this isonetheorythatworkswellforsome traders,you’dbetterbepretty good at picking short-term market direction if youhope to make money

consistently with thisapproach.

The alternative is to selloptions with more than 90daysremaining.Sellaheadofthecurve.Why?One reason,as we suggested earlier, isthat theadditional timevalueallows you the luxury ofselling at strikes very far outof the money. The secondreason is that if the marketcan avoid a sharp move

against you in the first fewweeks of your trade, youenter the last 90 days of theoption’s life at amuchmoredistant strike than the sellerwho has waited until now tosell his option. In otherwords, he has to sell closer-to-the-money strikes toreceive the same premiumsthat you received 30 to 60daysearlier.Asthepremiumsbegin to drop, your riskbeginstodropaswell.

The“DownandDirty”WaytoGaugeTimeDecayA quick “down and dirty”way to gauge where youroptionscouldbein30,60,or90 days is to look at optionprices for several months,sidebyside.Thisisalimitedtool because it does notaccount for marketmovement. But given arelativelystablemarketwherethe option seller is familiar

with the fundamentals, it canbe very effective in selectingproper strikes (see Figure7.6).

FIGURE7.6CrudeOilOptionTableShowingDifferencesBetweenPrices

If you are considering acertainstrikeandwant togeta rough idea of what youroption will be worth in 30days (barring more than amoderatepricemove),simplylook at the same strike pricethatissettoexpireonemonthsooner. For instance, inFigure 7.6, if you areconsidering selling the Maycrudeoil120call,lookattheApril crude oil 120 call and

see what the difference inpremium is. In this example,thedifference is$430 (168–125 × $10 per point). Youroption is likely to lose thatmuch in time value over thenext 30 days (although itcouldgainorlosemorevaluethroughmarketmovement orvolatility fluctuation). If youare comfortable with thatlevel of deterioration, youcould have the right monthandstrike.

We do say rough orapproximate becausealthough different contractmonths tend to hover aroundthesamegeneralpricelevels,they will trade most often atdifferent prices to reflect themarket’s expectations for thefuture. These differences inpricecanbemoreapparentinsome agriculturalcommodities that are subjecttoplantingandharvestcyclesthanfuturescontractssuchas

financialsorcurrencies.Ifthedifferences inmonthsare toogreat, simply adjust yourcomparison toa strike that isapproximately the samedistanceoutofthemoney.

Step4:SetaRiskParameter,ThenSitBackandWait

Thisstepislikelyself-evident

if you have ever tradedanything before. Whileselling options is different inmany ways from most anyother investment, this aspectof it remains constant. Byknowingyourexitpoint,yougiveyourselfpeaceofmind.

There are two ways tolose on a naked option. Thefirst is that it expires in themoneyandyougetexercisedat a loss.Since this ishighly

unlikely and in fact entirelyavoidable, we should mostconcern ourselves with thesecondway.Thesecondwayis that the market movesagainst your position to alevel that increasesbothyourmargin and your optionsvalue. At some point in thatequation, you want to closetheposition.

Risk management is animportantaspectofanoption-

selling portfolio. It will becovered thoroughly inChapter11.

Fornow,simplynotethatstep 4 in the formula issettingariskparameter.

UsefulTipsforPickingtheRightOptiontoSell

Tip1:UseOptionOpenInterestasaCluetoMarketDirection

Using open interest to gaugepublic sentiment can be anextremely valuable tool tooptionsellers looking to fadethepublic.Theexcerptonthefollowingpagewasaweeklyarticle written by James

Cordier on this very subject.In reading it again,we felt itwould cover this subjectexceptionally well in itsunalteredform.

Checkingopen interest ina particular stock orcommodity is another tool touseinyouroverallanalysisofpotential options to sell. Theapproach is just as effectivenow,ifnotmoreso,asitwaswhen the article was first

published.

OpenInterestCanBeaTip-OfftotheOpinionsoftheGeneralPublic

JAMESCORDIER,OPTIONSELLERS.COM

FROMOPTIONSELLERS.COMBLOG

More often than not, thegeneral public will be onthe wrong side of themarket, as is evidencedbythe oft-sighted figure that80 to 90% of futurestraders lose money. Sincethe general public oftenfavors buying options, onekey indicator ofwhere thepublic is positioned oftencan be determined bystudying option openinterest.

Begin by looking atopen interest in both putsandcallsofeachparticularmarket. If there is adiscernible discrepancybetween the number ofopen contracts in putsversus calls or vice versa,thereisagoodchancethatthe public is favoring onesideofthemarket.Agoodruleofthumb—ifgiventhechoice—is to fade thepublic. For instance, if the

open interest in puts in aparticular commodity is50% greater than the openinterest in calls, and mostof the tradersholding longoptions are smallspeculators (the generalpublic),thenthatisagoodindication that the publicfavorstheshortsideof themarket. Funds andcommercials would havesold the puts to the smalltraders. All other factors

beingequal,youmaywantto consider selling puts inthis situation. The reversewould be true if openinterest in calls wasdecidedlygreaterthanputs.

A perfect example ofthis phenomenon is takingplaceinthesilvermarketatthistime.Lookattheopeninterest in silver options,puts versus calls. Openinterest in silverputsasof

yesterday stood at 8,546.Open interest in callstotaled 52,677. Call openinterest is over six timesput open interest. One candeduce from this figurethat the public likes thelong side of silver. Thereasonsforthisareopentointerpretation, but I’d bewilling to guess that therearemore thanahandfulofhopeful futures traders outthere willing to put up

somehard-earnedcapitaltobet on a sweeping silverrally this summer. Andwhomightbesellingtheseoptions to them? Probablyprofessional traders andcommercial silver players(and maybe a handful ofsophisticated individualinvestors).

The caveat: These aremy own personal rules,opinions, and general

observations.Thisisnottoinsinuate that the publicalways will be on thewrong side of the market,norisittosuggestthatthiscan be used as a tradingsystem in and of itself.Nothing replaces solidfundamental and technicalanalysis. This is one ofmany factors one canconsider when selectingoptions to write. Optionbuyers, who often are the

small speculators in themarket, are trading thefutures market hoping forbig moves and big gains.This is why most smallspecs that trade areattracted tocommodities—for the spectacular. Theproblemisthattheselarge-scale moves that canproduce profits for optionbuyers generally are fewandfarbetween.

Itismycontentionthatthe smart money in thisbusiness profits from themundane. If we’re lucky,80 to 90% of futurestraders will continue todisagree.

Tip2:StrikeaBalanceBetweenPremiumandRisk

A frequently asked questionby many novice optionwriters is what type ofpremiums they should seekwhen writing puts or calls.This is often a matter ofindividualpreference,butwemay be able to offer somesuggestions.

PremiumVersusMarginThefirst factor toconsider ispremium collected versus

margin requirement. Anoption selling at a $400premiumwitha$600marginrequirement is a better salethananoptionsellingat$500with an $800 marginrequirement (as a return oncapital invested). It has beenour experience with SPANmargin that although marginrequirements decrease aspremiumsdecrease,returnoncapital invested tends todecrease as well as premium

decreases. Thus, an optionsold for a premium of $500mayhaveabetter returnasapercentageofcapitalinvestedthananoptionsoldfor$200.Again,thisisnotarulesetinstone; it is more of anobservation from years ofoption selling. However,when considering differentstrike prices, it may behelpful tocomparepremiumsofdifferentoptionswiththeirrespective margin

requirements.

SellingTooFarOutoftheMoneySome traders seek optionsthat are so far out of themoneythat theymayonlybecommanding premiums of$100 to$200each.Althoughthese options often are farenoughoutofthemoneythatthey probably will not begreatlyaffectedbyshort-term

market fluctuations, one hasto weigh the premiumcollected versus projectedrisk. For starters, thecommission paid to yourbroker will come out of thisrelatively small premium.Second,insteadofsellingfiveoptions for $600 each, sometradersmayelecttosell15ofthe $200 options, therebycollecting the same premiumwith a perceived lower risk.But is it lower risk? If your

risk parameter is risking todouble premium collected,the $200 option easily coulddoubleinvaluejustasfastasthe $600 option. Count inslippage on your exit order,and your loss on the cheaperoptions could exceed yourloss on the more expensive$600options (slippageon15options may be greater thanslippageonfive).

Third, look at what you

riskinaworse-casescenario,this being that both optionsgo deep in the money andyou,forwhateverreason,didnot get out beforehand.Eventhoughthe$200optionswereoriginally a few strike pricesfurther away, you sold threetimesmoreoptions tocollectthesameamountofpremium.Chances are thatwith adeepin-the-money move, the 15positions at a few strikesfurther out are going to be a

greater liability than the fivepositionsafewstrikescloser.

SellingTooClosetotheMoneyTheotherendofthespectrumis a trader who sells optionsfor high premiums at closerstrikes. This trader runs therisk of selling too close andbeing stopped on a smallmoveor,worseyet,haveheroption go in themoney on a

small move. A balance mustbestruck.Thereisnogeneralrulehereexceptthatyouwantto try to make sure that thepremium collected justifiesthe risk you are assuming.This holds true whether youaresellingoneoptionor500.

Tip3:SellLowDeltas

Althoughwepromisednottoget too involved with Greekfigures and equations, this isa good time to bring up theconceptofdelta.Delta is theamountbywhichthepriceofan option changes for everydollarmoveintheunderlyingcontract. Although we aren’tgoing to focus on delta to agreatdegreeinthisbook, thedelta of the option you areconsidering can be a greathelp in deciding the right

strikepriceforyou.Thedeltawill give you a good idea ofhow far the option pricewillmove in relation to theunderlyingmarket.

For instance, if you lookatthedeltaofanoptionanditreads 17, thismeans that forevery one point the futuresmarket moves, the optionprice will move 0.17 of apoint.Thissoundssimple,butremember that the delta is

constantly changing andreadjustingwitheverytickinthe market. Thus, the closertheunderlyingcomestoyourstrikeprice,thehigherwillbethedelta.

It is our recommendationthat you seek options withlow to very low deltas whenyou are selling. They willhave the lowest chance ofever going in the money.While this sounds like

common sense, some willargue that by selling optionswithlowdeltasonewillhaveto assume the greater risk oflarger position sizes than ifoneweretosellfeweroptionswithhigherdeltas.Maybeso,butwerecommenditanyway.If you know yourfundamentals and you canpick strikes that will not bereached,you’llhaveahigherpercentage of your optionsexpiring worthless, lower

stress, andmore consistency.With this type of winningpercentage, you should beable to withstand theoccasional oddball whoexceedsyourstrike.

Optionmargin,delta, andsize of position all comesecond to selecting the rightmarketinwhichtosell.Ifyoupicktherightmarket,noneofthese things shouldmatter inthe end. However, all your

picks will not be right, andthesefactorscanmatterinanadversemove.

Much of this is based onthe preferences of theindividual investor. We’vealways preferred to selloptionswithdeltaslowerthan20, with premiums in the$400 to$700 range,withnetmargin requirements of nomore than 2½ times thepremiumcollected.

Tip4:LearntoStaggerYourOptions

The option-selling selectionformula you have beenreading about in this chapteris the formula we followedfor our first several years inbusiness as a brokerage. Inthe years since converting toportfolio managers, thetrading plan has evolved

somewhat.We have added anumber of bells andwhistlestomake itmoreefficientandrisk adverse (i.e.,incorporating credit spreads,etc.). Nonetheless, theoriginal format for optionselection remains intact forthemostpart.

Staggering, while nottechnicallypartofthetopicof“Picking theRightOption toSell,” could have some

influence over what optionsyouselect.Staggeringoptionsis one of those bells andwhistles we added to thetradingplanlater.However,itis a very important bell, andthus, we felt it warrantedinclusioninthissection.

WhatIsStaggering?One of the complaints weinitially heard from ouraggressivetraderswasthatby

selling premium two to sixmonths out, the strategy was“slowandboring.”

Apparently,thefactthatitworkedwasbeside thepoint.Many investors who allocateaportionof theirportfolio tooptions on futures do so notonly for the opportunity formore sizable returns but alsoso that they can have a fun,exciting,andactiveportionoftheir portfolio that they can

get in and get their handsdirty, buying and selling andcalling plays. Sorry, but ifyou like action, the tradingplan you learn here may notbe for you, except the partaboutthepotentialforsizablereturns.

Many traders havecompared the mentalstimulation of this tradingplan with that of “watchingpaint dry” or “watching a

chickensitoneggs.”Theydothis for about the first 90days.Thentheystarttogetit.

You see, the final part ofoption selection under thisplanisaconcept thatwecallstaggering. Staggering is atermwecoinedoveradecadeagointhefirsteditionofthisbook. I have recently seen afew greenhorn optionbloggers try to claim it astheirown.Itisnot.

Regardless, staggeringworkslikethis:

StaggeringOptionsMonth1:Sellonetotwo

setsofoptionswithexpirationsoftwotosixmonthsaway.

Month2:Sellonetotwosetsofoptionswithexpirationsoftwotosixmonthsaway.

Month3:Sellonetotwo

setsofoptionswithexpirationsoftwotosixmonthsaway.

During the first twomonths, there is a goodchance that many, if not all,of theoptions soldwill haveshown little movement.Although the trader stillbelieves in the program, herattention starts to wander,thinking about possible daytrades in themarket she saw

on the news yesterday orthinking about taking a flyeron thathot stock she sawontelevisionyesterday.

But then a funny thinghappens. At the end of thethird month, the first set ofoptionsthatthetradersold90daysagoexpires.Thirtydayslater,anothersetexpires,andthen another. The wait paidoff.Theeggshatched!

As applied to your

trading, each month youcontinue to sell one or twosets of options—on average—depending on whenopportunities are present inthemarket.Thefirst60to90days may very well seemslow and boring—until youstart having options expireonce or twice per month.Then it’s not so boringanymore. This is what wemean by staggering. It ispositioning your portfolio to

have approximately one ormoresetsofoptionsexpiringeverymonth.

This is not to imply thatevery set of options that yousell are going to expireworthless.Butthisisanidealto which you may want toaspire with regard tostructuring your option-selling portfolio. It seems tohave immense popularityamong many of the traders

whom we have advised.Perhaps it is because of theregularityforwhichitstrives.Regardless, from apsychological standpoint, itcanbedesirabletobeabletolook at your statement andsee that you have optionsscheduledtoexpireatregularintervalsinthefuture.Thisistrue whether you are anincome- or growth-orientedinvestor.

TargetingHighPremiumOptionSalesAfterBig

Moves

Many traders will find amarket with clearfundamentals and becomeexcited about the trade

until they look at a chart.They see that the markethasalreadyhadasharprunor drop in price andtherefore think that themoveisoveror thatpricesare now too high or toolow.Thiscanbeamistake,and you could beoverlooking some of thebest opportunities on theboard.

First of all, if the

market has made a largemoveup or down, there isprobably a solidfundamental reasonbehindit.Findoutwhat it is. Is itsomething that ispermanent and cannot bechanged in the near future(e.g.,cropdamage),orisitsomething that had aneffecton themarketbut iseither in the process ofchanging or could changequickly without notice

(e.g.,a temporary“halt”toimportsorexportsduetoatradespat)?

Second,did themarketmakethismoveinarapid,violent explosion orcollapse, or did it achieveits current price level as aresult of a steady,continuing trend? If it’s atrend, your odds growbetter already because, aswe discussed earlier,

optionsexpireworthless atan even higher percentagerate when sold in favor ofthe trend. These can befertile grounds for sellersofoptions.

Ifthemarketjustmadea sharp move in eitherdirection, conditions in themarket are probably quitevolatile.Theupside to thisisthatthemarketvolatilitycandriveoptionpremiums

outrageously high andoftenmakethemextremelyoverpriced. This can be alucrative time for optionsellers. The downside isthatthemarketwillremainvulnerable to additionalvolatile moves in eitherdirection, meaning thateven your far out-of-the-money option could beaffected to a large degreebyshort-termpricemoves.Decisions on whether to

trade these markets willdepend on yourtemperament. If you are aconservative trader, it’sprobably best to stay outand leave it to the crowdwith a slightly largerappetiteforrisk.

This is only anobservation,butithasbeenourexperiencethatmarketsthat make large moves tothe upside tend to correct

or move back lower moredecisively and over ashorterperiodof time thanmarkets that crash lowertrying to recover. It mayhave something todowiththe fact that small specsprefertobelong.However,it also brings to mind anobservation made by Dr.Alexander Elder in hisclassicwork,TradingforaLiving.Dr.Eldercomparesslow and rapid market

declines to a man fallingdownandhisabilitytogetback up. If he simply fallsdown a flight of stairs, heusuallycanpickhimselfupand brush himself off andcontinue on with minimaleffort. However, if a manfalls out of a third-storywindow, it can take himconsiderably more time torecover.Dr.Eldercontendsthat themarkets behave ina similar manner. Thus,

bargain hunters who rushin to buy a commodity orstock after a rapid declinemay be in for adisappointment, unlessthey are truly long-terminvestors.Markets fall thatrapidlyforareason.Unlessthat reason has changedimmediately, don’t expectmarkets that have justcollapsed to rebound justasrapidly.

Selling Calls intoSpikeRallies

Marketsmakingnewhighsmay not be the mostdesirable time to sell calloptions.Thenagain, in theright circumstance, theycan be the optimummarketsforsellingcalls.

Markets in declineoften can be better and/orsafer opportunities in

which to sell calls. Again,we stress the advantage ofknowing the fundamentalsinaddition to the technicalindicators thatyoumaybeseeing on a chart. Abearish technical traderwho experiences a suddenrallyinthemarketmayseedanger and be frightenedout of his position. Abearish trader who knowsthe fundamentals andexperiences a sudden rally

inpricesseesopportunity.However, if you are

somewhat familiar withyour fundamentals andhave done some basichistorical price studies (oryour broker has), youprobablycantellthestrikesthat are more at risk andthe strikes that aredownright ridiculous.These “ridiculous” strikeprices are the target of the

astutesellerofpremium.In this, we are talking

about selling optionsagainst the existingfundamentals. Why?Because you may deducethat the fundamentals arebullish (or bearish) to themarketbutnot thatbullish(or bearish). In otherwords, the fundamentalsare bullish or bearish, butnow those factors may be

already priced into themarket.Whenthemediaorthepublicpicksupa storyand runs with it, pricesoften get overblown. Andoption prices can get wayoverblown. In this soleexception to trading withthe fundamentals, optionsshould be sold sparinglyand only when the traderbelieves that the markethas gotten entirely carriedaway.

The RidiculousStrikePrice

Small specs, whipped intoa frenzy by either themarket’s move and/ormedia reports,will rush tobuy all the calls (or puts)they can afford, regardlessofstrikepriceorpremium.If you can keep your headinthischaos,youoftencansit back and “pick off”

these absurdly out-of-the-money premiums andprofit handsomely whenconditions calm down,usually in a few days to afew weeks, with little riskto your position. By“absurd,” we are talkingabout selling crude callswith a $200 strike pricewithcrudeoilat$110.Weare talking about sellingcoffee calls with a $500strike price with coffee

prices at $300 per pound.These are both trades thatwere available within thelastfewyears.

It isoften thecase thatvolatility is already atmaximum levels in theseconditions and thus, theoptions can even havelower risk of appreciationthan in “normal” marketconditions. However, itnonetheless pays to

exercise two main riskcontrol measures that canhelp you to avoid a bigdrawdown:

1.Allocateonlyasmallportionofyourportfoliototradessuchasthese.Whiletheseareoftenthehighestprobabilitytradesontheboard,theconsequencesofbeingwrongcanbe

moresevere.Ifyourregularpositionsizeis10optioncontracts,maybetakeonlythreetofiveofthesetypesoftrades.

2.Thisistheoneinstancewhereyoumayusetechnicalindicatorstolookforsignsoftopsorbottoms.Inarapidmovehigheror

lower,lookforsignsthatthemarketmomentumisslowing.Forinstance,inamarketthathasbeenracinghigherrapidlyfordaysandthenopenshigherandclosessubstantiallyoffthehighsorevenlowerontheday,thiscanbeakeysignalthatthemarketis

reachingapeakoratleastslowingtoamoremanageablepace,oftenagoodtimetosellinflatedcalls(orputs)farbeyondthepointofexhaustion.

Conclusion

Youhavenowlearnedhowto

go about selecting marketsandstrikesforsellingoptionseffectively. For the purposesof this chapter, we havefocused on selling optionsnaked. Selling naked can bean excellent strategy, andportfolios can be builtsuccessfully on this strategyalone.

However, for manyreasons, some investors andmanagers (including myself)

prefer to incorporate optionspreads into their portfolios.Spreads can limit risk,increase leverage, and evenresultinhigherprofitsifusedcorrectly. Yet they can alsobe tricky and evendetrimentaltoyoursuccessifyou do not know what youare doing. The next twochapters explain sellingoptionsaspartofspreads.Asyouwilllearn,notallspreadsare created equal. In fact, in

my experience, only ahandful of the hundreds oftypes of spreads preached bythe pundits are actuallypractical for the individualinvestor. The ones that are,however, can add an extradimensionofboth safetyandprofitability to your optionsellingportfolio.

8

TheUseandAbuseofSpreadsHowtoKeepThemfromTakingYour

Money

Thus far we have onlydiscussed selling optionsnaked; however, a traderwishing to sell options like aprofessional may want toconsider spreading as analternative strategy. Butbeware: Of all the hundredsof different option-spreading

strategies available, there areonly a handful that we’vefound to be practical forindividualinvestors.

Somebrokersandauthorsin the industry are not goingto likewhat they read in thischapter. However, ourmission is towrite this bookina“nobull”manner.Wearenotgoing tosayoutright thatsomething doesn’t work orthataparticularstrategydoes

nothaveitsmerits.Giventherightmarketsituation,almostany strategy will work someof the time. Our intention isto share with you theobservationswehavemadeinworking with hundreds offutures option traders overmany years, and theobservations in this chaptermean no disrespect to theknowledgeable authors in thefieldofoptionspreads.

The problem with tryingto learn 101 different optionspread strategies,however, isthatonefirstmust learneachdetailed strategy and itsbenefits, drawbacks, profitpotential, and risk.As if thisis not difficult enough, theinvestor then must learn inwhat situations he issupposedtouseeachstrategy.It’snotenoughforthemarkettomoveupordown.

HypotheticalExample

The reverse triplescreaming phoenixspread works best in amarket that begins tomovehigher,thenmovesslightly lower, driftssideways for two tothreeweeks,makesaleftat the Wendy’s on thecorner, and then soarsinto expiration, makingnew life of contract

highsthedaytheoptioncloses out. In thissituation,theuserofthereversetriplescreamingphoenix spread wouldnet $2,500 per spread.Asyoucansee, it is theperfect type of spreadfor a market in thissituation.Butonlyif theVega turns net positivebefore the Thetabecomesneutral.

This is a fictitious

example, of course, but itserves to demonstrate ourfrustration with the public’sseemingly insatiable appetiteto “learn” complex spreadstrategies that they couldrarelyhopetouseeffectively.Market intellectuals love toteach these strategies andhow they work. I will stopthereassomeofthesepeopleare my colleagues and I donot wish to downplay theirwork. However, my

experience has been that amarket intellectual does notnecessarily make a goodtrader.

Many traders new tooptions believe that it isnecessary to learn all thesespread combinations beforethey can trade effectively.This is not the case. Again,our point is not that thesecomplex option spreadstrategies do not have merit.

However, if you are lookingat inverted butterfly spreadsand trying to determine theproperdeltabalance foryourtriple-ratiobackspread,you’dbetterbeaprofessionaltraderwho wakes up to a quotescreen every morning thatlooks like a Greek alphabet.At thevery least, you shouldbeaserious traderwhohasalot of time to dedicate totradingandalotofmoneytolose in the “educational”

phaseoftrading.Traders who use these

approaches effectivelygenerally are people whohave made trading their life,who know exactlywhat theyaredoing,andhavepaidtheirdues through many years oflosses in learning the propersituations in which to usethese approachessuccessfully. Our experiencehas been that the transaction

costs alone make many ofthese approaches impracticalfor the average individualinvestor.

The good news is thatknowing101differentoptionspreadsdoesnotmakeyouagoodtrader.Infact,itmaybedetrimental to your bottomline. Making money in thereal world means knowing afew good strategies andexecuting them extremely

well, over and over. Leavethe 101 strategies to theintellectualoption“theorists.”

We wrote this book forthe people who just want tomakemoney.Youdon’thavetobeon theProBass tour togooutandhaveagooddayoffishing.Youdon’thavetobeaprofessionaltomakemoneyselling options either.Nevertheless, there are a fewthingsyoushouldknowabout

spreading before you tossyourlineinthewater.

SpreadDefinitions

Verticalspreads.Thisreferstotradingacombinationofoptionsinthesamemonth,but

atdifferentstrikes.Thebullcallspreadisanexampleofthis.Thestrikesarehigherorlowerthaneachother,thusvertical.

Horizontalspreads.Horizontalspreadsrefertospreadsthatarethesamestrikebutdifferent

months.Thus,sellingaDecembercallandbuyingaFebruarycallatthesamestrikecouldbeconsideredahorizontalspread.Thisisalsosometimescalledacalendarspread.

Diagonalspreads.Diagonalspreads

combinebothahorizontalandaverticalspread.Forinstance,adiagonalspreadmightsellacallinDecember,andthenbuyacallinFebruaryatadifferentstrike.

OptionSpreads:

YourBroker’sFavoriteStrategy

You’ll find that optionspreading is approved of, ifnot outright encouraged, bymany futures brokers,brokerages, and advisoryservices (who are sometimesaffiliated with a certainbrokerage or group ofbrokerages). Manybrokerages love option

spreading and often willrecommend the strategy totheir clients—especially inthecasewheretheoptionsarenet long,or at thevery least,shortbutcovered.Why?

For two reasons. First,unlikefuturestradingorevenoptions selling, theadvantagesofbuyingoptionsor incorporating optionselling into a “covered”spread position is that the

trade has absolute limitedrisk. Thus, a brokerage cancalculatetheclient’stotallossin a worst-case scenario andwillmakesurethatthisfiguredoes not exceed the totalfunds in the client’s account.This reduces liability to theclientbutmoreimportantlytothe firm itself. Moreimportantly to the broker, itmeans he can kick back andnot have to worry aboutmanaging the risk or

“keepinganeyeonit.”This is not necessarily a

badthingforyou.Itcanworkagainst you, however. Witheach position having anabsolute maximum loss,traders (sometimesencouraged by their brokers)may position all their fundsinto limited risk spreads,leaving little or none asbackup.Misledbythelimitedrisk aspect of spreads, this

type of positioning showsterrible money-managementtechnique that has thepotential to damage anaccount.

Net long option spreadscan be especially popularamong younger, untestedbrokerswho do not have theknow-how or the experienceto sell options effectively.Employers of theseinexperienced brokers will

either encourage or requirethese brokers to recommendeitherbuying straightoptionsor buying covered-spreadpositions. Of course, if aclient gives an orderotherwise, they must fill it.But clients of these brokerswho rely on traderecommendations often willbe “steered” into coveredshort spreads, or preferably,outright long-optionpositions. This is one reason

it is important to know thebroker or trader with whomyou are working and hisexperience in futures andoptiontrading.

This assessment certainlydoesnotrepresenteveryfirmin the industry, and thesebrokers are not bad people.However, new brokers havetostartsomewhere,andmanyfirmswillingtohireandtrainbrand-newbrokerswantthem

to start out with limitedliability. In this way, whenclients lose money (whichthey almost invariably do iftheyusethistypeofapproachover time), they can losemoney“safely” (withno riskofdebitliabilitytothefirm).

The second but equallyimportant reason thatbrokerages love to usecovered spreads is this:Theycan generate a boatload of

commissions for the firm.Situations that often can beplayed effectively with afutures contract or a singlecallorputalsocanbeplayedwith an option spread. Theyare pitched to the client as awaytolimitriskandincreaseleverage, which very wellmaybetrue.Thefactthatthespreadmayhavelittlechanceof profiting (especially afterhefty commissions arededucted), however, is often

downplayed.Inotherwords, insteadof

buying a single option (astrategywithwhichit ishardenough to turn a profit), abroker may suggest amultiple-option spread inwhich one or more optionsare sold in order to pay forone or more options that arepurchased. Each spread cancontainthreetosixoptionsormore.Thus,insteadofpaying

one or two commissions, theclient pays three to sixcommissionsper spread. Fora full-service brokeragecharging$100perroundturnper option, this can run intosome substantial fees. It canbe expensive even with adiscountbrokerchargingonly$30 per round turn. The factthat the “net” out-of-pocketcost, or margin, per spreadmay be less than simplypositioning in an outright

futures or long option isirrelevant. This “net” figureoften will not include fees,and even if it does,commission costs versuspotential profit canmake thespread impractical andgenerally a poor choice ofinvestmentforthetrader.

To counter this heftycommission charge, somebrokers may tout a largepotential profit on the trade.

A $500 commission for asingle spread may not soundsobadifthepotentialprofitis$5,000. But look closely. Inmany cases it will take anenormousmoveinthefuturespriceor requireprices toendup in an extremely narrowrange to obtain thatpotentialprofit.It’salow-oddsbetandtheonlyonethatusuallywinsisthebroker.

Thisisnottosuggestthat

every broker in the businessisamoney-hungryconartist.Quite the contrary, mostbrokersaregoodpeoplewhodonottakeadvantageoftheirclients.As ineverybusiness,though, the brokerageindustryhasitsbadapples.

Thisisalsonottosuggestthat because a brokerrecommends a spread to youthatheistryingtoconyou.Inmany cases an option spread

can be a viable alternativeand a legitimate strategy toemploy in a particularsituation.

Even though we believethat some of these spreadsoften are impractical and notthe best strategy for theinvestor in many cases, theright option spread can blessits user with many benefits.In fact, option spreads canoften be a preferred strategy

inmanysituations.Butifyouuse amultiple option spread,youwanttomakesurethatifevery option in that spreadexpires worthless, you arestillmakingmoney.

Asyouwill see,wehavedevoted an entire chapter tooption spreads that we dorecommend to investors(Chapter 9). We are simplysuggesting that you carefullyconsider the risk/reward of a

spread. One question wealways ask before putting ona spread is “What are theodds this thing shows me aprofit?” How many thingscan gowrong andwe’re stillmaking money? We arelooking for the highest odds,not necessarily the highest“potential”profit.

TipsforAnalyzing

SpreadTrades

Tip1:KnowtheDifferenceBetweenPotentialProfitandPotentialforProfit

Potential for profit is hugelydifferent from potentialprofit.Abigsellingpointof some spreads is theirpotential profit. Consider the

followingexample.

Broker:John,ifthepriceofheatingoilincreasesby30%inthenext30days,thisspreadwillmake$3,500!

TraderJohn:Whatdoesitcosttogetin?

Broker:Amere$300,John!That’sovera1,100%returnifyou’reright—

excludingtransactioncosts,ofcourse.

TraderJohn:Whatismyrisk?

Broker:John,that’sthebestpart!Yourriskislimitedtothe$300youputin—excludingtransactioncosts,ofcourse.

TraderJohn:That

soundsprettygood.Isurecan’taffordtolosemuchmore.Butitsoundsprettysafe.

Broker:Sohowmanydoyouwant?

Has the broker lied orbrokenanycompliancerules?No, he hasn’t. He properlydisclosed risk. He simplyfocused the client’s attentionon potential profit. If the

underlying commodityincreasesby30%in thenext30 days, John’s potentialprofit will be 1,100%,excluding transaction costs.But what is the potential forprofit?Whatisthelikelihoodof this type of move in themarket?Probablyprettyslim,just like John’s chances ofshowinganykindofprofitonhistrade.

Although the broker’s

approachinthisexamplemaybelegal,itcertainlyfeelsabitunethical.ButthebrokersoldJohn what he wanted—limited risk. Most brokerswon’t come on this strong,butsomewill.

Nonetheless, manybrokerswilltrytopleasetheirclients by offering limited-risk types of traderecommendations in anattempt to appease the

client’sfearoflosing.

Tip2:Don’tBeAfraidofLosingonOccasion

Thisbringsustoanimportantpoint. It is said that fear andgreeddrivethemarket.Whilethis may be true, if you feeleither of these emotions toostrongly in your trading—

whether selling options orotherwise, you shouldn’t betrading. Your emotions willundermine you, and youwilllose.

Although nobody wantsto lose money, there is adifference between notwanting to lose and beingafraid to lose. If you aretrading scared or afraid tolose, you have already lost.Fear is common in new

traders and/orundercapitalized traders.Thisiswhymanyof these tradersaredrawntooptionbuyingorcoveredspreads.“Iknowmyrisk,” they tellyou.“Myriskislimited.”

This iswhy investors arewilling to put their moneyintoastrategysuchasbuyingan option that will expireclose to 80% of the time.“SureIlostallmymoney,but

Ilimitedmyrisk!”If you take nothing else

from this book, please takethispoint.

Theterm“unlimitedrisk”simplymeansthis:Youhavetomanageyourownriskonthistrade.

If it moves against you,you have to get out. Themarket is not going to do it

foryou. It issimplyanextrastep you have to take. Theterm itself impliesunwarranted fear. Respect it.Butdonotfearit.

If you walk into a pit ofcombat,doyouwant towalkinlookinglikeWoodyAllen,shivering and jumping atevery twitch of the market?Or do you want to walk inlike Clint Eastwood in AFistfulofDollars?Bothhave

no desire to get slaughtered.Both may take measures toprotectthemselves.Butoneisnotafraidtolose;theotheristerrified.Thisveryconceptoffear, or lack of it, is whatmakes one more likely toachieve victory while almostensuringtheotherofanearlyslaughter.

The markets work thesameway.Thisiswhywearegoingtostronglyrecommend,

right now, that you highlightthewords in theheading thatfollows.

Tip3:FocusonManagingRisk,NotLimitingRisk

If you use an investmentvehicle that has built-inlimited risk, you give up ahuge likelihood of chances

for profit. For success intrading, protecting yourinvestment capital is ofutmostimportance.Ifyouareafraid ofwhatwill happen ifyou lose it, though, youshouldn’t be trading. Themarket smells fear like arabidpitbull.

The investment classicMarket Wizards, by JackSchwager, seems toput fortha recurring theme in trading

or investing. Manyconsistently successfultraders and investors don’tthink of trading in terms ofhow much money they aremaking or losing. Successfultraders think of trading asplayingagame.Themoneyissimply a by-product ofplaying the gamesuccessfully. They do notthink of every trade in termsof making or losing money.This enables them to remain

unemotional, objective, andpatient in their tradingapproach.Theprimarygoalisstill tomakemoney. It is theway they approach it in theirminds that gives them anedge.

Ifsafetyiswhatyouseek,put your money in acertificateofdeposit (CD). Ifyou are afraid to lose, youshouldn’t be trading futuresor options. However, if you

cangiveup that fear and theneedforabsolutelimitedriskand instead focus onmanagingyour risk, youwillhave already placed yourselfabovemostsmall-spectradersinthemarket.

The industrycaters to thegreed and fear of smallspeculators, which is whybuying options and longoption spreads is so popularwiththisgroup.

FearVersusRespect

We want to clarify thisconcept of securing absolutelimited risk versus managingrisk. We don’t mean tosuggest that a trader shouldapproach the market like aWildWestcowboywithgunsablaze in the air. A healthyrespect for the market isessential. A great firefightermay not fear the fire he is

fighting, but he certainlyrespectsit.Ourpointisthatifyou fear themarket somuchthat you must have absolutelimited risk, the high priceyoupay for that luxurymostlikelywillsabotageyouinthelongrun.

Securing absolute limitedriskprimarilyreferstobuyingoptions. Many traders(especially new traders)become enamored of the

conceptoflimitingrisk.Theyare somewhat familiar withthe concept of risk in thefutures market, but it is asomewhat vague anddisturbing notion to them.Being able to participate inthese alluring markets whileabsolutely limiting risk isvery appealing. Buying callsor puts sounds awfully goodtothem.

But it is most often their

downfall.Togetthemostoutofthesemarkets,youhavetobewilling to forgoautomaticlimited risk in favor ofresponsibly managedunlimited risk—if thatmakessense.

The following boxillustratesthispointperfectly.

BettingonElvis:A

StudyinLimitingVersusManaging

Risk

I once read in thenewspaper that a Londongamblinghouse took a betthatElvisPresleywouldbesighted riding downLondon’s mainthoroughfare on top of a

famous racehorse thatdisappearedin1973onhiswaytoWimbledon.Onhisarrival, he would proceedto qualify for the men’ssingles tournament andface a famous Englishmobster who haddisappeared in the mid-1980s (who alsoapparently, would have toqualify for the men’ssingles at Wimbledon) inthefirst round.Thebookie

took the bet for 10¢. Ifthese events did indeedoccurwithinacertaintimeframe(DNAwouldhavetoconfirm that it was reallyElvis), the bet would paythegamblerUS$2million.The gambling house, inessence,hadunlimitedriskon the bet. Do you thinkthegamblinghouse’sdimewas safe? What if thegambling house could cutits losses as soon as

somebodysawElvisridingin on the long-lostracehorse?

The gambling househad, for all practicalpurposes,unlimitedriskonthebet.But itmanaged itsriskexceptionallywell.

The first way thegambling house managedits risk was by picking abet that had overwhelmingodds in the house’s favor.

It alsomanaged its riskbygiving itself leeway to“bail out” of the bet if itappeared as though thehouse might sustain asubstantialloss.

The better, however,wasabletolimithisriskonthe bet. His risk waslimitedto10¢.

Whichonedoyouwanttobe?

We are not suggesting

that the odds of sellingoptions will be this muchweightedinyourfavor.Weare only illustrating thedifferences betweenlimitingandmanagingrisk.

Thereareoptionbuyersand spreaders out therewho are willing to bet onElvis for the chance at biggainsandlimitedrisk.Thisconcept can be magnifiedwith the strategy of some

optionspreads.Wesuggestthat before you position inany spread, try not to getcaught up in the lowinvestment requirementand potential profit in thetrade. Look at the bigpictureandwhatyouroddsare of profiting from thetrade at all.Don’t fall intothe greed and fear trap.Don’tbetonElvis.

In keeping with this

theme, we tend to adviseagainst positioning inspreads that leave thetrader net long options(althoughthesespreadscanbe more exciting for theaction-seekingtrader).

The next several pageshighlight some of the mostpopular net long optionspread strategies along withsomeobservations.

I donot have the timeorspace here to call out everysingle spread strategy thatinvestors should bypass. Theones featured here are someof the most popular I haveseen pitched by brokers orivory tower option books. Ihavelosttoomuchmoneyonthese to ever use them again—regardless of theirproposed merits. They arelisted here so that you canavoid making these mistakes

by learningfrommyreal-lifeexperience.

SpreadsNotGenerallyRecommendedforIndividualInvestors

TheBullCallSpread(BearPutSpread)

The bull call spread (or bearput spread) is a brokerfavoritebecause it limits riskandincreasesleveragefortheinvestor,aswellasprovidesadouble commission for whatotherwise often could havebeenachieved(possiblymoreeffectively)simplybybuyinga call. Moreover, it is a netlong option spread, whichmeans it is for option buyersand therefore, we would notrecommend it on those

groundsalone.Wedocoverithere,however,becauseof itspopularity among novicetraders and brokers alike.Theyarepitchedasaway toreduce the cost of buying anoption, therefore enabling atrader to takemore positions(imaginethat!).

HowtheyGetYourMoneyBull call spreads soundgoodon paper, butwe have rarely

seen them work in practicalapplication. In myexperience, if you absolutelymust buy an option, yourodds are better for profitingon a straight-up long put orcall.Unlessthemarketmovesto a certain point above thehighest strike on the spreadand remains there throughexpiration, both optionsgenerally will expireworthless, resulting in a lossforthespreadholder.

A bull call spread isillustrated in the followingexample.

Example:JudyBuysaBullCallSpreadTrader Judy is bullish oncrude oil at $100 per barrel.Shedecides toemployabullcall spread strategy to takeadvantage of what shebelieveswillbehigherprices.In July, she buys a $130

December crude oil call for$800. She simultaneouslysells a December $135 callfor$300.Thesaleofthe$135call partially offsets thepurchase of the $130 call,lowering Judy’s out-of-pocket investment for thetrade.Thus,herinvestmentintheposition iscut from$800(which it would be if shesimply purchased the $130call) to $500 ($800 - $300)(seeFigure8.1).

FIGURE8.1CrudeOilChartShowing$130and$135StrikePricesProfit/losszonesof130/135bullcallspread.

Also, since any lossesaccruedbytheshort$135callare“covered”bythepurchaseof the$130call; thepositionhas limited risk. The risk islimitedtothe$500Judyputsupforthetrade.

Thepotentialprofitonthetrade is the differencebetweenthetwostrikes.Foracrude oil contract, thepotential profit on Judy’stradeislistedbelow.

PotentialProfitonJudy’sBullCallSpreadinCrude

Oil

LongCallStrike–ShortCallStrike×SizeofOneContract$135–$130×(1,000barrels)=$5,000

PotentialProfit

For Judy to reap this fullprofit potential, crude oilmust be above $135 atexpiration,inwhichcaseboth

options expire in themoney.The$130callisprofitableupto $135, at which point itsgains are offset by losses onthe$135call.

A bear put spread worksthe same way except on theothersideofthemarket(withputs) when the trader isbearishonthemarket.

As stated earlier, onpaper, the bull call spreadlooks great: low initial

investment, large potentialprofit, and limited risk. Itsoundstoogoodtobetrue!

It does, and it makes agreat sales pitch to novicetraders. Of course, there aresituations in which thisstrategy could work well.However, we’ve seen ourshareofbullcallspreadsandhave only seen them workwellinthetrader’sfavorinavery few situations. Let’s

examinewhy.Firstofall,wheneveryou

heartheterms“largepotentialprofit” and “limited risk,”your“Iwillprobablylosemymoney” antennae should goup.

TheFlipSideoftheBullCallSpreadAlthough the potential profiton this bull call spreadappearsattractive,whatisthe

potential for profit? For themaximum return to beachieved on this position,crudeoilpriceswouldhavetorally 35% prior to optionexpiration for Judy to reapfullprofit.

Granted the market’smoves in the previous eightweeks made this type ofmoveseemfeasibletohyped-uptraders.Buttoincreaseby35% in the face of rising

supply? It is certainlypossible for the market tomake this kind ofmove.Butis it likely? This is whereknowledge of thefundamentals becomes soimportant.

TheTroublewithPredictingBigMovesTheprobleminpredictingbigmoves is that the market istradingatitstruevalueevery

single day of the week. Youhave to see somethingcoming in the future that therest of the market does not.You have to predict almostexactlywherethemarketwillgo. Then it has to make asubstantial move in yourfavorinaveryshortperiodoftime.Whatisthepotentialforprofit?Probablyverylow.

In this case, the odds ofsuccess are even lower than

the strategy of buying the$200calloutright.Atleastinthiscase,ifthemarketmovedup marginally but did notquite reach $200, you mightbe able to profit from short-term appreciation of the calloption itself. In a bull callspread, theoptionsoftenwillhaveverysimilardeltas.Thismeans that both options’values will tend to move atnearly the same rate. Whatyouaregainingonyour long

$200 call, you are oftenlosing almost as much onyour short $205 call.Therefore, even if you wereright and the market movedup$10,$20,oreven$30perbarrel, chances are that youwould not have been able tocash out of your trade earlywith much of a profit,especially after commissionsare taken into account. Themarketwouldhavetoatleasteclipse the $200 strike and

remain there throughexpiration for the trader tomake any considerable profitatall.Inotherwords,thelongoptionhastogointhemoneyand remain there throughexpirationforthebuyerofthebullcallspreadtoreasonablyprofit.Andwe already knowthepercentagesand thereforecan predict the chances ofthathappening.

HowILearnedtheHardWay

This proved especiallyfrustrating to me as ayoung broker when, as ateam, we put countlesshours of research into amarket, came up with areasonable synopsis of themarket that, surprisingly,

oftenwascorrect,andthentried to position using anoption spread of thisnature.Atthetime,wefeltthat we were protectingclients and giving themwhat they wanted—lowinvestments and limitedrisk. Inhindsight,weweregivingthemlittlechancetoprofit from what was, atthetime,decentresearch.

What would happen is

wewould releaseabullish(bearish) outlook for amarket and thenrecommend a bull call(bear put) spread. Theinvestor would place thetrade, and the marketindeedwouldmovehigher.Theinvestorwouldcallin.

“You guys were right.That market did just whatyou said! How much didwe make?” the investor

wouldask.“Well John,” I would

reply, “we haven’t madeanythingyet.”

A long explanation ofoption strategy wouldensue. The market hadmoved higher, but neitherstrike had been attained.Thus, while the closer-to-the-moneylongoptionhadappreciated in value, thelosses from the more

distant short option hadalmost offset all the gains.Thus,with transactionfeesfiguredin,thepositionwasstillataloss.

Mostofthetime,inthefollowing weeks, brokerand client alike wouldwatchdisappointedlyasthemarket then topped out orwent into a sidewaystrading range as the bullcall spread slowly

deteriorated, and died onthevine.

Bull call or bear putspreads can work if themarket goes exactly whereyouthinkitisgoingtogoandstays there. But it has to bethere at or near expiration toreally make it worth yourwhile.Inotherwords,younotonly have to pick where themarket is going, you also

have to decide when it isgoing to be there. And thatcanbeverydifficulttodo.

Table 8.1 illustrates thebenefit to drawbackcomparison of bull call/bearputspreads.

TABLE8.1BenefitsandDrawbacksofBuyingaBullCallorBearPutSpread

WhyNotJustBuytheCall?As we now know, crude oilprices declined sharply intothe third quarter of 2008.While the options in thisexample would have expiredworthless, let’s assume for amoment that crude pricescontinued to rallyup to$210per barrel by October 2008.After transaction costs,slippage, and thepriceofhisexpired options, he would

have netted just over $4,000per spread. Had he simplypurchased the $200 calloutright, his profit wouldhave been over $8,000. Yetanother reason to stay out ofthe bull call: It limits yourprofit. If you are willing topay theheavyprice toobtainlimited risk, you should atleast retain your right to anunlimited profit and buy thestraightcalls.

As we will see in theupcoming chapter, doing theexactoppositeofthisstrategycan be a solid way to buildequity in an option sellingaccount.

TheButterflySpread

A favorite of many optionbooks (andmanybrokers,nodoubt)isthebutterflyspread.The butterfly seems to

promise all things to allpeople. Investors who spendthetimetolearnhowtouseitmust think they havediscovered the Holy Grail ofoption trading—until they trytouseit(seeFigure8.2).

FIGURE8.2ButterflyDiagram

The butterfly takes itsname from the shape of its

payoff diagram. The payofffromthebutterflyissupposedtobehighestatpointB.

HowTheyGetYourMoneyAgain, we’ll go back to thetheme of professional tradersversus individual investors.Although certain strategiescan be used effectively byprofessional and/or floortraders, they can be highlyimpractical for individual

investors.Thisisoneofthem.You have certain advantagesas an individual investor thatyou can use in your favor.Trying to coordinate thepositioning of multipleoptions at different strikeprices at desired premiumswhile taking commissionsand slippage into account isnotoneofthem.

Nonetheless, the butterflylooks great on paper. The

following is an example of atypical butterfly spread andhowitissupposedtowork.

Example:TraderMarySellsa

ButterflySpreadonCrudeOil

Trader Mary is

neutral on Aprilcrude oil. In otherwords, she thinksthat $100 is a fairprice for crude andbelieves that theprice will be nearthis level onexpiration day forApril options. With

themarkettradingat$100 a barrel, thetrader enters thefollowingposition:

Buys1Aprilcrudeoil$95callat250points($2,500)

Sells2Aprilcrudeoil$100callsat150points

($1,500)eachfora$3,000totalcredit

Buys1Aprilcrudeoil$105callat75points($750)(seeFigure8.3)

FIGURE8.3CrudeOilChartIllustratingaButterflySpreadThebutterflyspread

This is not the type ofbook that is going to explainall of the mathematicalformulas and scenarios ofhow the butterfly spread canprofit. However, themaximumprofitinabutterflyspread occurs if the marketexpires right at $100. In thiscase, both short $100 callsexpireworthless fora$3,000

gain. The long $95 callexpires 500 points in themoneyfora$1,500loss.Thelong $36 call expiresworthlessfora$750loss.

Therefore, the maximumprofit on this particularexample is $750. Maximumrisk on the trade is $250,which would result from alloptions expiringworthless oralloptionsexpiringabovethetop strike price. In other

words, the net debit on thetradeisyourmaximumrisk.

The butterfly spread andits many variations can bemade to sound very good—limited risk with profitpotentialthreetimestherisk.

However, though thelimited riskand sophisticatednatureof thebutterfly spreadmay look appealing, it hastwoinherentdrawbacks:

1.Thetraderhastopick

almostexactlywherethemarketisgoingandwhereitwillbeatacertaintimeinthefuture.Again,thisisverydifficultandexactlywhatwearestressingtoavoid.

2.Evenifthetraderdoeshappentodothissuccessfully,shehastocoverfourcommissionsplusfees

pluscoveranyslippageonthefillsoutofherprofits,whicharelimitedbythebutterfly.Theseheftyfeesforemployingthebutterflycancutanyprofitreceivedsubstantiallyandmakealossonthebutterflyallthemorepainful.

Other variations of thebutterfly spread include

spreads with names such asthe inverted butterfly, thecondor, and the cartwheel.Althoughthesecanqualifyascredit spreads, for anindividualinvestor,wewouldrecommend staying awayfromall of them. In fact, tryto avoid any spread that hasthenameofaninsect,bird,oranything you might find innature.

TheDiagonalSpread(TheFreeTrade)

This spread was not coveredinthefirsttwoeditionsofthisbook. However, as I havenoticed it appearing moreoften in option newslettersandonline advicewebsites, Ifelt itneededtobeaddressedhere.

Diagonal spreads areoften billed as “free trades.”

Have you ever heard it saidthat nothing in life is free?Well, it is a wise and truestatement.

Butbeforewedissectthiscommon strategy, let’saddresssometerminology.

Therearealmostasmanycategories for option spreadsas there are option spreads.However, three of the mainones are vertical, horizontal,or diagonal. An explanation

foreachfollows.

FreeTradeorFolly?Option spreads are likefashion trends. If youmissedit the first time, don’tworry.Justwait10or20yearsanditwillcomearoundagain.

Option spreads never goaway.Buttheydofall inandoutoffashion,atleastamongthe pundits who make theirliving selling newsletters,

books, and courses. This isespecially true in the waytheyarepackagedandsoldtothepublic.

Which brings us to thefree trade. Free trades werepopular among this group10to15yearsago.Ididn’thearmuchabout themforawhileuntil the last coupleofyears,whenanastutenewsletterguyresurrectedtheirpopularity.

Like any option spread,

fortherighttraderintherightsituation,thefreetradehasitsmerits. I simply feel it to beimpractical and a low-oddstradeforanyseriousinvestor.It’sgreatforpeoplewholiketo “play” or “dabble” in themarket—as I have seen itusedprimarilyasacheapwayto buy options. And that’sgreat. However, this bookisn’t for people whowant toplayordabble.

Whatisa“freetrade”?Afree trade is a variety of thediagonal spread, which Itypically do not recommendinthefirstplace.However,asthefreetradeiswhatsomanyare familiar with, we willfocusonithere.

Example:JohnEmploysa“Free”TradeAfreetradeisbestdescribedby example. Let’s suppose

traderJohnisbullishongold.In February, John sells anApril Gold 1400 call for$1,000. He then takes that$1,000andbuysaJuneGold1480 call for the same price,$1,000.

ThisisillustratedinTable8.2.

TABLE8.2John’sDiagonalCallSpread(FreeTrade)

On a price chart, John’stradewouldlooklikeFigures8.4and8.5.

FIGURE8.4AprilGoldChartShowingJohnSelling

AprilGold1400Callat$1,000JohnsellsanAprilGold1400callfor$1,000.

FIGURE8.5JuneGoldChartShowingJohnBuyinga1480Callfor$1,000JohnbuysaJuneGold1480callfor$1,000.

ObjectiveoftheFreeTradeJohn’s objective in this tradeis to have the April callexpire worthless, effectively“payingfor”hisJunecall.HewouldthenhopeforarallyinJuneGold and look to profitfromhis long 1480 call. If itexpires worthless, he stillbreakseven.

It soundsgreatwhenyoufirst hear it. But then again,

so did putting a gas tank intherearofaFordPinto.

HowTheyGetYourMoneyThere are several ways theycan get your money on thistrade, as shown in thefollowinglist:

1.Lowoddsofsuccess.Firstandforemost,thefreetradeisalongoptiontrade.Itisdesignedtoprofitfrom

alargemovebybuyinganoption.Wehavealreadycoveredthenumerousdrawbackstobuyingoptions.Inthisexample,let’ssupposeJohn’sAprilcalldoesindeedexpireworthless.Thatwillmeangoldwillbesomewherebelow1400inApril.ThatwillgiveJohnabout60daystogetamajorrallyin

goldprices.Hislongcallwillalreadyhaveerodedinvaluesincethetimehepurchasedit.Now,heneedsittostartappreciatingrapidly,rightatthetimeitentersthemostrapidtimeofdecay.Asweknow,buyingoptionsisrarelyastrategythatyoucanprofitfromconsistently.

2.Johnhastohaveseveralthingshappenperfectlyforhimtoprofit.Hehastohavegoldpricesremainsteadyfor45daysorso,thenrallysharply.Henotonlyhastopredictabigmove,buthistiminghastobeperfect.

3.Freedoesnotmeanriskfree.Johnmay

initially“payfor”hislongcallwiththesaleofashortone.Buthehasmuchgreaterriskthansimplybuyinganakedcall.Ifheisrightinthemarketbuthistimingisoff,goldcouldrallypriortohisAprilshortcall’sexpiration.ThiscouldmeanhisAprilcallisgoingdeepinthemoney,whilehislong

callfailstokeepupinvalue.John’smaximumriskonthistradeis$8,000(AprilGoldat1480onexpirationday.JuneGoldexpiringworthless).AlthoughJohn’schancesoftakingamaximumlossissmall,thereneverthelessremainssubstantialriskhere.Thatdoesn’tsoundfreetome.Ifyouareabig

goldbullandyouwanttobuyanoption,whynotjustbuytheoptionoutrightandhavelimitedrisk?Therearealotofwaysfornovicetraderstogetintotroubleusingthisstrategy—especiallysince“free”oftenconnoteslowrisk.Thatitisnot.

4.Youloseevenwhen

youbreakeven.Ifyousellatevenpricesandeverythingexpiresworthless,youarestillpayingtransactioncosts.Ifyoudomanyofthese(whichyouwillifyoueverhopetohitonawinner),thosecostscanaddupquickly.Remembermyrule:Igetpaidifeverythingexpiresworthless—andthat

meanscoveringallcosts,too.Afreetradedoesn’tdothat.

Suffice to say, any timeyou hear the word “free” ininvesting or trading, run forthe hills. My (Michael)youngest daughter came tome last year with the greatnewsthatshehadwona“freecruise”andhadjustfilledoutthe paperwork to claim herprize. You know the story.

Shegotthecallonthephone,….Sosheclaimedher“free”cruise, which eventuallyended up costing me about$4,000. No such thing as afreelunch.

The free trade strategyappeals to the crowd withlittle capital to invest and islookingtobuyalotteryticketon the cheap. But they giveup an awful lot to get their“free” option. Don’t make

theirmistake.

TheAbuseofSpreads

Although this list certainlydoes not cover all of theoption spreads to avoid(which is most of them), itgivesyouanideaofhoweasyit is to be misled intobelieving a certain option

spread is working to youradvantagewhen, in fact, it isputtingyouatadisadvantage.As we’ve stated repeatedly,any spread can work in therightsituation.Buthowlikelyisthatsituation?

Because of thecomplexity of optionspreading, it is easy foroption “educators” and self-appointed Internet gurus toleadyou intowoodsyoucan

get lost in. Many, especiallythose fascinated with themath and science of options,meanwellbutmisstheforestforthetrees.

Wehavereadcommoditynewsletters and brokerageadvisory services that takeoption spreading to aridiculous, almost shameless,bidformultiplecommissions.

For example, a recentrecommendation from a

newsletter we won’t namewas in coffee. It was selling11 coffee calls, buying afutures contract, and thenbuying an at-the-money putforprotection.Theyexplainitand, of course, it looks greaton paper. However, themarket would have to movesomewhathigher,butnot toohigh,fortheinvestortomakemoney—after paying 13commissions plus coveringthe cost of buying an at-the-

money put. It seemed to usthat the same thing couldhavebeenachievedsimplybybuying the futures contractoutright. But the writerspulled out the “limited risk”card that has such massappeal to thecommontrader.(Actually, if the coffeemarkethadsoared,riskwouldhave been unlimited.) In theend, the trade violated justabout every one of our “redflags” indicating option

spreadstoavoid.In the following box,

thereareafewrulesofthumbour experience has taught usthat may indicate a spreadyouareconsidering isone toavoid.

ChecklistforOptionSpreadsto

Avoid

Ifthespreadyouareconsidering exhibitsany of thesecharacteristics, it isbesttomoveon.

1.Youcan’texplainthespreadtoyourkid(wife,nephew,etc.).Ifthetradeistoocomplicatedforyoutoexplain

tosomebodyunfamiliarwithcommodities,youprobablyshouldn’tbeinit.My12-year-olddaughteraskedmeatthedinnertableonenightafewmonthsagoaboutwhatIdidatmyjob.Afterabriefexplanation,sheaskedhowpeople

makemoneyinvestinginthingslikeorangejuiceorpigs.Iwenttomybriefcaseandpulledoutarecentchartofcoffee.Itookoutapenanddrewalineacrossthetopofthepaperfromthestrikepriceatwhichwehadrecentlysoldnakedcalls.“This

charttracksthepriceofcoffee”Iexplained.“Ifthepricestaysbelowthisline,”Isaid,pointingtothehorizontallineIhaddrawn,“wemakemoney.”

Shesatinquietcontemplationforafewsecondsandthenexclaimed

triumphantly,“That’seasy!”

Exactly.2.Ifeverythinginthespreadexpiresworthless,youlosemoney(afterfees).Therearesomegoodreasonstousemulti-optionspreads,aswewillseeinthenextchapter.However,

ifyouaregoingtotheadditionaltroubleandexpensetoimplementaspread,itshouldbetotilttheoddsgreatlyinyourfavorandgiveyoumanywaystoprofit.Thisespeciallymeansthatifeverythingexpiresworthless,

youstillwin.Ifthisscenariomeansyoulosesomething,it’ssimplyagambler’sbet.

3.Thespreadrequiresthemarkettomovetoacertainplaceatacertaintime.Aswe’vediscussed,pickingwherethe

marketisgoingtogoisextremelydifficult.Pickingwhenitisgoingtogothereisnearlyimpossible.Weadviseoptionstrategiesthatrequireyouonlytopickwherethemarketisnotgoingtogo.Seekoutsimplestrategiesthatgiveyoua

verywideprofitzone.Themarketshouldbeinthisprofitzonealreadywhenyouenterthetrade.Inthisway,youforcethemarkettomoveoutoftheprofitzoneforyoutolose.Avoidalltradeswithverynarrowprofitzonesorzonesthat

appearfarawayfromthecurrentmarketprice.

Conclusion

Hopefully, this chapter hasgiven you some real-lifeinsight into option spreadingand what to avoid. Theseexamples by no meansencompass all of the ways

they get your money. Nordoes it encompass theimpractical, low-probabilityspreads that are available fornewtraderstostudy,analyze,and attempt to implement.This chapter also does notcoveralloftheclassicoption-spread strategies that havebeendesignedbyprofessionaltraders, but alas, areimpracticaltoallbutthemosthighly skilled professional orfloor trader. The guidelines

presented herein, however,should hopefully give yousome valuable insights tohelpyouavoidthequicksand.

Now that you’ve learnedwhat not to do, it is time forsomegoodnews.Thereareahandfulofoptionspreadsthatarepracticalfortheindividualinvestor to implement, andthat canput theodds sharplyin your favor and allow youto build a consistently

performing portfolio. It’stimetolearnhowtogettheirmoney!

As we’ve stated, in ourexperience, there are only ahandfulofoptionspreadsthatwe believe actually do offeryou, the individual trader, anadvantage in the market. Tomake money consistently,which is what we’re after,you need strategies that aresimple, and yet put you on

equalfootingwiththepros.The next two chapters

will give you the tools tooperate on their level—andput you head and shouldersover most of your option-tradingpeers.

9

RecommendedSpreads:TheFewandtheProud

SpreadStrategiesThatReallyWorkfortheIndividualInvestor

Asyouhaveseeninpreviouschapters, there are dozens, ifnot hundreds, of ways tocombine options oflong/short, put/call,strikes/months,andmore—all

inanefforttogainanedgeonthe market. Yet few actuallyoffer a nonprofessional,individual trader advantagesthat are applicable in mostreal-lifesituations.

This chapter is about thefew option spreads that dooffer you an advantage. Wehave spent the better part ofour careers separating thewheat fromthechaffwhen itcomestooptionspreads.And

onethingIcantellyouisthatthereisalotofchaff.

However,thespreadsyouwill read about here haveproven their mettle time andtimeagain.Theycanworkina variety of situations, aredurable, easily entered,managed, and exited. Mostimportantly, they can offeryou an edge if you use themcorrectly.

Just as we learned in the

last chapter, any spread hasthe potential to work in therightsituation.Theothersideto that coin is that no spreadis perfect for every situation.Thus, the first question wemust answer is when to useanoptionspread.

WhenShouldYouUseanOptionSpread?

Myanswertothisquestionisa simple one. You use anoption spreadwhen doing sowould give you a distinctadvantage over selling anoption naked. Writing aspreadmaynotalwaysbetheright strategy to use.Differences in premium maynot be wide enough tomakethe spreadworthwhile.Theremay not be enough liquidityin the strikes youwant. Youmay have to take strikes too

closetothemoney.Therearesomesituationswherewritingnakedmakesmoresense.

When I am looking toenter a market, I’ll look atboth naked writes and creditspreads to see what themarket is offering. I’lltypically look for one of thespreads you’ll see on thefollowing pages. If none areavailable at the rightpremiums but I still love the

market,I’llwritenaked.Butmy preferencewould

betospreadeverytrade.The reason for this, as

youwillsee,isthatusingtheright spread can addadditional advantages tosimply selling naked. Thespreads you will be learninghere will have some keycharacteristicsincommon.Inthe last chapter, we learnedthe characteristics of spreads

to avoid. The box“Characteristics of aFavorableSpread”isalmostareversalofthatlist.

CharacteristicsofaFavorableSpread

1.Ifeverythingexpiresworthless,

youstillprofit(afterfees).Bydefinition,thismeansyouwillonlywritewhatareknownascreditspreads.Acreditspreadmeansyoutakeinmorepremiumthanyoupayoutonthespread.Therefore,yougetacreditbywritingit.This

bookisaboutsellingoptions,notbuyingthem.Ineveryoneofthespreadsyouwilllearnhere,youwillbelookingtoprofitalmostexclusivelyfromtheoptionsthatyousell.Theoptionsyoubuywillbeusedprimarilyasprotectionorto

increaseyouroddsofprofitinonewayoranother.

2.Itiseasytounderstandandimplement.Youshouldbeabletoexplainittoyourgolfbuddyin30secondsorless.

3.Themarketshouldbeabletobehaveagreat

manydifferentwaysandyoustillprofit.Somespreadstrategiesrequireaveryspecificthingtohappeninorderforittoprofit.Thestrategyyouuseshouldonlyloseifaveryspecific,unlikelymarketmovementoccurs.Everythingelse

shouldresultinaprofitforyou.

4.Youshouldnothavetopredictwherethemarketwillgo.Thisissimilartothethirdpoint.Youshould,ofcourse,haveabullish,bearish,orneutralbiastoanymarketbeforeselectingyour

strategy.However,youwanttoleaveyourselfplentyofroomtobewrongandstillmakemoney.

5.Slowmoving.Wewanttimedecayhere.That’sall.Andwewanttheeasiest,smoothestridetoexpiration.(Rememberthe

Mercedes?)Wedon’tlike,orneedexcitement.YoucangotoVegasforexcitement.Hereyouwantboring,slow,steadymoneyfillingupyourcofferseverymonth.Thatmeansstrategiesthattendtobalanceouttheroleofvolatilityon

youroption’svalues.Youwantslow-movingtradesthatgettozerowiththeleastamountofupanddownswingsaspossible.Everythingshouldbeslowandboring—exceptyourannualstatement.

Thecreditspreadsyouareabouttolearnarethefewthathave stood out asexceptionally consistent overtime.

They are relativelysimple, yet relativelyeffective. They offer wideprofit zones and in manycases high probability forsolid profits, even after feesare factored in. They do notofferlimitedrisk,yettheyare

relatively easy trades inwhich to employ standardrisk-managementtechniques.

EnteringandExitingYourSpread

Before discussing thesestrategies, it is important todiscuss the entry and exit ofspread positions. Sellingnaked options by themselves

is a relatively simpleprocedure.Youdecideonthepremiumyoudesire,enterthesell order at that premium,and find out if you have anytakers. If it gets filled, great.If not, you can adjust yourpriceortryagaintomorrow.

Spread trading withoptions throws a differentwrinkleintotheequation.Theabsolute value of the optionsthemselves is not as

importantasthespread(pricedifference) between the two.Thatiswhatyouareplaying.Thatiswhereyourmoneyis.

A spread order can beplaced all at once—as aspread.Thus,youcouldplaceyour order as “Sell OneSeptemberCorn5.00callandbuyoneSeptembercorn5.50callata10¢tothesellside.”This means that you don’tcarewhat the absolute prices

of the options are, you justwant to make sure you sellthe 5.00 call for at least 10¢more than you buy the 5.50call. (In corn, this wouldmeana$500difference.)

This is the standard wayto enter a spread trade. It isalso the way you shouldprobably stick tomostof thetime. However, there is asecond, more adventurousway to enter that you may

choosetouseonoccasion.

“LeggingIn”toanOptionSpread

A more aggressive approachto spreading options is whatis known as legging in. Thetraderwholegsonthespreadtries to establish one side ofthespreadatafavorablepriceandthenwaitsforthemarket

to move in the otherdirection, giving him amorefavorable price on the otherend. In other words, he iswilling to leave himselfexposed on half the spreadwhilehewaitstoestablishtheotherhalfatadesirableprice.Although we’ve seen sometrades legged in veryeffectively, we’ve probablyseenjustasmanyresultinthetrader not getting the marketmove he had hoped for and

thushavingtoacceptamuchworse fill on the second halfof the spread.Worse yet, hemay not get a fill at all ormayhavetoadjusthisstrikes,giving him a less desirableoverall position. In otherwords, if you are trying toposition in two differentoptions tocompleteaspread,have limit orders on both: ifone gets filled and the otherdoesn’t, you could be leftexposed to risk that you did

notanticipate.Eventhoughtheremaybe

some situations wherelegging in may be worth ashot, we cannot bringourselves to outrightrecommend it. Much of thiswill depend on yourpersonality.Ifyouareslightlymore aggressive, you maywant to attempt to leg into aspread occasionally. If youdecide to go this route, you

should have real-time optionquotes and the ability towatch them every minute.The other alternative, ofcourse, is to have a qualitybroker experienced in optionspreadswhohastheabilitytowatch your spread closelyandpositionforyou.

Nowthatwe’vedispensedwith the preliminaries, let’sgetonwith it.The followingareourrecommendedspreads

forindividualtraders.

RecommendedSpread1:TheShortOptionStrangle

The short option strangle issimply a variation of sellingnaked puts and calls. As amatter of fact, it is sellingnaked puts and calls. It issimplydoingbothatthesame

time.Ashortoptionstrangle,or

simply strangle, as we willrefer to it, is the strategy ofselling a naked out-of-the-money call and a naked out-of-the-moneyputonthesamemarket. The strangle is mosteffective when the price ofthe underlying marketremains in a defined range.An example of a strangle isgivenbelow.

Example:TraderJohnSellsaStrangle

TraderJohnisnotsurewhichwayGasoline(RB)pricesareheaded. In January 2014, heidentifiedpricelevelsonbothsides of the market that hebelieved would be highlyunlikelytobeattainedbeforetheexpirationofMayoptions(April25).

In brief, John believes

that$3.20wouldbe toohighapriceforgasolinefuturestoattain in this period. He alsobelieves that the $2.60 levelwould substantiallyunderprice gasoline. Johnplacesthefollowingtrade:Hesells one May ReformulatedBlend Gasoline (RBK) callfor 240 points ($1,008) andoneMayReformulatedBlendGasoline (RBK) put for thesame premium, 250 points($1,050). As long as May

ReformulatedBlendGasolineis below $3.20 and above$2.60 at option expiration,both options will expireworthless,andJohnwillkeepboth premiums for a total$2,058 in profit, minustransactioncosts.

John’s out-of-pocketmargin to hold the trade,using the SPAN system, is3,460. John’s trade isillustratedinFigure9.1.

FIGURE9.1May2014RBOBGasolineChartIllustratingtheStrangleStrategyJohnsellsastrangle(aputandacall)onMayRBOBgasoline.

TheProfitZone

The area between $3.20 and$2.60 iswhatwe like to callthe profit zone. The profitzoneisthepricerangeonthechart that the underlyingmarket can be within atoption expiration for thetrader to keep all premiumscollected on the trade. Thisparticularstranglehasafairly

wideprofitzoneofabout60¢($3.20 – $2.60 = $0.60) (seeFigure9.1).

AdvantagesofSellingtheStrangle

In addition to meeting all ofthe conditions listed on thechecklist at the beginning ofthis chapter, John enjoysseveral key advantages of

employing the optionstrangle. These are listedbelow:

•Offsettingpricemovements.Asthemarketfluctuatesupanddown,thevalueofeithertheputorthecallwillincrease.However,thevalueoftheotheroptionwilldecrease,atleastpartiallyoffsettingtheincreaseinthefirst.For

instance,ifthemarketmoveshigher,thevalueofthe3.20callmayincrease,butthevalueofthe2.60putwilldecrease,thusoffsetting,atleastpartially,themovementinthecall.Eventually,ifthespreadworkscorrectly,thisbalancingactwillcontinuewhiletimedecaycontinuestoerodebothoptions.Thisisin

contrasttosellingnakedononesideofthemarket,wherethetraderhasnocounterbalanceonhisposition.Althoughthedecreaseinoneoptionmaynotoffsettheincreaseintheotherexactly,owingtodifferingdeltas,thebalanceisoftenenoughtogivethetraderamuchsmoother,less-volatileridetoexpiration.

•Lowermargin,higherdollar-for-dollarreturn.Becauseofthisbalancingeffect,theexchangesoftenviewstranglingasamoreconservativepositionthansellingoutrightnakedshortoptionsononesideofthemarket.Forthisreason,themarginrequirementforastrangleoftenwillbelessthanthesumofthe

marginthatwouldberequiredforsellingeitheroptionbyitself.Forinstance,thenetmarginrequirementtosellthe3.20callmightbe$2,000.Thenetmarginrequirementforsellingthe2.60putmightbe$1,900.Thesumtotals$3,900.Yet,ifbotharesoldtogetherasastrangle,themarginforbothtotals$3,460.A

strangle,then,oftencanofferahigherreturnoncapitalthansellingonesideofthemarket.

•Themarketdoesnothavetomakealargemoveforyoutoprofit.UnlikeseveralofthespreadsinChapter8,themarketdoesnothavetomakealargemoveforyoutoprofit.Itsimplyhastostayintheprofit

zone.Infact,itdoesnothavetomoveatall;itisalreadyintheprofitzone!Youdonothavetopickwherethemarketisgoingorwhenitisgoingtogothere.Inthiscase,theprofitzoneisfairlywide,offeringwhatappearstobeahighpotentialforprofit.

StrangleDrawbacks

Although the strangle is anexcellent option-writingstrategy to use in manysituations, like any otherapproach, it has itsdrawbacks.

•Itisvulnerabletolargemovesinthemarket.Whiletheoptionsoldontheothersideofastranglewilloffsetlossesofanadversemoveagainsttheother,

thisoffsettingeffectislimited.Ifatraderissimplysellingnakedputs,alargemovetotheupsidewillgreatlybenefittheposition.Thisisnotthecaseinastrangle.Abreakoutmoveinonedirectioncancausealossononeoftheoptionsthateclipsestheprofitontheother.Astranglestillhasunlimitedriskonthe

upsideorthedownsideandthereforemustbemanagedlikeanakedoptionposition.Thus,youcanandshouldclosetheposition(oratleasttheaffectedside)ifthemarketbeginstorunclosetoonestrikeortheother.

•Ithasalimitedprofitzone.Theprofitzoneforsellingnakedoptions

ononesideofthemarketisunlimited.Theprofitzoneforastrangle,nomatterhowwideitis,isstillfinite.Thepricemustremainwithinacertainrange.Strangling,then,isnotrecommendedforsharplytrendingmarketsbutratherformarketsthatthetraderfeelswillremaininageneraltradingrange.

StranglingVolatileMarkets

Trending markets are notalways ideal choices for thisapproach, but this does notmean that volatile marketsshould be overlooked forstrangling opportunities.Volatile markets often canstill trade in wide tradingranges, and the volatility canboost option premiums,

meaning that a strangleoftencanbesoldwithaverywideprofitzone.

For instance, in the earlypart of 2014, investorsworriedthat thestockmarketwasdueforacorrectionafterthe impressive performanceof 2013. Yet, the followingexample from one of ourweekly columns illustrateshow a strangle could havebeen employed in the S&P

500 futures contract with avery wide profit zone. Thispiece ran on a variety offinancial websites nearly 10yearsago.Weupdatedithereto apply to more currentmarket conditions. However,it is every bit as relevanttodayas itwas in itsoriginalpublication. The articleillustrates some importantpointsaboutstrangling.

Strangling the S&P

remains a “bread and butter”trade for many professionalandindividualtraders.

ANewBearMarketforthe

S&P500orJustaHealthy

Correction?OptionSellersNeedNot

Decide

JAMESCORDIER,OPTIONSELLERS.COM

Although day trading theS&P 500 is still a popularpastime amongmany “runand gun” traders today, itmay not be the bestapproach to long-termfinancialhealth.WhileI’ve

run intoa few traderswhoclaim to be good at it, Ihaven’t met one yet whohas retired with all theprofitshe’sbanked.

I have worked withseveral short-term tradersin the past and even usedthe approach myself on asmall scale. The resultswerefair,andImustadmitthat it is an exhilaratinggame. However, with all

the sophisticated technicaltools and up-to-the-minutereporting on governmentfinancial data and newsreleases, it simply seemsthat there is still toomuchleft to chance when short-term trading. This isespecially true whentrading a market such asS&P500 futures, amarketmore driven by emotionthan any other I can thinkof. Emotions are an

irrational animal and maynot respond theway a 50-daymovingaverageor thelatest governmentunemployment report saysit should. We never knowwhen a head fake by theFed, or a riot in aMiddleEastern country will drivethe market erratically inone direction for a day, aweek,orevenamonth.

Unlike trading a

physicalcommodity,wherecrop forecasts, demandtrends, and current supplycan be measured to acertain degree, the S&P500 can be affected by somany different variablesthat trading onfundamentals can bemuchmore difficult, in myopinion, than trading acommodity such assoybeans, coffee, or crudeoil. This is especially true

when trading futurescontracts for short-termgain, where the slightestdaily whim of the marketcanresult inbeingstoppedout or, at the very least, adisappointinglossthatmaycause you to question therationale of your position.In other words, you canguess the market right,whetherusingfundamentaljudgmentorgoodtechnicalsavvy,andbeknockedout

of themarketbya randomevent. Of course, this canhappen in tradingcommodities as well, but,in my opinion, it is muchmore likely to happenwhen trading the king ofthefuturescontracts.

The volatility of theS&P500,coupledwiththewide public interest intrading the contract, doescreate some outstanding

opportunities in theoptions,however.Whereasshort-term traders aretryingtodecidewhethertogolongorshortthemarketon today’s action, sellers(or writers) of options canchoose not to decide andsimply take a high-probabilitypositionoutsideallofthemarket“noise.”

To illustrate thisstrategy, look at the

horizontal lines in Figure9.2.DoyoubelievethattheS&P 500 will remainbetweenthesetwolinesforthe next 90 days? If youbelieve that theprobabilityishigh that itwill, thenanoption strangle positionmaybeforyou.

FIGURE9.2June2014S&PPriceChartIllustratingaStrangleandProfitZone

Shortoptionstranglescanofferawideprofitzone.

An option-sellingstrangle is the strategy ofselling a call above themarketandaputbelowthemarket—in this case far

above and far below. Inthis example, the trader isselling a May S&P 5002050 call for 240 points($600)andaMay1300putfor 320 points ($800). Ifthe May S&P 500 isanywhere between 2050and 1300 at optionexpiration on May 16,2014, both options expireworthless, and the tradernets the sum of bothpremiums, or $1,400 per

spread, minus transactioncosts.

The drawbacks to thistypeofapproacharethatifthe market moves beyondthese ranges, the trader issubject to thesamemarketrisk thathewouldbe ifhewereoutrightlongorshortan S&P 500 futurescontract. Drawback 2 isthat either option couldincreaseinvalueduringthe

lifeofthetrade,whichalsocould potentially increasemarginrequirements.

The benefits of theposition, however, aresubstantial. By selling onboth sides of the market,the losses created by anadverse move in onedirection are at leastpartiallyoffsetbygainsonthe opposing option. Ofcourse, as long as the

market price remainsbetween the two strikeprices, time decayeventually will erode thevalueofbothoptions.This“offsetting” effect of astrangle can create amorestable, less-volatilepositionfortheinvestor.

The obvious benefit ofthe trade is that the traderleaves the market a widerange of potential

movement from which hecan profit. Daily newsreports, breakouts, orcorrectionsareallthingsheno longer needs to worryabout, at least on a short-termbasis.

Theobjectivegenerallywould be to hold theposition through optionexpiration,thuskeepingallpremiums collected asprofit. Remember, for the

position to be profitable,the market must onlyremain in the describedrangeforaboutthenext90days. However, either orbothoptionscanbeboughtback at any time to closetheposition.This canbe akeyaspectofriskcontrol.

An option strangle likethis one is the type ofopportunity that we preferto recommend because it

providesawideprofitzonefor the investor. It is onethat I’ll advise any dayover trying to guess whattomorrow’snewspaperwillbring.

RiskManagementandtheStrangle

Managing risk on a stranglesometimescanbeeasier than

managing risk on a nakedposition on one side of themarket. A common risk-management technique foroption sellers is the 200%rule. The 200% rule statesthatyoubuyanoptionbackifit doubles in value. It’s agreat rule, especially forbeginners, because of itssimplicity. We will discussthis technique in the sectiononRiskManagement later inthebook.

If you use the 200% ruleon a strangle, then if the putand the call were sold atapproximately the samepremium, you could exiteithertheputorthecallwhenitdoubledinvalue.Theoddsof the market making acompletereversalandmovingfarenough tocause theotheroption to double would beunlikely, although notimpossible. Therefore, if the200% rule is used in a

strangle position, there is agood chance that one couldcomeclose tobreakingeven,evenwhenlosingononesideofthetrade.

Inotherwords,oneoptionwould be covered at 200%,whereas the other wouldexpire, leaving the trader neteven for the trade.Assumingeach option was sold for$500, the equation wouldworklikethis:

Of course, slippage andtransaction costs must befiguredintotheequation,soatrader would not truly breakeven. In addition, fordemonstration purposes, thisillustrationassumesthateachoption was sold for exactlythe same price when, in

reality,thisisrarelythecase.Regardless,losseswouldstillbe minimal in this example,which makes the strangle abit more attractive to risk-adverseinvestors.

Moreaggressiveinvestorscanchoose togive the losingside of the equation a largercushion for movement,risking it to triple originalvalue or more. They arewilling to withstand

temporary increases in thevalues of the options (to acertain extent) as long as theunderlying market priceremains within the profitzone.Thestranglegivesthemthis luxury because theyknow that the other side ofthe strangle at least partiallyoffsetstheirloss.

In conclusion, tradersgenerallyshouldusethesamerisk-management techniques

forastranglethatareusedforselling naked options on oneside of the market. Theoffsetting effect of thestrangle simply gives thetrader more flexibility indeployingthesetechniques.

RecommendedSpread2:TheVerticalCredit

Spread

In the previous chapter, welearnedaboutthebullcallandbear put spread. These werelong option (vertical debit)spreads we do notrecommend.

The opposite of thevertical credit spread comesin twovarieties: the bull callspread and the bear putspread.Theoppositeofthose

spreads are the bear call andbull put spreads, also calledverticalcreditspreads.

These are wonderfulspreadsastheyofferamyriadof benefits with very fewdrawbacks, and for thatreasondeserveattentionfromany serious option seller.Vertical credit spreads areone of the most popularspread strategies used byseriousoption sellers.This is

especially truewith themoreconservative income players.Theverticalcreditspreadisaversatile strategy that holdsup very well in adversemarket conditions. They arequitesimpletodeploy.

There are two types ofvertical credit spreads. Bullputspreadsareforbulls.Bearcallspreadsareforbears.

A bear call spread isillustrated in the following

example.

Example:TraderJohnDeploystheBearCallSpread

Scenario: Trader John feelswheatpricesarenearatopinearly Spring 2014 but is notsure where the top will be.Rather than risk sellingfutures and getting stopped

outorsellinganakedcall,heelects a more conservativestrategy that will still allowhimtoprofit ifandwhen therallystalls.

Trader John sells a JulyWheat840callandcollectsapremium of $800. He thentakes part of the collectedpremium and buys a JulyWheat9.00callfor$300.Thenet credit of $500 ($800 –$300) would be his profit if

the options expire with JulyWheat futures anywherebelow$8.40perbushel. (SeeFigure9.3.)

FIGURE9.3WheatChartShowing8.40and9.00StrikePricesAlongwithProfitZoneAbearcalloptionspreadinwheat.

CalculatingRiskonaVerticalCreditSpread

Tounderstandtheadvantagesof the vertical credit spreadyoumust firstunderstand therisks.Why?Becausesomeofthe best features of thevertical spread have to dowith risk control and

limitation.A vertical credit spread

has limited risk. Althoughthis sounds great, it is reallyirrelevant most of the time.Rarely, if ever, would youwant toholdthespreadto itsmaximum risk level.However, limited risk has astrong appeal to theconservative crowd andmakes a lot of new optionsellers feel better. Thus, it is

important that we cover ithere.

The maximum possibleloss on this trade would be$3,000. That is, the dollardifference between the twostrikes × size of contract,minus premium collected.Thus,max losscalculation inthis example could becalculatedasfollows:

($9.00–$8.40)=60¢×5,000bushels=$3,000–$500=

$2,500

This maximum losswouldonlyberealizedifJulyWheat futures were above$9.00 per bushel atexpiration. The profits fromthepurchaseofthe$9.00callwouldcoveranylossesabovethatlevel.

Although it does providelimited risk, as we’vediscussed, you would almostcertainlynothold this spread

to itsmaximumlosscapacity(nor would any reasonabletrader want to). Options canbe exited at any time andthereareplentyofgoodwaysto keep your risk far belowthismaximum level.Wewillrecommenda fewof these inamoment.

AdvantagesoftheVerticalCredit

Spread

The primary advantages ofusingthebearcallorbullputspreadarethreefold.

1.Peaceofmind.First,itallowsatraderthepeaceofmindofknowinghisworst-caselossscenario.Inotherwords,hecansleepverywellat

night.2.Durableinmanymarketconditions.Second,thespreadallowsatradertremendousstayingpowerinthemarket.Bullputandbearcallspreadsarerugged,durable,dependablespreads.ThinkaboutthecommercialforChevypickuptrucks.

Ifyouwanttodriveintoasaltmineanddriveoutwithatruckloadofpremiumandhaulituparockymountaintoyourbank,thisisyourspread.Let’sexplainthat.

Inthepreviousexample,ifJulyWheatbeganrapidlyincreasinginprice

andbegantoapproachthe$8.40pricelevel,chancesarethe8.40callwouldbeginincreasingrapidlyinvalue.Ifyouheldanakedcallatthisstrikeprice,oddsaregoodthatoneoftheriskparametersforexitingnakedoptionswouldbetriggered.

However,withthecoveredposition,the9.00callwouldbeincreasinginvaluealmostasrapidlyasthe8.40call.Therefore,profitsfromthelong9.00callaremakingupmuchofthelossontheshort8.40call.Forthisreason,inmostcases,youcanholdthespreadin

adversemarketconditions,upuntilthetimetheunderlyingcontractapproachesorevenslightlyexceedstheshortstrikeandstillexitthepositionatthattimewithacontrolledandoftenminimalloss.Inshort,itholdsupwellinadversemarketconditions.

3.Attractivemarginrequirement(highROI).Thethirdandpossiblymostenticingbenefitofwritingbullput(orbearcall)spreadsistheattractivemarginrequirementitgetsfromtheexchanges.Todemonstratethis,supposeinthepreviousexample,thetradersoldthe8.40

callnakedandcollectedan$800premium.Themarginrequirementtoholdthatoptionatthetimewasabout$1,400.Therefore,thereturnoncapitalinvestedwouldberoughly57%.

Bywritingthespread,sometradersmaybelievetheyare

“sacrificing”premiumorsomehowacceptinglesstobuyprotection.Yet,bybuyingtheprotectiveput,thetraderconvertshispositionfromoneofunlimitedrisktoabsolutelyfiniterisk.Therefore,theexchangelowersthemarginsubstantiallyforthesetypesofpositions.

IfyouwouldhaveenteredtheJuly2014bearcallspreadinMarchandfilledatthepremiumspreviouslylisted,thenet(out-of-pocket)marginonthespreadwasapproximately$700.That’sn71%returnoncapital.

Thatdoesn’tsoundlikeasacrifice

tome.

DrawbacksoftheVerticalCreditSpread

Of course, there aredrawbacks to any strategyand the vertical spread hassomeaswell.

•Remaininginthetrade

throughexpiration.Theprimarydrawbackofusingthisapproachisthattocollectandkeepthefullpremiumcredit,onemustgenerallyremaininthetradethroughexpiration.Thisdoesn’tsitwellwithmore“active”traderswhoprefertotradeinandoutofthemarket.

Nakedoption

sellingholdsanedgeherebecauseifatraderisimmediatelyrightinthemarketandgetsalargemoveinhisfavor,thenakedoptionpositioncanoftenbeclosedoutimmediatelyforaprofit.However,forthepositiontraderseekinganannualreturnonhiscapital,wepreferthecoveredpositionsinmany

situations.•Cannotbeusedinallsituations.Theseconddrawbacktousingthebullput(bearcall)spreadisthatitcannotbeusedinallmarketsand/orallsituations.Somemarketsmaynothavetheopeninterestinthedesiredstrikesforestablishingsuchapositionbutmaybe

morefavorabletonakedselling.Inaddition,thereareoccasionswhereadesirablespreadbetweenstrikesissimplynotavailable.Inotherwords,thecreditbetweenstrikesisnotworththeriskorissimplytoosmall.

Wewillgenerallytakethenetcreditaftertransactioncostsand

comparethistothemaximumriskonthetrade(eventhoughwehavenointentionofholdingthepositiontoitsmaximumloss).Ifthenetcreditisgreaterthan10%ofthemaximumrisk,itmaybeaviablecandidateforthisspread.Ifnot,itshouldprobablybediscardedinfavorofadifferentstrategy.

Anotherfactoryoumaywanttoconsideristhatabearcallorbullputspreadmustoftenbesoldslightlyclosertothemoneythananakedoptiontocollectasimilarpremium.However,onemustweighthisagainstthelimited-riskaspectthespreadoffersasopposedtosellingnaked.

RiskManagementontheVerticalCreditSpread

More aggressive traders canrisk a bull put or bear callspread until the first strikegoesinthemoney.Themoreconservative strategy is toexit the position when thedollarspreadbetweenthetwostrikes doubles (or triples—depending on your risk

tolerance) from the point atwhichitwasentered.

RecommendedSpread3:SellingCoveredCallsOnStocks

Okay, I know I toldyou thisbook was focused primarilyon commodities options.However,forthestockpeople

reading this, this strategyreallycannotbeleftout.

Selling covered calls is apopular strategy amongequityoptiontradersforgoodreason. Selling covered callsin equities can be done withvirtuallynoadditional risk tothe investor if she is alreadyassuming the risk of holdingthe underlying stock. Sellingcovered positions takes on aslightly different twist in

trading futures. This is sobecausetheleverageinvolvedin selling calls on futurespositions can make it a lesspractical strategy whenemployedinthisarena.

SellingaCoveredCallonaStock

Selling covered calls inequities is illustrated in the

followingexample.Mary is long 100 shares

of Caterpillar (CAT) stockfrom $95 a share. Maryintends to hold her stock forsometime.Ifthestockgetsto$100, however, she wouldliketosellitandtakeaprofit.Rather than put a limit orderonherstock,Marycansella$100 call and collect apremium.

Let’s say that it isMarch

and Mary decides to sell aJune $100 call for $200($2.00×100shares=$200).If CAT stock is anywherebelow $100 per share onexpiration day, Mary willkeep the $200 as profit, andshe will still have her 100shares. Therefore, Mary hasgenerated $200 in incomewithout assuming anyadditionalrisk.TheonlyriskthatMaryhas is the risk thatCaterpillar stock will

decrease, which she alreadyhad before she sold theoption. Therefore, the risk ofselling the option is nil. Theoption is covered becauseMary owns the underlyingstock.

Inaddition,Marypaysnoadditional margin for sellingthiscall.

But what if Caterpillarstockisat$101atexpiration?Mary’s option would expire

inthemoneyandbeassignedor exercised at $100 pershare. This means that 100sharesofCATwouldbesoldfor Mary’s account at $100per share, effectively closingMary’s CAT position at theprice she wanted. Mary stillkeeps the premium as hers.Therefore, Mary profited onthe appreciation of the CATstock and from the premiumofthecalloption.

To some, selling coveredcalls on equities is a “can’t-lose” proposition. To acertainextent, this isactuallytrue. You can’t lose on thecall itself.However, to sell acoveredcall,youalsohavetoown the underlying security.Therefore,youmustbereadyto accept the risk that thestock will decrease in value.But many equity tradersalready hold shares of thestock, and therefore, selling

callsonthosestockspresentsnoadditionalriskatallandisused as a good way togenerate income if theinvestor plans to hold thestockoverthelongterm.

DrawbacktoSellingCoveredCallsonEquities

Theonlydrawback toselling

covered calls in equities isthat it limits the upsidepotentialonthestockitself.Ifyou own the stock from $95and you sell a call at $100,you are capping yourpotential capital gain on thestock at $5 per share.However, to some investorsthis is perfectly acceptable.The question you must askyourself in employing thistechniqueis,“IsthepremiumIamcollectingworthcapping

myupsidegaininthestock?”If so, then selling coveredcallscanbeanexcellentwayto generate income on yourcurrentstockportfolio.

SellingCoveredCallsinFutures

Selling covered calls infutures is a different animalthan selling covered calls in

stocks. In fact, it is asdifferentasbuying100sharesof a stock or buying acontract for a commodity.Thedifferenceisinleverage.

TheLeverageDifferenceIf you buy 100 shares ofstockat$20ashare,youpay$2,000 and own the stock. Ifyou buy a contract on acommodity, you may put a$2,000 margin deposit down

to control a contract for$30,000 worth of thatcommodity. In the stock,smallchangesinpriceusuallymeansmallgainsorlosses.Incommodities, this is adifferentstory.

Ifyouboughtthestockat$60 and it fell to $59, youwouldhavealossof$100.Ifyou bought a contract forcrudeoilat$60and it fell to$59, you would be out

$1,000.Ofcourse,thisworkstheotherway,too,andprofitsfrom a correct futures guessin the market can besubstantial.

If you want to sellcoveredcallsinfutures,itcanworkexactlythewayitworksin stocks. If you are alreadyholding the underlyingcontract, there is noadditional risk to selling theshortcall.

The problem is, with theway futures contracts workwith leverage, most futurestradersarenotlookingtoholdthecontractforthelongterm.If the futures price startsmoving lower, chances arethetraderwillwanttogetout,or she will have a stop inplace and get stopped outbefore the market takes toomuch of her capital. In otherwords,wherethestocktradermaybeable simply to ride it

out and stay in for the longhaul, the futures trader oftencannotafford(orsimplydoesnotwant)todothis.

This is, however,irrelevant for our purposeshere. One of the reasons wesell options on futures is toavoid the pitfalls of tradingfutures contracts—which is awholedifferentballgame.

Needless to say, sellingcoveredcallsisrecommended

for theequity traders readingthis chapter. However, wedon’tconsiderittoprovideasmany benefits in the futuresarena.

KeyPointstoRememberAboutRecommendedSpreads

ShortOptionStrangle

Benefits

•Doublepremiums•Reducedmargin(increasedreturnonequity)

•Shortcallandshortputpartiallyoffsetadversemovesagainsteither

Drawback

•Vulnerabletobreakoutsineitherdirection

BullPutorBearCallSpread

Benefits

•Peaceofmind(limitedrisk)

•Stayingpower—durable

inadversemarketconditions

•Lowermarginrequirement—higherROI

Drawbacks

•Muststayintradelongertorealizeprofits

•Requiressellingclosertothemoneystrikes

•Maynotbeviableinlowliquiditymarkets

CoveredCallWritingonStocks

Benefit

•Noadditionalrisktoholderofunderlyingshares

•Noadditionalmarginrequirement

Drawback

•Limitsupsidepotential

inunderlyingshares

This chapter taught youthree high-odds optionspreads that can be bothpractical and effective if youuse themcorrectly.However,we have purposely left oneout. We have done thisbecausewe feel itdeservesachapter all its own. It is aspread with incredibleversatility. Because of this,we have deemed it Our

Favorite Option SellingStrategy of All Time. Afterlearning itsmerits inChapter10,perhapsyouwill,too.

10

TheBestOption-SellingStrategyEverTheRatioCreditSpread

Some spreads are used

becausetheymaximizedollarreturn. Others because theyprovide strong riskprotection. Others still areused because they canperform in the most variedkinds of market conditions.Few do all of these thingsexceptionallywell.

One does, however. It’scalledtheratiocreditspread.

The ratiocredit spreadorsimply the“ratio spread”has

become my bread-and-butterspread for all of the reasonsmentioned above. In thischapter, you will learn why.Youwill also learn how youcan use this strategy to buildan option-selling portfoliothat can generate small orlargeamountsofcashforyouinmostanymarketcondition.

The ratio spread (or ratiocreditspread)isastrategywerecommended to investors in

the first edition of this book.However,Iwascool to it forsomeyears, preferring to useother strategies that seemedmore straightforward. Ofcourse, I was not entirelypleased with the firstMaseratiIeverboughteither.Until I learned how to driveit.

This is a relevantcomparison because the ratiospread is the Maserati of

optioncreditspreads.It takesa little time to learn how tohandle it. But once you do,you can blow yourcompetition off the road.Please,haveaseatbehindthewheel.

WhatIsaRatioCreditSpread?

Aratiocreditspreadtypically

worksthisway.

1.Selectanoptionstrikeyouwishtosell.Usethesameanalysisyouwouldusewhensellingnaked.

2.Sellagroupofthoseoptionsandcollectthepremium.Typicallythismeanstwotofiveoptions.

3.Takepartofthe

premiumyoucollectfromthesaleoftheoptionsandbuyoneclosertothemoneystrikeinthesamecontractmonth.

Therefore, if you werebearishgold,youcouldsell3April Gold 1500 calls andcollect $1,000 each for a$3,000 total premium. Youcouldthentake$1,500ofthatpremium and buy one April

Gold 1450 call. Thus, yournet credit collectedwould be$1,500 ($3,000 – $1,500).Your trade would look likethis:

RatioCreditSpread

Sell3AprilGold1500CallOptionsfor$1,000each(totalof$3,000premiumcollected)

Buy1AprilGold1450

callfor$1,500NetCredittoyou:

($3,000-$1,500)=$1500

Yourratioofoptionssoldversusoptionsboughtisthreeto one. And you collected acredit. Therefore it is calledtheratiocreditspread.

Asyouread,youcanselltwo to five options for everyone purchased. However Ihave found the three to one

ratio offers the best balancebetween potential for profitandriskprotection.

Why would you want toselloptionsthisway?Forthatanswer,let’sexplorehowthisspreadworks.

HowDoesaRatioCreditSpreadWork?

Aratiocreditspreadcanofferyouthebestofbothworldsasfar as profit maximizationand risk protection. For thepurpose of this example, wewillusecalls.However,ratiospreads can just as easily bedeployed for bullish traderswishingtosellputs.

In short, you sell threecalls for the premium, buyoneforprotection.Inthecaseof selling calls, if themarket

moves higher (against theposition), the long, closer-to-the-money call is increasinginvaluealmostas fastas thethree short calls. Thus, youcanstay in the tradeandrideout a sustainedmove againstyour position. Yet, even ifeverything expires worthless,you still keep your premiumcredit. Oftentimes in ratiospreads, you might not havetogetoutofthepositionuntilyour short calls are actually

going in the money. That isone big reason you do ratiospreads.

Think about that for amoment. Unlike in nakedcalls, where if the optiondoubles, you are consideringbailing,theprofitonthelongcall allows you to remain inthe ratio spread for much,much longer. This gives theshort options more time tomove back in your favor or

simply stabilize, allowingthem to expire worthlessanyway. While it can stillhappen, you’ve got to bereally wrong about themarkettoloseonaratio.

However,theratiospreadalso has one hidden benefitthat can end up paying youmuch more. To learn aboutalloftheseadvantages,itwillbe best to demonstrate withanexample.

Example:JohnSellsaRatioCreditSpread

In February 2014, TraderJohn is bearish on thesoybeanmarket.Hewants tofade the recent price rally.WithMaysoybeanscurrentlytrading at $14.00 per bushelwith option volatility high,John sees that out-of-the-moneycallsareofferinggreat

premiums.John isbearishonsoybeans. He feels confidentthey cannot reach the $15.70pricelevelwithinthenext2½months, especially with theBrazilian harvest coming in.However, because he feelsthat the market could stillmove partially higher in theshort term, he decides toemploy a ratio credit callspread.

John executes the

followingtrades:

•JohnsellsthreeMay$15.70Soybeancallsfor17¢($850)eachforatotalof$2,550totalpremiumcollected.

•HethentakespartofthatpremiumcollectedandbuysoneMaySoybean$15.00callfor25¢($1,250).

Thistradeisillustratedin

Figure10.1.

FIGURE10.1SoybeanChartShowingStrikesofRatioSpreadDiagramofJohn’sratiospreadinsoybeans.

John collects a total of$2,550 ($850 × 3) inpremiums and pays back$1,250 of it to buy a closer-to-the-money call. Therefore,Johnnetsa$1,300credit.Theratioof thespreadis threetoone; that is, he sold threeoptions and bought oneoption.

WhatDoesThisAccomplish?ThreeMain

Things

1.Keepingtruetoourfirstruleofoptionspreads,ifeverythingexpiresworthless,Johnmakesmoney(thenetcreditcollected).Thus,JohnisprofitableaslongasMaysoybeansarebelow15.00atexpiration.

2.IfJohniswrongonhistimingandsoybeans

movehigherbutremainbelow15.70(strikepriceofhisshortcalls),JohncouldactuallyendupmakingMOREmoneythanifeverythingexpired.Inthisscenario,John’sshortcallswouldexpireworthless,allowinghimthekeepthepremiums,whilehislongcallwouldexpireinthemoney,meaning

hecouldsellitorexerciseitforaprofit.

3.TheprotectivelongcallmeanssoybeanscanmovesubstantiallyagainstJohn’sshortcallsandstillallowhimtoremainintheposition.Hisshortcallsare,forthemostpart,“covered”upuntilacertainpoint.

TheFourPossibleScenarios

If John enters this position,there are four things that canhappen. Let’s explore whathappens to John’s ratiospreadinallfour.

Scenario1:Soybeansstaybelow$1,500forthelifeofthetrade.Inthismost-likelyscenario,alloftheoptions,longandshort,expire

worthless.Asinanygoodcreditspread,Johnwouldmakemoney.Inthiscase,the$1,300netcredithecollected.

Scenario2:Soybeansmovehigher,above$15.00,pressuringtheshortcalls,buteventuallysettlebackbelow$15.00

atexpiration.Inthisscenario,Johnstillkeepsthe$1,300netcredit.Thedifferenceis,thespreadmovedagainsthimintheshortterm.Butitdidn’tmattertoJohn.Why?

Asthemarketmovedhigher,thethreeshort15.70

callsareincreasinginvalue,thusworkingagainstJohn.Yetthe15.00callisincreasingaswell,atleastpartiallyoffsettinganytemporarylossesonthe15.70calls.Ifthe15.00callgoesinthemoney,thisrateofappreciationwillincrease.Thus,the

lossesonJohn’sshortcallsarebeing,toalargedegree,offsetbyhissingle,closer-to-the-money,higherdeltalongcall.John’stradehasstayingpowertorideoutmildtosomewhatsubstantialadversemoves.

Scenario3:Soybeans

movehigherandstay.OptionsexpirewithSoybeanpricesabove$15.00butbelow$15.70.Thisistheleastlikelybutmostprofitablesituation.DidyoueverwatchThePriceIsRightand,attheend,theguyendsupwinningbothshowcases

becausehewassoclosetotherightprice?That’swhatthisscenariois.Inthiscase,Johngetstokeepallofthepremiumhegotfromsellinghis$15.70callspluswhateverthe$15.00longoptionisworthatexpiration.Highestpossibleprofitinthis

scenario?$6,050.Thehighest

possibleprofitwouldbeobtainedwiththeoptionsexpiringwithsoybeansrightat$15.70.Atthatpoint,the$15.00callis70¢inthemoneyandtheshortcallsareexpiringworthless.Itlooks

likethis.$3,500(valueof

15.00callat70¢inthemoney(0.70×5,000bushelsofsoybeansin1contract=$3,500)+$2,550(premiumcollectedfromsaleof315.70calls)=$6,050.

Obviously,ifbeansarebelow

$15.70,theprofitwillbeless.Regardless,youwillonly“hit”onaratiospreadlikethisabout1outof10times.However,whenyoudo,it’sanicelittlebonustoyouroption-sellingportfolio.

Oneimportantnotetomake:You

doNOTpositioninaratiospreadwiththegoalofmakingmoneyonyourlongcall.

Remember,weareoptionsellers.Tryingtomakemoneyonalongcallisalosers’game.Youusearatiospreadtobeabletostayinthe

spreaduntilyourshortcallsexpireworthless.Collectingyournetpremiumiswhatismostimportant.Makingmoneyonthelongcallissimplyawelcomebonuswhenithappens.

Scenario4:Soybeanpricesrallyand

continuerallyingbeyondthe$15.70pricelevel.Inthisscenario,assuminghedoesnotexitthetrade,Johnlikelytakesalossonhisratiospread.WhileIpromisedtogoeasyonthemath,calculatingthelossonaratiotakesalittleexplanation.Tounderstand

potentiallosses,youmustfirstcalculateyourbreakevenpoint.

BreakevenandRiskontheRatioSpread

In our soybean example,profit on the 15.00 callincreases gradually until itreaches the peak profit level

of 13.70. At this point, theshort calls go in the moneyandbegintoerodetheprofitson the long call. While thelong call will continue tooffset one of the short callsone for one, the other twoshort calls will begin to eataway at the $3,500 profitaccrued between 15.00 and15.70. Therefore, profitsbegin to decline above 15.70and keep declining until thefutures price reaches what is

known as the breakevenpoint.

The breakeven point iswhere the losseson the shortcalls becomes equal to theprofit on the long call (atexpiration). After this point,Johnbeginsaccruinglosses.

In this example, thebreakeven point is at $16.05.Breakeveniscalculatedasthepointatwhichthesumofthelossesonthethreeshortcalls

equals the profit on the longcall. This calculation isillustrated for John’s tradebelow:

CalculatingBreakevenonJohn’sSoybeanRatioSpread

BreakevenPoint:$16.05perbushel

Profitonthe$15.00whensoybeansareat6.05:

(16.05–15.00)=$1.05×5,000bushelpercontract=$5,250

Lossonthree$15.70callswhensoybeansareat6.05:

(16.05–15.70)=$0.35×5,000bushelpercontract=$1,750×3=$5,250.

Thus, at the $16.05 pricelevel, John’s long call iscovering one of the short

calls penny for penny. Theother two are more or lessnaked, in the money shortcalls at thatpoint.Therefore,in the rare and totallydeliberate circumstance thatyou find yourself still fullypositioned in the trade whenthe options reach yourbreakeven point, you shouldprobablygetout.(SeeFigure10.2.)

FIGURE10.2SoybeanChart

ShowingBreakevenLevelsandProfitZonesofRatioSpreadJohn’sratiospreadhasabreakevenpointof16.05.

Although these examplesand illustrationsare accurate,they make one majorassumption that can be atleastmarginallyunlikely inaratiospread.Thatassumptionis that you remain in all ofyour positions throughexpiration.Youmight.Buttoassume you will do this onevery trade would leave outone of the most importantadvantages of the ratio

spread.This is the advantagethat over time and manytrials,convincedmethatratiospreads were option sellergold.

HiddenAdvantagetoRatioSpreading:TheAbilitytoAdjusttheTradetoCutRiskorIncreaseProfits

To quote an unnamed wiseman, The best-laid plans goout the window once thebattlebegins.

If you’ve done anyamount of trading at all inanymarket,youknowthistobetrue.Thus,ithelpstohaveastrategythatcanbeadjustedonthefly.

In any other option-selling strategy we’vedescribed here, adjusting

typicallymeansclosingoutaposition and establishing anewone.

Withtheratiospread,youcan adjust it simply byshaving off part of theposition. You can adjust tocut your risk or to increaseprofit.

AdjustingtoReduceRisk

Forexample,ifwegobacktoour soybean example,suppose the market wasrallying. John is becoming abit concerned about hisspread,butheisnotreadytoexit it completely. He couldsimply shed one of his shortcalls(buyitback),effectivelyturninghisratiospreadintoa1 × 2. We’re not going torecalculate all of the mathhere. However, adjusting thetrade in this manner cuts his

risk on the short calls andallowshim toprofitmoreonhis long call if the marketremains strong. Regardless,hekeepshiscoreposition.

AdjustingtoIncreaseProfit

Or, suppose John’s marketanalysis is correct andsoybean prices begin to

plummet. John could at thatpoint elect to sell hisprotective call, getting backsomeofthepremiumhepaidfor it. Hewould then simplyholdhisremainingshortcallsnaked. This would mean ahigher profit on the trade ashewouldkeepallofhisshortcall premium at expirationwhile getting some of hislong premium returned(rather than losing it all atexpiration).

This can be a greatapproach as once optionsreach a certain “point of noreturn,” getting them to gaininvalueisextremelydifficult.When you notice two- orthree-day rallies in marketsand the calls are notincreasing at all, or are infact,declininginvalueontherally, you know that timedecay has taken over. Thatcan be a great time to sellyourprotection.

Aswewill see later, it islikelyyouwillbeabletoexitmany of your short optiontrades prior to expiration atmuch or most of yourpotential profit. The ratio isnoexceptiontothis.

There are about a dozendifferent ways to use thisadvantageintheratiospread.Usingitcangiveyouanedge—even over other optionsellers.

Nowthatwe’vecoveredafullexample,let’ssummarizethe advantages anddrawbacksofratiospreads.

SummaryoftheAdvantagesofSellingtheRatioCreditSpread

The ratiocredit spreadmeetseveryoneofourcriteriafora

good option-selling spread—with several bonusadvantages. All are listedbelow.

1.Paysthetraderifalloptionsexpireworthless.

2.Theprofitzoneiswide.Therearemanywaystomakemoney;onewaytolose.

3.Itdoesnotrequirethetradertopickwhere

orwhenthemarketisgoingtomovetobeprofitable.

4.Itcanofferasignificantpotentialprofitaboveandbeyondthepremiumcollected.

5.Itcanwithstandafairamountofpunishmentfromadversemarketmovement,givingit

substantialstayingpowerinthemarket.

6.Itcanbeadjustedandoptimizedasthemarketmoves,allowingthetradertokeephiscorepositionyetadaptittounexpectedsituations.

DrawbackstoRatioSpreading

No strategy is withoutdrawbacks. The ratio creditspreadisnoexception.Beloware the drawbacks ofemployingaratio.

1.Itcanbedifficulttocalculatemid-tradeprofitzonesandbreakevenpoints.Calculatingvaluesatexpirationiseasy.Calculatingwhatthevaluesoftheoptions

mightdoduringthetradeismoredifficult.Thus,itispossibleforthetradetoshowapaperlossatsomepointsduringthelifeofit,eventhoughthebreakevenhasnotbeenreached.Thiscanbeespeciallytrueifthemarketbecomesvolatile.Asvolatilityincreases,thevalueoftheshort

callscanbegintooutpacetherateofgainofthesinglelongcall.Thus,insomecircumstances,itmaybenecessarytocloseout,oratleastadjustthetrade,wellbeforebreakevenhasbeentested.

2.Itcanbecumbersometopositionatthe

desiredpremiumsonbothsides.Ratiospreadsworkbestinhigh-volumemarketswithafairamountofvolatility.Quietorlightlytradedoptionmarkets—notsomuch.

3.Ratiospreadssharethesamebasicdrawbacksofsellingnaked,theoretically

unlimitedrisk(pastacertainpoint)andpotentialformarginincreasesinadversemarketconditions.

4.Itemploysatleastthree,andasmanyasfiveorsix,optionsineachspread,potentiallyincreasingthetransactioncostofenteringthetrade.

However,thismustbebalancedagainstpotentialbenefit.

Conclusion

Although any option spreadwill have its drawbacks, theratio spread has proven, atleast to me, that itsadvantages far outweigh itsshortfalls. I’ve worked withand for high-net-worth

investors from six differentcontinents.Icantellyouthatwithalittlecoaching,thevastmajority of them have cometo prefer this strategy as theroad to smooth, low-stresstime decay. No, it’s notperfect.Yes,youcanstilllosemoneywithit.

However, a properlyexecuted ratio spread cannotonly increase your potentialforprofit,itcanalsoincrease

youroutrightpotentialprofit.Moreimportantly,itprovidesa valuable level of riskprotection that can keep youin themarket longafteryournaked option-sellingcompetitionhasexited.

If you lose on a ratiospread, your market analysismusthavebeenprettyfaroff.But when you do lose, it isoften at a slower rate andmoreunderyourcontrol.

These advantages arewhat earn the ratio creditspread its deserved title: TheMaserati of Option CreditSpreads.

11

Option-SellingMechanicsQuickTipsonLiquidity,Timing,OrderPlacement,Assignment,LimitMoves,andMore

Liquidity

The subject of optionliquidity isone thatproducesvarying opinions on what isrightandwhatiswrong;whatis safe and what is risky.Given the choice, anyinvestor would prefer highliquidity. But one of youradvantages as an individualinvestor is that there will beoption premium for you to

sell thatmaynotbepracticalfor a large institutionalinvestortotrade.Whereasthelargefundmanagermayneedto trade several hundred oreventhousandsofoptionsatasingle strike price andtherefore need very highliquidity, youmay only needa few hundred contracts ofopen interest to sell enoughoptionstosatisfyyourdesiredposition. This may give youaccess to options that may

have better odds of expiringworthless (i.e., further out ofthe money strikes) thanwould be available to theinstitutionaltrader.

We’ve seen manyinvestors trade for years inoptionswithasfewas500to700contractsandhaverarelyseen a trader run intoproblems with exiting aposition due to liquidity. Itmaytakeabitlongertogeta

fill,andonemayneedtobeabit more flexible on pricing(on entering or exiting theposition), but we cannotremember a time when thefloor broker said, “We havenobuyersatanyprice.”

Obviously, we wouldsuggest looking for optionswith higher liquidity. But donotpassupwhatyoubelieveis an excellent option tradesimplybecausetheoptionhas

onlya fewhundredcontractsoutstanding.We would drawthe line and say that mostinvestorsprobablyshouldnottrade options at strikes withless than 500 contractsoutstanding. The optimalopen interest to look for isoptioncontractswith1,000ormore contracts open interest.Obviously,themorecontractsyou intend to sell, the higheropeninterestyoushouldseek.You also will want to

consider the open interest inthe surrounding strikes. If allthe options tend to be in thesame range of open interest,then your strike is probablyokay. If your strike has 500contracts open interest andthe next higher strike has5,000contractsopen interest,there could be a reason. It isprobably best to go with thehigher volume strike in thiscase(seeFigure11.1).

FIGURE11.1GoldOptionPricesShowingOpenInterestItcanpaytocheckopeninterestintheoptionsyouwishtosell.

Timing

In trading futures, stocks, oranynumberofother typesofvehicles, timing of the entryis an essential element of asuccessful trade. In sellingoptions,itbecomessomewhatless important. One of thereasons that you sell optionsin the first place is to avoidthe “where do I get in?”

dilemma. Therefore, thetimingofyour tradeisnotasimportant as your convictionabout the long-termfundamentals. The flexibilityof selling distant options canmake up for a lot ofoversights or outrightmistakes in timing. Timingbecomes even less importantwhen it comes to spreadtradingbecause thespreadortotalcreditreceivedoftencanremainthesame,eventhough

the value of individualoptionsmaybefluctuating.

Nonetheless,althoughnotas important as in futurestrading, the right timing canbe the difference betweencollectingalargepremiumora small premium on youroption sale and thereforemust be something toconsider when placing atrade. Because this is not abookontechnicaltrading,we

arenotgoingtodelveintoallthe technical indicators andchart patterns that may ormaynothelpyoutopredictamarket rally, correction, orreversal. Suffice to say thattechnical indicators can beused in the timing of yourtrades to optimize premiumsonentryandpossiblyexits.

There are two schools ofthoughtregardingmomentumand the entry into a short

option trade.For purposes ofthis example, we will usesellingcallstoillustratethesetwo approaches. However,the methods can be reversedjust as easily and used forsellingputs.

Even though thesemethods may seem obvious,deciding which method tosubscribe to will help yousave time andmake decisionmakingeasierforyou.

Method1(moreaggressive).Sellthecallwhenthemarketismovinghigher.Tradersinthisschoolofthoughtselltheircallswhenthemarketismovingagainstthecalls,thusdrivingtheirvalueshigherandproducingmorepremiumforthe

sellers.Method2(more

conservative).Sellthecallswhenthemarketismovinglower.Whenthepriceoftheunderlyingcontractismovingawayfromyourstrike,thepremiumfortheoptionshouldbefalling.However,

themarket’smomentumisalreadycarryingitinthedirectionthatyou,thecallseller,wantittomove.Thiscanmeanalowerpremiumforyoubutalsocangiveyouroptiona“headstart”ondeterioration.

In the end, whichever

method is used generallycomes down to personalstyle.

OptionOrdersPlacement

Once you have determinedthat your option has enoughopen interest for yourintended purposes and havedecided that the timing is

righttosellthepremium,itistime to place your order.Severaltypesoforderscanbeenteredwhen sellingoptions,butforourpurposeshere,wewill review the two mostcommon:

Marketorder.Amarketorderisanordertosellyouroption(s)atwhateverpricethemarketiscurrentlywillingto

payforthem.Limitorder.Withalimit

order,youspecifythepriceatwhichyouarewillingtosellyouroption(s).Itisthenuptothemarkettodeterminewhetheritwantstopayyourpriceornot.

We strongly adviseagainst placing market

orders when selling optionpremium. You will want toplace limit orders whenselling your options. Thisensuresthatiffilled,youwillgetyourdesiredpremiumforthe option that you areselling. Do not be too eagerto enter the trade. Pick thepriceyouwant toget for theoption, place the order, andlet the market come to you.The order always can beadjusted. A market order in

an option is simply invitinghugeslippageandapoor fillforyourself.

HowtoPriceYourOption

There are two prices you’llwanttolookatbeforeplacingyour order: the bid and theask.At the risk of becomingtoo elementary, the bid and

theaskaredefinedbelow.

Bid.Whatthehighest-pricedbuyeriscurrentlywillingtopaytobuytheoption.

Ask.Whatthelowest-pricedselleriscurrentlywillingtopaytoselltheoption.

When these two come

together, an option tradetakesplace.

Inslowly tradingoptions,the bid and ask will have tobe considered before placingyour order. If there is a bidthathasbeensittingalldayat6¢ and an ask that has beensittingalldayat8¢cents,youmaystartwithanasksuchas7½¢ cents andwork down ifyou are willing to accepttheseprices.

In an actively tradedoption, generally the lastpricetradedisasgoodaplaceas any to price your limitorder if your objective issimply to get a fill. You canalwaysadjustitslightlylowerif your order is not gettingfilled. However, if you wantto enter an order at a higherasking price, you always cando so and wait to see if themarketmovesenoughtopushthe option value higher and

bring a buyer at your price.Some traders favor theapproach of placing “wish”ordersatthebeginningofthetradingdayatpremiumswellabovethecurrentlistedprice.Occasionally (as a result ofmarket movement or adesperate buyer), these getfilled.

Workingalimitordercanbetime-consumingifyouaredetermined to get a fill. A

good option broker can beveryhelpful in this regard. Ifyou have a good relationshipwith your broker, you cangive her “limited discretion”tofillyourorderinyourbestinterest. This can give thebroker the leeway to workyour order and makenecessary changes in theorder without contacting youevery five minutes. Ofcourse, you should only givethis type of freedom to a

broker in whom you haveestablished a great degree oftrust.

The other alternative, ofcourse, is to set your priceand wait for the market tocome to you. This can be anexcellent strategy. The onlyrisk is that themarketmovesawaywithoutfillingyoufirst,resulting in you not sellingthe strike price that youwanted.

NoLockLimitinOptions

One fear that many futurestradershaveisgettingcaughtin an adverse limit move. Inotherwords,thetraderislonginthefutures,andthemarket“locks” limit down. Thismeansthattherearefarmoresellersthanbuyers—somany,in fact, that the market hasmoved its exchange set limit

for the day and is locked atthatpricefortheday.Ifthereare no willing buyers at thatprice level, the market willremain at that price until thefollowing morning. In veryvolatile market conditions,the market can lock limitdown or lock limit up forseveraldaysinarowbecauseall theordersareononesideofthemarket.

Asafuturestrader,ifyou

areontherightsideofalock-limit move, it can be awindfallofprofits.Ifyouarecaught on the wrong side,quite the opposite could betrue.

Toputitbluntly,ifyou’recaught on the wrong side ofthemarket,andthemarket islocked limit, this means thatprices are moving rapidlyagainst you and you cannotget out. Your losses are

multiplyingdaily,andthereisnothingyoucandoaboutit.

To the fear mongers of“unlimited risk” in optionselling, the following factmay be of interest: Optionsdonot lock limit.Optionsdonot have a daily limit move.Therefore, you can almostalways get out. Granted, itmaynotbeatapricethatyoulike,butyoucangetout.Thisfact alone can provide peace

ofmind for traders who feargetting“stuck”inaposition.

Futures tradersoften lookat option values when thefutures contracts are lockedlimitupordown.Itisthoughtthat the option values willreflectthe“true”valueofthemarket.

It generally will take amajor fundamentaldevelopment to cause themarket to lock limit up or

down, especially for severaldays in a row. A goodexample is the cattle marketin December 2003 when thefirst-ever case of mad cowdisease(BSE)wasdiscoveredintheUnitedStates.

TheWorst-CaseScenario

New investors often ask us,

“What is the worst-casescenariowecouldface?”Ouranswer is that an asteroidcouldhittheearthandweareallvaporizedinamillisecond.Really. What is the worst-casescenariowhenyouflyonan airplane? The stockmarket? The economy? Icannot predict what a worst-case scenario would be.Another 9/11? The financialcrisisof2008?Whoknows.Ido know that you build

safeguardaftersafeguardintoyour portfolio so that if theworst case ever happens(which hopefully it neverwill) youhaveoptions (so tospeak).

The story I am about tosharewithyouissooldithasmoldonit.Butithappenedtome. At the time, it was aworst-case scenario. Andmanyoftherisk-managementsafeguards you read about in

this bookwere forged in fireon the day this story tookplace. It was my worst-casescenario.

OurWorstCase

On December 22, 2003, theU.S. Department ofAgriculture (USDA)announced that a cow in thestate of Washington hadtested positive forBSE.This

was as shocking as it wasunprecedented.

This was especially trueformeaswehadnakedshortput positions in the cattlemarket. The memory ofhearing the news will beetchedinmybrainforever.Itwas about 7 p.m. I waswrappingChristmaspresents,sipping on a glass ofMerlot,and hadCNN turned on lowin the background. I saw a

news anchor talking with aphoto of a cow in thebackground.Then a video ofa cow, stumbling and fallinginto a muddy pasture.Fortunately, the Merlot wasnot in my hand or it wouldhave spilled all over thecarpet.

Thenextmorning,almostanybody long in the cattlemarketprobablyhadthesamebasic thought: “Get out, get

out,GETOUT!”Unfortunately, if you

were long futures contracts,this would not be possible.Themarket was locked limitdown the morning ofDecember 23 and remainedso through the Christmasholiday and into thefollowing week. Witheverybodysellingandnobodybuying, the long futurestraders were stuck in their

positions with nothing to dobut watch the market openlimit down for several daysstraight and wait until itstarted trading again at amuchlowerprice(seeFigure11.2).

FIGURE11.2February2004LiveCattlePriceChartCattlepricesreacttotheBSE(“madcow”)announcementinlate2003.

Wewere short someputsand I knewwe couldget outifwereallywantedto.Butwehadsome room tomaneuver.And instinct toldme itmightnotbebesttojumpoutonthefirstdaydown.Why?

Often in the case ofjolting market news, themarket not onlywill price inaworst-casescenariobutalsowill likely overreact.Although the limit move in

cattle futures prices was 150points (1.5¢) at the time, theoptions were already pricinginamoveof18¢ lower.Theoptions had already priced aworst-casescenario.Thus,wefigured the situation couldonly improve! Put optionvalues reached theirpeak thefirst twodays after themoveas traders clamored to eithercover short put positions ortried to hedge long futurespositionsbybuyingputs.

Exiting long positionswas the only objective ofmany speculators. Althoughthis may not have been thebest course of action at thetime, it was indeed possiblefor option traders. The samecannot be said for futurestraders.

By the beginning of thefollowingweek,coolerheadsbegan to prevail. Marketlimits on futures were

expandedtoallowthemarketto start trading again. Andwhilethefuturesmarketpricewas still moving lower, avery peculiar thing began tohappen to the put optionvalues. They began todecrease! Nobody reallyknewhowmuchasinglecaseof BSE would affect beefdemandor prices in the longterm. However, in the firstfew days after theannouncement, all that

anybody wanted to do wasexitlongs,whateverwaytheycould. The option valuespricedintheoverreaction.

This is another testamentto selling far-out-of-themoney options. Althoughvolatility had driven theoption values andmargins toa much higher level, lossesforacattletraderwouldhavebeen much less if he wasshort puts rather than long

futures.Thesizeofhislosseswouldhavedependedonhowfar out of the money he hadsold puts. The further out ofthe money he had soldpremium, the less his losseswerelikelytobe.Onlyaboutone-quarter of our puts everwent in the money. Thisboughtusprecioustime.

By Monday, when thetrade began to look at thingsin perspective, the option

values began pricing thefutures market somewhathigher. Option traders whowaitedoutthemarket’sinitialreaction would have beenwisetowaituntilthispointtoexit. They still would havetaken losses, but they wouldhave been less severe thantheywere thepreviousweek,andpositionscouldhavebeenclosed out in an orderly,rationalfashionratherthaninpanic.

We eventually did closeall of our short puts.However, it ended up beingsimply a losing trade ratherthan the fiasco it could havebeen.

We use this examplebecause it taught me someextremely valuable lessonsabout structuring andprotecting an option-sellingportfolio. The pointsillustratedbelowareonesyou

can internalizenow—withouthaving to experience a “madcow”experienceofyourown.

1.Optionsdonotlocklimitupordown,andyoualmostalwayscangetoutifyouwantout,aslongasyouarewillingtoacceptthepricethemarketisoffering.Yet,inmovesmadebasedonbig,breakingnewswhere

panicbuyingorsellingisevidentsolelyfromthenewsstory,itisoftenbettertowaituntilthedustsettlesafterthemarket’sinitialsurgetoexitshortoptionpositions.Thefuturesmarketmaylocklimitupordown,buttheoptionmarketoftenwillpriceinaworst-casescenariointhefirstdayortwo

aftersuchanewsevent,onlytobackoffoncerationalthoughtreturnstothemarket.Thismeansthatout-of-the-moneyoptionvolatilityandthereforepremiumscanbeattheirhighestinthefirstfewdaysaftersuchanevent.Ifyourshortoptionsalreadyhavepricedaworst-casescenario,thesituation

thereforecanonlygetbetter,right?Lossesoftencanbeparedbywaitingafewdaysaftersuchanewseventtoexit.(Consequently,thedaysimmediatelyfollowingsuchaneventcanalsobeagreattimetoenternewshortoptionpositions.)

2.Itillustratesthedifferencesbetween

futurestradingriskandoptionsellingrisk.Putsellersasawholewouldhavefaredsubstantiallybetterthanfuturestradersinthistypeofmove.Thiswouldhavebeenespeciallytruefortradersfollowingourrecommendedapproachofsellingdeepout-of-the-moneystrikes.Futurestraderswould

havesufferedthefullbruntofthemove,andtheywouldhavebeenlockedintheirpositionsuntilthemarketdecidedtoletthemout,probablyatlossesashighas18to20¢percontract.Optiontraders,evenoneswhosoldnakedputs,couldhaveexitedatalmostanytime,mostlikelyatafraction

ofthelossesincurredbytheirfutures-tradingcounterparts.

3.Itillustratestheimportanceofdiversification.Ifcattleputswereonlyasmallpartofyourportfolio,thisincident,althoughunpleasant,probablywouldonlybeaminorsetbackinyouraccount.

4.Itillustratestheimportanceofsellingout-of-the-moneyoptions.Thisisfairlyself-evident.Thefurtheroutofthemoney,thelowerthelikelylossisinsuchamove.

5.It’sagreatargumentforusinglimited-riskcreditspreadssuchasthosecoveredinthe

previouschapters.

ClosetheDoorontheBoogeyman

This is the type of examplethat option-selling naysayerspoint to when they try toconvince you that optionsellingisnogood,dangerous,or other. That is theboogeyman they tell you

about.However, as you have

read, if you were positionedfarenoughoutof themoney,had properly diversified,deployed a proper risk-management technique, andkept your head, you couldhave exited your positioncalmly,absorbedtheloss,andmoved on. The impact mayhave been even less if youwereinapartiallycoveredor

spreadposition.However, the most

notable feature about thisexample is its rarity. Afundamental change in amarket with this speed andmagnitude could be a once-in-a-decade occurrence. Weare not talking aboutsomething like the soybeanmarket going through aweather rally. In that case,you know that you’re in the

growing season, and you’veprobably seen the weeklyweather reports growingincreasingly hot and dry (orwet,cold,etc.).Thisexampleis a completely unexpectedturn of events that could nothave been predicted throughany type of analysis (think9/11). You may sell optionsformanyyearsandneverruninto a case such as this.However, it is important toknow because, again, this is

the type of example theunenlightened “experts” lovetousetoscareyouawayfromselling options. You canreplace that fear withknowledge.

Youcannevercompletelyeliminate the risk ofsomething like this takingplace.Butyoucanplanforit,be prepared for it, and ifyou’ve managed yourportfolioproperly,learnfrom

itandmoveon.

OptionAssignment:WhenYourOptionExpiresintheMoney

Another fear that many newoptionsellersmayexperienceisthefearofgettingassigned.We’veheardthefearinmanya new trader’s voice at themere utterance of the

ominous word assignment.To these potential optionsellers,we have oneword ofadvice:relax.

In almost every case, ifyouaresellingoptionsasweare suggesting in this book,you will not be assignedunless you want to beassigned. In fact, beingassigneddoesnotnecessarilymeanthatyouareeventakinga loss. Although the idea of

assignment or having youroption executed may soundfrightening, it is really onlythe process of having yourinvestment shifted from onevehicletoanother.

Theoretically, optionssold on American exchangescan be executed or assignedatany timeduring the lifeofthe option. This process isinitiatedby theoptionbuyer.However, in almost every

case, this is not beneficial tothe option buyer unless theoption is actually in themoney and is at or nearexpiration. As we statedearlier, in most cases, if thebuyer of the option wants toexit the position, it is moreprofitable simply to sell itbacktothemarket.

In other words, for allpractical purposes, you donotneedtoworryaboutbeing

assignedunlessyouroptionisexpiring in the money.Therefore, if you don’t wantto be assigned, it is best tobuy your option back beforethis situation occurs. If youare using any of the risk-management techniquesdescribed in this book,chances are that you will beout of your options longbefore you were even in asituation where your optionsmightbeexercised.

If you do happen to getassigned, it is no big deal.There is nothing that youhave to do. It is all handledby your broker. Instead ofholding a short option, youare now long or short afutures contract from yourstrike price. If you do notwant to be in this position,you can simply close it outimmediately. Itwill cost youanextracommission,butitisjust as easy as buying or

selling an option. This isanother area where a goodbroker can be extremelyhelpful.

Example:JohnGetsAssignedonSilverCalls

Trader John was short aMarchsilver22.00callwhenthe option expired on

February 24 (see Figure11.3). When the optionexpired, futures closed at22.15,meaningJohn’soptionwas15¢inthemoney.John’soptionwas assigned the nextday, meaning that John wasnow short one contract ofMarch silver from 22.00. Hecould choose simply to holdthe contract and play thefutures market, or he couldimmediately close theposition for a 15¢ loss.

However, the loss would benogreaterthanitwouldhavebeen had he simply boughthis option back with theMarch contract at the sameprice.(SeeFigure11.3.)

FIGURE11.3JohnTakesAssignmentJohnacceptsassignmentasMarch22silvercallexpiresinthemoney.Hecanchoosetoholdthefuturescontractorsimplycloseitoutupon

assignment.

Even if the option isassigned, John still gets tokeeptheoriginalpremiumhecollectedfromthesaleof theoption.

Most importantly,however, is tonote thatJohnonlytookassignmentbecausehewantedtotakeassignment.If he did not, he could haveclosedhisoptionoutanytimepriortoitgoinginthemoney.

Conclusion

The topics covered in thischapter are the areas wheremuch of themisunderstanding and fearrelating to option selling iscontained. However,knowledgereplacesfear.Younow have an argument foroutsiders and “half-knowers”who tell you that optionsellingistoorisky.Youknow

something about the rightorderstoplacewhenenteringa position and what type ofliquiditywithwhichyoumaybecomfortable.Andalthoughnobody wants a limit moveagainst their position, youknow the reasons why it isbetter to be short options onsucharareoccasionthanitisto be caught in the futurescontract.

With this knowledge in

hand, it is now time toexplore the most importantsubject inoptionselling—thesubjectofriskmanagement.

12

ManagingYourOption-SellingRiskDefenseWinsChampionships

InFebruary2014,theDenver

Broncos entered the SuperBowl with the most prolificoffense in the NFL.QuarterbackPeytonManningwas coming off of his bestseasonever,havingsetmanyNFL offensive records inpassingandscoring.Fansandsportscasters alike waited tosee what kind of offensiveshow the Broncos would puton in the SuperBowl.But itwasnottobe.Why?

Because Denver ran intoarguably the NFL’s bestdefense in the SeattleSeahawks.TheBroncoswerebogged down, stopped, anddestroyed. The SeattleSeahawks became SuperBowlchamps.

The fact that Seattlewoncame as little surprise tomany old-school sportsenthusiasts.Thereisanaxiomin sports that has rung true

through the ages. Its truthruns the gamut from icehockey to football: DefenseWinsChampionships.

More often than not, ateam with a great defense iswhat gets it its Super Bowltrophy or Stanley Cup. Andthat axiom applies perfectlyto investing. In regard tomanagingyour option-sellingportfolio, having a good“offense” is, of course,

important.However, it is thequalityofyour“defense”thatwill likely have the biggestimpact on your overallperformance. If you manageyour downside risk properly,the profits take care ofthemselves.It’sthatsimple.

This chapter will sharewithyouhowtomanageyourrisk in option selling—nothow the “option enthusiasts”tell you to, but how itworks

in the real world of seriousinvesting.

Ifyoujustwanttosellanoption here and there, andhaveallthetimeintheworldto watch and tinker with it,youcanaffordtogetcuteand“experiment” with differentthings.Thenyoucantellyourfriends all about it onFacebook. However, if youare investing hundreds ofthousands, or several million

dollars into an option-sellingcampaign, a serious risk-management planmust be inplace.

There are no fancy trickshere. Just a few simple,proven,andeffectiverules.

TheKnockonSellingOptions:The“Other”Twenty

Percent

The fact that 75% to80%ofall options held throughexpiration expire worthlessalways produces an initialquestion in the new optiontrader’s mind: “What abouttheother20%?”

The knock on optionselling by outsiders ormarginally experiencedsellers, is that the “one big

loss” can come along andwipe out months of profits.This is true: It can happen.But the complaint typicallycomes from people who donotunderstand,orhaveneverlearned,how tomanage theirrisk properly. You do nothavetobeinthisgroup.

Having most of theoptions that you sell expireworthless is the easy part.What to do with the other

20%thenbecomesthewholeball game. Riskmanagementin option selling is probablythe most important aspect ofyourentireportfoliostrategy.

Even though we havepointedoutseveraltimesthatthe risks of option sellingoften are much fewer thanmost of the trading worldmakes them out to be, onecannot ignore the fact thatoption selling nonetheless

carries some inherent risks.Sizable chunks of accruedprofits can bewiped out if afew losing trades are left togoastray.

Thefocusof thischapter,then, is not on pickingwinners but on how tomanagethelosers.“HowdoImanage my risk?” is almostalways one of the primaryquestions a new or evenexperienced option seller

asks. Our hope is that afterreading thischapter,youwillbe able to enter into anoption-writing approach toyour portfolio confident thatyoucanhandleor at leastbefamiliar with appropriatestrategies of riskmanagement.

RiskManagementBeginsBeforeYou

EnteraPosition

We will begin with the oldwordsofwisdom:“Anounceof prevention is worth apound of cure.” Riskmanagementofyourportfoliobegins not after you enteryour position but before youenter any position. Riskmanagement will be one oftheprimaryfactorsyouusetodecide on an appropriate

strikeprice(s)atwhichtosellpremium.

Risk-ManagementPrerequisite1:SellFar-Out-of-the-MoneyOptionswithLowDeltas

Asyou learned inChapter 7,“How to Pick the Right

Option toSell,”manyoptionsellers point out that optionsexperience theirgreatest timedecay in the last 30 days oftheir trading life. The logicgoes that these would be theideal options to sell becausethey will show the fastestdeteriorationandthusshowaprofit sooner. Even thoughthis is true, generally it alsomeansthat inorder tocollectanyworthwhilepremium,thetrader will have to sell very

close-to-the-money strikeprices. Although this canpotentially generate quickprofits for the option seller,the problem is that even abrief market hiccup can putthe option in the money,possiblyproducingquickandsizablelosses.

Trying to sell short-termoptions puts you back in thegame of picking short-termmarket direction, the exact

situation we are trying toavoidbysellingoptionsinthefirstplace.

TraderTedLearnstheHardWay

We had a new clientrecently who was veryexcited about starting his

option-selling portfolio.For the purpose of thestory,wewillcallhimTed.

Based on long-termfundamental data andhistorical volatility, werecommended to Ted thathe sell far-out-of-the-money coffee calls for hisaccount.Tedlikedtheideaof the trade, but the factthat the options did notexpire for almost four

months troubled him. Itwas not the fact that hedidn’t think the optionswould be profitable—hedid. But four monthsseemed like an awful longtime to wait, even thoughthe trade would haveapproximately doubled hiscapital invested had theoptions expired worthless.Tedwantedaction.

“Ifya’ll thinktheprice

is going down, why don’twe sell the 76 calls thatexpire next month?” hereasoned.

The calls we wererecommendingtoTedweremore than 70¢ out of themoney, and coffee wastrading at about 70¢ perpound at the time. Coffeeprices would have had tomore than double for theoptionstogointhemoney.

Tedwanted to sell optionsthatwereonly6¢outofthemoney that expired in lessthan 30 days.Whereas theoptionsmayhavehadcloseto the same deltas at thetime,Ted’soptionsstoodamuch higher chance ofgoinginthemoney.

We tried to explain toTed that although thefundamentals painted arelatively bearish picture

for at least the next sixmonths, it did not meanthat prices could not stagea temporary rally in themeantime and put hisoptions in themoney. The140 calls we wererecommending wouldremain well out of themoney, even if the coffeemarketrallied10or20¢.

Tedwasunswayed.Hemade the mistake of

thinking that because thefundamentalswerebearish,it meant that the marketwould go down, period.UnfortunatelyforTed,thatisnotalwayshowitworks.Ted went ahead and soldthenear-month76calls.Ofcourse,thefollowingweekthe market experienced afund-led rally that saw itgain over 10¢ in just twoweeks. Ted eventuallybought back his positions

at more than three timesthe price at which he hadsold them, losing about$1,200peroption.

Sellersof the140callsbarely felt a pinch. Themarket rally was short-lived, and the coffeemarket again settled backdown into its previoustrading range. The 140calls expired worthless afewmonths later,doubling

the invested capital of thetraderswho had sold thematthetimeTedsoldhis.

Themoral of the storyis not that selling close tothe money is bad.Mathematicianswho arguethat optionswithmatchingdeltas carry the same riskarewrong.Onceanoptiongoesinthemoney,itsdeltaincreases very quickly.Sellingoptionsclosetothe

moneycanwork,butitisamuch more aggressivestrategythansellingfurtherawaywithmoretime.

DeepOutoftheMoney:LowerRisk,PeriodThe first building block inyour risk-control strategyshouldbetoselectfar-out-of-the-money options with lowdeltas. In limitingyourself to

these types of options, yougive yourself a wide marginof error for the market tomake short-term fluctuationswithout affecting yourposition drastically. Eventhough theseoptionscanstilllose money, you force themarkettomakealarge-scale,sustainedmove (against yourposition) before your optionswill reach your riskparameters. In addition,because the deltas are much

lower, if the market ismoving against you, theoption values generally aremoving against you muchslower than theywould be ifthey were in the money orclose to being in themoney.Thisgivesyouplentyoftimetomakedecisionsand,shouldit be necessary, to exit yourpositioninanorderlyfashionon your terms rather thanbeingforcedoutorpanickingand making a rushed,

emotionaldecision.

Risk-ManagementPrerequisite2:DiversifyYourOption-SellingPortfolio

Even though diversificationoften is heralded as anecessity in almost any type

of investment, nowhere is itmore crucial than in optionselling. By diversifying youroption sales across differentmarkets, you reduce yourexposure in any givencontract to a limited portionof your portfolio. Therefore,if aworst-case scenario doesunfold, it should not have alarge-scale impact on youraccount.

Bydiversifying,however,

we do not mean that youshould diversify your futuresoption-selling portfolio over25 different markets.Remember that optionselection may start withidentifyingmarkets thatoffervery favorable fundamentalsforsellingputsorcalls.Mostmarkets will have mixed orcloudyfundamentalsmuchofthetime.Donotdiversifyforthe sake of diversifying, butstrive to find other markets

with clear fundamentals inwhich to expand yourportfolio.Most of our optionportfoliosarediversifiedoverfour to six different futuressectors at any given time.Striveforthatmixinyours.

Diversifying acrossmanymarketsnotonlywillincreaseyour chances of havingmostof your options expireworthless, but it also willdecrease your chances of

having losers take sizablechunks out of your account.By diversifying only intomarkets with fundamentalsthatyoubelievearefavorableto your position, you canincreasetheseoddsfurtherinyourfavor.

Risk-ManagementPrerequisite3:SetYourRisk

ParametersWhenYouEntertheTrade

This is a standard rule offutures trading regardless ofwhether you are sellingoptions, trading spreads, ortrading outright futurespositions.

When I (Michael) waslearningtoscubadiveseveralyearsagointheFloridaKeys,one of the key safety points

constantly drilled into ourheadswasthis:Planthedive;divetheplan.Inotherwords,beforethedivereverjumpsinthewater, hehasworkedouta detailedplan as towhat hewants to accomplish, howmuch time it will take, howmuch air he will need, andwhen he will be back to theboat.

The same type of planshould be implemented in

your option-selling portfolio.Plan the trade; trade theplan. When you sell anoption, you should knowbefore entering the positionwhat your risk-managementplanwill be.What techniquewillyoubeusing?Whenwillit be enacted? What is yourbreakeven? What would beyour loss on the trade if thetechnique were implementedproperly? Improperly? Whowillbeputtingyourriskplan

into action—you, yourbroker,orsomebodyelse?

Knowing this and havinga plan in case the marketthrowsyouacurveball is thenumber 1 key to avoidingemotional decision making,which, as we know, is aprimary enemy of asuccessful trader. Countlessnumbersoftradersexperiencehefty losses that could havebeen cut to insignificant

amounts if a proper risk-management plan werefollowed.

“Let’s watch it for a dayandseewhatitdoes”isnotarisk-managementplan.

What are these risk-management techniques?Wewill now explore them alongwith the benefits anddrawbacksofeach.

Risk-ManagementTechniquesforOptionSellers

Manytraderswillcallandaskusaboutacomplextechniquethey read about that virtuallyensures they “can’t lose” ifthey work it properly. Thiswasnodoubtlearnedinsomeoptionbookorseminargivenby somebodywhomakeshislivingbygivingseminars,not

bytrading.“Isellacall,andifitgoes

inthemoney,Ibuyafuturescontract, and if the futuresmovesagainstme,Ibuyaputand…,”andtheycontinueonand on discussing offsettingandthenoffsettingtheoffset.

Rather than delving intoall these techniques andpicking apart piece by piecewhat can happen to youraccount,let’ssumitupintwo

short sentences: Don’t dothis.Itprobablywon’twork.

Not only will it probablynot work, but you alsoprobably will end up losingmoremoney than youwouldhavebyjustgettingout.Youwillpaymorefees,addingtoyour losses. You will spendmore time trying to untangleand watch and counter andoffset your growing position,all in an effort to get back

your growing loss. This istimespent thatcouldbeusedto find new and profitabletrades.

Trying to offset a losingshort option position withfuturescontractsisliketryingto get rid of the rats in yourgarage by releasingrattlesnakes.Youmaygetridoftherats,butthenwhat?

If you start using futuresasarisk-managementtoolfor

your option selling, you’rebackin thegameof tryingtotime the market and decidewhat it is going to do on ashort-term basis. As we’veindicated,ifyouaretryingtotradeshortterm,youcouldbeleavingthefateofyourfundsin the hands of Lady Luckmorethananythingelse.

Therefore, we stronglyrecommendtheKISS(keepitsimple, stupid) approach to

risk management in youroptionselling.Overtheyears,we have found that thesimplest approaches arealmost always the bestapproaches. The followingare the three techniques thatwe have found to be mosteffective in our years ofoption selling.The followingare the ones we’ve found tobethebest.

Risk-ManagementTechnique1:SpreadtheMarket

Optionspreadsarenotonlyatrading strategy but a risk-management technique.Selling naked options offersmany advantages, but for themore risk-averse investor, acredit spread may provide amore comfortable fit. Thespreads described in the

previous chapters areexamplesofhowspreadscanslow the market and reduceexposure.

For example, if youwerebearishwheatanddecided tosell calls above the market,you might choose to sell a7.00 call and collect apremium of $600. A nakedsellerwouldholdhispositionthere.However,ifyouwereamoreconservativetrader,you

maychoosetoturnthisintoacreditspread.Youwouldtake$200 of the premium youcollectedfromthesaleof the7.00callandbuya7.40call.This effectively turns thetrade into a bear call creditspreadinstead.

Inotherwords,bybuyingthe 7.40 call, you arepurchasing built-inprotection.Yournetcollectedpremium(or“credit”),isnow

only$400($600–$200)andyou have paid an extracommission. However, younowhave limited risk on thetrade.

If both calls expireworthless, you keep thepremiumyoucollectedminuswhat you paid for theprotection. If you arewrong,and the market and pricesmove higher, the long-callgains value almost as fast as

your short call, at leastpartially offsetting losses onyour short call. In addition,this can keep you in a trademuch longer without beingsqueezedout.

Protecting your shortoptions in this way also hasthe added benefit of carryinglowermarginrequirements.

Creditspreadsarenottheperfect strategy for everyoccasion and will tend to

produce profits at a slowerpace than selling nakedpremium. However, weconsideritanexcellent,albeitslightly sophisticated, risk-managementstrategy.Agoodoption broker or portfoliomanager can help you tomake the right choice inselecting your “coverage” sothatprofitscanbemaximized(seeTable12.1).

TABLE12.1BuyingOptionsto“Cover”ShortOptions

Risk-Management

Technique2:SetanExitPointBasedontheValueoftheOptionItself

Thisisthesimplestandoftenbestwaytomanageriskonanakedoptionorevenaspreadtrade. To limit your risk,simplyplaceanexitpointonthe value of the option (orspread)itself.Itinvolveslittle

calculation, is easy toimplement, and has the leastnumberofvariablesas farasknowing what youranticipated loss would be. Ifyou sell an option for 50points,youexitthepositioniftheoptionreaches100points(or90or120—whateveryourrisk—toleranceis).

In our experience, we’vefoundagoodplacetosetthis“stop loss” in many

circumstancesisatdoublethepremiumreceived.Note:THISISNOTAHARD-AND-FASTRULE.It is a guideline for you. Ifyou sold an option for $400,exit theposition if theoptionvalue reaches $800. Thisamount seems to give themarket plenty of room tomovewhile at the same timeholding losses to amanageablelevelifthingsdonotgoasplanned.

We will refer to this as

the 200% rule, but onlybecause it sounds better thanthe 200% guideline. It goeslike this. If the optionincreasesinvalueto200%ofthe value forwhich you soldit, you exit the position.However, this level isnotsetin stone and can be adjusteddepending on the individualmarketaslongasthisisdonebefore the trade is entered.Wedorecommend the200%ruletobeginnersnotonlyfor

its simplicity but also for itsoveralleffectiveness.

JustSayNOtoStop-LossOrdersMany traders assume thismeans placing a stop-lossorder like theywould if theyhada futuresorevena stockposition. We do notrecommend actually placinga stop-loss order for youroption.

The reason is this: Let’ssaythatyouplaceastop-lossordertobuyyouroptionbackat100points.Thismeansthatif your option is bought orsold for 100 points at anytime,yourticketistobefilledat thenext availableprice.Asingle fill for that option atthatpriceisenoughtotriggeryourstop.Ifsomebodyplacesamarketorder,itcouldeasilyfill at your stop price,triggering your stop, even

thoughitmaybeabit“outofline” with the rest of themarket.(Surely,afloortraderwould never do thisdeliberately!)Yourstoporderthenbecomesamarketorder,and inoptions,marketorderscan suffer tremendousslippage.

This can be especiallytrue if you are not trading inthe most liquid optionmarkets. You end up with a

terrible fill, and somebodyends up selling your optionsback to you and getting aheckofadeal(surelynotthefloortraderwhowouldnevertriggeryourstop).

If a trader sold an optionfor 50 points and enters astop-loss order at 100points,there is nothing morefrustrating than seeing theoptiontradeat75to80pointsall day and then jump

suddenly up to 100 points,see the options fill at 105,onlytosettlebackto75to80points for the day. For thisreason, some traders like toadd the variation that theoption value actually mustsettle above the stop point atday’s end before they willenter their exit order (for thefollowingday’sopen).Whilewe think that this can be agood technique, it doesexpose the trader to

potentiallylargerlossesiftheunderlying ismoving rapidlyagainstthetrader’sposition.

TheAlternativetoStop-LossOrdersinOptionSellingAlthoughitcanopenthedoorto second-guessing yourself,we advise using only self-ordered stops inimplementing this techniquefor the reasons stated above.While,inusingself-regulated

stops, it can be tempting to“hold”yourorderevenastheoption value exceeds yourrisk parameter, doing so isnot advised. Plan the trade.Trade the plan. In the longterm, it will save you muchfinancialpain.

Byself-orderedstops,wemeanactuallywritingitdownor entering an alarmon yourcomputer. Attaching anoutside stimuli to itmakes it

more real, and thus, morelikelytobeobeyed.

Our systems have “self-stops”programmedright intoour software systems. Thereare self-stops set on both theoption values and on theunderlying futures contracts.But no order goes to theexchange until we manuallyplacethem.

There is, of course, noguarantee that you will be

filled at your desired exitpoint,evenwhenusingastoporder. However, if you aretrading far-out-of-the-moneyoptions,youshouldbeabletocloseoutthepositionwithinafew points of your desiredexit level in most marketconditions. A good brokercan be very effective inhelping you to exit at therighttime.

TheMentalPainofStopping

YourselfOutThe drawback to thistechnique, of course, is thatsome or even many of theoptions that you exiteventually will expireworthless. This can cause adegree of “mental pain” tosome traders and create a lotof“shouldhaves”and“couldhaves.” But that’s a sucker’sgame. Don’t second-guessyour decision to take

manageablelosses.Granted, we have seen

many well-capitalizedinvestors choose to “ride itout,” especially if the optionis still far out of the moneywhen the premium hits theirrisk parameter. However, wealso have seen accountperformancehurtby riding itoutfortoolong.

Look at it this way: Ouroffices are on the western

coast of Florida. In Florida,wehaveourshareof tropicalstorms and hurricanes.Everysummer and early fall wehave to keep one eye on theweather forecasts to see ifthere are any “areas ofactivity” in the Gulf ofMexico, Caribbean Sea, andAtlanticOcean.Almosteverysummer therewillbeat leasta few storms that threaten tocomeourway.Thenewscastswill issue warnings of the

storm.HavingTampaBay inour backyards, we tend tolisten to these newscasts.Often if a storm isapproaching, the county willissue a voluntary ormandatory evacuation order.Many people do not like toevacuate(becauseofthetime,trouble,andmoneyinvolved)and commit themselves to“riding itout.”Mostof thesepeople have been veryfortunate over the years

because our area has notexperiencedamajorstormina long time. However, whatwillhappentothesepeopleifand when the big stormfinally does come?They andtheir families couldexperience severe trauma,injury,orworse.

Ifyouaretroubledbythefactthatyouexitedanoptionand it eventually expiredworthless, you should

consider the precedingexample.Youevacuated,andthestormmissedyourhouse.It cost you a small expense.Thismayhappenmanytimesto you. When the big stormcomes someday, however,youwillbe longgonebeforeitarrives(seeTable12.2).

TABLE12.2Premium-BasedExitStrategy

Risk-Management

Technique3:RollingOptions

The concept of rollingoptions is not necessarily arisk-control technique in andof itself. It is more of anexpansion on Technique 2.Rollingoptionscanbedoneifthetraderhasstoppedoutofashort option sale usingTechnique2yetstillfeelsthatthe fundamentals favor the

position and wants to be inthe trade. In thiscircumstance, the traderclosesouttheshortoptionsatdoublepremium(orwhateverher risk parameter was) and“rolls up” to a higher strikeprice (or down to a lowerstrike price if she sold puts).In other words, the tradercloses the original position(short calls) and sells morecallsatahigherstrikeprice.

This accomplishes threethings. First, it removes thetrader fromoptions thathaveeither increased in deltaand/orhavebecomeclosertothemoneyandputsherbackin options that are far out ofthe money with lower deltasand have a much lowerchance of going in themoney. Second, it allows thetradertostayinamarketthatshe feels eventually will beprofitable. Third, from a

psychological standpoint, itallows the trader to avoid orat least reduce a loss in thatparticular market, eventhoughinrealityitisactuallyanentirelyseparatetrade.

The concept of rollingoptions can be illustrated inthefollowingexample.

Example:TraderJohnRollsHisOptionIn January, Trader John is

long-term bearish on thecoffeemarket.AlthoughJohnisnotquitesurepriceswillgodown right away, he feelsrelatively confident thatcoffee will not be trading atsubstantially higher priceslaterintheyear.Johndecidesto sell five July coffee 2.00calls for 200 points ($750)each(seeFigure12.1).

FIGURE12.1JulyCoffeeChartShowing$2.00Calls

JohnsellsJulycoffee2.00calls.

Over the course of thenext 30 days, July coffeerallies more than 35¢ perpound because of supplyproblems out of Vietnam(perhaps John should havebeen paying closer attentionto the fundamentals at workin the coffee market).Althoughthisisafairlylargemoveforfuturestraders, it isofsomewhatlesssignificanceto John because at its highs,

Julycoffeewastradingatjustover 1.70 per pound, a full30¢ below his strike (seeFigure12.2).

FIGURE12.2July2008CoffeeChartShowingThirty-FiveCentRallyThirty-fivecentsisafairlylargemoveforfuturestradersbutnotassignificanttoJohn.

Nonetheless, John’soptions increase in valuefrom200pointsto400pointsduring the course of themove. John had decided onrisking the trade to doublepremium and therefore exitshis position at 400 points—a$3,750 loss (5 calls × $750loss on each call) plustransactioncosts.

John, however, isconvinced that the

fundamentals do not supportcoffee prices over $2.00. Hesees that the Julycoffee2.60callsarenow trading for200pointseach,withmuchlowerdeltas than the 2.00 calls.Johnsells11ofthe260callsfor200pointseach.

Why does John sell 11calls?He sells five to collectthe original premium heintendedtokeepasprofit.Hesellsfivemoretorecover the

loss he accrued in his 2.00calls. And he sells oneadditionaloptiontocoverthetransaction costs for rollingtheposition.

Therefore, if July coffeestays below 2.60without thecalls reaching John’s riskparameter,Johnwillerasehisloss and make his originallyintended profit on the $2.00calls.InJohn’smind,theloss“neverhappened”(seeFigure

12.3).

FIGURE12.3July2008CoffeeChartShowingJohn“Roll”HisOptionsJohn“rollsout”of2.00callsandinto2.60calls.

WhenRollingOptionsIsNottheBestChoiceIn this example, John indeedwould have been successful.However, rolling options isnotnecessarilybestforeverytrade in which you stopyourself out. If amarket hasmoved against your positionto thepointatwhichyouareforced out, there must be areason for it. It is best to

know what it is beforedeciding to reposition in thesamemarket.Inaddition,thisisatimewhereyoushouldbereexamining the originalfundamentalsthatcausedyouto enter the trade initially.Does the long-term (two- tofive-month) picture remainunchanged? If it remains thesame and you still like themarket and the position, thismay be a candidate forrolling.

A good question to askyourselfisthis:IfIhadneverbeen in thepositionandnowwere looking at this marketanew, is this a trade Iwouldenter, or do I see betteropportunities elsewhere? Donot make the mistake ofsimplyrollinginorderto“nottake a loss” or for “revenge”on themarket that took yourmoney. Johnmightmake hismoney back in soybeans,silver, or crude oil. He

reentered the coffee tradebecausehethoughtitwasthebestopportunityformakingaprofit.Thisistheonlyreasonyoushoulddosoaswell.

RisksofRollingThemajor risk of rolling, ofcourse,isthatthemarketcancontinue to move againstyour new positions,potentially magnifying yourlossestoapainfuldegree.For

this reason, rolling optionscan be considered a moreaggressive strategy for sometraders.

Thereisnorule,however,that states that the positionmust be doubled up. If youaresimplyconsideringsellingthe higher-priced strikes as acompletely new trade, anynumber of options can besold.

Rolling as illustrated in

John’s case generally is forthe highly capitalized traderwho is not intimidated bylosses. These traders, ofcourse,tendtoperformbetterover time than less-capitalized ones. However,they are willing to assumelarger short-term drawdownsaswell.

In theory, if a trader hasenough money, and if themarket continues to move

against him, he simply cancontinue to roll his positionsinto higher strikes, doublingdown each time. It is anoption play on the futurestrading technique of scaletrading.

Eventually, the market isgoing to reach a pointwhereit stops moving against thetrader, and the last set ofoptions that he sold willexpire worthless, giving him

allhismoneyback.However,this strategy can requirehoards of capital and canresult in substantial losses ifyou runoutofmoneybeforethe options expire. You winthroughawarofattrition.Forthis reason, it is notrecommended for mostindividualinvestors.

For most investors, oneroll will be enough. If youroll your positions and stop

outagain,youprobablyhavemisread the marketsomewhere and are bestmovingontoadifferenttrade(Table12.3).

TABLE12.3RollingOptions

Risk-Management

Technique4:BasingRiskonValueofUnderlying

The alternative approach tosetting exit points based onthe value of the option is toset exit points on the actualprice of the underlyingfutures contract. This isconsidered to be a moreaggressive approach to riskmanagement by some. It can

mean withstanding largeincreasesinthevalueofyouroption and/or marginrequirements over the shortterm. It also can be slightlymore difficult to gauge whatyour probable losses wouldbe.

Exiting the position withlittle time left on the optionsmay only result in nominallosses or none at all. Exitingthe position with much time

leftontheoptioncouldmeana larger loss. However, thistechnique can also increasethechancesthatyourpositionultimatelywillbeprofitable.

Let’s first examine whyan investor would want toconsider sucha strategy.Thefigure of 75% to 80% of alloptions expiring worthlesswould not take into accountoptionsthatyousoldandthenhad them double in value, at

whichpointyouexited them.Asdiscussedearlier,manyofthese would still expireworthless and thereforewould have to be consideredpart of the large percentagejust listed, yet for you theywould have been losingtrades.

Traders who can’t standthe thought of exiting anoption that they still feeleventually will expire may

wanttoconsiderthismethod.However, if this method isused regularly, chances arethat eventually one couldexperience a more sizableloss.Nonetheless, it canbeaveryeffectivemethodof riskcontrol,especiallyifitisusedonly in certain marketsituations, such as optionswith little time valueremaining.

TwoWaystoUsethe

UnderlyingMarketMethodThere are two ways one canemploy such a strategy. Oneis to hold the position unlessa certain technical conditionis violated (e.g., support,resistance broken, trend-lineviolated,etc.).

A second way toimplement this method is torisktheoptionuntilitgoesinthemoney.Inotherwords, ifyou sell a call or a put at a

particularstrike,riskthetradeuntil the futures reach thatprice. Thisworks betterwithoptions sold closer to themoney. It can be used withoptions sold at distant strikeprices and eventually shouldproduce profits most of thetime. However, in the eventthat the strike would beattained, losses could besubstantial. Yet, with strikessold relatively close to themoney,itcanbeanexcellent

method of risk control.Technicaltradersoftenpreferthis method because optionscanbesoldjustbeyondpointsofkeysupportorresistance.

The following exampleillustratesthisconcept.

Example:TraderJohnSellsT-BondPutOptionIn July, Trader John is long-termfundamentallybullishonT-bonds.Whenhesensesthat

there may be an uptrenddeveloping,he takes it ashiscue to position in the trade.However, John is afraid oftrading the T-bond futuresbecause short-term moveseasily could stop him out ofhisposition.Instead,heelectsto sell theDecember111putbecause he believes thatprices will at least remainabove that level throughexpirationinNovember.

John knows that a quickcorrectioninthemarketcouldoccur at any time that easilycould cause his option todouble or more in valuewithout actually reaching the111 price level. Therefore,Johndecidesthathewillstayin his options unless the 111price level is violated. Heaccepts the fact that hisoptions could increasesubstantially in value duringthe course of the trade. He

has backup capital availableshould this occur (see Figure12.4).

FIGURE12.4December2008T-BondPriceChartShowingRiskto111JohnsellsDecember110T-bondputsandrisksapricemoveto111.

JohnentersthetradewithDecemberT-bonds tradingatnear115.T-bondsexperienceseveral small dips lower andbackhigheroverthenextfewweeks, any of which mayhave stopped him out of afutures position. In late July,T-bonds experience a severedownturn, causing John’soptions to gain significantlyin value. However, the priceof T-bonds has not yet

reached his strike price.Instead of closing or rolling,John sticks it out, as per hisoriginal risk plan. He hasconfidenceinhisfundamentalconvictionandisnotgoingtobe swayed by short-termmarketswings.

Eventually, prices begintoascendagainandgoon toprove John right. The optionvalues come back to wherethey were, then begin to

decay, and ultimately expireworthless.

Traders with closingpositions at 200% ofpremium were losers. Johnwasawinner.

TheFlipSideWhat if, however, John hadbeen wrong? What if priceshad continued to fall all theway down to 111? Johnwould then have bought his

options back at whateverpricethemarketdemandedatthattime.Whileitisdifficultto determine what the valueof John’s options may be inthis situation withoutincluding several pages ofhypothetical forecastingmodels, John most likelywould have experienced aloss greater than the traderwho exited at the 200%premium level—more if themarket moved quickly and

reached his strikewithmuchtime left until expiration andless if it moved slowly andreachedthestrikewithonlyalittletimeremaining.

DownsideofUsingUnderlyingasYourRiskTriggerThis strategy, although veryeffective in many situations,carries a higher degree ofrisk. Experience with

fundamental analysis of aparticular market is reallywhat determines if this is anappropriateapproachforyou.Itisnotrecommendedforthebeginner(Table12.4).

TABLE12.4BasingRiskonValueofUnderlyingContract

Risk-Management

Technique5:TheBuyback—TakeProfitsEarly

Although this techniquemaynotmakeyoualotofmoney,it certainly might save youplenty. In this book, we talkoften about options expiringworthless at expiration. Intruth, in a successful trade,you will not need to hold itthat long. At least, you may

not want to. Options can bebought back at any time forthe going market price. Inmost cases, if the option hasdecayed substantially invalue, we recommend doingexactly that. As you knowfrom past chapters, as anoption moves ever closer toexpiration, as long as itremains out of the money,time decay will continue toerodethevalueoftheoption.Often, especially if a market

has moved favorably, whatwill happen is the optionvalue will decay down to anominal value even with 30to 60 or 90 days remaininguntil expiration. In this case,itcanbenefittheoptionsellerto buy back the option,thereby closing the trade andtakingtheprofitoffthetable.

Example:JerryTakesProfitonGasCall

Forinstance,let’sassumethatinJune,aninvestorJerrysoldthe November natural gas$30.00 call for $400 each.This strike was more than100% out of the money asNovember natural gas wasonly trading near $14.00 atthe time.The strikehadverylittle chance of going in themoney even if the uptrendcontinued. But notice howquickly the value of theoption decreased as the

market began to fall. (SeeFigure12.5.)

FIGURE12.5November2008NaturalGasFutures*

By mid-July, the listedprice of the option haddeclinedall thewaydown to$10 cash value—nearlyworthless.Yetthereremainednearly 90 days left untilexpiration on this option.Would this be a goodbuybackcandidate?

Absolutelyitwould.If this were your trade,

you could buy the optionbackfora$390profit($400–

$10 = $390). By doing this,you accomplish three thingsby harnessing the benefits oftheearlybuyback:

1.Youtakeover97%ofyourpotentialprofitfromthetradeandeliminateyourexposureintheposition.Atthispointthereislittletogainfromthisposition($10)andeverythingtolose.

Chancesareoverwhelmingthatthisoptionwillexpireworthless,butwhytaketheriskfor90moredaysifthereisnothingtogain?

2.Youfreeupvaluablemargin.Chancesarethispositiondoesnothavemuchofamarginrequirementatthispoint,butitisprobably

stillpullingafewhundreddollars.Byfreeingthismarginandeliminatingtheriskexposure,youcanredeployfundsinothermarkets,orsellmorenaturalgascallsasyounowhavenoadditionalexposurethere.

3.Youbookawinningtrade.Bytakingprofitsearly,youtakethe

tradeoffthebooks.Itisonelesstradeyouhavetomonitor,onelesslineyouhavetolookateachweek.Youfreeyourmindandcapitaltopursueotheropportunities.

For themost part,we dorecommend early buybackswhentheyareviable.Optionsdecay at different speedsdepending on the movement

in the underlying and timeuntil expiration. Some maybeboughtback threemonthsearly, some may be boughtback two weeks early, someyou may have to holdthroughexpiration.

In investor portfolios thatwe manage, buybacks aretypicallyconsideredwhentheoption premium has decayeddown to10%orbelowof itsoriginal sale price. If you

have made 90% or more ofthe potential profit on thetrade, you may want toconsider booking it. We callthisthe“10%rule.”

FIGURE12.6DailyOptionValueofNovemberNaturalGas30.00CallThisoptionpricechartshowsthedailyvalueoftheNovembernaturalgas30.00call.Noticethatasnaturalgaspriceswerepeaking(see

Figure12.5),theoptionvaluewasalreadybeginningtodecline,indicatingachangeintrend.Asthefuturespricebegantofall,theoptionpricedeclinedrapidlyand,bymid-July,wasnearlyworthless.(OptionValueChartcourtesyofIvolatility.com)

AdditionalPointsonRiskControl

TimeYourEntrytoHelpManageYourRisk

If you are comfortable withthe market and the strikeprice, using some traditional

technical indicators to helpyou timeyour entry (such asstochastics or simplemovingaverages)canbebeneficial.Ifyour research is good,chancesarethatyou’lldojustfine. Remember, this isoption selling. You have agreat deal of room to bewrong!However,agoodrisk-management plan will be inplace to take care of thosetimes when you are toowrong.

Although the technicalups and downs of a dailychart should not greatlyconcern a longer-term optiontrader, continue to watchlonger-term weekly andmonthly charts for possibletrend changes and/orbreakouts.Ifthesecorrespondwith your fundamentalanalysis, you could have agreatopportunity tosellcallsorputsformanymonths.Ifitis in contrast to your

fundamental analysis, youmaywant to reconsider yourposition or adjust your riskparameter.

ContinuetoMonitorFundamentalsDuringYourTrade

Not wanting to beat a deadhorse,butonceagain,thisallcomes back to fundamental

knowledge of the markets inwhich you trade. Know thefactorsorscenariosthatcouldoccur to produce a pricemove to your strike(regardless of what riskmethod you are using).Analyzethechancesofanyofthesethingstakingplace.Youcan never account foreverything, but you canaccount forwhat is currentlyknown.

You should continue totrack long-term fundamentaldevelopmentsoverthecourseof your trade. Fundamentalsare slow moving and do nothave to be monitored everyday, or even every week.However, just because thesefundamentals tend to changeslowly does not mean thatthey do not change. Mostnews items are notfundamental changes; theyare simply what they are,

news items. However, keepan eye out for new themesstarting to develop in yourmarket.

Talk of a new type ofbeetleeatingtheleavesofthecrop in which you areinvested may be just a newsitem. Continued talk of itover the course of severalweeks, along with talk of“crop damage” or potential“yieldadjustments,”couldbe

anothermatter.Majormacro-economic changes can alsoappear at different times andcreateeitherwarningflagsoropportunitiesforastuteoptionsellers. If there is afundamental change in themarket in which you arepositioned,anditseemstobeaffecting price, it can be agood idea togetout firstandask questions later. Justremember that generally ittakesamajordevelopmentto

change the long-termfundamentals of acommodity, and most newsstories that you hear or readabout themarket are, at leastas far as you are concerned,“noise.”

Experience is probablythe only way to learn thedifference.

Conclusion

In this chapter, you havelearned both beginner andadvanced techniques formanaging your short optionrisk. However, I wouldrecommend that unless youare a highly experiencedseller of premium, you stickwith simple buybacks basedon premium as your primarymeansofmanaging risk (i.e.,200% rule for risk and 10%rule for profit taking). Youcan’tgotoofaroffthetracks

ifyoustickwiththesetwo.If we could stress one

point about risk control inoption selling, however, itwould be this: Your risk-control strategy begins whenyouarelookingforoptionstosell. Your objective is not topickwinners.Your objectiveis to stay out of losers. Dothis, and your winners andyour profitswill take care ofthemselves.

Remember,DefensewinsChampionships. Your SuperBowl ring should be your1099inJanuary.

PART III

MARKETANALYSISANDOPTIONSELLING

13

FundamentalsTheDirtyLittleSecretAbouthowMoneyReallyGetsMadeinCommodities

In this age of computersoftware, “high-frequency

trading,” smartphones, andsmart tablets, you have aplethora of choices when itcomes to computer geniuseswho can “teach you how totrade.”

Thissoftwaredoes10,000volatility calculations andtellsyoutheexactbestoptionto trade. This one analyzes20,000 different chartpatterns and tells you whichmarkettobuy.Thiscourseor

seminar will give you 150different chart patterns towatchfor.Allyouhavetodois whip out your credit cardand instant riches are yoursforthetaking.

We didn’t know it wasthateasy.

We’regoingtosharewithyou a “dirty little secret”aboutcommodities.All thoselittle patterns and indicatorsand volatility studiesmay be

interestingtowatchandevenhave some merit in someinstances. However, if youreally want to know how amarket will behave (or notbehave), you have to bewillingtodowhattheseguysare not willing to do. Youhave to get in there and getyourhandsdirty.Youhavetolearn the fundamentals ofwhat is really moving yourmarket.

In commodities, it’s allabout supply and demand.Ditch the book on Fibinaccinumbers and pick up a bookonEconomics101.

If there is an uptrend inthe corn market, it’s not thelittleimaginarytrendlinethatis making it go up. It’sbecauseChinaislowoncornthis quarter and needs moreof it tofeedall thenewhogsandchickenstheyareraising.

It’s that simple. Not easy,mind you, for there is plentyof“noise”ingettingaproperread on a market. But at itscore, simple. Ifyou learn thethings that really matter,you’ll be better able to stayabove the noise and see thebigpicture.

Knowing the big picturegives you a much clearerperspective on what pricesare likely to do, or not do,

over the longer term. Foroptionsellers,thisisacrucialdetermination.

Learning a few thingsaboutsupplyanddemandinahandful of core commoditiescan give you a tremendousadvantage in these markets.Using these in conjunctionwith the strategy of optionselling is a powerfulcombination of which mosttraders, let alone individual

investors,areunaware.This is because, in

commodities, markets cangyrate back and forth for anumber of reasons over theshort term. But over theintermediate to longer term,they will always obey theirmaster, supply and demand.And this is the time framethat you are most concernedaboutasanoptionseller.

RecommendedReading

Jim Rogers, author ofHotCommodities and one ofthe most well-knowncommodities tradersofourgeneration, made a namefor himself by correctlycalling the commoditiesbull market of the last

decade. He appears onCNBC regularly, althoughI have never been in thestudio the same timeashehas. I finally had thepleasure ofmeeting Jim ataSouthFloridaconferenceafewyearsback.

His book is a “musthave” for anyone who hasnever invested incommodities and I highlyrecommend it. Although

someoftheexamplesareabit dated (itwas publishedin 2004), it is an easy-to-read primer for newcommoditiesinvestors.Jimis all about thefundamentals, and if youreadhisbook,youwillseewhy.

Knowing how to applyfundamental knowledge tooptionsellingcangiveyoua

tremendous advantage overmost people who are tradingcommodities,letalonesellingoptions.

TheGreatDebate

The debate betweenfundamental and technicalanalysts has raged fordecades. For novice readers,itmaybeimportanttoclarifythe difference before

proceeding any further.Fundamentals, by definition,consist of the economicfactors behind a commodityor financial instrument, suchassupplyanddemandandthefactors that affect, or couldaffect, supply and demand.For example, thefundamentalsofcottonwouldincludethesizeof lastyear’scrop, the amount of cottonleft from that harvest that isstill available for export or

domestic use, the pace ofexportsthisyear,theprogressof the upcoming crop, andprojected weather that couldaffect its growth. These areallfundamentals.

Technicalanalysis,ontheother hand, is the study ofcharts, chart formations, andan array of technicalindicators that affectvolume,pricemomentum, strength ofbuying or selling, and so on.

Because technical trading isboth quantifiable and easierto teach (e.g., buy whenpriceshitthisline),itattractsboththemathematicalandthestatistical crowds along withnovicetraders.

Pure technicians believethat all the currentfundamentals are alwayspriced into a futures contractat any given time andtherefore there is no use in

studying the fundamentals—it’sallinthepricepatterns.

This may be true to acertainextent.All thecurrentfundamentals probably arealready figured into price.What the pure techniciansoverlook is that studyingfundamentals is not done todetermine how they areaffecting price today, butrather it is done to projecthow these factors will affect

priceinthefuture.

WhyFavorFundamentals?

Our opinion is that bothshould play a role in tradingdecisions. However, forselling options incommodities, fundamentalsshould be given the lion’sshareofyourattention.

Why, after 46 combined(betweenthetwoofus)yearsof trading commodities, ofanalyzing trend lines, ofmeasuring stochastics againsttheMACDline,oflookingathead and shoulder tops andbottoms—why in the worldwouldwesaythis?

Fortworeasons.

1.Mostsmalltradersincommoditiesaretradingtechnically—

atleastprimarilytechnically.Theyhavelikelyneverlearnedhowtotrackorproperlyusethefundamentalsofthecommoditytheyaretrading.Thisisbecausetheythinktheyaretoodifficult,unimportant,orboth.

“Everybodyknows”howtotrade

technically.The23-year-oldkidwho’sstraightoutofcollegeandisgoingtomakehisfortunetradingcommodities(okay,thatwasmeatonetime,butthat’sbesidethepoint)knowshowtotradetechnically.How?Becauseeverytradingbookintheworldtaughthimthesamelessons.He

knowshowtodrawthetrendline.Heknowswhataheadandshoulderstoplookslike.Heknowswhatabreakoutonstrongvolumesupposedlymeans.Theproblemis,sodoeseverybodyelse.Withtheadventofmoderntradingsoftware,eventhepeoplewhodon’tknowabouttechnical

indicatorsareusingthem.Maybethatiswhytechnicaltradingisnotnearlyaseffectiveasitusedtobe.

Everybodyiswatchingthesameindicators,thesamepatterns,thesamesquigglylines.Howmanypeoplearegettingburnedtimeaftertimeonfalse

breakouts,fakereversals,andsoon?Howmanytimeshasithappenedtoyou?Small-timetraderscanplaythesegamesalltheywant.Incommodities,supplyanddemandareking.

2.Unlikestocks,commoditieshaveanactualenduser.Thus,commercialplayers

makeupabigpartofthevolumeincommoditiescontracts.Producersandendusersareconstantlyusingthefuturesmarketstohedgeagainstpriceswingsupordown.Thisis,infact,whythecommoditiesfuturesmarketswerecreated.Believeme,theguygrowingthewheathas

aprettygoodideaofwhathiscropisgoingtolooklikethisyear.AndtheguyatPillsburyhasaprettygoodideaofhowmuchwheatheisgoingtoneedthisyeartomakehisovenpopbiscuits.

Theseguystradeonsupply-and-demandfundamentals.Ifyouknowwhatthese

fundamentalsare,yougiveyourselfabigadvantageoverallofthe“techies”outthere.

TechieJoeandtheCornMarket

For example, let’s supposeyou are “Techie Joe” futurestrader. One day, your littlesoftwareprogramtellsyouto

sell short corn becausedoohickey line one crosseddoohickey line 2 for threedays. So, being thedisciplined technician thatyouare,yousellit.

The problem is, back inIndiana, the KelloggCompanydoesn’tlikethedryconditions in the cornfieldthisyearanddecidesit’stimetohedgeagainstapricespikelater intheyear.They’vegot

a lot of cornflakes to makeand don’t want to be payingtoohighapricefortheircornsupplies. So they buy 100tons of corn in the futuresmarket.Andtheybuyiteveryday for 10 days. And pricegoesupfor10days.Andyouget routed out of your cornposition and lose a bunch ofmoney. And the best part?Kellogg doesn’t give a rat’s@** about your littledoohickeylines.

Butifyouknewaboutthedry conditions in thecornfield, you probablywouldn’t have either. That’showthemarketreallyworks.

TheBestWaytoUseFundamentals

Fundamentalsshouldbeyourguide in deciding whichmarkets to trade.

Fundamentals will help youto determine the marketswhere conditions areappropriateforsellingout-of-the-moneystrikesononeside(or both) of the market.Remember that your goal isnottodeterminewhatpriceisgoing to do. That is whateverybodyelseisdoinganditis very difficult—even forprofessionals.Let themmakethatmistake—andpayforit.

Your job is only todeterminewhat is least likelyto happen. This is how youturn fundamental knowledgeintocash.

Technicals:ATimeandPlaceforEverything

If you are a technician andare offended by what I just

said, you can pull in yourguns. I did not say technicalindicators were useless. Isimply said in commodities,fundamentals shoulddetermine which markets totrade. Technical indicatorscanhelpyouwiththewhen.

TheProblemwithTechnicalIndicators

The problem with technicalindicators is that they rarelylookclearwhenyouareusingthem in a real trade.Technical analysis booksalways make it look verysimpleandeasybecausetheyuse examples in which theindicatorworkedverywell.

The truth is, in manycases, the technical buy-and-sell signals will not be veryclear, at least not until well

after the move has alreadytaken place. This is yetanother reason whyincorporating fundamentalsinto your thinking is soimportant.

I still give technicalssome weight in our tradingdecisions.However,asanoldtechnician turnedfundamentalist once toldme,“Technicals work … untiltheydon’t.”

I have learned, throughexperience, to use technicalsas more of a timing oroptimization tool. They areemployed after fundamentalshave dictated in whichmarketsweshouldbetradingand what is least likely tohappen there. As timing isless important in sellingoptions, technical toolssimply aren’t as crucial asgetting the overall marketviewright.Rememberthat in

option selling, even if youmiss-time your entry or areeven outright wrong onmarket direction, in manycases you can still end upmakingmoneyonthetrade.

One of our basicconvictions in this book isthat an option writer shouldselectthemarketinwhichshewould prefer to sell puts orcalls based on a fundamentalscenario that she feels will

make the market biasedtoward moving higher ormoving lower over theintermediate to long term.The trader can then look forfavorable technical setups asopportunities in which toenter positions in thesemarkets.

FundamentalsVersusTechnicals:

HowIWasConverted

BYJAMESCORDIER

My “rookie year” as acommodities broker was1984. That was over threedecades ago. But somestories from my first fewyears in the business stickin my memory as though

they happened yesterday.Thisisoneofthem.

As thenewguyon theblock, one of the mostcommonly askedquestionsthat I received frompotential clients was “Areyou a technical or afundamentaltrader?”

Myanswerwasalwaysthe same, “Technical, ofcourse.”

Atanygivenmoment,I

could pick up the phoneandbeaskedmyopinionofcocoa prices, pork bellies,or even Treasury bondsand have the answershortly after punching upthechart.

“Well,Mr.Duke,Icantell you right now that Iwould cover any shortpositions you might beholding incocoa. IshowaRelative Strength Index

reading of only 12, and itlooks like the slowstochastic could cross atanytime.”

“Interesting,” says Mr.Duke, “What about porkbellies? How do you seebaconpricesfaring?”

“As for bellies, stick afork in um, they’re done!That’s a head andshoulderstopforsure.”

“And Mr. Cordier,

what about interest ratesand the Federal Reserve?Whatdoyouseethere?”

“Well, Mr. Duke, thatone is a little tougher.” Iwould coolly reply, “ButlookingattheJunebonds,Ican’tremembereverseeinga market this oversold. Ithink I’ll give bonds astrong buy. Besides, Mr.Volkerwouldnotputusinarecession.Wouldhe?”

It was at the firstcommodity seminar I hadever attended that thetechnical seed was sown.The home office inChicagohaddecidedthatitwould send the brass tohelpgiveourbranchoffice90 miles to the north ajump-start. The office hadjust opened and consistedof the owner, twomanagers,andfourhungrykids who had just passed

their Series 3 (commoditybrokerlicense)exams.Thiswould be my first formaltraininginabusinessIhadbeen dreaming about formanyyears.

One nice suit afteranother would approachthe podium and, using thelatest technology inoverheadprojecting,wouldpoint out the highs andlowsofvariouspricecharts

where a savvy investorcould have made a smallkilling.

After listening to oneanalystexplainhoweasyitwas to go long on thebuysignals and take profits onthesellsignals,itwastimetohearabout formations—bull flags and bear flags,double tops and doublebottoms. Everyone there,including me, thought,

“Okay, these could be thesecrets to our futuresuccess!”

Turningtoafreshpage,I drew the chart that wasillustrated on the fuzzyscreenabove.

“Here is an exampleshowing a sharp rise inprice that is followedby aperiod of consolidation,otherwise known as a bullflag,” the speaker

continued. “The sharp riseinpriceisthepole,andtheconsolidation is the flag.Later, a break above theconsolidation will projectan equal increase in priceasthepoleitself.”

“Wow,thatseemseasyenough,”Ithought.

The next morning Iwent into the office armedwith what could be thetoolsIneededtobecomea

successfulbroker.ThefirstthingwastobacktestwhatI had learned the previousnight. Sure enough, afterlookingatjusttwoorthreecharts, I found that therewere pennants and flagsand heads and shoulderseverywhere! Shortlythereafter, out came thestraight-edge ruler, andlines were drawn aboveand below support andresistance levels. Sprinkle

inafewkeyindicators,andvoilà!

“I will be technicaltrader,thankyou.”

A few weeks later Iwas spending all of mytime studying the currentissues of CommodityPerspectivemorning,noon,and night. For severalhours each day I carefullypaged through onecommodity at a time,

lookingateachchartlikeasurgeon examining apatientuntilIfinallyfoundit. There it was right infront of me—Decemberwheat,bullflag!

This chart had a flagformation so clear, sodiscernible, so absolutelyperfect, that theonly thingit was missing were thestars and stripesthemselves. That weekend

I started saying to myself,“Blue Horseshoe lovesDecemberwheat.”

Monday morning washere, and it was time tostart onmy road to riches.The grain markets werecalled to open steady, so Iexpected that I should beabletoenterthetradeIhadstudiedallweekendlongatthe price I had hoped for.The flag formation

consisted of a “pole” thatmeasured11¢,followedbyfourdaysof consolidation.Buyhere, andwait for thebreakout to the upside,which should net us aboutadime($500percontract).Itwasjustlikeitsaidinmylessons. Now it was gotime!

The opening bell rangat 9:30, and wheat startedtrading at $2.44, up ½¢

from Friday’s close. Iplaced the order using alarge red telephone thathad no buttons, only areceiver. About tenminuteslater,thefloorwascalling back with the fill,$2.44½, up 1¢ on the day.Afteracoupleofhourshadpassed, trading slowedconsiderably, this afterwhat seemed like quite anactive open. Corn andsoybeans were both

sporting modest gains,whereas wheat pricesgenerally were steady to ashadehigher.Astheendofthe trading day was fastapproaching, grain pricesstarted moving higher.With each new high, thesoundof theclackerboardseemed to get louder. Attheclose,Decemberwheatsettledat$2.46½,up3¢onthe day and 2¢ above myentry price. What a great

business!After the dust had

settled, I pulled out mycharts and a pen to add a3¢ bar to the Decemberwheat.Thebreakout to theupsidehad started, andweshould look forward to apayday in the next coupleofsessions.“Thistechnicaltrading really does work!”Ithought.

As Iwas getting ready

to leave for the day, Inoticed my manager andanother broker huddled infrontofascreen.

“What do you seethere, Jerry?” I couldn’thelpbutinquire.

“Well it looks likewheat will be headinghigher. It crossed the wirethatEgyptisrumoredtobein the market for over200,000 metric tons of

wheat, and the sale couldcome as early astomorrow.”

Cha Ching! What agreatbusiness!

Driving home thatnight Ikept tellingmyself,“Don’t be greedy. If themarket is up 7more centsin the morning, take themoneyandrun.Sticktotheprogram. Do yourhomework, and find the

nexttrade.”I decided after a long

celebratory dinner that Iwoulddojustthat.

Pullingoutmycharts,Istarted paging through thedifferent commodities forhoursthatnight.Iwasatitagain. However, nothinglooked as good as wheatdid from a couple daysearlier, and it was gettinglate,soIwrappeditupfor

the night.Besides, I had abig day ahead of me. Mytradingcareerwasabouttotake off, courtesy of mynew best friend, the chartbook.

At 8:00 a.m. Tuesday,walking through the largedoubledoorsattheoffice,Icould not wait to get theopening call. My managerwas staring at his screen,so I poked my head into

the often-opened door andasked, “Did the Egypttender go through? Didtheybuyall200?”

Jerry looked up at mewith an unfamiliar smileand said, “Yeah, theyboughttheirwheat.”

“Yes!” I thought. “Butwhatiswithhim?Ohwell,maybehe should studyhischarts a little closer.” Iproceeded tomy desk and

pulled out my books andthe phone numbers of myclients long the wheat.Soon, I would have goodnewstoreport.

It was almost 9:30. Iwasabouttoreapthefruitsof my labor. Would thewheatmarketmoveup theadditional 7¢ today, ormight I have to wait awhilelonger?

Finally, the clacker

boardstartedclicking, firstcorn, and then soybeans.For some reason, wheatwas taking longer. Thenwheat opened. What?Down 4! Down 5! Whatwasgoingon?Whataboutthe bull flag? It wasperfect!WhataboutEgypt?

The broker in thecubiclenexttomestoodupandaskedinhisusualcalmvoice, “Cordier, what is

goingon?”“Wheat—the wheat is

downalmost6¢!”Isaid.Steve replied, “Well,

you know that Egyptboughtwheatlastnightand…”

“I know they did, sowhy is it falling?” Idemanded.

“It was French. Egyptbought210,000metrictonsofwheatfromFrance.”

“French! Schmench!What difference does thatmake!” I blurted,incredulous.

Steve,whogothisstartin commodities at a grainelevator,thensaidtomeinwhatwasalmostawhisper,“You … have a lot tolearn.”

As it turned out,December wheat hadrallied days before, when

rumorssurfacedthatEgyptcouldbeinthemarketwitha large purchase.Consolidation thenfollowed as traders waitedfortheannouncement.

Inthiscase, themarketmove of December wheatwas predicated totally bytheoriginofthewheatthatEgypt was about topurchase. An Egyptianpurchase of U.S. wheat

mayhavebeenpositiveforChicago Board of Trade(CBOT) wheat prices. Apurchase from France wasbenign. It was adisappointment for U.S.wheat traders, andtherefore,pricesfell.Itwasmyfirstlessonintheworldof fundamental trading,andthingshaveneverbeenthesamesince.

It was a huge eye-

opener to me to discoverthat there was a wholeother world of tradinginformation beyond mycharts, measurements, andindicators. The technicalcharts reflected what wasgoing on with prices andhow they were moving.Thefundamentalswerethereasons why they weremoving.

As I discovered,

relyingonmychartsaloneto try to predict marketmovement was like tryingto hit a baseball with oneeye closed: Yourperspectiveisalwaysgoingtobeoff.

FundamentalsandTechnicals:HappilyMarryingtheTwo?

The story in the boxed textillustrateshowimportantit isto know the fundamentals ofa particular market beforepositioning in that market.However, we also havepointed out that thisknowledge should not beusedat thecompleteexpenseoftechnicalanalysis.

Rather, it can be used inconjunction with technicalindicators to optimize one’s

overall positioning process.Remember our goal? Asmooth, steady ride toexpiration, right?Fundamentalscangetyoutheright market. Getting thetiming right can make it asmoother ride. Even forunconverted technicians,knowing the fundamentalscan help to boost returns bygiving you a better feel forwhich breakouts, reversals,and buy-and-sell signals are

morelikelytobetherealdealandwhicharefalsesignals.Asuccessful “marrying” of thetwocanbearevelationtoanykindoftrader.

ThePowerCouple

Forinstance,let’sassumethattwomarkets,orangejuiceandlive cattle, are trading in anarrow trading range. TheU.S. Department of

Agriculture (USDA) has justreleasedareportshowingthatthe most recent Floridaorange harvest yielded thelargest crop in five years.Frozen orange juice suppliesin storage are at a 12-yearhigh.Themarket isawash injuice.

Cattle,on theotherhand,will soon be experiencing adrawdowninsupplybasedonthisyear’s50-yearlowinthe

calfcrop.Bothmarketsbreakoutto

the upside. Both marketsindicate buy signals on keytechnical indicators. Whichmarket ismore likely to starta sustained uptrend, andwhich is likely to fall backintotherangeorlower?

Thesimpleansweris thatthe cattle market is morelikely to experience asustained move higher,

whereas the orange juicemarket is more likely to fallback down. Both haveexperienced a price breakouton the chart.However, cattlehasbullishfundamentals;O.J.has bearish ones. If I’m abettingman,Itakethecattle.

The pure technical traderwould buy both on thebreakoutandgivelittleregardto the fundamentals.However, given the same

situation over differentmarkets10timesinarow,thetechnicianwhotakesonlythebuy signals in markets withfavorable fundamentalsalmostsurelywilloutperformthe pure technician. It’s averypotentcombination.

HowYouCanUseFundamentalsandTechnicalsTogetherWe suggest selecting

potentialmarkets inwhich tosellpremiumbystudying thefundamentals first. Once aselect group of markets hasbeenplacedona“watchlist”consisting of markets withvery bullish or very bearishlong-term fundamentals,these markets then can bemonitored for technical buy-and-sellsignals.

WhyNew

CommoditiesTradersOftenFail(andNeverComeBack)

Novice traders often willfavor technicalsbecause theyare much quicker and moretangible to learn. There areformulas and measurementsandrules.Althoughtherealmof technical trading is

immense, a trader can learnone simple indicator, andbingo, he has an instanttradingsystem.He’sreadytogoatit.

Studying thefundamentals and how theyare likely to affect price ismore abstract. It requiresindependentthinking.Ittakestime, education, judgment,and experience. Theargument that fundamentals

are already “priced in” maybe something that puretechnicians tell themselves tofree their minds from theburdenofhavingtostudytheeconomics of a particularmarket.

Fundmanagersaremostlytechnicians and can movemarkets for short periods ontechnical buy-or-sell signals.These moves sometimes canfly in thefaceof theexisting

fundamentals. Therefore,even as an option seller, youmay not want to ignoretechnicalfactorscompletely.

Nonetheless, over thelong term (of which optionsellers are primarilyconcerned) a market’s pricewillultimatelybedeterminedby its fundamentals. For thisreason, it is crucial that yougain at least a basicunderstanding of what the

key fundamentals are for themarketsyouare trading. It isone of the key advantagesthat you have overmechanized fund traders andbeginners alike. They areslaves to their systems. Youcan use technical indicatorsandyet still retain the abilitytothinkforyourself.

Doing so can save youtime,preservepeaceofmind,andhelpyoumakealotmore

money.

UsingYourFundamentalData:TheLesstheBetter

What you are about to readmay sound counterintuitive.Butonceyoubeginfollowingfundamental information, itwill make perfect sense toyou.

You will find that thefewer factors involved inthe price makeup of aparticular commodity, thegreater the advantage offundamentalanalysis.

You will also find thatmost physical commodities,such as soybeans, unleadedgasoline, and coffee, willhave three to five keyfundamental factors thataffect most of their price

moves.Financialcontracts,onthe

other hand, can have manyfactors that can or couldaffectprice,manythatcannotbeforecastwithanydegreeofaccuracy (e.g., governmentdecisionsorvotes).Itmaybetrue then that fundamentalanalysis is more of a benefitto traders of physicalcommodities. When tradingfinancial contracts such as

bonds, currencies, or evengold (considereda financial),youmayhavetorelymoreontechnical savvy becausefundamentals often appearvery cloudy or mixed at anygiven time. This is why Iprefer, and recommend,trading real, physicalcommodities.

Theygrowsoybeansonceayear in theUnitedStates. Iknow where they grow it. I

know how much they need.And the U.S. governmentmeasures it everymonth andtellsmehowwell thecrop isprogressing and how closethey are to hitting their goal.I’lltakethatsevendaysoftheweek and twice on Sundayover trying to guess whatsome central banker orgovernment bureaucrat isgoingtodotomorrow.

TheSpecialSignificanceofFundamentalstoOptionSellers

Thereisonefinal,albeitkey,reason why we believe thatincorporatingfundamentalsisso important in sellingoptions. Technical trading isall about forecasting andmeasuring where and when

prices might move. Itpromises nothing inforecasting where prices willnot go. And as you alreadyknow, picking a least-likelyscenarioisyourprimaryand,frankly, only concern as anoptionseller.

Butwhatdoesthatmean?And why is that the case?Let’sconsideranexample.

WhyDon’tYouCareWherePriceGoes?

It would be nice if afterselling every option, pricesmoved immediately awayfrom your strike, providingfast deterioration and quickprofits for you. It happenssometimes. Other times itdoes not. Yet, in the end, itdoesn’t really matter if yourstrike is$3outof themoney

or3¢cents—youroptionwillstill expire worthless,yieldingthesameprofit.

This is why you aremainly concerned withselectingapricelevelthatthecurrentmarketwillnotreach.This is where fundamentalscan have special significancetotheoptionseller—theycanbe priceless in identifyingleastlikelyscenarios.

The debate between

fundamentalist and technicaltradersisalwaysaboutwhichis a more effective priceforecasting model. Whichone is more effective indeterminingwherepriceswillgo? There is, of course, nocorrect answer to this. Eitherway, it is very difficult todetermine where prices willgo.

Thepoint is,asanoptionseller, it doesn’t matter!

Option sellers care onlywhereit’snotgoing.Anditisin determining where priceswon’t go that fundamentalswill butter your bread. Thefollowing example illustratesthispoint.

Example:TwoFundamentalists—ButOnlyOneMakes

Money

Two fundamental traders arefollowingthedevelopmentofthisyear’sU.S.soybeancrop.One is a futures trader. Theother,anoptionseller.

At midsummer, themarket has already priced acertain-sized crop into themarket (as most techniciansargue it should). During thecourse of a week, rumors

begin to surface of a strangediseaseeatingawayat leavesin certain growing regions.Traders are unsure to whatmagnitude it has spread orwhat effect it will have onyields. The following week,the talk continues to swirl.More outbreaks are reported,and some people start tosuggestthatthefungusontheplantisstuntingthegrowthofthenewsoybeans.

At this point, the markethas already started to movehigher on the uncertainty.Nobody knows how thiscould affect yield or,ultimately,price.However, itis probably safe to assumethat yield will be at leastslightly affected. Does it notfollow logically that priceswould have to remainsomewhere higher than theywere a few weeks ago toaccount for this shortfall?

Thereiseitheralittledamageoralot.Eitherway,therewilllikelybefewersoybeansthanwe thought therewould be afewweeksago.

The futures trader isasking how high the marketcan go and/or if it can stillmove higher from today’sprice. But she is asking thewrongquestions.Shedoesn’tknow the answers.Whateverher trade, she is gambling to

somedegree.The option seller doesn’t

know if prices have toppedoutorareonlygettingstartedin a breathtaking movehigher.But it doesn’tmatter.It only matters that it seemslike a pretty good bet thatprices are not going to fallbelowwheretheywereafewweeksagobefore thediseasewasannounced.

Why? Because it appears

that supply is smaller nowthan it was then. By howmuch,wedon’tknow.Again,itdoesn’tmatter.It’ssmaller.Alltheoptionsellerhastodois sell puts below where theprice was a few weeks agoandwait.

This example issimplified of course, but itdemonstrates how a keyfundamentaldevelopmentcanbe exploited by an option

seller where it may be moredifficultforafuturestraderor(worseyet)anoptionbuyertoprofit. It illustrates whyknowing the fundamentals isso important for optionsellers.

PuttingItAllTogether:ExecutingYourFundamental

OptionSale

Now that you have learnedhow and why to usefundamentals and technicalfactorsinsellingoptions,let’sput everything together intoonetradeexample.

Example:TraderJohnSellsLiveCattlePuts

In researching thefundamentalsforlivecattleinlate 2013, Trader John hasdetermined that thefundamentals will favor theupside in cattle prices in thecoming months. As theeconomy recovers, U.S. beefdemandisnearall-timehighs.Demand from developingeconomies has resulted insoaring exports. Moreimportantly, however,ongoing drought in the U.S.

MidwesthasreducedtheU.S.cattle herd to the lowestlevelsinover60years.

Johnfeelsthatthemarketmay be significantlyunderpricedasthemarkethasnotyetfullyaccountedforthecattle shortages projected for2014 (by the USDA). Johnconsiders thisavery friendlyfundamental setup. At thevery least (IMPORTANT),hefeels it unlikely that cattle

prices will fall substantiallyin light of the projectedsupply shortages. He beginsto watch the charts forpossible favorable points ofentry.

Inthiscase,oneofJohn’sfavoritetechnicalindicatorsisa Bollinger band (shown inFigure13.1). Thewavy linesinthemiddleof thechartarewhat this popular technicalindicator looks like. When

price breaks above the topline, technicians take it as abuy signal. When pricebreaksbelowthebottomline,technicians take it as a sellsignal.(SeeFigure13.1.)

FIGURE13.1April2014LiveCattleChartwithBollingerBandsIllustrating“Buy”SignalsJohnsellsputsbelowthemarketontechnicalbuysignalsinafundamentally

bullishmarket.

Since John’s fundamentalbias is bullish (he believesthattheexistingfundamentalswill pull prices higher), hewill look for technical buysignalsasopportunitiestosellputs far beneath the market.He will not sell calls on thesell signals because hisfundamental bias is to theupside. Therefore, he takesonly the buy signals in thismarket and ignores the sell

signals.OnDecember31,hegets

a buy signal as the pricebreaks above the top line ofhis Bollinger band. Inaddition, price also breaksthrough long-term resistanceat 1.3453 per pound. For atechnical trader, this is astrong buy signal. For thefundamentalist, it comes in avery strong market. Johnpulls the trigger and sells 10

April Cattle 1280 puts for$500each.Hecollects$5,000inpremium.

History proves Johncorrect as cattle prices rallythrough early 2014 and Johnkeeps all premium as profit.(SeeFigure13.2.)

FIGURE13.2April2014LiveCattleChartShowingRallyinCattlePricesTechnicalbreakoutinCattlepricessupportedby

fundamentals.

Johnhastakenthelessonsfrom this chapter andsuccessfully applied them togenerate profits. Of course,prices could have reversedand moved lower and Johnwould have lost money. ButJohntakesthenecessarystepstoputeveryadvantage inhiscorner before placing histrade.That’sthesignofapro.And it’s how you can trade,too, by putting in just a bit

more effort than the otherguy.

Granted, technical setupsarenotalwaysascleanastheone in the example. This isanother reason why thefundamentals are soimportant. You don’t need aperfect technicalsetup toselloptions. But avoidingunfavorable setups can helpyouwiththetimingoftrades.

Conclusion

With the popularity of somany technical tools and theequipment now available tousers, themajority of tradersnow rely on technicalindicators to dictate theirtrading decisions. But thisbook isnot about trading thenext hot-tech IPO or“momentum” stocks. This isabout commodities. Old

school. Things that have avalue determined by realbuyers and sellers. In thisworld, supply-and-demandfundamentalsareking.

Ignorethematyourperil.Embrace them and you giveyourself a big advantage inthe market. They areavailable to all. But only afew know how to use them.You can join this elite groupand learn how the old guys

stilltakehomethemoney.Usingtechnicalindicators

and/orchartpatternscanhelpyou in the timing of youroptionsales.Butfundamentalresearch should alwaysdictate in which market(s)youtrade.

Fundamentals are notsome mysterious, invisiblehand guiding the market. Infact, they are commonsensesupply–demand figures that

can be analyzed andconclusions can be drawnfrom. In our business, wecontinually research thefundamentals of the futuresmarketsandpickouttheonesthatwebelieveoffer thebestoption-selling opportunitiesforourclients. Infact, this iswhere we spendmost of ourtime.Becausemanyinvestorsdo not have the time toperformthisresearchontheirown, they get our research

reportswithbothfundamentaland technical information forthe markets they are in. Irecommend you create theseforyourselfifyouaretradingon your own. They can helpyouclarifyandorganizeyourreasoningfortakingpremiuminaparticularmarket.

Even if you are workingwith a broker who is well-versed in fundamentalanalysis, it may help you to

know some of the basiceconomicsandkeyfiguresofindividual markets that canhelp to determine pricedirection(ornondirection).

For those who wish tolearnthekeyfundamentalsofsome of these markets forself-study, Chapter 14 is foryou.

14

KeyFundamentalsofSelectMarketsWhattoWatch,WheretoFindThem

Now that you have learnedthe importance offundamentals when sellingcommodities options, it’stimetolearnsomeofthekeyfundamentals that affectcertain markets and whereyoucanfindthem.

Every stock, everycommodity,andeveryfuturesmarket has fundamentalfactors that determine itsvalue. Fundamentals for a

stock may include factorssuchas the financialpositionof thecompany,profitability,price-earnings (P/E) ratio,andsoon.Fundamentalsforacommodity may includecurrent supply on hand,projected new crop growth,and consumer trends inpreferences. Fundamentals ina financial contract mayinclude government policies,interest-rate adjustments, andeconomic growth rates. For

ourpurposes,wewilldefineafundamentalasthecurrentorfuture supply and demand orany factor that can have aneffectoneither the supplyorthedemandforthatparticularcommodity or financialproduct.

Not to reviewEconomics101,but thebalancebetweensupplyanddemandultimatelywill be what determines theprice of a commodity or

financialproduct.Ifsupplyishigh and demand is low,pricesprobablywillbelowormove lower. If supply is lowand demand is high, pricesprobably will be high ormove higher. If interest ratesrise, fewer people want tobuy bonds, and bond pricesfall. If part of the soybeancrop isdamagedbya lackofrain in the summer, there arefewer supplies to go aroundinthefall,andpricesrise.

We have alreadydiscussed how tradingfundamentallycanbeamuchmore feasible approach inoption selling than in futurestrading. If a market isfundamentally bullish,chancesarethatithasalreadypriced in those fundamentalsto a certain extent. Thus, ifyou buy a futures contract,you may be buying rightbeforethemarketgoesintoacorrectivemode.However, if

the fundamentals remainbullish, chances are that thecorrectionwillbemildand/orshort-lived (by long-termstandards)beforepriceseitherstabilize or continue to presshigher. As a futures trader,these inevitable correctionscan force you out of yourpositionandcauselossesthatsometimes can be severe,even if your fundamentalanalysisiscorrect.

By selling options, youcan increase your chances ofprofiting from a correctfundamentaldiagnosis.Ifyouare bullish and sell puts, youcan sell at strike prices farbelow the market. Yourposition can withstand acertain degree of movementagainst it. However, if yourfundamental analysis iscorrect, the market will notgointoanall-outsellmodeaslong as these fundamentals

continue to hold up. Thus,evenifthemarkethasalreadypriced the existingfundamentals, it probablywon’t fall substantially,meaning that if you soldoptionsfarenoughaway,theyshouldbesafeandultimatelyprofitable—this is the idealscenario.

TheKey

Fundamentals:WhatYouShouldBeWatching

To form a fundamental biastowardthemarkets,however,you first must know the keyfundamentals thatyoushouldbe following. This is thepurposeofthischapter.Thereare some markets that lendthemselvesmorefavorablytofundamental analysis than

others. These are generallymarketswiththreetofivekeylong-term fundamentals towatch. Markets with manyfundamentals (such as thestock market or currencies)are more difficult to tradefundamentally and must begiven more technicalconsideration. Having somefundamental knowledge,however, can help you totradeanymarket.

The following are somekeyfundamentalstowatchinagroupofselectmarketsthatwe have chosen to review inthis book. This is certainlynotacompletelistofmarketsor fundamentals. However,thesearesomeoftheprimarycommodities that are suitedforoptionselling.

Energy

Mostpeople,evennontraders,are somewhat familiar withenergy fundamentals. Oil isproduced in the Middle East(OPEC), Russia, Venezuela,Nigeria, Norway, and theUnited States. Of theseregions, the Middle Eastremains the largest exporterofcrudeoil,fornow.

Yet, with the discoveriesof both the Marcellus andBakkenshalesandtheadvent

offracking, theUnitedStateshasbecomeamajorplayerontheworldoilstage.Alreadyamajorproducerofnaturalgas,the United States couldbecome energy independentwithin the next decade andquite possibly a becomeconsiderable exporterofbothoilandnaturalgas.

The United States is byfar the largest consumer ofcrude oil, followed byChina

and Japan. China’semergence as an economicforce since its entry into theWorld Trade Organization(WTO)in2001hasproduceda massive increase in crudeoil demand that has addedtremendously to the globaldailycrudeoildraw.

Energy markets areswayed heavily by seasonalfactorsaswell,thoughwearenot going to cover them

heavily in this chapter. Theseasonal tendencies of crude,heatingoil,unleadedgas,andnatural gas will be coveredextensively in Chapter 16 onseasonalanalysis.

In2008,crudeoil futuressoared to an all-time high inprices approaching $150 perbarrel. During the highs inprice, therewasmuchtalkofa global production peak.That, of course, ended with

the new discoveries inNorthAmerica.

New supply channelsfrom North America havemade crude oil prices lesssusceptible to supply shocksfrom the Middle East orelsewhere. Although energypricescanstillbeaffectedbygeopolitical events, theadvent of higher U.S.domestic production hasmade them less so. Energy

prices can also be veryseasonalinnature.Thesetwofactorstogethercanmaketheenergymarkets a great placetocollectpremiumforoptionsellers.

For supply/demandfigures, I recommend youmonitortheweeklyAmericanPetroleum Institute (API)report, which measuresenergy storage levels anddraws, and periodic reports

from theU.S.Department ofEnergy (DOE). Individualreports here are not asimportant as supply/demandtrendsinthereports.

GrainsandOilseeds

Soybeans

WhileChinaandahandfulofothernationsgrowsignificant

amounts of soybeans to feedtheir own populations, theUnited States and Brazil arethe world’s primaryexporters. For this reason, itisagoodideatofocusontheU.S. and Brazilian cropswhen analyzing soybeansupply.

TheU.S. soybean crop isusually planted in April andMay and harvested primarilyin September and October.

TheBrazilian crop is usuallyplanted in October andNovember and harvested inMarch, April, and May.Weather disruptions duringthegrowingseasonsoftencancausepricemoves.

Key figures to watch arethe U.S. and world endingstocks, current and projected.Ending stocks are acomprehensive figure andconsist of the amount of the

commodity left over at theend of the crop year. In theUnited States, the new cropyearbeginsonSeptember1.

Ending stocks are thetotal amount of supply leftover after total annual usagehas been subtracted fromannual supply. Therefore,ending stocks are a way ofmeasuring total supply anddemand.A rudimentary formof fundamental analysis is

looking at past years’ endingstocksandthenlookingattheaverage price level of thecommodity during that yearor the following year. Thereoften will be a correlationbetween prices and endingstock levels. You then cancompare thisyear’sprojectedending stocks with those ofprevious years where figureswere similar to get a roughidea of a price range towardwhich the market should

gravitate this year. Althoughthis may not tell you whereprices are going, it can be abig help in projecting whereprices won’t go. I keep ourclients updated on endingstocksthroughournewsletter.However, you can get themthroughtheUSDAwebsiteatwww.USDA.gov.

It goes without saying,then,thatanyfactorthatmaychange the projected supply

or projected demand couldchangeending stocks,which,in turn, could move prices.Weather, pests, shippingdisruptions, and politicalunrest are just a few of thefactorsthatcanaffectsupply.Increased or decreasedconsumption,tradespats,andcompetition from substituteproducts are a few of thefactors that can affectdemand.

A key fundamental shiftin the soybean and grainmarkets in the first twodecadesofthe2000shasbeentheemergenceoftheChineseas a major importer of cornand soybeans. The corn andsoybean bull market of thepast 15 years (see Figure14.1) has been drivenprimarily by unprecedenteddemand from China. Expectthistobearecurringthemeinmany commodities

throughout the comingdecade as growing globalpopulations and increasedstandards of living competewith biofuels for their shareofthegrainsupply.

FIGURE14.1SoybeanMonthlyChart

Most of the informationyou will need to get a basicfundamental picture of thegrain or any agriculturalmarket can be obtained forfree from the U.S.Department of Agriculture(USDA) at www.usda.gov.Thekeyreporttowatchisthemonthly supply/demandreport (which measures U.S.andworldsupplyanddemandand updates projected ending

stocks). Other key reports towatcharethequarterlygrainstocks report and plantingintentions (released in thespring).

Corn

IntheUnitedStates,cornandsoybeansaregrowninsimilarlocations during similargrowing seasons and oftencan be interchanged for one

another when farmers aredeciding on howmany acresof each to plant. Frequently,this is decided based onwhichcroptheythinkmaybemore profitable in a givenyear.

The United States is theworld’s largest exporter ofcorn.However,theU.S.shareof the export market hasshrunk considerably in justthe last decade. In 2005, the

UnitedStates suppliednearlytwothirdsoftheworld’scornexports. By 2015, thatnumber had fallen to onethird.Withtheadventofnewexporters such as Argentinaentering the trade arena,globalproductionfiguresandending stocks play a moreimportant role in priceforecastingforcornthantheyoncedid.

Nonetheless, the U.S.

supply and export demandremain the key figures onwhich to focus whenresearching corn. Most corninformation is released in thesame reports listed forsoybeansandcanbefoundatthe same place, the USDA.The news services listed inthe resources section of thisbook also can do a good jobof keeping a trader updatedon factors that could affectsupply and demand.

However, we stronglyrecommend focusing on themonthly figures released bythe USDA and not gettingcaught up in daily newsreleases.Theexceptiontothiswould be when you notice asupply or demand trenddeveloping.

Growing Chinese anddeveloping countryconsumption plus the adventof ethanol use in fuels will

mean strong demandcontinuing to underpin thecorn market well into the2020s.

Wheat

Unlike corn or soybeans,wheat is grown almostglobally. Whereas Europe,China, and India are largeproducers, the United Statesremains the world’s largest

exporter;however,theUnitedStates supplies only about20% of the world exportmarket.Majorcompetitorsofthe United States for theexportbusinessareAustralia,Canada, Argentina, and theEuropeanUnion.

Supply, demand, andending stock figures forwheat can be found in thesamereportsasthoseforcornand soybeans. However,

when analyzing wheat, oneshould paymore attention toworld figures as opposed toonly U.S. figures. Becausewheatisaglobalcommodity,events in other majorproducingnationscanhaveastrong effect onwheat prices(seeFigure14.2).

FIGURE14.2USDAReportShowingWheatEndingStocks

TheInterchangeableGrains

Grainandoilseedmarketsareunique in that there can becrossoverusesbetweenthem.Thus, a shortage in soymealmightcauseacattlefeedlottoswitchovertocorn.Arallyincorn prices might cause afood manufacturer to switch

overtowheat.Arallyorpricedecline inonecanoftenbeaprecursor to a similar pricemove in another.Often theseprice swings can happen intandem, even if thefundamentals of one do notaffecttheother.Thus,atraderof corn should also bemonitoring fundamentals inbothsoybeansandwheat,andvice versa. This is true fromboth a risk-managementperspective as well as a

profit-seekingperspective.

Example:CornVersusWheatIn the summer of 2012, theU.S. Midwest experienced aravaging drought. Corn andsoybean cropswere affected.By July, it became apparentthat autumn productionestimates would have to besubstantiallyreduced.

Wheat fields were less

affected. More importantly,global wheat production wasprojected to be more thanampleinthefall.Sowhydidwheatpricesrally,too?

It’s called a “sympathyrally.” Wheat, in somecircumstances,canbeusedasa “substitute” grain for cornor even soymeal. Wheatrallied because the marketconcluded that ascornpricesrose,feedproducersthatwere

able would increase wheatusageandcurtail cornand/orsoybeanusage.Therewasnoshortage of wheat. Yet therebecame an expected demandincrease in wheat. Thus,wheat prices rose in tandemwithcornandsoybeans.Thisis illustrated in Figures 14.3and14.4.

FIGURE14.3July2012WheatChartCornpricesriseondrought

concerns.

FIGURE14.4July2012CornChartWheatpricesrallyin“sympathy”withcorn.

This substitution effectdoes have its limits. Thus,grains and oilseed prices donot move in tandem. Oftenthere is, however, a loosecorrelation. Exploiting thatcorrelation can be anotherprofit avenue for moreadvanced option sellers. Ifyou study the fundamentalsof the grain markets, it willnot takeyou long tobegin tonotice both correlations and

discrepancies that you canuse to your advantage as anoptionseller.

(The “Texas Strangle” isone example of this that wesometimes feature in ournewsletter.)

The grain and oilseedmarkets, as a whole, areexcellentmarketsinwhichtotake option premium.Fundamental information isboth widely available and

often easy to interpret—atleast for the limited needs ofoption sellers.These are alsovery liquid markets in boththe futures contracts andoptions.

Manynew futures tradersstartinthegrainmarkets.

RegionalCommoditiesandthePlightofOrange

Juice

Whereas some commoditieshave an equal global value,such as gold, crude oil, andwheat, others may involveregional dynamics that canrequire a different level ofstudy.

Global commodities areproduced in several differentcountries, but there are othercommodities that may be

produced in only one or twospecific countries or regions.Because there are fewersupply figures to followwithsuch commodities, theysometimes can lendthemselves better tofundamental analysis thanglobally producedcommodities. These areknown as regionalcommodities. Regionalcommoditiesincludeproductssuch as orange juice, live

cattle,andlumber.Forinstance,Brazil is the

majorsupplieroforangejuiceto the United States. TheUnitedStatesusedtoproducethebalanceofitsorangejuiceneedsdomestically.However,whereasorangesaregrowninbothCaliforniaandFlorida,itismostly theFloridaorangesthatareusedtomakejuice.Inthe second decade of the2000s, a disease known as

citrus“greening”hasplaguedFlorida orange groves to thepoint where production hasdropped up to 50% overwhereithadbeenintheearly2000s. Eradicating greeninghas proved to be costly anddifficult.Unlikecropdiseasesin field crops where newplants emerge each year, anorange tree has a peakproduction life of more than20 years. Therefore, thedisease can carry over from

yeartoyear.Florida greening helped

drive juice prices to all-timehighs in early 2012 beforeBrazilwasabletopickuptheslack enough to ease theshortfalls (see Figure 14.5).Florida growers winning orlosing this fightwillbeabigfundamentaltowatchintothe2020s—as will Brazil’sincreasing (or failing toincrease)exports.

FIGURE14.5OrangeJuiceChartShowing2012RallyOrangejuicepriceshitall-timehighsinearly2012asFloridasupplyfearsgripthemarket.Asaresultofhigherprices,afundamentalshifttakesplaceinjuice.TheUnitedStatesbeginsimportingmoreBrazilianoranges.

Therefore, followingBrazilian and Florida orangeproduction can be a goodplace to start when studyingorange juice fundamentals.The Frozen ConcentrateOrangeJuice(FCOJ)contracton the IntercontinentalCommodity Exchange (ICE)isstronglyaffectedbyrisesordrops in Florida or Brazilianorangeproduction.Again,theUSDA is your source of

information. The monthlysupply/demand reports willlist projected productionfigures along with U.S. andBrazilian ending stocksduringthegrowingseasons.

Frozen orange juice is anexcellentexampletoillustratehow core fundamentals canoccasionally shiftdramatically. If a trader canrecognize the change, he cansell options and profit from

the same fundamental formonthsorevenyears.

This is a key example ofwhy knowing fundamentalscan be important for a traderin analyzing potential optionsales.

KnowHowTheyMaketheStuff

Another key point is tonote how some crops areproduced. Commoditiessuch as corn or soybeansarereplantedeachyearandthuscanoftenenjoytheoldadage, “High prices curehigh prices.” A shortageoneyeartypicallyresultsinhigher prices. Farmersrespond to these higherpricesbygrowingmoreofthat crop the followingyeartomakemoreprofit.It

iscapitalismatitsfinest.Other commodities,

however, such as cocoa,coffee, and orange juice,grow on trees, whichmeans much longer cropcycles whereunderproduction cannot beincreased overnight bysimply planting more nextyear.Thisoftenmeansthattrends in thesecommoditiescanbe longer

term in nature than moresupply-flexible marketslike corn or cotton whereproduction can beincreased or decreased onanannualcycle.

Cattle

Live cattle for deliveryagainst the ChicagoMercantileExchangecontract

are produced almostexclusively in the UnitedStates. Therefore,monitoringU.S. beef supply and U.S.beef demand is a keyapproach to making long-termpriceprojections.

TheUSDAcattleonfeedreport is released once amonth andbreaksdownhowmany young animals are onfeed and how many animalshave been marketed during

theprecedingmonth.Thus,itisagaugeofbothsupplyanddemandand is thekeyreporttowatchintheindustry.

Traders in cattle futuresoftenwatchwhatisknownasthe cash market. These arethe actual auctions of cattlerancherssellingtheircattletopacking houses. The pricespaid for these cattle oftenconstitute a goodmeasure ofdemandforbeefandalsocan

haveabroadeffectonfuturesprices, although the reversealso can be true. Cash cattleusually trades during the lasttwo or three days of thebusinessweek.Oftenpackersand producers will hold attheirbidoraskingpricesuntillater in the week when onerelents, resulting in the cattlebeingsold.

Cattle traders also watchdaily box beef prices, which

are a measure of whatsupermarkets and other retailoutlets arewilling to pay forcertain cuts of beef. Thesecan be obtained through agoodnewsservice.

The cattle market is onewhereaninformedtradercanoften “see” the future supplyworking its way through thesupply chain.While this canbe advantageous, demandtrends (and seasonal demand

tendencies) become morecrucial.

PreciousMetals

We have all heard of goldpricesquotedinsuchtermsasthe “Hong Kong a.m. goldfix”orthe“Londonp.m.goldfix.” Gold prices aresometimes hot, sometimesnot,butgoldisgoldnomatterwhere it is being traded.

Often thought of as a safehaven, gold always has beena staple benchmark offinancial security.Understanding the manynuancesthatcausetheyellowmetal to fluctuate in price,however, is quite thorny. Ononeoccasion,areportshowedarecoveringeconomywillbequite bullish for preciousmetals because gold isconsidered a hedge againstinflation.Thenanotherreport

suggested a robust economy,and gold prices sank withthoughts of higher interestrates.It’stoughtocall.

Newsofpotentialmilitaryconfrontations used to whipgold traders into a buyingfrenzy.Thesedays,thatisnotalwaysthecase.

Gold is often seen as aninflationhedgeandcanoftenbe linked to fluctuations intheU.S.dollar.Higherdollar

valuestypicallypressuregoldwhileafallingdollartendstobe supportive of its price. Inthecurrentage,goldtendstotakeitscuesfromtheFederalReserve.

TheGoldenAge forgoldwasthe“QEYears”whentheFed lowered interest rates tonearly zero.Gold had awildbull market from 2009through2011.Then it startedworrying when the Fed was

goingtotakeawaythecandy.It is likely that the Fed willplay a larger role in goldprices than will any otherfactor for the next severalyears.

This illustrates a keypoint about gold. The goldmarket trades like a financialmarket more than acommoditiesmarket.Investorand fund demand drive thismarket even though

newsletters will kid you thatdemand for jewelry plays arole. Gold takes its primaryprice cues from the financialnews pages and investorsentiment.

Nowlet’scomparethattohow some of its cousinsbehave.

GoldVersusIndustrialMetals

Industrial metals such ascopper, silver, and platinumsharesomeofgold’sfinancialproperties. However, thesemetals also carry an extradimension that can influencetheirlongertermdirections—information that can bebeneficialtooptionsellers.

Even though silver andevencoppercandoubleasaninflation hedge, they alsoderive a large part of their

price direction fromindustrialdemand.

AMetalsCaseStudy

As a glaring example, weneed look no further backthan the financial crisis,subsequent recession, andbeginning of quantitativeeasingintheUnitedStates.Inearly 2009, the metalsmarketshadallfallenonhard

times as recession hadsubstantiallycrimpeddemandexpectations. When theFederal Reserve began itsextended quantitative easing,it began an unprecedentedandextendedpricerallyinallmetals. At the peak of thisbull market, copper waschanginghandsatover$4.50a pound. Gold traded over$1,900 for the first timeever(Figure 14.6). Also enjoyinga high percentage gain was

silver, trading just shy of$50.00 an ounce (levels notseensinceBunkerHuntruledthesilverpit).

FIGURE14.6GoldChart:2009–2011

It was a rally sponsoredbyhugefundandspeculativebuying on the expectation ofa falling dollar and inflation.But there was anotherelement at work. From early2009 to the highs in 2011,gold prices increased by123%. Impressive to say theleast.

Copper prices, however,rallied by 208% (Figure14.7). And silver prices

soared by a whopping 371%(Figure14.8).

FIGURE14.7CopperChart:2009–2011Copperralliesby208%.

FIGURE14.8SilverChart:2009–2011Silvergrabsa371%pricegain.

Whythediscrepancy?All three markets were

enjoying voracious investordemand. Any investorproductfeaturingmetalsfrombullion to Exchange TradeFunds(ETFs)washot.

Copper, while generatingsome interest from investordemand,wasbenefitingmorefromtheexpectationofmoreindustrial demand. Despite arecessionintheUnitedStates

andEurope,China and someof the smaller emergingeconomiescontinuedtobuild.Thus,demandremainedbriskfrom these countries. Asindustrial users feared higherprices from investordemand,they began aggressivelyforwardbuyingtomeetfutureneeds. Copper was cheap aswell, having fallen furtherthangoldduring2008.

Therefore, while investor

demandwasfuelingallofthemetalsmarkets, the industrialmetals had extra rocketboosters derived from globalcommercialplayers.

But why did silveroutperformboth?

Because silver, in thissituation, enjoyed the best ofbothworlds.Silver,likegold,is also considered a stronghedgeagainstinflation.Yetitcontinues to have many

industrial uses around theglobe. Thus, it enjoyedmoreinvestordemandthancopper,yet more industrial demandthangold.

If you remember nothingelse about trading metals,remember this. Gold ismainlya financial instrumentwith its primary demandcoming from investors.Copper is primarily anindustrial raw material with

its demand coming primarilyfrom the commercial sector.Silversharesbothworldsandderives demand from bothindustrial and investmentsectors. The fundamentalpremise on which you arebasing your trade, then,shoulddeterminewhichmetalyou would choose to collectyourpremium.

CoffeeandtheSofts

Markets

I love trading coffee! And Ireally love selling options inthe coffee market. Coffee iswhat is referred to as one ofthe “Softs” markets. Softsinclude coffee, sugar, orangejuice, cocoa, and sometimescotton. Ironic since I believecotton is where the name“softs”comesfrom.Softsarealsosometimesreferred toas

“exotics.”I like taking premium in

softs (particularly coffee),because so few peopleunderstand the realfundamentalsthatdriveprice.Unlike most of the grains ormeats,whichare impacted toa large degree by U.S.production, many softs aregrown outside of the UnitedStates. Thus, clean, conciseUSDA data is not always

available. You have to dig alittle deeper to get the goodsinsofts.Butdoingsocanpayhandsomely.

The USDA does have“Ag Attaches” in many ofthese countries, and they doestimates. However, I havefounditbest,especiallyinthecoffee market, to look at anumberofdifferentestimates.The USDA will do aproduction estimate for

Brazilian coffee. But so willthe Brazilian government.Therearealsoseveralprivateforecasting companies thatrelease their own estimates.These can often be the mostreliable.To get all, I suggestgettingasubscriptiontoDowJones or BloombergCommodities newswires.These are often availablethrough the same companiesthat offer market quotes andcharting.

Let’stalkaboutcoffee.

CoffeeFundamentals

Fifty-seven differentcountries grow coffee,making it truly a globalcommodity. There are twobasic typesofcoffee, arabicaand robusta. Arabica coffeetends tohave amilder flavorandusuallyisgrownathigherattitudes. Robusta coffee has

a heavier flavor and tends tobe produced on low lands.Arabica is the preferredcoffee in the WesternHemisphere and trades at apremium price. Like manyfine foods, these two coffeesoftenareblendedtocreateyetanotherdistinctivetaste.

Arabica coffee is thecontract traded on theInternational CommodityExchange (ICE). Robusta

coffee is traded on theLondon InternationalFinancialFuturesandOptionsExchange (LIFFE). Arabicacoffee is theprimaryproductof many Central Americancountries and Colombia.Robusta is grown in manycountries,includingIndiaandVietnam.Brazil is by far theworld’s largest producer andexporter of both arabica androbusta coffees. Therefore,Brazilianproductioncanhave

a large impact on coffeeprices especially those at theICE.

Brazil grows more thanthreetimesasmuchcoffeeasthe world’s second largestexporter, Vietnam. Brazilianproduction takes on evenmoreweight forU.S.markettraders when one considersthat Vietnam primarilyproduces the robusta varietyofcoffee (traded inLondon),

whereas the majority ofBrazil’s production is that ofthe arabica variety traded ontheICE.

Brazil experiences anevery-other-year “on/off”cycle in coffee productionwhere higher productionyearsareusuallyfollowedbylower production years. Thisis a natural cycle of coffeetrees. The first thing tradersof coffee should be aware of

is if Brazil is in an “on” or“off” production year.Remember that futuresmarkets tend to “forwardprice”commodities about sixmonths ahead. This meansthat the markets will beginpricing in aharvestup to sixmonths before the actualharvestcomesin.

Okay. You already knowmore than90%of thepeoplecurrently trading coffee. But

let’sdigalittledeeper.Beginning in the late

1990s, coffee productionstartedtomigratenorthtothemore temperate states,concentrating in EspíritoSanto, São Paulo, andMinasGerais. This moved the bulkof production out of frost-prone areas and has largelyinsulated Brazilianproduction from headlinegrabbingfreezes thatplagued

themarketback in the1980sand1990s.AsBrazil’scoffeeindustry was enjoying hugeprofits from high coffeeprices,co-opsstartedpouringmoney into new production.Billions of young seedlingswere planted. This newinvestmentwould change thelandscape in coffee for yearstocome.

News of big profits soontraveledtotheFarEast,anda

new player began to emergein the coffee arena. Vietnamwas ripe to enter, with itscheap labor and near-perfectclimate. The world wouldmake room for yet anothercoffee supplier but, moreimportantly, a supplier withlittle domestic consumption.During the year 2000,Vietnamese robustaproduction topped 11millionbags, just 1million bags shyof an average yield from the

former powerhouseColombia. Of the 11 millionbagsproducedthatyear,over10millionwereavailable forexport.By 2007,Vietnameseannualproductionhadsurgedtomorethan16millionbags.

Flash forward to presentday. Vietnam is now theworld’s second largestproducer of coffee—primarily the robusta variety—making it a country to

watchfor fundamentalcoffeetraders. Brazil, however,benefitingfromexpandedandmore densely plantedhectares,continuestoleadtheworld in production of allcoffee,high-qualityarabicainparticular. World productionhas risen steadily since themid-1990s,settinganall-timerecord in 2013. (See Figure14.9)

FIGURE14.9CoffeeGlobal

ProductionChartGlobalcoffeeproductionhasrisensteadilysincethemid-1990s.

Yetcoffeedemandhasallbutkeptpace.“New”demandhas emerged in the lastdecade from growingmiddleclasses fromChinaand Indiainparticular.

This means that coffeecanstillbesensitivetosupplydisruptions. 2011 saw coffeeprices rally toover$3.00perpound on dwindling suppliesof high-quality Arabicablends. (see Figure 14.10)

Thiswasprimarilyaresultofpoor harvests in CentralAmerica. It is interesting tonote that during this time,supplies of lower qualitycoffeewereample.However,many brands of premiumcoffees,suchasthoseusedbyStarbucks,comefromsmallerarabica growers in CentralAmerica. Brazil provides alarge chunk of this. ButCentral American growersmake up a substantial

remainderofthepie.

FIGURE14.10CoffeeMonthlyPriceChart:2010–2011RallyCoffeepricesspikedin2010into2011.Volatilitycanremaininoptionpricesforyearsaftersucharally—regardlessofcurrentfundamentals.

What I love about coffeeis that volatility from pastmoves seems to remain inoption prices for yearsafterward—regardless ofcurrent fundamentals! Isanyone actually studying thisstuff or just watching a 20-year chart? All the publicremembers are the headlinesfrom several years ago. Thiscanbeabigadvantagetoyouas a fundamentally informed

option seller—in all of thesoftsmarkets.

HarvestCyclesinCoffeeCanMeanOption-SellingOpportunities

Coffee prices havehistoricallybeenmostvolatilein the Brazilian winter(despite the reduced frost

risk) which is June toSeptember and during thecoffee “flowering” season inOctober, in which the coffeebeans sprout. However, theMarch to April time periodhas also become a time towatch in recent years asVietnamhasbecomeabiggerplayer on the world stage.This is normally the time ofyearwhenVietnamese beanscome onto theworldmarket.Thefuturesmarkethasbegun

toshowagrowingimpatiencewithweatherortransportationdelays during this time. Anyand/orallofthesefactorscanbe potential opportunities foroptionsellers.

AWordon“Macro”Fundamentals

Itshouldalsobenotedinthischapter that there will be

times where macroeconomicfactors, such as the globalboom and then bust ofcommodities as a whole in2008, will overshadow theindividual fundamentals ofcertain markets at times.However, thesemacroeconomic issues aremerely larger scalesupply/demand issues inwhich (in the case of 2008)demand for manyindependent commodities

rises and falls at the sametimeduetooutsideeconomicforces. Even though thesetypes ofmarkets can providetheirownsetofopportunitiesandchallenges for theoptionseller, they are more theexception than the norm.Individual commoditiesmarkets tend tomarch to thebeatoftheirowndrummers.

In a normal market, theprice of coffee and the price

of natural gas have little incommon. Therefore, priceswill always return toreflecting these differences.This is why investing in abasket of commodities cantruly be a diversifiedportfolio.

FinancialFuturesFundamentals

You will notice thatfundamentals of financialmarkets such as bonds,currencies, and stock indexfuturesarenotcoveredinthischapter. This is not becausewe believe that knowing thefundamentals of thesemarkets isnot important.Wesimplybelieve, afteryearsoftrading them, that knowingthe fundamentalsheredonotofferadefinitiveedge.

Fundamentals of thesemarkets are so extensive andso subject to individualopinion and interpretationthat it would have taken awhole chapter to cover eachone. However, individualresearch into these marketscertainly can help to giveperspective to a purelytechnicalapproach.

DoYouTradeforFunorMoney?

About 10 years ago, Inoticed that my tradingperformance was so muchbetter in the physicalcommodities compared tofinancial futures. It wascrystal clear to me that

knowing the fundamentalsof the real commoditiesgaveusanedgetherewhilethere were simply toomany moving parts in thefinancial products. So Istopped trading financialoptions almost altogether.It was the best decision Ievermade.

It always amazes mewhen I talk to a client orpotential client who wants

to trade a market becauseshe“likes”it.Thesearenotbeginners. These are high-net-worth investors who Iassume have at least abasic knowledge ofinvesting.Yet,shewantstotrade theS&Pbecause she“likes” it. I typically havetwoquestionsforher.

1.Howmuchmoneyhastradingthismarket(actively)

madeyouinthelast10years?Notthestoryofthetimeyouhititjustright—justhowmuch,net,inthelast10years?

2.Doyouwanttotradeforfunortomakemoney?

Trading the S&P orbonds or currencies maysound sexy. Heck, it maybe fun. After all,

everybody has an opinionon theS&P.What ismorefun than being right?Makes great conversationat the club. Everybodyknowswhat you’re talkingabout. But tell them youjust took premium out ofthecocoamarket.Seewhatkind of look you get then.Then they’ll have twoquestionsforyou.

1.Whatispremium?

2.Whatisthecocoamarket?

This, of course doesn’tbother me. I have no cluewhat moves the S&P. Ihavemyopinions,justlikeeverybody else. But at theend of the day, a wordfromtheFedcanmakemewrong. Same goes forcurrencies, bonds, and therestofthem.

What moves coffee

prices?ThatIcantellyou.I cannot tell you exactlywherethepriceisgoingtogo. But I understand whatis moving it. Most can’t.Evenmost that are tradingit can’t. That’s a marketwhere an informed tradercan make money. That’swhatIcareabout.

If you care aboutmaking money more thanhavinggoodbanter for the

golf course, be willing togowhere the others won’tlook. And learn thefundamentals of thosemarkets—like the othersdon’t.

Conclusion

The fundamentals in thischapter should give you astarting point for researching

commodities and the type ofinformation that you willwant to seek. Thecommodities explored in thischapter certainly are not acomplete list, and you willwanttoresearchandcomparefindingsofyourownontheseand other commodities andfuturesmarkets.

Ourclientnewsletter,TheOption Seller, providescondensed and summarized

commodity fundamentals forour investors and clients. Ifyou would like to receive afreesampleofthenewsletter,visitwww.OptionSellers.com.

Thenexttwochaptersaredevoted to a branch offundamental analysis knownas seasonals. Seasonalanalysis can be a powerfultoolinformulatinganoutlookfor a market under any

economic condition. Thesechapterswillshowyouhow.

15

SeasonalTendenciesinOptionSellingAMostPotentProfitFormula

You are about to learn what

could be the most powerfulweaponinyouroption-sellingarsenal. Hidden from view,shrouded inmystery,scornedbytheuninformed,seasonals,as they are known to theinitiated, can give you realinsights into that “hiddenhand” that seems to movemarket prices ofcommodities.

But be forewarned:Introducing seasonals to the

uninformedcanbelikegivingacaveman fire. Ifheuses itright,hecanlightthewayforthe rest of his life. Use itwrong and he burns hisfingersoff.

Mostinvestorshaveneverheard thewordseasonals.Ofthecommodityinvestorswhohave, few have ever usedthem. Of the ones that have,very few know how to usethem properly (i.e., to

generateconsistentprofits).Like I said, to get to the

realgold in thisbusinesscantake some digging. We’regoingtosaveyouthetroublehere.

WhatAreSeasonals?

A seasonal tendency, orseasonal, is just that.Forourpurposes, we will defineseasonal tendency as the

tendency for prices of anindividual commodity tomove a certain direction at acertain time of year. A 15-year seasonal chart (whichyouwillseeinthischapter)issimply taking 15 years ofprice movement during acertain timeperiod eachyearand averaging them together.What this can reveal, ofcourse, is simply a tendency.Itdoesn’tmeanitwillhappeneveryyear.Ifitdoes,itmight

not happen at the same timeor the samedegree this year,ornext.

Those little disclaimersarewhatmake it so hard forfutures traders to profitconsistently with seasonals.There is no buzzer that goesofftotellyouwhentobuyitand sell it (although manyhave tried that)or toavoid italtogetherthisyear.

Traders and gurus have

tried different methods to“catch the move” of aseasonal tendency. Somehave achieved success forbrief periods, only to flameout in time. But just as thetraders in previous chapters,they are seeking the wronganswers to the wrongquestions. They are askingseasonals to tell them wherethe market is going (andworse yet, when it is goingthere).Youareonlygoingto

consult them to determinewherepricesarenotgoing.Inthat, you will find the truevalueoftheseasonal.

TheWrongWaytoUseSeasonals

Seasonal tendencies ofcommodities markets, orseasonals as they are knownto traders, are like option

sellinginaway.Theyareoneof the most interesting yetmisunderstood areas oftrading. This makes themvulnerable to misuse and, ofcourse, bad word-of-mouthfromthemisusers.

As in option selling,traders who see seasonalcharts for the first time maythink that they have justdiscovered the Holy Grail oftrading, the inside secret, the

realforcedrivingthemarket.The seasonal chart looks

so simple. Buy on this day;sellonthisday.Ithasworkedfor 14 of the last 15 years.There were a few authorsseveralyearsagowhomadealotofmoneysellingbooksonseasonal trades. There wereentire books that just gavelistsofdatestobuyanddatestosell.Allyouhadtodowasfollow it. It’s magic! Then

they all found out the hardwaythatitwasn’t.

Unfortunately, seasonalanalysis is much morecomplex than buying on onedayandsellingonanother,asmanytradershavediscoveredpainfully.These statistics areinterestingtolookat,buttheyare only reflecting a cyclicoccurrence in themarket. Tobe truly able to understandseasonals and trade them

effectively, you have tounderstand what theseoccurrences or fundamentalsare.Youmustthenbeabletotrack and measure them todetermine if they are indeedoccurring this year, to whatdegree, and on what timeschedule.Youmustknowthekey reason that typicallycauses thisseasonal tendencyto takeplace.Thenyoumustbe able to determine if thosesame fundamentals are in

place this year. Soundscomplex,butitisn’tthathardwithalittlestudy.

Trying to trade on acertain date and get out on acertain date because a booksays so is putting your faithsolely in statistics andaverages.Whatmany tradersunfortunately have found outisthatthemarketdoesn’tcareabout statistics and averages.Therefore,many traderswho

havetriedthistimingmethodand lost money concludedthat seasonals in general arenogood.This is a shame forthem but good for you!You’ll have less competitionand more people to take theothersideofyourtrades.Youare going to learn how youcan combine real seasonaltendencieswithoptionsellinginto a very potent profitstrategy.

WhyTradersLosewithSeasonals

Before we begin exploringhow to make money withseasonals, we first mustexamine why traders losetrading seasonals. There arethree main reasons thishappens. Let’s explore thesemistakes so you won’t makethem.

1.Theytrytotimethemarket.Thefirstmistaketradersmakewithseasonalsisthattheyassumethatbecausethemarketincreased(ordecreased)invaluebetweenagiventwodatesxofthelast15years,theywillmakemoneyiftheybuy(andsell)onthosesamedatesthisyear.Inshort,

theyforgettheyarelookingataverages,whichcanvarywidelyinindividualyears.

Thesedatesoftenshowcorrespondingprofitsthatcouldhavebeenmadehadthetraderdonethetradesinyearspast.Ifatraderlooksclosely,theseoftenshowthatafewyearshadbiggains,

whereasmanyyearshadminimaloralmostnegligentgains.Thenyoualsocanseethelosingyears.

Lookathowbigthelosseswereinlosingyearsasopposedtothegains.Oftenyouwillseeafewyearswithbigprofitsbutequallybiglossesinothersandseveralyearsin

betweenwithsmallorverysmallprofits.Therefore,atradercouldbetakingalargeriskforminimalgains.Thisiswhythetermaverageprofitcanbeverymisleading.

2.Theyfailtorealizethatwinningyearsoftencanhavelargemovesagainsttheseasonalaveragethata

traderwouldhavehadto“rideout”tocapturetheprofit,whetheritwaslargeorsmall.Iftheprofitfromthetradewas$300inyearxbutithada$2,500drawdowninthemeantime,doyoustillthinkyouwouldbeinthetrade?Evenifyouwere,isthatthetypeoftradeyouwanttobein—ridingouta$2,500

loserfora$300gain?Probablynot.Atleastnotifyouwantyourtradingaccounttolastforlong.

Toputitbluntly,tryingtotradeseasonalsbypickinganabsolutedaytogetinandouteveryyearisnotonlypointless,butitalsocouldbehazardoustoyour

wallet.3.Theytrytotradeseasonalsusingfuturescontracts.Theinitialmistaketradersmakeistryingtotimethemarketinthefirstplace.However,thebiggestmistaketheymakeistryingtodoitwithfuturescontracts.

Tradingfuturescontractsrequires

almostperfecttimingtobeginwith.Ifyoutrytotimeyourseasonaltradebycalendardates,eveniftheseasonalmoveoccurs,whatifitisaweekortwooffthisyear?Whatifyougolong,andthemarketdecidestotakeabigdipbeforemakingarunhigher,assumingthatamovetakesplaceatall?Youcouldbe

stoppedoutlongbeforethemarketevengoesintoaseasonalrally.

Thereisastrategy,however,thatcankeepyouinthemarket,evenifpricesdocorrectwhileyouareinyourposition.Infact,youcanprofitfromthisstrategyeveniftheseasonalmovedoesn’ttakeplaceatall.The

strategy,ofcourse,iscalledoptionselling.

TheRightWaytoApproachSeasonals

Selling options instead oftrading futures on seasonalscan be stunningly effective.However, knowing how andwhy the seasonal works andthe likelihood of it repeating

this year are key in asuccessful seasonal optionsale.Doyourmarketanalysisright, and the proper option-selling months and strikeswillbecomeobvious.

Looking at a book ofseasonaltendenciesisagreatplace to start in your searchforgoodoptionsales.Browsethrough the charts and lookformarketsthathaveastrongtendency to make a clear,

sustainedmoveupordownatacertain timeor timesof theyear. Look particularly formarkets that often go fromextreme highs directly toextreme lows (or vice versa)without a lot of “riffraff” inbetween.Markets thathaveatendency to go from yearlyhighstoyearlylowswithoutalot of ups and downs in themiddle can be excellentcandidatesforoptionsales.

Try not to pay too muchattention to the smaller upsand downs, or blips, on theseasonal average charts.Focus on the major movesandthelong-termtendencies.

Now let’s go through thesteps to performing asuccessful seasonal optionsale.

StepstoIdentifyinga

ProfitableSeasonalOptionSale

Step1:LearntoReadtheSeasonalChart—Properly

Figure15.1 is an example ofa seasonal chart. The solidline represents a 15-yearaverageofpriceperformancefor that particular contract

month. The dotted linerepresentsa5-yearaverageofprice performance. Thenumbers on the side of thechart are not prices: 0represents the lowest averagepriceoftheyear,whereas100representsthehighestaveragepriceoftheyear.

FIGURE15.1NovemberNaturalGasFive-andFifteen-YearSeasonalOverlaid*

The key word here isaverage. This chart tells usthat, on average, natural gasprices tend to increasebeginning sometime in earlyFebruary and continue rightup through mid-June, whenthey tend todecrease sharplyintosummer.Does thismeanthatyoubuynaturalgaseveryFebruary 1 and sell it everyJune15?Absolutelynot.Thisis only the beginning.

Seasonal averagesare simplyraw material for your trade.This provides you withcandidatesthatyouwillweedthroughtofindafewfinaliststhat have the highestprobabilitiesofsuccess.

The fact that these areaveraged from 15 years ofprice data can be veryconfusing to the novicetrader.Alarge,randommovethat happened to occur over

the course of a few yearsoften can skew the averageandmakeit looklikeasmallmove occurs every year,especially if you are lookingatafive-yearaverage.

This is why you want tolookforthemarketsthattendtomovefromoneextremetoanother and not try to catchthe short-term swings thatshowupon a seasonal chart.Lookatthebigpicture.

The second note aboutaverages is the time frame inwhich the move takes place.Again, the seasonal chartreflects the average timeframe. This means that aprice move in a generaldirection could have begunseveral weeks before orseveral weeks after what isbeing reflected on theseasonal charts. This isanother reason why tradingfuturescontractsonseasonals

is so tough. If you trade offthe5-or15-yearaverage,youmay get in too early for amove that occurs this yearand end up stopped out, oryou may enter the positiontoolateandmissamovethatalreadyoccurred.

Tip: Look for marketswhere actual priceperformancetracksclosesttotheaverages.

We recommend looking

attheactualpricechartsfromthelast15yearsinadditiontothe seasonal charts beforedeciding to trade a seasonalaverage.Theclosertheactualprice charts follow theseasonal, the better tradingopportunity you may have.Several years of widevarianceaboveandbelowtheseasonal average with astrong variation in timeframesmaycombine to forman impressive-looking

average, but it can betreacheroustotrade.

In contrast, markets thatdemonstrate close historicaladherence to the seasonalaverage can be good tradingopportunities. For instance,Figure 15.2 shows a 15-yearseasonal average for Junecrudeoil.

FIGURE15.2JuneCrudeOilFifteen-YearSeasonal*

The energy complex canoffersomeexcellentseasonalopportunities for optionselling. The cyclic nature ofenergymarkets isone reasonthatthehistoricalpricechartsthat follow match uprelatively closely to theseasonalaverage.Figure15.3demonstrates that June crudeoilhasexhibitedafairlycloseadherence to seasonalaverages in many of the

previous15years.

FIGURE15.3JuneCrudeOilFifteen-YearPriceHistory*Overthelast15years,howmanyyearswouldyouhavemademoneysellingputsfarbeneaththecrudemarketinDecember?

The seasonal averageversusactualperformancefortheDecembereuro,however,tells a different story (seeFigure15.4).

FIGURE15.4DecemberEuroFifteen-YearSeasonal*

TheseasonalchartfortheDecember Euro appears toshow a fairly steady ascentfrom lowest to highest pricefrom June through Octoberand then trailing off intoDecember. Yet when onelooks at historicalperformance in Figure 15.5,thereisawiderangeofpriceperformance that variesconsiderably from theaverage. This is an example

of prices combining toproduce a somewhatmisleadingseasonalchart.

FIGURE15.5DecemberEuroFifteen-YearPriceHistory*

Often a quick way todetermine if you have aconsistent seasonal pattern isto compare the 5-yearseasonal average with a 15-yearseasonalaverage.Iftheyarefairlyuniform,itcouldbeanindicationthattheseasonalmove is consistent.September coffee is a goodexample of this (see Figure15.6).

FIGURE15.6SeptemberCoffeeFive-YearOverFifteen-YearSeasonalAverage*Septembercoffee5-yearseasonalaveragesmatchupwellwitha15-yearseasonalaverage.Thiscouldindicateamoreconsistentseasonalpricepattern.

Ifthereisawidevariationbetween the 5- and 15-yearseasonal average charts, itcould mean that the movesthatoccurred in thepastmayhave been randomoccurrences that combined tomake a good-lookingseasonalaveragebutwerenotreally seasonal moves at all.Italsocouldmeanthatanewfundamental has beendeveloping in more recent

years that is forging a newseasonaltendency.

Step2:LearntheReasonsBehindaSeasonalTendency

Once you have identified aseasonal move that seems tooccur fairly consistently atcertaintimesoftheyear,itistime to find out why.

Seasonalmovesdonotoccurmagically. There issomethingthatcausesthemtohappenyearafteryear.

If you remember the old“Scooby Doo” cartoons, atthe end, Scooby or Shaggywould pull off the mask oftheghostandfind itwas justOld Man Johnson. Whenstudying seasonals, you haveto play the role of ScoobyDoo. You have to pull back

themaskandlookbehindthescenes to see what is reallycausing this “magical” moveto occur. Almost always,there is a key fundamentalbehind the mask. It’s not asupernatural force. It’s morelikelyOldManHarvest, OldMan Summer, or Old ManInventoryBuilding.

KeyFundamentalsOccurRegularlyinCommodities

The occurrence of a keyfundamental at specific timesof the year tends to beespecially true in physicalcommodities. These wouldinclude grains, softs, meats,andenergy.

These are consumablecommodities that often haveproductionand/ordistributioncycles that occur at the sametime of the year every year.There are some years in

which outside factors willmute a corresponding pricemove in the commodity, butin “normal”years, pricemaytend to favor movement inone direction during thesetimeperiods.

Finding out these keyfundamentals and learninghow, when, and where theyoccur will give you a keyedge in trading seasonaltendencies. Instead of simply

looking at a seasonal chartand betting that prices willmove higher because theaverages say they will, youcan follow the fundamentalsthat historically have driventheseasonaltendency.

For example, if it is amoveinrelationtoaharvest,youcan track theprogressofthe harvest. Is it on schedulethis year? What size ofharvest is expected?What is

theconditionofthecropthusfar? If everything points tothe expectation that this willbe a normal harvest year, itmaybe logical toexpect thatpricesmayreactastheyhaveinyearspasttotheupcomingharvest.Ifthereappearstobea special situation this yearthat could disrupt, enhance,or affect harvest in anotherway,however,youmaywanttodigdeeperbeforedecidingon positioning. Experience

canplayakeyrolebecauseitis difficult for a novice todeterminewhatmaydisruptakey fundamental and whatmightnot.

Step3:LookatThisYear’sPriceChart

After you have identified aconsistent seasonal patternand have confirmed that the

keyfundamental(s)thatcauseitappeartobetakingplaceonschedule this year, it is timeto look at the actual pricechart.

Thefirstthingtoconsideris if this year’s price actionhas coincided with thegeneral seasonal pattern thusfar. For instance, supposecoffee prices are seasonallyprojected to fall to an annuallow in September before

rallying.Yet,you lookat theprice chart in September andthemarkethasbeenonatwo-month extended rally. Theseasonal says to buy inSeptember.Yet, thepricedipthat is “supposed” to occurprior to the rally has nothappened,atleastnotyet.Doyou still want to buy justbecause the seasonaltendencysaysso?Whatistheproblemhere?

In a situation like this, itis possible that otherfundamentals may havecombined to drive pricesawayfromseasonalaverages,making conditionsunfavorable to a seasonalmove.

Another thing to consideris that the seasonal movecameearly thisyear and thatyou may have missed italready.Orperhaps it iswell

within seasonal norms, buttheseasonalaveragecharthasthe move taking place 30days later. This is why it isimportant to look at dailyprice charts and comparetheirpatternwiththeseasonalpattern. If it appears that thebasicpatternsofthechartarethe same but that this year’schart ismatchingup earlyorlater, it may be a good betthat the move you want tocatchcould takeplaceearlier

or later as well. Theimportant thing is theoveralllong-term direction. Thefollowing example illustratesthisconcept.

SeasonalExample:SoybeansJuly soybean seasonalaverages point to a seasonalmove higher beginning inFebruary(seeFigure15.7).In2014, this move did begin

when the seasonal averagesaid it should (see Figure15.8), then corrected brieflybut sharply in March beforeresuming the uptrend. Manyfutures traders would havestopped out or exited thetrade on this temporary pricebreak. The good news:Distant put sellers thatpositioned in February mostlikely would still have hadtheir options expireworthless.

FIGURE15.7JulySoybeanFifteen-YearSeasonalAverage*

FIGURE15.82014SoybeanPriceChart

Step4:ReviewRelativePriceLevels

You also will want to beawareoftheabsolutepriceofthe commodity whenconsidering the likelihood ofa seasonal move. If pricesgenerally have traded in arange between$4 and $8 forthe last eight years and this

yearprice isat$12,will thataffect your seasonaltendency?Itverywellcould.

This is why it is soimportant to know thefundamentals behind themove. If your seasonalaverage indicates that youshould buy, and the price isthis high, it could mean thatprices are too high to movemuch higher even thoughseasonal tendencies favor it.

If your seasonal averageindicatesthatyoushouldsell,this could mean that a moreprecipitousdeclinewilloccurthisyear.

Help often comes fromexamining price charts fromprevious years to determinehow prices reacted to theseasonal tendency in yearswhere price levels werecomparable with today’sprices.

SellingtheOptionontheSeasonal

You’vegonethroughthefourpreceding steps and haveidentifiedamarketwhereyoufeel a seasonal move up ordownis likelytooccur.Nowwhat? How do you knowexactlywhentoposition?

The truth is that youdon’t. Technical traders canusetheirfavoriteindicatorfor

clues when to go long orshortduringtheseasonaltimeframe. But miss by a fewdays in futures trading, andyou’reoutof the trade.Evenif all of your research pointsto a seasonal move, there isstillnoguaranteethatamovewill take place. And there isalways the possibility, ofcourse, that acounterseasonal move couldoccur. In other words, pricescould move in the exact

oppositedirectionfromwhichtheseasonalaveragesindicatetheyhaveinthepast.

Nonetheless, if you’vedoneyourhomeworkandfeelthat you’ve got a goodseasonal tendency fromwhich to trade, you’vealreadytakenagreatstrideintipping the odds in yourfavor.Nowit’stimetoreallyoverweighthescales.

Ifyour seasonal tendency

indicates that a strong andsustained price increase islikely to occur over the nextthree months, instead oftryingtotimeitperfectlywithfutures, simply sell putoptionsfarbelowthemarket.If your seasonal chartindicates that a long, gradualpricedeclineislikelyoverthenext eight weeks, instead ofshorting the futures, sell thecallshighabovethemarket.

In other words, take thehigh road.Don’t try tomakea killing. Settle for a solidprofit. Sell the optionsinstead,andifthemovetakesplace, great. You make yourmoney. However, if it doesnot take place, fine, you stillmake your money. Even ifthemarketmovesmoderatelyagainst you, you makemoney. If your timing is offand themovecomesearlyorlate,youstillmakemoney.

Remember our GoldenRule: Don’t try to guesswhere the market is going.You only have to decidewhere it is least likely to go.Seasonals can be atremendous force for yourportfoliointhisregard.

By selling the option onthe opposite side of theseasonal tendency, you forcethe market to make asustained counterseasonal

moveforyoutolose.Notjusta short-term correction ordelay,ithastomakeamajormove against thefundamentals thattraditionally have caused themarket to move in theoppositedirection.

You force soybeans tomake a sustained movehigher when supplies aremost plentiful, right atharvest.Youmakeheatingoil

launch a sustained trendlower rightwhen distributorsbeginaccumulatinginventoryfor winter needs, whendemandishighest.

Going back to the veryfirstchapterofthisbook,prosare playing odds—amateursareswingingforthefence.Inselling options with theseasonaltendency,you’renotbetting a seasonal move willtake place this year. You’re

only betting that a severecounterseasonal move won’ttake place. That’s high oddsinvesting.

Conclusion

Combining seasonaltendencieswithsellingdistantoptions can be a high-powered technique foraccumulating consistenttradingprofits.Itcan,infact,

be amost potent formula foroption-sellingsuccess.

This does not, of course,mean seasonal option sellingis without risk. As they say,past performance is notindicative of future results.You can still lose whensellingoptionsonaseasonal,even if you do everythingright. This is only a piece(althoughavaluablepiece)ofyour overall option-selling

machine. Other pieces (suchas risk management) mustalso be functioning properlyforoverallsuccess.

We’vediscussedseasonaltendencies and theimportance of knowing thefundamentalsbehindthem.Ingeneral, physicalcommodities such asagricultural and energymarkets tend to exhibitmorediscernable seasonal

tendencies than do financialcontracts.

An excellent resource fora wide variety of seasonaldata are our good friends atMoore Research Center, Inc.You can find contactinformation for them in theresourcessectionattheendofthisbook.

In Chapter 16, we willreview some of our favoriteseasonal patterns, what

causes them, and how youmaybeabletotakeadvantageof them in an optionportfolio.

16

TheBestMarketsforSeasonalOptionSalesAPrimerforSeasonalNeophytes

InChapter15youdiscoveredhow to use seasonaltendenciesandtogetthemostout of seasonal charts. Nowyou are about to learn someof the more attractive andconsistent seasonal patternsthatyoucanusetoselecthighprobabilityoptionsales.

This is by no means acomplete list of tradableseasonal patterns, but itshouldgiveyouagoodbasis

from which to begin yourown analysis of seasonalprice movements. These arebased on our experiences inselling options on thesespecificcommodities.

You will notice that thefocusof thisdiscussion isonthe fundamentals that causethe seasonal moves ratherthan exact dates to buy andsell.Itisonthesefactorsthatyou should place your

emphasisasaseasonaloptionseller.

Energy

With the weather patterns inNorthAmerica, seasonal ebband flow of supply anddemand for energy used forheating, cooling, andtransportation can bepronounced. The energymarket can offer some

excellent opportunities forseasonal option sellers,although the market cyclesmay not be what you wouldthink.

Forinstance,awinterrisein heating oil prices is oftentoutedinradioadsthatsoundlike advertisements for cardealership “blowout”specials: “Demand is highestaspeopleneedheatingoilandnatural gas to heat their

homes during winter,” theyreason.

Although it may be truethatactualusemaybehighestin winter on the retail level,distributors beginaccumulating inventory forwinter needs long before thefirst green leaf has turnedorange in Vermont. Thus,demand tends to increase asthis takes place, oftenproducing rising prices.

Traderswhopurchaseheatingoil contracts in the fall mayhave already missed aseasonalmove.

Whereastheentireenergycomplex shows someimpressive and relativelyconsistent seasonal patterns,option sellers may want tofavor crude oil and naturalgas contracts. This is sobecause volume and openinterest in heating oil and

unleadedgasolineoptionscanbe thin, especially if you aresellingoptionsinback-monthcontracts. Crude oil andnaturalgasoffersubstantiallymore liquidity.Therefore, forthe purposes of this chapter,we will focus on crude oiland natural gas contracts.However, if a tradercan findenough liquidity in heatingoil or unleaded gasolineoptions, there are some veryenticing seasonal tendencies

forthesecontractsaswell.

SellingPutsinCrudeOilorUnleadedGasolineinDecember

Crude oil and all thepetroleum contracts followdistinct seasonal cycles ofaccumulation anddistribution.Thesepatternsof

supply and demand tend tohold true regardless of theactualpriceofcrudeoil.Thisis what canmake them suchan effective tool in sellingoptions.

Crude oil is used byrefineries to make gasolineand heating oil. Refineriescan gear up their facilities toproduce more gasoline ormore heating oil dependingon what the market is

demandingatanygiventime.Refineries ramp up

heating oil production in latesummerandgraduallytaperitoff into fall. By December,supplies on hand have likelyreached adequate levels, yetgasoline production forsummer has not yet rampedup. Thus, refinery operatingrates often hit a low by latefall,earlywinter.

Notbycoincidence,crude

oilprices tend to fall to theirlowest levels of the year inthe November to Januarytimeframe.Thus,sellingputsin crude oil during this timeperiod often can be anexcellent trading approach ifthefundamentalsappeartobefollowing normal seasonalpatterns(seeFigure16.1).

FIGURE16.1MayCrudeOilFifteen-YearSeasonalAverage*

PricesAreLowbutWhySellPuts?

While demand for gasolineremains relatively stable fornine months of the year, theNorth American andEuropean summer generallyproduces a spike in demandfor retail gasoline. Not onlyare roads easier to navigate

withoutsnowandice,makingdriving easier, but school isout.

Summeristhetimeofthetraditional American andEuropean vacation, whichalmost always entails a roadtrip. In other words, summeris travel time in theNorthernHemisphere, which meansmore driving and requiresmore gasoline. There is nodebate that gasoline demand

inNorthAmericaandEuropeishighestduring the summermonths. Do you think that itis a coincidence that you areusually paying the highestpricesoftheyearatthepumpduringthesummer?

Yet trying to profit fromthistrendcanbetricky.Why?Ifyoulearnnothingelsefromthe seasonal chapters in thisbook, remember this: Priceprecedes consumption. What

do we mean by that? Let’stakealook.

PricePrecedesConsumption

To meet expected summerdemand, distributors beginstockpiling gasoline suppliesas early as January. Thismeans that refineries willhave to retool facilities to

focus on gasoline productionto meet this demand. This“restructuring” phasegenerally takesplace inearlyto mid-winter (in theNorthern Hemisphere), onceheating oil supplies aredeemed adequate to meetwinter needs. This meansrefineriesshutdownforafewdays to a few weeks to geartheir facilities for maximumgasolineproduction.

These temporaryshutdowns can often jump-start a rally in oil productprices because stocks oftenshow a draw during thisperiod.However, as gasolineproduction kicks into fullgear, demand for crudebegins to rise rapidly again,and thus prices often tend tofollow.Again,gasolinepricesgenerally are rising as wellduring this time asdistributors are accumulating

inventory, driving updemand.

Sometime in the April toJune time period, whendistributors begin todetermine thatsupplywillbeadequate to meet summerneeds, gasoline inventorybuilding will begin to slow,and production of unleadedgasoline will be curtailed,resulting in reduced demandfor crudeoil.Thus, crudeoil

prices often peak during theheight of the accumulationphase,inlatespring,andthenrecede slowly to reflect thereduced demand ofdistributors.

The energy market oftensuffers another low duringmidsummer as demand forcrude oilwanes.However, itis during this time thatrefineries once again switchover to heating oil

production, beginning thecyclealloveragain.

This is the normalseasonal cycle of the energymarket. There is no magichere. Just solidsupply/demandfundamentals.Of course, other factors alsoaffectthedailypriceofcrudeoil, such asweekly builds ordrawsinstocksorviolenceintheMiddleEast.Butseasonalcycles are the “big picture”

fundamentals. It will helptremendously to focus onthese in your trading. As anoption seller, you have theluxuryofbeingable to focuson thebigpictureandnotonthe day-to-day news andtechnical timing to whichmost futures traders arelimited.

Counterseasonal

Moves

Just because crude oil priceshave a good track record offollowing seasonal demandcycles, it does notmean thatprices cannot move in theopposite direction. This iscalled a counterseasonalmove, and although it is notthe norm, it will happenoccasionally. There are stillfactors that could counteract

seasonaldemandcyclesinallcommodities. Seasonaldemand cycles are a majorfundamental.Buttheyarenottheonlyfundamental.

For instance, crude oilprices in particular can besensitive to worldwidegeopolitical events.Althoughthis is certainly not the onlything that can cause acounterseasonal move, itwould be key factor to

consider.This is what is meant by

monitoring fundamentals todetermine if normal seasonalsupply-and-demand patternsare occurring on schedule.Youmustbeawareofoutsidefundamental developmentsthat could disrupt normalsupply/demand cycles. Youwon’t always be able todetermine if something mayor may not affect the cycle

dramatically, but animpending war is probably agood reason for pause.Supply/demandcyclescanbevery strong and can overridea lot of other fundamentals,even the ones currentlygrabbing headlines. Commonsense and experience will beyourguides.

HowtoPosition

Should you just start sellingcrude puts in November?Again, let common sense beyourguide.Forexample,ifitisDecember and crude oil isat the highest price levels ofthe year, the seasonalapproachmaynotbethebestplay this year. Yet, if themarket appears to be at leastnominally tracking seasonalaverages,positioninginfavorof those averages continuingmakesgoodsense.

Remember,althoughyouranalysis may forecastincreasing prices soon, youdon’t need a rally to profit.Your only stipulation is thatpricesdon’tfalldramatically.

Consequently, crude oilcall sales at the end of thecycle in late May to earlyJune can alsobe a solidwayto generate premium usingseasonalanalysis.

SellingNaturalGasCallsinMay

The peak use season fornatural gas is during thewintermonthsasitisquicklybecoming the primary fuelused for heating in NorthAmerica. Yet natural gasdemandsurgesinthesummermonths as well becausenatural gas is used by manypower plants to generate

electricity to power air-conditioning units duringhotter temperatures. Retaildemand during the wintermonths overlap withcommercial demand asdistributors are accumulatinginventories to meet summersupplyneeds.Thiswill oftenresult in prices trendinghigher during the winter andearly spring. This can alsomake for a good seasonalplay(discussedbelow).

This inventoryaccumulation cycle tends toclimax inMay and June. Bythis time, distributors havetypicallyaccumulatedenoughinventories to meet expectedsummer demand. Onceinventories are deemedadequate, wholesale demanddrops off substantially (seeFigure 16.2). This can oftenbe reflected in the price ofnatural gas. Thus, the monthof June can be an excellent

time period to sell calls innaturalgas.

FIGURE16.2AugustNaturalGasFifteen-YearSeasonalAverage*

It is ironic that this cycleoccurs precisely at the timethatdemandattheretaillevelisjustrampingupagain.Thisis a pure illustration of priceprecedingconsumption.

IsHurricaneSeasonstillaSeasonalFactorinNaturalGas?

Aside from this keyfundamental, however, thereis another reason why thistime period makes sellingnatural gas calls so enticing.TheAtlantichurricaneseasonofficially begins on June 1.The media has turned themonthofJuneintoanannual“hurricane”warning event asthey are always on thelookout for something withwhich to frighten the public(“better stay glued to this

channel or you could be indanger”).

This brings speculatorsoutindroves.However,thesespeculators (read “generalpublic”) will prefer to buycalls over the futures. Thus,demandforthecallscanoftensurgewithout anybigmovesin the underlying price. Inother words, impliedvolatilityoftensurges.

The hurricane play,

however, is largely a farce.Yet, there is often goodmoney to bemade here. Thebuying frenzy in the callsoften begins weeks ahead ofthe “official” start to theAtlantic storm season. Whatmanyofthesecallbuyersfailto realize is that the officialstart is typically not the realstart.

Speculators buy naturalgascallsinfearofahurricane

moving through the Gulf ofMexico and knocking outnatural gas rigs, therebyknockingsupplyoffline.Canit happen? Hey, we allrememberHurricaneKatrina.

However, Katrina was aonce-in-a-lifetime storm thathit a direct bull’s-eye onnatural gas rigs.Most rigs intheGulfcanhandlestormsupto aCategory 3 and not losemuch production. Even the

strongest of storms typicallyrequire a direct hit to knockproduction off line. Severalstorms have raged throughthe heart of natural gasproduction zones in the Gulfsince Katrina. Few, if any,produced any considerablepricemoves.

A final consideration isthe time frame. Whereashurricane season officiallybegins in June, anyone who

livesneartheGulfofMexicoknowsthatGulftemperaturesare rarely warm enough inJuneorevenJulytosupportamajor hurricane. It isn’t untilAugust or September thatmost Gulf Coast residentsbegin watching their tropicalweather reports in earnest.That is about a three-monthwindowtoselloptions to thehurricane speculators andreap some substantial timepremium.

What the hurricaneplayers reallymiss, however,istheadventofallofthenewsupply channels that havecomeonlinesincethetimeofKatrina. We are talkingspecifically about the adventofhydraulic frackingand theproduction of natural gasfrom wells on both theMarcellusandBakkenshales.

I (Michael) grew up inWesternPennsylvania,where

I stillhave familyandownalittle property. The county Igrew up in now looks morelike Saudi Arabia thanNortheast United States.There are wells everywherewithnewonesgoingupeveryday.

But the wells in my areaarenotoilwells.Thesewellsare pumping natural gas. Somuch they have not yetfigured out how to capture it

all yet.They burn the excessoff, producing huge fireballsintheskyatnightthatcanbeseen from a dozen milesaway. This is real “newsupply” and it has renderedtheonceall-importantGulfofMexico rigs less important.This means threats to Gulfnaturalgasrigsmaynothavethe impact on gas prices thattheyoncehad.

All of this being said, a

bona fide Category 3 orhigher hurricane entering theGulf of Mexico is usually agoodreasontocloseoutyourshortnaturalgascalls,ifonlyforprecautionaryreasons.

SellingNaturalGasPutsinJanuaryandFebruary

Aswesawabove,naturalgas

tends to follow similarseasonal tendencies as foundin petroleum, albeit forsomewhatdifferentreasons.

Aswithheatingoil, retaildemand for natural gas ishighest in the winter monthsfor heating needs. Asdiscussed earlier, natural gasisusedastheprimaryheatingfuel for newer homes,especially in northern andwesternregionsoftheUnited

States. Distributors in theseregions, then,must anticipatethis demand surge and beginaccumulatinginventoryinthemonths leading up to theheatingseason.Theseare themonths that wholesaledemandaccelerates,andpricetendstofollow.

Almost exactly likeheating and crude oil,accumulation begins to slowsometime in late autumn,

when distributors determinethat supply should beadequate to meet winterneeds. This often will beaccompanied by a drop inprices(seeFigure16.3).

FIGURE16.3NovemberNaturalGasFifteen-YearSeasonalAverage*

The second and possiblymore powerful seasonaltendencyfornaturalgastendsto begin in the heart ofwinter. It is ironic thatwhenretail natural gas demand ispeaking in the December toFebruary time frame, futuresprices often are near yearlylows. This can change veryquickly,however.

Retaildemand fornaturalgas peaks again during the

summermonths because it isused as a primary fuel togenerate electricity to powerair conditioners in southernand western regions of theUnitedStates.Withthisretaildemand spike expected tobegin in June, southernnatural gas distributors begintakingadvantageofthelowerprices and generally beginaccumulating inventorysometime in the January toFebruarytimeframe.

This accumulation phasecanbecomeverypronouncedinFebruaryandMarch.Thus,a price increasecorrespondingwith the risingdemand is often the result.Put sales far beneath winterandsummerlows,then,oftencanbeagreattradeinnaturalgas.

A key figure natural gastraders watch during thesetimes of the year is the

weekly injections intostorage,which is released bythe Department of Energy.This shows what kind ofsupply is being built tomeetsummerorwinterneeds.

An added benefit oftrading natural gas is thatunlike crude oil, which theUnited States still reliesheavilyonandimports tofillits demand needs, mostnaturalgasusedintheUnited

States is produced in NorthAmerica. This makes thecommodity lessvulnerable togeopolitical events overseasthan crude oil and itsproducts.

You can use technicals,common sense, and a goodbroker in timing yourseasonal option sales innaturalgas.

Soybeans

Agricultural commoditiestend to have distinctiveseasonaltendenciesthatoftencan be used very effectivelyin conjunction with anoption-selling campaign.Whereas seasonals in energyare based more on demandcycles, seasonals inagricultural commoditiesoften are more the result of

supplycycles.Crops that are grown in

the soil obviously will bedependent on the seasons fortheir growth cycles.Therefore, it follows thatsupplies would be highest atharvesttimeandlowestinthemonths just precedingharvests.

Soybeans have a verydynamic harvest cycle nowthat South America has

eclipsed the United States intotal production of soybeans.Until the early 1990s, theworld’s supply of exportablesoybeans was producedprimarilyintheUnitedStates.Thus, following one harvestcyclewasallthatwasneeded.

However,withtheadventofincreasingSouthAmericanproduction to today’s levels,major soybean harvests nowtake place twice a year, or

every six months. Soybeansare harvested in the UnitedStates in the September toNovember time frame,whereasautumnharveststakeplaceinBrazilandArgentinain the March to June timeperiod.

SellingSoybeanCallsDuringtheU.S.Summer

Soybeanpriceswilloftenputin harvest lows sometime inSeptember orOctober.At notime during the year willsupplies be higher than rightafterharvest.Thus, logicandEconomics 101 dictates thatwhen supplies are highest,prices will be lowest. Thisseems to be confirmed by aseasonal chart of Novembersoybeans.Pricestendtobreaksharply into the peak ofharvestseason.

The old pattern forNovember soybeansgenerally saw soybean pricesreaching an apex in May asU.S. supplies of old cropgenerallyweredwindlingandnewcropplantingjittersoftenwerepeaking.

Yet, growing worldwidedemand for food, grains inparticular, have made pricesultra-sensitive to weather.Severe weather causing real

orperceivedcropdamagecansend soybean prices jumpingduring summer months. Forthisreason,itappearsthattheseasonalhasshiftedlaterintothe summer, closer to whenthe U.S. soybean cropactually goes to pod inAugust, before the market issatisfied that the harvest issafe.Theseasonalpricebreakoccursinearnest.

Prices can still peak

during planting anxiety inMayandthengraduallypricein the “new crop” or newsupply into the fall harvest.Selling calls on May pricestrength can still be a solidseasonal play. However,selling calls on weatherrallies during the U.S.summermonthscanalsobeasound seasonal strategy (seeFigure16.4).

FIGURE16.4November

SoybeansFifteen-YearSeasonalAverage*

A bona fide crop-damaging weather event inthe United States can makeyouwronghere.But the realdeal doesn’t happen veryoften. Eventually, they stillharvest the beans. Weathercan make the “ridiculousstrike prices” mentioned inearlier chapters available inthismarket.

You can take a lot ofpremium out of the soybean

market as there are a lot ofbeginners playing here. Andthey love to buy call optionsin the summer. So do theirbrokers,asit’saneasysell.

SellingPutsonSoybeanHarvestCycles

Unlike equities, however,there is some common sense

present in the commoditiesmarket. Soybean prices tendto hit their seasonal pricelows in October, right at theend of harvest (the termharvestlowsisacommononewhen discussing agriculturalprices). Not coincidentally,thisisthetimewhensupplieswill be at their highest andthus, prices often at theirlowest(seeFigure16.5).Thiscan often be a good time tosellputsinsoybeans.

FIGURE16.5MaySoybeansFive-andFifteen-YearSeasonalAveragesOverlaid*Agriculturalmarketstendtomakepricebottomswhensuppliesarehighest—rightafterharvest.

SecondaryPutSalesinFebruary

South American soybeansgenerally are being plantedwhenU.S.soybeansarebeingharvested in October andNovember. Farmer sales ofsoybeans often are heaviestduring the winter months asU.S.farmerscashinsoybeans

from the autumn harvest anduse the proceeds to restocksupplies and equipment fortheupcomingcropyear.Thisselling often reaches a peakduring the heart of the U.S.winterandcanresult inpriceweakness.

This phenomenon isknown in trading lore as theFebruary break and hasgained a lot of notoriety,especially over the last few

crop years. However, oncethissellingclimaxisfinished,the U.S. soybean supply hasdwindledandtheworldlookstoward the Brazilian crop tomeetimportneeds.

Brazil, however,doesnotbegin harvesting beans untilMarch and the bulk of theharvest is typically notavailableuntilMay.Thislowperiod of supply can oftenresult in a spring price rally

that can last for severalmonths,especiallyifthereareany delays in planting thenew U.S. crop in April andMay.

As with other seasonaltendencies, trying to time thelowofaFebruarybreakwithfutures contracts can be liketrying to time your jump outof a falling elevator. Sellingoptions, however, does notrequirethepickingofalow.

Ifother fundamentalsandoutside news events havebeen taken into account,selling puts far beneath thesoybean market in Februarycan be as good a seasonalplayasany.Abrokerornewsservice with access to U.S.export and Brazilian cropestimates can be extremelyhelpfulinthisregard.

Again, remember thatthese are seasonal averages

and that the February breakcould occur as early asJanuaryoraslateasMarch,ifitoccursatall.

Grain

Corn harvest cycles areroughlythesameassoybeansin the United States. Cornfarmers, however, do nothave to contendwith a largeworldwide competitor as far

as exports go. China used toexport corn, but by the mid-2000s,thecountryfocusedontryingtogrowenoughcorntoavoid having to import largequantities. Today, with anexpanding middle class witha growing appetite for meat,Chinahasgrown into ahugeproducer of livestock, andthus,hasavoraciousappetiteforforeigncorn.

Brazil is not a large corn

producer, but Argentina hasbecome a considerableproducerofcorn.TheUnitedStates, however, remains byfar the largest exporter ofcornontheworldmarket.

Corn seasonal pricetendencies, then, are muchmore reflective of U.S.harvest cycles. There areseveral price tendencies tostudy in corn. However, oneof the more consistent is the

onewewillmentionhere(seeFigure16.6).

FIGURE16.6SeptemberCornFifteen-YearSeasonal*SellingCornCallsinMaycanbeanexcellentstrategy.

Corn is planted in AprilandMay(springintheUnitedStates) and harvested inSeptember and October (fallin the United States). Corntakes slightly longer todevelop than soybeans, andtherefore,theplantingofcornusually is started ahead ofsoybean planting. Althoughrumorsoftenwillswirlaheadof planting about dry soil ortoomuch rain, once planting

is completed and the crop is“intheground,”anxietytendsto dissipate, and prices tendtodeclineinanticipationofanew crop on the way.Therefore, selling corn callsinMaycanbeagoodwaytogenerate revenue throughpremium collection. Youdon’t bet on a price decline,you only bet against asubstantialrally.

Callsellersseekinghigher

premiums can begin sellingcalls as early asMarch if noabnormal fundamentaldevelopments are readilyapparent. Again, the furtherout of the money the better.Options sold in March willhave to be held longer,meaning that there is moretimeforpricetomoveagainstyour position before timedecay can begin balancingoutadversemoves.However,you alsomay be able to sell

strikes further out of themoney than youwill be abletoinMay.

Weatheranxietiescanstillcause corn prices to rally inthe spring. You want to bepositioned to ride out ralliesto take advantage of thebiggerpicture.

Real weather damage tocrops, however, is not ascommon as one may think.Furthermore, weather

problems don’t happenovernight. They happen overaperiodofweeksormonths.Set your risk controls andstickbythem,andyoushouldnot have to fear large lossescausedbyadverseweather.

FrozenOrangeJuice

Oranges for juice productiongenerallyareproduced in theUnitedStatesandBrazil.U.S.

oranges are grown in Floridaand California, thoughoranges for juicing comeprimarilyfromFlorida.

Becauseorangesgrowontrees, there is no plantingseasonfororanges.However,thereisagrowingseasonandharvest for oranges. Whilemuch of the orange juice inthefrozenconcentrateorangejuice (FCOJ) contract nowcomesfromBrazilianoranges

(see Chapter 14), seasonaltendencies for this contractarestillheavilyinfluencedbythe development of theFloridaorangecrop.

Orange juice for theMarch contract comes fromoranges harvested inDecember and January.Harvest season for Floridaoranges begins inDecember.Yet frost season in Floridabegins in December as well.

Thus, prices have a tendencyto run up in anticipation of“frost season” and then falloncethemainFloridaorangeharvest begins in December.This is the result of bothhedgersandsmallspeculatorsbuyingorange juiceaheadof“frost season.” The seasonaltendency says this is a greatopportunity for astute optionsellers to take their money.Weagree.

We wrote an article onthis phenomenon severalyearsagothatwethinkisstillrelevant in explaining thisseasonal tendency for thisbook. The article appears inthebox.

In summation of thearticle, prices tend to rise inOctober and November as afreeze premium builds intothe market. Once harvestbegins in December, prices

have a tendency to plummet.Eventhoughthepossibilityofa freeze occurring prior toharveststillexists,freezesareless likely now than theywere a decade or two agobecause the bulk of orangeproduction in Florida hasmoved further into thesouthern regions of the state.These areas have higheraverage annual temperaturesandthereforearelesslikelytofreeze.

OrangeJuiceFutures

ApproachingHarvestIsOftena

TradingOpportunityin

FCOJJAMESCORDIERANDMICHAELGROSS,

OPTIONSELLERS.COM

The coming freezeseason for Floridaoranges oftenencourages themarket to build in arisk premium. ByDecember, however,themarket has often

done so. But theproduction seasoncoincides with thefreeze season. Whatdoesthismean?Thismeans thatspeculators bid upprices of frozenorange juice futuresin November in

anticipation of“freeze season” inFlorida. Harvestusually begins inDecember.Therefore, barring akiller frost, themarket goes from afrost premium inprice to a situation

whereorangesupplyis the highest it willbeatanytimeduringthe year. Thus,orange juice pricesoften go from theirhighest points of theyear to their lowestin a matter of amonth. This

phenomenon isunique to theorangejuice market butoften can present avery lucrativeopportunity for calloptionsellers.

Is Freeze SeasonStill Freeze Season

for FloridaOranges?

Being in Florida, I amprobably quoted more onthe orange juice marketthan on any othercommodity. Orange juicealso happens to be one ofthe least written aboutcommodities on the board.This is why I believe thatorange juicehappens tobe

a great market to tradefundamentally. Theresimply is not a greatamount of informationavailable to the generaltradingpublicaboutorangejuice—atleastnotasmuchasthereisforamarketlikesoybeans, where we getdaily updates on cropconditions, soil moisture,andexportnews.

There has been a basic

fundamental change inorange production inFlorida over the last 15years.Muchlikethecoffeemarket (which also pricesin a “freeze premium” inthe month of May),producing areas graduallyhave moved out of thehigh-risk freeze areas inrecent years. In the 1990s,Florida’s orange crop wasravaged by a series offreezes. Instead of

replanting trees in thosesame freeze-prone areas,producers began plantingtreesmuchfurthersouthinthestate.Thosetreesbeganproducingasubstantialpartof the Florida orange cropby the middle of the lastdecade(2005–2006).

Today, Florida orange-producing areas aresignificantly further souththan15yearsagoandthus

are far less susceptible tothe damaging freezes thatgrabbed headlines in yearspast. The seasonal pricerally in orange juice hascontinuedtopersistmainlydue, in our estimation, tothesmallspeculator.

These days, it is blightand disease, not freezes,thatposethegreatestthreatto Florida oranges.Nonetheless, we believe

thatconditionsarerightforthe market to follow thehistorical preharvest pricepattern.

We are fortunate asoption sellers becausespec-ledfreezeralliesdriveupcalloptionpremiumstooverinflated levels andcanmake for an excellentoption sale. We are notsuggesting that a crop-damaging freeze is not

possible, only that it ismuchmoreunlikelythanitwas 10 to 15 years ago.Even in the unlikely eventthatacoldsnapoccurs,wefeel that ifoptionsalesareexecuted at higher strikeprices, traders should beable to ride out all but themost severe freeze. At thetime of this writing, it is80°Foutsidemywindow.

Look to be a seller of

orange juice calls over thenext two to fourweeks onrallies. We feel that theorange juice market isbasingforaseasonalswinghigher, and aggressivetraderscanpositionona3¢to 4¢ rally. However, wewill exercise caution andwait until the traditionalseasonal top in middle tolate November beforerecommendingpositioning.Wewillbeworkingclosely

withclientsinthetimingofthistrade.

Selling calls on aNovember toDecember rallyinfrozenorange juicecanbea high-probability andsometimes fast-profitopportunity. March calls athigh strikes often offer thebest bargains (see Figure16.7).

FIGURE16.7MarchOrangeJuiceFifteen-YearSeasonal*

Again,theseareaverages,and there isno rule that saysthat orange juice prices can’tmovehigher inDecember.Abroad look at the overallmarket and solid riskmanagement obviouslyremainvitalcomponents.Butthis seasonal tendencyremainsasintactin2014asitwas in 1999 and shouldcontinue to be for as long asorangesaregrowninFlorida.

SellingCoffeeCallsAheadofHarvest

Coffee is produced in manynationsacross theglobewithtropical climates. Brazil,however,isbyfartheworld’slargest coffee producer andcoffeeexporter,whichmakesthe market very sensitive tothe status of the Braziliancoffee crop each year. YetVietnamhasbecomeamajor

player on the world’s coffeemarket and is now theworld’s number-twoproducer.

Aswithoranges,coffeeisnot replanted each year likecorn or soybeans but rathergrows on trees (that actuallylook more like bushes).Therefore, there is noplanting season for coffee,but harvest cycles can makecoffee a good market for

seasonaltrading.Brazil begins to harvest

coffee in May of each year.But the market often beginstoforward-pricethenewcropof beans after the sensitiveflowering season late in theyear. Anxiety is often highduring flowering season inBrazil, and this is when thenext year’s crop is mostsusceptibletodamage(thisissimilar to pollination time in

corn or podding season insoybeans).

During this time, thecoffee tree develops flowers.Theflowersthendropoffandintheplaceofeachflower isacoffeebean.Thus,themoreflowers,themorebeans.Andthe better the weather, themoreflowers.

Prices tend to gainstrength through theflowering season as anxiety

builds. Yet by January, theflowers are gone and thebeans are emerging. Anxietyfades. Prices will oftenweaken(seeFigure16.8).

FIGURE16.8SeptemberCoffeeFifteen-YearSeasonal*

At the same time,Vietnam is harvesting coffeebeansandisalreadydumpingnew supply on the market.Thus, the combination offading anxiety over theBrazilian crop plus freshsupply from Vietnam, canoften see prices weakenthrough the early months ofthe calendar year. Sellingcoffee calls early in the yearcan be an excellent seasonal

play.SecondaryopportunitiescancomeinMayorJune,justpriortotheBrazilianharvest.

Cattle

Weather and the changing oftheseasonsalsohaveadirecteffect not only on beefproduction but also ondemandforbeef.Sinceabout90% of all beef produced intheUnitedStatesisconsumed

in the United States, cattleprices at the ChicagoMercantile Exchange areaffected by factors affectingthe U.S. herd and by factorsaffecting theNorthAmericanappetiteforbeef.

Media “pop analysis”dictates that beef demand ishighestinsummerbecauseofbarbeque season, thus priceswill be higher during thesummermonths.This isonly

slightly true. Although thereis a slight increase in beefdemand in late spring andearly summer, demand forbeeftendstowaneduringthehot summer months becausefamilies favor quick mealsand are eating on the run,with summer activities (e.g.,swimming, soccer, softball)taking precedence. Inaddition,lighterand/orcoolerfoods often are preferred insummerasopposed tositting

down to a pot roast. Yetseasonal charts confirm thatprices, at least of FeederCattle (young animals placedon feedlots), do indeed oftenpeakduringtheU.S.summer(seeFigure16.9).

FIGURE16.9SeptemberFeederCattleFifteen-YearSeasonal*SellingfeedercattleputsduringtheApriltoMaytimeperiodoftencanbeagood

summerplay.

Butwhyisthisthecase?It generally takes four to

six months after a youngfeeder calf is placed on feedbefore it reaches its optimalmeat production weight.Duringthesummermonths,itis easier to raise cattle. Notonlyistherelessstressontheanimal,butoften,feederscanput cattle out to graze inpastures instead of keepingthem “in the pen.” As cattle

canberaisedlessexpensivelythisway, it isnotuncommonto see more cattle on feedduring the warmer summermonths.Thesecattlewillthenreachmaturityduringthelatefallwhen theywillbebidonby meat producers. Thus,supply of slaughter-readycattle canoftenbehighest inthelatefall,earlywinter.

During the winter tospring period, the opposite

takes place.Cattle are harderto raise. Cold temperaturescan make it harder to putweight on the animals. Theymustalsobefedadietheavyin corn and soymeal, thusmaking themmoreexpensiveto raise. The result is oftenfewer live cattle beingdelivered to meat packers inthe late spring and summermonths.

Selling cattle puts during

wintermonths canbe a solidpremiumgenerator.However,individual-year fundamentalsmust be given their due.ThemonthlyUSDAcattleonfeedreport is the key report towatchinthismarket.

SeasonalsandFinancials

Wedonotputasmuchstock

in financial seasonals as wedo in physical commodityseasonals. For one thing, thefundamentalssupportingsuchmovesdonotappearassolid.Second,inouropinion,manyseasonal tendencies infinancials do not seem to beas consistent as those in thehardcommodities.Thereare,however, a few tendenciesyoumaywishtoexplore.

Many investors have

heard that the stock marketmakes a low in October.Whilesomemaydismissthisas myth, the seasonalaverages of the MarchStandard & Poor’s (S&P)contract seem to support thisviewpoint(seeFigure16.10).

FIGURE16.10MarchS&P500Fifteen-YearSeasonal*

Currencies also exhibit acurious tendency to have aseasonalpreference.Theyen,for instance, often mayexhibit a bias of weaknessagainst theU.S.dollar in lateautumn because that iswhenJapanese multinationalsrepatriate yen for the half-fiscal-year accounting (seeFigure16.11).

FIGURE16.11March

JapaneseYenFifteen-YearSeasonal*

Although there are manyfinancialseasonalsfortraderstoconsider,itisverydifficultto get a handle on all thefundamentals thatgo into theprice makeup of a financialcontractandgaugeiftheyarecoming together on time tomake a seasonal move.Financial contracts are alsohighly sensitive togeopolitical or economicnews.Sometimesevenminor

events can move the marketinlargeintervals.

Despite theimpressiveness of the chartson the next page, we havefoundthatfinancialseasonalsas a whole are not quite asconsistent as some of thecommodities, having manywide aberrations from theaverages.

Nonetheless, they dopresent occasional

opportunities for the righttraders. You may want tofurther research financialseasonalsonyourowntofindpotential option-sellingopportunities.

Conclusion

Several seasonal tendencieswere covered in this chapter,but thesearecertainlynotallthat are available. The ones

discussed here constitute alimitedlistof thosethathaveprovedthemostconsistentinour option-selling programovertheyears.Youmaywanttoexploreseasonalsfurthertodiscover other tendencies ofcertain markets that mayproveusefultoyou.

While seasonals certainlyare not guaranteed and areonly an average of a broadcompilationofdata, theycan

be very effective tools to anoptionseller.

Seasonal tendencies are afocusofourclientnewsletterTheOptionSeller. For a freesample issue, visitwww.OptionSellers.com.

OptionSellers.comInterviewwithJerryToepke,

Editor,MRCIPublications,

MooreResearchCenter,Inc.

(SeasonalResearchonFuturesMarkets)

Moore Research

Center, Inc. (MRCI)is the premierresourceon seasonaltendencies in theUnited States. WehavereliedonMRCIfor years for all ofour seasonal data.They havegenerously provided

all of the seasonalcharts you haveviewed in the lasttwo chapters. As aspecial treat for ourreaders, JerryToepke, editor ofMRCI publications,has agreed to do aninterview

exclusively for TheComplete Guide toOption Selling. Wehope you find hisinsightshelpful.

OptionSellers.com:ThankyouforbeinghereJerryandsharingyourinsightswithourreaders.Let’sgetrighttoit.

OS:Howlonghaveyoubeenstudyingseasonaltendencies?

JT:Iwasfirstintroducedtoquantitativeseasonalanalysiswhenin1988IcametoMooreResearchCenter(MRCI),atthetimenotonlyabranchofamajorcommoditiesbrokeragefirmbutalsothatfirm’scomputer

researchfacility.GrowinguponaMidwestfarmgavemeageneralfamiliaritywithseasonalpressuresandtendenciesforbothgrainsandlivestock.Uponlaterbecomingafuturesbrokerandtrader,seasonalityhadanevengreaterprofessionalimpact.ButwhenIarrivedatMRCI,SteveMoore

taughtmetheconceptsofseasonalresearchandNickColleytheintricaciesofquantifyingthemarket’sownhistoricalpricemovementstofindthosethatrecurredinthesamedirectioninamoreorlesstimelymannerwithagreatdegreeofhistoricalreliability.

OS:Whatgotyouinterestedinthisavenueofcommoditiesanalysis?

JT:Havingalreadybeeninthebusinessfor10years,Iwasinitiallyskeptical.ButIquicklybecamefascinatedbyhowtimelytheoptimizedentryandexitdatescouldbe.What’smore,Ithen

begantoseeandunderstandevenbetterhowseasonaltrendsandstrategiesfitwithseasonalconditionsandevents.Marketmovementbegantomakemoresense.Becausefuturesmarketsanticipate,seasonalanalysiscouldhelpmeanticipate.So,ratherthanbefrustrated,forexample,

byapricedeclinegoingintosoybeanharvestwhensupplieswerestillincrediblytightandthenarallyoutofharvestwhensupplieswerefinallyabundant,Icouldunderstandthephenomenonof“anticipationandrealization.”Further,ithelpedmebetter“read”amarketbecause

seasonalanalysiscouldtellmewhatnormalmarketbehaviorwasatanygiventimeofyear.Socomparingcurrentmarketactiontoseasonalmarketbehaviorgavemeanideaofwhethercurrentconditionswererelativelynormal—orwhetherthemarketwasconsciouslyorunconsciously

anticipatingsomepowerful,unusualconditionorevent.

OS:Whatdoesyourcompanydoforinvestorsand/orportfoliomanagers?

JT:MRCIdoesnotpresumetotellanyonehoworwhattotrade.Instead,alleffortsaredirectedtohelpothersresearchtheirtrades.

Thus,MRCIprovidesitsseasonalresearchviaseveralservicesandpublications.MRCIOnline,theprimaryservice,drawsfromabout40majorfuturesmarketstopresenteverymonth15seasonalstrategiesand15seasonalspreadstrategieswithentriesthatmonth.Eachstrategyhasan

optimizedentryandexitdatebetweenwhichthatmarketorspreadhasmovedinthesamedirectioninatleast80%ofthelast15years(ifavailable),atableofhistoricaldetail,anddaily/weekly/monthlychartsinsupport.TradeandSpreadReviewstrackthedailyperformanceofeach

strategyaspublished,andPortfolioReviewsshowtheresultsofeach.Inaddition,traderscanfindhistoricaldaily(manynolongerfoundelsewhere),weekly,andmonthlycharts;correlationstudies;seasonalvolatilitystudies;seasonalpatternsforeachdeliverymonthofall

majorU.S.andsomeinternationalfutures;etc.EachFriday,theWeeklySpreadCommentarydrawstwospreadsfromMRCIOnlineanddiscussesseasonalfundamentalsthatmayhavehelpedgeneratetheirseasonalpatterns;presentsthesupportingchartsandhistory;andthentriestohighlightany

relevantchartlevels,recentorupcominggovernmentofindustryreports,andanynewsthatcouldaffectthespreadthisyear.Forcommercialfirmsandthosewithspecialinterests,MRCIoffersaseriesofspecialhistoricalreports,eachofwhichanalyzesaspecificmarketcomplex(soy,metals,

forex)andpresentsseasonaltradingideasforyear-round.

OS:Whatdoyoufeelaresomeofthemoreconsistentseasonalpatterns—especiallyinthephysicalcommodities?

JT:Mostmarketshaveseasonalpatterns,eventhosenotsomuchinfluencedbyweather.

Forexample,onemightnotexpectcurrenciestohaveseasonalpatterns,buteachcountrydoeshaveitsownfiscalyearwhichcanaffectthetimingandamountofmonetaryflows.However,seasonalpatternsforseveralphysicalcommoditiesareperhapsmoreconsistent.Firstandforemost,onemight

thinkofheatingoil,gasoline,andnaturalgas—allwithdemanddrivenbypatternsofconsumptiondirectlyrelatedtoweatherandthechangeofseasons.Second,seasonalpatternsinnearlyallcrops—corn,wheat,soybeans,cotton,orangejuice,coffee,sugar,cocoa—haveevolvedinlargepartby

thetimingofharvestandpatternsofsupply.Finally,becausetheyareessentiallymarketsforliveanimalsratherthanstorablecommodities,seasonaldisparitiesinsupplyanddemandarealreadypartiallybuiltintothepricestructuresofcattleandhogfutures.Nonetheless,thetimingofcornharvesthas

helpedgenerateseasonalpatternsinbothcattleandhogslaughterand,thus,supply.

OS:Whatmarketormarketsdoyouthinkhaveseenthemostsignificantchangesinthelastfiveyears?Whyhavethepatternschanged?

JT:Untiljustafewyears

ago,U.S.interestratefutureshadwell-definedandsomeofthemoreconsistentseasonalpatterns.RatesthemselvesexhibitedastrongtendencytopeakseasonallyinApril/May—perhapsduetotemporarilytightenedmonetaryliquidityaspaymentofincometaxesduemid-Apriltransferred

massivefinancialassetsfromoutoftheprivateandintothepublicsector.Butthenthoserates,allelsebeingequal,consistentlyeasedthroughtheremainderoftheU.S.fiscalyearendingSeptember.However,theFOMC’sinterestratesuppressionofthelastfewyearsmayhavedisruptedor

distortedtheseasonalebbandflowofratessuchthatseasonalreliabilityhassufferedsomewhat.

OS:Whatadvicewouldyougivetosomebodywhoisnewtoseasonalanalysis?Whatkindofthingsshouldtheybelookingforinamarket?

JT:Mosttradersnewtoseasonalanalysistendtofollowtheentryandexitdatesliterally.Thathastendedtoworkoutwellovertime—aslongastheytakeallofthestrategiesdiversifiedbymarketratherthanexpectingeachandeveryonetoworkexactlyaspublishedeverytime.However,asthey

becomemorefamiliarwithseasonality,howitworks,andwhatitcanandcan’tdo,traderstendslowlytobecomemoreselective,applyingtheirownknowledgeandtradingknow-how,beingwillingtoenteradayortwoearlieroradayortwolaterwhenconditionswarrant,usingtradingand

money-managementtechniquesthatsuittheirownstyleandmarketperspective.Eventuallytheymayfindthattheycantellataglancewhetherorhowcloselyamarketmaybefollowingitsseasonalpatternandthushowtheymaybesttakeadvantageoftheseasonalresearchforthemselves.MRCI

entryandexitdatesareoptimized,afterall.Theyarenot“etchedinstone”butrathermeanttoguidetradersasthey“researchtheirtrade.”

OS:ThankyouJerry.Weappreciateyourinsights.

JT:Thankyou.

17

VolatilitySimplifiedAllYouNeedtoKnowAbouttheMostMisunderstoodOptionComponent

We promised we weren’tgoing to do it.We promisedyou would learn to selloptions effectively and nothave to relearn calculus. Sorelax.Youwillnot.Noteveninthischapter.However,itisdifficult to write TheComplete Guide to OptionSelling without at leasthavingsomediscussionaboutvolatility.

While we sidestep the

issue of volatility in otherchapters of this book, we donot mean to imply thatvolatility is unimportant tooption sellers. Quite thecontrary,volatilitycanplayasignificantroleinthepriceofan option and the pricemovement of an option. Itsimply happens to be ourcontention that the basefundamentals of theunderlying market are muchmoreimportant.

To use our footballanalogy again, knowing yourmarket fundamentals is youroffensive game plan. Yourrisk-management strategy isyour defensive game plan.Volatilityistheweather.Itisthe conditions you areplayingin.Inotherwords,thequality of your offense anddefense will ultimatelydetermineyoursuccessattheendoftheyear.Butvolatilitycanhelporhurtyoualongthe

way,anditissomethingtobeconsideredinyourgameplanwhenplanningatrade.

During our occasionalspeaking engagements, Ioftensenseacollectivegroanwhen we introduce theconcept of volatility. But incongruence with ourphilosophy of simplicity, weare going to attempt tosimplify the concept in thischapter, and tell you

everythingyouneed toknowtobesuccessful.

To begin,we should firstdiscusswhatvolatilityisnot.

TheTradingPlanYouDon’tNeed

Chances are, if you arereadingthisbook,youarenota professional portfoliomanager. You are not a risk

analysis manager at a hedgefund.Youarenota“quant.”

Chances are you are (orwere)adoctor,anaccountant,anattorney,abusinessowner,orasuccessinsomefieldthatyouhavedevotedyourselfto.Butoptiontradingisnotyourlisted profession. Therefore,many of the books, reports,and“whitepapers”writtenonthe mathematics of volatilityanalysis are not for you.Oh,

they may be promoted asthoughtheywereforyou,andthe authors may think theywrotethemforyou.But theyarenotforyou.

You have a practice torun, a business to oversee, acasetotryinthemorning—orbetter yet, a golf game orgrandchild’sbaseballgametoget to. Option trading is anextracurricular activity inwhich you have an interest.

But you didn’t count on thequantum physics. Don’t feelguilty. And don’t let themmake you feel guilty for notstudying it all and learninghow this skew outpaces thatskew but only in strikes ofthree standard deviationsfrom the mean. You don’tneedittomakemoney.

Yes,Iamquitesurethatasmall edge may be gainedthrough a tedious formula of

number crunching that willidentifytheabsoluteoptimumstrikewiththetheoreticalbestprobabilitiesofexpiring.Andguess what? Onefundamentally driven movecan make the whole pointmoot.

So while we attempt tokeepvolatilityinperspective,here is our first point fornonprofessional traders. Donot base your trading system

on volatility unless you havesome professional-gradesoftware, an expertknowledgeof it,andawholelot of time to implement it.There are many books,courses, and other help nowon the market that preachvolatility trading. Thesesystemswereverypopularintrading the S&P for severalyears in the early 2000s.Traders would sell thevolatility in the S&P. By

sellingthevolatility,wemeantheywouldfollowavolatilityindex (such as the popularVIX, Figure 17.1) and whenthe measurement got to acertain level, theywould selloptions on both sides of themarket(astrangle).Itworkedvery well for a couple ofyears. As one of my clientsonce toldme“A lotof smartpeopleweredoingit.”

FIGURE17.1VIXPrice

Chart*Volatilitycannotandshouldnotbetradedinavacuum.

But when we focus onvolatility alone, we tend toignore the realities going onintheunderlying.HowmanyS&P strangle players whotook premiums every monthfor several years were in themarket in mid-2008?Volatility was surging inSeptemberof2008.Volatilityalone dictated this as a goodtime to sell strangles.Knowing what happened in

October, do you wish youwould have sold calls andputs? That is where thefundamentalscomein.

WhatIsVolatility?

Before moving forward,we should again definevolatility as a quick

refresher on the subject.Stripallthefancyformulasaway and volatility issimply a measurement ofhow wide of pricemovements a market willmake before an optionexpires worthless. Whenmarkets are very active, inother words, making largedaily, weekly, or monthlyswings, theyare said tobe“volatile.” Volatility is arelative measurement, as

we will see. However, toputitsimply,morevolatilemarkets tend to increasethe value of the options inthat market. The widermovementsmeanthereisahigherperceivedrisktotheoptions and thus, higherpremiums are justified.Option buyers are moreeager to buy options inthese markets and optionsellers charge more forthem.

Sometimes, thesehigher premiums arejustified. Other times, itturnsintoasucker’sgame.Volatility can get “out ofhand” at times and makethe ridiculous opportunityavailable to sellers.Volatilityiswhyonecouldsell refined blend gasoline$4.20 calls in late 2008whenthefuturespricewasat $1.20 per gallon.Volatilityiswhyonecould

sell $4,500 gold calls in2011 with gold trading at$1,800 per ounce. Yourfundamentals should stilldetermine themarkets youtrade, but volatility canhand you some handsomegifts.

The simple rule ofthumb is that highervolatility favors optionsellers and lower volatilitydoes not. Again, this does

not mean that you shouldnot sell options in a lowervolatility market if youhave identified afundamental advantage.Volatility is but one factorto consider whenidentifying tradeopportunities.

HowDoIKnowifVolatilityIsHighor

Low?

Just because amarketmovesaround a lot does notnecessarily mean that theoptions in that market areoffering an out-of-ordinaryadvantage to sellers. Thereare two types of volatility:historical and impliedvolatility. But these areactually just two differentmethodsoftryingtomeasure

the same thing. Bothhistorical and impliedvolatility are trying toestimate how far a marketwill move in the future—regardlessofthedirection.

HistoricalVolatility

Historical volatility is ameasurement of how farprices move over a givenperiod of time from an

averageormeanvalue.We’renot going to go into howhistoric volatility iscalculated, but rather, howyoucanuseit.

Historicvolatilityisstatedas an annual percentage. Ifthe historic volatility for agiven market for a 90-dayperiod is stated as 32%, itmeans that if this samevolatility holds true for thenext year, the price of this

market (stock or commodity)could be expected to vary32%eitherwayfromtoday’sprice.

In other words, historicvolatility uses the underlyingmarket’s past pricemovements to estimate howfar this market will move inthefuture.

ImpliedVolatility

If there is one subject that isprobably most confusing tooption traders, it is theconcept of implied volatility.Implied volatility is stilltrying to predict how far themarket will move in thefuture. However, instead ofusing the historicalmovementsof theunderlyingto project this, impliedvolatility uses the pricevalues of the optionsthemselves. The problem

seems to come in thatindividual investors seem tothink that they need to knowhow to calculate impliedvolatility on their calculatorsand to learn all of theformulas necessary for doingso. You don’t. The simplestof software programs, quotesystems, or more (free orotherwise) will typicallycalculateitforyou.

UsingImpliedVolatility

Implied volatility works likethis. Let’s say Trader Johnwants to sell silver puts.Thedayhedecidestosellhisput,silvermakesamassivemovetothedownside,falling$1.00perounce inoneday.Seeingthis move in the market,traders (at least the public)rushtobuysilverputstotake

advantage of an additionalmove lower.Thedemand forthe puts themselves rises.Asthe market has just movedlower,however,thesellersofthe put options have becomemore fearful that their strikepricemaybereached(ortheysimply know that put sellersare less willing to sell).Therefore, they ask for ahigher premium to sell theiroptions. Put option valuestherefore rise. Implied

volatility measures themovement of the price ofthese options and uses it tocalculate the “expected”range of movement in theunderlying,basedonhowtheoption traders aremaneuvering.

Implied volatility (IV) isalso expressed as apercentage. Each individualoption will have its ownimplied volatility. The IV of

all of these options iscombined to create the IVofthe underlying. Impliedvolatilitywilloftenrisewhenconsiderable moves in themarkettakeplaceoverashortperiodoftime.

It is not uncommon forimpliedvolatilitytorisemoreon downside moves than onupside moves in the market.This is because fear is oftengreater on downside than on

upside moves. And whilethesetypesofdownsidemovewill generally inflate thevalues of the puts, we haveseen rare circumstanceswhere a sharp movedownward can create enoughfear and unpredictability inthe market that it increasesthe IV in all options in thatmarkettothepointwherecalloptions can actually increaseon value on the pricecollapse!

These types of surges inimplied volatility, however,can be outstanding option-selling opportunities,provided they are takingplace in a market you havealready identified asfundamentallyfavorable.

Selling“Overvalued”Options

Like market players ingeneral,optionvaluestendtooverreact to sharp moves inthe market. It has been ourexperiencethataone-ortwo-day extreme move in anunderlying’s price can causeoptionvalues tosurge.Thesecan be outstanding times forselling premium as theseoptions tend to experience aknee-jerk-like increase inimplied volatility (Figure17.2). Oftentimes, these

volatiledailypricerangesarenot sustainable and themarketwillcalmdownwithinashortperiodoftime,evenifitcontinuesonthesamepath.

FIGURE17.2SharpMovesintheMarketWillUsuallyIncreaseImpliedVolatility

For instance, suppose inJohn’ssilvertrade,Johnsellsa December silver $7.00 puton the day the marketdropped by $1.00 per ounce.The fear in the marketallowedJohntosellhisputataninflatedpremium.

Let’sassume that thedaybefore John sold his put, theput’s value was $400. Let’sfurtherassumethatonthedayoftheputsale,Johnreceived

$900 for this put. John soldthe put because (a) hisfundamentalanalysisdictatedthat silver would not reach$7.00 per ounce; and (b)because he chose to takeadvantageoftheinvestorfearinthemarketonthatday.

If the pricemovement ofsilver trades moves innarrower ranges over thecourse of the next severaltrading days, investors may

“come to their senses” andbegin to realize that silver isprobably not going to make$7.00.Itmaystillbeheadinglower, but the rate of itsdescenthasslowed.Investorsbegin to grow calmer.Implied volatility falls. SodoesthevalueofJohn’sput.

Withinafewshortweeks,silver prices are at the samelevel they were when Johnsold the option. But John’s

option is back to $400,simply because impliedvolatility levels havedeclined. John has alreadymade a $500 profit fromvolatilityalone ($900–$400=$500).

At this point, John couldclose out his option (buy itback) and take the profit, or,if he still believes silverprices are not going to $7.00an ounce, he may choose to

hold it and keep theadditional $400 in profit atexpiration.

The moral is, sweepingmoves in the market,particularly if they breakmajor support or resistanceon a chart, can often createconsiderablejumpsinimpliedvolatility. As these types ofpriceswingscanoftennotbesustainedoverlongerperiods,these short-term spikes in

volatility are often short-lived. And they are oftenopportune times to sellinflated premium and takeadvantage of these“overvalued”options.

HistoricalVersusImpliedVolatilitytoIdentify“Expensive”Options

Knowingwhenanoptionhasbecomeovervalued,however,isdifficulttoknowsimplybylooking at it. But there aresome indicators that couldlead you in the rightdirection.

Remember that whendealing with volatility,everything is relative. In theearly 2000s, when oil tradedat $30 per barrel, a $2.00dailymovewas considered a

major move and wouldcertainly warrant headlines.In 2008, oil prices regularlytraded in a $4.00 to $7.00rangeperday.A$2.00movecouldhappeninaminuteandwould hardly register a blipon the volatility scale.Relativity, then, is whatmatters in the volatilityworld.

There are literallythousands of methods,

studies, and formulas forworking with volatility andcalculating one’s odds ofsuccess.However,inkeepingwith the theme of this book,we are going to discuss onlymethods that we are (a)familiar with; (b) haveworkedwellinourportfolios;and (c) are simple andapplicable to themainstream,individualinvestor.

Imustprefacethissection

bygivingcredittoourfriendsat ivolatility.com, who haveassistedusmuch involatilitystudies. Over the years, wehavefoundthemethodbelowaneffectivetoolinsuggestingoptions that may beexhibiting overvaluedtendencies. But we muststress again that volatility isrelative, andyoushouldonlyuse these methods as anadditionaltoolinevaluatingapotentialoptiontrade.Thisis

notatradingsystem.If historical volatility can

beexpressedasapercentage,and implied volatility can beexpressed in the samecontext, then an overlay ofthese two charts, based ontheir daily changes, can tellussomething.

As historical volatilitymeasures the actual pricemovementsof theunderlyingand implied volatility

measures investorpredictionsof price movement based onoptionvalues,thenanoverlayof the two can show thedifference between optiontrader expectations and theactual historical price swingsin the market. Impliedvolatility will often follow asimilar path to historicalvolatility.Itiswhenthereisadiscrepancy between the twothat things begin to getinteresting.

If we take a three-monthhistorical volatility chart andthen compare how far aboveor below implied volatilityhasmovedbeyondhistorical,we establish a range (Figure17.3). Let’s suppose that atone point within the pastthree months, impliedvolatility was 30% abovehistoricalvolatility.Let’salsosuppose that that point wasnot achieved before or sincethat time. Amove tomorrow

that saw implied volatilitymove 31% beyond historicalvolatilitywould then indicatethat investor expectationswere far exceeding the six-month historical volatility—at least more than they everhave within the last sixmonths. When this happens,itcould indicate that investorexpectations are exceedinghistorical norms. Sometimesthis is warranted. Butoftentimes, it is not. If it is

investor or media hypepushing up this impliedvolatility, one could belooking at overvaluedoptions. It indicates thatinvestor expectations couldbe “out of line” with whathistorical price movementsuggests, and therefore onemightexpect toseeadropinvolatility as investorexpectationscomeback“intoline.” This would be similartowhathappenedwithJohn’s

silver option in the earlierexample.

FIGURE17.3UsingOurSuggestedModel,aThree-MonthVolatilityChartofComexSilverIndicatesThatVolatilityMayHaveFavoredSellersinLateAugustbutFavoredBuyersinOctober*

Inotherwords,toidentifywhat we might consider anovervalued option,wewouldlook for markets that showimplied volatility near orexceeding three-month highs(percentage wise) overhistorical volatility. Again,however, this is relative. Ifwideswingsbetweenimpliedand historical volatility arethe norm, then this methodmay not be that useful. It is

the variation from the normwhereoptionsellerscanlookforopportunity.

Whydowesuggest threemonths? Because this isgenerallywithinthelifespansof the options we choose tosell.Again, this is relative tothe user. Short-term tradersmight only use two to threedays of historical volatility,whereas longer-term playersmay use a year or more of

historicalvolatilitycharts.Thekeypoint is that you

are looking at how farimplied volatility currently isabove or below historicalvolatility and how thatcomparestowhereithasbeenover the last threemonths. Ifitishigherthanithasbeenatanypointwithinthelastthreemonths, it could beovervalued and be a goodcandidate for an option sale.

If implied volatility issubstantially lower thanhistorical volatility, and thisis clearly not the norm, thenonemay say it is a situationthat could favor an optionbuyer(althoughweclearlydonot recommend buyingoptions).

Of course, this wouldonlybetrueiftheunderlyingwas one in which you had astrongfundamentalbias.

Conclusion

The purpose of this chapterwas to take the sometimescomplex subject of volatilityandsimplifyitintoadistilledversion suitable for theindividualtouseathome.Wedonotpresent thischapterasthe “be all and end all” ofvolatility studies, as itcertainly is not. However, ifyourmainconcernistoknow

enough about volatility tomake money selling options,it should serve the purposewell.

Donottakethischaptertomean that an optionmust be“overvalued” in order tomake a good option sale.Aswe stress throughout thisbook, fundamentals of theunderlying market shoulddictate your option sales.Volatility is, at best, a tool

you can use in your decisionmakingor timingprocess.Atthe very least, it is a factoryou can consider whenanalyzingyoursale.

For instance, if you arebearish natural gas at $10.00and you can sell a call at a$20.00 strike, is it going tomatter toyou in the long runwhat the volatility was?Probably not. If you sell itwhen the option has become

historically “expensive,”you’ll probably get moremoneyforit.Theproblemis,the volatility isn’t alwaysgoing to be perfectly timedwith when the fundamentalopportunityispresent.

In general, markets withhigher historical volatilitiesoffer further out-of-the-moneyoptionswhichyoucansell. It is simply that whenimpliedvolatility surges,you

canoftensellthemformore.Consequently, if you do

sell an option and impliedvolatility surges afterward,the value of that option willprobably increase on you.However, if yourfundamental analysis issound, and your trade hasbeenstructuredproperly,youmayfinditbesttosimplyrideit out. The strategy of“rolling,” described in

Chapter 12, was specificallydesigned to counter impliedvolatility surges infundamentally soundmarketsin which you are alreadypositioned.

When identifying tradesfor our managed portfolios,weutilizevolatilityasoneofmanyfactorstobeconsideredbefore positioning in aparticular market. However,if you prefer a do-it-yourself

approach to working withvolatility, our friends ativolatility.com andOptionetics.com offer someexcellent resources forlearningandmeasuring.

I have knownfundamentaltraderswhohavesold options successfully foryearswithoutgivingvolatilitymuch thought. However,knowingwhatitisandhowitworks can give you an extra

edge in your option-sellingportfolio.

18

HowtoStructureYourOption-SellingPortfolioTipsonBuildingYourPremiumLadder

I had a friend in collegenamed Chip. Ever since Iknew Chip, he wasperpetually disorganized.Shortlyafterwegraduated,hecalled me one day andinformed me he was comingto visit me in Florida (helived in Pennsylvania). Iassumed he would call meback to set a date or getdirectionsormakesomekindofplanforhisvisit.

Five days later, Chipshowedupatmyfrontdoor.

“Howdidyougethere?”Iaskedhalf-bemused,half-perplexed.

“Idrove.”“Didyouhaveamap?”I

probed.“No,”heresponded.“Thenhowdidyoufind

myhouse?”

“Ikeptstoppingandaskingdirections,”herepliedquitematter-of-factly.

“ToFlorida?”Iaskedincredulously.

“Yes.”

Asitturnedout,Chiphaddrivenmorethan1,000miles,eventuallylocatingmyhouse,using only a vague sense ofdirection and a shamelesslyoutgoing personality. It had

taken him five days andseveral wrong turns, but heeventuallymadeit.

Chip knew how to driveand how to read road signs,buthedidnothaveaplanastowherehewasgoingorhowhe was going to get there.Believe it or not, someinvestors trade this way.Unfortunately, most are notas lucky as Chip. It is verydifficult togetwhereyouare

going if you do not have aplanforgettingthere.

Thisiswhyconstructingaplan for your option-sellingportfolio is so important. Inthis book, you’ve learnedwhy, how, when, and whereto sell options.Youhave theeggs,flour,sugar,andmixer.Butyoustillhavetocombinethe ingredients correctly andcook at the right temperaturetogetacake.

StepsforStructuringaSuccessfulOption-SellingPortfolio

Steps 1 to 3 involveestablishingatradingplanforyour portfolio—a theme wealludetoseveraltimesinthisbook. The remaining stepsinvolvehowtostructureyourportfolio and position formaximumgains andminimalrisk.Thesestepspulltogether

manyof the tradingconceptswehavecovered.

WhilewecertainlydonotrecommendtradinglikeChip,we also think it important tonot “overplan” your option-selling portfolio. Optionselling, especially onfundamentals, requires acertain degree of flexibilitythat you cannot write into acomputerized trading plan. Iknow the number crunchers

out there are alreadywrinklingtheirnosesbecausewearenotgoingtogivethema formula to plug into theirspreadsheets and “run thenumbers” for the next threeweeks. However, “paralysisby analysis” is just as big athreat as underplanning, inouropinion.Itisimportanttohave a general trading plan.But give yourself someleeway to make informedtrading decisions and

adjustmentsalongtheway.

Step1:SetYourObjectives

Constructing an effectiveoption-selling portfolio startsout like any self-help bookyouhaveeverread.Youmusthave a goal. You must haveanobjective.“Iwanttomakemoney” is not specific

enough.

“Iwanttomake40%annualizedreturnsafterfees”isspecific.

“IwanttogenerateXamountofquarterlyincome”isspecific.

“Iwanttodiversifymyoverallinvestmentholdingsintoanewassetclass”isspecific.

Your first step inconstructingyourportfolio isto decide why you arestarting the portfolio andwhatyouhopetoaccomplish.It sounds simple enough andyet many investors fail todefine this from thebeginning, which can resultin an unfocused trading planand inconsistent results.Knowing your objectivesfrom the beginningwill help

you to better define, build,and if necessary, adjust yourtradingplan.

This is the very first stepwetakewithanyclientofourfirmanditisthefirststepyoushould take as well. Even ifyou are hiring a professionaltrader to manage youraccount on your behalf, youmust first set your objectivesbefore any trading plan isconstructed.

Step2:DetermineWhatYouWillDoWhenYourObjectivesAreAttained

Again, it sounds simple. Butmost investors take the Chipapproach and decide as theygo. Knowing where you aregoing means making morefocused decisions. It is your

money. You can’t afford tobeunfocused!Whatwillyoudo if, and when, you meetyourobjective?

•Takemoneyoutofyouraccount?

•Addmoneytoyouraccount?

•Stoptrading?•Continuewithyourprogramwithanobjectiveofbuildingon

gains?(Bettersetanewobjective.)

Hitting an objective isgratifying and often a goodtimetoreevaluateyourgameplan. However, it helps tohave a general idea of whatyou will do when you reachyourportfoliogoal.

Step3:DecideWhat

YouAreWillingtoRisktoAchieveYourObjective

Itistruethatthereisnosuchthing as a free lunch. If youwant to attain 30%, 40%,50%returnsormore,youaregoingtohavetobewillingtoput some funds at risk. Youcan’texpect tomake40%onyourmoneytakingT-billrisk.Icannotcount thenumberof

investorswhohavecalledmeover the years and asked“what would my maximumdrawdownbe?”

We’re all adults here. Ifyou want the short, bluntanswer, your maximumdrawdown is 100% of yourequity and then some. If youaskforaworse-casescenario,then that is it. Just as if youbuyastockandthecompanygoes belly up, you lose your

investment. That’s a worse-casescenario.Thatiswhatistechnicallypossible.

However, if you want amore realistic answer, onewould have to do somethingterribly, terribly wrong toever end up in thispredicament. Like watchingyour grossly undiversified,over-positioned portfoliomovesharplyagainstyoudayafter day without doing

anything about it. Unlimitedrisk simply means that youhave to manage your riskyourself. The market is notgoingtodoit foryou.Ifyoubuyanoption,thestructureofthemarketallowsyou to restassuredthatyouhaveafiniterisk.The trade-off is that theoddsarehighyouroptionwillexpire worthless and, as abuyer,youwilllose.

Insellingoptions,youget

high odds of success in yourfavor. The trade-off is youhave to take steps tomanageyourownrisk.

And as we learned inChapter9,thereareplentyofeffectivewaysfordoing this.Step 3 of structuring yourportfolioistoknowwhichofthese methods you intend touse in your trading plan andhowmuchofyourcapitalyouarewilling to risk to achieve

yourobjectives.Aswetellinvestorswhen

helping them build theirtrading plan, your success asanoptionsellerwillhavenotsomuch to dowith the 80%or so of options that expireworthless. It will have moreto do with how you handlethe10%to20%thatdonot.

Chapter 9 discussesstrategies for managing riskon individual trades.But one

must also consider the riskapproachtotheportfolioasawhole. Below are thequestions you may want toanswer for yourself abouthow you want the riskmanaged in your ownaccount.

1.DoIwanttospreadorwritenaked?Nakedsellingcanofferfasterprofitsandearlyexits.Spreadscanoffer

limitedexposurebutlongertimeframesforprofitrealization.Wetypicallyrecommendacombinationofboth.However,youmustselectstrategiesthatnotonlymatchthemarket’stemperament,butyourown.

2.HowmuchofmyportfoliofundsdoIwanttokeepas

“reserves?”Nomatterhowmanymarketsortradesyouhaveonatanygiventime,youwanttokeepacertainportionofyourtradingaccountinliquidreserves.Asyoulearnedearlier,marginrequirementsforshortoptionscanfluctuateonadailybasis,dependingonmarketmovementand

volatility.Keepingahealthyportionoftheaccountincashreservemakesforamorestableportfolio.Youcandeviseyourowncomfortlevelfortheamountofcashyouchoosetokeepinreserve.Thissubjectisdiscussedingreaterdetaillaterinthischapter.

3.Thinkthroughhowyouwillhandlelossesandifyouhavea“dropdead”pointatwhichyouwillceasetradingandmodifyyourtradingplan.Moderate,periodiclossesaretobeexpectedandarepartofanynormaltradingprogram.Ifkeptmanageableinanoption-sellingprogram,

theycangenerallybemadeupwithyourothertradesaslongasyouarediversifiedproperly.However,ifyouexperienceasubstantiallossoveragiventimeperiod,youshouldhaveapredeterminedfigureinmindastoatwhatpointyouceasetradingandreevaluate.Trading,evenselling

options,whenyouarerattledorfrustratedisnotagoodidea.Setadrop-deadpointofwhatyouwouldbeuncomfortablelosing.Ifyouraccounthitsthatpoint,closeyourpositionsandtakeaweekortwooff.Comingbackandmakingadjustmentsismucheasierwithaclearhead.

Thereisnoanswerasto“what type of drawdownscanIexpect?”

Ihaveseentradershavea10% to 20% drawdown andfreakout. Ihaveseen tradersstart out on top and neverhave a drawdown (againstinvested capital). In general,if you are selling futuresoptions, you are targeting20% to 50% returns.Therefore, to stay in the

game,youshouldrealizethatdrawdownsof10%to20%ormore are not out of thequestion and that you shouldbecomfortablewiththistypeof movement on the fundsyou have invested. Realizethatthisisthenormalebbandflow of futures options andthat drawdowns of thisnature,while unpleasant, canalso be recovered somewhatquickly with this type ofstrategy.

Thatbeingsaid,thisisnoguaranteed annuity. You canlosemorethan20%.Youcanlose asmuch as youwant toloseorasmuchasthemarketcan take from you. Sellingcommodities options is anaggressive investment bytraditional standards.Although it is our opinionthat a properly managedportfoliowillwelloutstriptherisks,youhave tomakeyourown call. If you have never

invested in anything moreaggressive than 10-yearmuni’s,sellingoptionscanbea big step for you. If youalready sell stock options ortrade the S&P, then youalready have the rightmindset. It’s simply amatteroflearninganewsetofrules.

Step4:DiversifyYourOption-Selling

Portfolio

Once you have establishedyour initial trading strategyandriskparameters,itistimeto begin establishingpositions. It’s time to startsellingoptions!

One concept we haverepeatedly discussed is toonly sell options with themost clear-cut fundamentaladvantages. However, a

cornerstone to a successfulportfolioisdiversification.

Will you be able to fullydiversifyyourportfoliowhenyou first begin sellingoptions?Well,youcould,butwe would advise against it.Youwill look to sell optionsonly in markets offering adistinct fundamentaladvantage. This willobviously not be all marketsatalltimes.

At the same time, youwill want to build towarddiversifyingyouroptionsalesacross several differentsectors. A portfolio built onselling S&P options is notdiversified. I have talked tomany traders who basedwhole portfolios on sellingS&P strangles. Theseportfolios can do well for awhile,untilabigmovecomesalong. It is during thesemoves that S&P-only traders

tend to discover the value ofdiversifying.

One of the benefits oftrading commodities optionsis that one can sell optionsacross a widely diversifiedspectrum of physicalproducts. As we illustratedearlier, one can sell avarietyof stock options acrossseveral equity sectors, yet ifthe stock market as a wholemovesupordown,allstocks

tend to follow suit. Incommodities, except inspecial circumstances, this isgenerally not the case.Therefore, one may be shortsugar calls and short heatingoilputsandberightonboth.

Figure 18.1 illustrateshowasampleportfoliomightlook for a typical well-diversifiedaccount.

FIGURE18.1PieGraphShowingSamplePortfolio

Diversification

Note that this is only anexample and the face of thispie chart constantly changesinareal-lifeportfolio.Noticethat some markets are short-only calls, some only puts,andsomeareshortbothcallsand puts (strangled). Thisreflects the trader’sfundamental views of theunderlying markets—bearish,bullish, or decidedly neutral.Stranglesaretypicallywritten

inmarketswherethetraderisnot overly bullish or bearish,but volatility has surged tolevels where simply sellingdistant options on both sidesof the market looks like ahigh probability play. Notealso that when a categorydenotes short puts or calls ina certainmarket, these couldbe naked or coveredpositions.

Keeping your portfolio

diversified carries obviousbenefits. The typical knockon option selling is that onelosing trade can wipe outmonths of gains. (It wouldnotbesurprisingtolearnthatthis “drawback” probablyderived from nondiversifiedS&P traders.) Let’s face it,trades can go bad; marketscan make erratic, illogicalmoves. You can lose moneysellingoptions.Ifatradegoesbad,anditisyouronlytrade,

and you have 50% of yourportfolio in this trade,chances are that you aregoing to take it on the chin,even ifyouusedproper risk-managementtechniques.

Ifyouarediversifiedoverfive or six different marketsandonegoesbad,chancesarethat it’s only a smallpercentage of your overallportfolio. You take the loss,youmoveon.Youmakeitup

somewhereelse.Probably the most

difficultchallengewefaceasportfoliomanagers is not thetrading. It is getting optiontraders or even neophyteoption sellers to think aboutthisasaninvestment,andnotas trading. You manage theportfolio as a portfolio andnotasatradingaccount.

You plant your gardenand then let it grow.

Occasionally, you pick thefruit and/or pull up deadplantsandreplace them.Youdo not throw seeds everywhichwayandseewhatpopsup.Nor do you plant all onecrop and risk a blightdestroyingyourentiregarden.You don’t “load up” onsomething just because itlooks good. You have tothinkofeachtradeas tohowit fits in and balances theentire portfolio. For instance,

ifyouarealreadyshortcrudeoil and heating oil puts andyouseeanopportunitytosellunleaded gasoline puts, youcould be risking overloadingyour portfolio in a singlesector. This is true even ifselling unleaded gas putslookslikeanexcellenttrade.

This does not mean thatyou have to equally balanceyour portfolio across allsectors.Youoryourportfolio

manager may like somemarkets better than others orfeel there is lessriskinsometradesthanothers.Thereisnocrime in overweightingcertain markets at certaintimes.Whichbringsustoournextstep.

Step5:ManageYourCashMargin

Effective marginmanagement is crucial toyour success as an optionseller. Again, as we havestated several times in thisbook, over positioning, notmiscalling the markets, isprobably the number-onereason traders lose moneyselling options. In a futuresoptions account, your“available margin” is simplyyourcashbalance.Thisistheamount of cash you have

availableinyouraccountthatisnotbeingusedtoholdopenoptionpositions.

However,whatsomenewoption sellers overlook is thefact thatmarginrequirementsfor positions can, and mostdo, change—in fact, they doon a daily basis. SPANmargins foreachpositionarerecalculated and marked tothemarketat theendofeachday. Most of the time, these

changes will be nominal. Ifthe option is decaying, themargin requirement to holdthe position will change andyour available margin (alsoknown as excess equity)willrise. Consequently, if aposition is moving againstyou (or even if volatility issimply increasing), themargin requirement to holdthat position can increase.Thismeansthatyouwillwanttohaveexcesscashinreserve

to account for such changesin margin. Every position isnotgoingtoimmediatelyraceto zero and expireworthless.In fact, many of your shortoptionpositionsmay initiallyincrease in value. This isnormal.

Remember, one reasonweselloptionsissowedon’thave to time the market(althoughwecanalwaystry).We sell options to give the

market plenty of room tomovearound.Wedon’ttrytopickmarkettopsandbottoms.Long-term fundamentals canbe accurate in assessinglonger-termpriceprojections.Butifyousellyouroptioninthis market, the chances are50–50 that the underlying isgoingtomoveagainstyouthefollowing day. This doesn’tnecessarily mean the optionvaluewillmove against you.Butitcan.

Forinstance,youmaysellacallondayoneanddaytwothe underlying price of themarket goes up. Chances areyour option value, and thusyour margin requirement forthat position, may increase.Most of the time, if you areselling far out-of-the-moneyoptions, these increases willbe nominal and benign—especially if time value isrunning out on the option.But you nonetheless want to

have excessmargin availableinyouraccounttocoverthesemarginfluctuations.

For a moderate toconservative account, thistypically means holding atleast 30% to 40% of yourtotal portfolio in cash. If yousell all naked options, youmay want to hold slightlymore. However, this type ofcash cushion shouldbemorethanadequate tohandlemost

marketfluctuationsifyouareproperlydiversified.

TheMarginCallFearNew option traders tend toliveinfearofthemargincall.As we discussed earlier,margin calls are nothing tofear. It simply means youeitherhavetocloseapositionor increase your equity stakeif you wish to hold yourposition. If you are getting a

margin call, chances are youshould probably be closingsomething.

However, if you arefollowing these cashmanagement rules, thechancesofyoueverreceivinga margin call in an option-sellingaccountareremote.

Table 18.1 illustrates asuggested portfolio structurefor new option-sellingaccounts.Thesearepresented

for example purposes onlyandnorepresentationismadethat this structure will besuccessful for all accounts atall times. However, we tendto base our managedportfolios on these modelsand have found them to beeffective over the years.Perhapsyouwillaswell.

TABLE18.1ChartShowingDifferentStrategy

andPortfolioObjectives

Step6:DoNotOvertrade

Overpositioning usuallyresults from overtrading.Overtrading usually resultsfrom overzealous tradersready to pull the trigger onwhatevertheflavorofthedaymaybe.Remember,thisisaninvestment,not an“activity.”

This ismeant tobeslowandsteady.Manyofourmanagedportfoliosmayonlytradetwotofourtimespermonth.Youexecute a trade only wheneverything appears to be inyour favor. Yourfundamentals, your strike,your premium, your market.Work toward diversifyingyourportfolio,butdonotfeelthat you must immediatelydistribute your capital intoseven different sectors. Wait

for your opportunities; pickyourpoints.

Conclusion

Like any other type ofinvesting, a successfuloption-selling portfolio startswith agood tradingplan.Aninvestor should view heroption-selling portfolio as aninvestment,not an“activity.”Choose your main objective

fortheportfolioandwhatyouarewillingtorisktoattainit.Your portfolio should bediversified. Fortunately incommodities, truediversification is possible.Keep a healthy portion ofyourcapitalasbackupequity(incash).Donotovertrade.

TherearemanyChipsoutthereintheinvestmentworld.Any one of them wouldprobably be glad to tell you

the sob story of his tradinggone awry. If you want tomake money in the optionsmarket, don’t be like Chip.Haveaplan.

PART IV

GETTINGSTARTED

19

HowtoAvoidtheMistakesNewOptionSellersMakeLearnThemHereandSaveYourselfTime,Money,andHeadaches

Likemost other investments,or any other endeavor, thereis a learning curve that newoption sellers mustexperience on their way tobecoming successful. Nomatter howmany books youreadorhowmanyback-testedmodelsyoustudy,thereisnoreplacementfortried-and-trueexperience. And withexperiencecomesmistakes.

The purpose of this

chapter is to review themostcommon mistakes made bytradersnew tooption selling.Althoughwe generally try topreempt these mistakes bynew clients, there are thosewho insist on doing it theirway, right or wrong. Whileexperience ultimately willremainyour best teacher, theobservationsonthefollowingpages may make theeducational phase of yournew investment approach a

much more pleasant andhopefully profitableexperience.

Mistake1:TradingonYourOwnwithaDiscountBroker

While this statement maysoundself-serving,itisbasednot only on personalobservationsbutalsoonwhat

has been written in manyother books, courses, andtrade journals alike. Adiscount broker is an orderclerk whose job it is toanswer the phone and takeyour order. That is it.Discount brokers provide aservice tohighlyexperiencedtraders who do their ownresearch, their own analysis,their own portfolio planning,and their own tradeplacement.

These days, in manycases, you may not even betalkingtoahumanordertakeranymore. You can enterorders directly through yourcomputer.

If you have a lot of timeto invest in learning how tobe a semiprofessional traderand are committed to regularand sustained study ofcommodities fundamentals,this can be the eventual path

youwishtotake.However, if you are new

to trading commodities oroptions, especially sellingoptions, it may serve youbettertoworkwithanadvisorwho is highly experienced inthe field. If you are aninvestor with little time orpatience to do the legworkyourself, professionalguidanceiscrucial.

Inadditiontohelpingyou

with everything from bid/askspreads to calling you whensomething breaks in themarket that couldaffectyourposition, a good full-servicebroker can advise you onmarket news, orderplacement, stops, and riskcontrol, and provide a calmvoice of reason in adversemarket conditions. If thebrokerisreallygood,shecaneven advise you on newpositions that will make you

money.As a new option seller,

think of yourself as a flightstudent at the controls of a747.Fromyour training,youmay be able to fly the planefairly smoothly, maybe evenland it by yourself. Whathappens, however, whenyou’re trying to land in athunderstorm and all of thesudden the plane starts toshake and a strange alarm

goes off that you have neverheard before? Would youprefertohaveanexperiencedpilot,specializingintheplaneyou are flying, to talk youthrough the landing or eventake the controls? Or wouldyou prefer to have apassenger sitting beside yousaying, “What are you goingtodonow?”

Of course, a good full-servicebrokerisgoingtocost

you a little more than adiscount order clerk. Costscanbeanalyzedonanannualor per-quarter basis todetermine if your broker isworth the fees. However, agood broker can save youthousands in the long term.While nobody knows whatthemarketwilldotomorrow,an experienced broker willhelpyou to “land theplane.”Abetterbrokerwillkeepyouout of the thunderstorm

altogether.Thenaturalextensionofa

broker isaportfoliomanagerwhosimplyfliestheplaneforyou. Instead of sitting in thecockpit, making all of thosedecisions, watchingindicators,tryingtofigureoutwhat that alarm means, andworrying about landing thedarn plane, you simply sit infirst class (or in the cockpit“jump seat”) while an

experiencedcaptaintakesyoutoyourdestination.Ifyouarea trader, you likely are bestservedbyabroker.Ifyouaremore of an investor, you arelikely best served by aportfoliomanager.

Much of this, of course,comes down to personalityandtimeavailability.Areyoumore motivated by theenjoyment and challenge offlying—or are you more

about getting to yourdestination comfortably andsafely?

Suffice it to say that ifyouareinvestingsixorsevenfigures into an option-sellingportfolio, investing inprofessional guidance shouldbethefirsttradeyoumake.

Mistake2:Overpositioning

The second most commonmistake we see new optionsellers making isoverpositioning. Because ofthe high odds of success onany individual trade, manynewoptionsellersexperienceeuphoria at having their firstfew options expire and thinkthat theyhavediscovered theHolyGrail of investing.Thisoften can lead to a “can’tlose” mentality. Combinedwith the low margins of

selling futures options, thepotential tosellmoreoptionsthananaccountshouldsafelybe holding becomes arealistictemptation.

Don’t do it. Almostinvariably the position youchoose to “load up” on willbetheonethatsinks.

Even if you experienceearly success at optionselling, which we canhonestly say many of you

probably will, you cannotlose respect for the market.Unlike futures traders oroption buyers,whose path tosuccesslies intakingaseriesof small losseswhilewaitingfor one big winner, yourapproachwillbetheopposite.Yourapproachwillbetotakea series of many moderatewinnersand toavoidonebigloser.

Given the current rate of

success of most futurestraders and option buyers,yourchancesareprettygood.However, overpositioningyour account increases thechances that one loss couldaffect your overall portfoliosubstantially. We generallyrecommend that clients notmargin more than 50% oftheir total funds at anygiventime, and we recommendhaving that portiondiversifiedoverat least three

to five commodities at anygiventimeforaccountsunder$500,000. Any more of theformer or less of the lattercould mean that you areoverpositioned.

Mistake3:TradinganUndercapitalizedAccount

A pilot friend once said that

in training new flightstudents,planesweretakentohigher altitudes, givingstudents more room forrecovery if they made amistake.Thesameis trueforyour option-selling account.The more capital you have,the more room you have forrecoveryintheeventofabadtradeand themoreflexibilityyou have in yourdiversification and risk-managementtechniques.

Trading anundercapitalized accountoftenmeanstradingscared.Itcan lead to everything thatone should avoid in optionselling, includingoverpositioning, over- orunder-risking, and emotionaltrading.

Wegenerally recommendstarting a futures option-writingportfoliowithat least$250,000.Forourclients,we

typically recommend a $1million starting portfolio.Sure you can start with lessand“play”withit.Butinmyexperience, the guys whoplayaretheguyswholose.Ifyouaregoingtoselloptions,I suggest making a seriouscommitment to it. You aredoing something fewunderstand how to do. Do itright and you have thepotentialtodoverywell.Butyouhavetocommit.

The problem with manytraders is that they remain inagamblermind-setinsteadofaninvestmentmind-set.Manytradersareattractedtofuturesbecausetheybelievethattheycan take a small amount ofmoneyandturnitintoalargeamount of money in a veryshort period of time. Wealreadyknowthetrackrecordofmostofthesetraders.

Option selling is not

going to do this for you.However, option selling, ifdonecorrectly,cantakeasetamount of money and get avery good return on it—consistently. This is what ismeantbyan investor’smind-set.Whatdowemeanbyverygoodreturn?Ifyou intend totrade your account in aconservative to moderatemanner, according to thetechniquesused in this book,you realistically could target

a 20% to 50% annual returnon your capital. Do weguarantee that you can dothis? Of course not. Youmightneverhitit.Youmightlose money. But manyprospective investors ask fora ballpark target ROI. Basedonourexperience,webelievethat this is a realisticobjective.

You must, however, besufficientlycapitalized.

Mistake4:NotHavingaTradingPlanand/orExitStrategyEstablishedBeforeTradeEntry

Although many tradersdismiss the role thatpsychology plays in thetrading process, it has beennotedbymosttoptradersandauthors that failure tocontrol

emotions is probably thenumber-one reason traderslose money. Markets lookentirelydifferenttoyouwhenyouareanalyzingtradesfromadistance thanwhenyouarefollowing them with yourmoneyontheline.Nomatterhowcontrolledyouthinkyouare, your emotions probablyare affecting your thoughtprocess without you evenknowingit.

Think of it as a Dr.Jekyll–Mr. Hyde type ofsituation. Before you enterthe trade, you areDr. Jekyll,thecalm,rationalthinkerwhoforms and implements acontrolled plan. Once youenter the trade, you becomeMr. Hyde, instinctive,irrational, reacting andoverreactingtoeverypieceofstimuli passing in front ofyoureyes.There isa littleofthisinallofus,eventhemost

polishedprofessionaltrader.This is why most traders

develop a plan or a system.Systems do not have to becomplicated.Theyaresimplya set of rules you developbefore you enter the trade sothat you have a roadmap tofollow once you make the“change” from objectiveanalyzertoemotionalreactor.Rememberplanthetrade,andtradetheplan?Thisisanother

wayofsayingit.Systemscanrangefroma

couple of simple entry andexit guidelines written on apiece of paper to amultidimensional computerprogram. Frankly, youprobablycoulddojustaswellwith either in your option-sellingaccount.

The most important partof a system is the exitstrategy. You must know

when, where, and how youwill exit the trade and whatcircumstance will cause youto do so. Never change yourplanonceyouareinatrade.

One of the primary waysthat traders lose more thanthey should is by violatingthis rule. On the day theyenter the trade, they are Dr.Jekyll on the phone,confident, cool, in control.Then, several days or weeks

later, after the market hasshifted,thesamepersonisonthe phone, but it soundsnothing like the rationalfellowthatspokeearlier.Mr.Hyde is now in charge. Hisvoice is high, maybe a littlefaster, and he is excited andafraid. He asks his brokernervous questions, such as,“Whatdoyou think?”“Whatare they saying?” and “WhatshouldIdo?”

Nietzsche once said, “Aman without a plan is not aman.”Whilewearenotgoingto question the wisdom ofNietzsche’s philosophy, amore fitting quote for themodern-day investors mightbe, “Apersonwithout aplanisnotasuccessfultrader.”

Know your exit strategybefore you enter. Let Dr.Jekyll do the thinking part.All Mr. Hyde has to do is

carryitout.Weworkcloselywithour

investors in designing andsettingatradingplannotonlyfor their portfolios but foreach individual trade.However, if you are doingthisonyourown,you’llwantto make setting an exitstrategyyourtoppriority.

Selling options alreadyputsyouintoanelitegroupoffutures traders who actually

standachancetomakesomegood money in the market.Setting a pretrade exitstrategy will put you abovemost of even this specializedgroup.

Mistake5:TryingtoPickTopsandBottoms

Although you will have an

added margin for error insellingoptions, tryingtopicktops or bottoms remains oneofthehighest-riskapproachesto trading. Not only is ithigher risk, but it also isprobablyunwise.

Ifyouaretryingtopickatop or a bottom, you arebettingonareversalintrend.This means that you aretrading against the currenttrend andmost likely against

the current fundamentals.Markets can make fast andsometimes significant short-term moves in contrast toexisting fundamentals.However,amarketrarelywillestablish a long-term trendwithout some form of basefundamental driving it.Picking a top or a bottom istrading against the trend,which automatically reducesthe odds of your optionexpiring worthless.

Rememberthestatisticsintheearlier chapters? A marketdoesn’t have to have a trendfor you to sell options in it.However,ifthereisatrend,itis best to be selling youroptionsinfavorofit.

We had a client forseveral years who we’ll callSam.Samwouldbuyandsellfutures contracts because hethought the market was “toohigh” or “too low.”

Consequently, his strategyoften was to buy or sellagainst the trend. Samemployedacustomversionofscale trading in which hewould continue to add to hispositionasthemarketmovedagainstit.Histhoughtprocesswas that as long as he hadenough capital, he simplycould continue to averagedown until, eventually, themarketwouldreversefromitsextreme levels. Although

Samhadsubstantialcapitalinhis account, this strategyoften required him to meetmargin calls to continue tohold his positions. He was astubbornman,though,andhedid well for a while.Although he had some bigwins and big losses, he wasrunningat about evenafter acoupleofyears.

About halfway throughhis third year, Sam was

betting big that crude oilpriceswere“toohigh”above$26(thiswasofcourse,manyyears ago). He continued toshort futures, and pricescontinued to go up. As youcan guess, Sam’s story endsbadly.Crudeoilcontinued toincrease in price and soonexceeded $40 a barrel.Eventually,Samgotamargincall that he couldnot (or didnot want to) meet. In otherwords, he ran out of money

andwasforcedtoliquidateallhis positions at substantiallosses. His account wasnearlydepleted.

Although we tried onseveral occasions to convertSam to an option-sellingapproach, he was notinterested.However,althoughan option-selling approachmay have extended histradingcareer,webelievethathis strategy of positioning

suffered from a substantialflaw that eventually wouldhave done him in regardlessofthevehiclehewasusing.

Selling a market becauseit is “too high” or buyingbecause it is “too low”generallydoesnotmakegoodtrading sense. Whodetermines what is too highortoolow?Themarketdoes.If it is trading at a certainprice level, that is what the

commodityisworththatday.It’s not too high or too low.It’s just right. This is whyfundamental trading withfutures contracts is sodifficult. Youmay think thata market has bullishfundamentals,soyouhave tobuyitat thepriceatwhichitis currently trading. On thedayyoubuythecontract, theprice is not too low. It isfairlypriced.

With option selling, youcanpickapricefarbelow(orabove) the current fair priceandsay,“Thatpricewouldbetoo low. I do not think themarket will go there.” Sincethemarketisnotthereonthedayyousellyouroption,yourstrike price is too low, andtherefore, your trade is atleastlogical.

Theentirepointofsellingoptions is to avoid trying to

outguessthemarket.Noneedtodothatanymore.Therearemuch easier ways to makemoney than trying to picktopsandbottoms.

Mistake6:ForminganEmotionalAttachmentorAversiontoaParticularMarket

Although thismay fall underthe category of trading onemotion, it is commonenough that it deserves amention of its own. It is notuncommon for traders,especially new traders, tobecome emotionally attachedor averse to amarket. Theseare two extremes of what isbasically the same mistake:forming an emotionalassociation with a particularmarket—positiveornegative.

We’veseenitcauselossesasoften as we’ve seen itproducemissedopportunities.Bothareequallydamagingtoyour portfolio, and youshould guard against this all-too-commonmistake.

This phenomenonusuallydevelops after a traderexperiencesaverypositiveorvery negative experience orstring of experiences in aparticular market. The trader

thencomes to theconclusionthat a particular market is“good” or “bad.” The traderwho wholeheartedly jumpsintoatradebecauseshemademoney in itbefore ismakingthesamemistakeasthetraderwho refuses to enter a tradebasedonabadexperience inthat particular market in thepast.

As rational people, weknow that there is no such

thing as “good” or “bad”markets. If you bought acontractforcottonandcottonwent down, you lost moneyand therefore might behesitant totradecottoninthefuture. However, the traderwho sold cotton and made aprofitmaythinkthatcottonisa great market to trade. Thecotton market, however, islike the ocean. It could careless about your well-being,but it has no desire to cause

you harm either. You couldbaskcomfortablyinitswarmtropicalwatersordrowninitscold icy depths. It is up toyou what you do with it.However, it is not going tochange to accommodate you.Themarketisthesameway.

Let’s look at a commonexample. Trader Mary sellsputs in the Euro, and theyexpireworthless,nettingheraprofit.Maryfeelsgoodabout

the trade and therefore feelsgood about the Euro ingeneralandmaystart to takeaparticularinterestintradingit again. If the fundamentalsremain favorable to Mary’spositions, shemaybeable tocontinue to sell optionsprofitably in the Euro for alongperiodoftime.

The danger comes whenfundamentalsor the trendforthe Euro begin to change.

Marymay have formed suchastrongemotionalattachmentto trading the Euro that sheoverlooks the subtle signsthatabasicfundamentalshiftisstartingtotakeplace.Marycontinuestosellputsbecauseit has always been a goodtrade in the past. She feelsverycomfortablesellingEuroputs. The Euro is a “good”market. Mary’s emotionalattachment has turned tocomplacency, and she allows

it to override her objectivitywhen analyzing the market.Shemayevenallowherselftooverweigh her portfolio inEuros. When prices finallyturn, Mary could pay theprice for her emotionalattachment.

Iftheattachmentisstrongenough, Mary may continuetoposition in the same trade,refusing to accept that themarket conditions have

changed. We have seentraders take considerablelossesthisway.

You don’t have to makethat mistake. Don’t formemotional attachments tomarkets–goodorbad.

The“Revenge”Trade

Avariationof thismistake is

a trader’s urge to take“revenge” on a market inwhich he lostmoney. In thiscase, if a trader lost moneytrading soybeans, he has theopinion that “Soybeans tookmymoney,andIamgoingtogetitbackfromthem.”

Of course, this isirrational thinking as well.But it is another example ofMr. Hyde rearing his uglyhead to trash the organized

laboratory of your portfolio.Thetraderfeelsthathehasto“gethismoneyback”becauseitisbeingheldhostagebythemarket in which he lost it.Therefore,hemaywanttotrytorepositioninthesametradeor take the opposite positiontocapitalizeontheverymovethat took his money in thefirstplace.The trader refusestoacceptthathehadtotakealoss and feels that if he canget it back in the same

market,itwillsomehowerasethe loss altogether because itwasallpartofthesametrade.Nevermind thatmuch betteropportunities may beavailableinothermarketsandthatthetradermaybepassingup countless opportunities tomake his losses back manytimesover.

If you find yourselffeeling thisway, it is best totake a few days, or even a

few weeks, off from tradingand let yourself come downfrom this experience. Youwillbeinamuchbetterstateofmindtobeginapproachingthe market rationally whenyoucomeback.

TheEntrenchedBias

Even if your actions are notthis extreme, traders oftenform long-term biases in

particular markets based onpast experiences. Try not toletpastexperiencecloudyourjudgment when analyzingnewtrades.

Anexampleofthiscanbetaken from the BSE (MadCow) example we discussedinanearlierchapter.Aclientandgoodfriendofours,we’llcall “Tom,” was short putoptions when the news ofMadCowbroke.Eventhough

Tomhadbeenabletoexithisposition at reasonable losses,itnonetheless left abad tastein his mouth for tradingcattle. He had developed anemotional aversion, eventhough it had no basis inreality.

About 60 days after theMad Cow news had beendigested by the market, itappeared that an exceptionalopportunity was available in

the live and feeder cattlemarkets.Themainreasonthatcattle prices fell (other thanimmediate investor knee-jerkreaction)wasnotbecausethemarket believed that peoplewouldstopeatingbeef.Itfellbecause importers of U.S.beef closed their borders tothe product. Since exportsmade up about 10% of totalU.S. beef production, wepredicted that supplieswouldrise and, therefore, prices

wouldbelower.Cattle fundamentals

before the BSE scare,however, were extremelybullish. Demand was at arecord high, and supply wasnot keeping pace. The calfcropwasneara50-year low.The U.S. border had beenclosed to Canadian beef,whichmetupto10%ofU.S.demand, due to an earlierBSEoutbreakinthatcountry.

These fundamentals werestill in place, even after theexport pace was slowed.Withinaperiodofaboutnineweeks,cattlepriceshadcomeback to pre–BSE levels.Demand for beef had notwaned after the BSE scare,but the borders were stillclosed.

The public, however, hadseen the reaction of themarket after one incident.

This brought out the small-spec fortune-seekers whodreamed of retirement bybuyingcattleputsandhopingforanotherBSEoutbreak.

Put option pricesskyrocketed as more of thismoney poured into themarket. Whereas before thescare, option prices could besold maybe $7 to $8 out ofthe money for decentpremium, the same premium

now could be had at strikesmore than $20 out of themoney. What is moreinteresting is that theseoptionswereupto$10belowthe lows achieved during theBSEoutbreak.

Thekeyfundamentalhereis that price had to adjustlower fromBSE because theborders of the main U.S.imports had been closed.Now they were already

closed. They couldn’t beclosed again! Even in theunlikelysituationthatanotherBSE discovery would occur,if the borders were alreadyclosed,whywouldthemarketfall to the levels of lateDecember, let alone $10beneath them? Buyingoptions on a market becausesomething might happen isoutrightgambling.Bettingona price level that is highlyunlikely to be achieved even

in the event that the certainsomething takes place isdownrightfoolish.

Itlookedlikeaslamdunkto sell these puts so farbeneath themarket.YetTomwas downright opposed todoing any type of trading incattle. His emotions hadproduced an aversion totradingcattle.Inhismind,hehadtakenalossincattle,andtherefore, trading cattle was

bad.Tomhad lethisemotions

keep him out of what wouldhave been a very profitableopportunity.Ifhewouldhavesold the cattle puts at theselevels, he would have beenrewarded with options thateroded fairly quickly andsmoothly,inadditiontobeingpositioned in a seeminglylow-risk trade. This not tomention,hewouldhavemade

backallof themoneyhehadlost in cattle 60 days earlier.And although it was afundamentally sound trade, italsohadsomethingelsegoingfor it. It faded the public,which is almost always agoodidea.

Don’t let your emotionsget in the way of suchopportunities foryou.Acceptthatnomarketisgoodorbad.Onlyyourpositionisgoodor

bad. The market is like theocean.Itcaresnotaboutyourwell-being, nor does it wishyou any inherent harm. It isneutral.

Keep an open mind, andapproach each trade as abrand-new opportunity,independentofpastprofitsorlosses.

Conclusion

Through our careers, we’veseen many investors,especially investors new tooptionselling,makemanyofthe samemistakeswhen firststarting out. Although thesemistakes can be tremendouslearningexperiences,itmightbe easier to learn from themistakes of others first,without having to sacrificehard,coldcash.

If you can avoid these

mistakes, you’ll be able toskipoversomeof thepitfallsthat new option sellersmakeand give yourself a muchhigher chance of profitingconsistently.

Chapter 20 will explainhowtotellifyouhaveagoodbroker or portfolio managerand give advice on findingone.

20

FindingaGoodBrokerorMoneyManagerTheBestTradingDecisionYou’llEverMakeisChoosingtheRightProfessional

Robert Kiyosaki, in hisclassic bookRichDad, PoorDad, suggests that there areseveral strategies andphilosophies thatseparate therich in our society from thepoor and middle class.Kiyosaki points out that oneof these key differences isthat the rich tend to seekoutexpertstoadviseandmanagemuch of their financialaffairs,whereas thepoor andmiddle class seem to

subscribe more to a “do ityourself” mentality. Heargues that in an attempt tosave money up front byhandling legal, accounting,andinvestingmattersontheirown, the poor and middleclassendup losingmoney inthelongrun.

If you were being sued,would you read a book onlaw and attempt to defendyourself? Would you go

through all the ads in theYellow Pages to find thecheapest lawyer you couldfind?Orwould you seek outthe best litigation attorneyyou could find and launch arigorous defense to dismissthe case and countersue forcourtcosts?

If you needed heartsurgery,wouldyouseekouta“discount”doctor—perhapsafirst- or second-year intern

who agreed to cut you a“reallygood”deal?Orwouldyouresearchandinterviewtofind the most experienced,skilled surgeon you couldfind?

Most people would wantto hire the best in either ofthese situations.Yet,when itcomes to money matters,many look to hire the brokerwith the “cheapest”commission. They do this

because they do not see theneed or use for a qualifiedbroker, or they have had abadexperiencewithabrokerin the past. Nowhere is thismore true than in futurestrading. Everybody has astory about the broker who“didn’t get me out” or “toldme to buy on the high.”Others tell of outlandishcommission charges leveledbyanincompetentbroker.

It is true that thesebrokers exist. Yet it isunfortunate that many of thepeoplewhohavebeenturnedoff to brokers because of abad experience will neverexperience the pleasure ofworking with a trueprofessional.Theactionsofafew can tarnish the image ofthe hard-workingprofessionalswhosecompletefocus is on improving theirclients’performance.

Some traders don’t seethe need for a qualifiedbroker until they run intotrouble.Wecannot count thetimes that we have haddistraught traders call andexplaintheprecarioustradingsituation that theyhadgottenthemselves into and ask howtogetoutofit.

“I sold these options,”he’ll explain, “and then Ibought one of these to offset

it, but then XYZ happened.WhatshouldIdo?”

“Whydon’tyouaskyourbroker?”

“Hedoesn’tgiveadvice,”he’ll respond. “It says onyourwebsitethatthatiswhatyoudo.”

“Yes, I do. To myclients.”

We have spoken tobrokers and other accountmanagers who dedicate their

lives to studying themarketsand improving their clients’bottomline.Theyareamazedat the public’s expectationthat theirservicessimplycanbe obtained for free. Severaltimes a month our firmreceivese-mails fromreadersof our articles that statesimply,“Pleasesendmeyourbest trades with strikes andrisk zones. Thank you.”Thereareseveralvariationstothis request, but this is the

maintheme.Yet,iftheyreadan article by an accountantabout saving on their taxes,would they write a letter tothe accountant and ask forfreetaxadvice?

TheMostExpensiveAdvice:Free

This expectation, however,may not be all the public’s

fault. Some brokers whotelemarket their services willhand out recommendationsleftandrighttoanybodywhowill listen. Many onlinebrokers now offer “freetrading ideas” to their eagerfollowers.

“Ideas?” Really? Thisonline trader is so desperatefor action that he is taking“ideas”fromthetechgeekat10dollartrades.com. Beware

of the broker or websitepassing out free trading“ideas” like popcorn. Toparaphrase a quote fromMr.Kiyosaki’s book, “Freeadvice is often the mostexpensiveadvice.”

“You get what you payfor” is another piece oftimeless wisdom. This doesnotsuggestthatthehigherthefee, the better the broker ortrader.Itdoessuggestthat,on

the whole, if you wantcompetent advice andguidance, you probably arenot going to get it on thecheap. This holds true inalmostanyprofession.

Itistruethattherealwayswill be a certain portion oftraders who possess enoughknowledge and skillthemselves that they onlyneed an order taker or anonline trading platform to

place their trades. But I canassureyou,theseguysarenottakingtrading“ideas.”

We also forget that tomany,regardlessofwhattheysay, making money is nottheir primary reason fortrading. They trade as ahobby or pastime and seekthe challenge, excitement, orfunoftrading.Goingitaloneispartofthechallenge.Thereisnothingwrongwiththis, if

thisisyourthing.However, if your sole

purposeistoincreasethesizeof your investment, and youwant to do it using thesophisticated strategy ofoption selling, a broker ortraderwhoknowswhathe isdoing can be the differencebetween success and failure.A good broker or managershould pay for himselfmanytimesoverthroughthecourse

ofayearoryears.Throughout this book we

have told you about thevarious benefits andadvantagesofworkingwithagood trading advisor. Wepromised earlier to definewhatagoodbrokeroradvisoractually is and what oneactually does to help yourbottomline.Thischapterwilldescribe this alongwith howyou can find a good account

professional to help you selloptionsprofitably.

TypesofMarketProfessionals

Before we delve into thesubjectofwhatmakesagoodprofessional, let’s firstexamine the types of brokersand advisors that areavailable.

Discountbroker.Adiscountbrokerisgenerallyafirmthatemploysagroupof“brokers”whosejobisprimarilytobeanoperatororordertaker.Thisalsoincludesonline“self-placed”orders.Theironlyfunctionistotakeorders.Manyfirmsprovideonlineresearch,

quotes,andyes,even“tradingideas”fortheirclients.Theyareverypopularwiththeday-tradingset,aswellaswithprofessionaltraderswhowatchthemarketsasafull-timepursuit.Theyarealsopopularwithtrading“enthusiasts.”

Discountbrokersserveafunctionandareveryusefultothesetypesofindividuals.However,ifyourcareerorbusinessisnotfull-timetrading,youmaybebetterservedelsewhere.

Full-servicebroker.Full-servicebrokerscan

playseveralroles.Theycanactasaprofessional“caddy”toyourtrading,providingyouwithup-to-the-minuteresearchreportsandcustomcharts,callingyouwithmarketupdatesordevelopmentsinyouraccount,watchingyouraccountforyou,

assistingyouwithplacingtherightorders,personallyworkingyourorderforaspecifiedprice,andgenerallybeingtheretosupportyouinanywaytheycan.Aninexperiencedbrokercanstillserveyouwellinthisregard,aslongassheisfocusedonpersonalattentionto

youraccount.Somefull-servicebrokerscangive“tradingrecommendations.”

Itmightseemlikecommonsensethataprofessionalwhoisclosetothemarketeverydaywouldhavetopickupafew“tricksofthetrade”alongtheway.However,just

becauseapersonisabrokerdoesnotmeanthatheisagoodtrader,nordoesitmeanthatheiscompetentenoughtogivetradingadvice.Itisinthisregardthatgapsincompetencelevelsarewidest.Abrokerinthebusinessfortwomonthscangiveadvicejustas

easilyasabrokerinthebusinessfor20years.Andthereisnoguaranteethateitheroneofthemwillprovideyouwithgoodtradingadvice.Thisiswhydoingyourhomeworkisimportantwhenyouareselectingabroker.

CommodityTradingAdvisor.Acommoditytradingadvisor(CTA)isaspecializeddesignationandisquitedifferentfromacommoditiesbroker.Abrokergetspaidtoexecuteyourtradeforyou.ACTAgetspaidtomanageyouraccount.ACTAis

notabroker.Heisaprofessionaltrader.Inotherwords,youhireaCTAtotradeyouraccountforyou.CTAs(alsoknownasportfoliomanagers)oftenchargeanannualmanagementfee(usuallyasmallpercentageoftotalequityinyouraccount),inaddition

toan“incentivefee.”Theincentivefeeisapercentageofprofitsgeneratedinyouraccount.Thiscanbeinadditiontoanycommissionschargedtotheaccount.Therearealsosomethatwaivealloftheseseparatechargesandsimplychargeaflat

tradingfeeonindividualpositions.

If you hire a CTA, youareturningoverthetradinginyour account to aprofessionaltrader.CTAsarerequired to provide theirclientswithwhatisknownasa disclosure document thatdescribes in detail their fees,account sizes, the tradingplan that will be used toinvest your funds,

performance,andmanypagesdescribingrisks.

Likebrokers,CTAscomewith a wide range ofexperience and competence.AlthoughaCTAdoeshavetobe licensed, being a goodtrader is not part of therequirement.ACTAdoesnothave to pass any testdetermining his tradingsavvy. Therefore, like mostany other profession, their

skill level can range fromoutstandingtoverypoor.

While some CTAs havelittle more knowledge ortrading experience than theaverage individual investor,there are some skilledprofessionalsinthisfieldwhomanage millions of dollars.Unlikehedgefunds,however,CTAs typically manage youraccount individually for you—notmixingyourfundswith

other investors. Good oneswill work with you inplanning your tradingapproach, keeping youinformed as towhat is goingon in your portfolio and thestrategies being employed init.

WhatYouShouldKnowAboutBrokers

As I mentioned at the outsetof thisbook,myfirmisveryselectiveinwhoweacceptasa client. We don’t workcheap.Wehavea setwayofdoingthings.Andtolimitouradmissions, we set amoderately high openingaccount balance (at least bythe standards of the garden-variety investor). Althoughthis exclusive approach maybeaturn-offtosome,itlimitsour clientbase to the typeof

investorwhohasthemind-setand disposition we prefer towork with—as well as thatmostconducivetosuccess.

I tell you this not to besmug or noninclusive. Quitethecontrary:ItellyouthissoyouknowIhavenoconflictsof interest in recommendingwhat could be construed asthecompetition—orspeakinghonestly about otherprofessionals in this industry.

Ninety percent of the peoplereading this book will nevercontactmyfirm.That’sokay.

Thegoalofthisbookistohelp you sell options andmakemoneydoingit.Thisisregardlessofwhoyouchooseto help you manage yourfunds, what your tradingpreferences, net worth, orultimate investmentobjectives.

Brokeror“Salesperson”

While the trend has clearlybeen toward online tradingamong the mainstreaminvestment crowd, there aresome signs the tide isbeginningtoturnbacktowardworking with a full-servicebroker—especiallyamongthehigher-net-worth set.However, many books that

we have read on trading ingeneral are antibroker. Inother words, they encourageyoutodoeverythingonyourown because brokers arebasically commission-hungrysalespeople, eager to take asmuchof yourmoney as theycanbeforetheyhelpyoulosetherestinthemarket.

Havingworkedasbrokersin this business for acombined 26 years before

becomingportfoliomanagers,we feel thatwemay be abletoshinealittlelightontothisperception.

Sadly, insomecases, thisperception of brokers iscorrect.Insomecasesbrokersare salespeople convertedfromanother fieldwhogot alicense and now, instead ofselling advertising orcookware, are sellingbrokerage services. Although

this does not mean that theyare bad people, it doesmeanthat their ability to help youmakemoneyislimited.Ifyouare looking for a discountbroker, this may not makemuchofadifference.Ittakeslittletalenttopickupaphoneandplaceanorder.Ifyouarelooking for a marketprofessional to guide youthrough the goldenminefieldof the futures markets, itcouldbecritical.

Thereare,however,manyskilled professionals in thefield.You’lljusthavetolookalittlehardertofindthem.

The word broker canencompass somany differentjob responsibilities that therangeof individualsandhowthey view their jobs isendless. A choice that isrecommended to manybrokers starting out in thefieldistodecidewhetherthey

want to be traders or “equityraisers.” Since most brokers(or “account executives”) arenot good traders, they focuson raising equity.The test tobecome a futures broker ismainlyonrulesandtermsandhowthemarketworks.Thereis nothing about trading orhow to be a good trader.Therefore, if a broker wantsto be a good trader, in mostcases he has to learn on hisown. There are some larger

firmsthatoffersometrainingto help brokers trade better.In most cases, however, abroker is doing his bestwithlimited company or outsideresearch or his own verylimited knowledge to helpyouinvestyourmoney.

Whyshouldabrokerhaveto be a good trader? Hedoesn’t. There are greatbrokers who are not goodtraders. But if he is going to

give you recommendations,shouldn’t he be at least amarginally better trader thanyou?

ThreeTypesofBrokerstoWatchOutFor

TheSalesperson

Any professional from a

dentist to an attorney has tomarket his or her services.However, the manner inwhich these services aremarketed often tells asmuchabout thepersonorcompanythatisbeingrepresented.

There is noway to knowforsureifyouaretalkingtoagood or a bad broker by theway her services aremarketed.However,therearesome general guidelines that

cantipyouofftothefactthatyou may want to keeplooking.Thebrokerwhocallsyou out of the blue, with noprior contact, and begins apitch on a “great tradingopportunity”thatyouhavetoget in on “right now” isprobably not the marketprofessional that is going tobealong-termpartnerinyourinvestment program. Howdoes she know if it’s a greatinvestmentforyou?Doesshe

know your financialsituation? Does she knowyourrisktolerance?

Salesperson brokers haveonegoal—togetyouas their“customer.” They are oftenpeoplewhohavelittleinterestin futures or commoditiesexcept that it is the latestthing they are selling. Theycan be smooth talkers, butthey seldom last long in thebusiness. To be a true

commodities broker is ademanding job, and one hastolovehisworktoexcelinit.People with little interest inthe market who becomebrokers to “make a lot ofmoney fast” are oftendisappointed.

As we’ve stated, a goodbroker does not necessarilyhavetobeagreattrader.Buthe should have some interestin themarket and be able to

talk about it intelligently. Ifyou have somebody whocontinues to pitch you on asingle trade or commissionrate but stumbles repeatedlywhenyouaskanythingaboutthe market or trading, youprobablyhaveasalesperson.

TheRookie

Futures brokers have one ofthe highest turnover rates of

any profession, especiallywithin the first two years oftheir careers. Therefore, alarge number of new brokersenter the field every year.Being new does notnecessarily make them goodorbad.But theyaregoing tohave to learn thebusinessbymaking mistakes. Do youwant them to learn on youraccount?

Of course, some rookies

eventuallywillturnintogoodbrokers someday. However,youneed somebodywhocanhelp you now, and this isprobably not the person,especiallyifyouaregoingtorelyonherfortradingadviceandguidance.

TheGrifter

Almostallbrokers,aswellasthe firms that employ them,

are paid on a commissionbasis. This automaticallycreates a conflict of interest.With this arrangement, thebroker can becomesusceptible to allowing hisprimary interest be thenumber of trades that can begenerated from your accountrather than the performanceof your account. There arebrokers and evenunscrupulousbrokeragefirmswhointentionallyrecommend

that their clients get in andout of trades early and oftenfor the sole purpose ofgenerating commissionsrapidly. This is known aschurning,andit isnotonlyastrictviolationofCommodityFutures Trading Commissionregulations,itisalsoillegal.

In the movie BoilerRoom, Ben Affleck playedthe “pit boss” in a brokeragesuch as this. More recently,

Leonardo DiCaprio playedthesleaziestofbrokersinTheWolf of Wall Street. If yousaw the movie and thoughtthatitwasanexaggeration,itwasnot.

The “brokers” in thesetypes of firms cold-callhundreds of people in a dayand use high-pressure tacticsto get unsuspecting investorsto send them funds. If youfeel that you are being

pressured into investing infutures or have atelesalesperson who soundsextremely excited on thephone and is insisting thatyouhavetosendmoneyrightnow, you may be talking tooneofthesepeople.Theyareoftennotveryknowledgeableabout the market in generalandsometimesarehesitanttoanswer questions about thebackground of their firm orthemselves. But they usually

are very forceful andaggressive in telling youabout the “goldenopportunity” that they haveuncovered in the market,which, coincidentally,probably will be gone in afew short days (just enoughtime for you to send them acheck).

If you have doubts abouttheperson,askforhisand/orthe firm’s National Futures

Association (NFA)identification number. TheNFA does a good job ofweeding most of these typesofpeopleoutofourindustry,but there are always a fewwho slip through the cracks.The NFA is like the BetterBusiness Bureau for brokers.The NFA websitewww.nfa.futures.org givesthe background andcomplaint history of all itsbrokers and member firms.

All practicing brokers andfirms are required to bemembers. If the individual inquestion is not amember, orif the reporton thebrokerorthe firm pulls up a longlaundrylistofcomplaints,it’sbesttosteerclear.

If you can avoid thesetypesofbrokers,itwillallowyou to focus on merit andskillwhenchoosingfromtheremaining group of brokers.

Whatyouarelookingforisatrue market professional—apro.

However, if you want aquality, professional broker,chances are that you aregoing to have to find himbecause he’s probably notgoingtofindyou.Thisisnottosaythattherearenotgoodbrokers who telemarket theirservices. For years, this wasthe primary way for brokers

to find clients. If you haveever purchased or orderedanything even remotelyassociated with trading,chances are that your nameand phone number are on alist somewhere. Manybrokerage houses purchasethese lists for calling, e-mailing,ormailingpurposes.

These days, mostestablished, experiencedbrokers do not have to cold-

call phone lists to get newclients. An account manageror successful CTA mostcertainlydoesnot. If yougetan unsolicited cold call froma broker you have nevercontacted, it does not meanthat he is a bad broker or isdoing something unethical,but it could mean he or hisfirmisneworinexperienced,and this is how they have toacquirenewclients.

Because there are noclear-cut rules on how todetermine if abrokerhas therightstuff,youwillrelymuchon gut feel and commonsense. However, the listbelow may be helpful inknowingwhat toavoidwhensearchingfortherightbroker.Red flags that the broker onthe other end of the phonemaybeinexperiencedormaynothaveyourbest interestatheartfollow:

1.Thebrokerisvagueorelusivewhenyouaskhimforbackgroundinformationabouthimselforhisfirm.

2.Thebrokerstumblesorchangesthesubjectrepeatedlywhenaskedaboutmarketsortradingknowledge.

3.Thebrokerisoverlyenthusiasticaboutwhatsheistalkingtoyou

about.4.Thebrokerispitchingyouona“rareopportunity”ortellsyouthatyouhavetogetintothemarketrightnoworyouwill“missout.”

5.Thebroker’scompanyadvertisingishigh-profileradioorTVadstoutinghugeprofitswithlittleriskor

“proprietary”tradingstrategiesthathaveproducedhugeprofitsinyearspast.

6.Youfeelyouarebeingpressuredorgetthefeelingthatyouaretalkingtoausedcarsalesperson.Ifyou’veneverheardofthisbrokerorhiscompanybeforeandheispitchingyouonatrade

withinfiveminutesofintroducinghimself,thisisnotagoodsign.Abroker’sfirstconversationwithyoushouldgiveyouthefeelingthatyouaregettingtoknoweachotherandarebeginninganewprofessionalrelationship.

7.Thebrokerisaskingforexcessive

commissions.Full-servicebrokeragefirmcommissionsandservicesvaryincost,anditisdifficulttosayhowmuchistoomuch.Mostfull-servicefuturesbrokeragesthesedayschargesomewherebetween$49and$100perround-turncommissions.However,ifyouare

payingmorethan$100perroundturn,youareprobablypayingtoomuch.Ifthebrokerisaskingforalotmorethanthis,treatherlikearobberbreakingintoyourhousebecausethatisexactlywhatsheistryingtodo.Tellhernottocallback,andthenhangupthephone.We’veheardhorrorstoriesoffirms

charging$200to$300perroundturn.Thereisnobodywhocanjustifythatkindofcommission.Thetopstarsintheindustrywillchargeyoulessthanthat.Howcanasmooth-talkingsalespersonjustifythatkindofcommission?Shecannot,andchancesarethatsheorherfirmcaresabout

littleelse.

WhattoLookforinaGoodOption-SellingBroker,MoneyManager,orCommodityTradingAdvisor

Experience

Futures brokers have one ofthe highest turnover rates ofanyprofession.Manybrokerswho start in the businesswashoutwithin the first twoyears.The oneswhomake itbeyond this point must atleast have learned how to dosomething right. To succeedover the long term, a brokerhas to love what he or shedoes and be at leastcompetent in it. This is evenmoretrueforaCTA.

Look for a broker whohas been around the block.There will always be someyoung up-and-comers whomaybehonestandhelpfulonthephone,butyoudon’twantthemtolearnatyourexpensewithyouraccount.Ifyouareserious about your trading,especially in the advancedtechnique of option selling,and are hiring a CTA tomanageyourmoney,lookforsomebody with at least 5 to

10yearsofexperience.

Credentials

Just because somebody hasbeen in the business for awhiledoesnotguaranteethatsheisagoodbroker.Findouther background andaccomplishments in theindustry. Where has sheworked before? Does shehaveanyothercertifications?

DoesshehavealargeamountofcomplaintsonfilewiththeNFA?Youwanttofindoutifthis is her career or just herlatestjob.

If you are interviewing aCTA, check if his firm isregistered as a CommodityTrading Advisor. Has hepublished anything? Goodmoney managers oftenresearchmarkets and publishtheir findings (at least the

findings they want to sharewith the public). Has hepublished any articles inpublications you may haveheard of? Does he publish anewsletter?Doeshegiveanymarketopinionsorinsightstothe media? Look for thingsthat show that the moneymanager may have arespected name in theindustry. The more involvedheisinhisindustry,themorelikelyitisthatherespectshis

businessandhisclients.

Honesty

It should go without sayingthat thebroker ishonest, andgauging her level of honestyis up to your judgment.However, as a guideline,beware of brokers ormanagerswho talk about biggainsandlittlerisk.Disregarda broker who tells you that

you have to get in right nowor you’ll “miss out.” It islikely that this broker has asales quota to meet or acontest to win, and if youdon’tsendyourmoneytoday,she’sgoingtomissout.Thereare always newopportunitiestomorrow.Ifyoufeelalotofpressure to open an account,chances are that you aredealing with a salespersonbroker.

KnowledgeofOptionSelling

As we’ve said before, somebrokers are inexperienced orundereducated in sellingoptions and may be littlemore versed in it than youare. This is fine if you aredealing with a discountbrokersimplytoplaceordersfor you.However, if you arehiring a full-service broker

and paying for it, you aremore or less hiring anadvisor. This is even moretrue if you are hiring anaccountmanager/CTA.

For this reason,youwantto hire the best advice youcan find. You may have tointerview a few before youfind one who is friendly toand experienced in optionwriting. Be thorough. Somebrokers will say anything to

get you to open an account.“Option selling? Ah, yeah,sure,Idothatallthetime!”

Have some goodquestions for her, and listento how she answers them. Ifshestuttersandbacktracksorputsyouonholdafewtimesto get answers to yourquestions…. well, you knowwhattodo.

FocusedonYou,NotonHimself

Regardless of whether herealizesitornot,abroker’soraccountmanager’spurposeisto help you to succeed. Intalking to him, you shouldsense that you’ve found anally to help you through thecourse of your option-sellinginvestment.Ifyouinsteadgetthefeelingthat thepersonon

theother endof thephone isstanding on top of his deskhawking snake oil, his focusprobably isn’t on you. Goodbrokers or account managersknow that they’re good. Intalking to them, you shouldfeel like you’re talking to acool,relaxedprofessional.

Like any business, thefuturesindustryhasgoodandbad people in it. The goodnews is that the dishonest or

disinterested ones usuallydon’t last long as brokers.Brokers who open investors’accounts to “turn and burn”them to make a quick buckusually will get burnedthemselves before long. Thetrue professionals in theindustryhavelearnedthattheonly path to long-termsuccess is to put you, theclient,firstandtobuildlong-term, lasting relationshipsbuiltontrust.

By hiring a broker oradvisor,youaremoreor lesshiring somebody to go tobattle for you in the tough,winner-take-all world offutures options. Especiallywiththesophisticatedvehicleof option selling, you’ll needone with competence,honesty, and skill. You’llprobably have to wadethroughapoolofsalespeopleandrookiesbeforeyoufindabroker who has the right

combination of all three.Butthere are some talentedpeople out there who reallycanmakeadifferenceinyourtrading.

Your job now is to gofindone.

21

OptionSellingasanInvestmentFrequentlyAskedQuestions

At this point in the book, if

youarebeginningtoconsideranoption-writingportfolioorare getting some ideas forways to enhance or improveyour current portfolio, youmay have some questions onsome of the key points ofoptionsellingorhowsomeofthe aspects of the approachmay affect your particularsituation.

Many of our prospectiveclients tend tohave the same

questions,andwehave listedthem in this chapter alongwith our answers. Thequestion-and-answer formathas proved most helpful tomany prospective optionsellers,especially in thefinerdetails of the strategy thatmaynothavebeendiscussedthoroughly enough in otherchapters.

Hopefully, you will findthischapterusefulintyingup

some of the loose ends inanswering some of the moreobvious questions you mayhave in beginning an option-writing portfolio. Most ofthese questions are takenfrom actual conversationsbetween us and traders whoare considering an option-sellingapproach.Someoftheanswers may reflect ourpersonal bias in tradingtechniques. However, ourbiasesarecarvedoutofmany

yearsofupsanddownsinthefuturesmarkets.

Q:Whatisyouroverallviewoffuturestradingingeneral?

A: Interest in investing incommodity futures tradinghas grown rapidly amongindividual investors in the

pastdecade.Newrecordsarebeing set at the ChicagoMercantile Exchange involume in several contracts.Yet thisgrowthhasnotbeenequal in all parts of theindustry. It seems to beexpanding rapidly at bothends and shrinking in themiddle. Thus, electronictrading has really taken offand has seen modernexchanges like theIntercontinental Commodity

Exchange (ICE) thrive. Thesame is true for managedfutures,whicharegrowingatatorridpaceasinvestorslookfor seasoned professionals totrade futures and/or optionsfor them. The shrinkageseems to be comingwith thetraditional full-service brokerwho “helps” the client tradebut doesn’t do it for him. Itseems these days, peopleeitherwant to be all on theirown or have somebody

managingthewholethingforthem.

The majority of newclientsIgetnowarefirst-timecommodity investors. In theunstable world in which welive, people seem to berealizing that commoditiesarethestaplesoflifeandthatinvesting in them can bemuch more than just adiversification tool in aportfolio.Theproblemisthat

mostpeopledon’tunderstandleverage and that futurescontracts are a highlyleveraged investment.Tradingtheconventionalwayis a high-risk, high-returnproposition. Many tradersapproach the market as agamble. It has been ourexperience that if youapproach this highlyleveraged form of investinginaconservativemanner,youoften can achieve a very

attractive return on yourmoney.This iswhere sellingoptions on these contractscomesintoplay.

Q:Howdoyourecommendanewaccountgoaboutpositioninginthemarket?

A: We would firstrecommend limiting youramount of trades. Our mostsuccessful accounts don’ttrade very often. When wefeel there is an opportunity,we generally recommendtaking the most conservativeposition possible and thenenter it in numbers. In otherwords, instead of tradingevery day or every week in10 different markets, onlytradewhen you believe there

isastellaropportunitytosellpremium, and then don’t beafraid to build a positionthere. Our most successfulaccounts over the years haveonly traded an average ofthreetofivetimespermonth.It is not like long-term stockinvesting,whereyoubuyandhold forever. These thingsexpire every month so youhavetogogetmorepremiumeach time they do. But itshouldnotbelikedaytrading

either.

Q:I’vereadseveralbooksandotherliteratureonoptions,optionspreads,andstraddles,andsoon.Itseemsthattherearesome

strategiesouttherethatoffersomebigprofitpotentialswithlittlerisk.I’velookedatdelta-neutralstrategies,freetrades,andsoon.Doyourecommendany

ofthesestrategies?

A: Yes, if an opportunitypresents itself. If you readChapters9and10onspreadsand recommended spreadstrategies, you know thatsome spreads can beimpractical for individualinvestors.However, there aresome that can beadvantageous to you.

Strangling themarket can bea profitable approach incertain situations. We alsorecommend vertical creditspreads and ratio creditspreads.

Q:Whydoyousuggestnakedoptionsellinginsomesituations?

A: One of the strengths ofnaked option selling is itssheer simplicity. If you’rebullish on amarket, you sellputs. If you’re bearish, yousell calls.We’ve seen tradershave great success throughthe years by simply pickinggeneralmarket direction in afewselectmarkets. If they’rewrong, they can still makemoney. If they’re reallywrong, they get out if andwhentheoptionpremiumhits

their predetermined riskparameter.Weseenoneedtomake it more complicatedthanthat.

The downside, of course,is that themarket potentiallycan exceed your riskparameter. For this reason,some investors are morecomfortable in covered orspreadpositions,eventhoughitmaymeanslowerprofitsontheoptionssold.It isreallya

matterofpersonalpreferenceand risk tolerance. Wesuggest a mix of spread andnaked strategies acrossseveralmarketsuntilyoucandetermine which approachesaremorecongruentwithyourpersonality.

Q:Whatcriteriadoyouusewhenselectingmarkets

totradeandstrikepricestosell?

A:We use a combination offundamental and seasonalanalysis, and we are lookingatgeneralpricedirectionovera two- to six-month period.We are selecting far-out-of-the-money options with twoto five months’ time valueremaining. We try to selectpricelevelsthatcouldonlybe

achieved through a radicalchange in fundamentals. Theobject is toselect theoptionswith the highest probabilityofexpiringworthless,evenifwehavetowaitafewmonthsforthemtodoso.

Q:Fundamentals.Isn’tthatlong-termtrading?Whatabout

technicals?

A: Technicals can move themarket temporarily, buteventually,priceswillhavetoreflect the fundamentals. Ofcourse, we use technicalindicators in timing ouroptionsales,buttheywillnotdictate what markets wetrade.Many tradersandevenbrokersusetechnicalanalysisastheirsolemeansoftrading

simply because they don’tknow the fundamentals ordon’twanttotakethetimetolearn them. Learning thefundamentalsofamarketandhowtheycanaffectpricecanbe time-consuming anddifficult. However, in ouropinion, trading solely on atechnical basis is like tryingtohitabaseballwithoneeyeclosed: Your perspective isgoing to be off. If you’reinvesting capital into a

commodity trading idea, youshould at least try tobecomefamiliar with the basefundamentals of the marketyou’re trading or beworkingwith somebody whounderstands thesefactors.Anapproachusingacombinationof fundamentals andtechnicalsshouldhelptogiveyouthefullpictureofwhatisgoingoninamarket.

Q:Howaboutvolatility?I’vereadthatvolatilityisthemostimportantfactortopayattentiontowhentradingoptions.

A: Most option books toutvolatility as the most

important factor whendeciding which options totrade.Wearecertainlyawareof the volatility and wouldprefer to sell options at thehigher end of their volatilityranges. However, isn’t astudy of the factors likely toaffect the price of theunderlying more importantthan the volatility of theoption? Would you want tosell a put option in amarketwith extremely bearish long-

term fundamentals simplybecause the put optionswereexhibiting high historicalvolatility? (Think S&P putsinSeptemberof2008.)

We’ve had more successby incorporating someprojections for longer-termmarket direction (or at leastprojecting where the marketwon’t go) rather thanfocusingsolelyonvolatility.

Q:Whatabouttherisk?Doesn’tsellingoptionsentailunlimitedrisk?

A:Yes, theoretically it does.But the term is a bitmisleading. Unlimited risksimply means that you haveto manage the risk on yourpositionyourself—themarket

isnotgoingtodoitforyou—likewhenyoubuyanoption.Selling options can carry thesame risk as trading theunderlying contract, butusually less, andnevermore.Some traders will dismissoptionwritingas“toorisky.”(We find it amusing to notethat many of these traders,however, will trade futurescontracts without hesitation.)Withoutknowledge,anythingis risky. Experienced option

writers (who, incidentally,generally are commercial orprofessional traders who aregladlysellingoptionstosmallspeculators) know thatalthough selling an optionbears the same theoreticalrisk as a futures contract, thevalue of the option willalmost always move moreslowly than the futurescontract. Same risk butslower speed. Nonetheless,having an excellent risk-

management plan is the keytoconsistentprofits.

Q:Iknowthatiftheoptionexpiresoutofthemoney,IwillkeepallpremiumscollectedasprofitifIamtheoption

seller.Butwhatcanhappeninthemeantimeifthemarketismovingagainstmyposition?Willmyoptionvalueincrease?Willmymargin?

A: Yes. Both can increase.

Thisisonereasonthatyou’llwant to use only a certainpercentage of your accountfunds and keep the rest asbackup capital. Rememberthat while you will have afixedriskparameter inplace,you can still buy the optionback to close the position atany time. Your risk-management plan shouldrevolvearoundkeepinglossessmall. Certain spreads canlimit or reduce margin

increases and/or losses on anoptionposition.

Q:Howmuchwouldthevalueincrease?Howmuchwouldthemarginincrease?

A: It all depends on theoption,thevolatility,andhow

much time is lefton it.Keepinmindthatifyouaresellingfar-out-of-the-money optionswith low deltas, the valuesgenerally will increase veryslowly, even if themarket ismoving against you.Rememberalso,whensellingoptions, that the market canmove for or against you, buttimevalueisalwaysworkingfor you. The value of yourshort option almost alwayswillmove for or against you

at a slower pace than thefuturescontract.

Q:WhatpercentageofmyaccountfundsshouldIkeepasbackupcapital?

A: As a general rule ofthumb,wewouldrecommend

marginingnomorethan60%to70%ofyouraccountatanygiven time unless you arewilling tomeetamargincallshould you get one.Ultraconservative accountsmaywanttomarginlessthanthat; aggressive accounts canmarginmorethanthat.We’vewatched investors margin upto80% to90%of anoption-selling portfolio and rarelyhave a margin issue.However, we’ve also seen

them get margin calls andsubject themselves tooverpositioning. If they’regood positions, you can stillmake money by holdingthem. You just have to addmore deposit money in themeantime.Thetroublecomeswhen the investorsoverpositionandthencan’tordon’t want tomeet amargincall when it comes, even iftheirpositionsaregood.Thenthey have to take potentially

profitable positions off at aloss, after payingcommissions on those losingpositions. This can happeneven if the options onlyexhibit minimal fluctuations.The good news is thatmanaging your margin ispretty easy if you don’t gettoogreedy.

Q:Whatistherisk-

managementtechniquethatyousuggest?

A: As with any tradingmethod, you must learn totake some losses. Thedifferencewithoptionsellingis that, statistically, most ofyour trades should bewinners. Thus, it becomeseven more important not tolet one big loser eat away

your profits or, worse yet,cause a drawdown in yourportfolio. We suggestbeginners start out by usingthe “covered” technique thatwe described in the chapteron recommended spreads. Inotherwords, they should usea portion of the premiumscollectedtobuysomefurtherout-of-the-money options,providing at least partialcoverage. We also suggestexploring strangling

strategies to novice andexperienced investors, as thestrangle can offer a risk-balancing feature and canprotect traders from movesagainst either side, to acertainpoint.

For naked option sellers,wehavefoundovertheyearsthat the200%rule is a goodway to limit losses while atthe same time giving optionvalues room to fluctuate. By

the200%rulewemeanthatifthe option doubles in valuefrom the point at which yousold it, you exit the position.It is true that many of theseoptions also will expireworthless eventually.However,youcannottakethechancethattheoptionyouareholding will be the one thatmakes an extended moveagainstyou.Whenyoubeginto learn the personality of aparticularmarket,youmaybe

able to adjust the 200% ruleto allowmoreor less leewayincertainmarkets.Untilthen,itisagoodstop-outpointforbeginnerstohelpkeepyouontrack and away from biglosers.

Any of the techniquesdescribed in Chapter 12 canbeeffectiveinmanagingrisk.Again, much depends on theindividualinvestor.

Q:Withregardtothe200%rule,howoftendoesthishappen—anoptiondoublinginvalueafterI’vesoldit?

A: How often have youbought a far-out-of-the-moneyfuturesoptionandhad

it double in value for you?Much will depend on youroption-selling savvy andtechnique. However, withtime value working in yourfavor, the majority of youroptions sold should beexpiringworthless.

Q:HowmanyoptionsshouldItrytosellina

month?

A:Wewouldnotfocusonthenumberoftradesyoufeelyouhave to accomplish. Rather,focus on trading only whenanopportunitypresentsitself.Our experience withsuccessful accounts is thattheyusuallyestablishabout8to 10major positions a year.However, they may continueto sell options in these

positions as long as theycontinue to produce profits.Therefore, the number oftrades may vary. Thesegenerally are “investors” notlooking for “action” butrather for high percentagesand returns. If you arelookingforexcitement,you’llbe best served going to adiscount firm and opening aday-tradingaccount.

Q:Whatwouldyouconsideraposition?

A:Wedefine aposition as aseries of strike prices and/orcontract months all in onemarket. For instance, if youwere bullish on crude oil inthewinterof2013–2014,youmayhavesoldApril$75puts,May $130 calls, along withJune $70 puts. All of these

options together could beconsidered your position.You may take weeks ormonths to establish thisposition, staggering orlayering options at what youfeelareopportunetimes.Thisconceptof layering is centralto the approach werecommendtoinvestors.

Q:Couldyouplease

explainstaggering?

A:“Staggering”orlayeringisa concept we recommend to“smoothout”theequitycurveforinvestors.Itwasdesignedforinvestorsseekingasteady,income-producing tradingplan.Layering is thepracticeofsellingdifferentoptions indifferent markets withexpirationdatesaboutfourto

six weeks apart. If this isdone correctly, the tradershould have a set of optionsexpiring approximately oncea month. As some optionsexpire and others deteriorate,the trader then uses thepremiums collected to sellmore options three to fivemonths out, set up the sameway,increasingpositionsizesif he desires. Of course, notevery option sold will beprofitable, but this is the

structure for which you maywant to strive in an effort toproduce more evenlydistributed returns. One noteabout staggering: Your first60 to90daysof tradingmayseem slow because you aremore or less “filling apipeline.”After your first setof options expires, however,things should begin to get alittlemoreinteresting.

Q:Whattypeofpremiumsdoyourecommendanoptionsellertargettocollectonindividualoptions?

A:Much of that depends onthe investor and her risktolerance and return

objectives. Most of theoptionsthatourclientspreferwillcollectbetween$400and$700 in premium. Wegenerally won’t recommendsellinganoptionifithaslessthan a $400 premium. Youwant to strike a balancebetween time remaining onthe option and distance thestrike is out of the money.Thereisnohard-and-fastrulefor this. This part comprisesexperience and personal

preference.

Q:I’vehadbrokerstellmethatIcanoffsetorhedgetheriskofmyshortoptionifIbuyorsellafuturescontractatthepointtheoption

goesinthemoney.Isthisaviablestrategy?

A: This strategy looks goodon paper but often opens upthe proverbial can of wormsfortheinvestorusingit.Whatif the market moves youroption into the money, thenback out, and then back inagain?Areyougoingtokeepbuying it and selling the

futures contract(s) again? Orare you going to risk anadverse futures move thatwill cause losses faroutstripping any gain youmay receive by having youroption expiring worthless?Andthisdoesn’tevenincludethe additional transactioncosts you are going to incurby buying and selling thefutures contract(s). If youenter a futures contract,where are you going to set

your stop for that?Howwillyou time your entry? Nowyouhavetwotradestoworryabout instead of one. You’rewatching the market tick byprecious tick, trying to timeentryandexits,worriedaboutplacing stops, and trying toguess where the market willgotomorrow.Aren’tthoseallthe things we’re trying toavoidbysellingoptionsinthefirst place? Offsetting withfutures may work in some

situations,butourexperiencehasbeenthatit’sbesttosetafirm exit point when youenter a tradeandabideby it.Again,simplicityisyourbestavenuetosuccess.

Q:I’vefoundabrokerwhosellsoptions,buthetellsmetosell

optionswithonly30daysuntilexpirationorlessbecausethatiswhentheylosetheirvaluethequickest.Isthistrue,anddoyourecommendthisapproach?

A:Yes it is true.Yet for themost part, we do notrecommend this approachunless you are into active,fast-moving trading. It maywork better in stocks, withtraders willing to takepossessionof the stock if theoption goes in the money.However, if you are sellingoptions purely to collectpremium, especially infutures, the options you sellcould carry a higher risk of

goinginthemoney.It is true that the closer

options get to expiration, thefaster they begin to losevalue. This time decayacceleratesinthelast30daysin the life of an option.However, when an optionreachesitslast30daysoflife,chancesarethatithasalreadylost most of its time value.Therefore, the only optionsavailabletosellgenerallywill

be options very close to themoney. Selling options thisclose to where the market istrading can mean that eventhe slightestmarket “hiccup”can put your option in themoneyandyoutakethesamelossesyouwouldinafuturescontract. Once again, you’reback to day trading and—trying to pick short-termmarket direction—exactlywhatwe’retryingtoavoid.

Another reason thatbrokers may like torecommendsellingshort-termoptions is that they can tradein and out quickly, oftenproducing many morecommissionsthanalong-termapproach could net them. Ofcourse, all brokers are notlikethis,butyoushouldbeonthe lookout for ulteriormotives. Some brokers will“outbid” others oncommission rate, only to

make up the difference inincreasedtransactions.

Sell as far out of themoney as you can at strikesthatappearhighlyunlikelytoeverbeattained.

Q:HowcanIexpecttocollectanypremiumifIamsellingfaroutof

themoney?Aren’ttheseoptionscheapbecausetheyaresofaraway?

A:Onlyifyouarelookingatoptions that expire in theshortterm.Thefurtheroutintime you go, the further out-of-the-moneyoptionsyoucansell.Wearenotawareofany

official studies on this;however, our experience hasbeen that you should look totrade time value for distanceoutofthemoney.Whiletheyboth helpmake up the valueoftheoption,thereisa100%chance that time decay willhappen, yet it is always anuncertainty what the marketwill do. Therefore, sell thetime value and force themarket tomakealargemoveagainst you for you to lose.

Good research can help tosway the odds of positioningaway fromwhere themarketwill go in the longer term. Itcan do little to predict whatpriceswilldotomorrow.

Theonlycaveattosellingtime value is that if you selltoo far out, you leave toomuch time for fundamentalsto change in the market.Again, it is about striking abalance. You don’t want to

wait12monthstomakeafewhundreddollarseither.

Q:Ifoptionsellingissuchaneffectivestrategy,whydoesn’teverybodyjustselloptions?

A:Most people are attractedtofutures trading initially for

the potential for huge gains.They want to take some“play” money and, well,“play.” Since futures tradingoftenlooksscarybecausethepotential exists to lose morethan one has in the account,buying options starts to lookprettygood.Limitedriskandunlimited profit potentialsound about right for whatthey are looking for.Brokersclamoring for their businessknowthisandoftenwilldrive

thispointhome,especiallytotraders trying futures for thefirst time. Most of thesetradersbuyoptions,losetheirmoney, close their account,and conclude that futurestrading is“bad”and then telleveryonewhowilllistenwhata terrible investment futuresare and how anybody whoinvestswilllose.

A few, however, willstick around, curious as to

whomadeall themoney thattheylostandhowtheydidit.These few, along withsophisticated investors whohave already discovered theapproach on their own, willcombine with theprofessionals tomake up theoption-sellingcrowd.

Misunderstood risk,misunderstood margin, andthe general hesitance of theindustry to promote the

strategyaresometopreasonswhy most traders aren’tselling options. Comparedwith striking it rich in crudeoil or buying at the low ofwhat “research” shows willbe the move of the year,selling options looks prettyslow and boring. What doyou think is easier for asalesperson topitch toanewtrader, ready to hit it big incommodities?

You’ll find very fewinvestors whose first forayintofuturestradingwillbeinoption selling. The investorsselling options are usuallyintermediate to highlyexperienced investors whohave been down that roadyearsago.Theydon’tlookattheir option-selling portfolioas “play”money. They viewit as a serious investment.GamblingisforVegas.

We’veheardmanytradersrefer to their first experienceinfuturesas“payingfortheireducation.”Ifyouarenewtofutures,perhapsnowyoucanskiporat leastminimize thisoftencostlyfirststep.

Q:IseeStandard&Poor’s(S&P)putsthatIcansellforcloseto$500that

areavailableatstrikepricesthatIdon’teverthinkthemarketwillreachagain.Whatwouldbemymarginonanoptionsuchasthat?

A:There is noway to really

tell until you can give anexact option and strike priceandhaveaSPANmarginrunfor it. Most decent clearingfirms have SPAN softwareavailable and can providebrokers with the marginswithin minutes. Most of thetime, if you have SPAN forone option in a particularmonth, you can estimate themargins for other nearbystrikes in that same month.You also can purchase the

SPAN software from theCME. But that reallyshouldn’tbenecessaryunlessyouareaprofessional trader.Most of the options that ourclientssoldlastyearhadout-of-pocket marginrequirements of 100% to200% of the value of thepremiumcollected.However,larger and more volatilecontracts such as the S&Pindex can sometimes havelargermarginrequirementsas

a percentage of premiumcollected,meaninglessreturnoncapitalinvested.

Q:Ijustsoldanoptionforapremiumof$500.Ihadtoputupamarginrequirementof$600toholdthe

position.Therefore,Ihave$1,100totaltiedupinescrow.DoIhavetowaituntilthisoptionexpirestousethiscapital?

A:No.Ifandwhenthevalueof the option begins todeteriorate,notonlydoes the

premium gained becomeavailableinyouraccount,butthe margin requirementgenerally will drop as well.For example, if this optionfell to a value of $300, thatwouldmean that $200 ($500– $300 = $200) of the valueof that option would moveinto your general fundsavailable for you to use inanother trade. However, themarginrequirementmayhavedroppedto,say,$250aswell.

This would be an additional$250 back into your generalfunds for you to use toleverage new positions. Thisgradual deterioration effectcontinues until the optionexpires, and the option’svalueiszero(assumingthatitexpires worthless), at whichtime the full $1,100 will beout of escrow and back intoyour available balance. Ofcourse, by this time youalready may have moved

these funds into other trades.This means that you don’thavetowaitforoldoptionstoexpire to add new positions.Just remember that it canworkbothways.

Q:Whatwouldyousayisthenumber-onereasonthattraderslose

moneysellingoptions?

A: Overpositioning. Handsdown. Traders start outselling options, have a littlesuccess, and get so excitedthat they’re making moneytradingcommoditiesthattheygo way overboard with it.Bulgingwithoverconfidence,they load up their accountsand way overmargin

themselves. This can eitherset themup for a big loss orput them in a position inwhichtheycangetforcedoutof a trade on a very smallmove against them. Ofcourse, this assumes thattradershavesomeideaofthefundamentals and technicalsof the markets with whichthey are dealing. If a traderhasnoideaorisnotworkingwith somebody who has anidea of the base factors

affecting price, he may losebefore he has the chance tooverposition.Evenso, ifhe’sselling options, he probablycould go on tradingsuccessfully for a whilebefore the market eventuallycallshimout.

Q:Idon’thavethetimetowatchallthisandstudy

charts,fundamentals,andstrikepricesallnightlong.CanIstilldothisandbeeffective?

A: Of course. This is whyinvestors choose to go withmanaged accounts or hire anaccount advisor to do thelegwork for them. There are

investors who are justconcerned about a goodreturnanddon’thavetimetowatch the market, and thereare traders who like to be alittle more hands-on. Whattype you are will determinewhat type of industryprofessional can serve youbest. There are manycompetentportfoliomanagersavailable.Ifyouwouldliketolearn about professionallymanaged option-selling

portfolios, feel free to visitwww.OptionSellers.com.

Hopefully, this chapterhas answered some of thequestions that may havelingered in your mind.Chapter22willofferareviewandconclusiontothematerialcovered in all the precedingchapters.

22

PullingItAllTogetherAQuickReviewofWhatYouHaveLearned

Wehope thatby reading thisbook you have gained some

helpful insights into optiontrading and the futuresindustry ingeneral.Althoughthere are certainly otherbooks and publications thatyou can read that will giveyou layers upon layers oftheories,data,andstatistics,itisouropinionthateverythingyou need to know to beginselling options effectively iscontained within the coversofthisbook.

As you’ve noticed, a fewcentral themes have beenrepeated throughout thesechapters.Theyarelistedhere.

1.Sellingoptions,ifdonecorrectly,canoffersomewideanddistinctadvantagesovertraditionalinvestments,buyingoptions,ortradingfutures.

2.“Knowyourmarket”iseverybitasimportant,

ifnotmoreso,as“Knowyouroption.”Technicaltradingsometimescanhelptraderswithshort-termdirectionandtiming,butsellingoptionsforannualreturnsmeansprojectingwherepriceswon’tgointhelongterm.Thisiswhyknowingthefundamentalsofthecommodityyouare

tradingisimportant.3.Eventhoughoptionsellingcanbeaveryconsistentapproach,onelosingpositionthatisallowedtoruncancanceloutweeksormonthsofoptionprofits.Forthisreason,asolidrisk-managementstrategyisessentialandshouldbedecidedatthetimeof

entryintoaposition.

While these are the coreconcepts you have readabout, there are key pointsfrom this book that will bereviewed in the followingpages.Hopefully,thischaptercan serve as a summary ifand when you decide toreview the key concepts ofthebookatalatertime.

ChapterReviews

Chapter 1 disclosed toyoutheoptionsellers’secret:That the odds favor optionsellers—especially deep out-of-the-money option sellers.It is a secret that has beenclosely guarded byprofessional traders andmoneymanagersintheknow.Nowyouare“intheknow.”

Chapter2discussedwho

was selling options. Wedisclosed some of thecharacteristics of the clientswith whom we had workedand tried to draw lines ofsimilarities between them.Option sellers are a distinctsubset of the overallinvestment community and,assuch,seemtosharecertaincharacteristics.

Chapter 3 discussed theadvantages of option selling.

We reviewed a study ofoptions at the CME and sawhow the majority of optionsheldthroughexpirationdo,infact, expire worthless. Profittakingbecomesmuchsimplerand easier when sellingoptions.Timealwaysbenefitsthe option seller, giving himan advantage over the optionbuyer, who always has timeworking against him. Optionsellers also benefit from thefact that they do not have to

determine where prices aregoing to go. They only haveto determine where priceswon’t go, and they have alarge margin of error if theyare wrong. The timing ofentry into short option tradesis also very forgiving. Theseller of options does nothave to have near-perfecttiming like the futures traderdoes.

Chapter 4 compared

buying options with sellingoptions to illustrate thedifferences. We learned thatoption buyers face a distinctdisadvantage in themarket—one that becomes anadvantagetooptionsellers.

Welearnedthatanoptionis the right to buy or sell astock or commodity at aspecifiedprice.Thisrightcanbe bought or, in our case,sold. We learned why

investorsbuyoptionsandthedrawbacks to this approach,specifically that the marketgenerally must make a largemove in a short period oftime for an option buyer toprofit.Thevalueofanoptionis made up of time value,intrinsicvalue,andvolatility.

If the value of theunderlying contract movesbeyond the strike price of anoption(aboveacallorbelow

aput),theoptionissaidtobein themoney. If the value ofthe underlying contract is atthe strikepriceof theoption,theoptionissaidtobeat themoney. If the value of theunderlying contract has notyetreachedthestrikepriceofthe option, the option is saidtobeoutofthemoney.

Volatility should beconsidered when sellingoptions, but some traders

become too caught up inmeasuring volatility withoutthoroughly examining thefundamentals of theunderlying market, whichultimately can be moreimportant. The delta of anoption is a measure of itsvolatility. We learned that asellerofoptionscanhavethesame risk as a futures traderbut that the position movesmuch more slowly than afutures position, giving a

tradermoretimetoexit.Sellersofoptionscanexit

their positions by buyingthem back at the currentmarket price at any timeduring the life of the option(provided they entered themarket with sufficientliquidity). While an optionwill expireworthless as longas it does not go in themoney, the value of theoption, as well as its margin

requirement, can increase inthemeantimeifthemarketismovingclosertothestrike.

Chapter 5 comparedselling futures options tostock options. We explainedwhy we recommend futuresoptions to stock optiontraders. We discussed thegrowingpopularityof futuresas an investment vehicle andthe fact that most smallspeculators who enter the

marketendup losingmoney.Commercial traders aredefined as people in theindustry of a particularcommodity, such as a largesugar producer. Commercialsuse futures to hedge theirproduct against future pricemoves. Large speculatorsgenerally are fund managerswho can manage millions oreven billions of dollars inequity and often can movemarkets with their entry and

exits of positions. Both ofthese types of traders haveadvantages over the smallspeculator. We learned howselling options puts youabove all of this fray and onequal footing with theprofessionals.

Chapter6 taughtushowmargins work on shortoptions. In particular, welearned about SPAN marginonfuturesoptions.Buyingon

margininequitiestradinghasa completely differentmeaning from marginrequirements in futurestrading or option selling.Margin is the deposit thatyou,thetrader,provideoutofyour tradingaccount inordertoholdanoptionposition.Infutures option selling, thismargin is determined by asystem called SPAN, whichtakesvolatility,distancefromthemoney, and other factors

into consideration beforeplacing an appropriate “riskdeposit”onshortoptionsales.ThereisnotasetformulaforSPAN, but you should beable to get a SPAN marginforjustaboutanyoptionfromyour broker. Serious self-directedtradersalsocanorderSPAN software from theChicago MercantileExchange and calculateSPAN margins forthemselves. The benefits of

futures options over stockoptions include lowermarginrequirements, higherpremiums for distant strikes,and better liquidity in mostinstances.

Chapter 7 covered thewide subject of selecting theright option to sell forpremium. We introduced thebasic strategy of sellingnakedoptionsonfutures.Wesuggested limiting your

search for sellable options tomarketswithveryclearlong-termfundamentals,bullishorbearish, and then selling far-out-of-the-money optionswith low deltas in theopposite direction of thefundamentals. Werecommended selling optionswith two to six months oftime value in order to allowyou to sell strikes furtheroutof themoneyandstillcollectgood premium. Do not rule

out a market simply becauseit has already made asignificant move. Thesemarkets are often moving inthe direction they are for agood reason and can providegoodopportunities foroptionsales (in favor of the trend).Open interest often can be atipoff to what side of themarketthesmallspeculatorisbetting. Heavy open interestincalls and substantially lessopen interest in the puts of

the same market oftenindicate that the public isbullish on the market. Thiscanbe agoodopportunity tosell call options because thepublic is often wrong. The“sweet spot” of deteriorationof an option is generally thelast90daysofitslife.Sellingaheadofthistimeperiodwillenable you to collect themaximum premiums beforethe fastest period ofdeterioration occurs.

Staggering or layeringoptions throughout differentcontract months not onlyprovides diversification butalso allows an investor toexperienceoption expirationsnearly every month(conceding, of course, thatshewill have to cover a fewofthem).

Chapter 8 explored howspread trading is oftenmisused by risk-adverse

traders who focus too muchonlimitingriskasopposedtomanaging risk. We learnedhowspreadsoftencanrunupcommissioncostsandbenefitthe broker more than thetrader. Many spreads areimpractical for use byindividual investors and canhave costs that oftenoutweigh the benefits orsafetytheymayprovide.Itisimportant to focus more onpotential for profit than on

potential profit. Potentialprofit sometimes can lookverygreat,butthechancesofachieving it are often slim.Focusingonpotentialprofitislike trying to win the giantstuffedbearatthecarnivalbythrowing a ball into the can.The potential prize is large,but the chance of winning itis small.We learned that thefirst prerequisite of a goodoption spread is that if all ofthe options expire worthless,

you stillmakemoney.Manyspreads are so cumbersomeand difficult to implementthat they are notrecommended for individualinvestors. These includemultiple-option spreads suchasthebutterfly.Bewareofthe“free trade,” which can beanythingbut.

Chapter 9 covered thefew spread strategies werecommend as both

advantageous and practicalfor the individual investor.Spreads can be entered all atonetime,orthetradercantryto time his entry by enteringone sideat a time.The latterisknownaslegginginand isconsideredamoreaggressiveapproach. Spread strategiesthat we recommend are theshort-optionstrangle,thebearcall/bull put spread, andwriting the covered call,which we feel is more

practical in stocks than incommodities.Werecommendthatanyspreadbeestablishedat a credit or net shortoptions.Thismeansthatifalloptions in the spread expireworthless, the traderwillstillnet a profit aftercommissions.

Chapter10describedmyfavoritespreadstrategyofalltime, the ratio credit spread.The ratio credit spread

combines a built-in risk-control feature with theability to experience profitsbeyond just premiumcollected. It is possibly themost durable option spreadthere is and can generateincome in many differentmarket conditions. It has an“adjustability” feature thatmeans you can adapt it tounexpected marketcircumstances. However, thespread is not practical in all

marketsoratalltimes.Chapter 11 advised that

you should seek out optionswith open interest of at least500 contracts to ensuresufficient liquidity beforepositioning.Abidiswhattheclosest-pricedbuyeriswillingto pay for an option.An askis the price at which theclosest-pricedselleriswillingto sell an option. Optionpricescannotlocklimitupor

down like futures contracts.Therefore, you usually canget out of option positionswheneveryouwant,althoughit may not be at a price youwant to pay. Being assignedon an option, otherwiseknown as having an optionexercised, is a fear of manynew option sellers, but inreality it rarely happens andshouldn’t happen unless thatisyour intention. Itgenerallywill only benefit an option

buyertoexerciseheroptionifit is deep in themoney at ornear expiration. This can beavoided easily by buyingyour option back before itgoesinthemoney.Evenifanoption is exercised, it isgenerallynottheworst thing.In this event, you would beassigned a futures positionthat could be closed outimmediately, most likelyresulting in a loss similar towhat you would have

experienced in buying backyouroption.

Chapter 12 explains thekeytopicofriskcontrolwhensellingoptions.Defensewinschampionships. Riskmanagement begins beforeyou enter a position byselecting far-out-of-the-money options with lowdeltas for your selling.Diversifying your portfolioand deciding on your risk

parameters before you enterthe trade are alsokey factorsin managing risk. There aremany different ways tomanage or offset risks inoption selling. We do notbelieve in offsetting losingpositions with new positionsbecause they can create twoproblemsoutofone. Instead,we recommend two simplerisk-management techniques.These are basing your exitpoint on the value of the

option or basing your exitpointonaspecificpriceleveloftheunderlyingcommodity.Placing stops on options canbe an inefficient risk-controlmethod in your portfolio.Rolling options can be aneffectivestrategy inamarketthat you believe is stillfavorable to your views, butyourshortoptionvalueshavereachedriskparameters.

Chapter13 taughtus the

difference betweenfundamental and technicalanalysis and whycommodities option sellersmaywishtooverweighttheiranalysis towardfundamentals. Technicalsmay be helpful in timingtrades and projecting short-term direction, butfundamentals ultimately willdetermine the direction ofprices. Furthermore,fundamentals also can be

veryhelpfulinselectingpricelevels the market will notattain. After usingfundamentals to determinewhichmarketsshewillenter,atradercanthenusetechnicalanalysistoassistinthetimingof her entry.Most individualtraders do not understandhow to use fundamentals incommodities. Knowing themcangiveyouabigadvantage.

Chapter 14 reviewed

someofthekeyfundamentalsof a select group ofcommodities and futuresmarkets. Whereas somecommodities are producedand consumed globally,others may be producedand/or consumed regionally,giving them fewerfundamentals to follow andthereforemaking them easiermarkets in which to form afundamental opinion. It isimportant to focus on long-

term fundamentals that mayaffectpricesuptothreetosixmonths down the road. Keysources of fundamentalinformation include the U.S.Department of Agriculture(USDA), the AmericanPetroleumInstitute(API),theDepartment of Energy(DOE), major news services,andofcourse,yourbroker.

Chapter 15 examinedhow seasonal analysis can

assist a trader in makingsuccessful option-sellingtrades. Seasonals often aremisunderstood and misusedbynovicetraders.Aseasonalaverage is just that, anaverage. Markets can makewide variations from theaverage. A trader shouldfocus on the overall moveduring a certain time of yearand realize that although themarket may have a bias tomove higher or lower at

certain times of the year,trying tomatchyour trade toexact days based on aseasonal chart is unwise.Traders should realize thatbehind every seasonaltendencythereisusuallyasetof fundamentals that causesthe seasonal move to occur.Traders should know thesefundamentals and followthem closely. Traders alsoshould take the relative priceof the commodity into

account when consideringseasonaltendencies.Itiswiseto look not only at theaveragesbutalsoattheactualprice performance of the last15 years to determine howclose they have been to theaverage.

Chapter 16 containssome of our recommendedseasonal patterns to considerfor option selling. Theseincludesellingenergyputsin

December, selling soybeanputsinFebruary,sellingcorncalls in May, selling orangejuice calls in December, andselling coffee calls inJanuary.

Chapter 17 covered thebroad topic of volatility.Outlined were definitions ofvolatility,howit isused,andhow it ismisunderstood.Thekey concept was thatfundamentals almost always

trumpvolatility,yetvolatilityremains a helpful tool inselecting option trades. Weoutline a simple system fordetermining if an option isovervaluedorundervalued.

Chapter18 covered howto structure your options-selling portfolio. We learnedthat setting an objective andrisk parameters are theimportant first steps in anyportfolio. Discussed were

strategies for diversifying,managingmargin,andhowtotake profits and losses. Wecovered the concept ofstaggering. A key conceptwas that what determinesyour returns at year’s end ishow you manage losingtrades.

Chapter 19 listed someofthemostcommonmistakesthat new futures optiontraders make. These were

orderedasfollows:

1.Startingoffwithoutprofessionalassistance.

2.Overpositioning.3.Tradinganundercapitalizedaccount.

4.Notestablishingatradingplanorexitstrategybeforeenteringyourtrade.

5.Tryingtopickmarket

topsandbottoms.6.Forminganemotionalattachmentoraversiontoaparticularmarket.

Avoiding these mistakeswill not guarantee that youwill be profitable. However,itwillhelpyoutoavoidsomeof the most common pitfallsand may increase yourlikelihoodofsuccess.

Chapter 20 discussed

how andwhy to find a goodbroker or money manager.Believe it or not, who youwork with could be yourbiggest determinant ofsuccess or failure in sellingoptionpremium.Manyofthemost successful people inhistory have attained theirsuccess by surroundingthemselves with the mosttalented, competent advisorstheycouldfind.Thehardpartis finding them. A discount

broker is basically an orderclerk and offers cheapcommissions. A full-servicebroker can offer you a widerange of services and help.CTAsareprofessionaltraderswho can manage youraccount for you. All brokersand CTAs are legallyrequiredtoberegisteredwiththe National FuturesAssociation (NFA).Background information onall registered brokers and

firms is available to thepublic on theNFA’swebsiteat www.nfa.futures.org. Tofind a good optionprofessional, look for careerexperience, credentials,publishing history, honesty,experience with andknowledge of option selling,and a focus on you, not onhim-orherselforaparticulartrade.

Chapter 21 answered

some of the most popularquestions that investors newto option selling have beenknown to ask. Amongsubjects addressed wererecommended position sizes,diversifying,andcriteriausedfor selecting trades.Conservative traders shouldmarginnomore than50%oftheir portfolio at any giventime. Traders may want toconsider the200%rulewhenfirststartingout—ifanoption

doublesinvalue,getout.Werecommend targetingpremiums of between $300and $700. Selling optionsclose to themoneywith lessthan 30 days left producesquick expirations, but tradescan move almost as fast astrading actual futurescontracts.

AFinalWord

The information that youhave read in the precedingpages is the product of ouryears of trading futures andoptions.Through theseyears,we have come to theconclusion that sellingoptionsisthebestwayforthesmall speculator to competesuccessfully and consistentlywiththepros.Likeallfuturestrading or investmentstrategies, it has its risks. Ithas drawbacks. It has

detractors. Regardless, it hasbeen our experience thatinvestors choosing to selloptions as their primary (oronly) futures trading strategyhavefaredsubstantiallybetterthan the average futurestrader. It isnota strategy forthe action seeker. It is astrategy for the seriousinvestor.

Hopefully,theknowledgein these pages will help you

tobecomeasuccessfuloptionseller. At the very least, itmay help you to decide ifoption writing is a strategythat fits right with yourpersonality and individualinvestmentstyle.

Despite the gimmicks,hyped-up “courses,” andsalespeople disguised asindustry professionals, therearemany good people in thefuturesindustrywhocanhelp

you to be successful. We’velisted some suggestedwebsitesandresources in theback of this book that mayhelpyougetstarted.

You’ll want to interviewseveralbrokersand/ormoneymanagers before deciding onone that is right for youbefore you embark on anoption-selling portfolio. Ifyou already have a broker,youmaywant to reinterview

himorhertodeterminehisorher experience and viewstoward option selling. Youmay want to consider ourfirm, OptionSellers.com, forthese purposes as well. Youcan find our contactinformation in the back ofthis book. There are manycompetentbrokersandmoneymanagers around, however,andweencourageyoutotalkto other members of ourprofessional community

before making your finaldecision.

We wish you the best ofluck as you begin whatshould be an exciting newavenue in your lifetimeinvestmentprocess.

If you have questions orcommentsalongtheway,feelfree to write us an e-mail orvisit our website or blog atwww.OptionSellers.com. Afree sample edition of our

fundamentally based clientnewsletter isavailable toyouthere.

You’ve now completedThe Complete Guide toOption Selling. You’velearned the what, where,when, who, and how ofoptionselling.Nowitistimeto ask yourself the questionthat will decide yourinvestment future: Is optionsellingforyou?

REFERENCESANDRESOURCES

BibliographyCaplan,DavidL.TheNew

OptionsAdvantage.NewYork:McGraw-Hill,1991.

Elder,Alexander,TradingforaLiving.NewYork:Wiley,1993.

Kiyosaki,RobertT.,withSharonL.Lechter.RichDad,PoorDad.NewYork:WarnerBooks,2000.

Schwager,JackD.MarketWizards.NewYork:New

YorkInstituteofFinance,1989.

Summa,John.“OptionSellersvs.Buyers.WhoWins?”Futures,March2003,pp.52–55.

ResourcesOptionSellers.com401EastJacksonStreetSuite2310

Tampa,FL33602JamesCordier,Michael

GrossOption-SellingPortfoliosfor

High-Net-WorthInvestorsPhone:800-346-1949;813-

472-5760(outsideU.S.)E-mail:

office@OptionSellers.comWebsite:

www.OptionSellers.com.RequestYourFreeReportforQualified

Investors

BloombergFinancialNewsServicewww.bloomberg.comSubscriptionsavailable

ChicagoBoardofTrade(CBOT)141WestJacksonBlvd.

Chicago,IL60604-2994312-435-3558www.cbot.comThe exchanges have some ofthe best resources andeducationalmaterialavailableon trading futures andoptions.

ChicagoMercantileExchange(CME)

30SouthWackerDr.Chicago,IL60606-7499312-466-4410www.cme.com

CQG,Inc.201CentennialSt.Suite150GlenwoodSprings,CO

81601800-525-7082

www.cqg.com

DowJonesFinancialNewsServicewww.dowjonesnews.comSubscriptionsavailable

FuturesMagazineP.O.Box2122Skokie,IL60076-7822

888-804-6612;847-763-9565(outsideU.S.)

www.futuresmag.comArticlesandinsightson

tradingthecommoditiesandfuturesmarkets

www.Futuresbuzz.comFuturestradingwebsitewith

variousresourcesandcommentariesfornewfuturestraders

www.Ivolatility.comOptionswebsitewithvarious

tutorials,tools,andstudiesonoptionvaluesandvolatility

MooreResearchCenter,Inc.85180LoraneHighwayEugene,OR97405800-927-7259;541-484-7256

www.mrci.comTheexpertsonseasonal

analysis

InternationalCommoditiesExchange(ICE)OneNorthEndAve.NewYork,NY10282-1101212-748-4000www.theice.com

NewYorkMercantileExchange(NYMEX)WorldFinancialCenterOneNorthEndAve.NewYork,NY10282-1101212-299-2000www.nymex.com

TheHightowerReport

ResearchandAnalysisofCommodityMarkets

www.hightowerreport.com

ReutersFinancialNewsServicewww.reuters.com/finance.jhtmlSubscriptionsavailable

U.S.Departmentof

Agriculture(USDA)www.usda.govDataandreportson

agriculturalcommodities

U.S.EnergyInformationAdministrationhttp://www.eia.gov/Studiesandstatisticson

energysupplyanddemand

YourTradingEdgeMagazineSuite10,7NarabangWayBelroseNSW2085_61294863622www.yte.com.auInternationalpublicationwitharticles and insights on

trading the commodities andfuturesmarkets

INDEX

Please note that index linkspointtopagebeginningsfromthe print edition. Locationsareapproximateine-readers,and you may need to pagedownoneormoretimesafterclicking a link to get to the

indexedmaterial.

AmericanPetroleumInstitute(API),225,348

Askprice,172–173,347Assignment,inoptionselling,

178–179Attachmentstomarkets,

emotional,315–318“Atthemoney”options,48Authors’revelationson

optionselling,14–17Aversionstomarkets,

emotional,315–318

Backupcapital,335Barron’s,20Bearput(orbullcall)spread,

127–131BetterBusinessBureau

(BBB),326Bias,entrenched,317–318Bidprice,172–173,347Bloombergnewsservice,20,

100,236

Boxbeefprices,232Breakevenpoint,inratio

creditspread,164–165,167

Brokerormoneymanager,finding,319–330

commoditytradingadvisor,322–323

credentialsof,328discountbrokers,321experienceof,328focusof,329–330

“free”advice,valueof,320–321

full-servicebrokers,321–324

grifters,brokersas,325–327

honestyof,328–329knowledgeof,329overview,20–21,349rookiebrokers,325salespersons,brokersas,

324–325

Bullcall(orbearput)spread,127–131

Businessweek.com,20Butterflyspread,131–134,

346Buyback,55–58,197–199Buyingonmargin,80

Calloptions,44–46Capital,backup,335Capitalavailability,option

expirationand,340–341

Caplan,David,28Cashmargin,303–305Cashmarket,forcattle,232Cattlefundamentalsfor,232–233seasonaloptionmarkets

for,278–280CFTC(CommodityFutures

TradingCommission),65,325

ChicagoBoardofTrade(CBOT),62,214

ChicagoMercantileExchange(CME),27,62,84,232,331

Churningaccounts,325Clearance,80Closingyourposition,37CME(ChicagoMercantile

Exchange),27,62,84,232,331

CNBC,20,206Coffeefundamentalsfor,236–239

seasonaloptionmarketsfor,277–278

Colley,Nick,283Commercialtraders,64,345Commissions,brokerage,122Commodities.See

Fundamentals;Fundamentals,key;Seasonaltendenciesinoptionselling

Commoditiesoptionselling,23.SeealsoFuturesoptions

CommodityFuturesTradingCommission(CFTC),65,325

CommodityPerspective,211Commoditytradingadvisor

(CTA),322–323,328,349

Contracts,futures,65–66Copper,fundamentalsfor,

234–236Cordier,James,9,29,109,

148,210,275Corn

fundamentalsfor,227,229–230

seasonaloptionmarketsfor,272–274

Counterseasonalmoves,inenergyprices,264–265

Coveredcallsonstocks,155–157

Crudeoil,seasonaloptionmarketsfor,261–265

CTA(commoditytradingadvisor),322–323,328,349

Deep-out-of-the-moneyoptions,58,63,344

Deltalow,111–112forriskmanagement,183–

185volatilitymeasuredby,53–

54,344–345Delta-neutralstrategies,332Diagonalspreads,121,134–

137

Disclosuredocuments,322Discountbrokers,309–311,

321,349Diversificationinfuturesoptions,63,75importanceof,177forriskmanagement,185,

347instructuringoption-selling

portfolios,301–303DOE(U.S.Departmentof

Energy),100,225,348

DowJonesnewsservice,236Drawdowns,301“Dropdead”point,300

Elder,Alexander,115Emotionalattachmentsor

aversionstomarkets,315–318

Endingstocks,226,228Energyfundamentalsfor,224–225seasonaloptionmarkets

for,261–269crudeoilorunleaded

gasoline,261–265naturalgas,265–269

Entrenchedbias,317–318ETFs(ExchangeTrade

Funds),233Eurodollarsfuturescontracts,

27ExchangeTradeFunds

(ETFs),233Exitpointsetting

optionvaluebasis,188–190

underlyingfuturescontractvaluebasis,194–197

Exitstrategy,312–313“Expensive”options,293–

295Expirationmonth,choosing,

105–108

Fadingthepublic,104,108Far-out-of-the-money

options,183–185,339

Favorableoddsinoptionselling,26–28

Financialplanners,21Financialsfundamentalsfor,240–241seasonaloptionmarkets

for,280–281Forbesmagazine,20Fortune.com,20FoxBusinessNews,20Freetrades,332Freetrade(diagonal)spread,

134–137Frozenorangejuice,seasonal

optionmarketsfor,274–277

“Fullcashmargin,”80Full-servicebrokers,321–

324,349Fundamentals,205–221.See

alsoSeasonaltendenciesinoptionselling

incommoditypricing,99–100,104

executingoptionsaleswith,

218–220focusingon,207–209monitoringforrisk

management,200–201newtraderdifficultieswith,

215–216optionsellingsignificance

of,217–218overview,205–206technicalanalysis

combinedwith,214–215

technicalanalysisversus,206–207,333–334,347–348

technicalindicatorproblems,209–214

using,216Fundamentals,key,223–242forcattle,232–233forcoffeeandsofts

markets,236–239forcorn,227,229–230forenergy,224–225

forinterchangeablegrains,228

“macro,”240–241overview,223–224forpreciousmetals,233–

236forregionalcommodities,

230–232forsoybeans,225–227forwheat,228–230

Futuresmagazine,26Futuresoptions,61–77

buyingoptions,11commodity,331–332contractsandcontract

months,65–66contractsizesandpoint

values,66coveredcallson,157diversification,75financial,240–241managed,75–76marginson,66–75leverage,68–71

SPAN,71–76specifications,67–68

nakedoptionson,345–346optionexpirationstudy,

26–28overview,64–65seasonalresearchon,282–

285stockoptionsversus,345tradingseasonalswith,246volumeof,62–63

Gasoline,unleaded,261–265Gold,fundamentalsfor,232–

234,236Grain,272–274.Seealso

Fundamentals,keyGrantingoptions,51.Seealso

OptionsellingGrifters,brokersas,325–327Gross,Michael,275

Hedgefunds,optionsellingin,22

Hedging,withindexfutures

contracts,64–65Historicalvolatility,290,

293–295Horizontalspreads,121HotCommodities(Rogers),

206

ICE(IntercontinentalCommodityExchange),229,237,331–332

Impliedvolatility,290–291,293–295

Industrialmetals,

fundamentalsfor,233–234

Interchangeablegrains,fundamentalsfor,228

IntercontinentalCommodityExchange(ICE),229,237,331–332

In-the-moneyoptions,48,178–179,344

Intrinsicvalue,48–50Investment,optionsellingas,

331–341backupcapital,335

capitalavailabilityandoptionexpiration,340–341

far-out-of-the-moneyoptions,339

fundamentalsversustechnicals,333–334

futurestrading,331–332hedgingrisk,337–338managedaccounts,341marketandstrikeprice

selectioncriteria,333

marketmovementagainstposition,334–335

nakedoptions,333overpositioning,341positioning,332,336–337riskin,334riskmanagementfor,335–

336staggering,337Standard&Poor’sputs,

340strategies,332–333,339–

340targetpremiums,33730-dayoptions,338200%rule,336volatility,334volume,336

InvestorsBusinessDaily,20

Japaneseyenfuturescontracts,27

Kiyosaki,Robert,319

LarryKingLive,20LasVegasTradersExpo,9“Leggingin”tooption

spreads,144,346Leverage,68–71,157LIFFE(LondonInternational

FinancialFuturesandOptionsExchange),237

Limitmoves,inoptionselling,173–177

Limitorders,171–172Liquidity

infuturesoptions,63inoptionselling,169–170sufficient,347

Livecattlefuturescontracts,27

Locklimit,173,176LondonInternational

FinancialFuturesandOptionsExchange(LIFFE),237

Longoptionswithnointrinsicvalue,49–50

Losses,handling,300

“Macro”fundamentals,240–241

Mainstreaminvestmentindustry,10

Managedaccounts,341Managedfuturesoptions,75–

76Margincash,303–305definitionof,79–80

descriptionof,345ever-fluctuating,85–87freeingupinbuybacks,199onfuturesoptions,66–75leverage,68–71SPAN,71–76.Seealso

SPANmarginspecifications,67–68

futuresoptionsversusstockoptions,62–63

premiumcollectedversus,110–111

onstockoptions,80–83instrangles,146onverticalcreditspread,

154Margincalls,fearof,304–

305Marginexcess,82Marginoferror,inoption

selling,344Marketorders,171–172Marketsdirectionof,28–30

emotionalattachmentsoraversionsto,315–318

selectionof,96–102,333MarketWizards(Schwager),

125Minimumexchangemargins,

69Mistakestoavoid,309–318emotionalattachmentsor

aversionstomarkets,315–318

notradingplanorexitstrategy,312–313

overpositioning,311overview,349pickingtopsandbottoms,

313–315tradingonyourownwith

discountbroker,309–311

undercapitalizingaccounts,311–312

Moneymanagers.SeeBrokerormoneymanager,finding

Moore,Steve,282MooreResearchCenter,Inc.

(MRCI),282MRCIOnline,283–284

Nakedoptionsdescriptionof,51onfutures,345–346simplicityof,333startingwith,94–95instructuringoption

portfolios,300

Nasdaq100futurescontracts,26

NationalFuturesAssociation(NFA),326,349

Naturalgas,seasonaloptionmarketsfor,265–269

NeilCavutoshow,20NewOptionsAdvantage,The

(Caplan),28NFA(NationalFutures

Association),326,349

Odds,favorable,inoption

selling,26–28Oilseeds.SeeFundamentals,

keyOpeninterest,108–110,170Optionexpirationstudy

(Futuresmagazine),26–28

Options.SeealsoFundamentals

buying,44–50calloptiononS&P500

futures,45–46

exampleof,46–47intrinsicvaluein,48–49longoptionswithno

intrinsicvalue,49–50

optionsellingversus,11,344

peopleinvolvedin,22timedecayin,47–48

definitionof,44selling,50–58.Seealso

Optionselling,

advantagesof;Optionselling,overviewof

buybackin,55–58exampleof,50–52risksin,52–55

typicalsellersof,19–24Options,choosing,91–117expirationmonthchoice,

105–108goalsin,92–94lowdeltas,111–112marketchoice,96–102

naked,94–95optionopeninterestand

marketdirection,108–110

premiumandriskbalance,110–111

riskparametersetting,108staggering,112–117writeoutofthemoney,

102–104OptionSellers.com,109,148,

275,282

Optionselling,overviewof,9–17

authors’revelations,14–17bookpurpose,13–14mainstreaminvestment

industryversus,10optionbuyingversus,11,

344playingodds,11–12professionalstrategy,12–

13Optionselling,advantagesof,

25–41drawbacksversus,37–38favorableodds,26–28,344logicof,38–41marketdirectionnota

factor,28–30overview,344profitlevels,30–31riskcontrol,37simpleprofittaking,33–34timeissues,32,34–36

OptionSelling101:Think

LikeanOptionSeller(Cordier),29–30

Orangejuice,frozen,seasonaloptionmarketsfor,274–277

Orderplacement,inoptionselling,171–173

OsterDowJonesnewsservice,100

Out-of-the-moneyoptionsadvantagesof,177definitionof,48

deltatoindicate,58highpremiumsfor,63overview,344reducedriskof,102–104forriskmanagement,184–

186toofar,111,339

Overpositioning,311,341Overtrading,avoiding,306“Overvalued”options,291–

293

Pickingtopsandbottoms,313–315

Playingodds,11–12Pointvalues,offutures

contracts,66Portfoliostrategies,305Positioning,332,336–337Preciousmetals,

fundamentalsfor,233–236

Premiumandriskbalance,110–111

Premiums,target,337Pricechartson,255–257precedingconsumption,

263–264relativelevelsof,256–257

Pricingoptions,172–173Privatemoneymanagers,22Profitbuybacksas,197–199levelsof,30–31limitedpotentialfor,38

potentialforprofitversus,123–124

inratiocreditspread,165–166

taking,33–34,344Profitzonesinratiocreditspread,167inshortoptionstrangles,

146–147,149–150Protectivelongcalls,162Putoptions,44

Ratiocreditspread,159–168adjustingtocutriskor

increaseprofits,165–166

advantagesof,166–167descriptionof,159–160,

347drawbacksof,167operationof,160–165

Regionalcommodities,fundamentalsfor,230–232

Relativepricelevels,256–257

Reserves,instructuringoptionportfolios,300

Reutersnewsservice,100“Revenge”trades,316RichDad,PoorDad

(Kiyosaki),319“Ridiculous”options,103–

104Riskbalanceofpremiumand,

110–111infuturestradingversus

optionselling,176–177

hedging,337–338ininvestmentoptions,334ofloss,124–125managingversuslimiting,

125–127parametersettingfor,108inratiocreditspread,164–

166

inrollingoptions,194shortoptionstrangleand,

150–151instructuringoption-selling

portfolios,299–301inverticalcreditspread,

152–153,155Risk-aversetraders,346Riskcontrol,inoption

selling,37–38,52–55“Riskdeposit,”SPANfor,

345

Riskmanagement,181–201buyback,197–199diversification,185exitpointsetting,188–190,

194–197far-out-of-the-money

optionswithlowdeltas,183–185

fundamentalsmonitoring,200–201

forinvestmentoptions,335–336

knockonsellingoptions,182

overviewof,347parametersettingfor,185–

186rollingoptions,190–194spreadthemarket,187–188timingentries,200

Rogers,Jim,206Rollingoptions,190–194Rookiebrokers,325

Salespersons,brokersas,324–325

Scaletrading,194Schwager,Jack,125Seasonaltendenciesinoption

selling,243–259.SeealsoFundamentals

descriptionof,243–244overview,101–102,348pricecharts,255–256readingseasonalcharts,

246–254

reasonsbehind,254–255relativepricelevels,256–

257sellingoptionson

seasonals,257–259wrongwaytouse,244–246

Seasonaltendenciesinoptionselling,marketsfor,261–285

cattle,278–280coffee,277–278energy,261–269

crudeoilorunleadedgasoline,261–265

naturalgas,265–269financials,280–281futures,researchon,282–

285grain,272–274orangejuice,frozen,274–

277soybeans,269–272

Shortoptionstrangleadvantagesof,146–147

drawbacksof,147exampleof,144–145profitzoneof,146riskmanagementand,150–

151involatilemarkets,147–

150Shortoptiontrades,344–345Silver,fundamentalsfor,

235–236Softsmarkets,fundamentals

for,236–239

Soybeansfundamentalsfor,225–227,

256–257seasonaloptionmarkets

for,269–272SPAN(StandardPortfolio

Analysisofrisk)margindescriptionof,84–85,345estimatingmarginsby,340ever-fluctuating,85–87margindefinition,79–80overview,71–76

stockoptionsmargin,80–83

Speculators,65,345Spreads,119–140abuseof,137–139toavoid,127–137bullcall(orbearput)

spread,127–131butterflyspread,131–134diagonalspread,134–137

asbroker’sfavoritestrategy,121–123

exampleof,120–121lossrisk,124–125managingversuslimiting

risk,125–127potentialprofitversus

potentialforprofit,123–124

forrisk-aversetraders,346riskmanagementby,187–

188instructuringoption

portfolios,300

Spreads,recommended,141–158.SeealsoRatiocreditspread

benefitsanddrawbacks,158

coveredcallsonstocks,155–157

enteringandexiting,143–144

shortoptionstrangle,144–151

advantagesofselling,146–147

drawbacksof,147example,144–145profitzone,146riskmanagementand,

150–151involatilemarkets,147–

150verticalcreditspread,151–

155whentouse,141–143

Staggeringoptions,112–117,337

Standard&Poor’s(S&P)contracts

calloptionson,45–46contractsfor,26putson,340seasonalaveragesof,280–

281StandardPortfolioAnalysis

ofrisk(SPAN)margin.SeeSPAN(StandardPortfolioAnalysisofrisk)margin

Stockoptions

coveredcallson,155–157futuresversus,345marginon,80–83

Stop-lossorders,188–190Strikepricecontractmovesbeyond,

344atexpiration,30“ridiculous,”116selectioncriteriafor,333onS&P500pricechart,45

Structuringoption-selling

portfolios,297–306actionsafterobjectives

met,299cashmargin,303–305diversification,301–303objectivesetting,298–299overtradingavoidance,306risklevel,299–301

Summa,John,26,56–57“Sympathyrally,”229“Synthetic”price,74–75

Targetpremiums,337Technicalanalysis.Seealso

Fundamentalsfundamentalscombined

with,214–215fundamentalsversus,206–

207,333–334,347–348

indicatorproblemsin,209–214

30-dayoptions,338Timedecay

exampleof,47–48gauging,107–108inrecommendedspreads,

143“sweetspot”of,105–107thirty-dayoptions,105

Timingofentryintoshortoption

trades,344ofmarketentries,200inoptionselling,32,34–

36,170–171

Timingthemarket,245Toepke,Jerry,282Tooclosetothemoney,

selling,111Topsandbottoms,picking,

313–315TradingforaLiving(Elder),

115Tradingonyourownwith

discountbrokers,309–311

Tradingplans,312–313

200%rule,336

Undercapitalizingaccounts,311–312

Unleadedgasoline,seasonaloptionmarketsfor,261–265

U.S.DepartmentofAgriculture(USDA),100,214,226–227,231–232,236,348

U.S.DepartmentofEnergy(DOE),100,225,348

Verticalcreditspread,151–155

Verticalspreads,121Volatility,287–296descriptionof,289–290fundamentalsversus,344–

345historical,290toidentify“expensive”

options,293–295implied,290–291ininvestmentoptions,334

“overvalued”options,291–293

overview,348pricecharttodetermine,

54–55shortoptionstrangleand,

147–150tradingplan,288–289

WallStreetJournal,20Wastingasset,optionas,26WeeklySpreadCommentary

(MRCI),284

Wheat,fundamentalsfor,228–230

WorldTradeOrganization(WTO),225

Writingoptions,51.SeealsoOptionselling

Yahoo!Finance,20

ABOUTTHEAUTHORS

JamesCordier

JamesCordierisfounderandhead trader ofOptionSellers.com, the firstinvestmentfirmintheUnitedStates to specializeexclusively in managedoption-selling portfolios forhigh-net-worth investors. Hehas traded the commoditiesoptions marketsprofessionally for over 25years. James’s marketinsights have been featured

on CNBC, BloombergTelevision, Fox BusinessNews,andinTheWallStreetJournal, Barron’s,MarketWatch, and Forbes.His unique investmentapproach has been featuredby Morningstar Advisors,Trader Magazine, andForbes’s Robert Lenzner.With residences in Tampaand Chicago, James enjoyscoincollectingandboatingaswell as being active in

various charities in his sparetime. For information onworkingwithJames’sfirmortogetafreetrialsubscriptionto his client newsletter, visitwww.OptionSellers.com orcall800-346-1949.

MichaelGross

Michael Gross is director ofresearchatOptionSellers.comandworksdirectlywithmanyof the firm’s clients inplanning portfolio strategy.With more than 16 years ofoption experience as bothbroker and trader, Michael’spublished works on optionselling have been featured inYahoo Finance, Optionetics,Forbes, BloombergBusinessweek, and Futures

Magazine. His marketcommentshavebeenfeaturedin Fox Business News, TheWall Street Journal,Barron’s, andReutersWorldNews. An avid tennis player,he resides in theTampaBayarea with his wife, twodaughters, and their variouspets. To contact Michael orlearn more about workingwithOptionSellers.com, visitwww.OptionSellers.comwhere a complimentary

option selling report isavailable.