The Complete Guide to Option Selling

1. Option selling offers high probability returns with managed risk

Remember, Defense wins Championships. Your Super Bowl ring should be your 1099 in January.

High odds of success. Selling options provides a statistical edge, as 75-80% of options expire worthless. This allows option sellers to profit from time decay and overpriced premiums. However, proper risk management is essential.

Multiple ways to profit. Unlike buying options or futures, where you must correctly predict price direction, selling options can be profitable if the market moves in your favor, remains stable, or even moves moderately against you. The key is selecting appropriate strike prices and expiration dates.

Managed risk approach. While "unlimited risk" sounds scary, it simply means you must manage your own risk. Proper position sizing, diversification, and exit strategies can effectively control potential losses. Focus on where prices are unlikely to go, rather than trying to predict exact price movements.

2. Fundamentals trump technicals in commodity option trading

In commodities, supply-and-demand fundamentals are king.

Focus on supply and demand. Unlike stocks, commodities have real-world supply and demand factors driving prices. Understanding these fundamentals gives you an edge over purely technical traders.

Key fundamental factors:

• Production cycles and harvest timelines
• Weather patterns affecting crops
• Geopolitical events impacting supply chains
• Seasonal demand fluctuations
• Long-term consumption trends

Combine with technicals. While fundamentals should drive your market selection, technical analysis can help with trade timing and entry points. Use both for a comprehensive approach to option selling.

3. Sell far out-of-the-money options for optimal risk-reward

Don't try to guess where the market is going. You only have to decide where it is least likely to go.

Target "ridiculous" strikes. Look for options with strike prices far from current market levels. These options often have inflated premiums due to speculation, while having a low probability of ever becoming in-the-money.

Benefits of far OTM options:

• Higher probability of expiring worthless
• Less affected by short-term price swings
• Allows for larger position sizes with lower margin requirements
• Provides a wider "profit zone" for the trade

Time decay advantage. Selling options with 2-6 months until expiration allows you to benefit from accelerating time decay while still giving yourself room for market fluctuations.

4. Diversification and proper position sizing are crucial

Keeping your portfolio diversified carries obvious benefits.

Spread risk across markets. Diversify your option sales across different commodity sectors (e.g., grains, energies, metals, softs). This reduces the impact of any single adverse market move on your overall portfolio.

Position sizing guidelines:

• Limit exposure to any single market to 10-15% of portfolio
• Keep 30-50% of account in cash as a safety buffer
• Avoid over-leveraging, even with seemingly "safe" far OTM options

Stagger expirations. Structure your portfolio to have options expiring at regular intervals. This creates a more consistent income stream and allows for reinvestment opportunities.

5. Seasonal trends provide powerful option selling opportunities

Combining seasonal tendencies with selling distant options can be a high-powered technique for accumulating consistent trading profits.

Leverage recurring patterns. Many commodities exhibit predictable seasonal price tendencies due to production cycles, weather patterns, and demand fluctuations. These create optimal times to sell options with high probability of success.

Key seasonal trades:

• Sell natural gas calls in May (ahead of summer demand peak)
• Sell crude oil puts in December (low refinery demand period)
• Sell soybean calls during US growing season (weather speculation)

Combine with fundamentals. Don't blindly follow seasonal averages. Confirm that the underlying fundamental reasons for the seasonal tendency are still valid in the current year.

6. Volatility spikes create lucrative option selling setups

Volatility is why one could sell refined blend gasoline $4.20 calls in late 2008 when the futures price was at $1.20 per gallon.

Capitalize on fear. Market uncertainty and sharp price moves often lead to inflated option premiums. This presents opportunities to sell overpriced options, especially if you believe the extreme moves are temporary.

Identifying overvalued options:

• Compare implied volatility to historical volatility
• Look for options with implied volatility near 3-month highs
• Consider fundamentals to determine if volatility spike is justified

Patience is key. Volatility tends to revert to the mean over time. Even if you're initially wrong on market direction, inflated premiums often decay faster than usual once fear subsides.

7. Avoid common pitfalls of novice option sellers

Over positioning, not miscalling the markets, is probably the number-one reason traders lose money selling options.

Resist overtrading. The high probability nature of option selling can lead to overconfidence. Stick to your trading plan and avoid the temptation to take on too many positions.

Common mistakes to avoid:

• Trying to pick exact market tops and bottoms
• Selling options with too little time value remaining
• Ignoring fundamentals in favor of technical setups
• Failing to diversify across different markets
• Not having a clear risk management strategy

Emotional control. Develop a trading plan before entering positions and stick to it. Avoid making emotional decisions based on short-term market moves.

8. Work with experienced professionals to enhance success

If you are investing six or seven figures into an option-selling portfolio, investing in professional guidance should be the first trade you make.

Value of expertise. While self-directed trading is possible, working with an experienced broker or money manager can significantly improve your results, especially when dealing with sophisticated strategies like option selling.

What to look for:

• Several years of experience in commodity markets
• Specific expertise in option selling strategies
• Track record of consistent performance
• Transparent communication about risks and strategy
• Alignment of investment philosophy with your goals

Ongoing education. Even if working with a professional, continue to educate yourself about markets and option mechanics. This allows for more productive collaboration and better-informed decision-making.

Last updated: August 4, 2024