Liquidity: Lubricant of option selling
Many trades look great – in theory. Unfortunately, reality doesn’t always follow theory. Before you attempt an option trade, you need to know there’s a critical mass of market participation.
So far in this series on option selling, we have looked at the general case for selling options: that time decay represents a real edge for the average trader if the risk is properly understood and managed. Last month we contrasted some specific pros and cons between buying and selling options vs. trading the underlying futures. This month, we prepare to trade.
If you have decided to sell options, you now encounter a number of questiens. What makes an option worth selling? Which option markets are liquid enough to warrant our involvement? How should we look at the potential reward of a prospective short option position?
Because trading is scored in real money, we’re going to focus on practical, rather than theoretical answers to these questions. By the end of this installment you may feel ready to jump into a position. Please suppress that urge until we cover risk control and defense of a position next month. Until then, you may wish to grab a price chart and a recent matrix of option prices for a market that you are familiar with to help put this article in perspective.
Liquidity – many active buyers and sellers – helps assure competition for your order and, consequently, good fill quality. Because we are trading, not just buying and holding options, we want to deal only in liquid option pools. We’ll need to know where the hest liquidity is and how to recognize it when we see it.
“Tradeable option markets” (right) provides a quick reference to those commodities that offer the possibility of acceptable fill quality for at least some of their underlying options. The list is based on this trader’s recent experience and is subject to change. Copper options, for example, were once liquid but are not now. Some markets come close to being liquid, but fall short: the Swiss franc, feeder cattle and orange juice are good examples.
Within the listed commodities are puddles of illiquidity. By comparing the volume and open interest among the various strikes and expirations, you should be able to spot certain actionable patterns, such as:
* Close to the money: Most trading is at strikes near the money. If this were the only consideration we should prefer at-the-money straddles over out-of-the-money strangles and deep out-of-the-money strikes should be avoided entirely. Given a choice between similar positions, keep in mind that tighter range means better liquidity.
* Even strikes: Many markets have round-numbered strikes and intervening half-strikes. Crude oil options, for example, trade at strikes of $38, $39, $40, etc., per barrel. Those options are almost always more liquid than the intervening $38.50, $39.50 and $40.50. Why? Because traders prefer round numbers. Use this preference to your advantage and stick with the herd when possible.
* Calendar plays: The nearby month tends to be the most liquid, with some notable exceptions. Futures contracts on currencies expire quarterly. But there are currency options that expire every month – their pricing based on the nearest futures contract. Option liquidity tends to gravitate to the contract month rather than the nearer, non-contract month. This same effect can also be seen in the stock indexes.
What is the most useful measure of liquidity? Get the current bid/offer for the option you’re targeting and translate it into dollars. By shopping for the narrowest dollar range among your potential strangle alternatives, you can avoid ugly surprises when market order fills come back.
Volatility generates premium. Big, wild price moves normally cause option premium to swell – on both calls and puts. As sellers, our objective is to short the options just as volatility peaks, all else equal. Options sold at the end of such a price swing will therefore capture inflated premiums. As volatility eventually diminishes, the result is normally accelerated price decay: premium will shrink more quickly than it would have due to time decay alone. The ability to identify and capture fat premium is critical to potential success.
A textbook on selling options might advise you to identify trading opportunities by comparing implied volatility to historical volatility – a theoretically sound way of saying that you should sell options when their price is higher than usual. There are numerous ways to calculate both implied and historical volatility and none is readily available in real time – for free.
There is a practical and inexpensive solution, however: Sell options on those commodities with recent, abnormally wide daily trading ranges. If this approach seems too low-tech, be assured that implied volatility is not predictive – it is merely a backward-looking price comparison. With scant practice you should be able to develop a good sense of the ebb and flow of volatility by eyeballing the daily bars on a chart.
Above all, resist the urge to sell a call and put on a market simply because it is stable and quiet – and looks like it will stay within a range. To do so will almost guaranty that the premium sold will be minimal and your position, will be vulnerable to a sudden onset of gut-wrenching volatility.
Short options require margin because, like a futures position, they entail theoretically unlimited risk. How much margin? That’s a big question with both a complicated and simpler answer. The most important point to keep in mind is that you want to leave sufficient margin excess – free cash – in your account for defensive purposes. Until you are experienced and comfortable with selling options, plan on keeping at least 50% of your account in excess cash.
The complicated explanation: When you sell an option, your account is credited for the premium sold and debited for its unexpired value. Then the SPAN margining computer springs into action. SPAN looks at the options sold and compares their net risk to a futures contract on the same commodity. In general, the wider the sold strikes, the lower the margin. And the more evenly spaced the strikes, the lower the margin. For a typical short strangle, three or four strikes away from the money, the total net margin requirement can be estimated at approximately 75% of the futures margin – because the risk is less than that of the futures contract.
The simple explanation: Sold options spreads, and even naked calls or puts are less risky than a futures contract and, hence, have a lower margin requirement. But for planning purposes and for the sake of conservatism, just consider the margin requirement to be equal to the futures margin.
While it is possible for the net margin requirement to increase after we enter a trade, next month’s article on defense will show how to minimize and cap the requirement.
ASSESSING ALTERNATIVE TRADES
You’ve found some volatile, liquid markets with margins your account can handle. You’ve also identified fat premium at reasonably wide call and put strikes. Which among several trades has the best potential payoff? This decision can be aided by going through a process like the one summarized in “Position assessment” (page 57).
The first entry in the table represents the prospective payoff for a March coffee 110 call (400 points) and a 90 put (355 points). The dollar value of the options (400 + 355 × $3.75) is $2,831, about 92% of the $3,080 margin requirement. The 92% divided by the 60 days to expiration yields a potential daily return of about 1.5% – a nice return if we can hold it. But still, this particular coffee strangle would appear to be only about half as lucrative a potential trade as the 10-year T-note summarized on the next line.
Keep in mind what this table is not. It is not a prediction of market direction. Nor is it a prediction that the market will stay within the sold strikes. It is merely a means of judging which of several alternative trades is potentially the most lucrative return per margin dollar, per day. Other, non-objective considerations are also necessary. If your account already includes a bond strangle, coffee may be preferable to the 10-year T-note simply for the sake of diversification.
When selecting which month to sell, the quickest time decay usually occurs close to expiration. Time decay on options with more than 50 days to expiration is frequently non-existent.
And no matter how lucrative the potential return may look on a trade, it is unusual to be able to keep all the potential – and the risk remains theoretically unlimited.
Finally, for extra credit: How should we execute our entry into the market? Spread orders or separate, individual legs? Market orders or limit orders?
That should be plenty to mull over for this month. As always, feedback and arguments are welcome. Next month’s topic is bulletproofing of a strangle or straddle: How much potential profit are we willing to surrender for the sake of security?
Tim Zurick has been selling options for more than 10 years. He is a manager at Silver State Trading (www.sstfutures.com), a futures brokerage firm in Las Vegas. Tim is also a registered CTA and principal of Zurick Trading Group.
Copyright Futures Magazine Group Feb 2005
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