While painful for long-term investors, the bear markets in both stocks and commodities over the past 90 days has produced two market conditions that are extremely favorable to option selling: Long term trends and volatility.
As an option seller, these are the times to “make hay.”
As equity and long-only investors are experiencing a “deer in the headlights” syndrome, a small group of traders are selling options far out of the money in favor of the trends. These are options that often have a greater than 90% chance of expiring worthless. As option sellers know, a sound, fundamentally-based trend can be beneficial to one's bottom line, regardless of which direction the trend is moving.
A trader successfully riding a trend is much like a surfer successfully riding a wave. Sooner or later, you’re going to fall off the board but not before you’ve had a great ride. Selling options with a long-term trend is a way to rack up premium month after month with little stress, as long as the trend remains intact. Eventually the trend will change and you might (or might not) lose money or break even on your last set of options. If you’ve done it correctly, however, this last trade will only be a small percentage of your overall “trend take.”
While the media pundits moan daily about the horrible bear market and economy and try to give themselves hope that a bottom is near, you as an option seller, currently have some of the best long term trends available for trading in the last 10 years. The next generation of investment books written will use the commodities trends of the last part of 2008 as a perfect example of how money can be made by trading with the trend. If you are overlooking these because of the stocks/bailout/recession headlines, perhaps you will want to take another look.
No one knows where the bottom is in this whole thing or when these trends will change. However, implied volatility has made it possible to sell options so far out of the money that it is unlikely these strikes would ever be threatened before expiration, even in the event of a trend reversal.
A perfect example of this is in the silver market. A little over 2 months ago, we recommended selling silver calls in this newsletter in expectations of falling prices (See Bear Market Option Sellers 9/12/08 at www.OptionSellers.com Newsletter Archive”). A popular question from clients now is “What do we do now? Sell More? Play for a reversal? Look for even lower prices?”
The answer is, yes, yes and yes.
Obviously, option selling with the trend, in this case, would mean selling calls as almost all commodities markets are in downtrends. But we will suggest a twist with this trade.
Silver prices have declined more than 50% since their Mid-2008 highs. The markets are oversold, even though prices managed some strength at week’s end. But the fundamentals driving silver’s decline remain intact. The US dollar, despite America’s economic woes, remains a flight to quality currency for the world, at least for the time being. A strong US dollar keeps pressure on inflation hedges such as gold and silver. But silver also doubles as a commercial metal, used in everything from jewelry to computer chips. A slowing US and global economy has cut demand sharply across a swath of product categories. It is this duel reduction in both consumer and investor demand that his driven silver prices to their current levels.
Until one or both of these conditions are alleviated, the overall trend in silver prices is not going to change.
A correction, however, is another story. A rally in the stock market and/or a pullback in the dollar would almost certainly bring some fund buying (at least short covering) into the silver market. Silver prices could rally back to nearly $14 an ounce before encountering any significant resistance. While a technical bounce of this magnitude would be extreme, one may want to consider a trading strategy that could accompany such a move and still remain intact.
We at Liberty Trading suggest a strangle. Implied volatility for silver options is near six-month highs. This means that you can sell options further out of the money than you could when volatility was lower. For instance, call premiums of $500-$600 are available at strikes in the $19 and $20 levels for March and May contracts. That’s more than 100% out of the money and well above the $14 resistance levels. Barring an abrupt and complete trend reversal, these strikes should be safe bets for premium collectors.
However, a strangle is a sale of a call and a put. In a strangle, a move against one will often be a gain for the other, at least to a certain degree. As the put and the call have a “babysitting” effect on one another, it builds a stronger more resilient position. Eventually, as long as the futures price remains above the put’s strike and below the call’s strike, both put and call expire worthless – exactly what the strangle seller wants.
To balance the sale of the call, we like put strikes in the $6.00 range for the same contract months. Strikes in this range are offering premiums in the $500 range and are nearly 33% below the current price of silver. We think the shorts will have a hard time pressing prices much lower in the short term given the oversold nature of the markets. However, profits from the call sale will help keep us in the put if we are wrong.
Our gut feel is that silver will experience a corrective rally at some point over the next 30 days followed by a consolidation back towards or below the lows. However, the profit zone of the spread is so wide ($6 to $19) that you have a lot of room to be wrong and still make money.
I can’t say as much for the stock pickers.
Figure 1: SIAH9, Nov 14, 2008
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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