Selling far OTM (Out-of-the-Money) options on commodity contracts is a strategy that sells options not likely to be ITM (in-the-money) – and then letting the options value decay. As these options are sold, their price (the premium) is immediately credited to the trading account. The results should be one of the following:
- The option expires worthless and you keep all the credit.
- The option’s value goes down, and you elect to buy it back for a lesser value to close the trade out, you keep the difference as profit.
- The trade goes against the option. The option’s value increases so much, you exit the trade with a loss.
It is quite common for sellers of these options to close out the trade before the expiration date. For example if you sell an option for $100, and it’s value has gone down to $40, the trader elects to close out the trade to free up margin money- and to prevent the consequences of risking the present $60 profit in order to try to make the remaining $40. Many option sellers elect to close out these trades early (prior to expiration) when the option goes down to half the value (50%) of the price it was sold for.
As in all trading, sometimes when you have a profit, you prefer to “take the profits” rather than risk giving it up by remaining in the trade. So what if a trade goes against you? For example, you sell an option for $100 and its value unexpectedly goes up to $200. In this case, the loss (not counting commissions) would be (+100 initial credit minus $200) = a loss of $100. The rule-of-thumb used often is “When the price of the sold option doubles, get out and to not risk losing more.”
Sometimes, when (for example) that option is sold for $100, and as long as the options is STILL very far OTM, traders will wait for the options value to fall even more than 50%. In other words, the trader makes a judgment that the option will remain far OTM and holds the trade a bit longer to make even more profit. In this case, the trader holds the opinion that to do so, will not risk giving back the profit already available. Whatever decision the trader makes, depends on his/her assessment of the on-going trade.
(Please remember: my examples here and in the Time Farming Training Bulletin are based on selling a quantity of one option. In reality, most experienced traders are not trading only ONE option. Even small traders might be selling 5, 10, or other multiples. I keep the quantity at only ONE only to keep these examples simple and easy to understand.).
In Time Farming strategies, usually at least some options are sold two or three times per month. The time until expiration of the options can range from 30 days to 6 months, and sometimes longer, although most of my trades are 30 to 100 days until expiraton. Assuming that new positions are opened every two weeks or every month, then over time a trader will likely be closing trades every month to capture income. The amount of this income will vary of course, depending on the trades and the quantity of options sold. To be perfectly clear: This does not mean that a regular amount of profit will remain the same from month to month.
Even though most of the examples I use to help you learn about this type of trading, will be selling options with a 95% or higher chance of expiring worthless, there is always risk in these trades. Margin requirements for trades will vary daily as the underlying asset changes in price; this is why the trader must always have extra money in the trading account. Even though an options might require “an initial margin requirement” of (example) $434 dollars, as the trade moves against the trader (even if only temporarily) your broker will raise the margin amount due to the increased risk of the trade. The referred to as “mark to the market.”
MARK TO THE MARKET: The daily adjustment of margin accounts to reflect profits and losses based on that day’s price changes in each market.
It is a traders responsibility to understand this; if you have questions contact your broker.