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The 7 Best Kept Secrets of Building a Winning

Option Selling Portfolio

Confessions of a Professional Option Seller

By: James Cordier

***The information in this booklet has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

Copyright 2009 Liberty Trading Group, All Rights Reserved.

Futures and options trading involves risk of loss. Only risk capital should be used. iii

The 7 Best Kept Secrets of Building a Winning Option Selling Portfolio By: James Cordier

Table of Contents

Introduction ........................................................................................ iv

Secret #1 ................................................................................................1

Secret #2 ................................................................................................4

Secret #3 ................................................................................................7

Secret #4 ..............................................................................................11

Secret #5 ..............................................................................................14

Secret #6 ..............................................................................................17

Secret #7 ..............................................................................................20

BONUS: Secret #8 ..............................................................................23

What Is My Next Step? ......................................................................25

Recommended Reading .....................................................................26

About the Author ................................................................................27

Disclaimer ...........................................................................................28

Futures and options trading involves risk of loss. Only risk capital should be used.iv


Introduction

Option Buyers: Are you tired of being right the market and still losing money due to time decay?

Mainstream Investors: Do you feel like you’re being held hostage by an “old school” investment philosophy that deflates your net worth every time the whimsical market decides to move lower?

Stock Option Sellers: Do you get frustrated with the high margins and close to the money strikes you have to write in equities?

If you answered “yes” to any of these questions, this book is for you. If you’ve never explored the concept of selling options, these pages will serve as an informative introduction. If you have sold options but are looking to improve your “win ratio”, this book is your ticket. If you are seeking an alternative to “buy and hope,” searching for a new avenue of diversification, or simply looking for an investment that offers the potential for high returns, your time here will not be wasted.

The Chicago Mercantile Exchange estimates that close to 80% of options held through expiration will expire worthless. Limit this statistic to far out of the money options and the percentage climbs substantially. That fact alone begs the question, “Why aren’t more investors taking advantage of the option writing approach?”

For the most part, the answer is lack of understanding. Most investors do not have access to the right kind of knowledge, guidance, and expertise to help them understand and apply the strategy properly.

This is unfortunate. For a properly implemented option selling portfolio can not only be a positive investment experience, it can level the playing field with institutional traders. The key is how the strategy is applied. This booklet is geared towards starting you on a path that will help you learn the basics of selling options and ultimately, if you so choose, take the step of putting the odds in your favor and begin an option selling portfolio of your own.

Futures and options trading involves risk of loss. Only risk capital should be used. v


The first lesson I learned in my career (and learned early) was to sell options, not buy them. As an investor, there are three main reasons you want to sell options:

You put the odds in your favor1. : Most options will eventually expire worthless. By choosing to sell instead of buy, you automatically begin each trade with odds of success in your favor. If you sell an option and it expires worthless, you keep the premium you collected as profit. Option selling is often compared to giving up your chances for a home run in order to hit consistent singles over and over again. It has also been compared to running an insurance company. You collect many premiums and only “pay out” on a few. One of the key concepts in this book is limiting these “pay outs” so that your premiums can continue to accrue, month after month, year after year.

You don’t have to pick market direction2. : If you buy an option, you almost always need a large, fast move and perfect timing in your exit to show any type of reasonable profit on your trade. Selling an option avoids these requirements for success. The market can move up, down or stay the same – as long as your strike price is not attained, your option will eventually expire worthless, allowing you to keep the premium. Instead of picking where the market is going to go, you only have to pick where it is not going to go. Many traders tend to find this easier than trying to guess how the market will move tomorrow or next week. Granted, your profits are limited and you have to take losses when appropriate (if you let your losses run, they can keep running – this is where the term “unlimited risk” comes from – a term that professionals like to use liberally to intimidate newcomers. Strip away the monster mask, however, and unlimited risk simply means you have to manage your risk yourself, the market is not going to do it for you - as it does when you buy an option.)

You put time on your side3. . Did you ever buy an option and get a big, favorable move in the underlying only to be disappointed that your option showed only a nominal gain, if any at all? This is the effect of time decay working against the option. When you sell an option, you put time decay in your favor. Time works for you, not against you. This feature can give you staying power to ride out wide swings in the market, even if you were wrong on your trade prognosis.

Despite the impressive statistics, success is not guaranteed to all who sell options. Option selling, despite it’s high probability of success on individual trades, still maintains a certain degree of risk. It’s not an easy path to guaranteed riches. While we maintain that it is one of the most reliable methods of building income and returns in a portfolio, there is still no free lunch.

Futures and options trading involves risk of loss. Only risk capital should be used.vi


While this text is not a substitute for an overall educational program on option selling or for competent professional guidance, it will highlight some of the most critical factors of success should you elect to begin potentially generating income and returns by the selling of options. Resources for furthering your education or getting started in selling options are available at the back of the book.

I now invite you to sit back and learn from my experience. Enclosed in these pages are the seven most critical factors of success I have learned for managing an option selling portfolio. These facts have been learned hard and tested often in my 25 years of trading option portfolios. I hope you find them helpful in your pursuit of higher and more reliable investment returns.

James Cordier

June 2009

Futures and options trading involves risk of loss. Only risk capital should be used. 1


Secret # 1

Consider Commodities Options For Your Portfolio

If you are reading this seminar, I am about to make several assumptions about you. I am assuming you are somewhat of an experienced investor who has already “paid some dues” on the market battlefield. I am assuming that you are experienced enough that you may have already discovered on your own the inherent logic of writing option premium and have possibly already joined the somewhat elite investor circle that actively employ the strategy. I am assuming that you are somewhat comfortable with a certain degree of risk, as long as you understand it and know how to manage it. I am assuming that you either currently sell equity options for profit or are considering it. Finally, I am assuming that you are seeking an investment that can offer consistent returns in a market that has been anything but.

If I have made any incorrect assumptions, please don’t feel left out. This information will benefit you as well. However, whether you are or are not already taking advantage of the large percentage of options that expire worthless in the equities arena, you are doing yourself a disservice if you do not at least consider adding commodities options to your portfolio. In my opinion, commodities options simply offer too many advantages over equities for a serious investor to ignore. For stock option sellers, applying their strategy to futures can be an awakening of sorts.

Think of selling options on futures contracts like the S&P, Euro, Coffee or Crude Oil to be just like selling equity options…..on steroids. Higher risk? It depends. Higher returns? You be the judge. Lets take a look at the benefits and drawbacks of selling premium in the futures market.

If you have never sold any kind of option before, the following will help you understand the benefits of getting started with futures options. If you’re currently selling (or have sold) options on equities, you already know the game. The majority expire worthless. Time is always on your side. Entry and exit points don’t have to be precise. You don’t have to guess short term market direction. The same remains true in futures, with a few key differences.

Figure 1A

Equity Options Futures Options

Margin / ROI Low High

Distance out of the Money Close FarGood

Liquidity Variable (in most major contracts)

Diversification Little Much

Leverage Low High

Futures and options trading involves risk of loss. Only risk capital should be used.2


1. Lower Margins: A key factor that attracts many stock option traders to futures. Margins posted to hold short stock options can be 10 to 20 times the premium collected for the option. With the SPAN margin system used in futures, options can be sold with out of pocket margin requirements* for as little as 1 to 1 ½ times premium collected. For instance, you sell an option for $600 and post a margin of $600*. This can translate into a higher ROI on options that expire worthless. * Total margin requirement minus premium collected.

2. Attractive premiums can be collected for far out of the money strikes. Unlike equities, where to collect any worthwhile premium, options must be sold 1-3 strike prices out of the money, futures options can often be sold at strike prices far out of the money where adverse short term market moves will not adversely affect the position, yet time value erosion may be allowed to work less impeded by short term volatility. How far out of the money? In some cases, strikes can be sold and more than double or even triple the existing price of the underlying contract.

3. Liquidity. Many equity option traders complain of poor liquidity hampering their efforts to enter or liquidate positions. While some futures contracts have higher open interest than others, most of the major contracts like Financials, Sugar, Coffee, Grains, Energies, etc. have substantial volume and open interest offering several hundred to several thousand open contracts per strike price.

4. Diversification. If there is one thing that last year’s equity bear market taught us, it is the importance of being diversified. Commodities contracts offer a completely diversified alternative to trading the sometimes nonsensical equities markets. Commodities offer physical products that offer a decipherable set of supply/demand fundamentals that will ultimately dictate price. Regardless of how the economy is doing, people will still drink coffee, eat bread and burn fuel to keep their house warm. This means that these markets are more subject to fundamental price discovery and less vulnerable to (although not immune from) investor whims.

We are not bashing equity options. Quite the contrary. Many investors have achieved substantial returns with a properly managed option selling approach in equities. Our point is to make equity traders aware that there is another vehicle with similar (in some cases, more desirable) properties that is available for diversification. Gaining higher leverage can carry increased risk in some situations, but at the same time provide for higher returns in an option portfolio.



Like writing equity options, futures options selling can be approached in an aggressive or conservative manner. Trading plans can range from an aggressive, more leveraged approach to a conservative, lower risk approach. On the whole, however, futures option investors are in it for a higher return than those sought by the average equity option trader.

Secret #1 is to Consider using commodity options for potentially higher returns and/or diversification.



Secret #2

Sell Deep Out Of The Money Options (Trade Time For Distance)

Picture yourself driving a car.

If you drive down the highway at 95 miles an hour, you are going to get to your destination in a hurry. However, there are two major drawbacks: 1. There is a higher chance that you will be in an accident and 2. If you do have an accident, there is a higher chance you will get hurt.

If you drive down the highway at 40 miles an hour, you will have to wait longer to arrive at your destination. However, there is less of a chance of an accident and if you do have an accident, it will probably involve less damage to yourself or your vehicle than if you were traveling at 95 miles per hour.

The same holds true for selling options.

It is a common fallacy among option traders that in selling options, one must concentrate on options with 30 days or less remaining until expiration. The logic goes that as this is when options experience the fastest rate of time decay, why not only sell “short time” options and get the fastest time decay (and thus profits) possible?

I know of some traders that do utilize this strategy and hats off to them. However, I would consider this a very aggressive, almost day trading approach to option selling. The investors I work with tend to be looking for steady, consistent growth and income, not high speed thrills. If you fall into the former category, you may want to

consider selling options with more time left on them. Here is why.

9 4 1

Time Remaining Until Expiration (Months)

Time Value Prem

ium

Options are known as “wasting assets” and their value gradually decays as they approach expiration. If they expire out of the money, the option goes off the board worthless, meaning the seller keeps any premium he collected as profits. The chart above shows the rate of time decay of an option as it nears expiration. Note that the rate of decay accelerates as the option approaches expiration.



The value of an option is made up of three main components; volatility, time left until expiration, and how close the strike is to the price of the underlying market. You can sell an option with 3-4 months left until expiration that is deep, deep out of the money, and collect a solid premium in many of the most actively traded contracts. Now you can get that same premium for a 30 day option in that same market. The upside is that you only have to wait 30 days to expiry and, it the market behaves favorably, you will get very rapid time decay.

The trade off is, to get this premium, you will have to sell very close to the money. This means that even a small “hiccup” in the underlying market and your option could be in the money. Once in the money, an options value (and thus your loss) will accelerate at a faster pace.

For instance, in the example below, trader John is neutral to bearish crude oil. In May, with crude oil trading at $50 per barrel, he could sell a June Crude Oil $55 call, or he could sell an October Crude oil $90 call. Which one looks more comfortable to you? Suppose trader John is wrong and oil goes to $60. $65? How about $70? If it did, which option do you think John would rather be holding - One that is $10 in the money, or one that is still $40 out of the money?

Sure, you can buy out of either one any time you want. But I would much rather be buying back an out of the money call than an in the money call.

Now, I am not saying that you cannot lose money by selling deep out of the money options. What I am saying is that the market has to move quite a bit further to put your option in the money. Remember that as an option seller, you want your option to expire out of the money. It doesn’t matter where, as long as it is out of the money. By selling with more time, you can sell further out of the money. In my experience, this has been an advantage, especially if you are familiar with the fundamental factors driving the underlying contract’s price (see secret # 4).



Long term, sustained moves tend to require some kind of fundamental rational. One major advantage to selling options is to put your position high above or far below the market in order to avoid short term swings in the underlying caused by rumors, sensational news events or short term technical breakouts. Close to the money options are vulnerable to these types of events. Deep out of the money options are somewhat insulated.

Secret #2: To boost your win ratio and reduce your exposure to market “hiccups”, be willing to trade time for distance. Sell deep out of the money strikes.



Secret #3

Know Your Fundamentals

Imagine yourself as the sole outfielder in a Major League Baseball game. As a traditional outfielder, your job would be to try to predict where the batter will hit the ball, and then stand in that spot. That is what Option BUYERS do. But in this game, all you have to do is look across the entire outfield, and pick the spot where you think that hitter is LEAST likely to hit the ball. Then go stand there. When that hitter gets up to bat, he can hit it anywhere in that ballbark. As long as it doesn’t come right to you, he is out and you win. Is that a game you would like to play? If it is, you might like option selling.

If you were to play this game, and there was a large amount of money relying upon if this hitter misses you or not, do you think you might study up on each hitter before the game? Would you want to know things such as his batting average, his swinging motion, what kind of pitches he likes, what the wind is like today, if he hits better at day or night and most importantly, where he has tended to hit the ball in past ballgames under similar conditions?

Do you think this might give you some idea where the best place for you to stand would be – where he is least likely to hit to you? I can’t speak for you, but if this guy hit his last 9 out of 10 fly balls into left field, I would be standing in right field.

In baseball, we would call these items “stats”. In option selling, we call them fundamentals. Fundamentals are the study of the “real-life” factors driving the price of the underlying market such as production figures, harvest cycles, demand trends, and supply figures. Surprisingly, there are quite a few traders and investors who discard the fundamentals in favor of the easier to quantify technicals. Technicals have their place and we will cover that in a moment. But they can be much more effective when combined with the fundamentals – especially when you are trying to project where prices will not go.

Unlike many analysts and traders, I do not attempt to guess what market prices will do today, tomorrow, or next week. Instead, as an option seller my main concern is where prices will not go over the longer term. For making these types of determinations, I have found no greater ally, and no substitute for, an in depth knowledge of the supply/demand factors that ultimately drive the price of the underlying market.

Because when you strip away all of the reasons, motivations and double dipped Fibonacci/Gann criss-cross lines, it is core supply demand fundamentals that will ultimately determine the fair price for a btu of natural gas, a bushel of corn or an



ounce of copper. Natural gas cannot have its revenue’s embezzled by a corrupt corporate executive. Corn cannot go bankrupt. Copper is not going to miss it’s earnings target. It’s supply/demand fundamentals that commodities markets answer to.

If you are selling deep out of the money options, it is the long term trend (or non-trend) that is of most concern to you – not short term technical bounces or media hype. And any type of longer term move will require some kind of fundamental justification. In other words, the price of a pound of sugar will ultimately be determined by A. How much demand there is for sugar and B. How much of a supply of sugar is available. Sure, prices can fluctuate up and down for a variety of reasons – including all of those Gann lines and Stochastic crossovers that so many traders love to use. And they have their use. But over the long term, the technicals of a market will reflect it’s fundamentals. Let me repeat that.

Over the long term, the technicals of a market will reflect it’s fundamentals.

What does that mean? That means, if you have a technical indicator or system you like to use – great. You can still use it. As long as you know the fundamentals of the market first. Because if you do, you can only take the technical signals that agree with your fundamental view. For instance, suppose you are bearish the coffee market because bumper harvests in Brazil and Vietnam have flooded the market with beans. If you technical system gives you a bullish signal, you simply don’t act on it. Instead, you wait for a bearish signal, and then you sell distant calls. You will find this addition of fundamentals to a technical system to greatly enhance the efficiency of your trades – especially if you are selling options.

The point is, if you don’t want to be surprised by technicals, you better know your fundamentals. Or be working with somebody that does.

Fundamentals drive long term trends..



I recommend approaching the market this way for several reasons:

Short term trading is just too difficult - I’m sure there are some 1. consistently successful day traders out there. That being said, I’ve never met any!

Markets can move very sporadically over short term periods but over 2. the long term, will always have to adjust to reflect fundamentals.

As an intermediate term option writer, short term market gyration does 3. not concern you. You are concerned about longer term market direction and more importantly, where prices won’t go.

It is for these reasons that as an option seller, your first focus should be on long term fundamentals. We believe the most successful traders keep things very SIMPLE. The following creed is the approach I recommend you take. It has served me well over the years and I do not mind sharing it with you here:

“I do not know what price is going to do tomorrow or next week. But based on these fundamentals, and what prices have done in past years when supply and demand factors were similar to those of this year, I feel prices will have a very difficult time attaining a certain level. Therefore, I will sell calls (or puts) at that level and not concern myself with short term technical trading. Even if my market analysis is off a bit, time value is still working for me.”

While this type thinking can be difficult at first for the futures trader used to daily action (it was for me), I’ve found that this approach has improved my overall trading results tremendously.

Fundamentals are not easy to learn but once you know them, there are several that are not readily discussed by the media and can be used to your advantage as an option seller. While nothing is guaranteed and past performance is not indicative of future results, the annual cycles of the production consumption cycles cannot be ignored. For instance, did you know that

Knowing where the overall supply of a commodity is at any given time can give key insights into where prices probably will not go.



-The US corn, soybean and main wheat harvest occurs during the US Autumn, meaning supplies are highest at this time of year?

- Natural Gas stockpiles tend to be at their lowest at the end of the US winter and the end of the US summer?

-Silver is a byproduct of copper production? Surges and pullbacks in copper production can often occur regardless of the demand for silver. Thus Silver stockpiles 6 months out can often be gauged by examining copper production today.

Can you see how knowing how to use these bits of information could be tremendously effective in selecting the right options to sell?

There are several quality trade journals, online data sources, and government agencies such as the USDA, EIA, API (which offer free statistical websites) available for your use and analysis.

Or if you don’t have the time to devote to learning and studying these fundamentals yourself, you can simply hire a professional to do it for you.

Either way, if you learn to incorporate fundamentals into your option selling approach you can watch your efficiency soar.

Secret #3 is Know your Fundamentals



Secret #4

Build Your Portfolio By Staggering

A popular concept that goes back to my book The Complete Guide to Option Selling (McGraw-Hill 2005) is the concept I called Staggering.

There is no better place to study human psychology than in the world of the trader. Fear, greed, attack, defend. It’s all there. Above it all is the basic human need for control. We want control of our lives, control of our environment, control of our children, control of our income.

Maybe this book can’t help you with the first three but the last one is where we might be able to shed some light. One of the brightest attractions of an option selling portfolio is the ability to see into the future (albeit the ideal future). One look at your portfolio statement and you can see exactly where your portfolio will be in 60, 90 or 120 days if all of your existing positions expire worthless.

By selling options at certain time intervals one can almost “schedule” option expirations for different time periods. This allows an investor a degree of control over his projected return or income – a feature not present when simply buying a futures contract or shares of stock. For when buying the underlying, the investor is at the mercy of the market as to when or even if the market will move.

When selling an option, one takes a bit more control of ones destiny. You don’t need the market to move. It can move, but it doesn’t have to move. As long as it doesn’t move all the way to your strike, that option will expire worthless on expiration day. And you have access to every expiration day of every option on the board. You have the ability to “schedule” your expirations.

This degree of control is appealing to many investors.

Of course, not every option is going to slowly decay to zero for you. You may get stopped out of some. You may choose to exit some for other reasons. However, on the whole, you have the control to determine when your expirations will be.

And this is where the concept of staggering, or “layering” as we sometimes call it, comes in. Staggering is simply a method of “scheduling” these expirations in your portfolio so that you have different sets of options set for expiration every, or nearly every month. This is a strategy used by professional managers to help “smooth out” the equity curve for their private clients who like to see steady appreciation on each monthly statement.

But you can employ the same concept to structure your portfolio how you want it. By



doing this, you can look into the future and get a general idea of where you should be each month for the next several months, if everything goes as planned. Now lets face it, everything isn’t always going to go as planned, and you will take some losses along the way. However, if managed correctly, these can be incorporated and “rolled” into other positions that are working in your plan, keeping the equity curve as close to ideal as possible.

How do I Stagger Positions?

Option selling can seem slow for your first 30-60 days. During this time of establishing initial positions, it is often a matter of sell and wait, without much movement.

However, as the positions begin to near expiration and experience more substantial time decay, your portolio suddenly becomes more exciting. Seeing options decay day after day and “die on the vine” has a unique kind of exhilaration.

One possible way to structure your option selling portfolios is as follows:

Month 1 – Sell options 90 days out



What kind of options and at what strike you sell is important but not the subject of this chapter. The secret is the timing method. By the end of the first 90 days, your first set of options will be expiring. As these expire, you continue to roll them into another set of options 90 days out and continue this cycle throughout the year. Of course, you could do this at 120 day intervals or 150 day intervals as well. However, by incorporating this approach, you should have at least some options expiring nearly every month.



A sample portfolio is illustrated below. The options and contracts listed are for example purposes only and not to be construed as actual trade ideas:

June ............ Sell September Natural Gas Calls

September Corn Puts

September Coffee Calls

July.............Sell October Sugar puts

October Crude Oil puts

October Live Cattle calls

August..............Sell November Soybean calls

November Heating Oil puts

November Orange Juice calls

By September, the first set of options will expire and the cycle can be started over again.

It is true that in commodities, option expirations do not occur for each market at the same time each month. Some may expire at the beginning of the month, some at the end, and some even expire the month before the contract listed. However, the above illustration gives you the general idea.

WARNING: Staggering, attractive as it may be, is a general guideline to aim for. However, it is not your first priority in positioning your portfolio. Your first priority is to pick the best options to sell. If there are none available or there is not enough fundamental justification for a trade, you should not just “plug in” an option simply to fit your staggering plan. Don’t let staggering allow you to overlook your primary objective of picking winning trades in the first place.

Nonetheless, it is an effective blueprint for allowing you to attempt to capture what most investors cannot – CONTROL.

Secret #4 – Build your portfolio by staggering.



Secret # 5

Don’t Over Position

Secret #5 could be the most critical to your overall success in selling options. If you have ever heard brokers or other traders tell you how “risky” option selling is, chances are that they or someone they knew violated this key rule.

It is a fact that selling out of the money futures options carries the same, and in most cases less risk than trading the outright futures. Selling an out of the money stock option carries the same and in most cases less risk than trading the underlying stock. So why does everybody talk about the “unlimited” risk associated with selling options and what a “risky” strategy it can be.

It is because the margin for selling options is lower than the margin or cash requirement for selling the underlying market. In futures, due to SPAN margin, the cash requirement is substantially lower for selling an option on a contract than it is for selling the contract itself. While this is an attractive feature for selling futures options as it allows one to increase ROI, many traders are tempted to “load up” on a position and end up over leveraged.

It is the misapplication of leverage that causes problems for investors and helps perpetuate the “risky” reputation of option selling.

I have seen this mistake repeated by novice option sellers often.

Complicating matters is the fact that most options will expire worthless, meaning that new option sellers can often get “spoiled” by winning on their first several trades causing them to become less vigilant in their risk awareness.

A Story: Trader John started selling options with a $100,000 account a few months ago. While he was timid at first, watching his option values decay even as the underlying market bounced every which way has given him confidence (or overconfidence, in this case). One day, John finds a sugar option he really likes. To make the deal even sweeter, the margin is 1 to 1 to the premium (in other words, John collects $500 in premium and only put up $500 of his own money to hold the option). This means for each option he sells, they can make a 100% return if the option expires worthless. John sells 10 and sees the next day that he is only being charged $5,000 in margin requirement.



“Great,” John tells his broker, “Sell me 10 more.”

He continues to sell the same option, loading up for the big kill.

What inevitably happens is, John himself ends up the kill. For a lopsided position means that even a minor move in the underlying market can have a major impact on the overall portfolio.

Selling 50 options in the same market is fine if you have a $500,000 account. If you only have a $100,000 account, you are asking for trouble.

I don’t care how great the trade looks, how far out of the money it is, or how low the margin requirement, any trade can move against you – any trade.

The way to beat this is position size management.

In our portfolios, we advise investors to aim for about a 50% margin position. This means that if they have a $100,000 account, $50,000 can be used to hold positions. The remaining $50,000 should be held as back up equity.

Of this $50,000 in “working” capital, it should be diversified over at least 6-7 different commodities sectors. One upshot to commodities is that they can be a truly diversified market. While there are certain times where the whole of commodities will move up or down, they are quite a bit more diversified than are stocks, where an up or down day in “the market” (read the overall index) tends to affect most every stock. The price of Natural Gas has little to do with the price of coffee. The price of an ounce of silver has little to do with the price for a bushel of wheat. In commodities, one can get truly diversified.

Back to our example. Lets say that instead of loading up on the sugar options, John takes only a nominal position. He spends the next 45 days taking nominal positions in 6 other markets until he has $50,000 of his trading equity deployed. He now has half of his equity in positions and half in back up cash.

Each position comprises only 6 or 7% of his overall portfolio. If one of his positions does make a hard fast break against him, he can exit that position



and redeploy the capital into the other sectors with minimal impact on his overall portfolio.

Further diversification, covered spreads and hedging strategies can bring the individual position exposure down to 3-4% of the overall portfolio.

Of course, option selling does involve risk. But much of that risk depends on how the strategy is used.

Keeping small, diversified positions and an adequate cash cushion goes a long way towards avoiding alot of the problems option sellers can run into.

Secret #5 - Don’t make the mistake of over positioning.



Secret #6

Manage Your Risk Through Premium Value

A common question among new option sellers (or experienced option sellers used to writing equity options) is “How do I handle losses when my option goes in the money?”

It’s a fair question since options can appreciate quickly once they go in the money. In the money options are most certainly responsible for a large percentage of losses incurred by sellers of options and probably have contributed to the “risky” reputation of the strategy.

Fortunately, there is a simple answer. You don’t let your short options go in the money.

Now before you go shaking your head and thinking “yeah right, that’s easier said than done,” I ask you to hear me out.

Remember secret #2 – Sell Deep out of the money? If you are following this rule and are selling 50-100% out of the money – markets generally don’t move that far in one day. Markets generally don’t move that far at all but moving that far in 1, 2 or 3 days is fairly unrealistic. As we learned with secret #1, you can’t sell that far out of the money in equity options. But you can in commodities. And while the leverage is higher, you decrease your chances substantially of any of your options going in the money without you allowing it.

Therefore, if following secret #1 and #2, your primary risk will be the value of your option increasing – not your option going in the money.

Lets suppose it is August and Trader John decides to sell a December Silver 30.00 call and collect a $500 premium. Trader John is not necessarily certain that silver will not push higher but he feels the market may be getting overpriced and is due to come back down sometime in the near future. He does feel that with silver currently trading under $15 per ounce, it will not double in price and go to $30 an ounce before December.

John sells December Silver 30.00 call and collects a $500 premium.

EXAMPLE



The volatility has gone high enough that these distant options (over 100% out of the money) are showing good premiums. John sells the December Silver $30.00 call for $500.

A few weeks later, silver prices have continued to climb. While John’s $30 calls are still no where close to going in the money, they have appreciated in value. Each call is now worth $800 each.

At this point, John can still afford to hold his options and wait the market out. After all, this is one main reason we sell options instead of trading the underlying – to comfortably ride out adverse moves against our position. John knows time is on his side and the longer he can wait, the more it will come to favor his position and erode the option’s value. However, a fast, steep move against his position can temporarily drive the value of his option even higher.

A mistake many new traders make when a trade is moving against them is to “dig in” and resolve to hold the option regardless of market moves until it expires. The trader, having confidence that the underlying price of silver will not reach $30 prior to expiry, simply resolves to ride out the temporary spike in option value, knowing that time will eventually provide him with a worthless option, allowing him to claim his profit.

Granted, he is probably right. The market will probably not double and his option probably will expire worthless. The estimate for selling this deep out of the money is that 98-99% or more of these distant options will expire worthless.

That being said, through my 25 years of experience, I have learned that over the long term, it doesn’t pay to be a cowboy. We are not investing in order to get into a (you know what) contest with the market. Trader John could grit his teeth and ride out the price increase of his option. But at what cost to his overall portfolio? And at what cost to his psyche?

While his temporary losses on this option will only be on paper and will most likely be erased at expiration time, what did John sacrifice to ride it out?

For one, his margin requirement will most likely increase substantially. This means that there is less money he will have available to take advantage of other opportunities – all of which he will miss because his one position is hogging up much of his available equity.



Secondly, the building paper losses on this position will have to be covered as well, further drawing down available cash for other opportunities.

Thirdly, John will probably be less likely to spot these other opportunities anyway, because, regardless of what he says, the position becomes of great concern to him, and he finds himself focused every day on the daily price movements in silver. This is not a place a trader wants to be. In fact, we elected to become option sellers in the first place to avoid these types of situations.

In the end, John may eventually win on the trade. But the opportunity cost to his portfolio was a far greater loss than the loss John could have taken if he had a more conservative risk management strategy in place.

For these reasons, I have found that a risk management strategy based on the value of the premium is the most efficient and conservative means of managing risk on your short options. In the portfolios that I manage, we generally set a premium exit point at the time the trade is entered.

For instance, if John sold his silver option for $500, he might choose to exit his position when the premium doubles. So, if his option closed at a value of $1,000, he would close the position (buy it back) at that time for a $500 loss (1,000 minus $500 original premium = $500). Some commodity pits accepts stop loss orders but I do not recommend these with options. We manage all of our stop positions in house and only call the floor with them when triggered.

If John wanted to allow the market to move a bit more, he could elect to let the option appreciate to triple his collected premium before exiting. What value you set is less important than the fact that you do set a predetermined exit point.

The secret is, don’t get caught up in where, when and how to manage an in the money option. The best approaches are usually the simplest. Sell options far enough out of the money and going in the money shouldn’t be a concern. This allows you to manage the risk based on the value of the premium.

Secret #6 – Manage Risk Using the Premium Value



Secret #7

Take Profits EarlyIn The Complete Guide to Option Selling (McGraw-Hill 2005) we state one of the key benefits of selling options is there is no need to decide when to take profits; the market does it for you through expiration. This is true and it is a boon for the low maintenance trader with little time to trade his portfolio.

While an untended garden can still bear fruit, occasionally “weeding “ your option selling portfolio can increase your capital efficiency and boost your yields.

What we are referring to is buying back options early and taking profits prior to expiration.

As we have stated in past lessons, as an option moves ever closer to expiration, as long as it remains out of the money, time decay will continue to erode the value of the option. Oftentimes, especially if a market has moved favorably, what will happen is the option value will decay down to a nominal value even with 30-60 or 90 days remaining until expiration. In this case, it can benefit the Option Seller to buy back the option, thereby closing the trade and taking the profit off the table.

For instance, lets assume that in June, an investor sold the November Natural Gas $30.00 call for $400 each. This strike was more than 100% out of the money as November Natural Gas was only trading near $14.00 at the time. The strike had very little chance of going in the money even if the uptrend would have continued. But notice how quickly the value of the option decreased as the market began to fall. (See Figure 7A below)

Figure 7A – Daily Option Value of November Natural Gas 30.00 call

This option price chart shows the daily value of the November Natural Gas 30.00 call. Notice that as Natural Gas prices were peaking (See figure 7B), the option value was already beginning to decline

indicating a change in trend. As the futures price began to fall, the option price declined rapidly and by mid July, was nearly worthless. By mid-July, the listed price of the option had declined all the way down to $10 cash value, nearly worthless. Yet there remained nearly 90 days left until expiration on this option. (Natural gas option chart courtesy of ivolatility.com)



Would this be a good buyback

candidate? As a recent vice presidential contender would say, “You betcha!”

If this were your trade, you could buy the option back for a $390 profit ($400-$10 = $390). By doing this, you accomplish three things:

You take over 97% of your potential profit from the trade and 1. eliminate your exposure in the position. At this point there is little to gain from this position ($10) and everything to lose. Chances are overwhelming that this option will expire worthless but why take the risk for 90 more days if there is nothing to gain?

You free up valuable margin2. . Chances are this position does not have much of a margin requirement at this point, but it is probably still pulling a few hundred dollars. By freeing this margin and eliminating the risk exposure, you can redeploy funds in other markets, or sell more natural gas calls as you now have no additional exposure there.

You book a winning trade3. . By taking profits early, you take the trade off the books. It is one less trade you have to monitor, one less line you have to look at each week. You free your mind and capital to pursue other opportunities.

For the most part, I do recommend early buybacks when they are viable. Options decay at different speeds depending on the movement in the underlying and time until expiration. Some may be bought back 3 months early, some may be bought back 2 weeks early, some you may have to hold through expiration.

In investor portfolios that we manage, buybacks are typically considered when the

Figure 7B November 08 Natural Gas Futures

As Natural gas prices began to decline, the call option’s value quickly decayed to almost zero, several months prior to expiration.



option premium has decayed down to 10% or below of it’s original sale price. It will pay off over the long term. And in the end, that is what this booklet is all about – managing a winning, profit generating, income throwing option selling portfolio over the long term.

Secret # 7 is if you have made 90% or more of the potential profit on the trade, book it.

This concludes the 7 secrets to Building a winning option selling portfolio. We hope you find it a helpful resource in your investment education. Good luck in your trading and applying these concepts!

The remainder of this booklet is for high net worth investors only. Thank you.



BONUS SECRET (For High Net Worth Investors Only)

Secret #8

Work With A Professional

Secret #8 is for you, the high net worth investor. And it could be worth all of the other secrets in this book combined.

While this booklet contains some valuable tips, one certainly does not become an expert on selling options by reading a booklet or even by reading several books. If you have a high net worth, chances are you have developed a certain level of skill and success in your respective business or field.

What would you say to someone just starting out in your field? Do you think that despite their enthusiasm, they could do as good of a job as you?

If you have a serious illness, do you read a few books, try a few newsletters and then attempt to diagnose and treat yourself? If you find yourself with a serious legal situation, do you do some online research and then attempt to build and defend your case in court? (Physicians and Attorney readers can substitute “accountant” and “real estate agent”)

No. You hire the best doctor you can find or the best attorney you can locate.

So if you want to make a serious investment, do you treat it any different? Or do you try and go it alone?

Many investors do exactly that. There are many reasons they do it. Some like the “challenge” of learning a new skill. Some like the “mental stimulation.” Some like the excitement. And some just feel that their money is best invested by themselves, personally, regardless of experience level. The discount brokerage business has made a fortune convincing the public that they can do a better job trading their accounts than a professional can. And lets face it, in some cases, they may be right.

The key question to ask yourself is this: “Do I possess better portfolio management skills than the average of all market participants and by a big enough margin to overcome the transaction costs I will incur by making my own trades?”

If the answer is “yes” then trading on your own is probably viable.

If the answer is “no” then hiring professional help makes sense.



High net worth investors tend to be interested in one thing; Results. And many have found that the best results are often produced by hiring the best expertise.

Robert Kiyosaki makes this theme a focal point of his investment classic Rich Dad, Poor Dad. Kiyosaki suggests that one of the key differences separating the rich from the poor and middle class in our society is that the rich tend to seek out experts to advise and manage much of their financial affairs. The poor and middle class tend to subscribe to more of a “do it yourself” mentality. He argues that in an attempt to save money up front by handling legal, accounting and investment matters on their own, the poor and middle class end up losing money in the long run.

This becomes even more relevant when one considers the slightly sophisticated strategy of option selling in the often misunderstood commodities markets where it is estimated that 80% of investors lose and 20% take all the money. This is often a function of cool professionals taking the money of enthusiastic amateurs.

Finding the right professional to help you implement an option selling portfolio can be challenging. But the drawback of not hiring one is that you can fall victim to the people that did.

The problems with hiring a professional are twofold

A. You have to find a person or firm with the desired, specific expertise you seek

B. That person or firm must be trustworthy enough to act in your best interest at all times

The payoff however, can often be worth the search.

I still offer my personal portfolio management services to select individuals. There is a resource section in the back of this book if you would like to learn more about this. However, regardless of if you hire my firm or not, with this type of investment and the capital requirement it generally involves, I recommend you find some kind of professional guidance to assist you with an option selling portfolio. Reading secrets 1-7 of this booklet can help you understand the right things to do. Having somebody in your corner that has spent the last 15-20-25 years implementing them can be the difference between success and failure.

Secret #8 to building a winning option selling portfolio is hiring a professional to help you implement secrets 1-7.

(See the next 2 pages for additional resources in learning or implementing the option selling approach)



What Is My Next Step?If you found the information in this booklet helpful and would like explore the possibilities of putting the option selling strategy to work in your portfolio, the following resources are recommended.

Recommended Professional Option Selling Brokerage

Liberty Trading Group, Tampa, FL USA 800-346-1949

The “go to” brokerage for option sellers across the world. Here you can open a professionally directed or managed option selling account and work personally with some of the most experienced professionals in the field. Founder James Cordier still works personally with many of the firm’s US and global accounts.

Get condensed, in depth fundamental market reports to make sure you • are writing options with the fundamentals

Receive expert guidance and supervision on option selection, position • size, risk control and overall portfolio management to ensure you are selling options as efficiently as possible.

Have a custom designed option selling portfolio plan optimized • exclusively for you to minimize risk and maximize gains.

The firm offers accounts for the high net worth investor seeking exposure to the strategy but is a “non-expert” in option selling or commodities. Individual, Corporate and IRA accounts are accepted. Minimum investment is $100,000. A FREE Investors Information Pack, newsletter and tutorials are available at the firm’s website www.OptionSellers.com. Call or email to request more information or schedule a free consultation.

Liberty Trading Group401 East Jackson Street

Suite 2340Tampa, FL 33602

Phone 800-346-1949813-472-5760 (from outside the US)

Email: [email protected]: www.OptionSellers.com

http://www.optionsellers.com/


http://www.libertytradinggroup.com/signup.html



Recommended Reading

The Complete Guide to Option Selling - 2nd Edition by: James Cordier, Michael Gross (McGraw-Hill/July 2009) –The definitive guide to effectively selling options and generating returns. This is the revised, updated edition of the flagship book that started the Option Seller Newsletter and awakened the mainstream investment community to option selling as a desired portion of any investment portfolio. Learn how to select the best options for selling, how to manage risk, the only spread strategies that really work (and the ones that don’t) and what your broker is hiding from you. Easy and entertaining format. On sale at fine bookstores and online retailers (we recommend Amazon.com).

Recommended Newsletters

The Option Seller Newsletter – Bi-Monthly newsletter highlighting the key fundamentals of select commodities markets and analysis of option strikes available. This proprietary newsletter is available to clients of Liberty Trading Group only. However, a pubic version is available that still contains a wealth of free fundamental information and advice. Request a free Trial Subscription at www.libertytradinggroup.com

The Option Seller Email Seminar – This tutorial comes out twice per month and features a new option selling lesson in each issue. Designed to help you understand a different aspect of selling options in each issue and help you become a better investor. Request your FREE trial subscription at www.OptionSellers.com

*Price charts courtesy of CQG inc.

http://www.libertytradinggroup.com/book_info.html



About the AuthorJames Cordier is founder and head portfolio manager of Liberty Trading Group, an investment firm specializing in option writing portfolios for the individual investor. James’ market comments are published by several international financial publications and worldwide news services including The Wall Street Journal, Reuters World News, and Yahoo Finance. He appears regularly on CNBC, Bloomberg Television’s “On the Markets” and Fox Business News.

James has been trading commodities options for over 25 years. As his approach to selling options became popular with investors, he was approached by McGraw-Hill in 2004 to write a book on his methods. The book, “The Complete Guide to Option Selling” was published in 2005, authored by Cordier and fellow option seller Michael Gross.

James manages option writing portfolios for a worldwide client base. For more information on portfolios with his firm call 800-346-1949 or visit online at www.OptionSellers.com .

www.OptionSellers.com




***The information in this booklet has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

Copyright 2009 Liberty Trading Group, All Rights Reserved.

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