Out of the Money Options

Out of the Money Options – Buyer Beware, Seller… Take The Money
By Lee Lowell, Advisory Panelist, Mt. Vernon Research
Tuesday, November 1, 2005: Issue #255

About a year and a half into my days as an options market maker on the floor of the New York Mercantile Exchange (NYMEX), I discovered the strategy of selling short-term, out-of-the-money options (OTM).

For anyone who’s not familiar with the term “out of the money,” these are put options with strike prices that are lower than the price of the underlying futures contract. Call options that are out of the money have strike prices that are higher than the price of the underlying futures contract.

Selling these options is a great way to generate some income by taking advantage of options that expire worthless – while someone else is taking on the risk. Let me explain…

How to Pocket Cash From Traders Losing Their Bets

From 1991 to 1998, the years I spent on the floor, crude oil energy futures stayed mostly in the range of $15-$25 per barrel. I noticed that many people would pay good money for options that were well above and well below the current price of the nearest futures contract.

If oil was at $20 per barrel, people would buy options on the $15 puts and/or the $30 calls, hoping the price of oil would get to one of those two levels by the time the options expired. What I noticed was that these options were expiring worthless most of the time, because of the large distance that the futures contract had to move for the option to become profitable, plus the fact that the options had such a short life span.

So, I decided to start selling these options, which allowed me to pocket the money from the buyers. All I had to do was wait for expiration to see these options expire worthless.

Over time, I realized that due to the increasing potential of unrest in the Middle East, and the effect that OPEC had on the price of oil, I knew that there could possibly be more violent movements to the upside than to the downside. At that time, I started restricting my out of the money option selling tactics to just the put options.

People were still paying high premiums for these, and I was willing to sell them. What I didn’t realize at the time was that not only was I taking in monthly premium income, but I was also setting myself up to possibly buy crude oil at unheard-of cheap prices.

In the early ’90s, I was selling put options with strike prices from $15 all the way down to $9. If I was ever assigned on my short put options (meaning that the buyer executes his right to sell crude oil futures to me), I would be buying crude oil at very cheap levels – not such a bad thing to do with a worldwide commodity in such high demand. Turns out, I was never assigned on any of my short options, and that was mostly due to the short life span and large distance of being out of the money.

A Reliable Income Strategy

Over the years, I became the market maker that most of the brokers would come to when their clients needed to buy some out of the money put options. Other traders would shy away from these selling tactics, claiming the “unlimited loss potential” of short options. They said I was crossing over to the “Dark Side.”

But for me, the strategy was sound:

I was taking in good premium,
I could possibly buy crude oil at unbelievably low levels,
And I had risk-management plans in place.

The NYMEX futures contracts would trade electronically during the night after the open-outcry session closed, so if I had to protect myself, I could buy or sell futures contracts if need be.

After I left the NYMEX, I started a trading business from my own home office. I began trading stock options with the same methodology. I would sell put options below the market (out of the money) on stocks that I really wanted to own. This would allow me to collect the premium upfront, and potentially allow me to buy them at a great price.

When you are looking to buy a favorite stock at a cheaper level, selling put options is a viable strategy to potentially set a limit price while earning income in the meantime. The way I was using it on the NYMEX was mostly to collect the steady monthly premium income, but when applying it to the stock market, you are potentially setting yourself up to buy a great stock at a great price.

Good Trading,

Lee Lowell