Structuring Your Portfolio: The Recipe For Option Selling Success

As you most likely already know, selling options in commodities is a different ballgame than selling options in equities. Learning how to capitalize on these differences (some would call them advantages) can make your transition to commodities quite worthwhile.

Unlike equities, futures offer you the benefit of trading over a few dozen completely uncorrelated markets. In other words, the puts you sold in Exxon are going to be in a similar situation as the puts you sold in Microsoft as are the puts you sold in Bank of America. If the whole stock market rolls over, your puts are all going to be affected - probably with little regard to how good the fundamentals are for your individual stocks. Therefore while your short options in equities may feel diversified, they're all tied together by the singular category of "stocks" and are subject to moves in the index as a whole.

If you hold a commodities option portfolio, your options in natural gas have little to do with the price movements in silver, which have little to do with the price movements in wheat. True, outside influences such as currency fluctuations can cause some commodities prices to drift in the same direction over short periods of time. But over the long haul, commodities tend to march to the beat of their own drummer. In other words, not only are they diversified from equities; they are diversified from each other.
And therein lies the advantage which you should look to exploit in your commodities short option portfolio.

You'll want to diversify over as many different markets as you can comfortably handle. By "comfortably," I mean markets in which you have (or can obtain) a fair amount of fundamental knowledge. I also mean markets that are offering opportunities. There will not be option selling opportunities available in all markets at all times.

You should target a basket of uncorrelated commodities for your portfolio, typically 6-8 at any given time. In these, you may sell puts, you may sell calls, you may sell puts and calls. It all depends on the fundamentals of that particular market. Structuring your portfolio this way accomplishes three major objectives:

1. Diversifying over several uncorrelated commodities spreads your risk. If you do happen to have a market move against you, the structure of the portfolio itself helps you minimize any potential loss. I like to compare this to the way a nuclear sub is built. A submarine has a series of "flood compartments." If a hole is punched into one section of the sub, that compartment can be sealed off - containing the damage and keeping the sub afloat and moving in the right direction. A portfolio structured in this manner works the same way.

2. Positioning in this way provides many winning trades and a few losing trades. While closing out losers requires some discipline, the capital freed from closing losing positions can be redistributed into winning positions. This is operating in the exact opposite manner of investors who are tempted to "load up" on the next "can't miss" trade with an all or nothing philosophy.

3. It provides a strong layer of insulation to your portfolio from events in the outside world. For instance, I am often asked "What would happen to my portfolio if there was a terrorist attack, currency collapse, war in Iran, etc...It would affect some commodities, but not all. If you were on the right side of the market, it could have a positive impact. If not, you would close the positions that moved against you. Unlike equities, however, it is unlikely this would mean all of your positions at the same time. An event that spiked the price of oil would probably have little impact on your coffee positions.

While basic diversification is a concept right out of Investing 101, there are two main points that should be stressed:

First, if you have a stock option portfolio, you are probably not as diversified as you think. You may have sold options in a variety of sectors. But they are all still stocks. And stocks tend to move in the same general direction as a whole.

Secondly, if you do decide to diversify into commodities, do not make the mistake of saying "I only trade sugar options because my Uncle Ted was in the Sugar business." In addition to much higher option premiums, commodities offer you the ability to achieve real diversification, spread your risk, and take advantage of the large percentage of options that expire worthless across a variety of uncorrelated markets. Use them to the fullest and your portfolio will thank you.

The end game, of course, is to build a portfolio that consistently outperforms while reducing your exposure to a potential "hit" to your equity. Property diversifying your short options takes you a giant step in that direction.

***The information in this article has been carefully compiled from sources believed to be reliable, but its 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.