Collecting premium, with help from the Fed

The time may be right for a change of plan at the Federal Reserve. Here's one way you can profit even if you don't have perfect timing.

In 1975. the Chicago Board of Trade (CBOT) introduced interest rate futures to meet a growing demand for products that could protect against fluctuations in the cost of borrowing money. Treasury bonds and later T-notes became the most liquid futures markets as banks, investment firms and private funds all used the Treasury products to hedge against movements in interest rates.

Yet, at a time when interest rates and the cost of borrowing are at the center of not only financial but mainstream news media, most individual investors know little about trading these markets, and even less about doing it successfully. Much of the information available is complex and meant for a sophisticated or institutional audience.

But what about the individual investor? With the Federal Reserve dominating daily headlines, and the average investor finding he has a vested interest in the credit markets (whether he knew it or not), Treasury futures are gaining popularity. It seems that some traders are starting to feel just as comfortable guessing Ben Bernanke's next move as they are calculating soybean production estimates.

If you are intimidated by yield curves and basis points, don't be. The fact is, you don't have to dive into yield curve hedging strategies or explore rate inefficiencies with calculus that would make PIMCO's Bill Gross proud. There is a strategy that allows you to profit from changes (or non-changes) in interest rates. The strategy is option selling. Here, we will demonstrate how to apply the option-selling strategy to T-bond futures - at a time when winds of change may be blowing at the Fed.

WHY OPTION SELLING

Option selling has become increasingly popular with investors in recent years. For a long time, the term "unlimited risk" was enough to scare most investors away from selling options, especially options on futures. But many are now realizing that this term can be misleading taken out of context and such a high percentage strategy should not be overlooked in a serious portfolio. The CME Group did a study a few years back that estimated that approximately 80% of options held through expiration will expire worthless. With today's volatile markets, many investors are starting to believe this is a statistic they would like to see working to their advantage.

For most market participants, the hardest part of trading is trying to determine where the market is going to move and when. Option selling is a strategy that eliminates the need to predict when and where the market will move. In exchange for eliminating windfall gains, option selling offers smaller consistent gains over and over. While profits on each trade are limited, over time probabilities of success on each individual position are high.

To understand, consider selling options in terms of this football analogy: Most traders are busy trying to time the market, buying low and selling high. They are playing offense. They are trying to get the ball in the end zone. But scoring is hard. You can march down the field only to fumble on the one yard line. It takes exceptional skill, timing and discipline. Complicating matters, most traders don't punt on the fourth down, preferring to go for it.

With option selling, you don't have to make a big score. Option selling is similar to playing a prevent defense. You start the game with a few minutes left and a big lead. All you have to do is protect the goal line and run out the clock. You set your defenders back near the goal line and wait. The opposing team can do whatever it wants. As long as they are out of the end zone when the clock runs out, you win.

When you sell options, you do not have to decide whether the market is going up or down. You just need to decide where the market is not going to go. You select a price level above or below the market that you believe the market will not reach within a certain time period (generally within 60 to 90 days). You then sell an option at this price level and collect a premium for doing so. If the time period elapses and the market has not attained this price, the option expires and the investor who sold it keeps the premium as profit. If the market is trading at a level beyond the seller's strike price, the option is in the money. In this situation, the option seller takes a loss.

There is a risk in this strategy that the option could move in the money, but the risk is no more than that of a futures contract. Just like insurance companies, option sellers have to pay out from time to time. But remember, insurance companies make hefty profits by collecting many premiums, but only paying out on a few claims. Option sellers bank on the same principle. You are not immune from drawdowns, but statistically, the majority of your trades should be winners.

FOLLOWING THE FED

With all of the recent focus on the Fed, the U.S. Treasuries have been more active. As many investors follow financial and economic news, many feel they know what the Fed is going to do and, thus, know how interest rate futures will react. For those of us without a crystal ball, however, option selling is a better way to take advantage of this market. For option sellers, it is only important where prices won't go.