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June 29, 2011 by 1 Comment

Credit Spreads: Collect Premium while Keeping Your Clothes On

Readers of this blog should be very familiar with option spreads. We have written in the past (Option Spreads Examined Further: Measured Ways to Play Your Market Hunch, Bear Put Spreads: An Alternative to Purchasing Puts, and Bull Call Spreads: An Alternative to Purchasing Calls) about the different ways traders can participate in leveraged markets with measured risk strategies. In all of those cases, we looked at the buy side of those spreads in order to capture a high rate of return with a lower, set amount of risk. Those strategies should always be in a trader’s tool belt, but we cannot be quick to dismiss the other side of those trades, or the sell side option spread, known better as the credit spread.

Please click to view the Spreads risk disclosures below.

There will always be a place for buying options. However the option is used, if for protection or outright speculation, buying an option provides the opportunity to have unlimited returns with a set amount of risk. I encourage traders to buy options as opportunities are presented. Occasionally, however, the markets are trading with big daily ranges and high volatility, options get “bid up” and the cost due to volatility gets too high. In those cases, it might be better to simply “fade” that volatility by selling options and collecting premium.

Please click to view the Options risk disclosures below.

A sale of an option without any other position is known as a naked short option. The naked short option strategy is used as a way to make money based off where the market will not go. The strategy can be profitable, but over the long run it can bring sharp drawdowns or even the dreaded “account debit” if not properly managed. The problem Daniels Trading has with naked option selling is that it carries unlimited risk. Strategies, such as out of the money naked option selling, have a high probability of success which provide small gains that add up. Sure, there are people who have been successful constantly selling naked options. However, ask anyone who sells option premium in the Crude Oil markets during a supply shock, or someone who sold on short puts in the S&P before the Lehman Brothers bankruptcy, what their opinion is on that type of strategy and they will undoubtedly describe the feeling they had as one akin to being tied down with the market bearing down on them like a train rumbling down the tracks. It is impossible to predict the black sheep that create major market swings and the naked option sellers do not need many losers to be out of liquidity and out of the markets for good. One of Daniels Trading’s senior brokers often makes the great analogy that “[s]elling naked options makes an account’s value go up like an escalator and down like an elevator”.

These two types of spreads provide the opportunity to collect premium while still giving them protection so they can handle the unpredictable and inevitable market events. By selling out of the money-option spreads, one is taking on a higher amount of risk for a lower return, but the odds for success will also be higher. Let us look at an example:

Please click to view the Options and Spreads risk disclosures below.

Ken has $10,000 in an account. He is looking for a trade with a high probability of success. Over the last few days Ken has been watching the December Corn contract sell off from above 7.00 to below 6.30, which has left the bulls screaming for put protection. Ken is a fundamental trader and he has done some analysis, which in his opinion confirms that prices in corn will not fall below 6.00 before the December options expire. He wants to take a long position.  Still, he feels like a futures contract would not be a great strategy because if he is wrong he could be taken out of his position quickly; thus, he is susceptible to the “whipsaw” effect. He decides selling a put spread will provide greater margin flexibility and fits his risk profile better. While December Corn was in the midst of a sell off at 6.30, he decided to sell a 5.50-6.00 put spread in the December Corn options for 21 cents:

Sold 1 Dec 600 put for 46 ($2300)
Buy 1 Dec 550 put for 25 ($1250)
Max profit= 21 Cents ($1050)
Max loss=29 cents ($1450)

Ken’s breakeven is 5.79. He suffers a max loss if his December Corn options expire with Corn anywhere below 5.50. Ken knows his reward is not as high as his risk, but his analysis shows that Corn will stay over 6.00. So, he feels comfortable risking $1450 because Corn will stabilize somewhere over the 6.00 strike price where he sold the put. He also feels comfortable because he can let the markets workout what is taking corn lower. Ken is unconcerned with where he will be next week because his focus is on where he will be in four months. In the worst case scenario, Corn sells off below 6.00 and Ken can lose no more than $1450 dollars on expiration. If December Corn expires over his 6.00 short put, Ken is probably satisfied with the 10% profit he earns over the next five months. Another benefit to the trade is that Ken knows he has an additional $8,000 in free margin which he can use on other trades.

Tips for Trading Credit Spreads

Here are a few simple tips that can help you improve your chance for success and allow you to potentially capture the most profit possible:

Please click to view the Profits risk disclosure below.
  • Sell into heavy price moves. When the market is violent options buyers will often pay more for protection from volatility. The best markets in which to use this strategy are those that have had unsustainable recent price action.
  • Do not put all of your eggs in one basket. Diversify your spreads across multiple uncorrelated markets. Try to look for the markets that are driven by uncertainty.
  • Make sure your account is properly capitalized. Always choose spreads that your account can handle, especially if a max loss occurs.
  • Try to sell option spreads at least 30 days before expiration. The time value is higher and this value comes out of the option price on an accelerated level as expiration nears.

These tips can help generate consistent profits which can add up over time. When the next black sheep event occurs–they always do when we least expect–these tips may protect you from a debilitating drawdown. Remember, there are two key goals to trading: the first goal is to make money and the second is to keep it. This tips can help achieve both of those objectives.

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Spreads Risk Disclosure: A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts. It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread). In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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Options Risk Disclosure: An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price. Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different. For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option. Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options). Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised. The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero. Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received). The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

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Profits Risk Disclosure: Past results are not necessarily indicative of future results.

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Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
June 8, 2011 by 2 Comments

Option Spreads Examined Further: Measured Ways to Play Your Market Hunch

New option traders tend to overlook the strategy of combining two options to form spreads, which allow different degrees of market optimism or pessimism.  Option spreading is different than futures because a straight futures play only portrays one degree of bullishness/bearishness.  If one is long the futures, he better be very sure the market is going up from the moment he is filled on the position.  Sure, there are risk measurement tools we all use to make sure we don’t lose the farm, and no one can always picks the exact top and bottom, but when it comes down to analyzing trade setups, there is no reason to buy or sell a futures contract unless you have a strong conviction the market is going to go in the direction you think it will immediately.

Please click to view the Options and Spreads risk disclosures below.

Unfortunately, many traders have a hard time garnering that much conviction.  Some see various degrees of bullishness or bearishness in the marketplace, either due to fears of certain economic events or sentiment changes in the marketplace.  Therefore, they can’t bring themselves to buy the futures outright.  If this is the case, then a bull call spread or a bear put spread may be a better way to capture gains.  (If you have been a follower of this blog you should be familiar with these spreads, if not you can read the articles on bull call spreads and bear put spreads to get the basics behind each strategy.)

The Structure of the Spread is Very Important

When applying these strategies, the amount of bullish/bearish sentiment can be measured by the difference between the option bought (closer to the money) and the option sold (further from the money).  It is very important to have a specific plan in place; just picking arbitrary strikes will affect the risk/reward potential.  In options trading always apply the adage, “there is no such thing as a free lunch”.  That means the more you pay for the spread, the higher the profit or loss potential.  When placing a spread trade it is important to be careful about the strikes chosen, the trade setup should reflect how bullish or bearish you are.

When you place the option sold closer to the option purchased, you will lower the cost of the spread, but by doing so you will lower the spread’s earning potential.  If you place the option sold further away, you may have the opportunity for big gains but you are risking more to realize those gains.  The spread between the prices of different strikes will be determined by a few factors, but to make life easier I like to look at the difference in market delta between the option bought and option sold as my primary indicator (learn more about market delta).

A good rule of thumb trader’s use is called the “.20 to .30 delta rule.” This rule implores the trader to look at the deltas of each option, subtracting the delta of the purchased option from the delta of the sold option.  Ideally the difference should come out to be somewhere between .20 and .30.  The closer to .20 indicates that the spread is on the conservative side, the closer to .30 indicates it is on the aggressive side.  Sure, you can buy spreads with higher and lower deltas than .20 and .30, but in those cases bear put and bull call spreads may not be the best strategy.  Keep in mind these deltas change daily, it’s important to have this data handy before executing the trade.

Compare Plans

Trader Ann is bullish gold.  She believes that over the next two months the market will see a price appreciation of somewhere between 4% and 7%, but due to the uncertainty of the Federal Reserve policies and the European debt issues she worries she might have to whether some volatility in the meantime.  She believes picking tops and bottoms is a loser’s game, and knows she doesn’t have the stomach (nor the wallet) to afford a futures contract outright.  At of the close of the market today gold is trading at 1525, which would place her target anywhere between 1585 and 1620.  She has $10,000 dedicated to her trading and doesn’t want to risk more than 30% of the liquidity in her account on the trade.  Because she has a two month timeframe in mind, we will look at the August Gold calls that expire in 60 days.  For this example we will look to buy an “at the money” call and sell an “out of the money” call at one of the strikes mentioned above.  Ann will call her Daniels broker and price out a few different plans and decide which is best for her.  Let’s compare our two plans and see which one is more appropriate:

Plan #1
1525-1585 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1585 Gold Call for $2000 with a delta of .30.
Total premium paid for the spread is $2100, which will initially trade with a delta of .21

Max profit= $6000 (total gain between 1525 and 1585) – $2100 (cost of spread) = $3900
Max loss= $2100 (cost of spread)

Plan #2
1525-1620 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1620 Gold Call for $1300 with a delta of .21
Total premium paid for the spread is $2800, which will initially trade with a delta of .30

Max Profit= $9500 (total gain between 1525 and 1620) – $2800 (Cost of spread) = $6700
Max loss= $2800 (cost of spread)

Please click to view the Hypothetical Performance disclosure below.

Ann can now see by looking at the delta comparisons, how much she will make or lose initially from the option spread as the underlying futures prices move higher or lower.  The larger the delta on the spread, the more profit/loss she will take from a one point move in the August gold futures contract.  Based off these numbers she can apply them to her level of bullishness in Gold.  If she believes the market is more susceptible to an immediate move up she will enter the market via Plan #2.  If she feels a little apprehension about the short term prospects of gold she would probably be better off entering via plan #1.  Keep in mind Ann wants to participate now, she doesn’t want to try to perfectly try to time an entry.  Either way, she will get the exposure to the gold markets immediately, allowing her to handle the market swings as they come.

If she is correct and the market moves higher she will profit, if she is wrong and the market moves lower she will lose, as any directional trades result.  But Ann is more focused on where Gold will be in August and not today.  She obviously would rather be correct sooner rather than later, but as we learned about these spreads from past articles, they allow for the market to do its thing without worrying of a margin call.

As always, leverage cuts both ways and it is important to know exactly what you have on the line with each trade.  The way you establish these spreads should reflect your market sentiment.  If you have any questions on the strategies mentioned above or finding the delta on specific options please contact your Daniels Trading broker.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

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HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.  IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.  ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.  IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.  FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS.  THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
May 20, 2011 by 15 Comments

Bear Put Spreads:  An Alternative to Purchasing Puts

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy puts.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing puts is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here:  Options on Futures:  An Introduction to Buying Options.  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bear put spreads into your trading strategy.

What is a Bear Put Spread?

A bear put spread is a position that involves purchasing a put option on an underlying futures contract, while simultaneously writing a put option on the same underlying futures contract with the same expiration month, at a lower strike price.  As the name of the strategy hints, this is a position that is appropriate for a bearish market sentiment.

Why not just purchase a put?

This is one of the most common questions posed when a trader is first learning about bear put spreads.  Bear put spreads allow a trader to pay less premium to get involved in a position than simply purchasing a put.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a put that is closer to at-the-money.

How it works

As noted above, a bear put spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the put, but they also receive premium for selling a put as well.  For a bear put spread, a trader would typically purchase an at-the-money put and sell an out-of-the-money put to initiate a bear put spread.  The selling of the out-of-the-money put helps the trader finance the purchase of the at-the-money put.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Gary has a bearish sentiment on the crude oil market.  He decides the most cost effective way to get involved in the market is to enter a bear put spread.  Gary decides to get involved in July crude oil as it provides a reasonable time frame for the move he thinks will occur.  July crude oil futures are currently trading at 99.31.  Larry decides to enter a 99.00/90.00 bear put spread.  See below for the specifics on the options:

Purchase One July 99.00 Crude Oil Put Option for $3,920 (Pay)
Sell One July 90.00 Crude Oil Put Option for $1,130 (Collect)

Total Premium Paid for Position = $2,790 (3920 – 1130)

Gary’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$9,000 Difference in futures price (9*1000)
-2,790 Premium paid for call spread
$6,210 Maximum profit potential

Gary’s maximum risk is the $2,790 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July crude oil futures market is trading at under 90.00.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

  • July 99.00 crude oil put expires on June 16th, the option is exercised and Gary’s account is short crude oil futures contract from 99.00.
  • July 90.00 crude oil put expires on June 16th, assigning Larry’s account a long crude oil futures contract from 90.00.
  • The short 99.00 July crude oil futures is immediately offset by the long 90.00 July crude oil futures contract, allowing Gary to show a futures gain of $9,000 (9 * 1000).
  • Gary’s realized profit is the gain in the spread offsetting by the cost of the spread, or $6,210.

Conclusion

As you can see, there are opportunities in the options market using the bear put scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Spreads, Strategies Tagged With: , , , ,
May 19, 2011 by 1 Comment

Trading In Volatile Markets

This post originally appeared in FutureSource’s Fast Break Newsletter on May 17, 2011 where Craig Turner is a regular contributor on various futures trading topics.

Trading in volatile markets provides extraordinary opportunities but it also carries more risk.  For more aggressive traders, volatile markets can lead to larger than normal losses, but they can also provide rare opportunities that can be highly advantageous for your trading account.  If you are going to trade in volatile markets, or if you have positions and the markets become volatile, you need to know how to recognize the warning signs and navigate through the storm.  You have to be able to manage risk if you want to take advantage of substantial price moves.

1) Margins are Inadequate Guidelines in Volatile Markets

When a market is volatile, the first thing you should do is make sure the margin requirements are greater than the daily ranges in the market.  For example, when Silver was trading from $20 to $50, the exchange and clearing firms did not raise margins.  Anyone who has traded silver knows it can trade down 10% on its worst days.  In my opinion, margins should be at least a day’s trading range for any contract.  When Silver traded at $15 and $20, the biggest down days would be $1.50 to $2.00.  Margin for silver would be around $10,000 ($2.00 in the big contract).  This was appropriate for the contract.

Looking back, there was a big warning sign the Silver market could become a volatile market.  The red flag was the exchanges and clearing firms not raising margins as the Silver traded to $30 and then $40.  As the market climbed higher, the daily trading range was higher.  Margins stayed the same.  This meant that it was possible that too many traders were in the market without enough capital, which is always a recipe for volatility.

If you are trading a volatile bull or bear market, you need to use the possible daily trading ranges as a guideline for capital.  Exchanges and clearing firms are slow to act.  They are rarely ahead of the curve on margin issues, and they are usually caught off guard and have to increase margins after the damage is done.

By understanding that you need more capital on hand to trade volatile margins, you will have more staying power than the average trader.  The trader using margin as a guideline will not be able to stay in the position.  A trader who understands that volatile markets can have higher trading ranges than the exchange margin should be able to ride out the storm better.

2) De-leverage When the Markets Become Volatile

When the markets are volatile, it is not the time to double up.  If you are trading two contracts, it is the time to de-leverage and just trade one.  If you are trading one standard contract, it might be the time to shift gears and trade the mini contracts for a while.

When the markets become volatile, it doesn’t mean you have to stop trading.  Your opinion of the markets can still be correct but outside factors may be an issue.  For example, the US Dollar, European nations needing bailouts, wars in the Middle East, the natural disaster in Japan, can all affect the markets.  In my opinion, what you need to do is take on less risk during these times.  The only way to really achieve this is to de-leverage. The best way to do this is to reduce your position size so you can stay in the game.

3) Spreads May Help With Reducing Volatility

One possible way to hedge against volatility is to trade futures spreads.  Let’s say a trader has a long corn position in December 2011 corn.  The grain markets and commodity markets start to become volatile due to the US Dollar rallying because there are fresh concerns about the Euro and its member countries defaulting on their debt.  The soaring dollar is going to hurt the trader’s long Dec Corn position.

Let’s say the trader is very bullish on corn, understands the market could go down in the short term, and wants to stay in his position for the medium to long term.  Using the spread methodology, the trader would then short a different month in Corn to attempt to protect himself.  In this case, the trader would most likely short July 2011 Corn or Dec 2012 Corn.  Either way the trader can now better ride out the storm until the volatility passes.  Once the trader is confident again that corn will start moving higher, he just lifts the short corn leg of the spread and leaves the long Dec 2011 Corn position on.

What is nice about this option is the margin the trader was using for long 1 contract of corn (over $2000) is now about $500 for the spread.  Not only is the trader potentially reducing risk, he is also reducing margin requirements.  The trader does not have to come up with more capital to short an extra contract.  Because, on average, futures spreads reduce risk when compared to outright positions, the exchanges recognize this and require less margin.

4) Options Offer Protection on Existing Futures Positions

There are two ways to use options in volatile markets.

For those trading futures, you can use options to hedge against short term volatility.  Let’s say you are long December Corn and you think the market could sell off 20 to 30 cents before rallying a full dollar.  The trader can keep the Corn position on and also buy a December Corn put.  If the market really does sell off 20 to 30 cents, the trader can liquidate the option for a profit and then hold Corn as he looks for the bottom to come and the rally to start.

The second way to use options is to not trade futures during times of volatility and just use Option Spreads.  Let’s say you are bullish December Corn, you think the markets are going to be volatile, but you want a bullish position.  By using a bull call spread in December Corn, the trader has a defined risk and reward, and the short term volatility should not change the value of the spread nearly as much as a futures contract or just being long a single call option.

5) Summary

When the markets become volatile, traders need to have more capital for their positions.  Greater daily trading ranges means traders should have more capital per position.  If the trader does not have the capital for the increased volatility, they need to de-leverage.  One way to de-leverage is to either reduce position size or trade mini contracts instead of standard contracts.

Another way to de-leverage is to use futures spreads.  Traders caught in a volatile market can use futures spreads to potentially reduce the risk in their position.  They can leg out of the spread into their original position after the smoke has cleared.  Finally, traders can also reduce risk and de-leverage by using options with their futures position or just use option spreads, like a bull call spread or a bear put spread.

All in all, the most important thing to take away is that when the markets are volatile, traders need to reduce their risk exposure.  While volatility may provide extraordinary profit potential, it also may lead to greater than normal risk.  Traders need to manage this risk while still being able to take advantage of price movements in the market.  By reducing their risk exposure, traders will be able to stay in the game and have the opportunity to go after substantial price moves.

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Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Risk, Strategies Tagged With: , , , ,
May 18, 2011 by Leave a Comment

5 Tips for Option Writers

Tip 1:  Have a Disciplined Plan

Writing options should not be treated any different than any other type of investment.  You must plan your trade and trade your plan.  That being said, you must determine the profit and risk parameters around each trade.  In the case of writing options, your maximum profit is the premium collected upfront.  The struggle many option writers face is how to manage the position when the market begins moving against them.

Writing naked options are one of the most difficult strategies to manage because the risk is unlimited.  Leveraged markets, like the futures markets, can move very quickly, which can make it extremely difficult to properly manage risk.  Even if you have a mental stop to cut your losses, a severe move in the market might not allow you to exit at that point.  Premiums can double or triple before you have a chance to buy back the option.  This is why it is so important to have a concrete plan in place.  In the event a market does move against you, your trading plan will allow you to act quickly to prevent further damage.

If the concept of unlimited risk is unappealing, one solution to naked options would be credit spreads.  Credit spreads have predetermined trade parameters on both the profit and loss side of the trade.  You can easily determine your best and worst case scenario upfront.  The majority of options will expire worthless, but that doesn’t mean the position won’t go through its ups and downs.  By accepting the risk/reward parameters of the spread, you should be comfortable sitting through the day to day fluctuations and only make modifications if your long term outlook changes.

Tip 2:  Control Your Leverage

Options provide a fantastic opportunity with leverage; however it is important to be smart in how to use this leverage.  A unique obstacle option writers must overcome is margin.  Unlike the underlying futures, margin designated to selling options is not a flat rate.  Instead, margin is determined by SPAN.  SPAN is a set of sophisticated algorithms that determine margin according to your positions one day risk.  The distance a strike price is to the underlying, the time left until expiration, and volatility are all factors that can affect our margin.  That being said, margin is simply a guideline.  This is why leverage is so important.  You might be properly leveraged according to your margin on day one, but as time goes by and as the underlying futures moves, the margin can drastically change.  Dramatic, volatile moves can cause traders to exit positions early due to margin calls.  The greater the leverage, the more sensitive your position is going to be to these price swings.  This is another reason why many traders prefer credit spreads.  Credits have a defined risk and will in turn have less severe margin swings.

Tip 3:  Do Not Hang on to Worthless Options

The point of writing options is to collect the time premium and allow the value of the option to decay.  Although the goal is to have our options expire worthless, it does not mean we cannot buy the option back early.  This is especially true when there is a lot of time left on the option.  If 80-90% of the total options value has decayed, it does not make sense to keep on the risk of the position for the extra 10-20%.  There are certain strategies that will require holding the options until expiration, but unless your strategy involves writing far out of the money options for a few ticks, it would likely make sense to take the risk off the table.  It is important to continually reevaluate the risk and the management of the trade throughout the life of the position.

Tip 4:  Be Aware of Major Reports and Events

Whether you are a technical trader or a fundamental trader, you must be aware of key market reports and events.  You should have access to an economic calendar that will identify all scheduled reports.  We will need to keep these dates in the back of our minds when analyzing our trades.  As discussed in our last tip, if the majority of our option’s premium has been removed prior to a report, it might be best to take the risk off the table in case the report is extremely one sided.

Tip 5:  Choose Markets You are Comfortable With

We should have a good understanding of the markets current trend and the long term fundamental picture.  An awareness of the fundamentals, scheduled reports, and key technical areas (trend lines, moving averages, pivots, etc.) are vital aspects of how we analyze our trade.  The more comfortable we are with what is driving the market, the more confident we can be with our analysis.  The more we trust our analysis, the easier it will to evaluate our position and determine if a sudden move is a short burst in the market or the beginning of a new trend.  We should have a good feel for the market’s volatility and typical trading range, so we can identify when the current market environment begins to change.  This comfort and knowledge should help you stay more disciplined and follow the trading plan established upon entering the trade.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Strategies Tagged With: , , , , ,
May 17, 2011 by Leave a Comment

Bull Call Spreads: An Alternative to Purchasing Calls

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy calls.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing calls is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here: Options on Futures:  An Introduction to Buying Options).  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bull call spreads into your trading strategy.

What is a Bull Call Spread?

A bull call spread is a position that involves purchasing a call option on an underlying futures contract, while simultaneously writing a call option on the same underlying futures contract with the same expiration month, at a higher strike price.  As the name of the strategy hints, this is a position that is appropriate for a bullish market sentiment.

Why not just purchase a call?

This is one of the most common questions posed when a trader is first learning about bull call spreads.  Bull call spreads allow a trader to pay less premium to get involved in a position than simply purchasing a call.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a call that is closer to at-the-money.

How it works

As noted above, a bull call spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the call, but they also receive premium for selling a call as well.  For a bull call spread, a trader would typically purchase an at-the-money call and sell an out-of-the-money call to initiate a bull call spread.  The selling of the out-of-the-money call helps the trader finance the purchase of the at-the-money call.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Larry has a bullish sentiment on the gold market and believes it will continue in its bullish ways.  He decides the most cost effective way to get involved in the market is to enter a bull call spread.  Larry decides to get involved in July gold as it provides a reasonable time frame for the move he thinks will occur.  July gold futures are currently trading at 1512.5.  Larry decides to enter a 1510/1550 bull call spread.  See below for the specifics on the options:

Purchase One July 1510 Gold Call Option for $3,700 (Pay)
Sell One July 1550 Gold Call Option for $2,100 (Collect)
Total Premium Paid for Position = $1,600 (3700 – 2100)

Larry’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$4,000 Difference in futures price (40*100)
-1,600 Premium paid for call spread
$2,400 Maximum profit potential

Larry’s maximum risk is the $1,600 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July gold futures market is trading at over 1550.0.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

  • July 1510 Gold call expires on June 27th, the option is exercised and Larry’s account is long a gold futures contract from 1510.
  • July 1550 Gold call expires on June 27th, assigning Larry’s account a short gold futures contract from 1550.
  • The long 1510 July Gold futures is immediately offset by the 1550 July Gold futures contract, allowing Larry to show a futures gain of $4,000 (40 * 100).
  • Larry’s realized profit is the gain in the spread offsetting by the cost of the spread, or $2,400.

Conclusion

As you can see, there are opportunities in the options market using the bull call scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
December 30, 2010 by Leave a Comment

How to Collect Premium with Iron Condors

How to Collect Option Premium with the Iron Condor Strategy

Different circumstances call for different trading strategies.  Part of becoming a complete trader is a balanced, disciplined approach with an eye geared towards managing risk.  You can accomplish this by trading futures, options, or a combination of the two.  The difficult part is determining which approach will be the best for you, and this formula might be different for every trader.  In this article, my intention is to open your eyes to a more unique trading approach, collecting premium with Iron Condors.

I’ve heard a lot of myths and confusion in regard to iron condors, so I’m attempting to break this down for you in simple, easy to understand language.  In order to accomplish this, we need to have a basic understanding of credit spreads.

Understanding Credit Spreads

A credit spread is when you sell a closer to the money (more expensive option) and purchase a cheaper (further out of the money option) on the same underlying commodity at the same expiration.

Let’s take a look at an example using gold futures;

Gold futures    =    1400
1350 puts    =    $3500
1300 puts    =    $1500

Gold futures are trading at 1400 and we feel bullish on this market.  We could sell a 1350 put and purchase a 1300 put.  The premium in the 1350 put is going to be higher than the 1300 put because it is closer to where the market is currently trading.  We would collect the $3500 premium from the 1350 put and pay out the $1500 premium of the 1300 put at a net credit on the trade of $2000.  Our defined profit is the amount we collected between the 1350/1300 put spread, $3500 – $1500 = $2000.  We’re risking the difference between our two strike prices, (1350 – 1300 = 50 x $100/point = $5000.  And, since we already collected a premium of $2000, our defined risk is reduced to $3000 ($5000 – $2000 = $3000).

So… What is an Iron Condor?

An Iron Condor is simply a combination or two vertical spreads.  To create the iron condor, we would sell both a call spread and a put spread.  The idea behind this is to take advantage of a sideways market and allow us to design a strategy based on where we feel the market will NOT go.

How to Use an Iron Condor Strategy

Once again, let’s take a look at an example using gold futures.

The current price of gold is 1400.  We feel that the market will likely trade within a channel between 1350 and 1500 over the next 30-60 days.  Gold options are currently trading at the following prices:

1500 call    =    $3500
1550 call    =    $1500
1350 put    =    $3500
1300 put    =    $1500

In order to take advantage of a sideways market we would use an iron condor by selling the 1500/1550 call spread and the 1350/1300 put spread.

How to Calculate the Profit Potential

Profit/loss graph for a long Iron Condor at expiration.

We would place an order to sell the 1500 call and purchase the 1550 call.  We would collect $2000 premium on our call spread ($3500 – $1500 = $2000).  We would also sell the 1350 put and purchase the 1300 put.  We would collect another $2000 premium on our put spread ($3500 – $1500 = $2000).  This would define our profit potential to $4000 (total premium from call spread + put spread, $2000 + $2000 = $4000).

Maximum Profit Potential = Call Spread Premium + Put Spread Premium

How to Calculate the Defined Risk

We can also use these numbers to calculate our defined risk.  Our defined risk is the difference between our spread strike prices minus the amount we collected.  Since we have both a put and call spread, we know our risk is limited to only one side.  The market cannot expire above our call spread and below our put spread simultaneously, so we have a risk of just $5000 (1350 – 1300 = 50 x $100/point = $5000 or 1500 – 1550 = 50 x $100/point = $5000).  Note: If the difference between our strike prices were not balanced, we would use the greater difference.  However, this is before we take into account the premium we collected.  We have collected a total of $4000 for our put and call spreads upfront, so we can deduct this from our risk total.  Thus, our defined risk would be reduced to $1000 ($5000 – $4000 = $1000).

Defined Risk = Greater Difference between Strike Prices – Premium Collected

Benefits of an Iron Condor Trading Strategy

Now that we understand what an Iron Condor is, we need to understand why we would want to use this trading strategy.  Buying options are great in regard to their risk reward.  You can define your risk to a very small sum, while having unlimited profit potential.  The downside of this strategy is the probability.  The majority of cheap, far out of the money options will expire worthless.  So although you are only risking a few hundred dollars on each option, the odds of these being profitable are low. 

That being said, if the majority of options are going to expire worthless, then why don’t we just sell options? You can, but you are running the risk of that one cheap option turning into a very valuable option.  So you might have a defined profit a few hundred dollars with unlimited risk.

This is why the Iron Condor is an attractive strategy.  You are doing your part managing your risk because you know what the worst outcome can be.  You are also keeping the odds in your favor.  We know that the majority of all out of the money options are going to expire worthless, so we should have more profitable trades than losing trades.

In conclusion, an Iron Condor can be a simple strategy.  It is a combination of two credit spreads: one to the call side and one to the put side.  This allows you to take advantage of sideways markets and to design a strategy based on where you feel the market will NOT go.  This strategy allows you to define your risk, while keeping the odds in your favor, and providing you with a flexible and disciplined approach to the markets.

Free Download:  Futures and Options Strategy Guide

If you enjoyed this article and are interested in learning more about futures options strategies, sign up for fast access to our Futures and Options Strategy Guide, detailing 21 futures options strategies that you can begin using in your trading today!

Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Spreads, Strategies Tagged With: , , , , , , , , ,