If you are a “writer” of commodity options, you inherently have exposed and unlimited risk. However, it’s this risk potential that provides the capacity to reap rewards. Therefore, a savvy commodity option writer understands that managing risk is more important than reaping rewards. In a previous article, I detailed a strategy to execute a strangle with protection against those inherent risks. You can review the trading strategy here. In this article, I will discuss a strategy to help protect a current position. These strategies can be tailored to reach your short term objectives and long term goals.
On September 13 2012, I executed a strangle in Natural Gas. A strangle is a trading strategy to yield a profit on a market with a high probability that futures will expire within a range. A call option and a put option are sold outside of the trading range. The December 2012 Natural Gas market was trading within a range between the 3.700 and the 2.900 price levels. The trend was neutral. Both of the 50-day and 200-day Moving Averages were converging to the current price level. Other technical indicators were undecided on market direction at the time.
Strangle: Sold one December 2012 Natural Gas 4.000 call on 46 points and one December 2012 Natural Gas 2.800 put on 45 points for a total credit of $910.
Below is a screen shot of the December 2012 Natural Gas futures chart on September 13, 2012. The blue horizontal lines make up the range, at 3.667 and 2.909. The green lines represent the “written” strike prices. The red circles are my mental stop losses at 3.631 (7/31/12) and 3.055 (8/29/12).
The margin requirement at the time was $650 per spread, found using a SPAN analyzer. Keep in mind margin requirements fluctuate dynamically as the futures price changes.
Therefore, $650 in margin is set aside to potentially profit $910 but there is unlimited risk on this trade.
Below is a screen shot of the theoretical risk involved with this strangle using the Option Source program I employ daily. Each contour line represents a defined time period between now and expiration. If the underlying futures price trades towards a “written” strike price the theoretical value of that strike increases at a faster rate. Despite using mental stop losses, there is a possibility that you will not be able to liquidate a short option position due to a lack of trading volume, overnight market activity, or a “black swan” event.
Knowing this, I must protect the position and limit the risk on extreme moves. This can be accomplished by purchasing a call and a put in the same contract month as the strangle but doing so at a delayed time. I waited until the October 2012 options expired (9/25/12) and the December 2012 options decreased in premium price.
By doing so, I accomplished three things on my current position to benefit the bottom line (and potentially ensure longevity):
- The protective call and put are less expensive with less days until expiration.
- The strike prices can be purchased closer to the “written” strike prices, which further reduces the risk.
- The risk on the trade is capped.
Trade: Buy one December 2012 Natural Gas 4.500 call and one December 2012 Natural Gas 2.500 put for a debit of $160 or better.
The overall profit potential is reduced to $750 (not including commission and fees) but the risk of loss has been identified and limited.
As you can see below, the protective call and put limit the risk on the strangle. To the downside, the maximum loss is $2,240 (not including commission and fees). To the upside, the maximum loss is $4,240 (not including commission and fees). The figures are calculated based on the price difference of the strikes (short call minus long call, short put minus long put) minus the total premium collected on the entire trade.
If the market rallies above the 4.500 price level, you could potentially be assigned a short futures position on 4.000. You can simply exercise the 4.500 call, offsetting the short position. If the market sells-off below the 2.500 price level, you could potentially be assigned a long futures position at 2.800. You can simply exercise the 2.500 put, offsetting the long position. Each of these scenarios would result in the maximum upside or downside loss.
In addition to reducing the risk, the margin requirement is reduced. The entire trade now has a margin of $497 found using a SPAN analyzer. The margin should be stable as well, not fluctuating as greatly with changes in the underlying futures contract.
If we need to liquidate one side of the strangle due to a breakout, the protective options may be held and liquidated for a potential profit. Otherwise, if the underlying futures contract price remains between the current mental stop losses, let the options expire worthless and collect the full premium in the process.
Rinse, lather, and repeat. Hopefully you find this advanced strategy beneficial for your commodity option selling. If you have any questions feel free to contact me directly at 800.993.9656.