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Trading Option Spreads, While Fading Time Decay

December 19, 2013 by Don DeBartolo| Tips & Strategies

Commodity option contracts are decaying assets. Unlike futures contract values from which they are a derivative, option contract values are lost each day to time decay. Unless in-the-money at option expiration, the values of said contracts are zero. Therefore, it is prudent to liquidate long option positions even if the target price is not yet realized before time value diminishes the premium.

Below is a trade example detailing the execution of a commodity option spread and the subsequent liquidation before option expiration:

On October 15, 2013, the December 2013 Heating Oil futures price closed below a lower trend line. In addition to a Trend Line formation trigger, Head & Shoulders and 1-2-3 Top formations were in development. If futures were to trade through the trigger price, the low of 2.9215 (10/01/13), this would setup a short entry opportunity based on the chart formation breakouts.

Turning to the options market, as Heating Oil futures can be volatile and require a relatively higher margin requirement, a Bear Put spread position was established. A Bear Put spread involves purchasing a put option on an underlying futures contract, while simultaneously writing (selling) a put option on the same underlying futures contract with the same expiration month, at a lower strike price. This spread is best suited for a market with potential downside profit opportunity with limited risk. Recall, the two additional chart formation setups had not yet triggered. The spread though was executed on 10/16/13, with known risk, in anticipation of the breakout. The 3.0000 put option was purchased, while the 2.9800 put option was sold. The spread was executed for 85 points or $357 ($4.20 per tick). The maximum risk on the trade was the $357 premium plus commissions and fees. The maximum profit potential was $840 minus commission and fees or the premium paid.

Analyzing the December 2013 Heating Oil chart, the downside target was the low of 2.7650 (4/18/13). Soon after the execution of the spread, the futures price traded to a new recent contract low of 2.8905 (10/25/13). In the process, confirmed the additional chart formations breakout. After a retracement to 2.9860 (10/31/13), in between the spread strike prices, the market sold-off, establishing a new low at 2.8285 (11/07/13). When the spread was executed there were 40 days until option expiration. On November 11, it appeared the market bottomed out while key technical indicators were starting to turn bullish. Instead of waiting out option expiration, which was now fourteen days away, and even though the downside target was not yet triggered, it was prudent to liquidate the spread for a known profit of 175 points or $735. If both strikes remained in the money the total profit would have been $840. However, by giving up 25 points or just $105, a profit was secured while eliminating risk. Sure enough, the December 2013 Heating Oil technical indicators were correct and the futures contract rallied. By option expiration, November 25, the underlying futures market closed at 3.0321, above both strike prices. If the Bear Put spread was not liquidated it would have been worth $0.

Ideally, every option spread trade results in collecting the full profit potential. Nevertheless, you can only take what the market gives you. Had not given up $105 to make $735, the result would have been a loss of $357 plus commission and fees. While trading option contracts be prepared to adjust the trading plan to maximize profit potential. This is especially true while trading decaying assets.

Filed Under: Tips & Strategies

About Don DeBartolo

Don C. DeBartolo is a Series 3 licensed broker registered with the National Futures Association (NFA). As a former arbitrage clerk in the S&P 500 futures pit at the Chicago Mercantile Exchange (CME), Don has floor trading experience. Taking his trade execution expertise and ability to navigate a fast-paced environment, Don transitioned to the brokerage side of the business. Since 2005, he has worked at Daniels Trading, a brokerage firm in the heart of the financial district in Chicago. His responsibilities as a broker include providing market analysis, trade execution, and money management to his clients around the world. In March 2010, he developed a formal trade advisory for clients of the firm seeking specific trade recommendations and subsequent risk management.

Due to his widespread proficiency and experience with the futures and commodity options markets, he is able to offer his clients timely insight, specialized trade recommendations, and educational information through various videos and writings.

Studying at Loyola University Chicago, Don discovered the international sport of rugby. Still today, he plays for the Chicago Griffins, a member of the highest league of rugby competition in the United States. Skill and discipline are two traits that carry over from the pitch to the trading screens.

Risk Disclosure

WHEN INVESTING IN THE PURCHASING OF OPTIONS, YOU MAY LOSE ALL OF THE MONEY YOU INVESTED.

WHEN SELLING OPTIONS, YOU MAY LOSE MORE THAN THE FUNDS YOU INVESTED.

STRATEGIES USING COMBINATIONS OF POSITIONS, SUCH AS SPREAD AND STRADDLE POSITIONS MAY BE AS RISKY AS TAKING A SIMPLE LONG OR SHORT POSITION.

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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Risk Disclosure

THIS MATERIAL IS CONVEYED AS A SOLICITATION FOR ENTERING INTO A DERIVATIVES TRANSACTION.

THIS MATERIAL HAS BEEN PREPARED BY A DANIELS TRADING BROKER WHO PROVIDES RESEARCH MARKET COMMENTARY AND TRADE RECOMMENDATIONS AS PART OF HIS OR HER SOLICITATION FOR ACCOUNTS AND SOLICITATION FOR TRADES; HOWEVER, DANIELS TRADING DOES NOT MAINTAIN A RESEARCH DEPARTMENT AS DEFINED IN CFTC RULE 1.71. DANIELS TRADING, ITS PRINCIPALS, BROKERS AND EMPLOYEES MAY TRADE IN DERIVATIVES FOR THEIR OWN ACCOUNTS OR FOR THE ACCOUNTS OF OTHERS. DUE TO VARIOUS FACTORS (SUCH AS RISK TOLERANCE, MARGIN REQUIREMENTS, TRADING OBJECTIVES, SHORT TERM VS. LONG TERM STRATEGIES, TECHNICAL VS. FUNDAMENTAL MARKET ANALYSIS, AND OTHER FACTORS) SUCH TRADING MAY RESULT IN THE INITIATION OR LIQUIDATION OF POSITIONS THAT ARE DIFFERENT FROM OR CONTRARY TO THE OPINIONS AND RECOMMENDATIONS CONTAINED THEREIN.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. THE RISK OF LOSS IN TRADING FUTURES CONTRACTS OR COMMODITY OPTIONS CAN BE SUBSTANTIAL, AND THEREFORE INVESTORS SHOULD UNDERSTAND THE RISKS INVOLVED IN TAKING LEVERAGED POSITIONS AND MUST ASSUME RESPONSIBILITY FOR THE RISKS ASSOCIATED WITH SUCH INVESTMENTS AND FOR THEIR RESULTS.

TRADE RECOMMENDATIONS AND PROFIT/LOSS CALCULATIONS MAY NOT INCLUDE COMMISSIONS AND FEES. PLEASE CONSULT YOUR BROKER FOR DETAILS BASED ON YOUR TRADING ARRANGEMENT AND COMMISSION SETUP.

YOU SHOULD CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES AND FINANCIAL RESOURCES. YOU SHOULD READ THE "RISK DISCLOSURE" WEBPAGE ACCESSED AT WWW.DANIELSTRADING.COM AT THE BOTTOM OF THE HOMEPAGE. DANIELS TRADING IS NOT AFFILIATED WITH NOR DOES IT ENDORSE ANY TRADING SYSTEM, NEWSLETTER OR OTHER SIMILAR SERVICE. DANIELS TRADING DOES NOT GUARANTEE OR VERIFY ANY PERFORMANCE CLAIMS MADE BY SUCH SYSTEMS OR SERVICE.

GLOBAL ASSET ADVISORS, LLC (“GAA”) (DBA: DANIELS TRADING, TOP THIRD AG MARKETING AND FUTURES ONLINE) IS AN INTRODUCING BROKER TO GAIN CAPITAL GROUP, LLC (GCG) A FUTURES COMMISSION MERCHANT AND RETAIL FOREIGN EXCHANGE DEALER. GAA AND GCG ARE WHOLLY OWNED SUBSIDIARIES OF STONEX GROUP INC. (NASDAQ:SNEX) THE ULTIMATE PARENT COMPANY.

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