Alternative Commodity Option Trading 

Options offer traders an unlimited number of strategies with various levels of risk and reward.  Unfortunately, many retail traders are stuck in a long option only "rut" and may not be aware of the potential flexibility offered by alternative option strategies.  There is certainly a time and a place for buying outright options, but in my opinion most circumstances seem to favor an alternate approach.   

The purpose of this article is to briefly outline a few of my favorite option strategies in an attempt to introduce you to the possibilities.  It is not intended, however, to provide you with all of the tools and knowledge that you will need to immediately participate in the markets with this new found knowledge.  Nonetheless, I believe this to  be a valuable stepping stone and hopefully an eye opening experience.

This writing is a small sample of the possibilities available to traders through option trading.  For a more comprehensive explanation of these and alternative option strategies be sure pick up a copy of "Commodity Options" which will be on the shelves in early 2009.  We will also be adding a series of option trading educational articles to this site. 

Please note that the trading examples in this article do not include commissions or fees due to the fact that there is such a wide spectrum of rates.  Therefore, all premium collected must be reduced by the amount that you pay in commission and you must add commission to all premium paid.  Don’t forget, that each separate contract is charged a commission.  Thus, a three-legged option spread involves three separate commission charges.

Short Option Trading

I have witnessed beginning traders lured to the markets in droves looking to participate in long option strategies. Their attraction stems from the fact that option buyers are faced with the prospects of unlimited profit potential and limited risk in the amount of premium paid plus commissions and fees. 

The hazard in this type of mindset is that although one’s losses are limited, it is highly likely that an option buyer will lose some or all of the value of the option.  Several studies suggest that more options than not expire worthless, accordingly it seems logical that by simply selling options as opposed to buying them is a preferential strategy.

Contrary to what many might seem to  be the case, it is possible to buy a call option and lose money even if the market goes up.  This is due to time value erosion and decreases in volatility or demand for the instrument.  On the other hand, the seller of that same call could be profitable despite the fact that the futures price increased assuming that time value and or volatility has eroded.

Unlike buying a call, selling a call option is a bearish strategy. Call option sellers believe that the market will decline in the opposite direction of the strike price or at least manage to stay below it. 

I have found that it may be preferential for option sellers to initiate positions on a day in which the market is going against the soon to be position.  In essence, Call options should ideally be sold during times of elevated market prices and thus elevated call premium.  This could mean that the market is approaching the top of a trading range, or simply overbought.  Selling against the trend may seem like account suicide, but it can often be justified by inflated premiums.

Short Call Option

Why you would use them?

1. If you believe that the market is going down, bearish
2. The strength of your belief determines what strike prices you should sell
3. Sell out-of-the-money options (higher strike prices) if you believe prices are not going up
4. Sell at-the-money options (at current price) if you strongly believe prices are not going up (this isn't a recommended strategy due to the aggressive nature)

Profit Profile

1. The potential profit is limited to the premium collected minus commission and fees
2. Your reverse break even point at expiration equals strike price plus the premium collected
3. Reverse Break Even = Strike Price + Premium Collected – Commissions and Fees
4. The maximum profit occurs if the market is below the strike price at expiration

What is the Risk?

1. Exposes trader to unlimited risk; thus, these positions need to be watched closely
2. Your losses increase if the market rises faster than the time decay erodes the option value
3. The market trading above the reverse break even is equivalent to being short the futures contract
4. At expiration your losses increase by one point for each point market moves above the reverse breakeven point

Example 

This trade was recommended on The Stock Index Report written by myself and published daily by DeCarley Trading on August 8th. While the recommendation was aimed at those trading the full sized S&P, an e-mini trader could have executed a similar trade with less profit potential and less inherent risk. 

The original recommendation called for traders to sell the September S&P 500 1390 call option for $4 in premium or better ($4 in premium is equivalent to $1,000) and would have been filled on the 11th of August at or near the premium requested.  In this hypothetical example, we will use a value of $4.2 simply because that is the Black and Sholes value assigned by our charting software. 

In figure 1, you can see that although the order was placed on the 8th of August, it took a substantial rally in order to get filled.  Patience such as this can lead to missing trades but will also help you to avoid premature entry and potential disaster should the market see a spike in volatility. 

Figure 1

This particular trade creates a scenario in which there is a great deal of risk, in fact unlimited risk, above the RBE of the short option.  In this case, the RBE is 1394.2 and was calculated by adding the premium collected to the strike price of the short call option.  Keep in mind that transaction costs would reduce the amount of premium collected and shift the RBE and risk closer to the market.  The amount of premium collected represents the cushion, or the amount in which the trader can be wrong in their speculation that the futures price will be below the strike price at expiration before the trade results in a loss.

The maximum profit is equivalent to the premium collected ($4.2 or $1,050) minus any commissions and fees paid and occurs if the futures price is trading below 1390 at expiration.  However, the profit zone of this trade, or where this trades money at expiration, is impressive.  This is visually displayed in Figure 2.

Assuming that this short option is held until expiration and it was possible to sell the 1390 call for $4.20 ($1,050 for a full sized contract or $210 for a mini) in premium, it would be profitable with the price of the futures market at any point below the RBE of 1394.2 before considering transaction costs.  In other words, the only way for this position to be a loser at expiration is for the futures price to be above the RBE.  

It is important to note that although the position is still profitable in between the strike price of the short call and the RBE, the amount of the profit diminishes every tick that the market is trading above the strike price.  Once the market surpasses the strike price, it is equivalent to being short a futures contract and exposes the trader to theoretically unlimited risk.

Figure 2

It is easy to see that a short option strategy if implemented effectively can provide traders with an edge over the alternative.  In this particular example, the futures price was over 80 full handles away from the strike price of the short call.  The distance from the market and the amount of premium collected provides the position with plenty of room for error.  After all, I am not perfect and I assume that you aren't either.

What you should also know is that without proper risk management knowledge and instinct, what looks to be a great strategy can turn into disaster.  This is due to the fact that option selling involves unlimited risk and limited profit potential.  It is imperative that short option positions are monitored closely, additionally if you aren't ready for the responsibility and risk involved you should be working with a full service broker familiar with short option trading.  Although more options than not expire worthless putting the odds in your favor with short option trading doesn't produce automatic success.  It is critical that risk on the losing trades is properly mitigated before the damage gets out of hand.  This is where an experienced broker may come in handy. 

Swing Trading with Options

Being privy to the options and futures markets along with trial and error has nurtured a respect and an depth understanding of the markets.  I hope that our readers will allow themselves to step out of the box when it comes to option trading and look toward the potential of trading aggressive option spreads.

Markets spend most of their time trading in a defined range; this makes profiting on long option strategies very difficult.  Additionally, according to studies conducted by the CME, more options expire worthless than not.  For these reasons a strict long option only tactic seems to have dismal odds.   After all a long option play requires that the market make a substantial move in order to turn a profit to the trader and a range bound futures market likely won't deliver. 

Within every trading range, there are brief trends in which some traders may look to profit from by buying or selling futures contracts.  What most people don’t realize is that you can profit from a range bound market by using a combination of long and short option and futures. 

While a swing trading strategy most often involves outright futures trading, I believe that option spread trading provides traders with a vehicle that is capable of mitigating some of the market's volatility relative to going long or short a futures contract.  Doing so allows more room for error should the market speculation be off in terms of direction or timing.  An option spread affords traders with the luxury of having some room for error.   Keep in mind that once a futures position is executed, the trader is immediately exposed to unlimited risk and the profit and loss incurred becomes a reality.

We will show you an alternative to futures trading that slows the pace of profit and loss but is capable of returning a respectable profit should the circumstances fit.  Hopefully as we cover an example this concept will become clearer.Naturally, if something seems too good to be true there will be a catch.  The disadvantage of swing trading with options as opposed to futures contracts is the fact that the profit potential is often limited, but this depends on the structure of the trade. The example that we are about to cover does entail limited profit potential and unlimited risk.  Another negative aspect of aggressive option spread trading is the inability to actively trade in and out of a position without being able to overcome with transaction costs in the form of commission and the bid/ask spread paid to the executing broker. Additionally, short options can sometimes "get in the way" of your profitable long options.  Yet, these drawbacks shouldn’t discourage you from employing such a strategy.  

As you delve into this type of trading further,  you will see that the same short option that limits your profit potential when things go right will cushion the blow when things go wrong.  I strongly believe that if constructed properly and careful consideration is given to measures of volatility, a swing trading strategy using options provides traders with an aggressive vehicle that arguably provides better odds of success to a trader than an outright futures position. 

Bull Call Spread with a Naked Leg

Buy Call A

Sell Call B (higher strike price)

Sell Put C

When to Use

1. You think the market will go up, but purchasing a near-the-money outright call option position is very expensive
2. The goal is to produce a very inexpensive, or even free trade. A free trade occurs when you collect enough premium on the short legs of the spread to overcome most or all of the premium paid for the long legs.  Keep in mind that the term free does not imply that there are no transactions costs, margin, or risk.

Profit Profile

1. Profit is limited to the difference between the strike prices of the long and short call plus a net premium collected if executed as a credit
2. At expiration the breakeven is equal to the long call strike price plus the net amount paid for the spread plus the transaction costs paid if executed as a debit

• BE = Long Strike Price + Net Premium Paid (if a debit) + Commissions and Fees
• RBE = Short Put Strike Price - Net Premium Collected (if a credit) + Commissions and Fees

What is the Risk?

1. Risk on the downside (short put) is theoretically unlimited
2. The market trading below the short put is equal to being long the futures from the put strike price
3. At expiration if the market is between the short put and long call you lose the net paid for the spread if it was executed at a debit.  If it was executed as a credit, the trader keeps the premium collected

Perhaps the bull call spread with a naked leg is best used in a situation in which going long a futures contract could be considered to be an attempt at "catching a falling knife".  In other words, if you are interested in a counter trend trade this may be the most efficient way to aggressively play the market.  This is simply because the trade involves a long call in combination with a short call and a short put.  If the futures market is trading wildly lower, you may be able to get the long call at a reduced price and collect top dollar for the short put. 

Looking at Figure 3, you can see that in late July the bond market had made a swift down move and was approaching the 1st level of pivot support.  A trader without regard to risk management may simply buy a futures contract and hope for the best but a savvy trader may use a bull call spread.  Doing so allows him to gain exposure to the market without jumping in front of the bus. 

Figure 3

One version of a bull call spread with a naked leg would be to buy the September Treasury Bond 114 call and pay for it by selling the 116 call and the 112 put.  Based on the theoretical values available to us, it may have been possible to execute the spread for a net credit of $15.63 before considering commissions and fees.  The net credit is the result of collecting more premium for the short options than is paid for the long. Simply put, the market would have paid you  a little over $15 to do this trade making the trade essentially free to execute.  Please note that while this trade is 'free' in terms of out of pocket expense it still involves transaction costs, margin and unlimited risk below 112. 

The maximum profit is equal to the distance between the long call and the short call plus the net credit and minus transaction costs and occurs if the futures price is above 116 at expiration.  In this case it would be a little over $2,000  before commissions and fees. 

The margin required on a trade like this varies and is based on an exchange owned software package known as SPAN (Standard Portfolio Analysis of Risk).  However, given the distance from the market the margin on a trade like this is estimated to be about $1,000.  Keep in mind that the margin can increase to an equivalent of the futures contract.  This will typically occur if the futures price drops against the short put option. 

Figure 4

Once again, the risk is unlimited below the strike price of the short put.  For every tick that the futures price is below 112 at expiration the trader is responsible.  As you can imagine, if you are caught on the wrong side of a sharply declining market the losses can add up.  Thus, it is important that you imply proper risk management techniques. 

Nonetheless, at any point above the short put strike price this trade has no risk.  To put it directly, this trader could have been wrong in the direction of the bond market at expiration to the tune of 2 handles (the distance between 114 and 112) and still not incurred a loss on the trade ignoring transaction costs.

Because this trade was executed at a small credit, it will be profitable by the amount of the original credit ($15.63) with the futures at any point above 112.  With the futures between 112 and 114, the trader simply gets to keep the premium collected.  Above 114 the trade begins making money intrinsically until reaching its maximum potential at 116.  Above 116 at expiration the trader doesn't benefit from increases in market prices but does have the comfort in knowing that the maximum profit has been achieved.  For each tick that the market is trading above the strike price of the long call at expiration the trader's profit is increased by the same amount.

Conclusion

This article wasn't meant to be a step by step instructional piece on option trading, instead the intention was to give you an overall idea of the possibilities that exist when being creative with option trading.  There are an unlimited number of strategies and approaches to the market and which one works best for you is dependent on your personality and risk tolerance.  Before you will be able to understand option trading, you must first understand yourself.  Hopefully I have paved the way for you to explore your comfort levels by opening your mind to the alternatives.

*Futures and Options Trade Involves Substantial Risk of Loss and is Not Suitable for All Investors.

Does this article leave you wanting more?  Click here to open an account with DeCarley Trading today to receive a free 29 page e-book exploring the world of option trading.

Carley Garner

1-866-790-TRADE

cgarner@decarleytrading.com 

Carley Garner is the Senior Analyst at DeCarley Trading LLC where she also works as a broker.  Her book, "Commodity Options" published by FT Press is now available through all major book outlets. Visit www.DeCarleyTrading.com for additional free educational and informational content, Carley can be reached at cgarner@decarleytrading.com.