The Nuts and Bolts of Alternative Option Trading

An Introduction into the World of Alternative Option Trading

 

by Carley Garner of DeCarley Trading LLC

There have been many books written on options on futures trading, however I sometimes question the usefulness of the information provided.  It seems as though much of the literature available leaves the reader in a state of confusion; perhaps a majority of the bewilderment stems from the fact that most option theory is based on stock option trading and the transition to commodities isn't without its hitches. In my opinion, the practice of repackaging stock option trading strategy and theory in an attempt to appeal to and educate commodity traders can be misleading.  Additionally, there are large differences between option theory and option trading.  Some of what looks good on paper is difficult to execute efficiently in the real world, this is especially true in the world of commodity option trading.

It is a false assumption to believe that an “option is an option”.  They may be spelled the same, but they are vastly different due to the nature of the underlying vehicles.  As a result options on commodities take on completely different characteristics.  After all, everybody agrees that trading stocks is poles apart from trading futures. Why would anybody believe that trading options on stocks is synonymous with trading options on futures? 

Years of witnessing the perils of a long option only strategy led to my disappointment and pessimism in regards to a strictly option buying approach to the markets.  Time decay and the tendency of markets to stay range bound work strongly against the odds of consistent profits with such a strategy. 

As you read this article, please keep in mind that this is simply an introduction to the alternative option strategies available to those willing to move away from the conventional practice of simply buying a put or a call.  The beauty of option spreads is the flexibility and unlimited ratios of risk and reward that can be constructed by creative traders.  We hope that the trading methods in this article were written in a way that is meant to be easily understood and even more importantly easy to employ, but expect that you will have many questions and will be more than happy to answer any that you may have.  We can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

The Basics - How Options Work

There are two types of options, a call option and a put option. Understanding what each of these are and how they work will help you determine when to use them.  The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to exercise.  This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller. 

Call Options – Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time.

·         Buyers face risk limited to the amount of premium paid plus transaction costs and unlimited profit potential

·         Sellers face unlimited risk beyond the strike price of the option and profit potential limited to the amount of premium collected minus transaction costs

Put Options – Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time.

·         Buyers face risk limited to the amount of premium paid plus transaction costs and unlimited profit potential

·         Sellers face unlimited risk beyond the strike price of the option and profit potential limited to the amount of premium collected minus transaction costs

 

Traders that are willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known fact that more options expire worthless than not.  The premium collected by a seller is seen as a liability until it is either offset by buying it back, or it expires.  This is important, many beginning option sellers assume that because they receive the cash up front and they can see the amount of collected premium added to the ledger balance on their account statement, that it is somehow theirs.  Until the position is closed, the only thing that is certain is that there is risk on the table and the trade should be treated accordingly; this is the case regardless of the amount of money collected for the option or the amount of any open profit associated with the option.

   

 

Call (Bullish)

Put (Bearish)

 

Buy

   

Limited Risk

Sell

   

Unlimited Risk

 

 

Short Call Option

Sell an Out-of-the-money Call Option

 

By nature, options are a depreciating asset.  Just as a new car buyer will find that the value of their purchase diminishes once the automobile is driven off of the seller’s lot, an option buyer will find that the time value of their long option erodes with every passing minute.

Nonetheless, traders continue to be lured into long option strategies. This is likely due to the fact that purchasing an option provides traders with unlimited profit potential and the risk is limited to the premium paid.  The peril in this type of approach, as mentioned before, lies in the fact that although one’s losses are limited it is likely that an option buyer will lose some or all of the value of the option. 

Selling call options is a bearish strategy.  Unlike buyers of call options, sellers believe that the market will decline in the opposite direction of the strike price or at least be below the stated strike price at the time of execution. 

I am of the opinion that option sellers should initiate positions on a day in which the market is going against the soon to be position.  Doing so may translate into a higher premium collection and  accordingly create a scenario in which there is more room for error in terms of the futures price relative to the short call strike price.  For example, Call options should only be sold during times of elevated market prices and relatively inflated volatility.  This could mean that the market is approaching the top of a trading range, or simply overbought.  While doing so seems somewhat irrational, it can be justified in the fact that the premium collected will be greater as well as the odds of a correction. 

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