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?
- If you believe that the market is going down, bearish
- The strength of your belief determines what strike prices you should sell
- Sell out-of-the-money options (higher strike prices) if you believe prices are not going up
- 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)
- The potential profit is limited to the premium collected minus commission and fees
- Your reverse break even point at expiration equals strike price plus the premium collected
- Reverse Break Even = Strike Price + Premium Collected – Commissions and Fees
- The maximum profit occurs if the market is below the strike price at expiration
What is the Risk?
- Exposes trader to unlimited risk; thus, these positions need to be watched closely
- Your losses increase if the market rises faster than the time decay erodes the option value
- The market trading above the reverse break even is equivalent to being short the futures contract
- At expiration your losses increase by one point for each point market moves above the reverse breakeven point
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.
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
- You think the market will go up, but purchasing a near-the-money outright call option position is very expensive
- 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 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
- 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?
- Risk on the downside (short put) is theoretically unlimited
- The market trading below the short put is equal to being long the futures from the put strike price
- 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.
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.
Carley Garner is an experienced futures and options broker with DeCarley Trading, a division of Zaner, in Las Vegas, Nevada. She is also the author of "Currency Trading in the FOREX and Futures Markets", "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall. She has also contributed to the FT Press Delivers line of digital products, "Insights for the Agile Investor". Her e-newsletters, The DeCarley Perspective, and the Financial Futures Report, have garnered a loyal following; she is also proactive in providing free trading education.