An Insiders Perspective: Tips and Tricks
- Written by Carley Garner
Quoting Commodity Option Spreads
Keep in mind, the same concept can, and should, be applied to commodity option spreads. When it comes to option spreads, the premium is quoted in terms of the net. Thus, you would take the premium needed to buy the long options and subtract the premium collected for the short options. The difference is the value of the spread. In other words, if you are buying the spread you will be paying more for the long options than you are getting for the short options. If you are selling the spread, you are collecting more for the short options than you are paying for the long.
Let’s look at an example. If you were interested in executing a bull call spread with a naked leg, you would be buying a near-the-money call option and selling an out-of-the-money call option and an out-of-the-money put option. Each of the individual options that make up the spread, have their own bid and ask quotes. However, the bid and ask quote of the spread is derived by netting the corresponding premium values.
In this example, we are looking to buy the Dow 12,900 call, sell the 13,300 call and the 12,700 put. Thus, we are subject to paying the ask price on the 12,900 call, and collecting the bid for the short 13,300 and the 12,700 put. If we were interested in selling the spread, as opposed to buying the spread, we would be collecting the bid for the 12,900 and paying the ask price for the 13,300 call and the 12,700 put.
|Buy 1 June Dow 12,900 Call||2475||2525|
|Sell 1 June Dow 13,300 Call||750||875|
|Sell 1 June Dow 12,700 Put||1450||1600|
|Total Value of Spread||Even||325|
|Split the Bid||160|
In the example, the figures highlighted in red represent the prices that a trader looking to buy the spread would be subject to. As you can see, a market order would get filled at a price of $325 on the “buy side”. If a trader wanted to split the bid, they would put a limit order in at $160 (the actual midpoint is 162.5 but floor brokers only take orders in increments of 5). Also keep in mind that if your option spread has a “naked” leg, meaning that you are short more options of the same type (call or put) than you are long, you are subjected to theoretically unlimited risk. Once the market travels beyond the strike price of the naked short option, it is similar to being in the futures market.
This simply means that the commodity option trader would like the spread to be executed if it can be done at a cost of $160 or less without consideration of transaction costs. If nobody is willing to take the other side of the trade at your stated price, the order will go unfilled. Remember, commission is charged on a per contract basis, thus a three legged option spread involves three commissions once it is executed. Regardless of the rate you are currently paying, this is something that you should be aware of.
Another key point in terms of quoting option spreads is the premium is stated after reducing the spread to the smallest quantity. For example, if you were executing two options spreads the premium quoted would be stated on the price of one.
Using the example above, if a trader wanted to do a five lot they would be buying 5 of the 12,900 calls, selling 5 of the 13,300 calls and selling 5 of the 12,700 puts. The bid-ask spread for the ticket would still be Even bid at 325. However, the actual dollar amount paid for the spread would be $1,625 (5 x $325) if the trader paid the ask price before commissions and fees.