Option Strategies

In this section, we want to outline some of the options strategies that we like to use from time to time.

Covered Call Writing

David Hall Commodities Futures Trading, Market trading, top trader, trading news

In futures trading, covered call writing, is when you buy a futures contract long, and sell (write), a call option on that same futures contract at the same time.  So, for example, a typical covered call write trade could look like this:

Buy one December Gold at $1046 per ounce and then sell one December Gold ($1050 strike) call option at $30.00 per ounce.  These are actual prices based on 10/9/2009 prices as I wrote this.  The important thing here is to look at all the details of what is possible for this trade.  You want to know what the break even price is for this trade; you want to know what the maximum risk is; you want to know what your potential profit is and then everything in between.  The only time that you know for sure what the answer is to the first three questions above is only at expiration of the option.  Once the option gets to its expiration, there is no time value left.  The option either will have a value or it won’t, at expiration.  The “everything in between” comment before, means that before expiration, you really can only make educated guesses of what any option is worth.  Time value is determined by two things; how many days left until expiration, and how volatile the market is at the time.  The more volatile a particular price is, the more the options will be worth.  The longer time you have until expiration, the more an option will be worth as well.

So, in the case of the above example, here are the answers.  At expiration, which in this case is 45 days, the breakeven is the price you bought at, minus the premium you received.  So, $1046 – $30 = $1016, is your breakeven on this trade, gross. The term “gross” in this case is excluding commissions and other fees.  So, you know that at expiration, if December Gold closes above $1016, you know that you will at least have a gross profit.

Next we want to know what the maximum risk is.  The answer in the example above is that the risk is unlimited minus the call option premium you took in.  So, if gold prices fall and keep falling, especially below $1016 by expiration, you are subject to losing $100 for every dollar per ounce gold drops.  So, you are only protected for the $30 per ounce of option premium you would have received on this trade.

The maximum gain in the example above is calculated by looking at the price you paid for the gold compared to the strike price of the call option that you wrote.  In this example, you would have bought December Gold at $1046 and the short call strike is at $1050.  If December Gold closes above $1050 at expiration, then the short call will automatically be exercised and you will then have a short futures position at $1050, which would immediately offset with your long position at $1046.  That would result in a gross gain of $4.00 per ounce, or $400.  But don’t forget that you also get to keep the call option premium received at the beginning which was $30 per ounce or $3000 gross.  Combine the two totals and your maximum gain potential on this example is $3400.00.

The amount of margin required to do a trade like this will vary over time depending on what margin rate is set by the exchange and in turn your clearing firm.  Some clearing firms require clients to put up more margin money than the exchange requires.  Typically the margin requirement for covered call write trades is somewhat less than an outright margin requirement because your risk is reduced a little by the option premium that you received.

Why do people enter covered call write trades?  There are many reasons and I will write about a few.  Covered call writing reduces your risk somewhat only to the extent of the option premium you receive.  Covered call writing increases your odds of having a successful trade.  For example, if you get into a covered call write trade, and the underlying market you are trading literally moves in a small trading range for an extended period of time, then your futures contract may have no gain, but as time goes on, the option will lose value, thus giving you the gain of the option as your profit.  And finally, we find that most of the time, commodities move in cyclical sideways patterns, so taking in option premium gives you a chance to achieve what might have been your price target without ever actually reaching that target.

The main negative to using covered call writing is that you could be leaving a lot of profit on the table if the market rallies way past your option strike price, but since most of the time the market isn’t in a major move, covered call writing usually makes a lot of sense.  Besides, you can always buy back the short call if you think that a major move is ready to take place.

If you decide to execute a covered put write trade, then you are selling short a futures contract and writing a put option at the same time.  The results here are exactly the opposite of the covered call write.  In this case you are expecting prices to fall rather than rise.

Vertical Call Spreads

Buying a call at one strike price and selling another call of the same expiration date at another strike price.

Here is an example using Corn that trades in 5000 bushel increments.  If you are bullish in corn, and December Corn is trading at $3.62 ¼ per bushel with 40 days left until option expiration, you might do the following trade. Buy one December Corn ($3.65 strike) call option at 17 cents per bushel or $850 gross, and also sell one December Corn ($3.75 strike) call option for 13 cents per bushel or $650 gross.  So in summary, you would be paying out $850 and receiving $650 for a total cost of 4 cents per bushel or $200 gross.  The $200 gross cost is your maximum risk on the trade.  The maximum gain potential on the trade is the difference between the strike prices minus the cost to do the trade.  So the maximum gain would be 10 cents – 4 cents = 6 cents per bushel, or $300 gross profit.  So, vertical call spreads have a limited risk and a limited profit potential. This particular trade is probably not one that we would have entered, but is a good example on how these types of spreads work.  Vertical put spreads work the same, but in exactly the opposite direction.

Horizontal Call Spreads

Buying a call option at one strike price in one delivery month while simultaneously selling the same strike price call option in another delivery month.

For example, using corn again, you might be long term bullish in corn but near term expect prices to meander.  This could be a way to create a cheaper long term trade.  You could sell the December Corn ($3.70 strike) call option for 15 cents per bushel or $750 gross, and buy the March Corn ($3.70 strike) call option for 31 cents per bushel or $1550 gross.  The total combined cost of this trade is $800 gross.  In this trade, you are expecting corn to meander around for the next 40 days in the hopes that the short December call expires worthless, thus keeping the 15 cents paid up front and then letting the March call run free afterward on the expectation that prices will eventually rally.  Horizontal put spreads work the same but exactly in opposite direction.

Diagonal Call Spread

Is buying and selling any combination of calls of different strike prices and different expiration dates.

For example, using corn once again, you might still be long term bullish in corn but want to arrange the strike prices in a different way.  You might want to sell one December Corn ($3.70 strike) call option for 15 cents per bushel, or $750 gross, and buy one March Corn ($4.20 strike) call option for 15 cents per bushel, or $750 gross.  The total cost of this trade would be zero dollars gross.  In this trade, if December Corn meanders around for the next 40 days and expires worthless, then your March call option is now a free trade.  So if corn then rallies sharply, your March option has a chance to make you some money for no gross risk once the December option has expired worthless.  Diagonal put spreads work the same but in the opposite direction.