We’ve all witnessed the volatility in the commodity markets in 2007. Major moves in markets such as Soybeans, Crude Oil and the Stock Market have reminded us that investing can be a thrill ride, no matter where you are positioned. For option sellers, however, times of volatility can be times of opportunity. Volatility means far out of the money premiums available for collecting.
Options expire worthless better than 80% of the time. Option sellers don’t have to be right. For sellers of premium, close enough will do most of the time. Increased volatility means we may not even have to be that close.
Options expire worthless better than 80% of the time. Option sellers don’t have to be right. For sellers of premium, close enough will do most of the time. Increased volatility means we may not even have to be that close.
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But before we discuss volatility, we should first understand the reasons behind it.
There is no one particular reason for this recent volatility but rather a plethora of causes. One could sight the surging world demand for raw materials such as oil and it’s substitute, biofuels. The US “subprime” issue has kept the markets on edge, ever vigilant to predict any new action by the Federal Reserve. This has turned the value of the US dollar into a daily yo-yo – affecting prices of everything from silver to cattle. Of course, international tension between the US and Iran, Russia and China have kept the markets anxious as well, as they will most likely continue to provide a volatile backdrop to commodity markets in 2008.
Perhaps even more influential has been the billions of new dollars pouring into managed futures over the last two years. There are more dollars in managed futures at this time than at any time in history. Diversifying traditional equity portfolios into commodities has become a popular concept in the mid 2000s. This gives managed futures, or funds as they are known in the industry, even more power to push the market up or down (at least temporarily) with a massive volume of buy or sell orders.
As we stated, volatility can be a very good thing for traders, especially option sellers. However, volatile markets are played best with a flexible strategy; one that can withstand large swings against one’s position while not causing a nerve testing drawdown in the meantime.
Enter the credit spread. While there are many complex, mathematical, delta neutral explanations available for credit spreads, the basic concept is not difficult to understand. A credit spread is really just selling an option, and taking part of the premium collected to buy another option or options to protect the position. Two primary ways this “protection” of the short option can be accomplished is by purchasing a more distant strike or by purchasing the same strike in a different month. The premium left over after the purchase of this additional option is called the credit. In other words, the credit is the difference between the short call and the long call. In a credit spread, if both options involved expire worthless, the trader’s profit will be the credit.
What are the benefits of the credit spread?
The benefits are threefold:
1. Limited Downside Exposure
2. Margin Stabilization.
3. Staying power in the Market
The example below will illustrate these benefits.
Trade: The trader sells a May 75.00 crude oil put and collects a premium of $900. He then takes part of the collected premium and buys at May 70.00 put for $400. The net credit of $500 ($900-$400) would be his profit if the options expire with May Crude anywhere above $75.00 per barrel.
Risk: The maximum loss on this trade would be $4500. That is, the dollar difference between the two strikes (5 dollars x $1000 =$5,000), minus net credit collected ($500). This maximum loss however, could only be realized if May Crude futures were below 70 at expiration. The profits from the purchase of the 70 put would cover any losses below that level. While it does provide limited risk, one would not necessarily have to (nor would he want to) hold this spread to it’s maximum loss capacity. Instead, a recommended exit strategy will be described later.
If a trader is bearish a market, he can utilize this same strategy using call options. Thus a bear call spread.
The primary benefits of the bull put (bear call) spread are threefold. First, it allows a trader the peace of mind of knowing his maximum downside.
Secondly, the spread allows a trader tremendous staying power in the market. If May crude began rapidly declining in price and began to approach the 75.00 price level, chances are the 75 put would begin increasing rapidly in value. If one were naked a put at this strike price, odds are good that his risk parameters would be triggered. However, with the covered position, the 70 put would be increasing in value almost as rapidly as the 75 put. Therefore, profits from the long 70 put are making up much of the loss on the 75 put. For this reason, in most cases, a trader can hold the puts in adverse market conditions, up until the time the underlying contract approaches or even slightly exceeds the strike and still exit the position at that time with a controlled and often minimal loss. In other words, a vertical spread is a slower moving trade.
The third and possibly most enticing benefit of writing bull put (or bear call) spreads is the attractive margin treatment it gets from the exchanges. To demonstrate this, suppose in the previous example, the trader sold the 75 put naked and collected a $900 premium. The margin requirement to hold that option at the time was about $3,100. Therefore, not including transaction costs, the return on capital invested would be roughly 29% if the trade is successful.
By writing the spread, some traders may believe they are “sacrificing” premium or somehow accepting less in order to buy protection. Yet, by buying the protective put, the trader converts his position from one of unlimited risk to finite risk. Therefore, the exchange lowers the margin substantially for these types of positions. If a trader would have entered the May 05 Crude Oil 75/70 bull put spread yesterday and filled at the premiums previously listed, the margin on the spread was approximately $850. If the options expire worthless, that’s a 58% return on capital before transaction costs – in what appears to be a much safer trade than selling naked.
Of course, there are drawbacks to any strategy and the bull put spread has some as well. The primary drawback of using this approach is that to collect and keep the full premium credit, one must generally remain in the trade through expiration. This doesn’t sit well with more “active” traders who prefer to trade in and out of the market. Naked option selling holds an edge here because if a trader is immediately right the market and gets a large move in his favor, the naked option position can often be closed out immediately for a profit. However, for the position trader seeking an annual return on his capital, vertical spreads can be an effective tool.
The second drawback to using the bull put (bear call) spread is that it cannot be used in all markets and/or all situations. Some markets may not have the open interest in the desired strikes for establishing such a position, but may be more favorable to naked selling. In addition, there are also occasions where a desirable spread between strikes is simply not available. In other words, the credit between strikes is not worth the risk or is simply too small. We will generally take the net credit after transaction costs and compare this to the maximum risk on the trade (even though we have no intention of holding the position to its maximum loss). If the net credit is greater than 10% of the maximum risk, it may be a viable candidate for this spread. If not, it should probably be discarded in favor of a different strategy.
Another factor a trader may want to consider is that a bear call or bull put spread must often be sold slightly closer to the money than a naked option in order to collect a similar premium. However, one must weigh this against the limited risk aspect the spread offers as opposed to selling naked.
Exit Strategy of OptionSellers: We recommend risking a bull put or bear call spread until the first strike goes in the money. However, a second, more conservative strategy is to exit the position when the dollar spread between the two strikes doubles from the point at which it was entered. How the risk on the position is managed depends on the personality and risk tolerance of the individual investor.
There is no one particular reason for this recent volatility but rather a plethora of causes. One could sight the surging world demand for raw materials such as oil and it’s substitute, biofuels. The US “subprime” issue has kept the markets on edge, ever vigilant to predict any new action by the Federal Reserve. This has turned the value of the US dollar into a daily yo-yo – affecting prices of everything from silver to cattle. Of course, international tension between the US and Iran, Russia and China have kept the markets anxious as well, as they will most likely continue to provide a volatile backdrop to commodity markets in 2008.
Perhaps even more influential has been the billions of new dollars pouring into managed futures over the last two years. There are more dollars in managed futures at this time than at any time in history. Diversifying traditional equity portfolios into commodities has become a popular concept in the mid 2000s. This gives managed futures, or funds as they are known in the industry, even more power to push the market up or down (at least temporarily) with a massive volume of buy or sell orders.
As we stated, volatility can be a very good thing for traders, especially option sellers. However, volatile markets are played best with a flexible strategy; one that can withstand large swings against one’s position while not causing a nerve testing drawdown in the meantime.
Enter the credit spread. While there are many complex, mathematical, delta neutral explanations available for credit spreads, the basic concept is not difficult to understand. A credit spread is really just selling an option, and taking part of the premium collected to buy another option or options to protect the position. Two primary ways this “protection” of the short option can be accomplished is by purchasing a more distant strike or by purchasing the same strike in a different month. The premium left over after the purchase of this additional option is called the credit. In other words, the credit is the difference between the short call and the long call. In a credit spread, if both options involved expire worthless, the trader’s profit will be the credit.
What are the benefits of the credit spread?
The benefits are threefold:
1. Limited Downside Exposure
2. Margin Stabilization.
3. Staying power in the Market
The example below will illustrate these benefits.
Example: The Vertical Put Spread
The vertical spread is a versatile strategy that holds up very well in adverse market conditions. Typically, a trader bullish the market would look to write a vertical put spread. A bearish trader would seek to write a vertical call spread. This example illustrates the vertical put. Also called a bull put spread, this vertical put spread is an example only – not necessarily a recommended trade.
Scenario: A trader is neutral to bullish the crude market.
Trade: The trader sells a May 75.00 crude oil put and collects a premium of $900. He then takes part of the collected premium and buys at May 70.00 put for $400. The net credit of $500 ($900-$400) would be his profit if the options expire with May Crude anywhere above $75.00 per barrel.
Risk: The maximum loss on this trade would be $4500. That is, the dollar difference between the two strikes (5 dollars x $1000 =$5,000), minus net credit collected ($500). This maximum loss however, could only be realized if May Crude futures were below 70 at expiration. The profits from the purchase of the 70 put would cover any losses below that level. While it does provide limited risk, one would not necessarily have to (nor would he want to) hold this spread to it’s maximum loss capacity. Instead, a recommended exit strategy will be described later.
If a trader is bearish a market, he can utilize this same strategy using call options. Thus a bear call spread.
The primary benefits of the bull put (bear call) spread are threefold. First, it allows a trader the peace of mind of knowing his maximum downside.
Secondly, the spread allows a trader tremendous staying power in the market. If May crude began rapidly declining in price and began to approach the 75.00 price level, chances are the 75 put would begin increasing rapidly in value. If one were naked a put at this strike price, odds are good that his risk parameters would be triggered. However, with the covered position, the 70 put would be increasing in value almost as rapidly as the 75 put. Therefore, profits from the long 70 put are making up much of the loss on the 75 put. For this reason, in most cases, a trader can hold the puts in adverse market conditions, up until the time the underlying contract approaches or even slightly exceeds the strike and still exit the position at that time with a controlled and often minimal loss. In other words, a vertical spread is a slower moving trade.
The third and possibly most enticing benefit of writing bull put (or bear call) spreads is the attractive margin treatment it gets from the exchanges. To demonstrate this, suppose in the previous example, the trader sold the 75 put naked and collected a $900 premium. The margin requirement to hold that option at the time was about $3,100. Therefore, not including transaction costs, the return on capital invested would be roughly 29% if the trade is successful.
By writing the spread, some traders may believe they are “sacrificing” premium or somehow accepting less in order to buy protection. Yet, by buying the protective put, the trader converts his position from one of unlimited risk to finite risk. Therefore, the exchange lowers the margin substantially for these types of positions. If a trader would have entered the May 05 Crude Oil 75/70 bull put spread yesterday and filled at the premiums previously listed, the margin on the spread was approximately $850. If the options expire worthless, that’s a 58% return on capital before transaction costs – in what appears to be a much safer trade than selling naked.
Of course, there are drawbacks to any strategy and the bull put spread has some as well. The primary drawback of using this approach is that to collect and keep the full premium credit, one must generally remain in the trade through expiration. This doesn’t sit well with more “active” traders who prefer to trade in and out of the market. Naked option selling holds an edge here because if a trader is immediately right the market and gets a large move in his favor, the naked option position can often be closed out immediately for a profit. However, for the position trader seeking an annual return on his capital, vertical spreads can be an effective tool.
The second drawback to using the bull put (bear call) spread is that it cannot be used in all markets and/or all situations. Some markets may not have the open interest in the desired strikes for establishing such a position, but may be more favorable to naked selling. In addition, there are also occasions where a desirable spread between strikes is simply not available. In other words, the credit between strikes is not worth the risk or is simply too small. We will generally take the net credit after transaction costs and compare this to the maximum risk on the trade (even though we have no intention of holding the position to its maximum loss). If the net credit is greater than 10% of the maximum risk, it may be a viable candidate for this spread. If not, it should probably be discarded in favor of a different strategy.
Another factor a trader may want to consider is that a bear call or bull put spread must often be sold slightly closer to the money than a naked option in order to collect a similar premium. However, one must weigh this against the limited risk aspect the spread offers as opposed to selling naked.
Exit Strategy of OptionSellers: We recommend risking a bull put or bear call spread until the first strike goes in the money. However, a second, more conservative strategy is to exit the position when the dollar spread between the two strikes doubles from the point at which it was entered. How the risk on the position is managed depends on the personality and risk tolerance of the individual investor.
Via: OptionsSellers| by James Cordier, Michael Gross, Liberty Trading Group
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