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Today's Featured Article
Many investors today are curious how options work and how they can be used to potentially make money. First let's look at what an option is. An option is simply the right but not the obligation to buy or sell a futures contract at some pre-determined price at anytime within a specified time period. An option to buy a futures contract is known as a call option, while an option to sell a futures contract is referred to as a put option. The pre-determined futures price at which the futures contract may be bought, for a call, or sold, for a put, is called the strike price. The premium of an option is the value of the option.
Most investors are curious as to whether an option can be exercised before expiration or does the option need to be held till expiration. The option buyer can exercise the option before expiration. He can convert the option into a futures contract at the strike price. An option buyer can also sell the option to someone else. This is what we call offsetting a position. The holder of that option could also do nothing and let the option expire.
Now let's look at a different scenario of trading. Option Selling
. The option seller receives the premium from the option buyer at the time of the trade. An option seller's main goal is to have their option expire worthless and keep the premium they collected or buy the option back for a profit.
In selling options, one does not have to decide where the market is going to go. The seller simply has to decide where he thinks the market is not going to go. He selects a price level above or below the market that he believes the market will not reach within a certain time period. He then sells an option at this price level and collects a premium for doing so. If the time period elapses and the market has not reached this price, the option expires worthless and the investor who sold it keeps the premium he collected as profit.
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For illustration purposes the following are examples of option selling strategies. In the real world commissions & fees would come into play.
1. UNCOVERED WRITING
Uncovered, or naked writing, involves selling a call OR
put without entering into an underlying futures contract. A naked call writer has a neutral to bearish view of a market, while a naked put writer has a neutral to bullish view on a market. In most cases we recommend selling out-of-the-money options. This means selling a call with a strike price that is above the futures price or selling a put with a strike price below the futures price. In either case a dollar amount, or premium, is collected and credited to a client's account. In the case of a short call this premium is retained if, by expiration, the futures has moved lower, stayed the same, or moved higher but not up to the strike price of the call. In the case of a short put the
premium is retained if the futures has moved higher, stayed the same, or moved lower, but not down to the strike price of the put.
Example: March Silver is currently $18.25 an ounce. If you sell a March $24.00 call option for $1,000, on expiration you will keep the $1,000 if the price remains below $24.00
2. THE SHORT STRANGLE
A short strangle is a strategy in which a trader simultaneously sells both an out-of-the money put AND
out of the money call in the same market for the same contract month. This is the optimum strategy for trading sideways markets. All of the premium which is collected upon the initiation of a strangle will be kept if the underlying futures contract is between the strike prices on expiration.
Example: March Silver is currently $18.25 an ounce. Sell a March $24.00 call option and a March $15.00 put option. Both options are at least $3.00 out-of-the-money. Based on current prices if you sell these two options you will collect a total of $2,000. On expiration, you will keep the entire premium if March is above $15.00 and below $24.00.
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3. THE RATIO WRITE
The ratio write is a strategy in which multiple out of the money options are written and one closer to the money option is purchased. This, in effect, creates simultaneous covered and uncovered option positions. Ratio writing involves either selling two or more calls against a long call option position or selling two or more puts against a long put position. Instead of buying an option the same can be done with a long or short futures position. This strategy takes advantage of the fact that option premiums generally do not move dollar-for-dollar with futures prices. In other words, the delta of each option is less than one. This strategy enables the investor to potentially profit with
the long option, and at the same time retain the entire premium if the short options expire worthless.
Example: If June gold is currently trading at $1,143 an ounce then you could sell 4 June gold 1,800 calls at $600 x 4 = $2,400 and then buy one June gold 1,600 call at $1,400. Your initial credit would be $2,400 - $1,400 = $1,000. As long as gold trades below $1,600 at expiration, all options become worthless and the investor would keep the premium. Maximum potential profit is if gold lands at $1,800 on expiration; your profit would be $20,000 on the $1,600 call plus the initial $1,000 credit. Total profit would be $21,000.
4. THE COVERED WRITE
This is a strategy, which combines a futures position with a short option. A covered call write consists of a long futures and a short call; a covered put write consists of a short futures and a short put. Both strategies are used only when an investor expects little volatility in the futures price.
Covered call writes are generally used when an investor thinks the futures will exhibit an upward bias. Covered put writes are used when the investor's outlook is neutral to bearish. In a covered write, profits in the futures position will more than cancel the potential adverse move in the option premium, allowing the investor to earn a profit. If, on the other hand, the futures moves adversely there will be a profit in the short option that might or might not completely offset the loss in the futures. For the covered option writer, then, the ideal market is one in which the price of the underlying market moves in favor of the futures contract.
5. CREDIT SPREADS
Credit spreads are a conservative, lower risk strategy for trading options. Credit spreads are designed to earn a return either monthly or quarterly with pre-determined risk. A credit spread is simply selling a put or a call and buying a further out of the money put or call.
This strategy enables you to hedge an existing portfolio or even trade directionally. However, the most popular method is non-directional, selling a put and a call credit spread, at the same time. My most popular market has been the S&P 500. An example would be selling a February 1220 call and a 970 put. These positions would be protected by buying a 1250 call and a 940 put. With the S&P 500 trading at 1100 a total of $2000 would be collected. If the market on expiration remains between 1220 and 970 the $2,000 is retained. The total risk on the trade if nothing is done and the market exceeds 1250 or falls below 940 is $5,500.
In closing, not all strategies work for all commodities in all situations. A professional broker or trader must take into consideration the current volatility, time to expiration, momentum of the market as well as the percentage out of the money. If the risk reward is appropriate an exit or adjustment strategy should also be established prior to entering any trade.
*** TRADING FUTURES AND OPTIONS INVOLVES RISK. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. TRADE WITH RISK CAPITAL ONLY.
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About the Author
Ken Bronco
is a senior option specialist with Trader's Edge. Ken began his career at Morgan Stanley Dean Witter in 1998. Ken decided to make a career change from stocks to commodities and options in 2003. His main style of trading is selling options and collecting premium using credit spreads to give his clients pre-determined risk. Ken has uninterrupted registration with the National futures Association since 2003. Ken is a Graduate of Frostburg State in Maryland where he earned a degree in business management. While attending Frostburg Ken played football for the Bobcats and was captain of his team senior year. He then went on to receive his master's degree from Sonoma State in northern
California. Ken resides in Morris Township, NJ.
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Special Message from Our Author
Get Your Complimentary Booklet!
For a limited time, Trader's Edge is offering a complimentary booklet, "Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads". John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your complimentary booklet from Trader's Edge now!
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