This article originally appeared in the April 14, 2006 edition of FutureSource FastBreak
You may view it here.
[ Keep in mind that the specific trades referenced in this article are provided as educational examples and are not intended to be investment advice of any kind. For that you need to consult with a market professional who is familiar with, among other things, your investment objectives, your risk tolerance, and your available risk capital. ]
This is Part 1 of a two part article. In this section, we will discuss a couple of useful, but often under-used, option spread strategies. Please keep in mind that these are examples to illustrate a point. They may not be appropriate for all accounts. All trading involves risk of loss, and you should consider that prior to entering any trade.
If you asked me five years ago if we would be talking about $800 gold, I would have said it was unlikely. But during the bull run in gold during the last few years, and especially the last 12 months, it has become increasingly more likely that we will eclipse the old highs. The question then is how can we trade this market?
To take an outright position in the futures is currently a difficult proposition if you are not already long. The average monthly range over the past six months has expanded to $41.60 from just $21.22 during the previous six months. That means for the longer term trader that is looking for that move to $800, you now need to have at least a $4200 stop instead of $2200.
Chart Source: FutureSource
Along with increased volatility comes increased option premium. Due to the extreme bullish sentiment of the market, bullish fundamentals, and bullish technicals, call premium has made option buying outright a difficult trade as well. And I see many starry-eyed inexperienced traders buying far out-of-the-money options that have no chance of performing just because they don’t have the capital to buy strikes that are close-to-the-money. They are swinging for the fences, but are likely to strike out.
Between trading the futures from the long side with too tight of a stop and buying far out-of-the-money calls for cheaper premium, we are seeing a large number of speculators be generally right about the direction of the market, but still end up losing traders. A better way to approach this market then is may be with the use of option spreads. An option spread can get the trader an option position closer to the money for less cost than an outright position, and with a better probability of performing. We will look at a couple of possible option spreads in the Gold futures.
Let’s start with a bull call spread. This position gets us much closer to at-the-money for about the same cost as buying a far out-of-the-money call outright. We still have risk limited to what we pay for the position, just like an outright call, but it gives us a better chance of performing (which is more probable – gold going to 640 or gold going to 680?). The downside is that we give up the unlimited profit potential. But if we calculate our position correctly, that may not be a large factor.
June Gold is currently trading at around $600 per ounce. Options on the June futures expire the end of May (5/25/06 to be exact). That gives us a little more than a month on the June options. If gold continues its current upward momentum, our average monthly range tells us that we may move as high as $640 or as low as $560. Keep this in mind when considering what strikes you are going to look at.
We will look at buying a 620/640 bull call spread. This would mean that we are going to buy the 620 strike for June Gold and sell the 640 strike. Selling the 640 strike brings in some money to help pay for the 620. In exchange for this extra cash, we give up any upside potential beyond $640. But our monthly range tells us that is a reasonable stretch for the market and anything higher would be less probable.
Our maximum gain on this position is now the difference between the two strikes (20 dollars in gold is equal to $2000 per contract) less our net cost for the position (the 620 debit minus the 640 credit). At the time of writing this article, this was a total cost of $470 + commissions. So our maximum gain on this position would be $1530 – commissions. You can see from the accompanying chart that this limited gain area is outside the current average monthly range for the market.
Comparing cost/risk, to spend the same amount on an outright call position, we would have to buy the 640 for $480. To beat the net gain on our call spread, gold would need to be higher than 660 at expiration, and we know that is less likely based on the average monthly range, as you can see from the accompanying chart. Likewise, a $500 stop in the futures would be much too tight. I hope, in comparison, you are beginning to see the power of using option spreads rather than outright positions.
If you are more of “risk taker,” you may be inclined to sell option premium, which in the case of a running bull market like gold would mean selling puts. It is becoming increasingly difficult to find houses that will let you trade naked options and likewise, those positions come with unlimited risk for limited potential gain. However, one could use an option spread to limit the downside risk. Continuing with our gold market example, we will consider selling a 570/550 bull put spread.
A bull put spread, like the bull call spread we just discussed, is for bullish market conditions. However, unlike the bull call spread, this position leaves us with a credit rather a debit (cost). This position is constructed as follows. By selling the June 570 put, we are bringing in premium similar to selling naked options, but we limit our downside risk by buying the June 550 put with some of the premium we brought in on the sale of the 570.
If we sell the 550 put for $530 in premium and take a little of that premium to buy the 570 put for $200, we leave ourselves a net credit of $330. If we are wrong about the market, the most we can lose is the difference between the strikes, less our credit. In this case, the maximum risk is $1670. So for an outlay of $200, we changed an unlimited risk position to a position that has a capped risk. And the 570 strike gets us almost outside the average monthly range of the current market.
In part 2 of this article, we will cover a couple additional strategies and examples. We will also discuss how any of these positions can be flip-flopped for different market outlooks. For example, if you were bearish the gold rather than bullish, you could easily flip our example positions to a bear call spread or and a bear put spread. Also remember that any of these strategies can be used on any market that has listed options.
The risk of loss in trading commodity futures and options can be substantial. Before trading, you should carefully consider your financial position to determine if futures trading is appropriate. When trading futures and/or options, it is possible to lose more than the full value of your account. All funds committed should be risk capital. Past performance is not necessarily indicative of future results.The content of this article is Copyright Ã‚© 2007 by Chad Butler. No part of this article may be reproduced in whole or in part without express written permission of the author.