From the February 01, 2008 issue of Futures Magazine • Subscribe!

A powerful strategy for energies in 2008

We’ve all witnessed the volatility in the commodity markets in 2007. Major moves in markets such as soybeans, crude oil and equities have reminded us that investing can be a thrill ride, no matter how you are positioned. For option sellers though, times of volatility can be times of great opportunity. Volatility means considerable far-out-of-the-money premiums available for collecting.

Options expire worthless more 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). And, typically, higher-than-average volatility means we may not even have to be that close.

But before we discuss volatility, we should first understand the reasons behind it.


There is no one particular reason for this recent high volatility but rather a plethora of causes. There’s the surging world demand for raw materials, such as oil and the developing substitute of biofuels. There’s the U.S. subprime lending issue that has kept the markets on edge. The effect has been to turn the U.S. dollar into a daily financial yo-yo, which in turn affects prices of everything from silver to cattle. Of course, international tension between the United States and Iran, Russia and China has kept the markets anxious as well, and this likely will continue to provide a volatile backdrop to commodity markets in 2008.

Perhaps just as influential have been the billions of new dollars pouring into managed futures over the last two years. Money under management in this industry is at its highest level. Diversifying traditional equity portfolios into commodities started to become popular in the mid-2000s, and the trend continues. This gives managed futures, or long-only commodity 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 good thing for traders, especially option sellers. However, volatile markets are played best with a flexible strategy; one that can withstand large swings against a position while not causing a nerve testing drawdown in the meantime.


Enter the credit spread. While there are times when selling naked options may be a more efficient strategy (see “Naked but not overexposed,” November 2007), when volatility is extreme it pays to cap your risk. There are many complex, mathematical, delta-neutral arguments available for credit spreads, but the basic concept is not difficult to understand. A credit spread is really just selling an option and using part of the premium collected to buy another option (or options) to protect the short position.

This protection takes two primary forms: 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 expire worthless, the trader’s profit will be the credit.

These are the benefits of the credit spread:

1. Limited downside exposure.

2. Margin stabilization.

3. Staying power in the market.


The vertical spread is a versatile strategy that holds up very well in adverse market conditions. Typically, a trader bullish the market would attempt to write a vertical put spread. A bearish trader would look to write a vertical call spread.

An example will help to better illustrate a vertical put spread. Also called a bull put spread, this vertical put spread is an example only and not necessarily a recommended trade (see “Bull put spread”). The trader is neutral to bullish the crude market. Now, let’s look at the trade itself and the risk involved.

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 a 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 per barrel.

The maximum loss on this trade would be $4,500. That is, the dollar difference between the two strikes ($5 x $1,000 =$5,000), less the 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, you would not necessarily have to (nor would you want to) hold this spread to its maximum loss capacity.

If a trader is bearish a market, he could use this same strategy using call options. Such a strategy would be called a bear call spread.


The primary benefits of the bull put (bear call) spread are threefold. One benefit, of course, is that it allows a trader to have the peace of mind, knowing that his maximum downside is limited.

Second, 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 level, chances are the 75 put would begin increasing rapidly in value. If you were naked a put at this strike price, odds are good that your 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 make 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. Suppose that 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 were successful.

By writing the spread, some traders may believe they are sacrificing premium to buy protection. That’s true, but by buying the protective put, the position evolves from one of unlimited risk to one of finite risk. Therefore, exchanges lower the margin substantially for these types of positions. And, in trading, the percentages can make all the difference. If a trader would have entered the May 2005 crude oil 75/70 bull put spread and filled at the premiums previously listed, the margin would have been 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. The primary drawback of using this approach is that to collect and keep the full premium credit, you 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, 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 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. Thus, the credit between strikes is not worth the risk or is simply too small.

One way to determine whether the risk is worth it is to take the net credit after transaction costs and compare this to the maximum risk on the trade (even if you 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 you 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 to collect a similar premium. However, you must weigh this against the limited risk aspect the spread offers vs. selling naked.

As far as the exit strategy, consider risking a bull put or bear call spread until the first strike goes in the money. A more conservative strategy is to exit the position when the dollar spread between the two strikes doubles from the point it was entered. Managing the risk on this position depends on the personality and risk tolerance of the individual investor.


Credit spreads should be an optimum strategy for trading energy markets in early 2008. The markets experienced unprecedented volatility in 2007, which is still factored into today’s option prices, providing a variety of protected spread opportunities for those willing to do the legwork (see: “More risk”).

Despite this, the current environment might not be just quite right for writing puts on this market. Technical, fundamental and seasonal factors all indicate that this market is due for a correction (note the textbook head and shoulders top formation on the chart in “Bear put spread”). Seasonally, while heating oil stocks still have a bit of catching up to do, crude and unleaded stocks tend to build near year-end as demand fades. Seasonal average stock builds are clear for this time of year, with gasoline stocks tending to build through mid-February. This often has been accompanied by a corresponding price decline to account for the greater supplies.

Still, the market may be setting up for an attractive opportunity for writing put premium on crude or unleaded gasoline by mid-February if seasonal weakness does come into play. The example considered here may look enticing, but a better approach might be to write the 65/60 put spread following any correction. In the meantime, writing vertical call spreads in unleaded gasoline may be a solid shorter-term strategy for traders looking to collect premium on a seasonal decline in unleaded prices.

James Cordier is the founder of Liberty Trading Group and, one of the first futures firms in the United States to specialize in selling options. Michael Gross is an analyst with Liberty Trading Group. They are the authors of The Complete Guide to Option Selling (McGraw-Hill, 2005). They can be reached through their Web site,

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