From the June 01, 2009 issue of Futures Magazine • Subscribe!

Initiating a long-term volatility strategy

Question: How do you take advantage of a major move when you are unsure of the direction and timing of the move?

Answer: Initiate a long-term long volatility strategy.

The premium that you pay for an options contract is comprised of intrinsic value and time value. Intrinsic value is fixed, while time value varies constantly. Implied volatility is the estimated volatility of the price of the underlying that is implied by the current options prices. Those who think that value is too low believe that there will be enough volatility to justify the purchase of an option at that level. Those who sell that option believe that the market will not be as volatile as the current option demand indicates.

The current implied volatility for the at-the-money June options on July corn futures is 0.40. July options have an implied volatility of 0.43 and September options on September corn futures is 0.455. These levels are about double the norm for the past 20 years.

The volatility skew is a condition where implied volatilities vary by strike. A positive skew means that the implied volatility for options increases the further the option is from at the money; a negative skew means that the implied volatility decreases further out. Corn futures currently have a positively skewed implied volatility.

Back to our premise: you believe corn is due for a sharp price movement but can’t detect a direction. The implied volatility for the September options is about 12% higher than the June options and in the July options is about 8% higher than the June options, indicating that the most likely time for movement is in September.

You decide to buy a September corn strangle — buy puts above the market and calls below instead of a straddle (buying a put and call at the same strike).

You apply the same principles of the straddle while buying a put and a call of different strikes. You buy the September 420 call and 430 put. The premium for the 420 call is $0.42625 per bushel ($2,131.25). The premium for the 430 put is $0.46125 ($2,306.25), making the total premium $4,437.50. The upside breakeven point for this position is $5.1125. The downside breakeven point is $3.3375. There is plenty of time for the September futures to move that far in either direction. Remember the premium levels for these options have been at historically high levels for the past year.

You could soften the risk by selling near-term options against your long September options position. Sell the June 420 calls for $0.12625 and the June 410 puts for $0.13375. That adds up to $0.25 or $1,250.

However, you must consider that the underlying security for the June options contract is the July futures. You don’t immediately need to address that issue since the put and call share an equal proximity to the July futures, but if corn moves significantly, either the put or the call would be a candidate for exercise, requiring you to buy or sell the September/July futures spread. You want to have September options spread against September futures. Otherwise you’ll be subject to the expansion and contraction of the September/July time spread.

The second thing to take into account is the time decay. The June options will lose value much more rapidly than the September options that you are long. What started out as a strategy to purchase premium in order to benefit from a sharp movement in corn has morphed into a position that collects premium and needs adjustment from any sharp moves taking place. If you are confident that things will stay quiet for the short term, then you should you should stick to this strategy.

An alternative for you would be to sell a put and a call further out of the money, like the June 440 calls and 390 puts. You would collect less premium to offset the September strangle but it would require less maintenance.

After the June expiration cycle is over, you can decide whether or not you want to sell July or August premium against your position. The September premium will decay more rapidly the following month, so you would need to sell closer-in strikes in order to achieve equilibrium in decay.

When you place options positions, constant adjustments need to be made. It’s best to look at it as a labor of love. All of those adjustments can ensure profit. Who doesn’t love that?

Dan Keegan is an options instructor and head options mentor at

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