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

Profiting in trendless markets

Futures contracts that are relatively trendless invite trades that generate profits from movement in volatility instead of price. Delta-neutral spreads fit this need because typically, at least initially, the assets in the trade offset each other in terms of price changes relative to price movements in the underlying asset. Taking a loss on the trade would require futures prices moving strongly up or down, although the trader may skew the results to reflect a directional bias.

As of May, silver, crude oil, coffee, corn and wheat were in confined trading ranges for a few months.

In the case of corn, however, volatility levels are still elevated on a historical basis, allowing for higher option premiums and more profit opportunity in a delta-neutral trade. Corn futures also are of interest following the market’s response to the swine flu epidemic. In the first few days, lean hog futures absorbed a psychological market reaction that forced a gap down in price. Lean hog futures prices now appear to be moving sideways instead of going lower. This means that corn is probably safe from having a negative reaction to swine flu.

Corn had dropped about 50% from its 2008 high. While no one is talking much about ethanol, there is a degree of demand for corn from the creation of ethanol plants that was not there a few years ago, so there is not a likelihood for corn to drop dramatically further. At the same time, the economy continues to contract and there does not appear to be a significant recovery for another year, so there is not a lot of risk of corn demand spiking higher.

“Delta-neutral trade” shows two spread trades based on shorting calls on September 2009 corn futures against a long corn position. The number of options sold is determined by the reciprocal of the delta value at a particular strike price. Deltas are the slopes of the option price curve relating September calls to the futures contract. For example, on May 1, 2009, September corn futures closed at $4.225. The delta values at the 430 and 520 strike prices were 0.524 and 0.210, respectively.

Delta shows how much the call price will change for each dollar change in the futures. Of course, the slope is only accurate for one point on the option price curve, but it can be used to compute the upper and lower breakeven prices for the delta-neutral hedge at expiration, and the number of calls to sell against each long futures contract.

A call option price curve for September corn on May 1, 2009, was computed on the basis of a sample of option prices when the futures price was $4.225. The strike prices were selected for two reasons: first, their delta values were close enough to 0.5 and 0.2 to allow the number of call options sold to be equal to two and five. Second, the 430 strike is close to the underlying futures, so that selecting this strike would be relatively delta neutral while the 520 strike shows a bearish bias.

At futures prices from $6 to $2.80, separated by intervals of 20¢, profits are calculated by adding the gain or loss on the September futures contract to the change in the predicted values of two calls and five calls sold short, adjusted by adding the original premiums received. For each trade, the maximum profit occurs when the futures contract at expiration in September equals the strike price. At this price, the calls expire valueless, the trader keeps the option premiums, and the futures contract gains the difference between the initial price on May 1 and the price at expiration.

The profit diagram on “Delta-neutral trade” indicates the risk difference between the two trades. The 430 strike puts the breakeven prices at $5.19 and $3.49. The neutral stance places the trade in the approximate center of a spread of $1.70.

The 520 strike hedge with the bearish bias entails more risk. Although the spread between the breakeven prices is larger, from $5.66 to $3.46, a loss occurs much more quickly when the futures price increases.

Along with the higher risk, the trader at the 520 strike looks forward to a higher maximum profit. If the futures price at expiration is $5.20, the profit on the higher strike trade is $8,714, equal to the gain of ($5.20 – $4.22-4) times $50 per penny, or $4,875 for the futures contract, plus $3,839 from the sale of five calls. The maximum profit on the 430 strike trade is $4,002, equal to a gain of $375 on the futures contract and $3,627 from the sale of two calls.

Delta-neutral trades are similar to short option strangles in which a put and call are sold short near the breakeven strike prices. Both trades force the futures market price to move toward breakeven before the trade incurs a loss, and both have unlimited losses beyond the breakeven prices. Higher total premiums from the options sold occur with the delta-neutral trade because the calls are sold at the market.

Paul Cretien is an investment analyst and financial case writer. E-mail him at

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