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

Options: Taking control of a volatile situation

These are indeed volatile times.

While many commodity markets are coming off stupendous highs, few have risen, or have fallen, as far as the energy markets. Crude oil prices fell to levels this winter that were unthinkable last summer — prices that some said we’d never see in this country again — and once we got used to prices below $50, even pushing $30, crude has nearly doubled from those lows despite bearish supply/demand fundamentals. Yet, here we are, with surprising surges in either direction as the global economy searches for direction. As a trader, you should be asking yourself, ‘how do I make money from this?’

Unfortunately, the answer can’t be as straightforward as buy or sell. However, there is one that does involve a bit more work, a tool that traders can always turn to when volatility reigns: options. More specifically, option spreads.

Option spreads involve taking positions in two or more different options with different strikes or expiration dates, either puts or calls. These are immensely flexible positions and can be tailored for almost any goal or risk tolerance.

Here, we’ll build up to a discussion of one particular option spread that lends itself well to the current crude oil market and can serve you in similar times in all markets. First, though, let’s cover some option basics.

An option buyer gains the right to buy (calls) or sell (puts) a set amount of a specific commodity at a specified date in the future, at a specified price (strike price). On the opposite side of the buyer is the option seller (or writer). The option seller collects a premium in advance for selling the rights to the buyer. The size of the premium is set by its intrinsic value, time value and volatility.

Generally, the buyer of a call option is bullish. He or she believes the price of the underlying commodity will rise.

The seller of a call option expects futures prices to remain below the strike price until the expiration of the option. If prices remain stable or drop, the option expires worthless, and the seller does not have to meet the obligations of the contract. The seller has unlimited risk because he is obligated to deliver the underlying at the strike price if it is in-the-money, whereas the buyer’s risk is limited to the premium paid.

Many option sellers also hold a position in the underlying. For example, if the underlying prices fall, selling the call against a long position in the underlying enables the call writer to use the premium as downside protection to the extent of the premium received.

Like the rest of the commodities markets, the price of an option is determined competitively by market forces. Buyers and sellers are constantly active in the market, bidding the premium higher and selling it lower throughout the day.

NEVER ENOUGH TIME

As is true with so many things in life, time never passes at the speed you’d like. When you’re an option seller, the expiration date can’t come soon enough, and when you’re an option buyer, there is never enough time.

As such, time value is an important factor in determining option value. More time to expiration means there is more opportunity for the option to gain in intrinsic value and become profitable to exercise before it expires. Time value is determined by subtracting intrinsic value from the option premium: time value = option premium - intrinsic value.

One attribute of time value to be aware of is it evaporates more quickly the closer you are to expiration. If you are long an option, it slips away even faster right when you might need it most. This factor is important when you begin to build spread positions.

The other two factors on price are intrinsic value and volatility. In-the-money options have intrinsic value. The more an option is in-the-money (the value of the underlying long or short position is greater than the strike), the more it is worth. Out-of-the-money options have no intrinsic value. The further out the strike, the less the option will move based on the movement of the underlying. Premium value is also based on volatility. Higher volatility will equal higher premiums because it is an indication of the likelihood of the option moving in-the-money.

SPREADING YOUR WINGS

The different pieces to an option spread are called the legs. Each leg is made up of a different option and, as such, each leg behaves differently when price in the underlying market changes. In most cases, this means one option will gain while the other option will lose when the underlying market price changes. The spread trader’s goal is that one option leg will profit more than the other leg loses. This is possible because the option positions are not perfectly offsetting. They will have different strikes and/or different expiration dates so they behave differently in response to market dynamics. The key here is for additional legs to offset risk to a greater degree than it limits potential profits.

There are two things we know about current crude oil market dynamics. It is prone to bursts of volatility and prices are significantly lower than they were a year ago. While your own current fundamental analysis may suggest otherwise — the absence of a clear economic recovery certainly lends credence to this point — and your technical view might indicate a better time to initiate this trade, these two factors suggest an option spread that profits from increased volatility and a price recovery may be in order.

Given the above, all else equal, we’d like to find a trade with a bullish bias that will benefit during periods of high volatility, yet still protects us in the case of a further slip in prices. Given current economic uncertainty, we aren’t necessarily looking for a position that depends on higher prices, but we certainly don’t want to establish one that is looking for a price drop considering how low current prices are in the context of recent highs (see “It’s all relative”).

One spread strategy that fits this bill is the diagonal spread. A diagonal call spread involves selling a higher strike call option with an earlier expiration date and buying a lower strike call option with a later expiration date. This is similar to a covered call position with the later expiration date call playing the role of the long position in the underlying.

The hope is prices will rise but fall short of putting the short call in-the-money, while the longer-term, lower-strike call that was purchased will gain more, relatively speaking. The short nearer-term option will lose value due to time decay much quicker, as this effect accelerates as an option approaches expiration. The profit profile for this trade using call options is shown in “Two legs are better than one” (above).

There’s more to this strategy, however. While the ultimate goal is profit, short term we want to be able to pay for the longer-term call by repeatedly selling shorter-term calls against it. With the expiration of each shorter-term option, we hope to be in a position to sell another that will follow its predecessor in expiring worthless.

When you employ options, you give your portfolio another dimension. You have new ways to control your risk and manage your upside. In addition, you often gain more choices as market dynamics change compared with basic long or short positions in the underlying. It’s simply a smarter way to trade.

Kevin Kerr is the editor of Global Commodities Alert at www.kerralert.com and president of Kerr Trading International LLC at www.kerrtrade.com.

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