In October 2003, crude oil staged an almost perfect bull market rally from just less than $30 that ended in July 2008 at $147. It only took five months later to revisit $31.
The high on Aug. 6, 2009 in the December contract, $76.87, is close to the yearly high and the $77 level ($75 front month) has been tested several times during the last three months. That level also capped the rally in 2006 and could not be hurdled until October 2007. The “line in the sand” or bracket horizontal line appears to be $77. What stands out the most is the current head and shoulders bottom formation with $77 being the neckline.
If you wanted to be a seller against the neckline, you would want to be able to control risk, because if December crude oil closed above $77 that would be friendly, and a close or two above $80 would confirm a new bull market.
For markets as volatile as crude oil, it is best to use known risk strategies. There is no need to become emotional or be forced to exit your trade before you decide whether your market projections are still valid.
The high cost of buying an outright call or put option on most markets makes ownership quite expensive and in most cases a bad bet unless held for a short period of time. The vertical spread is my first choice in placing a bet on which direction the market will go, but to capture a larger profit on a bigger move, the vertical spread becomes expensive as well.
The next strategy to look at is the butterfly spread. The fly spread gives you the right to be long the same strike price as the outright option, but lowers the cost significantly.
The ultimate goal of this spread is to forecast where the market will be at expiration. If correct, the reward is great; if partly right, the reward is very good; and if barely right, you still get even money. If wrong, you know exactly what your risk is and the exact amount you will lose.
The simplest way to look at this spread is to understand that it is two vertical spreads. One spread you buy and one spread you sell. Here is one example:
December ‘09 crude oil settled at $74.16 on Aug. 28, 2009, the December options expire on Nov. 17. The December $74 put settled at $6.44 ($6,440 at $10 per $.01), the $64 put settled at $2.72 and the $54 put settled at 93¢.
If you wanted to “buy 1 December butterfly 74-64-54 put spread at 193” (that is how to place the order)
• Buying 1 CLZ9 74 put @$6.44
• Selling 1 CLZ8 64 put @$2.72
On Aug. 28 you would have paid 372 ($3,720) for the 74/64 vertical put spread.
And on the same order you would be:
• Selling 1 CLZ9 64 put @$2.72
• Buying 1 CLZ9 54 put @93¢
You would have sold and collected 179 ticks. Your total cost (not including fees) for the 74/64/54 fly on August 28 is $1,930 (372-179= 193 or $1,930).
This strategy is reflective of the opinion that on expiration, December crude oil will be trading at $64. If correct, you paid $1,930 plus commissions and it is worth $10,000. That is almost a 5:1 risk/reward, and if you use a $,1000 sell stop, a 10:1 risk/reward. If oil settles at $70, it would be worth 400 ticks ($4,000), about 2:1 after paying commissions.
An outright 74 put costs $6.44 ($6,440) and would be purchased because you thought that it could go to $60 or lower for example. If it did indeed go to $60, your profit would be $7,560. You paid $6,440 for a $14 move ($14,000-$6,440= $7,560 profit). About 1:1 risk/reward and it had to go to $60 to get that! The 74/64/54 fly at $60 is worth $6,000 (about 3:1 risk/reward) 74/64 is worth $10,000 credit and 64/54 would be a debit of $4,000 (64 put worth $4,000 and 54 expires worthless: $10,000-$4,000=$6,000. So even with a $14 move, the fly returns better than the outright put. You can figure exactly the outcome at expiration at any price and this is helpful when selecting the strikes you want to use to reflect what you think.
Instead of buying the outright 74 put for 644, or the 74/64 put spread for 372, I can buy the fly spread for 193 ticks plus commissions. At $72.07 you get your 193 ticks back, and if wrong and the market goes up, you lose 193 ticks, instead of 372 or 644. The 74 put has the high cost of time decay working against it, with the vertical spread greatly reducing that cost, and the fly taking most of it away.
With the 74/64/54 fly, the most you can lose is what you paid, and that would happen below $54 or above $74 at expiration. The most you can make would be if the market closed at $64.
If you think you can pinpoint the market, or believe you can be close, you can greatly reduce your risk and greatly improve your reward using the fly.
Howard Tylllas is registered with the CFTC as a floor broker and CTA. He has traded options since their inception. His Web site is www.howardtyllas.com.