A critical component of successful option selling is pairing the logic of selling option premium with the long-term fundamentals of a particular market. While this is a winning formula for extended success in the commodities option market, it certainly is not the only formula. At certain times, there may be other opportunities outside of your core fundamental holdings that may offer profitable opportunities for selling options — without necessarily forming a fundamental bias.
A variety of economic conditions, in the United States and abroad, have created an elevated level of volatility in a variety of markets. The U.S. dollar, coffee, sugar, soybeans, crude oil and gold all have seen their share of extreme price moves in the last six months. It was enough to have futures traders pulling their hair out trying to time the tops and bottoms.
For option sellers, however, these are the best of times; option sellers want and need volatility. The amount present in today’s markets has many eagerly rubbing their hands together, especially with commodity markets seemingly returning to more fundamentally driven price movements. High volatility makes it profitable to sell strikes so far out-of-the-money that they have little hope of ever being exercised.
Way out-of-the-money
While commodity markets appear to be returning to more traditional, fundamentally based price patterns of late, the volatility of the past 12 months remains present in many option values.
In leveraged commodities contracts, this means options available at 50%, 60% even 70% out of the money for option sellers to collect premium. By definition, there is little chance any of these options will ever go in the money. One of the seven secrets of successfully selling options is selling deep out of the money.
But that doesn’t mean that option buyers don’t think they can turn a buck by buying these kinds of options. While there is slim chance these types of options will ever go in the money, there is a chance that they could increase in value in the meantime, meaning the buyer of the option could potentially buy high and sell higher, turning an explosive profit. In addition, volatility and crowd psychology have a way of whipping speculators into a frenzy and ultimately making them do foolish things. Sometimes, this involves buying ridiculously priced options in hopes of securing big gains on the next leg.
The odds, however, are overwhelmingly in favor of the option seller who sells and holds on to these options through expiration. In most cases, time eventually will catch up with the option values and barring some cataclysmic event, erode them to zero, meaning eventual profits to the seller.
The primary risk to the far-out-of-the-money option seller then, is increased values and margin necessary to hold a position prior to expiration. Thus, it may serve an option seller well to use a strategy that could help to offset short-term increases in the value of an option while waiting for it to expire.
Enter the strangle
In some markets, a strategy known as a strangle can help pare the negative effects of short-term increases in an option’s value prior to expiration. A strangle is a strategy of selling both a put and a call at the same time. It is a go-to premium generator for many professional portfolios and likely has a place in yours, as well (see "Benefits of the strangle").
The put is sold far below the current price of the underlying futures and the call is sold far above the current price of the underlying futures. If the futures price is anywhere between the two strike prices at expiration, both options expire worthless and the trader keeps all premium collected as profit. Although strangles often can produce more premium for the seller than selling naked puts or calls, they also can be considered a more conservative strategy, as gains on one side of the strangle tend to offset losses on the other.
This "offsetting" effect allows a wider range of movement in the underlying contract without significantly affecting a trader’s equity. Meanwhile, time gradually erodes the value of both the put and the call. Strangles are best employed in non-trending markets but also can be put to work in some slower-trending markets.
Shorting cotton
Investors in a cotton option strangle can profit as long as cotton prices remain in a wide, predetermined range. "Trade specs" (below) details an example trade, placed on Aug. 15, 2011.
Also known as "bracketing," the strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. The primary benefit of a strangle is this: If the market is heading toward one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market. This offsetting effect allows the market greater flexibility to fluctuate as opposed to selling a straight put or call. Both the put and the call eventually will expire worthless, as long as neither strike price is exceeded.
A secondary benefit is margin. The phrase, "The whole is greater than the sum of its parts," often is true when writing strangles. The margin for writing a strangle often is less than the sum of margin for writing a naked put and the margin for writing the naked call. This concept is illustrated as such:
|
Margin requirement for writing March cotton 160 call: |
$1,230 |
|
Margin requirement for writing March cotton 68 put: |
$965 |
|
Total for writing both options: |
$2,195 |
|
Margin requirement for writing March cotton 160 call 68 put strangle: |
$1,820 |
|
Net margin advantage for the strangle: |
$375 |
Thus, writing a strangle not only can be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it also can increase an investor’s return on invested funds because of its favorable margin treatment by the exchanges.
Limitations & benefits
Strangles have their limitations. The option on the opposite side of the losing option can balance losses only so far. The balancing nature of the strangle generally will allow risk-conscious traders to exit gracefully if they are using the risk-management guidelines listed above.
Strangles are effective in volatile markets. Volatility can add value to strikes on both sides of the market that have little chance of ever going in-the-money.
Today’s markets have no shortage of volatility. Look for markets assigning value to ridiculous strikes, and don’t be afraid to sell both sides.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing in writing commodities options. Michael Gross is an analyst with Liberty. They co-wrote "The Complete Guide to Option Selling," 2nd Edition (McGraw-Hill 2009). More information can be obtained from their website at www.OptionSellers.com.
