Sometimes life hands us unexpected opportunities, like getting selected to shoot a basketball from half court for a $10,000 prize. You only need two qualifications: get selected and make the basket. Everyone likes to get a bonus; traders are no exception.
The bonus trade was discovered after decades of option trading and testing. It is a secondary chance to increase a profitable trade or turn a losing trade into a winner. On occasion, this profit can be substantial. This trade works with options on futures, stocks or exchange-traded funds (ETF).
The first part of the trade involves owning a long option contract. This strategy works with either puts or calls. There are many reasons to have a long option position. The trader could have bought the option in hopes of a directional move, but there are other scenarios as to why a trader would be long an option. They may have bought puts as insurance for a long-only portfolio. This is common for equity funds. They are long stocks and will buy puts as insurance against a down move.
There are also spread scenarios: Calendar spreads, credit spreads, debit spreads, ratio spreads, butterflies, iron condors, etc. Each of these option strategies is used for a specific purpose and involves at least one element that is long an option. When these positions are being rolled off, a bonus trade opportunity presents itself.
The bonus trade is a two-step process: own an option, and then simply engage the underlying futures or equity. Most times, because the option is way in-the-money, the trade will put you in a near Delta-neutral position.
Options have several components that are referred to as the “Greeks.” The mathematical model for options is based on calculations of the Greeks and traders need to understand how they work (see “Why options move,” below).
Here, we use examples from options on futures, but the bonus trade will also work with options on equities and ETFs. The bonus trade involves owning an in-the-money option.
A Crude Bonus
A trader placed a crude oil futures call debit spread in October 2015. The trader bought the 47.00 November call and sold the 48.00 November call. The 47 calls were bought for 66¢ and the 48 calls were sold for 44¢, creating a net debit of 22¢ (-$220/contract). This was the max risk.
By Oct. 9, 015 crude oil futures had moved to $49.67 per barrel. The 47 calls were now worth $2.85 and the 48 calls $2.04. If exited on Oct. 9, the result would have been a $590 profit (81-22= 59 or $590) on the trade, not including commissions. But instead of rolling out of the long call, it was time to engage a bonus trade. The call had 18¢ of time value. This can be calculated by adding the $2.85 premium in the call to $47, which equals $49.85 and subtract the futures price ($49.85-$49.67 = 18¢). This would be the entire risk on the bonus trade. To engage the bonus trade the trader exited out of the short 48 calls, leaving a long 47 call position. Next the trader shorted the underlying futures at $49.67 (see “Squeezing extra profit,” below).
The safety aspect of this trade is that if November crude oil kept rising, the risk on the trade is actually the miniscule time value on the call. If the market rallied the in-the-money call value will move 1 to 1 with the short futures. In this case there was 18¢ of time value. If the price rose to $100 the cost would still be 18¢ (see below).
Futures: 49.67 – 100.00 = -50.33
Option: 100.00 – 47.00 (strike price) =
53.00 – 2.85 (cost of the option) = 50.15
50.15 – 50.33 = -0.18
From a Delta perspective, the bonus trade starts off as a near Delta neutral trade. Remember, Delta is a measurement of how much the option will change in price for a change in the underlying. A long futures position has a Delta of +1.0 because for every 1.0 point move in the underlying futures contract, the options contract moves 1.0 point. A short futures position has a Delta of -1.0. For every point in a down move the option will move -1.0. This seems redundant, but is important when trying to understand options.
In the case of this trade, the short futures has a Delta of -1.0. The 47.00 call has a Delta of 0.99. Therefore the position is at a Delta of -1.0. A Delta of +/- 0.5 is what the bonus trade is looking for. The trade is almost Delta neutral with a lot of upside potential. The 18¢ is the time value when we got into the trade. So, even if crude oil rose above $50 in a short period, the risk is still just the time value.
Now the reward portion is twofold. Let’s say the market drops to $47, which is our call strike. The call would then have a Delta of 0.50; the futures are still at a Delta of -1.0. The position would then have a Delta of -0.50. Since we are short the futures, this turns into a profitable trade. The next trading day, Monday Oct. 12, the November crude futures closed at $47.09. The 47.00 call is now worth 84¢. The volatility is at 48% and the Delta is 0.5273. This has turned a -1.0 Delta to a -0.4727 Delta. Because the trader is short the futures at $49.67, this is a really good one-day event. The profit on the futures is $2,580 ($49.67 – $47.09 = $2.58, $2,580 on a 1,000-barrel contract). The option has dropped in value from $2.85 to 84¢. We exited the 48 short call at $2.04 for a net loss of $1.60, and the 47 long call at 84¢for a net profit of 18¢
48 call: Sold @ $2.04; Bought @ 44¢;
P/L = -$1.60
47 call: Sold @84¢; bought @66¢; P/L =
Futures: Short @$49.67; Exit @ $47.09;
2.58 + 18 - 1.60 = 1.16 * $1,000/barrel
= $1,160 - $590 (profit without bonus
trade) = additional $570 in profit
The bonus trade, one day later, with very little risk, added another $570 in profit nearly doubling the total amount made. If the price of crude dropped to say $40, the profit could have been even more pronounced. However, it’s best to exit the trade when the option Delta hits 50%. At this point, the option is all time value.
For long puts the trade works just the opposite. The trader goes long the underlying futures. This trade starts near a Delta neutral position. If the price keeps dropping then the put is a hedge against the futures so there is downside protection. However, if the price rises the Delta difference will become more positive. If the price reaches the put’s strike then there will be a Delta difference around 0.5 with the long futures at +1.0 and the long put at -0.5.
On July 18, 2017, with the September euro currency futures trading at 1.1599, a trader bought a weekly euro 1.1700 put at 131 (131 points in-the-money) with an expiry on July 28. The next day, July 19, the September euro dropped 44 ticks and closed at 1.1555. The option is now worth 162. The gain on the initial trade is 31 full ticks or $387.50 (0.0031 * 125,000 contract size). There are 17 ticks of time value left on the option.
Instead of exiting the trade, the investor decided to place a bonus trade. Since the trader already possessed the long put, they then went long the September euro futures at 1.1555. On July 20, the euro rallies 100+ points and closes at 1.1660. The 1.1700 weekly put is now worth 75. The trade is held to July 21. The euro continues to rally and closes at 1.17135. The futures has gained 158.5 ticks ($1,981.25). The weekly euro 1.1700 put is now worth 39. The option is completely at its all-time value. The trade is exited. The trader lost 123 ticks on the option, but gained 158.5 ticks on the future. That is a net gain of 35.5 ticks or $443.75. The trade risked the initial time value of 17 ticks ($212.50). Therefore the bonus traded added another $231.25 (see “Turning a trade,” below).
When the trader owns a deep in-the-money option, many times there is not enough liquidity to allow the trader to exit at a fair price. Therefore, a bonus trade will lock in a set amount of risk and also give the chance to receive a bonus if the market moves against the option before expiration. The cost is the time value of the option.
The trader doesn’t have to be in an existing long option trade to engage in a bonus trade. You could just buy an option and engage in a bonus trade near expiration. But then again they could just buy an opposite out-of-the-money option. So, instead of owning an in-the-money call option and shorting the futures, you’d just buy a put at the same strike price as the call. Same goes for the long put side. Instead of having an in-the-money put and going long the futures, the trader could buy the out-of-the-money call at the same strike as the put strike price. This would be a synthetic bonus trade. As long as the time value is equal or better than the bonus trade then it would be a synthetic.
The bonus trade works best when you can pick up a long option at a discount. This would actually guarantee a profit even if the market moved sideways or against the futures position.