Beginning commodity traders are often allured by the limited risk involved in long option trading. However, in reality it is the versatility of a combination of long and short options that can make option trading a valuable tool. While there are times in which simply buying a call or put are warranted, such as periods of low volatility and prices at or near long-term extremes, we believe that option trading is more efficient through the execution of multi leg spreads that include both long and short options.
In this article we will demonstrate some of the differences between a long option and a short option strategy. As you will see, the risks, rewards and objectives are highly different. While we tend to prefer short options, or a combination of long and short options, you should consider your risk tolerance and personality type before deciding which strategy fits your needs as a trader.
The nuts and bolts of optionsOptions come in two forms, call options and put options. The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to exercise. The monetary value of the option can be considered an asset, although eroding, to the option buyer and a liability to the seller.
Traders that are comfortable accepting increased levels of risk can write (or sell) options, collecting the premium and taking advantage of the well-known belief that more options expire worthless than not. The cash collected for a short option is immediately credited to the account, but isn’t a realized profit until either the option expires worthless or is bought back for a lesser price than it was originally sold. Keep in mind that it is entirely possible that the option value will increase, and you may be forced to buy the option back at a higher price than you originally sold it for.
Call Options – Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time.
Put Options – Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time.
An option spread is simply the combined purchase or sale of more than one option. As you can imagine, there are a seemingly unlimited number of possibilities. We are only going to brush upon a few, but if you are interested in learning more we teach this and much more free of charge through www.CommodityTradingSchool.com.
Long StrangleBuy Out-of-the-money Call
Buy Out-of-the-money Put
A trader that strangles the market is indifferent to the direction, but is anticipating a large move and a corresponding increase in volatility. The idea of making money whether the market goes up or down is desirable for many beginning traders. In their mind there is a fifty/fifty chance of the market going either up or down. If you have both a call and a put, how could you lose?
Well, there is a reason why people don’t simply buy strangles and wait for the market to go either up or down. It is not that easy. The odds are stacked grossly against the position. While it is true that the trade is directionless and has the potential to make money regardless of the path that the market takes, it is highly unlikely that the market will move enough to cover the original cost of the trade.
In order for a strangle to be profitable at option expiration, the underlying futures market would have to move enough to overcome the premium paid for both the put and the call (don’t forget about commissions) in the time period allotted. A market’s tendency to stay range-bound makes a move of this magnitude difficult to attain. The chart below visualizes the type of move necessary to return a profit to a strangle buyer.
To determine the break even points of a long strangle you simply take the strike prices and add or subtract the total premium paid. If the market rallies your break even on the strangle will be the strike price of the call option plus the premium paid for both the call and the put options. If the market is heading lower, the break even is the strike price of the long put minus the premium paid for both the long call and the long put.
A strangle holder will lose less for every tic the market makes beyond their strike price but before their break even point. Remember, in a long option strategy your maximum risk is what you pay for the options. Using the example above, if the price of May Corn was at $4.00 at the time of expiration, the trader would be in a losing trade, but it wouldn’t be the maximum loss of 25 cents, or the amount of premium paid for both the call and the put. Instead, the trader would lose the amount of total premium paid minus the intrinsic value (how far in-the-money the option is). In this case it would be 15 cents, or $750 (25 cents paid – 10 cents intrinsic value = 15 cents x $50 = $750).
In its simplest form, the trade results in the maximum loss unless the market is above or below the strike price of the long options. From that point, the trader loses less as the market approaches the break even point. Beyond the breakeven point, the trader is profitable. Short Strangle
Sell Out-of-the-money Call
Sell Out-of-the-money Put
The risk and reward profile of a short strangle is exactly opposite of the long strangle. Plainly put, if the buyer of the strangle is profitable the seller is experiencing a loss and vice versa. Accordingly, where the long option strangle position has a break even point as calculated as the strike price plus or minus the premium paid, the seller has a reverse break even calculated by adding or subtracting the premium collected. In other words, the BE and the RBE will be the same figure for the buyer and the seller, but the profit zones will be opposite of each other. The buyer makes money if the market trades beyond their BE, the seller makes money if the market trades between the RBE.
In this case, we are selling a corn strangle (short call and short put) for a total premium of 25 cents. If you recall, the $4.50 call had a premium of 10 cents and the $4.10 put was going for 15 cents. Of course, for the sake of simplicity, this example is hypothetical and doesn’t account for the bid / ask spread that the floor broker receives. A more realistic example would be a spread that can be bought for 25 cents could be sold for 24 cents.
To calculate the reverse break even points for the trade, you simply add the total amount of premium collected (25 cents) to the strike price of the short call, and subtract the total amount of premium collected from the strike price of the short put. This creates a trade that is profitable anywhere between $4.75 ($4.50 + .25) and $3.85 ($4.10 - .25) before commissions and fees. Between these two points, the trader receives a limited profit, however the maximum profit only occurs if the market is trading between the strike prices of the strangle at expiration.
Beyond the RBE’s of the trade, the position is exposed to theoretically unlimited losses. Thus, if the market drops below $3.85 before or at expiration, the position behaves similarly to a futures contract in that the risk is unlimited and the delta value is increased. Once again, the delta value of an at-the-money option is .50, so as the option becomes deeper in the money the delta value increases accordingly, but will never surpass the delta value of a futures contract, 1. So a deep in-the-money option is similar to holding a futures position in terms of risk and price fluctuation.
The maximum profit of 25 cents occurs if the underlying futures contract is trading between $4.50 and $4.10 at expiration. Beyond the strike prices at expiration, the trader is giving back “profits”, or the premium collected, until they run out 25 cents above or below the strike price at the corresponding RBE. Between the strike price and the RBE, the trader is profitable but as the underlying futures contract gets farther beyond the strike price the profit is decreased tic for tic.
For example, if the underlying futures contract was at $4.60 at expiration, the trade would be profitable by 15 cents before commission and fees. This is calculated by taking the difference between the strike price and the market, 10 cents, and subtracting that from the total premium collected, 25 cents (($4.60 - $4.50) - .25 = .15). Likewise, if the contract was at $4.70 at expiration the trade would only be profitable by 5 cents before commission and fees.
In our opinion, the decision between a long strangle and a short strangle depend on market characteristics and conditions. However, not all traders are monetarily and psychologically equipped to cope with the potential of theoretically unlimited risk.
We are often asked which is the best trading, but the answer that we give frequently disappoints. The best strategy for you is the one that meets your objectives in terms of risk and reward and allows you to sleep soundly at night.
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