Our resident options experts, James Cordier and Michael Gross, answer readers’ questions. Options Corner
Welcome to Options Corner The primary focus of this column is to address readers’ questions and comments relating to options. All levels of questions are welcome and all will receive a response. Given space considerations however, only some will be published. Those that are published will have personal details withheld. We see the column as an area that will be driven by you, our readers, so please feel free to get involved by emailing your questions to Options@YTEmagazine.com.
Q: Commodities have shown some volatile price movements over the past several months. Can you suggest any strategies for selling options in these conditions?
A: There are several good strategies for selling options in volatile markets. One we are currently favouring is the calendar spread.
A calendar spread is selling an option at a certain strike price and then buying an option at the same strike price in a nearer month contract. The difference in premium between the two is the credit the trader keeps as profit if and when the options expire.
Calendar spreads can be an effective tool for capturing the high premiums often offered in volatile markets, while protecting against the instability that can accompany such market conditions. The low margin requirements for such spreads are an added bonus, as they can increase ROI.
December $64 put/October $64 put calendar spread (crude oil)
Net premium (maximum profit) $500 ($800 – $300)
Estimated margin requirement $950
Both options expire with crude oil prices anywhere above $64
The trader sells the December crude oil $64 put for $800, and buys the October crude oil $64 put for $300 – essentially buying the same strike price in different months. The table provides a summary.
Risk management Calendar spreads can often be held even if both options go into the money. However, to avoid your trade getting ‘interesting’, we advise exiting if the premium spread increases by more than 100 per cent from the entry point.
How the calendar works for you If crude oil prices remain above $64 through expiration of the December option, both options will expire worthless. The trader
Calendar spread – December crude oil example A trader neutral to bullish crude oil might sell a December crude oil $64 put on the NYMEX for a premium of $800. If crude oil is anywhere above $64 per barrel at option expiration, the option will expire worthless and the seller will keep the entire premium as profit. To profit, the seller of the put does not necessarily need crude oil prices to rise, they just needs prices to not collapse.
However, while selling naked has potential for delivering profits quickly, it also has potential for the trader to be affected by greater volatility in the short term, so the trader may elect to use a calendar spread instead of writing the option naked.
Using part of the premium they collected when he sold the December $64 put, the trader buys an October crude oil $64 put for $300. They does this for one reason: protection.
Figure 1: December 2011 crude oil (NYMEX)