Commodities Roundup: Writing Options with Limited Risk
James Cordier & Michael Gross, Optionsellers.com
October 26, 2010
Hypothetical Situation: The futures trader has just read yet another article of how selling options can increase the returns in his portfolio. Curious, and somewhat excited, he picks up the phone and calls his broker. “I want to sell options. How would we go about that?”
“Sell Options!?” the broker gasps in disbelief. “Why would you want to do that? Don’t you know that selling options is risky!?” He then puts the investor on hold and calls the floor. “Buy 10 Natural Gas futures at the market!” he barks and then picks up the investor again. “Like I was saying, that’s probably more risk than you want to take.” He never blinks an eye.
This is the rap that option selling has historically received in much of the futures trading community. Many traders and brokers will more than willing trade the underlying stock or futures contract, yet shy away from selling options because of the perceived risk. In reality, selling options carries no more, and often much less risk than trading the actual underlying product. It has only been in the past few years that selling option premium has begun to catch on with individual investors. Unfortunately, the misunderstood risk in option selling has kept many investors from enjoying the fruits that the strategy can provide.
To be sure, option selling does involve risk. What many novice option sellers may not know, is that there are strategies in which one can sell options with absolute limited risk while still benefiting from time deterioration.
Unlike novices, professional traders often design their trading model with risk management as their number one priority. Professionals know that capital preservation is the first objective of any trading plan and generally build the rest of the model around it. Novice traders often get caught up in the favorable success percentages or profit potentials of selling options and may consider risk management as a secondary matter.
Do you want to manage your portfolio like a professional? Employing the strategy below is one such way you can do so.
The Covered Credit Spread
Covered option selling can offer many of the same benefits as selling naked, yet without the unlimited risk that makes many investors squeamish. This is why selling covered options can make an excellent “bread and butter” strategy for the serious option selling portfolio that is focused not on excitement and action, but on a strong annual return.
But what is “covered” option selling? Many people think of a covered position as selling an option and then owning the underlying contract – especially in regard to stocks. However, holding the underlying is only one way to cover an option and not necessarily one we would recommend, at least when trading futures options.
Options can be covered by other options. This can reduce margin and risk and in some cases, totally limit risk to an absolute amount. Yes, you can sell options and have limited risk.
The following covered strategy is one that we recommend as offering strong risk management benefits as well as very favorable SPAN margin requirements while maintaining high returns on funds invested.
The bear call or bull put spread (also known as a vertical spread)
EXAMPLE
Chart 1: MARCH 2011 COFFEE CHART
Bull Put Spread
Scenario: A trader is neutral to bullish the coffee market in November 2010.
Trade: The trader sells a March 1.60 coffee put and collects a premium of $1100. He then takes part of the collected premium and buys a March 1.50 coffee put for $500. The net credit of $600 ($1100-$500) would be his profit if the options expire with March Coffee anywhere above 1.60 per pound at the ICE Exchange in New York.
Risk: The maximum loss on this trade would be $3,150. That is, the dollar difference between the two strikes (10 cents x $3.75 =$3750), minus the net credit collected ($600). This maximum loss would only be realized if March Coffee futures were below 1.50 at expiration. The profits from the purchase of the 1.50 call would cover any losses below that level. While it does provide limited risk, one would not necessarily have to hold this spread to it’s maximum loss capacity (nor would any reasonable trader want to). The spread can be bought back at any time prior to expiration.
If a trader is bearish a market, he can utilize this same strategy using call options. Thus a bear call spread.
Benefits to the Investor
The primary benefits of the bull put (bear call) spread are threefold.
Peace of Mind: It allows a trader to know his worst case loss scenario. In other words, he can sleep at night.
Staying Power: The spread allows a trader tremendous staying power in the market. If March coffee began rapidly declining in price and began to approach the 1.60 price level, chances are the 1.50 put would begin increasing rapidly in value. If one were naked a put at this strike price, odds are good that one of the risk parameters for exiting naked options would be triggered. However, with the covered position, the 1.50 put would be increasing in value almost as rapidly as the 1.60 put. Therefore, profits from the long 1.50 put are making up much of the loss on the 1.60 put. For this reason, in most cases, a trader can hold the puts in adverse market conditions, up until the time the underlying contract approaches or even slightly exceeds the short strike and still exit the position at that time with a controlled or even minimal loss.
High ROI: The third and possibly most enticing benefit of writing bull put (or bear call) spreads is the attractive margin treatment it gets from the exchanges. By writing the spread, some traders may believe they are “sacrificing” premium or somehow accepting less in order to buy protection. Yet, by buying the protective put, the trader converts his position from one of “unlimited” risk to finite risk. Therefore, the exchange lowers the margin substantially for these types of positions. If a trader would have entered the put spread illustrated above at the premiums listed, the margin on the spread was approximately $850. That’s a 70% return on capital. That doesn’t sound like a sacrifice to me.
Drawbacks and Conclusion
Of course, there are drawbacks to any strategy and the bull put spread has some as well. These include the fact that credit spreads must generally be held through or close to expiration before full profit can be realized. In addition, spreads between options can vary based on volatility, meaning that this kind of credit spread is not always a practical alternative.
However, on the whole, a vertical credit spread can offer an alternative tool an investor can use to build a solid, risk conscious portfolio that will enable him to take advantage of the high percentage of options that expire worthless while still sleeping at night.
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group/Optionsellers.com
Optionetics.com ~ Your Options Education Site
