Commodities Roundup: Selling Strangles to Double Your Premium, Balance Your Risk

James Cordier & Michael Gross, Optionsellers.com
November 15, 2010

“If he shows up some day in a particularly foolish mood, you are free to either ignore him or to take advantage of him, but it will be disastrous if you fall under his influence.”

~ Ben Graham in his famous market allegory about Mr. Market

A core focus of The Complete Guide to Option Selling (2nd Edition, McGraw-Hill, 2009) is pairing the logic of selling option premium with the long term fundamentals of a particular market. While we at Liberty Trading are confident that this is a winning formula for long term success in the option market, it is certainly not the only formula – another key concept of the book. At certain times, there may be other opportunities outside of one’s core fundamental holdings that may offer juicy opportunities for selling options, without necessarily forming a fundamental bias.

While we are the highest proponents of fundamental trading, there are times when selling pure volatility becomes too tempting to pass up.

If Mr. Graham is looking down from somewhere on the strikes the public is buying in some of today’s commodities markets, he must surely be shaking his head and smiling.

A variety of economic conditions, especially in the United States have ushered in an era of unprecedented volatility in a variety of markets. The US Dollar, Coffee, Sugar, Soybeans, Silver and Gold have all proved turbulent markets for investors as of late and have many traders pulling their hair out trying to time their tops and bottoms.

For Option Sellers, however, these are the best of times. Option Sellers want and need volatility and the amount present in today’s markets have many eagerly rubbing their hands together. High volatility means strikes available so far out of the money that they have very little hope of ever being exercised. Consider some of the trades that were available in the commodities markets this week: May Soybean $20.00 calls selling for $875. Soybeans had a nice rally but did anybody believe they would trade nearly 25% above their all time highs into the heart of the Brazilian harvest? May Silver $50.00 calls selling for nearly $1500 at one point last week and yet silver prices never traded north of $29.00 per ounce since the Hunt Brothers. Did anybody think that silver prices were going to increase by nearly 100% within 20 weeks? (Keep in mind that silver prices have already rallied nearly 40% in the past few months)

The answer is no, most people did not. 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 buy high and sell higher – turning a profit. In addition, media attention has 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 will eventually 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 to his position prior to expiration. Thus it may serve an option seller well to utilize a strategy that could help to offset short term increases in the value of his option while he is waiting for it to expire.

In some markets, a strategy known as a strangle can accomplish this. A strangle is a strategy of selling both a put and a call at the same time. 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 can often produce more premium for the seller than selling naked puts or calls, they can also be considered a more conservative strategy, as gains on one side of the strangle tend to offset losses on the other side. This “offsetting” effect allows a wider range of movement in the underlying contract without significantly affecting a trader’s equity. Meanwhile, time value gradually erodes the value of both the put and the call. Strangles are best employed in non-trending markets but can also be utilized in some slower trending markets.

EXAMPLE – Short Option Strangle

Chart 1: May Silver Strangle, 12 Nov 2010

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. As stated earlier, the primary benefit of a strangle is this: if the market is heading towards 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 selling a straight put or call. Both the put and the call will eventually 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" is often true when writing strangles. The margin for writing a strangle is often less than the sum of margin for writing a naked put and the margin for writing the naked call. This concept is illustrated below:

Thus, writing a strangle can not only be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it can also increase an investor’s return on invested funds due to it’s favorable margin treatment among the exchanges.

Like any strategy, strangles have their limitations. The option on the opposite side of the losing option can only balance losses so far. The balancing nature of the strangle, however, will generally allow risk conscious traders to exit gracefully in such an occurrence if they are using the risk management guidelines listed above.

Strangles can be very effective in markets experiencing high volatility. Volatility can often make strikes available on both sides of the market that have little chance of ever going in the money.

Fortunately for sellers of strangles, today’s markets have no shortage of volatility. Look for markets offering the “ridiculous” strikes and don’t be afraid to sell both sides if Mr. Market is in the mood to buy them.

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