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Written by Carley Garner

An Introduction into the World of Alternative Option Trading

by Carley Garner of DeCarley Trading LLC

There have been many books written on options on futures trading, however I sometimes question the usefulness of the information provided.  It seems as though much of the literature available leaves the reader in a state of confusion; perhaps a majority of the bewilderment stems from the fact that most option theory is based on stock option trading and the transition to commodities isn't without its hitches. In my opinion, the practice of repackaging stock option trading strategy and theory in an attempt to appeal to and educate commodity traders can be misleading.  Additionally, there are large differences between option theory and option trading.  Some of what looks good on paper is difficult to execute efficiently in the real world, this is especially true in the world of commodity option trading.

It is a false assumption to believe that an “option is an option”.  They may be spelled the same, but they are vastly different due to the nature of the underlying vehicles.  As a result options on commodities take on completely different characteristics.  After all, everybody agrees that trading stocks is poles apart from trading futures. Why would anybody believe that trading options on stocks is synonymous with trading options on futures? 

Years of witnessing the perils of a long option only strategy led to my disappointment and pessimism in regards to a strictly option buying approach to the markets.  Time decay and the tendency of markets to stay range bound work strongly against the odds of consistent profits with such a strategy. 

As you read this article, please keep in mind that this is simply an introduction to the alternative option strategies available to those willing to move away from the conventional practice of simply buying a put or a call.  The beauty of option spreads is the flexibility and unlimited ratios of risk and reward that can be constructed by creative traders.  We hope that the trading methods in this article were written in a way that is meant to be easily understood and even more importantly easy to employ, but expect that you will have many questions and will be more than happy to answer any that you may have.  We can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

The Basics - How Options Work

There are two types of options, a call option and a put option. Understanding what each of these are and how they work will help you determine when to use them.  The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to exercise.  This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller. 

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.

·         Buyers face risk limited to the amount of premium paid plus transaction costs and unlimited profit potential

·         Sellers face unlimited risk beyond the strike price of the option and profit potential limited to the amount of premium collected minus transaction costs

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.

·         Buyers face risk limited to the amount of premium paid plus transaction costs and unlimited profit potential

·         Sellers face unlimited risk beyond the strike price of the option and profit potential limited to the amount of premium collected minus transaction costs

Traders that are willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known fact that more options expire worthless than not.  The premium collected by a seller is seen as a liability until it is either offset by buying it back, or it expires.  This is important, many beginning option sellers assume that because they receive the cash up front and they can see the amount of collected premium added to the ledger balance on their account statement, that it is somehow theirs.  Until the position is closed, the only thing that is certain is that there is risk on the table and the trade should be treated accordingly; this is the case regardless of the amount of money collected for the option or the amount of any open profit associated with the option.

	Call (Bullish)	Put (Bearish)
Buy			Limited Risk
Sell			Unlimited Risk

Short Call Option

Sell an Out-of-the-money Call Option

By nature, options are a depreciating asset.  Just as a new car buyer will find that the value of their purchase diminishes once the automobile is driven off of the seller’s lot, an option buyer will find that the time value of their long option erodes with every passing minute.

Nonetheless, traders continue to be lured into long option strategies. This is likely due to the fact that purchasing an option provides traders with unlimited profit potential and the risk is limited to the premium paid.  The peril in this type of approach, as mentioned before, lies in the fact that although one’s losses are limited it is likely that an option buyer will lose some or all of the value of the option. 

Selling call options is a bearish strategy.  Unlike buyers of call options, sellers believe that the market will decline in the opposite direction of the strike price or at least be below the stated strike price at the time of execution. 

I am of the opinion that option sellers should initiate positions on a day in which the market is going against the soon to be position.  Doing so may translate into a higher premium collection and  accordingly create a scenario in which there is more room for error in terms of the futures price relative to the short call strike price.  For example, Call options should only be sold during times of elevated market prices and relatively inflated volatility.  This could mean that the market is approaching the top of a trading range, or simply overbought.  While doing so seems somewhat irrational, it can be justified in the fact that the premium collected will be greater as well as the odds of a correction. 

Why Sell Call Options? 

1. If you believe that the market is going down, bearish
2. The strength of your belief determines what strike prices you should sell
3. Sell out-of-the-money options (higher strike prices). If you believe prices are not going up
4. Sell at-the-money options (at current price). If you strongly believe prices are not going up (this is not a recommended strategy)

Short Call Option Profit Profile 

1. The potential profit is limited to the premium collected
2. Your reverse breakeven point at expiration equals strike price plus the premium collected
3. Reverse Break Even = Strike Price + Premium Collected
4. The maximum profit occurs if the market is below the strike price at expiration

What is at Stake?

1. Exposes trader to unlimited risk; thus, these positions need to be watched closely
2. Your losses increase if the market rises faster (increased volatility) than the time decay erodes the option value
3. The market trading above the reverse breakeven is equivalent to being short the futures contract
4. At expiration your losses increase by one point for each point market moves above the reverse breakeven point

Short Call Option Trading Example 

This trade was recommended on The Stock Index Report written by myself and published daily by DeCarley Trading on August 8th. While the recommendation was aimed at those trading the full sized S&P, an e-mini trader could have executed a similar trade with less profit potential and less inherent risk. 

The original recommendation called for traders to sell the September S&P 500 1390 call option for $4 in premium or better ($4 in premium is equivalent to $1,000) and would have been filled on the 11th of August at or near the premium requested.  In this hypothetical example, we will use a value of $4.2 simply because that is the Black and Sholes value assigned by our charting software. 

In figure 1, you can see that although the order was placed on the 8th of August, it took a substantial rally in order to get filled.  Patience such as this can lead to missing trades but will also help you to avoid premature entry and potential disaster should the market see a spike in volatility. 

Figure  1

This particular trade creates a scenario in which there is a great deal of risk, in fact unlimited risk, above the RBE of the short option.  In this case, the RBE is 1394.2 and was calculated by adding the premium collected to the strike price of the short call option.  Keep in mind that transaction costs would reduce the amount of premium collected and shift the RBE and risk closer to the market.  The amount of premium collected represents the cushion, or the amount in which the trader can be wrong in their speculation that the futures price will be below the strike price at expiration before the trade results in a loss.

The maximum profit is equivalent to the premium collected ($4.2 or $1,050) minus any commissions and fees paid and occurs if the futures price is trading below 1390 at expiration.  However, the profit zone of this trade, or where this trades money at expiration, is impressive.  This is visually displayed in Figure 2.

Assuming that this short option is held until expiration and it was possible to sell the 1390 call for $4.20 ($1,050 for a full sized contract or $210 for a mini) in premium, it would be profitable with the price of the futures market at any point below the RBE of 1394.2 before considering transaction costs.  In other words, the only way for this position to be a loser at expiration is for the futures price to be above the RBE.  

It is important to note that although the position is still profitable in between the strike price of the short call and the RBE, the amount of the profit diminishes every tick that the market is trading above the strike price.  Once the market surpasses the strike price, it is equivalent to being short a futures contract and exposes the trader to theoretically unlimited risk.

Figure 2 

It is easy to see that a short option strategy if implemented effectively can provide traders with an edge over the alternative.  In this particular example, the futures price was over 80 full handles away from the strike price of the short call.  The distance from the market and the amount of premium collected provides the position with plenty of room for error.  After all, I am not perfect and I assume that you aren't either.

What you should also know is that without proper risk management knowledge and instinct, what looks to be a great strategy can turn into disaster.  This is due to the fact that option selling involves unlimited risk and limited profit potential.  It is imperative that short option positions are monitored closely, additionally if you aren't ready for the responsibility and risk involved you should be working with a full service broker familiar with short option trading.  Although more options than not expire worthless putting the odds in your favor with short option trading doesn't produce automatic success.  It is critical that risk on the losing trades is properly mitigated before the damage gets out of hand.  This is where an experienced broker may come in handy. 

Short Put Option

Sell an Out-of-the-money Put

When to Sell Put Options? 

1. If you believe the market is going up (bullish)
2. The strength of your belief determines what strike prices you look to sell
3. Sell out-of-the-money options (lower strike prices). If you believe prices are not going down
4. Sell at-the-money option (at current price). If you strongly believe prices are not going down (this is not a recommended strategy)

Short Put Option Profit Profile 

1. Your profit potential is limited to premium collected minus commissions
2. The reverse break even at expiration is equal to the strike price minus the premium collected
3. Reverse Break Even = Strike Price - Premium Collected
4. Maximum profit occurs if the market is above the strike price at expiration

What is at Stake? 

1. Exposes trader to unlimited risk; thus, these positions need to be watched closely
2. Your losses increase if the market drops faster (increased volatility) than the time decay erodes the option value
3. The market trading below the reverse breakeven point is equal to being long the futures contract.
4. At expiration your losses increase by one point for each point market is below the reverse breakeven

Short Put Option Trading Example 

In the last week of June 2006, the Euro had just completed a 61.8% retracement to create a good opportunity for put selling.  Remember, premium collection works best when you are selling against the wave not with the wave.  For example, you wouldn’t want to sell a put option as the market is rallying.

According to Black and Scholes theoretical option pricing, a trader could have sold a September 124.00 put for 90 points or $1125 before transaction costs.  Thus, $1085, assuming a $40 commission rate, is the maximum profit on the trade and occurs if the market is trading above 124 at the time of option expiration. 

The reverse break even on this trade would be 123.10 (124.00 - .90) providing the market plenty of breathing room.  Anything above this point returns a profit; any point below is like being long a futures contract.

Figure 3

Long Option Strangle

Buy Out-of-the-money Call

Buy Out-of-the-money Put

When to Buy an Option Strangle? 

1. When the market is range bound and you expect it to break out by making a large move but the direction is difficult to predict
2. Similar to a straddle but a generally less expensive strategy to implement; however, it should also be done during times of relatively low volatility and premium

Long Option Strangle Profit Profile 

1. The profit potential is unlimited in either direction.
2. The break-even point at expiration is equal to the strike price plus or minus the net cost of the spread plus or minus the transaction costs

BE on Call Side = Strike Price + Premium Paid +Transaction Costs

BE on Put Side = Strike Price – Premium Paid – Transaction Costs   

What is at Stake? 

1. Risk is limited to the amount paid for the position plus the transaction costs
2. Maximum loss is realized if at expiration the market is trading between the strike price of the put and the call.

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.

Figure 4

Long strangles require a substantial market move just to break even.  This leaves the odds of success on this type of strategy to be less than desirable in most instances.

A strangle holder will lose less for every tic the market makes beyond their strike price but before their breakeven 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 breakeven point.  Beyond the breakeven point, the trader is profitable. 

Figure 5

Short Option Strangle

Sell Out-of-the-money Call

Sell Out-of-the-money Put

When to Sell an Option Strangles? 

1. When the market is range bound and you expect it to stay in the range or fail  to make a large move before expiration
2. Similar to a straddle but you will collect less premium by selling out-of-the-money options.  A short strangle offers a wider margin of error

Short Option Strangle Profit Profile 

1. The profit potential is limited to the premium collected minus the transaction costs
2. Maximum profit is realized if the market at expiration is trading between the sold strike prices
3. The reverse break-even point at expiration is equal to the strike price plus or minus the premium collected for the spread plus or minus the transaction costs

RBE on Call Side = Strike Price + Premium Collected – Transaction Costs 

RBE on Put Side = Strike Price - Premium Collected + Transaction Costs 

What is at Stake? 

1. Risk is unlimited in either direction
2. The market trading above the sold call or below the sold put is equivalent to being on the wrong side of the futures contract
3. Having unlimited risk on both sides these positions need to be watched very carefully

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.

Figure 6

The Reverse Break Even is calculated by adding the total premium collected to the call strike price and subtracting the total premium from the put strike price.

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. 

Figure 7

A Strangle writer makes money anywhere between the RBE's, but makes less in between the strike price and the RBE.

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. 

Swing Trading Commodities with Options

Being privy to the options and futures markets along with trial and error has nurtured a respect and an depth understanding of the markets.  I hope that our readers will allow themselves to step out of the box when it comes to option trading and look toward the potential of trading aggressive option spreads.

Markets spend most of their time trading in a defined range; this makes profiting on long option strategies very difficult.  Additionally, according to studies conducted by the CME, more options expire worthless than not.  For these reasons a strict long option only tactic seems to have dismal odds.   After all a long option play requires that the market make a substantial move in order to turn a profit to the trader and a range bound futures market likely won't deliver. 

Within every trading range, there are brief trends in which some traders may look to profit from by buying or selling futures contracts;  this practice is often referred to as 'swing trading'.  What most people don’t realize is that you can profit from a range bound market by using a combination of long and short option and futures. 

Swing Traders are not looking to predict the overall direction of the market or to hold a bullish or bearish bias. Instead, the goal is to simply profit from the natural ebb and flow of the market.  In other words, swing traders attempt to capitalize on both the trending and retracement phases of the market.  The theory of swing trading is based on the assumption that all upward action must result in a corrective period, or vice versa.

While a swing trading strategy most often involves outright futures trading, I believe that option spread trading provides traders with a vehicle that is capable of mitigating some of the market's volatility relative to going long or short a futures contract.  I argue that doing so allows more room for error should the market speculation be off in terms of direction or timing.  An option spread affords traders with the luxury of having some room for error.   Take into account that once a futures position is executed, the trader is immediately exposed to unlimited risk and the profit and loss incurred becomes a reality.

We will show you an alternative to futures trading that slows the pace of profit and loss but is capable of returning a respectable profit should the circumstances fit.  Hopefully as we cover an example this concept will become clearer.Naturally, if something seems too good to be true there will be a catch.  The disadvantage of swing trading with options as opposed to futures contracts is the fact that the profit potential is often limited, but this depends on the structure of the trade.  With the exception of synthetic long options, most of the examples that we are about to cover does entail limited profit potential and unlimited risk. 

Another negative aspect of aggressive option spread trading is the inability to actively trade in and out of a position.  The inability stems from the difficulty of overcoming transaction costs in the form of commission and the bid/ask spread paid to the executing broker.  Additionally, short options can sometimes "get in the way" of your profitable long options. For  example, a trader that is long a call but also short a call with a distant strike price may find that the gains made on the long call are being nearly entirely offset with losses on the short call at any time prior to expiration.    

Yet, these drawbacks shouldn’t discourage you from employing such a strategy.  As you delve into this type of trading further,  you will see that the same short option that limits your profit potential when things go right will cushion the blow when things go wrong.  I strongly believe that if constructed properly and careful consideration is given to measures of volatility, a swing trading strategy using options provides traders with an aggressive vehicle that debatably provides better odds of success to a trader than an outright futures position. 

Bull Call Spread with a Naked Leg

Buy a Close-to-the-money Call

Sell an Out-of-the-money Call

Sell an Out-of-the-money Put

When to Use a Bull Call Spread with a Naked Short Put Option?

1. You think the market will go up, but purchasing a near-the-money call option outright is expensive
2. The goal is to produce a very inexpensive, or even free trade. A free trade occurs when you collect enough premium on the short legs of the spread to overcome most or all of the premium paid for the long legs.  Keep in mind that the term free does not imply that there are no transactions costs, margin, or risk.

Bull Call Spread with a Naked Leg Profit Profile

1. Profit is limited to the difference between the strike prices of the long and short call plus a net premium collected if executed as a credit or minus a net premium paid if executed as a debit
2. At expiration the breakeven is equal to the long call strike price plus the net amount paid for the spread plus the transaction costs paid if executed as a debit

BE = Long Strike Price + Net Premium Paid (if a debit) + Commissions and Fees

RBE = Short Put Strike Price - Net Premium Collected (if a credit) + Commissions and Fees

What is the Risk?

1. Risk on the downside (short put) is theoretically unlimited
2. The market trading below the short put is equal to being long the futures from the put strike price
3. At expiration if the market is between the short put and long call you lose the net paid for the spread if it was executed at a debit.  If it was executed as a credit, the trader keeps the premium collected

Bull Call Spread with a Naked Short Put Example

In this example we are looking at a July silver chart.  We have already identified two things.  For one; the market is in an uptrend (duh) and even more importantly; it is going up in a recognizable Fibonacci pattern.  However, on closer inspection we see that the daily swings from high to low are in the thousand dollar plus range per position.  In fact, the price of silver had recently dropped a dollar (a $5,000 profit or loss for anyone holding a futures contract) in a matter of days.  You can see that the market was experiencing extreme volatility on a daily basis.  In other words, the waves are great for surfing but the water is full of sharks.

Although a pattern has been identified and it seems as though this is an opportune time to jump in, a long futures contract would require an extremely deep stop loss.  In fact, a trader would have to place a sell stop about 40 cents below the current price in order to give himself a chance to survive the daily market swings.  This is a risk of $2000 in a market in which we are seeing 40 cent moves in relatively short periods of time…the probabilities of being profitable in such a venture aren't promising.

Due to the extreme uncertainty in the marketplace and the inherent risks of trading with outright futures contracts, this is the perfect opportunity to use an aggressive option spread.  In this case it is a bull call spread with a naked leg.  According to the information available to us, an opportune structured trade seems to be buying the 875 call and selling the 975 call along with the naked leg, the 775 put option.  The naked leg is approximately 90 cents below the underlying futures price at the time giving the trade plenty of room for error.  Below the strike price of the short put, the trader becomes exposed to unlimited risk and a position that is similar in nature to a futures contract.  To illustrate the differences in, selling this put is actually $4500 ($50 x 90 cents) less risky intrinsically that simply going long a futures contract.  

This assumption is based on the fact that a futures contract is immediately responsible for losses with every tick that the futures price goes down, a short put option at expiration is only responsible for the amount that the futures price is below the strike price of the short put.  Even more convincing,  once the futures price reaches the strike price of the short put the delta value is approximately .50 or half of a futures contract.  Thus you may not experience the wild hair raising, white knuckled fear that one might encounter trading silver futures in today’s markets. 

Based on theoretical values supplied by Black and Scholes models, the total out of pocket expense of the trade would be about $10 before commissions and fees.  This number is derived from the net premiums, the amount of premium paid for the long option minus  amount of premium collected for the short options.  The maximum profit of $4870, ($5000 intrinsic payout, minus $10 premium paid, minus $120 in commission paid on 3 legs at a $40 rate) on the trade occurs above 975 at expiration.  The breakeven point of the trade, before transaction costs, would be $10, or just 1/5th of a cent above the long call strike, 875.  Between the long call and the short call, the risk is limited to the premium paid ($10) plus commission.

As with anything else in life, trading this way comes with opportunity costs.  If there is a substantial swing in favor of the trade the value of the position will increase at a slower pace than a long futures contract would enjoy.  Additionally, the short call option not only limits the profit potential at expiration but at any time before expiration it may actually cut into profits experienced on the long call in the form of increased premium values due to volatility and demand factors. 

Now let’s take an objective look at the odds involved in this trade.  The position involves one long option and two short.  It has been said that more options than not will expire worthless and there are several studies that suggest that this is the case.  This spread involves two short options and one long...two out of three isn't bad.

Figure 8 

Bear Put Spread with a Naked Leg

Buy a Close-to-the-money Put

Sell an Out-of-the-money Put

Sell an Out-of-the-money Call

When to use a Bear Put Spread with a Naked Short Call Option? 

1. You think the market will go down but buying put options outright are expensive
2. The goal is to purchase a close to the money put for very little cost

Bear Put Spread with a Naked Short Call Option Profit Profile 

1. Profit is limited to the difference between the strike prices of the long put and the short put plus the net credit or minus the net debit
2. At expiration the breakeven is equal to the long put strike price plus the net amount paid for the spread
3. BE = Long Strike Price - Net Premium Paid (if a debit)
4. RBE = Short Put Strike Price + Net Premium Collected (if a credit)

What is at Stake? 

1. Risk on the upside (short call) is theoretically unlimited
2. The market trading above the short call is equal to being short the futures from the call strike price
3. At expiration if the market is between the long put and short call you lose the net paid for the spread if executed at a debit.  If executed as a credit, the trader keeps the premium collected

You have likely heard about the complications associated with trying to pick market tops, the bear put spread with a naked leg is one way of attempting to do so while giving the market some breathing room.  This trade is capable of benefiting from a price reversal, but if the strike price of the naked short call is placed appropriately the risk to the trader at expiration may be considerably above the current futures market price. 

I believe that this trade is best used during times of extreme price moves and high volatility.  Executing it under other circumstances may increase the odds of a compromising scenario regarding the short call option. 

Looking at the next figure, you will see how a typical bear put spread with a naked leg may be constructed.  As the Euro rallied to an new all time high in mid-July 2008 a trader may have been able to sell the 163 call while simultaneously purchasing the 157 put and selling the 154.50 put for a net credit of 15 ticks or $187.50 before considering commissions and fees. 

Because this trade was executed at a credit, it is capable of making money at expiration at any point below the reverse breakeven point of 163.15.  This was figured by adding the net credit to the strike price of the short call option.  Below 163.15 but above the strike price of 160 the trade is profitable in the amount of the difference between the RBE and the strike price minus the futures price.  For example, if at expiration the futures price is 163.05, the trader would still be profitable in the mount of 10 ticks or $125.  To simplify, the only way that this trade can be a loser at expiration is if the futures prices is above 163.15; however, the risk is unlimited above the RBE of 163.15. 

The maximum profit on the trade is limited to the difference between the strike price of the long put and the short put, in this case 157 - 154.5 and is equivalent to $3,125 ($12.50 x 250).  The maximum profit is achieved if the futures price is trading below the strike price of the short put at expiration, in this case it is 154.50.

Figure 9

Call Option Ratio Spread

Buy 1 at-the-money Call

Sell 2 or more out-of-the- money Calls

When is a Call Option Ratio Spread Appropriate? 

1. When you expect the market to move higher, but believe that the upside is limited
2. The objective is to put this trade on as a credit, a free trade or very cheap.  A free trade is one in which a trader collects more premium for the short options that is put forth for the long options.  Keep in mind that free does not mean without margin, transaction costs or risk.

Call Option Ratio Spread Profit Profile 

1. If executed as a credit the profit is limited on the down side to premium collected
2. Profit on the up side is limited to the difference between the long and short calls plus or minus the net credit or debit

What is at Stake? 

1. If the market expires below the long call your risk is limited to any premium paid for the spread
2. Because this trade involves more short calls than long the up side risk is unlimited above the short calls
3. Having unlimited risk this trade needs to be watched closely

Call Option Ratio Spread Example 

At the end of June of 2006, the September Crude Oil futures contract was in the process of a rebound from the quarterly low.  At the time, it appeared possible that we would see the market retest the all time high of about $77.60 for the September contract, however being a seasonally bearish time of year selling puts in this market would have been unwise.  Instead, a trader could have executed a bullish ratio spread by buying the 74 call and selling 2 of the 77 calls.  According to Black and Scholes theoretical pricing, this spread could be executed at a credit of about $240 before commission and fees.

This trade offers limited risk on the downside.  If the market does not rally, or drops instead, the maximum the trader can make is the premium collected before commission.  The risk on this trade is actually on the upside.  If the trader is too right and the market rallies beyond $80 she is exposed to unlimited risk. 

The maximum profit on the trade is $3240 ($3 x $1000)+($240) minus commissions paid.  Assuming a $40 commission, a trader could potentially net $3240; this occurs at expiration if the underlying is at $77.

Figure 10

Put Option Ratio Spread

Buy 1 at-the-money Put

Sell 2 or more out-of-the-money Puts

When to Use a Put Option Ratio Spread?

1. When you expect the market to market to move lower, but believe that the downside is limited
2. The objective is to put this trade on as a credit, a free trade or very cheap. This occurs when a trader collects more premium for the short options that is put forth for the long options.  Free does not entail a lack of transaction costs, margin or risk.

Put Option Ratio Spread Profit Profile 

1. If executed at a credit the profit is limited to the premium collected if the market is above the long put at expiration
2. Profit on the down side is limited to the difference between the long and short puts plus the net credit or minus the net debit

What is at Stake? 

1. If the market expires above the long put your risk is limited to any premium paid for the spread if executed as a debit
2. Because this trade involves more short puts than long the down side risk is unlimited below the short puts
3. Having unlimited risk this trade needs to be watched closely

Put Option Ratio Spread Example

In my opinion, one of the most opportune markets to employ a put ratio spread strategy in is the stock indices.  During times of excessive volatility, it is possible to construct a very large spread which translates into a large profit zone, at very little cost or possibly even a net credit.  I have often recommended that such trades be used as a hedge against naked short put options that are experiencing losses due to increases in volatility and price movement.  Although, such trades can also be executed as a purely speculative play and without any relation to existing trades.

In mid-March of 2008, equities were struggling and market volatility was extremely high;  as a result, put premiums were at top dollar.  Based on Black and Scholes pricing, it would have been possible to purchase a June 1240 put and sell 2 June 1140 puts for a net credit of 90 cents in premium or $225.  This is figured by netting the premium collected (57.40 - 56.50) and multiplying by $250 which is the multiplier for the S&P.  This strategy could also be employed using the mini version of the options, but would involve one fifth of the premium, profit potential and risk. 

Assuming fills as the prices noted above, the trade is capable of making money anywhere above the reverse breakeven point.  This is because the trader gets to keep the premium collected even if the market rallies in the opposite direction of the spread.  The maximum profit occurs if the futures price is at 1140 at expiration, this is because at that point the two short options will expire worthless and the long option will be worth the difference between the long and short options or $25,000.  Don't forget about the $225 originally collected to make the total maximum profit on the trade $25,225 before commissions and fees. 

The risk of loss on this trade is unlimited, but occurs well below the current market price giving traders a tremendous amount of room for error.  Unlimited risk can be found below the reverse breakeven point or 1039.10, this is figured by subtracting the amount of premium collected from the point which is equidistant to the short puts as the long put is to the short put (1040 - .90). 

In essence, this trade makes money as the market drops below the strike price of the long put and approaches the strike price of the short puts.  Once the short put strikes are surpassed, the trade is giving back profits until running out of money at 1040 without regard to the premium collected and the transaction costs paid. 

Figure 11

Synthetic Commodity Options

By definition, synthetic is a manmade object designed to imitate or replicate some other object.  Essentially we can do the same thing in the futures markets by creating trading vehicle through a combination of futures and options to replicate another trading instrument.  But it gets even better.  As the creator of the vehicle we can customize it to better suit our needs as well as design it to better take advantage of the underlying market. 

The delta value of any given trading vehicle can be roughly described as the how much money is made or lost with a 1-point move in the futures market.  A futures contract has a delta of 1.  In other words, for every point the futures market moves your position will make or lose the amount of that particular multiplier.  When speaking about a few points, the dollar amount might not seem significant, but when you are talking about swiftly moving markets you can see how so many futures traders are unsuccessful.  The same volatility that makes large profits possible is the same volatility that makes trading futures contracts too much for many to handle.  Lowering the delta of a trade is often a good idea in that it essentially lowers the immediate risk of loss.  However, it also lowers the pace of gains should you be right. 

Through the creation of a synthetic position you can actually decrease your delta as well as, in my opinion, increase the odds of success.  Let's take a look at two of the most commonly used of the synthetic positions. 

Synthetic Long Call Option

Buy a Futures Contract

Buy an at-the-money Put Option 

When to use a Synthetic Long Call Option?

1. When you are very bullish, but want limited risk
2. The more bullish you are the further from of the money (lower strike price put) you can buy, although a true synthetic call would involve an at-the-money put option
3. This position is sometimes used instead of a straight long call option due to increased flexibility
4. Like the Long Call it gives you substantial leverage with unlimited profit potential and limited downside risk

Synthetic Long Call Option Profit Profile 

1. Profit potential is theoretically unlimited
2. The break even at expiration is equal to the futures price + premium paid
3. For each point the market goes above breakeven, profit increases by one point

BE = Futures Entry Price + Premium paid

What is at Stake? 

1. This trade involves limited risk.  However, it is possible to incur a “cash call” should losses on the futures contract exceed the available cash in the account.  This is similar to a margin call, and would require liquidation or additional funding within three days.
2. Your losses are limited to the difference between the entry price of the long future and the option strike price plus the amount paid for the option
3. Maximum loss is realized if the market is below strike price at expiration

Synthetic Long Call Option Example

Traders typically use this strategy as a means of increasing the flexibility of a position.  Although the payout of a synthetic long call option is theoretically identical to that of a call option, the ability to leg out of the trade can be a huge advantage.  This approach works best in markets in which option premium is low, but keep in mind that markets are dynamic and those that are viable candidates for this strategy change quickly.

A trader looking to position himself ahead of the seasonal spring rally in the grains may look to go long a futures contract and simultaneously purchase a protective at-the-money put option.  Doing so allows traders to participate in the futures market without the inconvenience of lost sleep and excessive stress.

In 2005 a trader may have been able to purchase a May 520 put near the end of January for about 25 cents, or $1250 ($50 x 25) and go long a futures contract from $5.20 per bushel.  This creates a scenario in which they would make a profit anywhere above $5.45 (520 + 25) before considering commission, or about $5.46 ½ assuming a $40 transaction cost for each leg of the trade.  If you are a bean trader, you know that 546 1/2 cents per bushel for May soybeans is definitely possible; in fact we haven't seen prices that low in quite some time.  In the event of a market drop after the trade is initiated, a trader could opt to take profits on the long put and continue holding the long futures contract.  This is of course a form of “double dipping” and considered to be aggressive.  Nonetheless, the ability is there and can be a valuable tool if timed correctly.

Figure 12 

Synthetic Long Put Option

Sell a Futures Contract

Buy an at-the-money Call Option

When to use a Synthetic Long Put Option?

1. When you are very bearish, but want limited risk
2. The more bearish you are the further from the futures (higher strike price) you can buy, although a true synthetic put involves an at the money call option
3. This position is sometimes used instead of a straight long put due to its flexibility
4. Like the long put this position gives you substantial leverage with unlimited profit potential and limited risk

Synthetic Long Put Option Profit Profile 

1. Profit potential is theoretically unlimited
2. At expiration the break even is equal to the short futures entry price minus the premium paid
3. Each point market goes below the break even profit increases by a point

What is at Stake? 

1. Your loss limited to the difference between the futures entry prices and call strike price plus the premium paid for the option
2. Your maximum loss occurs if the market is above the option strike price at expiration

Synthetic Long Put Option Trading Example  

A trader looking to profit from a decrease in profits but isn't confident enough in the speculation to sell a futures contract or even construct an aggressive option spread may look to a synthetic put.  This strategy has nearly identical risk and reward potential as an outright put making it a potentially expensive proposition.  However, if the volatility and premium is right it can be a great way to sell a futures contract,  while retaining a piece of mind and the ability to easily adjust the position. 

Figure 13

In early 2007 the Treasury market had found itself caught in a trading range which spanned nearly a month.  The lack of direction successfully imploded option premiums associated with the complex.  According to hypothetical values available to us, at the end of March a trader may have been able to purchase a June 2007 T-Note 109 call option for about $750.  At that point, the option would have had just over 3 months of time value and provided a relatively lengthy and inexpensive opportunity to insure a short futures trader against an adverse price move in the futures market.  In other words, a trader could have simultaneously purchased the call and sold a futures contract knowing that their absolute risk is $750 plus any difference in the fill of the futures contract and the strike price of 109.   

The same trader would be facing theoretically unlimited profit potential and three months in the market essentially worry free beyond the cost of the insurance (call option).  With that said, in order for this trade to be profitable at expiration the futures price would have had to move enough in favor of the trader to overcome the premium paid for the option.  In this case it is about 24 ticks.  Assuming that the trader was able to sell the futures contract at 109 exactly, the profit zone would be at 108'08 (109 - 24/32). 

The payout of this trade at expiration may be identical to a long put option, but the flexibility provided to the trader is unmatched.  Unlike a long put, a synthetic long put can be pulled apart prior to expiration in an attempt at capitalizing on market moves.  Please note that doing so greatly alters the profit and loss diagram.

An example of an adjustment may be to take a profit on the short futures contract and hold the long call in hopes of a subsequent market rally and the possibility of being profitable on both the futures position and the long option.  Or, should the trade go terribly wrong from the beginning a trader may look to take a profit on the long call and hold the short futures in hopes of a reversal. Doing so would eliminate the insurance of the long call and leave the trader open for unlimited risk on the upside, but may be justified if the circumstances are right.

Conclusion

The most important aspect gained from this article should be the idea that options are extremely flexible and can be combined in an unlimited number of ways in order to achieve a common goal.  Which strategy to use depends on your personality, tolerance for risk and risk capital available. 

We understand that it is nearly impossible to touch upon all of the details necessary for a complete understanding of these topics within the confines of such an article.  Therefore, a DeCarley Trading representative is available to discuss any questions that you may have regarding the material covered or which strategy may best for you.  Feel free to contact us by email at This email address is being protected from spambots. You need JavaScript enabled to view it. or phone at 1-866-790-TRADE (8723). 

**There is substantial loss in trading options and futures.

Carley Garner is an experienced futures and options broker with  DeCarley Trading, a division of Zaner, in Las Vegas, Nevada.  She is also the author of  "Currency Trading in the FOREX and Futures Markets", "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall.  She has also contributed to the FT Press Delivers line of digital products, "Insights for the Agile Investor".  Her e-newsletters, The DeCarley Perspective, and the Financial Futures Report, have garnered a loyal following; she is also proactive in providing free trading education and a regular guest of Mad Money with Jim Cramer.

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