Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today’s futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
LIMITING YOUR RISK
I like the idea of selling futures options due to what seems like better odds than buying them, but I don’t like the idea of unlimited risk. How can I collect premium in the commodity markets with limited risk?
The strategy you are referring to is known as credit spread trading, sometimes referred to as an iron condor. In essence, it is the practice of selling options along with the purchase of insurance, which comes in the form of a long option with a distant strike price. If a trader sells a call option and purchases a call option in the same commodity and expiration month but a higher strike price, he has executed a credit spread. Keep in mind that options are versatile and there are an unlimited number of spread strategies that result in a credit (cash inflow), causing them to be referred to as credit spreads. However, the specific type we are discussing is the most common.
A trader using this strategy is willing to give up some of the profit potential of a short option trade for the luxury of knowing the worst-case scenario ahead of time. That said, it is important to note that limited risk may not mean less risk. Depending on how the credit spread is structured, namely the distance between the strike prices, it is possible for the risk, although absolute, to be very high.
Before we mull over the pros and cons, let’s look at a quick example to ensure that the strategy is clear. An S&P trader may want to speculate on lower prices by selling a call credit spread. Selling a September 1060 call for $9 in premium and purchasing an 1100 call for $3.25 brings in a credit of $5.75 ($9 - $3.25) before considering commissions and fees; this represents the maximum profit potential of the trade. For a full-sized S&P trader this is equivalent to $1,437.50, and for an emini trader, this translates into $287.50. The maximum risk is equal to the distance between the strike prices minus the premium collected, or $34.25 ($8,562.50 in the full-sized version and $1,712.50 in the emini). Now let’s weigh the advantages and disadvantages of a credit spread.
There are opportunity costs to having an insured short option trade in addition to the premium paid for the protective option. For instance, the purchase of an option with a distant strike price often requires that the trader sell an option with a strike price closer-to-the-money than had he sold the option naked (without the protective long option). The trader may have collected a similar amount of premium by simply selling the 1080 call. As you can see, the strike prices is 20 points farther from “danger” than is the case with the credit spread. Although selling naked options entails unlimited risk, there is less hazard in being farther from the market.
In addition, traders who execute credit spreads may find it more difficult to adjust the trade relative to a single short option simply because they are dealing with two options, not one. The trader may face larger bid/ask spreads and increased transaction costs. Similarly, it may be necessary to hold a credit spread until expiration in order to reap an acceptable reward. This is due to the incremental money spent on insuring the short option and the fact that the long option value will erode faster than the short option value. Using the call credit spread, if the S&P drops sharply (which is the intended direction) well before option expiration, it may be difficult to exit the spread at a profit because the call purchased as insurance may have lost nearly as much value as the short call.
Credit spread traders may also encounter increased amounts of stress during option expiration. Assuming the spread is held until expiration, they have to be concerned with two strike prices when it comes to the possibility of being automatically exercised by the exchange (this occurs when futures options expire in-the-money). Specifically, complications may arise if right before expiration the futures contract is trading between the strike price of the long and short options. In this case, the trader may be forced to buy or sell a futures contract in an attempt to offset the anticipated forced exercise by the exchange. However, as we all know, futures prices can move very quickly. An option that was in-the-money 20 minutes before expiration may be out-of-the-money once the bell rings. As you can imagine, unfortunate timing or circumstances may result in an unintended long or short futures position.
That said, I don’t normally recommend holding short option positions into expiration, but a spread trader may be tempted to do so in an attempt to maximize profit, whereas an outright option seller can be more nimble in entering and exiting positions.
But there are advantages to trading credit spreads such as limited risk. Even if the maximum risk of a credit spread is relatively high, the trader knows the worst-case scenario before getting in. This assurance can do wonders for a trader’s peace of mind. Last autumn, traders who sold put credit spreads in the S&P likely suffered massive losses, but at least they knew the risk going in.