Trade 2 Commodities at Opposite Extremes

Let's start out by saying that option selling is not for everyone. In fact, the average trader (and even more so the average investor) should not participate in such a strategy. Option selling comes with limited reward and substantial risk, but on the bright side of things, it also offers higher probability speculation. Option selling is a way to speculate in the commodity markets with a considerable amount of room for error. In short, it is a wager that something will not happen rather than a bet on whether something does happen. Further, it is similar to the thinking of insurance companies which issue policies knowing that most buyers will never file a claim against it, but occasionally there will be a massive payout due to the insured. The premise of option selling is simple: more options than not expire worthless. All else being equal, every minute that passes the value of an option erodes. Thus, if the underlying commodity market is directionless an options trader stands to benefit anyway. This cannot be said for those opting to buy or sell the commodity futures contract outright, and even more so for those purchasing call and put options. Directional option sales can make money in two ways. In addition to time value erosion, an option will lose significant value as the futures price moves further from the strike price of the option. For instance, a trader who sells a $4.00 natural gas call option against a sharp rally will see the value of that option plummet if natural gas prices do. This is because the sale of a call option is a bearish strategy in which the trader is betting the price of natural gas will not surpass $4.00. However, if the price of natural gas increases the value of the option will also increase to create a paper loss for the trader. Should the price of natural gas surpass the $4.00 strike price, the option seller is left with a position that mimics the risk of being short a futures contract outright (theoretically unlimited risk). Nevertheless, unlike a futures trader, an options trader can be wrong and still make money. No matter what happens, the option seller collects the premium immediately and that can be used as a risk buffer throughout the trade. Going back to the natural gas example, if the trader sold a $4.00 call for 10 cents (equivalent to $1,000) the breakeven point of the trade is $4.10 at expiration because between $4.00 and $4.10 the premium collected is buffering the risk (this is a simplistic example ignoring transaction costs). We've noticed a few commodity markets trading at extreme levels, in our opinion, that might be candidates for directional option selling opportunities in hopes of a price reversal; gold and crude oil. The following examples are for educational purposes only. Bearish Crude Oil Premium Collection Idea Crude oil futures have enjoyed a sharp rally in recent weeks on fundamental support, but looming in the darkness is a seasonal pattern that generally works against oil in early-to-mid-October. Further, as we have pointed out on previous rallies, most speculators are already all-in with bullish oil speculations. We might be nearing a scenario in which all the buyers are already in, the shorts are already squeezed out, and prices simply soften due to a lack of sustainable bid. That said, we aren't bold enough to sell a futures contract and hope for the best. Instead, we like the idea of selling a call spread with plenty of room for error. Specifically, we like the idea of selling the December crude oil $79.00 call option and then purchasing the November $82.00 call option as a catastrophic insurance policy. The result is a position that stands to make money if the price of oil trades sideways, lower, or even higher. The risk comes if oil moves up too much (near or beyond $79.00). We suspect the market will fail to climb above $75.00; nevertheless, we are giving this position plenty of room for error. The net credit would hypothetically be about 60 cents, or $600. This represents the maximum profit potential before considering the transaction costs and it occurs if the price of oil is at $79.00 or lower (nearly $6.00 higher than the current price). As you can see, this trade can be wrong by roughly $6.00 per barrel at expiration and still make money! There are few strategies that offer that to a trader. If we are wrong about a nearby reversal, the risk on this trade cannot be accurately predicted due to differences in options expiration but we believe it will be contained to roughly $2,000 to $2,500. That said, it would take a large and relatively unusual move for that outcome to play out. Remember, option sellers are accepting the fact that the risk outweighs the reward on any particular trade in exchange for a much higher probability of success per trade relative to most other strategies. View Chart » View in New Window » Source: QST The December options expire in 47 days, and the November (insurance policy) expires in 19 days. Thus, this position is intended to make money should we see a short-term pullback. If everything goes as planned, we would advise taking a quick profit in the coming week or two. The margin on this trade is a mere $650 per lot traded and the delta is a tame 15%. The delta is the rate of change the position experiences relative to the underlying crude oil price change. For instance, with a delta of 15%, if oil rallies $1.00 (equivalent to $1,000 to a futures trader) this position would lose 15 cents or $150. As you can see, the lower the delta the lower the risk. That said, Delta is dynamic, not static; the delta will increase as the price of oil moves higher against the position. Likewise, the delta will decrease as the price of oil moves lower in favor of the position. Bullish Gold Premium Collection Idea The gold market appears to be putting in a double bottom and seasonal tendencies suggest the path of least resistance should be higher for the time being. However, the gold market is emotional and treacherous, so we prefer playing this market with moderate risk positions. We like the idea of selling the February $1,150 put and then buying the December $1,125 put as a hedge; the net credit should be roughly $710 prior to transaction costs. The February options have about 120 days to expiration, while the December options have roughly 60 days. This should give the market plenty of time to turn around, assuming our analysis predicting a looming gold bottom is correct. The February $1,150 put has nearly doubled in value in recent sessions and appears to be giving put option sellers another chance to establish a position prior to what we believe will be a bullish cycle. If gold finds footing and makes its way higher, the February $1,150 put should lose value quickly, which would be favorable for this position. View Chart » View in New Window » Source: QST The maximum profit on this position is $710 per lot traded minus transaction costs. This is only achievable if the trade is held to expiration. However, the goal should be to exit this position in the coming weeks on favorable price movement. The maximum risk cannot be absolutely quantified due to the difference in expiration dates involved. We believe a sharp drawdown should be roughly limited to $1,500 to $2,000 should the trade go off the rails. Again, option sellers are not looking for high rewards vs. low risks, they are looking for high probability ventures with moderate reward potential. Keep in mind, the long December put expires well ahead of the February put, so the trade will be exposed to theoretically unlimited risk beyond that point if no further action is taken. Like the crude trade idea, above, the margin on this trade is $550 per contract and the delta is 14%. Accordingly, the speculation is relatively conservative in that it shouldn't see dramatic swings in profit and loss unless of course, the price of gold collapses. In this example, the price of gold can drop from $1,200 to $1,150 at expiration and still return the maximum profit to the trader. Bottom Line Those with substantial risk capital and risk tolerance, in addition to a certain level of sophistication, might find option selling to be a high-probability trading strategy. This is particularly true in the commodity markets where margins are generally lower than that of stock option selling and the strategy can be done in smaller accounts relative to the substantial size requirements at stock brokerages. Nonetheless, a higher probability strategy doesn't mean guaranteed profits, nor does it translate into stress-free trading. We recommend that option sellers hedge their bets with long options, like the discussed strategies. Although most options expire worthless enabling option sellers to profit on most trades, the small percentage of losing trades can devastate a trading account. We believe purchasing catastrophic insurance to protect the trade against tail-risk is a good way to prevent such a setback. On a side note, if you are interested in learning more about commodity options trading please consider my book Higher Probability Commodity Trading.

Trade 2 Commodities at Opposite Extremes

Oil and gold might present opportunities for counter-trend option sellers.

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