TRADING OPTURES AND FUTIONS
by Joe Ross
Extract: Chapter 16.1 - 16.3
This type of trade is known as a Long Straddle. It involves buying options at-the-money. Frequently when this trade is done, one of the options will actually be in-the-money - so much for precision in terminology! Options traders refer to the closest strike price as the at-the-money even though it is usually slightly in-the money or out-of-the money.
When volatility is low and options premiums are correspondingly low, the purchase of at-the-money options makes sense. The low premiums are bound to expand if the market moves in either direction within a reasonable amount of time. This trade, properly timed, is an Opture.
The amazing thing is that if volatility picks up and the price bars begin to get bigger, it is possible to make money on both the Puts and the Calls. However, this usually requires a sizable surge in volatility. More often, we make money on one side of our straddle and lose very little on the other side.
Even if the market breaks out and begins to trend, the opposite side options contracts will for a period of time not lose nearly as much value as is gained by the contracts on the correct side of the breakout. Often I can sell additional options to cover the loss incurred on one side of the Straddle. If the market moves up, I can sell a Call at a strike higher than the one I own. This creates a Vertical Spread and the proceeds of my Call sale more than compensate me for any loss on my Put.
Of course, if the market begins to trend, I can create a Fution by entering a futures position based on the fact that the market is trending. I use whatever entry criteria I normally would as a futures trader.
If the market seemed to set up a steady trend, then I could also write opposite side options to help fatten my account and embellish my Optures strategy. In a rising market, I would write Puts following each correction and breakout to the upside. In a falling market I would write Calls following each correction and breakout to the downside.
Options premiums in the subsequent month were low as prices entered a tight congestion. This is a rare event, which heavily favors options buying strategies. With futures prices at 2051, if I were to purchase both a Put and a Call with the market tightly congested as you see it at the end of the chart, I would have to pay only $650 for both at-the-money Puts and Calls. The at-the-money 2050 Call, which was actually one cent in-the-money, was selling for only 33 cents. The at-the-money 2050 Put, which was actually two cents out-of-the-money, was selling for 32 cents.
If the futures were to begin to trend, or break out in either direction, one or the other of the options would be in-the-money and the premiums would expand in tandem with rising Volatility. Dropping the side of the trade opposite the direction of the move would result in a Long Put or Long Call with unlimited profit potential.
The OptionVue Graphic Analysis above shows the profit potential of a Straddle held to expiration.
I'm not showing you a trade that was made at this point. What I am showing you is how a market, and the accompanying Profit/Loss graphic analysis looked at the time I considered using STRATEGY #1.
Trading options is usually a business of patience. The best options traders do not trade all the time. The same is true for the best futures traders. Instead they wait for an opportunity to strike. When prices move into congestion, I do not race into the market to make a trade. I am content to wait for everything to be right.
(The close of the large bar move as indicated by the arrow, as well as the Trading Range of that bar itself, was most representative of the range of prices that followed. That is why, when looking back, I began counting the Trading Range from, but not including, that bar. Also note, I did not count the large horizontal flat bar between bar 11 and bar 12. It was a holiday).
When I see a gap or long bar move, I immediately suspect that a congestion may follow. Moreover, once such an event occurs, I watch carefully for a Trading Range to follow. I begin to draw Trading Range lines after ten days are complete. If the market makes a new high, I adjust the range to accommodate the new high. Generally speaking, a new high, a new low, or both, will be made somewhere between 21-29 days after the onset of the range. In my experience the average is 25 days. Once that period of time has passed, I draw what at the time are the Trading Range high and low. It is only by looking back that I can see the truth ¾ the market is moving sideways. It is then that I begin to exploit the strategy outlined below.
I wait until prices move into the area between the inner bands and the Trading Range line. If prices move into the area between the inner low and the bottom of the Trading Range, and then reverse, I will sell out-of-the-money Puts. I like to sell just below the Outer Envelope, one strike price away from current prices. If prices move into the area between the inner high and the top of the Trading Range and then reverse, I will sell out-of-the-money Calls just above the Outer Envelope. I am especially fond of this trade when there is a month or less until the expiration of the options contract. Then I will be at risk no more than 22 trading days. During that time, the decay in the options premium will become increasingly rapid. I want to get this trade on as soon as I feel confident of the Trading Range, since further development of congestion will cause volatility and options premiums to fall. The situation at the extremes of the Trading Range favors my short options strategy.
The reversal bar at Day 25 was a Call selling opportunity I missed. When I see prices move outside the prior range and reverse, falling back toward or within the inner envelope, that's a tradable event.
The reversal bar at the low of the range, day 14, was not tradable, because at the time I did not feel I had sufficient data to define the Trading Range.
The following chart is an adjusted continuation into the next month. I did this so you could more easily follow the discussion of this market.
As you can see on the chart, I had only one other opportunity to write options contracts. I was able to write naked Calls. On the day I wrote the Calls, the futures closed at 2086, with 35 days until expiration. I wrote the 2150 Calls. At the time, I actually received .11, or $110 dollars per Call. These out-of-the-money Calls at the time I am writing are selling for .01. They are actually worthless with 2 days until expiration.
Well, that was easy enough. As long as prices expired at or below 2150, I got to keep the premium. But what if something had gone wrong? What if prices had suddenly moved up, or had begun to trend toward 2150? What then? How would I defend my naked Calls?
There are a number of things I could have done if prices began moving up:
1) I could have gone long the futures and thereby covered the Call. I could have done that on the basis of one futures contract for each Call written. Entering the futures would have enabled me to more than cover the Call. Remember, at a futures price of 2150, the Calls would have been moving approximately one half of what the underlying futures would have been moving.
Premiums on the options would have increased steadily as the futures climbed higher, but by the time the Calls would have been deep in-the-money and moving virtually dollar for dollar with the futures, the futures would have been ahead of the Calls. This means that I could have waited until the futures were at 2150 before actually entering the market. But it is much safer to establish a long position in the futures before the Call's strike price is reached. That way, if prices were to suddenly gap past me, putting my short options deep in-the-money, I would already be long the futures. 2) I could have written out-of-the-money Puts with sufficient premium in them to cover the premium I was losing as the futures moved up and the Calls were rising in price against me. This would have turned my naked Call position into a Short Strangle. A Short Strangle means having written both out-of-the-money Puts and Calls.
3) I could have rolled the Calls ahead. For instance, if and when the futures had reached a price of 2100, I could have bought back my 2150 Calls and written twice as many 2200 Calls, thereby placing even more premium in my account. A move like this would have still left me naked the Calls, but my options would still have been well out-of-the-money, with time decay working in my favor.
4) I could have done some combination of any two, or even all three of the above. If I felt strongly that prices would move much higher, I could have bought back the 2150 Calls and have sold the 2150 Puts. I have learned over the years that when I know I am wrong it is time to reverse! I'm going to look at an options model and do some "what-if" analysis. I will be looking only at Theoretical Values.
The actual prices of options shown in the model will not be correct, but the Theoretical Values in this market had been consistently very close to actual pricing throughout the period following the 25th day of the Trading Range.
I'll go on the assumption that prices reached 2100 and then 2150. Furthermore, I'll assume that prices reached 2100 five calendar days after I sold the Calls, and reached 2150 ten calendar days after I sold them.
Scenario A:
When prices reached 2100 with 33 days to expiration, the 2150 Calls were valued at .22, or $220. Since I received $110 for them to begin with, I am now $110 in the hole. At this point, I could take my loss plus costs and exit the market. But since I don't like to lose, I will write enough Calls at a higher strike price to pay me an additional amount for taking risk. If I decide to write the 2200 Calls, the entire transaction will look like this:
Buy back the 2150 Calls for $220 each. Calls originally sold at $110 each. Difference is a negative $110 each. Write two 2200 Calls at $100 each (total $200) for every Call originally sold at $110. Doing this would not do the job of paying me an additional amount for continuing to take risk. Scenario B:
If I have sufficient margin in my account, for every Call I originally sold at $110, I can elect to write three 2200 Calls at $100 each (total $300). Doing this will place a surplus of premium in my account.
Scenario C:
There is something else I can consider. I could attempt to write some Puts to go along with the Calls and thereby strangle the market. The options model indicates that if I write 2050 Puts, I can obtain .21 ($210) for each one I write. I have a choice, I can write three 2200 Calls and place a surplus in my account (Scenario B), or I can write one 2200 Call and one 2050 Put (Scenario C). Doing the latter will place $310 in my account, which is more than enough to pay for the Calls I need to buy back. Of course, this does not take into account my costs. At $20 commissions, I make only a small profit. I took in a total of $420 ($110 + $310) in premium and paid out $220. That's a net of $200, less $60 commission for a "bottom line" net of only $140. The poor results of this scenario reveal why I prefer not selling relatively low-priced options. Another possibility is rolling out to the July 2200 Calls which would give me $230 in premium by selling more time. I could also roll out to a July Strangle by writing 2200 Calls and 2050 Puts, but such a move is fraught with danger. It allows a lot of time for things to go against me. You can see the Theoretical values posted on the matrix.
Next, I'll try to do it all Strangle the market and go long the futures when prices reach 2150. Because I like to name things and could find no name for this tactic, I call it a Bull's Fandangle. Seasoned options traders will notice that this position acts very much like a Short Put and has similar profit/loss characteristics. Were I to Strangle the market and go short the futures, Iwould have entered into a Bear's Fandangle, which has much the same effect on my account as does a Short Call.
Since it didn't actually happen that way, I'll have to create a fictitious chart to show you what the market might have looked like at 2150. Creating such a chart is in keeping with one of the purposes of this course, which is to show you what I do with options when a market takes on a particular price pattern.
When I first entered this market on April 6th, my feelings were quite neutral. With prices in congestion, I felt the market might go nowhere and that the Trading Range would continue to remain intact. Remember, I sold a Call with prices at the top of the range.
I'll assume that with prices rising to 2100, I would have begun to feel somewhat bullish about this market, and that when prices reached 2150, I would have felt sufficiently bullish about this market to have gone long the futures. Those readers familiar with TRADING BY THE BOOK may have noticed this would have been a breakout of a Trading Range - a bullish signal!
I'll also assume that at 2100 I had followed Scenario C and written one 2200 Call and one 2050 Put. Doing that placed $310 in my account, which was enough to pay for the 2150 Calls I needed to repurchase at that point. Feeling quite bullish when the market achieves 2150, I go long the futures using whatever technique is convenient and comfortable for entry.
At that time, with 33 days before contract expiration, even though prices have risen in the futures, the value of the options is no greater than when I initially sold them. Time decay has worked to my advantage. My present position now is: Short a 2200 Call, short a 2050 Put, and long the futures at 2150.
From this point on, one of three things can happen:
1. Futures prices may rise above 2200: Since I'm long the futures from 2150, at expiration, my futures will be called away at 2200, giving me a profit of $500 in addition to the $310 I originally receive in options premium, for a total profit of $810 on the trade. 2. Futures prices may stay within the range of 2200 to 2050: I get to keep the $310 I originally received and I may have a net profit or loss on my futures, which I initially entered at 2150. Normally I will not risk a loss in the futures position which exceeds the amount of the options premium I initially received.
3. Futures prices may fall below 2050: I would be in big trouble. However, as described above, I generally will not allow the losses to exceed the amount of options premium credited to my account. If I were still long the futures, I would have to reverse to a short futures to cover the 2050 Put. I would have a $1,000 loss on the long Futures, but could recoup some of that by selling additional options. I would still have the $310 in original options premium.