Profiting With Futures Options

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David L. Caplan

Disclaimer: Trading in futures and options is not suitable for all investors as the risk of loss is substantial. Purchasers of options may lose lose their entire entire inves investment. tment. Sellers of O Options ptions ar are e subject to unlimited risk.

  Center for Futures Education, Inc. P.O. Box 309 Grove City, PA 16127 (724) 458-5860 FAX: (724) 458-5962 e-mail:   [email protected] e-mail:




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Expiration Volatility WHEN TO USE OPTIONS The Trading Edge When to Buy Options When to Sell Options When to Use Options with Futures OPTION SPREAD STRATEGIES Option Strategies that Provide the Trader with a   Significant Advantage

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UH SIE N“GFR NE NE OP O”PTION PO POSITIONS T EU ET TR RA AL DE THE “RATIO SPREAD” THE MOST OVERLOOKED OPTION   BUYING STRATEGIES (DON’T TRADE   ANOTHER FUTURES CONTRACT UNTIL   YOU READ THIS!) The In-the-Money Debit Spread Option Straddle Purchase VIII. III. THE THE MOST MOST OVER OVERLO LOOK OKED ED OPT OPTIO ION N SEL SELLI LING NG   STRATEGIES Cover overed ed Cal Call—Ad l—Addi diti tion onal al Inco Income me;; No No Ri Risk or Marg Margin in Calendar Option Strategy—Take Advantage of    Disparities in Futures and Options CONCLUSION APPENDICES 1. Common Option Strategies for All Markets 2. Neutral Option Spread Strategies 3. Option Strategy Summary 4. Glossary of Option Terms

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IV V .. VI. VII.



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INTRODUCTION Options provide one of the most overlooked opportunities available to traders to today. day. Properly us used, ed, options provide signif significant icant advantages for all traders; however, most traders tend to misuse them. Often traders who use options purchase or sell the wrong option, or use the wrong option strategy.

New traders often use options solely to limit risk, in which case they only buy them. They do lit little tle investigat investigation ion to determ determine ine whether the option was relatively “undervalued” or “overvalued,” or which strike price or month was the best. Typically, the conversation between a trader and his broker goes something like this: TRADER: “I think gold is going up.” BROKER: “O.K. What would you like to do?” TRADER: “I want to buy gold, but I only have $1,000 to risk.” BROKER: “Let’s see, with $1,000, we can buy 4 June $400 calls.” TRADER: “Great! Go ahead.” There is no consideration given to time decay or premium levels— the most important factors in option trading—or whether an option strategy would provide a better risk/reward ratio than a futures position. Traders who limit their analysis of options to buying a call option if  they are bullish on a market or buying a put if they are bearish with the expectation that they will profit if the market moves in the predicted direction not only fail to take advantage of the most important aspect of options (under/over pricing, premium disparity, and time decay), but also find that indiscriminate option purchases can lead to losses




1. “NEUTRAL OPTION POSITIONS” WITH A HIGH PROBABILITY OF PROFIT. THESE TRADES MEET THE FOLLOWING CRITERIA: A. They can be be profita profitable ble over over a wide range range of price pricess that that can can be calculated by statistical probability to be profitable a high percentage of the time; B. They can be be success successful ful without without having having to to predict predict exact exact market market direction; C. They They benefit benefit from from mispri mispriced ced optio options ns (premi (premium um dispar disparity ity)) and from from selling “overvalued” options; D. They They take take adva advant ntag agee of “time decay” of out-of-the-money options that will lose some of their time value every day. Bond Neutral Options


Figure 1



2. USING USING OPTION OPTION PURCHA PURCHASES SES IN CONSOLI CONSOLIDAT DATING ING MARKET MARKETS S IN COMBINATION WITH LOW OPTION VOLATILITY LEVELS L EVELS TO PRODUCE TRADES THAT CAN HAVE A 20-1 OR MORE PROFIT TO RISK RATIO! Option purchasing is one of the most misused of all trading techniques. Most traders prefer to purchase options because of their limited risk (with  prem  pr emiu ium m plus plus comm commis issi sion onss and and fees fees), ), and and thei theirr unli unlimi mite ted d prof profit it aspe aspect ct,, whic which h  provid  pro vides es the trader trader,, in effe effect, ct, a “lottery ticket” with the potential of large gains. However, similar similar to a lottery lottery ticket, well well over 90% of traders who  purcha  pur chase se opt option ionss in this this manner manner end up losing losing!! (In fact, fact, our “Neutral Strategies” are designed to take advantage of people who purchase options in this indiscriminate manner.) However, there is one situation where the odds in option buying are favorable and can produce some of our biggest gains. It is one of the easiest patterns of all to recognize and trade. This occurs when a market consolidates into a quiet trading range. Traders say that the market has reached its “equilibrium” level and that it will have very little movement. Futures contracts open near unchanged levels, and move only a few ticks in either direction every day. Traders are lulled “asleep” by this action. Option volatility then moves to record low levels making options very cheap. WHAT HAS HAPPENED IN THESE SITUATIONS ? THE MARKET HAS QUICKLY BROKEN OUT AND MOVED SHARPLY HIGHER. The soybean market in 1988; the coffee market in 1997, are examples of markets that were tradingvolatility just a few ticks a day forbroke long out periods of time with extremely low option that eventually and moved 

much higher. As an additional benefit, these situations are the easiest to recognize and trade of any possible technical pattern. That’s because they all look  and act the same. As you can see in Figure 1, they are all easily recognized  by the the long long,, con conso soli lidat datin ing, g, quie quiett acti action on.. We then then wait wait for for the the mar marke kett to “t “tel elll us” that it is ready to begin moving before initiating any trades. 3. USIN USING G OPTI OPTION ON STR STRATE ATEGI GIES ES AND AND PRE PREMI MIUM UM DIS DISPAR PARITY ITY TO INITIATE POSITIONS THAT PROVIDE SIGNIFICANT BENEFITS (DESCRIBED IN CHAPTERS III TO VIII).




Monthly Gold

Monthly Soybeans

Mo n t h l y C o p p e r



Figure 2


There are two types of options: calls and puts. A call option gives the option buyer   the the right to buy the underlying asset at a specified price (the strike price) within a certain time. It obligates the option  seller  to   to sell that asset at the strike price before the expiration date, should the call buyer  exercise his right. Conversely, a put option gives the option buyer the right to sell the underlying futures at a specified price within a certain time, and obligates the seller to take delivery at the strike price on or before the expiration date if the put buyer exercises his right. (Although the examples in this book refer to futures options, the principles apply to other option markets also). All option transactions are opened either by buying or selling a call or   put..  put Over 90% of options transactions are closed out with an offsetting sale or purchase of the same option, or by letting the option expire without exercising the right to take or tender delivery.

Options can be bought or sold to take advantage of a market move; for  example, if an investor thinks the price of gold is going to rise, he can purchase a call or sell a put on the futures. If he purchases a call and the price of gold rises, the investor will profit if the premium he paid for the call increases during the time he holds the option. If he sells a put instead and the price of gold rises above the strike price at expiration, the premium he received for selling the put will be his profit. If the investor anticipates the price of gold falling, he can buy a put or sell a call option.

Option Strike Price

The price (premium) that the option buyer must pay for an option is 9


determined by several factors. One is the strike price of the option; for  example, if gold is trading at $320 an ounce, an investor who is bullish on gold could buy a call option at a strike price of $310, $320, or $330 an ounce. A $310 call option is “in-the-money,” that is, the strike price is lower than the market price. This is the most expensive of the options in this example. The $320 strike price is “at-the-money” (close to the market), the second most expensive option. The $330 option is the “out-of-the-money” and is the least expensive of these options. The farther “out-of-the-money” an option is, the less expensive it is, because it is less likely to have any real (intrinsic) value before expiration. In our example, let’s say the December $310 call costs $1500; the $320 call costs $1000; and the $330 call costs $700. If, at the expiration of the December gold option, gold is trading at $330 an ounce, the $310 option would be worth $2,000* (gold options are for 100 oz. contracts) and thereby have a profit of $500* ($2,000 value minus $1,500 we paid for the option); the $320 option would be worth $1000 and our investor would break even; and the $330 call option buyer would lose his entire $700* investment. Although the price of gold has risen $10 dollars, his option still lost money,  becaus  bec ausee the pric pricee of gold gold did not not excee exceed d the pric pricee he paid paid for the the call. call. On the other hand, the seller of the $330 call was wrong in his price  pred  pr edic icti tion on for for gold gold,, but but he stil stilll prof profit ited ed on this this sale sale;; thus thus,, you you can can be ri righ ghtt in your prediction of market direction and still lose money! How is this possible? There are two reasons for this. 1. An option option is is a “wasti “wasting ng asse asset.” t.” The option option premiu premium m is partia partially lly compris comprised ed of time value; the longer the option has until expiration, the more value it should have. With every passing day, the option will lose some of its time Evenof if the the buyer of the call option correct in his assessment of thevalue. direction market—the market is isrising—the time value of  the option will decrease. Only when a sustained or swift, sharp upward move occurs will the call purchaser make money.

* Less commissions and fees.




  e   u    l   a    V   n   o    i    t   p    O   e    i    t   v   a    l   e    R 3





Figure 3 Option time premium declines slowly when there is a long time remaining until expiration. As expiration approaches, the disintegration accelerates.

2.  pr Options Opt ions are often ofte ns and overpri ove ced beca the publi peublic c iums isms willing wilso ling pay pay  prof ofes essi sion onal al writ wr iter ers an d rpriced gran granto tors rs because of opti opuse tion onssthe larg large prem premiu the the to publ public ic can speculate in the markets, attempting to make a large profit with a limited risk of loss (option premium plus commissions and fees). If options were not overpriced, grantors would be unwilling to sell them and take the risk of a theoretically unlimited loss.


A second important aspect in the determination of option premium is the time until expiration; for example, an October gold call will cost less to  purchase  purch ase than a December December gold call of the same same strike price. price. The reason: reason: the additional time before expiration gives the December option buyer a greater opportunity for profit.


The third item of importance is the volatility of the underlying futures contract. Volatility is a measure of historical price changes. A commodity such as soybeans or silver, which at times can be subject to violent price moves, normally commands very high premium values, especially during  period  per iodss of viole violent nt price price move moves; s; e.g., e.g., soyb soybean eanss during during the the summe summerr months months.. 11


Volatility is by far the most important aspect in option trading, yet it is the least understood and most misused. Volatility is a mathematical computation of the magnitude of movement in an option. This is based on the activity in the underlying market. If the market is making a rapid move up or down, volatility will increase. In a quiet market, volatility will be low. Monthly Corn Chart


Figure 4

When volatility is relatively low, a trader should look for option buying strategies, as the market is quite likely to make a strong move. When option volatility is high, option selling strategies should be considered to take advantage of the relatively premiums. An overlooked area overvalued is the difference in volatility between different months and strike prices of options. Often, premiums of out-of-the-money options can be distorted greatly; for example, in April-May 1994, soybean ratio spreads provided a high probability of profit because the volatility for  the out-of-the-money calls was double the volatility of the at-the-money calls. This scenario can lead to significant opportunities. When options approach expiration, volatility for all the strike prices tends to equalize. In this instance, if you purchase the most fairly priced calls (near the money), and sell the most overvalued calls (out-of-the-money), you could expect the options sold to lose premium faster as the market moves in either direction. Even if the market were to move higher (unless making a straight-up vertical move), this spread would also work as the nearer-to-the-money nearer-to-the-money option would 12


gain in value faster than the already overpriced out-of-the-money options. Another overlooked characteristic of volatility is that it tends to drop gradually, then level off; however, volatility increases can be characterized  by very very sharp sharp chang changes es driv drivin ing g opti option on prem premiu iums ms to extr extrem emel ely y high high le level vels. s. These events occur rarely, but when they do, they can be very damaging to those holding short option positions. An example of this was the volatility increase in many stocks at the beginning of the Gulf War. Oil volatility doubled, while other markets such as gold, bonds, and currencies increased 20% or more. Even in seemingly unrelated unrelated markets such as cattle, volatility increased dramatically.

Figure 5 Quickly rising volatility in crude oil caused option premiums to expand to very “overvalued” “overv alued” levels.

Changes in volatility affect the premium levels in options that are going to be purchased, as well as those already purchased purch ased or sold. An example of  this is crude oil and the S&P 500 option markets where volatility has ranged  between  betw een 20% to more more than than 100%. With high volatility, if one were to purchase an out-of-the-money option, he would need a substantial price rise before that option would be profitable at expiration. Both the expense of the purchase price of the option and time value would be working severely against him; however, with volatility at lower levels, this option would not only cost much less, but it would also require a smaller move for the position to be profitable. This is because, many times as prices begin to rise, volatility also increases increases,, thereby increasing



the premium of the option purchased. Option volatility can also alert the trader in advance to significant market moves. When option volatility is at low levels, there is a high probability that a large move is about to occur. Often, when a contract con tract is very quiet, traders seemingly “fall asleep,” not expecting anything to happen. Of course, this is exactly when everything explodes!

Figure 6

Again, in this case, historically low option volatility provided an advance adv ance indication of an impending breakout. (We wait for the market to tell us which way it wants to go before  jumping on board!)

The concept of option volatility and the time decay characteristic of  options are the two most important and overlooked factors factors in option trading. These concepts can be difficult to learn and use, but their proper use can result in a “trading edge” over the markets. When trading options, one must learn to be flexible, using what the market gives to best advantage. Sticking to one strategy may not be appropriate for current conditions. Changes in volatility levels require the use of different option strategies depending on the relative level of volatility in the option and underlying market as we discuss in th upcoming chapters. 14



Options should be used instead of outright futures contracts whenever  the trader can realize a “trading edge” or advantage. They are advantageous whenever they offer a higher mathematical probability of profit; less risk of  sudden, unpredictable, adverse market moves; a better risk/reward ratio; and/or increased trading opportunities. 1.  High  Hi gher er Prob Pr obab abil ilit ityy of Prof Pr ofit  it : Through the proper use of option  prem  pr emiu iums ms,, posit position ionss can can be cons constr truct ucted ed that that off offer er a high high prob probabi abili lity ty of   prof  pr ofit it.. For For exam exampl ple, e, sel selli ling ng an an outout-ofof-th thee-mo money ney,, over overva valu lued ed cal calll on an an overvalued, overbought commodity, or buying an at-the-money put in the same situation. A simple method of detecting an undervalued option is to compare current volatility to past readings. This can determine whether the volatility is at the high or low end of its range, commonly referred to as “theoretically under- or overvalued.” 2.  Less Risk of Sudden, Sudde n, Unpredictable, Unpredictab le, Adverse Market Moves:  Option  buyers  buy ers may insula insulate te thems themselv elves es from from larg large, e, unli unlimit mited ed loss losses es that that occur  occur  from overnight adverse moves by using one of many limited-risk option strategies. Options can also be used to prevent being “stopped out” intraday on a trade that later would become favorable. Even E ven close-only stops (stop orders to close out positions in the closing range if the contract reaches a predetermined loss level, ignoring intraday price movements), may inflict losses when the contract is limit up or down against the trader. As most futures contracts are subject to daily price movement limitations beyond which a trader cannot exit his position, he may find himself “locked in” for another day, which may be another limit day. By using limited risk option net and spread positions, a trader may greatly greatly reduce his trading risks. In such option positions, risk is limited only to the  premium paid for the option position plus commissions and fees. Because the option trader has 1) a predetermined risk, and 2) is not subject to being “stopped out,” he has more time to properly evaluate his position when there are sudden changes. 15



3.  A Better Risk/Reward Ratio R atio :

By selling overvalued and/or buying undervalued options, trades may be initiated to take advantage of disparities in option premiums.

Temporary inefficiencies in the market may provide the trader some of  the most significant trading opportunities with exceptionally high mathematical probabilities of profit. 4.  Incr  In crea ease sed d Trad Tr adin ing g Oppo Op port rtun unit itie ies: s:  Option strategists may enjoy opportunities that do not exist with outright futures positions lacking trend or having too much volatility. Moreover, option strategists are the only traders who can initiate trades to profit in flat, trendless markets. In fact, such markets provide the option strategist opportunities with some of the highest mathematical probabilities of profit, such as “Neutral Option Positions.”

When To Buy Options

Because an option contains time value, the purchaser of an option is  buying a “wasting “wasting asset” asset” that is declining declining in value. Option Option purchases, purchases, therefore, must be restricted to special situations. One of the best circumstances volatility is lowAn andoption the trader’s system or the is likely to faceisawhen change of direction. purchase allows themarket trader  to take a position with a limited risk of loss; however, unless a significant market move occurs, the trader should have set objectives that permit him to close out this position before time decay erodes the option premium. Here are a few points to remember: 1. Options Options that that are close close-to -to-- or in-th in-the-m e-money oney are are more more likel likely y to be prof profita itable ble than out-of-the-money options. You must have almost perfect timing to make money with far out-of-the-money options. Out-of-the-money options offer enormous leverage for big  moves  moves only.



2. Options Options are usual usually ly cheape cheaperr after after market market decli declines nes o orr in flat markets markets,, and relatively more expensive in bull markets. Small traders generally  pref  pr efer er to ta take ke a lo long ng posit positio ion n by purch purchasi asing ng calls calls;; they they have have les lesss de deman mand d for puts, thus, calls are usually more expensive than puts. The public  pref  pr efers ers to be be “long “long”” and and is pred predomi omina nantl ntly y buyer buyerss of ccal alll opti options ons..

When To Sell Options

Option sellers appear to be at a great disadvantage because their reward (profit) is limited to the premium they collect, while their loss is potentially unlimited.

However, the mathematical odds favor the option seller for several reasons.

First, option sellers have mathematical probability probability in their favor because options are usually overpriced. Options are often overpriced compared to fair value formula pricing because of the nature of the participants in the market. Second, in addition to their being overpriced, the seller of calls has a further advantage in that he will profit if the market is flat, moves lower, or  even if it moves slightly against him (higher). Only if the market moves swiftly and sharply against him will the option seller lose. Third, by selling out-of-the-money options containing value, the options continually lose time value and, therefore, some ofonly theirtime premium. Because naked option selling potentially entails an unlimited risk of loss, the trader should not only have predetermined parameters for taking profits and accepting losses, but also confine trading to market conditions that are most favorable, such as over bought/over sold markets, high option premiums, etc. The trader should carefully monitor his positions.



When To Use Options with Futures

Options may be pur  purcha chased  sed  to  to protect a futures position instead of using stop loss orders; for example, a trader who is bullish on gold purchases the the futures contract at 320. At the same time, a December 320 gold put is purchased for $500. In this case, risk is limited to $500 (plus commissions and fees), and the futures position can be held no matter how severely the market goes against it.   “Covered writing” of futures positions is also one of the best, most conservative, and overlooked of all option selling strategies. This is discussed in greater detail in Chapter 8.




There are virtually unlimited possibilities for different option trading strategies by combining and callsdates. on any given commodity different strike prices or differentputs expiration Such strategies are using used not only  by compa compani nies es speci speciali alizin zing g in the arbit arbitra rage ge of opti options ons and usin using g sophi sophist stic icat ated ed computer analysis, but also by investors at home with pen and pad, developing their own individual trading strategies. Options strategists also use technical and fundamental analysis of the underlying market, computer analysis of  option premiums and risk/reward ratios, and return on investment calculations that boost profit potentials. When two or more options are combined into one strategy, they are called a spread.

Combinations may serve to reduce risk and increase the probability of   profit  pro fit.. They may be used used in bull bull markets, markets, bear bear markets, markets, flat flat markets, markets, and volatile markets. Complex strategies range from spreads profiting from disparities in option premiums to spreads spreads that benefit solely from time premium decay. FUTURES CHARTS COURTESY FUTURESOURCE (800) 621-2628

Figure 7

We compare option volatility readings to determine whether option volatility is relatively high h igh or low, to know whether we should be considering option buying or selling strategies.



Option Strategies that Provide the Trader with a Significant Advantage 1. Neutral Neutral Option Option Positio Position—H n—High igh–med –medium ium option option v volat olatili ilitie ties/ s/ trading range market  (sell out of-the-money put and  out-of-the-money out-of-the-mo ney call of the same expiration month). The  Neu  Neutra tral  l  Option Position  is best used in markets that have extremely high  prem  pr emiu ium m (by (by sell sellin ing g far far out out-o -off-th thee-mo mone ney y optio options) ns),, and tradi trading ng range range markets at any volatility level that have little likelihood of significant movement. 2. Free Free Trade Trade—L —Low ow opti option on vola volatil tility ity trade/ trade/tre trendi nding ng mark market et  (buy close-to-the-money call or put and, if the market moves in the direction indicated, later sell much farther out-of-the-money call  or put at the same price). The Free Trade is used in trending markets to purchase options of low to medium volatility that are close to the money (particularly on pullbacks or reactions against the trend). Farther 

out-of-the-money options which can have much higher volatility levels are sold on rallies to complete the Free Trade. 3. Ratio Ratio Optio Option n Spread Spread—Pr —Premi emium um dispa disparit rity y betwee between n option option stri strike ke prices, high volatility in out-of-the-money options/mildly trending market (buying close-to-the-money option and selling two or  more farther out-of-the-money options). The  Rati  Ratio o Spread  Spre ad  is   is used when disparity in option premiums exists. This generally occurs in extremely high volatility markets such as gold, silver, and soybeans. In this case, the close-to-the-money option is purchased and two or more

farther out-of-the-money options (which can have up to twice as high option volatility levels) are sold. 4. Calend Calendar ar Opti Option on Spread Spread—Pr —Premi emium um dispar disparity ity betwee between n option option months, high volatility in close-to-expiration options   (sell  close-to-expiration close-to-expir ation month, buy deferred month in the same option). The Calendar Option Spread  is  is used to take advantage of disparities in volatility between contract months of the same option. The trend is not significant for this position as long as we feel the option we sell will  proba  pr obabl bly y not not be “in “in-t -the he-m -mon oney” ey” at eexp xpir irat atio ion. n. 5. In-the In-the-Mo -Money ney Debi Debitt Spread Spread—P —Premi remium um dispa disparit rity y betwee between n strike strike prices/trending market (buy in-the-money or at-the-money option



and sell farther out-of-the-money option).  The In-th  In-the-Mon e-Money-De ey-Debit  bit  Spread  is   is initiated initiated in volatile volatile markets that that are trending. trending. Similar to the ratio spread, the at-the-money option which is more fairly valued is  purcha  pur chased sed and and the the farthe fartherr out-of out-of-th -the-m e-mone oney y overva overvalue lued d option option is is sold. sold. 6. Free Fre e Option Opt ion Posi Positio tion—H n—High igher er optio op tion n volati vol atilit lity y in out-of-the-money options take advantage of strong technical support and resistance levels (buy near-money option, sell outof-the-money put and call). The Free Option Position Positio n allows you to  purc  pu rcha hase se an opti option on with with the the prem premiu ium m rece receiv ived ed fr from om sell sellin ing g othe otherr opti option ons. s.

You may want to use other positions or invent complicated multi-legged  positi  pos itions ons,, but we have have found found those those describ described ed above above to be effect effective ive ones ones that can be used practically by off-floor traders to provide a significant advantage. In the following chapters, we describe the situations where we use these positions, how to manage these positions, and we look at examples of  how they have worked in the past.




The  Neutr  Neutral al Option Optio n Position Posit ion is a trading strategy that provides the trader many benefits over a long or short futures or options position. While with option purchases and futures trades are only successful if the market moves in the direction predicted (without the trader being “stopped out” first), a Neutr  Neutral al Option Optio n Position Posit ion can be successful in a non-trending market or a choppy market (studies have shown that markets are in a non-trending or sideways pattern almost two-thirds of the time) or if the market moves slowly lower or higher. In addition to allowing the trader to be successful without having to  predict  pre dict the exact exact directi direction on of the market market,, the  Neutr  Neutral al Option Optio n Position Posit ion incorporates the advantages of: 1. Special Circumstances 2. Price Disparity 3. Option Time Decay

4. Mathematics 5. Probability 6. Money Management

This strategy involves selling an out-of-the-money put and an out-ofthe-money call containing only time value, with the expectation of collecting the entire amount of time value premium as the underlying futures remains within a wide trading range. We are, in effect, taking the other side of trades from participants on  both  bot h sides sides of the market market who are attemp attemptin ting g to pick pick the direct direction ion of the underlying futures contract. Some feel that the market is going up, while others believe that the market will head lower. lo wer. The traders who feel that the market is going up purchase calls, while those negative on the market  purchasee puts.  purchas We, in effect, are staying evenly balanced in our positions; however, we have an advantage in doing so. With our Neutr  Neutral al Option Optio n Position Posit ion we can  profit  pro fit on both both sides sides of of the the marke markett (if (if the the marke markett stays stays within within our predic predicted ted or adjusted trading range). For example, with treasury bonds trading near 113, we can take the view that the market is going to remain within the range between 110 and 120 and sell the 110 put and the 120 call. These options are sold to other traders who were acting acting on their prediction



of market direction—that the market was going below 110 (puts) or above 120 (calls). We were making no predictions other than that it would remain in a wide trading range. Neutral Option Position (110 Put—120 Call)

Market Price

Every day, both options sold lose some of their time value. Further, adjustment techniques are available, allowing us to “rebalance” this position when necessary. Remember, there is always unlimited risk of loss when an option is sold, so risk management is always important.



Figure 8 Adjustment of Neutral Option Position when futures approaches strike price or option sold.

The benefits of this position include: 1. Not Not having having to predi predict ct mark market et direc directi tion. on. 2. Being Being able able to to profit profit from both sides sides of the trans transacti action—b on—both oth from from the  buyers  buy ers of puts puts and and buyers buyers of call calls. s. 3. Being Being able able to take take advant advantage age of of the the “overv “overvalu alued” ed” time time v valu aluee of outout-ofofthe-money options because, while the amount of option premium changes from time to time, traders continue to buy options, thinking they can “beat the market.” 4. We can can incre increase ase the number number of of positi positions ons based based on favorabl favorablee market market conditions (high option premium), and we have forty different commodities from which to choose for the sale of options. 5. Finall Finally, y, we have have the abil ability ity to to both adju adjust st our our positi positions ons and and increa increase se our  our   positi  pos ition on si size. ze. It has been mathem mathemat atica icall lly y proven proven that with with suffi sufficie cient nt capital, the probability of making a profit becomes greater.




The  free trade trad e  combines the best principles of money management and the advantage of “undervalued” and “overvalued” options; however, tra de is that it allows you to build a the most exciting aspect of the  free trade large position in a trending market without increasing your initial risk. To initiate the fre  freee trade, trad e,  first purchase the best-priced option. When (and if) the price and volatility (premium) rise, sell a farther out-of-the-money option at the same price. Of course, if the market does not move in your  favor, you cannot complete the  free trade. tra de.   Another benefit of the  free trade is that after it is completed, there is no margin capital necessary, or   pote  po tent ntia iall loss loss (oth (other er than than brok broker erag agee fees fees and and cost costs) s).. Fo Forr exam exampl ple, e, in Febr Februa uary ry 1994, in bonds (see top of chart 8a), you could purchase the 112 and 110  puts.. Thereaft  puts Thereafter, er, the market market conti continued nued to decli decline ne ((see see bott bottom om of of chart chart 8a),

ands you could sellprice further such 106. and 108  put  puts at the same as out-of-the-money we purchased theoptions, 110 and 112asputs For example, if you purchased the 112 put put and paid 32 ($500) and thereafter sold the 106 put for the same amount, you would then have a position that had a net cost to you of $0 (except for commissions and fees) and a  prof  pr ofit it po pote tent ntia iall of of $6,0 $6,000 00.. 11900 11700 11500 11300 11100 10900 10700 J







F 11800 11500 11200 10900 10600 10300







Figure 8a





The free trade trad e accomplishes several objectives: First, it keeps your account intact if the market turns around. Just as quickly as markets rise, they can also fall. The free trade tra de position provides  prot  pr otec ecti tion on fro from m loss loss in in this this sit situa uati tion on.. Second, if the market moves in your favor, you can continue to add to your position on the next pullback. If the trend remains intact and the market  pulls  pu lls back, back, as it eventu eventuall ally y does, does, you are then then in a posit position ion to purcha purchase se another option to begin building a larger position. You can look to turn the second position into a free trade tra de using the same method without increasing your initial risk. By doing this you can take advantage of the normal swings of the market to purchase options when they are the cheapest and sell them when they are the most expensive, on rallies. Further, you will be purchasing “closer-to-the-money options” which are normally the most fairly valued options, and selling “out-of-the-money options” which are usually the most overpriced options. Also, the collateral benefits of the  free trade trad e —be  —bein ing g able able to look look at other potential opportunities because this position is secure from loss and requires less monitoring, and the emotional security of having your equity  prote  pr otecte cted—s d—shou hould ld not not be over overloo looke ked. d. Another benefit of the free trade trad e is that it gives you time to unemotionally examine your position without the panic other traders experience as their   profit  pro fitabl ablee posi positio tions ns begin begin to nose-di nose-dive. ve. Because Because you are protec protected ted,, you you can wait for emotions to subside and the market to give you a better indication of its next move. You can then decide to hold your position and look for full  prof  pr ofit it potent potentia iall (know (knowin ing g you are complet completel ely y prote protect cted ed from loss) loss),, or you can cash out and take your existing profits. The final benefit of free trades is that, when they are completed, because your capital is protected, you can turn your attention elsewhere. You may find opportunities in another commodity, or even in the market in which you have completed free trades to add more positions. This can be accomplished without increasing your original risk because your first positions are now risk-free! It is difficult to closely monitor more than two or three net positions, especially in volatile markets. The  free trade trad e  allows you to concentrate more fully on other situations. The  free trade trad e  also allows you to meet your objective of getting a “trading edge” over the markets by using options. You are taking advantage of the increased volatility of the out-of-the-money options, which can be quite exaggerated on market rallies.




A ratio spread  is   is initiated by purchasing a close-to-the-money option and selling two or more farther out-of-the-money options. For example, with November trading $6, we smay decide  No  Novem vember ber $7 callsoybeans and sell two $10 at calls. call s. Let’s Let’ assume assum e tha thatt to thepurchase $7 call isa trading at a premium of 20 cents and the $10 call at a premium of 12 cents.We would then pay 20 cents for the $7 call ($.20 X $50 = $1000); and receive two times 12 cents or 24 cents for the $10 calls we sell ($.24 X $50 = $1,200). In this case, because we receive $200 more than we paid out, we are doing the spread at a credit of 4 cents, or $200. FUTURES CHARTS COURTESY FUTURESOURCE (800) 621-2628

Soybean Futures Price Figure 9 - The probability of the futures futur es price achieving a given price level.  —Thee pr  —Th profi ofitt or loss poten potentia tiall of a soy soybea bean n rat ratio io optio option n spr spread ead comp compris rised ed of 1 lon long g   $7.00 call and 2 short $10.00 calls receiving a credit of $200.



Receiving this credit is very important when doing the ratio spread,  and  benefi  ben eficia ciall for for the the follow following ing reason reasons: s: 1. First, First, if if the market market goes goes up as we expect expect in this example, example, we will will receive receive a profit of $50 for every penny soybeans move over $7.00 at expiration (up to $10) for a maximum profit potential of $15,000. 2. Unlike Unlike a norma normall option option purc purchas hase, e, there there is is no cost cost for your your init initial ial opti option on  purchase  purc hase becaus becausee it was paid paid for by the the sale of the the two $10 $10 calls. calls. 3. In makin making g this this trade, trade, we are are also also taking taking advant advantage age of the the dispa disparity rity in option premiums between strike prices. We find in most markets options that are closer-to-the-money have lower volatility (premium costs) than farther out-of-the-money options. These out-of-the-money options have no intrinsic value because they have only what is known as “time value premium.” This is a specific amount people will pay for an option because it has a chance chance of becoming valuable some time in the future. There is more demand by smaller traders to purchase “cheap” options. This can greatly increase the time value of these out-of-the-money options to a point where they, at times, are much more expensive than one might expect. Because the options are so far out-of-the-money, it is very unlikely that the options will go into-the-money, yet the premiums do not reflect this lack of probability. Thus, they are, relative to the  proba  pr obabil bility ity of profi profit, t, much much more more expens expensive ive than than the the close close-to -to-th -the-m e-mone oney y options. By using the ratio spread   we can take advantage of this disparity in premium because it allows us to purchase the more reasonably  price  pr iced d closeclose-to to-th -the-m e-mone oney y option option and sell sell the the relat relative ively ly more more expens expensive ive options that are farther out-of-the-money. 4. The fart farther her out-o out-of-t f-the-m he-money oney options options we we sell sell will will also lose their their time time value faster as they approach expiration. Time value decreases for   both  bot h an option option at-the at-the-mo -money ney and out-of out-of-th -the-m e-mone oney y as it approa approache chess expiration. This decline in time value is much more dramatic for the out-of-the-money option. 5. Final Finally ly,, one one of the the bigg bigges estt bene benefi fits ts of the the ratio spread, is the fact that, if the market does not move as expected, as long as we obtain a credit



when the spread is initiated, we will not have a loss. In our example above, let’s assume that soybeans drop to $4. In that case, the options we purchased and sold will all be worthless at expiration. At that time, the net difference to our account from taking this position will be the $200 premium that we collected when we initiated this position; therefore, our account will increase by $200 (less commissions and exchange fees) even though the market moved against us! There is only one case where the ratio spread  can   can run into trouble: when the price of the futures exceeds the strike price of the options sold. For example, in our previous discussion of the soybean ratio spread, if at expiration in November soybeans expire at $10, we make 300 points times $50, or $15,000; however, if the price of soybeans exceeds $10, we begin to lose $50 of our profit for each penny that soybeans exceeds $10. At the  pric  pr icee of of $13 $13,, we we wou would ld brea break k eve even n on on thi thiss pos posit itio ion, n, and and ove overr $13 $13 we woul would d  begin  begi n to have a net net loss loss of of $50 $50 for for each each penny penny move move that that exceeds exceeds the price price of $13. To help control the potential for large losses under these conditions, we follow a rule that requires us to close out our ratio spread  if   if the futures  price  pri ce exceeds exceeds the strike strike price price of our short short option; option; therefor therefore, e, if soybeans soybeans ris risee above $10 at any time, we would recommend closing out the position. We normally find that if the market rises slowly toward the strike price of the options we sold, we still have a profit on the position when we close it out. Usually, only in the case of a quick rise is it necessary to close the  posit  po sitio ion n out as a loss loss.. The best time to initiate a ratio spread  is  is when the market has made a quick straight-up move. This is because this type of action normally increases the demand for out-of-the-money “cheap” options for the reasons mentioned above. This also seems to be when when there is the greatest disparity in premiums  betw  be twee een n the the cl clos osee-to to-t -the he-m -mon oney ey and and the the outout-of of-t -the he-m -mon oney ey opti option ons, s, prov provid idin ing g the best opportunity for ratio spreads. (The one exception currently is the S&P 500, when put option premium expands on market declines.) We feel that the benefits of the ratio spread  far   far outweigh the single  probl  pr oblem em area, area, that of the market market risi rising ng too too quickl quickly, y, too soon. soon. Also Also,, these these  probl  pr oblem emss are handle handled d by the rules rules we des descr cribe ibed d above. above. The abi abili lity ty to initi initiate ate a spread that can be profitable over a wide range of prices and market conditions (in the case of our soybean example this position is profitable from $0-$13!) allows you to have both financial and emotional security in the markets.




1. The In-The-Money Debit Spread The In-the-Money Debit Spread  consists  consists of purchasing an in-the-money option and selling an out-of-the money option of the same expiration month. It is a position that requires us to pay a premium—the cost difference between the option we purchase and the option we sell—in exchange for   potenti  pot entiall ally y receivin receiving g the diffe differenc rencee between between the the two stri strike ke prices. prices. For example, currently, the September S&P is trading at 1260. A trader  who is bearish on the S&P could purchase the September put 1260 for  4000 points ($10,000) and sell the 1240 put for 2800 points ($7,000) for a net cost or debit of $3000. The potential profit on this position is the difference  betwe  be tween en these these two strik strikee prices prices 1260 1260 minus minus 1240, 1240, 2000 2000 poin points ts ($5,0 ($5,000) 00) less less the initial cost of the option. As uninspired as this position may seem, it actually has substantial benefits over a short futures position including: 1. Lower cost 2. Limitation of risk  3. Ability to to take advantage advantage of premium disparity. disparity. The cost or debit of the September S&P in-the-money debit spread in this example is $3,000; however, the margin for initiating a short futures  posi  po siti tion on is su subs bsta tant ntia iall lly y high higher er,, at more more than than $10, $10,00 000. 0. This This al allo lows ws a tr trad ader er to commit less of his capital to any one trade. The second, and probably more important advantage, is limitation of  risk. While a short futures position burdens the trader with unlimited risk, the risk of the  In-t  In-thehe-Mon Money ey Debit Deb it Spread  Spr ead   is absolutely limited to the amount paid for the spread plus commissions and transaction fees. This can  be more more of a substan substantia tiall benefit benefit than than most most trader traderss rea realiz lize. e. Even though though many futures traders feel that they can limit their risks by the use of “stops,” what is not taken into account is that many times, they can be “stopped out”  becausee of the risk  becaus risk of taking taking a large large loss loss in a mar market ket that that has begun begun to make make a big move against this position only to then see the market reverse and



move in their favor. With the In-t  In-thehe-Mon Money ey Debit Deb it Spr Spread  ead  the  the trader knows that not only is his risk limited, but he is actually hedging some of his losses if the market goes against him with the gains on the option he sold. These factors can be very important, especially to a trader who finds that, although his ability to predict market direction is good, he is emotionally and financially unable to handle the normal market “noise” of corrections, even when the market is trending in his favor. This psychological advantage of knowing that your losses are absolutely limited can make the difference  betwee  bet ween n a winni winning ng or losi losing ng trade trade.. The third benefit of this position is being able to take advantage of  disparity in option premiums. In the spread described above, the volatility of  the 985 was less than that of the 965 put. This means that we were selling an option that was trading at a volatility higher than the option we were  purc  pu rcha hasi sing, ng, prov provid idin ing g anot anothe herr sign signif ific ican antt bene benefi fit. t. The advantages of this position seem so overwhelming that one wonders why anyone would trade the outright futures contract. Still, there are some disadvantages that should be considered by all traders before they initiate this position. First, we are initiating a spread of two positions instead of one, so there is an extra commission for each trade. Second, orders should always  be plac placed ed at at a spec specif ific ic limi limitt price price to avoi avoid d slipp slippage age that that can can occur occur with with less less liquid options. Third, profit on a “Debit Spread” is limited, as opposed to the unlimited profit potential of futures positions; however, we feel that these disadvantages are a small price to pay for the benefits that accrue with this type of position, and could make the difference between a profitable or  unprofitable trade. 2. Option Straddle Purchase

This “non-directional” option strategy is also greatly overlooked. The Option Purchase Straddle  is the purchase of a put and a call of the same month and underlying market. As in all option purchasing strategies, we recommend that at-the-money or close-to-the-money options be used. Similar  to the In In-the the-Mon -Money ey Debit Debi t Spread Spr ead,, risk is absolutely limited to the premium  paid  pai d for the optio options ns plus plus commis commissio sions ns and transac transacti tion on fees; fees; however, however, not only is the potential profit unlimited, but we can also profit by a move in either direction. This is why we call it a non-directional non-directional option strategy—we don’t care which way the market moves, as long as it moves. Sincedoes this not strategy be unsuccessful if thedirection, underlyingwe futures contract makewill a significant moveonly in either only recommend initiating this position during the following times:



1. Before Before impor importan tantt report reports, s, meeti meetings, ngs, and rele release asess of infor informat mation ion tthat hat could substantially affect the futures prices in either direction; 2. When When opt option ion volat volatil ilit ity y (pre (premi mium um cos cost) t) is is low; low; or  or  3. When the futures’ futures’ technical technical pattern pattern suggests suggests a large large breakout breakout is imminent. This strategy was recommended in July, 1997 just prior to the G-7 meeting. We expected these meetings to have a severe impact on the currency market, either by action or disappointment from non-action. Further, the option volatility in the D-Mark was near historical low levels in spite of  large daily moves occurring in the underlying futures market. This strategy worked well as the D-Mark jumped almost 200 points the day after the meetings concluded, allowing traders who initiated this position to turn their  call purchases into  Free Trades. In fact, since the market began to turn around right after this jump, the puts began to gain significantly in value, and on a continued move down, traders were in a position to turn the puts into  Free Trades. This is the ultimate of all positions, to have a Free Trade  in  both  bo th dire direct ctio ions ns,, and and be able able to prof profit it with withou outt havi having ng to pick pick mark market et dire direct ctio ion! n!


Figure 10 This is a triangle pattern in December Oats.



This position is also recommended when the market has moved itself  into an explosive chart pattern. Our favorite type of chart pattern for this  positi  pos ition on is is the the “tria “triangl ngle” e” patt pattern ern,, where where the future futuress have have made made lower lower high highss and higher lows over an extended period of time. The market then “coils” itself into a tighter and tighter trading range from which a large breakout always occurs. The problem is in guessing which way this move will take  place  pl ace.. The option option strad straddle dle remove removess this this questi question, on, allowi allowing ng the invest investor or to  profit  prof it by a large large move in either either directio direction. n. Further, Further, this is normally normally an opportune time to purchase options, as volatility often falls to very low levels as the market “quiets down” and moves into this trading range. Then, after  the breakout, not only does the option gain from the price movement, but volatility can increase substantially thereby also further increasing the value of the options purchased. These two positions are not only the most overlooked option purchasing purchasing opportunities, but they are strategies that can provide the investor with significant advantages in the right circumstances—a substantial “trading edge” over the markets.




We have discussed the benefits of the Neutr  Neutral al Option Position Positio n (which is favorite for choppy, or non-trending markets) and theour  Rati  Ra tio o Optio Opoption tion n Spre Spstrategy read ad,,  one of our flat, favorite option strategies when out-of-the-money out-of-the-mo ney option premiums are extremely overpriced; however, two  posit  pos ition ionss that that have have great great benefi benefits ts in many many situat situation ions, s, Covered Call Writing  and Calendar Spreads,  are also often overlooked. These overlooked strategies can provide a trader with overwhelming advantages when used in the right circumstances.   1. Covered Call Writing—Additional Income; No Risk or Margin This strategy is one of the best methods of increasing your returns without any additional risk, margin, or capital necessary. This strategy is initiated by selling an out-of-the-money option against a futures position. For example, a trader purchases a silver futures contract at $4.50. At the same time, he sells the September $5.00 call for $300. There is no additional cost or margin for this position because the calls you sell are “covered” by the long futures position. Thereafter, the market can react in four ways: a. It can move lower;  b  b.. It can remain remain stable; stable; c. It can move move high higher er,, but but rema remain in below below $5.00 $5.00;; d. It can move move abov abovee $5.0 $5.00 0 (an (an incre increase ase of over over 11%) 11%).. In the first three instances, the net effect of initiating the covered call would be to add a risk free $300 to our account to lower our losses in situation a), or increase our profits in situations b) and c). Even in situation d), which is the only scenario in which writing a call would be detrimental to us, the only loss here is the limitation of potential profits (an opportunity loss) above the $5.00 price. Our initial profits of $2,500 in the futures plus the $300 we received for selling the option (less commissions and fees) would be ours to keep. We just would receive no additional  profits if silver  really took off and continued to move substantially above $5.00.



There is also a variation of covered writing  that  that can provide the investor  with a more aggressive position with additional profits in a trending market situation. In this case, after purchasing the silver at $4.50, you also purchase a $4.50 call and sell two $5.00 calls. calls. Our existing position position now is long long one futures contract of silver at $4.50, long one silver $4.50 call; and short two $5.00 calls. In this situation, our maximum profit level is $5,600 if silver is at $5.00 by September, instead of the $2,800 that we could make if we purchased purchased only the futures without the aggressive option strategy. In fact, silver would have to go all the way from $4.50 to $5.50, a move of more than 22%, to make as much money with with the futures alone as we would make w with ith the aggressive option strategy. What’s more, only above $5.50 does this strategy  becom  be comee detri detrimen mental tal to us, us, as as profi profits ts are are lim limit ited ed above above this this le level vel.. In summary, this option strategy works as follows: 1. If silve silverr moves moves under under $4.5 $4.50, 0, there there is is no detrim detriment ent from from this this stra strateg tegy y (except for commissions and fees); 2. If silve silverr moves moves above above $4.50, $4.50, but but remai remains ns at at or below below $5.00, $5.00, our profits profits will be double what we would make with a futures position alone; 3. There There are are additio additional nal prof profits its ffor or tr trade aders rs while while silv silver er is betw between een $ $4.5 4.50 0 and $5.00, above those that would be made on the futures alone; and 4. Only Only above above $5.50 $5.50 are are profi profits ts limit limited ed (howe (however ver,, by this this time time we woul would d have made $2,800 for each option strategy and futures purchase).

2. Calendar Option Spread—Take Advantage of Disparities in Futures and Options Price

The Calendar Option Spread   is initiated by purchasing a deferred month option and selling a closer-to-expiration option. The advantage of this  posit  pos ition ion is the steep steep time decay decay that that closeclose-toto-the the-mo -money ney option optionss underg undergo. o. This in itself is a substantial advantage to an investor; however, there are two additional situations when this trade turns the odds overwhelmingly in favor of the option strategist. The first is when option option volatility for the closerto-expiration months isintrading at substantially higherislevels than the deferred option. This happens volatile markets, as there an increased demand for these “more active” options for speculation and hedging. Often, we find



that the deferred month options are “forgotten” and trading at volatility levels 50% or more below the active front month option. Examples of this occurred in 1996–1997 in the cocoa and coffee markets when they began to break out; in the grains during their rally attempt this spring, where front month premiums were higher; and in live cattle in May and June after it rallied to new highs. One of the best instances illustrating the benefits of this strategy occurred in the live hog option market. The spread between February and October  live hogs had moved from February being 100 over October in the beginning of June, to February being more than 150 under in July. Our research showed that this does not happen often and usually such a disparity in the futures contract is quickly corrected. Additionally, because of the volatility in the live hog market, the February calls were 20% less expensive than the October  calls; therefore, we recommended a Calendar Spread  to  to purchase in-themoney February call options while selling out-of-the-money out-of-the-money October options that were close to expiration and entering a period of their most severe time decay. This trade combined the best of both worlds for the Calendar  Spread  allowing:   allowing: 1. the trad trader er to take take adva advanta ntage ge of the the under underval valuat uation ion of of the defe deferre rred d month option contract; 2. the the overpr overpric icing ing of of the clo closese-to to-ex -expi pirat ratio ion n optio option; n; and and 3. the rapid rapid ttime ime decay decay of of the the close close-to -to-ex -expir pirati ation on opti options ons..



CONCLUSION When I began trading options in 1982, I decided that I would read and study all the books I could find on option trading, so that I could choose which methods worked worked best. What I didn’t know was that, if my education had been limited to this information, my abilities as a trader would have  be  been en str ssuch tric ictl tly yaslimi lihaving mite ted. d. aWhil Wh ilee ther there e isand no no money subs substi titu tute teanagement for for thi thiss know knowle ledge dge,, other  other  areas, trading plan management m principles, are equally necessary to succeed. When I began researching option trading, I was very excited because of the mathematical possibilities of combining options, and what I discovered as certain characteristics that seem to provide significant benefits, such as premium disparities between option strike prices and time decay of  overvalued options. After reading all existing option material, I felt almost helpless because there was no “road map” to guide my option trading from that point. I hope that this booklet can be the beginning point of your “road map to success.”




Appendix 1 COMMON OPTION STRATEGIES FOR ALL MARKETS Option Spread S tr a t e g y

Best Time Characteristics t o U s e

P os i ti o n

Neutral Strategies   Neutral Neutral Option Sell out-of-money  Po  Position

put a nd c a ll

Maximum use of t i me va l ue d e c a y

Tradi Trading ng range market with volatility peaking

 Gu  G uts

Sell in-the-money  put and call ca ll

Receive large premium

O p ti o n s h a v e ti m e value premium and market in trading range

 Arrbitrage  A

P ur cha se a nd sel l s im ila r o p tio n s simultaneously

Profit certain if d o n e at c r ed i t

A n y t i me w h e n c r e d i t is r e c e iv e d

 Co  C onversion

Bu y f u t u r es, b uy a t - the - mo ne y put and sell out-ofthe-money call

Profit certain if d o n e at c r ed i t

A n y t i me w h e n c r e d i t is r e c e iv e d

 Bo  B ox

S e ll c a l ls a n d p u t s

Profit certain if

A n y t i me w h e n

same strike price

d o n e at c r ed i t

c r e d i t is r e c e iv e d

 Bu  Butterfly

Buy at-the-money Profit certain if c a l l ( p u t ) s e ll 2 o u t- d o n e a t c r e d i t of-the-money calls (puts) and buy outof-money call (put)

A n y t i me w h e n c r e d i t is r e c e iv e d

 Ca  C alendar

Se l l n e a r m o n t h ,  buy far fa r month, month , same strike price

Small debit, trad trading ing ran range ge market

Near month time value will decay fa ster



Option Spread S tr a t e g y

Best Time Characteristics t o U s e

P os i ti o n

Mixed Strategies  Raatio Call  R

Buy call, sell calls of higher strike  price

Neutral, slightly bullish

La r g e c r e d it a n d di f f e r e nc e be tween strike  prices  pric es of option opt ion  bought  bou ght aand nd sold so ld

 Raatio Put  R

B uy put, s e ll put s of lower strike  price

Neutral, slightly b e a ri s h

La r g e c r e d it a n d di f f e r e nc e be tween strike  prices  pric es of option opt ion  bought  bou ght aand nd sold so ld


B uy put a nd c a ll

O p t io n s w i l l l o s e time value  premium  prem ium quickl quickly y

Opt i on s u nd er v al u ed a n d market market li likely kely to make a big move

 Co  C overed Call

B u y f u t ur e s , s e l l call

Collect premium o n c a l l s s ol d

Neutral—slightly b u l li s h

 Co  C o v er ed P u t

Sell futures, sell  putt  pu

Collect premium on p puts uts so sold ld

Neutral—slightly bearish bear ish

 P  Pu urc has e

Bullish Strategies  Bu  B uy Call

M o st b ul l i sh o p tio n p o sit io n

Loss limited

Un d e r v a l u e d o p t i o n wi t h volatility increasing

 Sell Put

Neutral–bullish o p tio n p o sit io n

Profit limited

O p t i on ov e r valued, market flat to bullish



Option Spread S tr a t e g y

Best Time Characteristics t o U s e

P os i ti o n

 , C ont ntii nu nue ed  Bullish Strategies , Vertical  Bu  B ull—Call

Buy call, sell c a l l o f h ig h e r strike price

Loss limited

Small debit, bullish market

 Vertical  Ve  Bu  B ull—Put

Buy put , sel l put of higher strike  price

Loss limited

La r g e c r e d it , bullish market

Bearish Strategies  Bu  B uy Put

Most beari sh

Loss limited

o p tio n p o sit io n

Un d e r v a l u e d o p t i o n wi t h increasing volatility

 S  Seell Call

N e ut r a l – be a r i s h o p tio n p o sit io n

Profit limited

O p t i on ov e r valued, market flat, bearish

 Vertical  Ve  Beear—Puts  B

B u y - a t - th e - m o n e y p u t , s e l l i n- t h e money put

Loss limited

Small debit, bearish market

 Vertical  Ve  Beear—Calls  B

Sell call, buy c a l ls a t hi ghe r strike price

Loss limited

La r g e c r e d it , bearish market



Appendix 2 NEUTRAL OPTION SPREAD STRATEGIES 1. Neut Neutra rall Stra Strate tegy gy (se (sell ll p put ut–s –sel elll call call)) Requirements: 1. Sell Sell outout-ofof-the the-mo -money ney put put and and out-o out-off-the the-m -mone oney y call call

2. Choose Choose options options as as far far out-of-th out-of-the-mo e-money ney as possible, possible, but still still colle collect ct worthwhile premiums 3. Cont Contra ract ct vol volat atil ilit ity y high high,, but but decr decrea easi sing ng Example: With bonds at 113 and in a range of 106 to 116 , sell the 120 call and 102 put. 2. Cale Calend ndar ar Spr Spread eadss (buy (buy far far mont month– h–se sell ll near near mon month th)) Requirements: Option premium lower in deferred month; equivalent or nearly equivalent out-of-the-money options at smallest net debit or at any credit. Example: With July sugar at 12 cents and October sugar at 12.75 cents:   Sell July 13 cent call .75 cent   Buy Oct.13 cent call 1.00 cent   2.50 cents debit and a difference of .7 cent between futures month prices.

3. Calendar Combination (combine calendar and strangle) Example: With July sugar at 12 cents: Sell July 14 cent call Sell July 10 cent put Buy Oct. 14 cent call Buy Oct. 10 cent put 4. Ratio Ratio Spre Spread ad (buy (buy closeclose-to-t to-thehe-mon money ey call call o orr put—s put—sell ell out-ofout-ofthe-money call or put) Requirements: 1. Large Large spre spread ad betw between een strike strike prices prices of o opti ptions ons bought bought and sold sold 2. Premi Premium um receiv received ed is greate greaterr than than premiu premium m paid paid 3. Future Futuress price price is not not like likely ly to to reach reach strike strike price price of of optio options ns sold sold 4. High High premi premium um for out-of out-of-th -the-m e-mone oney y option optionss sold sold

Example: Buy 1 July 12 cent call—Sell 2 July 16 cent calls



5. Ratio Ratio Cale Calenda ndarr Spre Spread ad (combi (combine ne ratio ratio and and calend calendar) ar) Requirements: 1. Larg Largee spre spread ad bet betwe ween en opt optio ions ns b bou ough ghtt and and sold sold 2. Zero Zero prem premiu ium m or or smal smalll deb debit it 3. Futures Futures price price not not like likely ly to to reach reach strike strike price price of of optio options ns sold sold Example: Buy 1 Oct 12 cent call and sell 2 July 14 cent calls 6. Rati Ratio, o, Calen Calenda darr and and St Stran rangle gle Combi Combina nati tion on Example: Buy (1) March 14 cent Sell (2) March 16 cent sugar call sugar call Sell Dec 16 cent Sell March 12 cent sugar call sugar put 7. Butte Butterfl rfly y (ratio (ratio spre spread ad plus plus purch purchase ase of of an out-o out-of-t f-thehe-mon money ey option) Example: Buy call or put Sell 2 calls or puts (Strangle or Straddle) Buy call or put Example: Buy Call Sell call and put (Straddle or Strangle) Buy put 8. Convers Conversion ion (buy (buy futur futures, es, sell out-of-t out-of-thehe-mone money y call(s) call(s),, and and buy buy at-the-money put) Requirements: 1. Look Look for an an at- or or close close-t -to-t o-thehe-mon money ey put put with with a premi premium um equal equal to to the debit on an out-of-the-money call (possible because calls are usually valued higher than puts). 2. Use Use when when mark market et has has decl decline ined d and and calls calls are overva overvalue lued d Example: Buy Sep. futures Buy Sep 925 put for 3000 points Sell Sep 930 call for 3000 points

(Risk = debit if put is at-the-money)



   t   u   t  .    b   e  ,    k    t   e   r   a    k   r   m   a    l   m   l   u   g    b   n   a    i   n   n    i    l    i   c   e   s   n    d   a    t   o   n   i   s    i   o   s   p   s   o   g    l   n    i    t   s   y   n   l   r    i   e   a    d   g   a   n   u   e    f   g   o    d   e    t    i    h    f   o   e   r    d   p    i   v   t    i   o   r   m   p   i    l   n   a   n    C   c   a

 .    d    l   o   s   s    l    l   a   c    d   n   a   s    t   u   p

  y    l    l   a   r   e    f    t    d   o    i   e    t   s    k    i   n   r    f   a   o   w   r   m   o   p    d    t    t    i    t   n   a   n   m   c    i   a    i    l   c    f    i    i  .   r    f   n    i   o   t   r   e    f   o    i   g   s    t   a   k   n   g    i    l   e   a    f   s   r   g   e   m   s   n   n    t    i   s    f   a    l   r   e   a    l   o   l   u    i   g   n    l   o    b    i   n   u   o    l    i    t   a    f    i   s   o    t    d    f    t    f   r   a   n    l    t   o    i   r   o   r   u    t   r   p   s   o   s    P   r   n   p   e   n    i   o   o    t  .   r   y   s    i   s    t   o   e   g   n   m    t    i    i   e   i   s   u  .    f   m    Y   f    t   a    t    i   o   a   o   o   s   r   r    R  n   p   m   c   m    t   r   e   e   e   u   n   g   s   p    A  m   r   r    i   c    t   n   n   p   c    0    i    i    d   n    M  e    f    0   y   r   e   k   o    d    l    i    l   o    5   a    l   r   c   e    M  u   s   v   e   e    l   o    P    l   s   o   c   l    i    d    3   U  q   e   o    E   x   t    &    S   n    W  u   o   m    Y   R    L   x   S    i   r    d   G   ;   o   m  ,  .    t    t   o    E   n   m   u   n    t   o   e   u   n   s    i    l   u   i    t   o   e   T   o    k   o   o    l   s    i   m    i    i   o    i   r   n    i    t    f    h   o    t   p   A    t   a    t   m   m   m   f   x    i   c   a   s   r    i    t   e   e   u   a    l   p   R   e   r   u    i   m   r   r   o   w    l    i   o   o   ;   p   p   a    d   p  .   m   m    d    k    A   T    d   d   e   n   v    S   s   s   o    t    d   n   e   r    i   ;   e   o   e   g   e    t   o   r   n   o   v   p    i   r    i    i    i    t   n    k    N   g   o    i    t    f   e    i    f   r   e   a    b   m   u   p   o    d   s   o   y   a   c    O   u    i   u   r    l   q   o   r    l   e    i   e    I   s    t   r   p   i   r   e   m   o   m   r   e   a   n   f   n    f   r    T    f   v   u   o   u    d    k  .   w   e    d   o   o   q   l   m    P   r   o   s   c   e   n   o   s   r   u   p   e   o    l   u   s   y   r    i    d   n    i   m   a   m    O    t    t   o   o   a    i   r    f   s    d    i   u    k    l    f   n   m   ;    l   w    t    i   o   s    f   c   o   n   e   o   i   s   o   a   e   r    t    b   r    i    l   m    i   o    /   n   s   p   i    i   a   a    l   e   s    t   g   e    d   o    t   a   b    i    k   s   e    t   r    k   e   r   c    t   p   a   a   r   n   r   n   u   q   n   d   e   p    i   r   s   o   i   o   t    i   s   r    l    /   m    t   u    i   p   i   e   o    f    d   e    t    i   n    l    d    d   o   r    t   e    l   s   o   m   a   a    t    i    d   e    i   p    t   a   o   r    l   u   v   n    i   n   g    t    i   e   c   c   n   a    i   e    i   o    E   q   m   n   m    k    t    i   s    i    l    i   a   w   e   r    t    h    l    l    i   a   c   r   c    i   e   a    l   —   m    i   n   g   m   n    i   e    k    t    d   m    t    i   u    L   t    R   m   s    t   r    i   s   e   u   v    i    H  e    L   o   a    b   n    U   n    f    h   r   m   —    d    t    i   r   o    A   w   e   e  ,   —   o    E   a   r    C   s   —    l    t   e    t   e    l   o   n   c    E   p    S   e    L    i   p   o   m   o    R   g   o    S   a    k    k    t    L    E    d    i    A  .    S   h   t    d    L   ;   r    A   d   s   s    R   g   —  r   a    t   a    H  e   e   c   n   g   i    d    E    i   r    E   m  o    U   i   s   a   n    h    t  .    i    E    d    S    i   o    L    H    C   g    /   u    T   o   e   g   r    C    L   m    /  .   r   n   m  q   g    U   i    A  a   n    T   c   i    i    G    t    i   p   y    R    d   e   e    l   r    S   m   s   r    U   d   r    F   n    N   t   e   e   o    U   g    b   e   o   u   t    P   i   ;    P   e   r   r    i    t    L    t   c   r    t    i    i    A    L    i    i   e   e   u   n    Y  m  n    l    L   i    f   a   u    T   a   u    l    L    l    R    l    l   r    i   e   o   q   o    U  r    A  o    E   k    T   o   q    t    U  w   a   r   e   e   e    S    P   r   v    C   p   r    S   s    S   c   r   m    B   p   m

 .   o    i    l   o    f    t   r   o   p   o    t   n   r   u    t   e   r    d    d   a   o    t   y    l    l   a   r    t   n   a   c    i    f    i   n   g    i   s   r   e    t    f   a    d   e   s   u    t   s   e    B    h   g    i    h   ;    t    d   e   r   o    t   c    h   e   s    l    l   a   o   r    t   c   x   s   e    f   m   u    i   o   g   m   n   e    i   r   r   p   t   o    i   o   n    t   o    l   a   m   u   s   q   e   e   i   r    d   u   r   a   q   e   r   w   e   ;    i    R   t    f   o   —  r    E   p    T    I    f    R   o   y    W   t    i  .    l    i   s    O   n    I    b   a    i   o    T   b    t   o   p    A  r    R   p   o




Someone who simultaneously buys and sells the same or equivalent options in different different markets.


The notice to an option writer that the option has been exercised by the option holder.


An option with a strike price equal to the market value of the underlying futures.


A measure of how an option’s price movement correlates to the movement of the option market as a whole.


An option which gives the option buyer the right to buy the underlying futures contract at a specified price within a certain time, and the seller of the option the obligation to sell the futures at the strike price if exercised by the  buyer  buy er before before the expira expiratio tion n date date of the option option..


An op option wr written ag against an an opposite position in the futures market.


Money received from the sale of options.


Money paid for the purchase of options.


The amount by which an option’s price will change for a unit change in the underlying futures price. price. An option’s delta delta may change from moment to moment as the option premium changes.


The action taken by the holder of a call option if he wishes to purchase the underlying commodity, or by the holder of a put option if  he wishes to sell the underlying commodity.




The date on which the option contract can no longer be exercised, and therefore becomes worthless.


Buying and/or selling offsetting positions to  provid  pro videe protec protectio tion n against against an an advers adversee change change in price.


Describes a call with a strike price lower than the futures price, or a put with a strike price higher than the futures price.


The am amount that an op option is in-the-money; i.e., futures price minus strike price for calls, or  strike price minus futures price for puts.


The sum of money which must be deposited and maintained by an option seller or futures seller.


Writ Writin ing g a futur futures es option option for which which the the writ writer  er  has no underlying futures position.


An opti option on with with no intr intrin insi sicc val value ue—a —a call call opti option on with a strike price higher than the futures price, or a put option with a strike price lower than the futures price.


The price of an option contract.


An option which gives the buyer the right to sell the underlying futures contract, and the seller the obligation to deliver the futures contract at the strike price on or before the expiration date, if the buyer exercises.


A position consisting of two or more options.



THEO TH EORE RETI TICA CAL L VALU VALUE E The price price of an option as computed computed by a mathematical model such as the Black-Scholes Model. TIME VALUE

The amount of an option’s premium exceeding the option’s option’s intrinsic value. The premium premium for  out-of-the-money options is all time value.


A measure of the change in the price of a futures contract over a period of time.



ABOUT THE AUTHOR  DAVID L. CAPLAN is an option trader, trading advisor, writer, and broker  specializing in option trading strategies. Mr. Caplan Caplan began his study of  options in 1982, when options were approved for trading on the U.S. futures exchanges. Since that time, Mr. Caplan has devoted himself himself fullfull-time time to

the development and trading of his option strategies. Since 1984, Mr. Caplan has published his monthly newsletter “Opportunities  In Options.” He is also the author of “The New Option Advantage, Using  Options to Obtain a Trading Edge Over the Markets,” an in-depth guide for option traders, “The New Option Secret,”  describing how to take advantage of option volatility—the most important element of option trading. Mr. Caplan structures option strategies using mathematical probability, option volatility disparities, and other benefits of options including time decay, limited risk and under- or overvaluation of options.

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