Using Options to Beat the Odds

By Paul Brittain/ www.commoditytradingschool.com

One of the biggest heartbreaks in trading futures is when a trader identifies a “perfect storm” opportunity in a market, only to be stopped out their position by the “shake and bake” better known as the volatility which occurs in the transition period just before the market reaches its target. Future Traders are forced out of the market due to standard risk management techniques, only to watch the market later perform just as they thought it would, especially when trying to capture a top or a bottom of a market. As a broker for the last 25 plus years I have seen this happen to traders too many times than I can count or care to remember. However, there is a way to help you ride out the “shake and bake” period by employing an option strategy designed to absorb much of the day to day volatility which could and should enable you to hang in there during the slice and dice that usually occurs just before a market explodes into a direction.

Before we actually get into the actual strategies we use, we should at least discuss basic option theory as well as the nature of options themselves, at least briefly. Here we go.

There are two basic camps in option trading, long option traders and short option traders.

The term “Long Option” refers to a trader that buys a “plain vanilla” option hoping to capitalize on the unlimited profit potential a long option offers while enjoying the fact that their risk is limited to the premium as well as transaction costs. Many traders assimilate being “long” as being bullish, well in the case of trading options you are bullish, but not necessarily on the underlying market, but bullish on the premium of the option you have bought. In other words you can be long a put option while hoping a market will drop in value in order to have the value of your put increase or long a call hoping the market will rise to increase the value of your call.

In reality more options expire worthless than not, to the tune of 8 out of 10 according to the claims of industry statistics, due to the fact that options are basically nothing more than a form of insurance and thus they are priced to favor the seller in exchange for taking the statistical risk they present. To get a clearer picture think of how many checks you have written to your insurance company verses how many checks they have written to you.

Get the picture? Well hold on, trading is a double-edged sword.

The 80/20 factor in Long Option Profit performance failure has attracted many traders to become “Short Option” Traders, AKA “Option Writers, Grantors, or Sellers”. They look to profit from the notion that the odds are so stacked in their favor, they feel comfortable in assuming the unlimited risk of writing options in exchange for the limited possible profit of the premium they collect minus transaction costs, not to mention the obligation of possibly having to deliver the underlying futures contract. Many traders though fail to realize that the actual dollar risk reward can wipe out the gains they made in one losing trade, in other words, even with the statistics in their favor, the two average losing trades can wipe out the gains made on the winning 8, and then some.

Which stance is right? Well…both are, depending of course on whether or not the trade performs as expected…however where one fails the other exceeds and vice a versa…again.

There are, however, other approaches, which can incorporate some of the benefits of both camps, which is technically more futures, but without the white knuckled 1 to 1 volatility experienced in futures as well as possibly capitalizing on the premium erosion nature that exists in the option market.

To simplify the approach, let’s start with the first. Consider the premium attrition that exists in the option market, if more options expire worthless than not, we can assume that any monies spent on option premium will succumb to the odds that exist in that market. With that in mind, common sense tells us that if the statistics continuously prevail, we can actually skew the odds of option performance if we use a balanced long/short option approach to trading options, in other words, for every option we buy we should also sell one…right? Yes, kind of, sort of, but not really.

Options are usually priced to not be intrinsically profitable based upon a markets nature to remain range bound. Again this is based upon the 80/20 rule, markets tend to spend 80% of their time trading in a range, 20% of their time adjusting their price from one range to another. Thusly, one barometer to judge whether a particular option is over or under priced is to check its intrinsic break even against a market’s recent trading range. More often than not, most options we consider are priced to intrinsically break even outside the markets established range, option market makers really heavily on this statistic, remember they only win when you lose.

To overcome these odds we look to either lower or skew an options breakeven by selling additional options, collecting the premium to help lower the cost of the primary option, which in turn moves the breakeven closer to the strike price, sometimes this method actually creates a credit spread which will twist the odds of a trade even more in your favor.

What are the Odds? Well there are several different sets of odds a trader needs to overcome. First there are the odds in being right in your anticipated market direction, those odds are 1 in 3, or you have a 33.3% chance of being right ( I know, you thought it was 50/50), a market can go up (1), down (2), or sideways (3). Then the market needs to move enough in the right direction (1 in 3) to overcome its intrinsic breakeven which according to statistics is about 1 in 5 or about a 20% chance. Yet even in the face of these odds, everyday traders scream d***the torpedoes, full steam ahead, and continue getting beaten bloody. They say that Wall Street is strewn with the bleached white bones of the everyday trader, the traders who ignore the odds on the hopes that this will be their day, this will be their trade that makes the big score, they probably also believe in Santa Claus (hey I am not saying I don’t!).

Using various option spread strategies can allow a trader to adjust the odds of trading enough in their favor to where they can dampen much of the day-to-day volatility or the shake and bake.

Let’s look at a recent trading opportunity in Cotton, which was trading within 12 cents of its 20 year low of 29 cents. Our goal is to start building a manageable position in the market; the dilemma is that when a market is in the process of bottoming or topping, it becomes even more volatile, and at $500 per penny, that could make for some hair-raising moments. Our solution is to create a synthetic futures position with by constructing a bull call spread and funding it by selling a naked leg below the market’s recent low as well as support level.

We first look for our primary option, which should be an at the money option, the closer the strike price is to the market, the higher the delta as well as the odds of the option ending up in the money. The 45 cent Call is selling at a premium of 4.32 cents or $2,160…that gives the option an intrinsic break even of 49.32 which is above the market’s recent trading range. We now look for our short option collar consisting of both a call and a put to help offset this cost. The short call is covered by the primary option so the short option does not incur risk, it does however limit the profit potential of the trade so we usually chose to sell the covered option as far from the money as we can while still collecting enough premium, we also usually try to sell this position outside the trading range. In this case we sell the May 50 cent Call and collect 2.61 in premium or $1305, this lowers the intrinsic of the trade to 46.71 (4.32-2.61=171). Lowering the intrinsic break even gives us a wider profit zone within the market’s recent range, but not really enough to satisfy our needs so we now look for a short put to sell to collect additional premium to lower the cost of the spread as much as possible while as far below the perceived support level as possible. This is where we assume the risk equivalent of a futures contract, we chose to sell the May 36 cent Put, although this the level where we now can experience similar risk of a futures contract, the dollar for dollar risk has been moved from the current market price of 44 cents down to below the 36 cent level making the trade approximately $4,000 less risky than going long the market at current prices.

Selling the put also lowers our cost to $150 as well as the intrinsic break even to 4530 which means if the market stays at the bottom of the range and doesn’t go higher, but doesn’t go below 36, our risk is limited to $150 plus transaction costs,. By lowering the break-even point we have widened our profit zone in the current trading range as well, and even though our profit potential is limited to $2,500, that’s 16 times our cost! This strategy also gives as the ability to adjust the spread by pulling the legs off as we see fit.

Paul Brittain 702-255-4107

Commodity Trading School/Alaron Las Vegas

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