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September 26, 2007

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!

This article will discuss a variety of options selling strategies and some pitfalls that often escape novice, as well as, experienced traders. Writing options and collecting premium can become a means of a consistent income stream for your overall portfolio. Whether you’ve been writing options for some time or simply looking at options to replace a strategy that has not been working for you, it is worthwhile keeping in mind that selling options can carry high risks and may become dicey at times. Granted, most people who speculate with stocks, futures or derivatives are aware of the risks that come with the terrain, but nevertheless, here are a few pitfalls to be aware of and to avoid. But first…let’s go over some basics.

Delta Neutral trading:
I look at option sellers as traders who wish to trade the market without completely depending on its direction. In my earlier article (“Delta Neutral - trading without predicting market direction”), I described the “Delta Neutral” strategy, which is a non-directional method of trading. Option traders who employ “Delta Neutral” philosophy sell options on both sides of the market (calls and puts). Whether they sell options far out of the money, fairly close to the money or at the money, they all have one thing in common, as “Delta Neutral” traders they look for the market to trade in a range. The desired range may be flexible, and can depend on a few factors such as the distance of the strike price from the underlying market, the premium collected at inception and the time to expiration, but all and all, since “Delta Neutral” traders sell options on both sides of the market, they look for the market to remain between the short strike prices. As soon as the market moves in one direction, the Delta is no longer neutral. There is an accepted range for delta fluctuation but if the market trends fast and far, “Delta Neutral” traders need to take defensive measures. If the market indeed trades within a relative tight band, “Delta Neutral” traders gain from the passage of time (time decay). Now that I’ve laid down the foundation, let’s take a look at some thorny situations to be aware of when writing options.

Pitfall #1: Confusing naked “Straddles” and naked “Strangles” with credit spreads:
Selling naked options is not, in my opinion, superior or inferior to selling credit spreads. Rather, it is a matter of risk tolerance and exposure, funds available and personal preference of trading (conservative or aggressive). “Some times, in some markets, under some conditions” -- is my approach to this issue. What is crucial to understand is that selling naked options carries with it unlimited risk. I am always surprised when fellow traders fail to realize the risk they are assuming.

I usually ask if a person writes naked options or prefers to apply limited risk strategies. If the answer is the later I then ask for an example. The answer that alarms me could be paraphrased as: “I am now in a Crude Oil credit spread, I sold the $80 call and a $70 put”. Well my friend, your position is not a credit spread and I am sorry to burst the bubble, your risk is not limited. Let’s take a closer look at this Crude Oil example.

It is virtually impossible to predict the time value and volatility influence on an option prior to expiration. When discussing the risk in options, therefore, I usually start from the end …the expiration. If the trader in this example collected at inception a total of 2 points ($2,000) his or her break-even point at expiration is 82 on the call side (80 +2 = 82) and 68 on the put side (70-2=68) excluding commissions and fees. Above and below these strikes this trade will be a loser on expiration. This loss is potentially unlimited.

I could only guess that the reason for the confusion arises from the true fact that in a naked short straddle (selling at- the-money options) and a naked short strangle (selling out-of-the money options) the potential loss on one side is offset to some extent by the gains arising from the deterioration of the option value on the opposite side of the market. Offsetting the risk - yes, limiting the risk - no.

A limited risk credit spread consists of an option sold closer to the underlying market and an option bought further away from the underlying market -- both with the same expiration date. For example, selling the 80 call and buying the 83 call creates a limited risk spread. The maximum risk prior to expiration in this example is three points minus the premiums collected and excluding commissions and fees.

Are calendar spreads less risky than credit spreads:
An option calendar spread is a spread in which options are bought and sold in two different months, usually on the same underlying market. It usually consists of selling an option in the closer month and buying an option in the further away month and on the same side of the market (i.e. either both are calls or both are puts). The intention here is to take advantage and gain from the faster time decay of the short-term option which we sold (options lose time value faster as they near their expiration date).

Many traders consider the calendar spread to be less risky than a similar width credit spread because the long option we own has more time value. To a limited extent that might be true. As long as the option we sold is out of the money and as long as the two months move in tandem, calendar spreads tend to gain less value than a similar width credit spread. There are circumstances, however, where this assumption may lead to sobering results if appropriate action is not taken. Here are two points to be aware of when trading calendar spreads:

Pitfall #2: Different months of the same commodity may move in dissimilar ways:
This phenomenon is not a rarity and can occur in perishable markets such as Grains or Energy. Let’s look at the Soybean complex for a moment. As you may know, the grains market is greatly influenced by weather conditions and disease. What you may not be aware of, is that weather conditions and some diseases (such as “rust”) may have a lesser or greater impact on soybean growth and health. It depends to a great extent on how mature the plants are. A soybean plant that is a mature plant may react to disease or harsh weather conditions very differently than a young soybean plant.

Furthermore, the rust disease or adverse weather conditions may occur after early harvest. If such an event transpires, it means that in the sort term there is plenty of crop (early harvest completed) but the longer-term supply may be in danger. This may possibly cause the futures market nearby month to decline while the further away month may rally on possible high demand and low supply. This scenario might be devastating to a trader who sold a short term put and bought the further away put.

A calendar spread carries more risk closer to expiration when the short option is in the money:
The ideal point of expiration for a calendar spread buyer is at the short strike. Let’s revisit the Crude Oil complex. If we sold a September 80 Crude Oil call and bought an October 83 Crude Oil call, September expiration at the 80 strike price would mean our September short position expiring worthless while our October 83 call should be carrying a hefty premium (it is virtually impossible to predict exactly how much).

That being said, many traders attempt to carry a calendar spread all the way to expiration as the market nears the short position. Alas, this coin is no different than others; it has two sides to it. As the short option (September 80 call) turns into an “in-the-money option” and nearing expiration, its Delta (the measure of change in an option value as a result of a move in the underlying market) becomes closer to 1.0 while the long option (October 83 call) is still out of the money and therefore has a lower delta. Translated into practical terms, on a move up the short option gains more than the long position, which results in a loss.

Another factor adding to the risk of an in-the-money calendar spread is the time remaining to expiration. It is the nature of options to converge with their underlying market at expiration. The closer to expiration, the more an in-the-money option moves like its underlying market. This means that if six weeks prior to expiration, Crude Oil is at $80 and the market moves up one dollar, the September 80 call we sold would gain approximately the same as the October 83 call, but if the same move occurs just days prior to expiration, the September 80 call would gain more than the October 83 call.

This time trap may prove to be treacherous since a calendar spread tends to keep its value until it nears expiration (barring any extreme moves in the underlying). Pay careful attention to your calendar spread as it nears expiration, if you are not aware of the risks associated and get caught in an “expiration squeeze” or other sudden moves, you might pay high tuition for the lesson.

Pitfall #3: Credit Spreads are always limited risk (true - but only prior to expiration)
Option writers use credit spreads to construct limited risk positions (somewhat similar to future traders who use stops). Credit spreads indeed offer limited risk and no gap open market will change that. That holds true however, only prior to expiration. This point is important to keep in mind, especially for those who prefer to let options expire rather than close the trade.

The scenario, which might lead to some unpleasant results, might be a combination of several common factors coming together:

1. The market trades against your spread position and violates the short strike to trade between the option you sold and the option you bought.
2. You get married to the trade, refusing to let go and set it free or adjust it.
3. It is expiration day and you are still in the trade, still believing it will turn around and give you back the love you deserve after sticking with it through hard times.
4. The market closes somewhere between your strike prices.
5. You are assigned the short option and now you are in the futures market

Let’s take a look at an example of an S&P credit spread to understand the gravity of the situation. The Standard and Poor August 2008 contract expired on August 17. The 17th was the third Friday of the month, which means expiration day for the August options (which trade of the September contract). Assume a trader sold the 1440 x 1460 August call spread and for whatever reason is leaving the options to expire.

The 1440 x 1460 is a limited risk trade by all accounts. Until expiration it carries a risk of 20 points or $5,000 ($250 x 20) minus the premium collected at inception and excluding commissions and fees. But the August contract expired at 1450.1. The long 1460 call the trader owned for protection expired worthless and the 1440 call was assigned in the form of a September S&P short futures. Monday, August 20th, was trading up and down but closed almost unchanged. August 21st and 22nd, however, were rallying days for the September S&P, closing on the 22nd at 1468.70. The rally would translate to a loss of $4,650 ($250 x 18.6). What was a limited risk position prior to expiration became an unlimited risk position when one side of the spread expired worthless while the other side was assigned as a futures contract. It is simple to avoid this pitfall, close your credit spreads prior to expiration. You may close a position days or hours prior to expiration but make sure that you are out of the market when the bell rings.

Conclusion:
In this article I have described a few pitfalls that accompany option writing strategies and that often times receive little or no attention at all: The confusion between selling naked positions and limited risk positions, the understanding of the risk profile associated with calendar spreads, and the importance of paying attention to details when trading credit spreads at expiration. I truly believe that writing options and collecting premium is a preferred approach to speculative trading. I also believe that being aware of the risk that is linked to different strategies is a key part and indeed rests at the core of successful trading.

David Rozen is a senior account executive with Trader's Edge. He is fluent in various futures and options trading strategies. David's favored method of trading is a non-directional (delta-neutral) trading, utilizing pre-determined, limited risk structures. He trades options on several complexes, including the Stock Indexes (S&P 500), the Interest Complex (30 yr. Bonds), Metals, Grains and Currencies.

David served as a commander in a combat unit of the Israeli Defense Forces (IDF). His service and commanding experience play a great part in his ability to evaluate situations and make decisions under pressure in real time. After his service, David continued to earn his degree in Behavioral Science from Haifa University, Israel.

Three years after joining Traders Edge, David joined Gene Ratti and Bill Chieco to create a partnership within Trader's Edge. David is fluent in both English and Hebrew and serves clients across the United States as well as England and Israel. David's professionalism and passion for trading as well as his dedication to providing the utmost in service to his clients have swiftly made him a rising star at Trader's Edge. David resides in Morris County, NJ with his wife and two children.

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!