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In This Issue:
Michael Sabo discusses an options trading strategy, called a strangle.
 
November 1, 2007
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How to Use Strangles in Options Trading

Options give investors and traders the opportunity to position themselves in a number of different ways. At the basic level, a call buyer has the right, but not the obligation, to purchase the underlying futures contract (go long) at a specific (strike) price on or before expiration. A put buyer has the right, but not the obligation, to sell the underlying futures contract (go short) at a specific (strike) price on or before expiration. I won’t go over the very basics of options here, but rather, discuss a particular strategy I would like to explore, called a strangle.

A long strangle position involves buying an out-of-the-money call and buying an out-of-the-money put with the same expiration dates. A strangle buyer profits from high volatility markets. This position can be useful if you are unsure of the market’s direction, but are expecting a dramatic move to either the upside or the downside. There is a lot of volatility in many commodities right now, so this strategy can be a viable one to consider.

You can also sell a strangle by selling an out-of-the-money call and selling an out-of-the-money put with the same expiration dates. This position profits when the market stays within a specific range.

(continued below...)


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Pros & Cons of Selling Strangles

There are a number of advantages that come from selling strangles. When you sell a strangle, you are not picking a direction as you would if you bought or sold a futures contract outright. You believe the market will stay inside a range. Because you are not picking a specific market direction, there is less emotion involved in the day-to-day market fluctuations. If the market goes up one day, the put will go down in value, and the call will go up in value. If the market goes down one day, then the short call will gain in value and the short put will decrease in value. Instead of worrying about direction, you believe the market will stay in a specific trading range. Many traders find that selling strangles can take a significant amount of the day-to-day emotion out of their trading.

As in any trade, there are risks involved in selling strangles. The first one that comes to mind is the unlimited amount of risk involved in this position. Additionally, selling strangles gives you a calculated maximum profit potential. The premium you collect from the buyer is the most you can make on that particular trade, less your commission costs. Let’s look at some examples of how we might incorporate this strategy in the corn, crude oil and S&P 500 futures markets.

Corn

Fundamentally, there is a very large corn crop this year, as a record amount of acres were planted. If you look at the yields that have been coming in, most farmers are indicating better-than-expected bushels per acre. However, prices aren’t coming down as much as most would expect given this much supply. This belief may already be factored into the market. There are also other factors that are supporting corn prices, such as competition for acreage and talk that next year’s acreage may be less.

On the technical side, I like to look at moving averages to formulate trading ideas, specifically, the 8-day, 21-day, 50-day and 200-day moving averages. I like to look for crossovers between these moving averages, along with support and resistance areas. You’ll notice on the chart below, that since mid-July, corn has been in a trading range. It’s been a sizeable one, but still in what I’d call a trading range.

If you are going to consider selling strangles in the corn market, you have to look at the various strike prices to see which ones are most advantageous. I probably wouldn’t do this trade in December corn because of the time value, but I would look a little farther out than that. I believe this market will stay range-bound until spring of next year.

Crude Oil

The crude oil market has been a highly volatile market and can be approached in a number of ways. Some traders have been purchasing strangles to take advantage of dramatic price changes, while other having just been positioning themselves in options outright.

Some people think that crude prices are very expensive right now, but people thought it was expensive at $30, at $40, and $50 a barrel--and now crude sits above $90. At this point, I think the trend is still up. Picking tops in markets can be a very dangerous and expensive thing to do, so options can be useful in this regard.

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Technically, when we look at the moving averages on the chart, we can easily see that this market has been in an uptrend. Not many traders would think of selling strangles in this market, but if you look at the chart closely, you’ll notice the ranges of 60-day blocks of time. If you look at June, July and August, you can see the lows coming in around $66, and the highs coming in around $76. You can see a $10 range during that long period despite the fact that crude oil has been in a bull market. Selling a $10 crude oil strangle would have presented an opportunity to profit during that time. Part of this stems from time-decay being involved, which is a basic characteristic of options. So we can see that selling strangles can be done in markets that trend upward, move sideways, or trend downward. All that matters is that the market stays within the range that we choose.

If a market really starts to trend more strongly as we saw in crude oil, you can always adjust the position. You can always buy back your short calls at any time to limit our risk and take a losing trade. Or you can buy it back and look to roll it up to a higher strike price in the same month. You can even buy back the entire strangle and roll it into the next month. A short strangle position can always be modified depending on your risk tolerance and your assessment of the market. If you are long a strangle, you can hold your position to expire at a profit or loss. You can exercise your options early to take a profit or loss.

S&P 500

Whether you’re an experienced options trader or not, selling strangles on the S&P 500 futures are a good strategy to look at right now. In my opinion, this strategy is best suited to take advantage of as we head into the new year.

The fundamentals look to keep this market in check. I don’t see this market making a strong rally into the end of the year, yet I also don’t see this market selling off before the end of the year. Therefore, you can play the range in this market by selling a strangle. I would suggest selling the 1600 call option and selling the 1500 put option. With the S&P 500 trading around 1540, this gives us a good amount of cushion to the upside and downside.

Looking at technical factors, I believe 1500 is a very psychological number. If you look at the 50-day moving average, it is currently coming in at around 1500 now. In the chart below, you’ll notice a sharp decline in August. We had several attempts to push this market up through the 1500 level. After several failed attempts to break the 1500 level, the market finally did after the Federal Reserve cut rates on September 18. This has helped us to keep the levels we are at right now. Therefore, I think 1500 is a good floor for the market right now and a good strike price to be selling a put.

On the upside, 1600 is another psychological level for this market. I don’t see the market, for some the fundamental reasons I mentioned, going above this level before the end of the year. Don’t get me wrong, I know there are a lot of bullish people out there. I’m also bullish on this market long term, but I’m also a realist.

Let’s cover the specifics of this strategy. Once again, we would sell a call at 1600 and sell a put at 1500 for the December E-mini S&P futures contract. When you have an options transaction, there is a buyer and a seller. The buyer pays the premium. As a seller of both the call and the put, you are collecting a premium from the buyer. Again, the concept behind selling a strangle is that you want to see the market in a range (between 1500 and 1600) before expiration (December 21).

For simplicity, let’s assume we collect 50 points in premium. If the option purchaser pays you, the seller, 50 points on the E-mini S&P 500, each contract point is $50, so we get $2,500 ($50 x 50 points) in premium from the purchaser, excluding commission cost. The option buyer is paying $2,500 to take the other side of that contract, excluding commissions.

If we receive 50 points in premium in selling the strangle, where are our breakeven points? To figure this out on the upside, we would add the 50 points we received in premium to the call’s strike price of 1600. That gives us 1650 as our first breakeven level. If the market trades above 1650 on expiration, this trade will lose money. Likewise, we would subtract 50 points from the 1500 strike price of the put. That gives us 1450. Therefore, if this market trades above 1650 or below 1450 on the expiration date, the position will lose money. If we trade between 1450 and 1650, this trade will make money. Of course, you will also incur commission costs which should be taken into account.

Keep in mind that this isn’t a trade that you just set and forget. This is a trade that you monitor on a daily basis. This is what I help my clients do on a day-to-day basis at our professional trading desk at Lind Plus. The nice thing about selling a strangle, in contrast to day trading or swing trading, is that the daily market noise does not necessarily scare us out of the market. You are not choosing direction on a daily basis.

Concept of Time Decay

One more aspect of strangles I should discuss is the concept of time decay. A short strangle position benefits from time-decay. In out-of-the-money options, like the ones I mentioned, all the premium is considered time value. The important thing to understand is that as an options seller, you are collecting the premium. Every additional day that goes by contributes to more time decay in those options, which make them more valuable to the option seller.

Many studies have been done on options, and one often cited is that approximately 80 percent of all options that are purchased and held to expiration end up expiring worthless. So, as the seller of an option, you collect the premium. There is a statistical probability of you being able to keep that premium, but there are also risks involved. Selling an option involves unlimited risk, like a futures contract. This strategy is not suitable for all traders. If you are willing to assume that risk and get away from choosing the daily direction of the market, this presents itself as a viable strategy. Please feel free to contact me if you’d like further clarification on these ideas, or to discuss strategies for your unique goals and risk tolerance.


About Today's Author:

Mike Sabo
Years Trading: 10
Favorite Movie: Casino

Michael Sabo is a senior market strategist with Lind Plus. He focuses on fundamental analysis and uses technical analysis to identify entry and exit points. He also focuses on understanding mass psychology in trending markets that cannot be explained by fundamental or technical analysis. He has traded options for his own account and is the former president and co-founder of United Futures Trading Company, Inc. and Investment Analysis Group, Inc. He can be reached at 312-788-2940 or 800-798-7671 or via email at msabo@lind-waldock.com.

You can also hear timely market commentary and trading strategies from Mike and other Lind Plus Senior Market Strategists through Lind-Waldock’s weekly Markets on the Move webinars. These events are free to attend, and you can ask questions via live online chat. Sign up at www.lind-waldock.com/events.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

Futures trading involves substantial risk of loss and may not be suitable for all investors. © 2007 MF Global Ltd. All Rights Reserved. Lind-Waldock. Futures Brokers, Commodity Brokers and Online Futures Trading. 141 West Jackson Boulevard, Suite 1400-A, Chicago, IL 60604.