Option Spread Strategies for Trading Volatile Markets – Part 3

Last week’s market action in the metals was a perfect example of why we would want to use option spreads in these markets.  It is interesting to note that quite a few traders looked at me cross-eyed when I was explaining the concept of limited risk/limited reward trades last week.  Some of those same traders are riding the emotional rollercoaster now of an unlimited risk/unlimited reward position (i.e. the silver futures).

If you are one of those unlucky ones that got whacked in last week’s metals market, I’m sorry.  I truly feel your pain because I’ve been there.  But it was those hard learned lessons that taught me that chipping away singles and doubles would bring in the home runs more often than swinging for the fences, and my risk of striking out was reduced.

As I have said before, and re-iterated last week, when markets go parabolic like this, technicals go out the window.  It becomes impossible (for me anyway) to speculate on market direction.  In my experience both as a trader and managing clients, the major difficulty in market conditions like this is being undercapitalized.  Increased volatility means bigger daily swings.  Those bigger daily swings usually mean being stopped out for the smaller trader as he does not have the capital to trade with such a wide stop. 

For the time being, I am not going to be discussing any new entries for the Silver.  If you are not in it already, you will need to be patient.  Trading is like waiting for the bus.  If you miss the first one, another bus will be coming along in 10 minutes or so.  But make sure you get on our newsletter for options trades, that way you will have them sent to you when they are released.  There are currently 61 days to expiration on the July options so when market conditions dictate; you need to be ready to act.

With that said, let’s look at a new position.  (If you have not read parts one and two of this article, make sure you get them.  The positions discussed there not only will give you some educational concepts, you will also be able to see how the trades work out.  Also, at the end of this article, you will be able to request additional option trades in this and other markets.)

I would like to introduce the concept of the calendar spread.  I know that there are people that find it interesting to learn about option spread trading but for their own trading, they prefer to swing for the fences.  And so far, I’ve been talking about hitting singles and doubles.  For those of you that want to take a shot and knocking one out of the park, the calendar spread is going to be your trade.

A calendar spread buys and sells the same option type (put or call), at the same strike price, but in different months.  The example trade is going to be based on gold making a run for the $800 level.  This trade will sell the August Gold 800 call and buy the December Gold 800 call.  Currently, this is a valid trade at a price of $850 or better.  And for you “swing for the fences” types, it has unlimited upside.

Chart © 2006 FutureSource

Our plan with a trade like this is based on a belief that gold will move to $800 or higher by December option expiration (11/27/2006), but not before August option expiration (7/26/2006).  This gives us the opportunity to collect some premium in the August to help offset the cost of the December.  This is similar to the concepts we discussed in parts 1 & 2 as we are trying to collect some money from the market to help pay down the cost of our position.

As I am writing this, August options have 90 days to expiration; December has 214, more than twice as much time.  90 days to make a move to $800 is a stretch (not to say it can’t happen), but 214 is definitely doable.  (Note: this trade could also be done at the $750 strike as well with a slightly higher cost.)

Now let’s talk about risk for a minute.  The calendar spread has unlimited risk for unlimited gain.  If that is like the futures, why would we want to do that instead of trading the futures outright?  The answer is because the unlimited risk is not if we are wrong about market direction.  If we are wrong about market direction in both months (and they will typically move together), then both calls expire worthless.  So downside market risk is limited.

The unlimited risk comes into play if the market explodes to the upside in the August futures, but not in the December futures.  Or, if both markets eclipse $800 prior to August, the short call is marked-to-market but the December is an unrealized gain.  There are a number of ways that you can adjust to handle these scenarios, but there is not enough space in this article to have a full discussion of damage control, so if you are considering a trade of this type, do not do anything until you know how to manage the risk.  Consult your broker first.

That brings us around to another important point.  You should be working with a broker that understands option spread trading (and the associated trade/risk management) and also has the experience to help you in these market conditions.  Currently, some firms are only allowing market orders in the metals options.  Try to get filled that way and you won’t be happy with the results.  An experienced broker might be able to work your limit order “not held” and may also suggest other possibilities (such as the eCBOT Gold options, traded electronically).  Don’t trip over dollars to pick up dimes (in other words, don’t try to save $10 or $20 on commissions only to lose $100, or $200, or more on your fill).

For those of you that are following along on the sidelines, I would encourage you to get moving on your account paperwork.  These market conditions can create opportunity that evaporates quickly.  A perfect example is the July silver 1300/1350 bull call spread.  When first recommended, it was 11c ($550).  Even with the break in silver, that spread is now trading at 30c (or $1500, as of this writing).

This brings up another good reason for a smaller account to trade option spreads rather than the outright futures.  When the market makes a limit move, if you are in the futures, you cannot get out.  However, the options continue to trade, allowing new positions to be entered and existing positions to be adjusted or exited.

I hope you are beginning to see the value of learning (and possibly utilizing) these trading methods.  They are definitely more complicated than just buying or selling the futures or just buying or selling a put or call.  The masses typically are singularly focused in their trade.  In other words, they take an outright long or short position in the futures and stay away from spreads.  From an education standpoint, that is certainly easier.  But if the masses are usually wrong, why would anyone want to duplicate what they are doing?

I would encourage you to request Parts 1 & 2 of this article as well as get registered for our ongoing option spread recommendations.  In addition to this you will also receive our Option Strategy Guide.

Our brokers at RJOFutures are well versed in options trading.  We would invite you to discuss these option positions with one of our brokers.  They can answer any questions you have, and help you construct a strategy appropriate for your account size and risk tolerance.

To contact us, visit our web site at http://www.rjofutures.com

Or call us toll free in the US at 800.441.1616, or outside the US at 312.373.5477

TRADING FUTURES AND OPTIONS INVOLVES RISK OF LOSS

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