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Someone, in the CL Skype conference, last friday, was talking about a simple options strategy on CL, "selling an ATM Call and a Put, with a not too far expiry date...".
Hmm, ok, the official name for this is a straddle, and shorting a straddle means unlimited max loss, and a limited profit.
I'm using options for a while now, and had always avoid the strategies where the max loss is, in theory, unlimited. In fact it's not unlimited (BTW, I haven't check LEH Calls value after the small problems they had...), but they can be more than huge.
I feel more confortable with strategies which gives a "limited losses/limited profit", or "limited losses/unlimited profit", so long Put/long call, bull call spread, etc, etc.
Anyway, as I'm curious (had only traded US and european stock options, never traded futures options), why not having a look at it, and try (on paper) this short straddle/unlimited risk .
For readers who are not very aware of what options are, how we can use them, and why they are (imho) more interesting than stocks, I'll try to show some basic things on options. Maybe in starting with a small capitalized paper account, and building a portfolio with options only, we'll see.
Few things before starting our first short Straddle trade on CL 01-10:
- I'm not an option expert, I'll try to show very basic things, nothing about vega vs gamma, volatility surface, minor greeks, ...
- with options, their is an unlimited number of possible strategies. In some (most) cases, the initial trade is not as good as it should be, then we'll try to adjust this initial trade, to limit our losses, or secure our profit.
- except in some specific cases, options are not for sclaping, or short term trades. Commissions, volume and slippage are very different from a small-cap stock (so forget ES volume/slippage/liquidity...). The shorter options trade is, in most cases, few hours (except during expiration day, but it's not 30 seconds...). The longest can be few months, or years.
- a stock option is a contract between two parties in which the stock/futures option buyer purchases the right (but not the obligation) to buy (Call)/sell (Put) X shares/contracts of an underlying stock/future at a predetermined price from/to the option seller within a fixed period of time
- I can write 50 more pages on this, but it's already too long, let's go...
So, first trade, on dec 11:
facts:
- CL 01-10 is trading @ approx. 70
- the JAN10 Futures options will expire on dec 16
what: a short straddle
- we sell 1 70.0 JAN10 Call @ 1.15$ (x1000)
- we sell 1 70.0 JAN10 Put @ 1.23$ (x1000)
why:
- we think CL 01-10 will not rise/fall too much until dec 16
- the time (theta) is on our side
profit if:
- on dec 16, CL 01-10 > 67.62
- on dec 16, CL 01-10 < 72.38
max profit:
- credit paid, 1115$+1230$, if CL 01-10 quote 70$ on dec 16:
-> who wants to buy a Call 70 if the underlying quote 70$ ?
-> who wants to buy a Put 70 if the underlying quote 70$ ?
max loss:
- unlimited, something like -2620$ if CL 01-10 quote 75$ or 65$
-> if CL 01-10 quote 75$, the Call 70 has a value of 75-70=5$
-> this Put costs us: 5$-1.15$=3.85$
-> the Call 70 has a value of zero (0), so we have a credit of 1.23
-> 3.85-1.23 = 2.62 (X1000$)
We'll see how this trade will go, tomorrow we'll maybe try something quite similar, maybe a strangle on another underlying.
Sam.....great post and thread. Will watch carefully to see how you make out. In the past I only ever went long or short on longer term options , usually 3-4 months with wide safety margin so look forward to what you are doing.
You said "time is on our side" and that "we think CL will not rise/fall much before Dec 16", yet you show we only make money if it actually rises or falls about 200 ticks from it's current position. It's my understanding if it only moves say 10 ticks from where it is right now, our options lose money, yes? Just wanted additional clarity on this to make sure I understand.
Ok, a few questions since I've never traded Options
- NinjaTrader is not compatible with Options and cannot be used, correct?
- ATM in this case means "at the money"
- Put is Sell, Call is Buy
- Theta is important, option expiry vs. actual contract expiry, price/time relationship?
Am I right?
Alright, from there let me ask some more:
- You said "not too distant" expiry date and that the CL Jan 10 options expire on Dec 16th. So I assume the closer to Dec 16th we get, the more the "price" changes for these options to be more in-line with what the actual CL 01-10 instrument is trading at? Am I right about this?
- Assuming I am right about above, then does the CL Jan 10 options track penny for penny (percentage) the actual CL 01-10 contract? I mean is it automatic or like the SPY ETF relationship with ES? Or are there actual divergences when it is better to trade when there is a divergence.
- You were talking about # of shares like with stock, so is qty (1) option equal to qty (1) futures contract? I mean is there such a relationship somehow? So if I was hedging, I would want to maintain the same # of "contracts to options" ratio?
The price of an option depends on:
- the underlying price (for CL 01-10 that was 70$)
- the strike price (70 for our Call and our Put)
- the time before expiration (6 days here)
- the volatility of the underlying
- the dividends (for stocks) which might be paid to the stock owner
- the interest rate
The time value is high when the options expires in a long time, and will be nearly zero the day of the expiration, and it's easy to understand:
- the probility to have CL @ 100$ in 9 months are higher than have it in one week
- the risk taken by writing (selling) a "Call 80 CL expiry July 2010" is higher than writing a "Call 80 CL expiry Jan 2010", this higher risk is included in the "time value" part of the option price
We also know that the "time decay" (theta) is not linear, and accelerate in the last 60 to 30 days before expiry. (This behavior is not the exactly same for DITM/ITM/ATM/OTM options, but keep it simple .)
So, in our case, we sold options with an interesting time value, and we know this time value will decrease rapidly in the next few days.
We can now lose money if CL rise/fall for more than 200 ticks (< 67.62 or > 72.38), if she (because CL is a she ) stays between 67.62 and 72.38, we have a profit.
The idea is also not to wait the last minute to close this trade, as we are naked, so I'll maybe get out of this one today.
At the end of dec 16, the option will have a 0 Theta value, so the theorical price for our Put 70, if CL 01-10 quotes 69$, will be: (strike price-underlying price) = 71-70=1$.
No, the volume are small, less liquidity, slippage, and big margin required (in this example, CL futures options).
Right, here 1 Call: the right to buy 1 CL car. For stock options, it's in most cases 1 Call: the right to buy 100 shares (but their are different classes, it can be 1 Call=10 shares for ex.).
Now, after the Short Straddle, a Short Strangle, on AAPL:
trade #2, on dec 15:
facts:
- AAPL is trading @ approx. 196
- we'll use DEC09 Stock options, expiration on dec 18
what: a short strangle
- we sell 5 200 DEC09 Call @ 0.74$ (x100 x5) -> 385$
- we sell 5 190 DEC09 Put @ 0.45$ (x100 x5) -> 225$
why:
- we think AAPL will not rise/fall too much until dec 18
- the time (theta) is on our side
profit if:
- on dec 18: 188.81 < AAPL < 201.19
max profit:
- credit paid, 225$+385$, if AAPL quote 70$ on dec 16:
-> who wants to buy a Call 200 if the underlying quote 199$ ?
-> who wants to buy a Put 190 if the underlying quote 191$ ?
max loss:
- unlimited, something like -1901$ if AAPL quote 185$ or 205$
So, a very risky trade, and a bad risk/reward ratio.
But if we look at the daily chart, 188 and 201 doesn't look very close, time decay is with us, and we may react quickly is something goes wrong.
Trade #1 on CL closed, net profit 889$. Not very big, but CL made a nice push up today, the down trend of these last times may be over.
And we don't want CL to go too high (72.48$)...
As some long electric power down are possible during the next few days, I had a limit order on this trade, executed without me (short covered @ 1.480).
Just a quick update, no options paper trade today:
- closing trade #1 was a good idea, as CL gets higher today (73.55)
- trade #2 on AAPL is fine (unrlzd P&L 350$), the main idea, 188.81 < AAPL < 201.19 on dec 18, still highly probable.
Wait & see...
Trade #2, the Short Strangle on AAPL is done, both options are expiring worthless, +587$, 2 2 days, no heat...
AAPL closed @195.19, so:
- the guy who bought our Call 200 will not exercise it
- the guy who bought our Put 190 will not exercise it
Thank you guys
Next week, another basic strategy, maybe a basic covered Put, and something more complex, an Iron Condor for example.
I am confused by the 'expiring worthless' and the 'the guy who bought ... will not exercise it', what does this mean exactly? That some other non-technical aspect (some other persons discretion) could have affected this negatively? Pretend you are explaining it to someone who has never traded options before Shouldn't be too hard to pretend...
Option contracts are wasting assets and all options expire after a period of time.
If nobody exercise the option bought before the expiration date, the option value is zero.
Let's take one of our AAPL strangle wing, the Call option:
- I sell an AAPL Call 200 Dec 18: imagine I'm selling a document, where is wrote: "the owner of this document have the right to buy me 100 AAPL stocks, before dec 18, at the price of 200$/stock".
- on dec 18, AAPL high was 195.43
- the Call 200 owner is not exercising his right to buy from me 100 AAPL @ 200, because he can buy them @ 195. Exercise his right to buy (a Call) will cost him $5 per stock, that's why the Call expires worthless.
So if it is left to discretion, then technically even if he could have exercised at 190 and made $5, he may choose not to for some unknown reason? Is this likely to occur or not?
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