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PRICE INTERRELATIONSHIPSAND THE DELTA FACTOR
The delta factor is a measure of the change in the price of your option relative to a change in the price of the underlying futures contract. Let’s say you have purchased a silver call because you expectthe price of silver to rise. You know there is a relationship betweenwhat you paid for the option (the premium), the current price orpremium being asked for that option, and the futures price of thecontract on which you have an option (the underlying futures).Can you expect a one-to-one relationship? If the futures priceof silver increases 10 cents per ounce, will the premium of that option increase 10 cents?The change in the option premium value is less than the changein the futures price, and that’s where the delta factor comes in.Remember all the factors that impact the premium price: volatilityof the markets, traders’ expectations, the current price trends, theamount of time until expiration of the option, the number of callsversus puts, and whether the option is in-the-money or out-of-themoney. You’ll learn through study of the options that the change inthe options premium will represent only a fraction of the change inthe price of the underlying commodity price. Logic dictates thereshould never be a higher demand for the option on a futures contract than there is for the futures contract itself.
HOW TO CALCULATE THE DELTA FACTOR
The delta factor is calculated by dividing the amount of price difference of your option by the amount of price difference in the underlying commodity. For example, if the price of your silver optionincreased by a nickel when the futures price of silver increased by adime, you would have a delta factor of 0.50 (0.05 divided by 0.10 0.50). This means that you would expect your silver option to increase at half the rate of the futures.A delta factor of 0.50 is common when an option is very closeto being in-the-money. The delta factor should never exceed 1.Therefore, the higher the delta factor, the higher potential there isfor profits as the underlying futures contract moves in price.The opposite is also true. The higher the delta factor, the more
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expensive the option and the higher the loss can be for buyers. Infutures and options trading, always consider the risk-reward ratio.A low delta factor means that there is less of a cause-and-effectrelationship between the option and its underlying futures contract.For example, a delta factor of 0.20 would mean that for every $1 increase in the value of futures contracts, the options premium wouldincrease 20 cents.HOW DO YOU USE AND TRADE DELTA FACTORS?
The delta factor is a gauge to help you anticipate what options tobuy and when to sell (or offset) the options you own. To begin with,let’s say you’re looking at three or four different options. You’re trying to decide which one to purchase.You start calculating the delta factors every day or every otherday for a week or so. If an option has a very low delta factor, below0.25, it may be deep-out-of-the-money, or in some other way it haslost its relationship with the underlying market. You should probably cross it off your list—unless you have a good reason for playinga long shot.As you track the delta factors of the other options, you may notice one becoming stronger than or outperforming the others in value. This is one reason for considering this option. However, it is definitely not the only reason. You must consider all the other elementsthat go into the calculation of the premium, which were mentionedearlier.Later on, when you’ve held your option for a while and havedecided to offset it, you’ll want to look at the delta factor from a different perspective. Is it getting stronger or weaker? Knowing thetrend of the delta factor of your option can sometimes help youmake selling decisions.THE DELTA FACTOR AS A PLANNING TOOL
The delta factor can also be used as a planning tool. For example,you’re considering buying a soybean call. You think between nowand the middle of February bean futures will increase by $2.00 perbushel.When you calculate the delta factor of the two options you are
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considering, the first one is 0.50 and the second one is 0.60. Thismeans that if your price projection of $2.00 is correct, the value ofthe first option will increase by $1.00 and the second by $1.20. If thesecond option costs only 10 cents per bushel more, it is probably abetter bargain, all other factors being equal, than the less expensiveoption.Always keep in mind that delta factors are not stable. Theychange whenever the price of the option premium and the price ofthe underlying futures change, which is almost constantly duringtrading hours. However, these prices usually move in tandem, except when the option approaches expiration causing its time valueto decay rapidly.You cannot calculate a delta factor once or twice and expect itto be valid days or weeks later, especially if your option is in avolatile market. Some traders calculate delta factors daily and thenconvert them to 3-, 4-, or 5-day moving averages. This smooths outthe fluctuations, giving a better picture of the price activity.SPREADING STRATEGIES
Spreading simply means trading both the long and short sides of amarket at the same time. The spreader attempts to make a profit byanticipating the amount of change in the price movement betweenthe two futures contracts or options. The price differential betweenthe two markets is the spread.There are various types of spreads. They can be described bymarket (exchange), commodity, or delivery month. You can trade“inter” or “intra” types of spreads or combinations of the two. Intermeans between two different entities; intra means within the sameentity. (See Figure 7.2.)
F I G U R E
7.2
Spread TypesLong corn/short wheat:Long CBOT wheat/short MN wheat:Long July/short September:Short CBOT corn/long CBOT corn:Short July corn/Long September corn:
IntercommodityIntermarket/exchangeInterdeliveryIntermarket/exchangeIntracommodity
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Spreads can also be described as bull or bear spreads. A bullspread is usually long the nearby delivery month and short a moredistant delivery month. The expectation of the bull spreader is thatif the price of the commodity rises, the effect will be felt strongest bythe closest delivery month. The bear spreader has the opposite opinion: If prices are destined to decline, the nearby month will be affected more severely.Also popular for grain futures traders are the crush spreadsand new-crop–old-crop spreads. The former is executed within thesoybean complex by spreading soybeans against their products,soybean meal and soybean oil. The term crush is derived from theancient process of crushing soybeans under high pressure to extractthe oil. Since the soybean processor purchases soybeans and sellsthe oil and meal, a crush spread would be long soybeans and shortsoybean oil and meal. A reverse crush spread would be short soybeans and long both soybean oil and meal.A new-crop–old-crop spread may also be described as an interseasonal spread. This type of spread would have one “leg” in oneof the delivery months available to market a crop that has alreadybeen harvested, and the other “leg” in a delivery month available toprice the unharvested crop. This is a popular spread when opposing factors are affecting growing crops and crops in storage.OPTION SPREADING
Spreading opportunities in options are far more numerous than infutures because spreading is available between a wide variety ofstrike prices and expiration dates besides market, commodity, anddelivery/expiration date. An option spread is similar to a futuresspread, consisting of a long and short position (a call and a put) inone option, with the call and put having either different strike pricesor different expiration dates. Spreading can also be used by an investor to reduce the risk inherent in writing either a put or a call option.VOLATILITY SPREADS
Volatility spreads are one of the simplest and most useful optionsspreads to learn and to use. The spread trader buys a put and a callat the same strike price. For example, let’s say corn is trading at $2.52
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per bushel. You buy a put and a call at a strike price near-the-money or in-the-money, at $2.50.You do this with the expectation of the corn market becomingmore volatile. For example, this situation can occur at the time of therelease of an important crop report, such as Planting Intentions. Youmay not be sure if the report will be bearish or bullish, but you expect it to cause a lot of excitement and, therefore, volatility!If this happens, the premium value of both your options couldincrease. Or if the market takes off north (bullish), your call becomesmore valuable. If it goes south, your put premium goes into themoney. Your net position should improve.If the impact of the report is already in the market with pricesand volatility unchanged, you lose. You must then decide whetherto hold your spread in hopes of future volatility or to take your loss.A little added advantage of this spread is that the premium is usually lower than the sum of the premium costs of both a put and acall purchased separately. A put-call spread purchased at the sametime at the same strike price is called a special double, which will bediscussed as a separate strategy.TIME OPTIONS
Another popular option spread is the time spread. It involves options with the same strike price but different expiration dates. Theprime objective of a time spread is to take advantage of the tendency of the time value of an option to decline at a very rapid rate before finally disappearing just prior to expiration. Typically, a put orcall with a nearer expiration date is sold (written), while a put or callwith an expiration date that is more distant is purchased. The option sold and the option bought both have the same strike price.The intent is to sell time. The more distant put or call loses itstime value at a slower rate, which limits the risk of such a positionby removing the potential for unlimited loss on sharp upsidemoves.PRICE INFLUENCERS
The price of the underlying contract is the prime determinant ofhow much an option spread will profit. If the spread position is established by selling the nearby option and buying the more distant
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when both options are at-the-money, the spread will be profitable ifthe futures prices remain relatively constant. It will tend to losemoney if the prices change.The spread will be at its widest when the price of the futurescontract is closest to the exercise price of the option. The spread willnarrow as the price moves away from the exercise price in either direction.BULL SPREADS
Option spreads that consist of options having the same expirationdates but different exercise prices are called price spreads. So, for example, if a study of the silver market indicates it is going higher,purchase a call.Suppose March silver is $5.50 an ounce and a $5.00 strike pricecall has a 43-cent premium, or $2,150. That might be too much of arisk. However, even though silver has been somewhat lacklusterover the past few months, it still seems to be headed higher. Youare just not sure of the timing. On the other hand, you don’t totallywant to miss this opportunity. An alternative would be to write acall with a higher exercise price. In this case, the March $5.50 silvercall could be sold for about 14 cents, or $700. The spread could becalculated as having a 29-cent debit. Such a spread is called a bullspread, and the risk in the position is limited to the amount of theoriginal debit.Risk limitation does not occur without giving up opportunity.If the risk is limited, so is the profit potential. The maximum profitin a price spread is computed by subtracting the original debit fromthe difference between the exercise prices of the two options.In this example, the debit or net premium cost is 29 cents andthe difference in the exercise price is 50 cents. You are risking 29cents to make 50 cents. At the March expiration, a price above $5.50would peg both options at their intrinsic value. If the price of silverdropped below $5.00, both options would expire worthless and themaximum loss would be 29 cents.BULL SPREAD RULES
The rules concerning option bull spreads that you must keep inmind are as follows:
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A bull spread profits only when the spread widens.◆ The maximum profit on the bull spread is the difference between the strike price and the debit (the amount of the costof the long side exceeds the proceeds of the short side).◆ The maximum loss is the debit, the net premium paid.◆
BEAR SPREADS
Basically, they are the opposite of bull spreads. Use them when youbelieve the market is about to plunge. If you project a declining silver market, you could sell (write) the lower strike price option, e.g.,$5.00, and buy the higher, $5.50. At the time the options expire, anyprice below $5.00 would cause both calls to expire worthless, allowing you to retain the premium of the option you wrote.The maximum loss would occur at any price over $5.50 at expiration. The options would be at their extrinsic value, having onlytime value. The rules for bear option spreads are as follows:A bear spread profits when the spread narrows.◆ The maximum profit on a bear spread is the credit (theamount the proceeds from the short side exceed the cost ofthe long position).◆ The maximum loss on a bear spread position is the difference between the strike price and the credit.◆
BULL TIME SPREADS
Just as you can trade bullish or bearish price spreads, you can tradebullish or bearish time spreads. A bull time spread would involvebuying a deferred month and selling the nearby month.If on the other hand you were bearish, a bear time spreadwould entail buying the nearby expiration month and selling a deferred expiration month. For example, buy a July silver call optionand sell an October silver call option. The rules cited earlier applyto bull and bear time spreads, as well as bull and bear price spreads.STRADDLE STRATEGIES
The straddle is another spread variation. It is similar to a spread inthat you trade both sides of the market at the same time, but there
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is a difference. A straddle is a type of spread that entails the purchaseof a put and a call (called a long straddle) or the sale of a put and acall (called a short straddle).Bullish and bearish trading strategies are valuable tools whenindications show where the market is headed. What do you do whenit looks as if the market is going to take off, but you don’t know inwhich direction? Or even more puzzling, how can you trade a trendless market?The answer is the straddle. The long straddle, like the volatility spread discussed earlier, is a trading strategy to take advantageof dramatic market moves, even when we’re not sure of the direction.THE LONG STRADDLE
In its simplest form, the long straddle involves the purchase of a putand a call that share the same expiration date and strike price. To besuccessful, a big market move must occur before the options expire.Use the corn market as an example. The primary growing region is the Midwest. Let’s say that it has been in a drought for thepast 2 years. By planting time, the subsoil moisture has not been replenished.Last year the crop got by with a series of timely rains. Justenough rain occurred when it was desperately needed. The year before the farmers were not as lucky. What will happen this year?The United States rarely has two down years of corn production in a row. Additionally, the price of corn is very sensitive. Whensupplies are scarce, the price skyrockets. When supplies are plentiful, the price plummets. When supplies are adequate, the pricemoves sideways.This year one of two things will likely happen. Either there willbe plenty of rain or there will be a drought. A full measure of rainwill wash out prices. A drought will pop prices to new highs. Howdo you trade these fundamentals?The price range could be anywhere from a low of $1.40 to ahigh of over $3.00 per bushel. Use a long straddle and buy a nearin-the-money put and call, at, say, $2.40. (See Figure 7.3.)As you can see, the money is made with this strategy on the extremes. The more the market declines, the more valuable the put be-
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7.3
Results of Long Straddle(In dollars)FuturePrice
CallPrice
PutPrice
Total
1.401.601.802.002.202.402.602.803.003.203.40
(20.0)(20.0)(20.0)(20.0)(20.0)(20.0)0.0020.040.060.080.0
80.060.040.020.00.00(20.0)(20.0)(20.0)(20.0)(20.0)(20.0)
60.040.020.00.00(20.0)(40.0) maximum profit(20.0)00.020.040.060.0
comes. The opposite is true of the call. At some point before expiration, the savvy trader would abandon one leg and exercise the other. The point is you’re in good shape to take advantage of a bull orbear run without knowing which will occur!You lose, of course, if the market trades trendless from the timeyou enter until expiration of the options. The maximum you lose isthe two premiums paid for the put(s) and call(s) and the associatedtransaction cost. The upside is theoretically unlimited until the bullor bear market ends.THE SHORT STRADDLE
The opposite trading strategy to the long straddle is the short straddle. Rather than going long a put and a call, you short or sell a putand a call. This is the ideal strategy to use when you think the market is going to be flat and lifeless for the duration of the options sold.Let’s use the same corn scenario described above, only now therains will be normal, crop production will be normal, and the market will trend sideways until your options expire. Rather than buya $2.40 call and put, sell them. (See Figure 7.4.)You find the short straddle attractive because it allows you to
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F I G U R E
7.4
Results of Short Straddle(In dollars)FuturePrice
CallPrice
PutPrice
Total
1.401.601.802.002.202.402.602.803.003.203.40
20.020.020.020.020.020.00.00(20.0)(40.0)(60.0)(80.0)
(80.0)(60.0)(40.0)(20.0)0.0020.020.020.020.020.020.0
(60.0)(40.0)(20.0)0.0020.040.0 maximum profit20.00.00(20.0)(40.0)(60.0)
take advantage of the normal decline in an option’s time value asit approaches expiration. In this case neither option is exercised,which means you retain the full premium on both sides. The danger is a serious price move, which could be very expensive.As with all trading strategies, you begin with an analysis of themarket. Always be prepared to adjust your position(s) wheneveryou discover that all or part of your underlying information haschanged or is incorrect.STRANGLING THE MARKET
The “strangle” is a type of straddle. It differs from the simple straddle in that both legs do not share a common strike price and are outof-the-money. They are similar in the sense that you are trading bothsides of the market and you can trade a long or a short strategy.Another critical characteristic is different: the return curve.With the simple straddle, the maximum return was available at onlyone price point. With the strangle, the maximum return is availableat several price points.Strangles also differ from straddles when it comes to the usual position taken by traders. The short strangles are more commonly used, where you’ll usually find straddlers on the long side.
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WHY USE A SHORT STRANGLE?
The basic strategy is the same for the short strangle as it is for theshort straddle or the volatility spread. You seek a market that youexpect to trade flat until the expiration of the options. The stranglestrategy becomes particularly attractive if there is a history of unexpected volatility in the market you plan to trade, or perhaps someseasonal patterns that might come into play. The short strangle, because of the reasons mentioned earlier, insulates you more from thiskind of threat than does the short straddle or volatility spread.The short strangle finds favor with traders over the short straddle because it further reduces risk. To begin with, you are tradingdifferent strike prices, and they are out-of-the-money. Therefore, theunderlying futures contract must move farther than with a shortstraddle, which has the same strike price and is in-the-money ornear-in-the-money, before someone will exercise one of the optionsyou wrote.As with most futures strategies, less risk means less reward.This is true here since the premium for out-of-the-money options iscomparatively lower.Suppose the bond market will be stable for the next 6 to 9months. Therefore, you enter a short strangle by selling an out-ofthe-money call at 74 and an out-of-the-money put at 72. The underlying futures contract is trading near 73:00. To simplify this example, let’s say both options have the same premium, $1,500. Thepremium you receive would then be $3,000, less any transactioncosts. (See Figure 7.5.)Notice how the maximum income to be gained has increasedfrom one price point on the straddle table to three price points forthis strangle, from the 72 put to the 74 call strike prices. Betweenthese two points, both options are still out-of-the-money. When bothoptions expire out-of-the-money, you retain the full premium. This,of course, is the maximum profit you could expect. If one of the legsof the strangle expires in-the-money, then your profits diminish proportionally.Futures prices can, at least theoretically, increase indefinitelyand can decrease to zero. When prices move dramatically againstone leg of the strangle, the option represented by that leg is likely tobe exercised. This means you’d be assigned an equal and opposite
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F I G U R E
7.5
The StrangleFuturePrice
CallPrice
PutPrice
CombinedTotal
6668697072737476777880
1,5001,5001,5001,5001,5001,5001,500(500)(1,500)(2,500)(4,500)
(4,500)(2,500)(1,500)(500)1,5001,5001,5001,5001,5001,5001,500
(3,000)(1,000)01,0003,0003,0003,0001,0000(1,000)(3,000)
position in the futures market. For example, if you are short a put, youwill receive a long futures position if the option is exercised. Since themarket is moving against you, it could quickly become expensive.CALCULATING BREAKEVEN
For this reason, strangle strategists often calculate their breakevenpoint. It is slightly different depending on the direction of themarket. For example, if prices go over the call strike price, it is likelythe short will be exercised. It is only when the loss exceeds the netpremium received that you become a net loser. You can definethe breakeven point by adding the call strike price to the net credit(premium received). Our 74 call strike plus the $3,000 premium, or3:00, adds up to a 77:00 as breakeven.The downside breakeven is determined by subtracting the premium from the put’s strike price. Once this price is exceeded, youbegin to lose money. In the example, you would reduce the 72 putby 3:00, which comes to 69:00.THE LONG STRANGLE
Most of this section was devoted to the short strangle as opposed tothe long strangle because the long strategy should rarely be used.
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Everything mentioned about the short strangle is true for the long—only in reverse.THE LONG SYNTHETIC
Synthetic means “artificial” or “not genuine.” A synthetic element ormaterial takes the place of one that naturally occurs. The most common example might be the invention of synthetic rubber and nylondeveloped during World War II when rubber and silk were unavailable in the United States.In options trading, you can use a strategy that utilizes optionsonly, but creates the same effect as trading the underlying futurescontract. The strategy is called the synthetic long or short.You create a synthetic long futures position through the purchase of a call option and the sale of a put option, where the two legsof this position share a common strike price and expiration date. Justas the name implies (long), you must be strongly bullish on the direction you expect the market to head.Suppose you do an analysis of the stock market. Your conclusion is that the Dow is headed much higher. You think nothing canstop it. Instead of taking a position in an underlying futures, like theStandard & Poor’s 500, you opt to trade a synthetic long. This meansyou will buy a call and sell a put. For this example, the S&P 500 istrading at 350. Assume, for simplicity’s sake, that the call and theput are in-the-money. It costs you 2 index points to buy the call, andyou are paid 2 index points for selling the put. Therefore, you breakeven, less the transaction costs.You decide to hold the synthetic long position until expiration.If prices shoot up as you forecasted, the call gains value and theshort expires worthless. You win on both by closing out or exercising the call and collecting the premium on the unexercised put.What happens if prices drop? In this case, you lose double.Your call expires worthless, causing you to lose the premium youpaid, and the trader to whom you sold the short exercises it. You arerequired to deliver a short futures position that is in-the-money.The third possibility is that the market moves sideways. Hereyou break even, less transaction costs. You keep the 2-point premium you received for selling the put and lose the 2-point premiumyou paid for the call. Keep in mind that the transaction costs are
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doubled on this strategy, compared with just taking a futures position in the underlying futures. (See Figure 7.6.)Now, both options do not have to be at the same strike price. Ifthe call is in-the-money and the put is not, you have a deficit sincethe premium you receive for the put will not cover the call. On theother hand, if the put is in-the-money and the call is not, you’ll havea credit. The only problem with this is that the underlying futures willhave to move farther in order for your call to start making money.
F I G U R E
7.6
Synthetics Options PositionS&PIndex
P/LCall
P/LPut
Combined
Futures
356354352350348346344342
420(2)(2)(2)(2)(2)
22220(2)(4)(6)
6420(2)(4)(6)(8)
6420(2)(4)(8)(8)
These figures illustrate how the synthetic options position (row 3) mirrors theperformance of a straight position (row 5) in the futures market. Negative numbers are in parentheses.
WHY USE THIS STRATEGY?
At this point you may well be telling yourself that this strategydoesn’t make sense—an outright futures position would be morelogical, and the only thing this strategy does is double the amountof commissions that must be paid. If this is true, why would anyoneeven consider it?You can use the long synthetic strategy to convert a long call orshort put options position to a futures position with the same advantages and risk. Consider that you already have purchased a calloption. After a time you decide the market is well supported, andyou want to optimize your position by gaining the short put premium. Your resulting position would be a synthetic long.
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THE SYNTHETIC SHORT
You can trade a synthetic short just as you could a synthetic long.For the synthetic short, you buy the put and sell the call. Again, youshould use the same strike price and expiration date. This strategymimics taking a straight short position in the futures market.The same risks mentioned for the long are experienced if themarket goes against you. In this case, you are looking for a bearishprice move. If prices go up instead of down, your call will be exercised and your put will expire worthless.As in the futures market, you must always do your prognostications first. If you call the market correctly