How to Sell an Option Strangle in Commodities

How to Sell an Option Strangle in Commodities
Feb

5

2016

How to Sell an Option Strangle in Commodities

Selling a Strangle not only allows you to Double the Premium you Collect, it also offers a Valuable Risk Protective Feature

Selling Puts and Calls in the same Market can provide some unexpected Benefits

A core focus of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is pairing the logic of selling option premium with the long-term fundamentals of a particular market. While we are confident that this is a winning formula for long-term success in the commodities option market, it is certainly not the only formula – another key concept of the book.

At certain times, however, there may be opportunities outside of one’s core fundamental holdings that can offer juicy opportunities for selling options – without necessarily forming a fundamental bias.

As you may have seen in James Cordier’s latest market update, strangles are becoming a favorite strategy for a variety of commodities in our managed portfolios this month. That is because despite what is happening over in the equities markets, fundamentals for some core commodities are beginning to balance out. This opens the door for investors to strangle the market with options.

This piece will explain how to employ this versatile strategy and turn it into a high odds play with potentially bigger ROI that simply selling naked or credit spreads.

What is an Option Strangle?

A short option strangle is an option selling strategy that involves selling both a put and a call in the same market. It is a “go to” premium generator in our portfolios and should be one for you too.

In a strait up naked option sale, you are picking a point above or below the market where you think prices will not go. A strangle is picking a point above AND below the market, where you think prices will not go. Strangles are best employed in markets that are trading in a range bound price pattern. However, we have also employed them effectively in steadily trending markets.

In a strangle, your put is sold far below the current price of the underlying futures and your call is sold far above the current price of the underlying futures. If the futures price is anywhere between the two strike prices at expiration, both options expire worthless and the trader keeps all premium collected as profit. Although strangles can often produce more premium for the seller than selling naked puts or calls, they can also be considered a more conservative strategy, as gains on one side of the strangle tend to offset losses on the other.

Benefits of the Strangle

  • Double Premium but not Double Margin (Higher ROI)
  • Offsetting Risk Effect makes more stable, durable position
  • Ability to profit over a wide range of price movements
  • Can produce in both trending or non-trending markets
  • Capitalizes on Market Volatility

In many cases, this “offsetting” effect can allow a wider range of movement in the underlying contract without significantly affecting your equity. Meanwhile, time decay gradually erodes the value of both the put and the call.

I apologize for the dated example as I didn’t have time to write up a new one this week. However, the concept is illustrated perfectly here. For a current example of a recommended strangle, I would refer you to your February Option Seller Newsletter where we highlight a current strategy for strangling the Gold Market.

EXAMPLE – Short Option Strangle – December 2014 Natural Gas

graph-strangle-natural-gas-dec
Trade date: July 22, 2014
Trade: Selling December Natural Gas 2.80 put and 6.00 call (Strangle)
Total Premium Collected: $1,600 ($800 put, $800 call)
Margin Requirement: $2,210
Option Expiration: November 25, 2014
Analysis: If price of natural gas is anywhere between 2.80 and 6.00 at expiration, both options expire worthless and seller keeps all premium collected as profit.
Risk Management: Conservative: Risk to one of the options doubling in value (Ideally, the other side would then expire worthless, resulting in the trader breaking even on the trade).

Moderate: Risk to one of the options tripling in value, resulting in an $800 net loss on the trade (assuming the other side expires worthless)

Aggressive: Risk to one side going in the money

• This trade is displayed for example purposes only. It is only to illustrate a concept. No representation is made that these options can or were sold at these premiums during the time period mentioned.


Why Should I use Option Strangle

Also known as “bracketing”, the strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. As stated earlier, the primary benefit of a strangle is this: if the market is heading towards one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market.

This offsetting effect allows the market greater flexibility to fluctuate as opposed selling a straight put or call. Both the put and the call will eventually expire worthless, as long as neither strike price is exceeded.

A secondary benefit is margin. The phrase the whole is greater than the sum of it’s parts is often true when writing strangles. The margin for writing a strangle is often less than the sum of margin for writing a naked put and the margin for writing the naked call. This concept is illustrated below:

Margin Requirement for writing December Nat Gas 6.00 call: $1,515
Margin Requirement for writing December Nat Gas 2.80 put: $1,160
Total: $2,685
   
Margin Requirement for writing December Nat Gas 6.00 call/ 2.80 put Strangle $2,210
Net Margin Gain $475

Thus, writing a strangle can not only be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it can also increase an investor’s return on invested funds due to it’s favorable margin treatment among the exchanges.

Like any strategy, strangles have their limitations. The downside of the strangle, of course, is that a steep breakout in either direction can result in a loss. The option on the opposite side of the losing option can only balance losses so far. The balancing nature of the strangle, however, will generally allow risk conscious traders to exit gracefully in such an occurrence if they are using the risk management guidelines listed above.

Strangles can be very effective in markets experiencing high volatility. Volatility can often make strikes available on both sides of the market that have little chance of ever going in the money.

Fortunately for sellers of strangles, today’s markets have no shortage of volatility. Look for markets offering the deep out of the money strikes and don’t be afraid to sell both sides if there are traders in the mood to buy them.

If you would like to learn more about writing deep out of the money options on commodities, I strongly recommend our new book, Option Selling on Steroids. It shows how selling commodities options can potentially deliver both bigger ROI and real diversification from stock options. To roll it out, we’re giving away some introductory FREE COPIES of the BOOK now at www.OptionSellers.com/Steroids.


Price Chart Courtesy of CQG, Inc.


***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.

  1. Glenn Roberts Says:
    February 6, 2016 at 7:22 pm

    Nice strategy overview. Thanks! I have tried the gold strangle per your recommendation (as a paper trade). The call is getting some heat especially with yesterday’s spike. However, I’m in the May contracts since TD Ameritrade doesn’t allow anything further out. Too risky, not enough liquidity, so I’m told. Had I been able to trade June per your recommendation I would be in great shape… This is another reason I am opening an account with your firm. Thanks for the great articles!

    • OptionSellers.com Says:
      February 8, 2016 at 3:46 pm

      Hello Glenn,

      Thanks and I’m glad you liked the article. Looking forward to working with you soon.

      Regards,
      Michael

  2. leonard lavine Says:
    February 6, 2016 at 6:59 pm

    a very interesting strategy…………….is there normally enough premium in stock options to use this strategy??????????

    • OptionSellers.com Says:
      February 8, 2016 at 3:49 pm

      Leonard,

      Thanks for your feedback. However, these are options on commodities options, not stocks. To answer your question, no, there is not enough premium in stock options to write options this far out. That is why we recommend commodities. If you’d like a good primer to learn the differences, I recommend our new book, Option Selling on Steroids. You can get a free copy at http://www.OptionSellers.com/Steroids.

      Thanks and best of luck in your investments.

      Michael

  3. Orville W Freymuth Says:
    February 6, 2016 at 4:34 pm

    Hi:
    Am I correct in stating that in your Natural Gas example if the price on 11/25/14 is between $2.80 & $6.00 I keep $1,600 on a $2,210 investment?

    Also, if the prices closed way above or way below the $2.80 or way above $6.00 on 11/25/14 the maximum loss to me is $800?

    Thanks.

    Kind regards,

    Orville W. Freymuth

    • OptionSellers.com Says:
      February 8, 2016 at 3:57 pm

      Dear Orville,

      Thank you for your question. Yes, you are correct that should the Nat Gas trade used in the example prove successful (which in hindsight, it did) you would make $1,600 on a $2,210 investment.

      However, your risk analysis is incorrect. Your maximum potential loss could be greater than $800 if you did not close the position. To learn how to properly gauge and manage risk in commodities options, I recommend reading The Complete Guide to Option Selling, 3rd Edition. You can get a copy at http://www.OptionSellers.com/Book.

      Regards,
      Michael

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