The Maserati of Option Credit Spreads
Michael: Hello, everyone. Welcome to the monthly Option Seller Radio Show. This is Michael Gross here with James Cordier, coming to you from Tampa, Florida- our main office. We’re going to talk a little bit about the markets, a little bit about trading this month. Quite a bit going on, including what could be the final game of the series between the Tampa Bay Lightning and the Pittsburgh Penguins. My colleague, James Cordier, happens to be a Tampa Bay Lightning fan, and, being from Pittsburgh originally, I’m a Pittsburgh Penguins fan. James, what do you think on the series possible finale tonight?
James: Well, it’s interesting, Michael, we’re using our backup goalie and he had little butterflies the first game or two. He wasn’t getting any support from the other players, and finally he is, and certainly a great series right now. We’re ahead 3-2. We being the Tampa Bay Lightning. For your sake, I hope it goes a little bit further. For our sake, hopefully we get to win tonight and we get to watch for a day or two before the Lightning hopefully take on the San Jose Sharks. We have a couple clients in the San Jose area and it would be fun to get a little friendly bet going there, too.
Michael: By the time our listeners hear this, they’ll know the results. They can visualize our reactions, I suppose. What a lot going on in the markets this month. Volatilities are subject of the month as an options seller. Volatility is obviously a very good thing, and probably the best place to start this month. You’ve been talking a lot about volatility in some of your videos, and I know we’re talking about it in the newsletter this month. Maybe just kick off, we’ve seen a lot of pick-up in the last 6 months across many sectors in commodities in volatility. What are some of the macro-reasons or why are we seeing this rebound?
James: The rebound in volatility is coming from the uncertainty, especially from the FED. Earlier this year, as we described, they were going to have four rate hikes in 2016. That got backed off to maybe one. Now, the Federal Reserve, one governor is being walked out after the other in front of the microphone, talking about possibly three or four rate hikes again. This back and forth is really gyrating currencies around the world, and certainly the currency play is directly affecting gold prices, silver prices, and oil prices. Volatility right now is through the roof, and this is certainly low-hanging fruit for option sellers. I know not everything applies to option selling however, because there is a world outside of this, but the volatility right now this is certainly a by-product of what’s going on, and certainly that does help what we do immensely.
Michael: Yeah, and a good point to make as an option seller, a lot of people asking now “Are they going to raise rates? Are they not going to raise rates?” People positioning on one way or the other are really gambling on a decision, and, as an option seller, you don’t have to do that. In fact, it really ushers in some of the strategies we talk about in our book as far as credit spreading. I know it’s one of your favorite ways to sell options. Maybe talk a little bit about that, how volatility does favor credit spreads, what advantages come to an investor for using a credit spread in this type of environment.
James: Michael, this environment, as we are referring to, certainly has the large volatility, which is blowing out premiums on option prices. In times of low volatility, in order to get decent premium, you do have to sell naked calls or puts based on if you’re bullish or bearish. Being naked is certainly not our first choice. Certainly we sell naked options because we don’t have the premiums available that further out strikes. Right now, it’s available by being able to sell protection against your short position, slow and steady option decay is what we’re after. Now, this environment offers that luxury to do that.
Michael: Yeah, you not only get the protection aspect of it, but a thing a lot of investors don’t always realize is, often times because you have that protective aspect, your margin requirement drops. There are certain occasions where credit spreading can even offer a higher ROI than selling naked. Would you agree with that?
James: It does. Not only does it help you stay in your position through ups and downs in the market, but it offers smaller margin requirements and it allows you the ability to participate in practically all the opportunities you see in the different markets. Often, if volatility is too high, selling naked just doesn’t allow you to protect assets like you’d like to. Smooth and steady is what the goal is, and having the ability to buy protection against your short position is the utmost performance year’s end. What we’re always looking for is slow and steady currently, and the only excitement we’re looking for is on December 31st reading statements.
Michael: Very good then. Let’s talk a little bit about volatility in particular markets. We’ve seen a little burst of volatility in the soybean market here over the last several weeks. We had talked last month about selling calls in soybeans, and we had a big move up in that market. It’s a good market to address because I think you can’t just assume that every option you sell is going to slowly decay to zero. Sometimes, the market moves against you. Maybe talk to our listeners and clients right now about how we reacted to that and how we recommend reacting to a market like that.
James: That is true. We’re selling options in eight different markets, and, from time to time, the market exceeds our expectations. A lot of what’s going on in commodities right now is headline driven. There are so many hedge funds and money managers right now chasing performance and chasing return, and they’re looking at eight commodities like we are. They see headlines for the gold market or for the soybean market or they’re having problems in Argentina getting soybeans to the market. That kicks in buying or selling form computerized generated funds, and that’s what happened to soybeans the last two or three weeks. There were headlines from Argentina and China was buying a little bit more soybeans than a lot of people anticipated, and soybeans rally an extra dollar probably above their fair value. As we talked about recently, later this fall, I think the United States is going to be producing a great deal of soybeans, probably in excess of what we need. The headline news really moves the markets and that is what happened over the last week or two. We did cover some of our short positions. We rolled up some of them to higher strikes, and we’re still holding a short position there, but from time to time the market exceeds your expectations and you know you have to take evasive action from time to time, and that’s what we did last week.
Michael: Sure. You’re talking about headlines; the big headline driving the soybeans was the May USDA report. The number that really jumped that really caused the spike is, not this year’s ‘15-‘16 ending stock, but the USDA is looking at next year, ‘16-’17 ending stocks. The trade pretty much had them coming in around 400 million bushel, and USDA says it’s only going to be 305, which is a pretty significant drop. It’s interesting, because the harvested acres are, more or less, the same as last year, but they knocked down the yield estimate. Not really sure why they felt they needed to do that yet, but they also bumped up demand substantially for next year. That, at least for now, they’re looking for substantially low ending stocks. I know you and I had talked earlier that we thought they would have to increase acreage because we’ve had a little bit of a wet spring, and that can cause them to shift some of the corn acreage over to soybeans. So, the jury is still out on that. The market has backed off since we got the big spike, but when we talked about defensive strategy, taking evasive action, so we’re short the calls and the market rallies, maybe explain the strategy we executed there to deal with that.
James: Well, we are selling calls earlier this year, based on the fact that we are going to have a very large crop come this fall. Quite often, soybeans will have a weather rally, a spring-summer rally. This year’s rally was based on a very large cut from the USDA, as far as ending stocks. We did cover some of our shorter positions. We rolled them up to higher strikes. That’s a trade that is going to not perform the way you hoped it would, but they don’t always do that and that was certainly one of them.
Michael: Yeah, and you had emphasized this previously, but the reason we roll strikes up like that is, often times after a big rally like that, that’s when the volatility is the highest, that’s when the premiums are highest. The fundamentals did shift a little bit, but they didn’t shift that much to where those higher strikes we felt would be threatened. In fact, as you mentioned, they were so far out that it was a difficult opportunity to pass up. So, often times, even if you’re in a market, you get a big move like that, the volatility that’s created by that move can often make it an optimum time to be selling options in that very same market. That’s one benefit of the roll. James, let’s move over and talk a little bit about oil prices. You have been in high demand this month from various media sources. You had an appearance on CNBC earlier in the month, and you’ve made a pretty bold prediction there on oil prices. Let’s talk a little bit about where prices are now and where you see them going later in the summer.
James: Michael, similar to headlines that have been driving a lot of the different markets, crude oil certainly is included as being one of those. There were some difficulties in Canada where some of the fires there were actually keeping production down. They’re looking at 2 million barrels a day in certain regions of Canada, which was knocked down to just 1 million barrels per day, simply because workers couldn’t get to the oil fields. That is going to be a situation that is going to be calming down in the coming days and weeks. That was a headline, there were some headlines out of Nigeria, Saudi Arabia has been making noise about getting away from production of oil as their main economic resource. All of these headlines will not change the fundamentals in oil going on later this year. As driving season, we’re into now, starts wrapping up a little bit later this year, investors and traders alike start looking at global supplies. Right now, there are tankers that circle each other just off the coast of China, just waiting for the phone call to come into port and unload their oil. There is so much oil right now floating on the Seven Seas, it’s record breaking. As this little bit of euphoria that’s right now developed in oil because it has finally rallied. When that subsides, and we think it will this fall, I think we’re going to see oil prices back down into the 30’s. Right now we’re trading in the upper 40’s, and we think this is a great opportunity based on fundamental availability of oil later this year. Supplies are going to be in a glut situation again, and selling calls right now in oil is one of our favorite opportunities, we feel.
Michael: It’s a pretty solid fundamentally based case, and I know when places like CNBC and Fox come calling, they typically want you to make a call. A lot of times, they don’t understand that we do that for them but we don’t necessarily have to do that in trading and the way you trade- you’re selling options. But, when you’re talking to reporters like that or you’re on camera, do you ever get a feel that they’re pulling one way or the other for what they want you to say?
James: That’s interesting, Michael. CNBC, I think, is probably notorious for bringing people on when the markets are rallying and they want to talk bullish. When oil is falling, they want to bring analysts on that are talking bearish. I think CNBC is probably the biggest culprit for simply frenzied, if you will, interpretation of what the market is doing. Rarely do they want to hear an analyst or trader talk about it’s a good time to buy oil when it’s falling. I remember back in January and February, we were on CNBC and saying this route in oil is probably almost over. Our girl in Los Angeles who helps us get on to the different television stations when they call us, they simply didn’t want to hear about buying oil back in January. Finally, they thought maybe we should take another perspective, and CNBC rarely wants to put someone on that has a contrarian view. I think they’re learning a little bit. Back in January, we were talking about going long oil and the whole world knew it was going to zero. Lo and behold, the market did rally. Now, recently, we were asked to be on CNBC, reluctantly, talking about bearish oil factors later on this year. So, you know, we talked about how we feel about the market. We’re not “Ra-Ra” cheerleaders when the market’s going up or down. We look at the base fundamentals and we make predictions on 3-6 months out. I know CNBC loves talking about what the market’s doing today and what it’s likely going to do tomorrow. As we know, no one knows these facts. If, in fact, a person that comes on CNBC knows what the market’s going to do tomorrow they wouldn’t be on CNBC, they would be on an island right now eating cracked crab, like they did at the end of Trading Places. Can’t we have both?
Michael: I know when they’re shooting you remotely, they’re shooting you from the studio here in town, but you’ve been in the studio right there with them before, as well. Do they ever talk when the camera goes off? Do they ever say, “I think it’s going this way” or “I wish you would’ve said that”?
James: I think one of the most interesting memories I have of being in New York and being on set was, I think, when we were interviewed on Bloomberg. They probably have several hundred people walking through the lobby, going in and out of the offices, going in and out of the green rooms, making sure that you have everything you want. When you see the anchors walking through the lobby at Bloomberg, they’re like gods there. When you’re sitting in the green room you’re also like a god, because everyone’s job at Bloomberg resides on providing great content. So, when you’re going to be on for a half hour-an hour, they’re looking at you like “Dude, don’t screw up. I hope you do something really interesting and speak intelligently, because my job relies on great content”. I think Bloomberg walking through their offices there was very memorable. We’re going to be invited to do that again this fall. We’re going to be on set there for probably a very long segment. I think Bloomberg, which is a fantastic operation, I think they cover the fundamentals more than anybody else. Some of the Fox, not as much, but CNBC, they’re “Ra-Ra” stations. Bloomberg actually gets down to the nitty-gritty. They actually talk about the fundamentals, the markets that are actually moving for fundamental reasons. It’s so much fun being on Bloomberg and that operation, I’ve found, is just a Class-1. It’s just fantastic being on there and to walk through the lobbies there, you have your credentials and people are looking at you like “Yeah, you’re the man”. It’s pretty cool.
Michael: That’s an interesting point. You know, in this month’s newsletter we interview Mark Sebastian. One of the many things he does is he’s a writer for the Street and Mad Money, and he works a lot with Jim Cramer. One of the things he said in the interview is that Cramer is a really smart guy, but he can’t always say what he thinks on the show because the network has certain rules or guidelines they have to abide by, or I don’t know the reasons- he didn’t really go into that. But, he says if you really want to know what he thinks you have to read what his blog on Real Money… I’m not going to spoil the interview. He was kind of speaking to that same thing, where they have a framework of where they want you to go and where they don’t want you to go, and it sounds like Bloomberg gives you a little more freedom to explore the fundamentals. If you do want to see that interview amongst our other items we’re covering in this month’s newsletter, you will be getting it next week. I think you’ll find that a very interesting interview. Mark brought some things to my attention that I was not aware of that takes place up there. James, we started off the show today talking about credit spreads. I know, we’re going to spend a little time here talking about one of your absolute favorite credit spreads that you describe as the “Maserati of option spreads” in our book, The Complete Guide to Option Selling. Maybe talk a little bit about what this spread is and how it works.
James: Of all the option trades that we do, a credit spread generally buying one against selling three, buying one against selling four, gives us an incredible amount of flexibility to be in the position for slow and steady decay. If in fact we see a market that we determine to be fair valued, we’re actually going to sell a credit spread on both sides of the market. Anyone who has read the Third Edition: The Complete Guide to Option Selling, I really suggest you take a look at chapter 10. It talks all about the “Maserati of all option sales”. Basically, what is does, is it allows the investor, whether they’re clients of ours and we’re managing the portfolio for them, or if you’re doing it yourself, it gives you an incredible amount of flexibility to stay in the position, allow your fundamental analysis of the silver market or the coffee market to actually play out the way you thought it would. So often, investors get involved in commodities or in Apple Stock or what have you, and the gyrations of the market simply take you out of your position. The “Maserati of all option sales” is a credit spread that’s done sometimes on both sides of the market, and it gives you an incredible amount of staying power to allow you to be in the market when your options expire or at the time that you want to pull profits and close out the position. Being in a credit spread, sometimes on both sides of the market, allows you to adjust the position, at the same time, keeping 80-90% of the premium that you sold your options for. Quite often, the protection that you buy you only need for 30-60 days. Sometimes, you want to keep it on until the end of the position, but the idea is for all of your options to expire worthless. Anyone reading chapter 10 in our book the Third Edition: The Complete Guide to Option Selling, can learn and understand the greatest trade in option selling that there is. If you do it yourself or if you want to manage an account that we do for you, I think you’re going to find that it allows you to stay in the trade and allows you to see the end of option expiration on the positions that you have. It seems to be boring, it seems to be slow, it really locks down your position, but, in essence, that’s what you want. More often than not, at the end of the year, having this credit spread on, you’re going to be very happy with the results if, in fact, that’s the way you traded throughout the year.
Michael: James, for those that haven’t read the book yet or read that chapter, you’re referring to the ratio credit spread where you’re selling maybe 2, 3, 4 options out-of-the-money, and then for every 2, 3, or 4 that you sell, you’re buying a closer-to-the-money option for protection. The reason you do that is it protects your distant calls, but it’s one of the only option spread that I know of, if the market moves the wrong way you can actually end up taking a higher profit on that. Is that correct in some circumstances?
James: There are some circumstances where your long protection actually goes in-the-money, and the further out options that you sold stay out-of-the-money. It is truly designed to hit singles and doubles all year long. If the market does make a slightly more dramatic move than you first anticipated, that long option can actually turn out to be extremely profitable. Of course, your options on the other side of this strangle, if in fact that is the position that you’re implying, that expires worthless and your one long option can actually go in-the-money. That is more than a single or a double. That’s not how we have positioned, that’s not the rationale for doing it, but if you are selling 10, one of those options can go in-the-money and just dramatically increase the profitability of this trade. The long options are there for insurance, they’re there for stayability in the position. The ability for this option trade to produce profits in extents of what you first anticipated is there, but primarily it keeps you in the trade and allows you to be there when the options expire, preferably worthless.
Michael: Again, for those of you that would like to read about it, that’s in chapter 10 of The Complete Guide to Option Selling. You’ll certainly want to take a look at that if you’re interested in it. That’s all we have for this month. We do recommend you look for the newsletter next week in your mailbox and/or e-mail box. If you’d like more information on accounts this month, learn all about what’s available, the different programs we have, you can get a full information pack at www.optionsellers.com/discovery. We also do still have some new investor interview consultations available in June. James, I don’t believe you have any account openings left in June, but do you know or do you have to check with Rosemary?
James: Rosemary said we are full for June.
Michael: Okay. We do have consultations available in June for July account openings, so if you would like to book one of those, feel free to call Rosemary at 800-346-1949. Have a great month of premium collection, and we’ll look forward to the outcome of the hockey games over the next 2-3 days. We’ll talk to you all next month.
James: As we say here in Tampa, “Go Bolts!”
Michael: Have a great month, everyone.