Two Markets Ripe for Option Strangles
Michael: Hello everyone. This is Michael Gross and James Cordier of OptionSellers.com. We are here with your July OptionSeller TV Show. James, welcome to the show this month.
James: Thank you, Michael. Always glad to be here.
Michael: We have a pretty full slate this month, so we’re going to jump right into things. First thing to talk about this month, obviously, is the FED rate hike coming down. It hiked another quarter point in June. So, that’s going to have a different type of effect on commodities. James, I know you talked about it in your weekly video, but maybe just cover that a little bit right now for our viewers and what that might mean for commodities markets.
James: Okay. Most recently, interest rates have been, here in the United States, pegged at zero. With this latest quarterly rise we are slightly off of zero- somewhere between half and one percent. The quarter point rise really wasn’t a big surprise, certainly, but what Janet Yellen specified was the rollback of the incredible amount of cash and bonds that the government is holding. This rollback of the size of what the government is holding is just incredible – it’s some 3.5 trillion dollars and we’re going to see them start to sell that back into the market.
Michael: So, how would that affect say… the first thing you think about when you think of interest rates is probably the U.S. dollar. How is that going to play out, do you see, as far as its affect on commodities?
James: Well, as we effectively went into quantitative easing, as you know, some 8 or 9 years ago, the talk of the town was “We’re going to have an incredible amount of inflation, we’re going to have inflation, and we’re going to have infrastructure spending creating inflation”. A lot of people weren’t familiar with quantitative easing or what that meant to interest rates. Basically, a lot of people would put commodities into their portfolio. Someone who has never traded commodities before, thought that having gold or oil or something like this as an investment because of quantitative easing thought that would be the way to go because, certainly, interest rates at zero was going to spur a great growth worldwide and inflation. It simply didn’t pan out that way. Now, rolling back the balance sheet of the federal government from 3.5 trillion dollars to 3, then 2.5, then 2, then 1.5 is going to reverse this thinking for the majority of the people who are looking for inflation hedges. The inflation hedge is probably going to be not so popular going forward. As a matter of fact, not only not having an inflation hedge in your account or in your portfolio, but the fundamental factors that create inflation aren’t with us anymore. So, we don’t have 0% interest rates, we don’t have quantitative easing, we have that rolling back, and a time where inflation never really actually took place, clearly everyone is very familiar with what happened to China the last 7 or 8 years with the infrastructure spending. That’s done. That’s complete. Without quantitative easing and without 0% interest rates, the need for investors to put gold or oil in their account just haphazardly just to own it as an inflation hedge, we think that that time has come. So, gold and silver and crude oil will rally on its own accord, but as far as simply people buying it, hedge funds, private investors, we think that’s in the 9th inning and that’s likely wrapping up.
Michael: Of course, we have better ways to take advantage of commodities prices other than buying them outright, as most of our viewers know. What we’re going to point out to those of you watching and listening, we talk often about how commodities are diversified and they are uncorrelated to equities and interest rates and that type of thing, especially the way we approach them or you would approach them as an options sellers, because, yes, when James is talking now about interest rates and it’s affect on inflation, that’s a bigger macro-type issue. That doesn’t mean that the individual fundamentals of these commodities aren’t still important and aren’t still a driving force in what’s moving them. If you’re trading commodities you want to be familiar with these macro factors, as well, because they can put a head wind or a tail wind depending on what side of the market you’re on. That’s why we talk quite a bit about them. We’re going to switch things up a little bit this month. We’re going to do our lesson portion first because we have a couple markets here that the lesson applies to. We want to review the strategy first so you understand it and then we’re going to talk a little bit about a couple of markets that we think are excellent opportunities for applying it. That strategy, of course, is the strangle, the option strangle, which is selling a call on one side of the market and a put on the other side of the market – one of our favorite strategies here. James, maybe you just want to briefly cover that for our viewers for how a strangle actually works.
James: Certainly. I think most of us who are following along and have been trading or investing in commodities or stocks for a period of time, we’re dating ourselves here slightly, but of course the great thing I like talking about, I know I’ve heard you say it as well, Michael, but it’s The Price is Right. The person guessing the window that the car or the showcase or something is going to be inside, basically, we are playing The Price is Right. When suggesting a strangle, we are identifying fair valued markets. From time to time, the idea that crude oil is about to make a large rally or a great fall, usually oil and gold are generally trading exactly at their fair value. Basically, what we’re doing is we are identifying where the market might be over the next 6-12 months. If we see the gold market, per say, trading around $1,250 right now, and we think it’s fairly valued, what we are going to do is put a strangle around that market. How you do that is by selling a call option way above the market, selling a put option at extremely low levels below the market, and expecting it to stay inside that parameter. For example, the gold market, there’s still gold bulls out there. Whether quantitative easing is over or not, there’s still gold bulls out there. You might sell an $1,800 or $1,900 call above the market, at the same time you would be selling a put. That would be the lower end of the bracket that you’re putting around the option strangle and possibly selling a $900 or $950 put under gold. Basically what you’re doing is you’re saying gold is going to stay inside of a $900 price range for the next 6-12 months. Now, that sounds like an extremely wide window, and that’s because it is. We’re talking about selling puts and calls some 40-50% above and below the market, and all we have to do is see gold stay inside that band and 6-9 months later these options are worthless and we’ve collected money on both sides.
Michael: James, something too I think our viewers would be interested to know about is we have a lot of stock options sellers, maybe you’re selling index options, and you’re thinking, “Well, I do that but it has to stay in a fairly narrow range for me to make money”, whereas if you’ve never traded futures before, you talk about sideways market but you use that term loosely because the range we can sell these options the market can do a whole lot of things. It can go up for a long time or it can go down for a long time and trade at a fairly wide range, and you and I call it sideways because we’re so used to those big ranges, but to somebody unfamiliar with futures they may say, “Oh the thing is screaming up”… Yes, but it’s still far away from our strike, so that’s probably a bigger difference they would have to get used to. Do you agree with that?
James: These $25 and $50 moves in gold, or these $2-$3 moves in crude oil, they make great TV., especially when they’re talking to someone on the floor and they’re hearing pandemonium going on. “What’s going on down there, John?” “Well, gold’s up $25 because of this or that”, and people are thinking “Oh my goodness, I need to get into this” or “Thank goodness that I did puts instead of calls, or what have you”. $800 or $900 trading range in gold, these parameters are likely not going to be seen tested, much less touched. Quantitative easing rallied gold up to $1,900 an ounce. That was an all-time high. These levels, in my opinion, won’t be seen for years. On the downside, being long gold from $900 or $950 is a very great value and we don’t see the market falling down to levels like that with the stock market trading at all-time highs and people talking about diversification. Part of that will be buying gold, because when the stock market does finally take a dip, and certainly it’s not a matter of when, but when it does take a dip gold is probably going to come back into flavor, but without inflation it’s not coming up too high.
Michael: Obviously a good article on the blog James wrote this month about that exact strategy, some of the bullish and bearish factors affecting gold and why we feel it should remain in those ranges. Obviously, if you haven’t guessed, our first market this month is gold, so James is already kind of explained the strategy at what we’re looking at there. With the current hike in rates, the current strength in gold, James thinks, is going to mitigate/stay in those ranges. Another thing we should probably talk about, James, is a lot of people when they hear us talking about strangles, and you write about them a lot or talk about them a lot because it is one of our core strategies here, is do you put the thing all on at once or do you wait until it rallies and sell the call or wait until it falls and sell the put? How do you know when to do that? That’s a strategy called legging-in. It’s a little more advanced for more advanced traders, but I know it’s something you like to do at times. Can you maybe just talk briefly about that or how you approach that?
James: That’s interesting, Michael. Approximately 2-3 weeks ago, just as the month of June was beginning, gold did have a rally. It tested up towards $1,300. We really saw a lot of resistance at $1,300 and we did start legging on gold strangles at that time. We were able to sell gold calls even higher than you can now because gold was on a bit of a rally. As long as you’re legging on a position, if you feel that if you don’t get the other side of a strangle on and you’re still good with the investment, legging on is a great idea. When gold rallied up to $1,300 recently, we were selling gold calls with both hands. Not that I knew the market was going to fall $50, which it seems like it has over the last week or two, but we’re quite confident it wasn’t going to the levels that we saw. Now with gold back and down about $40-$50 recently, we are applying our puts to our strangles, so we did successfully leg in to this gold strangle that we’re most recently involved with. As long as you are able to live with one side or the other, if you don’t get the other side on and you’re comfortable with that, legging on is a great idea. When we were putting on our calls here recently, the lowest a put we could sell was $1,000 and now we can sell the $900-$950’s, so we were rewarded in legging on this position. Generally, commodities will trade. Technically, gold is doing extremely well right now, and that gave us a window to make our strangle some $50 wider than it would have been had we just put the position on.
Michael: A lot of people watching are used to hearing us talk about bushels of soybeans or bags of coffee. It switched to macro here this month and it may seem a little bit different, but when you’re trading gold that is really what it is. It’s kind of a different animal than a lot of these other commodities. You have a lot of public interest in gold, everybody has an opinion on gold, but as an option seller that helps because the public interest comes in and they usually like to buy options. Would you agree?
James: Michael, so many investors right now are looking at diversifying away from the stock market, and that is not a call on what the stock market might do, it’s just that a lot of investors, I know you talk to perspective clients all the time and I speak to clients myself, and that is the keyword everyone is talking about right now: diversification. People delving into commodities often want to buy options. That’s their best way to get involved with it. A lot of them are newbies, of course, we have a special relationship with our clearing firm and we actually sell a lot of our options to banks, who have extremely deep pockets. Often when we are making a sale of a particular commodity available, a bank might hear about it and they might want to purchase a lot of these options from us, so we both get the excitement of the public to buy our options, as well as large banks. We mainly deal with banks in New York and London. They’re taking the other sides of our market lately, and it really gives us a great deal of liquidity as long as the conversation about things going on in the administration and things going on globally, the debt in China, constant demand for commodities, and lot of these are option buyers. Certainly, we are very happy to have them.
Michael: That’s a question we get often is “who is on the other side buying these options?” That’s a long list of people, but a lot of times it is banks and I doubt they’re buying them as an outright long strategy. Often times, these are part of complex spreads or hedges they might be putting on, but they’ve certainly got a lot of liquidity. We have a special guest that’s going to be on the show here later that’s going to talk a little bit about that with us; however, in the meantime, let’s finish our discussion here about strangles. If you would like to learn more about strangling the market, you can go to the blog. We do have our seminar videos there. Also, don’t miss James’ article last month on the gold market, The Golden Brackets. It’s exactly what we were talking about here. That’s also available on the blog. If you’d like to learn more about the strangles strategy, I do recommend our book, The Complete Guide to Option Selling: Third Edition. You can get that at OptionSellers.com/book. James, let’s move in to our second market this month. This is a market we’ve been talking about now for a couple months. Last month, crude oil was trading in the low 50’s. The media was ablaze with the story of how OPEC’s cuts and how high oil would go, and you were saying “It’s going down. It’s going into the low 40’s”, and here we are today at $43 a barrel. The market has come down and now we’re thinking of a different type of option strategy again. Maybe you want to talk a little bit about that.
James: Michael, very interesting point that you make. We were bearish crude oil when it was trading around 50-52 recently. It is headed to the low 40’s right now, or certainly it seems that way. You mentioned something very interesting a moment ago. What we do is we count barrels of oil and we count pounds of coffee and we count pounds of cocoa. Just laying out a fundamental analysis and a fundamental reason for getting into the market. When OPEC announced cuts, what people didn’t talk about then was the fact that they amped up production the weeks prior to this taking place. What that inevitably did was it locked in production at all-time record highs at a time when demand for oil right now is slipping slightly, basically because cars around the world no longer get 15 miles to the gallon, they get 30 miles to the gallon. The demand from China seems to be slowing just slightly. The main player in oil right now is the Permian Basin in the United States. Rate counts have doubled in the past year, and we’re going to be awash in oil, we think, in the 3rd and 4th quarter of this year. We are looking at crude oil starting to trade seasonally again. We mentioned this a couple of TV shows ago that the crude oil market, the seasonal trade this year, got hijacked by the production cut announcement in OPEC. We see crude oil returning to the seasonalities that we’re so accustomed to, and that is selling oil in June and July and buying it in December and January. We will likely be doing that again this year. The crude oil market is probably going to base out near 40, it’s going to rally near 50, and this window and this bracket around oil is likely going to be staying with us for quite some time. We know that, at least we feel we do, by counting barrels of oil and understanding the market. So many investors were piling into crude oil recently and the production cuts. Simply knowing what the fundamentals are and not watching headlines allows us to be a little bit ahead of the market. If you have option selling to produce a position for you, some 50% out-of-the-market sets up a nice scenario for us.
Michael: That’s pulling out, too. We talked last month about oil returning to its seasonality. Here we are at the beginning of July and all through June and crude oil did nothing but come down. I mean, it’s almost aligning with the seasonal chart again. Just like we discussed last week, the energy markets are some of the most seasonal markets on the board. Nothing guaranteed, of course, but just because of the cyclical nature of demand, it seems to match up- it’s definitely a factor you want to look at if you’re trading energy markets. James, we talked about the media’s effect on crude oil. Last month, they were all about OPEC and talking about potential rallies in the market and they are ignoring things like seasonals. I don’t know if they actually don’t know about them or they are looking for a story, but here we are and now the crude is falling. I’m watching CNBC this morning and Cramer’s on there talking about oil in the 30’s. Now they are bearish and they can’t get bearish enough. You’re talking about, really, looking at a strategy similar to what we talked about in gold, where we may be looking to trade both sides of a possibly range-bound market. Is that correct?
James: It is correct. Herd mentality in stocks, even more so in commodities, just takes place like you wouldn’t believe. The same absolute experts, the talking heads on TV, so bullish in oil when it was at 55 and 60, and it’s certainly going to go to 65 and 70. These exact same experts are now talking about oil going into the low 30’s. I think, sometimes, you could just watch CNBC, especially CNBC, and just do the opposite of what everyone’s doing, because when everybody is bullish, you can get one analyst and one expert all saying the same thing, “My gosh- oil is certainly going up. How high is it going to go? I’m not sure.” You can close your eyes and sell calls when that happens. Now, when the market is falling possibly into the 30’s this fall, that will be the time to get bullish for next summer. I think last TV show we did, I talked about passing not to where the market is but where it’s expected to be. This winter, when we have extremely low prices, we’re going to want to sell puts to the June and July time frame.
Michael: Do you like the strategy of strangling the market right now?
James: We strangled the market some 6 months ago when OPEC had made its announcement. We went long from 33 and short from 76. We love that position. Those positions are basically retired now. We’ve collected some 75%-80% on both of those positions. What we’re going to look at doing is that the fall has already begun. We just dropped practically $10 here in the last 2 months for oil. Our next position will be strangling the oil. We will be looking at legging on this position, and we will probably be putting our puts on as the first leg and then waiting for the market to rally some later on and putting on a call position. We will be strangling oil. We’ll be strangling oil probably for the next 2-3 years. We think we can see that far out. We think we know what the band is going to be. Right now, we’ve had a $9 decline on oil real rapidly. We could probably see it fall another $3-$4 and we’re going to start getting our calculators and pens out and starting writing some puts.
Michael: So, you think to a point there, and it’s a good point that we should probably make, because the point you’re talking about is a longer-term investment based approach. Some of the viewers watching today are probably traders, and there is a difference there between trader and investor. You’re talking about, “Well, we will leg this position on in the fall and then we’ll add another leg to it in the spring.” Those are long-term type projections, where some people used to trading options are thinking, “Well, what can I do today? What can I do today to make a profit by the end of the month?” That’s not really how we approach it. You can gear option selling to be that way if you want, but it’s really not an investment based approach that you have really shifted to and had a lot of success with.
James: You know, we don’t consider ourselves traders. We take a fundamental view on about 8 different commodities and we make positions as investments. The market does have gyrations, the stock market does, the commodities market will certainly gyrate from time to time, and we need those to pump up premiums on both puts and calls. The key to the fact is, if you’re a fundamental trader, you are able to stay with your position when the market has a small move against your position. We sell options, both in time and in price, much further out than probably most anyone does. We want to be invested in our positions and not simply be trading them. When you are selling options in commodities some 40%-50% out-of-the-money, granted it might be 6-12 months out, much further than most people would every consider selling options, especially in commodities, people say to us, “James, that leaves a long time in the market for you to be wrong.” We look at it as that gives us a lot of time to be right. So often, when you sell a short-dated option, the market will make a short move against you and knock you out of your position. Lo and behold, 30 days later, the market was doing exactly what you thought it would do, except you’re not holding your short option anymore. We get paid to wait. If you know what the fundamentals are and if you’re applying them in long-dated options, being paid to wait is much easier and it gives you the ability to be patient.
Michael: Great point to make. You talk about that a little bit in this month’s newsletter. We got questions about timeframe and what’s a good timeframe to sell options. That’s addressed in this month’s newsletter. The July Option Sellers will be out on July 1st. You can look for that in your e-mail box as well as your hard copy mailbox if you’re a subscriber. We’re going to take a little bit of a detour off of our usual schedule for our show this month. We brought in a very special guest for you. He’s going to bring you some different trading insights, and we will be back in just a moment with him.
All right, everyone, we are back. We have a very special guest with us today. With us is Mr. Dave Show. Dave is one of the floor traders that actually has been a tremendous help to OptionSellers.com. He gets our orders filled up to Chicago board to trade with a lot of our orders up there in the agricultural markets. Dave, welcome to the show.
Dave: Thank you very much. It’s nice to be here.
Michael: One of the things we’re going to talk about is, as a floor trader, Dave has some unique insight in option trading, getting fills, and how orders are actually getting through the system. One of the things we’ve talked about, a big topic, is electronic trading. Is it going to make floor traders go the way of box TV sets? We don’t necessarily feel that’s the case. There are still some benefits, substantial in our case, we feel, of still trading through the floor. Dave, maybe you can talk a little bit about that and what do you see happening with that?
Dave: I’d be happy to, Michael. The floor trading still exists because there is a marketplace and a need for it. Electronic trading certainly has its place. It’s used substantially in our markets, but especially in the options markets, which there are so many permutations and different strategies to ploy. It sounds very difficult to get that expressed on a screen and to get a response, a bid or offer, on that. Whereas in the pit, we have several hundred people on the floor that are participating and have instant access to whatever quote you’d like to get. It’s usually a best bid invest offer. It’s not a feeler kind of bid or offer. We have huge backing down there with these traders, different banks and different huge trading companies, and they keep their traders there to make the best market. As a trader and investor, you may wish to ask for a market at a strangle, spread, call, or whatever. You put down the screen and you wait for your RFQ to come back. You call the floor, you call your broker, and he can get you, in 3 or 4 seconds, a market that is tight and is deep and is transparent. So, if you have size to do, to move many hundreds or thousands sometimes of transactions, it’s much more efficient to do it that way in the pit where you get it all done at a specified price and at one time and the trade is completed.
James: That’s an interesting point. Quite often, we will be selling some strangles and some outright positions on the screen and it doesn’t seem like there’s that much volume on the floor until the screen trade actually takes place. I know, from time to time, we will bait the market, it seems. We will have a certain market to trade on the screen, maybe 100 lots, and then I will be speaking to you and I’ll ask you, “Does the floor see this trade? What do they think about it and can they help us move some size?” Can you speak to that?
Dave: James, that is very much often the case. We’ll have customers that when they need to move a large amount, they will tickle the screen with a bid or offer. They will also simultaneously put it in the pit. The screen has a much larger audience, granted, and there will be someone out there starting to lift the bid or take the offer and get your order filled. Once our pit community sees that, they will generally, as a mass feeding, come out and take on whatever we have to match the screen so that it stays with us instead of going on the screen.
Michael: Dave, one of the things we talk about and investors ask us there at home is, they’re trading 2 or 3 lot options on the screen and we talk about an economy of scale where instead of doing that they say, “well, I can’t get a fill.” Yet, if you want to sell a thousand it is easier to get a fill. Can you kind of speak to that or how that affects it with you?
Dave: Absolutely. There is a bid and offer for every market out there. Generally, it’s a certain range depending on how liquid the market is. We all see the parameters that the world is putting out on a screen. We, as traders in our pit, will generally, as a rule, be able to get inside that current bid or offer you see on the screen to make a tighter more liquid market, because if people in our pit are not trading 2’s or 3’s, they are equipped to trade 2 or 3 thousand. They are very well capitalized and they have management teams upstairs in the offices handling what they are doing in the pit. Any trade that is done in the pit, we’ll generally admittedly go up to the office and they’ll take it from there, and they’ll spread and hedge that off somewhere in the outside markets.
Michael: Dave, just in closing, in your professional opinion, you’ve been on the floor since 1980? So, you’ve been on the floor a long time. Do you think there will remain a place for floor traders in the next 10-20 years or do you see it going electronic?
Dave: That’s a long time, Michael. Let’s talk near-term. I think near-term there is certainly a place for us. The exchange has never stated they intend on doing anything but stay open. We provide a service, especially for the larger markets, and we expect to be there for many years to come.
Michael: That’s good. James, I know you and I, we still rely on those floor traders and really think they can still give us an advantage. Wouldn’t you agree with that?
James: It’s interesting, Michael, there are people probably trying to trade 2 and 3 lots. Like Dave mentioned a moment ago, we’re trying to trade 2 and 3 thousand lots. Wherever we can increase the volume and increase the liquidity, that’s something we’re always going to try and take advantage of. I know that when we’re selling options in the grains, Dave has probably brought more liquidity to the ability for us to do that than any other way to do it. We hope the floor stays around for a little bit longer, hopefully a lot longer, and we’ll transition if we have to, but right now we are glad to have you on the floor.
Dave: Thank you. I’m glad to be there.
Michael: Let’s hope he stays there. Well, everybody, thank you for tuning in to this month’s show. Just a reminder, if you’re interested in opening an account with us, we are fully booked for July and we are into our waiting list for August. If you are interested, feel free to call Rosemary. It’s 800-346-1949. She can get you schedule for our remaining consultations, which are still taking place in July. If you’re interested in learning more about our accounts first, you can request a discovery pack online at www.OptionSellers.com/Discovery. Have a great month of option selling. We will talk to you in 30 days. Thank you.