By James Mound

I am often asked why I am such a big believer in spreading options. Simply put (no pun intended), option spreading provides avenues to create definition to trades that futures or straight options do not. Allow me to explain.

When you buy or sell a futures contract you are making a simple judgment of market movement: will the market go up or will it go down? Your exit strategy then determines the risk to reward ratio of the trade as well probability. When you buy a put or call as a one option trade you are forced to make the same judgment of market direction, but are defined by limited risk and time as well as reduced probability. However, when you spread options with or against each other you can more easily define the risk, reward and probability scenarios of a trade and, in turn, open yourself to a world of choices. It is important to note that the risk of long option strategies are defined to the cost of the options, while certain alternative option strategies have unlimited risk.

Follow along with me on a brief analogy. Today you are being thrown into the heart of the Amazon Rainforest and just before your friendly Amazonian guide leaves you to be eaten by jaguars he offers you two choices. In his left hand is a pristine shiny Jim Bowie knife. In his right hand is a backpack loaded with a handgun, bullets, a first aid kit, a machete and a two month supply of food.

Pick one.

Assuming you are not suicidal you went with the backpack which leads me to an all important question: Why wouldn't you want all the possible tools in your tool belt when trading in this dangerous wilderness we call commodities? Futures traders have one way to trade the markets, option traders have another and option spreaders have yet another approach to finding profitable opportunities - why limit yourself? Option spreading allows a more complete trader to have a full arsenal of weapons to attack the market.

OK, not a believer yet? Let's try a different rationale using three hypothetical examples to prove the point: (Please note these examples do not include transaction costs, which can generally range from a few dollars per contract side to $50 or more depending upon your brokerage)
Example A: Futures

Buy Crude Oil at $60.00 with a profit exit target of $66.00 and a stop loss at $57.00. The trade has a 33% chance of hitting the profit target as opposed to the stop loss and has a risk to reward ratio of 1 to 2. Breakeven is $60 on the futures, risk is $3,000, reward is $6,000.

Example B: Straight Options

Buy a Crude Oil $60 call (market is at $60) for $2,000 with a profit target exit on the option of $6,000 (including cost) and you are risking the premium on the option. Excluding time premium, the trade must work 33% of the time to breakeven, but the probability is reliant on numerous factors such as time and volatility in the market to calculate the likelihood the market will move to $66 within the time frame of the option. Assuming you have a 50/50 chance of the market going above $60 and even less of a chance that the market will go above $62 (breakeven including the cost of the option), the odds of your profit target being hit is quite low. The risk to reward ratio is 1 to 2. Breakeven is $62, risk is $2,000, reward is $4,000.

Example C: Option Spreads

Buy a Crude Oil $60 call and sell a Crude Oil $66 call for a spread price of $1,000 (the long call costs $2,000 minus the premium collected on the short call [$1,000] = $1,000). Breakeven is now $61 and the profit price target is still the same as example B. The risk to reward ratio is now 1 to 5, and thus the trade must only be successful 20% of the time to prove profitable with the same price target as examples A & B (excluding time premium). Breakeven is $61, risk is $1,000, reward is $5,000.

Hopefully you are on board because now we can get into a real trade example.

On March 30th the FOMC (Federal Open Market Committee) met to discuss key interest rate policy and was the inaugural meeting of the new Fed Chairman Ben Bernanke. Moreover, the ECB (European Central Bank) recently had their policy meeting and raised rates a ¼ point, opening the door to speculation on the amount of rate hikes ahead of us. The 30 yr. T-bond market (the treasury instrument most sensitive to interest policy shifts), has just broken key technical support after the ECB's announcement and sits poised to react ferociously to the announcement after the upcoming meeting. But you are no swami and your better half tossed your tarot cards after your last trading fiasco. In fact, you don't have the slightest clue what the Fed is going to do, much less what the market reaction might be. And yet you recognize clear indicators of explosive volatility the day of the report and the days and weeks following. If all you could play is a futures contract you would have very limited trading choices. You could have stops on either side of your perceived support or resistance, thus stopping you into the trade after a predicted breakout occurs. Unfortunately, that strategy offers up a lot of potential problems. The market could easily reverse its reaction after getting stopped into the trade, causing you to get stopped right back out of the trade. The market may have any number of other events occur that cause the trade to go against you. You might have even missed a big part of the move just waiting to get stopped into the trade in the first place.

Instead, you could buy a call or a put, which forces you to pick market direction (which you have already admitted you can't predict) but with limited risk and big potential profits. You could even argue that buying options in general, going into a period of increased market volatility, generally offers the highest probability of success with the least risk. Nevertheless, this strategy misses the focus of the results of your analysis of the market. All you want to do is profit from the price volatility and avoid having to pick a direction. There are two basic strategies for this type of scenario that produce the DEFINITION you need in your trade design.

A straddle is an option spread that involves buying a put AND a call with identical strike prices as close to the current market price as possible. This allows you to profit on a selloff with your put, or a rally with your call. Let's say that T-Bonds are trading at 110-00 when you place the trade just prior to the report. You would purchase a 110 call and a 110 put for May (expires April 21st). For discussion's sake let's say you paid 32/64ths ($500) for the put and another $500 for the call. Then, by the trade's definition you are expecting the price volatility after the announcement to exceed $1,000. This could mean either holding both options until one side exceeded the necessary price movement to hit your profit target, or timing the exit of both options at different times to maximize the best possible return on each of them. This difference in strategies is determined by your forecast of the volatility being either in the form of a breakout and trend in one direction or a more choppy price action with back and forth volatility. This trade design confines the risk and reward of the trade to what you are truly confident in predicting. This is definition that adds a great weapon to your trading arsenal.

A strangle is similar to a straddle, but differs in that you purchase a put and a call equidistant to the price of the market. Using the same example as above, an example of a strangle would be to buy a 111 call and a 109 put. This changes the trade design because the cost will be significantly less than a straddle, which could potentially offer a higher Return on Investment (ROI). However, the necessary volatility becomes higher due to the greater distance the market price has to travel to exceed the strike prices and cost of the trade.

In conclusion, option spreading can provide trade design and definition that is not possible with simple futures or straight option strategies and can offer additional risk and reward (and probability) management while reducing emotion by increasing control over the trade design.

Learn to use these strategies and you will add a critical weapon to your trading arsenal.

Disclaimer: There is risk of loss in all commodities trading. Commissions and fees vary per individual and therefore are not included in profit, cost and risk scenarios. Please consult a James Mound Trading Group Broker before you trade for the first time. Losses can exceed your account size and/or margin requirements. Commodities trading can be extremely risky and is not for everyone. Some option strategies have unlimited risk. Educate yourself on the risks and rewards of such investing prior to trading. James Mound Trading Group, or anyone associated with JMTG or moundreport.com, do not guarantee profits or pre-determined loss points, and are not held monetarily responsible for the trading losses of others (clients or otherwise). Past results are by no means indicative of potential future returns. Any copy, reprint, broadcast or distribution of this report of any kind is prohibited with the express written consent of James Mound Trading Group LLC.