Option Spread Trading To Limit Risk & Capture Market Opportunities

High on any list of trading rules or guidelines are the ideas that prudent traders:

• set definite risk limits
• diversify

The reason for both guidelines should be obvious. When your trading capital is limited, you need to decide ahead of time how much you can afford to lose on any one trade. Further, when you have exposure to a variety of markets, your chances of having at least some success go up.

The trouble with this advice, you might say, is that with limited trading capital, it is difficult to follow. Consider the plight of a trader with a $5,000 trading account. Suppose this trader sees potential in the CBOT mini-sized Dow, soybean, and 10-year Treasury note futures markets. To trade one futures contract in each requires the posting of $6,550 in initial margin (note: margin requirements change from time to time; for current levels, visit this site's Margins  section):

CBOT mini-sized Dow	$2,500
Soybeans	$2,430
10-year Treasury note	$1,620

To keep within the $5,000 limit, this trader can only trade two of the three contracts. A Dow-note pair would require $4,120, which is 82% of the capital available. A Dow-soybean pair would require $4,930, which is 99% of the $5,000 trading account. A note-soybean pair would require $4,050, which is 81%. Committing this much of the trading capital leaves almost no room for error.

Options on CBOT futures provide means to trade market direction prudently. They also minimize exposure to loss and make it easier for traders with limited risk capital to diversify.

During the month of October 2003, for example, the stock market rallied 327 points, soybeans rallied 111 cents/bu, and 10-year Treasury notes lost 2-10. A futures trader who captured all of each of these moves could have earned $7,772.50. But suppose that this futures trader had been on the wrong side of all three markets and had lost $7,772.50. This is $1,222.50 more than the total initial margin.

One good way out of this dilemma is to consider trading options strategies. When you buy an option, the cost of the option defines the extent of your risk exposure. Strategies such as bull call spreads or bear put spreads involve buying one option that is close to the money and selling another farther out of the money. The credit from selling the option reduces the cost of the strategy and further reduces the loss potential. A careful use of strategies such as bull call and bear put spreads can be a prudent way to trade market direction and a useful way to build trading capital.

Three Markets-Three Outlooks

Think briefly about what this trader with $5,000 in trading capital might have known on October 1, 2003, about the stock, soybean, and 10-year Treasury note markets. Think also about what trades then prevailing market outlooks might have suggested.

The Dow had rallied more or less steadily from the beginning of June 2003 to mid-September to a high slightly over 9600. At that point, it dropped sharply, seemed to find support around 9300, and started moving back up during the last days of September. By October 1, this trader might have felt guardedly bullish. One way to trade this opinion is with a bull call spread. This strategy involves the buying of a call option with a strike price at or near the money and the selling of a call with a higher, farther out-of-the-money strike price.

The soybean market seemed up for grabs at the beginning of October because crop analysts were having trouble getting a handle on yield prospects. One analyst said she expected futures to move a dollar or more but didn't know whether the move would be up or down. One good way to trade this kind of uncertain situation is with an option strangle. This strategy involves buying a put and a call, both more or less equally out of the money. However, to lower the cost and the loss potential, you could trade a call or put spread. If this trader had believed the market was more likely to move up than down, a bull call spread would have expressed a guardedly bullish opinion.

The 10-year Treasury note market, which had rallied throughout September, seemed to hit resistance in the 114-20 area. This might have seemed a good time to short the market, and one way to do that is with a bear put spread. This trade involves buying a put near the money and selling a put at a lower, farther out-of-the-money strike price.

Note that all of the strategies mentioned lower the amount of capital that is exposed to loss, but they do so at the cost of limiting the potential for gain. That said, these can be useful strategies for many traders.

Initial Market Exposure

A word of caution is in order concerning the setting up of bull call or bear put spreads. The bought option will be near the money and relatively high priced. For example, with CBOT mini-sized Dow futures trading at 9436, 52 days to option expiration, and assuming 19.5% implied volatility, the prices for the 9500, 9600, 9700, and 9800 calls would be those shown in Exhibit 1.

Exhibit 1: A Sample of Call Option Prices

	October 1, 2003
Futures Price	9436
Days to Expiration	52
Implied Volatility	19.5%
Option Strike Price	Option Price (index points)	Option Price ($)
9500 call	247	1,235
9600 call	205	1,025
9700 call	168	840
9800 call	137	685

It is tempting to want to sell the 9600 call because it makes the trade "almost self-financing."  The net cost would be only 42 index points (247-205), or $210 (42x$5). The trouble with this is that the maximum possible gain for a bull call or bear put spread is the difference between the strike prices minus the net cost. A spread using the 9500 and 9600 calls has a maximum possible gain of 58 index points (100 point strike price difference with 42 point net cost = 58 point maximum possible gain). In contrast, the 9500-9800 spread can earn as much as 190 index points. Minus the initial 110 point net cost, the maximum net gain is 80 points, or $400. Granted, the 9500-9600 spread costs little, but it also earns very little return on investment. It might be better to pay more for the opportunity to earn more.

Suppose that on October 1, 2003, this cost-conscious trader had decided to use bull call spreads to trade the CBOT mini-sized Dow and soybean markets and a bear put spread to trade the 10-year Treasury note market.

Remember that an option buyer pays the full price of the option while an option seller collects the full price. The negative numbers in these tables indicate prices paid for bought options. The positive numbers (no sign) indicate the prices collected for sold options. The initial positions might be those of Exhibits 2a, 2b, and 2c.

Exhibit 2a: Options on CBOT mini-sized Dow futures

	October 1, 2003
Futures Price	9436
Days to Expiration	52
Implied Volatility	19.5%
Option Strike Price	Option Price
Buy 1 November 9500 call	-247
Sell 1 November 9800 call	137
Spread Price (index points)	-110
Spread Price ($)	-$550.00

The options on CBOT mini-sized Dow futures used in these examples will not be available for trade until February 5, 2004, but they are quoted here in index points as they will be when they become available. The dollar value of these options is the option price times the $5 futures multiplier, e.g., 247 x $5 = $1,235.

Exhibit 2b: Options on Soybean Futures

	October 1, 2003
Futures Price	687 1/4
Days to Expiration	23
Implied Volatility	30.1%
Option Strike Price	Option Price
Buy 1 November 700 call	-0.15250
Sell 1 November 760 call	0.02125
Spread Price (?/bushel)	-0.13125
Spread Price ($)	-$656.25

Options on soybean futures are quoted in cents per bushel (cents/bu), e.g., 15 1/4 cents per bushel. The dollar value of an option is the price (expressed in decimal form, thus 15 1/4 becomes 0.1525) times the 5,000 bushel futures contract size, e.g., 0.1525 x 5,000 = $762.50

Exhibit 2c: Options on 10-Year Treasury Note Futures

	October 1, 2003
Futures Price	114-20
Days to Expiration	52
Implied Volatility	8.8%
Option Strike Price	Option Price
Buy 1 November 114 put	-78
Sell 1 November  112 put	35
Spread Price (64ths)	-43
Spread Price ($)	-$671.875

Options on 10-year Treasury note futures are quoted in points and 64ths of a point. A 1-14 option quote indicates 1 14/64% of par. To make it easier to do the arithmetic at a glance, these exhibits translate these quotes into 64ths, e.g., 1-14 is given as 78 (64+14). The dollar value of this option is the price divided by 64 times 1,000, e.g., 78/64 = 1.21875, 1.21875 x 1,000 = $1,218.75.

Notice that these three options trades require only $1,878.125 in trading capital. This is 38% of a $5,000 account, and no one trade exposes more than 13% of the $5,000 to loss. Importantly, if everything goes wrong that can go wrong in all three markets, the maximum possible loss is $1,878.125. This trader still has enough capital in reserve to keep on working.

However, the next several exhibits show what could have happened if everything didn't go wrong and, in fact, several things went very right.

Offsetting the 10-Year Treasury Note Bear Put Spread

On October 15, 10-year Treasury note futures were trading at 111-07, 2-13 lower than the October 1 price. If this trader's market analysis indicated that this was a good exit point, the trade could have been offset by selling the 114 put and buying the 112 put. With futures trading at 111-07, 38 days to option expiration, and 9.5% implied volatility, the result of this trade would have been that shown in Exhibit 3.

Exhibit 3: Bear Put Spread-Options on 10-Year Treasury Note Futures

	October 1, 2003	October 15, 2003
Futures Price	114-20	111-07
Days to Expiration	52	38
Implied Volatility	8.8%	9.5%
Option Strike Price	Option Price	Option Price	Result
Buy 1 November 114 put	-78	204	126
Sell 1 November  112 put	35	-114	-79
Spread Price (64ths)	-43	90	47
Spread Price ($)	-$671.875	$1,406.25	$734.375

The result column shows that the 114 put earned more than the 112 put lost to produce a solid $734.375 net gain (before commissions and fees), a 109% return on investment ($734.375/$671.875 = 1.093). To emphasize, this trade made back the original $671.875 and added another $734.375 to this trader?s account.

At this point, this trader might have decided that falling interest rates would cause the 10-year Treasury note futures market to rally, and so have decided to replace the bear put spread with a bull call spread. Exhibit 4 shows the details of this strategy, assuming the same market data as column three of Exhibit 3, the buying of a 111 call and the selling of a 112 call. The net cost of this strategy is $812.50.

Exhibit 4: Bull Call Spread-Options on 10-Year Treasury Note Futures

	October 15, 2003
Futures Price	111-07
Days to Expiration	38
Implied Volatility	9.5%
Option Strike Price	Option Price
Buy 1 November 111 call	-94
Sell 1 November  112 call	42
Spread Price (64ths)	-52
Spread Price ($)	-$812.50

The Stock Market Bull Shifts to Bear Mode

On October 16, this trader might have decided the stock market rally was at least temporarily running out of steam. Exhibit 5 shows that, based on the data shown, offsetting this strategy at this time would have added $320 of new capital to the trading account. That amounts to a 58% return on investment.

Exhibit 5: Bull Call Spread-Options on CBOT mini-sized Dow Futures

	October 1, 2003	October 16, 2003
Futures Price	9436	9771
Days to Expiration	52	37
Implied Volatility	19.5%	16.5%
Option Strike Price	Option Price	Option Price	Result
Buy 1 November 9500 call	-247	365	118
Sell 1 November 9800 call	137	-191	-54
Spread Price (index pts)	-110	174	64
Spread Price ($)	-$550.00	$870	$320

Four days later, satisfied that the market was retreating to some lower level, this trader could have switched to a bear put spread. Exhibit 6 shows the detail of the initial strategy based on a 9759 futures price, 33 days to option expiration, and 16.5% implied volatility. This trade requires an initial outlay of $510, less than the cost of the earlier strategy.

Exhibit 6: Bear Put Spread-Options on CBOT mini-sized Dow Futures

	October 20, 2003
Futures Price	9759
Days to Expiration	33
Implied Volatility	16.5%
Option Strike Price	Option Price
Buy 1 November 9700 put	-164
Sell 1 November 9400 put	62
Spread Price (index points)	-102
Spread Price ($)	-$510.00

Offsetting the Soybean Strategy

On October 23, it was time to offset the soybean bull call spread. It wasn't that the rally showed signs of ending but rather that the options were about to expire. As Exhibit 7 shows, soybean futures had rallied from the initial 687 1/4 cent/bu to 763 cent/bu. This 76.5 cent/bu futures price increase led to a net gain on this strategy of 44.875 cent/bu, or $2,243.75.

Exhibit 7: Bull Call Spread-Options on Soybean Futures

	October 1, 2003	October 23, 2003
Futures Price	687 1/4	763 3/4
Days to Expiration	23	1
Implied Volatility	30.1%	23.3%
Option Strike Price	Option Price	Option Price	Result
Buy 1 November 700 call	-0.15250	0.6450	0.4925
Sell 1 November 760 call	0.02125	-0.0650	-0.0438
Spread Price (?/bushel)	-0.13125	0.5800	0.44875
Spread Price ($)	-$656.25	$2,900.00	$2,243.75

This large net gain amounts to a 342% return on investment ($2,243.75/$656.25 = 3.419).

Bearish Stock Market Sentiment Returns to Bullish

A day later, however this trader chose to determine exit points, it might have looked like time to offset the CBOT mini-sized Dow bear put spread. Exhibit 8 shows that in this 4-day period, the index dropped 187 points, and implied volatility remained essentially stable. Yet the bear put spread generated a $225 net gain which amounts to a respectable 44% return on investment ($225/$510 = 0.4412).

Exhibit 8: Bear Put Spread-Options on CBOT mini-sized Dow Futures (Dow 2)

	October 20, 2003	October 24, 2003
Futures Price	9759	9572
Days to Expiration	33	29
Implied Volatility	16.5%	16.4%
Option Strike Price	Option Price	Option Price	Result
Buy 1 November 9700 put	-164	249	85
Sell 1 November 9400 put	62	-102	-40
Spread Price (index pts)	-102	147	45
Spread Price ($)	-$510.00	$735	$225

With 26 days until the expiration of the options on CBOT mini-sized Dow futures, this trader might have thought the stock market bull run was resuming. Another bull call spread could capture at least some of this move. Exhibit 9 shows that given this market data, a spread long the November 9500 call and short the November 9800 call could have been initiated for $515.

Exhibit 9: Bull Call Spread-Options on CBOT mini-sized Dow Futures

	October 27, 2003
Futures Price	9587
Days to Expiration	26
Implied Volatility	16.0%
Option Strike Price	Option Price
Buy 1 November 9500 call	-157
Sell 1 November 9800 call	54
Spread Price (index points)	-103
Spread Price ($)	-$515.00

Closing Out the Remaining Trades

The end of the month is an artificial trade boundary, but it will do for illustrative purposes. Suppose this trader offset the two remaining trades on the last day of October given the market data shown in Exhibits 10 and 11.

Exhibit 10 shows that the final bull call spread using options on CBOT mini-sized Dow futures would have netted $250, a 49% return on investment ($250/$515 = 0.4854) in only four days. Exhibit 11 shows that the bull call spread using options on 10-year Treasury note futures would have netted $265.625, a 33% return on investment ($265.625/$812.50 = 0.3269).

Exhibit 10: Bull Call Spread-Options on CBOT mini-sized Dow Futures (Dow 3)

	October 27, 2003	October 31, 2003
Futures Price	9587	9763
Days to Expiration	26	22
Implied Volatility	16.0%	14.1%
Option Strike Price	Option Price	Option Price	Result
Buy 1 November 9700 put	-157	231	74
Sell 1 November 9400 put	54	-78	-24
Spread Price (index pts)	-103	153	50
Spread Price ($)	-$515.00	$765	$250

Exhibit 11: Bull Call Spread-Options on 10-Year Treasury Note Futures

	October 15, 2003	October 31, 2003
Futures Price	111-07	112-09
Days to Expiration	38	22
Implied Volatility	9.5%	8.5%
Option Strike Price	Option Price	Option Price	Result
Buy 1 November 9700 put	-94	109	15
Sell 1 November 9400 put	42	-40	2
Spread Price (index pts)	-52	69	17
Spread Price ($)	-$812.50	$1,078.125	$265.625

A Summing Up

Granted, there are strategies that promise to generate flashier returns than bull call or bear put spreads do. Yet these other trades may cost more to initiate "whether in terms of margin money or initial option price" and they may expose more trading capital to risk of loss. The selling of an option in each of the trades illustrated limits the potential of the trade, but it also lowers the cost and the potential risk. This makes it possible for traders with modest risk capital to participate in these markets in a prudent way.

In trading, as in other business endeavors, it is important to be able to stay in business, to keep on trading. These options strategies, which expose no more than 40% of the stipulated $5,000 account at any one time, help assure that this trader can keep on trading, even when some of the trades produce disappointing results.

Further, if a trader approaches these markets as a tortoise rather than as a hare, these strategies can generate satisfying aggregate returns. Consider the trade summary and tally sheet of Exhibit 12.

Exhibit 12: A Trade Record

Trade	Cost ($)	Net Gain ($)	Return on Investment (%)	Capital at Risk (% of 5,000)
10/1/03
Dow bull call spread	-550
Soybean bull call spread	-656.25
T-Note bear put spread	-671.875
Total Capital at Risk	-1,878.125			38
10/15/03
T-Note bear spread off		743.375	109
T-Note bull call spread	-812.50
Total Capital at Risk	-2,018.75			40
10/16/03
Dow bull call spread off		320	58
Total Capital at Risk	-1,468.75			29
10/20/03
Dow bear put spread	-510
Total Capital at Risk	-1,978.75			40
10/23/03
Soybean bull call spread off		2,243.75	342
Total Capital at Risk	-1,322.50			26
10/24/03
Dow bear put spread off		225	44
Total Capital at Risk	-812.50			16
10/27/03
Dow bull call spread	-515
Total Capital at Risk	-1,327.50			27
10/31/03
T-Note bull call spread off		265.625	33
Dow bull call spread off		250	49
Total Capital at Risk	0			0
Total Gain		4,047.75

The story of Exhibit 12 has several parts. First, notice that the maximum amount of the $5,000 trading account that is at risk at any time is slightly over $2,000, or 40%. Second, with the possible exception of the soybean bull call spread, none of these trades produces blockbuster results. Yet all of them make solid contributions to the trading account. Finally, in the aggregate, these six trades generate a total of $4,047.75. This swells the trading account from the original $5,000 to $9,047.75.

This makes it possible to expand trading activity in any of several ways. With more capital, traders can trade more markets, or they can trade larger size two soybean bull call spreads instead of just one.

Admittedly, this is an idealized account. The futures markets and the related options will not always perform in accordance with forecasts, and futures moves like the one seen in soybeans in October 2003 do not happen every season or even every year. That said, these examples do illustrate that traders with limited risk capital can diversify, limit risk, and otherwise trade prudently by using options strategies such as these. And they can earn solid returns if they stick with their trading plans. After all, the tortoise did win the fabled race.

 

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

"Dow Jones," "The Dow,"  "Dow Jones Industrial Average," "DJIA" are service marks of Dow Jones & Company, Inc. and have been licensed for use for certain purposes by the Board of Trade of the City of Chicago, Inc. (CBOT?). The CBOT futures and futures options contracts based on the Dow Jones Averages are not sponsored, endorsed, sold, or promoted by Dow Jones, and Dow Jones makes no representation regarding the advisability of trading in such contracts.