In this example we shall look at a Crude Oil futures contract and apply an Options Explorer strategy to it. First off, note that we get two different Crude Oil contracts - first there is Brent Crude, also known as UK Crude or British Crude. Brent Crude is the oil on which South Afican petrol prices are based. Then there is WTI Crude, or West Texas Light Crude or American Crude. For this trading example we look at the WTI Crude contract, specifically the April 2015 expiry. We pick it up around 11th February 2015, with 33 days left to expiry (of the April 2015 options contract).
Crude has been in an extended downtrend since mid-year 2014. Recently it hit a low of around $45 per barrel, made a sharp correction to $55 a barrel and is now trading sideways. We notice a very distinct '/\/\/' pattern that has formed - this usually the indication of congestion, or the start of a trading range. There is a war happening between the Bears that are not yet willing to see Crude correct, who want to see Crude drop further and the Bulls who want Crude to make a large correction. Thus:
- We have a neutral market (or sideways trading market, or flat market) - from observation
- Due to the long downleg, Crude Options are over-priced, they are very expensive (Options Explorer measures this quality for us - thus I got this bit of info from out of Options Explorer)
- Next I lookup a trading strategy in Options Explorer under the "Advanced Strategies" for these market characteristics (neutral market, expensive options) and I find a SHORT STRANGLE. This strategy advices we SELL a CALL option above the market and SELL a PUT option below the market
Back in Options Explorer, this is the Crude contract from above - note now presented as a line chart through the closing prices for the day. You can clearly see the distinct '/\/\/' - pattern that we mentioned above. We want to sell a call above and a put below this trading range. Now what I want to do is I want to put the market under a bit of pressure here (to perform) - I don't want to get too close to the market action. Thus I look at a strike price of $57 for the Call option, which is way above the trading range and similarly at the $47 strike price for the put option - way below the trading range. Why do we say this will put the market under pressure? Well, for the market to take out any of these two prices (and therefore for our SHORT OPTIONS to come under pressure) the market will have to either drop below $47 or trade above $57, which means it will have to break out of the level area, the trading range - it can't stay there, if it does it cannot put our position under pressure - which is what we want. Thus with this position we are setting it up such that the market has to do the abnormal - break out of the trading range - if it does not do that, then we make a profit. In other words we set it up such that the only way in which we can make a loss is if the market breaks out of the trading range - and if it does it of course is a clear signal to enter into the futures (buy or sell the futures) and trade the new trend.
We can simulate this position in Options Explorer - I draw lines for my entry day as well as how the position will look like after 5 days, 10 days, 15 days etc. From the simulation I can see that I will collect just over $3,000 in premium from these two options. By expiry date (33 days from now), if the price of Crude is trading anywhere above $47 and below $57 I will keep the money (both options will expire worthless). I am also able to monitor at what price and after how many days will I make what kind of profit, or when do I need to get out of the position. For example I can see that if, within 5 days, Crude drops to say $48, which is below the trading range, I will take a loss of $144. (the orange line). That however will mean it broke out of the trading range, I can now simulate the result if I then short a Crude futures (trading with the new downtrend), etc. In other words, Options Explorer helps me to simulate this position, play a bit devil's advocate, and plan ahead what I will do for different stuff happening in the market - I plan how I will respond to changes in the market beforehand - once I am in the market, I'll have a clear plan and will execute on that plan (I took emotion out of the trade)
My personal choice is to display the same information as above in a slightly different format - I draw the price limits where the position will hit break-even for every day into the trade versus the Crude Price on top of the Crude price chart. I also draw a line for where I will be taking a $500 loss on the same chart. This view allows me to get a feeling for the risk inherent in this position. As long as prices stay between those two thick yellow lines, I will be making a profit on this trade. The first three days will be the most crucial, thereafter my 'funnel' will start opening up and Crude will have to break out of the trading range if it wants to put the position under pressure. Now also note that I enter this trade on a Thursday afternoon - which gives the market only one trading day (Friday) thereafter it is weekend and we lose two days. Thus as from Monday Crude will have to break out of the trading range if I am to take a loss - if that is the case, then I am wrong and I will take the loss, but STATISTICALLY the odds are in my favour! This is what trading with Options Explorer is all about, to put the odds in your favour before you enter a position.
This is the end of the analysis. On the actual trading day I:
- Sell (short) the CL (Crude) C57 (Call 57) for a premium of $1,526
- Sell the CL P47 (Crude Put 47) for a premium of $1,550
- THUS: I collect (receive) $3,076 into my trading account - yes, someone is paying me to trade. This premium is non-refundable
I stay in this trade for 21 days (three weeks). Note that on the Friday after entry (the first day), I was slightly negative. As from the Monday (day three), the position was positive and it stayed positive for the rest of the time. 19 Days before expiry Crude broke out of the trading range to the bottom - I wanted to exit, but I were a bit slack (busy at work), only noticed this the following day when prices turned back up. As it stands, on that last little downturn I evaluated the position:
- I bought back the 57 CALL for $110 (price for the day)
- I bought back the 47 PUT for $460 (going rate)
- My profit = $3,076 - $110 - $460 - $11.00 (commission on four transactions - my Broker charges me only $2.75 per transaction) = $2,495 (or R29,940) for three weeks of - well, I didn't really do anything, I just waited..)
I required $15,790 margin to enter this transaction (thus this is not possible with a small account). However $2,495 profit in three weeks = 15.8% growth, not bad for three weeks and I did not exactly spend a lot of time in front of my PC trading - I monitored a position once a day, my only real headache was deciding when to get out.
Now, tell me there is a better way of trading than this!?