Welcome to the Fourth lesson from our
HOW TO PROFIT FROM COMMODITY OPTION TRADING course.Today we are going to discuss the low-risk CALL OPTION SPREAD STRATEGY.
CALL OPTION SPREAD STRATEGY:
A call spread is created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of futures prices. The profit on this strategy can increase by as much as 1 point for each 1 point increase in the price of the underlying commodity. However, the total investment is usually far less than that required purchasing the futures. The strategy has both limited profit potential and limited downside risk.
The option spread strategy is best used in markets where the underlying futures price has already moved higher making the implied volatility higher resulting in inflating option premiums.
In this type situation, a single call option purchase, as I explained in the buying a call strategy lesson, is not warranted because the implied volatility has already increased resulting in overvalued option premiums.
However, if our view of the market is bullish, we can use the combination of buying an option and simultaneously selling a higher strike price option in the same contract expiration month. By doing this we reduce the cost of the option we ,are buying by selling an overvalued out-of-the-money strike price option.
In this strategy we are taking advantage of those traders who insist on buying out-of-the-money options that are already overvalued as a means of participating in a price move that they normally could not.
The advantages of initiating a call option spread is we are reducing our overall cost of the strategy while still being able to participate in a potentially bullish price move in the underlying commodity. Our risk is defined because we can never lose more than the total cost of the spread including commissions and exchange fees.
The disadvantages include limiting the potential profit to the point difference between the strike prices of the option purchased and the option sold regardless of how high the underlying commodity rises. And we must pay two broker commissions because there are two options in the transaction.
As an example let’s say Dec. corn is trading at 3.00 and you purchased an at-the-money Dec. corn 3.00 call option for 20 points ($1000) while simultaneously selling an out-of-the-money Dec. corn 3.50 call option for 10 points ($500) for a spread price difference of 10 points or $500 plus two commissions and exchange fees.
At option expiration, if Dec. corn is trading at 3.00 or above our profit will be the difference between the two strike prices which is 50 points ($2,500.00). If Dec. corn is trading at 3.40 our profit will be $2,000.00 (40 points X $50.00 per point).
If Dec. corn is trading under 3.00 at option expiration both the 3.00 call that was purchased and the 3.50 call that was sold will expire worthless and we lose $500 plus two commissions and exchange fees. We can never lose any more than that regardless of how low corn futures trade!
This simple strategy allows us to take advantage of the two mistakes traders make from lesson number two. This increases our odds of becoming successful by lowering the risk.
Disclaimer - I am not a commodity trading advisor. The information on this site is for trading education only. There are no trading recommendations for any one individual made on this site and this information is paper trades for trading education. All trades are extemely risky and only risk capital should be used when trading.
U.S. Government Required Disclaimer - Commodity Futures Trading Commission Futures and Options trading has large potential rewards, but also large potential risk. You must be aware of the risks and be willing to accept them in order to invest in the futures and options markets. Don't trade with money you can't afford to lose. This is neither a solicitation nor an offer to Buy/Sell futures or options. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed on this web site. The past performance of any trading system or methodology is not necessarily indicative of future results.
CFTC RULE 4.41 - HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.