Flexibility—A Powerful Edge

Trading in pure assets is not the most flexible of activities. When we buy an asset, we profit if the price rises and we lose if it falls, and the opposite result occurs when we sell short. There is little the pure asset trader can do to protect himself from loss during or in anticipation of an adverse move in the asset’s price, aside from exiting the market. He might attempt to use other assets to obtain some insurance, paired stocks and intramarket spreads in futures being two common insuring tactics.

These tactics are, overall, a tricky proposition because the “protective” asset may be subject to its own adverse price move for reasons unrelated to the original asset, and the relation in the price of the two assets may itself change adversely over time for a wide variety of reasons. From the standpoint of flexibility, the pure asset trader is similar to a football quarterback whose playbook has only four plays: buy, sell, sell short, and short cover.

No matter how skillfully we may trade, having the flexibility to protect and enhance the expectation of our trading positions when and as we please must be nothing but advantageous to us. Options offer us this flexibility. More usefully still, options offer us the opportunity,literally, to design trades with desirably high positive expectation. Suppose the price of some asset, a stock or a future, is 60.

Suppose also that the asset has a regularly traded and reasonably liquid market in its options,and further that, through whatever type of market analysis we prefer,we believe this asset’s price is likely either to rise or to do nothing in the near future. Having looked at all these conditions, we decide to buy this asset. In the interest of eliminating our contest risk and moderately expanding our range of profitability, we might consider selling (“writing” is the usual term) a 65-strike call option expiring at some time in the future.

Suppose that we do write this option and receive, arbitrarily, a premium of 4 for it.Figure 3.3 shows the comparable profitability curves of this trade versus a simple asset purchase, on the date the option expires. The hypothetical dollar profit/loss on the vertical scale is what would result if we would execute such a trade in the “C” coffee futures traded on the New York Board of Trade (NYBOT).

The straight diagonal line is the same as the line through the point Pn in Figure 3.1, the profitability curve of an asset purchase. The other line, which begins as a diagonal and then flattens out, is the profitability curve of buying an asset and writing a call option against it, as in the present discussion.First Things First—Reduce the Risk:Throughout the text, we’ll assume that we pay a one-way or half-turn commission of $15.00 for all our futures and options trading.

For the sake of discussion,we’ll also assume we’ve paid 5 points of the bid-ask spread in the futures contract and 10–20 points of the bid-ask spread when writing an option.Bid-ask spreads in futures options can be sizeable, because liquidity in these options tends to be relatively low, so we are correct to assume a conservative,that is, high, bid-ask cost when trading these options.

Just for fun,we’ll assume no slippage (lucky us) from our intended purchase and sale prices respectively.The commission portion of our contest risk is just $30.00, so let’s compute the bid-ask portion. The New York “C” coffee contract involves 37,500 pounds of Arabica coffee and is priced in cents per pound. Again, by assumption,our cost of the bid-ask spread on the future is 5 points. In the coffee market, there are 100 points to the penny, so the bid-ask cost on the future works out to $0.0005 × 37,500, or $18.75, and our bid-ask cost on the option is four times that, or $75.00.

Summing these figures, our total contest risk is $123.75. Against this, we sold the call option for 4 cents: $0.04 ×37,500, or $1,500.00. Less our contest risk over the whole trade, this puts $1,376.25 net in our pocket, and the brokerage will require us to leave this sum in our trading account. However, these dollars earn interest (or if they don’t right now, we can and should arrange matters so that they will), so this requirement is not entirely unfavorable. At this point, after we’ve written the call option, our initial contest risk has vanished.

We have dollars in hand and are sitting in a trade we like at prices we wanted. Balancing this good news is our necessary acceptance of a now limited profit potential. If the price rises above 65.00 prior to the expiration of the call option we wrote, we will still make the 5 cents profit,$1,875.00, less a $15.00 exit commission, $1,860.00, due to the price movement from 60 to 65. We’ll keep the net premium, $1,376.25, we received from writing the option.