TOP FARMER INTELLIGENCE – Weekly Perspective by Bryan Doherty

1/10/2020

USING SHORT STRANGLES

In option trading, a strategy called a short strangle is employed by selling both an out-of-the-money call option and an out-of-the-money put option. Short strangles are used when you expect prices to remain range bound between the two strike prices. Time value erodes on both options with your goal to either buy both options back at a lower price, or for both to expire without value. In this week’s Perspective, we’ll suggest reasons why a strangle may benefit you.

Farmers could use strangles with the goal of adding value to their crop with willingness to accept a hedge (short futures position) at a higher price, and willingness to accept an ownership position at a lower price. The mechanics are as follows. When shorting an option, you collect premium. The owner of the option can “exercise” the option at any time, converting it into a futures position. In a strangle, you collect the premium on both options and are willing to accept a short position at the strike price of the sold call and are willing to be long at the strike price of the sold put. Let’s use a fictional example.

Let’s say July corn futures are trading at $4.00. If you sell a $4.30 call for 13 cents and sell a $3.80 put for 12 cents, you collect the premium totaling 25 cents. You positioned yourself so that, if corn prices remain between both strike prices, both options will lose their value by expiration (last trading day) and you will add 25 cents (less commission and fees) to the price of your corn. If July corn futures rally and are above $4.30 at expiration, you will be assigned a short futures position at $4.30. You have already collected the 25 cents of premium. This makes you effectively hedged at $4.55, well above the $4.00 futures price when you initiated the position. If prices drop and corn futures are under $3.80 at expiration, you will be assigned long futures at $3.80. Since you already collected $0.25 when you sold the options, you now have a break-even $3.55. If you have sold corn, you could use this long futures position at $3.55 as re-ownership.

Typically, option writing is a game of patience. Time value erodes slowly on options but does tend to accelerate toward option expiration. In our example, we used July options, and since we are writing this Perspective the first week of January, there are approximately 170 days until expiration. Other things to consider; you are not bound to these options, which means you can buy them back at any time. Should your bias change or you would like to move out of the position, you can do so by buying back the short call, the short put, or both options prior to expiration. Short strangles will also have a margin requirement because you are giving someone else the right to either be a buyer (calls you sold) or seller (puts you sold). Therefore you are exposed to unlimited risk if prices rally and significant downside risk if prices drop. Downside risk is technically not unlimited, as prices can only drop to zero.

On the surface, option writing may not look all that attractive, as it entails unlimited, or close to unlimited, risk with a limited profit potential. However, most options are worthless at expiration. The math is rather simple. Wherever price futures close at on option expiration, all calls above the market expire worthless, and all puts below the market expire worthless. Be sure to give critical thought to the risk and potential benefits that option writing may have. The strangle strategy is not for everyone, yet if you find you’re willing to take the risk, short strangles may be worth consideration.

As with any strategy, make sure you understand the risks and rewards. If you have questions on cash marketing strategies or would like ideas for your operation, contact Top Farmer at 1-800-TOP-FARMER extension 129. Ask for Bryan Doherty.

Futures trading is not for everyone. The risk of loss in trading is substantial. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. Past performance is not necessarily indicative of future results.

Author

Carol Tillmann