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IMPLIED VOLATILITY


Playing The Commodities Rebound With Options

01/13/09 08:29:17 AM
by Donald W. Pendergast, Jr.

Potash Corp. of Saskatchewan's dramatic decline appears to be over. Here's an interesting option play on this agriculture sector giant.

Security:   POT
Position:   Buy

Unless you've been living in a bomb shelter for the past seven months, you're more than aware of the massive slide in commodities and commodity-linked equities. Potash Corp. (POT) also got caught in the landslide, shedding about 80% of its value from the June high to December's low. Let's look at a monthly chart (Figure 1) and see if we can craft a low dollar outlay bullish option spread, one designed to gain through a unique blend of time decay, bullish price movement, and falling implied volatility.

FIGURE 1: POT, MONTHLY. With worldwide demand for fertilizer and animal fee remaining strong, opening a bullish option spread in POT for a credit could be an appropriate strategy.
Graphic provided by: MetaStock.
Graphic provided by: WB EOD Detrend from ProfitTrader for MetaStock.
 
Right now, the monthly cycle appears to have bottomed, based on the action in the stochastic (9,3,3) and detrend oscillators. Similar patterns are printing across the basic materials and energy sectors, lending extra confidence in this cyclical low assessment. The last time the monthly stochastic was this oversold was in December 2005; prices then proceeded to rise nearly 100% over the following 14 months before the stochastic leveled out in February 2007. Currently, POT is rising strongly from a major low, with the first major resistance (the Fibonacci 38.2%) level coming in at $122. For those who may be interested in playing the apparent recovery in POT with a zero-cash initial outlay, the following option spread might be attractive.



A little background first. Option implied volatility is slowly declining on POT, which means that selling options can be very beneficial. A strategy called a reverse diagonal call calendar spread involves buying a near-month, near-the-money call and then selling an out-of-the-money call in a deferred month:

Buy: 1 June 2009 $80 call at $18.40
Sell: 1 January 2010 $95 call at $19.40

Net credit: $1.00

The intention is to hold the trade until just before June expiration (when the long call expires), hoping that implied volatility will decline on the short call by then even as the price of POT shares continue to move higher on the strength of the bullish monthly cycle. (The spread needs to be closed out then or a trader will be still be short a naked January 2010 $95 call.)

Here are some reward/risk stats to consider before putting this option spread on, understanding that the greatest risk to this trade is that the price of Potash stock remains within a few dollars of its current price at expiration. Another risk is that implied volatility begins to rise again, inflating the value of the longer-term short call.

Date Stock price Volatility Gain/loss
------------------------------------------------------------
6/19/09 $122.00 Drops by 12 pts. $781
6/19/09 $84.02 Drops by 12 pts. ($570)
6/19/09 $47.54 Drops by 12 pts. $24

6/19/09 $122.00 Stays the same $454
6/19/09 $84.02 Stays the same ($866)
6/19/09 $47.54 Stays the same ($64)

That's quite a range of profit outcomes, but there are some simple rules that can be applied to keep the risks to a reasonable minimum. For example, if the price of POT stock becomes range-bound, not much beyond $80–90 by late April, a prudent trader would probably just close the spread out then rather than risking the maximum possible loss at June expiration. Here are some breakpoints that might make it easier to comprehend the wisdom of an early close out in a range-bound market:

Date Stock price Volatility Gain/loss
------------------------------------------------------------
4/19/09 $90.00 Stays the same ($242)
4/19/09 $80.00 Stays the same ($332)
4/19/09 $90.00 Increases by 6 pts. ($344)
4/19/09 $80.00 Increases by 6 pts. ($419)

Losses are no fun, but if the trade doesn't kick into bullish mode and is still in a range by April expiration, closing the spread for a modest loss make a lot more sense than hoping for a turnaround by June expiration, when the loss could be twice as much ($866).



Interesting, isn't it? This is a trade that is initiated with a $100 credit to a trader's account, and yet, if the trade doesn't pan out and appropriate risk control measures aren't implemented, a trader could lose nearly $900 (or even more if implied volatility spikes sharply higher). The keys to success with a reverse diagonal call calendar spread are simple:

♦ Identify a high-probability bullish trend in a market with very high implied volatility.
♦ Buy an at-the-money call and sell an out-of-the-money call in a deferred month, making sure the bid-ask spreads and volume/open interest figures are attractive.

♦ If the trend stalls and goes into a trading range, one that negates the original trending trade scenario, close the trade early for a modest loss.

♦ If the trade trends as desired, close the spread just before the long call expires.

If an option trader follows those simple rules, his/her odds of success should be greatly increased with this kind of option spread.





Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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