I’m often asked, what futures option spread strategies are the most popular?
Over the next several blog posts, I’ll be detailing the futures options spreads I’ve found to be the most effective when I trade options.
There are hundreds of variations of option spread strategies out there but in my opinion, there are only a few you need to familiarize yourself with.
We’ll start with one of the basics, the Debit Option Spread.
As the name implies, this type of futures option spread has an up front, out of pocket cost, or debit, when it is initiated.
The two biggest benefits of using a Debit Option Spread are…
- It offers a fixed amount of risk.
- It enables you to trade strike prices closer ‘to the money’.
Just like buying an option, your risk is fixed to the amount you paid (debit) for the futures option spread plus associated commissions and trade fees. However, by using the Debit Option Spread, you will be able to trade strike prices that are much closer ‘to the money’ or where the underlying futures prices are, with similar costs to an outright option purchase.
For example, let’s say you’re bearish the Australian Dollar and you are willing to risk approximately $700 on an option trade. With the December Australian Dollar futures contract trading at .7355, you could purchase a .7100 Put for 73 points or $730.00 (each point in the Australian Dollar futures contract equals $10). As you can see, this option is 255 points ‘out of the money’.
Conversely, we can use an Option Debit Spread to also go short the market. The Debit Option Spread in this case would consist of the following futures options…
Buy the .7300 Put @ 141 Points or $1,410 in premium paid
Sell the .7100 Put @ 72 Points or $720 in premium collected
The difference, or debit, is $690. We purchased the .73000 Put for $1,410 and we collected $720 in premium for the .7100 Put leaving us with a cost of $690 for this spread. Remember, you must also take commissions and trade fees into consideration when calculating your total risk and profit.
As you can see, the strike price we purchased at .7300, is very close to where the futures price is trading as opposed to the .7100 Put we used above if you were going to just buy a straight out Put option.
In this option spread, our max risk is $690 and our max profit is $1,310 (not taking into account commissions and fees). Risk is calculated by subtracting the premium received for the option sold from the premium paid for the option purchased. The max profit of a Debit Option Spread is the difference in strike prices less the debit paid for the spread.
In order to reach the maximum profit in a Debit Option Spread, the underlying futures price must be at or beyond the strike price of the option sold at expiration. In this example, we subtract the .7300 strike price from the .7100 strike price, which equals 200 points or $2000, and then subtract the debit paid for the spread, $690, for a max profit of $1,310. The fixed amount of profit is a disadvantage to the Debit Option Spread when comparing it to a straight out option purchase, which ultimately has greater profit potential, but I think being able to trade strike prices that are much closer to the money more than makes up for this.
In comparing both strategies, here are a few outcome scenarios for both strategies…
Scenario #1: Australian Futures market is trading at .7080 at expiration:
With the Debit Option Spread, we would realize our full $1,310 profit as both options expired ‘in the money’.
With the outright purchase of the .7100 Put, the option will have expired ‘out of the money’ worthless for a $730 loss.
Scenario #2: Australian Futures market is trading at .7054 at expiration:
Again, with the Debit Option Spread, we would realize our full $1,310 profit as both options expired ‘in the money’.
With the outright purchase of the .7100 Put, although the option expired ‘in the money’, we would still have a loss of 46 points or $460 as we have to take into account the 73 point premium paid for the .7100 Put option.
Scenario #3: Australian Futures market is trading at .6976 at expiration:
Again, we realize our full $1,310 profit with both options in the spread expiring ‘in the money’.
With the outright purchase of the .7100 Put, we would realize a 51 point gross profit or $510 after deducting the $730 paid for the option.
As you can see in the above scenarios, the Australian Futures market would have to drop all the way down to .6896 to get the same gross profit of $1,310 that the Debit Option Spread offered with the futures market trading at .7100, a 204 point difference!
Of course, we would sustain a total loss of the debit for the spread or the cost of the option in the outright purchase if the underlying futures price was above our strike prices at expiration in either scenario. However, futures options trades are not an all-or-nothing trade. You can liquidate the trade at any point prior to expiration to limit losses or take a smaller profit. Again, remember to account for trade commissions and fees as well.
Although I feel the futures Debit Option Spread is a very good alternative to an outright futures option purchase, it still carries the same risks of loss.
I hope you’ve found this futures options information valuable. If you have any questions about using this strategy, please feel free to contact me.
Principal Futures Broker
Series 3 & Series 30 Registered
Phone: 1-847-379-5000 ext. 101
Toll Free: 1-866-892-2030 ext. 101
Insignia Futures & Options, Inc.