Collecting Option Premium In The Grain Market

By Joseph Vaclavik AAA

There are several different strategies for collecting option premium in the grain markets, some of which may contain less risk than the novice trader may realize. Premium selling becomes particularly useful in times of trendless and uneventful market conditions. Rather than trying to trade futures back and forth within a range, more resourceful traders will often turn to premium selling in order to take advantage of a potential plunge in volatility. Selling option premium in the grain markets is easier once you learn the types of strategies available and find out when to use them. Read on to learn about these income-generating strategies. (For background information on investing in grains, read Grow Your Finances In The Grain Markets.)

Strategy 1: Naked Options
Any true options trader will tell you that in most cases, option selling is preferred over option buying due to issues involving decaying time value and volatility.

The most basic strategy in selling options in the grain markets is the basic naked sale. This involves selling either a call option or a put option.

A trader will sell call options if he believes the market will be below a given strike price at option expiration (likely a bearish trader) and will sell a put option if he believes the market will be above a given strike price at expiration (likely a bullish trader). (Keep reading about the bulls and the bears in Digging Deeper Into Bull And Bear Markets.)

A trader who believes the market will remain neutral may sell both puts and calls. There are two basic strategies for this:

  1. Strangle: Sell both a put option and a call option, both of which are out of the money
  2. Straddle: Sell both a put option and a call option, both of which are at the money

With both of these strategies, risk is virtually unlimited, while rewards are limited. A trader can make only as much as the premium collected, but is accountable for the entire move past the given strike. (Read more about this risky investing strategy in Naked Options Expose You To Risk.)

Strategy 2: Option Spread
To limit the risk inherent in a naked-option sale, a trader might choose instead to use an option spread. This strategy involves the sale of one option and the purchase of another option in order to hedge the risk of the option sold. (Learn more about how spreads hedge futures risk in Trading Calendar Spreads In Grain Markets.)

For example, a trader who believes the corn market will move higher decides to sell a put option with a 4.00 strike price at $0.20. As protection, he decides to buy a put option with a 3.50 strike for $0.10. The resulting trade is the sale of a 4.00-3.50 put spread. The spread was sold for $0.10, which is the difference between the sale and purchase prices of the two options. The maximum profit on this trade would occur if the option were to go off board when the underlying futures were over 400. The maximum risk is the difference between the two strikes minus the premium collected ($0.50 - $0.10 = $0.40 of total risk).

An opposite position can also be taken. For example, a trader who is bearish the soybean market will sell a 10.00 call option and will buy a 10.50 call option as protection. The spread will be sold for $0.12. The maximum profit will be achieved if the options go off board when futures are under 10.00. The maximum loss will be achieved if futures go off board above 10.50, at which point the loss will be the difference in the two strikes minus the premium collected ($0.50 - $0.12 = $0.38 of total risk).

What You Need to Know About the Grain Market
After examining these two basic strategies, the novice trader should have an idea as to how premium collection works. Now traders will have to perform their own analysis of the grain markets using knowledge of fundamentals. There are a few fundamental items to look for in these markets that are easy to identify and can help traders to know when and how to initiate these strategies. (Learn how a knowledge of fundamentals can benefit you in Fundamental Analysis For Traders.)

Trends And Their Causes
For example, let's say the corn market is on a three-month downtrend, caused by a decrease in feed demand combined with decreased export demand (ex., due to a rising U.S. dollar). Traders then would need to decide whether to sell call options or call spreads.

Trading with the trend is a strategy that works just as well with options trading as it does with futures. As with futures, traders generally should not take positions that fight a trending market. This is one of the most important strategies in trading options and is also one of the simpler scenarios for the novice trader to comprehend.

Ending Stocks Figures And Historical Price Levels
Ending stocks numbers can be found on the National Agricultural Statistics Service website. Traders looking to trade supply/demand scenarios in the grains should compare these numbers with historical charts and price levels and then decide where they need to be positioned. A year with historically low carryout relative to price would find many fundamentalists looking at selling put options or put spreads, while an opposite scenario would find many traders looking at selling call options or call spreads. (Learn all you need to know about interpreting USDA reports in Harvesting Crop Production Reports.)

Seasonal Patterns
In general, row crops (ex. corn, soybeans) will be strong to begin a calendar year and generally top out early in the summer. It is during this period that many seasonal traders will begin to sell call options and call spreads. These traders will likely then sell put options or put spreads during harvest, when lows are generally made according to seasonal patterns. Although these patterns are far from foolproof, they can help as an indicator or as confirmation of a notion. (Seasonal trends have been observed in other areas of the market as well. Read Capitalizing On Seasonal Effects to learn about how to time your investments.)

Conclusion
Using the strategies and techniques listed, traders who are new to the grain markets can approach option selling. Novice traders should begin selling spreads before moving to naked options because of the risk factors involved. Always keep in mind that risk is unlimited when selling naked option premium, but for those who can handle the risk and do the research, premium selling is another viable option for participating in the grain markets.

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