The last time I posted an article on selling far out of the money puts and calls (a short strangle) in Lean Hogs, was back in August 2013, click here. If you are not familiar with what a short strangle is, click here. I like the strategy when playing futures because one starts out with a credit, and then tries to maneuver to keep the money. When playing a futures contract, one has to pick a direction by going long, hoping the price goes up, or going short, hoping it falls. If you pick the wrong direction, you will immediately be showing a loss. Your timing has to be impeccable. But when selling out-of-the-money options, timing can be very imperfect since the market has to move a long way to get "in-the-money". You have a long time before you have to get concerned about the position working against you.
With short strangles, one is neutral and hopes that the market moves up or down a little, but stays trading between the strike prices of the calls and puts that were sold. Historically, 40% of the time the market is going sideways, while 30% it is trending higher, and 30% of the time it is trending lower. When going sideways (40% of the time), one has nothing to do when selling a short strangle, but sit back and collect the money. That is the optimum situation. When trending higher, one must manage the short calls to ensure they do not go into the money, and when trending lower, the puts become the side of the trade that one has to manage. However, if the market is moving higher, the puts are bound to go off worthless, and the premium collected will help buffer any losses one experiences with the price appreciation on the short calls. On an extreme move up, one can always buy a lower strike call or futures contract to cover the calls, or one can buy the calls back at a small loss, and then resell higher priced calls (rolling up the position). If one is bullish like I am right now, I can sell out-of-the-money puts to open the position and delay or never get around to selling the out-of-the-money calls.
Even though one has unlimited loss potential and limited gains, it is amazing how quickly the position shows a profit as each day the option decay works in the favor of the seller and against the buyer of the options. If a week or two goes by with the futures contract little changed, a nice profit will result as the volatility decreases and the option premiums on both the calls and puts decay a bit. Selling options is trading like you are a "bookie" or you are "the house". And in the long run when it comes to gambling, the house always wins, and you should too, if you set up your trades properly.
What Are Lean Hogs?
For specifications of the lean hog contact, click here. There is also a tab you can click from that page to see what the contract specs are for the options. The amount of money one has to put up as margin to trade a lean hog futures contract, is $1350 initially the first day, but drops to $1,000 maintenance after that first day. When April Lean Hogs move from 94 cents to 95 cents, they move up $1.00, or $400 in value. Each increment is .025 cents or $10.
Lets start with a look at the April Lean Hogs futures daily chart:
You can see that the price has recently fluctuated from a high of about $96 and a low of $90. That $6 range amounts to a difference of $2,400. The April contract and the April options will expire on the 10th trading day of the contract month, which works out to about the middle of April. That means there are about 9 1/2 weeks left before these options expire. By selling out-of-the-money calls, say priced at $100, and selling out-of-the-money puts, say priced at $87, I have been betting for the past month, that April Lean Hogs will expire somewhere between these two extremes. Due to time decay on the options, I had a good profit on both the calls and puts this week, and decided to buy back the $100 strike calls on the weakness we saw when April slipped to $93 this week. Now that we have bounced back closer to $95, the $100 strike call premiums have increased some and I may again sell some, especially if we move a bit higher.
When I originally sold my first $100 strike call in early January 2014, April Lean Hogs were trading about $91.50. A month later when I bot back that original call, April Lean Hogs were trading above $93. Since we were closer to the $100 strike price, you might think I would have to take a loss on the calls but I did not. Because a month had passed, there was enough time decay that the value of the call when I bought it back was less than the value I had sold it at, and I was able to make a profit. Later I also sold $100 strike calls when April Lean Hogs were at $94 to $95 and on the move to $93, I also made money on those calls.
The $87 puts I sold in early January when April Lean Hogs was trading about $90.50, have loss substantial premium value as we are now trading on Friday at $94.72, and as they approach zero, I might eventually cash them out and move over into the June Lean Hog Contract.
Fundamentals Are Bullish For Hogs Right Now
Fundamentally, there are lots of reasons to be bullish hogs right now. Porcine Epidemic Diarrhoea (NYSEMKT:PED) disease can kill up to 40% of young sucking piglets, and is on the rise, click here. Also, competing live cattle futures are trading at all time highs. As cattle prices rise, it makes pork prices much more attractive and keeps a bid under the pork price. Also, China buying out Smithfield last year should allow for lots of pork exports that will help support lean hog futures prices.
Which options to sell?
I started selling April Lean Hog puts in early January, about 4 months prior to expiration. I like to sell puts with premium values of .50 to $1.00 which means they are worth between $200 and $400 each. For every $400 of premium sold, I have to put up about $500 of margin security money. These out-of-the-money puts have a delta of about .15 to 35 which means they only move up 15 to 35 cents in value when the price of the underlying futures drops $1.00. The reason one tries to sell both calls and puts, is that one usually likes to be as delta neutral as possible, meaning the puts and calls that are short balance each other out, so one is not forced to call a direction of long or short. However, right now I am bullish enough that I don't mind being long live hogs and don't mind being short just puts and not balanced out with short calls. If I am short calls, we could get a rally and they could move into the money, and I would have to buy futures contracts to protect them. Rather than deal with that, I am content with just collecting the put premiums and waiting for a rally to sell strikes possibly higher than the $100 strike.
The thoughts and opinions in this article, along with all stock talk posts made by Robert Edwards, are my own. I am merely giving my interpretation of market moves as I see them. I am sharing what I am doing in my own trading. Sometimes I am correct, while other times I am wrong. They are not trading recommendations, but just another opinion that one may consider as one does their own due diligence.