Here is an options strategy to take advantage of on overheated cattle market that protects your downside from Carley Garner.
The live cattle market appears to be overheated based on price action and standard technical oscillators such as the Relative Strength Index (RSI) and Williams %R. As a result, call options have picked up substantial premium in a short amount of time.
More often than not, this is an opportunity for option sellers. Further, when looking at data over the previous five years, as well as a 15-year timeframe, the cattle market seems to struggle to hold gains in mid-to-late October. Thus, we are comfortable looking to sell call option premium in this market, with insurance of course, in hopes of a stalled rally stalls or a reversal.
Specifically, we like the idea of selling the February live cattle 128 call and simultaneously purchasing the December live cattle 125 call to act as catastrophic insurance for about $500 in premium before considering transaction costs (or 130 points). This $500 represents the maximum profit potential of the trade and comes with a margin requirement of $637 (see chart).
The February options expire in 105 days, which is a little longer than we generally like for a premium collection strategy but there aren't any options listed beyond December, and selling the December options would require a strike price placement that is too close-to-the-money for comfort. Also, selling December options takes away any good opportunities to hedge the position.
The February 128 call is about 8¢ out-of-the-money (the February futures is trading just over 120.00). The December 125 call is about 10¢ out-of-the-money, leaving this position with roughly 2¢ of intrinsic risk or $800, minus the premium collected for the spread ($500), leaving the intrinsic risk to somewhere around $300.
Keep in mind, we are using options that expire in two different months, so there is no way to calculate the exact risk but this trade is well-hedged; even if things get wild, the drawdown shouldn't exceed $1,000. However, there aren't any guarantees because the spread between the February and December future can fluctuate.
The December 125 call, which is being used for insurance, expires in 42 days; if the trade doesn't move favorably by then and is still an open position it will be necessary to either purchase more insurance, accept unlimited risk, or exit the position.
If everything goes as planned, we would like to be out of this trade within a few weeks. The February 128 call has gained value quickly and could lose it just as rapidly if the rally begins to stall.
Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. She has written four books, the latest is titled “Higher Probability Commodity Trading” (July 2016). Hear her talk about options and swing trades at the Las Vegas TradersEXPO.
