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Lean Hog Put Spread Exploits the Recent Selloff

06/25/2019 9:43 am EST

Focus: COMMODITIES

Carley Garner

Senior Strategist & Broker, DeCarley Trading

A horizontal put spread in lean hogs allows traders to more safely exploit high put premium, writes Carley Garner.

Yesterday we discussed a strategy to take advantage of recent volatility in the crude oil market where you do not have to accurately predict market direction to make significant profits.

Here we discuss another opportunity in the commodity space utilizing options in a market that has seen a great deal of volatility, lean hogs.

August lean hog futures traded limit down on Friday, which means puts are seeing some inflation and appear to be attractively priced for premium collectors (see chart below). However, seasonal tendencies are questionable, and the trend is obviously lower, so selling naked puts probably isn't the way to go as it entails too much risk. However, we have found a short option spread that offers little risk for what could be a high probability reward.

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It is to execute a horizontal put spread in lean hogs. This involved selling the August hog 70.00 put and then buying the July 70.00 put to act as insurance. The spread nets a credit of about $1.15 to $1.20 in premium ($460 to $480 on one option). The margin is minimal at $278 because the intrinsic risk is very small. The August future trades about $1 higher than the July, so the intrinsic risk is roughly $1 ($400).  That said, it is impossible to exactly quantify the risk because we are dealing with options that expire at different times.

Also, once the July put insurance expires (assuming the trade has not been offset prior), traders would be forced to either accept the unlimited risk that comes with naked option selling or exit the trade. Nevertheless, we believe the odds are good for this trade. A minor bounce will pull most of the premium from the August 70 put, which has nearly doubled in the last few trading sessions.  Also, the strike price of our options is at the contract low which occurred last summer and is substantially below trendline support.

If held to expiration, this trade would max out at the premium collected (about $460) minus transaction costs. For this to occur, the market simply needs to be above $70 at expiration. The August futures contract has never traded below $70; thus, the odds appear to be favorable.

This is a directional trade intended to perform best if the hog market either moves higher or at least stops going down. However, it too can make money whether hogs go up, down, or sideways. The market simply can’t fall below $70.

Conclusion

As you can see, from both of our recent examples, options enable traders to express their opinions in market pricing without the stress and risk of buying or selling futures contracts outright. All traders owe it to themselves to learn how options work; both equity and futures traders can benefit from the hedging advantages options provide.

*THERE IS A SUBSTANTIAL RISK OF FINANCIAL LOSS IN TRADING FUTURES AND OPTIONS.

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