While I’ve built my success on sure-bet plays that meet strict probability analysis requirements, there should be room in every portfolio for a little speculation. I am unquestionably bearish in the short- to intermediate-term — yet I am equally sure that, at some point, a new uptrend will bolster assets. For longer-term trades, one theme I have my eye on is commodities.
I think it’s still too risky to try and call any sort of bottom in oil and related equities, though there are certainly downside opportunities to take advantage of right now in the energy patch.
But if we’re talking about commodities that I like for upside potential for the longer-term, I am focusing on silver and corn, especially.
The situation with corn prices mirrors what we’re seeing in the oil sector, in which excess supply is pressuring prices to near-record lows. Still, while corn prices are depressed currently, my belief is that demand by China and India for ethanol made from corn will do much to improve the commodity’s prospects.
The movement toward more cars in those countries coupled with their pollution problems is pushing for cleaner fuel solutions, resulting in a huge demand for ethanol. It’s definitely a longer-term play — and speculative to be sure — but I would say that eventually corn is going to go up in price.
When it comes to speculative trades, I want to minimize my costs as much as possible simply because it’s a riskier bet. One of the best ways I know to reduce the cost of opening a trade is with a strategy called an options debit spread.
A debit spread is simply a way to lower the cost of opening a directional trade by buying to open (get long) an option while simultaneously selling to open (short) an option with a different, further out-of-the-money strike price to help offset the cost of the option that you bought.
For example, let’s pretend that you are bullish on Apple (AAPL). Full disclosure: I am not, and I am using this AAPL trade for illustration only.
With AAPL trading around $96, using a spread order through your broker, you could buy to open the AAPL Feb. $95 Calls for about $5.50 per contract and simultaneously sell to open the AAPL Feb. $105 Calls for about $1.50 per contract, which you would receive as a credit. This would make the net cost, or debit, of your trade $4.00.
$5.50 paid
–$1.50 collected
$4.00 net debit per contract
Those are the simple mechanics of a debit spread. In this example, you have lowered your cost of getting long the AAPL Feb. $95 Calls from $5.50 per contract to a cost basis of $4.00 per contract.
Now, if you want to leverage it further, you can use what’s called a ratio debit spread, in which you’re selling to open (shorting) 2 options contracts for every 1 option contract you buy. Let’s look at how this works using the same AAPL example.
With AAPL trading around $96, using a spread order through your broker, you could buy to open the AAPL Feb. $95 Calls for about $5.50 per contract and simultaneously sell to open 2 AAPL Feb. $105 Calls for about $1.50 per contract (a total of $3.00), which you would receive as a credit. This would make the net cost, or debit, of your trade $2.50.
$5.50 paid
–$3.00 collected
$2.50 net debit per contract
You could have just bought the calls for $5.50.
But using a debit spread strategy, you bought the calls and shorted calls for just $2.50. That seems like a great deal because you’ve cut your entry costs by 60% in this example — and often you can decrease your costs by more. But, with all good deals, there is usually a catch.
The “catch” here is that you must have a margin account and permission from your broker to execute debit spreads.
Each broker will have slightly different requirements for opening and using margin accounts but, in general, to open what’s known as a Regulation T (or “Reg T”) margin account, you just need $2,500 in additional money that is not allocated to any other securities. Your broker can answer specific questions about any other requirements and fees associated with margin.
There is also a margin requirement for a debit spread, which is deducted from that $2,500 margin account. The margin requirement for debit spreads will vary based on factors such as the strike prices you choose, how much time until expiration and the underlying stock price.
Your broker will be able to tell you exactly what the margin requirement is, but the Chicago Board Options Exchange (CBOE) provides a handy calculator, too, so you can explore what margin requirements look like before you actively trade. You can find that calculator here. For ratio debit spreads, you would select either “ratio call spread” or “ratio put spread” from the “What is the Strategy?” drop-down menu.
By now, you may be asking, “What’s this got to do with commodities and corn?”
I recently recommended my Maximum Options subscribers open a bullish, long-term speculative play on the Teucrium Corn ETF (CORN) by using a ratio call debit spread, and I think it’s a great play for you to get involved in. Let’s look at my recommendation and walk through the mechanics, including how you would profit.
Using a spread order, simultaneously buy to open 1 contract of the CORN Jan. 20th (2017) $23 call and sell to open 2 contracts of the CORN Jan. 20th (2017) $28 calls for a net debit of about $0.50.
If you take this trade, you’re essentially making a $50 bet per contract that CORN is going to move from its current levels around $21.50 up to $23 (the lower strike price of the spread) by 2017. While it’s a fairly conservative move, it is a speculative play, but I am comfortable with the low cost of about $50 a contract.
Let’s look at how this trade plays out.
As I write, the long CORN Jan. 20th (2017) $23 call is trading for around $1.25 a contract. The short 2 CORN Jan. 20th (2017) $28 calls are trading for around 40 cents a contract, which means you would ultimately collect double that at $0.80.
$1.25 paid for the long CORN Jan. 20th (2017) $23 call
–$0.80 collected for shorting 2 CORN Jan. 20th (2017) $28 calls
$0.45 net debit per contract
It’s important to note that the exact prices that you get on each option don’t matter, as long as you’re able to pay about $0.50 or less to execute the trade.
Using the CBOE margin calculator I mentioned above, it tells me the estimated margin requirement is about $300 per contract. Again, that $300 per contract is deducted from the $2,500 account, and you get it back when you exit the trade if all goes according to plan.
Speaking of exiting this trade, let’s look at how we can profit.
For this CORN trade to profit, ultimately, we want underlying CORN shares to be trading above the $23 strike price but below the upper $28 strike price.
If CORN moves up as I expect, the value of both the closer-to-the-money long CORN Jan. 20th (2017) $23 call and the 2 further-out-the-money short CORN Jan. 20th (2017) $28 calls will both increase in value. The hope and expectation is that since we opened the spread for $0.45 we will be able to eventually close it for a higher value to profit. Say, $0.90 for a 100% profit, or $1.35 for a 200% gain.
If there’s a profit, your broker should allow you to “unwind” or exit the spread with one click.
However, we will lose money if the value of the spread decreases from $0.45. If the value drops to, say, a net debit of $0.25, we could exit the spread for a 44% loss.
The “good news” is that with a regular debit spread, the only money you stand to lose is the debit you paid.
However, with a ratio debit spread, the potential loss is a bit more complex. For today, we’ll focus on the possible outcome specifically for the CORN ratio call debit spread. The risk is that essentially you’re short a naked call because we bought to open only 1 long CORN Jan. 20th (2017) $23 call but we are short 2 CORN Jan. 20th (2017) $28 calls.
When I take on a naked call, I pick a strike price that is high enough that I don’t expect the underlying stock to trade up to it. In this case with CORN, I chose the $28 strike call, meaning while I do think CORN will go higher, I do not expect it to trade up to our through $28. That’s why I said earlier that, ultimately, we want the underlying CORN shares to be trading above the $23 strike price but below the upper $28 strike price.
However, the risk here is that if we are still holding the position at expiration and CORN moves up sharply up through the $28 level, the call will be exercised. This means that for every 1 naked call option we hold, we would need to buy 100 CORN shares on the open market at an unknown higher price and then sell the shares at the $28 strike price for a loss. It sounds exotic, but it’s not, and it’s the reason we need to open this trade with a margin account.
It’s also why I recommend keeping your positions small, especially since this is a very speculative trade to begin with.
Look, I know it seems like a lot of work to profit. Could you simply buy the long CORN Jan. 20th (2017) $23 call for $1.25 and be done with it?
Absolutely.
But even without the benefit of my 40-plus years of trading, it’s easy to see that paying $0.45 to enter a trade is much more attractive than paying $1.25, which is the simple rationale for why I recommend ratio debit spreads to my Maximum Options traders and to you today.
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