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November 23, 2010 by Leave a Comment

What’s the Best Way to Manage and Liquidate a Futures Trade?

This post originally appeared on Scott Hoffman’s blog, FuturesInsightBlog.com, where Scott writes daily about the commodity futures markets.

In marketing my services I offer the user’s Guide to Swing Trader’s Insight (STI).  (Get a copy of the Guide to Swing Trader’s Insight).  I call the STI user’s guide a “Guide to Swing Trading Futures”.  With that title, I end up getting a number of people requesting it who think they will get a “Futures Trading 101” type piece.  I realized that I don’t yet have something suitable for people needing a Trading 101 type guide.

For this reason, I am currently in the middle of writing my Futures Trading 101 guide. In one section of this guide, I wrote up the process of entering a trade and then how to manage the trade once it is on.  In doing so I wrote up my thoughts on how to manage then exit a trade.  This is the hard part of futures trading–in my opinion–so I thought I would post this portion of the upcoming guide, especially after I discussed the trade exit issue this morning with a prospective trader.

There are two general methods futures traders use to liquidate a trade.  First, a trader can pick a profit target for a trade; a point at which he believes the market will stop moving in his favor.  If he feels there is such a price he may look to liquidate his trade at this price or shortly before it in case it doesn’t quite reach.

The other school of thought is that instead of picking a point to pick where to liquidate a trade, the trader adjusts his stop loss to reduce his risk then to lock in profit as the trade moves in his favor.  This allows the trader to continue to profit if it keeps moving in his favor.

Which of these should you use?  Realize that exiting a trade is often the most difficult decision to make when trading.  If you pick a profit target and exit when the market gets to it you forego additional profit if the market keeps moving in your favor.  If you choose to trail your stop loss and not use profit targets you will always end up giving back some profit as the market retraces to your stop loss.  Realize there’s no one right answer to this question.  Make sure you are consistent and conscientious in your approach, and keep records of your trades.  Over time you’ll figure out which approach works best for you, or maybe you will end up using different approaches in different situations

This is a sample of the analysis from my Swing Trader’s Insight advisory service.  For information on STI, and to sign up for a free two week trial, visit here.

The information contained here includes information from sources believed to be reliable and accurate, but no guarantee is made as to accuracy, nor do they purport to be complete. Opinions are subject to change without notice.  Past performance is not necessarily indicative of future performance.  The risk of loss in trading futures contracts or commodity options can be substantial, and therefore investors should understand the risks involved in taking leveraged positions and must assume responsibility for the risks associated with such investments and for their results.

© 2010 Scott Hoffman

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November 22, 2010 by Leave a Comment

Commodity Futures Trading: Everything is a Cross

This post is part of Craig Turner’s Innovative Trading Concepts series.

Every commodity futures position you’ve had in the past, currently hold, or hold in the future can be viewed as a “cross”.  The most familiar “crosses” are currency pairs, like EUR/USD or GBP/JPY, but “crosses” are not just for currencies pairs.  For example, when you buy crude oil, you are taking possession of a crude oil futures contract but you are giving up something in return.  You are giving up USD to buy crude oil.  Your long crude position is also a short USD position.  So if you are long crude, you are really in a long crude/short USD cross, or “Crude Oil/USD”.

Is this important?  Am I just being a smarty pants, know-it-all broker?  Consider this.  If you are long crude oil futures, what happens if the USD has a sharp and sudden rally?  Crude oil will decline because Crude is priced in USD.  This implies that if you are long crude, you also have a short position in the USD.  So if the USD rallies, there is a good chance that your “Crude/USD” position is going against you.

All Investments Have Currency Risk

What is even more important is to realize how much risk you have in your portfolio due to currency risk.  Let’s say you are long Crude Oil, Gold, Corn and the Euro.  You might think you have a nicely diversified portfolio of commodity futures positions.  However, they are all priced in the US Dollar (Crude/USD, Gold/USD, Corn/USD, EUR/USD).  In one sense, you have a massive short US Dollar position.  Again, it is important to remember for every long futures position you have that is priced in Dollars, your also have a short US Dollar position.

The US Dollar represents the US Economy

Why does this matter?  The US Dollar represents the US Economy as a whole.  The US Dollar represents systemic risk.  If you truly want to diversify your portfolio to have as little exposure to systemic risk as possible, you need to hedge out the US Dollar short positions.  Let’s say a European country’s banking system is about to fail, and their largest banks need to be bailed out by the European Union.  To make matters worse, let’s assume the market was completely caught off guard, and the Euro plummets and sends the US Dollar much higher.  The Dollar rally puts downward pressure in all commodity futures priced in dollars.  If you are long Crude, Gold, Corn and the Euro, they are all declining together.  The correlation between those four futures positions becomes 1.0 because they are all priced in Dollars.  They act as one large losing trade against the US Dollar.

Hedging Systemic Risk by Hedging the US Dollar

How do traders hedge out the USD and protect themselves against systemic risk?  The answer is simpler than you may have expected.  You simply need to be short a few markets that are priced in US Dollars.  Let’s say you are bearish on the US Stock Market, Live Cattle, Japanese Yen and Treasuries.  Being short Live Cattle is also being long the US Dollar.  When you sell Cattle, you receive Dollars in return, so a short Live Cattle position can be viewed as a USD/Live Cattle cross.  That means if you are short the Emini S&P (ES), Live Cattle (LC), JPY and the 30 Yr Bond, you are in USD/ES, USD/LC, USD/JPY and USD/Bonds “crosses”.  The Long US Dollar positions will help cancel out a majority of the Short US Dollar positions you have from being long Crude, Corn, Gold and the Euro.

By having a few short futures positions to go along with a few long futures positions, you greatly hedge out your US Dollar exposure.  The next time a major, unforeseen economic event happens, you are much more protected against systemic risk.  The short futures positions in the S&P, Bonds, Yen and Cattle help diversify the systemic risk built up in being long Crude, Gold, Corn and the Euro.  Your ability to hedge out part or all of your US Dollar risk is an insurance policy against the unknown systemic risks in our financial system.

All Positions are Crosses

In summary, get used to thinking of all of your futures positions as “crosses”.  By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to.  With the knowledge of understanding how systemic risk can effect your commodity futures investments and trading, you will be one step ahead of the average investor and trader the next time we are in a financial crisis.

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November 19, 2010 by Leave a Comment

Why America Needs a Strong US Dollar

This post is part of Craig Turner’s Innovative Trading Concepts series.

I’ve been hearing a lot lately that a weak US Dollar is good for America.  The theory is a weak US Dollar will increase US exports.  The American currency will be less valuable against foreign currencies, making US goods and services cheaper for foreign consumers.  This will lead to increased demand for US products, and we will sell more goods and services to the global community.

I have also heard that a weak dollar is good for the stock market.  As the US Dollar declines, more money moves into stocks, bonds and commodities.  The weak US Dollar sends these markets higher, which is good for investors.  Perhaps you have read these stories also, or seen pundits talking about them on television?

While these theories are 100% correct in their own microcosms of economics, they miss the point terribly in the great macro realm of how things really work in global economics.  Unfortunately, these “benefits” are only short lived, and in the grand scheme of things, the positive economic stimulus they provide is negligible.  A weak US dollar is just the short term silver lining for a brutal long term economic reality.  The weak US Dollar does massively more harm to our economy over the long term than any of the short term benefits provided by a weaker currency.

A Weak US Dollar Leads to Inflation

There are two major issues with the declining US Dollar, and we will start with the lesser of the two.  A declining US Dollar causes price inflation.  With high unemployment and low growth GDP, Americans’ earnings are not going to be able to keep up with price inflation.  All of the daily basic goods and services we need will cost more, making it harder on Americans to make ends meet.  We can see this today as grains, livestock, energy, and softs commodity futures markets soar higher, meaning higher prices for the US consumer in the not to distant future.

A Weak US Dollar Reduces Investments in US Businesses

However, while price inflation certainly hurts the average American worker on Main Street, the real problem is going to be the decline of investments in US businesses.  A weaker US Dollar causes money to flow out of the United States into foreign countries with strong currencies.  The money that leaves the US is money that could have been used for long term business investments.  This includes investments in medicine, technology, new business ventures, infrastructure and so much more.  A strong US Dollar keeps that investment money in the United States.  Foreigners keep their funds in Dollars because they have confidence in the US economy.  A weak Dollar sees that investment capital go elsewhere.  It is these types of investments that add millions of new jobs through innovation and entrepreneurial ventures.

We will not see the effects of the weak US Dollar until years to go come, when it is not the US that is creating high end jobs in new industries, new products, and new services.  Over time, as long as the US Dollar is weak and declining, those jobs and industries will be sprouting up where the foreign currency is strong and stable.  Long term investment capital wants strong currencies and pro-business government policies.  It is these two qualities that attract investment capital that will reduce our unemployment rate and produce real, sustainable growth in our economy for years (and generations) to come.

The next time you read an article or hear a commentator talk about the weak US Dollar and how it will help support asset prices, or how US exports will increase, just remember that these very short term economic gains will be greatly overshadowed by the long term harm a weak dollar causes in our capital investments in US businesses and industry.

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November 18, 2010 by 1 Comment

Dollar Cost Averaging: Jim Cramer vs. Dennis Gartman

This post is part of Craig Turner’s Innovative Trading Concepts series.

Jim Cramer vs. Dennis Gartman

Two of my favorite financial commentators are Dennis Gartman and Jim Cramer.  Say what you will about them (and I’ve read criticism about both), but they are well respected, successful traders that everyone can learn from.  One issue I have seen in blogs and message boards is there positions on “averaging down” or “adding to losing positions.”  While their approach to this issue differs, I think in the end they are doing the same thing, but just going about with different styles of trading.

“Never Add to a Losing Position” – Dennis Gartman

Dennis Gartman is a big believer in “never add to a losing position”.  Dennis Gartman comes from a commodity futures trading background, and this makes perfect sense.  If he wants to get long gold at $1400, then he will be long a $140,000 Gold futures contract ($1400/oz X 100oz = $140,000 Gold).  When he gets into a position, either that contract is going to hold those support levels and start going up, or he wants out.  He might get in due to technical or fundamental analysis, and if he is correct, he wants the market to tell him so.  If he is wrong, he is happy to get out with a small loss, which could be a break below the nearest support lines.

It makes sense to trade this way in commodity futures because of the leverage being used.  When you are trading on margin and leverage, the gains (and losses) can pile up fast.  Plus you can’t buy gold $25K at a time; you have to commit to the full value of the commodity futures contract.  For Gartman, $140,000 of Gold is the minimum amount to play and that is where he will start.

The Jim Cramer Method

Jim Cramer is primarily an equities trader and tends to buy his positions in 4 or 5 trades.  It is easier to do this in stocks because one share is typically under $100.  Let’s say Jim Cramer wanted to have an initial position of $140,000 in Ford when it is trading at $14.00/share.  That is 10,000 shares of Ford.  For that kind of size, you most likely have to split it up into 4 orders of 2,500 shares.  Plus, Jim Cramer is a fundamental expert and he might have a price range for Ford between 13.50 and 14.50.  He might buy his first 2,500 shares at $14.00 and wait to see what happens.  If it goes down to 13.75, he will buy 5,000 shares, and then pick up the last 2,500 on the next break or if it rallies back to 14.00.

Now, if the stock breaks below $12.50, he might be ready to get out and just take a loss if he thinks it is a bad trade.  One thing I don’t think Jim Cramer is doing is “averaging down” a loser.  I think he has a very strong opinion on where the market should be fundamentally, and he knows the market can go up and down based on news and events unrelated to the stock he is buying.  That reason, combined with the size of his purchases, probably makes it more efficient for him to buy his positions in multiple trades.

The most important thing to note is that Cramer is not getting into a full position and then buying a dollar lower and doubling up.  He commits to the size he wants in terms of shares and works the order for a few days.  If it loses too much value, he gets out.  He will also buy more as the price goes in his favor, a technique that Dennis Gartman also employs.

The confusion I see on the blogs and message boards is that Jim Cramer is averaging down losers.  However, what Cramer is really doing is defining a full position and then buying that position in 4 or 5 equal parts.  The dollar cost average exists because he breaks up his buys for the initial position, not because he is doubling up due to the market is going against him.

Cramer & Gartman Risk Management

Dennis Gartman and Jim Cramer may have different trading styles, but their risk management is the same.  They take small losses.  If something is not working out, they get rid of it.  They don’t throw good money after bad.  Dennis Gartman, being so involved in futures, is probably the more risk adverse of the two, and that is mostly likely due to the leverage used in futures when compared to stocks.

In the end, it doesn’t matter which method you use, as long as you have a risk management plan to limit the size of your losing trades.  Both Jim Cramer and Dennis Gartman recognize the importance of this trading practice and do their best to follow their own rules.  Traders need to find a style of risk management that fits their trading and investing styles, just like Cramer and Gartman have.  If you want to be a successful trader, make sure you always know the size of the position you want and the risk you are willing to take before you initiate the trade.

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November 11, 2010 by Leave a Comment

The Number One Rule of Trading

This article originally appeared in FutureSource’s Fast Break Newsletter, where Craig Turner is a regular contributor on various futures trading topics.

If there is one thing I’ve learned in all my years in the financial markets, it is never add to a losing position.  That means never “average down” a losing long position or “average up” a losing short position.  This is even more important when using leverage.  There is a very well-know saying, “your first loss is your best loss.”  What this means is you are best served taking a small loss before it becomes a larger loss, or even worse, a loss that eats up a majority of your trading capital.  In order to avoid this major trading mistake, we must first understand why traders add to losers, why traders should not do this, and what they can do to stop it from happening.

Why Traders Add To Losing Positions

Traders stay in losing positions for only two reasons.  Either they don’t want to be wrong about the market or they don’t want to lose money on the trade.  Sometimes it is a combination of both.  Regardless of which one it is, it causes traders to stay in positions that are going against them.

As traders are losing money, they figure that if they add to the losing position, they can bring the average cost of the position down.  For example, let’s say a trader wants to be short Crude Oil and he sells 1 contact of Crude Oil at $75.00.  Crude is now trading at $80, and the trader is down $5 in crude ($5000).  The trader then decides to sell short an additional 2nd crude oil contact at $80.  The average short position is $77.50 (the average of $80 and $75).

The trader now only needs Crude Oil to go $2.50 in his favor to get to breakeven at $77.50, instead of $75.00.  However, every tick Crude Oil goes against the trader past $80.00 a barrel is going to count twice a much, eating up available capital a double the rate.  To make matters worse, markets that are trending in one direction, tend to continue to trend in that direction.

Why Traders Should Not Add To a Losing Position

When a trader is in a losing position, the market is telling him he is wrong.  The market is the total sum of psychological, technical and fundamental knowledge.  The market is the total sum of all investor knowledge and market opinions.  It includes institutional money, sovereign wealth funds, hedge fund managers, trend following funds, commercial hedging interest, and every other participant, large and small.

If a trader continues to hold onto a losing position after the market says he is wrong, the trader is basically saying he is right, and the collective sum or the rest of the market is wrong.  In other words, the global consensus is telling the trader the world is round while the trader insists the world is flat.  This will almost always lead to larger losses.  Bullish markets tend to trade higher, and bearish markets tend to trade lower.  It takes something significantly fundamental or technical to occur in that market to change the trend.

Not only is the trader wrong shorting Crude at $75, he is twice as wrong shorting the market again at $80.  The losses are now piling up exponentially if he continues to add on to a losing position.  Plus, he has now doubled his leverage on a bad trade.  Meanwhile, if the trader had just had a $1 or $2 stop on the crude oil position, he would have taken his loss and been done with the trade.  He would have been able to admit he was wrong and move onto the next opportunity, instead of creating larger losses and letting other opportunities go by while he was in a losing trade.

Wait Just A Second, I Have “Averaged Down” and Made Money!

If you have averaged down losing positions before, chances are it may have worked in your favor.  The problem is, the one time it does not work in your favor you will blow out your account.  Every time you “average down” and succeed you are cheating trading death.  It is almost like a game of Russian roulette.  It only ends once, and when it does, it’s over.

“Markets Can Remain Irrational Longer Than You Can Remain Solvent” – John Maynard Keynes

When it comes to leveraged trading, there have never been truer words said.  Traders who want to hold onto losing positions “until they come back” to the price they entered may never see it happen.  A trader who has a $10K acct short 1 crude at $75.00, only has $10 of room before the account is drawn down to zero.  Most people think they will never let a position go against them that far, but it does happen, and there is no assurance that the market will come back to $75 before it gets to $85, causing the trader to liquidate the position for a very large loss.

THE SOLUTION

The simple solution is to never add to a losing position.  However, as an experienced broker, analyst, trading newsletter publisher and individual trader, I know that is easier said then done.  Here are a few rules to live by in order to help you stop adding to losing positions.

Place Stops Just Outside Normal Trading Ranges

When entering a position, traders need to give their positions enough room to work in their favor, but they also must have stops if the market moves decidedly against them.  For a swing or position trader, this means having stops just outside the most recent trading ranges.  It could be the previous day’s low/high, the past week, or right outside the natural support and resistance lines for the markets.  Traders need to define this risk parameter BEFORE they enter the trade.  Traders need to know what the risk is and make sure they are comfortable with the risk if they are wrong about the direction of the market.

Mental Clarity Can Only Be Achieved After the Losing Position Is Exited

When a trader is in a losing position and the market keeps on going against them, it is very difficult to approach the situation with a level head and clear mind.  The fear of losing money can be the greatest factor in the psychology of trading.  It causes traders to see things irrationally, as they do everything possible not to take a loss.  This leads to poor decision-making and bad judgment.  This is why it is so important to define the stop loss parameters before you enter the market and stick with it.

Unfortunately, sometimes traders get into a trade without a stop or let the position run too far against them.  If possible, try to imagine you are flat instead of in the position.  Then ask yourself, if you were flat, would you get back into the position? If not, you need to get out, and get out fast.  If the trader can’t honestly say what he would do, or can’t detach from the situation, the best thing to do is exit.  Getting out of a loser relieves stress and allows the trader to approach things with a level head.  Once the trader is out of the position, he can always get back in if he feels it is the right move.  Some traders don’t like this method because they don’t want to spend the extra commission for getting out and getting back in.  However, the clarity that is gained from exiting a losing position is invaluable compared to the extra transaction costs.  Don’t worry about a few dollars when thousands are at stake.

You Must Be Able to Admit When You Are Wrong and Take a Loss

Being able to admit you are wrong and take a loss is the first step in the journey of successful trading.  No one is perfect in trading.  Taking a small loss is a minor victory in trading.  Being able to let winning trades run and exiting losers for a small loss is what it is all about.  However, you can’t get to the winners if you take large losses.

It is OK to be wrong.  Actually, it is great to be wrong.  Why? Because if you can’t be wrong, you’ll never be right about the markets.  Trading is about taking risk and managing risk.  The trader who can exit a position going against him early is giving himself the change to win big on the next opportunity.

The Best Traders Add to Winning Positions & Use Stops to Protect Profits

The most successful traders I’ve seen not only cut their losers quickly, but they let their winners run and add on as they go in their favor.  They never average down losers, but they will certainly average up on winners.  While some might not want to trade multiple lots, I think the concept is very important.  When you have a winning position, the market is telling you that you are correct.  The collective sum of all knowledge in the market place is in total agreement with you.  This is the perfect time to add on another lot if you have the available capital without over-leveraging your account.

Some traders don’t want to add on at higher prices because it adversely affects their dollar cost average.  However, what traders need to realize is that markets trading higher tend to trend higher, and the opposite is true for bear markets.  If you find yourself in a great winning trade, and you see no reason why it should stop, that is a great time to add on.  When it comes to trading, you want to buy high and sell higher, or sell low and buy lower.  We are not in the business of picking bottoms and tops.  It is a one-way ticket to trading failure.

Successful traders also use stops.  As the market moves in their favor, they move their stop up to where they feel is below a reasonable support level.  They are comfortable with the losses or profits they will take if they get stopped out.  They let the market tell them if they are right or wrong and they accept the market’s decision!

Find a Broker Who Can Help You When You Need It Most

If you are having difficulty with adding to losing positions, you need to talk to your broker about it.  Regardless if you are a self-directed online trader or broker-assisted, you need to have a talk with your broker.  If you don’t have access to a broker with your current trading arrangement, consider finding a firm that will allow you to access to one regardless of whether you are a self-directed online trader or broker-assisted trader.

As a Senior Broker at Daniels Trading, I can honestly tell you from first hand experience how important it is to be able to work through these situations with someone who has an interest in the success of your trading.  Sometimes we are able to offer valuable advice about not adding to losing positions.  Sometimes it just helps for the trader to talk about the trade the same way a person tells their psychologist their problems.  In the end, it is the trader who works out what needs to be done just by communicating the situation aloud to another human being.  Either way, having a trained professional in the weeds next to you during battle can make a huge difference in your most difficult trading periods, and help you make sure you never return to that place again.

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November 5, 2010 by 39 Comments

Futures Options: Using a Delta Neutral Trading Strategy

This article originally appeared in FutureSource’s Fast Break Newsletter, where Drew Wilkins is a regular contributor on various futures trading topics.

Many traders are constantly looking for a way to manage risk.  Employing a delta neutral trading strategy can help to manage exposure to the markets.  This type of strategy will allow speculative traders to hedge their positions against adverse price movements.

How Does a Delta Neutral Strategy Work?

A delta neutral trading strategy involves the purchase of a theoretically underpriced option while taking an opposite position in the underlying futures contract.  A common question traders have after this explanation is, “How do I know if an option is theoretically underpriced?” I prefer to use a futures trading platform that provides this information.  At Daniels Trading we offer the Vantage platform, which will give you the theoretical price of an option — Download a 30-Trial of dt Vantage.

This example below looks at purchasing December gold calls and selling the underlying gold futures contracts.  See the screenshot below:

December Gold Calls

Click to View Larger Screenshot

We are going to focus on the 1360 December gold calls.  The last traded price was 1960, the bid-ask is 2010 by 2050, and the theoretical price is 2503.  With the bid ask being where it is, we’ll assume we can buy a 1360 call for $2030.  Notice that the theoretical price is $2503.  This lets us know that the option is undervalued by $473.  Knowing that the option is greatly underpriced, we would want to take advantage and buy calls.

The next question traders have is how to figure out how many underlying futures contracts to sell.  The option’s delta will give you the answer.  A call option will always have a delta value between 0 and 1.00.  Many traders drop the decimal points, and we’ll do the same.  If you look at the above screenshot, you’ll notice the far left column let’s you know the option’s delta.  In this case, a 1360 call has a delta of 49.  This means that one 1360 call will be the equivalent of 49% of an underlying contract.  Options that are at-the-money will always have a delta of around 50.  In-the-money options will have a greater delta than 50 and out-of-the-money options will have a delta lower than 50.  The underlying futures contract will always have a delta of 100.  In order to find the number of futures to short to be delta neutral, simply divide 100 (delta of underlying) by the option’s delta.  For the above example, you would divide 100 by 49 and get ~ 2/1.  So, for every two gold call options purchased you would sell 1 gold futures contract.

Since we are purchasing calls, their delta will always be positive.  Since we are selling the underlying futures, their delta will be negative.  The goal is to for the combined deltas to be as close as possible to zero when added together.  So, for the example above we purchased two options with a delta of 49 for a total delta of +98.  We then sold an underlying futures contract that has a delta of -100.  Our total delta is -2 (-100 + 98).  It isn’t zero, but it’s extremely close.

Make Adjustments to Remain Delta Neutral!

Once in the position, it is important to make adjustments in order to remain delta neutral.  As the price of the position moves, so does the delta.  An increase (decrease) in price of the underlying futures contract will increase (decrease) the premium of the option, as well as the delta.  Making adjustments along the way will allow for the position to be as close as possible to delta neutral.  A trader can make adjustments hourly, daily or weekly.  It is entirely up to him and what he is comfortable with.

A Delta Neutral Trading Strategy in Action

We’ll now take a look at a delta neutral strategy in action (Note:  This is different from the screenshot and examples above.  The similarity of the 1360 calls is a pure coincidence).  On October 7th, a trader thinks that the gold market is due to continue in its bullish ways.  December gold futures are currently trading at 1357.  He will look to exit the position on or before November 3rd before the FOMC announcement.  He decides that it is in his best interest to use a delta neutral options strategy in case his market outlook is incorrect.  He finds that the December 1360 Gold calls are theoretically underpriced.  He decides to purchase 10 calls for $3300 each.  The delta for the options is 50.  In order to be properly hedged, he will need to sell 5 underlying gold contracts to reach delta neutral.

  • Long 10 December 1360 gold calls for a total delta of +500 (50 * 10)
  • Short 5 December underlying gold futures for a total delta of -500 (100 * 5)
  • Total delta = 0

November 3rd is now here and the trader is still in the position.  His 1360 calls are now worth $1640 and futures are currently trading at 1338.  He decides to exit the position before the FOMC announcement.  He offsets his options at 1640 and buys back his futures at 1338.  The market did not continue its bullish ways.  But, the trader was hedged so he should be fine, right?  Let’s take a look:

Options:
$3300 (Premium paid per option)
- 1640 (Premium received for selling options)
$1660 loss per option for a total loss of $16,600 (1660 * 10 options)

Futures:
$1357
- 1338
19 points gained in futures
x $100 per point
+$1900 per contract for a total gain of $9,500 (1900 * 5 contracts)

Total Profit / Loss:  -16,600 + 9,500 = -$7,100 loss, not including commissions and fees

How did the position end up so poorly?  The trader had a delta neutral position and should have been protected, right?  Wrong.  Take a look at the headline above entitled, “Make Adjustments to Remain Delta Neutral!” The market is constantly changing; therefore the delta is always changing.  In our example, the trader actually made 11 total adjustments throughout the time he was in the trade as the delta increased or decreased, and his result turned out differently.  See the chart below:

Adjustment Chart

Click to View Larger Chart

As the price of the underlying contract decreased, the delta decreased as well.  In order to get back to delta neutral, the trader had to buy a contract back, essentially forcing him to buy at a low.  When the price of the underlying contract increased, the delta increased as well.  In order to get back to delta neutral, the trader had to sell a contract, essentially forcing him to sell at the high.  When the time comes to offset, his positions look as such:

Offsetting All Open Positions

Long 10 Dec 1360 Gold Calls (33,000 – 16400 = -$16,600)
Short 1 Dec Gold Futures Contract at 1373.7 (1373.7 – 1338 = $3570)
Short 1 Dec Gold Futures Contract at 1345 (1345 – 1338 = $700)
Short 1 Dec Gold Futures Contract at 1344 (1344 – 1338 = $600)
Short 1 Dec Gold Futures Contract at 1359 (1359 – 1338 = $2100)

So, let’s take a look at the profitability of the trade with the adjustments:

-16600
+11000
+ 6970
+$1,370, not including commission and fees

The adjustments made all of the difference.  There was only one case where the trader had to accept a loss to get back to delta neutral.  The adjustments to get to delta neutral helped him take advantage of the theoretically underpriced option even when the market went in a different direction than he originally anticipated.  Using a delta neutral trading strategy won’t always produce a profit, but it is a great strategy to help manage risk.  The example above uses a larger initial position, but the same principles can be employed with a much smaller initial position.

Options Risk Disclosure:  An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price.  Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different.  For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option.  Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options).  Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised.  The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero.  Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received).  The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.

Filed Under: Options, Risk, Strategies Tagged With: , , , , , ,