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December 30, 2010 by Leave a Comment

How to Collect Premium with Iron Condors

How to Collect Option Premium with the Iron Condor Strategy

Different circumstances call for different trading strategies.  Part of becoming a complete trader is a balanced, disciplined approach with an eye geared towards managing risk.  You can accomplish this by trading futures, options, or a combination of the two.  The difficult part is determining which approach will be the best for you, and this formula might be different for every trader.  In this article, my intention is to open your eyes to a more unique trading approach, collecting premium with Iron Condors.

I’ve heard a lot of myths and confusion in regard to iron condors, so I’m attempting to break this down for you in simple, easy to understand language.  In order to accomplish this, we need to have a basic understanding of credit spreads.

Understanding Credit Spreads

A credit spread is when you sell a closer to the money (more expensive option) and purchase a cheaper (further out of the money option) on the same underlying commodity at the same expiration.

Let’s take a look at an example using gold futures;

Gold futures    =    1400
1350 puts    =    $3500
1300 puts    =    $1500

Gold futures are trading at 1400 and we feel bullish on this market.  We could sell a 1350 put and purchase a 1300 put.  The premium in the 1350 put is going to be higher than the 1300 put because it is closer to where the market is currently trading.  We would collect the $3500 premium from the 1350 put and pay out the $1500 premium of the 1300 put at a net credit on the trade of $2000.  Our defined profit is the amount we collected between the 1350/1300 put spread, $3500 – $1500 = $2000.  We’re risking the difference between our two strike prices, (1350 – 1300 = 50 x $100/point = $5000.  And, since we already collected a premium of $2000, our defined risk is reduced to $3000 ($5000 – $2000 = $3000).

So… What is an Iron Condor?

An Iron Condor is simply a combination or two vertical spreads.  To create the iron condor, we would sell both a call spread and a put spread.  The idea behind this is to take advantage of a sideways market and allow us to design a strategy based on where we feel the market will NOT go.

How to Use an Iron Condor Strategy

Once again, let’s take a look at an example using gold futures.

The current price of gold is 1400.  We feel that the market will likely trade within a channel between 1350 and 1500 over the next 30-60 days.  Gold options are currently trading at the following prices:

1500 call    =    $3500
1550 call    =    $1500
1350 put    =    $3500
1300 put    =    $1500

In order to take advantage of a sideways market we would use an iron condor by selling the 1500/1550 call spread and the 1350/1300 put spread.

How to Calculate the Profit Potential

Profit/loss graph for a long Iron Condor at expiration.

We would place an order to sell the 1500 call and purchase the 1550 call.  We would collect $2000 premium on our call spread ($3500 – $1500 = $2000).  We would also sell the 1350 put and purchase the 1300 put.  We would collect another $2000 premium on our put spread ($3500 – $1500 = $2000).  This would define our profit potential to $4000 (total premium from call spread + put spread, $2000 + $2000 = $4000).

Maximum Profit Potential = Call Spread Premium + Put Spread Premium

How to Calculate the Defined Risk

We can also use these numbers to calculate our defined risk.  Our defined risk is the difference between our spread strike prices minus the amount we collected.  Since we have both a put and call spread, we know our risk is limited to only one side.  The market cannot expire above our call spread and below our put spread simultaneously, so we have a risk of just $5000 (1350 – 1300 = 50 x $100/point = $5000 or 1500 – 1550 = 50 x $100/point = $5000).  Note: If the difference between our strike prices were not balanced, we would use the greater difference.  However, this is before we take into account the premium we collected.  We have collected a total of $4000 for our put and call spreads upfront, so we can deduct this from our risk total.  Thus, our defined risk would be reduced to $1000 ($5000 – $4000 = $1000).

Defined Risk = Greater Difference between Strike Prices – Premium Collected

Benefits of an Iron Condor Trading Strategy

Now that we understand what an Iron Condor is, we need to understand why we would want to use this trading strategy.  Buying options are great in regard to their risk reward.  You can define your risk to a very small sum, while having unlimited profit potential.  The downside of this strategy is the probability.  The majority of cheap, far out of the money options will expire worthless.  So although you are only risking a few hundred dollars on each option, the odds of these being profitable are low. 

That being said, if the majority of options are going to expire worthless, then why don’t we just sell options? You can, but you are running the risk of that one cheap option turning into a very valuable option.  So you might have a defined profit a few hundred dollars with unlimited risk.

This is why the Iron Condor is an attractive strategy.  You are doing your part managing your risk because you know what the worst outcome can be.  You are also keeping the odds in your favor.  We know that the majority of all out of the money options are going to expire worthless, so we should have more profitable trades than losing trades.

In conclusion, an Iron Condor can be a simple strategy.  It is a combination of two credit spreads: one to the call side and one to the put side.  This allows you to take advantage of sideways markets and to design a strategy based on where you feel the market will NOT go.  This strategy allows you to define your risk, while keeping the odds in your favor, and providing you with a flexible and disciplined approach to the markets.

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Spreads Risk Disclosure:  A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts.  It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position.  An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread).  In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.

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, Spreads, Strategies Tagged With: , , , , , , , , ,
December 28, 2010 by Leave a Comment

Developing a Framework for Trend Trading

This post originally appeared in FutureSource’s Fast Break Newsletter, where Tim Chilleri is a regular contributor on various futures trading topics.

Trend trading is a popular method of trading but it is critical that you develop and use a framework to execute the trade.  The goal is to place yourself in a position to capitalize from a forming trend and get on the right side of the trade early.  I utilize this type of trading as an intuitive, rules-based discretionary trade.  This means that I attempt to understand the dynamics and psychology in the marketplace and use specific rules to manage my risk.

We will discuss a 1-2-3 set-up that gives you a framework for determining potential trends.  While this is a retrospective exercise, I believe it highlights the usability of this framework that you can take advantage of in other markets.  Without understanding the framework and without an example, it is difficult to learn how to search for these types of opportunities.

Let’s examine the core of a 1-2-3 trend trade:  fundamental analysis, technical perspective, and how news affects the market.

#1 Fundamental Analysis

Simply put, we are searching for a dislocation in supply and demand.  In order for a new trend to begin, a major underlying change in demand, supply, or both must occur (rare case to have both altered at the same time).  To illustrate, imagine a ball rolling down a hill in one direction.  Now imagine that ball hitting a rock that alters it direction by 20 degrees.  At the bottom of the hill, that ball will be in a significantly different place had the ball not hit the rock (the dislocation).  Dislocations form because perception of the underlying marketplace changes:

  1. Demand for buying increases (new buyers push markets higher as supply is steady)
  2. Demand for selling increases (new sellers push markets lower as supply is steady)
  3. Supply increases causing prices to fall (demand stays steady)
  4. Supply decreases causing prices to rise (demand stays steady)

These dislocations typically happen very quickly and can be unexpected.  The “unexpectedness” occurs because someone is trading on information you don’t have.  This creates an asymmetry of information.  Those in the “know” are early adopters while those out of the “know” either:

  1. In the trade already and the position moves in their favor (eg, getting lucky),
  2. Their position moves against them, or
  3. Do not participate in the move as they do not know the information.

In order to successfully identify dislocations, you need to fundamentally understand how that market operates.  For example, if the market is an agricultural commodity, you need to be aware of the demand and supply dynamics.  Is the crop just being planted? Is it in harvest? How is the weather affecting it? What factors will affect demand? Supply? At the end of the day, you cannot be reactive to potential unknowns (in my view, unknowns equate to risk).  You should be proactively thinking about how a market can become dislocated.

#2 Technical Perspective

Does the current technical perspective support my hypothesis that we are at the beginning of a new trend? Different traders use different analysis to give them different levels of comfort.  Personally, I like to layer different types of analysis to give me the confidence to trade an idea.  There are several that I find useful:

  1. Market Profile:  Gives me a visual for understanding of where trading has occurred in a market.  Simply put, Market Profile is a graphical organization of price and time information.  This input gives me an idea where a market will accept buying/selling and where it will not.  It helps me to understand if markets are trading in a fast (vertical) market or a slow (horizontal) market.  During fast markets, the market quickly moves directionally.  When viewing price levels on the price histogram, it looks like there is a “hole” as there are few contracts traded at the various levels.  Markets can trade very quickly through these levels as no value is established at each price and continues the directional move.  During slow markets, I look for tight, range-bound channels to develop.  I will track the number of contracts traded at a certain price over a given session using a simple histogram.  During slow markets, we’ll see trading within a specified range-bound price level.  Thus, over time, “value” is established as those prices are accepted by the market.  Graphically, it results in a “fat” area because the high congestion of contracts trading in that area.
  2. Moving Averages:  What are the 14, 50, and 200- day moving averages doing? Are we close to a crossover at any level? Again, a lot of traders use this information and trade off of it.
  3. Volatility:  Are we seeing range expansions or contractions? Do markets seem on edge? (I always imagine what it would feel like if we were trading in a pit in open outcry.  Are traders comfortable and quiet or is there a trading frenzy?)
  4. Formation:  What is it? Horizontal channel? Vertical Market? Are we breaking out of a horizontal channel into a directional move? Have we formed a diagonal channel? Pennant formation? Double top/bottom?
  5. Fibonacci Levels:  Gives me an idea of potential support and resistance areas.  Markets never move in straight lines and they can be useful to give you an idea of where a market can rise/fall before pausing to digest the price move.  Regardless of whether you think it is useful, many other traders look at them, which may help form market perception.  Furthermore, it may help you understand where long and short traders keep their stops.

In my opinion, technical analysis is much more of an art than a science.  There are times when it seems to work well and other times when it does not.  Remember, technical indicators and formations are digesting price information that has already happened.  It is very important to remember this but at the same time, since so many traders use them, it is important not to disregard them.  Technical indicators/formations can help us understand what has happened and potentially, what may occur- at the l very least, it helps give some context as to how the market has recently traded.

#3 News

How does news reflect the market’s sentiment? Said another way, how does the market perceive the news? If you believe we are in a breakout trade to the upside, good news should push markets higher.  Likewise, neutral/poor news will be brushed off without much of an effect to the downside- thus, the trend continues.  Likewise, on the downside, poor news should reinforce a lower market and neutral/good news is brushed off.

Now that we have a framework for how this trade works, let’s examine the March 11 Euro market.

#1 Euro Fundamental Analysis

Those following the world economy know the problems of Europe.  To begin, there high levels of sovereign debt for countries throughout the continent – from Greece and Spain to Ireland and Portugal.  Many believe there are more ticking time bombs waiting to come out of the shadows to announce their debt problems.  For example, last week there were rumors of France’s debt being downgraded.  In December 2009 through May 2010, the Euro began a slide of roughly 3000 points or 30 cents.  During this fall, the market was very concerned about several European governments remaining solvent, which precipitated the sell-off.  A factor in determining the value of a currency can be traced to its creditworthiness.  Think of it like a credit rating for an individual.  High credit worthiness equates to good credit and low interest rates to borrow at.  Bad credit, or the worry that the borrower can’t pay it back results in borrowing of higher interest rates and a lower credit.  This is similar to an entire country.  Good credit and low debt typically spurs value in the currency.  Poor credit and high debt typically leaves a country with lower value versus other currencies.

While the ECB (European Central Bank) and others helped stem liquidity worries and kept governments solvent, the Euro bounced off the May 2010 lows.  However in reality, they simply “kicked the can down the road”.  Instead of structurally addressing any real issue, they applied temporary fixes to keep governments running.  I used this information to understand that at some point down the road, the market would again worry about these same issues.  As such, it was only a matter of time until a major market dislocation occurred and the market moved into a new direction.

By looking at the daily chart of the March 11 Euro on Thursday, November 4th and Friday, November 5th.  The euro fell over 400 points (or 4 cents) in two sessions, which is a substantial move lower in the currency market.  This tells me that over this timeframe, the markets perception changed.  The 400-point move should have had bells, whistles, and lights flashing at your trading terminal.  A major dislocation has occurred.  New demand for sellers clearly emerged as longs exited and short sellers initiated new positions.

Daily March 11th Euro

Click Chart to See Full Size

#2 Euro Technical Perspective

In October 2010, the Euro market seemed to have stabilized after the run up from March 2010.  I viewed this transition as a period of indecision for the Euro currency.

  1. By utilizing Market Profile, it became evident that market traded in a comfortable horizontal channel.  The more time a market spends in the channel, the more likely a breakout to the upside or downside is coming.  (Since the backdrop of the market was worried about Euro zone problems, I was more interested in a break of the downside support).  Once the market broke 400 points in two trading sessions, I became very interested in constructing a trade to the downside as the market began trading fast (directionally).  While I was alert that a major dislocation had occurred, I was watching for a daily close below the horizontal channel.  This tells me that the market is now willing to trade outside the channel at new (lower) prices.  This begins to satisfy our criteria that the technicals support our hypothesis of a new directional move in the market.
  2. Moving Averages:  Let’s examine the 14, 50, and 200-day moving averages:

    14, 50, and 200-day Moving Averages

    Click Chart to See Full Size

    The red is the 14-day moving average, the blue is the 50-day, and the green is the 200-day.  Many trend traders will use various moving averages so it is important to be aware of them.  As we can see they cross over giving you support that the market may be moving lower.

  3. Volatility:  Volatility goes through an expansionary phase, as the daily ranges (difference between the daily highs and lows) are significantly higher than previous sessions.  This supports our hypothesis that we are entering a directional move to the downside.
  4. Formation:  While this has been a retrospective exercise, it is important to recognize formations as they unfold.  Once the horizontal channel was broken, we could establish a downward trend.  Trend lines can be effective measures of support and resistance.

    5. Trend Lines

    Click Chart to See Full Size

  5. Fibonacci Levels:  While never perfect, this type of analysis can be used to provide an additional level of data to understand potential targets and retracement levels and dynamics in the market.  The more experience and time you spend watching Fibonacci levels in different markets, the more useful this analysis will be for you.  With that said do not blindly anticipate that Fibonacci levels will provide exact stops and starting points for markets.

#3 Euro News

At the same time prices are being hacked lower, news stories begin to turn up the heat for the downside of the Euro.  On Monday, November 8th, the Portuguese and Irish government bond spreads hit their highest bps (basis points) in the Euros lifetime with Irish 10-year bond and the German Bund widened to 557 basis points while the Portuguese 10-year versus the Bund expanded to 450 bps.  The ECB was forced to answer tough questions regarding the record high Irish bond spread, and the ever-widening bond spread of the other highly indebted EU members like Greece, Spain and Portugal.

Throughout this recent downturn, Ireland and Portugal were in the spotlight.  Meanwhile, Greece is pretty much old news, and now it’s Ireland’s and Portugal’s turn taking heat from widespread investor skepticism.

Deficit figures from Euro stat in October only add to the pessimism.  According to Eurostat, Ireland’s budget deficit was the highest among EU members at 14.4% of GDP last year, ahead of Spain at 11.1% and Portugal at 9.3%.  Even in the United Kingdom came in with a deficit of 11.4% of GDP.  Looking forward, Ireland’s deficit is set to rise to 32% this year, a modern European record.  Furthermore, the debt projection is even dimmer for Portugal and other European Union countries.  Remember, the European Union has 27 member states with 16 utilizing the Euro as a single currency, with Germany at one end of the fiscally responsible spectrum and Greece and Ireland at the other end.  As such, each economy had various needs.

Even last week, the Chinese stepped in to buy Portuguese debt only to see the euro head lower in that trading session.  This tells me that the market brushed off neutral/positive news.  Furthermore, on December 23rd, Fitch Ratings agency downgraded the country’s debt one notch from AA- to A+.  All this information is analogous with lower prices as the market becomes more fearful and reinforces our fundamental and technical perspective.

Conclusion

To re-iterate, this has been a retrospective exercise designed to apply certain types of framework.  We reviewed a 1-2-3 set-up covering fundamental analysis, the technical perspective, and how news can reinforce a trend.  It is important to be aware of the fundamental factors in a futures market and how these factors can lead to dislocations.  We reviewed a few key technical themes includes Market Profile, Moving Averages, Volatility, Formation, and Fibonacci Levels.  Each of these requires time to understand what they are designed to do and how comfortable you are using each one.  As you can experience trading, the more useful technical indicators become as you understand how to effectively leverage them and what the shortfalls are.  Lastly, we saw negative news for the euro reinforce a lower trend satisfying the 1-2-3 requirement.  Europe will continue to face debt and funding issues as time moves forward.  By creating a straightforward framework, you can effectively manage your risk and put yourself in situations to capitalize off the changing sentiment of the Euro currency.

Please contact me directly using the Daniels Trading website if you would like to learn more about how to effectively construct a futures and/or futures option trade and learn important risk management techniques.  I also encourage you to register for our special offer for the dt Insider Market Advisory, which provides trade analysis with daily fundamental and technical market overviews.

Gain an Edge in Your Trading with the dt Insider Market Advisory

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Filed Under: Strategies, Technical Analysis Tagged With: , , , ,
December 17, 2010 by 1 Comment

Options on Futures:  An Introduction to Buying Options

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

One of the most common questions a futures broker gets is, “How do options on futures work?”  The truth is, options can be as simple or complex as you want them to be.  This article will focus on the basics of buying options on futures, basically starting from scratch.

There are two types of options, calls and puts.  The options can either be bought or sold.  We will only focus on buying options in this article.  Buying a call gives you the right to take a long position on the underlying futures contract.  Buying a put gives you the right to take a short position on the underlying futures contract.  Simply stated, when you think the market will go up, buy a call.  When you think the market will go down, buy a put.

Understanding the Strike Price

When purchasing a call or put, you will be doing so on an underlying futures contract (e.g. corn futues, gold futures, crude oil futures, etc.).  The price at which you purchase the option is called the strike price.  Options differ from futures in that you can purchase options at a variety of strike prices, whether the underlying market trades at the price or not.  When purchasing the option, you can either purchase strikes that are out of the money, at the money, or in the money.

  • Out of the Money Options – Out of the money call (put) options involve strike prices that are purchased above (below) where the underlying market is currently trading.
  • At the Money Options – At the money call and put options are strike prices that are purchased where the underlying market is currently trading.
  • In the Money Options – In the money call (put) options are strike prices that are purchased below (above) where the underlying market is currently trading.

See the following screenshot for February Gold taken from our Vantage trading platform.  Register for a complimentary demo of Vantage.

Feb Gold Chart

Click to View Larger February Gold Chart

This image is focused on calls.  The darker blue line going across the 1390 option is currently at the money.  The options from 1385 to 1350 are currently in the money, and the options from 1395 to 1450 are out of the money.  There are three columns you want to focus on.  They are the bid, ask, and last columns.  The bid shows you what someone is looking to pay to purchase a call.  The ask shows you how much money someone is willing to accept to sell the call, and last shows you what price the last trade took place.  The more in the money the call (from 1385 to 1350), the more expensive it becomes.  The further out of the money the call is (from 1395 to 1450), the cheaper it becomes.

Exercising a Purchased Option

Once a trader decides on a strike price and purchases a gold call, he will have the right to take a long position in the underlying gold futures market at the strike price purchased.  If the trader chooses to use this right, he will have to exercise the option.  Exercising the option is converting the call option to a long futures position at the strike price purchased.  For example, the trader purchased a February 2011 1400 gold call with hopes that the market would continue in an upward trend.  After a month of owning the option, the market is trading at 1435.  The trader decides that he would like to exercise the option and be assigned a futures position at 1400.  The trader will show a futures position with a profit of $3500 (100 (value per $1 gain in a gold futures contract) * (1435-1400)).  However, the entire premium gained in the option is not transferred to the futures position.  Why would the trader have exercised the position when it appears the position would have been more profitable as an option?  There are two reasons:  intrinsic value and time value.

Understanding Intrinsic Value and Time Value

An option is a wasting asset.  Options, like futures contracts, have expirations.  They tend to expire one month before the underlying futures contract.  Intrinsic value and time value, make up an options premium or worth.  Intrinsic value is the amount that would be credited to the traders account if the option was exercised and the subsequent long futures position is immediately sold at the market price.  In our example above, the trader has a 1400 call with the underlying market trading at 1435.  The intrinsic value of the option is $3500 (100 * (1435-1400)).  An option will only have intrinsic value if it is in the money.  Time value is what is left of the options premium.  The further away an option is from its expiration, the more time value it will have.  If the 1400 call has a premium of $5700, then the time value of the option is $2200 (5700-3500).  The intrinsic value and time value must always add up to equal the options premium.  As mentioned before, an option is a wasting asset.  The closer the option gets to expiration, the more the time value will decrease.  If the trader in the example above purchased the option on December 15th and exercised the position a month later, there would be very little time value still associated with the option.  Since the trader knew that he would have an extra month for the futures contract to potentially increase, he chose to exercise the option.

Offsetting an Option Position

A trader doesn’t always have to exercise an option.  In fact, most don’t.  Another way to get out of an option position is to offset the option.  Offsetting an option simply involves selling the option that you purchased.  For example, if you purchased a February 2011 1400 gold call, you can offset the call by simply selling it.  If the option still has time value, this is the way that you can capture it and make it more profitable.  In the example above, if the underlying gold price stays at 1435 and the trader holds the option to expiration, the option will be exercised and the trader will then hold a long futures position worth $3500.  If the trader thinks the price of the underlying will stay the same, he can offset the position by selling the call he purchased for $5700, capturing the remaining time value.

Another Example in the Gold Market

Now that the basics of buying options on futures have been covered, let’s take a look at another example.  A trader wants to get into a February 2011 gold option.  He thinks that the market is going to continue on its current upward trend, so he wants to purchase a call.  Keeping his account value in mind, the trader decides he is willing to spend $2500 on an option.  After looking at the image above with strike prices, he decides to place an order to buy a February 2011 1405 gold call.  He purchases the call option for $2500.  Knowing that an option is a depreciating asset, he closely monitors gold prices while he is in the position.  The trader is correct and the underlying gold contract increases to 1430 within two weeks.  The trader now thinks that the underlying gold contract is going to remain at its current level or decrease until his option expires.  The current value of his option is now $3700.  The trader knows that the intrinsic value is $2500 ((1430-1405) * 100).  He also knows that the time value on the option is $1200 (3700-2500).  Since he thinks that the underlying price will remain the same or decrease, he decides to offset the position to capture the additional time value in the option.  The trader ends up with a profit of $1200 (Premium of option when offset (3700) – premium when initially purchased (2500).

Options on futures don’t have to be the mountain that most make them out to be.  Simply learn the basics and increase your knowledge as you progress in your trading.  Before you know it, the mountain will become a molehill and you will have the knowledge to use options in your everyday futures trading.

Expand Your Futures Trading with Options on Futures

If you enjoyed this article and want to learn more about options on futures, please dowload our Options Trading Starter Kit.

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: Getting Started, Options, Strategies Tagged With: , ,
December 9, 2010 by 1 Comment

Forget What You Thought You Knew About Buying Futures Options

This is a revised version of an article that originally appeared in FutureSource’s Fast Break Newsletter on September 24, 2004.

Have you purchased an option position in the past, and had the market move in your favor, only to ultimately lose money on the trade?

Read this article and you might get some answers about why it happened…

Futures options are both widely used and often widely misunderstood.  Countless times I have heard stories from traders telling me how they bought a call, and the market rallied as they expected, yet they lost money.  This is not an unusual situation, as option prices are a function of more than just price.  Options are priced using the following:

  1. The underlying futures price
  2. The option’s strike price
  3. Current interest rates
  4. Implied volatility

While the first three items are self-explanatory, the last item, implied volatility, is a little more complicated.  For the sake of simplicity, I will offer a brief explanation of implied volatility

What is implied volatility?

Implied volatility is the option market’s best guess at how volatile the underlying futures contract will be during the remainder of the option life.  For example, we would reasonably expect implied volatility in corn to be greater in May, ahead of the critical pollination stage for corn, than we would in November, after the crop has been harvested.  Corn price volatility is usually more volatile in the spring and summer, as weather is a large unknown.  At the end of the season after the corn crop has been harvested, there is generally less uncertainty and therefore less price risk.  This is typically reflected by lower implied volatility in corn options in the fall.

A classic futures option buying example

Let us examine a classic example of how many traders buy options:

A trader reads a bullish article in a newspaper over the weekend regarding Orange Juice, and the potential for frost damage.  Orange Juice futures have already rallied to 80 cents, but could go much higher if a severe freeze were to damage the crop.  The trader suspects that if a freeze does not materialize, prices will likely sell off hard, and he does not wish to accept that risk.  Monday morning the trader pays 2.65 cents ($397.50) for a 90-cent call that has 90 days until expiration, and is 10 cents out of the money.  The implied volatility is relatively high at 40%, but the trader likes the security of knowing the most he can lose is the premium he paid plus fees.

Does this strategy appear sound? Have you perhaps purchased an option in a similar manner?

How you can be “right” and still “wrong”

Let us assume that there is a minor frost event that keeps prices from dropping, and at the end of ninety days orange juice futures have rallied 11 cents to 91 cents.  The trader was mostly correct in his analysis, because over the ninety-day period the futures have rallied 11 cents or 13.75%.  Unfortunately, our trader needed the market to be at 93 cents, or a 16.25% increase to break even.  The trader swears off options, or potentially worse yet, starts looking at only option selling strategies.

Too late, too far away, too much time

Let us dissect the trader’s actions and see what mistakes he made with this trade:

The first mistake was reading a newspaper article and simply buying a call the next business day.  If a major news event or story is in the newspaper, it is generally priced into the market.  At any given time, option prices will typically reflect any potential price risk that is anticipated for the underlying futures.  This is frequently made worse by the additional interest a news story or event brings to the market.  In our example, prices may have been higher for the options in part due to the frost concern news, and in part due to the demand for call options this news brought.

Do you ever know how far a market might move? Keep your strike prices close to the money.

The second mistake the trader made was to buy an option that was too far out of the money.  You will recall that he bought a 90 cent call when the underlying futures were at 80 cents – thus his chosen option strike was 12% out of the money.  In the world of Internet stocks, a 12.5% move is not unusual, but in the world of physical commodities that is a large move on a percentage basis.  Part of the reason that futures contracts offer leverage is that commodities typically do not make large moves in percentage terms very often.  The further away an option strike price is from the current futures price, the less likely it will trade in the money.  It is a simple fact of statistics that moves of greater variance are less likely.

Time may not be on your side…

The third and probably the most important mistake was the length of time remaining on the option.  I contend that an option with 90 days remaining until expiration has too much time value to potentially take advantage of a short-term expectation in the underlying futures contract.

A controversial claim?

The third item above is likely to raise many eyebrows as conventional wisdom suggests that short-dated options rapidly lose their time value and should be sold, not bought.  I argue that the trader would have been better off with a short-dated option for several reasons.

Start at the beginning – what is your core strategy?

By definition, an option is the right, but not the obligation, to buy or sell an underlying futures contract at a specific price within a specific time.  In my opinion, the greatest benefit to buying options is that if you are correct in your speculation, the option becomes a futures contract.  If you are wrong in your opinion of the market, your risk is limited to the premium you paid, plus execution fees.  With this approach, the strategy is to purchase an option that will very quickly behave like an outright futures contract, assuming your prediction of market direction is correct.

When most traders are in a winning trade, they wish they had more contracts on and when they have a loser they wonder why they entered the trade in the first place.  The proper use of short-dated options potentially allows the trader to have a larger futures position when they are right, and no futures position when they are wrong.

How and when can options “behave” like a future?  An explanation of “delta”

If we look at a long call option position, we see that an at-the-money call has a delta of 50.  This means that the option is expected to reflect 50% of any move in the underlying futures contract.  As the price of the underlying rises, the call option will reflect more of the futures price movement.  This will happen until the Delta is 100.  At that point, the call option is essentially equivalent to one contract of the underlying futures contract and its price should move in tandem with the futures.  The potential disadvantage for longer-term options in this regard is that longer time value slows the speed at which Delta changes.  In contrast, short-term options are quicker to behave like a futures contract because their Delta increases more rapidly when the market moves in their favor.

Short-term futures option example

The Analysis – more than just a newspaper story:

We will look at a new example using the 30-year Treasury Bond contract at the Chicago Board of Trade.  On September 13, 2004, our trader feels that bonds are heading higher.  He feels the Iraq war, along with higher oil prices, will keep interest rates low ahead of the election.  He anticipates that the market place will be disappointed by the retail sales on the 14th as the Southeastern US has been hit by hurricanes.  Our trader knows that the FOMC meeting is scheduled for September 21, 2004 and thinks the Federal Reserve action will be negative for long-term rates.

30-Year Treasury Bond Futures Chart

30-year Treasury Bond Futures Chart by FutureSource

The options vs.  futures decision

The morning of the 13th, our trader looks at three ways to potentially take advantage of his bullish market outlook.  The December bonds in the electronic market overnight trade are at 111-01, down 2 ticks from Friday’s close.  The December 111 call option which expires November 26, 2004, settled at 1-57/64 ($1890.625) on Friday and the October 111 call option which expires September 24,2004, settled at 44/64 ($687.50).  The trader thinks the bonds could rally 3 full points or $3000 per contract in the next two weeks.  If he is wrong, he feels the futures could easily lose 1 1/2 -2 full points or $1500-$2000 – a risk he is not willing to take on an outright futures trade.  Because of this, he decides that a long call option strategy will best meet his risk parameters and potential profit objectives. 

Which option strategy would you choose?

This is where things get interesting, as our trader has a couple of choices using call options.  Conventional wisdom would say to buy the option that has more time until expiration because it will decay at a slower rate if he is incorrect with market prediction.  In theory this is true, and if bond prices were to remain constant, the December option will lose a smaller percentage of its value daily.  Conversely, the October option will lose a larger percentage of its time premium every day, as there are only 2 weeks until option expiration (zero time value).

Theoretical Profit and Loss Graph

But remember: You want the option to potentially behave like a future…

At first, the fact that the October call will lose its entire time premium in 2 weeks seems like a negative characteristic.  But remember, for the option to behave like the underlying futures contract, it needs to have very little time premium remaining.  If he buys the December option, he will need to see almost 2 full points of time premium erode before the option behaves like a future.  In this example, suppose the bond market acts extremely well and rallies 5 points to 116-00 in the two weeks.  The October option will be worth its intrinsic value (amount it is in-the-money), or 5 points ($5000).  Our trader would have captured 4 10/32 ($4312.50) of the move with the October call.  On the other hand, the December option will likely be worth about 5 16/64 ($5250).  The option will have gained approximately 3 12/32 ($3375) of the 5-point move.  In this hypothetical example, the return on the October option was almost 1 full point, or $937.50 better than the December option.

Theoretical Profit and Loss Graph 2

Less time value = less risk when you’re wrong

The short-dated option worked better in the winning scenario, but what about when the trader is wrong? In simple terms, the October call cost about $1200 less than the December call, therefore the dollar risk is lower.  If the market went sideways over the 2 weeks and the futures settled at 111-00, the December options would outperform the October by about 20/64-24/64 or $312.50-$375.00.  If the market sold off during that time period the difference between the values would narrow.  In a worst case scenario where the bond market went only lower and both options expired worthless, clearly the October option would have provided a smaller loss.

Summary

It is important to note that although the examples provided in this article involved purchasing calls, all of the core principles discussed apply to purchasing puts for markets poised for a potential move to the downside

This article has sought to provide traders with a new perspective and method on how to buy options to trade specifically timed or news-based events.  I contend that short-time frame options potentially offer the best of both worlds.  With these methods, a trader may achieve their goal of owning an option strategy that acts like a futures position when they are correct, while maintaining the attractive option feature of having risk limited to the premium and fees paid to purchase the option position.

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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, Strategies Tagged With: , , ,
December 8, 2010 by Leave a Comment

Reducing Portfolio Exposure to the US Dollar

This post is part of Craig Turner’s Innovative Trading Concepts series and originally appeared in FutureSource’s Fast Break Newsletter, where Craig Turner is a regular contributor on various futures trading topics.

Many investors and traders have too much exposure to the US Dollar.  Owning stocks, bonds, real estate and commodities priced in USD creates massive exposure to the US Dollar.  When markets crash, most asset classes are sold heavily and the US Dollar increases, in what is referred to as a “flight to safety” market reaction.  The problem for most investors is that they conduct all of their investments or trades in US Dollars, so when the Dollar goes up, the rest of the market is going down.  When the market crashes and you need diversification the most, most assets are sold and capital flees to the US Dollar.

Risk Management & Undiversifiable Risk

Any investor or trader, who has spent some time reading about risk management, has come across the terms “systemic risk”, “systematic risk” and “undiversifiable risk.”  These concepts are built around the fact you are always long assets, and you are long in exchange for US Dollars.  Furthermore, because your portfolio is always made up of “long only” positions, you are always subject to market collapses.

Your exposure to market risk does not have to be so extreme.  You do have options, and it is easier than you think to reduce your “undiversified risk” in your portfolio.  One way to reduce this risk is to hedge out some of your exposure to the US Dollar.  This will not hedge out all of your undiversifiable risk, but it will help should the market crash.  If you want to reduce your exposure to the US Dollar, then you need to buy the US Dollar Index futures contract.

Reducing Undiversifiable Risk through the US Dollar Index

The US Dollar Index is a futures contract that prices the US Dollar against a basket of foreign currencies.  This basket of currencies is made up of the 57.6% Euro Currency (EUR), 13.6% Japanese Yen (JPY), 11.9% Great British Pound (GBP), 9.1% Canadian Dollar (CAD), 4.2% Swedish Krona (SEK) and 3.6% Swiss Franc (CHF).

If you are long the US Dollar Index, you are long the US Dollar and short the Euro, Yen, Pound, Canadian, Swiss Franc and Krona.  If you are short the US Dollar Index you are short the US Dollar and long the basket of foreign currencies.

If your portfolio is made up of entirely long positions, bought in US Dollars, you can reduce your exposure to the USD through buying the US Dollar Index.  The long position of USD in the US Dollar Index will cancel out with some of the short USD exposure in the long only portfolio, leaving those positions long in terms of the basket of foreign currencies.

Example: Long Gold

Let’s say you are long 100 oz gold at $1400/oz in the futures market.  You are long $140,000 of gold priced in USD.  This can also be viewed as gold vs.  USD cross, or Gold/USD.  In order to buy gold, you had to use US Dollars, so you are long gold and short dollars, which can be represented as long the Gold/USD cross.

Now let’s say you don’t just want to hold Gold in USD.  You want to hold Gold in a mix of USD and foreign currencies.  Your long Gold position is a Gold/USD cross.  To hedge out the USD, you need to be in a position that is long USD and short something else.  If you sold the EUR/USD cross, you would be short Euro and long USD.  That would look like a long USD/EUR position.  If you combined USD/EUR + the existing Gold/USD, the long and short USD would cancel each other out and you would be left with just GOLD/EUR, or long Gold in terms of Euro.

GOLD/USD + USD/EUR = GOLD/EUR

Now that we have that concept down, apply it to being long Gold (Gold/USD) and long the US dollar Index (USD/(EUR+GBP+JPY+CAD+CHF+SEK)).  Long the US Dollar index at 80.000 is an $80,000 total contract value.  Lets combine our long Gold and long US Dollar Index position and see exactly what it turns into:

  1. Long 100 oz Gold at $1400/oz = $140,000 GOLD/USD
  2. Long 1 US Dollar Index at 80.000 = $80,000 USD/(EUR+GBP+JPY+CAD+CHF+SEK)

The second position is long $80,000 US Dollar Index.  That $80,000 long US Dollar in the second position will cancel out $80,000 of the $140,000 short USD from the first position.  That leaves us long only $60,000 Gold/USD and the other 80,000 is now long Gold/(EUR+GBP+JPY+CAD+CHF+SEK).

  1. Long $60,000 Gold/USD
  2. Long equivalent of $80,000 Gold in terms of EUR, GBP, JPY, CAD, CHF and SEK.

I am now long gold in a basket of currencies.  You can apply this method to any asset.  The US Dollar Index’s total contract value is a multiple of $1000 against the Index.  So if you want to hedge out $800,000 of USD exposure in your overall portfolio, all you need to do is buy 8 US Dollar Index contracts at 80.000.  80.000 X $1000 = $80,000 total contract value.  $80,000 X 10 contracts = $800,000.

This example not only works with an investment in gold, but it can be any other futures contract, stocks, bonds, etc.  All you are trying to do is reduce the net exposure you have to the US Dollar.  If you think about it, if your total financial portfolio is made up of things you have bought (stocks, bonds, real estate, etc) with USD, you have one massive synthetic short US Dollar position (Portfolio/USD).  That is why when the markets crash, your entire portfolio goes down.  Everything is sold while the US Dollar is bid up.

Why Investors and Traders Need to Hedge their US Dollar Exposure

You never know when the next financial crisis will occur.  You never know when we have the next flash crash or when the next European nation will default on its debt.  By reducing your exposure to US Dollar, traders and investors can reduce their “undiversifiable risk.”

While the US Dollar Index can hedge out $80,000 of USD risk when priced at 80.000, the required margin for the US Dollar Index is only $1729 per contract.  For a few thousand in margin a trader or investor can efficiently and effectively hedge out some of their currency risk to the US Dollar.

Some investors and traders I work with ask me why not just use put options for protection.  The problem with put options is they are a wasting asset.  The time decay on the puts makes it expensive to hedge against the unknown.  Futures are not a wasting asset.  If the US Dollar is trading at 80.000 noah, well w, and it trading at 80.000 three months from now, the P&L is $0.  Anyone who ever bought an option, had the price of the underlying go unchanged for a few months, certainly knows that their option will be worth considerable less because of the time decay.

Take Action and Protect Your Portfolio

If you are concerned about your exposure to the US Dollar and US assets, you need to talk to your futures broker and figure out the best way to hedge some of your exposure to the US Dollar.  If you don’t have access to an industry professional who understands hedging portfolio risk, give us a call at Daniels Trading and we will be more than happy to help you reduce your “undiversifiable” portfolio risk.

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Filed Under: Currencies, Current Events, Market Analysis Tagged With: , , , , , , , , ,
December 7, 2010 by Leave a Comment

Developing a Commodity Futures Trading Strategy and System

This is a revised version of an article that originally appeared in FutureSource’s Fast Break Newsletter on April 08, 2005.

The futures markets are exciting and attractive to many individuals.  However, potential traders are faced with the daunting task of determining how they should make their trading decisions.  Potential traders need to develop a trading method that fits their personality, risk tolerance, time horizon and time commitment objectives.  We will discuss several trading styles and methods that will help the trader develop a method that best suits his or her needs.

Time Frame

Time frame may be the most significant aspect to consider when determining your trading method.  Someone who is a big picture person and looks at markets in macro terms would not be suited to day trading.  A long-term trend following system would be a method a macro-type trade would consider.  To trade with a long-term perspective is not suited for everyone.  It requires a great deal of patience and perseverance to hold a position for an extended period.  If a market trends higher over a 20-day period, it would be extremely rare that it would move higher everyday without closing lower on any given day.  It is very difficult for a person without a great deal of patience to sit through a few days or even a week of lower closes.  In a trade the eventual moves higher in the macro view, you may end up sitting through days if not weeks of a losing position.  For this reason, the long term, macro approach is usually employed by large funds and institutions.

Many futures traders like to exit all their positions by the end of the day.  These traders are more comfortable trading in terms of minutes and hours as opposed to days and weeks.  A day trading strategy has many appealing features, such as lower capital requirements and no overnight market risk.  The biggest draw back to day trading is the time requirement.  A day trader must be in front of a computer as long as they are involved in a trade.  It is the time requirement that makes day trading an unrealistic option for many potential traders.

Futures traders looking for something between day trading and long term trading usually fit into what is often referred to as swing trading.  The traditional view of swing trading is quick 1-5 day trade taking advantage of a shorter-term move.  This medium term time frame is popular as most traders place all their orders before the market opens and do not have to monitor their positions all day.

Risk

Risk usually correlates well with reward – usually, the bigger the risk, the bigger the potential reward.  Day traders normally risk less on an individual trade and are looking for a smaller profit.  They often will make many lower risk trades in search of numerous small rewards.  Long-term traders are willing to risk more per trade in search of the larger profit that a big market move can bring.

A fine example of this would be the crude oil market.  Crude oil is in the news everyday as we see a market that has moved above $65 per barrel.  A long-term macro trader may have bought crude oil futures a few months back at $45.  The crude market went from $45 to $60, and back under $50 before eventually rallying to new all-time highs of $66.  Many macro trades have had $70 crude in mind since this move started.  A trader unwilling or unable to withstand $5,000 per contract swings in equity would not have been able to hold on to their position.

Developing a Commodity Futures Trading Strategy - Crude Oil Futures Market

Click to View Larger Chart

In contrast to the above example, a day trader buying an e-mini S&P contract places a 3-point stop looking for a 5-point move higher.  The trader is right and as the trade moves higher he quickly tightens his stop order.  This trader is intending to initially risk $150 to make a $250 profit all before the close of the trading day.  Unlike the macro trader, a day trader is not looking for a longer term 50 or 100-point move in the index over a 1- 6-month period.

Personality

The trader is the only one who can truly determine what best fits his or her personality.  A person who does not have the time or the desire to sit in front a computer will not do well as a day trader.  A person who is not comfortable with taking large financial risks looking for even larger rewards would not do well as a long-term trader.

Personally, I do not have the disposition to sit with long-term futures positions, especially when they are going the wrong way.  Part of the problem may be the fact that I sit in front of a quote screen all day.  Sitting in front of a quote screen watching the markets tick-by-tick makes it difficult to see the forest through the trees.  For that reason, I am personally suited to either day or swing trade.  Day trading does not allow me to attend to any other business during market hours so it is not a practical alternative.  With a shorter term, swing trading, type system, I can place my orders in the morning determine my entry and exit points after the close and have market hours free.

Developing a Futures Trading Strategy

In looking for a futures trading methodology, write down the time frame preference as well as market beliefs you hold.  For example: a trend following method, with a swing trading time frame, that uses shorter-term breakouts as an entry.  A trader may look at a reversal system that uses a combination of bollinger bands and key reversals for entry setups.  There is no one method that suits all traders.  For any method to work, a trader has to stick with it.  A method that does not fit the trader’s personality will be difficult to follow.

A Theoretical Futures Trading System

Trader A is a busy professional who is comfortable with trades lasting anywhere from several days to several weeks.  He is very comfortable staying in a trade longer if it is making money, but does not like to stick around in losing trades.  The trader likes to trade in the direction of the trend and likes to use breakouts for entry points.

Trader A’s system uses the following parameters:

  • 21 day moving average
  • 5 day new high or low to determine entry
  • The system will enter a long trade if the market makes a new five bar high above the above the 21 day moving average and has traded above the average at least one of the past five days.
  • The trader will exit the position on a new five bar low.  If the new five bar low is below the 21-day moving average and the market has traded below that average at one of the last five days, reverse the position.

Developing a Commodity Futures Trading Strategy - Buying Strength and Selling Weakness

Click to View Larger Chart

The above example would be a basic futures trading strategy that the trader could back test on numerous markets to determine how it would have performed in the past.  If the basic ideas behind the method are sound, it is possible that the strategy will work in the future.  The ideas of buying strength and selling weakness have been around the markets for a long time.  Trading the long side above a moving average and trading from the short side below a moving average are also well-established trading ideas.

The trader would also need to select markets to follow with this system.  The trader would need to determine the amount of risk capital they have available and work backwards.  Unless a trader can afford to trade a basket of 30-plus contracts, they should look to select non-correlated markets with quantities determined by margin.  For example a system that traded 1 contract of oats and 1 contract of crude oil would be far heavier weighted in the crude oil.  To balance this, the trader would trade a quantity of oats that matched the margin for the single oil contract.  As a rule of thumb, this works well for balancing a portfolio of futures.  The margin requirement is determined by the volatility of the contract.

The above system has not been back tested and I would not recommend anyone trade it without first doing so.  Intuitively, this system is probably a good start for developing a methodology.  The basics behind the system make sense although the time frames may need to be adjusted.

Developing a futures trading strategy can be a very rewarding endeavor as it forces you to think about your personality as well as your market beliefs.  Developing a futures trading methodology will force you to have a reason for trading and makes it difficult to justify trades made on gut instinct and feel.

Filed Under: Getting Started, Strategies Tagged With: , , , , ,
December 3, 2010 by 1 Comment

Why Hedge with Gold in 2011?

Gold coinage goes back to 640 BC or earlier.  The metal has retained its value since, climbing to extreme highs.  The market has accepted the price levels of gold without waiting for any significant dips.  We have buying support from countries such as China and India.  Fund Managers have added Gold to their trading portfolios.  We often look to Gold in cases of national debt, currency failure, inflation, war or any conflict.

We have seen the US Dollar climb over the last month almost to the 50% retracement zone of $82.17.  We were at $89.00 in June and we saw $75.235 on November 3rd.  We have gone through the Fed’s added stimulus, the G20 with criticism regarding the weaker dollar and our latest relationship issues with China.  It is my opinion that due to the shelling of South Korea by North Korea, we now look to China to influence North Korea in the hopes that the recent aggression should not continue.  With this in mind, China would like to see a stronger US Dollar giving them the trade advantage of higher exports for China as their goods become more appealing.  The usual relationship between the Gold and the US Dollar is inverse, however; the US Dollar may consolidate at that potential retracement zone.  The safe-haven vehicles typically are the US Dollar, US T-Bonds and the Gold Market.  We have seen the allocations shifting from Gold to the US Dollar and T-Bonds.  The Euro Zone has also been a major factor in pushing up the US Dollar in that their debt woes and potential debt woes moreover give the market uncertainty and fear.  First Greece, now Ireland and in the potential future, we may see Portugal and Spain or more countries.  The unknown is always more fearful than the known.  Traders may seek a currency that is not influenced by the health or wealth of a country and that is resilient through the ages.  Globally, the price of gold has held its value.

CRB – Gold Chart

CRB - Gold Chart

Click to View Larger Gold Chart

Courtesy of CRB Charts.

While in our historical chart above, we see the price of Gold rise higher, we also see the dips that show our Gold still subject to market risk.  Each product has market risk which needs to be analyzed prior to any strategy that one may want to employ.  One should not look to Gold as the only product for their portfolio, but as an enhancement to market fluctuations within their current portfolio.  Diversification is typically key in surviving the varied market conditions that dictate our market price action.

If one was long the E-Mini S&P 500 or a stock indices or perhaps a portfolio, they would succumb to some recent dips.

Daily Chart

Daily Chart

Click to View Chart

The Gold Market may succumb to market risk in the same manner or it may diverge from the price action of another market.  One must be cautious to not overextend in the market.  As often when investors may hold their stock portfolios and receive margin calls to hold their accounts in check, they may liquidate the gold within their portfolios to accommodate the calls.  This defeats the purpose of diversifying ones portfolios.  The importance of marginable positions to cash cushion should be 1/3rd to 2/3rds.  One third in positions to two thirds cash available in the account to hold the potential positions within the account.  There have been many studies in Managed Accounts and the diversification within them, it typically shows the benefits of Stocks, Bonds and Gold to create a smooth equity curve.  The large investor, Fund Managers and countries typically may include Gold in their collection of assets.

The small investor that may have some hand-picked stocks and mixed investments may still want to incorporate Gold.  Often times the knowledge or lack of may prevent investors from selecting products that may potentially add to the net results.

Daily Chart

Daily Chart

Click to View Chart

Investors may partake in the Gold moves by a variety of methods: ETF’s (China recently approved the Countries first Gold mutual fund – The Lion Fund Management Co.), Bullion (local coin shops and other physical metal establishments, XAU, Gold Mining Stocks to mention a few.  The purest form of speculation in the gold market in my estimation is the futures market.  To control a 100 troy ounce bar of Gold, one may put up a margin deposit in line with the exchange guidelines for that product.  It is important to be sure that your excess venture capital can sustain a move within the market and place stops according to your risk tolerance.  One may trail the stop, if the position moves in your favor.

Sample of a futures trade:
Buy 1 GCJ11 at $1370.00, if filled Sell 1 GCJ11 at $1357.00 STOP.  (This would give you a $1300.00 risk and unlimited profit potential less commission and fees).

For those with fear of unlimited risk, one may purchase an option.  The option (call or put) gives you the right to a long or short position at your strike price if the market goes through it.  The option may be sold for a higher or lower premium anytime after you purchase it.  You do not have to risk the entire premium if the market goes against you.  You may exit anytime prior to expiration.  If the trade is working, you may exit the trade for a higher premium and a profit less commissions and fees of course.  The option is a wasting asset and will be subject to decline in value as time increases.

Sample of an options trade:
Buy 1 GCJ11 1550 Call option at a premium of 20.00.  The risk would be $2000.00 less commission and fees.  The profit potential would be unlimited less commission and fees.  The option would not need to trade through 1550 to potentially become profitable.  It simply needs the market to go up and inflate the premium before the time value deteriorates the premium of the option.

We just brushed over a glimpse of “Why Hedge with Gold?” to give you a brief overview on a potential addition of gold into your portfolio.  It is suggested that you work with your broker to be sure that the trade is within your risk tolerance parameters at all times.

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Filed Under: Market Analysis, Metals Tagged With: , , , , , ,
December 2, 2010 by 1 Comment

Trading Psychology: How to Build a Solid Foundation

The story of two home owners…

Joe and Bob have just purchased two beautiful beach front properties on the Gulf coast.  Both are very excited about this opportunity and begin building their homes right away.  As a few weeks pass, Joe’s home is almost finished, while Bob is still laying the foundation.  Joe has built his dream home in the matter of weeks, and Bob is still building and reinforcing his foundation.  Finally, after months of patience and hard work, Bob’s home is finished.

Later that year, a devastating storm comes crashing through their town.  The storm completely wipes out Joe’s home, while Bob’s home hasn’t budged.  Bob’s home is standing strong with minimal damage.

Joe built his home very quickly.  His only focus was to finish building his home, and he never considered the risk of building in this manner.  Yes, he was able to live in and enjoy his home for several months, while Bob had just began laying his foundation; however, as soon as the first storm came passing through, all of Joe’s work was washed away.  He was only concerned with the end result, and in the end, had nothing to show for it.

Bob had a much different approach.  His number one objective was to build a home with a strong foundation, knowing his home would have to weather a storm from time to time.  In the end, he experienced minimal damage.

A trader’s psychology is his foundation.

The same is true with commodity futures trading.  Markets are constantly changing.  As a trader, you need a strong foundation to weather the storm.  Over the last few years, as traders, we have had to weather a devastating storm.  We have endured crisis in our banking system, a housing bubble collapse, government bailouts, the flash crash, and overall weakness in economies around the globe.  There is no question markets have been challenging, but it is the foundation of your trading plan that will always keep you on your feet.

In my opinion, the foundation of every trader’s plan lies between their ears.  No matter if you are a day trader, an options trader, or long term position trader, your foundation revolves around your disciplined trading psychology.  How else can two traders following the exact same trading system receive completely different results? A trader’s psychology is his foundation.

In my opinion, a healthy trading psychology is:

  1. Being comfortable with the capital at risk
  2. Being confident in the strategy in place
  3. Remaining optimistic about future opportunities.

This is the foundation for your trading.

Be comfortable with the capital you’re putting at risk.

Nobody wants to lose money.  We wouldn’t invest if we thought we were going to lose our money, but we have to accept the fact that it’s possible.  You will never be a successful trader if you are not willing to accept this fact.  If you aren’t comfortable with the capital you have at risk, your emotions are going to takeover and make it impossible to stay disciplined with your trading approach.  Like the story of the two home owners, Bob wasn’t in a rush to reach his end goal.  He understood there was risk building a home on the gulf coast, but he felt the end result would be worth the risk.  The same is true for traders.  We need to accept the risk/reward parallel.

Be confident in your trading strategy.

It doesn’t matter if you are a technical trader or a fundamental trader; you need to have confidence in your plan.  You need to know why you are taking the trade, what you are willing to risk on this trade, and what your profit target is.  Without these parameters, fear and greed can easily take over.

This is why your trading strategy has to draw a distinct line in the sand beginning with the reason behind the trade.  If you don’t know why you are entering a trade, DON’T.  You must have a reason or idea behind every trade.  Once this reason is established, you need to set profit and risk parameters prior to entering the trade.  If the market moves to X, I will take my loss and move on to the next trade.  If the market moves in my direction to Y, I will take profit.  Without these distinct parameters, you are at the mercy of your emotions.

You need to “plan your trade, and trade your plan.”  Stay disciplined and do not deviate from this plan.  You are going to have winners, you are going to have losers, but this discipline is the concrete that holds your foundation together.

Remain optimistic.

I think there is a lot to be said about a positive attitude.  Do you feel trading becomes easier when you string together a few big trades? And does it become more difficult when you’re in a rut? I think a major factor of this is remaining optimistic.  When you’ve taken a few losing trades, you begin second guessing yourself.  You see an opportunity, but hesitate and miss the trade because you doubt yourself.  The next thing you know, that trade is a winner and you begin forcing trades to make up for the one that got away.

You need to stay positive.  You need to remain optimistic.

When you string together a few big winners, you have confidence in your strategy.  You see a set up and you take it.  You trust your plan.  You have to keep the same mind set when you are in a rut.  You understand not every trade will be winner.  It might take you longer than you think to reach you goal, but you need to focus on your foundation.  Just like Bob did not get frustrated and lose his patience as he saw Joe enjoying his home, you shouldn’t get frustrated with delayed results.  Focus on your foundation and the rest will fall into place.  You will be able to weather the storm so you can enjoy brighter days.

Accept your risk/reward parameters, understand that you are only risking this capital because you have confidence in your trading plan, and stay optimistic.  Every trade provides a new opportunity.  Be disciplined and trust that this foundation will allow you to accomplish your commodity futures trading goals.

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