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February 28, 2011 by Leave a Comment

Hedging with Commodity Futures:  It’s All About Managing Price Risk!

This post originally appeared in FutureSource’s Fast Break Newsletter on February 25, 2011, where Drew Wilkins is a regular contributor on various futures trading topics.

The goal of hedging is to transfer price risk from one party to another.  Hedging has been used for hundreds of years to help producers and buyers protect themselves from price risk.  By hedging, producers and users can set the prices they will receive or pay within a roughly determinable range.  However, hedging is still an underutilized tool that many choose not to use.  This article will help you to understand the benefits of using the futures markets to reduce price risk.

Why should I hedge?

That is the question you will have to ask yourself when trying to figure out the benefits of hedging.  Would you like to protect your crops against a decline in value?  As a buyer, do you want to insulate yourself from a significant rise in prices?  The futures markets can be used to hedge the risk in both of these situations.

Cash – Futures = Basis!

This is a very important formula to remember.  Basis is the difference between the cash price and the futures price of a commodity.  Basis consists of carrying charges and costs of transportation for the commodity to an exchange approved delivery point.  For example, if the cash corn market is at $6.93 and the futures price is $7.00, the basis would be -.07 (6.93-7.00).  As the delivery month draws near and the prices converge, basis approaches zero.

Long Hedges vs.  Short Hedges

There are two types of hedges, long hedges and short hedges.  Someone who is buying the commodity later in the cash market would be a long hedger.  Someone who is selling the commodity later in the cash market would be a short hedger.  A long hedger is someone who wants to protect themselves from price increases (user).  A short hedger is someone who wants to protect themselves against declining prices (producer).  A long hedge is also known as being “short the basis” and a short hedge is known as being “long the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative.  A hedger who is long the basis (short hedger) benefits from the basis becoming more positive.  In the corn example above, a long hedger would want the basis to get more negative.  A short hedger would want the basis to get more positive.

To sum it up, a long hedger wants to protect against increasing prices and benefits when basis weakens.  A short hedger wants to protect against decreasing prices and benefits when basis strengthens.

Real-World Example

A farmer who has been on the fence about hedging decides to hedge his corn crop.  He thinks that prices will remain around the current level or decrease in late August when he anticipates selling his new crop.  The cash price for new crop corn is $5.52 and the September futures price is $6.28.  The farmer anticipates that he will have 10,000 bushels of corn to sell.  Since the farmer wants to protect himself against a decrease in prices, he will be a short hedger.  His goal is to lock in the price of $5.52/bu for corn.  Each corn futures contract contains 5,000 bushels.  The farmer sells two September 2011 corn futures contracts at $6.28 on 2/23/11.

It is now September and the farmer’s instincts held true.  Cash corn prices are currently at $5.00 and September futures are trading at $5.25.  The farmer sells his grain in the cash market and offsets his position in the futures market on 8/28/11.

Change in Basis

Date Cash Futures Basis
02/28/2011 5.52 6.28 -.76
08/28/2011 5.00 5.25 -.25
= -.52 = +1.03 = .51

The farmer lost -.52 on the cash side, but his short futures position had a gain of 1.03.  The net result of the hedge is a gain of 51 cents per bushel.

0.51/bu (Gain in dollars/bu)
X 5000 bu/contract
$ 2550/contract
X 2 contracts
$5,100 gain in dollars

The net price received for the corn is calculated by adding the change in futures to the cash price at which the grain was sold.

Cash Price Received:    $5.00/bu
Gain on Futures:    +1.03/bu
   $6.03/bu

-OR-

Target Price:    $5.52/bu
Adjusted by net result:    +0.51/bu
   $6.03/bu

The farmer had a goal of getting $5.52/bu of corn when he placed the hedge.  The result of basis strengthening allowed him to actually achieve a price of $6.03/bu.

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have increased and the farmer would have lost money in futures and gained money on cash grain.  If that was the case, a user could have benefited by placing a long hedge!  Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range.  Reducing exposure to market surprises allows producers and users to plan their operations more confidently.

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Filed Under: Hedging, Risk, Strategies Tagged With: , , , , , ,
February 18, 2011 by 2 Comments

Commodity Futures Trading: All Trades are Spread Trades

This post originally appeared in FutureSource’s Fast Break Newsletter on February 15, 2011, where Craig Turner is a regular contributor on various futures trading topics.

Every position you’ve had in the past, currently hold, or hold in the future can be viewed as a spread trade.  You might be saying to yourself, “I only trade the Gold, Crude Oil or Equities, I don’t trade spreads or get involved in pairs trades.”  Au contraire, mon frere, I beg to differ.  For example, when you buy crude oil, you are long a crude oil futures contract but you are giving up something in return.  You are giving up USD to be long 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”.  You can apply this concept to any market you are long, whether it be stocks, real estate, or commodities.

Is this important?  Am I just being a smarty-pants, know-it-all broker?  Perhaps, but consider this.  Wouldn’t you want to know how much exposure your portfolio has to currency and systemic risk?  Wouldn’t you want to hedge that risk the best you can?  If this is important to you, then you need to understand the synthetic positions your current portfolio already holds.  Understanding your risk to currency and systemic risk will allow you to hedge against the next great-unknown event that causes the markets to crash.

Now that I have your attention, let’s go back to our crude oil example.  If you are long crude oil futures, what happens if the USD has a 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 declines and goes against you.

This is the same for any asset or market in which you have a long position.  Whether the position is in stocks, gold, real estate, or commodities, chances are you own these assets in terms of US Dollars.  The opposite is true when you are on the short side.  For example, let’s say you are short Gold.  When you short Gold you are now receiving USD in return for selling Gold.  You can view this as long USD and short Gold, also known as USD/GOLD.  Your synthetic long USD/short Gold (USD/GOLD) position will tend to lose money if the USD declines and make money if the USD increases in value.

All Investments Have Currency Risk

Understanding how much risk you have in your portfolio due to currency risk is the first step in hedging against systemic risk and the next big crash.  Let’s say your portfolio is long individual stocks and equity indexes.  If you are only just long the equity market, you also have one additional giant short USD position.  If you are long 10 stocks, the S&P 500 index, the Russell 2000 and the NASDAQ, you probably also own all of those in US Dollars.  You can look at that entire position as long equities and short the US Dollar.  Sounds like a spread trade to me.

This is not just true for equity portfolios, but for futures traders too.  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.  For every short futures position you have, you also have a synthetic long US Dollar position.

The US Dollar Represents the US Economy

Why does all this matter?  Who cares if all of your positions are held in US Dollars?  If that is what is going through your mind right now, then you need to consider the following.  What does the US Dollar represent?  The US Dollar represents the US Economy as a whole.  The value of the US Dollar is relative to other foreign currencies based on the strength of their economies, GDP, interest rates, employment and many other macro economic factors.  If the US Dollar represents the US Economy, then it must also represent systemic risk.  The state of the US Economy can have a major effect on the markets.  We only have to go back a few years when we were in the Sub-Prime crisis and Lehman Brothers failed to prove that point.  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.

For example, 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.

The same situation can happen to a portfolio that is made up of entirely individual stocks, equity ETFs and stock indices.  You may think you have a diversified portfolio, with equal weights to many different equity sectors.  However, if you are just long equities, you have a massive short USD position in your portfolio.  Think back to when the market thought Greece was going to have to default on its debt.  Did the US Dollar rally?  Yes, it did.  Did your stock portfolio lose value?  Yes, it did.  Luckily, Greece was bailed out and the market eventually made up the losses and traded higher.  However, what would happen if it was a major economy that failed?  What if it was an economy that could not be bailed out as easily as Greece (which in economic terms has an economy smaller in size than Massachusetts)?  What would happen then?  A repeat of what happened to the stock market in 2008 is not out of the question.

Hedging Systemic Risk by Hedging the US Dollar

How do traders hedge out the USD and protect against systemic risk?  The answer is simpler than you may have expected.  If you are long a market (and short USD) then you need to be short another market (and long USD).  The short USD and long USD positions will cancel each other out.

Let’s go back to our long Crude Oil example.  We are long Crude Oil, so then we must be short USD.  We are in a “Crude/USD” spread.  Now let’s say we are bearish Gold and we short that market.  We are short Gold, so then we must be long USD.  We are in a “USD/Gold” spread.

Let’s now assume those are the only two positions in our portfolio.  We are long Crude Oil and short Gold.  Take a look when we combine the two individual positions in our portfolio:

1) Long Crude, Short USD = CRUDE/USD
2) Short Gold, Long USD = USD/GOLD

CRUDE/USD + USD/GOLD = CRUDE/GOLD

We have hedged out the USD.  We now own Crude in terms of Gold.  What is important here is not the specific fact that we own Crude in terms of Gold and not USD.  The important thing to take away is the concept.  You can apply this trading technique to any market in order to hedge your currency risk, US Dollar risk, and ultimately your systemic failure risk in the markets.

When the markets crash, the US Dollar becomes a “flight to safety” asset, making most, if not all, assets priced in USD decline.  When the markets crashed in 2008 both Crude Oil and Gold declined to annual lows.  A portfolio just long crude oil would have taken a severe loss.  However, the portfolio that hedged out its currency risk would have been ride out the storm as its short positions were able to make up for the losses in the long positions.

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 will be better protected against systemic risk.  The short futures positions help diversify the systemic risk built up in the long positions.  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.

To learn more about Hedging Systematic Risk, please see our previous article solely dedicated to this very important subject.

Spread Trading

Traders who are aware of currency and systemic risk will actively look for alternative strategies to reduce this risk.  Many of them turn to spread trading, also known as pairs trading.  There are typically two types of spread trading, seasonal and non-seasonal.

Seasonal futures spread trading is when traders spread two related contracts based on seasonal supply and demand.  Many markets have seasonal cycles and traders will try to take advantage of those moves.  These seasonal patterns within the same market like being long old crop Corn and short the new crop.  Seasonal patterns also exist between different but related markets like Live Cattle and Lean Hogs.  The markets and months will change during the year, but one thing is the same, the traders are using historical seasonal patterns to enter and exit their positions.  If you would like to know more about this exciting way to trading the market, please see our Seasonal Futures Spread Trading article.

The second type of spread trading is what I call non-seasonal, which is just about every other kind of spread trading.  Some traders like to trade the Emini NASDAQ against the Emini S&P.  Some will trade Corn vs.  Wheat based on either fundamental or technical analysis, but not necessarily historical seasonal performance.  Others may just want to reduce their risk by getting either long or short the front month, and then do the opposite in the deferred months to hedge their systemic risk.  If you would like to know more about his kind of trading, please see our Wonderful World of Futures Spread Trading article.

All Positions are Spread Trades

Investors and traders need to get used to thinking of all of their futures positions as Spread Trades.  By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to.  If you think you could benefit from a publication that addresses the markets with these concepts in mind, then I highly recommend you register for a complimentary subscription to my weekly Turner’s Take newsletter.  With the knowledge and understanding of how currency and systemic risk can effect your investments and trading, you will be prepared for the next time we are in a financial crisis.

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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.

Filed Under: Spreads, Strategies Tagged With: , , , , , ,
February 17, 2011 by Leave a Comment

The Wonderful World of Futures Spread Trading

This post originally appeared in FutureSource’s Fast Break Newsletter on June 23, 2010, where Craig Turner is a regular contributor on various futures trading topics.

Why We Trade Futures Spreads

When it comes to Futures Spreads, many traders ask us what is the benefit of spreading futures contracts.  They want to know why we often choose to spread futures contracts instead of either being long or short a single futures contract or option, or use option spreads instead.  In our experience, futures spreads, also known as pairs trading, offers the leverage of futures contracts, helps hedge systemic risk, eliminates stops, and we get this reduced risk without having to pay up for time premium as options traders do.  When you factor in opportunity available, risk management, cost effectiveness and margin efficiency, Futures Spread Trading can be a far superior strategy over flat priced futures trading, options and option spreads.

Futures Spreads Defined

Futures Spread Trading is a strategy of simultaneously buying a particular contract and selling a related contract against it.  This strategy is also called pairs trading.  In pairs trading, one market within a sector is bought and a separate market in the same sector is simultaneously sold short.  This provides an investor with exposure to the relative performance of the two commodities with limited exposure to broader market and sector performance.

For example, let’s say you think the US is in the midst of a very strong and robust recovery and growth period (I know – it is very wishful thinking).  If that is true, then small cap equities will outperform large cap equities.  Smaller companies can grow much faster than larger ones in percentage terms.  A futures spread trader would see this as an opportunity to buy the Mini Russell 2000 and sell the Emini S&P 500.  The Russell 2000 is a small cap index and the S&P 500 is a large cap index.  In times of economic recovery and growth, small caps should outperform large caps.  In times of economic recession large caps should outperform small caps.

Benefits of Spread Trading

Trading spreads limits the exposure to systemic risk.  In other words, it minimizes the risk associated with outside factors that can affect commodity prices.

Let’s take an example.  Dec Corn is trading higher at $4.00 while July Corn is around $3.50.  After studying the fundamentals and/or charts, you feel Dec Corn should drop 25 to 50 cents while July Corn will remain unchanged.

You short Dec Corn.  The next day the Fed announces it is bailing out Europe.  Money floods the US and International financial system.  The US Dollar Index plummets, and over the next month the USD decline sends Dec Corn higher to $5.00, July Corn higher to $4.50.

If you had been short Dec Corn and long July Corn the spread would still be around 50 cents and you have time for Dec Corn/July Corn to narrow, which it certainly may do.  If you were only short December Corn you lost $1.

You may have been fundamentally correct, that Dec Corn was overvalued and should be sold.  But since you did not long the July Corn, you lost money even though you were correct about the market fundamentals.  The change in the value of the US Dollar turned the trade into a loser.

We use pairs to eliminate as much systemic risk as possible.  We want our trading to be about the relative value of two commodities or crops within the same market.  We want to minimize the effect of outside market forces as much as possible.

How Spreads Make (and lose) Money

There are two types of spreads.  The first is intra-commodity spreads, also known as calendar spreads, which are in the same commodity.  Intra-commodity spreads are all about the near month vs.  the deferred month.  A bull futures spread is when the trader buys the near month and sells the deferred month.  This is a bull spread because in a bull market the near months will move up faster than the deferred months.  For example, if Crude Oil is in a bull market, the price of the nearby futures contract will increase faster than the price of crude 6 moths out, and even more than the contract 1 year in the future.

On the opposite side of that is the bear futures spread.  That is when the trader sells the near month and buys the deferred month.  In a bear market, the near months will move down faster than the deferred months.  In the futures markets, the near months have the most volume and open interest, so those months are the ones that are going to make the biggest price moves.  The near months almost always move faster and farther in both bull markets and bear markets when compared to the deferred, less traded contracts.

The only times when the contracts tend to move up and down at the same time, is during market panics and major sell offs.  In those situations investors and traders tend to “shoot first, interrogate second,” as the good gets sold with the bad.  During the sell off it is most likely the nearby and deferred are being sold equally.

The second type of spread is an Inter-Commodity Spread.  This is a spread between two different markets, like Corn Vs Wheat or Heating Oil vs.  RBOB Gasoline.  Let’s say we think farmers are going to plant more Corn than Wheat.  That would be bearish for Corn prices and bullish for Wheat prices.  We would short Corn and get long Wheat.  It doesn’t matter if Corn and Wheat go up or down in value.  All that matters is that Wheat holds up better than Corn.  If the markets rally, we want to see Wheat gain more than Corn.  If the markets decline, we want to see Corn go down more than Wheat.

Hedging Systemic Risk

We trade futures spreads to hedge against systemic risk.  You never know when the next shock to the system or market crash will happen.  We’ve learned through out the years to never expose ourselves to more risk than necessary.

When a trader in long one contract and short another, they are hedging out the USD.  The USD represents the entire US economy.  If we can hedge this out of our positions, we do so immediately.  Let’s say we are long the Crude Oil (CL).  That means we are long CL but we had to put up cash margin to get that position.  The CL contract is priced in USD.  In that case, we are not just long the CL, we are also short the USD.  If we used USD to get long CL, we have a long CL/short USD position, or a CL/USD cross.  If Greece defaults on their bonds, sending the Euro into a tailspin, the USD will go up materially.  The rising USD puts pressure on Crude Oil, sending CL down.

The only way to offset this risk is to spread Crude Oil against a deferred contract or another market.  Let’s say July Crude is the front month.  We are bullish Crude Oil and we buy July.  To cancel out the USD we sell December Crude, creating a long July Crude, short Dec Crude spread.

Why do we do this? If we are long July Crude, we are really long July Crude(CLN) and short USD, or CLN/USD.  If we short December Crude (CLZ), we are really short December Crude and long USD, or USD/CLZ.  When you combine the CLN/USD and USD/CLZ, you get a CLN/CLZ cross.  The long USD and short USD cancel out.

If some catastrophic even happens on the other side of the world, causing the USD to rally and CL to decline, my spread should be intact.  Whatever amount July Crude decreases, most likely Dec Crude will go down to.  The outside event will have been properly hedged.

Leverage and Margin

Futures Spreads should reduce your margin, but more importantly, it will reduce the leverage you are using.  When you are long the Emini S&P 500 overnight, you have overnight margin of $5625.  When you are short the Emini DJIA, you have overnight margin of $6500.  However, if you are long the ES and short the YM, the margin is not a combined $12,125.  There is a spread margin credit and the total overnight margin is reduced to $2054.  That is about a 83% reduction.

Why are margins reduced? Futures spreads are generally less volatile than being just long or short a single contract.  The exchanges understand this and reduce the margin requirements.  Futures spreads are generally less volatile because they narrow down the trading ideas and factors involved in the trade.

When you are long the Emini S&P 500, you are not just long the S&P index.  You also have exposure to the USD and the US financial system as a whole.  This is massive exposure to events and conditions that are impossible to predict or account for.  When you spread a contract, you are hedging out the USD, or outside market forces, and just making the trade about two very specific markets.  There will be fewer factors and therefore fewer unknowns by hedging out the USD.  This is another reason why the margins are reduced.

The leverage traders are using in their accounts are also greatly reduced, which is a good thing.  Most traders over leverage their accounts.  Overleveraged accounts either lead to traders blowing out their accounts on a big market move against them or slowly bleeding the account to $0 because they use stops that are too close to the normal trading range.

Stops

Futures spreads do not have stops.  They are not accepted at the exchange.  Good news is you really don’t need them if you are properly leveraged.  It is one of our favorite aspects of futures spread trading.  I can’t stand it when an event half way across the globe sends the market down (or up) and it triggers a stop in one of my positions.  I may be correct about the bullishness of Gold or Crude Oil, but a 5% decline in the Japanese Stock Market stops me out overnight, and then Gold or Crude goes up again.

The nice thing about futures spreads is they typically eliminate the outside market risks if the spreads are thought out and executed properly.  In our experience, traders tend to put their stops within normal trading ranges.  This makes the trader need to be exactly right in direction and timing for a trade, or they will be stopped out.  Why do traders do this? Because they only want to risk X amount of money in a trade.  If X amount of money is smaller than the daily trading range Y, then traders are too leveraged for the positions in their accounts.

Either the traders need to use more capital per trade, or they can reduce their margin, leverage and risk by using futures spreads.  If traders want to take a bullish position in the market, they can buy the front month and sell a deferred month.  If they want to take a short position in the market, they can sell the front month and buy the deferred market.

Markets to Spread

Any market can be spread traded.  Some markets like the grains, livestock, energies, softs and financials are more common than the indices, currencies and metals.  All markets can have calendar spreads or inter-commodity spreads.  However, all markets might not have a spread discount.  Spreading Corn vs.  Wheat gets a 60% reductions in margin because they are related markets.  Spreading Coffee vs.  Cocoa has no margin reduction because the fundamentals of the two markets have nothing in common.  If the markets are related fundamentally, there is a good chance a spread credit exists.  To find out if markets have spread credits just go to the Margin/Performance Bond section of the Exchange web site.

Historical Seasonality

Many spread traders follow seasonal trends and patterns.  Many futures markets have seasonal patterns.  Crude Oil and RBOB Gasoline tend to increase during the summer while Heating Oil and Natural Gas tend to increase during the winter.  The Grain markets are seasonally the highest in the spring and summer months and lowest right after harvest in the late fall.

Traders follow these patterns and trade the seasonal channels.  For example, this time of year the grain markets tend to go up faster in the old crop vs.  the new crop.  Traders will buy July corn and sell Dec Corn, or buy July Soybeans and sell Nov Soybeans.  Any shortage in beans or concerns about the crops will cause the near months to rally faster than the deferred months.  This seems to happen more often than not, which makes it a very popular spread trade.

Summary

Traders looking for ways to reduce risk in futures positions should seriously consider spreads.  In times like these, no one knows when the next Greece is going to happen.  Futures spreads can help protect your risk against outside market events.  Futures spreads can reduce leverage and allow traders to take positions without the need for tight stops that will most likely just stop them out.  Futures spreads allows traders to take advantage of medium to long term moves with less capital.

Spread Trading Ideas

Natural Gas

Natural Gas has broken out to the upside since the BP Gulf Oil spill.  Many traders think just getting long Natural Gas is too risky because Natural Gas can be a very volatile futures contact.  Entering a Bull Futures Spread in Natural Gas gives the trader exposure to Natural Gas but cuts down on the volatility of just being long a single contract.  The trader also does not have to worry about losing time premium like he would with a call option or bull call spread.  Here is an example of how a trader would get long Natural Gas with a Bull Futures Spread.

Buy August Natural Gas and Sell December Natural Gas at -0.600 or better.  Risk to a close below -0.700 ($1000).  Target is -0.4000 ($2000).  Initial Margin is $1688 and Maintenance Margin is $1250 per spread.

Natural Gas Chart

Natural Gas Chart

Click to View Larger Natural Gas Chart

Corn

Corn looks to have bottomed and seasonally this is the time of year when Corn has its best chances for higher prices.  Corn prices can be volatile this time of year, especially due to changes in weather and USDA reports.  Traders looking to take a bullish position in Corn but cut down on the volatility can buy September Corn and sell December Corn, which is a Futures Bull Spread.

Buy September Corn and Sell December Corn at -10.50 cents or better.  Risk to a close below -12.50 ($100 risk).  Look for a rally in old crop Corn to send the spread to -5.00 (+$275) and a very bullish market to bring the contracts to even (+$550).  Initial Margin is $270 and Maintenance Margin is $200 per spread.

Corn Chart

Corn Chart

Click to View Larger Corn Chart

Sugar

Sugar made historic highs earlier this year.  Now that the new crop of Sugar is coming in, many analysts feel Sugar will be heading back down to 12 or 13 cents a pound.  There will be price spikes in Sugar as commercial users still need to buy Sugar until the new crop is delivered to the market.  To cut down on the volatility, traders can sell October 2010 Sugar and Buy March 2011 Sugar, which is a Bear Futures Spread.

Sell October 2010 Sugar and Buy March 2011 Sugar at -0.70.  Risk to a close above -0.50 ($244 risk).  First target is -1.14 (+$492.80).  Initial Margin is $840 and Maintenance is $600.

Sugar Chart

Sugar Chart

Click to View Larger Sugar Chart

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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.

Filed Under: Spreads, Strategies Tagged With: , , , , ,
February 16, 2011 by 1 Comment

Hedging Systematic Risk

This post originally appeared in FutureSource’s Fast Break Newsletter on March 10, 2010, where Craig Turner is a regular contributor on various futures trading topics.

Systematic risk is always a threat to even a well-diversified portfolio.  When it comes to trading, we are always aware of systematic risk, and look for ways to hedge it as much as possible.

What exactly is systematic risk?  It is the inherent risk of the financial markets crashing like they did in late 2008 and early 2009.  It can be caused by interest rate hikes, stock market crashes, a subprime crisis, a country defaulting on its debt (Greece?), or any event that causes massive panic selling.

When a market crashes everything gets sold except for “flight to safety” investments, and sometimes those are not even safe.  When the markets were falling in late 2008, the only assets that appreciated were the USD and Treasuries.  Gold, viewed by some as the ultimate “safe” investment, traded to annual lows into the $600s during the last stock market crash.

So how does someone hedge out systematic risk?  While you can’t hedge it out completely, there is something very important you can do to insulate yourself as best as possible.

For US markets, hedging out the USD is probably the best way to reduce systematic risk.  The USD is not only the United States’ currency, but it represents the US economy as a whole.  If you can reduce your exposure to the US economy, then you can reduce your exposure to systematic risk.  Hedging out your USD exposure is hedging your risk to sudden shocks to the US economy.

How do you hedge out the USD?  It is easier then you think.  For every US market you are long, you should try to find a position that gives you a short position.  This is something I always try to do in my Turner’s Take Newsletter.

For example, let’s say you are bullish on Corn and you think it is going to trade to 25 cents higher per bushel.  You are not just long Corn.  You are also short the USD.  Think of your trades as a cross, like the currency pairs.  When you are long the EUR, you are really long the EUR and short USD, or just EUR/USD.  When you are long Corn you have sold it in USD, which makes a Corn/USD cross.

Why is this important to realize that being long Corn is really a long Corn/short USD cross (Corn/USD)?  Let’s say there is a panic because Greece defaults on its debt.  Not only is the EUR sold heavily, driving the USD up, but a lot of “riskier” assets are sold during times of great uncertainty.  Everyone wants to get into cash and all commodities go down.  Corn falls 20 to 30 cents because it is priced in USD, and the dollar is soaring.

Nothing has changed fundamentally in the Corn market except the value of the USD.  Corn might still have better bullish conditions than before, but the rise in the USD has made your position a loser!

The good news is you can hedge out this risk if you were short a market in similar size that is priced in USD.  Let’s say not only were you bullish Corn, but you were bearish on Wheat.  Now you have a position that is long Corn (short USD) and short Wheat (long USD).  This is what the new positions look like:

1) Corn/USD
2) USD/Wheat

The USD cancels out and you are left with:

1) Corn/Wheat

If the USD rallies strong or declines rapidly, it will most likely affect Corn and Wheat the same.  If the dollar rallies strong, the loss in Corn will be mostly offset by the gain in Wheat.  This is not a perfect hedge against the USD, but it works often enough that allows traders to stay in positions when events beyond their control take place.

How does your trade ultimately gain/lose in value? By gaining or losing value relative to the two specific commodities.  Since we are bullish corn and bearish wheat, we feel that the value of corn will appreciate compared to wheat.

This is not just for fundamental traders.  Traders using technical analysis can benefit as well.  If corn has a bullish chart and wheat has a bearish chart, then the Corn/Wheat trade makes sense for technical analysis traders.

Yet another approach to the markets that hedges out the USD is seasonal spread trading, like Guy Bower and his ProTrader Digest newsletter.  Corn typically out performs Wheat in January as feed (corn) is in high demand for livestock and Wheat tends to stay steady or fall in value.  Being long Corn and short Wheat during January and February is not only a good seasonal trade; it is also a way to hedge out the USD.

Fundamental Example

In the examples below, we will cover spread trading that hedges out the USD and Systematic Risk.  We will go over how both fundamental and technical traders do this.

Fundamental Traders: Andy Daniels and the Daniels Ag Advisory are currently long July Corn and short Dec Corn.  They feel that the corn in storage is too wet to hold, and it needs to be sold into the market before it deteriorates.  That is going to put pressure on the July Corn contract, which is known as the “old crop”.

The DAA is also going to long December Corn, the “new crop.”  The old crop is in storage, and the new crop is in the ground.  The old crop, July Corn, will see selling pressure from farmers, while December will not.  By being short July and long December we are taking a bearish position in the market, while hedging out the USD risk.

Now, margin on Corn is $1,350 a contract, but for a spread in old crop vs. new crop the margin is not $1,350 X 2 = $2,700.  It is reduced to $270 per spread!  Why?  Because these spreads tend to be less volatile than just being outright long or short a single position in corn.  One of the reasons they are less volatile is because you are hedging out outside market risks (systematic risk).

Technical Analysis Example

Cotton recently had a bullish signal to get long around the same time the Sugar charts were turning bearish.  In markets that have large price moves, the corrections and daily ranges tend to be bigger than normal.  One way to smooth that out is being short one commodity and long another.

Cotton Chart

Cotton Chart

Click to View Larger Cotton Chart

Sugar Chart

Sugar Chart

Click to View Larger Sugar Chart

As you can see in the above charts, around February 10th Cotton was breaking out to the upside.  You could get long Cotton, but if you wanted to hedge out the USD risk you could also have shorted Sugar at the same time.  While there is no spread margin reduction for the two contracts, any major changes to the value of the USD would be hedged out.

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Filed Under: Hedging, Risk, Strategies Tagged With: , ,
February 10, 2011 by 5 Comments

Effective Habits of Successful Traders:  Why Do I Trade?

Why do I trade?  It’s a simple question, yet the vast majority of traders have not outlined why they trade.  How much time have you spent thinking about it?  Have you ever written down why you trade?  If you haven’t, how do you know what your true motivations are?  Have you sorted out what your objectives are?  These are critically important questions you must answer to begin employing effective trading habits.

The journey begins by examining the reasons why you trade and what your objectives are.  Do you trade make money?  Do you trade for the challenge?  Are you bored and want to pass time?  Do you seek the adrenaline rush of the unknown?  Do you want to spend time by yourself?  There are many reasons that people take on the challenge of trading, and your motivations will help determine how you will trade.  They will form your habits and dictate what kind of trader you must become to fulfill the objectives you have.

Why Trading Programs Fail

The vast majority of “trading programs” try to teach you a method or system as if it suits every trader’s personality and objectives.  This canned approach has it backwards.  You must determine who you are and your objectives to have a style that fits you – not a style that is taught as “the golden system”.  Because programs and methodologies are often not matched to the individual trader, the trader opens an account, loses money and then blames the system or program he or she learned.

As a broker, I have countless conversations with traders who are “searching for a new strategy” or “seeing what else is out there”.  Yet, I rarely hear traders discuss that they are working on understanding themselves as a trader.  Trading is an extension of who you are and how you view markets.  If you are very risk adverse, you’re going to need to develop a style where you can risk small amounts of equity while still fulfilling your profit objectives.  If you want to take on risk because you like to gamble, you’re going to have strategies with higher leverage ratios and open risk during trades.  If you prefer taking long-term bets and building large positions, your risk management is going to be significantly different than a day-trader looking to pick up several points on each trade.  Recognizing who you are as a trader helps you determine how you will develop your strategy and risk management techniques.

Understand Your Motivations and How They Affect Your Trading

By understanding your motivations, you will immediately identify why you make many of the trading decisions you do.  For example, if you need to have positions on, it means you’re trading for the thrill of it, the adrenaline.  The root of this motivation to trade has nothing to do with the markets – the markets simply offer an outlet for you to achieve the adrenaline rush.  Here is another example, if you trade fairly well but get impatient and lapse into phases where you take on more contracts than you normally would, this could mean you’re trying to make money quickly, which is never a good trading strategy.

If you are unable to recognize your true objectives for trading, it is extremely difficult to fulfill them!  It means you are likely capable of making decisions that, in retrospect, are very foolish.  I sometimes hear traders say, “I just don’t know what got into me” or “I just wasn’t thinking”.  I believe what they are really trying to say is, “how did I let that happen?  I didn’t even know I was capable of that.” They didn’t know they were capable of it because they don’t know what’s truly motivating them.

Trading will challenge you to make high pressured decisions while under stress.  Your body will instinctually react by letting blood flow from your brain to your body as it thinks it is a “fight or flight” response.  This cuts blood flow to your brain making it more difficult to process information and think clearly.  As such, you need to understand yourself well so you will not let the stress of a situation affect your ability to think clearly – you know why you trade and you have a plan in place.  This is the level successful traders achieve.

The Difference between Successful Traders and Unsuccessful Traders

Let’s contrast reasons for trading from unsuccessful and successful traders.  When I ask the average trader why they do this, I almost immediately and overwhelming hear “for the money of course!” I typically hear an air of dismissal as they are almost shocked I asked.  They believe this is not only the most important reason for trading, they believe it’s the only reason!

What you’re about to read may shock some of you but here it is:  if you solely trade to make money, you are ensuring your demise.  How can this be true?  I believe this because most people who try to only “make money” have a skewed sense of reality in the markets.  It is so utterly important to make money and never have losses to them, that they develop terrible habits that lead them into many losers.  The most common example (and something way too many average traders do) is enter a position and see what happens.  Many times, the trade will begin losing money.  So what do they do?  They sit and wait for the position to “come back”.  Their initial trade idea transforms from a money-making venture into a place where they hope it comes back enough for them to at least break even.  They are so overwhelmed by seeing a negative (red) number that they surrender control to it.  Sometimes the trade does come back and their “hold on and hope” process is validated.  This only makes the situation worse as this becomes a habit.  That is, until the trade doesn’t come back.  When the trade doesn’t come back, losses mount and margin calls are met.  A once average trade is now terrorizing your account.  You’re paralyzed as the trade is overwhelming you.  Finally, the position is liquidated for a massive loss.

Successful traders understand that there are times where it makes sense to exit a position for a loss in order to preserve capital.  They are not attached to their position because they understand they are simply using a financial instrument to achieve their objectives.

There are several variations to the scenario above.  For example, traders add to their position “averaging down”.  Again, they look brilliant when the trade comes back.  But the one time it doesn’t (and the day always comes sooner or later), massive losses are taken.  Legendary trader Paul Tudor Jones said it best, “Losers Average Losers”.  Another example is day-traders indiscriminately trading for no reason other than “trying to make money”.  I hear it frequently, “I just want to make $X a day doing this”.  If this is your reason for trading, I highly recommend you stop, close your account, and never look back.

At the core, most average traders associate successful trading with never taking losing trades.  By having specific risk parameters before putting on a trade and acknowledging that you need to take losing trades in order to achieve your objectives (whatever they are), you manage your risk more effectively.

Are you beginning to see how trading “to make money” doesn’t necessarily make the most sense?  This process leads you into making poor decisions and forming habits that will create misery in the markets.  Thus, you need to start thinking, why do I trade?  Is it just about the money?  If so, what kinds of decisions am I capable of making?  Why else am I doing this?  Do I like learning and gaining experience in the markets?  Would I do this activity if there wasn’t potential profit from it?

How does this compare with successful traders?  Typically, most successful traders possess “self-awareness” and have a thorough understanding of themselves and why they trade.  I typically hear successful traders discuss their trading in terms of:

  1. The Challenge:  Trading is hard and requires significant attention to detail.  This detail is both inner (my psychology) and outer (the markets).  While I understand that the market is a designed to fool and frustrate me, it gives me a landscape to construct and bet on price changes.
  2. The Fun:  I just cannot think of a better way than spend time following and thinking about markets.  It is an ever-changing and evolving landscape that forces me to be adapting all the time.
  3. The Game:  Trading is a three-dimensional, real-life game that results in real-life financial consequences.
  4. The Freedom:  Trading gives me a venue to exercise a limitless set of ideas.  I love the freedom I am given with in my trading world.  I trade when I want and how I want.  If it isn’t fun, I simply walk away from the markets because I know they will be there when I decide to come back.
  5. The Self-Responsibility:  Trading gives me a place where I and I alone are responsible for my trading results.  I take pride in how I act and do not blame others for my financial misfortunes.
  6. The Competition:  Trading is me versus the market, an amalgam of all characters from every corner on earth.  I compete against hedge fund managers, professional proprietary traders, farmers and amateurs like architects, doctors, MBAs, athletes, and students.
  7. The Money:  If I’m playing the game like I should, my reward is money. While I may have started trading “purely for the money”, it has evolved into something more.  I can trade full-time or supplement my income with trading.

There are many reasons for trading – some of them constructive, some of them not.  At the end of the day, it is about understanding yourself and your motivations.  I highly recommend taking time to actually write down your reasons for trading and review them often.  When you do, you’ll find yourself making clearer and smarter decisions since you have developed an “awareness” of yourself and why you participate in the markets.  As time goes on, your reasons may change, so it’s important to keep it up to date.  Taking time to complete this exercise is the beginning to better understanding yourself as a trader.  I believe you’ll find trading more enjoyable as you have outlined why you do it and what you want out of it.

Filed Under: Getting Started, Trading Tips Tagged With: , , ,
February 9, 2011 by Leave a Comment

Strike Gold:  Trade Silver Using Bull Call Option Spreads

Turbulent.  Violent.  Ferocious.  Vicious.

These are frightening terms many unsuccessful traders would use to describe their experiences when attempting to trade the Silver futures market.

Due to its large futures contract size – 5000 ounces of Silver per contract and an ever-increasing exchange margin requirement of $11,000+ per contract – traders and brokers have nicknamed Silver “The Widowmaker” for good reason as it seems to have an uncanny knack for punishing traders when they’re wrong, especially when traded irresponsibly by those who are impulsive, stubborn, undisciplined, and overleveraged.

Are you scared yet?

Adding physical silver bullion in the form of coins or bars is a vital component to every investor’s well-diversified portfolio, but that is an entirely different investment enterprise than trading the great white precious metal using leverage in the futures market.

As traders of futures and options on futures, we have to accept that any market can be erratic and unpredictable.  While extreme volatility, exaggerated price spikes, and large daily price ranges are to be fully expected and can be downright nasty, the Silver futures market is not something to fear or run away from.

Rich in history, the lure and appeal of successfully trading Silver, the “Poor Man’s Gold,” continues to attract and tempt a wide and growing variety of traders and investors from every corner of the globe.

GET COMFORTABLE:  ACCEPT RISK & DEFINE YOUR REWARD

If you’re willing to forego the often attempted but rarely achieved consistent daytrading profitability in favor of capital preservation and prudent risk management through the use of Bull Call Option Spreads, you may become a battle-tested trading veteran who would characterize the raging, white-hot Silver market as challenging, yet ultimately highly rewarding…maybe even exhilarating.

The January 2011 consolidation phase or technical correction – a “terrifying” 16 percent cliff dive in less than a month (the white metal boasts an 80%+ gain in 2010) – now appears to have run its course, resolving itself strongly to the upside, back in favor of the long-term bullish uptrend.

Below I will illustrate how you can “strike gold” by taking advantage of this opportunity to get long on the resumption of Silver’s long-term bull trend – in case you didn’t know, its going on 10 years and counting – by putting on a Bull Call Option Spread as it looks to challenge and surpass recent contract highs.

This trading strategy offers bullish traders and investors the opportunity to carefully define both their risk and their reward before deploying capital on the trade.  It allows one to trade the Silver market directionally with prudent money/position management – with the ability to “Get Long” using Silver futures option spreads without exposing your account to a very large exchange margin requirement ($11,000+ per contract) and the always present equity/event risk when holding a futures contract position overnight.

Here is a primer on how a Silver Bull Call Option Spread trading strategy could work for you:

BULL CALL OPTION SPREADS (DEBIT SPREADS) – THE NUTS & BOLTS

The terms bull and call imply a bias toward an upward price direction, so this strategy involves a spread that goes long the market by using call options.  Debit implies that you are paying for the trade and that the costs are being debited from your account.

Some refer to this as a vertical bull call spread.  What is usually involved in this strategy is:  the purchase of a close-to-the money or an in-the-money call and at the same time the sale of a further away strike price (out-of-the-money) call option of the same expiration date (or same expiration month).

The close-to or in-the-money call option may cost a great deal of money as it is near or lower to where the underlying futures contract price is trading, especially if there is substantial time remaining until the option’s expiration.  Traders spread this cost off (or finance it) by selling or writing a further out-of-the-money call option.

When you sell or write a call, you collect premium or receive a credit to your account.  This credit reduces the cost of the close-to or in-the-money call option.

The profit/loss profile for this strategy is a limited risk and a lower expense for the investor as premium costs are reduced (or financed) by the sale of the higher strike price call option.  The short call is covered by the long call, so there is a predetermined risk factored in this trade and no unnecessary risks associated with option writing or selling (aka naked shorts).

The maximum profit potential is limited to the value between the two strike price levels minus the premium costs, the commission, and exchange fees.

SPECIFIC MARKET EXAMPLE – THE STRATEGY:
May Silver 26.25/27.25 Bull Call Option Spread

Let’s review a specific market example:  After hitting a contract high of $31.27 on 1/03/11, near the end of the 1/25/2011 trading session the May Silver market continued trading lower while in the midst of a widely-publicized consolidation phase or technical correction posting a low of $26.575 during this session.  (The daily range on 1/25/11 was LOW:  26.54 to HIGH:  27.04)

For this example, we will use the May Silver 26.25/27.25 call option quote prices taken from floor brokers at the end of the 1/25/11 session.

ENTER THE SPREAD:  GETTING LONG on 1/25/11
(OPTION EXPIRATION DATE:  4/26/11)

BUY 1 May Silver 26.25 Call Option – pay $2.15 premium (-215 cents x $50) =
-($10,750) DEBITED From Cash/Account

SELL 1 May Silver 27.25 Call Option – receive $1.65 premium (+165 cents x $50) =
+$8,250 CREDITED To Cash/Account

NET DEBIT TO ACCOUNT TO BUY/GET LONG THE SPREAD

-$0.50 (-215 cents paid vs.  +165 cents received = -50 cents) =
-($2500.00) PREMIUM PURCHASE PRICE TO ENTER SPREAD

MAXIMUM PROFIT POTENTIAL AT OPTION EXPIRATION

The maximum profit potential is limited to the level between the two strike prices (27.25 – 26.25 = $1.00 or 100 cents x $50/cent = +$5000) minus the premium costs (-$2500), the commission and fees (approximately -$160 per spread at $75/RT/per option and exchange fees.  This would double if the spread is profitable and taken through expiration/converted to futures contracts then offset immediately).

(27.25 Call Strike – 26.25 Call Strike = $1.00 or 100 cents x $50/cent = +$5000) – (-$2500 – $160 or -$2660)
= +$2,340 POTENTIAL PROFIT / 93.6% GAIN PER SPREAD BEFORE COMMISSION/FEES

ULTIMATE OBJECTIVE

The ultimate objective would be for the May Silver futures contract to close above 27.25 on the Option Expiration pit session (4/26/11 @ 12:25pm Chicago Time) to max out the potential profit on this spread.

Upon option expiration, the call options would automatically be converted into long and short futures positions that immediately offset one another (there is no margin risk involved).  The difference between the strikes as described above minus the total cost of the spread or +$2,340 would then be credited as a positive gain back into your account in addition to getting back your original premium paid/trade cost of $2660.

BEST CASE SCENARIO

The best case scenario would be if the May Silver market surges higher than 27.25 at any time prior to option expiration, you can ask your broker to go to the floor to request quotes to find out what the current market value would be to liquidate the position (to sell back or cover the spread).

If we were to attempt to exit/liquidate/sell the spread prior to expiration, to obtain an approximately equal amount of maximum potential profit, the value of the spread would need to be quoted on the floor as Bid @ 100 cents – which is a 50 cent increase from the 50 cent entry/purchase price.

WORST CASE SCENARIO

If the market does not trade higher, you should guard against an erosion of spread premium value by using either a predetermined “mental stop-loss” level based on the futures price and spread quote values or overall loss of capital level and exit the spread, taking a reasonable loss.  Or, the worst case scenario would be the May futures closing on option expiration day below the 1st call strike of 26.25 to allow the spread to expire worthless upon expiration, losing the total premium paid.

TRADE CONCLUSION

On Tuesday 2/08/11, the May Silver market skyrocketed or spiked higher almost an entire dollar in a single session, putting the May Silver 26.25/27.25 Bull Call Spread into very profitable territory.

If one wanted to purchase this spread on the morning of Tuesday 2/08/11, it would cost a trader approximately $4.04 ($20,200) to purchase the May 26.25 Call and they would receive $3.08 ($15,400) by selling the May 27.25 Call.

The difference (or their cost to get long/purchase it) is $4,800 (or 96 cents), which represents the new value of our spread.  It has increased from the 1/25/11 entry price of $0.50 to the current price of $0.96 ($4.04 or -404 cents paid vs.  $3.08 or +308 cents received) = an increase of +$0.46 or $2300 gain to your account (46 cents x $50 per cent).

For all intents and purposes, this spread has nearly reached its maximum potential value at options expiration.  This is an extremely favorable position to be in.  At this point, the spread can (and should) now be liquidated/exited by selling it on the floor.  Or, if you prefer, you could hold the position through to option expiration (EXPIRATION DATE:  4/26/11) if you’re confident that the May Silver price will remain above 27.25.

However, I would strongly suggest placing a Good Till Canceled (GTC) limit order with your broker to use the floor to max out/liquidate or “sell the spread at maximum potential expiration value” as that eliminates your risk exposure, adds positive equity to your account (over +90% gain before commissions/fees), and allows you to refocus and reload for the next trading opportunity.

This is a strategy specifically designed to be somewhat more defensive or “conservatively realistic” in nature.  It did not shoot for the moon (an example of that would be getting long a May 35/40 Bull Call Spread when the market is trading at 20) but allowed you to enter the position relatively “close” to the market with a higher degree of probability for potential success and profitability.

FEAR NOT – EMBRACE OPPORTUNITY

The only thing to fear when using a Bull Call Option Spread is a complete loss of capital paid to purchase the spread.  Since you can clearly define what level of loss you are willing to tolerate in terms of the premium you are willing to pay for the spread, there’s really nothing to fear at all.  You must be comfortable with the risk of loss in any investment or trading endeavor in order to position yourself to reap the reward, if successful.

Bull Call Option Spreads (and conversely Bear Put Option Spreads if you’re bearish on a market) give you the flexibility to trade directionally with the ability to tightly manage risk by constructing how close the spread position is in relation to the market price and where you believe it will trade in the future (ie you can carefully position the strikes to be more defensive or aggressive in nature.  This particular spread example used an In-The-Money Call PURCHASE and an Out-Of-The-Money Call SALE).

This limited risk/limited reward type of trading strategy can be used singularly or even in conjunction with targeted long-term and short-term (intraday/countertrend) futures trades and can offer you a relatively risk averse way to potentially extract profits in the blazing Silver market – especially if you layer in multiple lots and farther out Bull Call Option Spreads (in terms of both price and time).

LEARN MORE ABOUT HOW OPTION SPREADS CAN WORK FOR YOU

If you would like to learn more about how option spread strategies could work for you and your trading, please contact me via the Daniels Trading website.

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Free Download:  Futures and Options Strategy Guide

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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: Market Analysis, Metals, Options, Spreads, Strategies Tagged With: , , , , ,
February 3, 2011 by Leave a Comment

How to Diversify Your Investment Portfolio with Commodity Futures

3 Straightforward Solutions for Investors Who Are Long on Interest & Short on Time

With the ever changing economic conditions, considering new investment opportunities has never been more important.  Diversification using the commodity futures markets has been a very popular avenue investors have turned to with goals of reducing portfolio risk and realizing positive gains on their overall investment portfolios.  One of the most common myths about the futures markets is that participating in them is a full-time commitment.  However, the truth is, there are several simple ways to become diversified using commodities without having to compromise time from life’s hectic tendencies.

Specifically, there are three great ways to participate in the futures markets with minimal time commitment:

  1. Futures Trading Newsletters
  2. Automated Futures Trading Strategies
  3. Managed Futures Investments

Futures Trading Newsletters

Following a Futures Trading Newsletter allows an investor to utilize information that is published by a credible trading resource about potential market opportunities.  For many futures trading newsletters, investors can have the newsletter advice (e.g. trade recommendations and trade signals) automatically executed on their behalf by a licensed commodity futures broker.  This enables investors to take part in intriguing market opportunities based upon fundamental and technical research, market analysis, and seasonal trends without committing the time to follow the newsletter and execute the trades on their own.  Although past results cannot predict future market outcomes, using this type of resource can be a great way to instill confidence for investors who are willing to rely on a futures market professional but who do not have the time to study the futures markets themselves.

Watch this 2½ minute video to learn more about Futures Trading Advice Signal Execution.

Now, take a look at the vast variety of futures trading advisories available at Daniels Trading:

Automated Futures Trading Strategies

Automated Futures Trading Strategies (also referred to as Automated Futures Trading Systems) revolutionized electronic trading when they were first introduced.  As it stands today, automated futures trading strategies are still one of the most popular ways for investors to access the futures markets.  These mechanical, computer-based strategies are developed using algorithms and can be automatically executed for investors trading accounts with professional supervision and monitoring by their brokers.  Before an automated strategy is published, it is normally back tested to generate hypothetical results based upon past market data and technical indicators.  As they have evolved, automated futures trading strategies have shown to be a viable “hands-off” investment option that can suit many types of investors based on their level of comfort, available risk capital and risk tolerance.

Watch this 2½ minute video to learn more about Automated Trading Strategy Execution.

To learn more about Daniels Trading Automated Futures Trading Strategies have a look at our automated strategy selection tools.

Managed Futures Investments

Managed Futures Investments give investors a fantastic avenue for diversification.  All trading decisions in managed futures programs are performed by a CTA, or Commodity Trading Advisor.  Each CTA has a unique trading style and approach to the futures markets.  In addition, it is important to find a CTA who is licensed and has a verified performance history.  Managed futures programs are designed for those who wish to start with a larger principal investment.  Generally, these programs start with a $50,000 to $100,000 minimum investment; however, initial funding can vary by CTA and the risk tolerance of each individual investor.

Watch this 2½ minute video to learn more about Managed Futures Investments.

For more information on Managed Futures Investments, please visit the managed portion of our website.

Given the stresses of everyday life coupled with challenging economic times, considering diverse investment strategies has never been more important.  And today, commodity futures market investments have never been more appealing.  With the ability to participate in Futures Trading Newsletters, Automated Futures Trading Strategies, and/or Managed Futures Investments, you can alleviate concerns about not having enough time in your life to feel comfortable becoming involved in a new investment opportunity.  Whether you are a busy investor or just seeking professional futures trading guidance, if would like to know more about utilizing these three straightforward solutions to leveraging the commodity futures markets in your own investment portfolio, please contact us.

Filed Under: Getting Started Tagged With: , , , , , , , , , , ,