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March 31, 2011 by Leave a Comment

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

Part Two:  A User’s Perspective

The goal of hedging is to transfer price risk from one party to another.  You may remember this from the initial article I wrote on hedging.  This article will focus on how users of a product can roughly lock in a price to transfer risk to another party.  If you would like to learn more about how a producer can roughly lock in a price, read my previous article here:  Hedging with Commodity Futures:  It’s All About Managing Price Risk!

Why should I hedge?

This is the question you will have to ask yourself when trying to figure out the benefits of hedging.  As a user, would you like to be able to roughly determine the price you will have to pay for a commodity in the future? The futures markets can help you do this.

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.

There are two types of hedges, long hedges and short hedges.  This article focuses on long hedges.  Someone who is buying the commodity later in the cash market is a long hedger.  A long hedger is someone who wants to protect themselves from price increases (user).  A long hedge is also known as being “Short the basis.” A hedger who is short the basis (long hedger) benefits from the basis becoming more negative.  In the corn example above, if it was a long hedger, he would want the basis to get more negative.

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

Real-World Example

A feed company will need to buy 25,000 bushels of corn on December 1st.  Due to rising per capita incomes around the world, the feed company believes that increased demand for feed grain and food could result in an increase in corn prices.  The company decides to place a long hedge on March 23rd to protect themselves from rising prices.  December corn futures are currently trading at $6.15/bu and the December cash market is currently at $5.83/bu.  Each corn futures contract contains 5,000 bushels.  The feed company buys five corn futures contracts at $6.15/bu.  The feed company’s goal is to lock in a price of roughly $5.83/bu for corn.

It is now November 30th and the feed company’s concern that corn prices would rise held true.  Corn futures are currently at $7.58/bu and December cash corn is at $7.46/bu.  The company exits its futures positions and buys the cash grain.  See the table below for the sum of the transactions.

Change in Basis

Date Cash Futures Basis
03/23/11 5.83 6.15 -.32
11/30/11 7.46 7.58 -.12
= -1.63 = + 1.43 = -.20

The feed company lost $1.63 on the cash side and gained $1.43 on the futures side.  The net result of the hedge is a loss of 20 cents per bushel.

- 0.20/bu
X 5000 bu/contract
$-1000
X 5 contracts
$-5000 loss in dollars

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

Cash Price Received:    $7.46/bu
Gain on Futures:    -1.43 (reduces cost)
   $6.03/bu

-OR-

Target Price:    $5.83/bu
Adjusted by net result:    +0.20
   $6.03/bu

Basis strengthened during the hedge, causing the feed company to pay more than they had hoped.  Remember that the goal of hedging is to transfer price risk and set the price you would like to pay in a roughly determinable range.  Had the feed company not hedged, they would have been stuck paying $7.46/bu of corn!  This is quite a large difference from the $6.03 they actually paid.

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have decreased and the feed company would have lost money in futures, but they would have paid less for the cash grain.  If that was the case, a producer could have benefitted by placing a short 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 users and producers to plan their operations more confidently.

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Filed Under: Hedging, Risk, Strategies Tagged With: , , , , , ,
March 12, 2011 by 1 Comment

Going Greek:  Understanding your Option’s Delta

Option traders are often speaking another language.  I want to help you understand how your option’s value is going to be affected by changes in the market.  We can calculate how our option is going to react to these changes by understanding the Option Greeks.  The Black-Scholes Model identifies 5 Option Greeks to help us forecast the value of our option (Delta, Gamma, Vega, Theta, and Rho).  These Greek’s will help identify our option’s reaction to changes in the price of the underlying futures contract, time decay, volatility, and interest rate.  In this article we are going to explore the Delta.

Exploring Delta

Delta is the measure of the degree to which an option is going to move relative to the underlying futures contract.  In other words, it is a measurement tool to find out the speed the option value will change in relation to a full point move in the underlying futures contract.

For example let’s look at crude oil:

If my option has a delta of 0.50, this means that for every $1.00 move in the crude oil futures, my option will go up or down by $0.50 (1.00*0.5=0.50).  In other words, my option’s value will fluctuate approximately half the rate of the actual futures contract.  So if crude oil were to move $3.00, my option value would change by roughly $1.50.

The higher the delta, the more sensitive the option is going to be to the underlying futures contract.  The options distance from the current market price, as well as the number of days left until expiration are two factors that will determine the options delta.

Call Option Delta

For call options, the delta can range from 0 to 1.  A one delta would mean that the option is going to fluctuate tick for tick with the futures.  A zero delta would mean that the options value is not going to be affected by the movement in the underlying futures contract.  That being said, the deeper in-the-money an option is and the less amount of time the option has until expiration, the closer the delta is going to be to one.  The further out of the money and the more time an option has until expiration, the closer the delta is going to be to zero.  An at-the-money option will have a delta of around 0.50 because there is a 50% chance the option can move in-the-money, and a 50% chance the option can move out-the-money.

Put Option Delta

Put options, on the other hand, will have a negative delta, but the same rules apply.  Deep in-the-money puts will have a delta closer to -1, and far out-the-money options will have a delta closer to 0.  At-the-money puts will have a delta around -0.50.

Every trade begins with an idea.  Whether you are hedging or speculating in the markets, understanding your positions delta will give you a clearer picture on how your trade is going to react to price fluctuations.  Your delta, accompanied with the rest of the option Greek’s will help you more accurately forecast your options value and properly manage your position.

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

Filed Under: Options, Risk, Strategies Tagged With: , , , , , , , , , , ,
March 9, 2011 by 2 Comments

Effective Habits of Successful Traders: Keeping a Trade Log

Do you keep a trade log recording your risk/reward parameters, results, expectancy, and other important statistics for each trade you make?  If you answered no, do you experience inconsistent results and regular draw downs in your account?  For most, this is not a coincidence.  Trading without a trade log is analogous to finding your way out of a desert with no map or compass.  At best, it is a struggle.  At worst, you never make it out alive.  Your trade log is your map guiding your trading by effectively evaluating your strengths and weaknesses to help you reach your goals.  Your compass is your “trading framework”, something that will be covered at another time.

How Do You Evaluate Your Trading Performance?

Your trade log supplies you with the cold, hard numbers of your trading.  It is a very important tool in trading yet few traders actually “keep their stats”.  On the surface, it does not seem like such a big deal.  However, a trade log does more than just list your numbers.  It gives you the capability to honestly evaluate your trading performance so you can understand your strengths and weaknesses.  Do you even keep a list of your strengths and weaknesses as a trader?  If not, how do you know what you need to improve?  The trade log is the beginning of this process.  In my opinion, it is equally important that you understand what you do well (so you can keep doing it) and recognize your flaws (so you can improve).  All traders make mistakes, but the good ones are able to contain them so they do not incur serious damage to their accounts.  Poor traders tend to compound their mistakes, which result in heavy drawdowns and uneven or inconsistent results.

Some examples of poor trading include:

  • Incorrect position sizing (the size traded e.g., 1 contract vs.  10 contracts)
  • Poorly or undefined risk (the amount you decide to risk before the trade is on)
  • No real plan to exit the trade (what are your objectives with the trade?)
  • Trading in a market without understanding the market type (up, trending market vs.  down, volatile market)
  • Averaging-down (adding to losing positions hoping they will “come back”)
  • Mental errors (e.g., changing the plan once in a trade)

Unless you are able to identify your errors and begin minimizing and eliminating them, there is no way to improve as a trader.

The most important trait for a trader to possess is the ability to take responsibility for his or her actions and their subsequent results in the trading account.  As a trader, you are solely responsible for what happens when you trade.  If you cannot take responsibility for your actions, you cannot accept that you need to change your trading.  Keeping a trade log will help you to take responsibly and make appropriate changes to improve your trading.

Benefits of Keeping a Trade Log

Keeping a Trade Log Establishes Discipline
Winning traders have excellent discipline.  They have a reason for getting in and more importantly, they have a reason for getting out.  Poor traders typically trade indiscriminately and “overtrade” or make too many bets.  This is a major mistake that leads to losses and can leave traders emotionally off-balance.  Once you start logging trades, you’ll be thinking about why you’re taking trades and how to construct them versus trading indiscriminately.

A Trade Log Allows You to Objectively Evaluate the Numbers
You’ll figure out quickly whether you are doing things right or not.  Winning traders enjoy reviewing their “stats” because it’s rewarding to follow your style and make trades you feel good about.  Poor traders have a tough time keeping their stats, let alone reviewing them.  It isn’t psychologically pleasing to review losses and think about lost money but you can’t effectively evaluate your trading without keeping the numbers.

Below are some critical trading statistics you should be tracking in your trade log:

  • # of Trades
  • Win Ratio
  • Loss Ratio
  • Unit Risk
  • Unit Reward
  • Expectancy
  • Trade Map
  • Distribution Chart

A Trade Log Helps You Determine Your Weaknesses as a Trader

Are you too risk-averse?
These traders keep stops too close and get stopped too often.  This means you are keeping stops within normal ranges of volatility.  This is frequently seen in day-traders who keep stops far too close and are regularly stopped out.  Many traders like this are under the guise they are managing their risk effectively when they are bleeding to death by a 1,000 cuts.  Worse, these types typically take profits too early because they are unused to them and “want to lock in profit”.  Their win/loss ratio doesn’t match the magnitude of their winners and losers.  Lots of small losers with even smaller winners equal consistent drawdowns.

Do you wing it?
These traders have no plan and simply throw around trade ideas with no real idea or understanding of why they’re doing it.  They will occasionally hit winning trades, even big winning trades, but they are capable of giving it right back to the market.

Do you use poor position sizing strategies?
Are you betting too much and taking on too much leverage in losing trades?  Are you too conservative with winning trades?

Do you ride losers?
These kinds of trades start out normal but turn against you at some point.  These traders typically do not have specific exit stops and limits.  When the trade starts going sour, the losses multiply and the trader’s psychology changes.  The idea of a winning trade turns into a position that one can only “hope” to come back to even.  The losses multiply and the trader digs his or her heels in.  Margin calls are met and then met again.  A once annoying trade has now snowballed into heavy losses.  Eventually, a large and unnecessary loss is taken.

A Trade Log Also Helps You Determine Your Strengths

Do you take contained losses and understand why you lost?
Paradoxical to conventional thought, successful traders take losses, but they are defined and manageable losses.  More importantly, when you take a loss, you should strive to understand why you lost.  Was it a poor entry or exit because you were emotionally compromised?  Was it poor risk management while the trade was on?  Was a significant technical level broken?  Did the market unexpectedly get volatile and your trading strategy simply didn’t fit the environment anymore?  The point is, if you identify why you lost, you can improve your trading.

Do you utilize appropriate position sizing strategies?
Successful traders fully understand the concept of leverage in futures so they know when to use it and when not to use it.

Have you developed a framework for your trading?
Successful traders use a methodology or a way to perceive or give context to what is they believe is happening in a market.  Are you a systematic trader using certain technical rules to govern your trading (e.g., a simple moving average(s) crossover)?  Are you a rules-based discretionary trader using specific rules for order entry and exit?  Are you a discretionary trader who has no real rules over the long haul?  Successful traders tend to be systematic or rules-based discretionary traders.  Most average traders are discretionary traders, thus, they are losing traders.

There are many trading concepts we have just covered and all of them relate back to keeping a trade log.  Let us examine the trade log to see how we set it up and use it.

How to Setup and Utilize a Trade Log

To start, download my sample trade log so you can follow along.

Trade Log Format
The table formatting is as follows:  contract traded, buy/sell, entry price, exit price, risk (in $), per unit risk, reward (in $), and per unit reward.  You will notice that this trader begins trading with $25,000 in her account and decides her per unit risk is $500, or 2% of the account opening balance.  Per unit risk and reward is a very important concept in trading.  You’ll notice with this trader, the most she is willing to risk going into a trade is 2 units of risk (2R or $1,000).  This trader did an excellent job of containing losses as she stuck to their plan of never taking losses bigger than 2R.  On the other side, the trader is able to put herself in a position for a reward greater than 2R.

The statistics of the trade log give you very important data

  • Number of Trades:  How many do you make?  Do you have a pre-defined plan for each trade or are you winging it?
  • Win/Loss Ratio:  Winning 30% of your trades versus 50% will impact your risk/reward ratio is needed to successful over the long-haul.
  • Winning %:  What is it?  If you are able to have winning trades 60% of the time, you can have smaller average winning trades versus someone with a 30% win rate.
  • Losing %:  What is it?  This is the flipside of the winning percentage as seen above
  • Scratch Trades %:  Do you even take scratch trades (trades that net you nominal gains/losses)?
  • Average Winning Trade:  What is the magnitude of your average winning trades?
  • Average Losing Trade:  What is the magnitude of your average losing trades?
  • Distribution Chart:  I recommend viewing each trade on a “distribution chart” to look beyond the “averages”.  This is composed of R-multiples on the x-axis and the number of each winning/losing trade on the y-axis.  This gives you a visual representation of your trading results.
  • Trade Map:  Lists each trade with defined buy/stop loss and stop before trade is even entered.  This helps you learn to define your risk and think about objectives for the trade.  This is where you will outline your risk management plan for the trade, when and where you move stops and why.  See an example of a “Trade Map”
  • Expectancy of your trading:  For every 1R ($500 in this example) of initial risk you take, how much do you get back?  In example provided, it would be +.86R or $430.  If your “R-number” is negative, you will lose money over the long-haul.  If your “R-number” is OR, you are a break-even trader.  And if you have a positive R, you are a winning trader.  Keeping this our example of 1R equals $500, an expectancy of -.25R means you will lose $125 for every $500 of initial risk taken.  If the expectancy is 0R, it means you’ll return $0 for every $500 you risk.  A positive expectancy is what every trader strives for.  A positive expectancy of .4R means the trader will return $200 for every $500 risked.

As you can see, a trade log is a valuable tool needed for successful trading.  It will begin to shine light into your trading habits and the forces you to evaluate your trading decisions.  Over time, you will learn the “expectancy” and distribution of your trading.  If you find that you do not like your results, you must be willing to evaluate your trading in an honest light and begin making the necessary steps to improvement.  The trade log can immediately impact your trading and your bottom line, so I encourage you to make it an integral part of your trading.

I invite all feedback and questions below or directly at 312-706-7649 (toll-free 877-224-1953) or via email at Tim Chilleri.

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Filed Under: Getting Started, Trading Tips Tagged With: , , , , , , ,
March 5, 2011 by 2 Comments

Basics of Futures Spread Trading

Futures Spread Trading has traditionally been known as a professional’s trading strategy.  However, we feel it is a trading method that should be in everyone’s arsenal.  Our goal here is to layout the basics of spreading so you will have a solid foundation of knowledge in this essential trading strategy.

Types of Commodity Futures Spreads

Inter-Commodity Futures Spread

Futures contracts that are spread between different markets are Inter-Commodity Futures Spreads.  One example of this is Corn vs.  Wheat.  Let’s say the trader thinks that the Corn market is going to have higher demand than the Wheat market.  The trade would buy Corn and sell Wheat.  The trader does not care if the prices of Corn and Wheat go up or down; the trader only wants to see the price of Corn appreciate over the price of Wheat.  If the grain markets sell off, the trader wants to see Corn hold its value better than Wheat.  If the grain markets are bullish, the trader wants to see Corn advance farther than Wheat.

Intra-Commodity Calendar Spread

An Intra-Commodity Calendar Spread is a futures spread in the same market (i.e. Corn) and spread between different months (i.e. July Corn vs.  December Corn).  The trader will be long one futures contract and short another.  In this example, the trade can either be long July Corn and short December Corn OR short July Corn and long December Corn.  In order to be in an Intra-Commodity Calendar Spread, the trade must be long and short the same market (i.e. corn) but in different months (i.e. July vs. Dec)

Bull Futures Spread

A Bull Futures Spread is when the trader is long the near month and short the deferred month in the same market.  Let’s say it is February of 2011.  You buy May 2011 Corn and sell July 2011 corn.  You are long the near month and short the deferred month (May is closer to us than July).  It is important to note that the near months for futures contracts tend to move farther than faster than the back months.  If corn is in a bull market, May (near month) should go up faster than July (deferred month).  That is why this strategy is called a Bull Futures Spreads.  Since the front months tend to outperform the deferred months, a trader who is bullish on corn would buy the near month, sell the deferred month, and would like for the near month to move faster and farther than the deferred months.

This relationship between the near and deferred months is not always true 100% of the time, but it is the majority of the time.  That is why when you are long the near month and short the deferred, it is called a bull futures spread.  The spread should go in your favor when prices are rising.

Bear Futures Spread

A Bear Futures Spread is when the trader is short the near month and long the deferred month.  This is the opposite of our Bull Futures Spread.  Again, let’s say it is February of 2011.  You sell May 2011 Corn and buy July 2011 Corn.  You are short the near month and long the deferred month.  This is a bear spread because the near months ten to move faster and farther than the deferred months.  If Corn is in a bear market, May (near month) should go down faster than July (deferred month).  This is not always true 100% of the time, but it is the majority of the time.  That is why when you are short the near month and long the deferred month, it is called a Bear Futures Spread.  This spread should go in your favor when prices are declining.

Futures Spread Trading Margins

Margins for individual contracts may be reduced when they are part of a spread.  The margin for a single contract of corn is $2025.  However, if you are long and short in the same crop year, the margin is only $200.  If you are long or short corn between different crops year (July vs.  Dec) then the margin is $400.  The crop year for corn is December through September.

The exchanges reduced the margins because the volatility of the spreads is typically lower than the actual contracts.  A futures spread slows down the market for the trader.  If there is a major external Corn market event, like the stock market crashes, the fed raises interest rates, a war breaks out, or a foreign country defaults on its bonds half way across the earth, both contracts should be affected equally.  It is this type of protection from systemic risk that allows the exchange to lower the margins for spread trading.  If you would like to know more about how Spread Trading hedges against Systemic Risk, please read my previous article, “Hedging Systematic Risk”

Futures Spread Pricing

Spreads are priced as the difference between the two contracts.  If May Corn is trading a 600’0 a bushel, and July is trading at 610’0 per bushel, the spread price is 600’0 May – 610’0 July = -10’0.  If May was trading at 620’0 and July was 610’0, the spread price is 620’0 May – 610’0 July = +10’0.

Futures Spread Quotes

When pricing spreads, you always take the front month and subtract the deferred month.  If the front month is trading lower than the deferred (like our first May vs.  July example), the spread will be quoted as a negative number.  If the front month is trading higher than the deferred month (like our second May vs.  July example), the spread will be quoted as a positive number.

Futures Spread Tick Values

Tick Values are the same for spreads as they are for the individual contracts.  If the spread between May Corn and July Corn is -10’0 cents, and the spread moves to -11’0 cents, that is a 1 cent move.  1 cent in corn is $50 for all months and spreads in the standard 5000 bushel contract.  The tick values are the same for spreads as they are for their individual contracts.

Contango Markets

A market is in Contango when the front months cost less than the deferred months.  This is also known as a “normal” market.  If a bushel of corn in May costs 600’0 and a bushel of corn in July is 610’0, that market is in Contango.  In normal markets, the deferred month should cost a little more than the front month due to the cost of carry, which is made up of storage costs, insurance on stored commodity, and interest rates payments for the capital needed to own and store the commodity.

Backwardation

When markets are in Backwardation, the near months are trading higher than the deferred months.  Markets in Backwardation are also called ‘inverted” markets.  They are the opposite of Contango or “normal” markets.  Backwardation typically occurs during bull markets.  When there is a substantial supply issue or increase in demand, the front months of a commodity will start to go up faster than the back months.  The front months are more sensitive to changes in supply and demand because the front months are the commodity months that are coming to the market for deliveries.  If there are supply decreases or demand increases, it is easier for the market to account for these in the deferred months, especially in the next crop year, also known as the “new crop”.

For example, let’s say it is February of 2011 and there is a shortage of corn.  The “old crop” months are March, May, July and September.  The “new crop” starts in December.  There is not much the market can do about the supply from March to September, when Corn is being planted, grown and harvested.  The corn that is made available during these months is coming out of stocks and storage.  However, the market does have some control over December and the months going into 2012, like using more farming acres for Corn.

New acres devoted for corn will help the new crop keep prices stabilized for the deferred months.  The near months will still increase because corn can not be harvested until the fall, but the deferred months should be able to help with demand and will not go up as fast as the near months.

Futures Spreads and Seasonality

Many commodities markets have seasonal periods of supply and demand.  Some commodities are in higher demand during the summer, like Gasoline and Crude Oil, while some have a higher demand in the winter, like Natural Gas, Heating Oil and Coffee.  Commodities also may have seasonal periods of supply, like the grain markets.  The Corn market has the greatest supply right after harvest in the fall, which can lead to lower prices during that time of year.

Traders will use spreads and try to take advantage of these seasonal supply and demand changes.  They look at the performance of spreads over the year during specific time frames to estimate the risk, reward, and probability of success.  If you would like to know more about Seasonal Futures Spread Trading please read my previous article, “Seasonal Futures Spread Trading”

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Finally, if you like this post, you may also like my article “The Wonderful World of Futures Spread Trading”.

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: Getting Started, Spreads, Strategies Tagged With: , , , , , , , ,