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May 23, 2011 by Leave a Comment

Futures Trading: What Are All of These Months?

Almost every new futures trader who I speak with understands basic market fundamentals but gets tripped up when learning about the different months in the futures markets.  While this can seem confusing, it is actually relatively straightforward.  Below I will tell you what commodity futures are, why they are traded in different months, and how they differ from other investments.

What is a Commodity Futures Contract?

Before figuring the months out, we should first establish some basic definitions.  To start, what is a commodity?  A commodity is a good for which there is demand.  It is any moveable good or article of commerce that is bought and sold.  Examples of commodities are stocks, bonds, corn, gold, and sugar, just to name a few.  Second, what is a commodity futures contract?  A commodity futures contract is a standardized binding agreement between two parties to buy or sell a commodity at a later date.  A futures contract can only trade on an exchange through a public auction where participants place bids and offers in a competitive marketplace.  A trade occurs when two parties agree on a price for the commodity futures contract.  Just as each share of stock that is traded has precise specifications, so does each futures contract.  An example is the gold futures contract.  A gold futures contract is traded on the Chicago Mercantile Exchange (CME).  The gold contract is standardized at 100 troy ounces and the commodity must meet particular grade and quality specifications.  Traders know that every gold futures contract traded on the CME has the exact same characteristics (and is fungible).  For more information on the definition of a futures contract please visit our Instant Futures Lesson on the Futures Contract.

The Difference between Futures and Other Tradable Assets

Much of the confusion that investors have regarding futures and the different delivery months stems from their knowledge of the stock and real estate market.  With stock and real estate, the investor actually owns the physical asset when he/she decides to enter the market.  Generally, the investor holds the investment that he is speculating in until he is ready to take a profit or loss.  However, with commodity futures, the trader is speculating on the price of the commodity without actually owning it.  Simply put, one can purchase a futures contract and not actually own the physical good.  The trader is simply speculating on the price of the underlying asset and owns the right to purchase or sell it in the future.  This allows the trader to hold a position in any given commodity without needing to physically hold the asset.

So, What about the Months?

Now that we know the definition of a commodity and a commodity futures contract, we can explore why there are different months associated with each contract.  Every commodity futures contract has a delivery month and these months can be traded forward for years.  Because we are trading a commodity futures contract and not the actual physical commodity, the futures contracts will eventually expire and the commodity must be delivered.  For example, an oil future contract can trade in September of 2011, December 2011, March of 2012, etc.  If you buy the September 2011 oil future (long 1 GLCU1), you must exit the trade by late August or you will take delivery of the crude oil.

Understanding Expiration and Delivery

Delivery will be made or received on any open futures positions once the contract month expires.  However, as most speculators are not interested in making or taking delivery of the commodity, they will close out their positions for that month before delivery.  The majority of traders close positions before delivery and few traders ever make or take delivery on futures contracts.  A good broker will ensure that you never have delivery issues.  However, if you are interested in making or taking delivery, a good broker can assist you with the details of performing this procedure.

When a futures contract is traded, the participants are agreeing to the month or delivery date in addition to the contract specifications.  For example, if you are trading soybean futures, you are trading a delivery month in the future.  You are not actually trading the physical soybean; you are trading a soybean that will be delivered at a future date.  The month represents when the soybean contract will expire (this is the point that the trader must have his position liquidated or he must take delivery).

Be Aware of the “Front Month”

Almost every futures contract has what is considered a “front month”.  The front month is the month where the majority of the trading volume and liquidity occurs.  It is also the month that is usually referred to when one talks about the price of the commodity.  There is no standard for the definition of what the front month is.  However, the front month is usually a nearby month and changes or “rolls” a few times a year.  Many contracts have different delivery months.  While this may seem confusing, simply checking the volume and the expiration date of the contract month can be a good way to determine where the front month is trading.  Your broker can also assist you with this.

Know Your Symbols

Lastly, when the month of the contract is listed, it is represented with a letter.  This is the standard for the futures industry.

Jan F Jul N
Feb G Aug Q
Mar H Sep U
Apr J Oct V
May K Nov X
Jun M Dec Z

Conclusion

Understanding that commodity futures contracts trade in different months is one of the first steps towards gaining market knowledge.  While there are differences between futures and other tradable investments, once you understand the basics, you can decide whether trading futures is right for you.  The different months of a commodity futures contract only represent when the contract is set to expire.  In the end, prices go up and prices go down.  The market waits for no man.  Knowing some technical details such as the different months can help traders, hedgers, and investors gain confidence and take advantage of the futures markets.

Watch our Futures Trading and You video below to learn more about “Gaining Knowledge”.

Futures Trading Simplified:  How to Gain Confidence & Learn the Process of Trading Commodities

Want to learn more about futures trading?  This is the guide for you.  We’ll make the mountain of learning a molehill with our informed “Roadmap to Trading”.  We know the route and have marked the way… all you need to do is follow!  Download your free “Futures Trading Simplified” eBook.

Filed Under: Getting Started Tagged With: , , , ,
May 20, 2011 by 15 Comments

Bear Put Spreads:  An Alternative to Purchasing Puts

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy puts.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing puts is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here:  Options on Futures:  An Introduction to Buying Options.  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bear put spreads into your trading strategy.

What is a Bear Put Spread?

A bear put spread is a position that involves purchasing a put option on an underlying futures contract, while simultaneously writing a put option on the same underlying futures contract with the same expiration month, at a lower strike price.  As the name of the strategy hints, this is a position that is appropriate for a bearish market sentiment.

Why not just purchase a put?

This is one of the most common questions posed when a trader is first learning about bear put spreads.  Bear put spreads allow a trader to pay less premium to get involved in a position than simply purchasing a put.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a put that is closer to at-the-money.

How it works

As noted above, a bear put spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the put, but they also receive premium for selling a put as well.  For a bear put spread, a trader would typically purchase an at-the-money put and sell an out-of-the-money put to initiate a bear put spread.  The selling of the out-of-the-money put helps the trader finance the purchase of the at-the-money put.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Gary has a bearish sentiment on the crude oil market.  He decides the most cost effective way to get involved in the market is to enter a bear put spread.  Gary decides to get involved in July crude oil as it provides a reasonable time frame for the move he thinks will occur.  July crude oil futures are currently trading at 99.31.  Larry decides to enter a 99.00/90.00 bear put spread.  See below for the specifics on the options:

Purchase One July 99.00 Crude Oil Put Option for $3,920 (Pay)
Sell One July 90.00 Crude Oil Put Option for $1,130 (Collect)

Total Premium Paid for Position = $2,790 (3920 – 1130)

Gary’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$9,000 Difference in futures price (9*1000)
-2,790 Premium paid for call spread
$6,210 Maximum profit potential

Gary’s maximum risk is the $2,790 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July crude oil futures market is trading at under 90.00.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

  • July 99.00 crude oil put expires on June 16th, the option is exercised and Gary’s account is short crude oil futures contract from 99.00.
  • July 90.00 crude oil put expires on June 16th, assigning Larry’s account a long crude oil futures contract from 90.00.
  • The short 99.00 July crude oil futures is immediately offset by the long 90.00 July crude oil futures contract, allowing Gary to show a futures gain of $9,000 (9 * 1000).
  • Gary’s realized profit is the gain in the spread offsetting by the cost of the spread, or $6,210.

Conclusion

As you can see, there are opportunities in the options market using the bear put scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

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

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

Filed Under: Options, Spreads, Strategies Tagged With: , , , ,
May 19, 2011 by 1 Comment

Trading In Volatile Markets

This post originally appeared in FutureSource’s Fast Break Newsletter on May 17, 2011 where Craig Turner is a regular contributor on various futures trading topics.

Trading in volatile markets provides extraordinary opportunities but it also carries more risk.  For more aggressive traders, volatile markets can lead to larger than normal losses, but they can also provide rare opportunities that can be highly advantageous for your trading account.  If you are going to trade in volatile markets, or if you have positions and the markets become volatile, you need to know how to recognize the warning signs and navigate through the storm.  You have to be able to manage risk if you want to take advantage of substantial price moves.

1) Margins are Inadequate Guidelines in Volatile Markets

When a market is volatile, the first thing you should do is make sure the margin requirements are greater than the daily ranges in the market.  For example, when Silver was trading from $20 to $50, the exchange and clearing firms did not raise margins.  Anyone who has traded silver knows it can trade down 10% on its worst days.  In my opinion, margins should be at least a day’s trading range for any contract.  When Silver traded at $15 and $20, the biggest down days would be $1.50 to $2.00.  Margin for silver would be around $10,000 ($2.00 in the big contract).  This was appropriate for the contract.

Looking back, there was a big warning sign the Silver market could become a volatile market.  The red flag was the exchanges and clearing firms not raising margins as the Silver traded to $30 and then $40.  As the market climbed higher, the daily trading range was higher.  Margins stayed the same.  This meant that it was possible that too many traders were in the market without enough capital, which is always a recipe for volatility.

If you are trading a volatile bull or bear market, you need to use the possible daily trading ranges as a guideline for capital.  Exchanges and clearing firms are slow to act.  They are rarely ahead of the curve on margin issues, and they are usually caught off guard and have to increase margins after the damage is done.

By understanding that you need more capital on hand to trade volatile margins, you will have more staying power than the average trader.  The trader using margin as a guideline will not be able to stay in the position.  A trader who understands that volatile markets can have higher trading ranges than the exchange margin should be able to ride out the storm better.

2) De-leverage When the Markets Become Volatile

When the markets are volatile, it is not the time to double up.  If you are trading two contracts, it is the time to de-leverage and just trade one.  If you are trading one standard contract, it might be the time to shift gears and trade the mini contracts for a while.

When the markets become volatile, it doesn’t mean you have to stop trading.  Your opinion of the markets can still be correct but outside factors may be an issue.  For example, the US Dollar, European nations needing bailouts, wars in the Middle East, the natural disaster in Japan, can all affect the markets.  In my opinion, what you need to do is take on less risk during these times.  The only way to really achieve this is to de-leverage. The best way to do this is to reduce your position size so you can stay in the game.

3) Spreads May Help With Reducing Volatility

One possible way to hedge against volatility is to trade futures spreads.  Let’s say a trader has a long corn position in December 2011 corn.  The grain markets and commodity markets start to become volatile due to the US Dollar rallying because there are fresh concerns about the Euro and its member countries defaulting on their debt.  The soaring dollar is going to hurt the trader’s long Dec Corn position.

Let’s say the trader is very bullish on corn, understands the market could go down in the short term, and wants to stay in his position for the medium to long term.  Using the spread methodology, the trader would then short a different month in Corn to attempt to protect himself.  In this case, the trader would most likely short July 2011 Corn or Dec 2012 Corn.  Either way the trader can now better ride out the storm until the volatility passes.  Once the trader is confident again that corn will start moving higher, he just lifts the short corn leg of the spread and leaves the long Dec 2011 Corn position on.

What is nice about this option is the margin the trader was using for long 1 contract of corn (over $2000) is now about $500 for the spread.  Not only is the trader potentially reducing risk, he is also reducing margin requirements.  The trader does not have to come up with more capital to short an extra contract.  Because, on average, futures spreads reduce risk when compared to outright positions, the exchanges recognize this and require less margin.

4) Options Offer Protection on Existing Futures Positions

There are two ways to use options in volatile markets.

For those trading futures, you can use options to hedge against short term volatility.  Let’s say you are long December Corn and you think the market could sell off 20 to 30 cents before rallying a full dollar.  The trader can keep the Corn position on and also buy a December Corn put.  If the market really does sell off 20 to 30 cents, the trader can liquidate the option for a profit and then hold Corn as he looks for the bottom to come and the rally to start.

The second way to use options is to not trade futures during times of volatility and just use Option Spreads.  Let’s say you are bullish December Corn, you think the markets are going to be volatile, but you want a bullish position.  By using a bull call spread in December Corn, the trader has a defined risk and reward, and the short term volatility should not change the value of the spread nearly as much as a futures contract or just being long a single call option.

5) Summary

When the markets become volatile, traders need to have more capital for their positions.  Greater daily trading ranges means traders should have more capital per position.  If the trader does not have the capital for the increased volatility, they need to de-leverage.  One way to de-leverage is to either reduce position size or trade mini contracts instead of standard contracts.

Another way to de-leverage is to use futures spreads.  Traders caught in a volatile market can use futures spreads to potentially reduce the risk in their position.  They can leg out of the spread into their original position after the smoke has cleared.  Finally, traders can also reduce risk and de-leverage by using options with their futures position or just use option spreads, like a bull call spread or a bear put spread.

All in all, the most important thing to take away is that when the markets are volatile, traders need to reduce their risk exposure.  While volatility may provide extraordinary profit potential, it also may lead to greater than normal risk.  Traders need to manage this risk while still being able to take advantage of price movements in the market.  By reducing their risk exposure, traders will be able to stay in the game and have the opportunity to go after substantial price moves.

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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: Risk, Strategies Tagged With: , , , ,
May 18, 2011 by Leave a Comment

5 Tips for Option Writers

Tip 1:  Have a Disciplined Plan

Writing options should not be treated any different than any other type of investment.  You must plan your trade and trade your plan.  That being said, you must determine the profit and risk parameters around each trade.  In the case of writing options, your maximum profit is the premium collected upfront.  The struggle many option writers face is how to manage the position when the market begins moving against them.

Writing naked options are one of the most difficult strategies to manage because the risk is unlimited.  Leveraged markets, like the futures markets, can move very quickly, which can make it extremely difficult to properly manage risk.  Even if you have a mental stop to cut your losses, a severe move in the market might not allow you to exit at that point.  Premiums can double or triple before you have a chance to buy back the option.  This is why it is so important to have a concrete plan in place.  In the event a market does move against you, your trading plan will allow you to act quickly to prevent further damage.

If the concept of unlimited risk is unappealing, one solution to naked options would be credit spreads.  Credit spreads have predetermined trade parameters on both the profit and loss side of the trade.  You can easily determine your best and worst case scenario upfront.  The majority of options will expire worthless, but that doesn’t mean the position won’t go through its ups and downs.  By accepting the risk/reward parameters of the spread, you should be comfortable sitting through the day to day fluctuations and only make modifications if your long term outlook changes.

Tip 2:  Control Your Leverage

Options provide a fantastic opportunity with leverage; however it is important to be smart in how to use this leverage.  A unique obstacle option writers must overcome is margin.  Unlike the underlying futures, margin designated to selling options is not a flat rate.  Instead, margin is determined by SPAN.  SPAN is a set of sophisticated algorithms that determine margin according to your positions one day risk.  The distance a strike price is to the underlying, the time left until expiration, and volatility are all factors that can affect our margin.  That being said, margin is simply a guideline.  This is why leverage is so important.  You might be properly leveraged according to your margin on day one, but as time goes by and as the underlying futures moves, the margin can drastically change.  Dramatic, volatile moves can cause traders to exit positions early due to margin calls.  The greater the leverage, the more sensitive your position is going to be to these price swings.  This is another reason why many traders prefer credit spreads.  Credits have a defined risk and will in turn have less severe margin swings.

Tip 3:  Do Not Hang on to Worthless Options

The point of writing options is to collect the time premium and allow the value of the option to decay.  Although the goal is to have our options expire worthless, it does not mean we cannot buy the option back early.  This is especially true when there is a lot of time left on the option.  If 80-90% of the total options value has decayed, it does not make sense to keep on the risk of the position for the extra 10-20%.  There are certain strategies that will require holding the options until expiration, but unless your strategy involves writing far out of the money options for a few ticks, it would likely make sense to take the risk off the table.  It is important to continually reevaluate the risk and the management of the trade throughout the life of the position.

Tip 4:  Be Aware of Major Reports and Events

Whether you are a technical trader or a fundamental trader, you must be aware of key market reports and events.  You should have access to an economic calendar that will identify all scheduled reports.  We will need to keep these dates in the back of our minds when analyzing our trades.  As discussed in our last tip, if the majority of our option’s premium has been removed prior to a report, it might be best to take the risk off the table in case the report is extremely one sided.

Tip 5:  Choose Markets You are Comfortable With

We should have a good understanding of the markets current trend and the long term fundamental picture.  An awareness of the fundamentals, scheduled reports, and key technical areas (trend lines, moving averages, pivots, etc.) are vital aspects of how we analyze our trade.  The more comfortable we are with what is driving the market, the more confident we can be with our analysis.  The more we trust our analysis, the easier it will to evaluate our position and determine if a sudden move is a short burst in the market or the beginning of a new trend.  We should have a good feel for the market’s volatility and typical trading range, so we can identify when the current market environment begins to change.  This comfort and knowledge should help you stay more disciplined and follow the trading plan established upon entering the trade.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

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

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

Filed Under: Options, Strategies Tagged With: , , , , ,
May 17, 2011 by Leave a Comment

Bull Call Spreads: An Alternative to Purchasing Calls

Options are a great way to get involved with the futures markets.  One of the most popular ways to trade with options is to buy calls.  This provides traders a way to trade the futures markets with a defined risk and unlimited profit potential.  One of the downfalls of purchasing calls is that they can be expensive if you purchase them at-the-money (If you need a refresher on purchasing options, see my previous article here: Options on Futures:  An Introduction to Buying Options).  One way to reduce the price of an option is to use spreads.  This article will teach you how to implement bull call spreads into your trading strategy.

What is a Bull Call Spread?

A bull call spread is a position that involves purchasing a call option on an underlying futures contract, while simultaneously writing a call option on the same underlying futures contract with the same expiration month, at a higher strike price.  As the name of the strategy hints, this is a position that is appropriate for a bullish market sentiment.

Why not just purchase a call?

This is one of the most common questions posed when a trader is first learning about bull call spreads.  Bull call spreads allow a trader to pay less premium to get involved in a position than simply purchasing a call.  If a trader has a smaller account, it will also allow them the opportunity to get involved with a call that is closer to at-the-money.

How it works

As noted above, a bull call spread deals with the simultaneous purchase and sale of options on the same underlying futures contract in the same expiration month at different strike prices.  Why is this done?  The trader obviously pays for the purchase of the call, but they also receive premium for selling a call as well.  For a bull call spread, a trader would typically purchase an at-the-money call and sell an out-of-the-money call to initiate a bull call spread.  The selling of the out-of-the-money call helps the trader finance the purchase of the at-the-money call.  The maximum profit would be the difference between the strike prices of the options minus the amount paid for the spread.

Example

Larry has a bullish sentiment on the gold market and believes it will continue in its bullish ways.  He decides the most cost effective way to get involved in the market is to enter a bull call spread.  Larry decides to get involved in July gold as it provides a reasonable time frame for the move he thinks will occur.  July gold futures are currently trading at 1512.5.  Larry decides to enter a 1510/1550 bull call spread.  See below for the specifics on the options:

Purchase One July 1510 Gold Call Option for $3,700 (Pay)
Sell One July 1550 Gold Call Option for $2,100 (Collect)
Total Premium Paid for Position = $1,600 (3700 – 2100)

Larry’s maximum profit on the trade is the difference in the strike prices minus the total premium paid.

$4,000 Difference in futures price (40*100)
-1,600 Premium paid for call spread
$2,400 Maximum profit potential

Larry’s maximum risk is the $1,600 he paid to enter the spread.

This spread will realize maximum profit at expiration if the July gold futures market is trading at over 1550.0.  The options will be exercised, offsetting each other at the strike prices assigned to each option.  See below for how this would work at expiration:

  • July 1510 Gold call expires on June 27th, the option is exercised and Larry’s account is long a gold futures contract from 1510.
  • July 1550 Gold call expires on June 27th, assigning Larry’s account a short gold futures contract from 1550.
  • The long 1510 July Gold futures is immediately offset by the 1550 July Gold futures contract, allowing Larry to show a futures gain of $4,000 (40 * 100).
  • Larry’s realized profit is the gain in the spread offsetting by the cost of the spread, or $2,400.

Conclusion

As you can see, there are opportunities in the options market using the bull call scenario above.  It offers a great way to get involved in options at a desirable strike price with a limited risk.  You don’t have to wait until expiration to exit the spread.  You can exit any time you’d like to limit losses or collect profits before expiration.

Free Futures and Options Strategy Guide

Discover how to structure your trades for maximum profit potential with these 21 futures and options trading strategies.  Download your Futures and Options Strategy Guide.

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

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

Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
May 16, 2011 by 4 Comments

Wheat By Any Other Name…

When it comes to trading wheat futures, it is paramount to know the types of wheat is out there and where to trade each variation.  As the summer begins to arrive along the southwestern plains, news continues to come out about the drought and hot temperatures there creating a poor quality crop.  The speculator in us all tells us to buy wheat as the supply coming online will be small and poor in quality.  We want to own what is scarce!

If this were corn or soybeans our strategy would be simple.  We would call our Daniels Trading broker and put in an order to buy Corn or Soybeans traded at the Chicago Board of Trade, the only domestic Corn or Bean futures contracts available.  When it comes to wheat futures, things aren’t as clear cut.  Wheat grown in the Western Plains is not the same wheat grown east of the Mississippi, and the prices will reflect that.  Each has different protein levels and is used in producing different end goods.  The supply and demand picture can be different as well.  So to potentially turn our inclinations into profits we need to make sure the instrument we are using is the correct and intended one.

There are three main types of tradable wheat with active, liquid futures contracts.  In this business each type is referred to by the city in which it is traded: Chicago Wheat (Soft Red Winter Wheat), Kansas City Wheat (Hard Red Winter Wheat), and Minneapolis Wheat (Hard Red Spring Wheat).  The classifications of “spring” and “winter” refer to the time of the year each are planted.

Kansas City Hard Winter Wheat

The most prevalent type of Wheat grown in the United States is the Hard Red Winter Wheat traded in Kansas City.  This Wheat is grown in Kansas, Texas, Oklahoma, and Nebraska.  The KC Wheat is used primarily in bread making and is widely used around the world.  KC Wheat represents half of the total domestic wheat production here in the US..  This type of wheat has a mid to high level of protein in it and can be used as a substitute for livestock feed if necessary.  It is in tight supply right now due to difficult growing conditions in the areas mentioned above.  The pit traded symbol for this type of wheat is KC, the Globex symbol is KE.

Chicago Soft Winter Wheat

Soft Red Winter wheat or Chicago Wheat is the most actively traded wheat contract and is traded at the Chicago Board of Trade.  When most people speak of wheat futures they are referring to this contract.  Chicago Wheat is mostly grown east of the Mississippi river in more humid environments.  Chicago Wheat is produced for its ability to be processed into flour.  It has light protein content and isn’t as good of a substitute for animal feed as other wheat and isn’t used in much bread either.  We typically find this type of wheat in our cakes and sweet flour based snacks.  The Pit symbol for CBOT wheat is W, and the Globex symbol is ZW.

Minneapolis Hard Spring Wheat

The third and least traded type of wheat futures contract is the Hard Red Spring wheat traded on the Minneapolis Grain Exchange.  Minneapolis Wheat is grown in the Dakotas, Montana, Wyoming, and Idaho.  It is typically the heartiest wheat available.  Due to its high protein content it is used in bread making and is a competent substitute for animal feed.  This crop is typically the last wheat crop to go into the ground due to its northern locale.  It is also the least traded of the three wheat contracts and in times of tight supply has seen the most volatile of price movements.  The pit symbol for “Minny” Wheat is MW, the electronically traded symbol is MWE.

There is a Difference

So now that we are aware of the different wheat contracts it is important to differentiate between them when constructing trade ideas.  If one is looking to just get long wheat, it might be a good idea to take a look at each crop individually to see which is more susceptible to market movements.  Spreading (ex.  Buying KC Wheat /Selling Chicago Wheat) is an effective way to isolate a certain crop and protect against outside market volatility.  The KC/Chicago example has been effective of late, the drought in the KC Wheat crop (Dec) has added close to an 80cent premium ($4000 per contract) over the Chicago wheat (Dec) in recent months.  So ,if a trader saw that the weather in the pan handle of Texas was getting worse and wanted to buy wheat to profit from crop destruction it would behoove them to look and see what type of wheat is grown in that area and where it is traded.  If they saw that the KC Wheat was grown there and placed a buy order on KC Wheat rather than the Chicago wheat the profits would have been greater.  It pays to know!

Whatever the strategy, it’s vital to know not all wheat is the same and needs to be differentiated when being traded.  If you have any questions on wheat and how you can potentially profit from it contact your Daniels Trading broker for assistance and trade ideas.

Free Grain Trading Starter Kit

Learn the basics of grain trading and discover potential opportunities in the agricultural markets.  Download your complimentary Grain Trading Starter Kit.

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 Tagged With: , , , , ,
May 10, 2011 by Leave a Comment

Hedging by Purchasing Options: A Margin Free Way of Risk Management

Talk with any hedger and they’re sure to tell you about an experience with trading on margin.  Margin is a good faith deposit that a hedger must have in their account in order to initiate a long or short futures position.  For example, the margin on a corn contract is currently $2,362.00.  This means that if you want to get into a corn futures position, your account must have at least $2,362.00.  In order to maintain the position, a hedger must meet maintenance margin requirements.  The maintenance margin requirement for corn is currently $1,750.00.  This means that the value of the hedgers account must always be above $1,750.00 in order to maintain the corn futures contract.  If the account value falls below $1,750.00, the hedger will be on a margin call.  The hedger will need to either deposit enough money in the account to get back to the initial margin area ($2,362.00) or liquidate the position to meet the margin call.  The hedger’s goal is to have their cash position hedged, so the logical decision is to meet the margin call and deposit funds into the account.

You can see how the above scenario can cause unneeded stress on a hedger.  Luckily, hedgers have the option markets as an alternative to an outright futures hedge.  This article will summarize how producers and users of commodities can purchase options for a margin free hedge.  If you aren’t familiar with how purchasing options works, see a previous article I wrote here: Options on Futures:  An Introduction to Buying Options.

Purchasing Options for Hedging

Purchasing options offers a margin free way to help roughly determine a price you will receive or pay for your commodity.  The costs to do this will only include the premium paid for the option plus the commissions and fees.  Purchasing an option for hedging has many of the same similarities of purchasing insurance on a vehicle.  Think about it, when you purchase insurance on a vehicle, you’re required to pay a premium for a certain time period of coverage.  The same applies to purchasing options on commodities.  You select a delivery month and purchase an option by paying a premium for the option.  The only money you have at risk is the amount paid for the option.  If the market benefits your cash position, the option will expire worthless and you will be out the premium paid.  The same applies to insurance on your vehicle.  If you don’t need to use the insurance, the coverage for that time period expires and you will be out the premium you paid for coverage.

Real-World Examples

John the farmer has 200 acres of corn he’d like to hedge.  Using an average of 150 bushels per acre, he expects he’ll have 30,000 bushels of corn to sell at harvest.  Given the recent rise in prices in the corn market, he wants to lock in a bottom price he’ll receive for a percentage of his corn.  He decides to hedge 50% of his crop, or 15,000 bushels.  He decides that the bottom price he’d like to receive is roughly $5.60 per bushel.  Since he will be selling his crop in October, he’ll need to use the December put options to hedge his position.  December futures are currently trading at $6.76.  Knowing that each put option represents the right to sell 5,000 bushels at a specified price; he knows he needs to purchase three options to achieve his hedge.  Options are quoted in cents, with each cent representing $50.  The current price for $6.00 puts is 40 cents, or $2,000 for each put.  John purchases three $6.00 corn puts for a total of $6,000 plus commissions and fees on April 19th.

You might be wondering why John purchased $6.00 puts when his goal is to lock in a price of $5.60.  The reason for this is that you have to find an option that will equal the price you are looking to receive after the cost of purchasing the option.  With his goal being locking in $5.60 per bushel, he knows that by purchasing the $6.00 calls for 40 cents each he will be able to lock in a price of $5.60.

October is now here and the December corn futures price is $5.50.  The $6.00 puts are now worth $3,500.  Due to the time value left in the puts ($1,000), John decides to liquidate them instead of exercising them into futures positions (refer to the article linked above to refresh your memory on time value and intrinsic value).

$3,500  (Gain from liquidating option)
-2,000   (Amount paid per option)
$1,500   gain per option
x      3    options
$4,500   gain from hedging with options
-1,500   (10 cent loss per bushel in cash grain times 15,000 bushels)
$3,000  total gain

Due to the option still having time value left, John was actually able to receive $5.70 per bushel for his corn (3000/3 contract = $1000 gain per contract / $50 per cent = 20 cents + cash price of $5.50 = $5.70 per bushel).  This is 10 cents higher than he initially was looking to receive for his corn.

Summary

Hedging with options is a great way to provide a margin free from of risk management.  Simply figure out the price you would like to receive for what you produce, and find an option that helps you lock in that price after the price of the option is paid.

Free Options Trading Starter Kit

Your comprehensive starter kit will include over 75 pages of professional options trading guidance and education.  With it, you’ll quickly learn the basics of options trading and discover the potential opportunities in trading options on futures contracts.  Download your free Options Trading Starter Kit.

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

Filed Under: Hedging, Options, Risk, Strategies Tagged With: , , ,
May 6, 2011 by Leave a Comment

Taking the Fear out of a Futures Account

I frequently talk with investors who are attracted to the opportunity and excitement of trading futures but afraid of the risks associated with the markets because they have limited knowledge of how the futures markets work.  Being a 21st century investor requires the flexibility to use all the opportunities available in order to diversify your portfolio and potentially enhance your returns.  With the right plan, investors may benefit from trading futures by embracing the associated risks and managing them wisely rather than running from them.

While trading futures and options can be intimidating, understanding the mechanics of the market and the associated risks can help you to gain comfort and confidence.  And, with the right tools at your disposal, you can take advantage of market sectors that others may be unaware of.  In an age where knowledge and speed are essential for getting ahead, using all the segments of the investment world will only allow for more opportunities to present themselves.

Getting Comfortable with the Mechanics and Risks of the Commodity Futures Market

No investor wants to put their money at risk without understanding the mechanics of the market, and the average investor often sees the futures markets as exotic and risky.  Many have the attitude, “better to be on the safe side than explore something new.” Since you’re reading this article, you’re likely open to at least considering the possibility trying something new, and that’s a good thing!

Accepting and Managing Risk

Instead of shying away from the issue of risk, let’s deal with it head on.  At Daniels Trading, we believe learning how to accept the concept of risk/reward and balancing your expectations is critical.  We’ve even made a short 3 minute video about it, which you can view below.

Now, to gain a better understanding of many of the specific risks involved in trading futures, I suggest you review our full risk disclosure.

Understanding the Mechanics of the Futures Market

To properly take advantage of market volatility, one must understand the process of how his or her money is working.  At Daniels Trading, we place a high priority on trader education, and we provide a variety of educational tools to assist you in gaining an in-depth understanding of both the decision-making and the trade execution process involved in futures trading.  There is a wealth of free educational material on the Daniels Trading and CME Group websites.  Additionally, contacting a knowledgeable broker can assist you in your quest for understanding the markets.

If you’re interested in learning more about futures trading, below are five excellent resources to get you started:

And, don’t forget, this blog is another great educational resource, so please continue to check back and explore all the articles.

Different Approaches to Trading or Investing in Futures

There are several ways to get involved with futures, and there is not one approach that works for everyone.  Some investors prefer the hands on approach of placing the trades themselves.  Some prefer the assistance of a broker to determine the trades to place.  Still others find comfort in a managed account where the trades are being placed by a licensed Commodities Trading Advisor that has a documented track record.  While each approach has its pros and cons, only you can decide what is right for you.  Speaking with a licensed futures broker can help you find the right approach for employing your strategies.  Learn more about the services offered by Daniels Trading.

Integrity of the Futures Markets and Safety of Customer Funds

Before opening an account, prudent investors want to ensure their money is safe and that the firm they choose has integrity.  With the news is constantly showing stories of Bernie Madoff, credit default swaps, TAPR money, housing foreclosures, and bankrupt investments paying only fractions to investors, many may assume that the futures markets are subject to these manipulations.

Futures trading accounts are customer segregated accounts.  In other words, futures accounts are not commingled with operating capital or pooled with other funds at the brokerage house.  The funds are held in an account at a bank separate from the brokerage house and the exchange.  Furthermore, clients have the freedom to access their funds whenever they want and are sent a statement of the activity in their accounts on a daily basis.  This statement is prepared by the brokerage firm and allows the clients the opportunity to see any transactions that occur in their accounts.

Investors can also check with regulating bodies such as the National Futures Association (NFA) and the Commodities Futures Trading Commission (CFTC) to ensure the integrity of the brokerage firm.  This provides increased transparency on the integrity of the firm.  There are few markets or products that have the regulations that the futures markets employ.  When a customer places a trade in the futures markets, he does this on a regulated exchange with competitive and transparent prices.  The market does not discriminate whether you are a large bank or individual speculator.  Everyone is subject to the same rules.  Ultimately, this serves investors in that they can research the firm, exchange, and product to ensure that it has the standards that they are seeking.

To learn more, read the NFA’s article “The Story Behind the Financial Integrity of the U.S.  Futures Markets”.

In summary, getting comfortable with the mechanics of the market, as well as accepting and learning how to manage the associated risks, are crucial steps to getting started with futures trading.  Furthermore, there are different approaches for trading or investing in futures.  Potential investors should understand the pros and cons of each approach so they may choose the option that best suits their needs.  Finally, knowing that the commodity futures industry is regulated and funds are kept in customer segregated accounts ensures investors that their accounts are safe from outside forces, allowing them to concentrate on the markets.  Armed with this knowledge, I hope potential investors can overcome their fear of the futures market and focus on taking the appropriate steps to achieving their trading and investing goals.

However, for good traders, leverage can make trading a very enjoyable experience.  For great traders, leverage is what makes them more profitable than they could have ever imagined.

Futures Trading Simplified:  How to Gain Confidence & Learn the Process of Trading Commodities

Want to learn more about futures trading?  This is the guide for you.  We’ll make the mountain of learning a molehill with our informed “Roadmap to Trading”.  We know the route and have marked the way… all you need to do is follow!  Download your free “Futures Trading Simplified” eBook.

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