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July 1, 2011 by Leave a Comment

An Option’s Delta. What Is It and What Does It Tell You?

Many traders have heard about an option’s delta, but they have no idea what it means or how they can implement it in their own trading strategy.  An option’s delta will give you the rate of change for an option, the hedge ratio for an option and an option’s theoretical equivalent to the underlying futures position.  This article will focus on helping traders become familiar with an option’s delta and its many uses.

Please click to view the Options risk disclosure below.

Delta is given as a value and quoted with a decimal will call options being from 0 – 1.00 and put options from 0 – (-) 1.00.  However, the decimal is commonly dropped when being discussed and we’ll do the same in this article.  For call options, the value ranges from 0 – 100.  For put options, it ranges from 0 – (-) 100.  A call (put) option with a delta of around 50 (-50) is referred to as an at-the-money option.  A call (put) option with a delta between 0 – 49 (0 – (-) 49) is referred to as an out-of-the-money option.  A call (put) option with a delta between 51 and 100 (-51 and -100) is referred to as an in-the-money option.

Delta helps traders figure out the rate of change for an option compared to the underlying futures position.  The underlying futures position will always have a delta of 100.  If a call option has a delta of 35, it can be expected to change in value at 35% of the rate of the underlying futures position.  Simply, if the underlying futures rises 1.00, the call option can be expected to rise by .35.  As an option increases in value, the delta will change and begin moving more like the underlying position.

Delta also helps traders figure out a hedge ratio.  This is when a trader wants to hedge an option position against the underlying futures contract, also known as being ‘delta neutral.’  Since the underlying contract always has a delta of 100, the hedge ratio is determined by dividing 100 by the options delta.  If an options delta is 50, then the hedge ratio is 100/50, or 2/1.  For every two options purchased, the trader would need to sell one underlying futures position to establish a neutral hedge.  To learn more about delta neutral trading, read my previous article:  Futures Options: Using a Delta Neutral Trading Strategy.

Please click to view the Options risk disclosure below.

Delta also helps traders figure out what an options theoretical equivalent is to the underlying futures position.  Since the underlying futures position has a delta of 100, each 100 deltas in an option position represents a theoretical position equivalent to one underlying contract.  If a trader has an option that has a delta of 50, the option is the theoretical equivalent of holding 50% of an underlying contract.  Delta also gives you the approximate percentage an option has of ending up in-the-money.  If a call option has a delta of 40, then the option has approximately a 40% chance of ending up in-the-money.  If a put option has a delta of -68, it has approximately a 68% chance of ending up in-the-money.  The closer the delta is to 100 for calls and -100 for puts, the greater the chance it has at ending up in-the-money.  Deltas that are closer to zero indicate that the option has less of a chance to end up in-the-money.

As you can see, an option’s delta can tell you many things.  It can tell you the rate of change for an option compared to the underlying position, the hedge ratio, and the theoretical equivalent to an underlying position along with the percentage chance it will end up in-the-money.  All of these can be helpful in understanding how an option moves.

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Options Risk Disclosure:  When selling options, you may lose more than the funds you invested.

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Filed Under: Options, Risk, Strategies Tagged With: , ,
June 29, 2011 by 1 Comment

Credit Spreads: Collect Premium while Keeping Your Clothes On

Readers of this blog should be very familiar with option spreads. We have written in the past (Option Spreads Examined Further: Measured Ways to Play Your Market Hunch, Bear Put Spreads: An Alternative to Purchasing Puts, and Bull Call Spreads: An Alternative to Purchasing Calls) about the different ways traders can participate in leveraged markets with measured risk strategies. In all of those cases, we looked at the buy side of those spreads in order to capture a high rate of return with a lower, set amount of risk. Those strategies should always be in a trader’s tool belt, but we cannot be quick to dismiss the other side of those trades, or the sell side option spread, known better as the credit spread.

Please click to view the Spreads risk disclosures below.

There will always be a place for buying options. However the option is used, if for protection or outright speculation, buying an option provides the opportunity to have unlimited returns with a set amount of risk. I encourage traders to buy options as opportunities are presented. Occasionally, however, the markets are trading with big daily ranges and high volatility, options get “bid up” and the cost due to volatility gets too high. In those cases, it might be better to simply “fade” that volatility by selling options and collecting premium.

Please click to view the Options risk disclosures below.

A sale of an option without any other position is known as a naked short option. The naked short option strategy is used as a way to make money based off where the market will not go. The strategy can be profitable, but over the long run it can bring sharp drawdowns or even the dreaded “account debit” if not properly managed. The problem Daniels Trading has with naked option selling is that it carries unlimited risk. Strategies, such as out of the money naked option selling, have a high probability of success which provide small gains that add up. Sure, there are people who have been successful constantly selling naked options. However, ask anyone who sells option premium in the Crude Oil markets during a supply shock, or someone who sold on short puts in the S&P before the Lehman Brothers bankruptcy, what their opinion is on that type of strategy and they will undoubtedly describe the feeling they had as one akin to being tied down with the market bearing down on them like a train rumbling down the tracks. It is impossible to predict the black sheep that create major market swings and the naked option sellers do not need many losers to be out of liquidity and out of the markets for good. One of Daniels Trading’s senior brokers often makes the great analogy that “[s]elling naked options makes an account’s value go up like an escalator and down like an elevator”.

These two types of spreads provide the opportunity to collect premium while still giving them protection so they can handle the unpredictable and inevitable market events. By selling out of the money-option spreads, one is taking on a higher amount of risk for a lower return, but the odds for success will also be higher. Let us look at an example:

Please click to view the Options and Spreads risk disclosures below.

Ken has $10,000 in an account. He is looking for a trade with a high probability of success. Over the last few days Ken has been watching the December Corn contract sell off from above 7.00 to below 6.30, which has left the bulls screaming for put protection. Ken is a fundamental trader and he has done some analysis, which in his opinion confirms that prices in corn will not fall below 6.00 before the December options expire. He wants to take a long position.  Still, he feels like a futures contract would not be a great strategy because if he is wrong he could be taken out of his position quickly; thus, he is susceptible to the “whipsaw” effect. He decides selling a put spread will provide greater margin flexibility and fits his risk profile better. While December Corn was in the midst of a sell off at 6.30, he decided to sell a 5.50-6.00 put spread in the December Corn options for 21 cents:

Sold 1 Dec 600 put for 46 ($2300)
Buy 1 Dec 550 put for 25 ($1250)
Max profit= 21 Cents ($1050)
Max loss=29 cents ($1450)

Ken’s breakeven is 5.79. He suffers a max loss if his December Corn options expire with Corn anywhere below 5.50. Ken knows his reward is not as high as his risk, but his analysis shows that Corn will stay over 6.00. So, he feels comfortable risking $1450 because Corn will stabilize somewhere over the 6.00 strike price where he sold the put. He also feels comfortable because he can let the markets workout what is taking corn lower. Ken is unconcerned with where he will be next week because his focus is on where he will be in four months. In the worst case scenario, Corn sells off below 6.00 and Ken can lose no more than $1450 dollars on expiration. If December Corn expires over his 6.00 short put, Ken is probably satisfied with the 10% profit he earns over the next five months. Another benefit to the trade is that Ken knows he has an additional $8,000 in free margin which he can use on other trades.

Tips for Trading Credit Spreads

Here are a few simple tips that can help you improve your chance for success and allow you to potentially capture the most profit possible:

Please click to view the Profits risk disclosure below.
  • Sell into heavy price moves. When the market is violent options buyers will often pay more for protection from volatility. The best markets in which to use this strategy are those that have had unsustainable recent price action.
  • Do not put all of your eggs in one basket. Diversify your spreads across multiple uncorrelated markets. Try to look for the markets that are driven by uncertainty.
  • Make sure your account is properly capitalized. Always choose spreads that your account can handle, especially if a max loss occurs.
  • Try to sell option spreads at least 30 days before expiration. The time value is higher and this value comes out of the option price on an accelerated level as expiration nears.

These tips can help generate consistent profits which can add up over time. When the next black sheep event occurs–they always do when we least expect–these tips may protect you from a debilitating drawdown. Remember, there are two key goals to trading: the first goal is to make money and the second is to keep it. This tips can help achieve both of those objectives.

Gain Access to 21 Detailed Futures and Options Strategies

What’s your trading strategy? To discover how to structure your trades, download your complimentary guide from Daniels Trading for helpful advice on using futures and options.  Sign up to get the free ‘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.

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

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Profits Risk Disclosure: Past results are not necessarily indicative of future results.

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Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
June 27, 2011 by Leave a Comment

Stop on Close

Stop on Close (aka Stop Close Only) is a risk management technique used by swing and position traders.  A Stop on Close is a stop order that uses the closing price as the stop trigger.  The Stop on Close is not an intraday stop order actively working at the exchange, it is an end of day stop that is manually executed.  For example, let’s say you are long Corn from $7.00/bushel.  You have a stop on close at $6.85.  If Corn closes at $6.85 or lower, then the trader would exit right before the close or on the open of the next trading session.

Please click to view the Stop/Loss Orders risk disclosure below.

The benefit of this method is that you are not stopped out intraday if there is a quick spike down in prices but then the market comes back up by the end of the day.  Let’s say you are long Corn from $7.00 and corn spikes down 20 cents intraday to $6.80 but then rallies 10 cents to $6.90 into the close.  You will still be in your position at the end of the day because we closed at $6.90, which is above the $6.85 Stop on Close price.

The drawback of this method is that the market can continue to move against your stop throughout the day.  If we are long corn from $7.00, our stop on close is $6.85, and we close at $6.75, that is 10 cents past our stop.  Our stop on close was 15 cents, but the actual loss is going to be 25 cents in this case.

If you use a Stop on Close, it’s possible you will be stopped out less due to intra-day (and overnight) spikes in the market.  However, when the market goes against you, the losses tend to be a little larger than the stop price.  That is the tradeoff between a regular stop and the stop on close method.

Stop on Close can be used for straight futures contracts, but is most popular with Option, Option Spread and Future Spread traders.  Options, Option Spread and Futures Spreads may not have stop orders accepted at the exchange, and if they did, you would not want to have a stop execute a market order for any of these trading strategies.  When you trade Options, Option Spread and Future Spreads, it’s best to use Limit Orders.

Please click to view the Options risk disclosure below.

With that said, a Stop on Close can be a very effective risk management tool for options traders and futures spread traders.  Options and spreads tend to move slower than the futures contracts, so prices typically do not move against the trader as much.  This allows traders the freedom to have a stop on close instead of a straight stop.

A stop on Close is a manual stop.  It is not an order that the exchange executes like Market, Limit and Stop orders.  Either the trader monitors the market or your broker does.  Stop on Close can be executed in two different ways.  If the stop is executed right at the end of the day, then it is probably apparent that the market will close past the stop.  Alternatively, if the stop is executed after the close, then the stop is executed at the beginning of the next trading session.  Both methods generate similar execution prices, so it is more preference than anything else.  Most traders and brokers exit on the open of the next trading session simply because not everyone has the time to monitor the market in the last minute of trading.

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Stop/Loss Orders Risk Disclosure:  STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE.  IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A “LIMIT MOVE”, IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.

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

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Filed Under: Risk, Strategies Tagged With: , ,
June 26, 2011 by Leave a Comment

Trade Management Essentials: THE EXIT – Managing Stops and Targets

This article orginially appeared on June 04, 2010 in FutureSource’s Fast Break Newsletter, where Brian is a regular contributor.

How difficult do you find it to enter into the market?  If you think about it, “getting in” is not that difficult.  The common problem that many traders face is not getting into a trade… the problem lies in the exit plan or when to get out.  In this article I will discuss my take on how I assist my client’s methodology of exiting the market.

Conquer the pitfalls of greed and fear:

  • Place stop orders to protect profits and limit orders to capture profits.
  • Always accept profits when objectives are reached.
  • Never adjust your stop order to allow more risk.
  • Never deviate away from your initial trading plan.
  • Setting stop orders to limit losses.

I would argue that finding an exit point is more difficult than finding an entry point.  Entering the market can be easy.  Your entry price is primarily driven by your level of confidence as well as aggressiveness.  Being very confident would translate into either a market order or close limit order.  If you like the idea but remain cautious, perhaps you would find comfort in a bit of confirmation and put your entry price in a stop order form and have patience to let the market come to you.  Stop orders typically seek directional confirmation.  While apprehension, greed and fear may be present at trade entry, they are typically more controllable at this stage.  They are based on the unknown and definite profits or losses are not present to more intensely challenge the decision making process.

Without a specific strategy in place, exiting a position invokes plenty of emotion and racing thoughts; greed versus fear coupled with the lack of a plan and stubbornness.  Level headed thinking and decision making needs to become the overriding thought process in order to breed successful trading.  Follow this 2 pronged strategy:  First, realize a bad trade as soon as possible, accept it, and exit for a small loss before it gets worse.  Second, capture profits on a successful trade by use of a limit order, stop order or exiting the trade all together.  Formulating and adhering to a plan upon entry into the markets ensures a “no-surprises” course of action and should always be implemented.

Those concepts are easy to understand.  The troublesome part is the patience and discipline to stay true to the trade.  Profit objectives and loss limits become compromised when levels are reached.  When a profit objective is attained, successful trades need to be exited.  Unfortunately, greed rears its ugly head.  So often these trades can be held onto a bit too long, while visions of grandeur dominate the psyche, meanwhile retracements erase portions of said profits.  When a loss limit is breached, unsuccessful trades need to be exited immediately.  Unfortunately, fear and stubbornness becomes the norm.  Common thoughts are those of “hope”, which never should be considered a trading strategy.

It can be valuable to place stop orders to protect and lock-in profits.  Once a trade has begun to move in your favor, setting a stop order ensures that under normal market activity your risk becomes less as you approach your reward objective.

Please click to view the Stop/Loss Orders risk disclosure below.

This, however, is not the end of actively practicing money management.  Continuing to adjust your stop order (or utilizing a trailing stop) as the market moves in your favor leaves nothing to chance regarding a successful trade.  When an initial profit objective is deemed acceptable and placed for any particular trade, it is important to remain willing to exit the trade at this level.

When you begin to compromise your initial intentions with those of the possibility of greater returns, greed has officially overcome your train of thought.  So often traders get involved in a losing trade and begin to mentally talk themselves into accepting more risk in hopes that the trade “just needs more time”.  They fail to accept the fact that they were wrong in their entry point and allow ideas of a market reversal to cloud their judgment.

Below are some common thoughts of a trader enveloped with greed and without a plan:

  • I have made a good trade… I will stay in my position and make it a GREAT trade.
  • I want more profits on this trade… I will buy the bottom and sell the top.
  • I think it is time to exit… What if there are more profits to be gained?
  • I am on the wrong side of the market… It just needs more time and it will start going in my direction.

Fear is an emotion that can be dealt with properly if handled before the onset of trading.  In my opinion, you are never more comfortable with a particular risk/reward level than you are when you first place that order.  You have a very particular reason for choosing these entry and exit levels.  That being said, knowing where you will be exiting the market upon placement of any order, whether it be for a profit or loss, provides a great deal of comfort to an inherently emotional situation.  This action also allows the market to move freely within a trading range while still providing protection against adverse movement in price.

Below are some common thoughts of a trader dealing with fear of the unknown and without a plan:

  • I like this trade idea… I don’t want to lose too much.
  • I have a decent profit… Should I exit now?
  • This trade has not turned out… Should I take a loss and move on?
  • This trade was a bad idea… What am I going to do now?

In my opinion, successful trading requires not only a well conceived plan to enter the market but, more importantly, a solid thought process anchored with preparedness for exiting the market.  If realistic goals and comfortable levels of risk are established before trading, the overall exiting process is significantly less emotional.  All things considered, removing emotion ahead of time should be the objective.

I help my clients achieve the highest level of confidence possible prior to entering or putting on a trade.  How do we accomplish this?  By using a specific set of order execution contingencies that allow for optimal risk/money management before and throughout the life of a trade.

Establishing a mutual climate of comfort is the first step towards forging a successful and lasting relationship.  To learn more, sign up for a trial of Cullen Outlook newsletter and follow along with every trade I make.

Trade Ideas:

JULY CORN:

SELLING at 355’0

  • Risk is 370’0
  • Objective is 337’0

Corn Chart

Click to View Larger Corn Chart

OCTOBER SUGAR:

SELLING at 14.35 on a STOP

  • Risk is 15.05
  • Objective is 12.50

Sugar Chart

Click to View Larger Sugar Chart

AUG GOLD:

BUYING at 1197.0

  • Risk is 1170
  • Objective #1 is 1230.0
  • Objective #2 is 1250.0 to 1282.0

Gold Chart

Click to View Larger Gold Chart

Follow the Moves of a Technical Trading Pro

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Stop/Loss Orders Risk Disclosure:  STOP ORDERS DO NOT NECESSARILY LIMIT YOUR LOSS TO THE STOP PRICE BECAUSE STOP ORDERS, IF THE PRICE IS HIT, BECOME MARKET ORDERS AND, DEPENING ON MARKET CONDITIONS, THE ACTUAL FILL PRICE CAN BE DIFFERENT FROM THE STOP PRICE.  IF A MARKET REACHED ITS DAILY PRICE FLUCTUATION LIMIT, A “LIMIT MOVE”, IT MAY BE IMPOSSIBLE TO EXECUTE A STOP LOSS ORDER.

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Filed Under: Strategies Tagged With: , , , , , , , ,
June 8, 2011 by 2 Comments

Option Spreads Examined Further: Measured Ways to Play Your Market Hunch

New option traders tend to overlook the strategy of combining two options to form spreads, which allow different degrees of market optimism or pessimism.  Option spreading is different than futures because a straight futures play only portrays one degree of bullishness/bearishness.  If one is long the futures, he better be very sure the market is going up from the moment he is filled on the position.  Sure, there are risk measurement tools we all use to make sure we don’t lose the farm, and no one can always picks the exact top and bottom, but when it comes down to analyzing trade setups, there is no reason to buy or sell a futures contract unless you have a strong conviction the market is going to go in the direction you think it will immediately.

Please click to view the Options and Spreads risk disclosures below.

Unfortunately, many traders have a hard time garnering that much conviction.  Some see various degrees of bullishness or bearishness in the marketplace, either due to fears of certain economic events or sentiment changes in the marketplace.  Therefore, they can’t bring themselves to buy the futures outright.  If this is the case, then a bull call spread or a bear put spread may be a better way to capture gains.  (If you have been a follower of this blog you should be familiar with these spreads, if not you can read the articles on bull call spreads and bear put spreads to get the basics behind each strategy.)

The Structure of the Spread is Very Important

When applying these strategies, the amount of bullish/bearish sentiment can be measured by the difference between the option bought (closer to the money) and the option sold (further from the money).  It is very important to have a specific plan in place; just picking arbitrary strikes will affect the risk/reward potential.  In options trading always apply the adage, “there is no such thing as a free lunch”.  That means the more you pay for the spread, the higher the profit or loss potential.  When placing a spread trade it is important to be careful about the strikes chosen, the trade setup should reflect how bullish or bearish you are.

When you place the option sold closer to the option purchased, you will lower the cost of the spread, but by doing so you will lower the spread’s earning potential.  If you place the option sold further away, you may have the opportunity for big gains but you are risking more to realize those gains.  The spread between the prices of different strikes will be determined by a few factors, but to make life easier I like to look at the difference in market delta between the option bought and option sold as my primary indicator (learn more about market delta).

A good rule of thumb trader’s use is called the “.20 to .30 delta rule.” This rule implores the trader to look at the deltas of each option, subtracting the delta of the purchased option from the delta of the sold option.  Ideally the difference should come out to be somewhere between .20 and .30.  The closer to .20 indicates that the spread is on the conservative side, the closer to .30 indicates it is on the aggressive side.  Sure, you can buy spreads with higher and lower deltas than .20 and .30, but in those cases bear put and bull call spreads may not be the best strategy.  Keep in mind these deltas change daily, it’s important to have this data handy before executing the trade.

Compare Plans

Trader Ann is bullish gold.  She believes that over the next two months the market will see a price appreciation of somewhere between 4% and 7%, but due to the uncertainty of the Federal Reserve policies and the European debt issues she worries she might have to whether some volatility in the meantime.  She believes picking tops and bottoms is a loser’s game, and knows she doesn’t have the stomach (nor the wallet) to afford a futures contract outright.  At of the close of the market today gold is trading at 1525, which would place her target anywhere between 1585 and 1620.  She has $10,000 dedicated to her trading and doesn’t want to risk more than 30% of the liquidity in her account on the trade.  Because she has a two month timeframe in mind, we will look at the August Gold calls that expire in 60 days.  For this example we will look to buy an “at the money” call and sell an “out of the money” call at one of the strikes mentioned above.  Ann will call her Daniels broker and price out a few different plans and decide which is best for her.  Let’s compare our two plans and see which one is more appropriate:

Plan #1
1525-1585 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1585 Gold Call for $2000 with a delta of .30.
Total premium paid for the spread is $2100, which will initially trade with a delta of .21

Max profit= $6000 (total gain between 1525 and 1585) – $2100 (cost of spread) = $3900
Max loss= $2100 (cost of spread)

Plan #2
1525-1620 August Gold Call Spread
Purchase One August Gold 1525 Gold Call for $4100 with a delta of .51
Sell One August Gold 1620 Gold Call for $1300 with a delta of .21
Total premium paid for the spread is $2800, which will initially trade with a delta of .30

Max Profit= $9500 (total gain between 1525 and 1620) – $2800 (Cost of spread) = $6700
Max loss= $2800 (cost of spread)

Please click to view the Hypothetical Performance disclosure below.

Ann can now see by looking at the delta comparisons, how much she will make or lose initially from the option spread as the underlying futures prices move higher or lower.  The larger the delta on the spread, the more profit/loss she will take from a one point move in the August gold futures contract.  Based off these numbers she can apply them to her level of bullishness in Gold.  If she believes the market is more susceptible to an immediate move up she will enter the market via Plan #2.  If she feels a little apprehension about the short term prospects of gold she would probably be better off entering via plan #1.  Keep in mind Ann wants to participate now, she doesn’t want to try to perfectly try to time an entry.  Either way, she will get the exposure to the gold markets immediately, allowing her to handle the market swings as they come.

If she is correct and the market moves higher she will profit, if she is wrong and the market moves lower she will lose, as any directional trades result.  But Ann is more focused on where Gold will be in August and not today.  She obviously would rather be correct sooner rather than later, but as we learned about these spreads from past articles, they allow for the market to do its thing without worrying of a margin call.

As always, leverage cuts both ways and it is important to know exactly what you have on the line with each trade.  The way you establish these spreads should reflect your market sentiment.  If you have any questions on the strategies mentioned above or finding the delta on specific options please contact your Daniels Trading broker.

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.

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

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HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.  IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.  ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.  IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.  FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS.  THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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Filed Under: Options, Spreads, Strategies Tagged With: , , , , ,
June 7, 2011 by Leave a Comment

Locking in Profit by Purchasing Options

One of the most common things you’ll hear a futures trader say is, “Make sure you lock in profits with stops!”  One thing some traders don’t realize is that you can lock in profits with options as opposed to using just a stop loss order.  This article will focus on how locking in profits is done and when it may be a useful strategy.

How it works

The most common way to lock in profits using options is done by purchasing an out-of-the-money call or put wherever you’d like to lock in profit.  An option gives you the right to buy or sell a futures contract from a specified price.  If you are long a market, you would want to purchase a put to lock in profit.  If you are short a market, you would want to purchase a call to lock in profit.  The amount of profit you will lock in is determined by the strike price plus the premium paid.

When This Strategy is Appropriate

A trader can use options to lock in profits any time they would like to.  However, they can be especially useful when a trader is expecting high volatility in the market they are trading.  Let’s say you are in a long futures position in the corn market and a crop progress report is due out in a few days.  You think there may be a short term correction in the market before it continues on its bullish trend.  You can simply purchase a put at whatever point you would like to lock in profits (remember to keep premium paid in consideration here).  If the market report comes out bearish and the market doesn’t continue in the bullish trend, simply exercise the put option to offset your long futures position at the strike price purchased.

Example

Frank is a speculator who is currently trading the corn market.  He has been long July 2011 corn from a price of $6.72.  July corn last traded at $7.50 and Frank would like to lock in some profit.  Since he is long the corn market, he knows he will need to purchase a put to lock in profits using options.  Frank would like to lock in around $2000 of his profits.  A $7.30 July corn put option is currently trading at 19 cents premium.  Each cent is equal to $50 in the corn futures and options market.  Knowing this, Frank decides to purchase the $7.30 put to lock in profits.

$7.30 (Put option purchased)
-0.19 (Cost of put option)
$7.11 (Price locked in after difference in strike and premium paid)
-6.72 (Initial long position)
$0.39 of profit locked in, or $1,950 (39 * 50)

Summary

Using options to lock in profits is a simple alternative to using futures positions.  They can give you the ability to ride out volatility swings with a defined exit point without having your position offset like you might with a futures stop loss.

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.

Stop Orders Risk Disclosure:  This website may make certain references to the use of stop orders as means of limiting losses or protecting profits.  Please note that there is no guarantee that any stop loss order will be executed at the stop price.  Therefore, there can be no guarantee that placing a stop order will limit losses or protect profits.  Accordingly, no representation is being made that the trading in customers’ accounts will be profitable or will not result in losses as the result of placing stop orders.

Filed Under: Options, Strategies Tagged With: , , , ,
June 3, 2011 by Leave a Comment

Want to be an All-Star Technical Trader? Consider Fundamental Analysis

A five-tool baseball player is said to be a potential All-Star when he has a well-rounded offensive and defensive skill set.  The ability to hit for power and average, run, throw, and field gives him the opportunity to excel in every facet of the game.

In trading, the ability to interpret charts, understand indicators, draw trend lines, and recognize support and resistance levels gives the technical trader an opportunity to excel in the markets.  However, one tool may be missing to become a potential All-Star Trader – fundamental analysis.  While one does not need to be an expert at fundamental analysis, paying closer attention to it will make a technical trader well-rounded.

The recent trade in Live Cattle is an example of keeping the fundamentals in mind.  Let’s go directly to the charts for an example.  On May 16th a breakout trade occurred in the August 2011 Live Cattle futures market.  With recent lows and a trend line surpassed an opportunity to short the contract presented itself.  Upon setting up the trading plan a downside target was determined with numerous technical factors taken into consideration.  Potential support at the 107.825 low (1/04/11), 106.750 high (12/07/10) or 104.125 low (12/08/10).  A 200-day simple moving average at 108.050.  A 50% Fibonacci Retracement level of the bull move dating back almost a year at 106.800.  MACD, Rate of Change and Stochastics were also considered.  It was determined to place the downside target at 104.200, just above the 12/08/10 low.  This target price was reached on May 23rd – I could have exited this trade at my initial target but I had chosen to cancel that profit target order.  Why?

I canceled the order because of fundamental information that potentially gave the opportunity to transform a good trade into a better trade.  On May 20th a Cattle on Feed report was released after the close of trade.  The report had extremely bearish information about the size of the cattle herd.  Analysts said that a limit down move ($3.00 below the previous day’s settlement price) the following trading session was not out of question.  The next session’s limit down price (104.100) would have been below the original target price (104.200).  On May 23rd the August Live Cattle traded and closed limit down to settle at 104.100.  The market opened lower the next session (103.875) and traded as low as 103.475 allowing the trade to accrue more profit potential by leaving the target open.  The stop loss was immediately lowered to 105.250 but the trade could have been liquidated for profits beyond the original target profit.

Traders need to be well-rounded in their approach and trade in the context of the bigger picture.  Once in a while fundamental analysis can help transform an average trader into an All-Star.

Free Trial to GBE Trade Spotlight

Each night we study the charts, using the GBE methodology.  When we find trade setups, we e-mail them to our subscribers.  We will identify one or two spotlight trade setups per week.  These e-mails are specific trade recommendations, with a defined stop loss and profit targets, so you have the facts you need to make a decision. Start your free trial to GBE Trade Spotlight.

Stop Orders Risk Disclosure:  This website may make certain references to the use of stop orders as means of limiting losses or protecting profits.  Please note that there is no guarantee that any stop loss order will be executed at the stop price.  Therefore, there can be no guarantee that placing a stop order will limit losses or protect profits.  Accordingly, no representation is being made that the trading in customers’ accounts will be profitable or will not result in losses as the result of placing stop orders.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.  IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.  ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.  IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.  FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS.  THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Filed Under: Strategies, Technical Analysis Tagged With: ,
June 2, 2011 by Leave a Comment

Using Covered Calls and Puts to Gain Trade Management Flexibility

What is a Covered Call or Covered Put?

A covered call/put is an option strategy used by traders who hold a long/short futures position and sell a call/put option on the same underlying futures.  If the trader is long the futures contract, the trader will sell an out of the money call.  If the trader is short the futures contract, the trader will sell an out of the money put.

Why Do Traders Use This Strategy?

This strategy provides traders with an opportunity to earn additional income when the market consolidates and provides some extra cushion if the underlying futures moves against them.  Under most circumstances, the strategy will be used when a trader has a directional opinion of the market.  The idea behind the strategy is to take a directional position on the futures and sell an option that is out of the money to a level they feel the market will have a difficult time reaching.  This allows the trader to hold their long or short position as well as take advantage of the options time decay.

Covered Call Example

Bob feels that the price of corn will increase over the next few months.  Currently corn is trading at $7.00 per bushel.  Bob buys one futures contract at $7.00.  Bob feels demand for corn is very strong at $7.00, but feels that this strong demand will begin to ration if/ when the price exceeds $8.00.  Based on this assumption, Bob decides to sell an $8.00 call option.  By selling the $8.00 call, Bob collects 25 cents ($1,250).  The sale of the option provides Bob with a 25-cent cushion in case of an adverse move in corn.  This will give Bob a breakeven price of $6.75 on his futures contract ($7.00-$0.25= $6.75).  If the market sells off beyond $6.75, Bob will be at a loss on the trade.  If the market moves higher, Bob will be at a profit but will be limited to a max profit of $1.00 ($8.00-$7.00).

Trade Management Flexibility

This strategy provides Bob with some flexibility on how he manages the trade.  If the market sells off, Bob can roll down his $8.00 call option to a call at a lower strike price.  This would allow Bob to collect additional premium and lower his breakeven.  For example, let’s say corn sells off by 40 cents and is now trading at $6.60.  The delta on Bob’s $8.00 call is 0.25, which means that his option will decrease at a rate of 0.25 for every 1.00 point move in the futures.  So if corn were to sell off 40 cents, Bob’s call option would drop in value by about 10 cents (40*.25= 10).  You can learn more about an option’s delta by reading my article “Going Greek: Understanding Your Option’s Delta”.  In this example, Bob will buy back his $8.00 call at 15 cents locking in a profit of 10 cents on the trade (25-15=10).  Bob can then sell a $7.75 call and collect an additional 20 cents.  Between the profit taken on the sale of his $8.00 call (10 cents) and the additional premium collected from the sale of his $7.75 call (20 cents), Bob’s new breakeven on the futures is $6.70 ($7.00-0.30= $6.70).  This will also reduce the max profit on his position to 75 cents ($7.75-$7.00= $0.75).  By using this strategy Bob is only down 10 cents on the trade.  Bob’s new breakeven is $6.70 and the futures is now trading at $6.60.  Had Bob only bought the futures at $7.00, Bob would be down $0.40 cents on the trade.

As you can see, this strategy does not remove all risk from the trade, but it does provide an alternative to trading the outright futures contract only. Like any trading strategy, it is important to enter the trade with a predetermined game plan, remain disciplined and stick to the plan.  Managing risk will still be a key component to your overall success as a trader, but this strategy can be used to help hedge your position’s risk.

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.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW.  NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN.  IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.  ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT.  IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING.  FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS.  THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Filed Under: Options 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.

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