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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 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.

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

Filed Under: Hedging, Options, Risk, Strategies Tagged With: , , ,
April 25, 2011 by Leave a Comment

5 Tips for the Option Buyer

Tip 1:  Have an exit plan.

It seems very elementary, but some traders will spend numerous hours looking for opportunities to enter a market, but put no thought into how and when they are going to exit.  Whether you base your trading decisions technically or fundamentally, you will need to know when you are going to take profits and when you are going to cut your losses.  Just because you define your risk when purchasing options, this does not necessarily mean you have to risk it all.  Technical traders should look for the area on the chart that proves a change in the markets direction and a point on the chart to take your profit.  Fundamental traders should closely track the news that is driving the market and exit when these fundamentals change.  Just like you don’t jump in your car without a destination, you don’t want to jump into a trade without one.  Trading is emotional and your ability to articulate your trade parameters will only help your long term success as a trader.

Tip 2:  Buy the time you need.

The beauty of options is their flexibility.  Purchasing options allow for flexibility with the timing on your entry and the timing involved for the market to make its move.  That being said, we pay for that time and flexibility.  After all, the value of an option is derived from both its time value and its intrinsic value.  The more time on the option, the more we are going to pay for it.  So if we expect a market to rise or fall within the next few weeks, it does not make sense to buy an option that expires in 12 months.  On the flip side, if you are looking for an extended move in a market that could take place over several months, then you want to make sure you buy enough time to allow for that to happen.

Tip 3:  Don’t try to pick the tops and bottoms.

Don’t try to pick the tops and bottoms.  Like many things in life, markets will tend to follow the path of least resistance.  Just like a swimmer would prefer to swim with the current, a market prefers to follow its momentum.  From time to time, we might convince ourselves that a market can’t go any higher or lower, but we must resist this urge and stick to our trading plan.  Until there is a clear signal that the trend has ended, we must remain patient and wait for the reversal to be confirmed.  Anything outside of this is option roulette.

Tip 4:  Consider the market’s volatility.

An options premium is valued by its location relative to the underlying futures contract, the time left until expiration, and the market’s volatility.  As an option buyer, we want to purchase an option when volatility is low.  Increased volatility means that markets are going to trade in a much wider range.  That being said, options will be rapidly moving in and out of the money, causing a spike in the options premium.  Ideally, we will buy in times of low volatility to allow us to take advantage of the spike in premium if and when the volatility does increase.

Tip 5:  Consider your delta.

Your option’s delta should give you a good idea on how your option is going to react to a change in the underlying.  The lower the delta, the less the options value is going to fluctuate.  The higher the delta, the more closely your option will trade to the underlying futures contract.  An option’s delta will help you determine where you will want to be positioned based on the anticipated move.  For more on delta, please see my previous article:  Going Greek:  Understanding Your Option’s Delta.

Free Download:  Futures and Options Strategy Guide

If you enjoyed this article and are interested in learning more about futures options strategies, sign up for fast access to our Futures and Options Strategy Guide, detailing 21 futures options strategies that you can begin using in your trading today!

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: , , ,
March 31, 2011 by Leave a Comment

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

Part Two:  A User’s Perspective

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

Why should I hedge?

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

Cash – Futures = Basis!

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

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

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

Real-World Example

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

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

Change in Basis

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

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

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

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

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

-OR-

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

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

Add Hedging To Your Plan

Hedging is a great risk management tool.  Yes, the corn prices in the example could have decreased and the feed company would have lost money in futures, but they would have paid less for the cash grain.  If that was the case, a producer could have benefitted by placing a short hedge!  Remember, the goal of hedging is to transfer price risk and set the prices one will receive or pay within a roughly determinable range.  Reducing exposure to market surprises allows users and producers to plan their operations more confidently.

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

Going Greek:  Understanding your Option’s Delta

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

Exploring Delta

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

For example let’s look at crude oil:

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

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

Call Option Delta

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

Put Option Delta

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

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

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

Filed Under: Options, Risk, Strategies Tagged With: , , , , , , , , , , ,
March 5, 2011 by 2 Comments

Basics of Futures Spread Trading

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

Types of Commodity Futures Spreads

Inter-Commodity Futures Spread

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

Intra-Commodity Calendar Spread

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

Bull Futures Spread

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

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

Bear Futures Spread

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

Futures Spread Trading Margins

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

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

Futures Spread Pricing

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

Futures Spread Quotes

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

Futures Spread Tick Values

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

Contango Markets

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

Backwardation

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

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

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

Futures Spreads and Seasonality

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

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

Receive a Free Subsciption to my “Turner’s Take” Newsletter

My Turner’s Take newsletter is a great way to follow the commodity markets and learn about futures spread trading.  If you would like to follow the commodity markets with us and receive futures spread trading recommendations, please sign up for your free subscription here:  Turner’s Take Registration.

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

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

Filed Under: Getting Started, Spreads, Strategies Tagged With: , , , , , , , ,
February 28, 2011 by Leave a Comment

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

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

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

Why should I hedge?

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

Cash – Futures = Basis!

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

Long Hedges vs.  Short Hedges

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

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

Real-World Example

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

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

Change in Basis

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

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

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

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

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

-OR-

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

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

Add Hedging To Your Plan

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

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

Commodity Futures Trading: All Trades are Spread Trades

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

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

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

Now that I have your attention, let’s go back to our crude oil example.  If you are long crude oil futures, what happens if the USD has a sudden rally?  Crude oil will decline because Crude is priced in USD.  This implies that if you are long crude, you also have a short position in the USD.  So if the USD rallies, there is a good chance that your “Crude/USD” position declines and goes against you.

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

All Investments Have Currency Risk

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

This is not just true for equity portfolios, but for futures traders too.  Let’s say you are long Crude Oil, Gold, Corn and the Euro.  You might think you have a nicely diversified portfolio of commodity futures positions.  However, they are all priced in the US Dollar (Crude/USD, Gold/USD, Corn/USD, EUR/USD).  In one sense, you have a massive short US Dollar position.  Again, it is important to remember for every long futures position you have that is priced in Dollars, your also have a short US Dollar position.  For every short futures position you have, you also have a synthetic long US Dollar position.

The US Dollar Represents the US Economy

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

For example, let’s say a European country’s banking system is about to fail, and their largest banks need to be bailed out by the European Union.  To make matters worse, let’s assume the market was completely caught off guard, and the Euro plummets and sends the US Dollar much higher.  The Dollar rally puts downward pressure in all commodity futures priced in dollars.  If you are long Crude, Gold, Corn and the Euro, they are all declining together.  The correlation between those four futures positions becomes 1.0 because they are all priced in Dollars.  They act as one large losing trade against the US Dollar.

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

Hedging Systemic Risk by Hedging the US Dollar

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

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

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

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

CRUDE/USD + USD/GOLD = CRUDE/GOLD

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

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

By having a few short futures positions to go along with a few long futures positions, you greatly hedge out your US Dollar exposure.  The next time a major, unforeseen economic event happens, you will be better protected against systemic risk.  The short futures positions help diversify the systemic risk built up in the long positions.  Your ability to hedge out part or all of your US Dollar risk is an insurance policy against the unknown systemic risks in our financial system.

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

Spread Trading

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

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

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

All Positions are Spread Trades

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

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If you enjoyed this article, please sign up for a free subscription to “Turner’s Take” commodity futures newsletter.

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

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

The Wonderful World of Futures Spread Trading

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

Why We Trade Futures Spreads

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

Futures Spreads Defined

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

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

Benefits of Spread Trading

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

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

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

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

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

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

How Spreads Make (and lose) Money

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

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

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

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

Hedging Systemic Risk

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

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

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

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

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

Leverage and Margin

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

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

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

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

Stops

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

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

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

Markets to Spread

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

Historical Seasonality

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

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

Summary

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

Spread Trading Ideas

Natural Gas

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

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

Natural Gas Chart

Natural Gas Chart

Click to View Larger Natural Gas Chart

Corn

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

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

Corn Chart

Corn Chart

Click to View Larger Corn Chart

Sugar

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

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

Sugar Chart

Sugar Chart

Click to View Larger Sugar Chart

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

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