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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 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: , ,
May 19, 2011 by 1 Comment

Trading In Volatile Markets

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

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

1) Margins are Inadequate Guidelines in Volatile Markets

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

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

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

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

2) De-leverage When the Markets Become Volatile

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

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

3) Spreads May Help With Reducing Volatility

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

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

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

4) Options Offer Protection on Existing Futures Positions

There are two ways to use options in volatile markets.

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

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

5) Summary

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

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

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

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

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

Filed Under: Risk, Strategies Tagged With: , , , ,
May 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: , , ,
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: , , , , , , , , , , ,
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 16, 2011 by 1 Comment

Hedging Systematic Risk

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

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

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

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

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

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

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

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

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

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

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

1) Corn/USD
2) USD/Wheat

The USD cancels out and you are left with:

1) Corn/Wheat

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

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

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

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

Fundamental Example

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

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

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

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

Technical Analysis Example

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

Cotton Chart

Cotton Chart

Click to View Larger Cotton Chart

Sugar Chart

Sugar Chart

Click to View Larger Sugar Chart

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

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Filed Under: Hedging, Risk, Strategies Tagged With: , ,
November 18, 2010 by 1 Comment

Dollar Cost Averaging: Jim Cramer vs. Dennis Gartman

This post is part of Craig Turner’s Innovative Trading Concepts series.

Jim Cramer vs. Dennis Gartman

Two of my favorite financial commentators are Dennis Gartman and Jim Cramer.  Say what you will about them (and I’ve read criticism about both), but they are well respected, successful traders that everyone can learn from.  One issue I have seen in blogs and message boards is there positions on “averaging down” or “adding to losing positions.”  While their approach to this issue differs, I think in the end they are doing the same thing, but just going about with different styles of trading.

“Never Add to a Losing Position” – Dennis Gartman

Dennis Gartman is a big believer in “never add to a losing position”.  Dennis Gartman comes from a commodity futures trading background, and this makes perfect sense.  If he wants to get long gold at $1400, then he will be long a $140,000 Gold futures contract ($1400/oz X 100oz = $140,000 Gold).  When he gets into a position, either that contract is going to hold those support levels and start going up, or he wants out.  He might get in due to technical or fundamental analysis, and if he is correct, he wants the market to tell him so.  If he is wrong, he is happy to get out with a small loss, which could be a break below the nearest support lines.

It makes sense to trade this way in commodity futures because of the leverage being used.  When you are trading on margin and leverage, the gains (and losses) can pile up fast.  Plus you can’t buy gold $25K at a time; you have to commit to the full value of the commodity futures contract.  For Gartman, $140,000 of Gold is the minimum amount to play and that is where he will start.

The Jim Cramer Method

Jim Cramer is primarily an equities trader and tends to buy his positions in 4 or 5 trades.  It is easier to do this in stocks because one share is typically under $100.  Let’s say Jim Cramer wanted to have an initial position of $140,000 in Ford when it is trading at $14.00/share.  That is 10,000 shares of Ford.  For that kind of size, you most likely have to split it up into 4 orders of 2,500 shares.  Plus, Jim Cramer is a fundamental expert and he might have a price range for Ford between 13.50 and 14.50.  He might buy his first 2,500 shares at $14.00 and wait to see what happens.  If it goes down to 13.75, he will buy 5,000 shares, and then pick up the last 2,500 on the next break or if it rallies back to 14.00.

Now, if the stock breaks below $12.50, he might be ready to get out and just take a loss if he thinks it is a bad trade.  One thing I don’t think Jim Cramer is doing is “averaging down” a loser.  I think he has a very strong opinion on where the market should be fundamentally, and he knows the market can go up and down based on news and events unrelated to the stock he is buying.  That reason, combined with the size of his purchases, probably makes it more efficient for him to buy his positions in multiple trades.

The most important thing to note is that Cramer is not getting into a full position and then buying a dollar lower and doubling up.  He commits to the size he wants in terms of shares and works the order for a few days.  If it loses too much value, he gets out.  He will also buy more as the price goes in his favor, a technique that Dennis Gartman also employs.

The confusion I see on the blogs and message boards is that Jim Cramer is averaging down losers.  However, what Cramer is really doing is defining a full position and then buying that position in 4 or 5 equal parts.  The dollar cost average exists because he breaks up his buys for the initial position, not because he is doubling up due to the market is going against him.

Cramer & Gartman Risk Management

Dennis Gartman and Jim Cramer may have different trading styles, but their risk management is the same.  They take small losses.  If something is not working out, they get rid of it.  They don’t throw good money after bad.  Dennis Gartman, being so involved in futures, is probably the more risk adverse of the two, and that is mostly likely due to the leverage used in futures when compared to stocks.

In the end, it doesn’t matter which method you use, as long as you have a risk management plan to limit the size of your losing trades.  Both Jim Cramer and Dennis Gartman recognize the importance of this trading practice and do their best to follow their own rules.  Traders need to find a style of risk management that fits their trading and investing styles, just like Cramer and Gartman have.  If you want to be a successful trader, make sure you always know the size of the position you want and the risk you are willing to take before you initiate the trade.

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Filed Under: Getting Started, Risk, Strategies, Trading Tips Tagged With: , , , , , , ,
November 5, 2010 by 37 Comments

Futures Options: Using a Delta Neutral Trading Strategy

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

Many traders are constantly looking for a way to manage risk.  Employing a delta neutral trading strategy can help to manage exposure to the markets.  This type of strategy will allow speculative traders to hedge their positions against adverse price movements.

How Does a Delta Neutral Strategy Work?

A delta neutral trading strategy involves the purchase of a theoretically underpriced option while taking an opposite position in the underlying futures contract.  A common question traders have after this explanation is, “How do I know if an option is theoretically underpriced?” I prefer to use a futures trading platform that provides this information.  At Daniels Trading we offer the Vantage platform, which will give you the theoretical price of an option — Download a 30-Trial of dt Vantage.

This example below looks at purchasing December gold calls and selling the underlying gold futures contracts.  See the screenshot below:

December Gold Calls

Click to View Larger Screenshot

We are going to focus on the 1360 December gold calls.  The last traded price was 1960, the bid-ask is 2010 by 2050, and the theoretical price is 2503.  With the bid ask being where it is, we’ll assume we can buy a 1360 call for $2030.  Notice that the theoretical price is $2503.  This lets us know that the option is undervalued by $473.  Knowing that the option is greatly underpriced, we would want to take advantage and buy calls.

The next question traders have is how to figure out how many underlying futures contracts to sell.  The option’s delta will give you the answer.  A call option will always have a delta value between 0 and 1.00.  Many traders drop the decimal points, and we’ll do the same.  If you look at the above screenshot, you’ll notice the far left column let’s you know the option’s delta.  In this case, a 1360 call has a delta of 49.  This means that one 1360 call will be the equivalent of 49% of an underlying contract.  Options that are at-the-money will always have a delta of around 50.  In-the-money options will have a greater delta than 50 and out-of-the-money options will have a delta lower than 50.  The underlying futures contract will always have a delta of 100.  In order to find the number of futures to short to be delta neutral, simply divide 100 (delta of underlying) by the option’s delta.  For the above example, you would divide 100 by 49 and get ~ 2/1.  So, for every two gold call options purchased you would sell 1 gold futures contract.

Since we are purchasing calls, their delta will always be positive.  Since we are selling the underlying futures, their delta will be negative.  The goal is to for the combined deltas to be as close as possible to zero when added together.  So, for the example above we purchased two options with a delta of 49 for a total delta of +98.  We then sold an underlying futures contract that has a delta of -100.  Our total delta is -2 (-100 + 98).  It isn’t zero, but it’s extremely close.

Make Adjustments to Remain Delta Neutral!

Once in the position, it is important to make adjustments in order to remain delta neutral.  As the price of the position moves, so does the delta.  An increase (decrease) in price of the underlying futures contract will increase (decrease) the premium of the option, as well as the delta.  Making adjustments along the way will allow for the position to be as close as possible to delta neutral.  A trader can make adjustments hourly, daily or weekly.  It is entirely up to him and what he is comfortable with.

A Delta Neutral Trading Strategy in Action

We’ll now take a look at a delta neutral strategy in action (Note:  This is different from the screenshot and examples above.  The similarity of the 1360 calls is a pure coincidence).  On October 7th, a trader thinks that the gold market is due to continue in its bullish ways.  December gold futures are currently trading at 1357.  He will look to exit the position on or before November 3rd before the FOMC announcement.  He decides that it is in his best interest to use a delta neutral options strategy in case his market outlook is incorrect.  He finds that the December 1360 Gold calls are theoretically underpriced.  He decides to purchase 10 calls for $3300 each.  The delta for the options is 50.  In order to be properly hedged, he will need to sell 5 underlying gold contracts to reach delta neutral.

  • Long 10 December 1360 gold calls for a total delta of +500 (50 * 10)
  • Short 5 December underlying gold futures for a total delta of -500 (100 * 5)
  • Total delta = 0

November 3rd is now here and the trader is still in the position.  His 1360 calls are now worth $1640 and futures are currently trading at 1338.  He decides to exit the position before the FOMC announcement.  He offsets his options at 1640 and buys back his futures at 1338.  The market did not continue its bullish ways.  But, the trader was hedged so he should be fine, right?  Let’s take a look:

Options:
$3300 (Premium paid per option)
- 1640 (Premium received for selling options)
$1660 loss per option for a total loss of $16,600 (1660 * 10 options)

Futures:
$1357
- 1338
19 points gained in futures
x $100 per point
+$1900 per contract for a total gain of $9,500 (1900 * 5 contracts)

Total Profit / Loss:  -16,600 + 9,500 = -$7,100 loss, not including commissions and fees

How did the position end up so poorly?  The trader had a delta neutral position and should have been protected, right?  Wrong.  Take a look at the headline above entitled, “Make Adjustments to Remain Delta Neutral!” The market is constantly changing; therefore the delta is always changing.  In our example, the trader actually made 11 total adjustments throughout the time he was in the trade as the delta increased or decreased, and his result turned out differently.  See the chart below:

Adjustment Chart

Click to View Larger Chart

As the price of the underlying contract decreased, the delta decreased as well.  In order to get back to delta neutral, the trader had to buy a contract back, essentially forcing him to buy at a low.  When the price of the underlying contract increased, the delta increased as well.  In order to get back to delta neutral, the trader had to sell a contract, essentially forcing him to sell at the high.  When the time comes to offset, his positions look as such:

Offsetting All Open Positions

Long 10 Dec 1360 Gold Calls (33,000 – 16400 = -$16,600)
Short 1 Dec Gold Futures Contract at 1373.7 (1373.7 – 1338 = $3570)
Short 1 Dec Gold Futures Contract at 1345 (1345 – 1338 = $700)
Short 1 Dec Gold Futures Contract at 1344 (1344 – 1338 = $600)
Short 1 Dec Gold Futures Contract at 1359 (1359 – 1338 = $2100)

So, let’s take a look at the profitability of the trade with the adjustments:

-16600
+11000
+ 6970
+$1,370, not including commission and fees

The adjustments made all of the difference.  There was only one case where the trader had to accept a loss to get back to delta neutral.  The adjustments to get to delta neutral helped him take advantage of the theoretically underpriced option even when the market went in a different direction than he originally anticipated.  Using a delta neutral trading strategy won’t always produce a profit, but it is a great strategy to help manage risk.  The example above uses a larger initial position, but the same principles can be employed with a much smaller initial 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: , , , , , ,
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