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June 27, 2011 by Leave a Comment

Stop on Close

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

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

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

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

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

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

Please click to view the Options risk disclosure below.

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

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

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

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

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

Trade Management Essentials: THE EXIT – Managing Stops and Targets

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

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

Conquer the pitfalls of greed and fear:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Trade Ideas:

JULY CORN:

SELLING at 355’0

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

Corn Chart

Click to View Larger Corn Chart

OCTOBER SUGAR:

SELLING at 14.35 on a STOP

  • Risk is 15.05
  • Objective is 12.50

Sugar Chart

Click to View Larger Sugar Chart

AUG GOLD:

BUYING at 1197.0

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

Gold Chart

Click to View Larger Gold Chart

Follow the Moves of a Technical Trading Pro

I’m a seasoned market technician, and with the Cullen Outlook newsletter, you can follow along with every trade I make.  You’ll receive concise, easy-to-understand trade recommendations directly from me.  I’ll tell you WHAT I’m trading, WHY I’m trading it, and HOW I’m trading it.  Make informed decisions and take action with confidence.  Get Your 2-Week Trial to the Cullen Outlook..

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

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Filed Under: Strategies Tagged With: , , , , , , , ,
May 10, 2011 by Leave a Comment

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

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

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

Purchasing Options for Hedging

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

Real-World Examples

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

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

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

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

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

Summary

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

Free Options Trading Starter Kit

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

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

Filed Under: Hedging, Options, Risk, Strategies Tagged With: , , ,
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: , ,
December 8, 2010 by Leave a Comment

Reducing Portfolio Exposure to the US Dollar

This post is part of Craig Turner’s Innovative Trading Concepts series and originally appeared in FutureSource’s Fast Break Newsletter, where Craig Turner is a regular contributor on various futures trading topics.

Many investors and traders have too much exposure to the US Dollar.  Owning stocks, bonds, real estate and commodities priced in USD creates massive exposure to the US Dollar.  When markets crash, most asset classes are sold heavily and the US Dollar increases, in what is referred to as a “flight to safety” market reaction.  The problem for most investors is that they conduct all of their investments or trades in US Dollars, so when the Dollar goes up, the rest of the market is going down.  When the market crashes and you need diversification the most, most assets are sold and capital flees to the US Dollar.

Risk Management & Undiversifiable Risk

Any investor or trader, who has spent some time reading about risk management, has come across the terms “systemic risk”, “systematic risk” and “undiversifiable risk.”  These concepts are built around the fact you are always long assets, and you are long in exchange for US Dollars.  Furthermore, because your portfolio is always made up of “long only” positions, you are always subject to market collapses.

Your exposure to market risk does not have to be so extreme.  You do have options, and it is easier than you think to reduce your “undiversified risk” in your portfolio.  One way to reduce this risk is to hedge out some of your exposure to the US Dollar.  This will not hedge out all of your undiversifiable risk, but it will help should the market crash.  If you want to reduce your exposure to the US Dollar, then you need to buy the US Dollar Index futures contract.

Reducing Undiversifiable Risk through the US Dollar Index

The US Dollar Index is a futures contract that prices the US Dollar against a basket of foreign currencies.  This basket of currencies is made up of the 57.6% Euro Currency (EUR), 13.6% Japanese Yen (JPY), 11.9% Great British Pound (GBP), 9.1% Canadian Dollar (CAD), 4.2% Swedish Krona (SEK) and 3.6% Swiss Franc (CHF).

If you are long the US Dollar Index, you are long the US Dollar and short the Euro, Yen, Pound, Canadian, Swiss Franc and Krona.  If you are short the US Dollar Index you are short the US Dollar and long the basket of foreign currencies.

If your portfolio is made up of entirely long positions, bought in US Dollars, you can reduce your exposure to the USD through buying the US Dollar Index.  The long position of USD in the US Dollar Index will cancel out with some of the short USD exposure in the long only portfolio, leaving those positions long in terms of the basket of foreign currencies.

Example: Long Gold

Let’s say you are long 100 oz gold at $1400/oz in the futures market.  You are long $140,000 of gold priced in USD.  This can also be viewed as gold vs.  USD cross, or Gold/USD.  In order to buy gold, you had to use US Dollars, so you are long gold and short dollars, which can be represented as long the Gold/USD cross.

Now let’s say you don’t just want to hold Gold in USD.  You want to hold Gold in a mix of USD and foreign currencies.  Your long Gold position is a Gold/USD cross.  To hedge out the USD, you need to be in a position that is long USD and short something else.  If you sold the EUR/USD cross, you would be short Euro and long USD.  That would look like a long USD/EUR position.  If you combined USD/EUR + the existing Gold/USD, the long and short USD would cancel each other out and you would be left with just GOLD/EUR, or long Gold in terms of Euro.

GOLD/USD + USD/EUR = GOLD/EUR

Now that we have that concept down, apply it to being long Gold (Gold/USD) and long the US dollar Index (USD/(EUR+GBP+JPY+CAD+CHF+SEK)).  Long the US Dollar index at 80.000 is an $80,000 total contract value.  Lets combine our long Gold and long US Dollar Index position and see exactly what it turns into:

  1. Long 100 oz Gold at $1400/oz = $140,000 GOLD/USD
  2. Long 1 US Dollar Index at 80.000 = $80,000 USD/(EUR+GBP+JPY+CAD+CHF+SEK)

The second position is long $80,000 US Dollar Index.  That $80,000 long US Dollar in the second position will cancel out $80,000 of the $140,000 short USD from the first position.  That leaves us long only $60,000 Gold/USD and the other 80,000 is now long Gold/(EUR+GBP+JPY+CAD+CHF+SEK).

  1. Long $60,000 Gold/USD
  2. Long equivalent of $80,000 Gold in terms of EUR, GBP, JPY, CAD, CHF and SEK.

I am now long gold in a basket of currencies.  You can apply this method to any asset.  The US Dollar Index’s total contract value is a multiple of $1000 against the Index.  So if you want to hedge out $800,000 of USD exposure in your overall portfolio, all you need to do is buy 8 US Dollar Index contracts at 80.000.  80.000 X $1000 = $80,000 total contract value.  $80,000 X 10 contracts = $800,000.

This example not only works with an investment in gold, but it can be any other futures contract, stocks, bonds, etc.  All you are trying to do is reduce the net exposure you have to the US Dollar.  If you think about it, if your total financial portfolio is made up of things you have bought (stocks, bonds, real estate, etc) with USD, you have one massive synthetic short US Dollar position (Portfolio/USD).  That is why when the markets crash, your entire portfolio goes down.  Everything is sold while the US Dollar is bid up.

Why Investors and Traders Need to Hedge their US Dollar Exposure

You never know when the next financial crisis will occur.  You never know when we have the next flash crash or when the next European nation will default on its debt.  By reducing your exposure to US Dollar, traders and investors can reduce their “undiversifiable risk.”

While the US Dollar Index can hedge out $80,000 of USD risk when priced at 80.000, the required margin for the US Dollar Index is only $1729 per contract.  For a few thousand in margin a trader or investor can efficiently and effectively hedge out some of their currency risk to the US Dollar.

Some investors and traders I work with ask me why not just use put options for protection.  The problem with put options is they are a wasting asset.  The time decay on the puts makes it expensive to hedge against the unknown.  Futures are not a wasting asset.  If the US Dollar is trading at 80.000 noah, well w, and it trading at 80.000 three months from now, the P&L is $0.  Anyone who ever bought an option, had the price of the underlying go unchanged for a few months, certainly knows that their option will be worth considerable less because of the time decay.

Take Action and Protect Your Portfolio

If you are concerned about your exposure to the US Dollar and US assets, you need to talk to your futures broker and figure out the best way to hedge some of your exposure to the US Dollar.  If you don’t have access to an industry professional who understands hedging portfolio risk, give us a call at Daniels Trading and we will be more than happy to help you reduce your “undiversifiable” portfolio risk.

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Filed Under: Currencies, Current Events, Market Analysis Tagged With: , , , , , , , , ,
November 22, 2010 by Leave a Comment

Commodity Futures Trading: Everything is a Cross

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

Every commodity futures position you’ve had in the past, currently hold, or hold in the future can be viewed as a “cross”.  The most familiar “crosses” are currency pairs, like EUR/USD or GBP/JPY, but “crosses” are not just for currencies pairs.  For example, when you buy crude oil, you are taking possession of a crude oil futures contract but you are giving up something in return.  You are giving up USD to buy 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”.

Is this important?  Am I just being a smarty pants, know-it-all broker?  Consider this.  If you are long crude oil futures, what happens if the USD has a sharp and 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 is going against you.

All Investments Have Currency Risk

What is even more important is to realize how much risk you have in your portfolio due to currency risk.  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.

The US Dollar represents the US Economy

Why does this matter?  The US Dollar represents the US Economy as a whole.  The US Dollar represents systemic risk.  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 short positions.  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.

Hedging Systemic Risk by Hedging the US Dollar

How do traders hedge out the USD and protect themselves against systemic risk?  The answer is simpler than you may have expected.  You simply need to be short a few markets that are priced in US Dollars.  Let’s say you are bearish on the US Stock Market, Live Cattle, Japanese Yen and Treasuries.  Being short Live Cattle is also being long the US Dollar.  When you sell Cattle, you receive Dollars in return, so a short Live Cattle position can be viewed as a USD/Live Cattle cross.  That means if you are short the Emini S&P (ES), Live Cattle (LC), JPY and the 30 Yr Bond, you are in USD/ES, USD/LC, USD/JPY and USD/Bonds “crosses”.  The Long US Dollar positions will help cancel out a majority of the Short US Dollar positions you have from being long Crude, Corn, Gold and the Euro.

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 are much more protected against systemic risk.  The short futures positions in the S&P, Bonds, Yen and Cattle help diversify the systemic risk built up in being long Crude, Gold, Corn and the Euro.  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.

All Positions are Crosses

In summary, get used to thinking of all of your futures positions as “crosses”.  By thinking of your investments this way, you will have a greater handle of the currency and systemic risk your portfolio is exposed to.  With the knowledge of understanding how systemic risk can effect your commodity futures investments and trading, you will be one step ahead of the average investor and trader the next time we are in a financial crisis.

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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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November 11, 2010 by Leave a Comment

The Number One Rule of Trading

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

If there is one thing I’ve learned in all my years in the financial markets, it is never add to a losing position.  That means never “average down” a losing long position or “average up” a losing short position.  This is even more important when using leverage.  There is a very well-know saying, “your first loss is your best loss.”  What this means is you are best served taking a small loss before it becomes a larger loss, or even worse, a loss that eats up a majority of your trading capital.  In order to avoid this major trading mistake, we must first understand why traders add to losers, why traders should not do this, and what they can do to stop it from happening.

Why Traders Add To Losing Positions

Traders stay in losing positions for only two reasons.  Either they don’t want to be wrong about the market or they don’t want to lose money on the trade.  Sometimes it is a combination of both.  Regardless of which one it is, it causes traders to stay in positions that are going against them.

As traders are losing money, they figure that if they add to the losing position, they can bring the average cost of the position down.  For example, let’s say a trader wants to be short Crude Oil and he sells 1 contact of Crude Oil at $75.00.  Crude is now trading at $80, and the trader is down $5 in crude ($5000).  The trader then decides to sell short an additional 2nd crude oil contact at $80.  The average short position is $77.50 (the average of $80 and $75).

The trader now only needs Crude Oil to go $2.50 in his favor to get to breakeven at $77.50, instead of $75.00.  However, every tick Crude Oil goes against the trader past $80.00 a barrel is going to count twice a much, eating up available capital a double the rate.  To make matters worse, markets that are trending in one direction, tend to continue to trend in that direction.

Why Traders Should Not Add To a Losing Position

When a trader is in a losing position, the market is telling him he is wrong.  The market is the total sum of psychological, technical and fundamental knowledge.  The market is the total sum of all investor knowledge and market opinions.  It includes institutional money, sovereign wealth funds, hedge fund managers, trend following funds, commercial hedging interest, and every other participant, large and small.

If a trader continues to hold onto a losing position after the market says he is wrong, the trader is basically saying he is right, and the collective sum or the rest of the market is wrong.  In other words, the global consensus is telling the trader the world is round while the trader insists the world is flat.  This will almost always lead to larger losses.  Bullish markets tend to trade higher, and bearish markets tend to trade lower.  It takes something significantly fundamental or technical to occur in that market to change the trend.

Not only is the trader wrong shorting Crude at $75, he is twice as wrong shorting the market again at $80.  The losses are now piling up exponentially if he continues to add on to a losing position.  Plus, he has now doubled his leverage on a bad trade.  Meanwhile, if the trader had just had a $1 or $2 stop on the crude oil position, he would have taken his loss and been done with the trade.  He would have been able to admit he was wrong and move onto the next opportunity, instead of creating larger losses and letting other opportunities go by while he was in a losing trade.

Wait Just A Second, I Have “Averaged Down” and Made Money!

If you have averaged down losing positions before, chances are it may have worked in your favor.  The problem is, the one time it does not work in your favor you will blow out your account.  Every time you “average down” and succeed you are cheating trading death.  It is almost like a game of Russian roulette.  It only ends once, and when it does, it’s over.

“Markets Can Remain Irrational Longer Than You Can Remain Solvent” – John Maynard Keynes

When it comes to leveraged trading, there have never been truer words said.  Traders who want to hold onto losing positions “until they come back” to the price they entered may never see it happen.  A trader who has a $10K acct short 1 crude at $75.00, only has $10 of room before the account is drawn down to zero.  Most people think they will never let a position go against them that far, but it does happen, and there is no assurance that the market will come back to $75 before it gets to $85, causing the trader to liquidate the position for a very large loss.

THE SOLUTION

The simple solution is to never add to a losing position.  However, as an experienced broker, analyst, trading newsletter publisher and individual trader, I know that is easier said then done.  Here are a few rules to live by in order to help you stop adding to losing positions.

Place Stops Just Outside Normal Trading Ranges

When entering a position, traders need to give their positions enough room to work in their favor, but they also must have stops if the market moves decidedly against them.  For a swing or position trader, this means having stops just outside the most recent trading ranges.  It could be the previous day’s low/high, the past week, or right outside the natural support and resistance lines for the markets.  Traders need to define this risk parameter BEFORE they enter the trade.  Traders need to know what the risk is and make sure they are comfortable with the risk if they are wrong about the direction of the market.

Mental Clarity Can Only Be Achieved After the Losing Position Is Exited

When a trader is in a losing position and the market keeps on going against them, it is very difficult to approach the situation with a level head and clear mind.  The fear of losing money can be the greatest factor in the psychology of trading.  It causes traders to see things irrationally, as they do everything possible not to take a loss.  This leads to poor decision-making and bad judgment.  This is why it is so important to define the stop loss parameters before you enter the market and stick with it.

Unfortunately, sometimes traders get into a trade without a stop or let the position run too far against them.  If possible, try to imagine you are flat instead of in the position.  Then ask yourself, if you were flat, would you get back into the position? If not, you need to get out, and get out fast.  If the trader can’t honestly say what he would do, or can’t detach from the situation, the best thing to do is exit.  Getting out of a loser relieves stress and allows the trader to approach things with a level head.  Once the trader is out of the position, he can always get back in if he feels it is the right move.  Some traders don’t like this method because they don’t want to spend the extra commission for getting out and getting back in.  However, the clarity that is gained from exiting a losing position is invaluable compared to the extra transaction costs.  Don’t worry about a few dollars when thousands are at stake.

You Must Be Able to Admit When You Are Wrong and Take a Loss

Being able to admit you are wrong and take a loss is the first step in the journey of successful trading.  No one is perfect in trading.  Taking a small loss is a minor victory in trading.  Being able to let winning trades run and exiting losers for a small loss is what it is all about.  However, you can’t get to the winners if you take large losses.

It is OK to be wrong.  Actually, it is great to be wrong.  Why? Because if you can’t be wrong, you’ll never be right about the markets.  Trading is about taking risk and managing risk.  The trader who can exit a position going against him early is giving himself the change to win big on the next opportunity.

The Best Traders Add to Winning Positions & Use Stops to Protect Profits

The most successful traders I’ve seen not only cut their losers quickly, but they let their winners run and add on as they go in their favor.  They never average down losers, but they will certainly average up on winners.  While some might not want to trade multiple lots, I think the concept is very important.  When you have a winning position, the market is telling you that you are correct.  The collective sum of all knowledge in the market place is in total agreement with you.  This is the perfect time to add on another lot if you have the available capital without over-leveraging your account.

Some traders don’t want to add on at higher prices because it adversely affects their dollar cost average.  However, what traders need to realize is that markets trading higher tend to trend higher, and the opposite is true for bear markets.  If you find yourself in a great winning trade, and you see no reason why it should stop, that is a great time to add on.  When it comes to trading, you want to buy high and sell higher, or sell low and buy lower.  We are not in the business of picking bottoms and tops.  It is a one-way ticket to trading failure.

Successful traders also use stops.  As the market moves in their favor, they move their stop up to where they feel is below a reasonable support level.  They are comfortable with the losses or profits they will take if they get stopped out.  They let the market tell them if they are right or wrong and they accept the market’s decision!

Find a Broker Who Can Help You When You Need It Most

If you are having difficulty with adding to losing positions, you need to talk to your broker about it.  Regardless if you are a self-directed online trader or broker-assisted, you need to have a talk with your broker.  If you don’t have access to a broker with your current trading arrangement, consider finding a firm that will allow you to access to one regardless of whether you are a self-directed online trader or broker-assisted trader.

As a Senior Broker at Daniels Trading, I can honestly tell you from first hand experience how important it is to be able to work through these situations with someone who has an interest in the success of your trading.  Sometimes we are able to offer valuable advice about not adding to losing positions.  Sometimes it just helps for the trader to talk about the trade the same way a person tells their psychologist their problems.  In the end, it is the trader who works out what needs to be done just by communicating the situation aloud to another human being.  Either way, having a trained professional in the weeds next to you during battle can make a huge difference in your most difficult trading periods, and help you make sure you never return to that place again.

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November 5, 2010 by 39 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: , , , , , ,
August 4, 2010 by Leave a Comment

6 Uncommon Risk Management Tips for Futures Trading

In this article, I’ll discuss six risk management methods investors may not normally consider but should be actively practicing while trading in the futures market.  Properly managing one’s risk may not reap bountiful profits in and of itself, but in my experience, it ensures that your short-term trading doesn’t result in short-term involvement in the markets.

Be realistic.

  • Know the size of your trading account.
  • Understand how leverage can affect it.
  • Ensure you are appropriately margined given your risk tolerance.

Utilize your futures broker.

Talk straight with your futures broker and discuss you’re your goals for risk management upfront.  Ask your broker what amount of leverage is appropriate for you given your risk tolerance and account size.  Discuss your trading style and ideas for minimizing risk through relevant trading strategies.

Managing Risk

By talking candidly and developing an open, trusting relationship, you can ensure your broker has a clear understanding of your needs and expectations in regard to risk.  This will allow your broker to better serve as your trading advocate. Having this additional set of eyes – no less a professional’s eyes – watching your account can go a long way to helping you manage risk and achieve your futures trading goals.

Address risk upfront.

Managing risk should begin before a trade is even made.  Questions should be abundant prior to entering the market.  On the contrary, there should be very few questions once a position is established.  By addressing risk early in the trading stage, you leave nothing to chance when emotions run high.

Understand the markets you are trading.

It is important to realize that some markets are not for everyone and being involved in highly volatile markets requires proper capitalization and a definite discipline.  Understand the effect of adverse price action and how it would translate to your account balance.  This fundamental understanding needs to be addressed before trading in a particular market.

No matter where you get a trading idea, whether it is speaking to your futures broker or forming an opinion on your own, it is important to understand the market being considered.  Understanding why the market is where it is, what the market’s typical trading range is and what important events are on the horizon (i.e. upcoming report numbers, news stories or any other pertinent fundamental/technical information) could provide crucial insight in regard to the timing of certain trades and the amount of margin that may be appropriate given your objective.  Again, utilize your futures broker to assist you in this area.

Trade within your comfort zone.

Simply put, do not overtrade.  It is not necessary to take full advantage of reduced margins in the futures market.  Having multiple positions on in the same market should be a trading style reserved for traders with enough capital in their accounts to back such a stance.  In my opinion, keeping your margin to equity ratio at or below 40% is a good rule of thumb for maintaining proper leverage.  Be sure to consciously remember that as much as profits appreciate with multiple contracts on, the losses accrue on the same scale.

Refrain from too much diversification.

While diversification is generally a good thing, it is also important to realize that you can be too “diversified”.  Having positions on in many different market sectors can be detrimental if the entire market is experiencing a broad spectrum bullish or bearish tilt, as you could be on the wrong side of many markets all at the same time.

In conclusion…

Success is not always measured by profit size alone.  It is also highly dependant on proper money management.  Capital preservation and proper risk management is the key to remaining present in the markets.

By no means are the ideas I have put before you the only things to be considered when managing risk.  But I will say, in all the years I have serviced clients and their accounts, these ideas are some of the least considered, yet most valuable.

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