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February 9, 2011 by Leave a Comment

Strike Gold:  Trade Silver Using Bull Call Option Spreads

Turbulent.  Violent.  Ferocious.  Vicious.

These are frightening terms many unsuccessful traders would use to describe their experiences when attempting to trade the Silver futures market.

Due to its large futures contract size – 5000 ounces of Silver per contract and an ever-increasing exchange margin requirement of $11,000+ per contract – traders and brokers have nicknamed Silver “The Widowmaker” for good reason as it seems to have an uncanny knack for punishing traders when they’re wrong, especially when traded irresponsibly by those who are impulsive, stubborn, undisciplined, and overleveraged.

Are you scared yet?

Adding physical silver bullion in the form of coins or bars is a vital component to every investor’s well-diversified portfolio, but that is an entirely different investment enterprise than trading the great white precious metal using leverage in the futures market.

As traders of futures and options on futures, we have to accept that any market can be erratic and unpredictable.  While extreme volatility, exaggerated price spikes, and large daily price ranges are to be fully expected and can be downright nasty, the Silver futures market is not something to fear or run away from.

Rich in history, the lure and appeal of successfully trading Silver, the “Poor Man’s Gold,” continues to attract and tempt a wide and growing variety of traders and investors from every corner of the globe.

GET COMFORTABLE:  ACCEPT RISK & DEFINE YOUR REWARD

If you’re willing to forego the often attempted but rarely achieved consistent daytrading profitability in favor of capital preservation and prudent risk management through the use of Bull Call Option Spreads, you may become a battle-tested trading veteran who would characterize the raging, white-hot Silver market as challenging, yet ultimately highly rewarding…maybe even exhilarating.

The January 2011 consolidation phase or technical correction – a “terrifying” 16 percent cliff dive in less than a month (the white metal boasts an 80%+ gain in 2010) – now appears to have run its course, resolving itself strongly to the upside, back in favor of the long-term bullish uptrend.

Below I will illustrate how you can “strike gold” by taking advantage of this opportunity to get long on the resumption of Silver’s long-term bull trend – in case you didn’t know, its going on 10 years and counting – by putting on a Bull Call Option Spread as it looks to challenge and surpass recent contract highs.

This trading strategy offers bullish traders and investors the opportunity to carefully define both their risk and their reward before deploying capital on the trade.  It allows one to trade the Silver market directionally with prudent money/position management – with the ability to “Get Long” using Silver futures option spreads without exposing your account to a very large exchange margin requirement ($11,000+ per contract) and the always present equity/event risk when holding a futures contract position overnight.

Here is a primer on how a Silver Bull Call Option Spread trading strategy could work for you:

BULL CALL OPTION SPREADS (DEBIT SPREADS) – THE NUTS & BOLTS

The terms bull and call imply a bias toward an upward price direction, so this strategy involves a spread that goes long the market by using call options.  Debit implies that you are paying for the trade and that the costs are being debited from your account.

Some refer to this as a vertical bull call spread.  What is usually involved in this strategy is:  the purchase of a close-to-the money or an in-the-money call and at the same time the sale of a further away strike price (out-of-the-money) call option of the same expiration date (or same expiration month).

The close-to or in-the-money call option may cost a great deal of money as it is near or lower to where the underlying futures contract price is trading, especially if there is substantial time remaining until the option’s expiration.  Traders spread this cost off (or finance it) by selling or writing a further out-of-the-money call option.

When you sell or write a call, you collect premium or receive a credit to your account.  This credit reduces the cost of the close-to or in-the-money call option.

The profit/loss profile for this strategy is a limited risk and a lower expense for the investor as premium costs are reduced (or financed) by the sale of the higher strike price call option.  The short call is covered by the long call, so there is a predetermined risk factored in this trade and no unnecessary risks associated with option writing or selling (aka naked shorts).

The maximum profit potential is limited to the value between the two strike price levels minus the premium costs, the commission, and exchange fees.

SPECIFIC MARKET EXAMPLE – THE STRATEGY:
May Silver 26.25/27.25 Bull Call Option Spread

Let’s review a specific market example:  After hitting a contract high of $31.27 on 1/03/11, near the end of the 1/25/2011 trading session the May Silver market continued trading lower while in the midst of a widely-publicized consolidation phase or technical correction posting a low of $26.575 during this session.  (The daily range on 1/25/11 was LOW:  26.54 to HIGH:  27.04)

For this example, we will use the May Silver 26.25/27.25 call option quote prices taken from floor brokers at the end of the 1/25/11 session.

ENTER THE SPREAD:  GETTING LONG on 1/25/11
(OPTION EXPIRATION DATE:  4/26/11)

BUY 1 May Silver 26.25 Call Option – pay $2.15 premium (-215 cents x $50) =
-($10,750) DEBITED From Cash/Account

SELL 1 May Silver 27.25 Call Option – receive $1.65 premium (+165 cents x $50) =
+$8,250 CREDITED To Cash/Account

NET DEBIT TO ACCOUNT TO BUY/GET LONG THE SPREAD

-$0.50 (-215 cents paid vs.  +165 cents received = -50 cents) =
-($2500.00) PREMIUM PURCHASE PRICE TO ENTER SPREAD

MAXIMUM PROFIT POTENTIAL AT OPTION EXPIRATION

The maximum profit potential is limited to the level between the two strike prices (27.25 – 26.25 = $1.00 or 100 cents x $50/cent = +$5000) minus the premium costs (-$2500), the commission and fees (approximately -$160 per spread at $75/RT/per option and exchange fees.  This would double if the spread is profitable and taken through expiration/converted to futures contracts then offset immediately).

(27.25 Call Strike – 26.25 Call Strike = $1.00 or 100 cents x $50/cent = +$5000) – (-$2500 – $160 or -$2660)
= +$2,340 POTENTIAL PROFIT / 93.6% GAIN PER SPREAD BEFORE COMMISSION/FEES

ULTIMATE OBJECTIVE

The ultimate objective would be for the May Silver futures contract to close above 27.25 on the Option Expiration pit session (4/26/11 @ 12:25pm Chicago Time) to max out the potential profit on this spread.

Upon option expiration, the call options would automatically be converted into long and short futures positions that immediately offset one another (there is no margin risk involved).  The difference between the strikes as described above minus the total cost of the spread or +$2,340 would then be credited as a positive gain back into your account in addition to getting back your original premium paid/trade cost of $2660.

BEST CASE SCENARIO

The best case scenario would be if the May Silver market surges higher than 27.25 at any time prior to option expiration, you can ask your broker to go to the floor to request quotes to find out what the current market value would be to liquidate the position (to sell back or cover the spread).

If we were to attempt to exit/liquidate/sell the spread prior to expiration, to obtain an approximately equal amount of maximum potential profit, the value of the spread would need to be quoted on the floor as Bid @ 100 cents – which is a 50 cent increase from the 50 cent entry/purchase price.

WORST CASE SCENARIO

If the market does not trade higher, you should guard against an erosion of spread premium value by using either a predetermined “mental stop-loss” level based on the futures price and spread quote values or overall loss of capital level and exit the spread, taking a reasonable loss.  Or, the worst case scenario would be the May futures closing on option expiration day below the 1st call strike of 26.25 to allow the spread to expire worthless upon expiration, losing the total premium paid.

TRADE CONCLUSION

On Tuesday 2/08/11, the May Silver market skyrocketed or spiked higher almost an entire dollar in a single session, putting the May Silver 26.25/27.25 Bull Call Spread into very profitable territory.

If one wanted to purchase this spread on the morning of Tuesday 2/08/11, it would cost a trader approximately $4.04 ($20,200) to purchase the May 26.25 Call and they would receive $3.08 ($15,400) by selling the May 27.25 Call.

The difference (or their cost to get long/purchase it) is $4,800 (or 96 cents), which represents the new value of our spread.  It has increased from the 1/25/11 entry price of $0.50 to the current price of $0.96 ($4.04 or -404 cents paid vs.  $3.08 or +308 cents received) = an increase of +$0.46 or $2300 gain to your account (46 cents x $50 per cent).

For all intents and purposes, this spread has nearly reached its maximum potential value at options expiration.  This is an extremely favorable position to be in.  At this point, the spread can (and should) now be liquidated/exited by selling it on the floor.  Or, if you prefer, you could hold the position through to option expiration (EXPIRATION DATE:  4/26/11) if you’re confident that the May Silver price will remain above 27.25.

However, I would strongly suggest placing a Good Till Canceled (GTC) limit order with your broker to use the floor to max out/liquidate or “sell the spread at maximum potential expiration value” as that eliminates your risk exposure, adds positive equity to your account (over +90% gain before commissions/fees), and allows you to refocus and reload for the next trading opportunity.

This is a strategy specifically designed to be somewhat more defensive or “conservatively realistic” in nature.  It did not shoot for the moon (an example of that would be getting long a May 35/40 Bull Call Spread when the market is trading at 20) but allowed you to enter the position relatively “close” to the market with a higher degree of probability for potential success and profitability.

FEAR NOT – EMBRACE OPPORTUNITY

The only thing to fear when using a Bull Call Option Spread is a complete loss of capital paid to purchase the spread.  Since you can clearly define what level of loss you are willing to tolerate in terms of the premium you are willing to pay for the spread, there’s really nothing to fear at all.  You must be comfortable with the risk of loss in any investment or trading endeavor in order to position yourself to reap the reward, if successful.

Bull Call Option Spreads (and conversely Bear Put Option Spreads if you’re bearish on a market) give you the flexibility to trade directionally with the ability to tightly manage risk by constructing how close the spread position is in relation to the market price and where you believe it will trade in the future (ie you can carefully position the strikes to be more defensive or aggressive in nature.  This particular spread example used an In-The-Money Call PURCHASE and an Out-Of-The-Money Call SALE).

This limited risk/limited reward type of trading strategy can be used singularly or even in conjunction with targeted long-term and short-term (intraday/countertrend) futures trades and can offer you a relatively risk averse way to potentially extract profits in the blazing Silver market – especially if you layer in multiple lots and farther out Bull Call Option Spreads (in terms of both price and time).

LEARN MORE ABOUT HOW OPTION SPREADS CAN WORK FOR YOU

If you would like to learn more about how option spread strategies could work for you and your trading, please contact me via the Daniels Trading website.

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Free Download:  Futures and Options Strategy Guide

With this complimentary guide, you’ll recieve 21 Futures on Options Trading Strategies to complement your trading.  Sign up for fast access to our Futures and Options Strategy Guide!

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

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

Filed Under: Market Analysis, Metals, Options, Spreads, Strategies Tagged With: , , , , ,
December 30, 2010 by Leave a Comment

How to Collect Premium with Iron Condors

How to Collect Option Premium with the Iron Condor Strategy

Different circumstances call for different trading strategies.  Part of becoming a complete trader is a balanced, disciplined approach with an eye geared towards managing risk.  You can accomplish this by trading futures, options, or a combination of the two.  The difficult part is determining which approach will be the best for you, and this formula might be different for every trader.  In this article, my intention is to open your eyes to a more unique trading approach, collecting premium with Iron Condors.

I’ve heard a lot of myths and confusion in regard to iron condors, so I’m attempting to break this down for you in simple, easy to understand language.  In order to accomplish this, we need to have a basic understanding of credit spreads.

Understanding Credit Spreads

A credit spread is when you sell a closer to the money (more expensive option) and purchase a cheaper (further out of the money option) on the same underlying commodity at the same expiration.

Let’s take a look at an example using gold futures;

Gold futures    =    1400
1350 puts    =    $3500
1300 puts    =    $1500

Gold futures are trading at 1400 and we feel bullish on this market.  We could sell a 1350 put and purchase a 1300 put.  The premium in the 1350 put is going to be higher than the 1300 put because it is closer to where the market is currently trading.  We would collect the $3500 premium from the 1350 put and pay out the $1500 premium of the 1300 put at a net credit on the trade of $2000.  Our defined profit is the amount we collected between the 1350/1300 put spread, $3500 – $1500 = $2000.  We’re risking the difference between our two strike prices, (1350 – 1300 = 50 x $100/point = $5000.  And, since we already collected a premium of $2000, our defined risk is reduced to $3000 ($5000 – $2000 = $3000).

So… What is an Iron Condor?

An Iron Condor is simply a combination or two vertical spreads.  To create the iron condor, we would sell both a call spread and a put spread.  The idea behind this is to take advantage of a sideways market and allow us to design a strategy based on where we feel the market will NOT go.

How to Use an Iron Condor Strategy

Once again, let’s take a look at an example using gold futures.

The current price of gold is 1400.  We feel that the market will likely trade within a channel between 1350 and 1500 over the next 30-60 days.  Gold options are currently trading at the following prices:

1500 call    =    $3500
1550 call    =    $1500
1350 put    =    $3500
1300 put    =    $1500

In order to take advantage of a sideways market we would use an iron condor by selling the 1500/1550 call spread and the 1350/1300 put spread.

How to Calculate the Profit Potential

Profit/loss graph for a long Iron Condor at expiration.

We would place an order to sell the 1500 call and purchase the 1550 call.  We would collect $2000 premium on our call spread ($3500 – $1500 = $2000).  We would also sell the 1350 put and purchase the 1300 put.  We would collect another $2000 premium on our put spread ($3500 – $1500 = $2000).  This would define our profit potential to $4000 (total premium from call spread + put spread, $2000 + $2000 = $4000).

Maximum Profit Potential = Call Spread Premium + Put Spread Premium

How to Calculate the Defined Risk

We can also use these numbers to calculate our defined risk.  Our defined risk is the difference between our spread strike prices minus the amount we collected.  Since we have both a put and call spread, we know our risk is limited to only one side.  The market cannot expire above our call spread and below our put spread simultaneously, so we have a risk of just $5000 (1350 – 1300 = 50 x $100/point = $5000 or 1500 – 1550 = 50 x $100/point = $5000).  Note: If the difference between our strike prices were not balanced, we would use the greater difference.  However, this is before we take into account the premium we collected.  We have collected a total of $4000 for our put and call spreads upfront, so we can deduct this from our risk total.  Thus, our defined risk would be reduced to $1000 ($5000 – $4000 = $1000).

Defined Risk = Greater Difference between Strike Prices – Premium Collected

Benefits of an Iron Condor Trading Strategy

Now that we understand what an Iron Condor is, we need to understand why we would want to use this trading strategy.  Buying options are great in regard to their risk reward.  You can define your risk to a very small sum, while having unlimited profit potential.  The downside of this strategy is the probability.  The majority of cheap, far out of the money options will expire worthless.  So although you are only risking a few hundred dollars on each option, the odds of these being profitable are low. 

That being said, if the majority of options are going to expire worthless, then why don’t we just sell options? You can, but you are running the risk of that one cheap option turning into a very valuable option.  So you might have a defined profit a few hundred dollars with unlimited risk.

This is why the Iron Condor is an attractive strategy.  You are doing your part managing your risk because you know what the worst outcome can be.  You are also keeping the odds in your favor.  We know that the majority of all out of the money options are going to expire worthless, so we should have more profitable trades than losing trades.

In conclusion, an Iron Condor can be a simple strategy.  It is a combination of two credit spreads: one to the call side and one to the put side.  This allows you to take advantage of sideways markets and to design a strategy based on where you feel the market will NOT go.  This strategy allows you to define your risk, while keeping the odds in your favor, and providing you with a flexible and disciplined approach to the markets.

Free Download:  Futures and Options Strategy Guide

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

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

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

Filed Under: Options, Spreads, Strategies Tagged With: , , , , , , , , ,
December 7, 2010 by Leave a Comment

Developing a Commodity Futures Trading Strategy and System

This is a revised version of an article that originally appeared in FutureSource’s Fast Break Newsletter on April 08, 2005.

The futures markets are exciting and attractive to many individuals.  However, potential traders are faced with the daunting task of determining how they should make their trading decisions.  Potential traders need to develop a trading method that fits their personality, risk tolerance, time horizon and time commitment objectives.  We will discuss several trading styles and methods that will help the trader develop a method that best suits his or her needs.

Time Frame

Time frame may be the most significant aspect to consider when determining your trading method.  Someone who is a big picture person and looks at markets in macro terms would not be suited to day trading.  A long-term trend following system would be a method a macro-type trade would consider.  To trade with a long-term perspective is not suited for everyone.  It requires a great deal of patience and perseverance to hold a position for an extended period.  If a market trends higher over a 20-day period, it would be extremely rare that it would move higher everyday without closing lower on any given day.  It is very difficult for a person without a great deal of patience to sit through a few days or even a week of lower closes.  In a trade the eventual moves higher in the macro view, you may end up sitting through days if not weeks of a losing position.  For this reason, the long term, macro approach is usually employed by large funds and institutions.

Many futures traders like to exit all their positions by the end of the day.  These traders are more comfortable trading in terms of minutes and hours as opposed to days and weeks.  A day trading strategy has many appealing features, such as lower capital requirements and no overnight market risk.  The biggest draw back to day trading is the time requirement.  A day trader must be in front of a computer as long as they are involved in a trade.  It is the time requirement that makes day trading an unrealistic option for many potential traders.

Futures traders looking for something between day trading and long term trading usually fit into what is often referred to as swing trading.  The traditional view of swing trading is quick 1-5 day trade taking advantage of a shorter-term move.  This medium term time frame is popular as most traders place all their orders before the market opens and do not have to monitor their positions all day.

Risk

Risk usually correlates well with reward – usually, the bigger the risk, the bigger the potential reward.  Day traders normally risk less on an individual trade and are looking for a smaller profit.  They often will make many lower risk trades in search of numerous small rewards.  Long-term traders are willing to risk more per trade in search of the larger profit that a big market move can bring.

A fine example of this would be the crude oil market.  Crude oil is in the news everyday as we see a market that has moved above $65 per barrel.  A long-term macro trader may have bought crude oil futures a few months back at $45.  The crude market went from $45 to $60, and back under $50 before eventually rallying to new all-time highs of $66.  Many macro trades have had $70 crude in mind since this move started.  A trader unwilling or unable to withstand $5,000 per contract swings in equity would not have been able to hold on to their position.

Developing a Commodity Futures Trading Strategy - Crude Oil Futures Market

Click to View Larger Chart

In contrast to the above example, a day trader buying an e-mini S&P contract places a 3-point stop looking for a 5-point move higher.  The trader is right and as the trade moves higher he quickly tightens his stop order.  This trader is intending to initially risk $150 to make a $250 profit all before the close of the trading day.  Unlike the macro trader, a day trader is not looking for a longer term 50 or 100-point move in the index over a 1- 6-month period.

Personality

The trader is the only one who can truly determine what best fits his or her personality.  A person who does not have the time or the desire to sit in front a computer will not do well as a day trader.  A person who is not comfortable with taking large financial risks looking for even larger rewards would not do well as a long-term trader.

Personally, I do not have the disposition to sit with long-term futures positions, especially when they are going the wrong way.  Part of the problem may be the fact that I sit in front of a quote screen all day.  Sitting in front of a quote screen watching the markets tick-by-tick makes it difficult to see the forest through the trees.  For that reason, I am personally suited to either day or swing trade.  Day trading does not allow me to attend to any other business during market hours so it is not a practical alternative.  With a shorter term, swing trading, type system, I can place my orders in the morning determine my entry and exit points after the close and have market hours free.

Developing a Futures Trading Strategy

In looking for a futures trading methodology, write down the time frame preference as well as market beliefs you hold.  For example: a trend following method, with a swing trading time frame, that uses shorter-term breakouts as an entry.  A trader may look at a reversal system that uses a combination of bollinger bands and key reversals for entry setups.  There is no one method that suits all traders.  For any method to work, a trader has to stick with it.  A method that does not fit the trader’s personality will be difficult to follow.

A Theoretical Futures Trading System

Trader A is a busy professional who is comfortable with trades lasting anywhere from several days to several weeks.  He is very comfortable staying in a trade longer if it is making money, but does not like to stick around in losing trades.  The trader likes to trade in the direction of the trend and likes to use breakouts for entry points.

Trader A’s system uses the following parameters:

  • 21 day moving average
  • 5 day new high or low to determine entry
  • The system will enter a long trade if the market makes a new five bar high above the above the 21 day moving average and has traded above the average at least one of the past five days.
  • The trader will exit the position on a new five bar low.  If the new five bar low is below the 21-day moving average and the market has traded below that average at one of the last five days, reverse the position.

Developing a Commodity Futures Trading Strategy - Buying Strength and Selling Weakness

Click to View Larger Chart

The above example would be a basic futures trading strategy that the trader could back test on numerous markets to determine how it would have performed in the past.  If the basic ideas behind the method are sound, it is possible that the strategy will work in the future.  The ideas of buying strength and selling weakness have been around the markets for a long time.  Trading the long side above a moving average and trading from the short side below a moving average are also well-established trading ideas.

The trader would also need to select markets to follow with this system.  The trader would need to determine the amount of risk capital they have available and work backwards.  Unless a trader can afford to trade a basket of 30-plus contracts, they should look to select non-correlated markets with quantities determined by margin.  For example a system that traded 1 contract of oats and 1 contract of crude oil would be far heavier weighted in the crude oil.  To balance this, the trader would trade a quantity of oats that matched the margin for the single oil contract.  As a rule of thumb, this works well for balancing a portfolio of futures.  The margin requirement is determined by the volatility of the contract.

The above system has not been back tested and I would not recommend anyone trade it without first doing so.  Intuitively, this system is probably a good start for developing a methodology.  The basics behind the system make sense although the time frames may need to be adjusted.

Developing a futures trading strategy can be a very rewarding endeavor as it forces you to think about your personality as well as your market beliefs.  Developing a futures trading methodology will force you to have a reason for trading and makes it difficult to justify trades made on gut instinct and feel.

Filed Under: Getting Started, Strategies Tagged With: , , , , ,
December 2, 2010 by 1 Comment

Trading Psychology: How to Build a Solid Foundation

The story of two home owners…

Joe and Bob have just purchased two beautiful beach front properties on the Gulf coast.  Both are very excited about this opportunity and begin building their homes right away.  As a few weeks pass, Joe’s home is almost finished, while Bob is still laying the foundation.  Joe has built his dream home in the matter of weeks, and Bob is still building and reinforcing his foundation.  Finally, after months of patience and hard work, Bob’s home is finished.

Later that year, a devastating storm comes crashing through their town.  The storm completely wipes out Joe’s home, while Bob’s home hasn’t budged.  Bob’s home is standing strong with minimal damage.

Joe built his home very quickly.  His only focus was to finish building his home, and he never considered the risk of building in this manner.  Yes, he was able to live in and enjoy his home for several months, while Bob had just began laying his foundation; however, as soon as the first storm came passing through, all of Joe’s work was washed away.  He was only concerned with the end result, and in the end, had nothing to show for it.

Bob had a much different approach.  His number one objective was to build a home with a strong foundation, knowing his home would have to weather a storm from time to time.  In the end, he experienced minimal damage.

A trader’s psychology is his foundation.

The same is true with commodity futures trading.  Markets are constantly changing.  As a trader, you need a strong foundation to weather the storm.  Over the last few years, as traders, we have had to weather a devastating storm.  We have endured crisis in our banking system, a housing bubble collapse, government bailouts, the flash crash, and overall weakness in economies around the globe.  There is no question markets have been challenging, but it is the foundation of your trading plan that will always keep you on your feet.

In my opinion, the foundation of every trader’s plan lies between their ears.  No matter if you are a day trader, an options trader, or long term position trader, your foundation revolves around your disciplined trading psychology.  How else can two traders following the exact same trading system receive completely different results? A trader’s psychology is his foundation.

In my opinion, a healthy trading psychology is:

  1. Being comfortable with the capital at risk
  2. Being confident in the strategy in place
  3. Remaining optimistic about future opportunities.

This is the foundation for your trading.

Be comfortable with the capital you’re putting at risk.

Nobody wants to lose money.  We wouldn’t invest if we thought we were going to lose our money, but we have to accept the fact that it’s possible.  You will never be a successful trader if you are not willing to accept this fact.  If you aren’t comfortable with the capital you have at risk, your emotions are going to takeover and make it impossible to stay disciplined with your trading approach.  Like the story of the two home owners, Bob wasn’t in a rush to reach his end goal.  He understood there was risk building a home on the gulf coast, but he felt the end result would be worth the risk.  The same is true for traders.  We need to accept the risk/reward parallel.

Be confident in your trading strategy.

It doesn’t matter if you are a technical trader or a fundamental trader; you need to have confidence in your plan.  You need to know why you are taking the trade, what you are willing to risk on this trade, and what your profit target is.  Without these parameters, fear and greed can easily take over.

This is why your trading strategy has to draw a distinct line in the sand beginning with the reason behind the trade.  If you don’t know why you are entering a trade, DON’T.  You must have a reason or idea behind every trade.  Once this reason is established, you need to set profit and risk parameters prior to entering the trade.  If the market moves to X, I will take my loss and move on to the next trade.  If the market moves in my direction to Y, I will take profit.  Without these distinct parameters, you are at the mercy of your emotions.

You need to “plan your trade, and trade your plan.”  Stay disciplined and do not deviate from this plan.  You are going to have winners, you are going to have losers, but this discipline is the concrete that holds your foundation together.

Remain optimistic.

I think there is a lot to be said about a positive attitude.  Do you feel trading becomes easier when you string together a few big trades? And does it become more difficult when you’re in a rut? I think a major factor of this is remaining optimistic.  When you’ve taken a few losing trades, you begin second guessing yourself.  You see an opportunity, but hesitate and miss the trade because you doubt yourself.  The next thing you know, that trade is a winner and you begin forcing trades to make up for the one that got away.

You need to stay positive.  You need to remain optimistic.

When you string together a few big winners, you have confidence in your strategy.  You see a set up and you take it.  You trust your plan.  You have to keep the same mind set when you are in a rut.  You understand not every trade will be winner.  It might take you longer than you think to reach you goal, but you need to focus on your foundation.  Just like Bob did not get frustrated and lose his patience as he saw Joe enjoying his home, you shouldn’t get frustrated with delayed results.  Focus on your foundation and the rest will fall into place.  You will be able to weather the storm so you can enjoy brighter days.

Accept your risk/reward parameters, understand that you are only risking this capital because you have confidence in your trading plan, and stay optimistic.  Every trade provides a new opportunity.  Be disciplined and trust that this foundation will allow you to accomplish your commodity futures trading goals.

Filed Under: Getting Started 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: , , , , , ,