The financial markets provide participants with difficult decisions in every situation. An envious but no less difficult position is one that involves a winning trade. There comes a point when the desire to take profits overcomes the desire to stay in that profitable position. The psychology involving loss of profits can be even harder to master than the psychology of entering a trade and facing loss of principal. We hear it often in common investing mantras – “hogs get slaughtered”. Keeping that in mind, how does one know which winners to let run and when to not be a greedy pig? The answer might be more strategic than psychological.
The Corn market has put many in this position. One year ago, the market for December 2011 corn was trading just over 4.50. Strong fundamentals combined with loose monetary policies have created a demand for the product from not only a production standpoint, but an investment perspective as well. Those with the foresight to have purchased corn a year ago would be sitting on a solid winner with December corn around $7.40 today. However, with the recent European crisis coupled with high prices curbing demand, the holders of length in the market face tough trading decisions. Do they cut the trade short? Or do they hang on in hopes of continued supply shortages and a push over $8.00?
The savvy trader will look to his trusty option tool belt. Much like Batman’s utility belt, traders need to have tactics at their disposal to assist them while combating any perceived market situation. View using options like Bruce Wayne uses his crazy weapons to escape stressful situations. Regarding the case described in corn, one should look to the ratio call spread as a way to hedge some downside risk while giving themself the chance to profit in case of a move higher.
The ratio call spread involves the simultaneous purchase of a call with the sale of two or more calls. In this example, our ratio spread will be a one to two, buying one close to the money call and selling two further out of the money calls. Because we’re assuming that the corn market might be a bit “toppy”here, we want to do this spread at a “credit” – this means that we will collect a higher premium from the sale of the two calls versus what we’d spend on the premium for the long call. Let’s look at an example:
Glen has been long one December Corn futures since it was at 5.00. He is a long-term thinker. Glen believes that because of the inability of the government to print more corn combined with their ability to print more money, the corn market will go up drastically over the medium term – possibly as high as $10.00. Alternatively, because of the constant US/European financial crises, he knows his position could see heavy liquidation if these crises were to escalate in the short run. He could just exit the trade and wait for these crises to pass, but he also understands the upside risk that exists due to these central banks devaluing their currencies to solve their issues. In his opinion, this would cause the rally to continue and doesn’t want to miss it.
At this moment, December Corn is trading at 7.40. With the harvest season around the corner and farmers selling their crops, we typically see a drop in prices. Glen is going to look to buy a ratio call spread at a credit to protect some downside risk. He will look to buy one 7.70 December Corn call and will sell two 8.00 December Corn calls expiring in 74 days.
- Buying 1 Dec 770 call for 30 cents, paying $1,500 before fees
- Selling 2 Dec 800 calls for 23 cents each (46 cents combined), collecting $2,300 dollars before fees
This move will give Glen 16 cents of downside protection while capping his profits on corn at 8.00 over the next 74 days, which will cover his long futures. The spread also has an upside – if corn expires over 8.00, Glen would collect maximum profit on the difference between his long 7.70 call and short 8.00. That would give him another $1,500 in profit to go along with the profits he will receive from his long futures contract from 7.40 to 8.00 ($3,000).
In the short run, the ratio spread will make money as the corn market falls, offsetting some of the losses Glen will take on his long corn contract. If the market would rally higher, Glen will make money up until 8.00 from his futures contract and call spread. The risk from putting himself in this position would be the elimination of profits over 8.00. Glen accepts that risk because he knows there is no such thing as a free lunch and is fine sacrificing profits over 8.00 for protection here at 7.40. It is that tradeoff that will compel him to get involved in a spread like this.
The ratio spread works well in accompanying positions for any trending market. This trade might also work well for those who have been long commodities like Gold, Bonds or Sugar. For more questions on developing your own option tool belt, please contact a Daniels Trading broker.
Options on Futures Contracts: A Trading Strategy Guide
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