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Commodity Options Trading and Hedging Volatility in the World’s Most Lucrative Market
| Date post: | 20-Jun-2015 |
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Commodity Options
Trading and Hedging Volatility in the World’s Most Lucrative
Market
Available at all major book outlets
“Hidden behind the warm and fuzzy palaver is fierce intelligence and an aggressive stance—Commodity Options is a real wolf in sheep’s clothing.” ~ Phyllis Feinberg with The Investment Professional
There is substantial risk in trading futures and options!
Our purpose…
It isn’t realistic to cover all
of the strategies detailed in
“Commodity Options” within
a relatively short
presentation. However, we
hope that you walk away
from this with a sense of
what makes commodity
options appealing relative to
more commonly traded stock
options and a basic
understanding of long and
short option strategies.
An Option is an Option…Think Again
Not all options are created equal
While the mechanics of calls and puts are the same, commodity options and options on stocks trade and behave differently due to vast disparities in the underlying contracts in which the options are written.
You wouldn’t trade futures and stocks in the same manner, so why would you assume that you could do so with their derivatives?
Commodity Options vs. Stock Options
Commodity Options
Leveraged underlying asset
Leverage on Leverage
More risk and potential reward
Markets are efficient and therefore the increased leverage is somewhat built into option pricing. However, and explosion in volatility may lead to increased opportunity
Stock Options
Non-leveraged underlying asset
All options are leveraged to a point but stocks themselves are not margined vehicles
Commodity Options vs. Stock Options
Commodity Options
All futures contracts have finite life spans and are subject to expiration
Because of futures contract expirations, it may not be accurate to assume that once exercised a position can be held for a long period of time
Futures contracts held into expiration face the delivery process
Stock Options
Stocks exist indefinitely, there is no expiration date
Many stock traders sell puts with the intention of taking delivery of the underlying stock and holding it indefinitely
Commodity Options vs. Stock Options
Commodity Options
Commodities do not pay dividends and therefore have a tendency to trade in long-term ranges (with the exception of the 2007/2008 rally of course)
As a whole, commodity options are less liquid than stocks. Accordingly, traders must be selective in market and strategy
Additionally, there are less than 20 option markets with sufficient liquidity for the average retail trader
Stock Options
Many stocks pay dividends causing the long-term valuation of equities to be an up-trend
Stock option traders enjoy liquid markets with thousands of possible underlying assets
Commodity Options vs. Stock Options
Commodity Options
Time horizon – commodity option access and liquidity tends to be within 2 or 3 months until expiration
Many commodity options are trade in an open outcry environment and therefore quotes can be costly. For electronically executed options many brokerage firms offer free real-time bids and asks
Stock Options
Stock traders have access to LEAPS which may have expiration dates years in advance
Readily accessible quotes
Commodity Options vs. Stock Options
Commodity Options
Commodity option traders enjoy preferential tax treatment.
Gains are taxed on a 60%/40% blend between long-term and short-term gains
No need for a line by line account of trading activity, profit and loss is reported to the IRS in one lump sum
No interest charged on borrowed funds
Stock Options
Stock option traders are typically subject to short-term capital gains which are taxed at a higher rate than short-term
May face additional monetary burdens on marginable balances
The Mechanics of Calls and Puts Call Put
Buy Limited Risk/ Unlimited Profit
SellUnlimited Risk/ Limited Profit
Call Options – Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time. Conversely, the seller of a call option is obligated to deliver a long position in the underlying futures contract from the strike price should the buyer opt to exercise the option.
Put Options – Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time. The seller of a put option is obligated to deliver a short position from the strike price (accept a long futures position) in the case that the buyer chooses to exercise the option. Keep in mind that delivering a short futures contract simply means being long from the strike price.
Breaking Even at Expiration
A break even-point describes the point at which a long option trader becomes profitable at expiration
The reverse break-even point stipulates the price at which an option seller is profitable at expiration
BE = Strike Price +/- Premium Paid +/- Transaction Costs
RBE = Strike Price +/- Premium Collected +/- Transaction Costs
Think Outside of the Box
Open your eyes to the potential of both long and short options
Most speculators are lured to long only option strategies due to the prospects of limited risk and unlimited reward
Limited and less aren’t necessarily synonymous
Why long options aren’t always a great “option”
Time Decay
80/20 Rule
Time Limit
Market Direction
Time Decay
Options are an eroding asset, each minute that passes reduces the value of any given option. Buying an option is similar to purchasing a car only to see the value plummet once it is driven off of the lot.
This is true even if the direction of the underlying market is congruent with the option. Therefore, options can only increase in value if the directional movement of the futures market outpaces time value erosion.
80/20 Rule
It has been said that the commodity markets spend approximately 80% of the time trading in a range and the other 20% of the time redefining that range.
Assuming this is true, the same logic can be applied to long options simply because it takes a substantial price move in the futures market for long option positions to be profitable.
Studies have shown that more options than not tend to expire worthless
It isn’t a coincidence that most literature and analysis suggests that the probability of an option expiring worthless is between 70 and 80%
Market Direction
Upon purchase of an option, there is approximately 33% chance of market going in the anticipated direction
This makes sense. After all, the market can go up down or sideways
Base on our simple assumptions, this leaves an option buyer with a 66% chance of loss
Time Limit
As we all know, options and even the underlying futures contracts have an expiration date
To be profitable, option buyers must be right about the direction of the market, the size of the move and the timing in which it will happen.
The Time and Place for Long Options
Low Volatility – Option premium can become cheap during periods of low volatility
Lottery Tickets – Sometimes it is a good idea to purchase low priced options in hopes of an explosion in volatility. If it happens, the payoff could be large in terms of percentage.
Extreme Prices – Markets at or near all-time highs are prone to violent reversals at a time in which countertrend premium is “cheap”.
Quiet Markets – Certain markets tend to trade with low levels of volatility and or leverage; as a result, it is often possible to find affordable options with attractive prospects for success.
Why Sell Options?
Many beginning traders are turned off by the prospects of limited reward, unlimited risk and a margin requirement.
However, option selling is based on the same premise that insurance companies and casinos operate on.
They collect premium or gaming revenue over time knowing that eventually claims will be filed and jackpots will be won. However, if they manage their risks correctly, they will have collected more than they are obligated to pay out.
Why Sell Options?
Time is money
Option premium is an eroding asset to the buyer but an eroding liability to the seller
As time passes, the option to buy or sell a futures contract at the stated strike price becomes less and less valuable
The last 30 days of an options life tends to see the largest pace of erosion
Selling options with considerably more than 30 days left may be accepting unnecessary risk for very little reward
Why Sell Options?
Reduce market and trading account volatility
A deep-in-the-money option behaves similarly to a futures contract but anything other than will typically fluctuate at a slower pace
Profit and loss will, under most circumstances, respond less to fluctuations in the underlying market…and you get the money upfront
Why Sell Options?
More room for error
Nobody is perfect in predicting direction, timing and magnitude
Option sellers have the luxury of being wrong while maintaining the possibility of being profitable
The premium collected acts as “cushion” for adverse price movement in the underlying futures contract in that the extrinsic premium collected offsets intrinsic value of the option at expiration
The only scenario in which a short option is a loser at expiration is in the case of a futures prices that is trading beyond the reverse break-even point
Essentially, a trader can make money whether the market goes up down or sideways. The risk occurs when the market moves too far in the unintended direction
Speculators that believe a market is overbought and due for a correction may look to sell a call option as opposed to selling a futures contract or buying a put option.
Futures traders face immediate risk of incorrect speculation; likewise put buyers must be accurate in timing and direction in order to overcome premium erosion. Short call traders enjoy ample room for error because risk of loss at expiration doesn’t occur until the futures price trades above the reverse break even point of 1394.20.
Neutral Short Option Strategies
Short Option Strangles – Sell an out-of-the-money call and an out-of-the-money put
Strangle writers aren’t speculating on a market direction, instead they are hoping for a lack of direction
The trade can only lose on one side not both
Discounted margins
The reverse break even point is equal to the premium collected on both the call and the put
Accordingly, risk is shifted farther away from the market
Neutral Short Option Strategies
The allure of a short strangle is the ability to profit from a market regardless of its direction
The risk of a short straddle is being caught in an exploding market
Beyond each of the reverse break-even points, the trader is exposed to unlimited risk
As we will see on the next slides, a strangle writer makes money anywhere between the RBE’s but makes less in between the strike prices and the corresponding RBE.
Example…
“We are all just one trade away from humility.” Marv from the movie Wall Street
While the odds favor option sellers, they face theoretically unlimited risk.
In the right (or wrong) circumstances, losses can be devastating
Accordingly, risk management and good instincts are imperative
Double out rule – Mental stop risking the amount collected
Sell more premium – With deep pockets, it may be possible to sell more premium to adjust the break even point on the original trade
Cover with futures contracts – Dangerous but effective in directional markets
One-by-two ratio writes – Offer intrinsic insurance but pose immediate extrinsic risk in the case of volatility explosion
Selling Commodity Options can be Hazardous to your Wealth
All short options are subject to unlimited risk but there are a few that should generally be avoided
Lumber
Natural Gas and Unleaded Gasoline
Hogs, Cattle, Pork Bellies
Oats and Rice
CRB Index!
Even in Liquid Markets…
Disaster can Strike…
Available at all major book outlets
“The focus is resolutely practical: this is indubitably a hands-on self-help manual for traders.” - Phyllis Feinberg, The Investment Professional
