commodity risk management
Here you will find the basics of trading in commodities. This section will be most useful to beginning futures traders, but its content shouldn't be overlooked by those with trading experience. The goal of these articles to help traders fully understand the risk and reward prospects of participating in the commodity markets.
Despite what you may have read in commodity trading books, magazines, or even heard on infomercials, trading options and futures entails substantial risks and is not suitable for everyone.
On the other hand, trading in futures and options can be financially rewarding, but you must realize that where there is potential opportunity there is a corresponding amount of danger.
For this reason, only risk capital (money that you can afford to lose without altering your lifestyle) should be allocated to a commodity trading account.
The risk in trading futures stems from the leverage provided by the exchanges, combined with the speculative nature of the commodity markets. Unlike an investment in stocks or bonds, futures traders aren't buying or selling assets. Instead, they are buying and selling obligations to make or take delivery of the underlying commodity. In other words, futures traders don't own anything other than a liability. Further, commodities don't pay interest or dividends to buffer investment volatility. As you can image, this sets the stage for a considerable amount of risk and reward.
The ability to easily buy or sell futures and options contracts in any order creates opportunity, but it also breeds aggression; and this can sometimes be too much for beginning commodity traders to overcome. We urge traders to live by the motto "less is more".
The leverage in commodity trading is created by the ability to share in the profits and losses of a substantial amount of the underlying asset for a relatively small good faith deposit. Simply put, futures exchanges require a small margin deposit comparative to the total value of the commodity contract being traded, this allows a reasonably small move in the futures price to have a large impact on the value of your trading account. It is not unlike the leverage most home buyers experience; they put a down payment of 5 to 20% but their capital gains and losses are determined by the full value of the property.
With that said, please note that being a successful futures and options trader is challenging yet achievable. In my experience as a commodity broker, I have found that the only way to "beat the market" is through the ability to overcome emotional and psychological barriers. Unfortunately, this is something that can only come through practice...unless of course you were lucky enough to be born with the appropriate personality for trading.
We at DeCarley Trading hope to play a part in your journey through the markets and insist that you consider both the sides of the coin before choosing to trading options and futures. We look forward to hearing from you.
An Introduction to Popular Commodity Option Trading Strategies
There have been many books written on options on futures trading, however I sometimes question the usefulness of the information provided. It seems as though much of the literature available leaves the reader in a state of confusion; perhaps a majority of the bewilderment stems from the fact that most option theory is based on stock option trading and the transition to commodities isn't without its hitches. In my opinion, the practice of repackaging stock option trading strategy and theory in an attempt to appeal to and educate commodity traders can be misleading. Additionally, there are large differences between option theory and option trading. Some of what looks good on paper is difficult to execute efficiently in the real world, this is especially true in the world of commodity option trading.
It is a false assumption to believe that an “option is an option”. They may be spelled the same, but they are vastly different due to the nature of the underlying vehicles. As a result options on commodities take on completely different characteristics. After all, everybody agrees that trading stocks is poles apart from trading futures. Why would anybody believe that trading options on stocks is synonymous with trading options on futures?
A New Look at an Old Futures Trading Topic
There are an unlimited number of ways to skin a cat, and trading is no different. Despite your futures trading strategy, risk tolerance or trading capital, having a plan is one of the most important components of achieving success in these treacherous commodity markets. However, we believe that the most important characteristic of a profitable futures and options trader is the ability to adapt to ever-changing market conditions. Assuming this, it seems logical to infer that a commodity trading plan should be established; nevertheless, just as rules are meant to be broken, futures trading plans should be flexible to accommodate altering environments and new events.
The premise of properly planning a commodity trade is similar in nature to a business plan. It is a relatively detailed outline of the structure of the futures and options speculation and the contingency plan, or plans, should the market go against the trade. Once again, I believe that trading plans should not necessarily be set in stone; behaving as if they are could lead to financial peril.
There are two primary components of a commodity trading plan: price prediction and risk management. Price prediction is simply the method used to signal the direction and timing of trade execution. This may involve fundamental or technical analysis, or both. Risk management specifies when to cut losses, when and how to adjust a position, or better yet when to take profits.
Commodity Futures Price Speculation (Hopefully Prediction)
The only way to make profitable futures and options trades is to buy low and sell high. This is true whether you are trading derivatives, or baseball cards. Although it is a simple concept in theory, in practice, it is much more difficult to implement than one may think. In order to successfully buy something at a low price and sell it at a higher price, the trader must first be accurate in his speculation.
Determining an opinion on where commodity market prices could, or should, go is only half the battle. Once you have done your homework in both fundamental and technical analysis, you must be able to construct a prospective commodity trade that will be profitable if you are correct and hopefully relatively painless if you are wrong.
Timing is Everything when Trading in Commodities
In futures and options trading, timing is everything. I constantly remind my clients and prospects that there is a big difference between being right in the direction of a commodity market and actually making money. I have witnessed traders be absolutely correct in their speculation of futures price movement, but miss getting into the trade due to unfilled limit orders, or entering the commodity position too early (which can cause the trader to run out of money or patience before the price move occurs).
Attempts at commodity price prediction can be based on technical oscillators, psychological barometers, supply and demand, or anything else that provides clues to price direction and timing. I am a firm believer that there aren't right or wrong trading tools but there are right and wrong ways to use them. Simply put, trading indicators can be compared to guns; guns don't kill people, people kill people. In trading, oscillators or charting tools don't siphon trading accounts; unfortunately traders sometimes do it to themselves by acting too aggressively to trading signals, or ignoring them altogether.
Further, while it isn't important which indicator you use to time a futures trade entry and exit, it is important how comfortable and confident you are in using it. This is especially true in reference to computer generated oscillators such as the MACD and Slow Stochastics. In the long run, I believe blindly taking all buy and sell signals triggered by such indicators would yield similar results. Accordingly, the primary factors playing a part in whether a trader experiences profits or losses are likely the ability to avoid panic liquidation, properly placing commodity risk management techniques in place, and exiting option trades that have gone bad before it is too late. In other words, I believe that good instincts and experience are more valuable than any technical indicator, or supply and demand graph, that you will run across.
Once you have determined your speculative tool of choice and determined your conclusion on the direction, or lack of, it is time to construct a strategy that will benefit if your assessments are accurate and mitigate risk if you are wrong. This may include the use of options, futures or a combination of both. The method that you choose should be based on your risk tolerance, personality and risk capital.
Options, Futures, or Both
Commodity speculators have an unlimited number of "options" when it comes to trading vehicles. The key is to find an approach that will provide you with a manageable risk profile, while still leaving the potential for a profit that you will be satisfied with. Throughout the process, keep in mind that the relationship between risk and reward isn’t linear. Only a fine balance between the two will allow the trader the probability of a reward rather than the dream of one. Accepting reckless amounts of risk may pay off for a lucky few, but for the masses the results will be dismal.
Depending on the characteristics and personality of the trader, a stock market bull might purchase an e-mini S&P futures contract, purchase an e-mini S&P 500 call option, sell an e-mini S&P 500 put option, or even use a combination of long and short options and futures contracts, to construct a trade with various risk and reward prospects.
Likewise, a crude oil bear might opt for a limited risk option spread such as an iron butterfly or he be willing to accept large amounts of risk and volatility by choosing to short a futures contract outright. I couldn't possibly touch on each of the commodity market strategy possibilities in within the realm of this article but you should be aware of the opportunities available to you, and which fits your personal trading profile, before ever putting money on the line. If you are interested in exploring commodity trading strategies outside of simply buying or selling a futures contract, you might find my book “Commodity Options” helpful. It outlines several commodity option spreads and even synthetic strategies in which futures and options are combined to construct a hedged position in the futures markets.
Risk Management is Imperative when Trading in Commodities
The "meat" of a proper futures trading plan is risk management. This is concerned with establishing thresholds of loss that you are capable and willing to accept in exchange for potential rewards. In the case of futures traders, this may simply mean picking a stop loss price and placing the order in conjunction with a profit target (limit order).
Once again, trading plans are for guidance and shouldn't be followed blindly. Don't be the futures trader that misses taking a healthy profit while trying to squeeze out an extra $20 because the price came within ticks of a working limit order but failed to trigger. Also, even if your trading plan doesn't involve a trailing stop don't be a fool. Markets don't go up or down forever, if you have a large open profit tighten your stop loss order, or place protective options or option spreads and walk away.
Managing Commodity Market Risk is an Art not a Science
Creativity can be a valuable tool in futures trading. Think beyond the traditional practice of using stop loss orders to manage risk, because there are an unlimited number of possibilities. For instance, experienced futures traders might choose to incorporate selling option premium against a correctly speculated futures contract as a form of risk management. Doing so converts the trade into a type of “covered call” or “covered put”. The premium collected from the short option not only produces income, but it provides a hedge against a price reversal. This is because a long futures contract and a short call option benefit when the market moves in the opposite direction (they counter act one another). Likewise, in-line with this strategy you may want to use the proceeds of the covered call or put strategy to purchase an option to protect your risk of an adverse futures price movement.
As you can see, well-informed traders have a plethora of strategies to adjust the risk and reward of a futures position. A trading plan couldn't possibly cover all market scenarios, and adjustment possibilities, but writing down a few potential ideas may keep you from freezing in the heat of the moment.
If you are interested in exploring the endless possibilities in regard to futures trading management, and strategy creation, please visit our futures and options trading educational video archive.
Risk and Reward: Give Yourself a Chance!
When deciding how much risk you are willing to take in the commodity markets and setting your profit objectives, you must be realistic. Beginning futures traders are often surprised to hear that many of the best traders struggle to keep their win/loss average above 50%. With these odds in mind, it doesn't make sense to consistently risk more on a trade than you hope to make should you be right. For instance, if your average risk is $500 you should have an average profit target of at least $500. Anything other than this puts the odds greatly in favor of your competition.
Commodity Option Sellers Face Optimal Win/Loss Ratios but That Doesn't Guarantee Success
Because more options than not expire worthless, commodity option sellers often have much better win/loss ratios than futures traders. However, the drawback of an option selling strategy is the reality of accepting theoretically unlimited risk in exchange for limited profit potential. In the game of commodity option selling, winning far more trades than you lose is only the beginning. An option seller must be savvy enough to prevent the small percentage of losing trades from wiping out months of profit. My intention isn't to deter you from selling options, in fact this is the strategy that I prefer and recommend as a commodity broker to my clients. However, those that partake in this practice must be ready and willing to face the consequences during draw-downs.
U.S. futures exchanges don’t accept stop loss orders on options. Even if they did, it wouldn’t be in the best interest of traders. This is because it wouldn’t be feasible to place stop orders on most options, or option spreads, due to the nature of the bid/ask spread and the seemingly high probability of being stopped out prematurely. Remember, a stop order becomes a market order as soon as the named stop price becomes part of the bid/ask spread. If the bid/ask spread is wide due to a lack of liquidity, a stop order will be triggered and filled at a dramatically inopportune time and price (unfavorable slippage).
Instead of placing stop loss orders, short options should be monitored closely; keeping a "mental" stop in mind is important. I typically advise traders to use a double out rule. This means for every naked short option, whether it is within an option spread strategy or sold individually, you should strongly consider buying it back at a loss if its value doubles from your entry point. In essence, if you sell a crude oil option for .50 cents or $500 ($10 x 50) and following your entry the option doubles in value (appreciates to $1.00 or $1,000) it may be fair to say that you were wrong. At this point, a trader should strongly consider liquidating the position and moving to the next opportunity. Failure to do so may convert a moderate loss into something much more.
Unfortunately, in fast moving markets the value of an option sometimes explodes in value very quickly, making the double-out rule impossible to implement. Even so, the double out rule should be part of the overall trading plan. This doesn't necessarily mean it is an exact science; trading is an art and should be treated as such. Imagine being short a put option in a declining market that has reached the designated double out point, but the market is approaching significant support. If you strongly believe that the futures price will hold support, exiting your position at top dollar in panic, doesn't make sense. However, on the flip side; if you find yourself counting on hope rather than rational logic, you have let it go too far. Sometimes the line is difficult to see until it has already been crossed but its times like this that make or break a trader. I believe the ability to properly manage these scenarios come from instinct and experience; it cannot be attained from reading a book or attending a seminar.
The 10% Rule in Trading
Many futures trading courses and literature claim that a commodity trader shouldn't risk more than 10% of their trading account on any one trade. This seems to be relatively sound advice but might, or might not, be feasible for everyone. For example, a risk averse trader may not be psychologically equipped to handle such a loss which can easily lead to irrational trading behavior. On the contrary, a well-funded-trading account might be risking a substantial amount of money if risking 10% of the commodity trading account.
Most beginners underestimate the value of psychology. Once the balance is broken it is hard to regain logic and can lead to large losses. For example, a trader that opens an account with $10,000 and immediately loses $1,000 on the first trade may dedicate subsequent trades to recovering losses sustained on the original. In other words, they are often tempted enter a market prematurely and aggressively to make up for lost ground. This behavior would demonstrate an example of a trader that simply isn't capable of taking such a large loss without detrimentally impacting the original trading plan.
An additional drawback of the 10% rule is the fact that during volatile market conditions, whether trading options or futures and depending on the risk capital available, it may not be possible to construct a trade with reasonable odds of success without surpassing the appropriate percentage. In this case, the market is often best untouched, but as humans we are naturally drawn to that of which we shouldn't.
Leave Multiple Contract Trading to the Pros and Well Capitalized
As a long-time commodity broker, one of the most destructive things that I have witnessed traders do is execute multiple futures contracts in a moderately funded account. Inexperienced traders are under the assumption that trading several futures contracts simultaneously will maximize their "return", but what they are actually doing is maximizing risk and minimizing the probability of a successful trade. Despite the emotions involved, commodity trading isn't about feeding your ego it is about making money...right?
Stop the Loss!
Futures traders often look to manage risk of loss through the use of stop loss orders. A stop order instructs the broker to exit an outstanding futures position if market prices move adversely enough to reach the named price. However, keep in mind that a stop order can also be used to enter a market. Such a stop order is often placed above areas of significant technical resistance or below support in an attempt to capitalize on a potential price break-out.
In order for stop orders to be effective, they must be properly placed. Anything less will result in either too much risk, or premature liquidation of a trade that may eventually go in favor of the position. This too is an art and not a science. Where stop orders should and shouldn't be placed isn't a black and white decision. There are many areas of gray involving market conditions and characteristics as well as the personality, account funding and risk tolerance of the commodity trader.
If you are a beginning trader this may be a good argument in favor of using a full service commodity broker. However, you must realize that even a well experienced futures broker or advisor can't see into the future and is subject to the same frustrations as you may be. Nonetheless, in theory she may be a little more savvy, and that could have a positive impact on performance in spite of the slightly higher commission rate.
Be warned, stop orders aren't a guarantee of risk. Because a stop order becomes a market order once the stated price is reached, there may be slippage; in rare cases, a substantial amount of slippage. An experienced commodity broker might be able to help you in constructing an option strategy to be used as an alternative in risk aversion. The use of options in place of stop loss orders provide traders with additional lasting power because it eliminates the possibility of being stopped out of a commodity market on a temporary price spike. For example, a short option or futures position may be hedged by a one by two ratio write if the volatility and premium allows.
The ability to place a stop order or limit the risk of a futures trade through options and option spreads should eliminate some of the stress and emotion involved in trading. Rather than losing sleep over a trade gone bad, those with stop orders or protective option positions (insurance) can relax knowing that he has done his homework and has mitigated his risk in commodity trading.
It is Your Money
We don't all wear the same shoe size, or have the same hobbies, so why should we all use the same trading strategy and risk management techniques? The truth is that we shouldn't. My perception of what constitutes reasonable timing of entry, and how much money and emotion to risk on a particular trade, is likely far different than yours. Commodity trading is an ambiguous game; there isn't a right or wrong answer to most aspects of speculation. For example, the same trading "ingredients" may work for one person but not for another due to differences in experience, education, risk capital and emotional constraint.
Only you will be able to determine what works for you; discovering what that is requires patience, discipline, and an open mind. The most important feedback on your progress will be your commodity account statements. This isn't to say that you should hang up your trading jacket if you experience a drawdown, or even a complete account blow up, but it is important that you are realistic. Some people tend to only remember the good trades and others only remember the bad. Each of these distorted perceptions of reality can have an adverse effect on your commodity trading. Successful traders remember the good trades and the bad trades, but most importantly learn from all of them.