learn to trade options
Too many speculators avoid commodity option trading strategies because of the perception of difficulty. However, with a little practice, trading options on futures contracts will become second nature. In our opinion, the effort put into learning commodity option strategies is well worth the effort. Not only does option trading reduce the volatility and risk of trading in commodities, but it also increase the odds of success if employed correctly. Our goal is to provide futures market participants with the resources needed to learn to trade commodity options in a manner optimal to their risk tolerance and trading risk capital.
A Brief Introduction to Commodity Option Trading
The world of commodity options is diverse and cannot be given justice in a short article such as this. The purpose of this writing is to simply introduce the topic of options on futures. Should you want to learn commodity options trading strategies in more detail, please consider purchasing "Commodity Options" published by FT Press at www.CommodityOptionstheBook.com.
Why Trade Commodity Options?
Just as there are several ways to skin a cat, there are an unlimited number of option trading strategies available in the futures markets. The method that you choose should be based on your personality, risk capital and risk aversion. Plainly, if you don't have an aggressive personality and a high tolerance for pain, you probably shouldn't be employing a futures and options trading strategy that involves elevated risks. Doing so will often results in panic liquidation of trades at inopportune times as well as other unsound emotional decisions.
Commodity options provide a flexible and effective way to trade in the futures markets. Further, options on futures offer investors the ability to capitalize on leverage while still giving them the ability to manage risk. For example, through the combination of long and short call and put options in the commodity markets, an investor can design a trading strategy that fits their needs and expectations; such an arrangement is referred to as an option spread. Keep in mind that the possibilities are endless and will ultimately be determined by a trader's objectives, time horizon, market sentiment, and risk tolerance.
Knowledge is the most valuable commodity!
Before you trade commodities, you'll need significant practical knowledge of the associated risks and futures market characteristics. That's where this book comes in. You won't find boring theories or bewilderingly complex commodity trading strategies here. Instead, you will find specific guidance on accessing commodity markets cost-effectively, avoiding common beginners' mistakes, and improving the odds of successful futures and options trades.
Drawing on her extensive experience as a commodity broker, Garner shows how to calculate profit, loss, and risk in commodities, and choose the best futures brokerage firm, service level, data sources, and futures market access for your needs. Garner demystifies the industry's colorful language, helps you clearly understand what you're buying and selling, and walks you through the entire commodity trading process.
She concludes with a refreshingly new look at topics such as futures trading plans, handling margin calls when trading in commodities, and even maintaining emotional stability as a trader.
Know the players, know the language, know the techniques
Master the basics painlessly and avoid beginner's mistakes
Choose the right commodity brokers, services, trading platforms, and tools
Get what you need; don't pay for what you don't need
Make sense of confusing commodities quotes
Know what you're buying, what it costs, the returns you're earning, and the risk you're taking build a flexible trading plan that works to help predict price, manage risk, and make trades that reflect your analysis.
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.
Carley Garner's futures, options, and FOREX trading books have been reviewed by several national publications. Here is a sample of some of the trading community book reviews.
Learn to trade futures, options, and FX with Carley Garner books!
Carley Garner, a futures broker at DeCarley Trading, is the author of multiple trading books. The intention of the publications is to compile lessons learned as a long-time commodity broker, and deliver them to readers in simplified and efficient educational material for futures, options, and FOREX traders.
In line with our commitment to providing free commodity trading education, we've put together a handful of options trading educational articles.
Whether your strategy involves selling options on futures, buying options, or even a combination of both, we believe the articles in this section will be useful to you. If you would like to expand on these options trading strategy ideas, we encourage you to read "Trading Commodity Options with Creativity", which covers several options strategies in detail.
For more information, visit www.TradingCommodityOptions.com
It isn't free, but it's close...If having this book saves you 1 tick in the commodity options markets, you have almost recouped your investment.
Trading Commodity Options...with Creativity takes readers on an unfamiliar voyage destined to simplify the options on futures markets and arm market participants with the knowledge to employ smarter commodity market strategies.
Many books have been written on options trading, but most focus on the academic side of options suggesting there are black-and-white answers and reliable mathematical formulas to determine profit and loss. Yet, options traders must be ready and willing to deal in gray areas, approximations, and guesswork. Trading Commodity Options...with Creativity bridges the gap between traditional options trading literature and real-life trading examples. Through tough-learned lessons, this book tackles the nearly impossible task of streamlining the process of developing an appropriate options strategy for any market environment and risk tolerance, then making the necessary mid-trade adjustments to improve the odds of success.
Visit www.TradingCommodityOptions.com for more details!
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.
*If you have already enjoyed a trial of this futures trading newsletter, please open a commodity trading account with DeCarley Trading to continue to receive it.
The DeCarley Perspective is a trading newsletter with a focus on the commodity futures markets and options on futures trading. It is distributed to commodity trading clients of the DeCarley Trading brokerage service.
This commodity trading newsletter, written by Mad Money on CNBC, Bloomberg, and RFD-TV contributor, Carley Garner, provides a refreshingly honest and comprehensive perspective of the current commodity and financial market environments. The DeCarley Perspective is distributed several times throughout the month to those with an active commodity brokerage account with DeCarley. This newsletter covers both the futures and options markets for commodity products such as grains, meats, softs, metals, energies, currencies, interest rates, and stock indices.
In each edition of the newsletter, futures broker Carley Garner, of DeCarley will share insights into fundamental commodity market analysis in addition to the seasonal outlook of various futures markets. This futures trading newsletters includes a substantial amount of technical analysis performed on the commodity markets, with visual charts to support opinions. "The DeCarley Perspective" may contain specific trading recommendations (primarily option trading strategies) or broad-based commodity trading strategy ideas.
All fields must be completed to be granted a trial
*There is substantial risk of loss in trading futures and options!
The Financial Futures Report is a commodity trading newsletter distributed to DeCarley Trading futures brokerage clients, free of charge.
DeCarley Trading newsletters and educational articles are written by experienced futures broker and frequent television contributor, Carley Garner. Carley has managed to "garner" a loyal following in the trading community. Both beginning and experienced futures traders will likely find the content useful and hopefully profitable; particularly those day trading the e-mini S&P. Whether you trade options or futures you will likely be pleased with the guidance provided by The Financial Futures Report. If you are serious about learning to trade futures, this is a must-have!
The Financial Futures Report newsletter includes daily futures market commentary on Treasury futures (futures symbols ZB, ZN, and ZF) and stock index futures (futures symbols ES, NQ, YM), trade recommendations (largely option trading strategies), an insider's perspective, honest and reliable analysis, and commodity market strategy.
All fields must be completed to be granted a trial
* DeCarley Trading reserves the right to terminate trial subscriptions at any time. If you have already enjoyed a trial subscription, please open a trading account with DeCarley to continue receiving the newsletter.
How to Construct a Put Option Ratio Spread in the Futures Market
Options are eroding assets; therefore, it isn't necessarily wise to spend a substantial amount of money to purchase an option that will face depreciation, as well as dismal odds of success. Instead, it is often a better idea to sell options of different types or strike prices to pay for those that you would like to purchase. A put ratio spread does just that. A trader that is interested in buying a put option in hopes of a market decline, or to simply protect other positions in their trading portfolio, may finance their purchase through the sale of two distant strike priced puts. Here are the details of a put option ratio spread.
Put Ratio Spread
Buy 1 at-the-money Put
Sell 2 or more out-of-the-money Puts
When to Use a 1 by 2 Ratio Put Spread
• Moderately Bearish Option Strategy - When you expect the market to market to move lower, but believe that the downside is limited
• Low Cash Outlay in Exchange for Downside Risk - The objective is to put this trade on as a credit, a free trade or very cheap. This occurs when a trader collects more premium for the short options that is put forth for the long options. Free does not entail a lack of transaction costs, margin or risk.
Ratio Put Spread Profit Profile
• Possible Profit even if the Option Spread Expires Worthless - If executed at a credit the profit is limited to the premium collected if the market is above the long put at expiration
• Limited Profit Potential, but Unlimited Risk - Profit on the down side is limited to the difference between the long and short puts plus the net credit or minus the net debit. The risk is theoretifcally unlimited on the downside.
What is the Risk of Trading a Put Ratio Write?
• If the market expires above the long put your risk is limited to any premium paid for the spread if executed as a debit
• Because this trade involves more short puts than long the down side risk is unlimited below the short puts
• Having unlimited risk this trade needs to be watched closely
Example of a Commodity Put Ratio Spread:
Perhaps one of the most opportune markets to employ a put ratio spread strategy in the futures market is in the stock indices. This is because of a concept known as the “volatility smile” which tends to keep the value of puts, particularly deep out-of-the-money puts, overvalued. This is because traders know equity markets tend to take the stairs up, but the elevator down. It is a market than can, and will, see precipitous declines from time to time; accordingly, speculators are willing to bid the price of puts higher to increase their odds of being at the right place at a the right time.
Compliments of the volatility smile, it is often possible to construct a put ratio spread strategy using the e-mini S&P futures options providing the trader with a relatively large profit zone at little cost, or maybe even a credit. For instance, with the e-mini S&P 500 futures price near 2185 it might have been possible to purchase a 2050 put with roughly 60 days to option expiration for 32.00 points, or $1,600. The dollar amount is determined by multiplying the premium by $50 (32.00 x $50 = $1,600).
Obviously paying $1,600 for a single option speculation is a rather expensive venture. A trader might opt to finance the purchase of the 2050 put with the sale of 2 1980 puts for 17.00 per option, or 34.00 points. We now know that the dollar value is figured by multiplying the premium by $50; accordingly, selling the 1980 puts would bring in a total premium of $1,700. This creates a credit of $100 to the trader. Simply put, the “market” is paying the trader $100 to participate.
A put ratio spread such as this one be used by the bears as a way to enter the market without the immediate risk that comes with the strategy of selling a futures contract. Put ratio spreads might also be used as a means of hedging existing bullish strategies, in this case it can often be looked at as cheap insurance. For example, a trader that is short a put outright faces unlimited risk, but adding a ratio spread beneath it can be a way to cheaply hedge some of the downside risk. However, this insurance policy has a deductible in the form of downside price risk should the market drop extremely sharply. Let us explain the mechanics by looking at the recommended trade in detail.
Click on the image to enlarge.
Planning and Implementing a Ratio Put Spread
We will assume that the trade above could have been executed at a credit of $100, or at worse even-money. “Even-money” simply means that the trader is collecting the same amount of premium for the short options as is being paid out for the long option. In other words, from a cash outlay standpoint the trade is free. Should the spread be executed as a credit of $100 as expected, the position is better than free in that if it expires worthless the trader still gets to keep the initial $100 in premium collected. Keep in mind that a free trade, or one that provides a credit to the trader, doesn't imply without risk of loss or margin.
This trade involves a long put and two short puts; thus, it faces theoretically unlimited risk beyond the reverse breakeven point. Likewise, the exposure of the short puts creates limited profit potential in that gains on the long put will eventually be offset by losses in the two short puts should the market decline substantially. In this instance, the profit is limited to a handsome sum of $3,600; calculated by multiplying the distance between the long put and the short put by the multiplier for the contract ($50) and adding a credit of $100 ((2050.00 – 1980.00) + 2.00) x $50 = $3,600)).
The simplest way to explain the payout diagram of this trade is based on the potential payout at expiration. Upon expiration of this spread, and assuming a fill of a 2.00 point credit, it will be profitable with the futures price trading anywhere from 2052.00 to 1908 without regard to transaction costs. In essence, the spread makes money as from 2050.00 down to 1980.00. If the e-mini S&P 500 futures price at option expiration is at 1980.00 the option spread trader reaps the maximum profit of $72.00, or $3,600.
If the futures price is below 1980.00 at option expiration, the trade is giving back profits until it runs out of money near 1908.00; this level is known as the reverse break-even point. As the futures price drops below 1980.00, the trader faces theoretically unlimited risk. Such a scenario is similar to being long a futures contract from 1908.00. For every point that the futures price moves below the reverse breakeven point, the trader loses $50. I would like to point out that there is only one way for this trade to be a loser at expiration and that is if the futures market is trading beneath 1908.00, which is 142 points beneath the price of the e-mini S&P 500 futures at the time the trade was initiated. To reiterate, ignoring transaction costs, at any point above 1908 through infinity, the trade is either breaking-even or profitable.
Keep in mind that while this trade does face unlimited risk, the risk is distant from the market price at the time of entry. This is in stark contrast to the risk faced by a futures trader. I have learned that you can never underestimate the markets, but the odds of a 142 point drop in the e-mini S&P in the next 60 days prior to option expiration, isn’t necessarily high.
Put Ratios for Risk Management
As mentioned above, this trade can be used as an insurance policy. I have been known to point clients toward a trade similar to this one as a means of providing a quasi-hedge against short put positions that are under pressure. At expiration, this spread insures a move below 2050.00 to 1980.00 tick for tick. As explained, below 1980.00 the trade gives back profits...thus the insurance policy begins to become less valuable. Below 1908, the trade that was intended to be a hedge short put options, now becomes a burden that results in even more losses. Therefore, when using ratio spread as a means of risk management you should be aware of major support and resistance levels and place the strike prices of the spread accordingly. You don’t want your “cheap” risk management technique to become an expensive lesson.
Disadvantage of Ratio Put Spreads
It is important to note that a ratio spread can sometimes involve unintended consequences at any point prior to expiration. At option expiration, there is no time value in the options and the profit and loss will be strictly dependent on the aforementioned calculations. Nevertheless, due to the time value still present in the option premium, it is possible for a spike in volatility to create a scenario in which the combined value of the short puts gain in value faster than that of the long put. In other words, it is possible for the market to move in the anticipated direction but create a loss to the trader. Assuming that the futures contract is trading above the reverse break even at expiration the losses will be only temporary; however it is never fun to be a part of an explosion in volatility which turns a good directional speculation into a losing trade.
Conclusion on Ratio Write Option Trading
Ratio spreads can be a powerful trading tool but proper construction and execution are key in producing favorable results. Poor timing in terms of volatility and price, along with incorrect strike price placement, might result in a very unpleasant trading experience.
Traders are often lured to into the futures markets with a fascination for day trading.
The thought of buying and selling leveraged contracts without overnight risk is appealing to many, but underestimated by most. As a retail commodity broker, I have had the pleasure, and the pain, of watching futures day traders attempt to profit through strategies ranging from scalping, to "position" intra-day trading, which spans several hours.
My observations of the futures markets have led me to the conclusion that day trading is perhaps one of the most difficult strategies to successfully employ. However, for those that have the perseverance to dedicate themselves to the practice, contain the natural ability to eliminate emotions, and have enough experience under their belt, day trading in the futures market might be one of the most potentially lucrative forms of commodity market speculation.
The term day trading can be used to describe an unlimited number of futures trading strategies and approaches that involve buying and selling a commodity contract in the same trading session. Many are system based, meaning that trading signals are executed according to specific technical analysis set ups; others incorporate a trader's instinct. The approach that you take in the futures markets should be dependent on your personality and risk tolerances; not necessarily what has worked for somebody else. Let's face it; there are only about twenty to thirty commonly used technical oscillators available in most trading platforms. If there were absolute magic to any of them more people would have discovered the Holy Grail to futures trading. Rather than expecting a technical indicator or a computer generated oscillator to do the work for you, I believe it to be more productive to properly educate yourself to the risks and the rewards of the commodity markets. This includes the less technical, and thus less talked about, aspects of day trading.
Futures Day Trading is Mental
I believe that becoming a successful day trader in the futures markets come down to instinct and the ability to control emotion. If you have ever been involved in athletics, you have probably heard the adage that performance is 95% mental and only 5% physical. I have found this to be true in trading as well, although instead of being physical trading is technical. Quite simply, it isn't which technical analysis oscillators and indicators you use, it is how you use them. Perhaps more importantly, how you deal with fear and greed that comes with risk exposure in the commodity markets as you are charting your futures trades. Here are a few day trading tips that may aid in the mental preparation.
Know the Futures Market Volatility and Accept the Consequences
You often hear futures traders talk about their need for volatility. It is a common perception among the trading community that higher volatility is equivalent to higher opportunity, and therefore profit potential. Call me a "girl", but I happen to be a contrarian when it comes to this point of view. Sure, if the markets are moving there is an increased chance for you to catch a large move and make history in your trading account. However, there is another side to the story; let's not forget that if the market goes against your futures trade you could be put in an agonizing position. Also, if you are a trader that insists on using stop loss orders, increased levels of futures market volatility translates into amplified odds of being stopped out prematurely.
I am not suggesting that you avoid the futures markets during times of explosive trade; however, you must fully understand the consequences and be willing to accept the inflated risk of trading accordingly.
In my opinion, the most convenient way of measuring commodity market volatility is through the use of Bollinger Bands. The bands allow a trader to visualize the explosion and contraction of market volatility with similar movements in the bands. Simply put, as the Bollinger bands get wider, the volatility and market risk is also on the rise. Conversely, tighter Bollinger bands suggest relatively lower levels of volatility. Please note that I didn't say lower levels of day trading risk; this was intentional.
Figure 1: E-mini S&P 500 Futures - Traders can visualize futures market volatility through the use of Bollinger Bands. It is a good idea to do so on a daily chart to get the big picture of market volatility.
Narrow bands indicate that futures market volatility is relatively low, but if the contraction is excessive enough it may signal an extraordinary spike in price is imminent. Markets go through times of quiet trade, but such times are often followed by large and sudden increases in instability. As you can imagine, being in the futures market at such times could be similar to winning the lottery or they could mean financial peril. Before executing a futures day trade in a fast moving market, or one that is trading quietly, you must be aware of market tendencies to properly assess the risk of initiating a futures day trade. Being conscious of all of the potential outcomes of your futures day trade may prevent panic liquidation or the infamous deer in the headlights failure to act.
Commodity Trader's Tool Box
Technology has provided traders with an abundance of readily available information at their fingertips. Accordingly, I strongly believe that traders should properly understand and utilize the resources available to them. It doesn't make sense to pick a single indicator or oscillator and expect it to tell you the whole story; instead it should be viewed as a piece to the puzzle. With that said, it can often be counterproductive to bog yourself down with too much information or guidance; this is often referred to as analysis paralysis.
In my opinion, it is a good idea to pick three or four tools that fit your needs and personality. For example, if you are an aggressive trader with a high tolerance for risk you may opt for a quick oscillator such as the Fast Stochastics. If you are a slower paced individual, the MACD may better suit your needs as it is a much slower moving indication of trend reversals.
It is important to note that after you have entered a trade you shouldn't change the oscillator that you are watching simply because the original isn't telling you what you want to hear, or in this case see. This can be a tempting practice for traders that are caught in an adversely moving market and are in search of a reason to stay in the trade for fear of taking a loss.
Mental "Stop Loss"
As you are probably aware, a stop order (AKA stop loss) is an order requesting to be filled at the market should the named price be hit. A trader long a futures contract may place and stop order below the futures price to mitigate the risk of an adverse price move. Likewise a trader holding a short futures position may place a buy stop above the current market price as a risk management tool against a possible rally. Once executed, the trader would be flat the market at or near the named price.
Most traders or trading mentors will tell you that you should always use stops; I am not most. I argue that experienced and disciplined traders may be better off without the use of live stop orders and believe that mental stops may be a better alternative. Supporting my assumption is the theory that the dollar amount of the risk on any given trade is conceivably higher through the use of mental stops as opposed to actual working stop orders but the risk in the long rung may be less through the reduction of untimely exits.
The concept of a mental stop is simply picking out a price level at which it is fair to say that your position may have been an incorrect speculation and manually exiting the market once your pre-determined price is hit. Using mental stops as opposed to placing an actual stop loss order may prevent the natural ebb and flow of the market from stopping you out at what ultimately becomes premature.
I am sure that you have all fallen victim to the stop order that was triggered to exit your trade only moments before the market reversed course and left you behind. Not only is this a frustrating place to be, but it often has an adverse impact on trading psychology going forward. Unfortunately, it doesn't seem to be uncommon for inexperienced traders to behave somewhat recklessly in an attempt to get their money back from the very market that took it from them. It is easy to give in to this mentality, but doing so will almost always end negatively.
The use of mental stops requires a considerable amount of discipline and may not be appropriate for all traders and strategies. If you have a consistent problem controlling your emotions (we all fall victim to fear and greed at some point), stop orders are a must. Without them you may be put into a position in which a single losing trade can wipe out weeks or months of hard work, or worse put you out of the trading business forever.
Even those that have an adequate ability to stay calm during unfavorable market moves may find losses pile up in violent market conditions. For example, there are times in which it is very difficult to exit a position once the named price is hit without considerable financial suffering. If you are not mentally capable of accepting this possibility, placing outright stop orders may be a better alternative for you despite its limitations. Remember, if successful trading is largely determined by the mental capabilities of a trader it is imperative that you know yourself well enough to steer clear of situations that may lead you to behave emotionally as opposed to rationally.
Figure 2: Mini Russell 2000 future - Stop loss orders are a great way to minimize futures market exposure, but I believe them to be a great source of frustration as well. If you are disciplined it may be better to work without stop loss orders.
Be Creative with Options on Futures
It is no secret that more retail traders lose money than not in the realm of futures and option trading. I have observed that day traders could face even more dismal odds of success. However, don't let this deter you from participating in the commodity markets, instead use it as your incentive to be different. If a majority of people are day trading futures contracts unproductively, perhaps you should be interested in trading strategies that are a bit out of the norm.
Buy Futures Options Instead of using Stop Loss Orders
During the last few days of the life of a commodity option they time value, and thus the premium, of the instrument has often eroded to affordable levels. If this is the case, it is sometimes possible to simply purchase a call or put option as an alternative to placing a stop loss order. This strategy can also be viable in option markets that have more frequent expiration dates; particularly the weekly options written on the stock indices and grains. Keep in mind, however, that during times of excessive volatility even options with little time to expiration can remain too expensive to make them a viable substitute for stop loss orders. In other words, using long call and put options instead of stop loss orders to limit risk of a futures trade is only situationally beneficial.
In essence, the purchased futures option creates a synthetic trade in which the day trade risk is limited to the amount paid for the option plus any difference in the entry price of the futures contract and the strike price of the option. This is because the futures option will act as an insurance policy against the futures price moving above the strike price of the long call or below the strike price of a long put. Beyond the strike price of the option, losses in the futures contract are offset with gains in the option at expiration.
The premise of such a day trading strategy is to reduce the possibility of being prematurely stopped out of what would eventually become a profitable trade. However, it is important to realize that using long options as a replacement for stop loss orders should only be done if the risk is affordable. If the options are relatively expensive to purchase, the risk of loss will be too high; depending on the situation it might render this approach impractical. Keep in mind, the foundation of buying commodity options instead of placing stop orders is to limit risk of loss, not to increase it. To reiterate, paying more for a protective futures option than you originally intended to risk on the day trade should be a red flag, and lead you to explore other alternatives.
Counter Trend Futures Trading
Based on observations made during my years of being a futures broker, it seems as though most day trading futures strategies are very simple; identify an intraday trend and "ride" it until it ends. It sounds easy enough; but is it? I will be the first to admit that day trading is not my forte. Nevertheless, through the scrutiny of the futures trading practices of others, compliments of my profession as a futures broker, I strongly believe that intra-day trend trading is much more difficult than one would imagine.
The problem with a futures market trend is it is only your "friend" until it ends. By the time many trend trading methods provide confirmation to execute a futures trade, the market move has already been missed. Psychologically, I have a difficult time buying a futures contract that has already risen considerably. Likewise, selling a futures contract after it has already established a down-trend may simply be too late. After all, the overall objective is to buy low and sell high. Buying high and selling higher may work at times, but the common theory that commodity markets spend a majority of their time range-bound seems to work against intraday-trend trading in the long run. Only during times of exceptional market moves will it be possible for a futures day trader to ride a trend long enough to recoup what may have been lost on false signals and failed break-outs of the range.
Patient day traders might find that they fare better by looking to take advantage of extreme intraday futures price moves in hopes of a temporary recovery to a more sustainable level. Doing so may provide less profit potential and if done correctly less trading opportunities but may pose better odds of success.
Identify Extreme Futures Market Prices
Futures market prices have a tendency to overshoot realistic valuations, only to eventually come back to an equilibrium price. Emotion plays a big factor in this phenomenon but the running of stop loss orders are also a primary driving force. Traders often place sell stop orders under known areas of support and buy stop orders above known areas of resistance. As you can imagine, there are often several stop loss orders placed on futures contracts with identical or similar prices. Once these orders are triggered, a swift move in prices in the direction of the stop orders takes place but often has a difficult time sustaining itself. Understanding that stop running can artificially move a market quicker, and in a larger magnitude, than what would have transpired without the stop orders, a trader could attempt to take advantage of the subsequent rebalancing in price.
For example, an e-mini S&P trader may notice the market drop five handles in a very quick fashion with little fundamental news to drive the move. This type of trade may be the result of a market that has simply triggered a batch of sell stops. As the futures stop loss orders were filled, the buying didn't keep up with the selling and the futures price dropped accordingly. However, if our assumption was correct and the move was based on sell stop execution, instead of fresh (legitimate) short selling, it is practical to believe that the futures market will rebound some, if not all, of the losses artificially sustained. A futures day trader may look at this as an opportunity to buy the futures contract in an attempt to capitalize on a partial or full retracement of the drop.
Figure 3 : Intraday Wheat Futures Chart - Extreme market moves followed by a retracement to an equilibrium level are common as stop loss orders are triggered creating large commodity price spikes.
Naturally, before entering a futures day trade some technical confirmation must be made. After all, the theory that a market drop was the result of sell stop running was an assumption not a fact. Overbought and oversold technical indicators such as Slow Stochastics, Relative Strength Index (RSI), and W%R (Williams Percent R), might be helpful in determining whether or not prices were pushed to a level extreme enough to encourage buying.
Most of the available technical analysis oscillators were developed with the intention of identifying overbought and oversold conditions. In their simplest forms, both overbought and oversold markets are the result of prices overshooting their equilibrium price.
Most technical analysis indicators represent extreme prices relatively well. Thus, traders looking to buy on dips may find them helpful, but shouldn't expect them to be fool proof by any means. Computer generated oscillators are great tools but they aren't a guarantee. They can tell you what the market has done, but only you will be able to translate that into what the market may do next.
Although day trading in the futures markets is a challenge, there is likely a reason why so many active futures traders of all skill levels and sizes are attracted to the practice. There are obvious market opportunities in intra-day trading and with enough patience, practice and fortitude you may become one of those that have achieved profitable long-term trading results. However, there is also rationale as to why we don't all quit our jobs and day trade commodities for a living. Despite what may be relatively conservative risk on a per trade basis and a lack of overnight event risk, day traders face substantial risk in the long-run through the possibility of several small losses. If you aren't willing to commit yourself to the labor of futures day trading, I suggest that you consider less labor intensive strategies.
The NASDAQ futures weighed on stocks, but the broad market is marching on.
From a historical perspective, this week is not the time to be a stock market bear. As we've outlined, the market generally likes to move higher into Fed meetings and quarterly futures expiration also tends to put upward pressure on pricing. This is true, at least until the Friday morning Triple Witch. From there, things sometimes turn sour. Thus, the ES bears will likely have better entry points in the coming sessions if they are patient.
We've also heard chatter about a Bradley turn date occurring on the 20th of this month, and others are noting June 26th as a potential reversal date based on moon cycles. We don't normally pay attention to these types of things, but the fact that they coincidentally appear to be in line with the charts make them at least worth noting.
The Financial Futures Report is a commodity trading newsletter focused on the e-mini S&P futures, the 30-year bond futures market, and the 10-year note futures.
The author, Carley Garner, is an experienced commodity broker with plenty of stories and insight to share. Garner keys off of her decade-plus experience as a futures broker to help readers navigate the options and futures markets. The Financial Futures Report contains general stock index futures and Treasury market commentary, but it also details trading ideas (primarily option trading strategies), technical analysis including support and resistance levels, and commodity trader chatter.
This publication is offered exclusively to DeCarley Trading commodity brokerage clients, but can be obtained temporarily via a trial.
1. As a futures option seller, it takes money to make money...leave plenty of excess margin in your commodity trading account
Short option traders must be properly funded to be capable of riding out any storm that might materialize. During times of excessive commodity market volatility, many traders turn to the limited risk of option buying. This has a tendency to artificially inflate commodity option prices, due to the increase in demand for the securities. Also, in a more volatile market environment, commodity traders often believe it is more likely that a long option strategy will have an opportunity to pay off. I argue this is a false perception because options on futures buyers must overcome their cost of entry before turning a profit; the higher the price of the option on the way in, the bigger the obstacle to being profitable will be. Nevertheless, in all of the excitement traders often behave emotionally rather than logically; as a result, they exuberantly bid up the prices of low probability options to shocking levels.
Short-Option position sizing
In most options and futures markets, you would want about $10,000 in a trading
account for one, or two, commodity options sold. In some of the higher margined markets such as gold, it would likely be in your best interest to have much more. Another way to determine the appropriate account and position size is excess margin. Generally speaking, it is a good idea to utilize 50% of less of your account when trading short options. Simply put, if your account size is $10,000 you should aim for trades that will require a margin of $3,000 to $5,000. On the flip side, the excess margin listed on the bottom of your statement should be between $7,000 and $5,000.
Some might look at the funds not being used toward margin as a missed opportunity, or a waste of risk capital. However, nothing could be further from the truth. Undercapitalized commodity option sellers will almost undoubtedly get into trouble. Without plenty of excess margin in a commodity trading account, it can be difficult to survive the normal ebb and flow of the futures markets. In addition, a lack of capital dramatically increases the odds of a margin call, which can result in pre-mature liquidation of an option trade. If the situation is dire enough, the liquidation might be at the hand of your commodity broker; which is an unpleasant experience for all parties. With that said, not all commodity option brokers are created equal (see the next talking point).
2. The commodity broker you choose for your option selling account DOES matter!
Unfortunately, many beginning option sellers overlook the impact their choice of commodity broker has on the bottom line of a trading account. Even worse, they assume the only affect their option broker will have on their trading results is the per contract commission charge. As a long-time futures broker I can assure you, there is much more to the relationship between a trader and his commodity brokerage than transaction costs.
Regardless of whether a commodity option trader is placing orders online though a futures trading platform, or by phone or email with a broker, the choice of a brokerage firm will eventually play a big part in the success or failure of a commodity option trading strategy. This is because many futures brokers are averse to allowing their clients sell options on futures; even those brokers that allow it often take other actions to reduce risk exposure to the brokerage such as restricting the commodity option contracts available to trade, increasing short option margin requirements (above and beyond the exchange minimum SPAN margin), and even force liquidating client positions at the first sign of trouble. Futures brokers with heavy handed risk managers can wreak havoc on an option selling account. Imagine your option broker liquidating your trades at a highly inopportune time, before a margin call is triggered, and without notifying you. Such an event can be a costly and frustrating experience; but it can also be avoided by ensuring your commodity option broker is willing and capable of servicing your account type.
My commodity brokerage service, DeCarley Trading, specializes in handling option selling accounts.
3. Most futures and options traders lose money!
Whether trading futures or options, a common mistake commodity traders make is to blindly follow the lead of random trading books, business news stations, popular financial newspapers, and magazines. The ugly truth is most commodity traders lose money. Knowing this, why in the world would you want to do what "everyone else" is doing? In light of the success rate of the masses, you probably don’t want to join them. Most traders are buying options, and or employing futures trading strategies; a much smaller percentage of traders are selling commodity options. Perhaps option selling is the prime “contrarian” strategy, and should be considered by all market participants for the simple reason that it is unpopular…and historically speaking, unpopular ideas in trading sometimes turn out to be the gems.
4. Sell Commodity Options on the contrary
As opposed to simple premium collection without a purpose, such as carelessly selling calls and hoping nothing happens, I feel like the best odds of success is to patiently wait for market panic or excitement of the masses and to play the other side of the trade. Warren Buffet said it simply, "Be fearful when others are greedy, and greedy when others are fearful"; he wasn’t referring to option trading but the concept can certainly be applied. For instance, some of the best option selling opportunities occur following massive price spikes in a particular direction. When such a price extension occurs most speculators are busy buying options in the direction of the trend at obscenely high prices, when the best trade is often to be a seller of those over-priced options. Of course, this type of approach is equivalent to catching the proverbial “falling knife”. If what you believe to be the exhaustion of a trend, turns out to be the early stages of a much larger move the trade could be in danger of substantial losses.
Selling options as a contrarian isn't easy money, but I do believe it might be advantageous from an odds perspective. After all, times of directional volatility and emotion often involve excessive option premium and this makes it a great time to be an options on futures seller. If you were a store owner, you would prefer to sell hot products at high prices, as opposed to items on the discount rack. Option selling is no different.
Of course, the trick is to be patient enough to improve the probability of your entry being at the peak of volatility; this is easier said than done. However, completely disregarding commodity market volatility when implementing a short option strategy could lead to painfully large losses regardless of whether the futures price ever touches the strike price of the short option.
5. Who are candidates to sell commodity options?
Before choosing to implement an option selling strategy in the futures markets, you must first honestly assess your ability to accept the prospects of unlimited risk and margin calls. Not everyone is capable of managing the emotions that come with these two characteristics of the strategy; and even those who are, will have moments of weakness. As a seasoned commodity option broker, I can attest the markets are capable of making a grown man cry. Failure to keep trading emotions in check could mean letting losers get out of hand, or panicked liquidation at unfortunate prices. Either scenario could be psychologically and financially devastating to an option selling strategy.
Heavy commodities and light economic data weigh on stocks
Two consecutive days of sharp crude oil declines reminded traders of the chaos energy markets inflict on the financial markets. As a result, the e-mini S&P suffered moderate losses in overnight trade. However, it was weak economic data that kept prices under pressure throughout the session.
February retail sales came in at a a negative .1% for both the headline number and ex-auto. Although this was an improvement from January, it is hardly reason to go out and buy stocks. Similarly, the Empire Manufacturing data improved markedly from last month to a positive 0.6, but simply posting a slightly positive number isn't enough to get investors excited. Today's PPI data, reported a decrease in prices at the producer level of .2%. Thus, last month's hint at inflation was dissolved.
Tomorrow we'll hear about the latest data on consumer prices and housing starts, but I'm not sure it will matter to the market. All eyes are on the FOMC interest rate decision, which will be released at 2:00 Eastern.
The missing piece to the puzzle?
As commodity brokers, we take pride in offering free futures and options trading newsletters to DeCarley Trading clients. Our goal is to keep both futures, and options, traders on top of current events and market opportunities, while ensuring they fully understand the risks and rewards of commodity trading.
Sign up to receive a free trial of our commodity trading newsletters delivered directly to your in-box. Each newsletter contains an honest and fresh perspective of the futures markets, along with actionable trading recommendations for futures and options traders.
Carley Garner, an experienced commodity broker for DeCarley Trading in Las Vegas, has followed up her previous three titles with Higher Probability Commodity Trading, a comprehensive futures and options trading book focused on trading strategy development, commodity market analysis, and much more.
The book received rave reviews from some of the top names in the industry, and we are confident you will enjoy it too! Jon Najarian, co-founder of Najarian Family Office and CNBC contributor, believes this book is "A great read for both beginner and advanced commodity traders." Tobin Smith, CEO & Founder of Transformity Media Inc, and former co-host of Bulls and Bears on Fox News refers to Higher Probability Commodity Trading as "..an MBA in trading for the price of a few cups of Starbucks!" And Phil Flynn of Fox Business News has declared "If you are only going to read one book on the futures market this has to be it."
How to create a Synthetic Put
The term synthetic is often used to describe a manmade object designed to imitate or replicate some other object. Futures and options traders can do the same thing by creating a trading vehicle through a combination of futures and options to replicate another trading instrument. You may be asking yourself; why you would go through the hassle of mimicking an instrument instead of simply trading the original? The answer is simple, as the creator of the vehicle, we can customize it to better suit our needs as well as design it to better take advantage of the underlying market.
Through the creation of a synthetic position, you can actually decrease your delta as well as, in my opinion, increase the odds of success. Let's take a look at an example of a long synthetic put option.
Synthetic Long Put Option
Sell a Futures Contract
Buy an at-the-money Call Option
When to Use Synthetic Puts
• When you are very bearish, but want limited risk
• The more bearish you are the further from the futures (higher strike price) you can buy, although a true synthetic put involves an at the money call option
• This position is sometimes used instead of a straight long put due to its flexibility
• Like the long put this position gives you substantial leverage with unlimited profit potential and limited risk
Profit Profile of a Synthetic Put Strategy
• Profit potential is theoretically unlimited
• At expiration the break-even is equal to the short futures entry price minus the premium paid
• Each point market goes below the break-even profit increases by a point
The Risk in Trading Synthetic Puts
• Your loss limited to the difference between the futures entry prices and call strike price plus the premium paid for the option
• Your maximum loss occurs if the market is above the option strike price at expiration
Example of a Synthetic Put Option in the Futures Market:
A commodity trader looking to profit from a decrease in prices but isn't confident enough in the speculation to sell a futures contract, or even construct an aggressive option spread, might look to a synthetic put.
A synthetic put option strategy has nearly identical risk and reward potential as an outright put option, making it a potentially expensive proposition. However, if the volatility and premium are right it can be a great way to sell a futures contract, while retaining a piece of mind, and the ability to easily adjust the position because the purchased call option provides an absolute hedge of risk above the strike price.
A trader that is bearish on the U.S. dollar might opt to sell a dollar index futures contract near 96.60 in hopes of weakness. Should the trader prefer to have limited risk, and be willing to pay an “insurance” premium for protection, might purchase a 97.00 call option for 60 ticks, or $600, because each tick in the dollar index futures and options is worth $10 to a commodity trader.
Click on image to enlarge.
With a synthetic put option in place, the trader can sleep at night knowing the worst case scenario is a loss equivalent to the distance between the future entry price and the strike price of the call option, in this case $400 ((97.00-96.60) x $10), plus the cost of the long option purchased to insure the trade, or $600 (60 x $10).
The payout of this trade at expiration may be identical to a long put option, but the flexibility provided to the trader is unmatched. Unlike a long put, a synthetic long put can be pulled apart prior to expiration in an attempt to capitalize on market moves. Please note that doing so greatly alters the profit and loss diagram.
An example of an adjustment may be to take a profit on the short futures contract and hold the long call in hopes of a subsequent market rally and the possibility of being profitable on both the futures position and the long option. Or, should the trade go terribly wrong from the beginning a trader may look to take a profit on the long call and hold the short futures in hopes of a reversal. Doing so would eliminate the insurance of the long call and leave the trader open for unlimited risk on the upside, but may be justified if the circumstances are right.
If you are in search of a commodity options book that features this option trading strategy, and others, visit www.CommodityOptionstheBook.com.
Carley Garner, and DeCarley Trading, have compiled a vast resource of educational material aimed at helping people learn to trade in the commodity markets.
Whether you intend to trade futures, futures spreads, options, option spreads, or you haven't determined a commodity market strategy, we believe you will find useful and applicable information here. In addition to the dozens of futures and options trading articles listed below, we offer visual learners free access to our commodity trading video archive. Visit DeCarleyTrading.com for details.
Page 1 of 2