Futures Options Trading » Trading Principles

Commodity Options Trading: Volatility Matters

pwohlstand — Mon, 01 Sep 2008 03:16:26 +0000

It’s amazing how many people who are just entering into the realm of commodity options trading don’t seem to keep in mind the basic factor that makes options do what they do, and that’s volatility. If you understand the effect that volatility has on the options market, you will understand how sometimes extraordinary profits can be pulled from trading commodity options with very little relative investment. When you trade options, you are basically trading volatility, nothing more, nothing less. There’s no such thing as a “stable” option. Remember the option is only going to be as stable as the futures contract that the option represents. If there’s a whirlwind of speculation going on in the futures contracts (a la crude oil), you can guarantee automatically that option writers are padding their premiums to compensate for any potential moves that the market might make against them. Simply put, volatility is the measure of “nervousness” that’s in the markets, based on a sense of uncertainty as far as what the futures prices might do, or where those prices might go. Volatility is basically reflected in the sharp rises and drops in option premiums, and the degree of fluctuation that those premiums experience. If you use it right, volatility can be your best friend. Once you understand a little about market psychology, you can truly exploit volatility to create some serious profits in a relatively short period of time. That’s one thing that I emphasize to people when I talk about commodity option trading, is the fact that you have to be ready to “strike while the iron is hot”. Unfortunately, options trading is not something you can do as a “set and forget” type of investment; it requires your active involvement. Reason being is because there are opportunities that crop up in the options markets all the time, but if you hesitate, or fail to recognize the opportunity when it’s staring you in the face, you will definitely miss out on the whole enchilada.

Before I get sidetracked, let me mention the fact that there are two types of volatility in commodity options trading (and really all options trading for that matter): Historical and implied. Historical volatility is basically the “track record” of a given futures market’s price swings. In other words, how stable (or unstable) have market prices been throughout history? There are all kinds of charting tools to measure historical volatility, and it’s good to study them to get a “feel” for how a market’s prices will have regular peaks and valleys, especially more seasonal-based commodities like the grains (corn, wheat, soybeans, etc.) and for the most part the softs (coffee, sugar, cocoa, etc.). Implied volatility is the kicker-it’s basically the market’s guess at how stable (or unstable) prices will be in the future. The basic reason why it is important to understand volatility is because it will tell you what your best plan of action is, as far as what type of position to take in the markets. If you expect volatility to increase, it’s NOT a good idea to write options. Conversely, if you expect volatility to decrease, buying options will prove to be a disappointment, because time decay will “do its dirty work” on the option’s premium, and you’ll see your profits (if any) eroding away right with it. So, to put it in a positive light, if you believe that volatility will increase, it’s better to buy options, and if you believe that volatility will decrease, it’s better to sell (or write) options.

Well, I have to sign off for now; I’m actually about 20,000 feet in the air, making my descent into Atlanta. I just thought that I would take the time to post some more thoughts about commodity options trading while I was in flight…it’s amazing how (and when) inspiration will hit.

What It Takes to Trade Commodity Options

pwohlstand — Fri, 15 Aug 2008 04:03:31 +0000

In the realm of commodity options trading, you have to be prepared to face the uncertainties and volatility that the futures markets can throw at you. Make no mistake about it, when you enter into the arena of futures options trading, you are truly throwing down the gauntlet for the “ultimate challenge”. You have to keep in mind that options is simply a game of educated guesses. It’s always based more on what everyone thinks the market is going to do, instead of what it is actually doing. It is vital for you to make that distinction before even beginning to enter a trade. The options markets are inherently speculative. The whole drama of it is the big question mark about what the markets may or may not do. This is where you get volatility skews and parity in puts and calls. This is why option writers pad their premiums the farther out in months the options go, because they realize that the farther the timeline extends, the more probability there is for uncontrollable events to affect market prices. It has always been the sign of “options noobs” to buy cheap out-of-the-money calls that have a large amount of time left, only to see their option values decay as time passes, while the market simply doesn’t “shake up” enough to affect premiums to their advantage in any way. A lot of people fall victim to the misconception that 80% of options expire worthless, and while that sure seems like it’s true, it’s not–80% of options are never exercised, mostly because they are later offset. The reason why I mentioned this here is because if you plan on buying a cheap out-of-the-money call with a ton of time left, be prepared to see a dramatic drop in the value of your option as time passes, unless the underlying market does some major moving & shaking during your “holding period”. When this major drop in value happens, if you are wise, you will exit by offsetting your position instead of allowing your option to expire worthless. This is an integral part of money management, which is probably the number one requirement for a person to successfully engage in commodity options trading; you have to conserve your trading capital and not try to be some super-hero, willing to hock your house on a lucky chance. Know when you’ve been beat…I repeat, you gotta know when you’re getting your butt kicked in the markets, and exit gracefully, even if you take a hit in your trading capital. It’s better to be prudent than to struggle with trying to “be right” and “teach the markets a thing or two”…the only thing that will happen is that they’ll teach YOU a thing or two, and have you pay tuition for the lessons.

So it becomes very important in futures options trading to pay attention to what’s going on with the underlying futures contract, because the option’s movements are always going to be based on this, no matter how strange they may behave sometimes. And again, always keep in mind that option writers are not dummies; they’re like insurance underwriters…they’ve done their homework, they know the percentages and probabilities of profits or losses for each strike price, and for the most part, they adjust their premium prices accordingly. Occasionally, they will get blown out by sudden market spikes or sell-offs, but at the end of the day, it is an art to recognize a truly undervalued option, and then be able to properly capitalize on trading it. In this blog we will go into various commodity options trading strategies, and learn how to recognize these opportunities in the markets when they present themselves. I can’t promise some majorly structured lessons, like a curriculum or anything, but I will share some of my successful trades (and some of my duds), and you can hopefully see these trades in action. One thing is for sure; with every trade, no matter if you come out with a profit or exit with a loss, you learn something. You pick something up. You have another tidbit of information to add to your trading repertoire, and you’ll always be better prepared for the next trade than you were for the last one. This, my friend, is some of what it takes to cut the mustard in trading commodity options.

What Does Commodity Option Trading Mean to Me?

pwohlstand — Sat, 02 Aug 2008 21:54:17 +0000

Here I’ve written some thoughts on commodity option trading, and what it means to me…I want to develop in the art of being a good trader; this means more than just making a bunch of money. I want to truly develop discipline and skill as a trader, and to constantly challenge myself to become a better trader. I believe that making a ton of money will naturally follow when you develop into being a good trader. Good trader=root; Tons of $$$=Fruit. I truly believe in the ”base hits” theory; enough base hits will eventually equal the home run. In other words, steady, consistent profit-taking when trading commodity options is more in line with sound trading principles (in my mind) than waiting on (and betting on) a “home run”. This helps me to avoid falling into the “jackpot mentality”, where you’re trying to play the markets like you would play the lottery. Any time a person approaches commodity options trading with a gambling, “fast-buck” mentality, they’ll see profits running in the opposite direction. Those who attempt to make a killing in the markets end up getting killed. I fully believe in being aware of (and respectful of) the power of leverage at all times. Leverage truly is a two-edged sword. You must treat it with respect, and never be presumptuous or arrogant about the markets, as if you can always predict their movements. I believe in maintaining the attitude of flexiblility, where even my most informed decisions about how I’m going to enter or exit a trade, could be wrong based on the market’s movements. I believe in using the widsom that God gave me to keep me from making a trading decision that would be thoroughly disatrous. I don’t think there’s any shame in (or even anything wrong with) taking a loss. I believe that taking a loss in trading commodity options can actually be part of a winning strategy. It’s stupid to commit to a trading idea once you realize you’re going the wrong direction. It’s like the guy who gets “pot committed” in poker; it’s hard for him to walk away because he has put so much money in already…so he continues betting (and bluffing) until the entire fantasy comes crashing down on him, when the final hand is played. No need to do any of that drama; you just have to be smart in commodity option trading, and know your risk levels, as well as know when to say “uncle” and throw in the towel. Live to trade commodity options another day.