Futures For You
| INSIDE THE FUTURES
WORLD
Want to learn how the futures markets really work? Carley Garner, senior analyst for Alaron who also writes the company's Dow/NASDAQ Report and the Bond Report newsletters, responds to your questions about today's futures markets. To submit a question, post your question to our website at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. |
Carley Garner |
OPTIONS OR FUTURES?
Should I be trading commodity options or commodity futures?
This is a difficult question to answer because it is a decision that traders must make based on their tolerance for risk, their personality, and trading style. However, it is my opinion that in general, option trading is the optimal choice.
I am not referring to long optiononly strategies, although sometimes they are appropriate. Instead, I believe that option selling or option spread trades that involve both long and short options are preferential. We all agree that the key to successful trading is putting probabilities in your favor. Going against the grain or taking long shots may pay out at times, but it isn't likely to be a viable long-term approach.
We like to make it a rule of thumb to sell at least one option, possibly two, for every option we buy. This strategy attempts to exploit the theory that more options than not expire worthless. Assuming this is true, all else being equal, the odds of a trade that involves one long option and two short options will face superior probabilities than simply buying a call or a put. Naturally, everything comes with a catch. Selling naked options involves theoretically unlimited risk and a margin requirement.
An additional benefit to option spread trading is the reduced volatility of the position relative to the underlying futures contract. For example, the delta value (rate of change in position value relative to change in futures) of a futures position is one. This means that for every tick that the futures price moves, the value of the position will make or lose the identical amount. Option spreads tend to have much lower deltas. As the underlying market fluctuates, the spread position will oscillate to a lesser degree. Obviously, this works for a trader as well as against. In a market that is moving in the desired direction, you would likely prefer a higher delta. Nonetheless, giving up potential gains is one of the opportunity costs of lowering the delta of the trade. On the other hand, if you are in a position that is experiencing an adverse price move, you will appreciate the decreased sensitivity to price, or delta.
In line with an increased probability of success, option spreads make it possible to shift the breakeven point to a more attainable level. Looking at an example without regard to transaction costs, buying a corn $4.00 put alone for 20 cents would require the market to be below $3.80 at expiration for the trade to be profitable. Alternatively, by selling a $4.50 call for 10 cents and a $3.50 put for 10 cents to pay for the long put, the breakeven point on the trade moves up to $4.00 instead of $3.80. Thus, at expiration the trade will be profitable anywhere below $4.00. The risk is limited to the commission paid, assuming that the market stays below $4.50. The catch is that the trader is exposed to unlimited risk above $4.50 and the profit potential is capped at $3.50 or $2,500. Even so, the overall prospects of a winning trade are increased enough to justify the drawbacks. Further, unlike buying or selling a futures contract, there is some room for error in an option spread. In this example, the trader can be wrong up to $4.50 at expiration before the trade becomes a loser.
That said, there are strategies such as an iron condor that are capable of mitigating market volatility, shifting the breakeven point to a more favorable level, involving limited risk and no margin.
STOPS ON OPTIONS/SPREADS
Can stop orders be placed on options or option spreads?
The answer to this question is yes, but perhaps the question should read "Should stop orders be placed on options or option spreads?" The answer to that question, in my opinion, is no.
Unlike futures contracts, option volume can be somewhat sporadic. As a result, the bid/ask spreads can be relatively wide, causing stop orders to be increasingly likely to be hit. This is especially in the case of an option spread. Traders using stops on options may find themselves stopped out of a trade prematurely without the underlying market reaching their desired exit point. For this reason, I recommend using "mental" stop orders. Of course, this requires that the trade be monitored, and there are no guarantees you will be quick enough to exit the trade at the preferred price, but it may prevent early liquidation.
Conceivably, the largest drawback to using mental stop orders in option trading is the fact that this leaves the trader dependent on his or her ability to pull the plug on a trade gone bad. If you have ever been in this situation, you know that admitting you were wrong and locking in a loss is one of the most difficult things to do. If you were selling options throughout 2007, due to excessive volatility in both the commodity and financial markets, it is quite possible that you found yourself in an awkward situation more than once.
In stark contrast to the behavior of previous years, last year's markets were hot-blooded and unpredictable. Seasonal tendencies were all but forgotten, all-time highs were surpassed without a hitch, and miniature crashes in the equities markets became a habit. Many option sellers met their match. Yet that is what trading is all about. Regardless of the strategy or the instrument (options or futures) used, markets and thus the effectiveness of a trading approach move in cycles. Good and bad times are to be expected, although it may be much easier to embrace the good times than it is to survive the bad times.
Originally published in the April 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.
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