Inside The Futures World
Want to find out how the futures markets really work? DeCarley Trading senior analyst and broker Carley Garner responds to your questions about today's futures markets. To submit a question, post your question at http://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Commodities And Recessions
Is it safe to invest in commodities during an economic recession?
Given the economic turmoil we are experiencing, I have been asked this question often. Before I answer, there are a few points I would like to make.
I have yet to find a scenario in which it is appropriate to use the word “safe” when trading in options and futures. There are strategies in which risk can be relatively low, but in my opinion, “safe” implies there is no risk, and that isn’t the case. My idea of a safe investment is the purchase of Treasury bills, not speculating in highly leveraged markets.
In addition, I hesitate to use the word “investing” when it comes to commodities because most traders utilize leverage extended to them by the exchange. The buying and selling of leveraged assets can be better categorized as trading. Commodities don’t have a long-term tendency to increase in value the way stocks do. Unless you are eliminating the leverage by putting up the entire contract value of the commodity before buying a futures contract, you are speculating on price rather than investing in what you believe to be an appreciating asset — thus, trading, not investing.
Historically, commodity prices in general have suffered during recessions due to decreased demand. However, while indexes such as the Reuters-Crb suggest that commodities are dogs during a recession, a few thrive or at least outperform in such conditions due to shifts in consumer behavior.
For example, demand for wheat is believed to increase during tough economic times as consumers opt for cheaper alternatives such as breads and pastas over beef and pork. Decreased consumption of protein has a negative impact on grain prices as a result of a lower demand for feed. However, wheat plays a relatively marginal role in the feeding of livestock relative to corn and soybeans. All else being equal, wheat has the potential to outperform beans and corn as the economy falters.
Another commodity that tends to perform well in a recession is gold. Given that the current downturn is global, this relationship has the potential to be magnified due to a lack of faith in most major currencies. Thus, the desire for investors to hold hard assets combined with a lack of confidence in the euro, yen, and US dollar should be beneficial for precious metals.
It is also important to realize that the markets are looking forward, and at the time of this writing, many commodity prices seem to reflect dismal economic conditions. Despite the tendency of many commodities to struggle throughout recessionary periods, you should be looking for buying and even selling opportunities in those with a tendency to outperform during such times. Just as confirmation of the recession comes after the fact, so will confirmation it is over. Contact your broker for ideas on how to take advantage of a commodity rally without risking your shirt.
Waiting For The Market To Move
If the market direction is uncertain, can’t I buy a call option and a put option and wait for the market to move?
It seems like an obvious trade. After all, the market is going to either go up or down, right? The truth is there is a third direction — sideways. The practice of simultaneously buying a put and a call is known as an option strangle, or a straddle in which the strike prices are identical and at-the-money. While it is true that puts are designed to make money when the market goes down and calls are purchased in anticipation of the market going up, profits for strangle and straddle traders can only be made if the market moves enough to overcome the premium paid for both options. This can be difficult to do.
For example, near the end of January it may have been possible to buy a March crude oil $41 straddle (both at-the-money-options) for about $7.50 in premium (keep in mind that each dime in price is equivalent to $10 to the trader). A trader could have purchased both a $41 call option and a $41 put option for a total cost of $7,500 ($7.50 x $10). As an option buyer, the risk of this trade is limited to $7,500, but most traders will have a difficult time justifying such a large amount of money on a single trade, especially with the unattractive odds for success that a long option strategy poses.
If held until expiration, this trader would have to see March crude rally from $41 to $48.50 or drop from $41 to $33.50 to break even on the position before considering transaction costs. Anywhere from $48.50 to $33.50 would result in a losing proposition in the amount equal to the premium paid minus the distance between the strike price ($41) and the futures price. For example, if March crude was trading at $40 at expiration the $41 call would expire worthless, but the put would be worth $1,000 (1.00 x $10). Because the trader paid $7,500 to enter the spread, the total loss would be $6,500.
You may be thinking that a strangle, the simultaneous purchase of an out-of-the-money call and put, would be a better alternative, and I agree. However, while the risks are lower, the probability of success seems to be equally dire. In future columns, we will cover strategies that may make traders more open to success with various levels of risk and reward. Stay tuned.