The buying of options (verses writing them) is the most popular way most new commodity traders start out. Little do they know that over time, their chance for success is 10% at best. The option premium cost over a year is tremendous. Read how most pros use commodity options and how you should too.
Let's talk about the time advantage futures contracts have over options. If you bought a futures contract and the market went sideways for a full year, depending on the carrying charge differences between months, you could possibly break even on the year. But there is a chance of getting stopped out. So what? Get stopped out of the futures contract and then re-evaluate the situation. You most likely have most of your capital still intact and can always get back in. Or simply let the trade go and look for something better.
With options, many traders feel locked in after a loss and go down with the ship. They figure they have "limited" loss and the market may come back. Maybe, maybe not.
Successful futures traders with accounts under $20,000 are more likely to buy small lots - one or two futures contracts with loose stops. They will also consider buying an option as a HEDGE against unlimited risk. That's the right reason to buy an option. (as well as selling (writing) them to collect the premium as they erode in time) Buying options to reduce the risk of a futures contract or naked option position for small, critical periods of time is the correct way.
Many new option buyers let their options erode to nothing once the market goes against them. Option premiums have a tendency to get slammed during adverse moves in percentages far greater than the underlying futures contact's move. It's not unusual to see an option get cut by 50% in one day while the futures contract has moved the equivalent of 10%. (this is the futures contact's actual move times the margin leverage) Of course, an option can double in one day, which keeps the public hoping and buying more.
Some option buyers purchase options when "the cat is out of the bag" and pay greatly inflated premiums. This happens when dramatic news hits the market and the futures move sharply. But if the cash market then goes sideways, the futures contract prices stay intact, while the premiums in the options get sucked back out. Again, I've seen times where options have dropped 50% in value in a single day's time, while the futures contract price went sideways.
The bottom line is that an option buyer is paying a huge price to avoid taking on "risk." The professional option sellers taking the other side are the ones putting their hands in the fire and taking on the risk. The market pays us to add liquidity and take on risk. It penalizes us (through high option premiums in this case) when ducking risk and liquidity to feel comfortable.
Buying options for EVERY trading signal is the path to ruin. It cannot be done successfully over a long period of time because of this heavy premium expense load. There is a time to buy options when the market falls asleep. This happens near a major, dull bottom. They can also be a good value after a big correction market clean-out, or generally when nobody wants the option, for whatever reasons.
You must pick your spots carefully. Remember that to get the very best option buys you want the previous holders to be panicking and dumping them wholesale. Always wait for a selling panic to buy and a buying panic to sell on whatever time scale you trade. This gives you a great price cushion buffer in case you are wrong and need to dump the position later yourself! At these panic times, call option premiums can be so deflated that you can sometimes own an option (at or near the money) for a little more than the carrying charge cost of a futures contract. (That's cheap!)
Let's talk about the time advantage futures contracts have over options. If you bought a futures contract and the market went sideways for a full year, depending on the carrying charge differences between months, you could possibly break even on the year. But there is a chance of getting stopped out. So what? Get stopped out of the futures contract and then re-evaluate the situation. You most likely have most of your capital still intact and can always get back in. Or simply let the trade go and look for something better.
With options, many traders feel locked in after a loss and go down with the ship. They figure they have "limited" loss and the market may come back. Maybe, maybe not.
Successful futures traders with accounts under $20,000 are more likely to buy small lots - one or two futures contracts with loose stops. They will also consider buying an option as a HEDGE against unlimited risk. That's the right reason to buy an option. (as well as selling (writing) them to collect the premium as they erode in time) Buying options to reduce the risk of a futures contract or naked option position for small, critical periods of time is the correct way.
Many new option buyers let their options erode to nothing once the market goes against them. Option premiums have a tendency to get slammed during adverse moves in percentages far greater than the underlying futures contact's move. It's not unusual to see an option get cut by 50% in one day while the futures contract has moved the equivalent of 10%. (this is the futures contact's actual move times the margin leverage) Of course, an option can double in one day, which keeps the public hoping and buying more.
Some option buyers purchase options when "the cat is out of the bag" and pay greatly inflated premiums. This happens when dramatic news hits the market and the futures move sharply. But if the cash market then goes sideways, the futures contract prices stay intact, while the premiums in the options get sucked back out. Again, I've seen times where options have dropped 50% in value in a single day's time, while the futures contract price went sideways.
The bottom line is that an option buyer is paying a huge price to avoid taking on "risk." The professional option sellers taking the other side are the ones putting their hands in the fire and taking on the risk. The market pays us to add liquidity and take on risk. It penalizes us (through high option premiums in this case) when ducking risk and liquidity to feel comfortable.
Buying options for EVERY trading signal is the path to ruin. It cannot be done successfully over a long period of time because of this heavy premium expense load. There is a time to buy options when the market falls asleep. This happens near a major, dull bottom. They can also be a good value after a big correction market clean-out, or generally when nobody wants the option, for whatever reasons.
You must pick your spots carefully. Remember that to get the very best option buys you want the previous holders to be panicking and dumping them wholesale. Always wait for a selling panic to buy and a buying panic to sell on whatever time scale you trade. This gives you a great price cushion buffer in case you are wrong and need to dump the position later yourself! At these panic times, call option premiums can be so deflated that you can sometimes own an option (at or near the money) for a little more than the carrying charge cost of a futures contract. (That's cheap!)
Part Three of Four Parts - Next!
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.
Thomas Cathey - 27-year trading veteran heads the managed futures division of Thomas Capital Management, LLC. View his TimeLine Trading market predictions and get his complete 44+ lesson, "Thomas Commodity Trading Course" - they're all free. http://www.thomascapitalmanagement.com/commodity/welcome.htm Main site: http://www.ThomasCapitalManagement.com
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