The buying of options (rather than 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 premium cost over a year is tremendous. Read about how the pros use commodity options and how you should too.
There are many ways to hold a speculative position in futures contracts and hedge yourself against unlimited risk. All methods will cost you something. The market is a wash and gives nothing away. It will reward you only if you uncover an advantage that the majority misses. You must use the proper trading vehicles and analysis to capitalize on these situations. The wild card is that the market and optimum tools are always changing.
I talk about the dangers of option buying from experience. Over the years, I've done well buying and selling futures contracts as well as other traders I know. But, except for a few tremendous gains when the market collapsed while holding put options, I've seen most traders lose consistently when straight buying options. This erosion happens even when the market forecast is correct. That is the most disheartening part - to have the move take place and the options erode in value. Unless you are expecting an unusually fast move in a short period of time, find a way to use futures contracts for the job.
Writing (selling) options is a good way to capitalize on this eroding asset. Again, there are no free lunches and it takes as much skill to make money writing options as it does trading futures contracts. Writing options also contains as much risk. This threat of risk is your reality check to make sure the market will pay you for your skills. Without taking on risk, you are an outsider trying to play a pro's game.
Let's not forget about the spreads when trading commodity options. Except for some very active financial markets, option bid and offer spreads are usually so wide you can drive a truck through them. The New York commodity option pit markets are notorious. An illiquid market is the problem with many commodity futures options.
Some trading is so thin you simply cannot get in or out without paying an outrageous price. After buying, try to sell it back minutes later and you might be down 30%. I've seen times when some option spreads have been one-bid to three-offered. Even 3/4 point is considered a good spread in some commodity option markets. Unless you follow a few rules to getting in and out, expect to pay. In defense, most financial commodity option markets are reasonably liquid and active.
When you add up the spreads in illiquid markets over a year's trading, they can be many times more than the brokerage commissions you paid! These are expenses that may take you from profitable, to break-even, to even losing for the year. Many traders think that they can pay these expenses "just this time" and the trade will take off and make it all up. This attitude gets contagious in a wild commodity bull market as traders buy at any price.
Trading has to be viewed over a long series of trades. Some trades will be losers, some will be break-even and some will be winners. They must be all taken together. Calculate your expenses to arrive at one bottom line. If the best pros have a hard time scratching out 50%-100% gains per year with their low overhead and expertise, how can you expect to cover greatly higher option expenses and come out ahead?
In contrast, most futures contracts are very fair in their spreads since they are more liquid. For example, the e-mini futures contract, (currently priced at 1200) if scaled down to equal 120, has an equivalent bid/offer spread of about 1/40th of a point! Now that a fair and low entry-exit expense!
I simply want to make you aware of what you're up against when buying options. Being aware is being prepared. You need to have skills, an edge, reasonable expenses, the proper trading vehicles and good advice to survive and prosper trading commodities. My advice is don't get lazy and depend only on the false security of buying options. Learn to use these trading vehicles like a pros. Take on the risk of futures, option spreads and other strategies that require more experience. Take on the challenge to learn more about commodity trading strategies.
Read my free course lessons #26 and #29 to find useful information on using futures and option hedges to avoid these pitfalls. I hope this lesson will help to clear the fog, false hope and comfort of buying these eroding assets. You will discover there are much better vehicles and techniques for position trading.
Good Trading!
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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