Commodity Option Buying - The Hidden Dangers PART 4 What The Option Pros Don't Want You To Know

By Thomas Cathey

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
Article Source: http://EzineArticles.com/?expert=Thomas_Cathey

Commodity Option Buying - The Hidden Dangers PART 3 What The Option Pros Don't Want You To Know

By Thomas Cathey

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.

There are special times when options can be bought. There are special reasons too. I've seen good buys when sugar is wallowing at its lows around 4-5 cents. Buying a nine-month-out call option near the money costs only 20 basis points. These are the times to take notice and buy options assuming you have a forecast showing a good rally. (or decline)
Another good time to buy is simply when the option gets way undervalued from current market volatility conditions and you are looking for it to swing back to its volatility norm. Reverse everything mentioned above when buying put options. You want to see panic buying and short covering so that the put premiums are deflated, of course.

The market pays you for having skills that are better than the average trader. It also pays you for taking on risk. Buying a load of inflated options based on the crossover of a moving average and then sitting on them for a few months takes no skill at all! In addition, there is really no "unknown risk" being taken. Yes, you pay your option premium, but it's really your bribe to the market to make you feel comfortable.

The option writer is the guy really taking on uncertain risk and is feeling uncomfortable. The market usually will favor him if only for that reason. A smart pro writing options will then lay off some of his risk by hedging some future contracts (or opposite side options) against the option write. How can he make money doing that? He locks in money because you were willing to pay a higher than normal option premium and/or were willing to buy at the offer price, giving him some spread and premium slush to work with.

It takes no skill to enter and maintain a position when buying a load of options. None at all. But entering a market with a futures contract and staying on-board requires sharp timing skills and a forecast that works out without a large adverse move against you. The good part is you have all the time in the world for the futures contract move to take place! No ticking clock eroding premium like an option. (there may be a small futures carrying charge when long, but it works for you when short)
Someone might say it's a wash... the advantages outweigh the disadvantages. But I say if you are a skilled position trader, holding futures have a tremendous advantage over buying put and call options. Generally, beginners have few skills and pay the price by getting wiped out due to eroding option premiums.

Many brokers will encourage beginners to buy options because they are very low time maintenance and of little risk for them. The broker and client become cheerleaders cheering or gagging as they watch the news. Lots of "safe, no risk" entertainment for a few months. Maybe one or two out of ten trades work out. But the end result is always the same.

These traders eventually lose all their money to the option writers and simply fade away. Nice ride while it lasted. Next. Buying a load of options removes "responsibility" to the market. If you're wrong, the account erodes slowly (or quickly) while you're fat, happy and hoping for a miracle .
In contrast, if you're sloppy entering a futures contract trade, you get booted out on your rear end within a day or two. There is instant feedback and pain. There's hard work and risk servicing a group of futures trading clients. But that's the price that must be paid for the chance for higher probability market success.

More advanced option buyers like to do "free" option trades where they buy two, and then sell one or two to take in some buffer cash. This is actually a decent idea and can reduce expenses or lock in some profits when the market chops or backs off after a rally. However, your upside potential is also reduced. No free lunches. See my free course lesson # 26 for more details on "free trades."

Part Four 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
Article Source: http://EzineArticles.com/?expert=Thomas_Cathey

Commodity Option Buying - The Hidden Dangers PART 1 What The Option Pros Don't Want You To Know

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.
I am going to tell you some things about option buying that may save you a lot of money over your lifetime. This applies to both commodity and stock options. First of all, buying commodity options as a routine way to participate in a market's price move for long term trading is a losing proposition over the long haul. In fact, it's probably the leading cause for commodity trading failure by the public.
Most beginning speculative option buyers (and many brokers) wave the flag saying options have limited risk and you can only lose the money you put in. This is true. But at what cost? Paying a hefty option premium to the market for the privilege of holding it for several months is the price you pay. These premiums add up to a tremendous cost over time.
If you are in the market for a year, whether trading options in and out or holding long term option positions, the clock is always ticking and eroding those option premiums. There is a small window when commodity options are priced at good values and can be bought, but it is a tiny fraction of the time when markets get out of line and the historical volatility gets low. The majority of the time, long term option buying is a formula for failure.
In some cases, it may cost you 100% or more of your account value just to pay and maintain that eroding premium privilege for a full year. For example, it is common to pay about $1000 for a three month call option that is near the money. (near its strike price) If the futures market simply chops sideways, goes down or even rallies slightly, the option will expire worthless in three months. Do this three more times to cover a full year and you've spent $4,000 to simply hold ONE out-of-the-money call option for a year.
Multiply this times ten options and you're talking some serious money paid to the "insurance man" so you can feel comfortable for a year. Bear in mind it is not necessary to have an adverse move against your position for the entire year for this to happen. Think about these statistics and realize that most commodity pros consider it a great year if they earn "just" 30% on their accounts - for the year!
How can one pay many times that cost in option premiums and come out ahead? In compaison, if you were holding futures contracts, they would have been near break-even at year's end. That's a tremendous difference to start with. Also remember that when buying options, a good win/loss ratio for a skilled long term trader is only about 10-20% accuracy. This is low but normal and requires huge gains on the winning trades. This win/loss method information is throughly discussed in my free course lessons #2 and #21.
There is a tendency for many option buyers to "load up" and buy way too many options for their account size. I've seen it over and over. Option buyers are very prone to feeling comfortable and becoming "boy plungers." In contrast, serious futures contract traders are very aware of the potential risk and usually take extreme precautions by trading small for their account size. (small is always a good idea for survival - see free course lesson #28)
Remember that I am talking about the dangers of simply BUYING options and holding them. Selling options (writing them) or using them to hedge the risk of futures or using them in spreads to pay for an option buy position, can work well. To use options efficiently means spending the time to find the proper combination to lay off your risk while still participating in a chance for profit.

Part Two 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
Article Source: http://EzineArticles.com/?expert=Thomas_Cathey