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Trading with Options

Briefly, a commodity futures contract is a commitment between two parties to exchange a specific type, quantity, and quality of commodity at a specific date in the future. The commodity may be agricultural like wheat, corn, or cattle. There are also financial futures like treasury bonds, currencies, and stock indices. All futures contracts operate similarly with the recent exception that some are delivered in a "cash equivalent." A cash delivery simply means that the seller gives the buyer the cash value of the contract upon expiration rather then the actual commodity.

Futures contracts are obligations to take or make delivery of the commodity or financial product. On the expiration date, remaining open contracts must be satisfied by delivery. This is the primary difference between futures and their related options.

An option on a futures contract represents the right, but not the obligation, to buy or sell at a specific price called the "strike." As with futures, an option buyer goes "long" while sellers go "short." If the option is the right to buy, it is a "call." The right to sell is called a "put." When you buy options you pay a "premium." This premium is based upon the perceived likelihood that your strike will be reached within the time your option is open. Premium values change with market perception. Generally, traders refer to two factors that influence premium values. The first is "volatility," which is the degree to which prices move within short periods. The second is "time value" and relates to the period before expiration. The longer the time period, the greater the premium. The greater the volatility, the greater the premium.

Any strategy to buy or sell put and call options is fundamentally based in a forecast for price movement. Obviously, you might buy a call option if you believe prices will rise beyond the strike before expiration. A put would be bought if you thought prices would fall below the strike before expiration. On the other hand, you could sell a call if you believe prices will not move higher within the time before expiration. You can sell a put if you believe prices will remain above the strike before expiration.

A major consideration when buying options is your financial exposure. Once purchased, your loss is limited to the premium paid. With futures, losses can only be limited by the use of stops. Stops are not always effective in fast-moving or illiquid markets. If you sell options, your exposure becomes unlimited. However, you collect premium up front.

When COMMODEX issues a buy signal, the assumed transaction is to purchase the futures contract... to "go long." However, options expand your potential strategy because you can rely upon the same signal to buy a call option, sell a put option, or do both. The same set of choices exists in the opposite direction. When COMMODEX generates a sell signal for the futures contract, you might buy a put, sell a call, or do both.

Another interesting expansion of your profit opportunities exists when COMMODEX remains neutral. Prior to options, neutral signals translated into no action and no profit potential. However, if you assume prices for the underlying futures contract will remain stable while COMMODEX is neutral, you can sell call and put options to collect premiums from both. Clearly, only one side of this double transaction can ever lose because if the call goes beyond the strike, the put will expire worthless and vise-versa. This gives you an increasingly popular approach to using futures in conjunction with options.

ADVANCED TECHNIQUES

Once familiar with options, there are several more advanced applications using COMMODEX. For example, puts and calls may be substituted for stop protection. If you enter a long position based upon a COMMODEX buy signal and the stop is too far away, you might consider a put to limit your downside exposure if the premium is affordable. The opposite transaction using a call would apply to a short position.

The COMMODEX TREND INDEX operates as a highly accurate "overbought" and "oversold" oscillator. This implies that a high positive index value warns of a possible downside correction. If you are holding a long position and the TREND INDEX climbs to a high level of +60 or more, you might sell a call above the market against your open futures position. This is called a "covered write" because you are protected against a breakout above the option strike by your long futures position. If the market continues higher, you still collect your premium. However, your profit on the futures position will be limited or "capped" at the strike price. This same strategy works in the opposite direction for short positions and INDEX values below -60.

In major bull or bear moves, you might use "rolling" calls or puts to protect profits or as a premium collection strategy. In August of 1990, energy prices soared in response to Iraq’s invasion of Kuwait. Call option premiums rocketed to incredible levels. When prices reached toward $40 per barrel, the COMMODEX TREND INDEX numbers began to indicate an overbought condition. By selling calls, some traders were able to collect huge premiums which appeared to be distorted in value. When prices failed to climb, these huge premiums evaporated leaving the sellers with considerable gains. As the futures prices eventually retreated, call option premiums remained high in fear that the bull trend would rapidly and powerfully resume. By "rolling" the sale of call options down with declining futures prices, a trader could have actually made more money than if he (or she) had been only short futures contracts.

Nimble traders can frequently take advantage of extreme volatility and high premium values as long as they have a good foundation for making their trading decisions. That’s why the COMMODEX buy, sell, or neutral signal is so important. COMMODEX provides the "reference" point from which you can plan and implement sophisticated money-making strategies.

There are many intricate aspects to options valuation and trading. Strategies like long or short "strangles" and "straddles" can compliment your trading program. There are "butterfly spreads" and "condors." For more comprehensive knowledge about options, it is wise to research and read more on the subject. Your local bookstore is likely to carry several excellent introductory and advanced books on the subject. In the meantime, you can use COMMODEX to investigate and test strategies using options on paper. Once you are comfortable with your "paper trading" program, you can move to actual trading.