The more effort you put into reviewing an investment, the better your odds of success.

- Scot Hicks

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July 24, 2007

Looking for options trades that make sense?

New from Trade Center: The Options Sense Advisory Service. Options Sense is an options advisory service delivered once each trading day. Using proprietary models and analysis, you are offered value strategies. These high probability strategies attempt to capture option premium as opposed to simply buying an option. Why not see for yourself? Sign up for a COMPLIMENTARY Trial!

Futures and options trading involves substantial risk and is not suitable for all investors.

As commodity traders we tend to go were the action is. Sure, there are contrarian traders out there. Those that seek out the quiet markets and wait for the inevitable push in one direction or the other. However, most of us seek out the market that is making some noise. Think of it as the loudest craps table in the establishment. In the futures market, that table is the grains table. Corn, wheat, soybean meal have all been making major market moves. The question is, will the dice stay hot, or roll a seven. In the following paragraphs we will look at the grain markets and specifically how the rising volatility in the grain options markets may have created potential trading opportunities. Is big volatility a good thing?

Before we go into options, volatility and some strategies, we first need to take a look at the markets making the headlines. Driven by weather concerns and underpinned by the wheels of international supply and demand, the grain markets have produced some spectacular market moves in 2007. On top of this is the pure dynamic nature of the markets as well. While corn, drowning in what is perceived as a bountiful harvest, has recently made new lows, soybean meal has made record new highs. Wheat prices too have benefited from strong demand and weather worries. As most veteran traders know, this is par for the course when it comes to summer and grain prices. Many years ago when I was a grain analyst on the grain-trading floor at the Chicago Board of Trade, a big thunderstorm occurring on La Salle Street in Chicago would send the grain markets plummeting with traders forgetting that it was 100 degrees and bone dry, throughout the entire Midwest. But, at this time of year, the slightest bit of information, good or bad will send the grain market careening in one direction or the other, even if it is raindrops on one Chicago street.

O.K., we may have identified the loudest craps table in the  establishment, but where do we place our chips?  There are a myriad of squares on that green felt table and just because there is a lot of hooting and hollering, does not necessarily imply success. In my opinion, the options market offers opportunity. Without a doubt, there is substantial risk involved in participating and before you put down a single dollar you need to understand the game.

What is Option Volatility?

The formulas involved can be quite complex, but the basics of the answer are as follows. Volatility is a measure of the magnitude and rate of change in prices of the underlying futures contract. For example, the big day-to-day swings in the prices of the grain markets have produced exceptionally high volatility levels. This is also known as Statistical Volatility. Call it a “loudness indicator.”  Again, I am oversimplifying some very complex concepts but the important thing to recognize is that option volatility can be used as a barometer of market activity.  

Another measure of option volatility is known as Implied Volatility. This mathematical computation attempts to measure the expected volatility an option by incorporating the price of the option. Astute option traders will seek out anomalies between Statistical and Implied volatility. Is an option overpriced or under priced? 

Lets look at some examples of how current grain market volatility measures up to some slower paced markets:

Market	Statistical Volatility	Implied Volatility
Corn	36.9%	33.6%
Chicago Wheat	36.3%	32.7%
KC Wheat	31.4%	32.3%
Soybean Meal	29.1%	31.5%
Soybeans	23.5%	27.3%
5-Year Notes	3.5%	3.2%
10-Year Notes	5.3%	5.0%
EuroFX	4.4%	5.5%
British Pound	4.2%	5.6%
Japanese Yen	6.1%	7.0%

Clearly, you can see that the corn market is measured as a completely different animal than interest rate futures for example. Again, this does not mean that 5-Year Notes don’t move, or that wheat will continue making new highs. As traders we merely look for small clues or maybe an edge. Perhaps this is one that can help you.

High Volatility Options Strategies

In my opinion, when option volatility is high, the preferred strategy is to utilize strategies that sell options rather than buy them. The logic being that with extremely high option volatility there is a chance that option prices are unduly inflated and that one may profit from a decline of option prices back to more average levels of implied volatility. For good measure I will add another risk disclaimer that the risk of loss in trading options is substantial and not suitable for all investors.

Covered Writes

This involves buying or selling the underlying futures contract and simultaneously selling options against this position. For example, if you believe corn will continue to go down you can sell a futures contract then also sell a put option. The logic is that should prices decline (less than the premium you sold the puts for) or stagnate, you can make money on the underlying futures contract and collect the potion premium. The risk in this strategy is that an accelerated move down could cause your option to be exercised and generate potential losses.

Naked Writes

This strategy involves simply selling either puts or calls with no underlying futures position. To be sure, this is a risky play, but with inflated volatility and option prices an options investor may be able to identify options that are inflated in price and perhaps may be sold with the expectation that they could be bought back at a cheaper price in the future.

Short Straddle

This involves selling a put and a call pair with the same strike and expiration with the expectation that the underlying price stays in between the two strike prices. The logic is that both options will expire worthless.

Conclusion

I believe that the grain market and specifically options strategies offer opportunity. I hope I have depicted properly that this is highly speculative. There are rewards and the commensurate risks. Hopefully this will provide a spark of interest to you. Do your homework.

After college graduation in 1986 Scot Hicks began his futures career on the floor of the Chicago Board of Trade working as a runner on the grain floor. Scot progressed to doing grain market research and then began handling client business in 1988. From that time on, he has been involved in some capacity of futures trading system administration or management. Scot hasn't seen it all, but he has seen a lot. Over the years he has written articles for Futures Magazine, and SFO Magazine. Scot's articles have also appeared on Bondheads.com. Scot currently oversees operations for an Introducing Broker head quartered in California called Trade Center, LLC.

Looking for options trades that make sense?

New from Trade Center: The Options Sense Advisory Service. Options Sense is an options advisory service delivered once each trading day. Using proprietary models and analysis, you are offered value strategies. These high probability strategies attempt to capture option premium as opposed to simply buying an option. Why not see for yourself? Sign up for a COMPLIMENTARY Trial!