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What's better than limited risk and unlimited potential?
- John Garrity |
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Today's Featured Article
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Who out there feels like they have been getting whip-sawed by these violent markets lately? The Funds are more a part of Commodities than ever before. It’s hard for the individual investor to keep up with the volatility that these Funds have created lately. Buying Options is a more conservative way to get involved. You are going into the markets knowing your exposure. You don’t have to worry about waking up in the morning and seeing the Dow Jones Futures gap 300 points higher and running your stop loss by $3,000. I am going to go over a few Option strategies that will take advantage of the increased volatility this time of year. Generally, August through November are good
months to get involved with Options. Soybeans
This is the time of year when the grains tend to drop in price due mainly to Harvest Pressure. Last week I noticed the bull trendline was snapped when we gapped lower on 8/16. There is a lot of room to the downside. If we see support around $7.00/bushel and we are currently around $8.20/bushel, how might we take advantage of a possible $1.00 break in prices? Let’s say you only have $3,000 in your trading account. You believe selling a future is too much risk for your size of account. What about buying a Put Option? You will have unlimited potential with limited risk. You don’t want to risk anymore than 20% of your account on this trade, because you obviously don’t know
if you are going to be right. You also want to leave some excess cash in case you see something else that looks attractive. Trade:
You purchase a November Soybean 740 Put for 10 cents, which equals $500. This is about 17% of your $3K account. You are left with about $2,500 of excess equity. November Soybeans are currently trading around $8.20. Next month the harvest typically begins and there is talk that the US is going to have a great crop. Let’s assume the November Soybeans price drops to $7.00/bu, and that is the profit objective. At that point, the 740 Put would be in the money by 40 cents, and perhaps with time value the option may be worth something closer to 50 cents, or $2500. This was your objective, so you sell the option for 50 cents and realize a hypothetical gross profit of about $2000. Your
account would now be worth something closer to $5,000 if this were the only trade you did.
This is the most basic form of trading Options. You pick a direction, up or down. You ask yourself how much you are willing to risk. When you buy a Put or Call you give yourself unlimited potential with limited risk. The good thing about this strategy is if you are wrong you know your exposure and you can sell this option to recoup some of the premium you paid. If you are wrong over the next month and Soybeans rally, you should be able to sell your Option and not lose your entire investment. |
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Wheat You notice Wheat has suddenly consolidated around the top and you believe the market will drop in price due to the Funds exiting their position. The Wheat market has been extremely volatile this year. You would like to take advantage of the juiced up Call premium. You do a ratio credit spread in December Wheat (WZ7). This trade has unlimited profit potential with potentially unlimited risk. Trade:
You sell one December Wheat (WZ7) 8.00 Call for around 13 cents or a $650 credit and buy two WZ7 560 Puts for a total of 5 cents or a $250 debit. You received about a $400 credit per strategy. We have unlimited potential on multiple WZ7 560 Puts. We have unlimited risk on the naked WZ7 800 Call. You tell yourself you will risk a double out stop on the naked 800 Call, or a risk of about $650 per naked 800 Call. If the WZ7 800 Calls trade at 26 cents or higher you are throwing in the towel. Your objective is for December Wheat to test $5.00/bu, for a profit of about $6500 per strategy. Expiration is around Thanksgiving. The front month Wheat contract last year at this time was around
$3.50/bu, so it has nearly doubled in value! You know there is Wheat damage, but you believe this has been factored into the price. If the news comes out and the damage is not as bad as originally thought, guess what? If Wheat settles between 800 and 560, this strategy will gross $400 per spread, excluding commission and fees. Your worst case scenario is your stop loss on your 800 Call gets elected and the 560 Puts expire worthless, resulting in an approximate loss of about $900 per spread. |
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Sugar It seems that most rallies in the Sugar market are met with substantial resistance, perhaps from fund selling, and the market comes back down dramatically. Let’s say you believe in time Sugar will move higher in price, but you don’t know when. How do I take advantage of higher prices sometime in the future? You want to give yourself plenty of time. You might also want to sell some Call premium, just in case Sugar prices don’t move higher until next year. Trade:
You purchase the October ‘08 Sugar 1000/1200 Call Spread for about $500 cost and risk. You buy the October ‘08 Sugar 1000/call for $1000 cost and you receive $500 credit for 1200/call. Your risk is limited to $500 in this example, the cost of the Call Spread. Your potential is the difference in the two strike prices which is 200 points or about $2240 less the cost of the spread ($500), which will equal approximately $1740. You have over a year until expiration. The reason why I used a Call Spread is if Sugar goes flat for a half of year you can hypothetically buy back the October ‘08 Sugar 1200 Call back for less than what you sold it for and gain on the short Call
Option. Your net position now would offer unlimited potential with the long October ‘08 Sugar 1000 Call. The downside to the original spread, if left alone, would be if Sugar prices exploded above 1200 your potential gross profit on the spread is limited to the 200 points.
While the volatility of late can be a hair-raising experience, there are trading methods that are available that can help futures traders define their risk and simultaneously allow them to take advantage of market moves if their research or guesswork is accurate and the correct movement in the market is predicted. The strategies discussed above are readily available for those who have the time to do their homework, or choose to work with a strategist who is experienced and can devise and discuss the trading plan with them. *Take into consideration some of the values mentioned in this article are hypothetical or estimated, is located at the end of the article. |
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About the Author
| Since his arrival in Futures and Options in 1995, John Garrity has served as an equity raiser, currency analyst, and has trained hundreds of clients in the art of trading. Mr. Garrity provides all of his clients with a fundamental and technical analysis on various markets by writing a daily Garrity Report that is e-mailed twice each trading day. Mr. Garrity comes from a family with over 30 years of experience in the agricultural markets. His Father trades at the Chicago Mercantile Exchange in the Meats. |
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