Even Tiger Woods has a coach.

- Sterling Smith

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October 5, 2007

Sign up for you complimentary CD-ROM "Trading Commodity Futures". Brought to you by FuturesOne

Sign up and get your complimentary educational seminar. This interactive CD-ROM introduces you to the fundamentals of futures trading. It lays out easy to follow trading examples along with additional resources to help today's commodity trader. This comprehensive educational CD-ROM was developed by the Chicago Mercantile Exchange and brought to you by FuturesOne. To get your complimentary personal CD and learn more about this great offer go here.

The first futures contracts were developed to centralize buying and selling of a uniform commodity, and shortly thereafter techniques were developed to use these contracts to manage risk.

In today’s Fast Break I am going to discuss risk management from two sides, one from the use of futures and options to alleviate inherent business risk, and the second how to use some of the same logic to help protect a speculative trading account.

Nearly every for profit business has some sort of commodity price risk. Airlines run the risk of higher fuel prices; a lumber yard has unique risks associated with the price of lumber. A farmer has risks of board prices dropping as well as basis dropping.

While it is neither practical nor desirable to eliminate all risk, there are ways to manage and/or mitigate it. The first step in doing this is determining and defining exactly what risks your operation is exposed to.  

Using a farm as an example, a farm produces grain and thus has price risk from falling grain prices, and also has price risk from falling basis (basis is the difference between the CBOT price and what the actual purchaser of the grain will pay for it).

The simple answer here would be “Sell futures when the price high.” Well if you have been around here as long as I have, you know this a lot easier to say than to do sometimes, for example, take a look at the price move in the wheat, $7.00 not very long ago was considered very expensive wheat, but now at $9.00 a bushel, $7.00 looks like a deal. So if you did sell $7.00 futures as a hedge, you know exactly what I am talking about.

The better answer in this case and any many cases is to look at your options. Options like puts and calls. The best hedge is one that lays off the risk, (protects from downward price movement), has minimal internal exposure (the cost or hazard of the hedge itself) and does not take away opportunity.

The hedger who chose to sell wheat futures alone when wheat reached $7.00, did lock in $7.00 for his wheat, and was very well protected if prices had gone down. The problem develops when prices climb. In the case wheat rallied another $2.50 a bushel (this a substantial move considering wheat ranged between $2.30 a bushel and $3.00 a bushel from 1998 to 2002).

The futures-only hedger suffered from two maladies; first the trading account endured $12,500 a contract of distress. Many people have trouble dealing with this and the margin calls this can generate, and end blowing out of hedges, which can be a disaster if prices fall later. The second issue was missing out on a $2.50 move.

The option hedger, in particular the put buyer had much better situation, his costs were known upfront and did not of risk if prices climbed. Another advantage is that an option position, depending on how it is constructed may have a fair amount of time, and may work as time passes.

The main reason most people don’t use options has hedging tools is that they do not understand them, or do not have the time to really examine what they are doing. A well designed option hedge can protect from price risk in clear and defined manner. If you have difficultly with understanding this get some help as there is plenty of material and resources out there.

Remember risk management is just that risk management, and before you can manage it you have to have a clear idea of exactly what the risks are. Hedging is no different than any other kind of trading, in one key aspect, discipline, as once you have a well thought out plan in place you need to stick with it.

While I work with all types of customers, like to use the skills I use with commercial entities to help traders out there are speculators. Some of these same techniques that I would use for a farm or an ethanol plant can work to help speculators control their risk.

Speculators often times have trouble with managing and keeping risk under control, and this stems from more different reasons than I can explain in a limited space. I can say this: I have seen very few consistently successful speculators who do not manage their risk. I think part of this stems from being able to understand risk means that given person understands the markets more thoroughly than do most other participants, which further helps with their success.

With the big moving markets that we have now, being in the market longer when you are on the right side of things can greatly enhance performance. The downside of this is when the reversals come can the can be swift and massive, if short lived. Well thought through strategies can help guard those profits and make enduring the storms easier.

The key to all of this is correctly understanding the markets and understanding what the risks are, and how to protect best against them. Speculators are very similar to commercial participants in many ways and very often have similar needs. The great advantage the speculator has over the commercial is that he chooses which markets he/she is in and when to get in, as opposed to the commercial trader who is in the market because he has to be.

REPRODUCTION OR REBROADCAST OF ANY PORTION OF THIS INFORMATION IS STRICTLY PROHIBITED WITHOUT THE WRITTEN PERMISSION OF FUTURESONE AND STERLING J SMITH. THE INFORMATION REFLECTED HEREIN IS DERIVED FROM SOURCES BELIEVED TO BE RELIABLE; HOWEVER, THIS INFORMATION IS NOT ASSURED AS TO ITS ACCURACY OR COMPLETENESS. OPINIONS EXPRESSED ARE SUBJECT TO CHANGE WITHOUT NOTICE. THIS MATERIAL AND ANY VIEW EXPRESSED HEREIN ARE PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND SHOULD NOT BE CONSTRUED IN ANY WAY AS AN INDUCEMENT TO BUY OR SELL COMMODITY FUTURES OR OPTIONS CONTRACTS. FUTURESONE AND ITS OFFICERS, DIRECTORS, EMPLOYEES AND AFFILIATES MAY TAKE POSITIONS FOR THEIR OWN ACCOUNTS IN CONTRACTS REFERRED TO HEREIN. TRADING FUTURES INVOLVES RISK OF LOSS. DO NOT DUPLICATE.

This publication is strictly the opinion of its writer and is intended solely for informative purposes and is not to be construed, under any circumstances, by implication or otherwise, as an offer to sell or a solicitation to buy or trade in any commodities or securities herein named. Information is obtained from sources believed to be reliable, but is in no way assured. No assurance of any kind is implied or possible where projections of future conditions are attempted.

Futures and options trading involve risk. The valuation of futures and options may fluctuate, and as a result, clients may lose more than their original investment. In no event should the content of this market letter be construed as an express or an implied promise, assurance or implication by or from FuturesOne or Sterling J Smith that you will profit or that losses can or will be limited in any manner whatsoever. Past results are no indication of future performance.

This week's author is Sterling Smith. FuturesOne Vice President and Broker, Sterling Smith, CTA is creator and publisher of the FuturesOne Power Index, is a veteran broker and market analyst. Beginning in the futures industry as a risk manager for a large FCM, he moved to a major clearing firm and learned from some legendary traders. He incorporates the benefits of these insights to help every client construct better trading plans and to enhance their understanding of the marketplace.

Sign up for you complimentary CD-ROM "Trading Commodity Futures". Brought to you by FuturesOne

Sign up and get your complimentary educational seminar. This interactive CD-ROM introduces you to the fundamentals of futures trading. It lays out easy to follow trading examples along with additional resources to help today's commodity trader. This comprehensive educational CD-ROM was developed by the Chicago Mercantile Exchange and brought to you by FuturesOne. To get your complimentary personal CD and learn more about this great offer go here.