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Today's Featured Article
If you listen to the markets they will tell you how to trade. The markets I am referring to are the commodity markets.
Not only is there a plethora of different commodities to trade, but there are numerous ways of implementing strategy. The strategies I will discuss are trend following, option ratio writing and credit spreads.
A trend following system is what its name implies -- following a trend. For decades commodity trading advisors, proprietary traders and money managers have successfully used trend following systems to reap huge profits. The concept is simple enough, if the market breaks out to the upside you go long and place a sell stop behind your position; if the market continues to run you raise the stop and continue to trail the stop below the market. In a falling market the same is done in the opposite direction.
Systems differ on what qualifies as a breakout and how far from the market the stops be placed. Breakouts are generally determined by using a moving average. The moving average can be based on the closing or average price from the previous 5 to 120 days. A breakout is usually signaled when a predetermined percentage move above or below the moving average occurs. If a market continues in one direction without big corrections the strategy is extremely profitable.
On August 6th Natural Gas opened at 4.023 and closed at 3.743. This 7% decline would have given a sell signal to almost all trend following systems. For the next nine out of ten trading days the market fell. The low for the month occurred on August 27th at 2.692. Remember in trend following you can never enter or exit at the best price because you need the market to move from those levels to trigger a signal. Grabbing even a bit of this $10,500 move in three weeks would have been outstanding.
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The commodity markets as a whole have been very volatile so far this year which means they are telling you trend following is not the answer. Sure you will get exceptions in markets but most markets remained in a channel, not a trend like natural gas. When a market is choppy at best you will often get stopped out, at worst you will be whip-sawed. Volatility is the enemy of trends. Volatility requires you to place stops far away from the current level to avoid being stopped out. Therefore you are taking on more risk.
If volatility has been the norm for this year we need to listen to what the market is telling us. The implied volatility being high relative to the historic volatility inflates the value of options, making them over-valued. In such an environment it is advisable to be a net seller (collector) of premium.
The outright selling of naked options is one such strategy. At times and in certain markets it may be the advisable method but always the most dangerous. I will concentrate on two tamer yet potentially very profitable ways of being a net seller.
The ratio write is a strategy where the trader purchases one option close (or closer) to the money and sells multiple options farther out of the money.
The implied volatility in November Crude Oil and December Gold Options are roughly 47 and 26.50 respectively, while the historic volatility is only 35.7 and 15.2. Clearly the implied volatility is much higher than the historical, causing inflated premium. To take advantage of this we did ratio writes in Crude Oil and Gold.
In Crude Oil we bought a November $87 call and sold three November $92 calls. Prior to any commission or fees we collected $1000 per spread. By using a ratio write (buying one $87 and selling three $92) as opposed to naked (just selling 3 $92 calls) the margin is decreased from $6840 to only $3750. Span margin recognizes that for the $92 calls to get in the money the $87 call must be worth $5000 [($92-$87) x 1000 barrels]. As long as Crude Oil by the expiration date of October 15th stays below $92, the short options expire worthless and the profit is made. Our breakeven point is $95, meaning if on expiration Crude Oil is below 95 we are profitable and above we have a loss. If the
position is never sold or adjusted potentially the risk is unlimited.
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A ratio write we recently established is one of the most amazing trades I have seen in 28 years. We sold 4 July 2010 $60 Silver calls. That is not a misprint, $60 Silver calls. To help protect the position and lower our margin we purchased 1 July 2010 $38 Silver call.
Prior to any commissions or fees we collected $1100 per ratio write. If we just sold the 3 naked $60 calls our margin would be $2677, but because we purchased the $38 call our margin is reduced to $1300. Span recognizes that for the $60 calls to get in trouble the $38 call would be worth [($60-$38) x 5000 oz] $110,000. Yes, your profit potential is $110,000 plus the amount you initially collected, the $1100. Your break even point is $67.35. Any point below this on the expiration date of June 24, 2010 and the trade is profitable. Anything higher and a loss occurs. Again, your loss can be unlimited if the position is never sold or adjusted. These are exciting times and trading
opportunities exist.
The credit spread is our most popular and consistent way of trading. We have been trading credit spreads in the S&P 500 since the inception of the firm. An example of a recent credit spread: On the call side we sold an October 1080 call and limited our risk by purchasing an October 1100 call at the same time we sold an October 940 put and limited our risk by buying an October 900 put. Prior to any commission or fees we collected a net of 11.4 points or (11.4 x $250) $2850. If the market on the expiration of October 16th is between 940 and 1050 the entire premium is retained. Our break even point is 929 on the downside and 1091 on the upside. Our downside risk is limited to $7150 while
our upside risk is limited to $2150. Again, this assumes the position is never sold or adjusted.
In summation you must adjust your style of trading appropriate to what the market is telling you. The market will tell you the volatility, the trend, the momentum, option value and more. But, you must know how to listen and trade accordingly.
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About the Author
Mr. Ed Carr
graduated from Allegheny College with a Bachelor of Science in Economics. He continued his education by obtaining a Masters in Business Administration in Finance from Fairleigh Dickinson University. His initial career foray was as an account executive of a large commodities brokerage firm. In five years he was ranked as a top producer and was promoted to management. Shortly thereafter he was recruited by a major brokerage firm and became their Vice President.
In 1987 he put his experience to use and founded Carr Investments Incorporated. Carr Investments had professionally handled thousands of clients worldwide for ten years. In 1998 the assets of Carr Investments were acquired by Trader's Edge Inc. Mr. Carr took over the role of President and Jonathan Lubow as Vice President.
His vast experience has enabled him to market four unique ways of trading options that have been utilized by many firms, as well as individuals. Mr. Carr has appeared as a guest on several investment shows and given numerous seminars and lectures to professional investors, corporations and individuals throughout North and South America. Mr. Carr has been married for over twenty-five years, has four children and resides in Morris County New Jersey.
Ed is also a contributor to Optionsscholar. |
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Special Message from Our Author
Get Your Complimentary Booklet!
For a limited time, Trader's Edge is offering a complimentary booklet, "Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads". John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your complimentary booklet from Trader's Edge now!
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