Warren Buffet has often sited the old metaphor for stock indexes vs. stock pickers - a rising tide floats all boats. Warren also pointed out that only truly talented or patient stock traders can make money in an outgoing tide. While this may be true, it is very tough to make money if you are long stocks when the overall market turns bearish. The drawback to picking stocks is that no matter how great the fundamentals, the product, or the PE, if the overall stock index turns lower, chances are the stock’s price will suffer or at least struggle to move higher.
The recent bull market in stocks has kept diversification on the back burner for many investors enjoying the recent rising tide in U.S. and international equities. But diversification among asset classes is a cornerstone of modern investment planning. And this does not mean diversified among large cap, small cap, international and utility stocks. These may be diversified stocks, but they are still all stocks. And while equities have been on a tear as of late, there are clouds on the horizon. Many analysts estimate that the Chinese stock market may be up to 80% overvalued. Morgan Stanley issued this week what many are calling a red-light sell signal for all European stocks. And this week’s sharp pullback in U.S. stocks has given many investors pause. We however, are not predicting a bear market for stocks, nor are we making any forecast for stocks. What we are doing is pointing out the value of diversified holdings in your portfolio.
To achieve true diversification, many investors are turning to commodities. Granted, in a world where shares of a company can be subject to downgrades, internal accounting irregularities and the index phenomenon described above, owning quantities of hard assets or consumable goods like sugar, oil or silver holds quite an appeal for many investors. What once was the domain of the highly sophisticated or extremely wealthy investor is now becoming commonplace for the average investor. The unfounded fears of a truckload of corn being dumped on your lawn have been replaced by a gradual understanding of commodity markets by mainstream investment media. Commodity ETFs and Index funds have sprung up to serve the investor not yet ready or willing to invest in actual futures contracts.
While ETFs and index funds are good vehicles to offer portfolio exposure to commodities, they have their drawbacks. Commodity ETFs typically are a basket of stocks from companies involved in the production, processing or selling of a specific commodity or group of commodities, such as Monsanto or Southern Copper. While these can be good investments, the key factor is that they are still stocks and still subject to the mood of the overall market. If you seek true diversification, ETFs may not offer what you seek.
Commodity index funds offer a broad exposure to the commodities markets as a whole and can help investors diversify from equities. The drawback to commodity index funds: commodities prices have to go up. Index funds track an index of commodities prices and make money if commodities prices rise as a whole. If commodity prices rise, you will do well with an index fund. But there is a problem with betting on prices to increase as a whole.
Commodity prices are not nearly as correlated as stock prices. In other words, while a rising stock market can benefit all stocks, commodities encompass such different products with different supply/demand fundamentals, it is uncommon for these markets to all trend together at any one time. Granted, there is some correlation involved in certain markets and the advent of commodity funds has many managers buying across the board at certain times, which can influence the index. Global prosperity and increased populations can increase demand for raw materials that can support many markets simultaneously. Inflation can play a role as well. But this can be more of a gradual, long-term phenomenon. During the course of a typical year, commodities prices are trading independently of each other.
For instance, a drought in the Midwest United States can drive up soybean prices, but have little effect on a pound of coffee from Brazil. A supply disruption in crude oil should have little effect on frozen orange juice prices. Lower gold prices should not affect how much distributors are paying for natural gas this week.
Therefore, rather than plow funds into a commodities index and hope that a group of somewhat independent markets rally together, one may choose a more flexible strategy that can capitalize on rising or falling prices in individual markets. We are not talking about investing in the actual futures contracts but rather the practice of writing options on these futures contracts.
To the uninitiated, option selling on futures contracts may sound like a complicated vehicle in which to immerse a portion of ones portfolio. However, it is a strategy used regularly by hedge fund and commodity fund managers and can generate solid returns and income in up or down markets.
Selling options on futures offers the investor double diversification. On one hand, he is entirely diversified from the stock market. On the other, he has funds working in a basket of commodities that can be completely diversified from each other. In addition, with commodities option selling, it does not matter if prices move up or down. The investor can be positioned on the long side, short side, or even both sides.
Granted commodities are typically for investors willing to assume a higher risk for the opportunity to generate higher returns. Option selling on these contracts simply offers a twist that may take some of the high-speed aspect of out the investment.
What is commodity option selling? The strategy and the vehicle are far too complex to describe in a single article. However, at the risk of oversimplifying, selling options on futures contracts is not about picking where prices will go. It is simply picking levels where that commodity’s price will not go.
The example below illustrates how a fund manager may position using this strategy.
With October crude oil trading near $70 per barrel, a manager is bullish crude oil and wants to get his clients long. Instead of buying October crude futures and risking a correction, he sells the October crude $55 puts for $400 each, meaning he collects $400 for every option that he sells. To do this, he puts up a deposit of approximately $1,000 per option. This deposit is called ‘margin’ in futures, not to be confused with the term margin as it applies to stock trading.
This premium goes into escrow that is held through his main account. When option expiration arrives, if October crude oil futures are anywhere above his $55 strike price, the option expires worthless and the fund manager keeps the premium as his profit, plus he gets his deposit back.
The fund manager then can take a longer-term bullish or bearish view of a market and position accordingly, without having to subject his customer funds to the daily whims of the futures price.
Of course, he can lose money-selling options too. If crude prices begin to fall, the option value could increase in the short term. If the manager feels prices are headed to $55 or below, he may wish to buy his put options back, which incidentally can be done at any time. If prices are moving lower, he may have to do this at a price higher than where he sold the options, meaning he would have to give the premium back and then some, creating a loss.
Typically, if prices were moving against his position, he would want to buy out before the futures fell below his $55 strike price, as losses below that level could begin to accelerate. However, as expiration of the option nears, it becomes increasingly difficult for the option to gain value, even if futures prices are moving against the strike. Thus, if the manager feels prices will remain above $55, it is often in his best interests to ride out a price decline.
Conversely, if the manager was bearish oil prices, he could sell call options $10 to $15 above current price levels. If this were the case, the options would be profitable if crude prices were anywhere below his strike price at expiration.
Option values will typically move slower than the actual value of the futures contract, which can translate into a somewhat more stable portfolio than if the trader was trading actual futures contracts.
They key is keen risk management combined with a diversified approach – which one can certainly attain in the commodities markets as described above.
Individual investors can use this same strategy in their personal portfolios. However, as this is a somewhat sophisticated investment approach, we advise working with an experienced option broker/and or professional fund manager in employing the strategy – especially for investors new to commodities and/or options. Knowing the fundamentals of the individual commodities is of premium importance, in our opinion, if one wants to be consistently successful. Even more reason we recommend working with a commodities option specialist.
One final note on selling commodity options: The Chicago Mercantile Exchange estimates that more than 80% of options held through expiration will expire worthless. This means that if you or your fund manager is willing to sell commodity options and hold through expiration, your odds of success leap substantially from just going long or short the market. Thus, there may be more reasons than just diversification for considering commodity options in your asset allocation.
James Cordier and Michael Gross
Liberty Trading Group
(800) 346-1949
http://www.libertytradinggroup.com/
HYPERLINK "http://www.optionsellers.com/" www.optionsellers.com
James Cordier is head trader and president of Liberty Trading Group, an investment firm specializing exclusively in option writing on commodities. James’ market comments are featured by several international financial publications and worldwide news services including The Wall Street Journal, Yahoo Finance, CNBC and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, HYPERLINK "http://www.optionsellingguide.com/" The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
Be sure to watch Liberty Trading Group’s James Cordier discuss option selling on commodities – Live on CNBC from May 31, 2007. The full interview is now available In the News page of our website.
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
