Due to strong demand, rising fuel and input costs and restrictions on world exports, agriculture markets have experienced record volatility in recent months. One way to profit from price volatility while limiting your risk is through the use of options.
There are many advantages to trading options instead of the underlying futures. Controlling risk, particularly in today’s volatile markets, is one of the greatest advantages.
“In today’s hyperactive volatile markets, the advantages [of options] are the ability to manage risk and time,” says Howard Tyllas, a Chicago Board of Trade member and commodity trading advisor. “Futures trading in today’s world [takes place] in some of the most amazing markets I’ve ever seen. I’ve seen sectors and markets move like they’re doing now, but not all at once and at such a long time period with no end in sight.” Tyllas says these market conditions are “exactly what options were made for.”
Average true range (ATR) is a measure of volatility and is often used in determining where to place stop loss orders. As you can see in “Another world” the ATR, which most commonly is a measure of the average daily range over the previous 14 periods, in soybeans has quadrupled since the beginning of 2007 and has increased even greater for wheat. A market could be expected to move within its ATR without altering the prevailing trend, which is why a trader may place a stop just outside of the ATR. But while an ATR of 12¢ would require a trader to risk slightly more than $600 for a one lot trade, an ATR of 50¢ would require that trader to risk more than $2,500. This means the trader would either have to place her stop closer and risk being stopped out of a trade that would have eventually been a winner or put all her proverbial eggs in one basket. This makes commodity options worth exploring.
Mark Longo of The Options Insider.com notes that margin requirements on futures contracts can be expensive, but commodity options let futures traders reduce risk in their portfolios and “allow market participants to trade commodity contracts with smaller initial investments and with much higher leverage.”
James Cordier of Liberty Trading Group also cites lower margins and lower risk as two of the benefits of options. “Commodity options offer traders the opportunity to participate in the futures arena with lower margins and often lower risk than in the outright futures contracts,” Cordier says.
An option on a futures contract gives its holder the right, but not the obligation, to buy or sell the contract at a specified price on or before its expiration date. There are two types of options: a call, which gives its holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call option is in-the- money when its strike price is less than the futures contract price, at-the- money when the strike price equals the contract price, and out-of-the-money when the strike price is greater than the contract price. The reverse is true for put options. When you buy an option, your level of loss is limited to the option’s price, or premium. When you sell an option, your risk of loss is unlimited. Levels of risk in options depend on numerous variables such as how close the strike price is to the price of the underlying, the amount of time value and the Greeks (see “Options glossary”).
“If you’re someone who’s really risk averse and conservative, you might wish to buy an option because your maximum potential loss is limited to the amount that you spent to buy the option. If you’re someone who’s more sophisticated, with a higher risk appetite, you might move into selling options,” says Dan O’Neil, executive vice president of futures at optionsXpress.
But you need to remember that trading is a game of risk and reward. You pay a price for reducing your risk. While buying out-of-the-money options does reduce your risk, it also requires a larger move in the underlying for that option to show a profit than if you purchased an at-the-money option or simply traded the underlying. This is a function of delta (see “Options glossary”). A common refrain of neophyte option traders is, “The market moved the way I expected but my strike price didn’t go up.”
Michael Gross of Liberty Trading Group says that there are ways to reduce risk in options selling and that in the end it’s still less risky than trading futures. “Option sellers take on the same risk as futures traders — in theory. However, the fact that out-of-the- money options increase in value slower than a futures position means that selling options is still a much slower trade than trading futures. Option sellers can obtain limited risk in their trades too, however, through the use of covered credit spreads,” Gross says. Covered credit spreads occur when you sell an option for premium, and then buy a further out-of-the-money (cheaper) option for protection. The difference between the two is called the credit. The credit becomes the option sellers’ profit if both options expire worthless. Cordier and Gross say covered credit spreads are “a way to get the best of both worlds — the high percentages of selling options combined with the limited risk aspect so important to mainstream investors diversifying into futures.”
Since option prices increase as volatility increases, levels of volatility can determine whether you wish to buy or sell. “Volatility can be an asset or a detriment depending on how you like to trade and how you structure your option positions,” O’Neil says. “If you have bought options, you want to see an increase in volatility because option values will rise. If you think volatility’s high, you’ll want to be a seller of options because…you’ll benefit when volatilities decline.” Cordier says, “Sellers can benefit from high volatility as they can typically sell options at strikes further out of the money.”
One strategy that some traders use is the protective put, which is buying a put option along with a futures contract. The put option acts as an insurance policy in case the market goes down. O’Neil explains, “if the market does go down, you’re going to lose money on your futures contract, but your put option is going to increase in value, so you’re protected to the downside. If the market goes down, you have protection, but if the market goes up, you make money on your futures position.” This is a good strategy if your ideal stop price is outside of your risk tolerance.
Another popular strategy is a covered call strategy, wherein you buy a futures contract and sell an out-of-the- money call option. Likening this strategy to a limited insurance policy, O’Neil explains that if the market goes down, you’re going to lose money on your futures contract, but the call option you sold is going to expire worthless and you get to keep the amount of money that you received from selling it, providing a cushion to the downside. “In exchange for getting that cushion to the downside, you’re also limiting your upside potential. If the futures market rises, you’ll make money on your futures contract until the market reaches the strike price of the call option that you sold, and at that point, your profit option would be capped. So you’re giving up some of the upside potential in return for limiting some downside potential,” he says.
Longo says the protective put strategy can become expensive in the midst of high volatility, so he suggests that traders offset the expense by combining the protective put with a covered call. In this position, known as a collar, “the revenue from the covered call increases your downside protection and also offsets the cost of the protective put,” Longo says, adding that the collar position “is very popular with fund managers and others looking for low-cost ways to reduce their portfolio risk.”
Tyllas says the best options strategy to start with is a vertical spread, which is purchasing one strike price and selling another strike price at the same expiration date. He suggests keeping a journal of settlement prices of the options and comparing them to the settlement prices of futures on a daily basis. “You’ll learn more through that observation than reading 20 books about what a vertical spread is,” he says.
According to O’Neil, commodity options are gaining in popularity with equity options traders. “We’re seeing a lot of equity option traders migrate over to commodity options because commodities are so much in the headlines and because people tend to gravitate to where the action is,” he says, adding that the principles, strategies and knowledge on the equity options side can be easily transferred to options on futures.
“When used properly, options actually reduce the risk of equities or futures portfolios,” Longo says.
If you are thinking of venturing into commodity options, be aware of the risks involved and start slowly. “Start off small,” O’Neil advises. “Develop a strategy, build your confidence, and then consider increasing your trading and position sizes.”
While options, in general, are a tool to trade the markets with less exposure than outright futures, they are more complex and must be understood or they can actually increase your risk. Trading is a game of risk management. The greater risk you take, the greater potential reward and usually each step to reduce your risk reduces your potential reward.
