There is a catch 22 with trading options. Beginner and less capitalized traders can benefit from options but understanding options requires a more in-depth knowledge of markets and volatility than most beginning traders have. Volatile times create volatile markets that produce daily price swings of significant equity for the average $50,000, or lower, account.
From a money management point of view, allowing more than a 5% loss on a given trade does not make sense. When you consider the average trading range of today’s markets is between $1,000 and $4,500 per contract, 5% does not buy much time if your trade starts out the wrong way. If the market goes against you for three days you might lose 25% of your account with one contract and find yourself needing to get out to preserve capital when you are wrong the market. If the markets turn around, it is hard to get back in for a worse price and still not have security if the trade once again moves against you. How do you get a known risk and buy the time needed to see if your trade idea will work? Options!
As noted above, the trouble with options is that if you do not know the basics, you could be right the market and wrong what you do. Starting out with a simple strategy with a known risk that can buy you the time needed is a vertical spread, which involves buying one strike and selling another, having the same expiration date. This reduces the expense of time decay if you want to go out six or more weeks until expiration and the significant difference in price of the same option without selling an option against it. The sacrifice is you also have a known (limited) reward.
The fundamentals for soybeans are bearish based on the September U.S. soybean stocks to use ratio of 7% (based on a 205 million bushel carryover) that suggests a 2009 price of $6.50 vs. the USDA’s November 2008 forecast of $9. Keeping it brief, the funds are not investing in the grain market as they were last year. Worldwide economies are slowing and commodities in general have ended an almost seven-year rally.
The two factors that could make soybeans rally significantly from here are if the U.S dollar falls out of bed, and/or if the hot/dry weather in South America persists. You witnessed what the soybean market could do in 2008 when we received too much rain during the planting season. Even though with an Indian summer we had a great crop, while it was raining the market was betting the weather would not be as perfect as it turned out to be. Unless you have a known risk to protect you from unlimited losses to the upside, it is hard to be short.
Because I believe soybeans will come down in price going into March 2009 unless the factors mentioned come into play, I want to buy a put spread to reflect that way of thinking.
On Friday Dec. 26, March soybeans settled at $9.565. March options expire on Feb. 20. The March soybean $9 put settled at 35.5¢ and the $8 put settled at 11.25¢.
The easy, plain and simple strategy is to buy a March $9 put and sell a March $8 put for 24.25¢. You pay 24.25¢, which is the difference between the $9 put you bought and the $8 put you sold and collected money from the sale. If you buy the $9 put alone it would cost 35.5¢. Alone or spread, both have the right to be short March futures from $9. The spread limits your profit if right as well as if wrong.
Bottom line is that the risk is the 24.25¢ that was paid, and the most it can be worth is $1 (see chart) if at $8 or lower on expiration day (about 3 to 1 risk/reward ratio). You can get out of an option or spread at any time, or morph into another strategy if your thoughts change. Each $.01 is $50. (5000 bushels X $.01 = $50)