Many traders contend that the number one rule of trading is to only risk money you can afford to lose. This advice goes beyond trading; it is a truth for starting any business. When it comes to trading specifically, a more apropos rule is this: Put the odds in your favor. But it’s fair to ask: What are the odds? And how, exactly, do you put them in your favor?
One advantage that physical commodities have over many other trading vehicles, such as stocks and bonds, is that most can be directly affected by seasonal tendencies. This can be based on many factors related to production and demand. Production factors might be growing seasons, weather-based shipping schedules, hurricane season or livestock birthing cycles. Demand factors might be based on business calendars, seasonal consumer preferences or heating and cooling days.
What this means on a practical level is that during every calendar year, as these seasonal factors conspire to move a market in one direction or the other, each commodity has a bias to rise or fall at different times. Of course, these repeating production and demand factors are not the only variables that move markets. Many bucket shops ensnare suckers by claiming they can take advantage of seasonal energy demand by buying into winter and waiting for the check once the snow comes. It is never that simple. However, seasonal tendencies are real and the bias they create is reflected in historical analysis for many markets. For traders, this means they don’t have to understand the fundamental rationale behind a particular move or bias, they just have to know it exists to put the odds in their favor.
One obvious market to explore for seasonal tendencies is corn. Millions of acres are planted every spring and harvested in the fall, year in and year out. “Corn over time” (below) is a seasonal chart for the corn market that is based on 55 years of cash prices.
The corn market is biased toward setting an annual low in the fall and peaks in early summer. It’s important to remember that this chart is a composite, and no one year necessarily matches this composite directly. Some years have been bull years, while others have been bear years. This is shown by the chart at the bottom of the graph. Even if a commodity has followed its historical seasonal tendency in nine out of 10 years, it is no guarantee that prices will rise in the 11th year.
So what? Once presented with this information, you should now be asking, “How can traders make money with this knowledge?” In the most obvious sense, if traders thinks it is a typical bull year, they would want to go long corn in the fall, when it’s traditionally at its seasonal low price, looking for an increase in prices into the following June.
Whatever your approach, you must manage your risk in every trade and evaluate a position based on the risk and reward expectations you have for it. For example, a lot of traders preach the rule of thumb that trades should only be considered that have a two-to-one or three-to-one measure of potential reward versus potential risk. Again, achieving this is easier said than done, and it depends on the likelihood of being right on the direction of the trade.
Seasonal trades, in theory, put those odds in the trader’s favor. Some trades, if they are promising enough, can be entered if they offer only one-to-one reward versus risk. A trader can take them with the confidence that the historical odds are on the side of being right.
With corn, if you expected the market to follow its seasonal bias, you would buy corn futures contracts at the beginning of October with the hope that prices would rise without taking too much of a dip in the meantime. The required margin (currently $2,025 initial, $1,500 maintenance) would be necessary.
Such a trade is not a place-it-and-forget-it proposition, however. It’s important to realize going in the risk you face to maintain this trade. Every time corn ends the day one cent lower per bushel, the trader must deposit $50 in his or her trading account to cover this drawdown. With the current daily price limit being 20¢, a trader may have a margin call of as much as $1,000 (20 cents x $50 for each penny) in a single day. The trader must put up that additional money quickly or be forced to liquidate the position at a loss.
There’s also the possibility that you are right, just not right enough. For example, corn prices may only rise 20¢ between October and the next June. The trader had to invest the initial margin of $2,025 and maintain that position in the face of any dips that occurred in the meantime, creating a less than one-to-one edge.
There is another way to get more bang for your buck, however.
Options on futures allow you to put up less money, incur less risk and potentially enjoy greater profits. A call gives you the right, but not the obligation, to assume a long position in the underlying at the option’s strike price. A put gives you the right, but not the obligation to assume a short position. Most options traders, however, don’t assume those positions. Instead, he or she trades (buy and sell) the options contracts themselves as they gain and lose value in the marketplace.
In practice, when a trader buys an option, it works like buying a piece of the futures contract. At worst, the trader can lose only that piece they buy, nothing more. There can never be a margin call. The size of the “piece” bought depends on several things, mainly the contract month and strike price of the option. But the best part of buying options is that the trader can only lose the amount paid for them. This is known as a premium, and if the market goes in the expected price direction, the “piece” of option bought, or the size of the premium in the marketplace, gets bigger and the trader can sell at a profit.
Seasonal tendencies are never a sure thing. A trader must first have his or her defense in place before going on the offense. Relying on option buying strategies is an automatic way of accomplishing this because you can only lose the price you paid. Buying an option or option spread limits the potential loss to the dollar amount invested.
Here are two ways an options play might be constructed, assuming a trader thinks that that corn will follow seasonal tendencies: lows in October and highs in June.
In early October, a trader could buy March, May or July 2011 corn calls 30¢ higher than current prices. Don’t just rely on the premium as your stop-loss, also set a dollar amount that you are willing to risk. This depends on your account size and risk tolerance, but many traders have a per-trade risk of 2% to 5% of their total risk capital.
The advantages of this position are that it has unlimited upside profit potential, the position cannot lose more than what was paid for the option and the position allows a lot of time for prices to work higher. The disadvantages are the options themselves will be expensive because they are so far from expiration (they have a lot of time value), and there may be a higher cost for them due to increased implied volatility. Finally, the liquidity of these far-from-expiration options may be limited and the bid-ask spreads may be wide.
Alternatively, in early October, a trader could buy a March, May or July 2011 bull call spread. Choose the call 30¢ higher than the current month’s prices. For example, if March 2011 corn is trading at $4, buy the March $4.30 call. To reduce the cost and risk (and potential profit) simultaneously, sell an equal number of higher March calls, from 10¢ to 30¢ higher ($4.40, $4.50, $4.60). This would give the position a “window” of profit, but also a ceiling. Again, the idea is to exit the trade before the expiration date, and the trader should set a dollar amount that he is willing to risk as a stop loss.
The advantage of this position is that it could profit by an increase in corn prices over a few months without any greater risk than the cost of the net debit for the spread. This spread debit cost is usually much less than the cost of purchasing the call options alone. In some cases, several spreads could be purchased for the price of a single call option, increasing leverage with no extra risk. Depending on the current option prices and a few other factors, the trader may be able to enter such a call spread for $200 or less with a potential profit of $500 or more. The position also limits the risk of paying too much for the options based on volatility and the bid-ask spread for each option.
The main risk is that this position will not make as much profit if corn prices make a strong move above the higher strike price of the short option. There also is the outlay of two commissions instead of one for the spread. Nevertheless, this is a strong, conservative way to trade because there aren’t many years when corn prices make a huge up move.
Many commodities have seasonal tendencies. It would be worthwhile to study each market. Some, such as orange juice and coffee, have had spectacular moves as the result of supply-side shocks. These are markets that face seasonal frost issues that tend to cause a spike in volatility regardless of whether the crop faces serious danger. This makes the use of options even more ideal. Both of these markets also tend to make seasonal price lows in early October (see “October lows,” below). Trading options on those markets have a lot of advantages over futures, as well.
Again, there is no sure thing and all trading entails risk, so always use stop-loss orders and plan for the worst to happen but keep the odds in your favor.
Daniel L. Harris was an independent floor trader and member of the Chicago Mercantile Exchange for 13 years. He now trades off the floor and occasionally publishes trading ideas on www.onceadaytrader.com.