Picking a low in any market can be quite profitable for a trader who times it right. Unfortunately, it is also difficult. The road to riches from picking lows in bear markets is littered with the financial corpses of those who got their timing off by even a hair. It’s nearly impossible in futures unless you have deep pockets and nerves of steel. There is a better way to play this without assuming the risk of an outright futures position, however.
In most cases, buying options is a sucker bet. Too many new traders get lured into it as a low-risk way to play the futures markets. (“Your losses are fixed!”) However, buying options has a low success rate. The odds are high that long runs of small losing trades eventually will empty your trading account.
A better route is selling options. Yes, you take on more risk than buying, and the profit potential is limited. But by selling an option, you put the odds of success in your favor. And the risk can be managed. You just have to do it yourself.
Here is how it works. If trading a harvest low in corn, you would begin looking at put options in October for the corn market. How close or far away your strike is from the actual price of corn is dependent on your risk tolerance. The object is to pick a price level that corn will not reach and sell a put option at that strike price for a specified premium. If the option expires with the value of corn anywhere above that strike price, your option expires worthless and you keep the premium as your profit.
The downside to this strategy is that if you’re wrong and corn prices tank, the value of your option will increase. You might have to buy it back at a loss, depending on how much you are willing to lose. Decide how much you are willing to risk prior to entering the trade. If the option increases to that value, buy it back.
The upside is that you do not have to pick the low in corn to be profitable. You can be way off in your pricing or timing and still make money on your trade. If you sell a put option 50 cents below the market, corn can keep falling and you can still hold your option. All corn has to do is be anywhere above your strike at expiration and you win. The high odds and forgiving nature of short options is what attracts many sophisticated investors to the strategy, as long as they are comfortable managing their own risk.
The USDA projects average on-farm corn prices to be from $4.40 to $5.20 for the 2013-14 crop. As a trader, looking to sell puts on the March contract below that range seems to be a high-odds proposition. Sell further away if you seek less risk, closer if you seek higher premium.
Experience shows that premiums in the $400-$500 range work well for corn. You likely will have to go out to the March contract to get them. That’s OK. As an option seller, time is always on your side.
Michael Gross is co-author of McGraw Hill’s “The Complete Guide to Option Selling.” Email him at email@example.com.