Premium Sellers: Beware of widow makers

There are two markets that are clearly much scarier than others in terms of selling calls in the commodities space: Natural gas and coffee. The reason for this is simple: they have a history of putting traders out of business. Repeating history, in February both of these markets were extremely volatile. For example, on Jan. 21, March natural gas traded as low as $4.203, by Feb. 24 the same contract traded to $6.493. That is 54.5% move higher in just over a month! Natural gas is not a small contract, a 1¢ move equals $100.

Based on the price jump just discussed, that is $22,900 per contract. As shown by the monthly natural gas chart (below), this is not the first time or the most drastic example. In 2005, natural gas traded as high as $15.78. In 2008, it traded as high as $13.694. In 2012 it traded as low as $1.902. And this is where experience truly pays. Sell calls in there? No Thank You!

 

The Coffee market has not been much better historically and also exploded in February. On Jan. 29, March coffee traded at $1.16. On March 5, coffee traded to $2.04. That is almost 76% higher in just over a month. With a 1¢ move or a $375 value change. The move from $1.16 to $2.04 amounts to a $33,000  per contract. This is scary stuff, and not unheard of historically as the chart below shows.

 

While there are rewards to be reaped, selling premium is not an easy investment strategy and chances are that anyone who’s telling you otherwise has not been able to produce solid returns and manage risk consistently over a long period of time. This is a space where experience and disciplined risk management really pays, as the widow maker examples of natural gas and coffee show.

Those markets, however, are not alone. Study the moves made in lean hogs, live cattle, wheat, soybeans and sugar in February just to name a few. My advice to anyone interested in premium selling is to understand that sharp moves in commodities will almost always go further than you think possible. Be patient and have a defined risk management model in place for when a trade explodes against you. Act like a robot when exiting or rolling and do not be a deer caught in the headlights. Of course that is easier said than done, but take it from me, someone who has learned these lessons the hard way.

 

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About the Author
Robert Schroeder

Head of Global Futures and Options Execution at RCM Asset Management and Principal at Side Op LLC, began his career in 1995 on the trading floor of the Chicago Board of Trade (CBOT) before moving to First American Discount Corporation in 1997 where he focused on technical analysis. After First American Discount Corporation was purchased by MF Global in 2000, Robert was head trader of one of MF Gobal’s high-volume desks, focusing on Managed Futures. Robert Schroeder also runs Side Op LLC, and can be reached at rschroeder@rcmam.com.

To learn more about Robert Schroeder’s Side Op LLC trading program and to access a copy of the performance capsule and disclosure document, visit www.sideopcta.com.

TRADING FUTURES, OPTIONS ON FUTURES AND RETAIL OFF-EXCHANGE FOREIGN CURRENCY TRANSACTIONS INVOLVES SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FOR ALL INVESTORS. YOU SHOULD CAREFULLY CONSIDER WHETHER TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR CIRCUMSTANCES, KNOWLEDGE AND FINANCIAL RESOURCES. YOU MAY LOSE ALL OR MORE THAN YOUR INITIAL INVESTMENT. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

 

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