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An Options Strategy

For Trading Explosive Commodity Moves

Two important points on this trading strategy to begin with;

  1. If you're not patient and want short term action then it's not for you
  2. Most people who buy options lose their money overtime
The reason option buyers lose money overtime is mainly due to -
  1. They don't fully understand how options work and their inherent advantages/disadvantages - See - an introduction to Options
  2. They have little or no idea of the critical role that volatility plays when pricing options and therefore tend to buy expensive options - Click here for more information on option volatility

Commodity Options - Occasional explosive profits

Commodities are interesting speculation vehicles.

The laws of supply and demand are generally more pronounced than in financial markets which means prices can really get out of control from time to time. For example, if the weather seriously effects the planting, the growing or the harvesting season in Cocoa/Coffee/Soybeans etc prices can literally double overnight. And you don't get these moves in the stock indexes.

The Option strategy

The trading strategy is simple. It attempts to buy long dated call options (long dated = a long time till expiry) when a commodity's price has been sliding for many months, if not a few years. Price should also be making multi-year lows.

When that happens, you buy deep out of the money calls with at least 1 year till expiry. The assumption is that commodity prices trade in cycles and nothing stays high or low forever.

How to find the commodities to trade

As indicated at the beginning of this article, these types of trades happen infrequently. Perhaps 1 every few years. So you don't need to do a lot of research.

At the beginning of every month I visit TradingCharts.com and then look at the following monthly charts -

If you look on the website you'll see other commodities listed but their volumes are too small to be considered for option trading.

It therefore takes me about 15 minutes to quickly scan for something interesting, ie a market that has been falling for many months, if not years, and is also at multi-year lows.

Rules and Guidelines
  • Look to buy call options when the market is either at multi-year lows

  • Option volatility in the commodity options market often works in reverse to stocks. With stocks, volatility will usually rise when prices decline and vice-versa. This is because fear gets magnified during market declines. But commodities have a finite supply so fear usually increases when prices rise. Perhaps the market starts to think there might not be enough supply to satisfy demand

  • Do not enter into these trades when option volatility is high, but as the market will be at multi-year lows chances are it will be at low levels

  • Research is not important into the commodity in question. Plus, most research is normally price driven, for example if prices are declining the majority of research reports will suggest lower prices and vice-versa

  • Buy call options with at least 1 year in duration

  • Don't haggle too much about the bid-offer price, expect the market makers to overcharge you a few ticks. For example if the fair price of an option is 25 ticks, don't worry about paying 27 or 28 ticks

  • Do not follow the market daily as it will only drive you mad. This is a long term trade so it doesn't really matter what happens today, this week or even this month

  • The strategy will not work overtime if you take small profits on the majority of your trade. You're looking for 500%+ profit rather than 100-200% - these sound a lot but they're common with commodity options if the underlying rallies sharply

  • If the market does make an explosive move higher it's a prudent move to sell at least 25% of your options to lock in some profit

  • Another good time to sell a further 25% is if you see the papers start publishing articles on the commodity in question on their front pages (financial section is ok)

  • If the trade works the remainder of the position should be sold in stages if/when the market goes parabolic - i.e. up in a straight line

  • Money Management - A sound strategy is to risk 1%-3% of your total investment portfolio on any one of these trades
Finally only play with money that you can afford to lose. It's quite probably the strategy loses money for a number of trades before raking in a mega profit.
Summary

The market conditions for these trades, prices slumping month after month + prices reaching multi-year lows, don't happen that often in the commodity markets. But when they do the risk/reward is often excellent, so good that it's possibly a crime to not buy some call options.

But you must be patient alongside having a good grounding of how options work and specifically the role that volatility plays when pricing an option.

Finally, these option trades make sense. Nothing stays low (or high) forever and you're hoping that a market in the doldrums gets set alight and explodes into action at some stage in the future. But if there's one downside to the strategy it's related to the problem of buying options, ie the importance of timing.

And this is why it's important to buy options with at least 1 year till expiry.

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