Back in the March issue of the LearnMoney newsletter an article was published labelled 'Buying Commodity Options For Explosive Profits'. It was suggested that restricting oneself to always buying options was generally a losing proposition over time. But occasionally excellent trading opportunities arose where buying call options made good sense and have the potential to result in explosive profits.
It was proposed in the March article to look at commodities and buy long dated out of the money calls when the price of a commodity is at historical lows. The reasoning was simple, commodities have a finite supply and can also be affected by weather, shipping and supply problems etc. This in turn means that sharp price increases can and do occur, often out of the blue.
These types of trades though do not always work but the profits when generated can run into several hundred percent. It therefore possible that one could get just 1 or 2 trades out of 10 right and still make excellent money, reflecting George Soros' maxim that 'it doesn't matter whether you're right or wrong, only how much you make when you're right and how much you lose when you're wrong'.
The other advantage about buying calls in these types of situations is that although you are trading in (commodity) markets that can be extremely volatile, your risk is 100% defined at the cost of the option(s).
The Current Sugar Market
Back in March of this year Sugar fitted the bill perfectly for this kind of trading and we purchased a combination of the July 2005 8.5 Cent and July 2005 9.0 Cent call options. The two options were priced at around 19 ticks and 14 ticks which equated to $213 and $157 respectively (1 tick is worth $11.20).
As can be seen from the above chart the price of Sugar has had an excellent run up to stand last night at $8.73 basis the July contract. The move since March has translated into options prices of 94 ticks (8.5 calls) and 63 ticks (9.0 calls), gains in excess of 350%.
As indicated in the original rules for the strategy 25% of the options have been sold to lock in a profit therefore making it impossible for the trade to now lose money (breakeven is now our worse case). A further 25% will be sold if the price of Sugar advances anymore combined with receiving some media attention. Apart from that we think that there's a good chance that Sugar will and can go a lot higher.
Generally this has been an excellent trade and we are writing about it not to pat ourselves on the back rather to highlight the potential of another similar commodity option trade that is starting to appear on the horizon. Incidentally it was noted in the original article that the majority of these trades will actually lose you money. But the reason the strategy is likely to be very profitable overtime is that when things go right profits are explosive and more than make up for the small losses experienced on losing trades.
