Commodity Market Forecasts - How Do I Trade Them? - Part 2 - Decrease Risk And Increase Staying Power

Producing a high probability trade forecast is not easy. Just as difficult is determining the best trading strategy and vehicles to capitalize on the forecast. Read on to learn some of my favorites trading strategies.

Another method to trade a projected move is to write a commodity option and protect it with another one of a different time frame. The choice depends on the price of the options and their time curves.


Let s take an example. I remember a time when sugar was selling for about 6 cents and you could cheaply a buy 7-cent call out for 12 months. There was barely any premium in them. At the time you could sell the close in 2 month sugar 6.5 calls for a reasonable premium and continue to repeat this until the 12 month call expired. This would permit about six hedged writes over a year s time.

These were low risk commodity option trades because the risk was only $625 a trade, being protected by the long call. Finding a long term insurance policy option like this and using it to keep rolling over short term options writes is a great technique.

This technique will not work if the market is real active and running, but if you catch a market that is asleep, buy the cheap, far-out in time hedge. If the commodity futures market then comes to life and option premiums expand, you will do even better to cover the option writes and hold the original call for the rally.

The opposite of this method can sometimes be the right choice also. Let s say you expect soybeans to trend higher over time. If we write a close in strike put option with lots of time, we will collect a hefty premium. If the market is destined to trend higher, then the biggest risk is probably within the first month or two. If we can make it through the first two months, perhaps the underlying futures market will have gone far in our favor.

Buying a cheap put that has only a month or two until expiration will give us the needed protective hedge. After two months, if the market makes a favorable rally, we will be out of immediate danger as the short-term put option expires.

By doing this we pay a small premium for insurance, but get to keep the majority of the initial write premium in the following months, assuming the market holds firm or continues to rally.

Bear in mind that simply writing commodity options without predicting direction is a wash over the long term. Generally, the commodity market will not pay you simply to sell options in a range. You need to be useful by taking on risk. If simply selling options in a range worked profitably for the long term, everyone would be doing it and eventually the premiums would erode to the point of being minuscule.

There are other commodity option trading methods such as buying a call and selling a higher call to help pay for the first. And there s a high-risk method of buying a call and selling two puts to fully pay for the call but this is like holding two naked long futures and is not achieving our goal of reducing risk.

I find the best method for developing an option strategy is to first find a high probability, low risk futures trade. You MUST forecast direction to get an option edge, even when writing them. This forecast can even be a chopping market to write options or trending market for option position trades or spreads. Then use option analysis software to scan for the best option combinations to do the job.

Some traders make the mistake of relying entirely on the option analysis program to find undervalued or overvalued options, etc. But options are often that way for a reason and the market is reasonably efficient. You need to know direction.
Sometimes the forecast is questionable or the options are too expensive for buying or too cheap for selling, etc. It's all a balancing act to finally come up with the optimum plan for a particular market.
More on this in later articles.

Part Three of Three Parts - Next

By: Thomas Cathey

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Thomas Cathey - 27-year trading veteran heads the managed futures division of Thomas Capital Management, LLC. View his market forecast TimeLine Trading charts and get his complete 44+ lesson, "Thomas Commodity Trading Course - all free." www.thomascapitalmanagement.com/commodity/welcome.htm Main site: www.ThomasCapitalManagement.com