A Brief Introduction to Options

The world of options is diverse and cannot be given justice in a short article such as this.  The purpose of this writing is to simply introduce the topic.  Should you be interested in getting involved or learning more, please consider purchasing "Commodity Options" published by FT Press at www.CommodityOptionstheBook.com.

Why Trade Commodity Options?

Just as there are several ways to skin a cat, there are an unlimited number of ways to trade in the options and futures markets.  The method that you choose should be based on your personality, risk capital and risk aversion.  Plainly, if you don't have an aggressive personality and a high tolerance for pain, you probably shouldn't be employing a trading strategy that involves elevated risks.  Doing so will often results in panic liquidation of trades at inopportune times as well as other unsound emotional decisions.

Commodity options provide a flexible and effective way to trade in the futures markets.  Options offer investors the ability to capitalize on leverage while still giving them the ability to manage risk.  For example, through the combination of long and short calls and puts an investor can design a strategy that fits their needs and expectations; such an arrangement is referred to as an option spread.  Keep in mind that the possibilities are endless and will ultimately be determined by a trader's objectives, time horizon, market sentiment and risk tolerance.

Alternative Commodity Option Trading 

Options offer traders an unlimited number of strategies with various levels of risk and reward.  Unfortunately, many retail traders are stuck in a long option only "rut" and may not be aware of the potential flexibility offered by alternative option strategies.  There is certainly a time and a place for buying outright options, but in my opinion most circumstances seem to favor an alternate approach.   

The purpose of this article is to briefly outline a few of my favorite option strategies in an attempt to introduce you to the possibilities.  It is not intended, however, to provide you with all of the tools and knowledge that you will need to immediately participate in the markets with this new found knowledge.  Nonetheless, I believe this to  be a valuable stepping stone and hopefully an eye opening experience.

This writing is a small sample of the possibilities available to traders through option trading.  For a more comprehensive explanation of these and alternative option strategies be sure pick up a copy of "Commodity Options" which will be on the shelves in early 2009.  We will also be adding a series of option trading educational articles to this site. 

 How to create a Synthetic Put

The term synthetic is often used to describe a manmade object designed to imitate or replicate some other object.  Futures and options traders can do the same thing by creating a trading vehicle through a combination of futures and options to replicate another trading instrument.  You may be asking yourself; why you would go through the hassle of mimicking an instrument instead of simply trading the original?  The answer is simple, as the creator of the vehicle, we can customize it to better suit our needs as well as design it to better take advantage of the underlying market. 

Through the creation of a synthetic position, you can actually decrease your delta as well as, in my opinion, increase the odds of success.  Let's take a look at an example of a long synthetic put option. 

How to Construct a Put Option Ratio Spread

Options are eroding assets; therefore it isn't always wise to spend a lot of money to purchase an option that will face depreciation as well as dismal odds of success.  Instead, it is often a better idea to sell options of different types or strike prices in order to pay for those that you would like to purchase.  A put ratio spread does just that.  A trader that is interested in buying a put option in hopes of a market decline or to simply protect other positions in their trading portfolio may finance their purchase through the sale of two distant strike priced puts.  Here are the details of a put option ratio spread. 

An Introduction to Popular Option Trading Strategies

by Carley Garner of DeCarley Trading LLC

There have been many books written on options on futures trading, however I sometimes question the usefulness of the information provided.  It seems as though much of the literature available leaves the reader in a state of confusion; perhaps a majority of the bewilderment stems from the fact that most option theory is based on stock option trading and the transition to commodities isn't without its hitches. In my opinion, the practice of repackaging stock option trading strategy and theory in an attempt to appeal to and educate commodity traders can be misleading.  Additionally, there are large differences between option theory and option trading.  Some of what looks good on paper is difficult to execute efficiently in the real world, this is especially true in the world of commodity option trading.

It is a false assumption to believe that an “option is an option”.  They may be spelled the same, but they are vastly different due to the nature of the underlying vehicles.  As a result options on commodities take on completely different characteristics.  After all, everybody agrees that trading stocks is poles apart from trading futures. Why would anybody believe that trading options on stocks is synonymous with trading options on futures? 

Option Volatility Trading with the VIX 

The adage buy low and sell high was originally used in reference to price, but can also be applied to the practice of trading volatility.  In fact, even as an option trader looking to trade market price as opposed to volatility, ignoring measures of potential explosiveness while entering or exiting a market could mean financial peril.   While many traders, whether beginner or pro, understand the concept of buying options during times of low volatility and selling them during times of high volatility, emotions often lead a well planned strategy astray.

Unlike traders that are looking to profit from a directional move in price, volatility traders are more interested in the pace at which the market is moving than the direction.    However,  I argue that it is important to chart both price and volatility.  Doing so provides trades with a better understanding of the 'big picture'.