An Introduction to Popular Commodity Option Trading Strategies

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? 

Years of witnessing the perils of a long option only strategy as a commodity broker led to my disappointment and pessimism in regards to a strictly option buying approach to the commodity markets.  Time decay and the tendency of markets to stay range bound work strongly against the odds of consistent profits with such a strategy. 

As you read this article, please keep in mind that this is simply an introduction to the alternative commodity option strategies available to those willing to move away from the conventional practice of simply buying a put or a call.  The beauty of option spreads is the flexibility and unlimited ratios of risk and reward that can be constructed by creative futures traders.  We hope that the commodity option trading methods in this article were written in a way that is meant to be easily understood and even more importantly easy to employ, but expect that you will have many questions and will be more than happy to answer any that you may have.  We can be reached at www.DeCarleyTrading.com. 

The Basics - How Options on Futures Work

There are two types of options, a call option and a put option. Understanding what each of these are and how they work will help you determine when to use them.  The buyer of an option pays a premium (payment) to the seller of an option for the right, not the obligation, to exercise.  This financial value is treated as an asset, although eroding, to the option buyer and a liability to the seller. 

Call Options – Give the buyer the right, but not the obligation, to buy the underlying at the stated strike price within a specific period of time.

·         Buyers face risk limited to the amount of premium paid plus transaction costs and unlimited profit potential

·         Sellers face unlimited risk beyond the strike price of the option and profit potential limited to the amount of premium collected minus transaction costs

Put Options – Give the buyer the right, but not the obligation, to sell the underlying at the stated strike price within a specific period of time.

·         Buyers face risk limited to the amount of premium paid plus transaction costs and unlimited profit potential

·         Sellers face unlimited risk beyond the strike price of the option and profit potential limited to the amount of premium collected minus transaction costs

Traders that are willing to accept considerable amounts of risk can write (or sell) options, collecting the premium and taking advantage of the well-known fact that more options expire worthless than not.  The premium collected by a seller is seen as a liability until it is either offset by buying it back, or it expires.  This is important, many beginning option sellers assume that because they receive the cash up front and they can see the amount of collected premium added to the ledger balance on their account statement, that it is somehow theirs.  Until the position is closed, the only thing that is certain is that there is risk on the table and the trade should be treated accordingly; this is the case regardless of the amount of money collected for the option or the amount of any open profit associated with the option.

	Call (Bullish)	Put (Bearish)
Buy			Limited Risk
Sell			Unlimited Risk