A Brief Introduction to Commodity Option Trading

The world of commodity 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 of options on futures. Should you want to learn commodity options trading strategies in more detail, 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 option trading strategies available in the 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 futures and options 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. Further, options on futures 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 call and put options in the commodity markets, an investor can design a trading 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.

Carley Garner's futures, options, and FOREX trading books have been reviewed by several national publications.  Here is a sample of some of the trading community book reviews.

Learn to trade futures, options, and FX with Carley Garner books!

Carley Garner, a futures broker at DeCarley Trading, is the author of multiple trading books.  The intention of the publications is to compile lessons learned as a long-time commodity broker, and deliver them to readers in simplified and efficient educational material for futures, options, and FOREX traders.  

In line with our commitment to providing free commodity trading education, we've put together a handful of options trading educational articles.  

Whether your strategy involves selling options on futures, buying options, or even a combination of both, we believe the articles in this section will be useful to you.  If you would like to expand on these options trading strategy ideas, we encourage you to read "Trading Commodity Options with Creativity", which covers several options strategies in detail.  

For more information, visit www.TradingCommodityOptions.com 

 It isn't free, but it's close...If having this book saves you 1 tick in the commodity options markets, you have almost recouped your investment.

www.TradingCommodityOptions.com

Amazon

Barnes & Noble

Trading Commodity Options...with Creativity takes readers on an unfamiliar voyage destined to simplify the options on futures markets and arm market participants with the knowledge to employ smarter commodity market strategies.

Many books have been written on options trading, but most focus on the academic side of options suggesting there are black-and-white answers and reliable mathematical formulas to determine profit and loss. Yet, options traders must be ready and willing to deal in gray areas, approximations, and guesswork. Trading Commodity Options...with Creativity bridges the gap between traditional options trading literature and real-life trading examples. Through tough-learned lessons, this book tackles the nearly impossible task of streamlining the process of developing an appropriate options strategy for any market environment and risk tolerance, then making the necessary mid-trade adjustments to improve the odds of success.

Visit www.TradingCommodityOptions.com for more details!

The NASDAQ futures weighed on stocks, but the broad market is marching on.

From a historical perspective, this week is not the time to be a stock market bear. As we've outlined, the market generally likes to move higher into Fed meetings and quarterly futures expiration also tends to put upward pressure on pricing. This is true, at least until the Friday morning Triple Witch. From there, things sometimes turn sour. Thus, the ES bears will likely have better entry points in the coming sessions if they are patient.

We've also heard chatter about a Bradley turn date occurring on the 20th of this month, and others are noting June 26th as a potential reversal date based on moon cycles. We don't normally pay attention to these types of things, but the fact that they coincidentally appear to be in line with the charts make them at least worth noting.

www.HigherProbabilityCommodityTradingBook.com 

Amazon

Barnes & Noble

Carley Garner, an experienced commodity broker for DeCarley Trading in Las Vegas, has followed up her previous three titles with Higher Probability Commodity Trading, a comprehensive futures and options trading book focused on trading strategy development, commodity market analysis, and much more.  

The book received rave reviews from some of the top names in the industry, and we are confident you will enjoy it too! Jon Najarian, co-founder of Najarian Family Office and CNBC contributor, believes this book is "A great read for both beginner and advanced commodity traders."  Tobin Smith, CEO & Founder of Transformity Media Inc, and former co-host of Bulls and Bears on Fox News refers to Higher Probability Commodity Trading as "..an MBA in trading for the price of a few cups of Starbucks!" And Phil Flynn of Fox Business News has declared "If you are only going to read one book on the futures market this has to be it."

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.

Synthetic Long Put Option

Sell a Futures Contract
Buy an at-the-money Call Option

When to Use Synthetic Puts

• When you are very bearish, but want limited risk
• The more bearish you are the further from the futures (higher strike price) you can buy, although a true synthetic put involves an at the money call option
• This position is sometimes used instead of a straight long put due to its flexibility
• Like the long put this position gives you substantial leverage with unlimited profit potential and limited risk

Profit Profile of a Synthetic Put Strategy

• Profit potential is theoretically unlimited
• At expiration the break-even is equal to the short futures entry price minus the premium paid
• Each point market goes below the break-even profit increases by a point

The Risk in Trading Synthetic Puts

• Your loss limited to the difference between the futures entry prices and call strike price plus the premium paid for the option
• Your maximum loss occurs if the market is above the option strike price at expiration

Example of a Synthetic Put Option in the Futures Market:

A commodity trader looking to profit from a decrease in prices but isn't confident enough in the speculation to sell a futures contract, or even construct an aggressive option spread, might look to a synthetic put.
A synthetic put option strategy has nearly identical risk and reward potential as an outright put option, making it a potentially expensive proposition. However, if the volatility and premium are right it can be a great way to sell a futures contract, while retaining a piece of mind, and the ability to easily adjust the position because the purchased call option provides an absolute hedge of risk above the strike price.

A trader that is bearish on the U.S. dollar might opt to sell a dollar index futures contract near 96.60 in hopes of weakness. Should the trader prefer to have limited risk, and be willing to pay an “insurance” premium for protection, might purchase a 97.00 call option for 60 ticks, or $600, because each tick in the dollar index futures and options is worth $10 to a commodity trader.

Click on image to enlarge.

With a synthetic put option in place, the trader can sleep at night knowing the worst case scenario is a loss equivalent to the distance between the future entry price and the strike price of the call option, in this case $400 ((97.00-96.60) x $10), plus the cost of the long option purchased to insure the trade, or $600 (60 x $10).

The payout of this trade at expiration may be identical to a long put option, but the flexibility provided to the trader is unmatched. Unlike a long put, a synthetic long put can be pulled apart prior to expiration in an attempt to capitalize on market moves. Please note that doing so greatly alters the profit and loss diagram.

An example of an adjustment may be to take a profit on the short futures contract and hold the long call in hopes of a subsequent market rally and the possibility of being profitable on both the futures position and the long option. Or, should the trade go terribly wrong from the beginning a trader may look to take a profit on the long call and hold the short futures in hopes of a reversal. Doing so would eliminate the insurance of the long call and leave the trader open for unlimited risk on the upside, but may be justified if the circumstances are right.

If you are in search of a commodity options book that features this option trading strategy, and others, visit www.CommodityOptionstheBook.com. 

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 a commodity 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 commodity 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 in a commodity market before speculating in options. Doing so provides trades with a better understanding of the 'big picture'.

In my opinion, the most efficient means of trading equity market volatility isn't through the VIX index, or any other similar measure. High levels of leverage, a lack of options on futures market, and a tendency for the index value to erode over time are major factors working against the viability of doing so. Instead, I believe that traders should look to buy or sell options on S&P 500 futures, or more specifically the e-mini S&P (symbol ES). The S&P 500 is a broad based stock index and its value is sharply impacted by market sentiment and the corresponding volatility. Thus, a trader that is of the opinion that volatility will increase may look to buy volatility through the purchase of options written on S&P 500 futures and those looking for volatility to decrease may look to sell volatility buy going short options on the index. Accordingly, insiders often refer to the practice of buying or selling options as "going long volatility" or "going short volatility".

Trading S&P 500 Volatility through Premium Collection in the Futures Market

As mentioned, one way to speculate on variations in volatility is through the practice of option selling, often referred to as premium collection. It is important to realize that I am referring to trading American style options which allow traders to buy, sell or exercise options at any time prior to expiration. This differs from the European style versions that offer far less flexibility. The increased level of flexibility tends to have a positive impact on the value of the option and thus the amount of premium collected for selling it. In other words, option buyers may get more value using European style options (referred to as end-of-month options in the S&P) due to lower premiums; conversely this concept works in favor of option sellers of American style options.

Why Option Selling?

Option sellers are in the business of collecting premium, much like an insurance company, under the assertion that in the long run the premium collected should outweigh any potential payouts. This theory is based on the assumption that more options than not expire worthless, which has been suggested by several studies including one conducted by the Chicago Mercantile Exchange. Unfortunately, similar to insurance companies who are sometimes forced to honor their policies on excessive claims, commodity option sellers are vulnerable to monster market moves than can be potentially account threatening. Preventing such disasters ultimately come down to timing of entry along with a good understanding of futures market volatility, market sentiment, and market knowledge. Additionally, experience, instinct and, of course, luck will also come into play. Yet, in my judgment option selling is a superior strategy in the long run.

Futures options selling advocates and equity market volatility traders seem to migrate to the S&P 500 futures market (e-mini S&P). There are other stock index futures such as the e-mini Dow Jones Industrial Average and the e-mini NASDAQ, but the e-mini S&P offers the most liquidity as well as a broader based index with smoother price movement.

CBOE's Volatility Index Futures (VIX)

An important measure of volatility when referring to the S&P 500 is the now infamous Chicago Board Options Exchange's Volatility Index, often simply referred to as the VIX. According to the CBOE, the VIX is a "key measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices" and has become one of the most prominent measures of market sentiment in the world. In “normal” market conditions, the VIX spends a majority of its time below 20. As chaotic price action in the financial markets heat up, the VIX can see spikes into the 30 or 40 levels. However, in historically extreme circumstances such as the 2008 financial crisis, the VIX can trade into the 70s, or even higher.

The VIX futures contract is the sole futures offering on the CBOE exchange. As a result, not all futures brokers offer access to trade it. Additionally, receiving real-time VIX quotes in a futures trading platform isn’t necessarily a given.

The VIX futures market offers contracts expiring each month. The margin to trade VIX futures fluctuates around $3,000 per contract and the point value is $1,000, making it a very volatile holding in any commodity trading portfolio. For instance, fi the VIX moves from 15.00 to 16.00, the trader would have made or lost $1,000 per contract with a margin deposit of just $3,000. If you’ve followed the VIX, you know that it doesn’t take much time to travel a full point. Thus, most traders are probably better suited trading e-mini S&P options, than dabbling with highly levered VIX futures.

Increased values of VIX are highly correlated with higher option premium in the ES (e-mini S&P) options due to inflated expectations of future volatility built into options on futures prices. Assuming he is willing to accept the risk of participating in such a market, times of inflated expectations of volatility, and therefore over-priced options, are ideal conditions for an experienced option seller.

The Quest for Implied Volatility in Futures Options

Unlike the VIX which is derived from the underlying futures price, among other factors, implied volatility is a component of option price. The implied volatility of a futures option, is the amount of volatility implied by the market value, or price, of the option. In other words, the implied volatility is forward looking in that it incorporates the current market precariousness as well as what market participants are expecting at some point in the future.

You may also find that market emotion and sentiment are a component of futures option implied volatility. As long commodity option traders scramble to “buy” volatility through the purchase of options in an attempt to profit from the latest hype, option premiums can and do explode exponentially. As a sidelined options on futures seller, these types of conditions should be inviting. The premise of this approach is to attempt to sell options to buyers that are simply "late to the party". The key is making sure that as a seller you aren't too early.

Selling Puts can be Lucrative, but the Option Strategy Comes with a Hefty Price Tag

It is often the case that selling puts is more lucrative than calls, but the added reward carries baggage in the form of additional risk. Due to the increased levels of risk, timing becomes crucial. By nature an option selling program in the futures markets tend to leave room for error in the execution. Nonetheless, being short puts in a spiraling market can quickly change that.

The phenomenon of put premium in the stock indices being larger than call premium is often referred to as the volatility smile. The volatility smile is a long observed pattern in which at-the-money options have lower implied volatility than out-of-the-money options along with the idea that there is more value in owning a put relative to an equally distant call. This scenario seemed to be born after the crash of 1987 in the U.S.

While there are no crystal balls to let us know when a futures market will turn around and how low that it might go before it does, being aware of historical patterns in price, volatility and market sentiment may help to avoid a compromising situation. Let's take a look at the relationship between the VIX and the S&P.

VIX and the S&P 500

Looking at the chart below, it is obvious that the S&P 500 has been able to forge recoveries during times of spiked volatility as measured by the VIX. Armed with this knowledge, it may be a viable strategy to look at erratic, and many times irrational, trade as a point of entry for put sellers.

Short Put Option Trading Example

For example, based on this assumption put sellers may have fared well during the lows in 2001, 2003 and 2007, and 2011. That is of course assuming that the option seller wasn't early in his entry. If a short volatility trader enters a market prematurely, there is a strong possibility that the trader will be forced out of the market prematurely due to lack of financing or margin. Let's take a look at one of the most opportune times in history to be a volatility seller (sell puts in the S&P).

Beginning in the middle of 2002 and throughout the beginning of 2003, put sellers with savvy timing may have done very well. However, trading is a game of risk and those selling puts during those times were accepting great amounts of risk in order to reap the reward.
Let's take a look at a continuous S&P 500 futures chart during the 2002/2003 lows. While the VIX is a great indication of volatility and extreme market sentiment, it is also helpful to look at indicators of volatility such as standard deviations. Luckily, the creation of Bollinger Bands allows us to visually determine market volatility through the line plot of two standard deviations from its mean. Times of high volatility are denoted by wider bands, or a larger standard deviation, and times of decreasing volatility result in narrowing bands.

As futures market volatility increases, so will option prices.  During such times, commodity option buyers are forced to pay extremely high prices for options that in theory are more likely to expire worthless than not.  On the other hand, option sellers are provided top dollar for accepting theoretically unlimited risk.

Higher premiums collected not only increase a futures market trader’s profit potential but it also increases the room for error. The money collected for a short option can be viewed as "cushion" in that it defines the amount in which the trader can be wrong and still make money by shifting the reverse break even further from the market. The RBE of a short put is calculated as follows:

RBE = Put Strike Price - Premium Collected + Commissions and Fees

As you can see, the more money that the option seller collects, the deeper-in-the-money the option can be at expiration without resulting in a loss to the trader. 

According to the hypothetical data available to us, in July of 2002 with the September futures e-mini S&P price near 780, it may have been possible to sell the August S&P 500 futures 680 put for $4.3 in premium which is equivalent to $215 before commissions and fees (each point in the e-mini S&P is worth $50). If this was the case, a trader could have collected a little over $200 U.S. dollars for an option that was, at the time, approximately 100 points or nearly 13% out-of-the-money.

$215 per contract before transaction costs might not sound like a lot of money, but considering the margin on the trade (required deposit in a trading account) was under $1,000 most traders could have sold them in reasonable multiples. For instance, selling 5 of the August 680 puts might have brought in a little over $1,000 in premium for a margin requirement of less than $5,000. Those that like to calculate return on margin, it would have been roughly 20% had the option seller held the short futures options to expiration a mere four weeks down the road.

*This chart assumes selling a single option in the full-sized S&P futures, which is equivalent to 5 e-mini S&P options. We recommend using the e-mini version of the options due to liquidity and option market transparency benefits.

At expiration, this trade would yield the maximum profit of $1,075 before commissions and fees if the futures price is above 680. Ignoring transaction costs the reverse break even on the trade is at 675.70. This simply means that this particular trade makes money with the e-mini S&P futures price trade anywhere above 675.70 before commissions and fees. Please note that the amount of commission paid will reduce the premium collected and shift the RBE closer to the market. To look at it in another perspective, the trader can be wrong by 104.3 points after entering the trade still manage to break even. If the trader's goal is to put the odds in their favor, this seems to be a commodity option trading strategy to consider.

Selling Options on Futures with the VIX can be an Attractive Trading Strategy

Without regard to transaction costs, futures and options trading is a zero sum game; for every winner there will be a loser. Thus, putting your odds ahead of those of your competition is a must. In my opinion, selling options during times of high volatility, while exercising patience, and incorporating experience, is doing just that.

With that said, where there is reward there is risk; in efficient markets you cannot have one without the other. A short option strategy in the futures markets should only be attempted by those that have ample risk capital to allow for potential drawdowns as well as the ability to manage fear and greed. Fearful traders are vulnerable to panic liquidation at inopportune times in terms of market volatility and option pricing. Likewise, greedy traders are tempted to sell options closer-to-the-money in hopes of higher payouts but the risk may turn out to be unmanageable. I strongly believe that less is actually more when it comes to premium collection. Trade less, collect less, and hopefully enjoy more success.

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?