Commodity Option Buying - The Hidden Dangers PART 3 What The Option Pros Don't Want You To Know

Thomas Cathey
 


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The buying of options (verses writing them) is the most popular way most new commodity traders start out. Little do they know that over time, their chance for success is 10% at best. The option premium cost over a year is tremendous. Read how most pros use commodity options and how you should too.

There are special times when options can be bought. There are special reasons too. I've seen good buys when sugar is wallowing at its lows around 4-5 cents. Buying a nine-month-out call option near the money costs only 20 basis points. These are the times to take notice and buy options assuming you have a forecast showing a good rally. (or decline)

Another good time to buy is simply when the option gets way undervalued from current market volatility conditions and you are looking for it to swing back to its volatility norm. Reverse everything mentioned above when buying put options. You want to see panic buying and short covering so that the put premiums are deflated, of course.

The market pays you for having skills that are better than the average trader. It also pays you for taking on risk. Buying a load of inflated options based on the crossover of a moving average and then sitting on them for a few months takes no skill at all! In addition, there is really no “unknown risk" being taken. Yes, you pay your option premium, but it's really your bribe to the market to make you feel comfortable.

The option writer is the guy really taking on uncertain risk and is feeling uncomfortable. The market usually will favor him if only for that reason. A smart pro writing options will then lay off some of his risk by hedging some future contracts (or opposite side options) against the option write. How can he make money doing that? He locks in money because you were willing to pay a higher than normal option premium and/or were willing to buy at the offer price, giving him some spread and premium slush to work with.

It takes no skill to enter and maintain a position when buying a load of options. None at all. But entering a market with a futures contract and staying on-board requires sharp timing skills and a forecast that works out without a large adverse move against you. The good part is you have all the time in the world for the futures contract move to take place! No ticking clock eroding premium like an option. (there may be a small futures carrying charge when long, but it works for you when short)

Someone might say it's a wash. . . the advantages outweigh the disadvantages. But I say if you are a skilled position trader, holding futures have a tremendous advantage over buying put and call options. Generally, beginners have few skills and pay the price by getting wiped out due to eroding option premiums.

Many brokers will encourage beginners to buy options because they are very low time maintenance and of little risk for them. The broker and client become cheerleaders cheering or gagging as they watch the news. Lots of “safe, no risk" entertainment for a few months. Maybe one or two out of ten trades work out. But the end result is always the same.

These traders eventually lose all their money to the option writers and simply fade away. Nice ride while it lasted. Next. Buying a load of options removes “responsibility" to the market. If you're wrong, the account erodes slowly (or quickly) while you're fat, happy and hoping for a miracle .

In contrast, if you're sloppy entering a futures contract trade, you get booted out on your rear end within a day or two. There is instant feedback and pain. There's hard work and risk servicing a group of futures trading clients. But that's the price that must be paid for the chance for higher probability market success.

More advanced option buyers like to do “free" option trades where they buy two, and then sell one or two to take in some buffer cash. This is actually a decent idea and can reduce expenses or lock in some profits when the market chops or backs off after a rally. However, your upside potential is also reduced. No free lunches. See my free course lesson # 26 for more details on “free trades. "

Part Four of Four Parts - Next!

There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.

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

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