Getting into a market is simple. Getting out with a maximum profit is difficult and is an art. How do we know when to take a profit and when to take a loss? Will I miss the big move if I get out now? Here's some methods that can take the mystery out of what to do at these critical times.
Have you ever been in this situation? The commodity futures market has rallied and you hold a profitable commodity call option position. You believe the rally has topped out for now and the market is ready to make a normal decline correction in a bull market. But your long-term forecast says the up-move still has another month to go. What do you do?
A Novice commodity trader would probably sell out now or panic into the first sharp decline, losing his long term position. Chances are he would not get back on board for the big move. Another scenario is he sits through the correction and gets stopped out giving back a good portion of his profits. Another possibility is he survives the correction, the options erode in value and never recover – for a total loss. Another is the market goes sideways. And finally, the market corrects slightly and then goes on to new highs.
Of all these scenarios, the last one is the only instance where he is assured of capturing the big move. This assumes the commodity futures market moves up past the option strike price before the options expire.
Now let’s back up and start again with a different approach. We are at the top of a profitable futures contract rally holding TWO call options. We expect a temporary decline. What if we sold ONE futures contract as a hedge to lock in profits on the first option and to protect against a decline on the second option? (a 2:1 option to futures ratio) If the decline comes as expected, we cover the futures contract at the lows for a profit. We then continue to hold the two calls for a resumption of the rally back up. This is a way to trade the swings and still hold onto our long-term position.
What if the commodity futures market continues up without a correction after we short the futures contract? If the options have a delta of near .50, then the futures contract loss will balance out the options gain. We are hedged. If the option deltas gain as they normally do in a sharp rally, then there is an additional profit despite the hedge.
The advantage of using a future for hedging an option gain is that the futures contract is usually liquid. This lets us trade in and out without a big bid/offer penalty. Using options as a trading hedge is not usually economical. Many options are known for wide spreads due to illiquid markets. This costs you too much getting in and out. However, there are some financial option markets that are very liquid and good for the job. Look for daily volume of at least 1000 option contracts to pass the liquidity test.
Part Two of Two 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.
Main site: http://www.ThomasCapitalManagement.com