A while back, I received several emails from readers wanting to know if they should short the crude oil market because of its lofty price levels. I responded that I don’t give specific trading recommendations, but I certainly do want to help my readers succeed at the difficult task of trading futures markets. Given the sharp runup in crude at the time, and the rising volatility of the grain futures during that same timeframe, it was a good time to discuss trading options on futures–specifically buying puts and calls. You can also sell options, but your financial risk is not limited like it is when you buy an option. I won’t get into selling options in this feature.
I know that many beginning (and even veteran) traders think options trading is too complicated, and they don’t have a clue about the vega, theta, delta and gamma pricing formulas–or the strangles, straddles, butterflies and other such options trading methods. Well, don’t worry. I’m not going to get into those complex strategies in this column.
Entire books have been written on options and options trading strategies, but I will only focus on basic low-risk and limited-risk trading strategies for beginning traders (and veterans, too). I’ll also talk about using options to “hedge” winning trading positions in volatile markets. I do suggest that if you are interested in trading options, you should read a book or two on options trading. Again, you don’t have to be a rocket scientist to employ simple options trading strategies.
First, I am going to assume readers know the definition of an option on a futures contract, and also the difference between a put option and a call option and “in the money” and “out of the money.” (If you don’t know the meaning of these terms, that’s okay. Just go to one of the big futures exchange websites, and you can find a glossary of trading terms, digest the options terms and then read this article.)
Back to the big runup in crude oil recently. It certainly is tempting to want to short that market at present levels. However, remember that to successfully trade futures you not only have to be right on market direction, you also have to be correct on the timing of the market move. Furthermore, you can be right on market direction and very close to being right on timing the trade, but still lose your trading assets because of market volatility. In crude oil, for example, a trader could establish a short position two days before the top in the market is in, and still be stopped out and lose his trading assets because of the high volatility.
Purchasing options allows you to limit your financial risk and let’s you ride out volatile market swings without the worry of increased margin calls.
Buying a put or call that is out-of-the money is a good, inexpensive way to wade into futures trading. The money the trader lays out to his broker for the option purchase is all the trader has to worry about losing. No margin money. No margin calls. He can sleep well at night. And he is still trading futures, learning the business, honing his trading skills.
Here’s another trading tactic to think about regarding purchasing options in volatile markets. Just because you have a buy or sell stop in place, that does not guarantee you will get out of the market (filled) close to your stop. For example, weather markets in the grains and soybean complex futures often produce limit price moves–sometimes for two or more sessions in a row. If you have a straight trading position on in soybeans and the market moves against you by the limit, or multiple limits, your protective stop is virtually worthless. But if you had hedged your straight futures position with a cheap out-of-the-money option purchase, you have limited risk in a volatile market. Let’s say you are long soybeans at $5.00 in a very volatile market. You may initiate that trade on the long side, but then purchase a $4.50 put option that limits your trading risk to 50 cents a bushel ($2,500 per contract). The trade-off here is that you are gaining peace of mind and losing some profit potential. But for many, that’s well worth it. You can stay in the game to trade again another day, and not get wiped out by a limit price move.