The Hidden Dangers of Buying Commodity Options: Part 4
...Continued from Part Three.
FUTURES VS. OPTIONS
There are many ways to hold a speculative position in futures contracts and hedge yourself against unlimited risk. All methods will cost you something. The market is a wash and gives nothing away. It will reward you only if you uncover an advantage that the majority fails to see. You must use the proper trading vehicles and analysis to capitalize on these situations. The wild card is that the market and the optimum tools are always changing.
I talk about the dangers of option buying from experience. Over the years, I've done well buying and selling futures contracts, at least as well as other traders that I know. But, except for a few tremendous gains when the market collapsed while holding put options, I've seen most traders lose consistently when straight buying options. This erosion happens even when the market forecast is correct. That is the most disheartening part - to have the move take place and the options erode in value. Unless you are expecting an unusually fast move in a short period of time, find a way to use futures contracts for the job.
WHEN IN DOUBT, PALMS OUT
Writing (selling) options is a good way to capitalize on this eroding asset. Again, there are no free lunches and it takes as much skill to make money writing options as it does to trade futures contracts. Writing options also contains a great deal of risk. This omnipresent risk is your reality check to make sure the market will pay you for your skills. Without taking on any risk, you are an outsider trying to play a pro's game.
FUTURES VS. OPTIONS
There are many ways to hold a speculative position in futures contracts and hedge yourself against unlimited risk. All methods will cost you something. The market is a wash and gives nothing away. It will reward you only if you uncover an advantage that the majority fails to see. You must use the proper trading vehicles and analysis to capitalize on these situations. The wild card is that the market and the optimum tools are always changing.
I talk about the dangers of option buying from experience. Over the years, I've done well buying and selling futures contracts, at least as well as other traders that I know. But, except for a few tremendous gains when the market collapsed while holding put options, I've seen most traders lose consistently when straight buying options. This erosion happens even when the market forecast is correct. That is the most disheartening part - to have the move take place and the options erode in value. Unless you are expecting an unusually fast move in a short period of time, find a way to use futures contracts for the job.
WHEN IN DOUBT, PALMS OUT
Writing (selling) options is a good way to capitalize on this eroding asset. Again, there are no free lunches and it takes as much skill to make money writing options as it does to trade futures contracts. Writing options also contains a great deal of risk. This omnipresent risk is your reality check to make sure the market will pay you for your skills. Without taking on any risk, you are an outsider trying to play a pro's game.
SO WIDE YOU CAN DRIVE A TRUCK THROUGH THEM
Let's not forget about the spreads when trading commodity options. Except for some very active financial markets, options bid and offer spreads are usually so wide you can drive a truck through them. The New York commodity option markets are notorious for this. The resulting illiquid market is the main problem with many commodity futures options.
Some commodity options trading is so thin that you simply cannot get in or out without paying an outrageous toll. After buying, try to sell it back minutes later and you might be down 30%. I've seen times when some option spreads have been one-bid to three-offered. Even 3/4 point is considered a good spread in some commodity option markets. Unless you follow a few rules for getting in and out, expect to pay through the nose. (In their defense, I should note that most financial commodity option markets are reasonably liquid and active)
When you add up the cost of a year's worth of illiquid options spreads, the resulting expense can be many times more than your brokerage bill! These are expenses that may take you from profitable down to break-even and even to losing for the year. Many traders think that they can pay these expenses "just this time" and the trade will take off and make it all up. This attitude gets contagious in a wild commodity bull market as traders buy at any price.
IN IT FOR THE LONG HAUL
Trading profitability has to be viewed over a long series of trades. Some trades will be losers, some will be break-even and some will be winners. They must all be analyzed together and then calculate your expenses to arrive at one bottom line. If the best pros have a hard time scratching out 50%-100% gains per year with their low overhead, how can you expect to cover higher option expenses and come out ahead?
In contrast, most futures contracts are very fair in their spreads since they are more liquid. For example, the e-mini futures contract, (for this example, let's assume the S&P is trading around 1200) if scaled down to 120, has an equivalent bid/offer spread of about 1/40th of a point! Now that's a fair entry & exit expense!
I simply want to make you aware of what you're up against when buying options. As my mother used to say, being aware is being prepared. You need to have skills, an edge, reasonable expenses, the proper trading vehicles and good advice to survive and prosper when trading commodities. My advice is don't get lazy and depend only on the false security of buying options. Learn to use these trading vehicles like a pro. Take on the risk of futures, option spreads and other strategies that require more experience. Take on the challenge to learn more about commodity trading strategies.
I hope this article will help to clear the fog, false hope and comfort of buying these eroding assets. As you become more experienced, you will discover that there are much better vehicles and techniques for position trading. Good Trading!
Some commodity options trading is so thin that you simply cannot get in or out without paying an outrageous toll. After buying, try to sell it back minutes later and you might be down 30%. I've seen times when some option spreads have been one-bid to three-offered. Even 3/4 point is considered a good spread in some commodity option markets. Unless you follow a few rules for getting in and out, expect to pay through the nose. (In their defense, I should note that most financial commodity option markets are reasonably liquid and active)
When you add up the cost of a year's worth of illiquid options spreads, the resulting expense can be many times more than your brokerage bill! These are expenses that may take you from profitable down to break-even and even to losing for the year. Many traders think that they can pay these expenses "just this time" and the trade will take off and make it all up. This attitude gets contagious in a wild commodity bull market as traders buy at any price.
IN IT FOR THE LONG HAUL
Trading profitability has to be viewed over a long series of trades. Some trades will be losers, some will be break-even and some will be winners. They must all be analyzed together and then calculate your expenses to arrive at one bottom line. If the best pros have a hard time scratching out 50%-100% gains per year with their low overhead, how can you expect to cover higher option expenses and come out ahead?
In contrast, most futures contracts are very fair in their spreads since they are more liquid. For example, the e-mini futures contract, (for this example, let's assume the S&P is trading around 1200) if scaled down to 120, has an equivalent bid/offer spread of about 1/40th of a point! Now that's a fair entry & exit expense!
I simply want to make you aware of what you're up against when buying options. As my mother used to say, being aware is being prepared. You need to have skills, an edge, reasonable expenses, the proper trading vehicles and good advice to survive and prosper when trading commodities. My advice is don't get lazy and depend only on the false security of buying options. Learn to use these trading vehicles like a pro. Take on the risk of futures, option spreads and other strategies that require more experience. Take on the challenge to learn more about commodity trading strategies.
I hope this article will help to clear the fog, false hope and comfort of buying these eroding assets. As you become more experienced, you will discover that there are much better vehicles and techniques for position trading. Good Trading!
About Thomas Cathey
Thomas Cathey is a 27-year trading veteran and the CEO of Thomas Capital Management, LLC. Mr. Cathey heads the CTA managed futures division and also advises brokers. He directs three managed programs that include; writing diversified commodity options, writing S&P 500 options and day trading the e-mini futures contract.When time permits, he also mentors his fellow traders as a trading coach.
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