The strategy we lay out below is one that has been featured at Instant Commodity Trader to average >150% ROI on trades. Does it work every time? Of course not, but we have consistently seen 70% of trades have triple-digit gains on trades that take just days or weeks. This was achieved by minimizing risk through trading commodity options. As speculators in the commodity futures market, we believe a track record like that is worth sharing.Trading futures contracts entails substantial risk, while options limit your risk to the cost of the option you purchase. If you pay $400 for an option, the most you can lose is $400. Why risk $4000 on a futures contract margin, when you can be in the market with an option at a fraction of the cost?
Using the strategy below for trading profitably with options, you’ll have about 3 months to be right about the direction the market is headed anyway since options have a decaying time value and eventually become worthless if they expire ‘out of the money’.
Options are priced out at different ‘strike prices’. For example, Coffee options are sold in intervals of 25 points, such as 1900, 1925, 1950, etc. Each market’s options have different strike price intervals, but as you can see, the commodity futures price may be higher or lower than an available strike price. What makes an option ‘out of the money’ or ‘in the money’ is whether the strike price is above or below the current futures price and whether you are long or short the market.
Option prices are based on 2 components: Intrinsic Value and Time Value. Options expire, so Time Value is a function of how far away the expiration date is and will eventually reach zero as the option’s expiration date approaches. Intrinsic value is how far ‘in the money’ the strike price of the option is.
For example, if coffee futures for September are currently trading around 186, and we wanted to go long coffee futures, we can buy a Call option that is either ‘in the money’ if the strike price of the option is less than 186, or ‘out of the money’ if the strike price of the option is higher than 186, or ‘at the money’ if the strike price is exactly 186.
That difference between the current futures price and the strike price of an ‘in the money’ option is the Intrinsic Value component of the option. Add to that the Time Value component, and the sum total is the price of that option. The more ‘in the money’ and further away from expiration an option is, the higher the price. The further ‘out of the money’ an option is and the less time left until expiration, the lower the price.
The ‘out of the money’ options are cheaper because they don’t have an Intrinsic Value component at all. The further away strike prices get from the current futures price, the lower the cost of the option since prices would have to move violently for very far ‘out of the money’ options to become ‘in the money’ and have any Intrinsic Value. The only value they currently have is time and your expectation that prices will rise making your Call option ‘in the money’.
Stick with ‘out of the money’ options, usually 3 strike prices out of the money and with about 3 months of time until expiration. That gives you a good balance between the strike price being close enough to the futures price so a market move in your favor in the next few months will result in your option becoming ‘in the money’, and the cost of the option being affordable enough to limit risk.
Most people shy away from options. Here’s how to pick options to trade:
1) Check to see if ‘at the money’ options are a better value than the margin on a futures contract. Usually, they are. In some markets you’ll find it makes more sense to purchase a futures contract instead.
2) Make sure there is liquidity in the market. Don’t trade in markets that have few buyers/sellers. Look at the contract month you are about to trade and see how much Open Interest there is for that contract month’s futures contracts. Be sure the Open Interest is in the tens of thousands of contracts and there is Open Interest in options too.
3) Pick a contract month that is about 3 months until options expire. Options usually expire a month before the futures contract Last Trading Day.
4) When choosing the strike price, bear in mind prices may have retreated or surged past your initial entry point. Pick a strike price that is within 3 strike prices from the entry price you were watching. Don’t chase a runaway market.
5) Pick a Strike Price that is about 3 strike prices ‘out of the money’. If it’s not much difference in cost for one that is 2 or even 1 strike price ‘out of the money’ then buy that instead.
6) Don’t risk more than you can afford to lose. Just because the option you want costs $3000 doesn’t mean you can’t sell it before it expires worthless. If the market moves against you, you can always liquidate your option at bearable loss while it still has some Time Value left on it.
7) Calculate the profit potential between your option strike price and the anticipated market move (the 50% Retracement Level) and determine if the risk vs reward is acceptable for the cost of the option.
Look for trades where the potential exists to double or triple your investment in a short period of time. No need to risk large amounts of capital on small profit potential. Sure, you may choose to exit the market with only 30% gains, but that’s still better than almost anything else out there.