By Stein, Jon
Futures (Cedar Falls, IA) , Vol. 19, No. 1
What to watch for in less liquid commodity options
A customer of a Chicago-based discount futures brokerage firm wanted to buy December 5.25 silver puts for 20.0[cents] (per ounce or $1,000 for the 5,000-oz. contract) when the market began rising. Soon he saw "15.0" on his screen, yet his order wasn't filled.
"In an illiquid market, you can't force people (in the pits) to trade," the trader's broker explains.
Another speculator bought out-of-the-money October sugar calls in May 1988. In weeks, the market soared to new highs. The $1,300 position was worth more than $22,000. But, when the market topped out in July, it fell as quickly as it had risen. When he took profits, he got only about $4,000.
Being stubbornly bullish wasn't his only problem. Buyers, particularly of calls, had basically disappeared.
Mention options, and most brokers will be accommodating. But mention copper or wheat options, and you'll probably get a snicker. Many brokers contend such markets aren't worth their energy or their client's money.
Still, many speculators trade options markets with worrisome low levels of liquidity. In fact, signs are their ranks may be growing.
"There's a whole army of people out there who would like to trade commodities but don't think they have the money to," says Thomas Dorsey, president of Dorsey, Wright and Associates, a Richmond, Va., firm specializing in options, explaining why some traders look to options instead.
But the term "lesser liquid" itself is frightening. While investors can obtain good fills quickly in options on futures markets such as Treasury bonds, Eurodollars, crude oil, Japanese yen or Deutsche marks, it's often a different story with options on copper or gasoline futures.
Compare the average daily volume in December T-bond options -- about 25,150 calls and 23,075 puts -- to that of copper, wheat, the British pound or heating oil, which range from less than 800 to just over 300 calls and from 500 to less than 250 puts (see graph below). With put and call total volumes averaging from 800 to 2,000 contracts per day, these markets are thin but tradable. Most traders find options markets trading less than 800 contracts per day impossible.
Contracts with lesser liquidity share certain characteristics other than relatively low volume and open interest. Typically, these options are relatively expensive. An option's price reflects the volatility of the underlying market. In a less liquid market, the volatility implied by the option price is often much higher than the actual, or historical, volatility. If this difference gets too far out of whack, it is warning, "Stay out!"
"Liquidity is a function of volatility of the underlying future. When you see a big spread between the implied and historical volatilities, then that market's not so liquid," says Jim Zamora of Zahr Trading, a commodity options group in New York.
With all this to face, why would anyone dabble in low-liquidity markets in the first place?
Professional options traders would explain that options give a trader the opportunity to trade volatility, not just price. That's true. But most players in less liquid markets often look merely for a limited-risk, margin-free alternative to futures. For example, many small speculators have had success using options to pick a market top or bottom.
Certain tactics also can help reduce risk associated with lower liquidity.
The first piece of advice from Sheldon Natenberg, an independent trader in Chicago, is not to enter a market with low volatility. As long as you must pay up for these markets, he says, at least get one that will move.
It is likely the market will move fast enough for traders to make money? …