Ins and Outs of Commodity Options

Article excerpt

The record volatility in today's agricultural markets is threatening to take the small retail trader out of the game. Fortunately, there's a way to maintain your opportunity while capping your risk through the use of commodity options.

Due to strong demand, rising fuel and input costs and restrictions on world exports, agriculture markets have experienced record volatility in recent months. One way to profit from price volatility while limiting your risk is through the use of options.

There are many advantages to trading options instead of the underlying futures. Controlling risk, particularly in today's volatile markets, is one of the greatest advantages.

"In today's hyperactive volatile markets, the advantages [of options] are the ability to manage risk and time," says Howard Tyllas, a Chicago Board of Trade member and commodity trading advisor. "Futures trading in today's world [takes place] in some of the most amazing markets I've ever seen. I've seen sectors and markets move like they're doing now, but not all at once and at such a long time period with no end in sight." Tyllas says these market conditions are "exactly what options were made for."

Average true range (ATR) is a measure of volatility and is often used in determining where to place stop loss orders. As you can see in "Another world" (right) the ATR, which most commonly is a measure of the average daily range over the previous 14 periods, in soybeans has quadrupled since the beginning of 2007 and has increased even greater for wheat. A market could be expected to move within its ATR without altering the prevailing trend, which is why a trader may place a stop just outside of the ATR. But while an ATR of 12# would require a trader to risk slightly more than $600 for a one lot trade, an ATR of 50# would require that trader to risk more than $2,500. This means the trader would either have to place her stop closer and risk being stopped out of a trade that would have eventually been a winner or put all her proverbial eggs in one basket. This makes commodity options worth exploring.

Mark Longo of The Options notes that margin requirements on futures contracts can be expensive, but commodity options let futures traders reduce risk in their portfolios and "allow market participants to trade commodity contracts with smaller initial investments and with much higher leverage."

James Cordier of Liberty Trading Group also cites lower margins and lower risk as two of the benefits of options. "Commodity options offer traders the opportunity to participate in the futures arena with lower margins and often lower risk than in the outright futures contracts," Cordier says.

An option on a futures contract gives its holder the right, but not the obligation, to buy or sell the contract at a specified price on or before its expiration date. There are two types of options: a call, which gives its holder the right to buy the option, and a put, which gives its holder the right to sell the option. A call option is in-the-money when its strike price is less than the futures contract price, at-the-money when the strike price equals the contract price, and out-of-the-money when the strike price is greater than the contract price. The reverse is true for put options. When you buy an option, your level of loss is limited to the option's price, or premium. When you sell an option, your risk of loss is unlimited. Levels of risk in options depend on numerous variables such as how close the strike price is to the price of the underlying, the amount of time value and the Greeks (see "Options glossary," page 58).

"If you're someone who's really risk averse and conservative, you might wish to buy an option because your maximum potential loss is limited to the amount that you spent to buy the option. If you're someone who's more sophisticated, with a higher risk appetite, you might move into selling options," says Dan O'Neil, executive vice president of futures at optionsXpress. …