September, 2006
Options Series Part 5
Hedging Your Position in a Wild Market
This last year has been a volatile one in several of the favorite commodity markets. When the markets are wild like this they are very interesting, but too crazy to trade with outright futures contracts. Many of you have started to use the options market to reduce your exposure and still have a chance to participate in the awesome moves.
For those of you who are unfamiliar with options, here is a 10 second explanation. Options can be purchased. When you buy an option you are buying the right to buy or sell a specific commodity at a specific price for a specific amount of time. A call is the right to buy and a put is the right to sell. The strike price is the price agreed upon and the premium is the cost of purchase.
When you purchase a call or put the amount of the premium is typically considered to be the risk. That allows you to trade with a good grasp on what your maximum risk will be.
I have found that most traders have a strong opinion about where their market of choice will go. That makes it easy for them to sometimes spend substantial amounts of money for their option positions. If the market does what is expected, there will be plenty of money to go around. The trader goes home happy.
Sometimes it doesn't work that way. Because of that it has been my recommendation for many years that traders spend some of their
trade dollars for insurance. The way to do that is to invest 80% of the allocated funds on the investment and the other 20% on options that will win if the market goes the other way.
For an example, if you thought Gold was going to go from $650 to $750 per ounce you could buy 5 December 650 calls for $1000 each.
If you are right, you make $50,000. If not, you could lose $5,000.
If, however, you only bought 4 December 650 calls and spent the other $1000 on 1 December put, you would make $40,000 - $1000 for your insurance. Not bad but not as good as $50,000. The difference is that if the market decided to go down to 600 instead, (which it will sometimes do), the $1000 spent on the put will be worth $5000 and the money spent on the investment will be available for some other opportunity.
This is a simple ploy that I think every option buyer should use whenever they make an option purchase. It will pay off more often than you think.
One of the new services we are offering traders at Dillon Gage is a “clients only” web page where we put out trade ideas each day that will identify the market, the entry point and the method of entry. It will also give the trader a suggestion for how much the risk is estimated to be and as the trade progresses, where an objective could be established. If one of the trading ideas seems appealing, the client can make a quick phone call for a more complete explanation and order placement.