Archive for August, 2010
I thought I’d save two birds with one blog post. A reader of mine kindly suggested that I write more about options, so I’m going to do that wrt to the WSJ article today entitled Coffee Futures Are Near A 13-Year High.
From the article:
Coffee futures remain close to a 13-year high, as tight supplies and the prospect of dry weather hurting next year’s Brazilian crop have sent roasters scrambling to secure beans.
So if we are at multi-year highs, you might be bullish but are scared to enter the market at these levels. One of the ways you can be bullish and limit your downside is with options.
Notice that being scared is a function of fear, an emotion, and is not a financial term, yet it can have a profound effect on your finances. Smart financial decisions rarely feel good, but I digress…
Instead of buying December Coffee futures and posting the initial margin of $7,700 for the directional trade, you can use call options to capture the upside. It’s true you can cut your initial margin substantially if you just bought outright calls, but today I’m going to show you how to implement a Bull Call Spread — a position where you are simultaneously long and short 2 calls in the same account. [Trade this at your own risk. This is for educational purposes only.]
Options are all about floors and ceilings. You determine those floors and ceilings by the Strike Prices you select. They are probably the one instrument that you can trade that you can use to bet where the market IS NOT going to go, as much as where it might go.
In order to implement the Bull Call Spread, you need to buy the lower strike price and sell the upper strike price. In this case, I’ve chosen a call that is close to being At-The-Money and one that is 10 points higher. [see the chart above and the highlighted prices].
Buy the November 182.50 Call at 4.94 (a debit)
Sell the November 192.50 Call at 1.94 (a credit)
This will create a net debit of 3.00 or $1,125 per spread. This is your total cost to own the spread — it is also your maximum loss on the trade. [You get this number my multiplying .03 by 37,500 lbs - the size of the standardized contracts. Three points is represented as .03]
Keep in mind that if you have $25,000 in your account, you’re looking at risking 4% of your capital on this spread. That’s very aggressive to put it in perspective, and I’d say that there’s not enough equity in your account to withstand the emotional hit of losing that 4% several times in a row. An account with $100,000 would be more like it — and that’s true even though the spread itself is considered to be more conservative a trade than an outright, directional trade in coffee futures.
Any time you have a debit or a net debit, that represents your Max Loss on the trade. Don’t forget, if you trade the coffee futures outright, long or short, you always have unlimited loss potential.
In this case, you are saying “I’m bullish above 182.50 but only up to 192.50.” Because you are only bullish up to a point (192.50), you are going to have the buyer of the 192.50 call pay you in order to help finance the purchase of your 182.50 call.
The beautiful thing about a spread like this is that everything that you can earn or lose takes place between the strike prices. Theoretically, the absolute value of the difference between the strike prices is equal to the sum of the max gain and the max loss. Let’s take a look:
|SP1 – SP2| = Max Loss + Max Gain
|192.50 – 182.50| = 3.00 + Max Gain
Therefore 7.00 points = Max Gain
The break-even is the net debit added to the lower strike price:
182.50 + 3.00 = 185.50
Notice that you have a better than 2:1 payoff in this case. That says nothing about the probabilities of either of those outcomes, but your are bullish and you are trading with the trend while prices are approaching multi-year highs.
Here’s a graphic depiction of what’s going on (please pardon my handwriting):
At 182.50 or below, you suffer a total loss. Between 182.50 and 185.50, you lose incrementally less as the price of the contract approaches the break-even (noted as B/E on the graph). Between 185.50 and 192.50 you profit, with profits increasing incrementally as the contract approaches 192.50 where you experience the feelings of the max gain.
Beyond 192.50 you get nothing more because you are capped at 192.50 – remember you sold the call to someone else and you are obligated to deliver coffee futures at that price. You are considered “covered” in this case because you own a lower strike price (has to be the same underlying mais bien sur!!!)
Spreads are about using those floors and ceilings to make financial trade-offs that you are willing to make. Instead of paying $1,852.50 (.0494 x 37,500) to own the 182.50 call option outright, and have the unlimited upside that goes with it, you are giving up the potential for unlimited upside for a lower cost of $1,125. In the process you are lowering your cost by $727.50 or almost 40%.
If the contract goes to 192.50 or higher, you’ll have a gain of $2,625 or about 133%.
This spread trade can be implemented by commodity hedgers too, whereby the gain to the investor would be the savings to the hedger.Read More
A reader asked to interview me about 6 months ago. I didn’t see the benefit at the time, but I get enough questions that I thought I might give it a go. The interviewer is a reader of MartinKronicle and he did a great job for someone with no experience. His name is Gavin Murphy – an Irishman – living in London and we recorded the call via Skype.
In the interview I answered a lot of great questions that I think emerging CTAs and aspiring Prop Traders can benefit from. I hope that I’ve taken on and dispelled enough of the conventional wisdom and what I believe to be misbeliefs in developing your career and how to learn about trading.
Among the topics are the misconceptions of the benefits of trading a system versus specializing in one commodity, what indicators are overrated, another way to consider the ATR, and how to employ the Grúdlann Gheata Shan Séamuis emotional stop-loss system.Read More
“…terrifyingly bullish…” was the quote that stands out for me. Where did all these headlines go? One minute you had some jammy dodger in London who was going to kill your Valentine’s Day plans and then nothing.
Such is the life of reading the headlines about commodity traders and the wild positions they take. It’s a drag that the papers don’t have qualified journalists who actually know something about the commodity markets. The good ones are way too inside baseball. One that I like to read is John Kemp at Reuters.
Here’s the story the broke the news back on July 16 in the Financial Times:
Low inventories could drive prices higher if demand remains strong. Cocoa hit a high of £2,732 a tonne this week and some dealers say it could now top £3,000 a tonne. “It reminds us of 1976,” said one senior cocoa trader. In 1977 prices spiked above £3,300.
Armajaro appears to believe that the market is going to spike significantly higher by September, traditionally the tightest period of the year as chocolatiers ramp up production ahead of Christmas and the main West African crop has not yet come to market.
Although stocks of cocoa exist in warehouses not registered on any exchange, the delivery to Armajaro represents almost all the 270,000 tonnes of available stocks at Liffe-registered warehouses.
“The question is: what happens to those stocks?” said another trader. “Are they going to be marketed? If not, it becomes terrifyingly bullish.”
Well, we know that Mr. Ward has his beans on ice — literally — they are being refrigerated. Just because the contracts are lower than where he took delivery, does not mean he’s lost anything on the trade. He could have hedged, sold it forward, or engaged in a swap transaction.
The red circle on the graph above indicates the contract around the time Mr. Ward took delivery. That was around July 18, or “18 July” if you do things backwards like they do in London. (I’m heading to London soon btw.) Since then, the contracts have sold lower and it doesn’t look like anyone cares about his alleged hoarding (which it’s not).
Don’t believe everything that you read. It’s what’s not written that you miss…Read More