Commodity Market Forecasts – How do you trade them?

Producing a high probability trade forecast is not easy. Just as difficult is determining the best trading strategy and vehicles to capitalize on the forecast. Read on to learn some of my favorites trading strategies.

Let?s say you?ve done your homework. You?ve identified a pivot point, a futures market direction and have projected a time frame for the move. The only thing missing is the price amplitude. In other words, how big or small will the price move be?

Generally, the magnitude of the move will always be the unknown. With TimeLine forecasts we will always have an idea of the direction and time frame, but it is up to real world commodity market forces to decide how far the move will carry.

The way to handle price uncertainty is through time and price diversification. Since we don?t know how far price will carry, we need to have a commodity trading vehicle that will respond to both a small move and a large one as well. If we choose to use commodity options, buying far out-of?the-money options is a bad bet for small price moves.

The move may take place while the option value goes nowhere. In addition, to buy an expensive option with a close strike and lots of time can be a bad bet if the market moves immediately against us and sucks its premium away quickly.

To handle time diversification, we need to compromise by buying two different options with different expiration months. We would buy an expensive option with a close strike with lots of time and also a cheaper, farther away option with less time. (Notice we have price diversification here too)

The long-term option is to be held for the complete move. It will gain similar to a futures contract once it?s in-the-money. The shorter-term commodity option is used as the trading vehicle to be liquidated on the first sharp move in our favor. Getting a fast double or triple is a good goal for the shorter-term option.

An option spread (selling an option against the purchase) is another way to take in some premium to help pay for the option purchases. Also, "granting" to create a "free" option trade is another technique. These more complex option strategies are well covered in other lessons.

To get even more price diversification, we scale out on price. And we get our time diversification by scaling out in time too. No one knows exactly when and where a price move will end. Simply having two completely different commodity options and scaling out will result in both time and price diversification when we liquidate.

How do we handle profit taking for the longer-term option? One way is to grant another option against it or to sell a futures contract as a hedge when a short-term rally has peaked. This hedge is removed once the correction is over. Read a complete treatment of this technique under our free course lesson #26 entitled, ?The Thomas Swing Method.?

Another method to trade a projected move is to write a commodity option and protect it with another one of a different time frame. The choice depends on the price of the options and their time curves.

Let?s take an example. I remember a time when sugar was selling for about 6 cents and you could cheaply a buy 7-cent call out for 12 months. There was barely any premium in them. At the time you could sell the close in 2 month sugar 6.5 calls for a reasonable premium and continue to repeat this until the 12 month call expired. This would permit about six hedged writes over a year?s time.

These were low risk commodity option trades because the risk was only $625 a trade, being protected by the long call. Finding a long term ?insurance policy? option like this and using it to keep rolling over short term options writes is a great technique.

This technique will not work if the market is real active and running, but if you catch a market that is asleep, buy the cheap, far-out in time hedge. If the commodity futures market then comes to life and option premiums expand, you will do even better to cover the option writes and hold the original call for the rally.

The opposite of this method can sometimes be the right choice also. Let?s say you expect soybeans to trend higher over time. If we write a close in strike put option with lots of time, we will collect a hefty premium. If the market is destined to trend higher, then the biggest risk is probably within the first month or two. If we can make it through the first two months, perhaps the underlying futures market will have gone far in our favor.

Buying a cheap put that has only a month or two until expiration will give us the needed protective hedge. After two months, if the market makes a favorable rally, we will be out of immediate danger as the short-term put option expires.

By doing this we pay a small premium for insurance, but get to keep the majority of the initial write premium in the following months, assuming the market holds firm or continues to rally.

Bear in mind that simply writing commodity options without predicting direction is a wash over the long term. Generally, the commodity market will not pay you simply to sell options in a range. You need to be useful by taking on risk. If simply selling options in a range worked profitably for the long term, everyone would be doing it and eventually the premiums would erode to the point of being minuscule.

There are other commodity option trading methods such as buying a call and selling a higher call to help pay for the first. And there?s a high-risk method of buying a call and selling two puts to fully pay for the call ? but this is like holding two naked long futures and is not achieving our goal of reducing risk.

I find the best method for developing an option strategy is to first find a high probability, low risk futures trade. You MUST forecast direction to get an option edge, even when writing them. This forecast can even be a chopping market to write options or trending market for option position trades or spreads. Then use option analysis software to scan for the best option combinations to do the job.

Some traders make the mistake of relying entirely on the option analysis program to find undervalued or overvalued options, etc. But options are often that way for a reason and the market is reasonably efficient. You need to know direction. Sometimes the forecast is questionable or the options are too expensive for buying or too cheap for selling, etc. It’s all a balancing act to finally come up with the optimum plan for a particular market.

How about futures contracts? Is there a way to reduce our risk when buying futures? The risk problem with futures is they are marked to the market. This means they always have a ?delta? of 1.0, meaning they track the cash market closely. With options, as the market moves against you, the delta will shrink and erode more slowly. Plus, you can only lose what you paid for the commodity option.

With a futures contract, it?s more like trading on a razor?s edge. The advantage is the futures contract does not erode in premium like an option. Generally, if a cash market does not move for two months, the future stays flat with little or no loss while the option will surely lose its premium value.

So how do we hedge our futures contract? Here?s how: Let?s say we go long a futures contract. We then buy a put option with a strike price that is near the current futures contract price. If the market went sharply against us, normally the loss could be very large – holding a naked future.

But with the put option hedge, loss is limited to the premium we paid plus the difference between the option strike price and where we put on the futures contract. Bottom line is we can use the option as our synthetic futures contract ?stop loss? order. If the maximum we can lose with the put option hedge is $1,000, we know our true risk no matter what happens.

The advantage here is STAYING power. Let’s say the futures contract (with no hedge) took a $3000 dip against us, but then rallied to finally make a big profit. We would have probably been stopped out holding the naked futures contract, whereas the option hedge would let us ride through the adversity with a maximum limited loss at any time of $1,000, until option expiration. In addition, we have protection from an overnight market gap surprise. This one benefit alone may be worth the hedge.

Trading futures while using this option hedging technique will take some "insurance premium" profit out of the bottom line, but when you consider the possible risks of holding naked futures overnight, one has to wonder why someone would not always want to make their stop loss order in the form of a hedged long put. (Or for a short future, use a long call hedge)

Just having a market forecast is not enough. Not every ?low-risk, high probability? trade works as we expect. Some turn into high-risk, low probability trades. Having a few strategies like this to reduce our risk will shave profits somewhat, but will usually help our equity curves to trend smoother without the chaotic dips.

Account survival is first, but second is a smooth, up-trending account equity curve. It is well worth the small hedging premium we pay. Scaling in and scaling out in both price and time will also help to smooth out this curve.

Having these techniques available to you will give you more confidence to hold through adversity for the bigger moves. It will also reduce your fear of market unknowns.

Good Trading!