The Hidden Dangers of Buying Commodity Options: Part 1
GOING LONG
I am going to tell you some things about option buying that may save you a lot of money over your lifetime. This applies to both commodity and stock options. First of all, buying commodity options as a routine way to participate in a market's price move for long term trading is a losing proposition over the long haul. In fact, it's probably the leading cause for commodity trading failure by the investing public.
Most beginning speculative option buyers (and many brokers) wave the flag and trumpet the fact that options have limited risk. This is true. When it comes to buying options, you can only lose the money that you invest.
However, this limited risk comes at a price. Paying a hefty option premium to the market just for the privilege of holding an option for several months is a hefty price indeed. Over time, these premiums can add up to a tremendous, and even crippling, expense.
THE CLOCK IS TICKING
If you are in the market for a year, whether trading options in and out or holding long term option positions, the clock is always ticking and eroding those option premiums. There is a small window when commodity options are priced at good values and can be bought, but it is a tiny fraction of the time when markets get out of line and the historical volatility gets low. The majority of the time, long term option buying is a formula for failure.
In some cases, it may cost you 100% or more of your account value just to pay and maintain that eroding premium privilege for a full year. For example, it is common to pay about $1000 for a three month futures option that is near-the-money. If the futures market simply chops sideways, goes down or even rallies slightly, the option will expire worthless in three months. Do this three more times to cover a full year and you've spent $4,000 to simply hold ONE out-of-the-money call option for a year.
That's a significant amount of money to pay to the "insurance man" just to feel comfortable for a year. In comparison, if you were holding futures contracts, they would have been near break-even at year's end. That's a tremendous difference. Think about these statistics and realize that most commodity pros consider it a great year if they earn "just" 30% on their accounts - for the entire year!
LOADING UP
There is a tendency for many option buyers to "load up" and buy way too many options for their account size. I've seen it over and over. Option buyers are very prone to feeling comfortable and becoming "boy plungers." In contrast, serious futures contract traders are very aware of the potential risk and usually take extreme precautions by trading small for their account size. (As a general rule of thumb, small is always a good idea for survival.)
Remember that I am talking about the dangers of simply BUYING options and holding them. Selling options (writing them), using them to hedge the risk of futures or using them in spreads to pay for a long options position can work very well. To use options efficiently means spending the time to find the proper combination to lay off your risk while still participating in a chance for profit.
Continued in Part Two...
"
I am going to tell you some things about option buying that may save you a lot of money over your lifetime. This applies to both commodity and stock options. First of all, buying commodity options as a routine way to participate in a market's price move for long term trading is a losing proposition over the long haul. In fact, it's probably the leading cause for commodity trading failure by the investing public.
Most beginning speculative option buyers (and many brokers) wave the flag and trumpet the fact that options have limited risk. This is true. When it comes to buying options, you can only lose the money that you invest.
However, this limited risk comes at a price. Paying a hefty option premium to the market just for the privilege of holding an option for several months is a hefty price indeed. Over time, these premiums can add up to a tremendous, and even crippling, expense.
THE CLOCK IS TICKING
If you are in the market for a year, whether trading options in and out or holding long term option positions, the clock is always ticking and eroding those option premiums. There is a small window when commodity options are priced at good values and can be bought, but it is a tiny fraction of the time when markets get out of line and the historical volatility gets low. The majority of the time, long term option buying is a formula for failure.
In some cases, it may cost you 100% or more of your account value just to pay and maintain that eroding premium privilege for a full year. For example, it is common to pay about $1000 for a three month futures option that is near-the-money. If the futures market simply chops sideways, goes down or even rallies slightly, the option will expire worthless in three months. Do this three more times to cover a full year and you've spent $4,000 to simply hold ONE out-of-the-money call option for a year.
That's a significant amount of money to pay to the "insurance man" just to feel comfortable for a year. In comparison, if you were holding futures contracts, they would have been near break-even at year's end. That's a tremendous difference. Think about these statistics and realize that most commodity pros consider it a great year if they earn "just" 30% on their accounts - for the entire year!
LOADING UP
There is a tendency for many option buyers to "load up" and buy way too many options for their account size. I've seen it over and over. Option buyers are very prone to feeling comfortable and becoming "boy plungers." In contrast, serious futures contract traders are very aware of the potential risk and usually take extreme precautions by trading small for their account size. (As a general rule of thumb, small is always a good idea for survival.)
Remember that I am talking about the dangers of simply BUYING options and holding them. Selling options (writing them), using them to hedge the risk of futures or using them in spreads to pay for a long options position can work very well. To use options efficiently means spending the time to find the proper combination to lay off your risk while still participating in a chance for profit.
Continued in Part Two...
About Thomas Cathey
Thomas Cathey is a 27-year trading veteran and the CEO of Thomas Capital Management, LLC. Mr. Cathey heads the CTA managed futures division and also advises brokers. He directs three managed programs that include; writing diversified commodity options, writing S&P 500 options and day trading the e-mini futures contract.When time permits, he also mentors his fellow traders as a trading coach.
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