The Hidden Dangers of Buying Commodity Options: Part 2
...continued from Part One.
THE TIME ADVANTAGE
Let's talk about the time advantage that futures contracts have over options. If you bought a futures contract and the market went sideways for a full year, depending on the carrying charge differences between months, you could possibly break even on the year. But there is a chance of getting stopped out.
So what? If you are stopped out of the futures contract, then step back and re-evaluate your situation. It is highly likely that most of your capital is still intact. As a result, you can always get back into the trade at a different price or just let the trade go and move on to something better.
THE DANGERS OF EROSION
Successful futures traders with accounts under $20,000 are more likely to buy small lots - one or two contracts with loose stops. They will also consider buying an option as a HEDGE against unlimited risk. This is the right reason to buy options - as well as selling (writing) them to collect their premium.
Many new option buyers let their options erode to nothing once the market goes against them. Options premiums have a tendency to get slammed during adverse moves, usually in percentages far greater than the underlying futures contact's move. It's not unusual to see an option's premium get cut by 50% in one day while the futures contract has moved the equivalent of 10%. Of course, an option can double in one day as well, which helps drive the "lottery ticket" mentality that motivates many options buyers.
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THE TIME ADVANTAGE
Let's talk about the time advantage that futures contracts have over options. If you bought a futures contract and the market went sideways for a full year, depending on the carrying charge differences between months, you could possibly break even on the year. But there is a chance of getting stopped out.
So what? If you are stopped out of the futures contract, then step back and re-evaluate your situation. It is highly likely that most of your capital is still intact. As a result, you can always get back into the trade at a different price or just let the trade go and move on to something better.
THE DANGERS OF EROSION
Successful futures traders with accounts under $20,000 are more likely to buy small lots - one or two contracts with loose stops. They will also consider buying an option as a HEDGE against unlimited risk. This is the right reason to buy options - as well as selling (writing) them to collect their premium.
Many new option buyers let their options erode to nothing once the market goes against them. Options premiums have a tendency to get slammed during adverse moves, usually in percentages far greater than the underlying futures contact's move. It's not unusual to see an option's premium get cut by 50% in one day while the futures contract has moved the equivalent of 10%. Of course, an option can double in one day as well, which helps drive the "lottery ticket" mentality that motivates many options buyers.
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Some option buyers purchase options when "the cat is out of the bag" and pay greatly inflated premiums for their efforts. This happens when dramatic news hits the market and the futures move sharply. But if the cash market then goes sideways, the futures contract prices stay intact while the options premiums get sucked back out. Again, I've witnessed many occasions where options premiums have been cut by 50% or more in a single day's time while the futures contract price went sideways.
The bottom line is that an options buyer is paying a huge price to avoid taking on "risk." The professional options sellers on the other side of the trade are the ones putting their hands in the fire by taking the real risk. The market pays us to add liquidity and take on risk. It penalizes us (through high option premiums in this case) when ducking risk and liquidity just to feel comfortable.
PICK YOUR BATTLES
Buying options for EVERY trading signal is the path to ruin. It cannot be done successfully over a long period of time because of this heavy premium expenses.
You must pick your spots carefully. Remember that to get the very best option buys you want the previous holders to be panicking and dumping them wholesale. Always wait for a selling panic to buy and a buying panic to sell. This gives you a great price buffer in case you are wrong and need to dump the position later yourself! At these panic times, call option premiums can be so deflated that you can sometimes own an option (at or near the money) for a little more than the carrying charge cost of a futures contract. Now that's what I call a bargain.
Continued in Part 3...
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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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