The Good, the Bad and the Ugly - Part Two

---

...Continued From Part One

The Harsh Reality        
On average, many commodity traders achieve perhaps 30-50% accuracy when they hold positions for 2-3 days. Thatís an excellent batting average for this time frame. However, the problem is that these traders think they can take small profits and large losses and still survive.

As we all know, the trading game is all about probability. Probability will eventually catch up with you if you are trading at 50% accuracy and taking smaller gains than losses. You must work out a trading plan that makes you take profits in proportion to the accuracy of your trading method.

Trading OTM Options
One area that magnifies this problem is commodity options buying and selling. Generally, selling far OTM options with a month or less to expiration can sometimes net you a win/loss accuracy of 90%. However, the profits are generally small and that 10% loss can often swallow much, if not all, of your gains. This illustrates an important principal of commodity risk management: risk management is much more difficult when your profits are small.


Conversely, buying far OTM options can yield accuracy of as low as 10%. If the rare winning option is held for a big gain, it MAY make up for the repeated small losses. Unfortunately, that is not always the case. This is where your option trading and analysis skills make the big difference and give you an edge to rise above the crowd.

Getting The Edge
Just a small edge can mean so much. Itís analogous to the difference between a golfer who hits par and one who hits a few strokes under par. Which golfer do you think wins the most tournaments? Itís the same thing with commodity futures trading. A little edge means so much and itís worth striving for.

Buying commodity options can be a tough game. Remember, to win when buying an option, the futures contract must move in the correct direction and do it quickly in the time granted. Thatís the only way to win. The commodity option will lose if the underlying futures contract price goes nowhere, goes in the wrong direction or even moves slowly in the correct direction! Thatís why 10-20% accuracy is a good average for buying far OTM, long-term commodity options.

Succeeding in buying commodity options means that you need to exploit the trades that work. Forget about taking small profits, or play another game where you can take smaller profits (a.k.a. - day trading). The saying, "you canít go broke taking a profit" does not apply to long term commodity options buying (and stock options buying).

Conversely, when selling (writing) a commodity option, you will profit if the option simply does not go above a certain point in one direction by expiration time. Itís "easier" to be right when selling far OTM options. Unfortunately, the profits are very small in comparison. Also, the occasional loss that comes along can sometimes be disastrous. The commodity market really does price things accordingly. Thereís no free lunches. Thatís why you need to develop your edge or let someone else trade your money.

To repeat, there are three ways to be wrong when buying commodity options, hence the low accuracy rate. On the flip side, there is only one way to be wrong when selling (writing) them, hence the high accuracy of this strategy. Call it a wash, if you will, but you really need an outside edge to beat this commodity game.

If you do not know what your edge is, then you don't have one. It's as simple as that. If that's the case, then the market pros who have an edge will eat your lunch. It may not happen not right away, but over the long run they will take your money...            
  
Continued In Part Three...
"

---

View Thomas Cathey's post archive >