Trading commodities like a pro: Futures & options

When trading commodity futures, you will notice that the price of the futures contract will be different to the current cash market price. This difference is called 'basis' and takes into account the costs of storage, transportation, handling, quality and local supply and demand issues.

As a speculator, it is important to remember to close your position before the expiry date as you do not wish to receive a phone call asking where you want your barrels of oil to be dropped off.

In order to trade futures, you must post a deposit called 'margin' representing a fraction of your total position value. Because you don't have to put up the full amount, your potential gains or losses are magnified. In the past few months, the exchanges have raised margin requirements at short notice owing to greater commodity-price volatility. This has forced some speculators to close positions in a hurry, intensifying volatility in the market.

To safeguard yourself against increased margin requirements, it is prudent to put some extra funds into your account as a cushion. Futures contracts operate in the same way as contracts for difference (CFDs) with profits and losses added or subtracted respectively to the account each night based on the closing price. If funds in the account fall to below the margin requirement due to trading losses, you will get a margin call, asking you to deposit more money in order to keep the position open.

The initial margin is the amount of cash that needs to be deposited with the exchange to open the transaction and the maintenance margin is the amount needed in the account at the close of business after subtracting any trading losses.

Commodity Options

Options can be very complex, but there are some basic strategies such as the 'long call' and 'long put' that anyone can use profitably.

The commodity options market is a fairly liquid one and there is good activity with both hedgers and speculators participating. It is fully regulated and most listed commodity options are traded on one of the big exchanges such as the Chicago Mercantile Exchange (CME) or Liffe, which is part of the NYSE Euronext group.

The benefits of purchasing commodity options include risk that is limited to the premium paid, unlimited profit potential in the case of call options, no margin requirement, as well as their application in a wide range of strategies.

The buyer of an options contract pays what is called a 'premium' to the seller. The amount paid will depend on demand and options pricing characteristics such as the 'strike price,' or price at which the option gives the buyer the chance to buy the underling asset or enter into another contract.

With a 'call' option, the purchaser is buying the right – but not the obligation – to enter into futures contract at a future date at an agreed price. It is important to note that the seller of a call option is exposed to unlimited risk, as theoretically there is no ceiling to which a price might rise. So, the seller of an oil option with a $100 strike price would have to deliver the underlying for $100, even if the oil price soared to $200 – or more.

If you think prices are going up, you will buy a call option, conversely if you believe prices are going down you can buy a put option. The put option gives you the right to sell a futures contract at an agreed upon price at a future date. The future date is known as the 'options expiry.'

The strike price is set at set intervals above and below the current market price. You will select the strike price at which you wish to enter into the transaction at the future date. This will depend on your view on where the market will be at the expiry date.

There is a huge variety of markets to trade, some of which might not be obvious, but nevertheless offer good opportunities. For example, the US pork industry had sales of over $97bn in 2005. Prices can move quickly as a result of supply and demand issues caused by weather and disease, for example.

Chart 1 displays prices for the CME lean hog contract. Fundamental research might tell us that lean hog is moving higher owing to increased demand, but at the same time the technical view says that there is a confirmed resistance level at the $77 level, sitting just above the current trading bar on the chart. This could make for risky trade were you to take an outright futures position.

CHART 1: CME FROZEN PORK BELLIES DAILY TWO-YEAR WEEKLY

A simple options strategy, however, would be to purchase a call option with a strike of $74. This gives you any upside potential from here and limits your downside risk to the premium paid. The premium on the $74 call option for August expiry closed at $2.325 at the end of the trading week for the chart. This means you can have unlimited upside potential above $74. And, of course, you don’t need a stop-loss, because your maximum risk is $2.325, which is the premium you paid.

There are three probable outcomes in the life of an option that a trader needs to calculate at the outset of the transaction. You need to work out the maximum profit potential, the maximum loss and the break-even point. The break-even point is the primary decision-making number. For call options, the higher the current market price compared with the strike price, the more expensive the options.

More and more traders are turning to options as they can get started in trading with just a fraction of the money that would be required to trade the equivalent position using futures.

Advanced commodity option strategies.

With the constant fluctuation in commodity markets, options allow an investor to execute additional strategies by combining both put and call options (see table 2).

Volatility refers to the price fluctuations of the underlying asset. An option's premium will be influenced by the likelihood – as interpreted by market participants – that the underlying asset will move above or below the various strike prices on offer. Generally, higher volatility means higher option premiums. Commodity volatility strategies are complex, more information on how to trade these can be found at www.cmegroup.com.

Portfolio protection is also possible by purchasing put options to hedge your long-commodity futures positions. This gives you profit protection with the advantage that you can still participate in any upside movement.

Table 1: Futures contract margins

Table 2: Advanced commodity option strategies