Thursday, October 31, 2013

Commodity Options: A Safer Strategy in a Volatile Market

If there was some way to design a roller coaster based on a volatility graph of the average futures contract, you would have quite a thrill ride on your hands. For those who may not be fully aware, volatility is a measurement of how “herky-jerky” the markets are on a daily basis. When volatility is high, that means that price action is expected to be wild and loose, and when volatility is low, there will be a lull in price action. One thing is for sure—neither the wild periods nor the lulls last forever, which is the reason why volatility exists in the first place. Volatility is what gives you the opportunity to profit in the markets—if prices stayed stagnant all the time, there would be no way to make any money, because there would be no expectations of price movements, which means that there would be nobody betting on the price to move in a given direction, which in turn means no buying or selling of futures contracts.

But, as we all know, the entire futures market functions around what people THINK a particular commodity will be worth in the future. This prompts them to assume the risk of entering into a futures contract, which can be financially lethal if they not properly margined, or if they are overleveraged. If you’ve ever experienced the unpleasant “pit in your stomach” feeling of getting a margin call (and I have), you know how stressful it can be when you’re assuming more risk than you’re really comfortable with.

So, for that reason, I believe that options are a great alternative to futures contracts, as they are a way to still participate in the futures markets, but for a fraction of the overall risk. Options are basically contracts that give you the right, but not the obligation, to buy or sell a futures contract for a specified price (called the “strike price”) at a specified time in the future. The two basic types of options are call options and put options. explains call options here; put options follow the same format, but basically act as a “mirror image” to call options.  There’s a WHOLE lot more to options trading than I care to get into right now, plus I’m  getting ready to eat dinner, so I’m  going to sign off for now. But I’ll leave you with this thought: Notice in my post title I said that commodity options are a safER strategy in volatile markets, but they are not completely risk-free—no investment is. Just don’t lose your head in these crazy markets.