Hedge risk to develop discipline
By Brian Hoops
Tuesday, May 24, 2005 9:57 AM CDT
The very essence of speculation is assuming risk in exchange for the potential for profit. Traders have to assume the risk of financial loss for the potential for financial gain. In doing so, traders will often undertake more risk than necessary when they trade commodities without much regard for reducing their trading risk.
One of the most under-used principles in trading the markets is risk reduction. Trading commodities means having a large amount of leverage in terms of controlling large sums of a given commodity for a small percentage of the value of the commodity. Learning how to reduce the leverage of trading commodities is one of the most important things you will ever do. With that in mind, let's look at a strategy that can help.
If you are long futures, sell an out of the money call option. Employ this strategy when implied volatility is high and prices are technically overbought. This will offer you some protection and help provide you discipline for hanging onto your winners. When you sell an option, you collect the option premium. If prices pull back, you can buy the call back and make money on the option, and your emotions will be kept in check as the market temporarily works against you. If prices rally after you sell the call, you'll make more money on the futures position than you will lose on the call.
Futures always have a 100 percent delta, where an out-of-the-money call option will have a delta of 50 percent or less. In essence, you will reduce your position in half, for the tradeoff of having some protection. Additionally, this will allow you to keep your stop on the futures below the trend reversal point, and that increases your odds of success.
The best thing about the strategy is that you make more money in almost every conceivable outcome. If prices chop around or stay flat, you earn the premium of the option as the option decays and you lose nothing on the futures position. If the market goes up slowly, you'll still make every point on the futures and you will only lose slightly on the option because of the time decay. If the market would drop lower, you'll get stopped out of the futures, but will also make money on the short call option.
Another strategy to employ if you are long futures is to buy a close-to-the-money put option. The long put strategy essentially works in the same manner as the short call strategy, however the put option will give you unlimited downside risk until the option expiration, versus the limited profit potential of the short call option. You should employ this strategy when volatility is low and prices are oversold.
If you are just entering into a long position, buy the put at the same time. By buying the put, you have a limited downside risk to the cost of the option plus any difference in the strike price and the entry price. This will give you the discipline to hang onto your trade and allow the trade the time to develop. If prices move against you, you have the protection of the option, if the market moves in your favor, you will only lose the cost of the option but have the gain of your futures position.
To summarize, these strategies works great in keeping emotions in check and as a way of reducing risk. Give these strategies a try next time and watch your profits multiple.
Brian Hoops is president and senior market analyst of Midwest Market Solutions, Inc., a full-service commodity brokerage and marketing advisory service. Daily market commentary and trade recommendations are available on the Internet at http://www.midwestmarketsolutions.com or subscribe by e-mail at bhoops@iw.net, call toll free at (866) 203-9655, or write to Midwest Market Solutions, 1028 Broadway Ave., Yankton, SD 57078.
Comments »
Comment on this story
Comments will be approved within 48 hours
|
