Commodity Futures and Options Trading- Money Management, Risk and Trading Logic, PART 2
Possibly the most important aspect to get right in trading is survival. This is number one. Without surviving the bad times we are gone, with no hope. Money management and risk may sound like boring subjects, but read on to see how exciting they can be once you learn the concrete reasons and logic for their use. You may never trade the same way again!
Here’s the harsh reality. On average, many commodity traders trade at perhaps 30-50% accuracy when they hold positions for 2-3 days. That’s a GOOD batting average for this time frame. But, the problem is they think they can take small profits and large losses and still survive. It’s all about probability and doing the correct thing over a long period of time. Probability will eventually catch up if you are trading at 50% accuracy and taking smaller gains than losses. We must work out a trading plan that makes us take profits in proportion to the accuracy of our trading method.
One area that stands out and magnifies this problem is commodity options buying and selling. Generally, selling options far out-of-the-money with a month to expiration can sometimes give you win/loss accuracy runs of 90% + at times. However, the profits are small and that 10% loss is often a big one that can take back much if not all the little profits. Commodity account risk management is more difficult when the profits are small.
And, conversely, buying options way out of the money can yield results as low 10% accuracy. But IF the rare winning option is held for a big gain, it will make up for the many small losses – but not always. This is where your option trading and analysis skills make the big difference and give you an edge to rise above the crowd.
Just a small edge can mean so much. It’s like the difference between a golfer who hits par and one who hits a few strokes under par – who wins the tournaments? Or baseball batting averages of 275 vs: 325 – or pitchers who can throw 85 mph compared to one who can throw 99 mph. It’s like night and day. It’s the same thing with commodity futures trading. A little means so much. It’s 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. That’s 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 goes it the correct direction, but not fast enough! That’s why 10-20% accuracy is a good average for buying way out of the money, long term commodity options.
To succeed buying commodity options means you need to exploit the trades that work out. Forget about taking small profits, or play another game where you can take smaller profits, like day trading and other methods. The saying, “you can’t go broke taking a profit” does not apply to long term commodity option buying. (And stock option 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. It’s “easier” to be right when selling a far out-of-the-money option, but the profits are small in comparison and the occasional loss that comes along can sometimes be big. The commodity market really does price things accordingly. There’s no free lunches. That’s why you need to develop your edge or let someone who has one, trade your money.
To repeat, there are three ways to be wrong when buying commodity options, thus the low accuracy rate; and only one way to be wrong when selling (writing) them, thus the high accuracy of the method. The win/loss ratio and the percentage of accuracy reflects this. Call it a wash, if you will. 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 and the market pros with an edge will eat your lunch over time. Maybe not right away, but over a long run of probabilities, they will take your money away.
Part Three of Five Parts – Next!
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.