The business media has been abuzz with a number of success stories of people who have become immensely rich through commodities options trading. Although the whole business segment is experiencing a severe recession at present, this type of trading goes on and thanks to options, you can make money even if prices are going down. But you still have to understand the inherent high risk and reward of this kind of trading. Beginners should exercise caution before starting to get involved in the commodity trade.
An option is a contract that gives its owner the right to buy or sell a particular commodity at some time in the future. There are two fundamental types of options: call and put. A call option can be utilized to buy a commodity, while a put option is used to sell. You make money if a price discrepancy develops between the price specified in your option contract and the then-current market price. The good thing is that you do not need to own a particular commodity to engage in options trading.
Your judgment is crucial here. If commodity prices are likely to go up, you can buy a call option which will allow you to purchase a commodity at a lower price while selling it at the higher market price once it has increased. To buy a call option, you do not need to pay the full amount it would cost you to purchase the commodity. All you have to pay is a small fee for the option contract.
What happens if the price goes down, instead of rising? If you own a call option, you lose the fee you paid. Your option has become useless because the market price has gone down. If you had known that beforehand, you could have purchased a put option. A put option allows you to sell a commodity at a certain price in the future. If market prices drop below the price specified in the put option, you can make money by selling or exercising the option: You buy the commodity on the market and resell it at the higher price specified in the put option, pocketing the difference — minus the fee you paid for the option — as your profit.
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Commodity Option Trading System,
The best commodity option trading system is one that suits the kind of market environment in which you are trading. Commodity prices are well known to be extremely volatile and unpredictable at times. All you have to do is compare long term charts of some commodities like soybeans, sugar or oil to those of stocks and you’ll quickly realize how different the trading environment can be.
So it’s important you choose a commodity option trading system that fits well with this kind of price action. One factor that should be borne in mind is that the supply and demand for many commodities are seasonal in nature. Understanding this will help you to develop a trading approach that takes advantage of this.
Which Commodity Option Trading System is Best?
Let’s divide our discussion into two parts here.
1. Trending Markets
Understanding the seasonal influences on commodity market prices will help you to anticipate when a change or continuation of trend is most likely. This being the case, you can choose to simply ‘go long’ (i.e. buy) either call or put options, usually with at least 90 days to expiry, so that you can take advantage of this.
The best options to purchase under these conditions are those that are either at-the-money (ATM) or first strike price out-of-the-money (OTM). You don’t want to go too far away from that, or your option values will not increase much even with a big move. OTM options are cheaper than ATM ones, and this means your profit potential is magnified once the options are in-the-money. It is not uncommon for a well timed OTM option on a commodity to increase 1,000 percent in value once a new trend begins.
So never underestimate the connection between seasonal factors on commodities and the advantage that newly trending markets provides.
The In-The-Money Debit Spread
This commodity option trading system is a good one for newly trending markets and involves purchasing an in-the-money option and selling an out-of-the-money option, both with the same expiry month. One advantage of this approach, is that the implied volatility in the OTM option will often be greater than for the ITM option. This disparity not only lowers your initial costs, but should the price of the underlying go against you, the overpriced OTM ‘sold’ option value will evaporate much more quickly than the ITM bought option, enabling you to repurchase the sold option for profit.
If the price of the underlying continues in your favour, the price of the ITM option will increase at a rate closer to the rate the underlying increases, due to a higher delta and the sold OTM option will not experience this same rate of increase until it becomes deeper in-the-money.
2. Volatile Markets
Commodity options are unlike stock options in that the underlying is a product rather than a company. Products like wheat, sugar, oil and bonds are more affected by natural disasters and international news events than company share prices, unless the company’s fortunes are heavily connected with a particular product.
For example, war breaks out in any middle eastern nation. What happens next? Oil prices become very volatile. A hurricane sweeps over a major sugar producing area. What happens? Sugar prices soar… and so on.
Implementing the right kind of commodity option trading system as soon as news of this kind breaks, can result in profits that are not only healthy, but quite safe as well.
Straddle or option strangle positions in newly volatile markets can be quite lucrative, as they are ideally tailored for large moves within a short time frame. They are also non-directional, so you don’t care which way the underlying price moves, as long as it is significant. Quite often, there will be an initial reaction to the news, followed by a reversal once its effects are known. This is the ideal time for the straddle or strangle to come into play.
The volatility that is ideally suited to these types of trades usually works best at the beginning of a bear market. Bear markets are characterised by wild swings, as panic, followed by buyers taking up bargain opportunities, causes the market to gyrate back and forth with large swings.
Owen has traded options for many years and writes for Options Trading Mastery – a popular site about the best option strategies. It includes a whole section about commodity options trading.Article Source: http://EzineArticles.com/?expert=Owen_Trimball.