Know Your Commodity Before you Implement Any 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 commodites 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. On the other hand, some commodity markets such as gold, are typically volatile when certain chart patterns appear, so adapting your commodity option trading system around the straddle could prove very useful.
There are a number of ways you can implement and exit straddle trades. For some examples of this, take a look at:
Straddle Option Strategy