All About Futures and Commodity Options

Most people undoubtedly start trading Futures Options or Commodity Options by buying Puts or Calls. That is the simplest way to trade and your risk is defined - you can't lose more than you invest. Unfortunately, the time erosion of these options can eat you alive if you are not careful. You have to know the timeframe of your trade and buy the proper month and strike price of Options. There's nothing worse than expecting the market to move up while you are long calls and the market stays flat. Then, your options expire worthless (100% loss) and the market rallies the next week. Professional Futures Option Traders are aware of time decay of Commodity Options and realize they are theoretically losing money each day on their trades.

Futures Options Volatility Premiums

The more the particular Commodity Market is panicked due to drought, politics, etc. the more volatility premiums are added to the price of these Futures Options. For example, if the Corn crop was planted a bit late due to weather problems and the weather forecasts for Iowa and the Midwest are calling for a a heat wave over the next two weeks of 100 degree temps. The Corn market would probably rally quickly. Commodity Traders would quickly buy Corn Futures and Corn Futures Options, thus bidding the price higher and adding to volatility. Since there is a more likely chance for a huge rally, those Selling Futures Options will demand a higher premium. Far out of the money options will be bid to outrageous premiums, because Traders believe they can get more leverage buying far out of the money options since there price is lower. In reality, it is a longshot prices will ever reach the "panic" prices people will be discussing. The moral of the story is - Be cautious chasing markets by buying far out of the money Futures Options.

How about Selling / Writing Futures Options

Some good work has been published by James Cordier and Michael Gross of Liberty Trading Group. They manage money for high net worth clients and their specialty is Selling Futures and Commodity Options. Their book The Complete Guide to Option Selling (McGraw-Hill 2005) outline many of the Futures Options Strategies they implement and the best setups for trades.

The basic theory is that selling Futures Options puts the odds in your favor. There is theoretically more risk since you can lose more than your investment, unlike buying options. This scares many investors who seek the safety of only losing your premium as the worst case scenario. However, the statistics show that most options expire worthless and the odds of making a positive return selling Futures Options is greater. An analogy of selling options is that of being a bookie. People place the bets with you (you write the futures options and they pay you the money) and if the bet doesn't payoff (options expire worthless) you keep the money. How many bookies go broker compared to how many gamblers going broker? Consider yourself Vegas or the House. If you manage your money properly, you should continue to win in the long run, since the odds are in your favor.