While you’re buying your Sweetheart Chocolates, Consider putting some money to work in Cocoa Futures.
Commodities, futures contracts, options . . . it all sounds so intimidating to investors not yet familiar with this rapidly expanding asset class. Yet as February brings the buyers of sweets for the sweet, you may consider that commodities are the most basic of investments. They are the products we use every day, from gasoline to orange juice to the sugar and chocolate you may be buying this month. The question is, how do you invest in this stuff?
A core focus of The Complete Guide to Option Selling (McGraw-Hill 2005) is pairing the logic of selling option premium with the long term fundamentals of a particular market. This is the strategy we recommend to clients – but it is certainly not the only way to invest in commodities.
Nonetheless, for this type of trading, volatile price movement is a good thing.
A variety of economic conditions, especially in the United States have ushered in an era of unprecedented volatility in a variety of markets. The US Dollar, Crude oil, Soybeans, Silver and Gold have all proved turbulent markets for investors as of late and have many traders pulling their hair out trying to time their tops and bottoms.
For Option Sellers, however, these are the best of times. Option Sellers want and need volatility and the amount present in today’s markets have many eagerly rubbing their hands together. High volatility means strikes available so far out of the money that they have very little hope of ever being exercised. Consider some of the trades that were available in late 2009:
- Selling May Silver 30 calls (you make money if July Silver futures are anywhere below $30 an ounce in April)
- Selling June Gold $2000 calls (you make money if June Gold futures are anywhere below $2000 per ounce in May).
- Or, you could have sold March Natural Gas 10.00 calls and made money if Natural Gas was anywhere below $10.00 in March (Natural Gas is just above 5.00 at the time of the is writing).
The reality however, is that most people did not. Most readers of this column are probably unfamiliar with the concept of commodities futures trading – let alone selling options on these contracts.
That’s OK. For helping you understand this specific type of investment is the purpose of this column.
Many people getting started in commodities futures trading begin by buying options. This can be a mistake. Buying options offers limited risk. But the chances of making money by buying options is slim. That is why sophisticated investors often look to take the opposite side of these beginners and sell them these options. It is a fact that over 80% of all options held through expiration will expire worthless.
But that doesn’t mean that option buyers don’t think they can turn a buck by buying these kinds of options. While there is slim chance these types of options will ever go in the money, there is a chance that they could increase in value in the meantime, meaning the buyer of the option could buy high and sell higher – turning a profit. In addition, media attention has a way of whipping speculators into a frenzy and ultimately making them do foolish things. Sometimes, this involves buying ridiculously priced options in hopes of securing big gains on “the next leg.”
The odds, however, are overwhelmingly in favor of the option seller who sells and holds on to these options through expiration. In most cases, time will eventually catch up with the option values and barring some cataclysmic event, erode them to zero – meaning eventual profits to the seller.
The primary risk to the far out of the money option seller then, is increased values and margin to his position prior to expiration. Thus it may serve an option seller well to utilize a strategy that could help to offset short term increases in the value of his option while he is waiting for it to expire.
In some markets, a strategy known as a strangle can accomplish this. A strangle is a strategy of selling both a put and a call at the same time. The put is sold far below the current price of the underlying futures and the call is sold far above the current price of the underlying futures. If the futures price is anywhere between the two strike prices at expiration, both options expire worthless and the trader keeps all premium collected as profit. Although strangles can often produce more premium for the seller than selling naked puts or calls, they can also be considered a more conservative strategy, as gains on one side of the strangle tend to offset losses on the other side. This “offsetting” effect allows a wider range of movement in the underlying contract without significantly affecting a trader’s equity. Meanwhile, time value gradually erodes the value of both the put and the call. Strangles are best employed in non-trending markets but can also be utilized in some slower trending markets.
A good example of how to employ such a strategy is in the Cocoa market.
Traditional investors may cringe at the thought of investing in such an exotic market. But cocoa is a legitimate futures contract trading thousands of contracts every day by commodities and hedge funds on the ICE exchange (formerly the New York Board of Trade).
And, as an individual investor, it’s open to you as well. You just have to know how to go about it – or work with a firm that specializes in such investments.
Therefore, in the spirit of the Valentines Day season, and the accompanying surge in Chocolate demand, we are outlining a strategy
that you can employ today to invest in cocoa. Unfortunately, it’s not as easy as buy before Valentines Day, expect a price increase due to the increased demand, take your profit. Seasonal surges are already factored into price. Everybody knows it’s coming. Sorry!
However, the option strategy we will describe will show you how to make money in the cocoa market as long as prices stay in a wide, defined range for about 12-16 weeks.
About 2/3 of the world’s cocoa production come from 4 West African nations: The Ivory Coast, Ghana, Nigeria and Cameroon. Cocoa prices have benefited recently from lower production (see chart below, a weaker US dollar and a new source of demand beginning to materialize from developing economies such as China, India and Brazil. As the middle class continues to grow in these nations, more of it’s residence have disposable income to spend on “ luxuries” such as chocolate.
However, the world’s largest consumers of cocoa such as the European Union (40% of world demand) followed by the US (12% of world demand) have just been through a major recession. Cocoa demand is down.
The combination of lower supply and lower demand could help keep prices in a somewhat defined range this year.
For this type of price outlook, you can consider an option strangle as an investment.
EXAMPLE – Short Option Strangle
Trade date: Jan 12, 2010
Trade: Selling July Cocoa 480 Calls and 240 Puts (Strangle)
Total Premium Collected: $800 ($400 put, $400 call)
Margin Requirement: $1650
Option Expiration : June 4, 2010
Analysis: If Cocoa prices are anywhere between 480 and 240 per tonne at the expiration date, both options expire worthless and seller keeps all premium collected as profit.
Risk Management: Conservative – Risk to one of the options doubling in value (Ideally, the other side would then expire worthless, resulting in the trader breaking even on the trade).
Aggressive – Risk to one side tripling in value (resulting in a net $400 loss if other side expires worthless).
Also known as “bracketing”, the strangle can be a profitable approach as long as the futures price is anywhere between the two strike prices at option expiration. As stated earlier, the primary benefit of a strangle is this: if the market is heading towards one strike or the other, the increasing value of the nearer strike price is offset, at least partially, by the decreasing value of the option on the other side of the market. This offsetting effect allows the market greater flexibility to fluctuate as opposed selling a straight put or call. Both the put and the call will eventually expire worthless, as long as neither strike price is exceeded.
A secondary benefit is margin. Strangles often have a lower margin requirement since this balancing effect of the put and the call reduces the risk to a certain extent.
Thus, writing a strangle can not only be an effective tool in helping to mitigate risk by letting puts and calls balance each other, it can also increase an investor’s return on invested funds due to it’s favorable margin treatment among the exchanges.
Like any strategy, strangles have their limitations. While they are useful in non-trending or at least non-violent markets, a price breakout in either direction can cause losses to accumulate on one side of the strangle if the trade is not exited. The option on the opposite side of the losing option can only balance losses so far. In addition, having options on both sides of the market virtually doubles the chances of being on the wrong end of such a breakout.
The balancing nature of the strangle, however, will generally allow risk conscious traders to exit gracefully in such an occurrence if they are using the risk management guidelines listed above.
While strangles are generally not recommended for markets experiencing strong trends, they can be very effective in markets experiencing high volatility. Volatility can often make strikes available on both sides of the market that have little chance of ever going in the money.
Fortunately for sellers of strangles, today’s markets have no shortage of volatility. And if you are looking for a fundamentally supported market in which to employ the strangle, Cocoa could be a good bet.
That goes for your Valentines day gift as well.