A coherent commodity options trading strategy makes all the difference between the dabblers and the folks who bank consistent, repeatable profits no matter which way the market’s headed. That’s because a well-defined strategy doesn’t just help smart traders identify which trades to take, it also provides guidance when things don’t go as planned.

Here’s an exclusive look at how my trading strategy picks winners 80% of the time…

The commodity options trading strategy employed by Resource Trader Alert is to purchase limited risk options or option spreads with solid reward to risk ratios. Equally important is buying enough time until expiration for our plan to move into profitability.

The option price is determined by a few main factors that we balance in order to purchase the best value for the money.

Simply stated, the more time you buy translates into more expensive option premiums – that’s because your window of opportunity is being extended. Additionally, the greater the price movement in the market raises relative costs because of the price volatility component. For example, something that hasn’t had recent significant dollar moves like Live Cattle versus faster moving Crude Oil has cheaper options.

Commodities contracts themselves typically have approximately a twenty to one leverage. For example, a Gold contract controls 100 ounces at $1100 an ounce representing a cash value of $111,000 for a deposit of only $7000. The financial gains and losses are therefore magnified with $1000 for each $1 movement in price. As you may expect, undisciplined outright futures without risk control have turned many large fortunes into small ones. That’s why we stick with limited risk options.

Commodity Options Trading Strategies: Beyond Time and Volatility — Delta Payoff

I’ve been asked by a few readers to go into a little more depth on my options philosophy, so let’s pull back the curtain…

Because of the underlying leverage in commodities, the additional leverage in the options can amplify and multiply returns from modest price movement. The selection of the In-the-Money versus the At-the-Money versus the Out- of the- Money options is based upon cost.

The higher the Delta, which is the percentage that the option price moves in comparison to the underlying asset, the more expensive the option premium. You get what you pay for, so another way to look at Delta is to see it as the approximate probability of the option being at the strike price at expiration.

The Resource Trader Alert strategy is to buy options or option spreads that are one or two strike prices from current levels because they have a good payoff that will increase as the market moves further in our desired direction (and still, it’s a little more complicated than that – but I can’t give away all of my secrets!).

This tells us that there’s a 50/50 chance mathematically that prices are above 3200 at expiration (before the increase from our analysis edge.) At the same time the out-of-the-money 3700 option leg will gain little in comparison. With six months of time and a close to the market strike price we have selected a high probability play that has the nice return potential.

Commodity Options Trading Strategies: The All-Important Exit Strategy

Money management is a very important part of my trading plan. I can’t repeat enough that our plays are always limited risk with the maximum financial exposure limited to the total premium paid. That said, it’s never my intention to let an option expire worthless if and when the trades fail to develop as we intended.

The rule I follow is to monitor a position closely if it loses half of the premium from our entry price. With options, that means either the market has moved significantly the opposite direction or the time to expiration is approaching.

It’s a tough call to salvage the position, since I’ve seen plenty of options run from near worthless to highly profitable, but for some traders it is good discipline to sell out and recover premium for another day.

The ultimate trick is to avoid that scenario – that’s why so much detailed analysis goes into any options pick I make. I’d much rather spend time finding an excellent commodity trade than spend time trying to figure out how to salvage a mediocre one.

It all comes back to commodities,
Alan Knuckman

February 24, 2010

Alan Knuckman

Alan Knuckman brings two decades of commodity trading experience to his role as managing editor of Resource Trader Alert, a weekly newsletter providing analysis and real-time updates on current and evolving market conditions. His options, futures, and currencies experience have made him a sought after commentator on issues shaping both hard (extracted or mined) and soft (grown or produced through the agriculture industry) commodities. He is a frequent guest on major international media outlets including CNBC, Sky News, MarketWatch, Bloomberg, Fox Business Network, CNN Money, and Reuters.

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