evolution of trading methodology
Over the last few months, my trading habits have taken a turn for the more conservative. Fortunately, this turn wasn't due to a bad loss in the markets, but rather I've been experimenting more and more with the use of options.Ideally, I would like to participate in the futures markets no matter what's going on in my life. If I'm out of town I don't want to feel like I have to check the computer or call the brokerage house for price quotes every day (not that I wouldn't anyway--being a hobbyist and all), but still I don't want to feel obligated. So the idea of using stops to limit (to a large extent) the potential for catastrophic losses is always a great idea--there are limitations though. Some markets require more patience than others and sometimes there will be a high potential trade without a nearby support or resistance level for effective stop placement. In cases like this, I like to evaluate the prices of options on the futures contract I wish to trade.
A recent example of this is the lean hog market. As of late, we've seen a pretty steep run-up in the price of August lean hogs. Anything that goes up so quickly usually has a pretty nasty correction to the downside. If there is a total reversal, then that price action to the downside generally happens at an accelerated pace (markets that go up fast fall even faster). No matter what your opinion about markets like this, there is definitely an opportunity that is presented in some cases through the use of options.
If a trader anticipates a correction to the downside in a market that has enjoyed a steep upward trend, then shopping for an inexpensive put option is a great way to limit one's risk exposure, while at the same time stepping in front of a freight train. The beauty of this approach to purchasing options is that as the freight train is rumbling along and gaining momentum, the prices of the put options below the market become more affordable.
While this method of trading generally won't yield as high of a return on a dollar-for-dollar basis, I have experienced a higher percentage return on initial investment with this strategy. This affords the trader an opportunity to hit more base hits and leave open the possibility for a home run without exposing yourself to unlimited risk by trading the outright futures. Over time, consistent base hits add up to make for pretty impressive overall returns.
In the hog market mentioned above, I purchased put options on the August lean hog contract for $600 each on 6/19 and each one already has a market value of over $1000 as of 6/24. That $400 return may not seem like a lot to those that have hit home runs trading futures, but that's a 67% return on the initial $600 outlay. Not only that, but you have a capped risk of $600 per option should your contrarian thinking approach backfire.
posted by jared @ 4:08 PM
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