Cotton and Orange Juice

Cotton:

I think I jumped the gun on this one. Option sellers like when there is large move in a commodity and the option premiums on that side go way up. With cotton moving up to 96 cents, I finally sold some $1.20 call options. However, cotton has since skyrocketed to $1.02, and the premium on my $1.20 options has risen 2.5x. My general rule of thumb is to exit a trade at a loss if the premium has increased by 3x.

My mistake in this trade was going against a strong rally AND against the fundamentals -- that is, ignoring the fact that even though cotton prices are nearing all-time highs, they deserve to be at this level and were poised to go higher. I even knew that cotton was trading at $1.13 in some places in China (and apparently at $1.40, as I've now read). It seems there is a bit of a short squeeze going on now too as traders on the short side are running out of margin. There is apparently not much resistance until you get to the $1.17 level (the all-time high). Still, most people seem to be saying that cotton is in a bit of a bubble now, and only panic buying will cause it to move higher. But who knows how much longer the panic buying will continue. If the current price rises much higher, I can't justify the risk and will have to exit the trade at a large loss.

Orange Juice:

Orange juice is experiencing a pretty big rise too - it moved its 1-day limit of 10 cents today, to close around $1.60, all on fears of a tropical storm forming that could hit Florida and damage crops. I'm looking to sell calls in this situation, of course :) This situation is quite different than cotton though. Florida's orange harvest is expected to be on par with last year's, and demand for orange juice hasn't been as low as it is now since the late 1990's. So the only thing driving the rally is the fear of a storm damaging crops.

So when selling calls here, it's basically a gamble on the storm -- in most cases you'll win (first it has to actually form, then it has to hit Florida, then it actually has to do some damage), but you have to be prepared for the worst. The highest price orange juice futures have ever traded is $2.09, and I'm looking to sell calls around $2.40. So I think this trade would be much safer than the cotton one.

Current trades:

My other trades are going perfectly:

- I exited my $100 oil calls after making 75% of my potential profit (the usual point at which I exit a trade). This was a perfect example of trading the fundamentals. The economy is still weak and there is a huge oversupply of oil. People were overly optimistic about economic recovery and I couldn't believe oil kept rising to close to $80.

- I have a $1100/$1500 gold strangle (sell $1100 puts, sell $1500 calls). Because I've always expected gold to keep rising, I only sell calls at very high levels ($250-$300 above current price). This has served me well, as gold has risen about $100 since my $1500 call trade, now at a price of almost $1300, and my $1500 calls are still quite safe. I expect to exit this trade in a week or two.

- I have a 0.87/1.025 CAD strangle. The 1.025 call trade was a bad one -- way too close to the money. I got impatient as I really wanted to be in a strangle, and didn't wait long enough for a good rally in the CAD to be able to get good premiums at a higher level. The CAD can move 5 cents in a day so I like to trade around 10 cents away. If the CAD stays at current levels, I'll be exiting the 0.87 puts later this week as I should reach about 75% of my potential profit.

Option Selling Update

A little while ago I decided it was time to go really go all out with my option selling. After 8 months of trading a fairly small portfolio, I felt I now had a pretty good feel for trading these markets. I'd experienced some dramatic moves in my positions, got exposure to a fairly diverse number of commodities, and confirmed my trading rules of thumb that help guarantee me a good chance of 50-100+% returns per year.

So at the end of July, I started increasing my account size considerably and now trade a very large account. I made some really good trades in the first month (especially Natural Gas, Gold, and Soybeans). I made 5% in the 1st month, and that was while gradually ramping up the size of the account. That makes my 10-month portfolio performance equal to about 82% (due to compounding), and so I'm on target to reach about a 100% one year portfolio gain -- we'll see though. That works out to about a 6% monthly gain, and I hope to continue that average going forward.

I'm currently in trades on Gold, the Canadian Dollar, and Oil. Here's what I'm keeping my eye on for potential upcoming trades:

Sugar:

One of my first trades was with sugar when it was crazy high at 26 cents or so, and I was selling calls at 38 cents at really high premiums since everyone thought it could keep rising. Well it eventually dropped to 14 cents or something after that and there have been no good premiums at safe distances in price. But recently it's risen above 20 cents again. I have to look at what people are saying and if the fundamentals really justify the price, but usually fears of shortages are overblown, just like last year. So I may look at selling some calls.

Cotton:

I have never traded cotton, and I don't really know anything about it. But it is reaching crazy all-time highs. World-wide stocks are at the lowest since 1990, demand is high, crops have been disappointing everywhere, and Tropical Storm Hermine is threatening more US crops. So Cotton is around 92 cents, and it looks like the highest it ever reached was close to 120 cents in 1995. There are some really good call options at 120 cents with only 66 days to expiry that I'm looking at selling. I don't know if that strike price is too risky though. I probably need to look into it more.

Natural gas:

Believe or not, I'm actually looking to buy call options on NG. It's the same story as last year: storage levels are very high and demand is really low, and so the price has been plummeting. Spot price has gotten below $3.70 and it is getting about time for a rebound. In history, 70% of the time, natural gas prices rise in September and October. This is what happened last year -- of course the price first dropped like a rock to the $2 range, and then proceeded to rise to $5 before the end of October. This week would historically be the perfect time to buy options that expire at the end of October, but it's really hard to time this right. The bottom could drop out of the price and we could see the $2 range again. Who knows. Also, the futures already price in some expected autumn gains, and so prices really need to rise to be profitable in a call-buying scenario.

9-month performance

Here are some up-to-date stats on my option selling portfolio at about the 9-month mark:

• 9-month portfolio gain: +73% (~6% per month)
• # of completed round-trip trades: 28 (56 individual trades)
• Profitable trades: 26.
• Unprofitable trades: 2
• Average length of trade: 40 days (shortest: 5 days, longest: 93 days)
• Average portfolio gain per completed trade: ~2%
• Average # of simultaneous open positions: 4
• Avg percentage of original premium retained: 70% for profitable trades

While everything looks like it has gone better than expected, I did do something really stupid and encountered a worst-case scenario, and just about lost all my gains because of it...

May Craziness:

One of the important rules is to not overposition yourself. When the Canadian Dollar (CAD) was around 0.98 at the end of april, I sold puts at 0.90. For the CAD, I was at the limit of what I should be putting into one position. However, on the morning of May 6th, the CAD started to drop and the premiums were rising, and I didn't want to miss out, so I sold some 0.86 puts as well.

Of course, the May 6th craziness happened that afternoon, and the CAD matched its biggest ever intraday point move -- about a 4 cent drop to 0.93 cents before recovering a bit. What was scariest was that there were no "asks" during the few hours when the price was plumetting, so I don't know if I could have exited my trade if I wanted to. That's something I never expected -- that in a worst-case scenario, I may not be able to get out of a trade because liquidity just disappears. When the asks started showing up again, my 0.90 puts were at 7x their value.

I usually place my trades such that I can easily handle a 10x increase in premium, even 20x. But in this case I had double my normal position. I never did exit the trade, as the dollar started recovering. but it gets worse...

Later in May, the dollar had recovered pretty good, but the premiums were still nice and high on the puts, and I bought some 0.89 puts. Now I was 3x overpositioned in the CAD. Sure enough, the CAD dropped 2 cents in one day and eventually ended up around 93 cents again. The premiums on each trade were up 6x, 3x, and 2.5x. On top of that, I had some other trades temporarily in the red, and so the 50% portfolio gain I had at the beginning of May was now completely wiped out on paper.

My margin was maxed out, so I had to exit a couple of trades at a loss. I should have never entered more CAD trades, and I should've exited them when they reached 3x my premium. I didn't want to lose all I had built up though, and I was fairly confident the CAD would stay above 90 cents. If the CAD dropped anymore, I would've been in big trouble. I got lucky though -- the CAD recovered, and I held onto all the CAD trades until they were profitable again a couple of months later.

The good that came out of this was:

- I saw how the markets behave in a panic situation

- I learned first-hand how important it is not to overposition

- The panic situation kicked some sense into me so I doubt I'll do a stupid move like that again.

- I saw that my "rules" do work (my strike price choices, position limits, exit strategy, etc.), if followed, and with them I can handle a typical "worst-case scenario". Even with being 3x overpositioned and not exiting when I should have, my portfolio was down 'only' 35% in a nightmare of a scenario. Imagine if I only had the one CAD position as I should have, and if I exited it properly. I would've only lost about 10%. (Of course, there's always the never-before-seen worst-case scenario that could theoretically wipe me out, but that's the small risk I take with option selling to make incredible gains)

- It reinforced that the most important thing is to be far enough out of the money.

May Market Crash! No, wait.... Nevermind!

Today was one of the craziest days on the market. The DOW had it's biggest intra-day point drop ever, falling over 1,000 points from 10,800 to just under 10,000 -- over 9%. 9% for an index! Then as quickly as it dropped, it jumped up, closing down only 3% by the end of the day. Here's what the day looked like:

But that wasn't the weirdest part. Accenture, a $40 stock, within a few minutes ended up trading at 4 cents, 1 cent, and then immediately right back up to $40. Here's the full day picture:

And here's the close-up of a single 1 minute timespan at the craziest moment (click the image for a larger version):

Remember, the chart above spans just 1 minute! There were a couple of times when there would be a trade at $30-ish or so, and then the very next trade would occur at 1 cent, and the next trade back at $30-ish. But it wasn't just one single oddball trade caused by some glitch. You can see that there were hundreds of trades (over 400, actually) in this 1 minute that gradually brought the stock price to its knees.

A few other stocks supposedly traded down at the 1 cent level as well. Also, Procter & Gamble, an extremely stable stock, briefly dropped from $60 to just below $40, before immediately returning to $60.

So What Happened?

Markets were already spooked with the riots in Greece today and the whole Greek Debt Crisis. Original sources were trying to place the blame of the market crash on a "fat finger" -- someone accidentally entering a billion-dollar order instead of a million-dollar one, which then supposedly set off a wave of automated selling. But a lot of people are saying that the markets had already dropped a lot before any supposed erroneous trades or price quotes occurred, and the drop was led by large moves in the currency markets.

A summary article:

http://www.reuters.com/article/idUSTRE6455ZG20100506

Here is one article that places the blame on automated high-frequency trading:

http://www.zerohedge.com/article/day-market-almost-died-courtesy-high-frequency-trading

I think it will take a few days for people to fully analyze the situation and for us to get some good, interesting articles on what happened today. I personally think that this is something that could happen any time due to the highly-automated world of trading we now live in, and it's quite scary. The Accenture graph above shows what strange things can happen when only the computers are in control.

I think this quote sums up everything the best:

"We did not know what a stock was worth today, and that is a serious problem," -- Joe Saluzzi of Themis Trading.

6-month Performance

Before talking about the crazy markets today (next post), I thought I should post my 6-month performance numbers. My options trading portfolio was up 50% at the 6-month mark (April 25th, 2010). That's still with no losing trades to date. I don't feel like gathering all the stats, so I'll just leave it at that.

4-month performance

Well I started my option selling adventure with my first trade on Oct.26, 2009, and I've now reached the 4-month mark, Here are some up-to-date stats:

• 4-month portfolio performance: +37%
• # of trades: 11 completed, 3 currently open
• # losing trades: none
• Average trade length: 39 days (shortest: 17 days , longest: 2 months)
• Futures traded: Gold (6 trades), Canadian Dollar (4), Sugar (2), Cocoa (1) , Soybeans (1)
• Avg. percentage of original premium captured: ~66% (e.g. sell for $600, buy back at $200)

What's interesting is most of the trades have been for expiry dates that are almost 4 months out, but I only held them for about 1/3 of that time (39 days on average) and yet made 66% of the total potential premium in that time. This highlights the true option time decay curve I posted, which showed how you can typically capture about 50% of the premium in 1 month (i.e. the option price should halve in about 1 month).

Another thing I noticed is that commissions/fees are eating up about 12% of my trade profit on average -- much higher than I was expecting before I started doing this, but it makes sense. OptionsXpress commissions/fees on futures options are about $15 per contract. For something like the Canadian Dollar, which is a 'smaller' contract than something like Gold, I'll typically sell 2 contracts and buy those back later for a $60 total round-trip cost for something that might only net me around $400.

The Time Decay Lie

The way we make our money in option selling is from time decay. The premium of the option we sell is fully comprised of "time value" and as this erodes, our realized profit increases. So determining when to sell options such that the time decay is maximized is very important to us.

Do a google image search on option time decay and you'll get a bunch of results that all look like this:

Every textbook on options will have this graph. If you naively based your option selling on this graph, you would say it's best to sell options with 1 to 2 months until expiration. It looks like most of the time value is still in the option and it doesn't begin to drop off rapidly until after this point.

It doesn't help when the authors of The Complete Guide To Option Selling, who are supposedly the experts on option selling, reproduce this graph in their book and on their website here, and say "Notice that the value decays the fastest during the last 30-60 days of the option's life". They then go on to advocate selling at 3 - 5 months to expiry, which confuses readers since it seems to contradict what they just said and what the graph shows... but it's all because the graph is a lie!

What these graphs fail to tell you is that they are showing the typical behaviour of an *** At-The-Money *** option. We are selling Far-Out-of-They-Money options, and the difference is huge!

As a simple gut-check that the graph must be wrong, look at any far out-of-the-money option with 30 days remaining until expiry, and you'll see that it is practically worthless. What was once worth maybe $400 with 90 days remaining is lucky to be worth $50 with 30 days remaining. Anyone who has sold options knows that there is no value left by the time you hit the 30 day mark.

So what does a typical out-of-the-money option time decay chart look like? Here's one I put together a few months ago, showing an 82 cent put option strike and 106 cent call option strike for the Canadian Dollar when it was around 94 cents. I simply looked at these strikes in different option months to get an idea of how the price would change over time, assuming the futures price and sentiment didn't change.

Well well well... the curve has completely changed! You could infer from this graph that the farther from expiry, the faster the time value decays -- the exact opposite of what the standard option time decay chart implied!

Now before anyone goes and starts selling options that are 1 year from expiry, please note that:

• the farther away from expiry, the more time the commodity's fundamentals have to shift and the more time the futures contract has to move towards to your strike price. E.g. the CAD could easily move to 0.82 over a full year. Thus, you should be selling farther out-of-the-money the farther you move out in time, which means you won't get as much premium, so it may not be worth it.
• If there is a move against your position, these long-out options often start to behave a little more like At-The-Money options, because if people are thinking there is a shift in the trend, the premium could remain high for a long time. You can't easily wait out these moves. E.g. from 12 months left to 10 months left, an option premium may not change that much depending on how the future's sentiment has changed. However, with a 3-month-to-expiry option, the option almost has to really start losing it's value within 2 months, and you'll have a 3 month maximum time to wait it out.
• The graphs don't always look like this. For example, with Sugar, the futures contracts show that the prediction is for sugar to drop drastically in price in about a year. So the call options that are a year out are actually not much different in price than the ones that are 4 months out.

Based on the trades I've done, the optimal time-to-expiry to trade seems to be around 90 to 130 days to expiry.

I seem to be able to find good value in this range at strikes that seem reasonably safe. With less time than this, the premium is already dropping too much and commissions will eat up a bigger percentage of the premium, or I have to trade too close to the money or overposition myself to get a good premium. With more time than this, it can be hard/frustrating to wait out moves against my position. Also, since more people are trading the closer months, it is harder to trade the farther out months with less liquidity and crazier bid/ask spreads.

As a side note, one rule of thumb I try to follow is that for any option I'm about to sell, I should expect it to halve its value in 1 month. So If I'm looking at a June option, I check out the May contract, and it should currently be at about half the premium of June's at the same strike price. This is just one of many rules of thumbs I follow to help me confirm that the trade I'm making is a good one.

Portfolio Return Graph

This is just a quick follow-up to my last post about making a 50% annual return. Remember, that number was assuming 80% of our trades are successful. Since the largest factor determining portfolio return is that percentage of successful trades, I thought it would be more interesting to see a graph showing this relationship, based on the same formulae from my previous post:

You can see we only need about 60% of our trades to be successful in order to break even, assuming we follow a strict exit strategy on bad trades. If 100% of our trades are successful (which is definitely attainable), we can make almost 120% in a year! And these numbers are actually a little conservative, since the formula assumes most of the trades are held to expiration (the scenario "c" example in the previous post), which in reality should almost never occur.

I'm coming up on the 4 month mark of my option selling adventure. In a couple of weeks I hope to post my 4-month portfolio return, reflect on the trades I've made, and talk about my future plans.

Option Selling - Part 6 - 50% Return?

I claimed that I expect to make a 50% annual return on my portfolio with option selling. To see how I might arrive at such a number, let's look at:

1) the expected gain on a successful trade

2) the expected loss on an unsuccessful trade

3) the percentage of successful vs. unsuccessful trades

4) the expected overall portfolio return.

1) Expected Gain on Successful Trade

By following various rules of thumb and with my experience so far in picking what seems to be reasonable trades, it seems I can make about $600 premium on a 4-month trade that should require about $1500 in margin. (This can be linearly scaled within reason - e.g. $450 premium on a 3-month trade for about $1200 margin).

The way I calculate the return on this trade is simply $600 / $1500 = 40% over 4 months.

It should be noted that most people actually calculate this trade return as 66.7%. Because you receive the $600 premium immediately, you can put this money to work in another investment, and so your "effective margin" or "out-of-pocket margin" on the trade is really only $1500 - $600 = $900. $600 / $900 = 66.7%. I'm taking the conservative approach of not allowing the premium to be re-invested, because even though the premium is received upfront, you're not guaranteed to keep that cash until the trade is closed out.

40% return over 4 months is what we will receive if we hold the trade until expiration. However, we often will make a higher percentage return because we don't usually need to hold the trade until expiration.

Let's look at the 3 general scenarios that could occur in the first month of a successful trade:

a) the futures price moves favourably for us (away from our strike price).

b) the futures price stays roughly the same.

c) the futures price moves against us (towards our strike price).

In scenario (a), the option price will drop significantly. The option we sold for $600 may only be worth $200 after 1 month, in which case we'd make $400 if we bought it back, or maybe $350 after commission. This works out to a 23% return on investment in 1 month ($350/$1500).

In scenario (b), based on my observations on far out-of-the-money options, the option price will typically drop to half its value in one month. Again accounting for commissions, we would net at least $250, or 16% in one month.

In scenario (c), the option value may rise or stay roughly the same price (depending on the speed and extent of the futures price move), causing us to stay in the trade. Since we are still talking about successful trades here, even if we have to hold until expiration we will end up keeping the full premium. This is just the simple example first described, which I said nets us 40% in the 4 months, or about 10% per month.

Even if scenario (c) happens most of the time, scenario (b) happens sometimes, and scenario (a) almost never happens, and ignoring compounding on the shorter trades, our average trade (or successive trades) will return over 50% in a 4 month period.

(Example math: 23% monthly return 10% of the time, 16% monthly return 25% of the time, 10% monthly return 65% of the time = 23*0.1 + 16*0.25 + 10*.65 = 12.8% average monthly return * 4 months = 51%)

This isn't even accounting for strangles, where we saw we can significantly increase our rate of return, usually over 60% minimum (if held to expiration) in a 4 month period on both of the 2 trades that comprise the strangle. Again, since we can often exit early, we can expect to average over 65% in a 4 month period on strangles.

2) Expected Loss on Unsuccessful Trade

I haven't yet talked about risk management and how much you can expect to lose on a trade gone bad. Really, it is up to you. The book suggests exiting a trade when the option price doubles. I find this a little too restrictive due to the volatility of option prices, so I would say a good rule of thumb is to exit a trade when the option price triples.

If we sold the option for a value of $600 and it triples to $1800, our loss is the $1800 to buy it back minus the $600 premium we originally received, which equals $1200. Since our initial investment was the $1500 margin, our loss is $1200 / $1500 = 80% loss.

It gets more complicated analyzing strangles because there are 2 trades, one successful and one unsuccessful. A typical strangle would be where we sell a put for $500 and sell a call for $500, for a total $2000 margin requirement. If one option tripled and we bought it back, and we assume the other option expires worthless (a valid assumption), the overall loss would be ($500 + $500 - $1500)/$2000 = -25%. i.e. this is the same as losing 25% on two separate trades.

3. Percentage of successful trades

With no history of trading, I have to make an educated guess on this number. I'm going to estimate I can achieve 80% success rate on single trades and 64% on strangles (since a strangle is two separate trades, supposedly each with an 80% success rate, so there's an 80%*80% = 64% chance of success on the overall strangle).

I know this number is pulled out of the air, and it is the variable that will most affect our overall rate of return, but I think it is a reasonable guess. Only time will tell, of course.

4. Overall Portfolio Return

I'm going to try to make half of my trades part of a strangle (e.g. on 8 trades, 4 would be single trades, and there would be 2 strangles (each comprised of 2 trades of course)). Reviewing the numbers, over a 4 month holding period:

- we expect to make 50% on a successful single trade

- we expect to lose 80% on an unsuccessful single trade

- 80% of the trades will be successful

- we expect to make 65% on the trades that comprise a successful strangle

- we expect to lose 25% on the trades that comprise an unsuccessful strangle

- 64% of the strangles will be successful.

(50%*0.8 - 80%*0.2)*0.5 + (65%*0.64 - 25%*0.36)*0.5 = 12% + 16.3% = 28.3%.

Thus, our 50+% average trade return over 4 months drops to an average 28.3% return when accounting for losing trades.

One important guideline that I'm following is that I will only invest half of the cash in my account and leave the other half as cash. This is a very important rule as you need to make sure you have enough room for margin requirement increases that will occur when trades go against you. Since only half of the portfolio is invested, this turns the 28.3% trade return into an approximate 14% portfolio return over 4 months.

Extending this to a full year, and allowing for compounding, our expected yearly return is (1.14 * 1.14 * 1.14) = 1.48 = 48%.

And there you have it, the math behind how I expect to make about 50% per year (before taxes).

The biggest variable, and the one that will affect my portfolio performance the most, is the percentage of successful vs. unsuccessful trades. Also, it has taken me a while to find trades and get up to half of my account cash invested. If I can't keep half of my cash invested, my overall portfolio performance will suffer.

Option Selling Part 5 - Strangles, SPAN Margin

The Canadian dollar is currently around 94 cents to the US dollar. With the weak U.S. dollar, Canada's stronger economy, news such as Russia diversifying into Canadian dollars, I think the fundamentals are strong for the CAD, and I'm very certain it will stay over 82 cents over the next couple of months.

I can (and did) sell 2 March puts (about 100 days to expiry) at a strike price of 82 cents. I received $640 for this sale, and it required $1200 margin. This means I will make about 50% in 100 days on this trade if the CAD/USD exchange rate stays over 82 cents.

Now, I also think the CAD price will be kept in check and will not skyrocket to $1.10 in a short period of time. With the US dollar so beaten down, there may even be a short-term US dollar rally here. I am able to sell 2 March calls at a strike price of $1.06 for a $560 premium. By itself, this trade would normally require around $1100 margin. So we can guess our total return and margin requirements are as follows:

Trade                                Premium     Margin

----------------------------------------------

Sell 2  0.82 March Puts         $640      $1200

Sell 2  1.06 March Calls         $560      $1100

Total:                                  $1100      $2300      
$1100/$2300 = 48% ROI.

However, this is not what really happens. In futures trading, margin requirements are calculated using a special algorithm called SPAN margin. The algorithm is a secret (you have to pay $1000 or something to even buy a program that will calculate it for you, although your broker has the program and will calculate it for you). All you need to know is that it calculates a 1-day risk value on your entire portfolio covering 16 different scenarios.

If you look at our trade above and really think about it, we didn't add much risk by adding the 2nd trade. If the CAD moves significantly in one direction, the losses in the one option will be partially, if not mostly, covered by the gains in the other option. E.g. if the CAD goes to 98 cents, the 1.06 calls may double in value (+$560), but the puts will then also drop to maybe $200 (-$440), so we've effectively hedged our position pretty well. The SPAN calculation recognizes this since it analyzes our whole portfolio, and thus only requires an extra $500 margin for adding the 2nd trade instead of a full $1100 if the trade were by itself.

With SPAN margin, our trade actually looks like this:

Trade                                Premium     Margin

----------------------------------------------

Sell 2  0.82 March Puts         $640      $1200

Sell 2  1.06 March Calls         $560      $500

Total:                                  $1100      $1700      
$1100/$1700 = 65% ROI.

A trade like this where you both sell a put and sell a call in the same expiration month is known as a Short Option Strangle, which I'll just call a Strangle from here on (because we're always "short" by being sellers of options).

I love strangles because you simultaneously increase your ROI while lowering your risk, which is totally counterintuitive -- normally to increase your ROI you have to take on more risk.

You could argue that you are taking on some more risk with a strangle, because a major market move in either direction is now bad for you, whereas with a single position, the market has to move in a specific direction to affect you negatively. However, I believe this type of risk is more than offset by the hedging nature of the trade.

In fact, if you follow a strict rule of exiting both trades and repositioning the strangle if one of the option's value doubles, you almost can't lose money. As I described earlier, if the CAD moved up to 0.98 and the call option doubled, you could probably exit the trade for less than a $200 loss. You could then place a new strangle at a higher price range, say 86 cents and $1.10, again for a total $1100 premium. Even if you had to reposition your trades like this 5 times until you were finally successful, you'd still break even in the end!

I try to do strangles whenever it makes sense. However, when the sentiment on a commodity is really bullish or bearish, it can be too difficult to do a low risk strangle. Right now, many commodities have a lot of bullish sentiment, and so the puts are practically worthless until you get to the strikes that are quite close to the current price -- too close for our comfort as far out-of-the-money option sellers.

Option Selling - Part 4 - Futures Options vs. Equity Options

Here's an article by the book authors that summarizes the advantages of selling options in the futures markets versus the equities market:

http://www.traderslog.com/optionscomparison.htm

It really boils down to the 1st reason listed: margin requirements are way less in the futures markets, meaning your ROI is much higher.

I can typically sell a far out-of-the-money futures option with 3 months to expiry and receive a $500 premium, while only requiring about $1500 or less to be set aside (the margin). That's a 30% return in 3 months. A similar type of trade in the equities market supposedly might get you a $300 premium and require $3000 in margin -- only a 10% return.

It's really the difference between whether you want to make $50,000 over 10 years or make $500,000 over 10 years.

Margin requirements can be even further reduced in the futures market due to the SPAN margin system, which takes into account your whole portfolio when determining your overall risk exposure. My favorite trade type that takes advantage of this is a short option strangle, which allows you to significantly increase your return on investment. I'll talk about SPAN margin and Strangles in my next post.

As for the authors' 3rd reason for why to trade futures options, that being that the futures options markets are more liquid, I don't think the statement has much weight. I haven't done any equities option selling, but I can't imagine it being less liquid than what I see in the futures options markets. Some commodities hardly have any options traded in a day. Yes, I'm looking at you, Cocoa -- not a single trade of the May options at any strike price over 2 days. And the bid/ask spreads, if there actually are any bids or asks, are simply insane. So the futures options markets are anything but easy to trade in.

Option Selling - Part 3 - The Book and The Strategy

After researching books on option selling, I ended up buying the book "The Complete Guide to Option Selling (2nd edition)" by James Cordier & Michael Gross.

This is the book to buy if you're interested in option selling in the futures market. Actually, I think it is the only book out there devoted to the topic, but thankfully it is a great book written by experts who explain things very clearly, and whose views I could fully agree with every step of the way. However, do NOT buy this book to learn about the futures market or options trading, as it does assume you have some knowledge in these areas. I skimmed some good introductory books in Chapters/Indigo a long time ago, but I don't remember their titles.

In the book, they present a fairly specific approach to selling options, and they sold me (no pun intended) on their techniques, even completely changing my mind on a few key strategies (longer-term vs. shorter term options and naked selling vs. spreads).

James Cordier's company is Liberty Trading group, and their website is here: http://www.libertytradinggroup.com/

Oh, and I should've posted this perfect introduction to option selling from their site for my "Why Sell Options" post: http://www.libertytradinggroup.com/benefits.html

But the point of this post is to point out the core strategy that I'm following, which is explained here: http://www.libertytradinggroup.com/strategy.html

Since the above links explain the concepts so well, there's nothing really for me to add here. If you're too lazy to read the links, the core concepts are:

1) Knowing your fundamentals

2) Selling with 3-5 months to expiry

3) Selling deep out-of-the-money options (as in 50 - 100% out-of-the-money).

4) Proper risk management.

The only thing I've noticed in my trading adventures so far is that it's really hard to find an option that's 50 - 100% out-of-the-money with any decent premium. Although, I guess I've been looking closer to the 3-month expiry dates than the 5 month ones. I need to learn to not be so scared to go out longer term. However, I still think those percentages don't make sense in some commodities. For example, with gold, knowing the fundamentals (concept #1), you know trying to sell gold puts at $550 (50% of price) is ridiculous -- everyone else knows this too, which is why you can't get a gold put at that strike price for even $20. So I think there's some leeway in those percentages. But the key is to go farther out of the money than you think (I'm already close to getting burnt by not following this advice in one of my trades).

Option Selling - Part 2 - Why Sell Options?

So what are the main reasons for selling options?

1. Odds are on your side

Studies have shown that about 80% of options expire worthless. This holds true in bull and bear markets, for both put and call options. The large majority of those who buy and hold options will lose 100% of the premium they paid for it. For a detailed article on these stats, see this article: http://www.tribecacapital.com/pages/sellers_vs_buyers.pdf.

As the article mentions, more than 80% of the buyers are actually losing money, because even if an option expires in-the-money, the buyer had to pay a premium for the option, and so the option would have to expire a certain percentage higher than the strike price for them to break-even. There's certainly a large number of options that expire in the money but where the buyer still comes out at a net loss. The only unfortunate thing about the study is that there is no information on the percentage of people who still make a profit on options that end up expiring worthless by selling the option before expiration - e.g. selling during a temporary price spike.

I'm surprised at the 80% number, but I guess it just shows how the option contracts that are out there are not evenly distributed around the asset price. For 80% of the options to be expiring worthless, most people must be "gambling" on out-of-the-money strike prices that are rarely ever going to be reached.

If we only look at options that are far out-of-the-money, the odds of them expiring worthless are obviously higher. You're looking at maybe a 95% chance of keeping the buyer's premium if you sell these options. Of course, the farther out of the money you go, the lower the premium you'll receive, so there's a balance to find.

By being a seller of options, you already start with the odds on your side before you even make a trade.

2. No need to predict where the market will go

Let's say gold is at $1000 and you think it will go down. You could sell a gold futures contract. However, if you guess the direction of the gold price incorrectly, of course you will lose money as gold rises. But even worse is that when you're right about the longer-term direction, you can still lose money from short-term moves. For example, gold might spike to $1050 and you might be forced to exit your trade at a loss as part of your risk management (as you're already at a $5000 loss now). But gold could then reverse and drop to $950, meaning you were right about the direction in the end, but you still lost money on the trade due to the volatility.

Now let's say you instead had decided to sell a gold call option at a strike price of $1300, which expires in 3 months, and you get $500 for this sale. Gold can stay the same, drop, or even go up, and as long as it is under $1300 at expiry you keep the $500 premium from the buyer. Even if you were completely wrong and gold skyrocketed a whopping $250 to $1250 at expiry, you'd still keep the $500 premium. (And even if gold were to skyrocket to $1250 before expiry, you'd likely be able to get out at less than the $5000 loss you would have taken with the futures contract itself when its price reached a mere $1050. Note: this addresses point #5 later on.)

This is one of the best things about selling options. You can be completely wrong about the direction of the market (as we traders often are) and still make consistent profits, as long as you are selling far enough out of the money and not overpositioning yourself (i.e. being greedy).

3. Time is on your side.

For an option buyer, every day that goes by, the option loses some of the "time value" that makes up the premium of the option. If the underlying security doesn't move, time will gradually erode the value of the option. Option buyers know how depressing it is watching your option gradually lose its value while you wait for a move in the underlying asset.

As an option seller, time is always working for you. When selling far out-of-the-money options, ALL of the value of the option is time value and this time value can drop quite quickly. For most options you sell, you will be able to buy the option back a month before expiry to close out the trade early for almost nothing. This allows you to capture most of the potential profit early and get into some other trade, instead of waiting another month to just collect a measly extra $50 or so.

4. It's easy.

Do you stress out about timing your trade entries, figuring out when to exit when the trade goes against you, find it hard to monitor the markets daily - or hourly? With selling options, you simply enter your trade and wait. You don't have to time things perfectly (you might not collect as big of premium if your timing is off, but even movements against your position will likely not affect you if you are far enough out of the money). It's easy to take profits... because you don't have to! You just sit and wait and let the option expire worthless -- no action required on your part. It's much less stressful too, as even a move against your trade is of no concern unless it's a significant move.

5. Lower risk than owning the underlying asset (in my opinion)

I may try to provide a realistic example of this some other time, but knowing me, I won't get around to it. The gold example in point #2 above pretty much illustrates the point.

And those are the key benefits to selling options.

Option Selling - Part 1 - Introduction

I mentioned a while back that I've discovered my trading destiny and would post about it. Well here it is...

The investment approach I am going to be following in my futures trading account from this point forward is Option Selling, also known as Option Writing. More specifically, I will be selling far out-of-the-money naked options on futures with 2-4 months until expiry. I believe this is the ultimate strategy for making consistent small profitable trades that will result in an average portfolio return of about 50% per year.

What is Option Selling?

Most investors have heard about options. If not, there are many places you can read about options trading, such as here: http://www.investopedia.com/university/options/option.asp.

Usually only the buying of call or put options is discussed. But think about it -- when you buy an option, you are buying from someone who is selling, or writing, that option contract. The buyer pays the seller a premium for the contract, and the seller keeps this full premium as long as the underlying instrument does not reach the strike price.

As an option seller, you are no longer predicting or betting on where the price will go; you are picking a price level (usually an extreme one) and betting that the price will not go there. You can be completely wrong about the direction that the price ends up moving and still make money, as long as it doesn't reach your extreme price level.

A Comparison:

Selling options is often compared to selling insurance. Say I own a car insurance company. I might sell a 1-year contract to 1000 drivers at an average of $1000 per contract for a total of $1 million. i.e. the buyers each pay me a $1000 premium to protect them if they get in an accident. I know that 90% of these drivers will not end up using their insurance for the year. The other 10% (100) of those drivers that get into accidents and choose to use their insurance will cost me an average of about $4000 per accident. That's $400,000 I have to pay out. $1 million in premiums - $400,000 in payouts = a profit of $600,000. Not bad.

I ensure that the 10% figure will stay that low buy only selling insurance to low-risk drivers. If I were to sell to high-risk drivers, I might charge a $2500 premium.

Insurance companies are just playing the odds, and making sure those odds are always in their favour. And that is why insurance companies are always profitable.

Now this example isn't perfect, because in the options world we don't have to sit by and watch while "accidents" happen. In the car insurance world, you can't control the fact that there might be a $1 million claim that comes up. But imagine for a moment if I could monitor all the cars in real-time, and when I see an accident about to happen, I could slow down time itself to bullet-time. So I see Joe starting to slide on some ice and headed for another vehicle. There's a chance his car might get totaled, which would cost me, say, $20,000. So I phone Joe up while he's sliding and say, "hey, I'll make you an offer: I'll give you your $1000 back PLUS an extra $3000 to cancel our contract right now". Joe thinks he can avoid the vehicle, and if not, it will just be a fender-bender, and so he says "Deal. Sweet!" And we're both happy.

In the options world we can manage our risk during the lifetime of the trade like in the above example. When selling far out-of-the-money options, we always have plenty of time to get out at a reasonable loss even if there is a severe move in the market.

A quick note on risk:

Usually any mention of selling options is relegated to a paragraph on how it is extremely risky (unlimited risk!), extremely complicated, requires huge amounts of capital, and is a technique only employed by full-time professional traders, and everyone should stay away from it!

The truth is that selling an option -- even naked selling -- is no more risky than buying/selling the underlying stock/futures contract itself, and usually much less risky when done properly. One quick example is described here: http://daytrading.about.com/od/options/qt/ShortOptionsRisk.htm.

Option selling is not understood by even most professionals, and the exaggerations of risk and misinformation around selling options are just perpetuated by such professionals. This myth of incredible risk is so pervasive that is hard to convince people otherwise, and it means that most people stay far away from selling options.

Selling options on futures is more risky than selling equity options, but only because of the leverage that exists in the futures market, not anything to do with option selling itself. In other words, selling a futures option is typically no more risky than buying/selling a futures contract itself, and when done properly, is way less risky. I will try to talk more about risk some other time.

Summary

I should have just linked to this article, because it covers everything I've said and much more, and is way clearer than what I've written.

Next Steps:

Here are the topics I hope to cover over my next set of posts:

- Why Sell Options?

- The Strategy

- Futures Options vs. Equity Options

- 50% return? Yeah right.

- Risk: Naked Selling versus Spreads

- Risk: Selling Options is less risky than owning the underlying asset?

- My trades so far and potential trades - Sugar, Gold, Orange Juice

- Strangles

Sprott And Gold Update

Everyone knows from practically my first post that Eric Sprott is my idol, and I haven't mentioned Sprott in a while, so it's probably a good time to do that.

For anyone who thinks that the worst is over and everything is hunky-dory, please read the latest (October, 2009) "Markets at a Glance" article by Eric Sprott here: http://www.sprott.com/main3.aspx?id=54.

If that article isn't enough to scare you, I don't know what is. And remember, Eric Sprott is alway right :)

Who knows how this state of affairs will eventually affect the markets, but it seems that one thing is fairly certain: the U.S. dollar is toast. Other countries have begun to recognize this. As mentioned in the article, countries have historically supported their own currencies by stockpiling about 63% of their foreign currency holdings in US dollars on average, and this number is now down to 37%.

Furthermore, today the IMF sold 200 tonnes -- or $ 6.7 BILLION worth -- of gold bullion to India. Details and commentary are here:

http://www.businessday.co.za/articles/Content.aspx?id=85875

This was about half of a previously-planned sale by the IMF, but no one expected one big transaction like this. People are speculating China may buy the other half. This is further evidence that countries are trying to get away from the U.S. dollar. This news caused gold to shoot up from $1060 to $1085 today, even while the U.S. dollar was up.

This is great for my Sprott mutual funds holdings, which as you know are heavy in precious metals and energy. (Yes, most of my investments are still in Sprott funds, even though I've been focusing on my trials in short-term trading this last year or so). I just checked the Year-to-date numbers for the funds I'm in:

Sprott Fund YTD returns:

• Sprott Gold & Precious Metals Fund: +90%
• Sprott Energy Fund: +52%
• Sprott Canadian Equity Fund: +26%

Not bad, however they still haven't made back the brutal losses from last year. Remember, you need a 100% gain to recover from a 50% loss.

While gold could pull-back short term, I'm still a big believer in holding gold for the long term. I agree with the guys at Sprott that gold is gradually on its way to $2000 over the next few years. Everyone laughed at them at all their previous gold price predictions, but they all came true.

Natural Gas - Final Trade Update

I am now out of Natural Gas, and I actually ended up making a small profit in the end.

I closed out my December contract at $4.84 today (which I had went short on at $5.00) for a $400 gain. Combining that with my November contract that I lost $150 on, my final outcome of my natural gas trades was a very small profit of about +$220 after commissions.

The warmer weather and maxed out natural gas reserves has caused natural gas to finally come down as expected. That cold snap in October combined with other factors that caused the price to rise sure had me scared for a while -- as I mentioned, I was down almost $4000 at one point. But the fundamentals prevailed in the end.

There is still weakness in natural gas for the short-term, but it is too risky to bet on this now with winter approaching. And besides, I am moving on to bigger and better things...

NG trade

Natural gas continued its climb the first couple of days last week, with November futures reaching over 5.30 and the December futures reaching over 6.00. At those prices my contracts were down $1400 and $2500 respectfully. Finally prices began descending Wed, Thurs, and Fri.

On Friday, my November contract almost touched my break-even price of 4.75. With only Monday and Tuesday left before expiry, I decided to sell at the end of Friday at 4.81, for a small loss of $150. I didn't want to risk holding over the weekend, just in case prices went up. (Remember, even a 0.20 rise would be a $500 loss).

Today (Monday), prices continued their decline with quite a large drop. November closed down 27 cents at around 4.50, with 1 trading day left. So if I had held on just one more day, I could've turned a $500+ profit. Oh well, things could have gone much worse, so I'm happy getting out when I did, considering where things were at just a week ago.

The drop was nice because now my December contract is down to 5.20. I had planned on taking a large loss on it, but who knows, it might actually go under $5.

Anyway, after this trade, I think I'm done with trading pure futures. Too risky and too stressful. I know, I know, I only made 1 trade. And I'm glad it didn't go exactly as planned, or else I may have fooled myself into thinking it was easy money. But all is not for naught! The setting up of my OptionsXpress account was all part of a larger plan to eventually reach my trading destiny, which I am now ready for... and I'll leave that for my next post.

NG Update

It was a bit of a scary week with all the cold weather. Natural gas spot price kept going up, reaching 4.25, but the November futures kept bouncing off 5.10 or so. Luckily, last Thursday's Storage Report showed a larger-than-expected 69 bcf net increase in stocks, reaching a total of 3658 bcf for Oct.2, which I think helped keep the ceiling on the futures price, as I had hoped it would do.

I've been watching the weather forecast all week, here: http://www.weather.gov/forecasts/graphical/sectors/conus.php?element=T

(Turn off "Table Mouseover Effect", click +12 hrs if necessary to show "High" Temperatures", click the word "High", then use the "Next Image" buttons at the bottom to view each day's forecast up to a week ahead).

A week ago you could see that the cold weather would end around today (Wednesday), which turned out to be correct, and now for the next week it looks like it will be much warmer.

Natural gas prices have dropped quite a bit the last two days. Spot price is now at 3.80 and November price is 4.44. People think the drop was primarily related to news that UNG will begin to move its investments out of futures to other instruments due to anticipated regulatory restrictions and position limits on futures trading. See this article for more details:

http://online.wsj.com/article/SB125544223957682433.html

The weekly storage report gets released tomorrow (data is for the week up to Oct.9), and it should show the total stocks are above 3700 bcf, which I think will scare people.

Looking at the detailed historical data provided by the EIA, storage usually tops out between Oct.25 and Nov.16, most often right around Nov.7. I'm predicting that this year's storage will probably top out around 3900 bcf, based on historical patterns and extrapolating for this year. If this happens, certain regions will likely reach their maximum capacity and not be able to take any more natural gas.

So the fundamentals look perfect for a further drop in natural gas prices over the next couple of weeks... at least to me. However, all the trading reports I have access to on OptionsXpress keep saying everything looks bullish, there is strong support, prices are set to rise, etc.

Weather

November natural gas has still been hovering around $5 (good thing I didn't sell more at 4.70!). Spot price is now up to $3.20.

What worries me is a cold weather front that will be moving through the northern states over the next week or two. Temperatures are expected to be much colder than average. This could really push prices up a lot.

Hopefully the natural gas storage report released on Thursday will help keep the spot price from shooting up too much. Also, next week UNG supposedly has to start rolling their November contracts into the December ones, and the shorts are hoping that this will force the November contract price down.

Natural Gas - no new trade

After some research, I've decided it's not worth the risk to enter into any new NG position.

The commenter on my last post prompted me to look into the price action history for the last 2 big spread spikes seen in the graph. These details can be found in the historic weekly EIA updates (see here: http://tonto.eia.doe.gov/oog/info/ngw/historical/ngwu_2006_07.html).

Well, it turns out that right after the $1.50-$2 spread back at the end of September 2006 occurred, the spot price rallied $3 over the next month! Spot went from an average of about $4 to over $7, while the Nov Future went from about $5.60 to over $7 as well (actually expiring below the spot price). There was no major reason stated for the increase other than cold weather.

For the 2nd largest spike, in Nov 2007, this time the spot price didn't really move at all, and the futures contract did come down over $1 to close the spread.

I've been reading a bunch of message boards and it's amazing how split the view is on what the November futures are going to do. A lot of people actually think it will go up and close in the $5 to $6 range. And of course a lot of people, like me, think the price will have to drop. Another big topic is UNG, which controls a large percentage of natural gas futures, and there seems to be a lot of confusion on how they are affecting the market. I think there is a lot of manipulation going on.

I've decided not to sell another contract because:

a) The market knows best - Nov must be $4.70 for a reason. In 2006 the market was right.

b) There is a lot of uncertainty in what the price will do; there are a lot of people on both sides of the fence.

c) Colder weather is expected next week.

d) I calculated that I could only handle about a $1 increase in the futures prices if I sold another contract. No trade is worth the risk of getting wiped out over such a small move. Currently I can weather a $2 increase in futures price (which would probably require a $3-4 increase in spot price - in 24 days).

I still think Nov will easily drop below $4. Even with colder weather, the latest economic news shows the demand isn't there, and storage is at record highs, so I can't see a repeat of 2006 happening. But whatever, I'm just going to play it safe and be happy with the small gains I'll make if I'm right. And if I'm wrong, at least I shouldn't lose my shirt.

Natural Gas Insanity

Yesterday (Friday), the natural gas spot price dropped a whopping 60 cents from 2.92 to 2.32, a 20% drop. And what did the November futures contract do? It went up 25 cents! All futures months went up. This is insanity.

Over the last week the spot price has dropped over a dollar, while the November futures contract hasn't moved. With the Nov contract closing at about 4.72, this has resulted in a $2.40 spread between the spot price and near-month futures contract, which by the way has only 25 days left until expiry.

Here's a graph I found showing that this is the largest spread in over 3 years (and I bet even longer) - check out our spike on the right:

Image source: http://graphics.thomsonreuters.com/109/US_GASSPREAD1009.gif

Link is from this article: http://www1.hymarkets.com/html/news/2009/10/2/1254509240nN02332141.html

I've been scouring the latest news stories & blogs, and no one is offering any real explanations. They're all basically saying, "wow, there's a crazy spread" and that's it.

This premium cannot last another week, so it seems like an opportunity of a lifetime to make money. When the markets open Sunday evening, I'm going to try to sell another Nov e-mini contract -- or two -- at anything I can get above 4.50. I doubt it will fill because the price will likely open lower than that.

Birthday trade

Today I sold 1 e-mini November natural gas contract (QGX9) at 4.75.

It was up 23 cents from yesterday's close. I really can't see this rally having much more steam. I've read that the rise is due to a combination of short sellers getting out and people being more optimistic about the economy (an improving economy will boost demand in NG). That's all fine and dandy, but the reality is:

- Natural gas inventories are going to reach record highs - they'll increase until mid-October.

- Weather/Temperature has been very favorable.

- There have been no hurricanes.

- There has been no sign of increase in demand yet.

So yes, sure, NG demand will pickup at some point, but for the next month there is no justification for the spot price to keep going up. I'm still reading analysts predictions of NG falling below $3 in October, mainly citing the inventory levels and favorable weather (meaning no big increase in demand).

Current spot price is either 3.44 or 3.59. The site that shows 3.44 showed yesterday's close at 3.37. That would mean it only increased 7 cents today, while the futures all increased about 25 cents, which seems strange, so I'm wondering if the 3.59 number is more accurate. I don't know what its previous day's number was though. I still have to find a site with spot prices I can trust. Either way, I have anywhere from a $1.16 to $1.31 buffer, with 34 days left till expiry. I feel very safe in this trade. In 4 trading days the Nov contract will become the near-month contract, as the Oct one expires on Sep.28th. It will be interesting to see the behaviour of the Nov contract when that happens.

The weekly inventory numbers will be released tomorrow morning. As long as the inventory increase isn't way lower than expected, I think NG will drop quite a bit in the coming days. But who knows, because right now the rally is against me.

NG trade

I entered my first futures trade today! I sold 1 e-mini December futures contract at $5. That contract is QGZ9 if you're curious (QG = natural gas e-mini, Z = december, 9 = 2009). Current spot price was around $3, Oct contract (which expires in about 9 days) was 3.20, Nov was 4.35. The Dec. contract ended up at 5.07 the last I checked.

This trade requires about $1300 margin, and for every $1 move in the contract price, I lose/gain $2500. With futures, you need to be aware that the required margin value doesn't change over time, but your Futures Buying Power does, and this is what determines whether you get a margin call (i.e. are forced to liquidate or add more money into your account).

Futures Buying Power = (Total account value (cash and futures positions) - sum of margin requirements for your open trades). So say you start with $10,000. Your account value and futures buying power are both $10,000. If you buy/sell 1 e-mini NG contract, your account value is still $10,000, but your Futures Buying Power is now reduced to $8700 ($10,000 - $1300 margin requirement). If the trade moves against you by $1, that's a $2500 move, so that means your total account value will be $7500 and your futures buying power will be $6200 ($7500 account value - $1300 margin). This trade would have to move about $3.50 against you for you to get a margin call -- i.e. the point when your account value drops to $1300 and your futures buying power is $0.

Here are some things I learned:

• I was wrong about futures trading 24/7. They usually stop trading at 5:15pm on Friday and resume at 6:00pm on Sunday. They trade from 6:00pm to 5:15 every weekday. However, hardly anyone seems to trade in the evenings, or even that much in the afternoon. So basically it ends up being not much different than stock-trading hours.
• The e-mini contracts have waaay lower volume than their corresponding regular contracts, and the spreads are horrible. E.g. when a regular NG contract is at $5.00, the corresponding e-mini contract might have a bid of $4.95 and an ask of $5.05, and a single trade won't happen for 10 minutes.
• Because of the bad spread, when an e-mini trade does occur, the trade price is usually 2-3 cents lower than what the latest trade of the regular contract was at. E.g. When my order at $5.00 went through, I could've gotten a normal-sized contract at $5.03 at that moment.

It might have been better to buy the Nov contract, since it will drop more within the next month than a later contract, assuming spot price stays the same or goes lower, but I thought I'd give myself a little more time in case their is a temporary spike here. I'm tempted to sell another contract, for a total of 2, but I should probably play it safe on my first trade.

I am hoping for NG to drop in the coming weeks (obviously) and to sell my contract at $4 for a $2500 gain.

Here's another interesting article:
http://www.zerohedge.com/article/why-has-natural-gas-spiked-60-labor-day

Natural Gas Links

I found some great links that provide pretty much all the up-to-date information one needs to understand what's currently going on in the natural gas world:

Weekly Natural gas update (updated every Thursday evening):

http://tonto.eia.doe.gov/oog/info/ngw/ngupdate.asp

Weekly storage report (updated every Thursday morning):

http://www.eia.doe.gov/oil_gas/natural_gas/ngs/ngs.html

EIA Short-term Energy Outlook (updated monthly):

http://www.eia.doe.gov/emeu/steo/pub/contents.html

Natural gas continued it's mini-rally today. Dec contract jumped about 35 cents to 4.95. I can't check the markets until the afternoon tomorrow, but I may enter a short position then unless the rally appears to still be just as strong.

Some choice quotes from the most recent articles above:

"EIA expects that the Henry Hub price of natural gas will average $2.25 per MMBtu in October 2009, which is the lowest monthly average spot price since September 2001. Prices are projected to bottom out in October, and then rise through February 2010, averaging $4.59 per MMBtu in February, and fall from March through August 2010."

"Despite a 20-percent drop in prices and a 45-percent drop in working natural gas drilling rigs since the start of the year, total natural gas production increased slightly from January to June 2009. This current production trend reflects significant improvements in horizontal drilling technology and robust productivity from shale gas discoveries in Louisiana, Oklahoma, Arkansas, and Pennsylvania."

"As electric power demand for air conditioning wanes, a continuation of recent natural gas supply trends could cause spot natural gas prices to fall below current projections before cooler temperatures induce higher demand for space heating. In the projections, prices rise modestly in 2010, reflecting increased economic activity and lower production levels as a result of the current drilling pullback. However, it will take some time to work off current inventory levels and enhanced production capabilities should limit significant increases in prices throughout the forecast period. On an annual basis, the projected Henry Hub spot price averages $3.65 Mcf in 2009 and $4.78 Mcf in 2010."

Trade Update: DXO

I mentioned that I sold most of my DXO a couple of weeks ago. I was planning to hold onto the remaining amount (about 20%) for a while, but lo and behold, Deutsche Bank decided to shut down DXO due to concerns over new regulatory restrictions imposed on the futures exchange. There is some info about this here:

-http://www.dailymarkets.com/stocks/2009/09/09/why-did-the-double-leveraged-oil-etn-dxo-close/

-http://247wallst.com/2009/09/01/the-death-of-an-energy-etf-dxo/

They are supposedly redeeming the notes at today's closing value, but just to be safe, I sold yesterday at 4.37, since there was nice spike in the price anyway. That was about my break-even price.

I'm just glad this happened now after I was able to sell at a profit, and not when I was temporarily down 50%!

On another note, my futures trading account with OptionsXpress.ca is finally all setup! Too bad I didn't set this up sooner -- I'm up $5000 in my virtual trading (I was able to sell Dec Natural Gas at 5.09, and it's now at about 4.60). I'm going to wait to see what happens tomorrow because as I feared, NG dropped pretty far before my account got setup, and now a rebound has finally begun. The spot price was down as low as 1.83 and just jumped up to around 2.45 in 2 days. The Dec contract got down to 4.30 and rebounded to 4.70.

I don't want to sell into a rally, so I'm going to wait until there is a down day. BTW, there are a whole bunch of comments on my last post that talk about the risk involved here.

Natural Gas Futures

The NYMEX natural gas September contract (expires at the end of August) is around $2.80 right now. This is the lowest price in a long time.

There is a huge oversupply of natural gas right now. Almost every article I read talks about how the near future for natural gas prices looks grim, and no-one expects it to go over $4 anytime soon unless there is a major hurricane (hurricane season is just starting) or a really cold winter.

Here are some recent articles to read:

http://seekingalpha.com/article/156703-natural-gas-grim-outlook-through-late-2010

http://www.cattlenetwork.com/Natural-Gas-Outlook--Spot---Futures-Decline--Storage-Continues-To-Increase/2009-08-13/Article.aspx?oid=826606

It's all over the news in Alberta too. The alberta natural gas price has been forecast to even fall under $1 in the coming weeks:

http://www.calgaryherald.com/business/Natural+prices+could+fall+below+report+warns/1928706/story.html

(Note: prices in Canada are quoted in different units, but the conversion factor is close to 1.1, I believe).

So why I'm I interested in this? Well, the NYMEX December contract (expiring end of November) is currently trading above $5 right now. Every 1 dollar move in natural gas is a $10,000 change in value for a single contract (which requires about $10,000$5000 margin).

Now it seems to me that the December contract is very optimistically priced. If the Natural Gas spot price were to remain at its current price for the next month, the December contract would likely drop to around $4.20, judging by November's current price. This would be an $8000 gain / 80%160% gain in one month if you had sold the December contract (like shorting a stock).

It seems like easy money, however:

- the price is so low, it could easily rebound a bit. A $1 move up means a $10,000 loss. Natural Gas has many times historically moved $2 or more within a single month.

- the market is usually smarter than you. If it's so obvious that prices are going to stay low, then why is the December price currently still over $5? There must be something the big players know that I don't.

I'll have to play it careful. For one, I wouldn't actually buy the regular contract - it's too big and I could lose all my money. There is a mini natural gas contract that is 1/4 the size ($2500 for a $1 move). I'd only sell a couple of those. Secondly, I'll probably hedge my trade by buying a nearer term contract, in case prices do go up. I'll have to figure out mathematically what makes the most sense.

I worry that I won't get my account setup soon enough though, and by then prices will have dropped further, making it too risky to sell natural gas at such low prices. I wanted to get in at the beginning of August, when I first started reading up on all this dire news on natural gas. At that time, the December contract was above 5.50. Already I'd be up about $5000 on 1 normal-sized contract.

Oh well, if natural gas doesn't work out, I'll probably buy into gold on dips and sell on short rises. A $10 move in gold is a $1000 gain on one contract (about $5000 margin). I feel way more familiar with gold anyway.

Futures/Commodities Trading

For a long time I've been interested in commodity/futures trading. It's this bizarre world: trading contracts dealing with wheat, sugar, orange juice, oil, gold, frozen pork bellies.... And everything is crazy leveraged: You can control some amount of a commodity with just 1/20th of its value. E.g. You can put down a $5000 deposit (the margin) to buy 1 contract of gold, which is 100 ounces, which is worth around $94,000 at today's prices. You can make or lose thousands of dollars per day.

It used to be only the uber-rich would play in commodities, other than farmers who would buy futures to actually hedge against changes in the markets that would affect their income negatively. But in more recent history, new "mini" contracts have sprouted up that are 1/2 to 1/10 the size of the regular contracts, allowing smaller players to get into the market. It is also easier to setup futures trading accounts nowadays. However, I've never run across anyone talking about trading futures, other than one older family friend years ago. You just don't hear Joe in the office talking about his soybean contracts doing well.

The commodity markets are hard to learn about and understand. There is not much good information out there and I think it takes a lot of experience to really get a feel for things. Even though there are trillions of dollars traded in futures each year, there aren't many little guys participating. It is risky. I remember reading stats on how most amateur futures traders end of losing most of their money, mainly due to not understanding and managing the risk involved.

Anyway, it is really interesting stuff and I'm going to try to get my feet wet. I was surprised that there aren't more online brokerages that offer futures trading accounts. In fact, I couldn't find one true Canadian one that looked trustworthy and mature. After much research, I finally settled on OptionsXpress.ca. They're still an American company which happens to have a small Canadian arm to allow us Canadians to get involved.

OptionsXpress really impressed me. They have an amazing website with tons of information on it. It makes you feel very welcome and comfortable. All of their information is easy to follow and understand, and they are completely open about everything. You really seem to know a lot about them after reading through the site (compared to some sites that don't have much info and thus seem more shady). They seem trustworthy, their trading platform seems solid and easy to use, they have tons of help and examples for every type of trading action available, all sorts of common questions are answered in their FAQs, and they have a Live Help feature -- it all really gives you peace of mind. I actually used their "Live Help" feature and chatted online with a person, who was very helpful and answered all my questions. I've started the process of setting up an account, and everything has been so smooth so far. They give you FedEx shipping labels for free overnight shipping of your application, and you get automated emails for each stage in the process (e.g. "We just received your application and are now processing it). I'm looking forward to using them. However, who knows, I may not even get approved -- it's a two step process: first creating a regular equity/options account, and then applying for futures trading.

It seems the most popular online broker is interactivebrokers.ca/.com. They have crazy low fees and apparently have the most powerful trading platform, but I've heard it's very complex to use because of this. They seem geared more towards experts than to first time traders, so I didn't feel comfortable going with them. All the other brokers I looked into just didn't seem as organized, informative, and trustworthy as OptionsXpress.

The first thing I want to trade, if I can get an account setup soon, is probably the most volatile commodity out there: Natural Gas. More in my next post...

Trade Update - DXO, DIG, FAZ

It's been a long time since I've updated this blog, but I actually haven't done any trades until recently anyway.

Yesterday I sold most of my DXO at $4.85 and the rest of my DIG at at $30.24.

Oil is up to $74 and I decided to get out. I made about 15% on the DXO trade - not very much, but I had a LOT of money in that trade.

I'm a little disappointed. I said that holding DXO would be an easy 100% gain, and it should've been (DXO went below $2 a couple of times and is now about $4.85). I bought too much too early on the way down and had no more money left to buy when it was really low. Even with not timing it well, I still actually made about 30%, if we're just talking in US dollars. What really hurt me was the change in exchange rate. Most of my DXO was bought when the Canadian Dollar was at a low $0.78 to the US dollar, and now it's at $0.93. So I "lost" over 10% in gains due to the Canadian dollar skyrocketing. Due to "the constant leverage trap" with leveraged ETFs/ETNs, DXO did not perform as well as it could have if it didn't drop so low at the beginning. It also switched over to using the July 2010 futures contract as its basis, which has way more premium built in to it, meaning it wouldn't perform as well as near-term contracts assuming oil only moves up slowly.

So why'd I get out? Oil recovered nicely to $75 as expected, but I don't see reason for it to go much higher right now. The economy still sucks and the markets are irrationally optimistic -- the markets have been in a huge extended rally, so I thought I would get out while things are good before the next "storm" hits. I'm not saying oil won't keep going up. I just don't want to bet on it doing so. I think Oil will do really well long-term, but short-term, I'm too scared and so I'm taking my profits. I would consider re-entering if oil drops to $60.

FAZ - let's not even mention that. Worst trade ever. I'm still holding some of it which is pretty much worthless right now. Again, FAZ/FAS are only for day traders. They both lose money over the long term and are too volatile for non-day-traders to be playing. Luckily I didn't put much money into that, so my gains on DXO still far exceeded those loses.

On DIG, I believe I made just a couple of percent on the last 1/3 of my position that I sold. So I've averaged about a 25% gain on my full DIG position.

What's next? I'll save that for my next post.

Argggggh...

Well FAZ dropped 41% in one day! That's probably one of the biggest one-day moves ever of one of these leveraged ETFS. And I didn't sell - stupid me. Here's what went down.:

I bought FAZ perfect timing, and the markets gradually dropped the next 3 days. I was up about 15% on Wednesday and thought about selling, but decided to wait one more day. And then out of nowhere -- Wells Fargo sends out a pre-release announcement about their expected earnings. Maybe I'm just not paying attention, but I didn't know this was going to happen. Their earnings statement date isn't until April 22nd, one of the later ones in fact, and here they go letting their numbers out before any of the other banks. And of course the news was really good. Here's the deal: Wells Fargo was always one of the healthiest banks out there. They didn't get involved in any subprime loaning, they didn't need any bailout money (but got some like all banks), and so of course they're doing well! I'm no conspiracy theorist, but this was obviously all planned out to downplay the bad news of bad banks. I bet some serious institutional money was thrown into the markets timed with the release to help spur this rally. Seriously, everyone is over-reacting to the news, but I guess everyone wants a rally.

If I knew there was any news coming out, I would've gotten out. That was my plan as you could see from my last post. But I also said I would only hold 2 - 3 days, and I didn't get out when I should have. I should have at least set a stop at my break-even point, and even with the huge gap down, I would have only lost about 15%. I even still had time to sell Thursday morning, and I actually considered switching to FAS to try to recover my losses (which would have worked becase FAZ was down 20% at the beginning of the day, and ended down 41%, and so I would've made about 20% on FAS just in the last half of the day).

I should've sold no matter what, because I'll never break even. Huge drops like this are horrible to recover from in leveraged ETFs which have to match the *daily* performance of an index. Here's an example to show why:

Say some index is at 100 and it's inverse 3x ETF (e.g. FAZ) is at $100. Say the index goes up 14% in one day, meaning the 3x ETF drops 3*14 = 42% (like FAZ did). The index would now be at 114 and FAZ would be at $58. Now say the index returns to it's previous level the next day. This would require only about a 12% drop (114 * (1 - 0.12) = ~100). That means FAZ would increase 12*3 = 36%. FAZ would end up at $58 * 1.36 = ~$79. So while the market has returned to where it originally was, the holder of the 3x ETF is down 21%.

Let me re-iterate this: Even if the markets return to their previous level the very next day, the holder of the 3x ETF is down 21% !!! This is why huge movements in ETFs are so detrimental, and also why you do not want to own them long-term. This is known as the "Constant Leverage Trap". You can read more about this here.

Bah. Luckily I didn't put too much money into this, but I did put in more than I should've for such a risky play. I really need to start learning from these mistakes. I even said last time that FAS/FAZ were too crazy and you have to be a day trader to use them... and then I jumped back in anyway and got burnt again. Sigh....

FAZ

I bought some FAZ (3x inverse financials) near the end of Friday at 15.93. The market kept rising in the last 10 minutes and FAZ closed at 15.60.

It's of course a risky trade, being a 3x leveraged fund, and I'm buying in the midst of a rally. In one month, the Dow has gone from 6600 up to 8000, and FAZ has dropped from over $100 to it's current value of around $16. The trade is a gamble, but I'm betting that after a month of large gains, the markets will pullback here, especially since the Dow has now reached the key resistance level of 8000. It could fly through it -- anything's possible -- but I think it's much more likely to get stuck around the 8000 range or bounce off it. It's been a pretty large rally and the economic news is still pretty dismal. Earnings season is now here (roughly from Tuesday to 6 weeks later), and the news should be bad.

Take a look at the chart below to see the Dow 8000 and 9000 resistance/support levels:



I think one of the riskier things about this trade is that I'm buying pretty early, without any confirmation of a change in direction of the markets. I probably should have waited to see if the DOW blows through 8000 or starts to drop. Instead, I'm trying to time the top perfectly, which usually doesn't work out too well :)

I don't want to set a stop on this trade, because the 3x ETFs are so volatile it would probably get hit and I would lose money now matter which way the trade eventually goes. I'm pretty confident DOW won't go above 8400 right now. I'm planning to sell in 2-3 days.