Futures For You
INSIDE THE FUTURES WORLD

Want to find out how the futures markets really work? Carley Garner, a senior analyst for Alaron who also writes the company's Dow/NASDAQ Report and the Bond Report newsletters, responds to your questions about today's futures markets. To submit a question, post your question at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
Carley Garner



With margins at or near all-time highs, how should a small speculator approach commodity trading?

Very carefully. The futures exchanges have effectively doubled, even tripled, if not more, the margin required to hold many popular futures contracts. It wasn't that long ago that the margin on a full-sized corn futures was near $400; now, the Chicago Board of Trade (CBOT) requires that you have at least $2,025 in your account before putting on a contract. As a result of the margin increases, many of the small speculators feel as if they are being squeezed out of commodity trading.

However, there are affordable ways to get involved in the markets. In the case of the grain complex, the mini contracts have suddenly become very attractive. A few years ago, it was difficult to make enough money trading mini-grain futures to make up the transaction costs, let alone give traders the adrenaline rush or profit potential that many are yearning for.

Today's markets are a completely different environment. Despite wider bid/ask spreads and lighter volume, more and more small speculators are looking toward the minis as a way to participate in commodities without risking devastating losses. All futures contracts, even minis, theoretically involve unlimited risk regardless of the contract size; nevertheless, mini grains are a fifth the size of a full-sized contract. So for every penny in price movement, a mini-grain trader makes or loses $10 as opposed to $50, as would be the case with a full-sized contract.

At the time of this writing, the new daily limit in soybeans is $1.05, which means that the profit or loss of a mini-bean contract could fluctuate by $1,050 in a single trading session. This is likely more than enough excitement for many small speculators. Likewise, the daily limit on wheat is 70 cents, which represents a $700 move per mini contract. To give you some perspective, the current margin required to trade a mini-corn futures is $405, but it takes $1,215 to hold a mini-wheat contract, and a mini soybean is margined at $2,025.

Is there an affordable way to trade commodities and maintain limited risk?

If trading futures, or mini futures, isn't for you, then option trading may be a viable alternative. While many option spread strategies involve unlimited risk and margin, a long option-only approach will allow smaller traders to enter extremely volatile markets with limited risk. Under more normal circumstances, I am not a big fan of simply buying options due to what I consider dismal odds of success in most cases.

However, long options may be a wise move in certain situations. For example, once a commodity market reaches either an extreme high or low, purchasing an out-of-the-money countertrend option may be the smartest way to play it. I like to compare this type of trading to buying a lottery ticket. The odds of the market trading beyond the strike price of the option may not be great, but the payoff could be handsome if the conditions are right.

A perfect example of this is the recent drop in grain prices. Those savvy enough to be buying puts as soybeans and wheat traded at astronomical prices, $16 and $13, respectively, may have walked away big winners. Of course, picking the top is nearly impossible. Such a strategy would likely involve several failed attempts and options expiring worthless before one of them finally pays off, but that comes with the territory.

Alternatively, if you are looking for less dramatic market moves but don't have the margin (or guts) to trade a futures contract or option spreads with naked legs, iron butterflies may be the strategy for you. For example, if you are a soybean bull you may look to buy the July 1260 call, sell two 1400 calls, and buy a 1540 call for about 25 cents in premium. Assuming we could get filled, the spread would have a price tag of $1,250 but with a maximum potential of $5,750 before transaction costs and risk limited to the amount paid to enter the trade. Given market conditions and the alternatives, this is a relatively cheap way to enter the soybean market. Keep in mind that the margin on soybean futures has been raised to $4,388.

With market volatility at such high levels, should we be selling options?

You often hear traders say that when the markets are volatile you should be selling option premium and when the markets are quiet you should be buying it. While this is a great rule of thumb, there are some glaring omissions. The premise is to sell options after volatility has exploded in hopes that the volatility will contract before it expands. If you are short options prior to a major spike in volatility, there is a good chance that you will pay dearly both financially and emotionally. In essence, when entering a short option trade, the question isn't whether volatility is relatively high, but whether it will get higher before conditions calm down.

Naturally, this isn't as easy as it may seem. Just as we can't see into the future in regards to price action, we cannot determine volatility fluctuations with absolute certainty. All we can do is to do our homework and make an educated guess.

In addition, option sellers may enjoy higher volatility because it results in higher option premium. However, it is important to realize that highly priced options aren't a coincidence. Higher premiums directly translate into higher risk.

That said, I am a big fan of option selling but due to market conditions, I believe that precautions should be taken and traders should be picky on which trades to take. In the case of Treasury futures and stock index futures, I like the idea of countertrend option selling once the market has reached an extreme as measured by trading ranges and standard deviations. Anything in between may be pushing your luck.

Originally published in the June 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.

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