Futures For You
INSIDE THE FUTURES WORLD

Want to find out how the futures markets really work? DeCarley Trading senior analyst and broker Carley Garner 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


TOO LATE TO BUY CRUDE?

The energy markets are moving. Is it too late to buy crude oil, or is this dip a long-term opportunity?

Without a crystal ball, there is no way of knowing for sure. What I do know, however, is that crude oil is one of the most difficult markets to make money in, regardless of whether you are a futures or option trader. The margin requirement is extremely high, and so is the volatility and risk. In my opinion, long option strategies are nothing more than buying high-priced lottery tickets due to inflated implied volatility, premiums, and bid/ask spreads. Short option strategies and spread strategies face similar obstacles.

Unless you have deep pockets and a high tolerance for risk, there are better markets to trade. A crude oil price chart can be deceiving in that it seems as though it would have been easy to make large profits by simply being long. After all, according to Congressional hearings, it is the "greedy" speculators that have gotten us into this mess.

Nevertheless, for the average retail trader the intraday and daily price swings can be financially unmanageable and psychologically unbearable. Imagine being long August crude oil futures during July 2008. In the first two weeks alone, you would have made or lost $10,000 several times on one contract.

Sure, if you were savvy enough to buy the dips and sell the rallies, you would have been able to afford that new luxury car you were eyeing, but for many it would have been pure agony. The oil futures tycoons that you hear about rumored to have netted millions of dollars buying crude oil futures contracts were likely people with significant risk capital backing their speculation. Unlike you and me, they were able to execute a position and step back without micromanaging the details or even losing sleep.

I am the first to admit that I was wrong about crude oil several dollars ago; I expected the price of a barrel of crude to stay below the $100 mark. I was wrong. Luckily, I was also wise enough to realize that this market isn't for everyone. I would never intentionally deter a client from trading or speculating in any manner he chooses, but I warned those looking to participate that the odds of success were stacked against them. Volatility and risk aren't necessarily synonymous with reward.

That said, there is a way to gain exposure in crude oil without being subject to lofty margin charges and elevated option premium. An iron butterfly is similar to a long option strategy in that the risk is limited to what you pay to enter the trade plus commissions and fees. Unlike a typical long option strategy, the spread is relatively affordable and allows a trader to benefit from a close-to-the-money position. Naturally, nothing in life is free; there are drawbacks to the iron butterfly strategy.

The biggest obstacle is the burden of not seeing much in the way of profits until close to expiration, due to time value in the short options. As we know, markets move fast, and being able to trade in and out of a position easily (preferably with a profit) is essential.

An iron butterfly appears to be complicated on the surface, but it isn't as complicated as it seems. In its simplest form, it is the purchase of a close-to-the-money option, the sale of two out-of-the-money options with identical strike prices, and the purchase of a subsequently equidistant option. All options in the spread must share the same type, call or put, and expiration month.

Let's look at an example. In the case of crude oil options, you may want to play the long side of the market without jumping in front of the proverbial freight train or spending a fortune on an option that could expire worthless. In early August, it may have been possible to buy a September $121 call, sell two $126 calls, and buy a $131 call for a compound cost and risk of about $850 plus commissions and fees (four round-turns).

If you were able to buy the spread for 85 cents in premium or $850 (crude oil is worth $10 per penny to a futures trader), you would have paid that much more for the long legs of the spread than were collected for the short legs. The maximum profit potential is capped at the distance between the strike price minus the cost of the spread. In this case, it is $4.15 ($5 - $0.85) or $4,150 (4.15 x $10) and occurs if the futures price is trading at $126 at expiration. Don't forget about transaction costs, because four round-turns will most certainly take a toll on the profitability of the trade.

In essence, this spread would make money intrinsically (at expiration and before considering the initial cash outlay) as the market rallies above $121 and approaches $126. Once the price of crude rises above $126, the intrinsic profits are given back until hitting $131. However, you have to account for the 85 cents in premium that was originally paid for the spread. Thus, the breakeven point at expiration would be at $121.85 ($121 - $0.85) and the reverse breakeven on the trade will be at $130.15 ($131 - $0.85). At expiration, the trader would be profitable anywhere between $121.85 and $130.15 with the maximum profit of $4,150 before transaction costs occurring at $126 -- not bad for a total risk of $850 before commissions and fees.

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

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