As a trader, one of the key things I try to consciously do is nurture my instinct by talking to other traders and investors as often as possible. It still amazes me how much of a difference of opinion there is about what people believe will be revealed as we enter the new millennium. Many highly esteemed names literally predict an economic earthquake that will measure ten on the Richter scale, while others who have looked at exactly the same research claim that the consequences will be very mild. As a trader, I need to evaluate the data and develop a strategy that I feel not only gives me an advantage, but allows a large amount of errors, while still remaining low risk!
In his book, “A Business Without an Economist,” author William J. Hudson puts forward a theory worthy of any consideration by traders. (Especially now with Y2K just around the corner) Declares:
1) The demand for answers will always be greater than the supply.
2) Therefore the price of the answer will be high.
3) Therefore, a very large offer of answers will appear.
4) Therefore, most of the answers will be false, especially if they are tested in reality.
I have this STATEMENT on my computer as a reminder to myself that markets are very humiliating mechanisms. The key question we as traders must continually ask ourselves regarding any trading strategy we enter is, “What if I’m right? And what if I’m wrong?”
As I assess the economic landscape and scan the market to find trading opportunities, I need to pay attention to one fact: THE NAME OF THE GAME MANAGES RISK!
With this in mind, let’s assess some of the important facts:
Many commodity markets have bounced sharply from their twenty to thirty year lows.
When I compare this FACT with the REALITY that INFLATION has returned to the economy, it creates some very interesting trading opportunities for the OPTION smart trader. In my opinion, the key to any trading strategy is that it MUST be low risk because there are so many possible outcomes that can happen.
The purpose of this strategy is to eliminate the need for time adjustment of the market by developing a method that reduces my exposure to losses. Before I provide you with the mechanics of this tactic, let me illustrate an unusual possibility so that we can clarify the trade definition of RISK. Let’s say you’re confident that on March 1, 2005, you think gold will be trading at $ 3,000 an ounce. (I said weird!) Based on this scenario, even if you disagree wholeheartedly, how could you trade that view and still risk very little? Most people think that RISK is defined as TRUE or WRONG at the outcome of a trade. However, risk-sensitive traders are only concerned about their exposure to the chances of LOSS.
If you thought Gold would trade $ 3,000 an ounce, you could enter the market as well
very conveniently buy several call options that will give you the right to buy gold at a price of $ 500 an ounce. In this case, the most you could lose is the money you put in to buy options and you would have a RIGHT but no obligation to buy gold at a price of $ 500 from now until March. However, just because you have LIMITED RISK, you still have a large exposure to loss. The reason is that if GOLD doesn’t reach $ 500, you would lose all the money you put in to buy options.
The way a professional would trade this scenario is to finance the trade with OPTIONAL SALES. When you SELL an OPTION, you are actually creating an OBLIGATION that you are forced to abide by the contract. For example, if you SELL a Gold Call for December for $ 500 and receive the money, you have actually agreed to deliver Gold to the buyer options at a price of $ 500 from now until December 2004.
As a seller of this option, the most you can earn is the premium you have collected, and your RISK above is theoretically unlimited. If gold is traded at $ 800 an ounce in December 2004 and you have not reimbursed this option, you are required to deliver the gold to the option buyer at the originally agreed price of $ 500 an ounce. If that happened, you would actually have a loss of $ 300 per ounce on every contract you sold. It’s not very attractive, especially since every gold contract is 100 ounces big. The loss becomes $ 30,000 per contract. That’s a big risk!
The way to reduce the risk RISK to a minimum is to expand it compared to other OPPOSITE options.
In the example above, let’s say a merchant bought a $ 500 gold call option on March 1 for a premium payment of $ 6.00 per ounce ($ 600). Each gold contract is 100 ounces, so this trader would pay $ 600 per option. RISK is very clearly defined here as $ 600. However, if this same trader SOLD a (1) GOLD Gold Call option in December of $ 500 (NOTE THAT THE PROCESS OPTION WILL EXPIRE BEFORE the March option) and collect a premium of $ 300, they actually reduced their initial risk to a difference between $ 600 which they paid out and the $ 300 they collected, or $ 300.
Let me point out what this merchant did. They have pledged to deliver 100 ounces of gold at a price of $ 500 an ounce from now until December, and at the same time have the right but not the obligation to own 100 ounces of gold at a price of $ 500 an ounce from now until March. They established a BULLISH CALENDAR position by SELLING a Call option in the coming month and using the money raised from the sale of that option to fund their Call Option purchases in the deferred month of the option expiration.
What this strategy actually says is that the opinion of traders is that Gold will withdraw after December, but before March. While it doesn’t seem very exciting right now, if that expected disruption happens within that time frame, a dealer positioned in this style would sit in the driver’s seat. They would basically look at a maximum risk exposure of $ 300 with the possibility of unlimited growth potential. (YES, I understand that with $ 430 gold at the moment, that possibility seems extremely remote.) However, it is precisely this type of trading tactic that makes a lot of sense in markets that are trading at historical lows.
The key to successful trading is minimizing risk while gaining additional information. The closer you get to the expiration of the option, the more information you will have about the feasibility of this tactic. The key, however, is that you played the game without exposing yourself DOWN. That my friends are the path to long-term success in any high-impact transaction. As William J. Hudson said,
“Most of the answers will be false, especially if they are tested in reality!” Worth thinking about.
Just another way to swing for fences without much risk.
STUDY AND BE CAREFUL OUTSIDE!
TRADE RISK IS ESTABLISHED, SO ONLY “RISK” MEANS SHOULD BE USED. Valuation may vary and as a result, clients may lose their original investment. The content of this website should in no way be construed as an express or implied promise, guarantee or implication of anyone that you will profit.