Martin Kronicle

I was quoted today in HedgeWorld on the likelihood of a commodity bubble.

My Platinum / Gold Spread study posted below was also highlighted.

I just listened to my podcast with Tony Saliba again, and I can’t help but be very impressed with Tony’s techniques in trading options and how he always maintained an edge. So it got me thinking about another blog post about him and how you might be able to benefit from his way of thinking. I’m going to give you one easy idea today, and then bring in some more advanced ideas going forward.

Risk management is at the very heart of trading commodities. One of the things new traders need to understand very quickly, is that you have unlimited loss potential regardless of whether you’re long or short.

For those of you with experience trading equities, you’re used to knowing that you have limited liability with stocks: they can only go to zero. In commodity futures trading, your margin is what’s at stake and it doesn’t take too long to exhaust your resources.

Here’s an example:

The margin for COMEX Gold is approximately $5,400. The contract size is 100 ounces. Divide the contract size into the margin and you get $54.

Say you buy Feb COMEX Gold today at $1,130 for your account. You deposit the requisite margin into your account. A sudden drop to $1,076 – $54 lower – and your account is at zero. Wiped out. Worse, if it moves down further before you act, you may have a negative balance in your account. If it dropped $60 for example, you’d have to deposit $600 into your account to bring it back to zero.

One way you can avoid that, Saliba-style, is to own an outright call option or own a vertical call spread. Here’s why…

Outright Call Option on Gold Futures:

If exercised, you establish a Long position in gold and you’ll have to make sure that you can put down the $5,400 in margin mentioned above. However, the cost of an at-the-money Call Option right now is priced at $13.30 or $1,330 per single contract. And that’s all you’d need to establish a Long Call position. The $5,400 only would come into play if you exercised the option. That makes it a limited-liability play, and now you effectively have a built-in Stop order on your equity. You can only lose the debit balance. The thing to watch is “how much is the $1,330 as a proportion of your overall equity?” You don’t want to over-leverage your account.

Vertical Call Spread (specifically, a Net Debit Vertical Bull Call Spread)

This spread has many names, but essentially you’re trading off the upside above a specific number (the higher strike price) in return for selling that option to someone who will help you pay for the lower strike Call Option. You’d do this because you think gold can rise, but only so far before it stalls. These trades can be both fundamentally and technically based.

Buy the 1130 Call at $13.30
Sell the 1145 Call at $7.50

Net Debit is $5.80 or $580 per spread. That is the most you can lose, and you lose it when gold is at 1130 or lower.

Your max gain occurs when gold is at 1145 or above, but you don’t profit incrementally above 1145 because you sold the option to someone else who will in return for the premium of $7.50.

Your break-even is the net debit of $5.80 on the trade ADDED to the lower strike price of 1130 or 1135.80.

To calculate the max gain on the trade, you can use the following equation:

Max Gain (MG) + Max Loss (ML) = |SP1 – SP2| the absolute value of the Strike Price differential

MG + $5.80 = $15

Therefore, the MG is $9.20 and the ratio of MG/ML is 1.58.

I’m not saying go do this trade, but I am illustrating how Saliba might think about setting up such a trade so you can get inside his head. Option spreads are all about floors and ceilings and making trade-offs for your advantage.

In the outright gold Call Option trade, you paid $13.30 to have unlimited upside, but you have a higher max loss. In the Call Spread example, you paid $5.80 to make a maximum potential profit of $9.20, but have only 43% of the downside of the outright Call Option.

Next time, I’ll talk about when you’d want to use the outright position over the spread, and vice versa.

Michael, if I am in the middle of riding a good trend on lets say, a few soybean contracts for example, do brokers offer automatic contract rollovers or will I have to roll it over myself?

Not that I know of, but you can always ask. There may be a technological tool to do that, but I don’t know about it or use it. I don’t know of any manager who would give them such discretion, but there may be ones that do.

Sometimes, managers enter a spread order to roll thereby offset an existing position and enter a new one. They can do that “at mkt” or via a “limit” order.

Existing position:

Long 5 March Soybeans.

To roll with a spread order “at the market,” you’d do the following:

Sell 5 March Soybeans / Buy 5 May Soybeans @ MKT.

In this case, you’d get filled at the prevailing market prices: the bid for March and the Offer for May.

To roll with a spread order, whereby you liquidate your Long March position and establish a Long May position, but at a specific price differential between the March and May contracts, you’d enter a spread Limit order (sometimes written LMT).

Sell 5 March Soybeans/ Buy 5 May Soybeans @ 6 – 0 May

This will instruct your broker to execute the spread, not just one leg of it, ONLY when the differential between the bid price on the March’s and the Offer price on the May’s is 6 cents premium to the March contract (written 6-0). In this case, both contracts can change substantially in price, but not until the spread differential reaches 6 cents, with May being 6 cents premium to March, will the order get filled.

I have never traded with either of these types of orders, nor do I foresee using either of these methods. Generally speaking, the more qualifiers you attach to an order, the more illiquid it becomes. This goes for stocks too.

I am pretty sure that most retail accounts cannot stay long after the First Notice date since they can be elected for delivery, so you’d have to roll or at least sell your position out and go flat. If you don’t do it, they may liquidate you automatically.

In Broke: The New American Dream, Michael Covel has taken on anyone and everyone who is taking advantage of the little guy. This was one of the first questions he asked me.

Trivia: Maria Bartiromo and I were to be filmed on the same day. She – in the morning, me – in the early afternoon. She canceled, and Michael was basically there double-clicking his mouse until I showed up at about 1 pm.

Not enough is written about spreads, and over the course of this year I’m going to change all that. In the commodity space, spreads are the lifeblood of the floor community. Fundamentally, they are relative value trades. They also set up well for commodity traders, because as such, commodity traders are ready to go long as well as short.

Not so for the typical equity trader. Even the talk of an equity pairs trade takes 6 levels of approvals from your compliance department. [Then you have to call 45 friends to figure out that there is no rebate on a commodity short sale, but I digress...]

Besides giving you more ways to be right, and potentially lower margin requirements than outright directional trades, spreads can be used as leading indicators. Take for example, the relationship between Gold and Platinum. Gold is a precious metal (and an industrial metal) and most readers will associate it with jewelry, it is involved in many electronic devices. Here’s a look at the April 2010 COMEX Gold chart.

April COMEX Gold

Platinum is used for jewelry too, but it is mostly an industrial metal in refining petroleum products and in catalytic converters. Here’s a look at its chart – the April 2010 NYMEX Platinum.

April 2010 NYMEX Platinum

The idea being if the economy is expanding, platinum should outperform gold, relatively speaking. So if you thought inflation was at bay, you could have bought Platinum and sold Gold using the April 2010 contracts shown above. [Whatever you do to the platinum contract is what you do to the spread. In this case therefore, you would have bought the spread.]

Here is what the spread looks like through tonight’s settlement:

April Platinum - April Gold Spread

What you see here, is that platinum (as you expected) outperformed gold over this period of time, and especially in the last few weeks. Buying the spread in this case would have netted the trader approximately $2,600 per spread (Buy 1 Platinum/Sell 1 Gold) Here are the calculations:

Spread Calculation

You’ll see that you made all your money due to the Platinum position. You lost on Gold, but the gains on the Platinum more than covered the losses in Gold. Very rarely will you make on both legs, as they’re called. Sometimes in certain grain spreads, but don’t count on it with the PL/GC trade.

Don’t employ excessive leverage b/c you may be afforded lower initial margin on a trade like this. Take advantage of the long-term view here and let the economics evolve. Follow the trend of the spread. Here is a 15 year seasonal view of this spread, courtesy of Jerry Toepke at Moore Research (Used with Permission).

15 Year Historical Study

You buy a spread when you want it to widen, or increase in value. Can you come up with all the ways this spread can widen? I’ll send a free copy of Broke: The New American Dream to the first one who emails me the solution. [Hint: I just came up with 5 ways.]

This particular spread shows what can happen when the EXPECTATION of the economy is/was favorable. You can use this spread as a leading indicator on INFLATION. Once the spread starts to narrow, or decrease in value, you reverse these positions and sell the spread. Even if this spread trade is not for you, watch its trendline b/c once it’s broken, it will indicate that the market’s perception and outlook on inflation is a worry. And that is information you can use across all your asset classes.

I will have a full course on spreads and seasonal trades for the Certificate Program called, appropriately, Spreads and Seasonals. This course is one of the Electives and will only be available for those who’ve taken the 4 Core Courses.