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.