As a trader, one of the key things that I try to consciously do is to cultivate my instincts by talking with other traders and investors as often as possible. It still amazes me how large the divergence of opinion that exists regarding what people believe will unfold as we enter the new millennium. Many very respected names are literally predicting an economic earthquake that will measure a 10 on the Richter scale while others having looked at the exact same research claim that the consequences will be very mild. As a trader I have to evaluate the data and develop a strategy that I feel not only gives me an edge but allows for a great deal of error while still being low risk!
In his book, "Business Without Economists" author William J. Hudson submits a theory worthy of every traders consideration. (Particularly now with Y2K just around the corner) He states:
1) The demand for answers will always be greater than the supply.
2) Therefore, the price for answers will be high.
3) Therefore, a very large supply of answers will emerge.
4) Therefore, most answers will be false, especially when tested against reality.
I have this STATEMENT posted on my computer as a reminder to myself that markets are very humbling mechanisms. The key question that we as traders must continuously ask ourselves with regards to whatever trading strategy we enter into is, "What if I am right? And What if I am Wrong?"
As I assess the economic landscape and scan the marketplace for trading opportunities there is one fact that I must pay attention to: The NAME of the GAME is Managing RISK!
With this in mind, let’s evaluate some of the important facts:
Many of the Commodity Markets have bounced sharply from their twenty to thirty year lows.
When I cross reference this FACT with the REALITY that INFLATION is back in the economy, it creates some very interesting trading opportunities for the OPTION savvy trader. The key to any trading strategy in my opinion is that it HAS to be low risk because there are so many possible outcomes that may occur.
The purpose of this strategy is to eliminate the need for timing the market by developing a method minimizing my exposure to loss. Before I provide you with the mechanics of this tactic let me illustrate an outlandish possibility so that we can get clear on a traders definition of RISK. Let’s say that you are convinced that on March 1, 2005 that you think that Gold is going to be trading at $3,000 dollars an ounce. (I did say outlandish!) Based upon this scenario even if you wholeheartedly disagree, how could you trade this viewpoint and still take very little risk? Most people think that RISK is defined as BEING RIGHT or WRONG on the outcome of a trade. However, a risk sensitive trader is only concerned with their exposure to chance of LOSS.
If you thought that Gold was going to be trading $3,000 an ounce you could enter into the marketplace and very inexpensively purchase a couple of Call Options that would give you the right to purchase Gold at $500 an ounce. In this instance, the most that you could lose is the money that you put up to purchase the options and you would have the RIGHT but not the obligation to purchase Gold at $500 between now and March. However, just because you have LIMITED RISK you STILL have a great deal of EXPOSURE to LOSS. Reason being, that if GOLD does not get up to $500 you would lose all of the money that you put up to purchase the options.
The way that a professional would trade this scenario is that he would finance the trade through OPTION SELLING. When you SELL an OPTION you are in effect creating an OBLIGATION that you are forced to abide by contractually. For example if you SELL a $500 December Gold Call and receive money you have in effect agreed to deliver Gold to the option purchaser at a price of $500 between now and December 2004.
As a seller of this option, the most that you can make is the premium that you collected and your upside RISK is theoretically unlimited. If Gold is trading at $800 an ounce come December 2004 and you have not offset this option you are obligated to make delivery of Gold to the Option purchaser at the originally agreed upon price of $500 an ounce. Should this occur you would in effect have a loss of $300 per ounce on each contract that you sold. Not very attractive, especially since each Gold contract is 100 ounces in size. The loss becomes $30,000 per contract. That is a lot of risk!
The way to minimize RISK is to SPREAD it off against other OPPOSITE Options positions.
In the above example, let’s say that a trader purchased 1 March $500 Gold call Option for a premium payment of $6.00 an ounce ($600). Each Gold contract is 100 ounces so this trader would be paying $600 per option . The RISK here is very clearly defined as $600. However, if this same trader now SOLD (1) GOLD December $500 Gold Call Option (NOTE THAT THE DECEMBER OPTION WILL EXPIRE BEFORE the March Option) and collected a premium payment of $300 they have in effect reduced their initial risk to the difference between the $600 that they paid out and the $300 that they collected, or $300.
Let me outline what this trader has done. They have obligated themselves to make delivery of 100 ounces of Gold at a price of $500 an ounce between now and December and simultaneously they have the right but not the obligation to own 100 ounces of Gold at $500 an ounce between now and March. They have established a BULLISH CALENDAR position by SELLING a Call option in a nearby month and using the money that they collected in the sale of that option to finance their purchases of the Call Option in the deferred option expiration month.
What this strategy is in effect saying is that it is the traders opinion that Gold will make its move after December but before March. Although it does not appear very exciting now, should this anticipated disruption occur in that time frame a trader that positioned themselves in this style would be sitting in the drivers seat. Essentially they would be looking at a maximum risk exposure of $300 with the possibility of unlimited upside potential. (YES, I realize that with Gold at $430 at present time that possibility appears extremely remote.) However, it is this kind of trading tactic that makes a great deal of sense in markets that are trading at historical lows.
The key to successful trading is to minimize your risk as you acquire more information. The closer you get to option expiration the more information you will have regarding the feasibility of this tactic. The key however is that you played the game without exposing yourself to a great deal of DOWNSIDE. That my friends is the path to long term success in any highly leveraged transaction. As William J. Hudson stated,
"Most answers will be false, especially when tested against reality!" Worth thinking about.
Just one more way to swing for the fences without taking a great deal of risk.
STUDY AWAY and let’s be careful out there!