|An Insiders Perspective: Tips and Tricks|
My Favorite Market Indicator
One of the most common questions that I get from clients and prospects is, “What is your favorite indicator”. In my opinion, it really doesn’t matter which indicator I like, they are all very similar and blindly followed would likely yield similar results in the long run. What is more important is what your personal favorite is, and can it help you make money in these treacherous markets.
Nevertheless, my favorite market barometer isn’t an oscillator at all. Instead I try to gauge market psychology, partly based on the behavior of clients and prospects. The trading practices of the general public can be used in price speculation. Unfortunately, I have found that the average speculator tends to lag the market considerably. In fact, they are often so far behind that once they react to a market move, the current trend is coming to an end. Believe it or not, a market top or bottom can sometimes be anticipated by a large influx of phone calls made by traders looking to participate in a market that has been making its move for a substantial period of time. An even better indication that a market may be in store for a reversal is a sudden influx of “virgin” commodity traders looking to buy a particular commodity that they saw a story about on the news.
For example, when crude oil was trading at its all time high around $150 per barrel, the phone was ringing off of the hook in many commodity brokerage firms. Random and inexperienced commodity traders were banging down the door looking to open a trading account to get long crude oil, or better yet, buy $200 calls. As a broker, it is my job to warn of the potential consequences of being late to the party, so to speak. However, ultimately it is the clients money and they are capable of making their own decisions. If after a friendly warning they insist, it is my job to get them the best possible execution.
During times like this I ask myself; “Where were all of these people when crude was trading under $15 per barrel?” That was the time to be rushing to the energy markets.
Unfortunately, this was a prime example of the general public being behind the move. Crude oil didn’t really garner much attention until it broke the $80 mark; at that moment the masses became interested. Looking back to early to mid 2008 it seems highly likely that the average trader lost a lot of money by being late to the rally.
As a broker, I am able to observe the behavior of clients with various capital backing, experience, trading strategies, etc. In this particular case, it seemed that by the time many of the inexperienced traders began to enter the market the trend was coming to an abrupt end. For example, our average client is a prospect for several months prior to opening an account. During this time frame they become comfortable with their level of understanding and the potential risks and rewards. However, during the “crude oil frenzy it seemed that many prospects were rushing to open accounts. Their mission was to buy call options in a market that they strongly believed would be trading at $200 or higher at sometime in the near future. It was almost as though people felt that the market was going to leave without them, and they threw caution to the wind to pay excessive premiums for options that were deep-out-of-the-money.
As a trader, it is important to be able to recognize mass hysteria for what it may be…the end of a market move.
Trading the News
By nature, markets are efficient and all knowing. Simply put, the price of any given commodity already reflects all available information. While information that you see on TV or read in the newspaper is new to you, it is not new to the market. By the time that the information reaches you, it has already been accounted for in the market price of a given commodity. This is even truer in today’s markets with the advent of electronic overnight markets. The futures markets are trading nearly 24 hours a day, allowing instant price reaction to new information.
As a principle, we have found that a trader should never execute a trade solely based on a recently read article or viewed newscast. Once the information has traveled to you, it is already too late. This is where technical analysis comes in.
The market will often tell you the news, before you actually hear it. You may not know exactly what it is, but you will see that prices are reacting positively, or negatively, to an outside force. This is the time to be reacting, not after the news has traveled to you.
Trading Economic Reports
While it may seem exciting, it is generally a good idea to avoid playing economic or agricultural reports. The release of new information to the marketplace often creates an immediate “knee-jerk” reaction that can be very difficult for a futures position to absorb. Obviously it would be impossible, and irrational, to avoid the release of all reports it is prudent to avoid major occurrences such as the monthly employment report or the Gross Domestic Product readings.
Not only is it a good idea for traders to be flat the market during major releases, but in most cases we believe that they should avoid placing trades immediately before or after the announcement. Market moves have a tendency to be swift and often directionless. Unless you are much more talented than I, this creates a risky proposition with little room for success.
If you must be in a market ahead of an announcement that has the potential to trigger a violent move, I believe that you would be best positioned in a directional option spread. For example, if you strongly believe that a market will drop post announcement, you could sell an out-of-the-money call option and buy an out-of-the-money put option and maybe even sell an out-of-the-money put. Unlike a futures position that has the potential to immediately create massive gains or losses, an option spread takes some of the volatility out of the trade. If an option spread is filled at a credit, it is possible to be wrong and make money doing it. In such a case, the gain would be limited to the premium collected and the theoretical risk would be unlimited, nonetheless the potential to profit from an inaccurate speculation remains.
In essence, assuming that the market goes in the direction that you predicted, you may not make as much as you would have had you executed a futures contract but if you are wrong you won’t lose as much. In fact, depending on how the trade is structured and the time horizon that you are in the trade it is possible that you can be wrong and still not lose money.
For instance, if you execute a directional option spread containing both long and short options at a credit and the spread expires worthless the trade will be profitable by the amount of the original net credit minus the transaction costs such as commissions and exchange fees. This is true even if the market doesn’t go in the anticipated direction, assuming that all legs expire worthless. Of course, such a trade involves naked options and theoretically unlimited risk making a grossly adverse move potentially risky, which is the opportunity cost of executing a trade at a credit.
Bid / Ask Spread: Don’t get Mad, get Smart
One of the biggest mistakes that beginning commodity traders make is to ignore the bid-ask spread. The bid is the price at which you can sell an option or futures contract, while the ask is the price at which you could buy an option or futures contract for. At any given time, there will be two different prices, one is the price if you are a seller and the other is the price if you are a buyer. In essence, traders will always pay the higher quote to buy and receive the lower quote when selling. If a trader was to simultaneously buy and sell an option, they would sustain a loss in the amount of the bid-ask spread. The difference between the two prices is known as the bid-ask spread.
This spread is the amount of money that the executing broker, or market maker, requires as compensation for accepting the risk of taking the other side of the trade, and providing liquidity to the market. As a market maker, once a trade is executed they must turn around and find someone to take the opposite transaction in order to offset the position. As you can imagine, the broker is exposed to risk during the time that the position is open. The more risk deemed in participating in the trade, the higher the bid-ask spread will be.
The size of the spread is largely dependent on the liquidity of the market. The higher the liquidity of an option market, or a particular month and strike price, the lower the spread will be. This makes sense, a market maker is accepting less risk when taking the opposite side of a liquid contract because they can immediately offset if they wish.
In some markets the bid-ask spread is inconsequential, however, in others it can be massive and should not be overlooked. For example, copper option traders have little room for error due to the “invisible” transaction cost of the bid-ask spread. It is not uncommon for the spread to be a full cent of premium or more. Each cent in copper is $250, so a trader may be facing a scenario in which immediately after getting in to the trade the market would have to move in favor of the position by approximately 2 cents in premium, or $500, just to break even. These kinds of obstacles can leave the odds grossly against a retail trader.
While copper is an exaggerated example, this gives you an idea of how such knowledge could avoid unnecessarily learning this the hard way by placing a market order and being reported a “shocking” fill. A good way to keep the floor brokers “honest” is to split the bid.
Before placing an option order, ask your broker to contact the trading floor for an accurate bid-ask quote. If they can’t get it for you, consider getting a new broker. Of course, market orders would be filled at the bid if it was a sell order and the ask price if it was a buy order. However, experienced option traders often place a limit order between the bid and the ask price with the intention of luring a floor broker to execute the trade. As the market fluctuates up and down, there is a strong chance that the trade will be executed at your named price. Nonetheless, anytime that a limit order is placed there is risk of “missing the trade” or not getting filled on the order. However, over time I believe that the money saved in hidden transaction costs, namely the bid-ask spread, will outweigh any supposed profits lost on missed trade.
Of course, splitting the bid with limit orders is only a guideline. There are times in which timely execution is necessary, such as a fast moving market, and a market order would be more appropriate. Should you find yourself in such a situation, it is important to have an experienced broker with contacts on the trading floor; doing so may improve the efficiency of your fill.
Many beginning traders get frustrated because they see that an option last traded at a specific price, or settled at a specific price, but they cannot get an order filled at that particular price. Some of the difference may simply be due to the fact that they are viewing an “old” quote and the underlying futures contract has since moved, but part of the price discrepancy can be attributed to the bid-ask spread. After all, we don’t know whether the quoted price was a buy or a sell.
This spread makes it possible for retail traders to speculate; don’t get frustrated simply learn how to mitigate its impact on your trading results. By splitting the bid, traders play a small part in determining their fate as opposed to being at the mercy of the market.
For example, if you are interested in buying a call option on the Dow Jones futures contract and the broker tells you that it is “450 bid at 550” it would cost you $550 to buy it. If you wanted to sell it, you would receive $450 in premium. In this example, you may want to place a limit order to buy the option at $500 which is half of the difference in the spread. By the way, you will rarely hear a broker identify the ask price. They will simply say the bid, and then denote the ask price by saying “at”. So in the case of grain options, if the bid is 6 cents and the ask price is 7 cents, it would be stated by saying “6 bid at 7”. Some brokers can be very busy, and the faster they can get their point across the better.
Quoting Commodity Option Spreads
Keep in mind, the same concept can, and should, be applied to option spreads. When it comes to spreads, the premium is quoted in terms of the net. Thus, you would take the premium needed to buy the long options and subtract the premium collected for the short options. The difference is the value of the spread. In other words, if you are buying the spread you will be paying more for the long options than you are getting for the short options. If you are selling the spread, you are collecting more for the short options than you are paying for the long.
Let’s look at an example. If you were interested in executing a bull call spread with a naked leg, you would be buying a near-the-money call option and selling an out-of-the-money call option and an out-of-the-money put option. Each of the individual options that make up the spread, have their own bid and ask quotes. However, the bid and ask quote of the spread is derived by netting the corresponding premium values.
In this example, we are looking to buy the Dow 12,900 call, sell the 13,300 call and the 12,700 put. Thus, we are subject to paying the ask price on the 12,900 call, and collecting the bid for the short 13,300 and the 12,700 put. If we were interested in selling the spread, as opposed to buying the spread, we would be collecting the bid for the 12,900 and paying the ask price for the 13,300 call and the 12,700 put.
In the example, the figures highlighted in red represent the prices that a trader looking to buy the spread would be subject to. As you can see, a market order would get filled at a price of $325 on the “buy side”. If a trader wanted to split the bid, they would put a limit order in at $160 (the actual midpoint is 162.5 but floor brokers only take orders in increments of 5). Also keep in mind that if your option spread has a “naked” leg, meaning that you are short more options of the same type (call or put) than you are long, you are subjected to theoretically unlimited risk. Once the market travels beyond the strike price of the naked short option, it is similar to being in the futures market.
This simply means that the trader would like the spread to be executed if it can be done at a cost of $160 or less without consideration of transaction costs. If nobody is willing to take the other side of the trade at your stated price, the order will go unfilled. Remember, commission is charged on a per contract basis, thus a three legged option spread involves three commissions once it is executed. Regardless of the rate you are currently paying, this is something that you should be aware of.
Another key point in terms of quoting option spreads is the premium is stated after reducing the spread to the smallest quantity. For example, if you were executing two options spreads the premium quoted would be stated on the price of one.
Using the example above, if a trader wanted to do a five lot they would be buying 5 of the 12,900 calls, selling 5 of the 13,300 calls and selling 5 of the 12,700 puts. The bid-ask spread for the ticket would still be Even bid at 325. However, the actual dollar amount paid for the spread would be $1,625 (5 x $325) if the trader paid the ask price before commissions and fees.
The Trading Bottom Line
The purpose of this article was to simply bring attention to some very simple concepts that those privy to the industry insiders are aware of, but the retail public may not realize. Even those that are aware of the tips and tricks offered in this writing, find it hard to overcome their trading emotions enough to apply the knowledge.
While there is a degree of luck involved in futures and options trading, consistent gains can only be realized by those who put the probabilities in their favor, and even then there are no assurances. Understanding and implementing strategies that comply with the aforementioned items may help you to achieve such probabilities in your trading. Nonetheless, don’t forget that regardless of the strategy used there is substantial risk in futures and options trading and isn’t suitable for everyone.
**There is substantial loss in trading options and futures.
Carley Garner, senior analyst at DeCarley Trading, is the author of "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall. Her trading e-newsletters, The Stock Index Report and the Bond Bulletin, are widely distributed and have garnered a loyal following; DeCarley Trading is proactive in providing free trading education.
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