The Nuts and Bolts of Alternative Option Trading
- Written by Carley Garner
Swing Trading Commodities with Options
Being privy to the options and futures markets along with trial and error has nurtured a respect and an depth understanding of the markets. I hope that our readers will allow themselves to step out of the box when it comes to option trading and look toward the potential of trading aggressive option spreads.
Markets spend most of their time trading in a defined range; this makes profiting on long option strategies very difficult. Additionally, according to studies conducted by the CME, more options expire worthless than not. For these reasons a strict long option only tactic seems to have dismal odds. After all a long option play requires that the market make a substantial move in order to turn a profit to the trader and a range bound futures market likely won't deliver.
Within every trading range, there are brief trends in which some traders may look to profit from by buying or selling futures contracts; this practice is often referred to as 'swing trading'. What most people don’t realize is that you can profit from a range bound market by using a combination of long and short option and futures.
Swing Traders are not looking to predict the overall direction of the market or to hold a bullish or bearish bias. Instead, the goal is to simply profit from the natural ebb and flow of the market. In other words, swing traders attempt to capitalize on both the trending and retracement phases of the market. The theory of swing trading is based on the assumption that all upward action must result in a corrective period, or vice versa.
While a swing trading strategy most often involves outright futures trading, I believe that option spread trading provides traders with a vehicle that is capable of mitigating some of the market's volatility relative to going long or short a futures contract. I argue that doing so allows more room for error should the market speculation be off in terms of direction or timing. An option spread affords traders with the luxury of having some room for error. Take into account that once a futures position is executed, the trader is immediately exposed to unlimited risk and the profit and loss incurred becomes a reality.
We will show you an alternative to futures trading that slows the pace of profit and loss but is capable of returning a respectable profit should the circumstances fit. Hopefully as we cover an example this concept will become clearer.Naturally, if something seems too good to be true there will be a catch. The disadvantage of swing trading with options as opposed to futures contracts is the fact that the profit potential is often limited, but this depends on the structure of the trade. With the exception of synthetic long options, most of the examples that we are about to cover does entail limited profit potential and unlimited risk.
Another negative aspect of aggressive option spread trading is the inability to actively trade in and out of a position. The inability stems from the difficulty of overcoming transaction costs in the form of commission and the bid/ask spread paid to the executing broker. Additionally, short options can sometimes "get in the way" of your profitable long options. For example, a trader that is long a call but also short a call with a distant strike price may find that the gains made on the long call are being nearly entirely offset with losses on the short call at any time prior to expiration.
Yet, these drawbacks shouldn’t discourage you from employing such a strategy. As you delve into this type of trading further, you will see that the same short option that limits your profit potential when things go right will cushion the blow when things go wrong. I strongly believe that if constructed properly and careful consideration is given to measures of volatility, a swing trading strategy using options provides traders with an aggressive vehicle that debatably provides better odds of success to a trader than an outright futures position.