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Commodity Risk Depends Upon Trading Strategy

 August 08, 2007 10:53 PM


 

Many believe that commodity trading is risky and rightly so. This is reinforced even by the disclosures required by federal regulators that emphasize the inherent risk of commodity trading and its corresponding unsuitability for many members of the investment community. However, the degree of risk of a commodity trade depends upon the type of strategy being used. Several types of strategies can be used to participate in a market move and each has different degrees of risk. They are listed below from low risk to progressively higher risk. (The list is not exhaustive: some of the more complicated strategies have been left out.) These strategies are all directional trading strategies meaning that they are used to capitalize on a movement up or down of the market's price.

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Option Spread Purchase............... Risk Rating: 1

This a low-risk strategy. If prices are expected to rise, then the trader can buy a bull call option spread. If prices are expected to decline, then the trader can buy a bear put option spread. Option spreads can be a little difficult to understand initially and to execute, but the trader can (hopefully) rely on their broker for support in this area.

Outright Option Purchase............... Risk Rating: 1.5

An outright option purchase is still a low-risk strategy, but because the initial cost and hence, maximum loss, is larger than that for a corresponding option spread, it is a little more risky. This is an easier strategy to employ, though. If prices are expected to rise, then the trader buys a call option and if prices are expected to decline, the trader buys a put option.

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Futures with Protective Option............... Risk Rating: 2.5

This strategy is moderately risky. If prices are expected to rise, then the trader can buy a futures and simultaneously buy a protective put option. If prices are expected to decline, then the trader can sell a futures and simultaneously buy a protective call option. Because option prices tend to move less than corresponding futures prices, the trader may want to rely on their broker's assistance in formulating this strategy.

Covered-Write............... Risk Rating: 3

This strategy is slightly more risky than the previous ones. If prices are expected to rise, then the trader can buy a futures and simultaneously sell an out of the money call option. If prices are expected to decline, then the trader can sell a futures and simultaneously sell an out of the money put option. Protection in an adverse scenario is not as effective as in the above strategies. Again, the trader may want to rely on their broker's assistance in formulating this strategy.

Futures with Excess Margin............... Risk Rating: 4

This strategy relies on an outright purchase of a futures (with a protective stop) if prices are expected to rise, and an outright sale of a futures (with a protective stop) if prices are expected to decline. With every futures contract, the trader maintains higher margin in the account than what is required. For instance, if the maintenance margin on a contract is $1,500, then the trader may trade as if the margin were twice or three times that amount. This has the effect of reducing the leverage and lowering the volume of trading, both of which lower risk.

Futures with No Excess Margin............... Risk Rating: 5

This strategy is identical to the above strategy with the exception that no excess margin is maintained in the account. All of the trader's risk capital is being used to meet margin requirements on futures positions (each of which has a protective stop order). This is the riskiest trading strategy (apart from reckless trading such as trading without a stop order or day trading to avoid margin requirements altogether). The futures trader should know each of these strategies and focus on those which are consistent with their overall tolerance towards risk.



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(1)
 
10/10/2009 12:46:24 PM
raghu by raghavendra
i want some information
Rating: (1) (0)

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