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Lessons for the Beginner
By: Rick Thachuk   Wednesday, August 8, 2007 10:45 PM
You determine that by selling the same contract of a different expiration month, that position will protect you from any further loss until the downward period is over. (You have essentially established a hedge position.) Once prices have bottomed, you can simply buy back that short position (leaving you long the original contract) and ride the bull market to the top. Sounds simple and appealing, right?

Unfortunately, this strategy assumes that you can pick the bottom, and you can't. It won't be obvious when the market has bottomed. Instead, this strategy will keep you guessing (you will find that you put on the spread, then take it off prematurely, then put it back on again, then realize that it should have been taken off last week, etc....) and this will generate more stress and ultimately, worse performance than simply closing the initial position. Let's face it: if you think that the market is bullish but prices keeps falling, then you are wrong. It's best to close the long position and re-think the trade.

Beware the cost of option premiums.

Buying a call option if you think that prices will rise, or buying a put option if you think that prices will fall have the appeal of limited downside risk. The most that you can lose on a trade is the premium paid for the option plus transaction fees. Unfortunately, option premiums can be expensive and this, coupled with the fact that the majority of options expire worthless, means that it is difficult to make profits over the long run from a strategy of only buying options.

Realize that when you buy an option, you are expecting two things: that the price will go in your direction, and that it will do so by the time that the option expires. The best way to evaluate this strategy is to calculate the break-even point of the option purchase (ie. where the futures price has to be in order to recoup the cost of the option and commissions), and then decide the likelihood of that event occuring prior to the option's expiration. If you do this, you will realize that the purchase of deep out-of-the-money options, while inexpensive, have an unrealistic break-even point and are usually a bad investment.

So what does work?

Accounts in excess of $20,000 have the financial strength to hang on to positions until prices move in their favor. That is, they can afford to take greater amounts of risk. For accounts $5,000 and under, though, such flexibility does not exist and the trader must look to minimize risk. The best way to do this is to choose futures contracts that are not very volatile and that have correspondingly low margin. The grains and soft commodities (cocoa, sugar, orange juice, cotton) fall into this category. You can also look at trading half-sized contracts, most of which are traded on the Chicago Board of Trade.

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