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Commodity Options Trading and Hedging Volatility in the World’s Most Lucrative Market

Many books have been written about options on futures, unfortunately we believe that many of them are either contradictory or just a meandering compilation of exchange-generated research and material. In our opinion, much of the available literature leaves you even more confused than you were before you opened the book. With this book we hope that we have taken a step toward changing what has been the norm in this genre. The biggest mistake that some authors make is to apply stock option theory to options on futures. It is a misguided perception to believe that an “option is an option.” Although they are spelled the same, they aren’t comparable. The nature of the underlying vehicle differs greatly, causing the options to take on completely different characteristics. After all, everybody agrees that trading stocks is different from trading futures, so why would anybody assume that trading options on stocks is synonymous with trading options on futures? It is our observation that authors of such material may simply be looking to capitalize on book and course sales through the recycling of stock option theory. In the early 1980s the industry was dominated by operations that would now be referred to as a “long option only” houses. At the time, options on futures were not readily available in the United States. The instruments that were being sold were “dealer granted” precious metal options, which were based on actual metal holdings of the option writer at the time of the contract origination. In the mid-1980s, the various exchanges started introducing options on futures known as Exchange Traded Options or ETOs. The explosion in this new trading vehicle was nothing short of breathtaking. Based on experience and speaking with others in the industry, during this time many retail customers were still limited to trading long option strategies. What we found is that they were either dissuaded by the brokerage firm or flatly refused permission to employ short option strategies. Several excuses were given, but the arguments
From the Library of Melissa Wong
were in our opinion one sided and weak. It has been said that the most common basis for keeping the public away from short options is the perceived risk. However, we believe that in most cases this view holds no merit mathematically or practically. Surely option selling is no more risky than trading futures contracts; after all you get the money up front. Nonetheless, insiders were making a lot of money selling options to individual traders, and they likely wanted to keep it that way. In fact, much like the world of finance coined the term “cash cow” to describe a business with healthy income but requiring little maintenance, insiders have dubbed option selling the “cash cow” of the futures markets. However, we must point out that in business and trading alike, there are inherent risks, and the risks can be substantial, especially when trading commodities. Fortunately, things have changed over the years. Option selling is now conveniently available to all traders who want to partake. The result appears to be a more level playing field for market participants. Years of following the trading strategies and recommendations of the popular option trading gurus forced us to witness the disappointment of strictly long option strategies. Due to time decay and the tendency of markets to stay range bound, the strategy only delivered minimal random profits. Even those recommended by the so-called experts in the field didn’t yield better results, at least as far as we could see. Frustrated by the situation, we chose to take control of our and our clients’ destinies by researching, developing, and implementing an option trading method that had the potential to capitalize on both the advantages and disadvantages of long option trading. To do so, we had to disregard the long option strategies instilled into many of us and take into consideration only what was real. The descriptions of the trading methods used in this book were meant to be easily understood and, even more important, easy to employ. The strategies outlined throughout this book can be effective and efficient option plays; accordingly we and our clients use many of them on a daily basis. In fact, we are so comfortable that our approach to the markets is viable in the long run that we choose to publish our trades on the Internet and distribute them by e-mail before we execute them in the marketplace. We like to call this “The Good, the Bad, and the Ugly” because we show it to you without filters. We stand by a simple statement “Seeing is Believing”!

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