Managing Volatility with Options

Last week we discussed the growing volatility in many of the best trending markets of the year. We noted that the uptick in volatility had to do with three primary sources. China’s attempt to cap inflation and put the breaks on their over heating economy, Irish bank solvency issues and the nervous anticipation surrounding Spain and Portugal and finally, money managers who were late to arrive are trying to capture year end performance and match their benchmarks. We can now add some certainty to last week’s assumptions. China did raise their rates. The European Union is actively striking a deal with Irish banks as well as taking an official look at Spain and Portugal and finally, money is flowing into stock index futures.

 

We can see through the Commitment of Traders data that commodity trader index funds are flowing into the stock index futures. This group has added approximately 50,000 contracts on last week’s minor correction and contributed greatly to the market’s ability to close virtually, unchanged for the week. Money managers will frequently use the added leverage of futures when chasing performance on the long side of the market or when hedging the risk of their portfolio when a downturn is expected. The fact that this buying pressure has been more than offset by commercial short selling only increases the uncertainty at these levels as the market’s largest players fight it out with ever growing conviction.

 

The same pattern is playing out in several sectors as these forces work their way through the markets. We’ve seen soybeans rally nearly 36% this year and silver was up 67%. The commodity market’s biggest winner for 2010 was cotton. Cotton was up more than 125% until news began leaking out of Asia that the textile industry was slowing down. These markets have all contracted considerably over the last two weeks as questions persist about the health of the global economic system and the stability of international trading relationships are re-examined.

 

Taking a look at any of these charts quickly makes clear two things. First, the trend is most definitely higher. Two, the pullbacks in these markets, when calculated on a dollar basis, are large enough to test even the strongest of commodity bulls. Commodity markets are leveraged instruments whose contract sizes were determined many, many years ago when prices were much lower. Consequently, the dollar value of the same percentage swings is much greater at these elevated prices. For example, a five percent swing in cotton at this time last year translated to a $1,671 swing in your account balance. Today, that same five percent swing is worth nearly $3,000.

 

The question that I’ve been asked most frequently over the last two weeks is, “How can I trim the dollar value risks of my commodity account while maintaining a comfortable diversification in case the stock market craps out in the face of a Euro Zone meltdown and a constricted China?”

 

My first response is that some commodities offer multiple contracts in various sizes. There are currently four listed contracts for gold. These range from the full size, 100-ounce contract down to a micro contract of 10 ounces. If this doesn’t work for your market of interest, I suggest using options to construct a hedge on an existing position or limit the risk when initiating a new one. Many people hear the word, “options” and their eyes glaze over as their memory drifts back to trigonometry and exponential curves. A better way to think of options involves using the insurance industry as an example.

 

Insurance is used to transfer risk. Buying the policy limits the potential of loss for a fixed cost up front. The seller of insurance collects a fixed fee up front while assuming the liability of the risk associated with the policy. This means that there are two ways trade options. Buying an option provides you with full protection for a flat fee. However, like most insurance policies, you may never have a covered incident to collect on. The premium you’ve paid in for the coverage you’ve selected will expire just like any other policy. The alternative is to be the seller of the option. You will collect the premium up front and if there is no collectible claim during the period, you keep the all of the premium when the contract expires.

 

I’d like to introduce one technical term for options trading and provide one example of how this all fits together. Insurance agents have actuaries. Actuaries are the number crunchers that provide them with the expected payout on any given policy. They’re the ones that make car insurance more expensive for a 16-year-old boy than for his 40-year-old mother. In options trading, the actuary is called, “delta.” Delta determines the probability that that option will be, “in the money,” at expiration. If an option is in the money, then it would be a collectible insurance incident. Delta is a probability and is bound by the 0% to 100% probability scale.

 

Given the large imbalance of positions in the stock market, options can be used based on the degree of protection one wishes to purchase. An option with a delta of 15 means that the market believes there is a 15% chance that the it will qualify as a covered incident on the policy issued. This option can be used to provide 15% protection to an existing position or, cut the contract size of the given market by 15%. Either way, the option can be combined with a futures position to limit the volatility of the account’s balance. Given the magnitude of the global issues being discussed and the elevated levels that many markets are still trading at, limiting the volatility of the account’s cash balance seems like a worthwhile endeavor.

 

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

 
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