Personal Finance (Sec. 6.3)

Fundamentals of Finance by Adam J. McKee

SECTION 6.3: Commodities and Options

Commodities are basic goods that are completely interchangeable with other similar goods.  Raw metals are a good example of a commodity; if a shipbuilder needs 100 tons of iron, they don’t differentiate between suppliers.  They just want the specified amount of “iron” at the best price possible.  Most agricultural products are considered commodities.  Poultry farmers want corn to feed their chickens; they want corn, and they want it at the best price.  They really don’t care much where it was grown or who grew it.

Of course, the quality of the commodity matters; commodities are graded and must meet certain standards (“basis grade”) to be placed in a particular classification.  From a retail perspective, commodities are often the inputs (raw materials) that go into the production of other products.  A barrel of crude oil is usually considered a barrel of crude oil, and you as the consumer don’t really care who owned and operated the production platform.

The buying and selling of commodities is usually carried out at special exchanges that set standards for both quality and quantity of the commodity being traded.  Commodities are usually traded as futures contracts.   A futures contract is a legally binding agreement between two parties to deliver a commodity (or financial instrument) for a specified amount at a specified future time.  Farming is mostly a futures contract based business.

Bread companies buy wheat futures from farmers; the future date is necessary because the wheat has to be grown before it can be delivered.  Futures contracts came into being because they were mutually beneficial to producers and consumers alike.  Producers needed a ready market for their products, and consumers needed a guaranteed source of raw ingredients.  Futures are also a hedge against market fluctuation; bread companies can lock in a wheat contract that doesn’t send the price of bread through the roof in a drought year.  McDonald’s, for example, couldn’t figure out how to sell McNuggets until brilliant investors showed them how to use futures contracts to keep the price of chicken relatively constant over time.

There are two basic varieties of futures contract buyers.  There are hedgers, and there are speculators.  The hedgers are the actual users of commodities that are trying to lock in a supply of a commodity at a good price.  The speculators are only interested in the profit that can potentially be generated by buying and selling the contract, and they have no real interest in the underlying commodity.  Like any other financial instrument, if you can buy futures contracts low and sell them high, you can make a lot of money.

Successful speculation in the commodity markets requires that you have a good understanding of what causes commodity prices to rise and fall.  If you grow 1000 acres of corn and spend an hour a day following the corn markets and corn growing conditions throughout the United States and abroad, then maybe you could make some money trading corn futures.  Commodity futures are what investors call a pure play because there aren’t many other factors to consider besides the current value of the commodity.  Fortunes can be made in minutes, and they can also be lost.  Unless you have some extreme advantage in knowledge of the commodity that most people don’t have, then stay away from this volatile space.  The logic of this is why I advise staying out of energy sector stocks.  The close ties to commodity prices makes the space just too hard.

For the average investor, the most important thing to understand about commodities is that the fortunes of many companies are intricately linked to some commodity.  If you own those companies, you’d better keep up with the commodity that they rely on.  Let’s say you have Exxon stock in your portfolio.  Exxon ($XOM) is at its heart an oil company, and they will be doing great when oil prices are high.  When oil prices fall very low, Exxon’s bottom line is not as stellar.  When oil climbs up to record highs, then oil companies like Exxon have awesome bottom lines and their stocks explode upwards.  If you really want to be in this space, you can find less volatile stocks in the oil service companies like Schlumberger ($SLB) and Halliburton ($HAL), and pipeline plays like Midland Magellan Partners ($MMP).

Stock Futures and Options

In a parenthetical note above, I mentioned that commodities are not the only thing you can trade in futures; you can trade stock futures as well.  Single Stock Futures (SSFs) are an agreement between two investors to deliver a specified number (almost always in blocks of 100 shares) of a particular stock at a specified future time for a specified price.  A slightly different investment instrument is a stock option.  With a futures contract, you are required to deliver the goods or securities per the contract when the contract expires.  When you buy options, you are under no such obligation.  Options are in essence contracts that grant the right (but not the obligation) to buy or sell an underlying asset at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option.

There are options for just about everything these days.  I joked with a colleague that we should start selling options contracts on the daily average temperature in Bemidji, Minnesota.  Hedge fund guys could buy them in the summer and short them in the winter to show clients massive gains, and retail investors would take the opposite side of the trade so that they could show huge losses in their trading accounts just prior to tax season, then gain their money back in the spring.   Most serious traders trade a limited, well-established basket of option types, often selecting only one that they attempt to master.  Here are some commonly traded option types:

Stock Options:  As the name suggests, the underlying asset for these contracts are exchange-traded shares (stocks) of public companies.

Index Options:  These are very similar to stock options, but they have an entire index (e.g., the Dow Jones Industrial Averages, the S&P 500, the Nasdaq Composite, and the Russell 2000).

Forex/Currency Options.  Just as stocks are traded on exchanges, so are currencies.  You can buy, for example, Euros with U.S. Dollars or U.S. Dollars with British Pounds.  The exchange rates vary on an ongoing basis (all of the time), and currency options allow the buyer to lock in a specific price.

Commodity Options.  The underlying asset for this type of option can be the actual physical asset such as bushels of corn or barrels of oil, but most often it is a futures contract for the underlying commodity.

The above options all represent similar mathematics for traders relying on probability and statistics for an edge, but the forces that drive markets tend to be quite different.  Because I am such a strong advocate of stocks as the bulk of retirement portfolios, it makes sense for the retail investor (investors that have day jobs that don’t involve financial markets) to focus on trading stock options rather than any other type.  A requisite for trading any option is that you know how to trade the underlying security.  It is foolishness to trade Forex options if you don’t know how those markets work and how to profit from such trades.  Trading index options is another related alternative.  You can also trade options on ETFs that mimic the indices (e.g. $SPY, $IWM, and $QQQ).  The advantage is that ETFs trade just like stocks, so you know how to trade the underlying as well as the options once you understand stock options trading.  They will follow the same rules that you already understand.

Note that these contracts trade on the open market much like stocks; you can sell them to another trader that has different trading strategies than you do.  As a general rule, you want to make sure to sell your options before they expire or you will return to your trading account Monday morning to find your options contracts gone and several hundred stocks in their place.  In other words, you have exercised your right to buy the stocks per the contract.  When you own an options contract that is “in the money,” your brokerage will exercise it for you so that you do not lose the value you have gained when your contracts expire worthless.  This is a double-edged sword, and something that you will rarely (if ever) want to happen.

As you’ve probably already guessed, the world of options trading has its own special language, and some of the strategies and tools used by options traders are extremely difficult to understand if you are not a math savant.  Still, the basics of how they work are simple, and anyone can learn to trade basic options strategies.  The key thing to understand about options is that they are essentially just contracts, and you are paying a price (called the premium) for those contracts.  All options contracts are for a specified period of time; when they expire without being used, they become absolutely worthless.    If you leave your GE stock sitting in your portfolio without paying attention to it, it will trade within a fairly predictable range, and you will either profit or lose a small percentage.  With options, you will always lose money as time passes.  This “time decay” is a feature of options that you can’t afford to ignore.  To put it another way, you don’t invest in options, you trade them.

Why would you “invest” in something that always loses value as time passes?  There are many reasons, but the one most commonly cited by options novices is because of leverage.  Options are traded in blocks that represent 100 shares of stock.  So you can spend a small amount of money and capture the gains of a large amount of stock–if the stock moves in the right direction!  If the cost of the underlying security goes against you, you can lose most or all of your money very, very quickly.

The mechanics of options trading is very similar to trading stocks.  A major difference between stocks and options is that (as the name implies) you have many, many options representing a single underlying stock.  The reason for this wide array of different contracts that you can buy and sell is that different investors want different kinds of contracts.  The most noticeable difference between contracts is the strike price.  The strike price is the price of the underlying stock that is specified in the contract (you will never actually see a written contract; all exchange-traded contracts are standardized, and your broker will make you read the rules before you can trade options).  The strike price of a contract cannot change, and thus is the benchmark by which movements in the underlying stock’s price are judged.

Recall that the two basic options types are calls and puts.  If you buy a GE call with a strike price of $20, you are betting that the price of GE stock will rise above $20 before the expiration of the contract.  If you buy a GE put with a strike price of $20, you are betting that the price of GE stock will fall below $20 per share before the contract expires.  Note that if you get the direction of the bet wrong and let all of the contract’s time run out, it will expire worthless and you will have lost all of your money.  When considering options, it is important to realize that the price of an options contract has a value derived from two sources, both of which can have a value of zero.  When options traders talk about intrinsic value, they are talking about the money that you’d make if you exercised your option, took control of the stock, and immediately sold it.  In our above example where you bought a 20 GE call, if GE is trading at 21, your contract has an intrinsic value of $1.00.

You probably noticed that $1.00 doesn’t sound like much of a gain.  That figure is misleading and brings up another aspect of options trading that confuses the novice.  Recall that when you buy an options contract, you are buying the right (but not the obligation) to buy (call) or sell (put) a block of 100 stocks.  Since all of the figures concerning the contract are specified in terms of single stock, you must multiply all dollar amounts by 100 to get at the real profit and loss numbers.  For example, if our GE calls above are selling for $1.00 that means that the contract will actually cost you $100 to buy (plus brokerage commissions).

The other component of options prices is what some traders call extrinsic value.  Extrinsic value is also called time value because the number of days remaining in the contract are a key determinant of contract prices.  This makes sense because the more time that your stock has to move, the more likely it is that it will move in the direction that you predicted by the amount that you predicted so that you can make a hefty profit.  The less time you have, the less likely you are to win your bet.

A closely related idea that plays heavily into the extrinsic value of options contracts is “market speed,” most commonly referred to as volatility.  There are several ways to get at volatility, and several other ways to think about what it is and how it works.  Perhaps the most common way of measuring it is to use the standard deviation of price changes (expressed as a percentage) of stock movements made during a particular time frame.  Some stocks are rather placid, much like waves on a calm sea.  There are some slight up and down movements, but these tend to be rather predictable and unalarming.  Investors prone to anxiety tend to like low volatility stocks; the subdued price action means that they can sleep well nearly every night.

Investors (speculators) that are in the game for a quick profit tend to like high volatility stocks; these are the stocks that tend to be like waves on a stormy sea.  The waves rise to startling heights, and then come alarmingly crashing down again.  Long-term investors tend to hate these types of price movements (or just ignore them), but day traders and options traders often regard volatility as a requisite for fast money.  That is not to say that all options traders (and strategies) need volatility to make money.  There are many options trading strategies that offer regular, low-risk profits for risk-averse traders.  No matter what kind of options trader you are, you must care about volatility because volatility is a key factor in the pricing of options.  The more volatile a stock tends to be, the higher the options contract premiums.  Buyers of options during times of high volatility can get the direction of the underlying stock right and still lose money.

If you Google “stock option strategies” you’ll be overwhelmed with ideas on how to get rich trading these fascinating securities.  You’ll also be invited to join online “trade rooms,” buy books, buy DVDs, attend seminars, and sign up for college programs.  You can spend thousands of dollars on access to the “secrets” of options trading.  After months (or years) of intensive study, you’ll eventually learn that there are no “secrets.”  All of the “secrets” you need to know, you probably learned in an undergraduate statistics class and your experiences trading stocks.  You have to understand percentages, confidence intervals, and probability distributions.  Retail traders that have degrees in math, science, or (especially) the social sciences are at a distinct advantage because they have learned (or should have) the probability and statistics facets of options trading that many investors have trouble grasping.  When your professor told you that it would “pay” to “pay attention” in statistics class, I’ll wager he had no idea that the statement was true in a literal sense!

If you absolutely love games of chance like poker and blackjack because you think you can use your intellect and instincts to “beat the dealer,” then you are a likely candidate for options trading.  Anyone can learn to trade options as an intellectual pursuit, but without the gambler’s curiosity that makes the study interesting, you’ll find it painfully boring and not likely learn enough to be profitable.  If you have a serious math phobia, you will need a therapist to help you get over it before you can learn to trade options.  If you do have the gambler’s curiosity, you will be excited to learn that with options trading the house doesn’t have an edge.

With options trading, the house usually makes its money on commissions, fees, and interest.  They don’t have a stake in the outcome of your hand.  You are playing against other traders, and there are enough “greater fools” out there to take the opposite side of any trade (traders refer to this condition of being able to easily find a trader to take the other side of your trade as liquidity).  As with stocks, however, you should never wager against the “smart money.” Traders refer to massive hedge funds and institutional investors that trade in big enough blocks to move markets as the “smart money.”  Warren Buffet, for example, can send a stock up 10% just by telling a reporter he is thinking of buying it.  When you hear about “unusual activity” in options, it means that someone–or some institution–has purchased a block of options that represents a staggering sum of money.  Many traders will jump in with them, which often creates a sort of self-fulfilling prophecy.  These effects are often short-lived, and you should not trade this momentum if you are not very, very competent.  They may, however, give you trading ideas that you can substantiate with careful homework.

Hail Mary Options Trading

Even if the complexity of the options market makes your head hurt and you know that you want no part of it, you should still understand the basics of buying a call or a put when a golden opportunity arises.  Football fans are familiar with the idea of a Hail Mary pass.  This is usually a very long, typically unsuccessful pass made in a desperate attempt to score late in the game.  The idea is that if it works, you can win the game for your team.  If it fails, you haven’t really lost anything new since your team was going to lose the game anyway.

Once in a great while, an experienced investor (or trader) will realize that something very big is going to happen with a stock, and she becomes nauseated because she doesn’t have enough capital to take advantage of the move that she is absolutely sure is about to happen.  In absolute terms, a 20% move in a stock (which most investors would consider a good year) doesn’t mean much if you only have $1000 to invest.  Sure, making $200 is nice, but the “smart money” made millions on the trade, and that fact is galling.

If you ever find yourself in this boat, then you may want to consider the risks and reward of what I refer to as a “Hail Mary” trade.  You make the biggest bet you can afford that your “sure thing” will happen by buying options in your predicted direction as close to the date that the big move will happen as you can get them.  By making your biggest bet with options that have very near expiration dates, you’ve maximized the number of shares of the underlying stock you can control and profit from.  The reason that such opportunities are rare is that big profits usually come from contrarian trades where you foresee something that very few other people see and most of the Street is betting against you.

The Street isn’t stupid (most of the time), and the consensus is a powerful force.  If everyone knows something is going to happen and they have had (just a little) time to process the implications of whatever catalyst is going to happen, then good (or bad) news is already baked into the stock price.  It is strange and unexpected that causes price explosions.  In days where computer algorithms scour the internet in search of news and execute stock orders in fractions of a second, you can’t compete without some sort of edge that the algorithms can’t duplicate.

Let’s say that you are sitting at your computer pouring over option chains on Tesla ($TSLA) stock when you get a tweet from Mr. Musk that he has decided to personally lead a mission to Mars.  The algorithms may not immediately grasp the implications of that tweet, and human traders will need a few seconds to consider it.  You see in a flash of insight that Mr. Musk can’t very well stay on as CEO of Tesla if he is on a mission to Mars, so he must step down.  You also believe that the fortunes of Tesla are intricately linked to the charismatic Mr. Musk and that Tesla stock will plummet (at least in the short term panic) when the Street realizes this fact.  In a decisive moment of truth, you place an order for 1 put at a strike price of $342.50 on TSLA for a total cost of $1000 when the stock is trading at $343.14.

As the Street processes the news of Elon’s intrepid expedition, the stock reacts and plummets down to $232.50, losing over 30% of its value in a few minutes.  Bottom feeders come in at that level, smelling a deal.  This provides some buying pressure and the stock starts to trend back up a little.  You sell the put when it bounces back down to the bottom, which you’ve decided was the $232.50 level.  If you had shorted the two shares you could afford to cover with your $1000 investment, you would have made around $200 (because you could only afford the very small short position consisting of two stocks).  Not bad for a few minutes work!

Remember, with a put you are controlling 100 shares of stock.  When your $10 put that you paid $1000 for ($10 x 100 shares) sells, the intrinsic value has moved from zero to the difference between the strike price of $342.50 and the price of $232.50 where you sold the contract.  You lose $10 per share because of the option premium.  This means that your profit from the trade was the $342.50 strike price (it doesn’t matter that the stock was selling for more than that when you purchased the position) minus the $232.50 price where you sold the put.

That comes to $110.00, which doesn’t include the premium you lost (for ease of computations, let’s say that there were mere seconds of trading left before the market closed on expiration day and there was no time value left, so only intrinsic value remained when you sold).  That means you made $100 per share off of the trade.  That $100, as you will have noticed, is less than the $232.50 you would have made by shorting the 2 shares of stock.  But remember, that $100 is your profit per share, and your put gave you the right to the profit from 100 shares.  So that comes to 100 shares times $100 gives you a total profit of $10,000.

If a tenfold increase doesn’t excite you, then you aren’t going to enjoy trading.  You may be asking, “Why doesn’t everyone spend all the cash they can come up with on options if it is that easy?”  The answer, you probably have guessed, is with the risk.  What if the big crash didn’t happen after all?  Let’s rewind that scenario and see how it would play out differently under different circumstances.  Let’s say that CNBC reports that hackers hijacked Elon’s Twitter account for a few minutes and that he wasn’t responsible for the Tweet.  The stock didn’t have time to react in a big way before the report came out, and $TSLA kept trading as it usually does.  You try desperately to sell the “out of the money” put for what you invested in it, but get no takers late on expiration day.  You aggressively put in sell orders with lower and lower prices and finally manage to get rid of it at $0.05.  After fees, you lost a little more than your $1000 investment when the bell rings.

The takeaway from our two hypothetical scenarios is twofold.  The first point is that options trading is attractive to many because the upside is unlimited for call options, and put options are limited only by the fact that stocks can’t go below zero in value.  Either way, the profit potential is absolutely huge when compared with the initial investment if stocks make explosive moves in the direction that you predicted.  The second point is that explosive moves that result in tenfold profits are exceedingly rare and can result in you losing everything you invested.  This leaves you with two important questions to ask yourself:

  1. How sure am I that this stock will make a huge move in the predicted direction in the allotted amount of time?
  2. How am I going to feel if my contract becomes worthless and I lose everything I invested?

What this suggests is that you should make Hail Mary bets only when you are absolutely sure that things will go your way.  You should also be sure that you can afford to lose the bet and still sleep at night.  Making such bets with the rent money is pure folly.

If you want to make money trading in options, you need to make small bets (5% of your total options investment pool is a common strategy) so that when luck goes against you, you aren’t wiped out and can play another hand.  You also need to make high probability bets.  One of the things I like most about options is that you know the probability of success going into the trade (assuming market conditions remain similar throughout the life of the contract).  If you read a book on casino betting, you can learn the “house edge” on nearly every game (that is played according to the rules).  Casinos make billions of dollars every year, and they certainly don’t depend on luck.  They depend on some very smart people doing a lot of probability calculations.

When you play blackjack, for example, you are praying for luck and rubbing your lucky rabbit’s foot, but the casino is assured of a profit because it has an edge of one half of one percent (0.5%).  The edge is even higher when patrons are making bets based on poor strategies and lubricated with free alcohol.  You may have a lucky streak and make a profit by playing 25 hands, but the casino takes advantage of the laws of large numbers and makes its profits on slivers of thousands and thousands of hands.  For roulette, the house has a 5% edge.  That means that the house is going to keep (on average over many, many bets) $0.05 of every dollar bet.  Casinos get very, very upset when patrons do things to mess up their carefully calculated edges.  That is why card counters are identified and banned and the banned list is shared with other casinos.  When you trade in options, you don’t have to beat the dealer.  Beating the dealer is a critical concept when dealing with casinos because, rest assured, the casino always has the edge (and why I call casinos and lotteries the Stupid Tax).  You can become the casino—you can know your edge and play only the games that give you the edge you are looking for.  Professional options traders don’t make Hail Mary bets.  They make high probability bets with relatively small stakes and carefully control their risks.  Think you cannot make money like that?  Pull the balance sheet on your favorite casino.

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