By Andy Hecht, Editor, Trade Hunter
In chess, it is said that you need to think three moves ahead.
I’ve played a lot of chess in my day, and I can tell you this is easier said than done. Just when I thought I’d figured out my opponent’s next move, he’d change things up on me.
I baited him once with my bishop. Instead, he took my pawn. It was an unexpected variable that redefined the outcome of the game.
I quickly learned that it’s much more important to develop strategies that can improve your position rather than trying to predict potential moves.
Investing is a lot like chess in that way.
If you think an asset will go up in price you buy it. If you think an asset will go down in price you sell it.
But what happens when you expect the price of an asset to move big… you just don’t know if it’s going to explode or go in the tank?
That’s the situation commodity investors find themselves in today. With all of the volatility in the markets these days, identifying how a commodity’s price will swing is difficult to pinpoint.
But there is an easy and safe strategy savvy investors can use to profit – even if you don’t know where the market is headed.
History Tends to Repeat Itself
Markets tend to react similarly to technical factors over time. Often, these signals give traders and investors clues as to what triggers an asset’s price to move up or down.
Market volume (the number of trades) and open interest (the number of open positions), for example, can influence markets. When markets become too overbought, they tend to correct and go down. When markets become too oversold, they tend to correct and go up.
That’s why watching technical indicators is so important. It keeps you one step ahead of the pack and puts you in a position to profit.
I didn’t realize the importance of technical indicators until I’d been trading for a number of years. That’s mainly because there’s much more information available today than there was three decades ago.
I relied almost exclusively on fundamental analysis. Understanding how markets operate fundamentally is one of the most effective indicators of an asset’s future price movement. A severe drought, for example, could affect this year’s grain harvest. Tighter grain supplies will likely lead to higher grain prices. Or a transportation snafu can affect an entire market because of late delivery.
But if there’s one thing I’ve learned throughout my 30-year career, it’s that…
Fundamentals Are Always Changing
When my opponent took out my pawn instead of my bishop, it completely altered the way I played the rest of the game.
The same is true in investing. A macro event like the debt crisis in Europe or the economic slowdown in China can drastically change underlying market fundamentals.
Even if the long-term fundamentals of a market are bullish, these macro events can create unexpected volatility in the short term that affects the direction of an asset’s price.
These events are inherently unpredictable.
So, as a trader, what can you do to profit from a big move you know is coming… whether it goes up or down?
With options you can make money if the market moves dramatically up or down. By using a long volatility position, you’re making a simple bet that the market will move with fury in either direction.
It involves simultaneously buying both a call and a put option. If the market moves significantly higher, the call option will make more money than the put option loses. The trade will be a winner.
If the market moves significantly lower, the put option will make more money than the call option loses. The trade will be a winner.
It’s a strategy that works. Here’s how…
Taking a Long Volatility Position in Crude Oil
The whole world watches crude oil prices. This commodity is a key benchmark that reflects the global economic climate. Crude is also produced in some of the most volatile countries in the world.
Fears of a double-dip recession in the U.S., debt problems in Europe and concerns that China is experiencing a slowdown in growth have caused crude oil prices to fall from a high of over $115 to a low of just under $75 a barrel this year.
A further deterioration in the global economic situation could cause prices to plummet further as demand for the commodity plummets. Oil traded as low as $32.50 in 2008 during the housing and banking crisis in the U.S.
On the other hand, heightened tensions between the major oil-producing countries could cause crude oil prices to skyrocket. Oil traded up to $147 in 2008.
Without a crystal ball, we can’t predict where oil prices will head over the coming months.
March crude oil futures traded on the NYMEX are currently priced at $87 a barrel. These futures have traded in a wide range between $100 and $75 over the past three months. Technical indicators are not telling us much at this point. Crude oil is neither overbought nor oversold, and it has very little momentum at current prices. Volatility, however, is high. This indicates that traders are expecting a big move, but they are not sure which way!
In this situation, a commodity options trader could purchase an at-the-money call and put option, called a long straddle. If you were to buy, say, a March 2012 NYMEX Crude Oil $87 straddle, it would cost around $17. Let’s take a look at an illustration of this long straddle on NYMEX crude oil futures:
Long straddles make money if the market moves by more than the premium that is paid. That means this position becomes profitable if NYMEX crude oil is above $104 (87 + 17) or below $70 (87 – 17) by the expiration date.
Every dollar above $104 or below $70 would be a profit to you.
In options trading, using a long straddle when you don’t know where the market is headed, but you know it’s going somewhere, will make you a winner.
Happy Trade Hunting!