Friday, September 28, 2007

The Commodity Swing Method, PART 2 - Lock In Profits, Reduce Risk And Trade The Swings

Getting into a market is simple. Getting out with a maximum profit is difficult and is an art. How do we know when to take a profit and when to take a loss? Will I miss the big move if I get out now? Here's some methods that can take the mystery out of what to do at these critical times.

So what would be the ideal market scenario to profit using the Thomas Swing Method? Let's take an example. We are long two calls and the futures market rallies. We sell one future contract and the futures market declines. We cover the future contract at the lows and the market rallies to new highs. We sell another futures contract and the market declines, and so on. Essentially, we have taken all the option rally profits and strung them together into one line (like a string) by absorbing their declines, using the futures contract as a hedge.

Let's look at a less favorable situation. Once hedged with the short futures contract, if the futures market declines sharply into a new bear market, we still might do well if the options lose their value but the futures contract keeps profiting. Conversely, if the market explodes to the upside, the deltas of the options get closer to 1.0, so that at some point the two options will more than cancel out one futures contract and will show a reasonable profit. These are interesting possibilities considering how limited the profit chances are just holding eroding call options alone.

What is the most undesirable outcome? If the futures market goes sideways after the hedge, then the options will erode (as normal) and the futures contract will stay near break-even. Do not continue to hold the hedge if the options erode to a delta below 0.5 or have less than 30 days to expiration. This is approaching a naked futures contract since the commodity options have a smaller offset. Another overall negative is you will need to maintain margin for the futures contract no matter what commodity options you hold.

This strategy can be reversed for a long commodity put option position. (looking for a decline) You would buy a futures contract against two put options after a profitable decline.

The Thomas Swing Method is a technique any long-term commodity option holder should consider. Holding on for the big swing can be easier when we lock in short-term profits along the way. It takes a good feel of short term timing to execute this method properly. Spend time practicing this strategy on paper until it's clear. It's another tool to have ready in your trading arsenal when buying and holding commodity options for the big swing.

Good Trading!

There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.

Thomas Cathey - 27-year trading veteran heads the managed futures division of Thomas Capital Management, LLC. View his TimeLine Trading market predictions and get his complete 44+ lesson, "Thomas Commodity Trading Course" - they're all free.

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