Another Trading Example

With our first example we have shown you a nice trending market - well, it did not turn out as nice in the end, but the opportunity was there! Just maybe this - a shrewd investor would have moved his stop loss to protect at least half of his profit in that trade. Thus on realising the initial $450 in profit, you should have moved your stop-loss in the futures trade to 374.5, protecting $225 of your profit. Then, when the correction came two days later you would have been stopped out of that trade with a $225 profit!

Here a different problem. Let's look at what Crude Oil has been doing:

This is Crude Oil, the April 2015 contract. Crude Oil has been trading down for a couple of months, made a small correction and now went into a trading range, going up-down-up-down..? It can stay in this range for a long time. Will it break up and make a large correction? Will it break to the downside and continue to drop? We don't know.

So how do we trade this? You cannot trade this with a Futures, since you do not know in what direction it will break out - the futures will be just too risky (at $1,000 per point - per $1 price change - you can take a substantial loss if you get it wrong). However we can trade this with Options! The strategy is simple - we sell a CALL option at a strike price above the market action - let's say at $60 per barrel. This option will only get into trouble if the oil-price breaks to the upside and starts trading above $60. We then do the same on the downside - sell a PUT option at $45 and dare the market to break out to the downside. The market can only go one of the two directions - thus one of our options will make money, the other one we will get rid off the moment that the market shows us in which direction it would like to break out!!

Here is our market as a line chart:

60 and 45 is quite far away from the price action. Let's go for 57.5 and 47.5! First, we SHORT a 57.5 CALL option. We collect $1,720 premium for this option.

The loss lines are at -$750 and -$1,500 respectively. Next, we SHORT a 47.5 PUT option. We collect and additional $1,170 premium for this option! Thus our total premium income from these two options are $2,890. We receive this money in our trading account, we will use this to get out of the trade if or when we need to:

This graph needs some explaining. Do you notice how the break-even line for our call now curves upward - giving us a better break-even profit than before!? This is because of the premium we collected for the put option! If the market moves upwards towards the CALL, then it automatically moves away from the PUT - making us money - the PUT will get into profit. This profit now adds to the net situation and although the CALL is making a loss, the loss is less than when we did not have the profit from the PUT. And vice versa!
OK, this is the situation. We now carefully monitor what Crude Oil does. If it breaks to the upside, we get rid of our CALL and profit on the PUT. If it breaks to the downside, we get rid of the PUT and profit on the CALL. We monitor the situation daily...

This is the situation 20 days (three weeks) later:

CRUDE is still going nowhere - it is still undecided. If we get out of this trade right now, buying back both the CALL and the PUT, we will realize a profit of $1,673. WHY? Because time is running out and both of our options are losing value over time! The risk is much less now than what it was a month ago, therefore the options are cheaper to buy back now (less premium) than when we sold them!

This trade is possible with options. Nothing like this is possible with the Futures. With the Futures you just have to wait for Crude to show its hand, until then you cannot trade it!

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What do I need to Trade?

So.. - what do you need to be able to trade these markets?