Time to cover the definition of a bullish market. As we discussed, there are only two kinds of options, Puts & Calls. In the most simplistic form, you want to buy a Call option when you feel the price is going up and you want to buy a Put option when you think the market is going down. We are going to be bullish sugar in the following example so we would look at buying a Call.
A simple way to remember Puts & Calls is that Puts=Plummeting Prices and Calls=Climbing Prices.
Strike prices in Sugar trade at .50 increments, like 10.00, 10.50, 11.00. (Strike prices are set by the exchanges and you are not able to pick your own strike price.) The first thing that I would do after deciding that I was bullish this market is to go back to the long term charts and find the next major resistance above the current price.
As you can see in figure directly below, the next major resistance is 15.38 which came from the Monthly chart.
When drawing out support and resistance lines on my Daily chart, I use red for resistance and blue for support lines. I also use green lines for Common Numbers which was covered in my first course. If the resistance is from a monthly chart, I use a line thickness of three, two if it’s from a weekly chart and one if it’s on the daily chart. Track-n-Trade makes this very easy for you to do. This way, I can glance at my daily chart and see exactly where monthly, weekly and daily support and resistance, as well as common number areas are. This makes the chart much more visual and easier to understand. It helps my charts “talk” to me.
Now, since I’m bullish my main focus is on the next level of major resistance. I will use this area as a profit target using a call option.
Also, I’m going to share with you something that will help you in all your trades in both futures and options and it’s a little known secret off the trading floors. It’s that many times support & resistance areas are option strike prices! Or, to put it another way, option strike prices often become support or resistance levels.
My friend Scott Barrie who was a floor trader tried to explain the reason for this. He was very thorough in his explanation and probably spent a half hour on the phone with me. To be honest, I did not understand it at all. I understand simple things like the sun comes up in the East every morning and sets in the West and that support & resistance areas are often option strike prices. I don’t know why either of these two things occurs and to be quite honest, I don’t care. I’m just content in knowing that they do happen. I also don’t understand why all food that taste good is fattening and don’t ask me how I know this either!
Now since we are bullish, we want to consider buying a call option but which one should we buy? The closer the strike price is to the current price of the futures market the more expensive it is. As an example if sugar is trading at 10.00 then a call option with a strike price of 10.00 would be more than one with a strike price of 10.50 and a strike price of 11.00 would be cheaper than the 10.50 Strike Price. I will explain more about this as we go along.
I’m a firm believer that you MUST use proper risk controls when you trade or you won’t be around very long. One of the key mistakes new traders make is that they risk to much of their account on any one trade or have too much at risk in any one market (like the Grains, Metals, Meats, etc.)
With a small account (and I think anything less than $10,000 is a small account) that you should not risk more than 5% ($500) on any one trade and the larger your account the less percentage you should risk. In other words, with a $100,000 account you might only want to risk 1% on a trade but with a $10,000 that’s almost impossible because you could only risk $100 (1%)and there are not many trades worth taking that only have a $100 risk. And when figuring your risk also include commissions and some slippage.
It’s probably a good time to mention that what you pay for an option is not what you have to risk on the trade; that’s completely different. What you pay for the option is your maximum risk. Let’s say that you have a $5,000 account and you only want to risk $250 (5%) but there is a great option that cost $500 which is 10% of your account. Well you can buy the $500 option and then offset it (get out of the trade) if the value drops to $250 which would be a $250 (5%) loss. So the option premium was 10% of your account but the risk you take is only half that or 5%.
You don’t have to keep the option and let it expire worthless, you can offset your position anytime you want to. In this respect, it’s like a futures contract; you don’t have to keep a futures contract until it expires either.
I’m going to give you two different examples here; one for a $5,000 and one for a$10,000 account. With a $5,000 account you can risk up to 5% or $250 and of course with a $10,000 it’s twice that or $500 but it’s still only 5% of your account. I used the Options Plug-in in TNT to find the cost of these two options. The strike price of 13.50 is .20 points (option prices are shown in points and in dollars in Track-N-Trade Pro) or $224 and the strike of 12.50 is $470.40. So with a $5,000 account you could buy one 13.50 call for 20 points ($224) and with a $10,000 account you could buy one 12.50 call ($470). And yes with a $5,000 account you could still buy the $470 option and get out of it if you lost $250.
The first thing to decide is your exit strategy and the risk you want to take. Like I said, we are going to use the total premium cost as our risk in this example. So we could set exit targets several different ways. We could say that we are going to sell the option if we make 200% and it TRIPLES in value or we could say that we are going to let the market tell us when to sell it.
Now hold on David, what do you mean it has to triple in value to make 200%? Don’t you mean doubles in value? Remember in my first course, I always talked about keeping your risk reward ratio at 2:1 or better? Well you have to do the same thing in options. So if you paid $250 for an option, that money is gone forever, you don’t get back your premium whereas in trading futures, you put up a deposit (margin) and you get that back if you exit the trade with a profit. In options it doesn’t work that way. The premium you pay for the option is gone forever, you don’t get it back.
So if you paid $250 for the option and decide the entire option premium is what you are going to risk then how much do you need to make to have a 2:1 risk/reward ratio? That’s right, you need to make a $500 profit. So to make a $500 profit on an option that you paid $250 for, then the option must increase in value to $750. Why? Because you paid $250 for it and have to deduct what you paid from your profits. $750-$250 is $500 or a 2:1 return. If the option went up to $500 and you liquidated it, then you would only have a profit of $250 and your risk was $250 which means your risk/reward ratio was only 1:1. And yes, if you are thinking that your plan could have called for you to offset the option and get out of the trade if it dropped in value to $125 and sell the option if it went up to $375 which would give you a 2:1 Risk/Reward Ratio. If that was your plan BEFORE you got into the trade, then you could take the profit when the option doubled in value. There are many ways to skin a cat. (Sorry cat lovers)
Okay, I’ll quit rambling and get back to the example again. Since the next major resistance on this chart is 15.38, I’m going to look for resistance somewhere around 15.00 to 15.38. Why 15.00? Because 15.00 is an option strike price. Remember I told you earlier that many times option strike prices will become support or resistance levels. REMEMBER THIS!
Now, I’m going to show you what would have happened if you had bought one of these options. See the figure below.
Notice the market went almost straight up and made double tops with bearish candles just below15.00 which was an option strike price and we’ve already talked about strike prices often become support or resistance levels.
Now, look at the MACD indicator and you can see there is a big divergence going on between the price, which was going up, and with MACD going down. Remember from my first course that Divergence is when an indicator like MACD is going in one direction and the price is going in the opposite direction. This is telling me that this rally is running out of steam and with the potential double tops, it’s probably time to take profits on this trade.
As you can see, the 12.50 call is now worth $2,497.50. Deduct what we paid in premium of $470.40 and that gives us a profit of $2,027.10 which is a net profit of 431% easily exceeding our 2:1 risk/reward ratio. And on the 13.50 call we made a net profit of $1,300.50 ($1,523.50 less $224) or a 579% again exceeding our risk/reward ratio of 2:1. We made a higher return, percentage wise, on the lower priced option. I will get into the details as to why later in the course but this is not always the case.
Now, there are different strategies that we could have used, like buying two 13.50 calls with a $10,000 account rather than one 12.50 call. Right now, I just wanted to give you an example of how call options work and show you an example of profits that can be made while you have 100% control over your risk.
Now, not only do you know the definition of a bullish market, but you know how to play the game with several bullish scenarios.
Learn more about David's Personal Coaching with Common Sense Commodities for leading edge information and training in commodities and options trading.
* Testimonials are not a guarantee of future success. All information is for educational use only and is not investment advice. Trading financial instruments, including Stocks, Futures, Forex or Options on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in any of these financial instruments you should carefully consider your investment objectives, level of experience, and risk appetite. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. The possibility exists that you could sustain losses exceeding your initial investment. You should be aware of all the risks associated with trading and seek advice from an independent financial adviser if you have any doubts. Past performance, whether actual or hypothetical, is not necessarily indicative of future results. All depictions of trades whether by video or image are for illustrative purposes only and not a recommendation to buy or sell any particular financial instrument and do not factor in trading costs in trading examples due to varying commission and fees among traders. The impact on market prices due to seasonal, market cycles or news events may already be reflected in the price. See full risk disclosure. See full risk disclosure.