“Jeff’s analysis is unique, at least among academic derivatives textbooks. I would definitely use this material in my derivatives class, as I believe students would benefit from analyzing the many dimensions of Jeff’s trading strategies. I especially found the material on trading the earnings cycle and discussion of how to insure against price jumps at known events very worthwhile.” —DR. ROBERT JENNINGS, Professor of Finance, Indiana University Kelley School of Business   “This is not just another book about options trading. The author shares a plethora of knowledge based on 20 years of trading experience and study of the financial markets. Jeff explains the myriad of complexities about options in a manner that is insightful and easy to understand. Given the growth in the options and derivatives markets over the past five years, this book is required reading for any serious investor or anyone in the financial service industries.” —MICHAEL P. O’ (more…)

Options come in two different flavors. Call options give the contract holder the right to buy the currency. Put options give the contract holder the right to sell the currency to someone else.

When the contract expires the actual value of the options is whatever the holder will get by actually exercising the contract. If the holder will gain nothing by exercising the option then the actual value of the option is zero. The value of the option at any other time during the contract is what is called the intrinsic value, that is the value if the holder were to exercise the option at that time.

The intrinsic value is partially based on the set price of the contract, which is also known as the “strike price”. A call option has an intrinsic value if the current price of the currency is higher than the strike price. This would allow the contract holder to buy the currency at less than the current value and then re-sell it for a profit. A put option has an intrinsic value if the current price is less than the strike price of the option.

Any time an option has a positive intrinsic value it is said to be “in the money” if the intrinsic value is negative then the option is considered to be “out of the money”. It can also have a value of zero which means that the current price is the same as the strike price in which case it is considered to be “a the money”. Options should only be exercised when they are “in the money”.

There are complicated formulas used to calculate the intrinsic value of an option, these formulas take into consideration both the current price as well as the time value. The time value is calculated based on the market conditions, including things like interest rates on both currencies as well as the time left in the contract. The pricing of options is delicate; they must be low enough to attract buyers but also high enough to attract the sellers as well.

Options are primarily used to minimize risk in FOREX trades. They help to protect against unexpected fluctuations in the market. When you buy an option your potential loss is limited to the price of the option. When you sell options your potential loss can be significantly higher. The seller gains the premium for selling the option but depending on how the market moves their loss could be unlimited.

As a hedging tool, there are many different types of options available. They are often used to minimize the potential for loss due to fluctuations in the foreign exchange market by companies that trade overseas.

In the FOREX market there is a special option known as a digital option. A digital option pays a specified amount at expiration if certain criteria are met. If the criteria are not met there is no payment.

To us a digital option the trader must first decide which way the market is moving. They then decide on a payoff amount if the market moves as expected within a certain time frame. Using this information they can then calculate the price of the digital option.

For example:

The price of the euro is currently trading at about 1.2400 and you expect it to rise to 1.2800 within 3 months. You decide to buy a put digital option with a payoff of $5000. The cost of the option is $800.

If at the end of the 3 months the euro is more than 1.2800 you get $5000. If the price is less, you lose $800.

Options can be a valuable trading tool for all FOREX traders.

1. How much of your total portfolio will be used to enter a trade. For the purchase of regular blue chip shares, I would suggest between 10-20% no more. If trading CFDs Options etc, you may want to lower this figure to 5-10%

2. What is that maximum you are prepared to loose on this trade, if it goes bad? This is where your stop loss will be used. I would recommend not risking any more than 10-15% of the amount that you have invested.

3. If you were to get stopped out; how much of your total portfolio would you loose?

For example if you have $10,000 in your trading account. You use $2000 to enter a trade (20%), you set a stop loss 10% below your buy price. The maximum that you could loose would be $200 or 2% of your total account which is acceptable. It is best to keep this figure within 1 to 3%.

Stop Losses

If you are to become a successful share trader, it is imperative that you develop robust risk management strategies which enable you to cut your losses short, should the trade go against you. Part of your strategy should always be using Stop Losses.

A stop loss is a price point where a trader will sell a security once a certain price has been reached. So as the name suggests, stop losses are there to limit an investor’s loss on a stock position. Basically, a stop loss is used to either preserve capital when a recently entered trade has turned against you or to protect your profits in a winning trade.

Stop Loss to Preserve Capital

This is where it is easy to make a mistake because the stop loss you place will be dependant on the market and instrument you are trading and whether you are using leverage to trade with. For example, the stop loss you might use to trade blue chip shares would likely be different to one you place on a speculative stock due to volatility.

Also, if you are using leverage to trade, a 10% move in a stock could equal to a move of 100% or more in an options or CFD trade. So, it is essential that when setting your stop loss you understand the market you are trading.

Before you make the decision to enter a trade, you should know (using your trading plan) what the maximum capital you are prepared to risk and set you stop loss accordingly.

How to set a Stop Loss?

When setting your stop loss you need to be close enough to the buy price so that you do not lose more than 1% to 3% of your total capital (although, if you are starting with a small trading account, exceeding this level may be unavoidable) but far enough away so that the stock has room to move in case it falls briefly after you buy into it.

When setting a stop loss on regular Blue Chip shares; you can either set it as a percentage of the buy price or at a price point. In your trading plan, it is best to work out both stop losses, and then use the one that gives you the least amount of loss.

For example: You want to buy ABC Corporation as you believe it will rise in price. The stock is currently trading at $10.00. Say your trading capital is $100,000 and you want to use 20% ($20,000) to purchase the stock, and set a stop loss of 15% below your buy price. Your stop loss calculation should look like this:

Buy price $10.00 x 15% = $1.50. Stop loss equals the buy price of $10.00 minus $1.50 which equals $8.50. If the stock price was to fall below $8.50, the trade would automatically be closed.

Protecting Profit

Stop losses can also be used to protect profit in a trade that is going well. The rules that you have set out in your trading plan to enter and exit a trade will come into play here. We will cover them later in the course.

However many traders will use a trailing stop loss; which means as the stock price moves into profit, your stop loss incrementally moves with it maintaining a safe distance and always there should the trade turn against you unexpectedly.

In the above example of ABC Corporation. If you were to set a trailing stop loss $1.50 below your buy price of $10.00 and the stock reached a high of $13.50 before turning against you. The stop loss would have been executed at $12.00, locking in a $2.00 per share profit or $4000 in this case.

Until next time…Happy Trading!

www.TransWorldFutures.com

Seasonal Spread Trade for Consistent Returns

Spread trading is a unique trading concept not all that familiar to the average commodity investor. The typical commodity trader analyzes a particular market, either from a technical or a fundamental standpoint, sometimes combining the two; makes a determination as to whether the market exhibits either a bullish or bearish bias, and then wagers by going long a futures contract or purchasing a call option, or by going short a futures contract or buying a put option. There are a number of variations on the theme, but the idea is basically the same.

The following demonstrates the inherent disadvantages, in the above two scenarios, of an outright futures position or the purchase of an option;

1. Size of account. The average investor has a limited account size, and can only withstand a certain amount of drawdown associated with any particular trade. The limited size of trading account necessitates the placement of a protective stop order above or below the position. The premature assumption of a position and the inherent volatility associated with commodity markets leaves the position vulnerable to a one or two day move that triggers the stop order, sidelining the trader as the position oftentimes turns back around. As the market moves in the trader’s favor, the advisability of using trailing stops, adjusting the protective stop in the direction of the trade makes sense in theory, but oftentimes the market will open well above or below the stop order, blowing out the stop and oftentimes taking away a substantial amount, if not all of the profit that was being locked in.

2. Time. In the case of an options purchase, you are basically purchasing time. As the purchaser of an option, the time clock and the calendar become your worst enemy. The value of your option depreciates as you wait for the market to move in your direction. Typically the purchaser of an option witnesses the market go up and down, as the value of his option changes, all along the remaining time value decaying on an accelerated curve as the option expiration day grows nearer.

Spread trading on the other hand, is a way of effectively combating the above two problems. Time no longer is an enemy and volatility, to a certain extent, is effectively reduced. Margins are substantially less due to the relative conservative nature of the “hedged” trade, which the commodity exchanges themselves recognize. Margin requirements, for a spread, can be reduced anywhere from 20% to 90%

Spread trading has no directional bias. The market can go up or down, the trade is based only the relationship between the long and the short position, i.e.- as long as the long side of your spread outperforms the short side you will be profitable. Spread trades can be in the same commodity with different delivery months (i.e. buy July Lean Hogs and sell December Lean Hogs), or different commodities (i.e. buy March Swiss Franc and sell March Australian Dollar). Generally speaking, both sides of the trade will have the same overall directional bias, as in being both long and short in the Grains (long July Corn/short March Corn) , or in the Meats (long Live Cattle/short Feeder Cattle), or in the Metals (long Gold/short Silver). This allows for the built in “hedge”.

Seasonal spread trading is another opportunity to take advantage of this manner of trading. As there are many seasonal tendencies associated with various commodity markets, there are also seasonal tendencies associated with seasonal spread trades. Seasonality is a seasonal cycle that forms a similar, reliable pattern every year for many years.

Reliable seasonal tendencies are all around us.

Everyone is familiar with weather seasonality. In the winter months the temperature is colder than in the summer months.

Farmers will plant crops and harvest crops at about the same time every year.

In the summer months, Crude Oil is usually higher than in winter (because people drive cars more in summer).

In the winter months heating oil is usually higher than in the summer (because more people are trying to stay warm in winter).

At TransWorld Futures, www.TransWorldFutures.com, we go back over 15 years of research and analyze high percentage seasonal spread trade patterns. If a commodity doesn’t exhibit a high seasonal correlation, it is tossed out of the data base.

Any spread trade that has been successful 80% of the time or better over the past 15 years is certainly a possible candidate for exhibiting a seasonal tendency and worth analyzing further. Once the high percentage entry and exit dates are determined, it is time to examine the trade on the technical setup. Is the spread overbought or oversold, what are the resistance points? Basically does the trade look technically as well as fundamentally sound. There are a number of advisory services that offer seasonal spread trade recommendations based on historical analysis, but, by ignoring the technical set up, may result in entering the trade too early, resulting in unnecessarily large draw downs, or in entering too late, missing the trade altogether. We attempt to alleviate the stress, and do the leg work for you. The results from this unique form of trading have to be seen to be believed. Please contact one of our friendly brokers today, and learn about one of the most consistent trade indicators.

Rob Rutger

Senior Analyst

TransWorld Futures

Rob@TransWorldFutures.com

Toll free: 1-877-843-4519

International: 011-813-241-1902

Fax: 1-813-241-1927

www.TransWorldFutures.com

How to protect diversified portfolio?

You can diversify by owning bonds as well as stock; owning small, midsized and large companies; and by owning different funds, some of which some are value oriented, while others are growth oriented. More sophisticated approach will be to use Commodity fund and Hedge funds. Commodity index fund is a good alternative asset class to reduce over all risk of a diversified portfolio.

You can follow any one of the following option to protect down slide of your investment
a. Purchasing out-of-the-money puts and calls, for very small sums of money, and be content when they expire worthless.
b. You can also buy future but it involves more money.
c. If you have a home loan with a variable-rate mortgage loan, that can be protected by buying out-of-the-money bond puts.
d. A retired couple with a large municipal bond portfolio might consider a combination of owning some precious metal warehouse receipts and at the same time using a small portion of their interest stream to purchase out-of-the-money gold calls.
e. You can sell US dollar index or buy Euro. You can involve in Forex trading in small amount.
f. Considering strong bull market, you can go long term long on commodity and roll over your contract every month end.

How to protect bond portfolio against dip in currency
If dollar price decreases, price of municipal bond decreases but commodity price will increases.

In this case exercise option to buy commodity and sell USD.

How to hedge Large cap stock against fall of USD.

Any increase in US dollar, reduces stock price and commodity price.
The options purchased should behave in the opposite manner of the basic portfolio and should not be purchased for speculative gain through trend watching, market timing, or chart pattern recognition.

While classic diversification attempts to reduce the overall volatility of the portfolio, real diversification provides customized insurance against a drop in value of the primary assets . The asset class used as a hedge must have an inverse relationship or correlation with the asset being hedged. Simply put, as the price of one goes up, the price of the other should go down.
Your investment philosophy is to own a small part of the company for at least 20 years. This ownership mentality will really give you money in the long run.

In the high bull market do partial profit book regularly. If market sentiment is strong bull, use Future and options strategies.
If market sentiment is strong bear buy put option. Use 5% of your money in Future and Options trading.
You should use Future and Option for portfolio management of your stock portfolio. Option trading basically used to hedge your asset and also make some speculative gain.

In strong bear market, your blue chip companies can generate good income if you use covered call option regularly. It’s not difficult to get 40% p.a. ROI by writing Covered Call Option.

In short, the stock market is a voting machine and much of the time it is voting based on investors’ fear or greed, not on their rational assessments of value. Stock prices can swing widely in the short-term but they eventually converge to their intrinsic value over the long-term.