After a bull move of historic proportions copper has finally seemed to “quite down” some. Typically, after a large move such as this a market will enter an expanded trading range. While we don’ t know what the implied volatility of any option is, we do know all the other factors. Therefore, we can input these other factors – time till expiration, strike price etc., into an options pricing model, such as Black Scholes, and calculate what the implied volatility is.
Present support levels, as determined by Fibonacci Arc, Fibonacci Retracement and SR Channel Support, have been annotated in the July copper chart above.
Please keep in mind that the SR Channel indicator generates moving support zones. Next week when a new bar is established the indicator will change. I expected COMEX copper prices to chop sideways to moderately down here as the SR Channel moves higher until it intersects with prices. At that point the market could potentially begin another bull leg.
The short-term trend remains in bullish mode as determined by the AD indicator.
Possible Commodity Options Trading Ideas:
Commodity futures options premiums are comprised of:
- Time Till Expiration
- Underlining Price
- Strike Price
- Implied Volatility
Option implied volatility varies for each individual commodity option. This is typically referred to as a volatility skew, call/put slope or the smile. After large moves, more so on the bull side, option implied volatility in out-of-the money options tend to be much higher (overpriced by probability that the option will expire in the money) than options closer to the money.
If you need more clarification on this issue please feel free to contact me.
To take full advantage of the current high implied volatility, as well the call slope, look to initiate option spreads that contain short legs to it.
Basic primer on Commodity Futures Options.
For more advanced options trading concepts I highly recommend reading:
Option Volatility and Pricing: Advanced Trading Strategies and Techniques by Sheldon Natenberg.
Option Market Making: Trading and Risk Analysis for the Financial and Commodity Option Markets by Allen Jan Baird.
An example of an option spread where theta (Time Erosion Greed) is working to your advantage:
Settlement Prices for Wednesday May 31, 2006
July Copper Futures – 361.05
July Copper 405 Call – 12.10 ($3,025.00)
July Copper 425 Call – 8.00 ($2,000.00)
July Copper Options – 27 days left till expiration
Buy 1 July 405 Call
Sell 2 July 425 Calls
The option spread will generate a credit spread of about $1000.00. Maximum profit potential is $6,000.00.
This spread will be profitable if copper prices are:
Bearish, sideways or moderately bullish.
The breakeven price at expiration is $4.45/Pound. Considering the current sideways price action in copper futures the probability the copper prices will hit $4.45/pound within the next 27 days is highly remote.
Note: Just about all of the high-end option software on the market have probability calculators built into them. However, markets can sometimes do the impossible so be sure to use proper risk management.
Volume and open interest in COMEX copper futures tend to be rather small in the serial months. The active months are – G, J, M, Q, V, and Z. For additional information on this matter please see the Aaron Trading Commodity Futures Contract Rollover Guide.