A good -- and safe -- way to get familiar with commodities is to try some paper trades. So, here's some holiday homework to try out.
Commodities, unlike stocks, are leveraged vehicles that come with expiration dates. This makes trading in them both potentially lucrative and devastating. The following are a few commodity option strategies we offered to our brokerage clients. These are not intended to be recommendations; they are merely educational examples. If you are not privy to the risk of trading commodity options, particularly selling them, please do not attempt this without the help of a professional...even then, it might not be a good idea.
Fire Up a Natural Gas Play
A common assumption is that natural gas prices will go up during the winter months due to cold weather driving up consumption. But the futures markets generally price a weather premium into the market going into the winter season; as a result, the path of least resistance is generally lower for natural gas through late December. Last year, and on average, the April gas futures contract tends to find a low in the last few weeks of December (but the front month contracts, which are priced much higher to accommodate winter weather often continue their decent).
On a weekly chart of natural gas, the complex (based on front-month charting) is nearing long-term trendline support. This should at least slow down the selling in the front months but in the latter months, such as April which are priced much lower, the selling "should" start to dry up. Also on a supportive note, the Freeport LNG plant that closed due to an explosion earlier in the year is coming back online. Its closure mitigated the ability of U.S. producers to export natural gas to Europe to make up for the Russian shortfall. This provided a much-needed opportunity to replenish domestic supplies and put downward pressure on prices.
As a word of caution: Momentum and thinly traded holiday markets are a lethal combination. So, the bulls should approach the market with a nibble rather than swing for the fence. A natural gas futures flush toward $4.00 in the front month contracts is possible. For this reason, those looking to play the upside might consider the strategy of selling an April put at a strike price they would be comfortable holding the futures contract from (we are thinking $3.50 is an attractive price). That said, natural gas futures expire monthly, so holding the exercised futures contract would be temporary -- unless the futures contract is rolled into the May contract, In our view, this should probably be the goal if the opportunity presents itself.
To clarify, selling an April put is a way to work an indirect limit order to buy natural gas futures at the strike price of the short put should the option be in-the-money at expiration. The advantage of doing it this way is the premium collected up front acts as a risk buffer on the downside, but a source of profits if the market turns higher from here. The risk, on the other hand, is unlimited below the strike price of the put. This is not a suitable strategy for small accounts or risk-averse traders.
Paper Trade Idea: Sell April natural gas $3.50 put near $0.33, or $3,300
Total Credit = About $3,300 minus transaction fees
These options expire on March 28, with 94 days to expiration
Margin = $3000
Risk = Unlimited below $3.50
Maximum Profit = 33 cents or $3,300
Pour Some Sugar ... on Paper
Sugar futures found a way to rally, despite mostly bearish seasonality in December and roiling crude oil prices earlier in the month. But we have to wonder if the uptrend line will reverse the rally in the same way it did in November.
Also, the daily chart for the Relative Strength Index is showing a bearish divergence. This occurs when the futures market is making a new high but the indicator is not. This can be a sign of a rally that is running out of buyers. A cheap, easy, and limited-risk way to play is to purchase a March 20.75 put for about 70 points, or $784. This option is near-the-money with about seven weeks to expiration.
Paper Trade Idea: Buy March sugar 20.75 put near 70 points.
Total Cost = About $784 plus transaction fees
These options expire on Feb. 15, with 55 days to expiration
Margin = $0
Risk = Limited to the cost of entry (about $800)
Maximum Profit = Theoretically unlimited