Call Option Spreads Provide Opportunities in Commodities
by Blake Robben
During the next 6-9 months, I believe sugar and natural gas will move substantially higher. However, since commodity markets can be choppy, I don’t recommend buying the futures on these commodities outright. Rather, I would recommend call option spreads that involve a downside risk parameter, which allows a trader to know the risk upon entering into the trade.
Sugar
In November of 1974 sugar reached a peak price of 65 cents per pound. In November of 1980 the market spiked again to 45 cents. While I’m not calling for that dramatic of a spike in sugar, I am looking for sugar to clear the February 2006 high near 20 cents.
I would recommend a long-position that involves a July 2009 sugar call spread. Many of my clients want longer term trading ideas, rather than short-term active trading strategies and this is a great way to position yourself in sugar.
The July 2009 sugar call spread expires in June of that year. Specifically, I recommend buying the 15 cent call and selling the 20 cent call to reduce the purchase price of the 15 cent call. At the time of this writing, this spread has a cost of about $1,100, excluding commissions. The maximum profit potential on a trade like this is the difference between the two strike prices (20 – 15 = 5 cents), minus what was paid for the spread.
Each penny in sugar is $1,120. Therefore, the 5 cent difference in the strike prices equal $5,600 (1,120 x 5 = 5,600). Then we subtract the purchase price, which at the time of this writing was about $1,100, and that gives a $4,500 maximum profit potential at the June 2009 expiration (excluding commissions). To realize the maximum profit potential of this call spread, sugar would have to be trading above 20 cents at expiration.
You can find out the risk/reward ratio of a trade by dividing the maximum profit ($4,500) by maximum loss ($1,100). In this instance, this call spread is has about a 4-1 risk/reward ratio. This is part of the reason why I like this spread. In any call spread, my preference is to consider those positions that can create 4-1 risk/reward ratios for my clients.
On the fundamental side of things, it is expected that sugar consumption will exceed production this year, which could be very bullish for the commodity. I strongly suggest this call spread position because it allows you to have a bullish position on the commodity, without dealing with the short-term risks involved in trading a futures contract outright.
Natural Gas
Natural gas is another commodity I am bullish on for the longer term. This market tends to spike on unpredictable weather conditions. The March 2009 call spread would do very well if there was a colder than normal winter, or an early frost. We also still have an active hurricane season which could lead to a spike in natural gas.
Specifically, I would recommend buying the $10 call and selling the $12 call against it. My expectation is that the market will break through the high it reached just recently, in June 2008. This particular call spread expires in February of 2009.
At the time of this writing, one of these call spreads would cost about $4,400, which is not necessarily a trade for the small account, as my last recommendation was. The maximum profit potential is the difference between the two strikes ($2), or equivalently $20,000, minus our cost of about $4,400. This trade, excluding commissions, would give a maximum profit of $15,600, if natural gas trades above $12 at expiration.
Remember that these numbers are changing on a daily basis, so feel free to call me at 800-266-0551 if you would like more specific numbers. The risk/reward ratio on this call spread is about 3.5, which I believe is favorable. Although it isn’t as favorable as the 4-1 risk/reward ratio I showed in sugar, I think natural gas is more susceptible to sharp spikes in price.
Keep in mind that natural gas is down about 50 percent from the highs it made back in just one month ago in July. I believe that over the long term, natural gas will rebound from this drop as the winter draws near. It’s only a matter of time before prices spike again.
These call spread positions allow a trader to position themselves in a market with less margin and risk than an outright futures position. Since prices are always changing, please contact me for more specific trade recommendations.
Blake Robben is a Senior Market Strategist with Lind Plus. He can be reached at 800-266-0551 or via email at brobben@lind-waldock.com.
Good luck and good trading!
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