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Use Options for Long Term Trading

Use Options for Long Term Trading

Investors usually think of stocks as long term investments and options for short term strategies. Of course, it is possible to make short term trades in stocks. It is also possible to use options for long term options trading basics strategies. This demonstrates the versatility of options.

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  • There are a number of reasons an investor might want to take a long term position with options. They may believe the stock has extraordinary potential and is likely to be in an up trend for years. In this case, options can offer the possibility of larger dollar returns.

    This is true because options are usually significantly less expensive than the stock. To benefit from a long term up trend, for example, an investor would use a call option. Calls give the buyer the right, but not the obligation, to buy 100 shares of a stock for a predetermined price for a specified amount of time.

    A call option expiring six months or more from now could be considered a substitute for owning the stock. One advantage of the option contract would be that it costs less to buy, perhaps 20% of the amount of the stock, or less.

    Another advantage of the option contract is that risk is predefined. When you buy an option, you can never lose more than the amount you paid for the contract. This is true for stocks as well. But, since options cost less than stocks, the maximum risk of an options contract will be smaller in dollar terms than the potential loss on 100 shares of the same stock.

    A disadvantage of options is that there is a time limit. All options contracts expire at some time in the future. At that point, if the price of the stock is below the exercise price of the call option, the call is worthless and the buyer faces a loss of 100% of the purchase price.

    Matching Expiration Dates to Market Opinions

    When deciding whether to use a short term or long term option, it is important to consider the reason you are considering the trade in the first place. Short term opinions should use options which expire fairly soon. A short term opinion would be one based on a short term market indicator.

    For example, many traders follow a 2-period RSI, the popular Relative Strength Index calculated with just two periods of data instead of the default calculation using 14 periods. This is a short term indicator that predicts a market move over the next few weeks. For this tool, short term options work best.

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  • On the other hand, some indicators are focused on the longer term. One tool that fits into the longer term is applied to futures market. This is the Commitment of Traders (COT) data. While the indicator is based on futures market data, it can be applied to exchange traded funds or ETFs.

    COT data is collected and published by the Commodity Futures Trading Commission (CFTC) every week. Traders in futures markets are classified as commercials, large speculators and small speculators.

    Commercials are the large users of a commodity. In the silver market, commercials include miners who produce the metal and users like jewelers and manufacturers who need silver for various applications. In any market, commercials tend to be the insiders with the most knowledge of the market.

    Large speculators are hedge funds and other large investors. They tend to follow trends and will often be on the wrong side of the market at major turning points. Small speculators are individuals and are not a significant part of most futures markets.

    COT data is a long term indicator because it takes time for large speculators and commercials to get in and out of positions. When using this indicator, it would be important to use options with more distant expiration dates.

    Analyzing the Silver Market With COT Data

    Precious metals, including gold and silver, have sold off recently. Because silver trades at a lower price than gold it usually makes a larger percentage move even though both markets often move in the same direction. This makes silver an excellent choice for smaller accounts since large percentage moves could mean larger gains.

    Sell offs in futures markets could be caused by a number of factors. It could mean commercials are repositioning and selling contracts. Or, it could mean a hedge fund needed to raise cash quickly. There are many other reasons but COT data can help point to the direction of the next important trend.

    The chart below shows the COT data for silver. It has been converted to an indicator using the formula for the stochastics indicator. When the indicator is high, that group of investors is bullish. Low readings indicate bearishness. Commercials are shown as the green line. Large speculators are shown in black.

    Commercials are bullish and large speculators are bearish. When using COT data, it is often best to be on the same side of the trade as the commercials, the insiders in that market. Last time this setup occurred, silver prices rose more than 15%. A similar move could unfold in the future.

    Using ETFs to Trade Metals

    iShares Silver Trust (NYSE: SLV) tracks day to day changes in the price of silver. SLV holds silver. As of June 27, the trust held 339,888,953.50 ounces of silver. This means the ETF is equivalent to owning silver. An option on SLV offers leveraged exposure to the price of silver

    Remember that COT data reflects long term opinions of market participants. Commercials are using the futures market to offset their own risk months in the future. For example, a miner may need to deliver silver in six months. They may have a production problem and then use the futures market to obtain supply.

    While we don’t know why commercials are bullish, we know that they are bullish. This indicates we should consider buying call options to benefit from the potential increase in prices that commercials seem to anticipate.

    SLV has a number of options available. Because we are trading based on a long term market indicator, long term options expiring in six to twelve months are most appropriate.

    Trade Specifics

    SLV closed on Thursday at $15.92. There is an option series expiring in March 2018 that provides exposure to the market for nine months. This is a suitable option to use with COT data.

    The March 2018 call with an exercise price of $15 is trading at $1.65. Buying this contract will be profitable if SLV is above $16.75 at expiration. This price level is found by adding the options premium to the call’s exercise price.

    Based on the chart, a reasonable price target for SLV is $18.60. This is a price level where the ETF is likely to encounter resistance.

    With SLV at $18.60, the March 2018 $15 call would be worth at least $3.60. This would represent a gain of more than 100% on the option. Of course, the gain could be larger than that of SLV moves higher than $18.60. The risk is limited to the amount to the amount paid for the option.

    This trade demonstrates the flexibility of options. They can be used to implement strategies with short term indicators or with long term indicators as they were in this example. Risks are always limited and profits can be significant.

    This strategy, buying a call option, is one of the simplest options strategies. There are more complex strategies available to traders. It’s even possible to use more complex strategies to lower the cost of this trade which would also decrease the risk in dollar terms. Some of those strategies are covered in other articles.

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