Posted by: usset001 | April 22, 2009

Answers to exam questions of April 17

quiet-exams-in-progress1Several days ago, I posted a hypothetical situation where I was wildly bullish on the price of wheat. I asked you to act like my broker and make trading recommendations based on my market opinion. I also wanted you to be specific concerning buy vs. sell, put vs. call, which commodity, delivery months, etc.

Here are my answers with a little discussion…

(a) a futures position   I recommend the purchase of wheat futures   This one I answered for you and it was a simple answer at that – if you are bullish wheat then buy wheat futures.

 (b) an interdelivery spread position   Buy nearby wheat futures and sell deferred wheat futures, e.g. buy Jul’09 wheat futures and sell Dec’09 futures   This is called a bull spread and it gets its name from the tendency of nearby contracts to gain in value relative to deferred contracts when prices are rising. Interdelivery spreads are common and popular among speculators as they offer a different way to play the market with much lower margin requirements.

 (c) an intercommodity spread position   Buy wheat futures and sell corn futures  Arbitraging the price of different commodities is another common and popular form of spreading. Modest margin breaks apply and you diminish the risk of being caught in a limit up or limit down day. By the way, a legitimate intercommodity spread involves two commodities that share some fundamental relationship. Corn, soybeans and wheat, for example, compete for the same productive acres and serve as substitutes in some markets (like feed). Silver, copper and aluminum are all industrial metals. Likewise, heating oil and natural gas are common energy sources and spreads within the energy group are common. However, buying soybeans and selling aluminum would not (in my opinion, anyway) be viewed as an intercommodity spread.  

 (d) the purchase of an option   Buy a call option on wheat futures   Rather than buying wheat futures, we can buy the right to buy wheat futures, also known as a call option. Should I buy an at-the-money call 0r an out-of-the-money call? Do you recommend a bull call spread? Option strategies can get complicated in a hurry. The advantage of a simple call purchase is your loss is limited to the premium paid and your potential gain is unlimited. Be forewarned, however, that options premiums for grain futures are currently sporting a high price.

 (e) the sale of an option  Sell a put option on wheat futures   The flip side of buying a call is selling a put option. Like selling insurance, your gain is limited to the premium received while your loss is unlimited 

I like this exam question because it sheds light on the many ways a trader has to act on a strong market opinion.

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