One of the things many traders struggle with is managing risk and volatility. Volatility is ever-present in the markets. The energies, grains and metals have all had volatile months. The intra-day market swings, what I refer to as the market noise, or the market volatility, are becoming pretty big. For markets like crude oil, it’s no longer uncommon to see swings of a couple dollars a day. This type of volatility brings a lot of opportunity, and more importantly, a lot of risk that must be managed in a disciplined way. I’m going to talk about how to manage volatility using options, and recommend a strategy in a market I like right now, silver.

Whether your account is small, medium or large, daily market volatility can put you in a position where you can be right about the market’s direction, but still lose money by getting spooked out of your trade, or stopped out. Most traders have experienced it at one point or another. You pick a direction, enter your position, and place your stop. The market then moves against you, stopping you out, and then continues in the direction you originally anticipated.

Stops are not the only way to protect your position. There are numerous other strategies that can be employed. Incorporating options with futures trades, what I like to call combination trades, are one way to soften the blow, should the market turn against you. This strategy can help you more effectively manage the risk of your positions.

In my ten plus years working and helping clients in these markets, I can tell you that risk management is the biggest key to being successful in trading. A lot of people talk about risk management and understand its importance, but I’m not convinced many are placing it as a priority. We should all know that we are going to be wrong at some point. Trading involves taking losses. Just as a boxer must be able to take a hit, so should you. The key to trading is, if we’re wrong, we want to give up as little as possible.

The Silver Market

You can employ this type of combination trade using options in the silver market. You want to take advantage of the long-term trend in the market, but don’t want to get stopped out because of short-term volatility.

For the past 4-5 months, metals such as gold have rallied strongly, but silver has not participated as much in this rally. Over the next six months, I believe we’re going to see a stronger showing in silver prices going forward.

Let’s look at some of the fundamentals. The U.S. dollar is still under pressure, and I don’t believe the Federal Reserve is very concerned about trying to support it. The European Central Bank is definitely concerned as the euro has made all-time highs against the dollar recently. European exports have thus become more and more expensive.

Inflation is still a risk in the U.S. economy and metals are commonly viewed as hedges against inflation. If the Federal Reserve continues to lower rates to try and stimulate the U.S. economy, we could see a larger demand for precious metals on the industrial side. Additionally, foreign governments are not buying as many U.S.-backed Treasuries as they have in the past, and there is speculation that some may even consider selling them.

All these factors give me reason to be moderately bullish on silver prices for the next 6-8 months. Let’s look at possible trading strategies.

Using Options as Stops

I think silver prices will make a move higher going into the new year. How much higher? That I don’t know. I don’t try to pick tops or bottoms in markets. I think that’s a dangerous and expensive thing to do. If we are trying to position ourselves for the long term to take advantage of the trend, I recommend using options.

You could buy a futures contract outright and place a stop to protect yourself against heavy losses. But where would you place your stop? What if you get stopped out and then the market moves in the direction you had anticipated? You don’t want to get stopped out just because of short-term volatility, when you have a long-term strategy in place.

Instead of placing a stop-loss order, we can position ourselves with options. In this case, I would consider the July 2008 silver $20 calls, trading near 25 cents as of October 25. We will use rounded numbers for simplicity, to easily demonstrate this example. You can adjust the trade depending on current market conditions. I recommend working with a professional if you aren’t certain where to initiate these trades.

First, you would go long on the futures contract. Let’s assume you go long at $14 an ounce. Then, you would sell four $20 silver calls at 25 cents each. Four contracts multiplied by 25 cents each gives you $1 in premium. The full-size silver contract is a 5,000-ounce contract and a one-cent move equals $50. Therefore, the $1 in premium from the four calls equal $5,000 in total premium. Keep in mind, you also need to add in your commission costs.

Let’s look at the breakeven point of this position on the downside. If you collected $1 in premium and initiated your position at $14 in the futures contract, you are expecting that between now and June, when these options expire, silver will be above $13 an ounce. That is your breakeven in this position on the downside.

Here’s how we calculated that. We take the premium we collected, the four calls multiplied by 25 cents each, and that gives us $1. Because we are long one futures contract at $14, we subtract the premium we collected ($1) and that puts our breakeven at $13 an ounce.

Now let’s look at the breakeven point of this position on the upside. The strike price on our calls is $20, so we have $6 in room before our four short options come into play. However, we’re long one futures contract; so essentially, one of these calls is covered. The rest are naked calls, exposed to bigger risk.

At $20, we are effectively are short three contracts. If silver goes from $14 to $20, you bring in $6 in profit along with your $1 in premium from the four calls you shorted, which gives us a total profit of $7 at the $20 level. To calculate the breakeven we take three contracts and divide it into the $7 profit and get $2.33. We add that to the $20 strike price and we get a breakeven on the upside of $22.33. Anything above $22.33 and we would lose $50 for every penny multiplied by three contracts.

In summary, our breakeven points are at $13 and $22.33. This strategy will be profitable if the market trades between $13 and $22.33, less your transaction costs.

Benefits of Using Options

This is a position that is moderately bullish on silver. By entering into this position you would be anticipating the price to stay between $13 and $22.33. The benefit of this strategy is that by incorporating options, you don’t have to pay attention that much to the day-to-day market noise. The other benefit is, if this market stays range-bound, these options will get the benefit of time decay.

Because this position has a long-term focus, you’re not going to see an immediate, quick time decay because time decay accelerates as the option contract gets closer to expiration. However, you will see some of the time decay taking place. This isn’t a trade where you set it and forget it, but it’s also not a trade that needs minute-by-minute monitoring. This is a position trade. You’re trying to capitalize on major trends in the market.

Rather than putting a position in without a stop, which is something I would never advocate, why not put a position together that gives you the ability to cushion the blow if the position doesn’t go your way on a day-to-day basis?

If silver does start to take off and we start to see it pushing up to $20, say three months down the road, there are always other strategies we can do to adjust our positioning. We can add additional futures contracts and sell further out-of-the-money calls to manage the risk on the new futures. We can continually push our options up higher and adjust our positions if something like this happens.

The key thing to remember here is that stops are not your only risk-management tool. Options can be used in a number of ways to help you manage your risk in volatile markets.

Michael Sabo is a Senior Market Strategist with Lind Plus, Lind-Waldock's broker-assisted division. He can be reached at 312-788-2940 or 800-798-7671 or via email at msabo@lind-waldock.com.

You can reach him via phone at 800-798-7671 or via email at msabo@lind-waldock.com.