Stocks & Commodities V. 26:13 (54-62): Option Credit Spreads On Commodities by Sam Bhugaloo

Option Credit Spreads On Commodities by Sam Bhugaloo

Here are some techniques for selling out-of-the-money credit spreads that can ensure a favorable percentage of success.

AS I write this in late August 2007, the headlines across the world are all about the credit crunch that has affected all stock exchanges. The US Federal Reserve surprised markets on Friday, August 17, 2007, by cutting the primary discount rate, which governs direct loans from the Federal Reserve to banks by 50 basis points. The week also had other dramatic headlines such as Countrywide Financial, the biggest US mortgage lender, borrowing the entire $11.5 billion available in bank credit lines after finding itself unable to access short-term financing. Japan’s benchmark Nikkei index fell almost 9% as Asian markets fretted over the subprime cuts. The CBOE Volatility Index, also known as Wall Street’s “Fear Gauge,” rose to 37.50. That is its highest since October 2002, when the bull market in stocks began.

Hedge fund managers in 2007 have had to add a new category to their investment calls. In addition to the categories of “buy,” “sell,” and “hold,” there is “apologize.” Analysts said quantitative hedge funds (or quants), who use computers to make trades based on mathematical equations and account for a quarter of all equity hedge funds, had been battered in recent weeks amid persistent rumors of forced selling as their models failed to cope with heightened volatility.

In the UK, pension funds have lost billions of pounds as a result of the credit crunch fear. According to actuaries Aon Consulting, the UK’s 200 biggest final salary pension schemes had a deficit of £26 billion at the end of trading on Thursday, August 16, 2007. We all appreciate that investment in equities and its returns are considered to be a long-term strategy and that a week’s decline in the stock markets should be viewed in the context of the overall economic factors. However, this may be of little comfort; those who are close to retirement and not on a guaranteed benefit pension could feel the pinch, as they do not have time to ride out the market volatility and make back losses. The current problems should act as a reminder for pension fund managers and trustees about the dangers that are inherent in investing too heavily in equities.