Using Options (LEAPs) to Swing Trade Long-Term Commodity Cycles

Commodity markets are known for their long-term boom-and-bust cycles. These cycles can last for several years and can offer tremendous profit potential for the long-term swing trader. However, trading commodities directly can be capital-intensive and risky. An alternative approach is to use Long-Term Equity Anticipation Securities (LEAPS), which are options with an expiration date of more than one year. This article will detail a strategy for using LEAPS on commodity ETFs to swing trade these long-term cycles. The holding period for these trades is typically 6 to 18 months.

Understanding the LEAPS Edge

The edge in using LEAPS comes from the leverage and the defined risk that they offer. With a LEAP option, you can control a large amount of the underlying commodity ETF with a relatively small amount of capital. Your maximum loss is limited to the premium that you paid for the option. This allows you to participate in the long-term trend of a commodity without having to tie up a large amount of capital or risk a catastrophic loss.

Entry Rules

• Cycle Identification: The first step is to identify a commodity that is in the early stages of a long-term bull or bear market. This can be done by analyzing the long-term charts (monthly and quarterly) and looking for a major breakout or breakdown.
• LEAP Selection: Once you have identified the commodity, you will select a LEAP call option (for a bull market) or a LEAP put option (for a bear market) on a relevant ETF. The option should have at least 18 months to expiration and a delta of at least 0.70.

Exit Rules

• Time-Based Exit: The position is typically held for 12 to 18 months, or until the long-term trend shows signs of reversing.
• Profit Target: The profit target is a 100% return on the premium paid for the option.

Stop Loss Placement

• No Hard Stop: We do not use a hard stop loss for this strategy. The maximum loss is limited to the premium paid for the option.

Position Sizing

• Risk per Trade: Risk no more than 3% of your trading capital on any single trade.

Risk Management

• Time Decay: Time decay (theta) is a major risk when trading options. By using LEAPS with a long time to expiration, we can minimize the impact of time decay.
• Volatility Risk: A decrease in implied volatility can hurt the value of our option, even if the price of the underlying ETF moves in our favor.

Trade Management

• Rolling the Position: As the expiration date of the LEAP approaches, you can roll the position to a longer-dated option to continue to participate in the trend.

Psychology

• Long-Term Perspective: This is a very long-term strategy that requires a great deal of patience. You must be able to ignore the short-term noise and focus on the long-term trend.