Trade Adjustment in /ZW

On January 31, I entered into a short wheat position by selling the /ZW July 540 Call options. This was the second half of a two-commodity strangle (or pairs trade) where I also entered into a long position in soybeans (/ZS). The soybean side of the trade has performed well and is currently showing a healthy profit. However, wheat has continued to rally since the day the trade was established. This morning, /ZW rallied strongly, fueled in part by massive short-covering as it broke above a key resistance level. At one point, it was up $8.75 (nearly 2%) for the day. The intraday chart shows the exceptional volatility that /ZW experienced today.

Click Chart to Enlarge


When the trade was placed, I sold two contracts for $6.00 each. Using the Kelly formula, I determined that I should set my stop loss at $14.00. During today’s rally, that level was reached triggering my orders to make an adjustment. The assumptions that I made when I entered the trade originally have not changed. However, it is important to be persistent and consistent in following your trading plan. As discussed in this weekend’s video update, I bought back both of the July 540 calls for $14.00. This resulted in an $800 loss on the trade. That may seem like a large loss, but keep reading. It is not as painful as it may sound initially!

As /ZW continued to rally, I was able to sell four contracts of the /ZW July 600 calls for $6.50 each. This brought in $1300.00 in premium – more than enough to offset the $800 loss and still offer the potential for a profitable outcome in this trade. Note that when I rolled to the higher strikes, I doubled the number of contracts but maintained the same expiration cycle. This is important, as it allows me to offset the loss without adding more time to the trade. Also, the margin requirement did not change hardly at all even though the number of contracts was doubled.

The probability of profit on this trade is now up at a very comfortable 95.34%. Incidentally, by the end of the trading session, /ZW had given back all of its gains for the day and ended down $8.50! Of course, that has resulted in the 600 calls showing a nice profit already!

The profit and loss graph below shows the trade as it stands now, taking into consideration the original position and loss that was incurred. The maximum profit on the trade (considering the loss) is $500 ($1300 premium received today – $800 loss).

Click Chart to Enlarge

Despite that /ZW ended down nearly 2% on the day, I am not frustrated that I made the adjustment trade. In fact, the adjustment trade only impacted my maximum profit potential by $100 (plus the cost of some additional commissions). In the process, I managed to significantly increase my probability of profit by taking advantage of the temporary increase in implied volatility during today’s trading session.

I now use the Kelly formula to assist me in setting my stop-loss points for every trade. We have incorporated it into the TWA website. If you sign up for a free membership, you will be able to access the Kelly Calculator by clicking here.