In this educational feature we'll discuss trading options on futures-specifically, buying puts and calls. You can also sell options, but your financial risk is not necessarily limited, whereas it is when you only buy options.
Many beginning and veteran traders alike think options trading is too complicated, and they don't have a clue about the vega, theta, delta and gamma pricing formulas, much less the strangles, straddles, butterflies and other spreads related to options. Option trading strategies can become as sophisticated as you want them to be.
First, we'll assume that readers know the difference between an option and a futures contract, between a put and a call and "in the money" and "out of the money."
Let's look at real-life examples Recently, there was a rather substantial rally in energy prices from crude oil to gasoline to heating oil. It certainly was tempting for many traders to want to short those markets at seemingly ridiculous higher price levels. However, remember that to trade successfully you not only have to be right on market direction, you also have to be correct on the timing of the market move. Furthermore, you can be right on market direction and very close to being right on timing the trade but still lose your trading assets because of very short-term moves that went against your market positions before going in favor of those positions. For example, a trader could have established a short position in crude oil in the vicinity of $70 per barrel two days before the top in the market was in, yet be stopped out and lose his trading assets because of the high volatility that caused the market to jolt back and forth at the $70 per barrel price level. Source: VantagePoint Intermarket Analysis Software
By purchasing options, one could likely limit their financial risk and have the staying power to ride out volatile market swings without the worry of margin calls. Buying a put or a call that is "out-of-the-money" is a relatively inexpensive way to wade into trading. The money the trader invests in the option purchase is all the trader has to worry about losing because margin calls usually pertain to futures contracts or short option positions that are passing thresholds of cash available to absorb losses. The purchaser of the option should remain vigilant, however, because option premiums lose value quickly once the option moves into its last 30 days of life. This premium erosion is referred to as time decay. If the investor's indicators (in this example the VantagePoint Trend Forecasting software has been used) show a crossover that would indicate that a market move has likely run its course, then the prudent investor would sell out his long [purchased] option and get out of there before it disintegrates, especially if reasonable profit can be taken. The market may go nowhere for many days, but the sand continues to run down into the lower portion of the hourglass as expiration day looms near and can mean trouble for the option premium. The reason VantagePoint was used for this article is that VantagePoint can forecast trends with nearly 80% accuracy, which has proven to be very helpful to traders using options strategies.
Also, remember that anyone considering trading options on futures needs to check the open interest level on the particular "strike price" they are contemplating trading. Just as in straight futures trading, the more liquid strike prices in options that are commensurate with higher open interest are usually more desirable to trade. The powerful thing about brilliant neural networks such as VantagePoint is that the crossover points are often in the area of liquid, high open interest strike price options due to the consolidation in prices as the market coils and gets ready to make its move.
Here's another trading tactic to think about regarding purchasing options in volatile markets. Experienced traders know that out-of-the-money options can lose time-value. Therefore, they often will use the option as a quasi-insurance policy for a futures contract instead. Just because you have a protective buy stop or sell stop in place when trading straight futures contracts, that does not guarantee you will get out of the market (filled) close to your stop. For example, weather markets in grain and soybean complex futures can produce limit price moves, sometimes for two or more sessions in a row. If you have a straight futures trading position in soybeans and the market moves against you by the limit, or multiple limits, your protective stop is virtually worthless.
If you had hedged your straight futures position by purchasing a cheap out-of-the-money option, you have limited risk in a volatile market. For example, let's say you are long soybeans at $5.50 in a highly volatile market. You initiated that trade on the long side but then decided to purchase a $5.00 put option that limits your trading risk to 50 cents a bushel ($2,500 per contract), plus the price of the put option purchase. The trade-off here is that you are gaining peace of mind while giving up some profit potential. You stay in the game to trade again another day and won't get wiped out by a limit price move. For many traders the ‘sleep factor' is critical to minimize the chance that their emotions would unduly affect their trading decisions. Source: VantagePoint Intermarket Analysis Software
There are trade-offs in purchasing and trading options on futures, as opposed to trading straight futures. If you purchase "out-of-the-money" options, the market has to move in your favor for a period of time before your option becomes "in-the-money." During periods of high market volatility, the prices of options can and usually do increase substantially.
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