Trading and Hedging Strategies Using Options on Futures

By Jim Wyckoff   ISSUE 610 | OCT 2007

Options can seem intimidating to many traders, but they don't have to be. You don't have to be an expert trader, or have a huge account size, to use them to your advantage. They are a great trading tool for many reasons. Let's take a look at a few.

Why Purchase Options?

When you take a long futures position, you are exposed to virtually unlimited risk. Buying options means knowing your financial risk–it's defined for you. You don't have to worry about a margin call if you are wrong in your opinion of the market. Your loss is known; it's what you pay for the option, plus your commission costs. Of course, no investment is without risk, but options can help traders sleep better at night. I like that. I am a big advocate of money management. I want to be able to survive the losing trade so I can be back to trade another day, and buying options can allow me to do that. Options allow you to weather markets, whereas stops may not accomplish that goal. You can get stopped out within minutes of placing your trade, even if the market comes back minutes later, and you are ultimately proven right in your option. Options give you wiggle room–you have time until expiration to weather market ups and downs.

Options are a great way to wade into futures trading. If you are newer trader, you just need to worry about the price you pay for your option. You really don't worry about complicated concepts such as "Greeks," or complicated strategies, to participate in these markets.

Contrary Opinion Trading with Options

I like to use options to go against the grain; that is, against the general consensus opinion. Below is a chart of the December 2007 corn contract. I see several opportunities that had unfolded over the past several months that you could have successfully employed options purchases. Look at September 2006, and see December corn was trading under $3 a bushel. Over the past 30 years or so, a range of $2.20 - $2.50 in corn has marked the lower part of the historical trading range. When you see the market at the far ends of historical, or "normal" trading ranges, that's when you want to look for a breakout. And that's when buying call options may be prudent. Purchasing calls would have been a good strategy here at the low end of the trading range, as corn did break out above $4 in July 2007. Currently, with corn at the higher end of its range, you may want to consider a put purchase. Once prices get into higher levels, they don't tend to stay there for very long.

Looking at a long-term chart, you can see where the market really hit a top, pushing above $5 in 1996. The great thing about options is, you don't have to be exact on your timing of a market top or bottom. With futures, you will likely be stopped out if your timing is off in a volatile market, but options offer you a window of opportunity if the market goes against you, to potentially move back into your favor.

Replacing Protective Stops with Options

Options can be used as stops in conjunction with a futures position, acting as a hedge. The 1988 nearby corn chart offers a classic example of this. In April and May of 1988, the market was trading in a sideways fashion, then in Mid-May there was a breakout, then more sideways trade, then off to the races by June. On the way up when you see a breakout, you take a long futures position if you think the trend has more room to move, and buy out-of-the-money put options as a hedge, in case the market faces a correction along the way.

When markets make big moves like this, and are volatile, like grains can be during the growing season, having a position over a weekend carries quite a bit of risk. Buying options as a hedge in case the market goes violently against you would be prudent. I've heard it said 85 percent of options expire worthless. That might indeed be the case, but it's pretty irrelevant. If the options served their purpose, they protected me, so that doesn't matter.

Employing Options in Volatile Markets

Options purchases today are more prudent than ever. If you look at the monthly Continuous Commodity Index, a compilation of 17 commodity prices rolled into one index, you will see a strong price uptrend, 30+ year highs. Volatility is here and now in the commodities markets. Employing options is a good idea in volatile markets. Sometimes you might hear options premiums are very high in volatile markets, but that's not necessarily a bad thing. For you traders, keep in mind, crude oil has been leading several others, it's an outside market. Other traders in other markets will keep an eye on crude oil. Purchasing options in volatile markets gives you staying power. You can't expect to get in at the very top on the short side, or bottom on the long side, and ride the whole trend to profit. Options give you time for a trend to unfold in your favor.

Watching for a "Collapse in Volatility"

If you look at a bar chart, any timeframe, you see markets fluctuate. To me, a collapse in volatility occurs when three or more price bars in a row have shrunken, or are noticeably smaller than the prior ones. It may be three bars, or it may be 10, but that chart picture leads me to believe the market is coiling for a breakout. We can't know for sure which way the breakout may occur; that's where your technical analysis methods and indicators can help. But this suggests a bigger price move is on the horizon, and when you see this setup, you might consider buying a put and call and see which way the market breaks out.

Optimum Contract Month and Strike Price

What is the optimum contract month, and strike price, you should consider when trading options? There is no right answer. I personally prefer to buy cheaper, out-of-the-money options, costing less than $1,000 per contract. If these aren't winners, you aren't out that much money. How far out of the money should you go? There is always a trade-off. The father out-of-the money you go, the more that market has to travel in your direction to accrue profits. So you pay less for those options, but as you get closer to being in the money, the premium you pay generally scales upward. I've purchased options with six months to expiration, and also less than six days to expiration. Look at the market, your strategy, your pocketbook, and in what timeframe you feel the market may move.

It's also important to keep an eye on volume and open interest. I've rarely had a problem on fills, but if you are looking at a strike price in a market that's well out-of-the money, and the volume and open interest are low, I'd be concerned. In general, you want to trade the most liquid markets. But keep in mind, when it comes to options, there is time to add open interest as expiration nears, if you are buying farther from expiration.

I like to use a strategy of buying calls on a pullback, and buying puts on strength. When you time your purchase during corrections in either direction, it can usually save you some dollars. If you are long-term bullish corn or soybeans, for example, wait for a corrective pullback, then buy your call options. Or if you are bearish , use a bounce within the downtrend to buy your put options.

Purchasing Options in Anticipation of Weather Markets in the Grains

Options can be used as part of a seasonal trading strategy. Let's look at an example in grains. While history doesn't always repeat and you can't rely solely on statistics, we typically see some type of weather scare affecting agricultural prices during the North American growing season from April – August. Whether a planting delay, dry spell, or unusually chilly, wet weather will result in a 24-cent rally in corn or $2.50, we don't know. But odds are high you'll get a price pop at some point in the U.S. growing season, because markets tend to overreact to such news, often trading on emotion. You can therefore consider buying call options in April or May as crop planting begins. The key with this strategy, is when to get out. As these markets see these rallies, there are also going to be pullbacks. Unexpected rain, for example, may bring drought relief. So you can also look at weather to purchase put options, too. Traders always overreact in both directions, and to me, trading weather in the summer can be exciting, and fun.

Top 10 Trading Mistakes

No matter what or how you trade, there are some trading mistakes worth repeating. Keep these in the back of your mind, so you don't repeat them yourself! Here are my "Top 10 Trading Mistakes" I see all traders make, in no particular order.

1. Failure to have a trading plan in place before a trade is executed. Any fool can get into the market, but it's the pros that know how to get out.
2. Inadequate trading assets or improper money management. You can successfully trade futures and options even if you have a smaller account, but don't trade markets you can't handle, and have a money management plan in place. Options may be good vehicles for smaller accounts, and as money management tools.
3. Expectations that are too high, too soon.
4. Failure to use protective stops. You can use options as stops for protection, too.
5. Lack of patience and discipline.
6. Trading against the trend, or trying to pick tops and bottoms in markets. This is especially true in straight futures positions, where you can lose big if you are wrong. If you do think a top or bottom is in, you can use puts or calls as a hedge.
7. Let losing positions ride too long. Being underwater, and hoping the market will move in your direction, is a bad thing. Markets will do anything and everything possible to frustrate the largest amount of traders, including you.
8. Overtrading. If you are experiencing a losing streak, don't trade more. Scale back and rethink your strategy.
9. Failure to accept complete responsibility for your actions. Don't blame your broker or your newsletter writer. You are the one that pulls the trigger on the trade.
10. Not getting a bigger picture perspective. History shows markets gravitate to highs and lows, and knowing where they are can give you a trading edge.

Jim Wyckoff is proprietor of the "Jim Wyckoff on the Markets" analytical and educational advisory service. He has a Web site at www.jimwyckoff.com and can be reached at jim@jimwyckoff.com.

You can hear more about Jim's approach to trading in a webinar presented by Lind-Waldock and CME Group Inc. on October 24, 2007, titled Futures Options Forum: Advanced Strategy Sessions for Traders. It will be available in coming days at no charge in our webinar archives at www.lind-waldock.com/events. You can also attend the remaining two webinar events in the Futures Options Forum series, on October 31, and November 7, at 3:30 p.m. CT. Just go to www.lind-waldock.com/events to register at no cost.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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