As you can see in Figure 2.6, we got stopped out for a loss and then the market took off and hit our profit target exactly where we thought it would. The problem was that we were not there to take that profit because we got stopped out! Don’t you just hate it when that happens? I know I do.

Would there have been a better way to have made this trade and still be long the market with a futures contract but not have gotten stopped out? Sure, we could have used a lower protective stop, but that would have not been a good idea because it would have greatly affected our Risk/Reward Ratio.

Now think about this for a moment because we discussed this in my first course, Common Sense Commodities. Figured it out yet? I bet you did and that you came up with the solution of buying an option instead of using a protective stop in the futures market. In other words, you can buy a Put to help protect your downside risk. Remember, a Put goes up in value when the market goes down (usually). So, if you were long the futures market and had a Put for protection if the futures market went down you lost money on the futures market, but you made money on the Put option. It’s the best of both worlds.

Keep in mind that you will always lose more money in the futures position than you will gain on the option if you use them for protection. It has to do with the Delta of the option, and we will discuss this more a little later in the course.

There are several different strike prices you could have used to purchase your Put.

Two available strike prices we could buy an option below our entry price at 87.74 are: See figure 2.7

86.00 for $1,080 85.00 for $780

Which strike price is the best one to use as a protective stop? Well, it’s best to use one that is one or two strike prices below where our protective stop would have been in the futures market. For this example, we are going to buy an 85.00 Put for $780. If we had kept the futures stop as protection, we would have only been risking $610 on the trade but we stand the chance of getting stopped out. Remember with a Put for protection you can’t get stopped out. I still only want to take a $610 risk on this trade, so if the WHOLE TRADE (both Futures & Options) goes against me $610 I would offset the option (sell it) and offset the futures side (sell a contract) and be out of the trade totally.

One thing I want you to look at, for now, is keeping the option until our profit target is hit (unless we lose $610 on the trade (remember you will lose more on the futures contract if it goes against you (down) than your Put will increase in value, so be sure to keep up with your NET gain or loss on the trade) at which time I would exit the trade. At this time, you can decide if you want to offset (sell it) the option if there is any value left, or you could just hang on to it in case the market does in fact hit the resistance that we think it will and reverse direction and start to come back down again. If that happens, then the Put Option would start going back up in value. If this does in fact take place, we will make money on the way up with the futures contract, take profits, and then maybe even make money on the way back down with the Put option.

Another option (pun intended) that we have would be to offset the option if the market takes off if we have enough profits in the trade from the futures contract. Then we could lock in profits with a protective stop in the futures market. But for now, I’m just going to assume that we will keep the Put option during the whole time and get completely out of the trade if our profit target is hit or we take a loss of $610 on the trade. Let’s place the trade.

Let’s look at figure 2.8. We were filled on the order, long one Futures with a Put for protection but look at what happened! The market did in fact rally some, went back down, went back up, hit resistance, and then dropped like a rock in just two days. If we had used a futures contract with a protective stop, we would have been stopped out with a loss.

I know, I know, you are sitting there thinking that if the market did a 180 on us and headed down from the start, we would have had a losing trade. And you know what? You’re right we would have lost but we would not have lost as much as we would have if we had been stopped out on the futures contract and not used the option at all. In most cases this is a win-win situation and should be considered on every trade you make using a futures contract.

READ THAT AGAIN

Now, let’s go forward to the same date we would have been stopped out on in the futures contract and see what these options would have been worth. Figure 2.10

The options are now worth:

$2,440 for the 88.00 call

$1,690 for the 89.00 call

$1,240 for the 90.00 call.

To figure out what we would have made for a profit, we have to subtract what we paid for the option from what we got for the option when we liquidated it. Of course, there are commissions involved but for now, we won’t factor them in.

Strike Price Premium Paid Premium Collected Profit

88.00 $1,160 $2,440 $1,280

89.00 $760 $1,690 $930

90.00 $440 $1.240 $800

Net Gain or loss:

The 88.00 Call = $2,240 - Paid $1,160 - Profits = $1,080

The 89.00 Call = $1,690 - Paid $640 - Profits = $1,050

The 90.00 Call = $1,240 - Paid $410 - Profits = $830.00

Total value of the options = $5,170

Total paid for the options = $2,210

Net profits = $2,960

Let’s look and see what our percentage of return would have been if we had gone long a futures contract at 87.12 and purchased the 85.00 Put for $780 for protection.

This is about the same dollar risk ($2,210 is what we paid for the options) we would have taken if we had purchased an 89.00 Call for $760 and not purchased a futures contract. So let’s compare these two figures. Please look at figure 2.11.

Let’s see how we did. We got a bad fill on the entry (it happens) so we were long from 87.57 rather than from 87.12 so we made $2,530 on the futures contract and we liquidated the Put for $110 which we paid $780. So we lost $670 on the Put and made $2,530 on the futures contract for a net profit of $1,860. We would have only made $930 if we had purchased one 89.00 Call. Listen to me now, we made twice as much by going long a futures contract and buying a Put for protection as we would have made by just buying one Call option and we took no more risk. Read that again! The reason we made more on the trade is that the futures market went up in value faster than the option went up in value.

I could have also liquidated the Put when the price took off and passed the double resistance which was just about my entry price of 87.57 and not have lost as much on the Put. You can liquidate an option anytime you want to. Okay, David, I’m starting to see the value in all this but there has to be a catch somewhere but I can’t find it. Help me out here. Okay the downside, and it’s not a big downside, is that you have to have the cash in your account to afford to buy the option AND enough cash to put up the margin on the futures contract. That’s it. An easy pill to swallow isn’t it? Oops, I almost forgot, you have two commissions to pay, one for the futures contract and one for the option you purchased.

I am also going to talk about Delta later on in the course so in all honesty you maybe should have bought two Puts, not just one. More on that later.