Comparing Options to Futures

Which Is Best

Years ago, when I started trading, I looked at options as foolhardy strategies. I thought if I was making money trading futures then why trade options at all since they say over 80% of them expire worthless. Well, this way of thinking goes to prove one doesn’t have to be brilliant to make money trading. I could not have been more wrong. As a matter of fact, it was one of the more stupid observations in my entire life.


I was even stupid enough to look at options and try to compare them with futures contracts, thinking that since a futures contract always seemed to make more money than an option, then why would I want to trade options. What I was failing to do was to look at how powerful different options strategies can be and to look at the Risk/Reward ratios that options can offer. Not only can I limit the risk on a trade to the amount I pay for an option, often I can even risk less money with an option and I can also have a higher rate of return per dollar risk!

READ THAT AGAIN!


Also, options allow someone to trade markets that they would be unable to trade with a small account, as the Energies for example. Now I’m not saying that Futures contracts should not play a vital role in your trading strategy because you want to use both Futures and Options. Now, I want to show you what I mean about options vs. futures and money put at risk vs. profits that can be made. Look at (Figure 3.12.)


We have the perfect trade set up here. A possible trend reversal, a bottom Blip, positive looking indicators, 3:1 and 10:1 Risk/Reward ratios, and with a $10,000 account I can buy three contracts and still be within my 5% risk on a trade. Trades like this one just don’t come along every day. As a matter of fact, I’m so confident in this trade that I’ve already told the kids to pack for Disneyland for that dream vacation I’ve been promising them for years.


So, I call the broker, go long three contracts, and go around telling everyone how smart I am for finding such a perfect trade. I even tell them what I’m planning on doing with all the profits I’m about to make.


I’m in the trade now and the market is doing exactly like I thought it would. I’m filled with three contracts and making money on the trade. I feel so confident now and I’m kicking myself for not buying ten contracts rather than just three. (Figure 3.13.)


Well, sometimes the best-laid plans don’t always work out, do they? Let’s take a look at Well, sometimes the best laid plans don’t always work out do they. Let’s take a look at Figure 3.14 and see what really happened.


I can’t believe it! Why did they do this to me? This was the perfect trade; a “no way to lose” proposition and I got stopped out and missed the entire move. The market did exactly what I thought it would too. I feel like an idiot. What am I going to tell the wife and kids now?


Has this ever happened to you? Well it has to me and I can tell you it’s very frustrating when the trade does exactly what I thought it would after getting stopped out for a loss. Talk about adding insult to injury! I can’t believe it! Why did they do this to me? This was the perfect trade; a “no way to lose” proposition and I got stopped out and missed the entire move. The market did exactly what I thought it would too. I feel like an idiot. What am I going to tell the wife and kids now?

Now of course losses happen in options but they do allow you to have more staying power. Remember earlier in the course I showed you a way to use an option as a protective stop? This is a perfect example of how that would have been a better choice. Would you have made as much as you would have made on the futures contracts if you had not been stopped out? Let’s look at Figure 3.15 and see what we could have done.

Notice that 200.00 Puts were selling for $287.50. Now, if we had a $10,000 account, how many Puts could we buy and still keep our risk to 5% or $500? Did you say just one or did you say three? Well if you said one or two you were only partially correct. Why? Because we were going to be long three futures contracts, we want to buy three protective puts. Now the puts cost us $287.50 each or $862.50 plus commissions but who said we had to risk the entire premium? What you needed to look at was risking $500, not $862.50! How do you do that is the question and the answer is easy. If the ENTIRE TRADE loses $500 in value total, then you exit the trade. Of course, you do not have to keep the Puts if they go against you. Take a look at Figure 3.16.

As you can see, the biggest draw-down we had was in the middle of January for $112.50 and we are still in the trade. Remember, we were taking a $500 risk on this trade, so we were not stopped out like we would have been with a straight futures contract using a sell stop for protection. These options gave us some breathing room. Now of course we could have taken profits when the price went up and hit 220.00 at the first of January, when it hit resistance at the top of the 50% level, but since this is for example purposes only we will assume that we didn’t do that and are still in the trade, long three futures contracts from 202.00 with three 200.00 Puts for protection.


Of course, let’s see if the price did hit our target(s). We know it hit our first target, the 50% level, but did it ever hit our 2nd target? Let’s look at Figure 3.17 to find out.