Let’s move into What is a Bearish Market! Hopefully by now you are starting to see how to trade options to be part of your overall trading plan. There are really just three things to think about right now; being bullish, being bearish and trading a flat market with options.
Let’s now take a look at buying a put in a market that we think is going down.
Figure 2.3 is a chart of March 2006 corn which recently broke out of a top Head & Shoulders pattern and had the expected bounce off the neckline. Remember we covered this in my first course so I won’t go into details about a this again here. Remember this part of the blog is really just an options trading how to for beginners.
Everything seems to be shaping up to look at buying a put option. I’ve used Track-n-Trade to find the cost of three different options. By the way from now on, I’m going to use “TNT” when I refer to Track-n-Trade as I’m getting tired of typing it out!
Look at the chart and you can see that there are three different strike prices. The 230.00 put cost $625, the 220.00 cost $381.25 and the 210.00 cost $212.50. If you were using the total premium as your risk then even with a $10,000 account you could not buy the 230.00 put (if you risk all of the premium) because it cost $630 and the most you can risk is $500(5%). You could however buy one of the 220.00 puts or two of the 210.00 puts and still be within your 5% risk/reward ratio. With a $5,000 account you would be limited to buying the 210.00 put for $212.50.
Just for example purposes let’s say that we are going to buy two of the 220.00 Puts for $381.25 each for a total of $636.50. Now this is over our 5% rule even with a $10,000 account. But, we could control our risk and say that if the value of these options dropped in ½ down to $190.62 each or $381.24 total for both of them then we would exit the trade and take our losses.
Now that we have decided the risk how do we plan our exit strategy? Simple, we have two choices. We could exit the trade when the option doubles in value giving us a 100% return since we only risk 50% of the premium or we could wait and see if it hits the support at 195 and then exit the trade, even if it did not give us a 2:1 return at that point. I can tell you from experience that the option would easily give that kind of return by the time it reached 195.00 since it would be deep in-the-money at that point.
So, here was our plan; we buy two 220.00 puts for $381.25 each or a total of $762.50 in total premium and if the options drop in value by 50% we exit the trade and if they double in value or the price drops down and hits the support line at 195.00, we take profits.
I can read you like a book about now! You are probably sitting there thinking you have another idea. Since we bought two options, if they double in value, then we could sell one of them and keep the other one and play with “their” money! Right? Absolutely you could do that and it’s not a bad idea. But for now we are just going to take profits if we can on both, or exit the trade if they go against us. Let’s see the outcome in Figure 2.4
Don’t you love it when a plan comes together? By the end of October, the options that we paid $381.25 for are now worth $662.50 and we offset the options and exit the trade with our 2:1 risk/reward ratio intact. Remember we made double on what we paid for the option but since we were only going to risk ½ of the premium, it gives us a 200% return on the money we were risking. Of course we could also keep the option if we wanted to.
You are probably dying to find out if the price ever came down to 195 aren’t you? Well open up your own TNT program and find out because I’m not going to tell you.
Using Options as Stops
Let’s look at a prime example of how an option could have turned a bad trade into a good trade. Don’t ask me how I know! Yes, I have losing trades and you will too. Someone who tells you they don’t probably lies about other things too.
Look at Figure 2.5 which is a chart on Dec. 2005 US Dollar. Notice how this looks like the perfect set up to buy a futures contract. The market is heading up, MACD has crossed the zero line and Slow Stochastic has crossed up and it’s been oversold. We would be trading with the long term trend on a pull back and by all indications it’s a perfect trade. Right? Well sometimes even the perfect looking trade goes bad.
We have a 4.75:1 Risk Reward Ratio on futures trade. We are risking $610 to make almost $3,000. This is an incredible Risk/Reward ratio and these trades don’t happen that often. We put our protective stop in at 86.49 (just under support) our entry to buy on a stop at 87.10 and to take profits at 90.05 (just under resistance). So let’s assume that we made this trade exactly as planned. Let’s look at and see what would have happened.
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 affected our Risk/Reward Ratio of 4.75:1 and it would have been above the previous support level.
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 on the futures 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 a 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 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 would 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 as 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 have 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
But David, hold on for a minute… could we not have just purchased a Call Option instead of going long a futures contract and buying the Put for protection? Of course we could have done that.
Three strike prices we could have purchased:
$1,160 for the 88.00 Call
$760 for the 89.00 Call
$440 for the 90.00 Call
In real life you would probably purchase just one of the strike prices. But you could purchase two or more options at different strike prices. For this example I want to show you what each of the strike prices would have cost. Look at Figure 2.9
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 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.
So the best return we could have made $1,280 on the 88.00 call. 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 we would have taken if we had purchased a 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 that 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 an 89.00 Call. Listen to me now, we made twice as much by going long a futures contract and buying a Put for protection than we would have made by just buying a Call option and we took no more risk. Read that again!
The reason we made more on the trade is because the futures market went up in value faster than the option went up in value.
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.
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* Testimonials are not a guarantee of future success. All information is for educational use only and is not investment advice. Trading financial instruments, including Stocks, Futures, Forex or Options on margin, carries a high level of risk and is not suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in any of these financial instruments you should carefully consider your investment objectives, level of experience, and risk appetite. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. The possibility exists that you could sustain losses exceeding your initial investment. You should be aware of all the risks associated with trading and seek advice from an independent financial adviser if you have any doubts. Past performance, whether actual or hypothetical, is not necessarily indicative of future results. All depictions of trades whether by video or image are for illustrative purposes only and not a recommendation to buy or sell any particular financial instrument and do not factor in trading costs in trading examples due to varying commission and fees among traders. The impact on market prices due to seasonal, market cycles or news events may already be reflected in the price. See full risk disclosure. See full risk disclosure.