RedGage

Options can be an alternative to using a stop loss. The goal is to show the difference between a pure synthetic option, an at-the-money option and a futures position versus an option hedge, and an out-of-the-money option and a futures position. 

Using an option as a hedge is a great way to lock in your money management strategy . But what happens if the market stalls out as it is heading in the direction of your underlying futures contract? You can exit the trade completely or you can sell an option at or near the apex or the low and collect a premium. This will convert your position into a collar position and by default (if you don’t exit the underlying futures contract) a covered option position. 

We take an example and look at it more closely. In Table 1 we have gold futures set up. Overall the market is bullish—it’s above the 50-day MA. It has pulled back to a previous high, $860, which has become a short-term point of support. By purchasing gold on its way up, we get a fill at $883. If we had attempted to put on a synthetic option, an $885 put would have cost us $1,470, whereas a $860 put costs only $300. 

The difference between $860 and $883 is $23 or $2,300. With a stop loss at $500, 5 percent of a $10,000 account, we have only $800 committed to our potential loss instead of $1,470. This decreases how much money we are paying for the intrinsic value of the option, particularly because we are only looking to diminish our loss and we are unambiguous about the market’s direction (see Table 1). 

Table 1: Gold Option Hedge

                        Long Futures                                       Buy Protective Put/Premium

Entry                $883                                                    $860 ($300)

Convert It 

With gold reaching unexplored territory, it is impossible to predict what height the gold contract could reach. It could go as high as $2,000 per ounce, but without any precedence at these lofty levels gold has developed intense volatility. This volatility struck on February 1, 2008, when gold dropped $30 in one day. 

So while the gold market itself is still in a bull market, individual daily fluctuations cannot be ignored. In this instance we lose over $3,000 in profit from our futures position. The hope is that the market will retrace, but there is no guarantee. To make up for part of the losses, we sell a call at $945 for $620 in premium. This converts our position into a collar. Our put option is paid for, and we get an additional $320 to cover some of our losses. 

We are still optimistic that the market will rebound; we just don’t know when. In Table 2 the market not only rebounds, but it exceeds $945. Our futures position returns $6,200 and we lose both the put and call premiums of $920. 

Table 2: Convert Option Hedge to Collar

                        Long Futures               Put Premium               Call Premium

Entry                $883                            $883 (–$300)               $945 ( $620)

Exit                  $945                            $945 (expired)                        $945 (exercised)

Profit/loss        $6,200                       -$300                           -$620

The only reason we employ this strategy is so we can cover the cost of the put option, just in case our $500 stop loss is hit. The extra $320 will diminish our $500 stop loss to only $180. This is important, because while we may lose our profits on our futures position, we have set ourselves up for success on our put, and our account’s principal of $10,000 is preserved. Our stop loss goes from 5 percent to only 1.8 percent. 

If the market rebounds, as it did in this case, our option is paid for if the market doesn’t exceed $951.20 (strike price plus premium); but if the market does exceed it, our original futures position is profitable enough to cover the $920 loss (cost of put and return of call premium), plus any exercise of the call will be covered by the futures position itself. 

Risk 

This type of conversion has few drawbacks. As with any collar trade, you will have to give up any of your futures contract profits that exceed the sold option’s strike price . The put premium will be lost to you if your futures position is successful, plus your profit opportunity will be stuck between where you place both of your options. 

Conclusion 

Whether you are converting a collar trade into a ratio spread or you are selling options, your success is not because of how smart or clever you are; it is based on how well you follow the rhythms of the market. If the rhythm of the market dictates you can switch your original position or you can add onto your position, then do so without hesitation. If the rhythm of the market dictates that you exit a trade, then you must exit without hesitation. The worst actions that can be taken are to force a trade to become something it is not or to give up too early. 

This article was designed to highlight just a few of the different types of conversions that are possible as you blend advanced and basic strategies together. In no way this is comprehensive list of all of the different scenarios and possibilities. This article is designed to highlight the fact that as you become comfortable with calculating your profit and loss potentials ahead of time, you give yourself the ability to trade in such a way that you can prepare for multiple opportunities while you are in the same trade.