Joe Fallico is a registered commodity futures broker & holds Series 3 & Series 30 licenses. He is president of Insignia Futures & Options.
Stopped out of your futures trade again?
We’ve all experienced it – you think you’ve found the perfect trade. The trend is up; the technicals are bullish and the fundamentals are screaming, “Buy, Buy, Buy”. You pull the trigger and go long and set a protective stop. The next day, the market comes right down to your stop price, knocks you out, and turns right back around and heads for the stars.
To me, nothing is more frustrating than this scenario and for that reason; I’m going to show you how to avoid this “stop running” in your trading.
The solution: use futures options instead of stop orders…
By purchasing a protective futures option, you can gain a few advantages over using a futures stop loss order.
First, let me explain the mechanics and set-up of using futures options instead of stop loss orders…
We first identify a trade. For this example, we’ll use a Corn futures contract. As you can see in the Corn futures chart below, prices have been trending upwards. Based upon my technical and fundamental analysis, I decide the Buy a Corn futures contract @ 368 1/4.
Dec'20 Corn Futures Chart
Now that I’m long the market, I need to protect the position. Normally, most traders would now place a sell stop somewhere below a support level or at a predefined dollar amount. For this example, we’ll use a sell stop at 353 3/4, (at a close support level) which would equate to risking $725. However, I’m not going to use a futures stop loss order for this trade, I’m going to buy a futures Put option instead to protect this trade.
With Corn futures trading at 368 1/4, I’m going to buy the closest ‘at the money’ Put option, in this case, a 365 Put. This futures option Put is currently trading at 10 cents or $500.00 (corn futures & options equate to $50 per cent). I also have to add in the difference between my futures entry price and the futures option strike price: 365 Put – 368 1/4 = 3 ¼ cents or $162.50. This gives me a total maximum risk on this trade of $662.50 ($500.00 + $162.50). No matter what happens, I cannot lose more than this amount (plus commissions and trade fees).
As you can see, the risk for both methods (stop order vs. put option) is very close, $725 vs. $662.50. But there are some good advantages to using a futures option instead of a stop loss.
With a futures option protecting or hedging a futures trade, you have a fixed, guaranteed amount of risk.
This is due to the fact that if the market were to turn and go against your futures positions, you will be gaining the same amount on the option position, as you would be losing on the futures position. With a stop loss order, you are never guaranteed to be filled at your futures stop price.
We all know and have probably have experienced price slippage. This means that even though your futures stop price is at 353 3/4; you can be filled at a price much worse as stop prices are never guaranteed. In fact, markets like Corn that have daily price limit restrictions, your stop order can be filled a lot worse. If Corn were to close today at 354, just shy of the futures stop price of 353 3/4 we used in our example and tomorrow the Corn futures market opened ‘Limit Down’, your Stop order would be activated but you would be filled at 329 , if you were to even get filled at all (Corn prices are limited to a 25 cents move, up or down, from the previous day’s closing price). If this were to occur, what you thought would be a $625 loss would now be a whopping $1,962.50 loss! Now this is a rare occurrence but definitely can happen. What’s more likely is a gap opening from the previous closing price. Again, if Corn futures closed at 354 today, and gapped open tomorrow at 349, your futures stop order of 353 3/4 would be activated but you’d be filled around the opening price of 349.
That’s a total loss on the trade of $962.50, $237.50 more in losses than you were anticipating with your stop loss order.
Another advantage to using a futures option over a stop loss order is it will give you staying power in a choppy market.
As previously mentioned, prices can trade right down to your stop price, get you out and then turn right back up and head in the direction you anticipated, leaving you behind with a loss. This won’t happen if you use a futures option to protect your position, as the option will keep you safe with it’s fixed amount of risk.
Of course, there are some disadvantages to using a futures option instead of a stop loss order. The first being additional commissions and trade fees although it would only be one side if the futures stop loss order were to be hit in comparison.
The other disadvantage would be that the cost of the option has to be accounted for when determining your profit of the futures position. Using the above Corn futures trade example, we went long at 368 1/4, the futures options we purchased had a strike price of 365 and had a cost of 10 cents. This means that Corn prices have to rise to 378 1/4 just to cover the cost of the futures option.
You must determine if your price objective will move beyond the break-even price for this strategy to be cost effective.
This strategy only works when the cost of the option isn’t too high. If we were looking at a more volatile market, such as Crude Oil at this present time, futures options prices tend to be too high for this type of trade set up to be cost effective.
In my opinion, I would look to utilize this strategy any time I’m looking for a large move in a futures market and I can purchase a protective futures option relatively cheaply leaving me room for profit.
Futures option strategies can be confusing at times but I encourage you to further investigate them, as they can be advantageous to your trading at the right times.
There is a risk of loss in futures trading. Past performance is not necessarily indicative of future results. The use of a stop loss order may not necessarily limit your loss to the intended amount.
© 2020 Joe Fallico