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Published On: Fri, Nov 2nd, 2012

Combining Options and Futures

In the world of options trading one seldom finds a trader who knows a lot about futures trading. Options traders would usually immediately raise objections such as ‘unlimited risk’ and ‘high slippage’ when someone mentions the word ‘futures’.

Futures traders, on the other hand, seldom have even the most basic knowledge of the options market. They view it as ‘exotic’ and ‘extremely complicated’.

The truth is, however, that combining the two might often create a unique risk profile that is very difficult to create using options or futures only.

Example: a protective put using futures

Assume for example the case of trader John, who already went long on 100 gold futures recently. The risk profile of this trade looks like this:

 

 

 

 

 

 

Fig. 9.28(k)

The trade has unlimited profit potential to the upside; to the downside its loss potential is only limited by the price of gold.

Trader John firmly believes that 3 months from now the price of gold will be higher than today, but in the meantime it might drop substantially – creating many sleepless nights for John. This is unless John knows he can use a protective put strategy to keep him in the trade.

This is done simply by buying 100 put options for every 100 ounces of gold in the futures portfolio. The resulting risk profile would look like the one illustrated in Fig. 9.28(l) below.


 

 

 

 

 

Fig. 9.28(l)

Trader John can now sleep soundly. Even if the price of gold drops to next to nothing, the maximum he can lose on this trade is the cost of the put options – and he retains the unlimited profit potential to the upside.

Additional examples

In the above example Trader John protected a futures position against losses using an options contract. The reverse scenario is also possible: one could indeed protect an options position using a futures contract.

When a naked call runs into trouble, a trader could, for example, simply set up an offsetting long position in futures. The original naked call has a risk profile which looks like this:

 

 

 

 

 

 

 

Fig. 9.28(m)

If the price of the underlying asset (in this example it was gold) should suddenly start to rise sharply, the trader would be in deep trouble. Entering into an offsetting long trade in futures would, however, magically transform the risk profile to the one below.


 

 

 

 

 

Fig. 9.28(n)

What happened here? The naked call suddenly no longer has an unlimited risk potential to the upside (where the danger lies in this case). It has in fact been transformed to something very similar to a naked put. In fact: it has been transformed to a naked put using a strategy called a synthetic put!

So even if trader John was originally 100% wrong about the direction of this trade, he could still walk away as the winner by converting a losing naked call into a winning naked put using a combination of futures and options.

Conclusion

The examples above are just to get the reader’s appetite whetted for this very interesting and potentially lucrative subject. There are many other opportunities out there where combining futures and options could transform a losing trade into a winning one.

 

 

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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