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Option strategies can be an effective way to reduce your risk exposure to a specific market while still allowing for profit opportunities.

- Chad Butler

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April 27, 2007

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A successful trading plan must include a sound money management plan. Get your complimentary guide, "The Basics of Money Management" today. You will gain a better understanding of risk control, position size, stop placement, and much more. Don't wait -- get it now!

Today's Featured Article
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Strategies to Reduce Risk in Volatile Markets
By Chad Butler, RJOFutures

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About the Author

This week I received a question about reducing one’s risk in a volatile market. Of course, the first thing that comes to mind is to use a stop. However, while stops are often thought of as a way of reducing risk, I consider stops a way of employing risk control. In order to reduce risk, one must look to alternatives such as options.

Option strategies can be an effective way to reduce your risk exposure to a specific market while still allowing for profit opportunities. There is not space here for a complete discussion of every possible strategy of reducing risk using options. I will focus on two – a futures position protected with an option, and the debit spread.

First you must decide how much risk you are comfortable with. There are many ways to determine this, but suffice to say that you must have a dollar amount of risk that makes sense when considered in light of 1. your risk tolerance, 2. the market, and 3. your account size. Fear and greed must be in check. Too much fear and you will not pull the trigger, too much greed and you are likely to get in over your head. You should have an idea of what this amount is before you begin considering what markets you will trade and what strategies you will employ.

A word about stops:

As I mentioned earlier, stops are often thought of as a way of reducing risk. I consider stops a way of employing risk control . The only way to actually reduce your risk using stops is to use a tighter stop. This is not always a wise strategy as it may put you in range of being stopped out without other factors of your strategy changing the market outlook. There is nothing worse than being stopped out of the market only to see the market turn and take off without you. Stops are certainly an important part of any trading strategy, but used improperly, they will almost assure a losing trade. (For more on stop placement, see this week’s special offer “ The Basics of Money Management.”)

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Long Futures/Long Puts or Short Futures/Long Calls

A popular strategy that is often misunderstood and misused is using an option to cover your risk on the futures. Used correctly, however, this strategy can be an effective way of reducing risk in a volatile market. It is most often used by traders that are trying hold a long term trade in a volatile market, and they want to avoid being stopped out.

This strategy is constructed by being long an option that would offset your futures position. For example, if you were long December gold futures, to employ this strategy, you would be long a December gold put. If you are correct about the market direction, the put should expire worthless (or you could sell it before that happens) and you will be gaining on the futures. However, if you are wrong about the market direction, the put should offset your losses on the futures.

This strategy works well is both theory and practice, provided that you keep a few caveats in mind. First, it is absolutely essential to understand that if the market is moving against you, any gains on the put will be unrealized gains while the losses on the futures are marked-to-market daily. Simply put, cash is flowing out of your account to cover your losses at market close each day, but you will not receive any gains from the put until you sell it. In this case, you should know that you may be required to answer a margin call if you are going to hold the position.

As an example, we will assume you are long August gold at 680.00 expecting a long term move. Your analysis tells you that you have two potential stop levels, one at 650, and one at 625. This is a significant amount of risk. The first being $3000 and the next being $5500. However, you were able to purchase an August 680 put for $1500. Since your futures position and the strike price are the same, your only risk is the amount you paid for the option, equivalent to a stop at 665.

Gold Chart

If you cannot view the gold chart, go here.
Chart Provided by RJOFutures Research

In this example, your maximum loss at expiration would be the difference between the futures entry price and the put strike price less the amount paid for the option. In this example, that is a $15 risk on the price of gold, putting your risk level at 665.00. The key here is “at expiration.” Many things can happen between now and December. For example, if gold moves to 672.90, you will be receiving a margin call (assuming minimum margin was posted). While your put would likely be gaining by a similar amount, it would not be available as cash to post against losses in the futures. Cash would only be available if you sold the option. So you must be prepared for this scenario. If you hold the position until expiration, or if you exercise the option, you have a defined amount of risk. But you need to have appropriate capital to hold the position through that period.

Another important consideration not outlined in this simple example would be the difference between your futures position and the option strike price. If there is a difference between these, you need to factor that in to your risk analysis. Also, it is important to note that this strategy could also be used on a short futures position by buying a call option.

While this is an effective strategy of reducing risk for traders that want to trade long term positions, it is not very useful for short term traders. Since the idea is to reduce risk, it should ultimately be used in lieu of a stop when the appropriate stop placement would be a greater dollar amount of risk.

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Option debit spreads

The debit spread gets its name from the fact that it is constructed by buying an option for one price, and simultaneously selling an option for another price, the difference of which is a debit, or cost, to the trader. The two strategies that fit our discussion are the Bull Call Spread and the Bear Put Spread. Each of these has similar traits relevant to the topic of risk control. First, they both have limited and defined risk. Additionally, while they have a limited profit potential, they can often be entered much closer to the current market price for a cost similar to buying a far-out-of-the-money option. The difference between the two strategies is one (bull call spread) profits from bullish markets, the other (bear put spread), as the inverse, profits from bearish markets.

An option spread can get the trader an option position closer to the money for less cost than an outright position, and with a better probability of performing profitably. As an example, consider the bull call spread. This position is constructed by purchasing an option close to or at-the-money and simultaneously selling a strike price farther out-of-the-money. The closer to the money option will cost more that is gained by selling the other option, leaving the trader with a net debit. That is the cost of the position. Since this is a limited risk position, the cost of entry is the net risk.

The maximum possible gain on this position is the difference between the strikes less the cost of entry. Appropriately constructed positions have a higher probability of achieving a maximum gain that does applying the same amount of capital to purchasing option outright. This is because we can be much closer to at-the-money for about the same cost as buying a far out-of-the-money call outright. We still have risk limited to what we pay for the position, just like an outright call, but it gives us a better chance of performing (which is more probable - gold going to 700 or gold going to 800? Answer: it has to go through 700 on its way to 800). The downside is that we give up the unlimited profit potential. But if we calculate our position correctly, that may not be a large factor.

Here is a simple example. If we were to buy the August gold 700 call for $2000 and at the same time sell the August gold 720 call for $1300, we would have a position with a cost or $700. If gold is at 720 or higher at expiration, we would have a gain of $2000 less our cost of entry for a net of $1300. Compare that to buying a call option outright. With $700 to spend, we would have to go out to the 750 call. At expiration, gold would have to be above 763 to out perform our option spread. So which has the greater probability?

(For more details on this subject, see “Using Option Spread Strategies to Trade Volatile Markets,” Fast Break, April 14, 2006.)

Reducing Risk vs. Controlling Risk

Ultimately, if your concern is to reduce risk in a given market, you need to be familiar with a number of strategies to achieve your objective. In some cases, it may appropriate to simply use a stop order against your futures position. In other situations, as we have discussed, an alternative strategy may be advantageous. A lot of this is going to depend on variables such as your account size, risk tolerance, investment objectives, market conditions, and a host of other issues. This week’s offer, “The Basics of Money Management,” contains in depth discussion on the topics of risk and money management and includes some thought provoking approaches to improve your trading strategy. A well thought out plan is essential to any effective trading strategy.

THE RISK OF LOSS IN TRADING FUTURES AND OPTIONS CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER TRADING FUTURES AND OPTIONS FITS WITH YOUR INVESTMENT OBJECTIVES.

About the Author
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Chad Butler is a Senior Market Strategist with R.J. O'Brien. His market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs. Chad's published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, SFO Magazine, and other trade publications. He currently writes market research for RJOFutures and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.

Special Message from Our Author
----------

A successful trading plan must include a sound money management plan. Get your complimentary guide, "The Basics of Money Management" today. You will gain a better understanding of risk control, position size, stop placement, and much more. Don't wait -- get it now!

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Disclaimer: The Commodity Futures Trading Commission has asked us to also advise you that trading futures is not without risk. While there is opportunity for incredible wealth building, there is also the risk of losing even more than you invested. Of course, that's not unlike most other businesses. But informed traders are the best traders! Opinions expressed by Fast Break authors are not those of FutureSource.