Trading Futures and Options

This will be quite exciting, let's put all the knowledge about futures and options on futures to practice. Below a couple of examples to show you how you would trade these markets, the risk involved, etc. This should give you a very good feel for the difference between trading a futures contract and an options contract on the futures market. We will follow this introduction with some detail on what exactly you need to allow you to trade in these markets. But first the fun stuff...

Here is a futures market:

For those who want to know, this is Corn, the MAR 2015 options expiry. The x-axis on this chart shows the number of days left until the options on this future will expire (24 days to expiry). Corn is in a downtrend (I have drawn a trend-line connecting the high points) - we see the typical "sawtooth" down-correct-down-correct-down pattern. The general feeling is that if Corn takes out the latest low - the one at 36 days, at a price of 380, then it will continue down, well at least that is the highest probability - nothing in live is certain. But we can hardly see it suddenly just rocking up.

There are THREE ways to trade this futures market - well there are many, but three 'basic strategies'. We will call them Strategies 1, 2 and 3. (Note for simplicity we will stick to trading one contract).

Strategy 1 - Futures

We can SHORT the Futures. We will short it at a price of 379 - thus we wait for confirmation first that the price has taken out the recent low (continuing the downtrend) before we enter the market. This is how our profit / loss will look like:

Note that only once the price has traded down to 379 will we enter this position - in other words only when price has reached the thick yellow line. This line is our profit-loss line. If the futures price continues below this line, we make a profit, if it goes above, we make a loss. The faint yellow lines indicate a $250 loss and a $500 loss respectively.

Strategy 2 - Options

We can Long a PUT Option. (We buy a put and a put will give us a short futures, remember). Thus, if (or when) the price reaches 379, we Long a 380 strike Put option. This option will require a premium of $415.
Again, remember we only enter this position when the price reaches down to 379. The premium we pay will be $415. Note we could buy this option right now (without an acknowledgement that the price is continuing down - in that case, since the put is out of the money, it will be cheaper, we will pay only $369 for the option). Our loss is LIMITED to the premium we have paid! Thus the maximum loss we may suffer on this trade is if the option expires worthless (price above 379). The thick yellow line shows our net profit/loss (in other words taking the $415 that we paid into account), if price moves below this line we will be making a profit - potentially unlimited, above it we will be making a loss. The faint yellow line shows a $250 loss. The second faint line is a $400 !! loss (maximum loss is $415 no matter what the price does, thus we adjusted this line to $400 instead of $500).

What have we done with this strategy? Well, we adressed the risk in the trade - we specifically limited our risk to around $400. We have bought ourselves the right to be wrong! We have to have gotten it really, really, badly wrong to loose (or loose big). There will be plenty of opportunity if we are wrong to realize that we are and get out of the trade! The "price" we paid for this is we have shifted our chance to make a profit down, thus the commodity not only have to move down, it has to move sharply down and stay down.

Strategy 3 - Options

The previous two strategies have been relatively straight-forward. Strategy 3 requires a bit of thinking...
We may SHORT a CALL Option! Think about it for a moment. The buyer (long) of a call, will get a long futures. Therefore the other party to this deal (the guy who went short the call) will get the opposite position - he will get a short futures. And that is what we want in this case, we want a short futures. Thus we go Short a Call! Let's go for a slightly out of the money call, at a strike price of 385, which sells for a premium of $299. Thus, we receive (someone is paying us) $299 premium for our call option:

Again, the thick yellow line is our break-even line and the two faint yellow lines are a $250 and $500 loss respectively. What happened here? Not only did we reduce the risk (of a loss) in the trade, we also changed the break-even line to an upslope - yes, it means we will make a PROFIT even if we are wrong!!
(This by the way is what is marketed as only for the big institutional investor with the financial backing able to tolerate the extreme high, potentially unlimited risk associated with selling options!)

In terms of risk, compare this trade to our futures trade (Strategy 1). For the futures, you would have taken a $250 loss at a price of 384. With the option a futures price of 384 will result in a small loss, only right at the outset, and a PROFIT further down the line. Likewise with the futures a price of 389 would see you take a $500 loss, with this option, 389 will see you taking less than a $250 loss and if down the line, even a profit! RISK-wise, we have turned the situation completely on its head!!

But what did we have to give up, what is the price? We were willing to give up on the potential profit in the trade! We have limited our profit to the $299 premium that we have received for shorting this option! If the price of the futures goes down, the option will expire worthless and we will keep the $299 premium and that is it. With the Futures, your profit potential is unlimited (as with the long put). Corn is valued at $50 per point. Thus for every $1 change in price, we could make $50 in profit. As the price of Corn drops (if it does) we can potentially make a lot of profit. With Strategy 3 however, we have limited that profit to a maximum of $299. Our gain for this willingness to take less profit is the favourable position that you see on the price graph.

Thus, with Strategy 3 we will make money (1) when the price drops, but also (2) when the price stays level. We will even make money if we are wrong and there is a slight increase in price! However if we are wrong we should get out of there. With strategy 3, we are allowed to be wrong, even if we are, as long as we are not too wrong, we can get out of the wrong trade for free!

How is this possible? Remember our "Greeks"? We had a greek "theta" - he said that the option reduces in value (time value of our option) with time. Thus, as time goes by, the option becomes cheaper! This is what we see at work here. Every day of time that goes by, the option becomes cheaper - we sold for $299. Tomorrow the same option will sell for $286, the day after for $273, etc. Thus we will make approximately $13 per day profit just because the time is running out - it is this time value "gain" that you see in the upslope of our breakeven profit/loss line.
We have the same for our long option of course, but in this case it works against us- with the long option we PAID the premium, every day that the value of the option decreases means we will get less for it when we sell it again, making a loss - and therefore our profit/loss line have a downslope - we are losing out on time!

Let's see what happened with Corn, maybe it will put matters into perspective for you. This is the situation for Corn three days later:

I show the break-even lines for all three strategies on the same graph. Corn did what we expected and dropped through our target of 379. At the moment the situation is as follows:
Strategy 1: PROFIT - $450
Strategy 2: PROFIT - $278
Strategy 3: PROFIT - $161
Strategy 1 is your highest risk/return strategy and understandably is much more profitable than any of the other two strategies. Strategy 2, your long put offers you unlimited profit for a limited loss, it is turning into a nice profit - however there is still a lot of time left (risk), which is accounted for in the price you have to pay to get out of the option. With Strategy 3 you limited your profit to a maximum of $299 by expiry date; you have captured some of that profit in the current situation, but there is still 21 days left before the option expires. What would you do at this point in time? Wait another couple of days, you could make some very nice profit here..- or take your profit and get out?

We stay in for another three days:

Nothing wrong here..- it is just the nature of the market, what we referred to as the "sawtooth" effect, it goes down, correct, goes down, correct, etc. The correction is a little bit higher than expected, but the downtrend is still nicely intact.
Strategy 1: LOSS - $-225
Strategy 2: LOSS - $-134
Strategy 3: PROFIT - $26
Inline with our risk/return strategies, strategy 1 is the highest risk and the position is in trouble (don't you wish you took the $450 profit?). Strategy 3 however allows us to be wrong and is still in profit! What do you do NOW - wait for the next leg of the downtrend to take out the previous low at 370, or do you exit?

This is the situation at option expiry!

Unfortunately, things did not work out as we would have liked - that last spike was the end of the (short-term) downtrend, corn stayed more or less where it was, going into a trading range, up-down-up-down-up - uncertain as to what to do next.
Strategy 1: LOSS - $-525
Strategy 2: LOSS - $-415
Strategy 3: PROFIT - $55
With Strategy 2 your option expires worthless and you loose the premium you paid for it. With Strategy 3 your option is in the money, but only sightly. You are exercised and go short corn at 385. With corn currently trading at 389.88 your corn futures position is at a loss for 4.8 points = -$244. But you did collect $299 premium when you sold the option, putting you at a net profit of $55. You now have to decide whether you hold your short futures or get out of it?

We have three very different trading strategies here. Trading directly in the Futures market, allows you to take very nice profits - if you are right! If you are wrong you will loose equally fast! With options you are able to mitigate the risk in the trade, a little bit by buying (long) an option and quite substantially with shorting an option. In the end it is all up to you, your trading style, how deep your pockets are, how much of an appetite for risk you have.. - Do you want to play on the wild side, looking for large profits, occasionally having to bite the dust, or are you looking to slowly, consistently build your account?