The DeCarley Perspective Trading Newsletter
Long and short options can tame the risk of futures trading
This newsletter was emailed to brokerage clients on July 11, 2018.
Futures contracts don’t have to be scary, deleverage them!
The futures market is the Las Vegas buffet of the financial world. It is the place were glutton is not only free, but it is encouraged. However, just as frequenting buffets will lead to an expanding waistline, failure to approach the futures markets reasonably will lead to adverse consequences. Nevertheless, within both venues, it is the consumer that chooses the level of indulgence.
It is easy to become intimidated by the futures markets. After all, the stories of life-changing losses (and sometimes gains) are abundant. The amount of leverage provided to traders by the futures market is stunning; and unmanageable for most traders. To put it into perspective, a crude oil futures trader can buy or sell a single 1,000-barrel futures contract valued near $75,000 (while the price of crude is at $75.00 per barrel) with a minimum margin deposit of $3,245. To clarify, a speculator can make a wager on $75,000 worth of crude oil using the futures markets with less than $3,500; this means that regardless of account size the trader is making or losing money based on the value of $75,000 worth of oil. Further, each $1.00 price change in oil results in a $1,000 of profit or loss for a futures trader; a trader with the minimum funding could either double or deplete the trading account with a mere $3.50 move in oil. This form of speculation is obviously exciting but is closer to rolling the dice at the craps table than investing.
Yet, what most fail to realize is the challenges posed by the commodity markets are often self-inflicted obstacles; excessive leverage and risk are available to traders of all sizes and skill levels, but traders can “opt out” by taking steps toward deleveraging.
Let’s take a look at how futures, and options on futures, traders can reduce leverage with a goal of creating a reasonable and efficient method of commodity speculation.
Overfund and under-trade the account.
The simplest method of taming the futures market is to fund a trading account above and beyond the exchange minimum requirement. Going back to the crude oil example; although a brokerage will authorize a client to buy a crude oil futures contract with a mere $3,245 in the trading account to utilize a massive level of margin, the trader could purchase a futures contract in an account funded with $75,000 to completely eliminate the leverage. The lack of leverage creates a scenario in which the profit and loss on the speculation will fluctuate at a tolerable pace. A $3.50 move in oil would result in a 4.6% change in account value, not the doubling or depletion of the account using the maximum allowable leverage.
Obviously, not everyone has $75,000 to dedicate solely to a crude oil speculation but perhaps fully funding the account to eliminate all leverage isn’t necessary, for instance, a trader executing a single oil futures contract in an account funded with $35,000 might enjoy the best of both worlds. Further, there is an E-mini futures contract listed on the CME Group’s New York Mercantile Exchange which is half the size of the original; thus, E-mini oil traders can completely eliminate the leverage by allocating $35,000 to the position.
There are other “options” to deleveraging futures.
In my view, a preferable way to tame the futures market is to trade antagonistic long and short options around a futures position with the intent of reducing position volatility, deleveraging risk, and possibly even creating a second source of income or profit potential. In fact, it is even possible to a create option strategy to overcome the second largest obstacle to traders (a lack of dividend cash flow). In other words, with options, it is possible to transform a highly leveraged futures contract into a reasonably manageable position with the benefit of cash flow income to cushion risk.
For example, a trader going long a November soybean futures contract near $8.70 per bushel, might sell a $9.00 call for about 30 cents (or $1,500) and then purchase an $8.20 put for 14 cents (or $700). Because the futures contract stands to benefit from higher prices and the two options should benefit from lower to sideways prices, the profit and loss of the position far less volatile than trading the futures outright. In fact, this position would move 65% slower than the futures contract alone. To illustrate, if soybeans dropped 10 cents, this position would lose 3.5 cents or $175 rather than the $500 loss a futures trader would have incurred. Of course, this example is simplified and there is no way to predict the exact profit or loss on the option strategy at any time before expiration, but I believe the figures I provided are a legitimate guess in the near-term.
Perhaps the greatest aspect of the new deleveraged version of a futures market position is the ability to benefit from time value erosion in addition to an accurate directional speculation. In this example, the trader would have collected a net credit of 16 cents, or $800 (the difference between the premium paid to purchase the put and the premium collected for the short call option). This premium credit can be viewed similarly to a dividend in that it cushions the position against adverse price movement, but it also creates a scenario in which the trader can profit if the price of soybeans trades sideways rather higher as expected. In short, it provides the trader with two ways to potentially make money; an upward directional move or time value erosion of the options.
If you are wondering what the margin, risk and profit potential is on a trade such as this; you are asking the right questions. The purchase of a 5,000-bushel soybean futures contract valued at $43,500 without any option hedges would run a margin charge of about $2,000 with unlimited profit potential and a max risk of $43,500 if the price of soybeans fell to zero (obviously an unlikely scenario). Converting the position into a limited risk venture with the ability to benefit from time value erosion by selling the $9.00 call option and buying the $8.20 put option caps the profit potential to 46 cents ($2,300). This is calculated by adding the net credit and the distance between the futures contract entry and the short call. The max profit would occur at expiration if the price of soybeans is above the strike price of the short call ($9.00). Above $9.00 the trader fails to benefit because gains on the long future are offset tick for tick by losses on the short call option. Nevertheless, the trader makes something as long as the futures price is above $8.54 at expiration (Entry Price – Net Credit). The maximum risk on the trade is also capped at $1,700 if soybeans are below $8.20 at expiration. To summarize, as long as the price of soybeans is at $8.54 (16 cents below entry price) or higher at expiration the trade makes something; thus the trader can be moderately wrong in direction and still make money.
The option hedged version of the trade comes with a margin charge of about $650. Accordingly, by trading options against a futures position, it is possible to convert an otherwise dangerous futures speculation into something that more resembles a dividend paying stock (limited risk and income). Of course, futures and options on futures have expiration dates so, unlike stock trading, it isn’t possible to hold on “forever” until the market recovers.
Why deleverage futures rather than trade ETFs?
A fair question to ask is: Why wouldn’t a trader simply buy a commodity ETF? The answer is simple; ETFs are highly inefficient. Most EFTs are simply funds that take investor money and us it to purchase futures contracts outright. While most are deleveraged, they generally involve high transaction costs and frequent fund rebalancing can be taxing on returns. In fact, it is not uncommon for the underlying commodity to make a large up move and leave the associated ETF behind. If you are seeking an efficient vehicle for commodity speculation, it is probably best to go directly to the source…the futures markets.
*THERE IS A SUBSTANTIAL RISK OF FINANCIAL LOSS IN TRADING FUTURES AND OPTIONS.