Regardless of your strategy, time frame, experience level or account funding—if you have ever traded futures, you have almost certainly experienced the agony of watching a market move without you following an untimely market exit.
Whether you are stopped out, ran out of margin money, or simply can’t take the pain any longer; once you are on the sidelines it is impossible to recover from a poorly-timed speculation. In addition, traders using stop loss orders are exposed to the risk of prices gapping through their stated price, excessive fill slippage, and even limit up or limit down moves.
Unfortunately, there are no mulligans in trading, but there is a way traders can enter the market with lasting power, absolute risk management (even during limit moves), and peace of mind—synthetic calls and puts.
HOW IT WORKS
A synthetic strategy is one in which a traders uses the combination of at least two financial instruments to mimic the payout of another. In my view, the simplest and most useful synthetic strategies are calls and puts. Specifically, a synthetic call is a strategy in which a trader goes long a futures contract and simultaneously buys a put option for protection.
Similarly, a trader executing a synthetic put would go short a futures contract and purchase a call option as an absolute hedge. In both cases, similar to a more traditional stop loss order, the purchased option acts as an insurance policy to limit the risk of adverse price moves. The result is a trade that enjoys unlimited profit potential with the comfort of limited risk. Of course, insurance is never free; the purchase of the options creates a scenario in which the trader must first overcome the burden of the insurance before the trade becomes profitable.
Nonetheless, the luxury of having the opportunity to hold the trade with no additional risk and without the jeopardy of being prematurely stopped out of the trade regardless of how fast or far the futures market moves adversely is substantial.
Because a synthetic call or put strategy involves limited risk, it is also a nearly margin free strategy. Some brokerage firms will require a minor margin deposit to account for the possibility of temporary volatility in which the futures losses don’t quite keep up with gains on the purchased option, but for our purposes we’ll assume the trade requires no margin. Of course, just because there isn’t a margin requirement doesn’t mean that you can execute the strategy in an account without money. To put the trade on a speculator will need at least the cash on hand needed to purchase the protective option, and preferably a bit more.
Synthetic calls and puts can be executed in any market, but because the strategy involves the liability of costly insurance it is a good idea to avoid markets that have high priced options. Conversely, markets that offer “cheap” options are perfect candidates. Some markets we’ve found to be optimal for this strategy are the Treasury notes, the Dollar Index, soybean oil, corn, and, in certain circumstances, maybe even the mini NASDAQ.
HERE’S AN EXAMPLE
A trader who is bullish soybean oil can buy a futures contract and place a stop order to protect from runaway losses, but he runs the risk of getting stopped out of the trade before the market makes its move in a favorable direction. Trading without a stop, on the other hand, leaves the trader vulnerable to unknown and unlimited risk. In such a case, it isn’t uncommon for traders to manually exit the trade at large losses only to see the market turn on a dime and move in the intended direction while they watch from the sidelines.
Using a synthetic call option prevents either of these scenarios from playing out. Even if soybean oil drops to zero, the trader will be suffering the maximum allowable loss by the strategy but will still have a foot in the door. Should prices sharply reverse, the trade is still active. In other words, a trade that is stopped out at a loss has no hope of recovering without re-entering the market to add risk and frustration to the trade. On the other hand, a trader holding a synthetic call is in a situation in which the damage has been done, but things can only get better.
For instance, on July 8 a trader might have opted to purchase an August soybean oil futures contract at 46.96; to insure the position against runaway losses, the same trader could have bought an 47.00 put expiring in 18 days for 71.5 points. The result is a long futures position with limited risk and more lasting power than a traditional stop order (see figure).
In this example, the trader faces a total risk of 67.5 points or $405 plus commissions and fees. This is figured by netting the cost of the protective put option and the distance between the futures entry price and the strike price of the long put. Because the futures entry price was below the level at which the insurance kicks in (47.00), the trader automatically locks in a gain of 4 ticks should the put expire in the money.
This is because the CBOT division of the CME Group automatically exercises any option that expires in-the-money. Accordingly, the worst case scenario would occur with the futures price below 47.00 at expiration. At that time, the short put that was purchased for insurance would be exercised and the trader would be assigned a short futures position from 47.00. The assigned futures position would automatically offset the long futures that was purchased from 46.96; thus a 4 tick payout. Nonetheless, the trader must also account for the premium paid for the long put option to define the total risk. Some quick math determines the maximum loss potential on the trade of 67.5 ($405), figured by subtracting the distance between the futures entry and the strike price of the option (.04) from the cost of the option (71.5) and multiplying by the tick value ($6), or ((.715 -.04) x $6) = $405).
Had the trader placed a stop order rather than purchasing a put option, he would be faced with the difficult decision of placing a tight stop which is likely to be executed at a loss, or to place a stop below the previous swing low near 45.50 to create a risk of $900 on the trade, this is double that of purchasing the 47.00 put. It also leaves the trader vulnerable to have his stop order elected just before the market reverses. Clearly, the purchase of the put offers lower risk and more lasting power in this circumstance.
Ideally, the price of bean oil will rally to provide the trader with the prospect of theoretically unlimited gains. Obviously, most traders would be willing to take a quick profit; therefore, few would stick around for the possibility of windfall profits if they presented themselves but in theory anything can happen. As we all know, a bird in the hand is worth several in the bush.
Naturally, insurance is never free. If you want to enjoy the luxury of price protection with the wherewithal to withstand price fluctuations, you have to give something up. With this strategy, the opportunity cost is the necessity to recover the cost of the insurance in the form of futures gains before a profit is possible.
Specifically, bean oil would need to rally to 47.675 (46.96 + .715) before the trade would be profitable at expiration. Likewise, should the market rally to the previous swing high allowing the trader to exit the futures contract at 49.50 the futures portion of the trade would be profitable by $1,524(2.54 points x $6), but after accounting for the money lost on the long put option, which would likely be worthless at that point, the total profit would be $1,095 (182.5 x $6). Nevertheless, I doubt many traders would complain about such an outcome.
Disclosure: There is substantial risk of loss in trading futures and options.