Using options as a protection is a strategy that can be used by investors. If you hold a long stock position and want yourself protected against downside risk, you can sell a call option at a strike above the current share price, and use the proceeds to buy a put option at a strike below the current share price. This limits your upside, but protects you against a massive downside. The strategy is called a collar.
Protection for Traders
Now for traders, things are different. If you want to protect a long futures position by purchasing put options on the futures contract, this is similar to a long call. So you could effectively purchase a long call instead. This raises the question, why you would want to have a long futures position and a long put?
I think there is an answer to this question. The bid/ask spread for options is typically larger and there is less liquidity in the market, so if you frequently trade in out of your positions and if you are trading large, the futures market is a better place to be. In this case holding puts on index futures along with a long futures position makes sense to me, as it allows you trade in and out of your index futures position and have additional protection, in case that the market moves against you.
Stop-Loss or Long Put ?
As an alternative, protection can also be offered by a stop-loss. But if you had protected your long position during the flash crash last May with a stop market order,
- you would probably not have got a decent fill, as the tape was lagging behind
- you would have no longer been in your position, after the market had pulled back
So a long put would have protected you against slippage and against selling your position at an unfavorable price.
But the protection does not come free. If you buy insurance, the cost is the premium, and the question is whether the regular losses inflicted by the insurance premium are higher or lower than the one-time loss which is suffered during the crash. The best protection is offered by put options, which are not far out of the money, and those are the most expensive ones, as everybody wants to use them.
The following 7 users say Thank You to Fat Tails for this post:
I would turn this question on its head and say I would rather hold an options position, long or short, and use the futures contract as the hedge.
If you are trying to hedge a futures contract with an option you would find thet an ATM option only has a delta of 0.5 so you would require twice as many options to cover your futures position. This brings up liquidity, spread and commission problems. Also the volatility is huge with at the money strikes so the premium you pay is large and if forced to hold for any length of time the you would suffer from time decay as well.
On the other hand if you traded options directionaly, especially short puts or calls, and hedged with futures you would need only half as many futures to cover your option loss, at least initially, plus you get the added liquidity and close bid/ask spread with the futures and you benefit from the time decay.
The following 3 users say Thank You to britkid99 for this post:
@britkid99: Thank you for your suggestion, I love to discuss that type of questions....
A short option position cannot be hedged with futures
If you sell a naked call, there is a limited upside (the premium) and an unlimited downside in case that the underlying moves up. You may want to hedge that by entering a long futures position which transforms the naked call into a covered call. Unfortunately the covered call has the same risk profile as a short put. So in fact you have not hedged your position but just transformed your short call into a short put. The risk is now sitting on the other end of the price scale.
You cannot hedge short options positions with futures or stocks. You are compensated for the risk of a short option position with the premium which you have collected.
A long option position cannot be hedged with futures
If you buy a call option, then the downside is limited to the premium paid, which means that the position is already hedged to some extent. If you add a short futures position to the long call, then you get further downside protection in case that price moves down, even profits if price moves far enough, but you lose all the benefits, if price moves up. You have now transformed your long call into a long put. This is a hedged position as it was before. The limited risk is now sitting on the other end of the price scale.
You cannot hedge long options positions with a futures or stocks. You can only transform a long call into a long put and vice-versa.
To conclude, your way of "hedging" just transfers the risk of the directional position by changing the direction, but then your risk is sitting on the other end. This is not what I would call a hedge.
On Wednesday, October 10th @ 4:30 PM Eastern US, Carley Garner will be presenting a webinar on futures.io (formerly BMT) which covers Options Trading (specifically Futures, but it will be a broad overview). I've asked Carley to put together a multi-part webinar, so this is Part 1 and will just be "Basics - 101".
Due to time constraints, please do not PM me if your question can be resolved or answered on the forum.
Need help? 1) Stop changing things. No new indicators, charts, or methods. Be consistent with what is in front of you first. 2) Start a journal and post to it daily with the trades you made to show your strengths and weaknesses. 3) Set goals for yourself to reach daily. Make them about how you trade, not how much money you make. 4) Accept responsibility for your actions. Stop looking elsewhere to explain away poor performance. 5) Where to start as a trader? Watch this webinar and read this thread for hundreds of questions and answers. 6) Help using the forum? Watch this video to learn general tips on using the site.
If you want to support our community, become an Elite Member.
The following user says Thank You to Big Mike for this post: