OPTIONS
Which Is Best For You?
Options Or Stops?
by Joe Luisi
Options may cost less and give you more flexibility than outright stops. Here's how to choose between options and stops and some ways of using both throughout the life of the trade.
Stops are essential, but they don't have to be orders to buy or sell stock or futures. Options are sometimes preferable to futures or stocks, due to their limited risk: if you own them, you can only lose the cost of the option. Here's how to go about it.
FIGURE 1: BRITISH POUND. An ascending triangle portends a bullish breakout and provides a good stop point in case of failure.
Once you take a futures position either buying or selling, you should place a stop to get you out of the market if your analysis turns out to be wrong. Typically, traders use a swing high or low as a stop point, or maybe a recent high/low, or lowest low/highest high of the last x number of days.
Some use a money stop, say $500. The only problem with a money stop is that if a market becomes volatile, the $500 stop may actually be too tight.
Why not buy a put or call at the same level or close to the price you got in your trade? Although I will speak of futures, this technique can also be used by stock traders, with one option per 100 shares purchased or sold. If you're trading futures, you will have a one-to-one relationship: one options position per futures contract. Take a look at this strategy.
THE IDEA
Let's say you look at your numbers and conclude that the market will move higher, so you buy a futures contract. Your fill price is 70.00 and you place your stop at 65.00. In this case, the stop represents five points at $100 per point, or $500. So if you're wrong, you will lose $500.
Now, if there are several weeks till expiration and you can purchase a $70 put for less than $500, then your risk is dramatically reduced. If the market moves higher, then you make money with your futures position and the put option you bought will decrease in value. If that's the situation, you have two options: hold onto the option until you get out of the futures trade or exit the option early.
When the market moves in my direction enough to bring a futures stop to breakeven, I sell the option and trail the stop as the market moves higher. If my analysis turns out to have been wrong from the beginning and the market sells off, then my loss with the futures position is offset by the gain in the put option I purchased. Now granted, the loss will be greater than breakeven due to the premium I paid to buy the put option. Depending on the time left on the option and the quickness of your move, you may actually recoup some of your premium by exiting the futures position and selling the put option. A sell signal works the same way, only using call options.
Private trader Joe Luisi can be reached at 717 558-6407 or via Internet at https://www.jaltrading.com/. He specializes in consultation and system development for the futures markets.
Charts were reproduced from CRB Charts, a service of Bridge/CRB (https://www.crbindex.com or 800 621-5271).
Excerpted from an article originally published in the November 2000 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2000, Technical Analysis, Inc.
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