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Want to find out how the futures markets really work? Carley Garner responds to your questions about today's futures markets. To submit a question, post your question at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. |
Carley Garner |
ON THE MINI-DOW
Assuming I am long a futures contract, how do I get a guaranteed stop-loss on the mini-Dow?
The truth is that stop-loss orders are never guaranteed. By definition, a stop order becomes a market order once the named price is hit or becomes the bid or offer. In the case of the mini-Dow, orders are routed and executed electronically so the slippage tends to be far less than what may be experienced in an open outcry environment. However, slippage can and will happen regardless of the venue. There is an order type known as a "stop limit" in which a trader can name the amount of slippage that she will accept, but this isn't recommended because she may end up without a stop order working at all. This occurs if the market drops sharply enough to trade through the stop limit price without the stop being filled.
In addition, while intra- and interday gaps are less frequent than they were, they can still wreak havoc on your stop orders. If the market gaps through a stop order, the slippage can be large. The only way to guarantee the risk on a futures trade is to use an option as insurance against incorrect speculation. That said, you and I both know that insurance on anything is far from free, and the same principles apply to trading.
For example, if you go long a mini-Dow futures contract from 11,000 and simultaneously purchase a 10,900 put option to limit risk, you are replacing a stop-loss order with the put option. Once again, limited risk isn't cheap, but it may be worth your peace of mind.
In this case, the total risk on the trade would be the difference between the entry price of the futures contract (11,000) and the strike price of the put option plus the premium paid for the long option. As you can imagine by this simple example, depending on your overall strategy and goal, the slippage on the stop-loss may be peanuts relative to guaranteeing your risk. An at-the-money option with three weeks to expiration can be $1,000 or more in the mini-Dow. Of course, if you are a long-term trader, options may be preferable in that they will prevent you from being stopped out prematurely and take some of the guesswork out of the trade.
If I am long a mini-Dow, how do I protect myself from a market crash?
As mentioned previously, long put options are a way to define the risk on a particular trade and a form of insurance against an adverse market move. Keep in mind that just as you pay for car insurance month after month, claim or not, insuring your futures position or stock portfolio is similar in nature. Depending on the placement of your strike price, the insurance may be costly and could only become relevant in the event of a catastrophic market move. Nonetheless, if you are long stock index futures and the market crashes, you will be glad that you insured your position.
ALTERNATIVES TO LONG PUTS
If simply buying long put options is an expensive way to insure a long stock index position, what are the alternatives?
Insurance is never free but it can be affordable. The beauty of option trading, or specifically using options to hedge a position in the futures market, is flexibility and the ability to determine your level of risk and reward.
Sometimes the worst market environment brings out the best hedging opportunities. Following the Dow Jones Industrial Average's (DJIA) plunge during the week of June 27, I recommended to my clients and newsletter subscribers to mitigate their downside risk on any short option positions (this could have also been done for those long futures) by executing a one-by-two ratio put spread using the September options.
The increased level of volatility inflated put premium and allowed a wider cheaper spread than what may have been otherwise possible. Specifically, the recommendation was to buy the September 10,900 put and sell two of the 10,300 puts. The spread could have been executed for even money (free) or a small credit. Note that free doesn't mean without margin, risk, or commission; it simply means that the trader collects as much, or more, on the short options than he pays for the long option.
This particular spread is intrinsically (at expiration) profitable anywhere between 10,900 and 9700, ignoring transaction costs, and returns the maximum payout of 600 points ($3,000 in the mini-Dow and $6,000 in the full-sized Dow) at 10,300. On either side of 10,600 the benefit of the trade diminishes as it approaches either 10,900 or 9700. This trade is an insurance policy in which the benefits match the losses on a futures contract from 10,900 to 10,300. Below 10,300, the benefits are erased by every tick lower makes until finally at 9700 the intrinsic profits are eliminated and the trade faces unlimited risk on the downside on this option spread alone.
Insurance can be affordable, but it can never be free; remember, this
trade was executed at even money or a small credit. Thus, this insurance
policy didn't require a monetary cost, but it does require that the trader
accept unlimited risk below 9700. Accordingly, if the market gets progressively
worse, the trade executed to hedge a declining market may become a problem
rather than a solution if prices fall too far. An alternative to this strategy
is an iron butterfly, in which a protective put is purchased to limit the
risk on the spread. In this case, the purchased put would have a strike
price of 9700 creating an iron butterfly in which the risk is limited to
the cost of entry plus commission.
Originally published in the September 2008 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.
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