I call them the synthetics, but technically what we have created is a “synthetic option.” The reason why traders enjoy options so much is that, unlike futures, which have unlimited risk, they have a limited risk, but unlimited gain potential. The problem with trading options by themselves is threefold.
First, in order to succeed when purchasing an option outright, you have to be skilled at picking the right strike price. The strike price has to be far enough away to be of a reasonable price and a reasonable likelihood of the market’s reaching it. Otherwise, you may find that the volatility of the option has driven the price up so much that the likelihood of your making a decent return on the option becomes difficult. This leads to the second problem.
Just because the underlying futures or spot market has hit your targeted price doesn’t mean you are suddenly making money. In order for an option to become profitable, the market must hit your strike plus the premium you paid in order to obtain the option. Many a new option trader has been baffled by the fact that the market is at or slightly exceeding their strike price, and yet the value of their option is below where they purchased it.
Which brings us to a third problem-delta. The delta represents the rate of speed at which the option market moves in relation to the underlying futures or spot contract. Even if the option is in the money, there is no guarantee that the value of the option will move in tandem with the underlying market. It could move faster, but often it moves slower. A one-point move in the underlying contracts can mean that the option moves at half the speed, 0.5 or, at 80% of the speed, 0.8, of the underlying market. This can be frustrating and can sometimes mean that trading the options may be more trouble than they are worth. After all, 70% to 80% of options do expire worthless.
There are “synthetic futures,” but I believe they are a little advanced for this article and don’t serve the purpose of being truly risk management techniques by themselves.
Now let’s talk about the “synthetic option” and why it is superior to the regular option.
As we have talked about the daisy-chain relationship among the spot market, futures, and options, so should the hierarchy of trading be. If you can trade full-size futures and spot contracts by putting up 80% or better of the face value, that is your best trading bet. Money management-wise, you will be able to weather more of the up-and-down fluctuations and really be able to see how trades come to fruition, much like the stock market.
Your second best bet is to use leveraged futures or leveraged spot. While you are not as capable of weathering huge fluctuations, you are putting up a little money to be able to earn money just as if you were an actual banker, farmer, or major wholesale buyer. The futures markets move in tandem with the spot and have the most volume next to the spot market. While the futures market is meant to be insurance for the spot market, it still functions pretty close to the way the stock market does.
Your last resort should be the options market. Options may be the least expensive, but they also lack significant volume, based on the strike price, and they are the least like the spot or futures market. They really are designed as insurance tools.
For the most part, I recommend that you use the futures or spot contract every chance you get, and let options operate as your primary insurance tools.
In a synthetic option position, that is exactly what happens. When you put on a futures position, you have unlimited risk and unlimited gain potential. Stops are used to mitigate your risk, but they can be incomplete. By using an “at-the-money” option, tied directly to your futures contract, you have effectively limited your risk, while still retaining your opportunity for unlimited gain.
By creating this synthetic option, you get the benefit of the regular option with none of its drawbacks. You don’t have to worry about whether delta is one for one, you don’t have to worry about selecting the right strike price because you are in “at the money,” and you are in control of your “premium.” If the market is going your way, you do not have to retain the option you purchased. You can exit it any time, minimizing the amount that you paid for it, while still having gains in your primary futures position.
So you can have all of the benefits of a futures position and the key benefit of an option position-limited risk-at your fingertips. This is one of the simplest, yet most overlooked, risk management techniques I know.
A little later we will look at something similar-hard stops. There are some subtle differences, so watch out for them.
While the market is underneath the 50-day MA, 252, it has also based out on the horizontal support line around 235. Since the goal is to catch the market on any potential upswing from this support level, we go long at the first entry signal we see; in this instance, we an “entry signal” at the inverted hammer. We search out a protective put option close to the 237 entry price, and we put on a 235 put option to protect ourselves.
The price distance between 237 and 235 is $100-fairly close protection. Our first profit target is 252, 50-day MA, potential $850, and the option we purchased for $400. Using our 50% money management rule on holding on to options puts us with a potential loss of $300 to gain $850-well within the “risk one to gain two” money management rules.
There are several reasons you may want to execute a synthetic option instead of purchasing a call position outright. The first reason is the cost of the call option. The closer an option’s strike price is to the current futures month, the more expensive it is, particularly if it is in the same direction that the general market sentiment is going in.
Second, options don’t always move one for one in price with the futures contract. So by having your futures position, you are accruing gains faster. Finally, synthetics allow you to ride out larger fluctuations in the marketplace, while giving you the opportunity to hold on to larger positions for a longer period of time.
What’s the Worst that Can Happen?
Scenario 1: If the market stays sideways, the time value of your option erodes and you lose all of your option premium of $400.
Scenario 2: The market tanks, so on your futures position you lose the $100 distance between your 237 entry and the option kick-in at 235. Depending on the delta of the put option, you would need to reach 231 or better before you could begin to make profits off of your option position.
You have the opportunity to lose $100, or you could make money from your put position without chasing the market or being whipsawed-not a bad opportunity.
The great part about it is that you can calculate all of your opportunities for profit and loss in advance.