I call them the synthetics, but technically what we’ve created is a “synthetic option.” The reason traders love options so much is that unlike futures, which have unlimited risk, they have limited risk but unlimited profit potential. The problem with options trading itself is threefold.
First, to succeed in buying an option, you must be proficient in choosing the right strike price. The strike price must be far enough away to be a reasonable price and a reasonable chance that the market will reach it. Otherwise, you might find that the volatility of the option has driven up the price so much that the chances of getting a decent return on the option become difficult. This leads to the second problem.
Just because the underlying futures or spot market has hit your target price doesn’t mean you’re suddenly making money. For an option to become profitable, the market must hit your strike plus the premium you paid to acquire the option. Many new option traders are baffled by the fact that the market is at or slightly above their strike price, and yet the value of their option is lower than where they bought it.
This brings us to a third problem delta. The delta represents the speed at which the options market moves relative 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 line with the underlying market. It could go faster, but often it goes slower. A one point movement in the underlying contracts could mean that the option is moving 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 is more effort than it’s worth. After all, 70% to 80% of options expire worthless.
There are “synthetic futures,” but I believe they’re a bit advanced for this article and don’t serve as true risk management techniques in and of themselves.
Now let’s talk about the “synthetic option” and why it is superior to the regular option.
As we’ve talked about the daisy-chain relationship between the spot market, futures, and options, so should the hierarchy of trading. If you can trade full-size futures and spot contracts by betting 80% or more of face value, that’s your best trade bet. In terms of money management, you’ll be able to weather more of the ups and downs and really see trades blossom just like the stock market.
Your second best bet is to use leveraged futures or leveraged spot. Although you are not very able to withstand large swings, you put a little money in order to make money, just as if you were a real banker, farmer or large wholesale buyer. The futures markets move with the spot and have the largest volume next to the spot market. While the futures market is meant to be insurance for the spot market, it still functions quite 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 are the least similar to the spot or futures market. They are really designed as insurance instruments.
For the most part, I recommend that you use the futures or spot contract every chance you get, and let options work as your primary insurance instruments.
In a synthetic options position, that’s exactly what happens. When you take a futures position, you have unlimited risk and unlimited profit potential. Stops are used to limit your risk, but they may be incomplete. By using an “at-the-money” option linked directly to your futures contract, you have effectively mitigated your risk, while still retaining your chance of unlimited profit.
By creating this synthetic option, you get the benefit of the regular option without its drawbacks. You don’t have to worry about delta being one to one, you don’t have to worry about selecting the right strike price because you are “at the money” and you are in control of your “premium”. If the market moves in your direction, you do not have to keep the purchased option. You can exit it at any time, minimizing the amount you paid for it, while still making a profit on your primary futures position.
So you have all the benefits of a futures position and the main advantage of an options position – limited risk – at your fingertips. This is one of the simplest yet most overlooked risk management techniques I know of.
A little later we’ll look at something similar – hard stops. There are some subtle differences, so beware.
While the market is below the 50-day MA, 252, it is also based on the horizontal support line around 235. Since the goal is to catch the market on a possible uptick from this support level, we go long on the first entry signal we see; in this case we give an “input signal” at the inverted hammer. We look for a protective put option that is close to the entry price of 237, and we place a put option of 235 to protect ourselves.
The price gap between 237 and 235 is $100 – pretty good protection. Our initial profit target is 252, 50 days MA, potential $850, and the option we bought for $400. If we use our 50% money management rule when holding options, we have a potential loss of $300 to $850 to win – well within the “risk one to win two” money management rules.
There are several reasons why you might want to execute a synthetic option instead of buying a full call position. The first reason is the cost of the call option. The closer an option’s strike price is to the current forward month, the more expensive it is, especially if it moves in the same direction as general market sentiment.
Second, options don’t always move in price one at a time with the futures contract. So by having your futures position, you build profits faster. Finally, synthetics allow you to absorb larger market swings while holding larger positions for a longer period of time.
What’s the worst that could happen?
Scenario 1: If the market continues sideways, the time value of your option erodes and you lose all of your $400 option premium.
Scenario 2: The market is sinking, so on your futures position, you lose the $100 gap between your 237 entry and the option’s kick-in at 235. Depending on the put option’s delta, you would see 231 or better must achieve before you can start making a profit on your options position.
You have the option of losing $100, or you can make money from your put position without chasing the market or getting whipped – not a bad chance.
The beauty of this is that you can calculate all your chances of winning and losing in advance.