Be Creative with Options on Futures

It is no secret that more retail traders lose money than not in the realm of futures and option trading.  I have observed that day traders could face even more dismal odds of success.  However, don't let this deter you from participating in the commodity markets, instead use it as your incentive to be different.  If a majority of people are day trading futures contracts unproductively, perhaps you should be interested in trading strategies that are a bit out of the norm.  

Buy Futures Options Instead of using Stop Loss Orders

During the last few days of the life of a commodity option they time value, and thus the premium, of the instrument has often eroded to affordable levels.  If this is the case, it is sometimes possible to simply purchase a call or put option as an alternative to placing a stop loss order.  This strategy can also be viable in option markets that have more frequent expiration dates; particularly the weekly options written on the stock indices and grains. Keep in mind, however, that during times of excessive volatility even options with little time to expiration can remain too expensive to make them a viable substitute for stop loss orders.  In other words, using long call and put options instead of stop loss orders to limit risk of a futures trade is only situationally beneficial.    

In essence, the purchased futures option creates a synthetic trade in which the day trade risk is limited to the amount paid for the option plus any difference in the entry price of the futures contract and the strike price of the option.   This is because the futures option will act as an insurance policy against the futures price moving above the strike price of the long call or below the strike price of a long put.  Beyond the strike price of the option, losses in the futures contract are offset with gains in the option at expiration. 

The premise of such a day trading strategy is to reduce the possibility of being prematurely stopped out of what would eventually become a profitable trade.  However, it is important to realize that using long options as a replacement for stop loss orders should only be done if the risk is affordable.  If the options are relatively expensive to purchase, the risk of loss will be too high; depending on the situation it might render this approach impractical. Keep in mind, the foundation of buying commodity options instead of placing stop orders is to limit risk of loss, not to increase it.  To reiterate, paying more for a protective futures option than you originally intended to risk on the day trade should be a red flag, and lead you to explore other alternatives.