Protecting a Futures trade with an Even-Money Option Spread

January 21, 2010

This example involves speculation in a given market using futures and then using options to protect the position.  For example, suppose an investor was bearish the E-Mini S&P market and decided to sell a futures contract at 1130.00.

If the investor was correct, it is then possible to combine options with the futures position in order to create a hedged position with very limited risk.  Note that this technique will only work favorably if the initial directional bias in the futures market is well-timed and moves lower (assuming a short futures position is held).

If the market in which the investor is short sells off, it is then possible to buy a call option at the same strike as the futures position.  Simultaneously, the investor can sell a put option at a price that “pays for” the call option – this option spread is sometimes referred to as an “even money” spread, as the price paid and the price received are offset.

If the futures were to fall to 1115.00 shortly after the trade is put on (within a day or two), at the time of this writing, the theoretical prices of the 1130 call option and the 1095 put option are virtually identical.  This means the “even money” hedge could be placed.  The futures position can earn an additional 20 points (the difference between 1115.00 and 1095.00).  If the market turns and rallies, then the position does not lose money – the futures are offset with the call option and the price of the call option and sell of the put option have already been offset (by the even-money spread).

Note that this trade does incur an initial speculative position in the futures market.

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