Limited Risk Futures Trade Combined with Options as a Hedge

January 13, 2010

This type of strategy is very interesting because of the flexibility in defining risk and reward.   It has limited risk, which you can define by choosing strike prices that work for you.  The idea concept is fairly simple.

A futures position is taken in the direction of your bias.  It is immediately hedged with an option to absolutely define maximum risk.  To reduce the cost of the hedge, we also sell an option.  The option we sell also defines the reward we are aiming to achieve.  Note that if you seek more reward on the trade, the option that is sold covers less of the cost of the option that is hedging the futures.  This is a classic example of risk and reward – they are correlated.

You can use this strategy in any market.  It is best to trade in liquid markets, such as Bonds, E-Mini S&P, 10 Yr Notes, or grains.

This can be a bull or a bear trade – the direction is determined by whether your directional bias and if you are long or short futures.  This spread is very flexible, as defining the risk and reward is quite easy to do.

In the example below, March ES futures are at 1140.00 – the strike of the call that is purchased is 1150.  This means the maximum loss, on a rally, is the difference between the short futures and the call strike = $500.

The additional cost to the trade is attributed to the price of the call we buy versus the price of the put we sell.  The call is a little more expensive than the put we sell.  We can buy a lower strike call – this reduces risk if the price of the lower strike is less than the new difference in strikes between the futures and call strike.  For example, 1140 futures vs an 1150 call = $500 + price of call – price of put we sell.  If we lower our strike on the call to 1145, we reduce our futures loss to $250.  But note that the lower strike call option will cost more – therefore, you would only lower the strike if the cost of the option was less than the new difference in strike price vs. future price.  In this case, it would make sense to lower the strike to 1145 if the cost of the option was less than $250.  In essence, you would gain $250 on the hedge for some price less than that (perhaps you could buy the 1145 option for $175).

Note that this type of trade provides a psychological edge because of the limited risk.  This often makes for better trading decisions.

Your profit potential is the difference between your short futures sell price and the lower strike price = 30 points, which is $1500, less the cost of the hedge, which is the price of the long call minus the price of the short put.

Below is a depiction of this strategy, structured for a bearish move in the mini S&P 500 march futures contract.

Click image to zoom.

e-mini SP bear spread

Bearish Spread with Limited Risk Using Futures and Options

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