One of the most common things you’ll hear a futures trader say is, “Make sure you lock in profits with stops!” One thing some traders don’t realize is that you can lock in profits with options as opposed to using just a stop loss order. This article will focus on how locking in profits is done and when it may be a useful strategy.
How it works
The most common way to lock in profits using options is done by purchasing an out-of-the-money call or put wherever you’d like to lock in profit. An option gives you the right to buy or sell a futures contract from a specified price. If you are long a market, you would want to purchase a put to lock in profit. If you are short a market, you would want to purchase a call to lock in profit. The amount of profit you will lock in is determined by the strike price plus the premium paid.
When This Strategy is Appropriate
A trader can use options to lock in profits any time they would like to. However, they can be especially useful when a trader is expecting high volatility in the market they are trading. Let’s say you are in a long futures position in the corn market and a crop progress report is due out in a few days. You think there may be a short term correction in the market before it continues on its bullish trend. You can simply purchase a put at whatever point you would like to lock in profits (remember to keep premium paid in consideration here). If the market report comes out bearish and the market doesn’t continue in the bullish trend, simply exercise the put option to offset your long futures position at the strike price purchased.
Frank is a speculator who is currently trading the corn market. He has been long July 2011 corn from a price of $6.72. July corn last traded at $7.50 and Frank would like to lock in some profit. Since he is long the corn market, he knows he will need to purchase a put to lock in profits using options. Frank would like to lock in around $2000 of his profits. A $7.30 July corn put option is currently trading at 19 cents premium. Each cent is equal to $50 in the corn futures and options market. Knowing this, Frank decides to purchase the $7.30 put to lock in profits.
$7.30 (Put option purchased)
-0.19 (Cost of put option)
$7.11 (Price locked in after difference in strike and premium paid)
-6.72 (Initial long position)
$0.39 of profit locked in, or $1,950 (39 * 50)
Using options to lock in profits is a simple alternative to using futures positions. They can give you the ability to ride out volatility swings with a defined exit point without having your position offset like you might with a futures stop loss.
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Spreads Risk Disclosure: A spread is defined as the sale of one or more futures or option contracts and the purchase of one or more offsetting futures or option contracts. It should be recognized, though, that the loss from a spread can be as great as – or even greater than – that which might be incurred in having an outright futures or options position. An adverse widening or narrowing of the spread during a particular time period may exceed the change in the overall level of futures or option prices, and it is possible to experience losses on both of the futures or options contracts involved (that is, on both legs of the spread). In addition, spread trading increases transaction costs because the customers will be charged commissions on each leg of the spread.
Options Risk Disclosure: An option on a commodity futures contract is a right, purchased for a certain price, to either buy or sell a commodity futures contract during a certain period of time for a fixed price. Although successful commodity options trading requires many of the same skills as does successful commodity futures trading, the risks involved are somewhat different. For example, if a customer buys an option (either to sell or purchase a futures contract or commodity), the customer will pay a “premium” representing the market value of the option. Unless the price of the futures contract underlying the options changes and it becomes profitable to exercise or offset the option before it expires, the customer’s account may lose the entire amount of such premium (together with the costs of commissions and fees incurred to purchase such options). Conversely, if a customer sells an option (either to sell or purchase a futures contract or commodity), the customer will be credited with the premium but will have to deposit margin due to its contingent liability to take or deliver the futures contract underlying the option in the event the option is exercised. The writer of the option is however at unlimited risk with respect to the call option written, and risk on the put option of the amount should the price of the futures contract drop to zero. Sellers of options are subject to the loss which occurs in the underlying futures position (less any premium received). The ability to trade in or exercise options may be restricted in the event that such trading on U.S. commodity exchanges is restricted by both the CFTC and such exchanges, and it has been at certain times in the past.
Stop Orders Risk Disclosure: This website may make certain references to the use of stop orders as means of limiting losses or protecting profits. Please note that there is no guarantee that any stop loss order will be executed at the stop price. Therefore, there can be no guarantee that placing a stop order will limit losses or protect profits. Accordingly, no representation is being made that the trading in customers’ accounts will be profitable or will not result in losses as the result of placing stop orders.