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.