Hedging Futures with Long and Short Options
Beginning commodity traders tend to migrate to the practice of trading futures contracts as opposed to options due to their simplicity. After all, a futures trader has the ability to place a stop loss order, he can easily determine his profit and loss with absolute certainty based on incremental price movements, and he has nearly 24-hour liquid market access. However, there are some flaws in this thinking.
For starters, stop loss orders arguably cause more harm than good in some scenarios. If this statement is confusing to you, imagine being stopped out of a short e-mini S&P position on the evening of June 24th near 2119 only to watch the market crater seconds later by 120 points! Not only would the trader have likely taken a steep loss, but the emotional trauma of missing one of the best short trades of a lifetime wouldn’t have sat well with the trader either.
On the other hand, those futures traders who opt not to use stop loss orders but also have a hard time cutting losers, might have run out of margin, equity, or nerve before the trade paid off. You might recall the S&P rallied roughly 80 points in the days leading up to the Brexit crash. In short, despite the luxury of simplicity, trading futures contracts outright can be challenging, and expensive for those in the wrong place at the wrong time. In my opinion, traders can turn to the options market for viable strategies aimed at mitigating the risk of loss and avoiding untimely stop outs or panicked liquidation. In short, options offer traders risk management with the benefit of lasting power.