In a new market note published today by TABB Group, “Futures with a Stop vs. Defined Outcomes with Options on Futures,” Russell Rhoads, TABB’s head of derivatives research, explores the use of options on oil futures contracts as an alternative to trading the underlying futures contract.
Many futures traders use stop orders to limit losses when the market is not moving as they hoped. However, Rhoads says, there are times an option on futures order offers a similar risk / reward scenario without some of the uncertainty that exists with stop orders. As he explains, successful traders focus on the risk of a trade as much as, if not more, than the potential positive outcome of a trade. In the case of a negative result for a futures trade, they will use either a hard stop order or a mental stop in the form of some sort of notification that a price level has been reached. An alternative can be an option trade where the ultimate risk and reward are defined at the beginning of a trade, regardless of the subsequent price action out of the underlying market.
“There are trade-offs to using options on futures as opposed to a directional option trade,” according to Rhoads, “but setting the worst-case scenario is a definite benefit for options on futures vs. futures.”
Traders enter into a long or short futures trade with a couple of price levels in mind. One is the price target, and the second is a stop price or other parameter they’ll use to determine whether it’s time to exit a trade at a loss. This price may be a function of a trader believing a trend they were riding is no longer in place or may be based on their own maximum loss threshold. Some traders will set an alert that notifies them of this violation of negative price action or others may actually place an order to exit a trade if this price threshold is hit.
“Any trader who doesn’t have some type of risk management method in place,” Rhoads warns, “won’t be a trader for long.”
The 3-page note with five exhibits is available for download by TABB derivatives, futures and options clients and pre-qualified media at https://research.tabbgroup.com/search/grid. For more information or to purchase the market note, write to info@tabbgroup.com.