Diversify Risks Using Options on Futures
Options on futures can provide additional opportunities to manage risk and diversify your portfolio. While many traders are interested in trading futures, they may also want the flexibility that comes with trading options.
An advantage of options on futures is the ability to reduce risk in your portfolio in different ways. Whether you are looking to trade in an uncorrelated market to diversify risk, hedge existing positions to limit risk, or directly trade more volatile markets at a reduced cost from the futures contact alone, options on futures can be a way to do this.
Trading options on futures provides many trade set ups with varying risks and rewards depending on the strategies chosen to trade and provides many different markets to choose from. This course will look at a few examples of how risks might be managed in your portfolio by using options on futures.
Large Moves with Limited Risk
In markets like oil, gold and silver, you can see swings of over 2% in one day. These markets may offer great set ups for someone who likes to trade volatility, but may seem like too large a swing in price for other traders.
One way to participate in these markets without as much exposure is to trade the option. As an options on futures trader, you can still be involved in the same large move but risk less if the market moves against you by purchasing a put or call or trading a spread. An options buyer is only risking the amount paid for the trade, otherwise known as the premium.
If the E-mini NASDAQ 100 future (NQ) is trading at 5,022, a trader could buy a 5,020 call in NQ that expires in four days, costing around 24 points.
Assume at the time, the 14-day Average True Range (ATR) for the NQ is around 50. Using the ATR as a guide, a move of 25 points up or down each day on average is expected. Buying the NQ call would allow an options on futures buyer the ability to stay in a trade while only risking one day’s move, but with four days of possibility for the trade to profit.
Even though the futures contract might have a large move, which could potentially have unlimited risk, the options buyer of a call or put is only risking what she/he paid for their option. While the price of options is always fluctuating based on the underlying, the options on futures trader knows their risk exposure because they have only risked what they paid.
In addition to limiting risk, options on futures can complement existing equity strategies and add diversification by allowing trades to be placed in uncorrelated markets. Markets like corn, wheat, soy, etc. will move differently than stocks or the S&P 500.
A trader who may want to have multiple trades can spread their risk out in different markets while using similar trade set ups. An equity trader might be in several equities at the same time and also trade, for example, one of the grains. In addition to diversifying by asset class, options on futures provide ease-of-access to all the major equity indexes. This allows the options trader to participate in the broad market just like an exchange traded fund (ETF) or cash-settled index.
A variety of markets can be opened up to you when you add options on futures to your trading portfolio. This range of choice offers market participants additional opportunities to diversify.
Top Options on Futures for Individual Investors
- E-mini S&P 500
- E-mini NASDAQ
- Crude Oil
- Henry Hub Natural Gas
- 10 YR Treasury Note
- Euro FX
- Japanese Yen
- British Pound
Managing Portfolio Risk
Another unique quality of using options on futures to manage portfolio risk is to hedge specific positions against certain risks in various ways.
Because of the varied asset classes that futures contracts represent, investors can selectively hedge most, if not all, asset classes in their portfolios. From an investor who wants to hedge with the S&P 500 contract to one who wants to reduce or hedge foreign currency exposure with options on currency futures. An investor can hedge the fixed income portion of their portfolio with bond options on futures.
An added benefit of hedging with options on futures is that they allow positions in futures contracts to be hedged in the same ratio. If you own one E-mini S&P 500 futures (ES) contract, then you could potentially offset risk using one ES option contract.
For many traders, finding ways to manage risk in a trading portfolio is a priority. As you can see, options on futures provide many ways to manage risk and optimize a diversified portfolio. Whether you are looking to reduce your cost base in trades, hedge to manage portfolio risk or complement trades in equity markets, there are advantages for the options on futures trader. Take a look and see if diversification with options on futures is appropriate in your circumstance to diversify risk in your portfolio.
Peter Knight Advisor