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Do you think trading is easy? Some say it's
like playing chess and twister at the same
time with an octopus who happens to be a
lawyer. Others describe it as being
blindfolded while chasing a greased pig
through a forest at midnight. In any case,
ignoring any possible advantage can be
expensive. Using futures and options
together, you can wield more leverage with
less risk, improving your chances for
survival and success. The One-Two-Three
Combo Punch technique uses two options and
one futures towards reducing risk and
keeping your account alive.
Traders often divide themselves into two
camps: those who only trade futures, and
those who only trade options, or to be
precise, those who only buy options. There
are excellent reasons for sticking to one or
the other.
The futures only folks point out correctly
that a large percentage of options expire
worthless and that all things being equal,
an option loses its component time value
while a futures does not. They say that even
if the market moves in favor of an option,
it is never a one to one relationship as
opposed to a futures trade. Margin is a
deposit you get back if things go well,
while paying for option premium is a sunk
cost, plus commissions. Futures traders like
to be able to say "I'm in", or "I'm out" and
not fiddle around waiting for an option to
do something. To them, options are a gray
area they feel dulls their edge.
Options buyers argue you can't tell how much
you're risking when you trade futures due to
slippage and changing margin requirements,
among other uncertainties. They point out
that when a market moves unfavorably against
an option, it won't lose value as quickly as
a futures contract. Option traders claim
that they can sustain their positions
through market moves that would have stopped
them out in the futures, sometimes several
times.
This division can exist as easily in the
mind of one person. Reviewing an account
that carries both futures and options will
usually show no connection between them.
Futures are traded for the sake of futures,
and options are treated as individual
trades, or, spread against themselves. The
two instruments pass each other like blind
ships in a foggy night, rarely coming
together to work as partners within an
overall strategy.
Some say that it's too complex to make
futures and options work together. I
disagree. There are more moving parts in the
trade than just doing an option or just
doing a futures, but it isn't difficult.
This brings me to an important point: There
are many who pound home the gospel of
keeping things simple, but they do so at the
expense of remembering that there is no free
lunch. In fact, I have often bought someone
else's lunch in exchange for their advice
(worthless) on how to keep things simple.
After paying for this kind of advice several
times, I've come to the conclusion that some
things are simply not simple, but not very
difficult either. Consider that a unicycle
is simpler with one wheel than a bicycle
with two, but much harder to ride. Or, to
put it another way, spreading peanut butter
on a slice of bread is easy, but making a
sandwich with all the goodies requires a
fraction of extra effort and tastes far
better.
Both sides could argue all day and be right,
but the result is a large group of traders
who never combine futures and options on
purpose and never know how well this
strategy can work. I'm going to focus on one
style of combining futures and options, but
remember that there are lots more worth
investigating. I call it the One-Two-Three
Combo Punch, because when it works it
diminishes risk and expense. The only thing
left standing is the chance to make money.
Here's an example showing how to set it up
using a market that is trending down
(reverse everything for an uptrend).
Step One: Find a market that looks
like it simply cannot go any lower and has
around four months left to trade. It should
be so tempting that you can barely stop
yourself from calling your broker and
getting long. or buying a call.
Notes on Step One: This step might be
considered by many to be vague. What I want
to take advantage of here is the emotional
power that traders, regardless of
experience, often find themselves unable to
resist when they see markets making new
lows. This potent emotional force causes
traders to see what they think are solid
formations in support of going long, or
purchasing call options when really, the
formations are deadly mirages. Of course,
these actions are contrary to the prevailing
trend, and the rationalizations begin.
One of the most popular and sexy terms a
trader can use to seduce himself into
believing in his choice is to say "Well, I'm
a contrarian trader, so is Warren Buffet,
isn't he? Being a contrarian, in my opinion,
is something you should consider in the
planning stages of a trade, not a label you
slap on your forehead after you get in and
are searching for excuses to stay in. Here
is what I think really happens, and why the
often self-applied-after-you-are-in
contrarian label is not all contrarian.
Webster's Dictionary defines the word
contrarian:
Main Entry: con·trar·i·an
Pronunciation: kon-'trer-E-n,
Function: noun
Date: 1657
Definition: a person who takes a contrary
position or attitude; specifically: an
investor who buys shares of stock when most
others are selling and sells when others are
buying (See also Warren Buffet).
Here's how the logic comes together. If ,
according to generally accepted industry
statistics, approximately eight out of ten
traders lose money trading in the long run,
then, in a downtrend, eight people will be
losing by being positioned against the
trend, and two will be gaining by following
the trend. If being a contrarian is doing
the opposite of what the crowd is doing,
then, you would NOT be a contrarian by being
counter-trend. An amazingly important
distinction. Let me reiterate, according to
the generally accepted evidence, it is
impossible to follow the crowd and follow
the trend at the same time. To go against
the crowd, go with the trend.
The idea that the crowd is not short in a
downtrending market goes against what we
think must be true, namely, that there must
be more sellers than buyers for a market to
go down, right? Not exactly. Of the ten
traders, the two who are short can be short
four contracts each, one to each of the
eight traders who is long. If the traders
who are short are right about the trend,
they will add to their positions by going
short again. The eight traders who think of
themselves as contrarians will believe
themselves to be even greater contrarians if
they buy another contract while the market
is going down against their first position.
At the end of the day, we have the same
number of real contrarians and fake ones,
but the market has gone lower, with the
trend. (This scenario is a simulation meant
only to show that things may not be as they
appear.)
Apparently, trying to figure out when a
trend will change and going against the
current one is part of human nature. Trading
this way has been going on for hundreds of
years, and shows no sign of stopping for the
next several hundred years.
However, I don't want to make it appear easy
to follow the trend, you can get stopped out
and make a loss even if you are trading with
the trend, but if you spend your energy
looking to participate in existing trends
rather than entering trades against trends
you think will soon turn, you should be able
to increase the odds in your favor.
The strange result is that it's much harder
(and much lonelier) to go with the trend,
than to go against it. It's no wonder that
many gurus and books about trading tell you
to eliminate, to the greatest degree
possible, and with extreme prejudice, your
emotions when trading. They say you need to
be like a machine rather than a human being,
because you obviously can't trust the way
you feel and still expect to succeed.
Because of this, many are attracted to
"system trading" as a way out from under the
weight and strain of being emotionally
misled by what they see in the markets.
Alas, the statistics for system traders are
not much different, if at all, than for
traders who don't use them.
Systems are blindsided by many things, but
the most often cited reason for trading
system failure is curve fitting. Curve
fitting happens when a system designer,
using historical price data, keeps tweaking
the rules that make his system buy or sell
until he can't improve the results. This is
also called optimizing a system's
parameters. The system will work beautifully
for the data used to develop it, but will
often stumble badly when used with current
price data. Why? Because history doesn't
repeat itself, and even though it often
rhymes, systems are not designed to
understand poetry. The so-called contrarian
ingredients used in making most systems look
good on paper, are the same ingredients that
trouble non-system traders. The old saying
is "garbage in, garbage out".
Misunderstanding the word "contrarian", and
the concept it stands for, is often at the
very root of what plagues most people when
they try to apply their talents towards
becoming successful traders. The solution to
this problem is, in my opinion, to turn your
emotions into a powerful tool by
experiencing them as fully as possible. The
more strongly you feel about about going
long in a market, the greater the chance you
will make money by doing the exact opposite
and going short, or buying puts. By all
means, even if you don't apply the combined
futures and options strategy outlined here,
do your best to trade with the trend. If you
do, you won't find yourself in a crowd, but
more and more alone, which is how they say
things are at the top.
This means, really, that you have to learn
to trick yourself into doing what's good for
you. In my experience, it's possible to do
this, even simple, but not painless. To
repeat step one, find a market that is
making multi month or multi-year lows, feel
how badly you want to go long or buy calls,
and if you really think you're going to miss
out if you don't, go short or buy puts. It
should hurt. This kind of pain is not vague,
it is sharp, pointed, and specific.
Step Two: Find the put options two or
three strike prices below the current price
of the market. Determine how much they cost
and how many days they have before they
expire. If they cost around $300 or less,
and they have 60 days or more of time before
they expire, buy a pair. (The closer the
strike prices of the options you buy to the
current market price, the better.)
Notes on Step Two: Here is where you get to
hold your breath. The time between now and
step three is when this trade experiences
maximum risk, which is everything you've
spent so far, including commissions. If the
market completely stops going down, and goes
up, don't be too surprised. After all, you
were trying to pick the bottom, and you did.
However, this is a rare occurrence. Since
the market can go sideways, or retrace, it's
often good to wait at least two weeks before
selling back the puts and getting out of the
trade completely. I suggest setting a a
mental stop to sell back the options at
around one third of what you paid for them.
No need to let them dribble away to nothing
and drain your confidence to trade. But
remember, trends are like that battery
bunny, just when you think they're over,
they keep going and going, and will often
revive options that are aimed in the
direction of the trend. Frequently, you will
not proceed to step three. Instead you will
either sell back the puts and take your gain
that way, or exercise them if you have come
to the belief (enlightened) that the market
will continue even lower.
Step Three: By now, you will have the put
options either at or very close to being in
money. If it has taken a lot of time to get
here, consider selling back the options.
Otherwise, check to see how much time
remains before first notice day in the
futures. If there are at least thirty days
remaining, the trade is still worth doing.
Place an order to buy the futures contract
at or below the strike price of the options.
Notes on Step Three: When filled, you will
have one covered long futures position that
will not require margin except in very rare
cases, and the other put option. If this put
gains enough value to cover the costs of
buying both puts, plus all commissions, I
recommend selling it back. Now, the money
you spent in the beginning for both options,
plus commissions, plus the commissions you
spent to initiate the futures position, is
back in your account, along with the covered
long futures position.
If the market keeps going down, and stays
down until the expiration of the options,
your account will show a purchase and sale
at the same price (if you are long from the
strike price of the option). Should this
happen, your account will be like it was
before you did the trade, except for any
commissions on closing out. That's the bad
news. The good news is that if you were
right about the market being at a bottom,
you now have a long position ready to mop up
the new uptrend. And it's not just any long
position, it's special because it doesn't
require margin, or a stop loss, which often
knocks you out just before the best part of
the trade. Another benefit is that you can
now afford to have terrible timing. You may
miss the actual bottom by weeks and still be
there to see your ship come in, turning what
might have been a loser into contender, or
even a winner by knockout!
Of course, if the position develops gains,
you can offset it, or let the market take it
out with a standard following stop order.
Don't allow the market, with its many
confusing twists, to command more respect
from you than it deserves. Yes, it can feel
like an octopus is beckoning you, with all
its tentacles, to jump in and play against
the trend now, or, like you are pursuing a
piglet in the dark only to wind up chasing
your own tail, but, by learning and applying
your skills it ought not to feel that way
forever. In this article I've done my best
to introduce you to two exclusive clubs you
may wish to consider joining, as well as
some ideas on how to join them: Those who
trade with trends, and those who combine
futures and options on purpose.
For working examples of this and other
strategies, or to execute this approach in
your own account, you are invited to call or
email Carmen Lopez, or myself, Chuck
Hackett, at Access Futures and Options
(1-888-443-6140). Ask for our free starter
kit!
Disclaimer and Disclosure of Risk Statement
You should understand that trading in the
futures and or options markets is not for
everyone. There is substantial risk of loss
when trading futures and or options.
Carefully evaluate whether trading in the
futures and or options markets is
appropriate, as such trading is speculative
in nature. When trading futures, you may
sustain losses which exceed your margin
deposits. Purchasing options may result in
the entire loss of premiums and commissions
paid for such options. Options sellers
should understand that they may be at risk
of assuming a long futures position in the
case of selling a put or a short futures
position in the case of selling a call from
the respective strike prices of such
options. Past results are not necessarily
indicative of future results.
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