Futures & Options Knockout Punch
by Chuck Hackett
The 1-2-3 Combo Punch
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
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: \kən-ˈtrer-ē-ən, kän-\
: 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.
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.
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
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
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
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.
Accumulating Wealth One Tic At A Time! ®
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