Trading Options on Futures Contracts: Tips With Selling Short
Knowledge of put and call options, as well as knowing what trading long and short means, is a vital prerequisite to get the most out of this article.
When you sell options short on stocks or futures, the odds are in your favor. That’s because options lose value as they reach expiration due to time decay.
When you sell short1, you can buy options back at a lower price and keep the difference as a profit or let them expire and keep 100% of the funds received, less the commission.
Most traders only think of buying options (going long). They lose most of the time. The person buying options needs to be right with his or her assumption of the direction the underlying instrument will take.
When you sell short, time decay is your friend. Even if you’re wrong, you can still make a profit if the stock or future doesn’t move too far in the wrong direction.
I’ll give you some tips for successfully trading options on futures.2
Sell Premium on S&P Futures When Volatility Is High
Selling options is known as selling premium, but you want that premium to be as high as possible, so you increase the chances of it eroding in value quickly. Remember that term, Time Decay?
In order to know that you are getting a decent premium, the best indicator is the volatility. Every commodity has a different volatility indicator.
For example, I sell premium on the E-mini S&P Futures options. I keep an eye on the VIX. That’s the implied volatility of the S&P 500 index options.
The Chicago Board Options Exchange (CBOE) calculates the VIX on a continuous bases while the futures are trading.
When the VIX is historically low, I wouldn’t think of selling short. However, when I see an opportunity because the S&P suddenly shot up or down, I check the VIX. If it also moved up, I might consider selling a put or a call option, depending on which way the market moved.
When you expect the market (or commodity) to go up, sell a put. That means you’re long the market. A put option will lose value when the market goes up. It will also lose value if the market doesn’t move at all. That's due to the incredible time decay again.
Reversely, if you expect the market to drop, sell a call. That means you’re short the market. A call option will lose value when the market goes down or stays the same.
Define Your Risk to Limit Losses
When you buy a stock, you risk all the money you invested. With options, you have more control over your risk, as long as you include the following method with all your trades. (This works for stock options as well as options on futures).
I'll explain it with an insurance analogy. You sell short, and you buy insurance to lock yourself into a max loss. The insurance is actually an out-of-the-money option that you buy real cheap.
Here’s a simple example to show how this works:
In the last section, I spoke about selling either a put or a call. Remember, when you sell short, you collect the premium for that sale. That is also known as selling naked.You’re not protected if things go wrong, as I’ll explain.
If it loses value, which is what you want, you can buy it back at the lower price and keep the difference as your profit. In some cases, you may just let it expire worthless, and you keep everything (less commission from the initial sale).
However, if the underlying future commodity does not go the way you thought it would, the option can grow in value. If that happens, you can lose on that trade because you would have to buy it back at a higher price.
The difference is a loss in that case. Time decay may help a little, but only if it doesn’t move to extremes. If things really get bad, that option can grow tremendously, and you can lose a lot.
However, here’s where defining your risk becomes beneficial. If you buy another option way out of the money at the same time when you sell short, you lock yourself into a fixed max loss.
Here’s a quick example without getting into particulars, and ignoring commissions:
Say the S&P is trading at 2100. You think it won’t go below 2000 in the next 30 days.
You sell a put option to expire in 30 days at a strike of 2000 and receive a premium of $8. Each E-mini S&P option is for 1 S&P contract, and each contract has a $50 multiplier, so you receive $400. (The multiplier defines the actual value of each futures contract, known as the notional value).
At the same time, you buy a put option at a strike of 1900, and you pay $2.90 (option price) multiplied by the $50 S&P multiplier, which is $145.
Therefore, you receive $400 less $145, or $255 for the trade. Sure, you get less than the full $400, but that long option locks you into a defined risk of $5,000.
How did I arrive at that risk figure? You sold an option at a strike of 2000 and bought one at a strike of 1900. That’s a 100-point difference, also known as the spread. Multiply that by $50 (the S&P multiplier). 100 x 50 = $5,000.
Actually, your true risk is even lower. It’s $4,745. That’s because you received $255 for the trade ($5,000 – $255 = $4,745).
Sell E-mini S&P PUT
Buy E-mini S&P PUT
If you didn’t buy that long option and the market kept going the wrong way, you could lose endlessly, up to infinity. Of course, your broker would give you a margin call and pull you out before that happens, but at a tremendous loss, nevertheless.
When you define your risk, you’ll never get a margin call. No matter how bad things get, you can’t lose more than the amount you defined as your risk – $5,000 in this example.
You can make that risk larger or smaller, depending on your risk tolerance, simply by making the spread larger or smaller.
In case you’re wondering what the percentage gain is, if the option expires worthless, divide the amount you received ($255) by the risk ($5,000). That’s a 5% profit in 30 days. Keep repeating that, and you’re making 60% per year on a $5,000 investment. However, I don’t recommend being greedy.
Take Profits Early
Greed is our enemy. Many people hope to keep all the money by waiting and letting the trade expire worthless because options tend to lose value over time, due to time decay.
They think they are saving the commission since they don’t have to buy it back. However, this strategy is impractical for two reasons:
First: Markets and commodities can turn around any time and move quickly in the wrong direction. Therefore it works best to take profits when you have a 50% gain on the options trade. There is no need to wait for expiration. A gain can be lost if the market turns on you.
Of course, you can always roll down. But rolling takes extra resources, and you might just be priced out of the market if you need to keep rolling month after month.
That’s why you should close the trade when you have a 50% gain.
Second: The second reason why waiting for expiration is impractical is that you are tying up your money for the entire time of the trade. If you already have a 50% profit within a month, take it.
That will also free up your resources so you can enter a new trade when the opportunity presents itself. You might find yourself repeating several trades in a month to make much more without using extra resources. Isn’t that better than waiting for that single trade to expire?
There you have it. Remember to use your due diligence when you enter a trade. Never be greedy and take your profits early. That’s the best strategy.
Advantages and Disadvantages of Futures Contracts
Futures trade like stocks, but you own part of the company when you buy shares of stock. The difference is that futures are contracts for a future sale or purchase. You are committed to buy or sell the commodity that the contract relates to at a later date at a specific price.
One of the best things about trading options on futures is that IRS Section 1256 allows you to report 60% of the gains as Long Term. That is true, no matter how short a time you held the trade. It’s true for futures as well as the options on futures. With stocks, you need to hold over a year for that tax advantage.
Another advantage is that futures only require a small amount to hold the contract. That gives you leverage, but leverage can work against you fast when the price of the future goes against you. That’s why selling options helps, since the options decay as time goes on.
Nevertheless, you need to keep a close eye on things. If you let it go too far in the wrong direction, you would end up having to repurchase the options at a higher price or take delivery on the futures commodity. You wouldn’t want to do either. So as you can see, that’s one of the disadvantages.
As long as you learn to get out quickly when you’re wrong, this type of activity can be quite fruitful.
Now that I covered the most crucial factor to understand, I’ll continue with a list of pros and cons:
Pro: You can buy or sell those futures contracts as easily as trading stocks.
Con: You tie up margin while holding the futures contract, no matter if you buy long or sell short.
Pro: You have leverage. The margin is nowhere near the actual value of the commodity. That’s called the Notional Value. The definition is beyond the scope of this article, but I’ll say it in a few words: It’s the market value times the leverage.
Con: Remember that you are dealing with a contract. If the trade goes against you and you don’t buy back the option to close the trade, then you may end up having to pay the full price of the underlying commodity upon expiration.
Pro: There are no day-trading limits with futures. The IRS will consider you a day trader if you trade stocks more than three times each day. That does not apply to futures contracts, so you can take quick profits with small intraday swings and get right back in again. Doing this with stocks can sometimes cause “Wash Sale Penalties.” But not with futures.
Con: Futures pricing is recorded as Marked to Market. That means you have to pay tax on the gains even if you hold a contract into the next year.
Pro: Futures trade nearly 24 hours a day. They only pause on weekends and a few minutes at the end of each day for exchange record keeping.
Pro: Most Futures Options can't be exercised before expiration. That’s known as European Style trading. There are some exceptions. American Style can be exercised anytime, as is the case with most stocks.
Which approach do you think is best suited for you?
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
Questions & Answers
I trade ES. What is the best way to protect my account balance from flash crashes?
As with any trade, put a protective stop order on it. Make sure it’s GTC.
I always choose the max loss I’m willing to risk, and I put a stop at that price. Don’t make it too close or you will be stopped out prematurely.
You can even use a trailing stop so your profit growth is locked in as the price rises.
If your broker doesn’t support stop orders on Futures, get another broker.
© 2016 Glenn Stok