Which to trade – Forex, Futures? Or Even Options on Futures?

Both futures and forex trading have their advantages and disadvantages.

Trading forex – or foreign currency pairs – gives greater leverage than outright futures trading, of up to 100:1.

This means that for every $1000 put up in margin, you can trade with up to $100,000 in currency value. If you put up $30K, you could trade with $1 Million of currency. This means that if there is a 1% move in the value of the currency pair that day, it would give you a profit/loss of $10,000. This would be great if you were right, but disastrous if you were wrong as you would have lost your entire trading account.

Trading futures, you usually get leverage of around 5-6%, so you can do much more with your money trading forex. Having said that, you may be able to get much more leverage using options on futures…

Deep out the money options will cost little but if you are right on your prediction, you could make a vast sum in a short period of time. For example, Feb Gold is trading at 455.00 on December 3rd 2004. You expect a sharp drop in prices to trend-line support at 435. You have $100,000 to trade with. 435 Feb gold puts are priced at $500 each – quite cheap as they are deep-out-the-money. You have enough to buy 200 puts ($500 x 200 = $100,000).

On Dec 10th, the market has plummeted to 435 and you exit your position by selling your 200 puts. In effect, you sold the futures at 455 and bought futures at 435, giving a profit of $20 per contract. There are 100 troy ounces per contract so you make $2000 per contract. You bought 200 contracts so you have made $400,000 in a week, or 400% on your money while the market has dropped less that 5%.

If you had done an outright futures trade, you may have had to put up $2000/contract in margin, so you could only have traded 50 contracts as opposed to the 200 using options. If you had sold 200 futures at $455 and bought at $435, you’d have made $200,000 or 200% on your investment.

Options on Futures – The Pros and Cons of Trading Futures with Options

The Myth of Unlimited Risk Trading Options

If you are the buyer of the option (call or put), the only money you risk is the premium paid to the seller. If you are the seller of the option you could, in theory, have unlimited risk as the price of a commodity could go to the moon. For example, if you sell a 450 gold call option, you give the buyer the right to buy a futures contract from you at a market price of $450, which he could immediately offset by selling a futures on the market at “infinity”.

Of course, the probability of gold going up to “infinity” is impossible, so the risk isn’t exactly unlimited, but you get the idea. If you sold a 450 put option, you give the buyer of the option the right to sell a futures contract to you at 450 (i.e. you have to buy it from him at 450). If the price of gold fell to one cent, the buyer of the option could sell a futures contract to you at 450 and immediately offset his position by buying a futures contract at one cent. (You, as the seller, would have to offset your position by selling at the market price of one cent). Again, the chance of gold falling from $450/oz to $0.01 is virtually impossible so your risk as the seller is greater in theory than in reality.

A call option buyer expects the underlying futures market to go up. He buys a call option from the option seller to buy the futures contract at a certain price… and if the futures market goes up enough, he can offset the position by immediately selling the futures contract for a higher price on the futures market.

If he thinks the price of the futures contract will go up significantly, he could buy a deep out-the-money call option. For example, Feb Gold futures are trading at 450. He thinks the price of gold will rocket to 500 by the time the option expires in a few weeks time. He could buy Feb 500 call options for $300 each. If gold then went to 500, he could exercise his option, buy a contract from the option seller at 450, immediately offset it by selling a futures contract in the pits for the market price of 500 and make $5000 per option (less commissions and the $300 paid in premium).

What if things didn’t go as the call buyer planned? If gold tanked, he would not exercise his option and he would only have lost the $300 in premium.

If gold did go up but not as far as he thought, say to 490, he would not exercise the option because he would make a loss of $1000 (buy at 500, sell in the futures market at 490, x Gold futures contract’s $100/point).

Similarly, if gold stayed roughly the same, it would be unlikely that he would exercise his option as he’d lose the premium of $300/option.

The call buyer also has other choices he could make. For example, he could have played it a little safer and bought call options with strike prices of 470. They’d be profitable if gold went to 470, not his higher target of 500. Because there is a greater chance that gold would get to 470 rather than 500, the seller is entitled to more premium as his risk is greater. The 470 Feb gold options might cost the buyer $1600 each.

Or, the trader is convinced gold will skyrocket but it might take longer than he initially thinks. To give himself a bit more elbow room, he might decide to buy the April gold 500 options, which would give him a couple of extra months for gold to move as he anticipated. As there is more time, there is more chance of gold reaching this level so the seller may be entitled to a greater premium of $2000 per option.

Looking at the above example from the view of the seller: “This guy thinks gold is going to rise to 500! He must be insane!” You, as the seller, believe gold might go up a little, but will then settle at roughly the same price. You can sell 500 Feb gold call options to this lunatic for $300 each. The chances of him exercising the option are virtually non existent in your opinion, and the $300/options is money in the bank.

If this guy thought gold was going to 470, you might think he was, not quite a lunatic, perhaps a bit strange? Still there is a chance that gold could go up $20/contract. To make the risk worth your while, you can sell him call options for $1600 each. Again, you feel there is little chance of gold getting this high, of him exercising the option, and this is easy money for you to collect.

What if the trader had just bought futures contracts and forgotten about the gold options? If he’d bought a Feb gold futures contract at $450 and the market dropped to $430, he’d be down 20 x $100 = $2,000. With his Feb gold options he’d only be down the premium of $300, worst case scenario. Gold could drop to 350, then go up to 500 where he could exercise his option and make a profit. At any time, he’d only be down $300 in option premium. With buying a futures contract, he’d be down 450-350 = 100 points x $100/pt =  $10,000. So you see, in this case, the risk is less (and limited) buying an option.

However, if you trade futures, you do not have to pay the premiums which can often be expensive if there is a reasonable amount of time left before the contract expires, or if the strike price is near to the current futures price. If you get a signal to buy gold futures but do not think it will go that high, you may be better off buying a futures contract than a call option.

For example, Feb gold is at 450 and you get a signal to go long. Gold has been trending up for some time and you do not think it will get much higher. But you want to stick to your trading system and go long. You buy a Feb gold futures contract. All you pay is the commission charge (say of $20). Gold futures go up to 455 and you place a stop loss at 450. Worst case scenario now is that you exit the trade at the same price that you entered (less commission, spread and slippage). Say this happens, you have broken even. If you had bought a call option, you would have lost $300.

Say you didn’t get stopped out and gold went up to 465. You then got a signal to exit. You would make 450-465 = 15 points x $100/pt = $1500. If you had bought the 500 or 470 call options, you would not be able to exercise them for a profit unless gold got to 470 or 500. At this point you would still be down $300 in premium on your call option as opposed to being up $1500 with your futures trade.

Other pros and cons of options

Some futures markets have high volumes making it possible to get fill prices near to where you want them to be, for example near your stops. Futures markets with high volumes include S&P 500, NASDAQ, Treasury Bonds, major currencies, crude oil and gold.

Other futures markets do not have as much volume and this can sometimes make it difficult to get an order filled quickly. In a fast moving market, this can make the difference of $100s of dollars on a trade. For example, you are long Crude Oil with a stop loss at 41.20. The market plunges through this level and you might get a fill at 40.80 including the spread. This is a difference of 40 cents per contract and Crude trades at $10 per cent. Therefore, this has cost you $400.

If you had traded a thinner market such as Heating Oil, which has volume approximately one-seventh that of Crude at the time of writing, you might end up losing $1000 with a bad fill.

You should be aware that this problem can be greater when trading options on futures as the markets are even less liquid. It might take a while for your option order to be filled near the price you would like.

Conclusion

If your futures trading system is right most of the time and gives you the chance to lock in a breakeven or profit, say 70% of the time, you may be better off trading outright futures contracts than paying a large amount in premium on options.

If your trading system is often right in the long-run, but you regularly see the market move against you before you are proved right (which can see a large drawdown with the high leverage of futures), you could be better off trading options.

If your system times market break-outs accurately, then buying options near to expiry might be a good idea. The premium will be low and the payoff high in a short period of time.

If your system is good at finding markets that are likely to congest, or are likely to slow in trend, then perhaps writing/selling far out-the-money options might be a good strategy for you. Chances are the market would not break to these price extremes, the buyer of the option would rarely exercise his options, and you’d regularly take his premiums, maybe 80% of the time or more.