As you all know by now, I am a proponent of trading E-Mini futures. It is an excellent trading environment for smaller investors because the Chicago Mercantile Exchange (CME) makes it a level playing field for one and all. No matter how many contracts you trade, getting filled is still FIFO (first in / first out), which is not necessarily so with the New York Stock Exchange or the Nasdaq. And there is only one exchange for each instrument, so there is only one price. Again, not necessarily so with stocks or Exchange-Traded Funds.
I know that a lot of you use options in your portfolio but you haven't yet taken the plunge to integrate futures into your overall trading strategy. Today I have a way that you can use both to put your money to work while protecting your capital.
The Way the 'Big Guys' Trade
Trading E-Mini futures is not just for smaller investors. It is also used by larger investors to protect their trades. How does this work and, more importantly, how can you use E-Minis to protect your options positions?
If there were one word that could describe trading options, that word might be"insurance."
If you look at many of the option strategies, they are designed so that, in some way, you invest in both calls and puts to protect your investment. Trading just one side (either up or down) is considered risky.
When you short a call option, for example, but don't own the underlying instrument, the option is described as "naked" -- or "uncovered" by a long position to protect you if the position moves against you.
Why would you short (or "sell to open") a call or a put? Many investors do this because you receive a credit upfront. That is, you receive money at the outset of your trade, with the goal being that the option value decreases over time, allowing you to keep most (if not all) of the money you collected. This strategy depends on the underlying security moving in the "right" direction, or not moving at all.
But what if the position does not go your way? With stock options, you can typically exit your option trade at any time, so you don't have to be stuck in a position that's not working for you. But when the market, and the underlying stock, moves very quickly, it's important to have a safety net to "cover" your position.
Brokerages frown upon investors trading uncovered options. If the price of the underlying asset moves in the opposite direction than you expected, meeting your financial obligation might result in substantial loss to you.
But if you have to purchase some kind of an "insurance policy" for every option trade (i.e., buying a call in the opposite direction against the put you already own), it provides a layer of much-needed protection. However, buying protection can cut into your profitability.
Another Way to Hedge
Enter the S&P 500 (SPX) E-Mini futures. Here's an insider's tip on what the big boys do to cover their potential losses.
Since the middle of July, the Chicago Board Options Exchange (CBOE) put/call ratio has been plunging. It is now down at its lowest levels since March. March is when the S&P 500 moved up considerably.
The CBOE equity put/call ratio demonstrates the trading volume of put options vs. call options. When the put/call ratio is low, market sentiment is very bullish. Because the market has been flying back up, larger investors have been capitalizing on the run by purchasing SPX call options.
However, on the remote chance that the market does pull back, these investors are placing SHORT STOP LIMIT orders on the S&P 500 E-Mini futures. The stop limit says, don't execute this trade unless the price falls so far that it hits the lowered limit price, at which time, execute my short trades.
Since the market has been steadily climbing, the short limit orders have not been getting executed, so it hasn't cost the big boys anything to buy call options. By placing short stop limit orders on the S&P 500 E-Mini, if the value of their call options goes down due to bad economic influences, their short positions on the S&P 500 E-Mini will make their trading a wash.
While they won't make any money, at least they break even.
How do we know this is true?
Normally, Monday mornings tend to bring light trading in the S&P 500 E-Mini. After all, it is Monday. But on Aug. 17, 2009, by 8 a.m., more than 400,000 contracts had already been traded, and the S&P 500 E-Mini was down 22 points.
Why?
Japan's Nikkei Stock Index plunged 3.1% on poor economic earnings announcements, taking the Shanghai Composite (down 5.8%) and the Hang Seng (down 3.5%) with it. The CBOE Volatility Index (the VIX, also known as the "fear index," as it is used as a measure of trader sentiment) shot up 14.9% to 27.89.
Because the Asian markets fell so heavily, they triggered the S&P 500 E-Mini to be down 22 points. Those larger investors saw their short Stop Limit Orders get executed. It was the first time in a long time that Short Limit Orders were hit. And a lot of money was lost!
The bottom line? Anything can happen in the markets, and you must be prepared for it. Not every trade is going to be a winner, but with the right protection in place, you can walk away from the losers without losing everything.
I know that a lot of you use options in your portfolio but you haven't yet taken the plunge to integrate futures into your overall trading strategy. Today I have a way that you can use both to put your money to work while protecting your capital.
The Way the 'Big Guys' Trade
Trading E-Mini futures is not just for smaller investors. It is also used by larger investors to protect their trades. How does this work and, more importantly, how can you use E-Minis to protect your options positions?
If there were one word that could describe trading options, that word might be"insurance."
If you look at many of the option strategies, they are designed so that, in some way, you invest in both calls and puts to protect your investment. Trading just one side (either up or down) is considered risky.
When you short a call option, for example, but don't own the underlying instrument, the option is described as "naked" -- or "uncovered" by a long position to protect you if the position moves against you.
Why would you short (or "sell to open") a call or a put? Many investors do this because you receive a credit upfront. That is, you receive money at the outset of your trade, with the goal being that the option value decreases over time, allowing you to keep most (if not all) of the money you collected. This strategy depends on the underlying security moving in the "right" direction, or not moving at all.
But what if the position does not go your way? With stock options, you can typically exit your option trade at any time, so you don't have to be stuck in a position that's not working for you. But when the market, and the underlying stock, moves very quickly, it's important to have a safety net to "cover" your position.
Brokerages frown upon investors trading uncovered options. If the price of the underlying asset moves in the opposite direction than you expected, meeting your financial obligation might result in substantial loss to you.
But if you have to purchase some kind of an "insurance policy" for every option trade (i.e., buying a call in the opposite direction against the put you already own), it provides a layer of much-needed protection. However, buying protection can cut into your profitability.
Another Way to Hedge
Enter the S&P 500 (SPX) E-Mini futures. Here's an insider's tip on what the big boys do to cover their potential losses.
Since the middle of July, the Chicago Board Options Exchange (CBOE) put/call ratio has been plunging. It is now down at its lowest levels since March. March is when the S&P 500 moved up considerably.
The CBOE equity put/call ratio demonstrates the trading volume of put options vs. call options. When the put/call ratio is low, market sentiment is very bullish. Because the market has been flying back up, larger investors have been capitalizing on the run by purchasing SPX call options.
However, on the remote chance that the market does pull back, these investors are placing SHORT STOP LIMIT orders on the S&P 500 E-Mini futures. The stop limit says, don't execute this trade unless the price falls so far that it hits the lowered limit price, at which time, execute my short trades.
Since the market has been steadily climbing, the short limit orders have not been getting executed, so it hasn't cost the big boys anything to buy call options. By placing short stop limit orders on the S&P 500 E-Mini, if the value of their call options goes down due to bad economic influences, their short positions on the S&P 500 E-Mini will make their trading a wash.
While they won't make any money, at least they break even.
How do we know this is true?
Normally, Monday mornings tend to bring light trading in the S&P 500 E-Mini. After all, it is Monday. But on Aug. 17, 2009, by 8 a.m., more than 400,000 contracts had already been traded, and the S&P 500 E-Mini was down 22 points.
Why?
Japan's Nikkei Stock Index plunged 3.1% on poor economic earnings announcements, taking the Shanghai Composite (down 5.8%) and the Hang Seng (down 3.5%) with it. The CBOE Volatility Index (the VIX, also known as the "fear index," as it is used as a measure of trader sentiment) shot up 14.9% to 27.89.
Because the Asian markets fell so heavily, they triggered the S&P 500 E-Mini to be down 22 points. Those larger investors saw their short Stop Limit Orders get executed. It was the first time in a long time that Short Limit Orders were hit. And a lot of money was lost!
The bottom line? Anything can happen in the markets, and you must be prepared for it. Not every trade is going to be a winner, but with the right protection in place, you can walk away from the losers without losing everything.
Barbara Cohen
Contributing Editor
Contributing Editor
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