You have decided that the market is going to have a rally and you want to go long. (buy) We can either buy an option or buy a futures contract. But we don't want the expensive premium time erosion of the option or the risk of the futures contract. What to do?
We will have to do some homework and see how the options are currently priced. They may be cheap, average or expensive. The premium they command is dictated by the market's expectations of volatility and direction. A promising bull market will charge high premiums for calls. And conversely, a demoralized, beat-up market will often let you have the options cheaply.
Let's look at buying an option first. Automated option analysis software is how I find the best values. Lets say it costs $1000 for three months of time and its strike price is near the current market. If we hold it for three months and the market goes nowhere, our $1,000 is gone. Of course, we can sell it at any time beforehand for whatever the market will give, if we choose. If the market rallies, we participate in profits as far as it goes, with no limit.
So how do we protect ourselves against this $1,000 premium erosion if we are wrong in our forecast? We could sell a similar call option with a strike price ten full points higher and credit our account for $600. (a possible scenario) This will reduce our erosion risk to $400 of potential loss. Now if the market rallies, we will profit until the market moves up ten points. (to the strike price of the second option) After that, there is no more gain. In essence, we have exchanged the unlimited upside potential of a single option for a limited upside... plus the advantage of losing only $400 instead of $1,000 if we are wrong. That's a reasonable compromise to smooth out our equity curve.
The option selections are best done with an automated software program designed to evaluate option premiums and strategies. The program will show the best option candidates. You will see profit and loss projection curves and information to choose the best options. You may find the options are not priced favorably for your use and opt to use a futures contract instead. More on this later.
A more aggressive option strategy would be to sell TWO call options against the first and take in $1200. This would leave a credit (profit) in the account of $200 in case the trade went sideways or declined. In other words, if you are wrong, you would still make $200 if the options expired anywhere below the strike price of the second two options you sold. The negative feature is if the market goes higher than the second two option strikes, you would begin giving profit back until you either liquidated one or took a loss.
If you are a new trader, this strategy may sound complicated, but it's really an easy idea to understand once explained to you a few times. The bottom line is there is a way to insulate yourself from the tremendous erosion of buying options while still being able to participate in a portion of the upside move. Next we talk about protecting ourselves against adverse moves while holding futures contracts.
Part Three of Three Parts - Next!
There is substantial risk of loss trading futures and options and may not be suitable for all types of investors. Only risk capital should be used.