When making the transition from a pure speculator to trading the market like a speculator, a set of ground rules must be put in place. The first ground rule is the decision to choose a trend. No matter what time frame you buy and sell in, there is an overall trend that the market is moving in. In fact, as of this writing gold, oil, and the euro had all been on a bullish trend for over four years. During that time there have been pullbacks in the market-counter-trends. Once the market reached certain plateaus the trend would resume. Therefore a conscious decision must be made to actively trade either the trend or the counter-trend.
The best choice is to actively trade the counter-trends; then an option can be purchased as a hedge on the trend. With this trading combination, you operate just like a true hedger. There are two ways to look at this trade. The first way is that you are protecting your counter-trend trades by using an option as a hedge. The second way you can look at it, which is more in tune with why the markets were developed, is that your option trade is following the trend, generating income gradually, and you are protecting that asset, almost like a true hedger's cash position, every time you are actively trading the counter-trend. No matter how you look at it, you are getting the best of both worlds, trend and counter-trend, yet as an active trader you are reducing your commission by almost 50 percent.
The average active trader is constantly buying and selling in and out of the market, attempting to catch a few ticks from a stock index, or a few pips from currencies, or a few cents from stocks-all of them attempting to outperform the market. By using an option as a hedge to follow the trend, there is no need to flip-flop between being either long or short. You are successfully placed in both positions simultaneously. Using options as a hedge is completely separate and distinct from two other option strategies-option-spot or option-futures strategies.
Benefits
The options hedge strategy has many great benefits for the active trader; commissions can be reduced, strict trade management strategies can be followed, and trading systems can be properly tested for their viability.
Being able to reduce commissions can justify the risk management strategy alone. Active traders are constantly in and out of the market. If they are actively trading the S&P 500 or some other stock index, racking up several hundred to several thousand trades per month is not unheard-of. There is constant buying and selling pressure, with the ultimate goal of making a fixed daily amount; $500 to $1,000 per day is the typical target.
Reality smashes into any ideal goals that active traders have once they see how much they lose on the losing trades and the amount they rack up in fees and commissions. Regardless of how much or how little they pay in commissions, they can easily find themselves generating twice as much cash activity, in losses and commissions, as they take home as profits. Using an option to follow the trend requires only one commission, and the only loss involved is the erosion of premium. This saves active traders 50 percent of the commissions that they would have usually paid, along with cutting in half their potential for losses in their active trading.
Not all active traders attempt to buy and sell back-to-back. There are some traders who focus on momentum trading only, so on any given day they are only long a market or short a market. While they may not get a reduction in commissions, they will benefit from having the option playing cleanup if the momentum of the day is not in sync with the overall trend of the market.
Another key benefit is the ability to refine entry and exit signals. When the entry is limited to a specific type of situation, in this case counter-trends, trading entry signals can be honed. Whether these signals work or not will quickly become apparent without the trader needing to be wholly committed. This also allows for easier journaling of specific trading strategies.
If all of these benefits aren't enough, futures traders also have the ability to reduce their margins. Whenever they combine options to diminish their risk, regardless of how they do it, margins are reduced at the commission merchant level.
Pitfalls
Picking the right option is the largest pitfall when implementing this option hedge strategy. Years ago a British television game show, The Weakest Link, was imported to the United States. Losing contestants were told, "You are the weakest link!" Every time the option as a hedge strategy is proposed, those words ring in my head. The strategy is sound in both theory and practice, but the strike price of the option is essential to its success. That may mean that the average active trader may not be able to afford to use this strategy if the option is expensive or if the option exceeds the price of the underlying asset by too much.
For those active traders who focus on the Emini markets, their commissions and day trading margins can be exceptionally reasonable. As long as a trader is willing to not hold a position overnight, the margin for the Emini S&P can be as low as $250 per contract. The standard Emini S&P contract margin typically runs over $4,000, depending on volatility, when a contract is carried overnight. The day trading margin and overnight margin are tremendously different. This difference allows traders with as little as $2,000 in their accounts to trade the Emini S&P. This has to be taken into account when suggesting to active traders to use options as a hedge for their trading.
There are only two types of options that can be purchased to hedge a position, an in-the-money option and an at-the-money option. Either of these options can follow the trend effectively while the active trader executes counter-trend trades. The primary drawback is expense.
Finally, no matter whether the trader purchases an option for the front month or for a further-out month, he must balance the expense of the option against what his day trading margins are and what the ultimate goal is in protecting himself.