Option Insurance Long (O.I.L.)
Explained
What is an ‘Option Insurance Position’? A lot of traders will look this strategy and say, "Oh, that is a covered futures position" or "Hey, you are just using an option as your stop instead of a stop loss order". Well, they are both right and they are both wrong.
They are right that you use an option to control losses instead of a stop loss order to control losses. Where they are wrong is the timing. Most traders will add the futures and the option at the same time. Your risk can be rather large in this type of strategy, as an at-the-money option can be very expensive. It also doesn’t guarantee you profit, just losses no worse than the cost or premium of the option and the difference between the strike price and your futures entry price. When evaluated in that fashion, the risk reward ratio can take a real beating as the large chip on the table will then require an inordinate sized move in your favor to justify the risk.
Keep in mind that a majority of trades lose and a majority of traders lose. BUT, many traders are correct in their prediction of ultimate market direction, they just can't sustain the drawdown involved in most futures trades. So instead of a futures, they get an option and then hang on to the option for too long or they get antsy as soon as they have a couple hundred dollars profit and exit before the market reverses on them. They then watch as the market takes off and they are left watching from the gallery. This roller coaster ride of human emotions may be why new traders do so well paper trading, but when they use real funds they end up losing money.
So the question is "How do you establish a position that will enable you to stay in a market for an extended period of time, but not worry about escalating losses on your futures position?" The Option Caddie suggests using what is called an "Option Insurance Long" position, also known as an O.I.L. (the opposite is an Option Insurance Short or O.I.S.). This strategy consists of an option and a futures contract, but they are NOT added at the same time.
How do you enter the O.I.L. strategy? Like trying to find your golf ball in the rough, it takes a little searching. Find a market that has a potential bottom showing up after a sizeable drop over the past few weeks or months. Another favorite is a market that shows a great potential for a ‘Mother Nature’ event like a freeze, a flood or a drought. Base this ‘potential’ bottom pattern on seasonal tendencies, oversold indicators or whatever method you feel comfortable with. You don’t need to get in at the bottom of the sell-off as you would with a straight futures trade, you just want to know where the bottom is to calculate a 50% retracement target of where the next move is likely to go to. 50% retracements are one of the most common chart events that occur. Look at any chart and you are likely to spot several moves that are then retraced 50%.
Take a look at the March ’02 Wheat chart as an example. After selling off rapidly from a mid-summer rally this market bottomed out in October (actually a double bottom with the September low) after a 47-cent sell off. An exact 50% retracement up of that rapid fall targeted 296 ˝ as the goal. In late October this market hit 303, an almost dead-on 50% retracement! At any time over the next 4 sessions you could have purchased a March ’02 Wheat 290 Put for 10-cents ($500). The normal expectations would for the market to then retrace 50% back down, of the original 50% retracement up. That means a return lower of 15-cents after the original 30-cent rally up. That places the next target @288.
So after spotting the original 50% retracement and adding the March ’02 Wheat 290 Put, our goal was to add a futures position below the strike price of the Put that was just purchased. Well, on December 7th that is exactly what occurred as the March ’02 Wheat contract completed a fall from 303 down to 277. At the same time the March ’02 Wheat 290 put got as high as 17 ˝, not even double the original investment. This move lower was just over a 50% retracement of the original retracement up. At that point the Put was in-the-money an amount more than equal to the amount spent to originally to buy it. You could have added a Long March ’02 Wheat futures @280 or lower on 3 of the next 6 sessions. By adding @280, we lock in a 10-cent profit which covers the original cost of our March ’02 Wheat 290 Put.
To recap, once your option is at-the-money, a Long futures position can be added and you cannot have any losses on the futures position. Your only risk is the premium on the option. If you are able to add the futures position lower than the strike price in an amount equal to the points you spent to acquire the option, you cannot have any losses on the futures or on the option! You can now hold the futures position with no losses for as long as the option has time value. You can wait out fake breaks, rapid reversals or anything else that occurs. You are no longer a slave to the screen, but can take a wider view of the market and the long-term direction it is headed.
How can this position have no losses? The Put is a contract that states the holder (buyer) of the Put has the option but not the obligation (that means it is their choice) to sell March ’02 Wheat @290. If March ’02 Wheat is selling for MORE than 290 you wouldn't want to sell for less, would you? You simply have profits on your futures position and smile as your option expires worthless. It did its job of keeping you in the market through any ups and downs. Of course, before the futures position is established you have a risk, the original premium paid for the option. Quite a bit different than the risk involved in most futures trades when you start out. In a way you are ‘fading’ yourself by buying a Put in a market you want to go up. You do want it to eventually go up (after you add the Long futures), but first want to see that healthy, cleansing pullback after you add the Put. Additionally, by adding the Put first, you are also going in the direction of a market that has been trending down, which means you are trading in the direction of the long-term trend. If the 50% bounce up was just a hiccup, you now have a put in a market that has been trending down for weeks or even months!
Something else to be aware of is what happens as the market drops AFTER you have established both the options and the futures? What if the market keeps going down? What if Wheat returns to the contract lows below 270? That would have a loss of 10 cents on the futures, which is $500. We aren't concerned about how low the market goes because of our guarantee, but we do need to have cash available. Futures are cash adjusted EVERY day based on the market for that day. If Wheat drops 10 cents, $500 is debited from the account. If Wheat rises 10 cents, $500 is credited to the account. We know we eventually get all funds back, but do need cash in the account. The option gains or loses VALUE, not cash. Think of the futures as a DEBIT card and the option as a CHARGE card. One affects your bank balance immediately (debit card) and the other isn't affected until the bill arrives in the mail (credit card) and you pay it off (you exit the option).
The reason for using an O.I.L. strategy is mainly from wanting to utilize a conservative trading posture. Most traders see a straight futures position as the most aggressive trade and buying a call or put as a very conservative trade. The O.I.L. and O.I.S. strategies allow you to do a trade with the aggressive reward side that futures offer, but the conservative risk side offered in options trading.
Sounds like the best of both worlds. Having an option as protection for a futures position allows you to have the absolute risk defined. Once both the option and futures are acquired, you can relax and not concern yourself with day to day fluctuations in that particular market. You can direct your attention to the overall long-term trend reflected on the Weekly and Monthly charts.
Of course, I could simply go Long (or Short) and not use a stop. Sometimes called ‘Deep Pockets’ trading, this requires a good deal of capital to withstand significant draw down in funds before the market might turn back in your favor. Deep pocket trading is not always a good idea for speculators with small accounts or for new traders.
You could also simply purchase a Call (or Put) and wait out the market. A very common trading strategy but the rewards are less than in a futures position. In addition, at-the-money options are expensive and are a big drain on potential profit.
Any of the above strategies will work if your timing is correct and you have successfully chosen the contract bottom or a good pullback to enter on. But how often do you do that? Most traders that buy an option see gains at one time or another. In fact, seeing an option you purchase double in value isn’t all that unusual. Traders generally aren’t looking for their options to double in value so they can exit. That simple type of 2:1 risk reward ratio will likely doom you to losing all of your money.
REMEMBER.........you don't have to be exact on your entry point in spotting a bottom. We can have false 1,2,3's multiple #1 points, break moving averages, break double bottoms and any other market timing indicator that traders use (and lose with) that tell us that this is the bottom. IT DOESN'T MATTER. Remember we get a selling price of 290 because we own the March 290 Put. This is our original risk. We don't need a stop because of the 290 Put and no margin is held because of the 290 Put. Once entered, you can continue to hold the position regardless of how low the market goes.
We don't need to pick the EXACT bottom, just NEAR the bottom.
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