Although options are complex financial instruments, traders who are new to options can use them for a very simple, yet effective strategy: short term protection for spot positions. The first thing you must have is a platform that trades both spot and options in the same account.
Using Long Options as Protection
Consider the following six-month (180-day) spot price chart for the cross rate:
We can see that the spot price fell to around 0.99 about 160 days ago, rallied to slightly more than 1.08 at 120 days, and then retreated to the same 0.99 level about 50 days ago. Let’s assume that we bought the spot market at 1.00 after it bounced off of that support level of 0.99. Since then we saw profits up to 1.05, but then gave much of that back as the market retreated to 1.01.
Let’s also assume that there is currently affecting this market some other source of uncertainty. It might be a geopolitical problem, a potential natural disaster, an election, or something similar. Long-term we may still be bullish XYZ (bearish the USD), but short-term we may have some concerns for a price drop.
A reasonable strategy here might be to put in a GTC (‘good ‘til cancelled’) stop-loss order at either 1.00 (our breakeven) or at some level slightly below 0.99 (violated support). That would certainly limit our losses, but it would also take us out of the market entirely.
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Alternatively, we can buy a put option with a strike price of 1.00 or 0.99 (or another price that we might choose). This will give us the right to sell our spot position at the strike price on the expiration date of the option. The following table lists the value of 1.00 put options for various expirations and spot prices (based on a 10% volatility and a current spot price of 1.01):
For example, if we bought a 30-day 1.00 put, it would cost us .0072 * 100,000 = $720. If, after 5 days (when it would be a 25-day option), the spot price fell to 1.00, that option would increase in value to 1.04 ($1,040). We would have seen a $1,000 loss in our spot position, but it would have been offset by a $320 ($1,040 – $720) gain in our option position, resulting in a net loss of only $640. As the market falls further, the option will become in-the-money, and it will provide more protection as its delta increases.
Because of put-call parity, a long spot position with a long put will gain and lose money in the short term at the same rate as a long call would with the same strike price and expiration.
It is important to note that for this strategy to be effective, we should not be too concerned about the consequences of the option on expiration day. That is because we are purchasing this put option for short-term protection and we should be out of this trade within 10 days or so. If a longer time frame is needed, then a longer-termed option is needed. Options with longer expirations will cost more in cash, but will also experience less time decay each day.