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Chapter 6. Eight winning option trading ... > Use options to hedge a profitable fu...

8. Use options to hedge a profitable futures position

If you are a trend-following trader, like I am, and you are lucky enough to catch a major move that is showing massive unrealized profits, the great dilemma is when to cash in. You know you inevitably will have to give up a large portion of your paper gains if you wait for confirmation of a trend change. Yet, top and bottom picking are very hard things to do. There is only one top, and there is only one bottom in major moves of importance, which could develop over hundreds of trading sessions. Many times, the most important leg of a major move takes place in the past 48 hours. Why not use put options to lock in bull-move profits and calls for the bear-move profits? Commercial hedgers use options all the time. Trading is a business, and options are a prime tool as an individual trader to hedge your profit while still allowing for additional profits. For example, you own soybeans in a major drought. You're in at $7 and the market is now $9. There is no rain in the forecast, it's mid-July, and with another two weeks of this, the old rallying call of “beans in the teens” will become a reality. Options aren't cheap, but this is a situation in which I would buy premium anyway. The $9 August puts are running 40¢. Buy them. This is a no lose situation. It's cheap insurance at 40¢, yet you assure yourself a $1.60 profit per contract, $8,000 per contract, and that's not bad. In addition, this is insurance you hope you never need to use. Let the good times roll if the forecasts prove correct! They're not always correct, as I've found out. During the drought of 1988, no weather service that I know of called the end. It was a long holiday weekend, and when we went home on Friday, it was more than 100 degrees with “no chance of meaningful precipitation for at least two weeks.” Soybeans were approaching $11 with “beans in the teens” a virtual certainty. It remained hot and dry Saturday and Sunday with not a cloud in the sky. Then, seemingly out of nowhere on Monday afternoon, with the markets closed, the skies opened. It poured rain over a wide area, and we were greeted with a multiple limit down situation beginning with our return Tuesday at the open. If I had only used puts to lock in the significant paper profits, and it turned out to be a mistake, it would have been the kind of mistake we like to make. On the other hand, buying options to lock in profits on futures is the best way I know of to avoid premature “profit-taking-itis.” This affects us all at one time of another.

These options are wonderful tools. They're not a panacea, but to an extent, the options can offer you the best of both worlds. Constantly be on the alert for ways to use them to your benefit!


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