Russell Rhoads TABB Group Followed! | Profile | More Share Many futures traders use stop orders to limit losses when the market is not moving as they hoped. However, there are times when an option on futures order offers a similar risk-reward scenario without some of the uncertainty that exists with stop orders. TABB Group head of derivatives research Russell Rhoads examines the use of options on oil futures contracts as an alternative to trading the underlying futures contracts. TABB Group recently published a report comparing a futures trade using a stop loss level with an option spread that has a defined risk and reward (“Futures with a Stop vs. Defined Outcomes with Options on Futures”). Futures traders often will take a position with the intent of exiting a trade if the price action does not match up with their forecast. Either a stop order is placed, or a price alert is set to let the trader know a trade is not going his way. The most common stop order consists of a trade that is trigger when a certain price is hit. The futures trading example used in our recent report involves selling short a June Crude Oil (CL) contract at 60.00 and either placing a stop loss order or alert to exit the trade when CL hits 62.00, which would be a loss of 2.00, combined with a limit order to cover the short at 57.00, which would result in a profit of 3.00. There are weekly option expirations on many markets, and this is true for options on CL futures as well. This example uses pricing from March 27; there are options available that expire in 12 trading days, on April 12. The specific trade that offers a similar potential outcome to the above futures trade with a stop loss order involves buying the CL Apr 12 62 Put for 2.60 and selling the CL Apr 12 57 Put for 0.45, for a net cost of 2.15. The common term for this trade is a bear put spread; the payout, if held to expiration, appears below: Exhibit 1: Short CL Future at 60.00 versus CL 57 / 62 Bear Put Spread Payoff Source: TABB Group Calculations The payoff for the bear put spread is closely aligned with the short CL futures position between the 57.00 and 62.00 price points. The trade loss is capped at 2.15, which was the cost of this spread. This result would occur if the trade were held through expiration and the CL futures contract price were at 62.00 or higher. The maximum potential gain is 2.85, which occurs at expiration if the CL futures price is at 57.00 or lower. In this case the 62.00 put is worth 5.00 more than the 57.00 strike put. The profit of 2.85 is the result of paying 2.15 for a spread that is now worth 5.00. Both the maximum loss and gain only would be achieved if the trade is held to expiration. To learn more about the use of options on oil futures contracts as an alternative to trading the underlying futures contracts, Futures with a Stop vs. Defined Outcomes with Options on Futures,” by Russell Rhoads.