That was my original plan, but I was convinced otherwise. I'm not exactly sure of the pros and cons of each, or how to fine-tune the strategy.
Bottom line: With naked long in options, you cannot be wrong and you have to be lucky in order to win. With underlying + protection OTM options, you can be wrong and not lucky and you can still win. Let me explain: With naked long in options, you have to be not correct of the move but you have to be REALLY sure of the move and the move is going to be a big one in a relatively short time basically before the option expires, then it's worth it to save some cost upfront by investing in options because both the price move, delta and the volatility, IV is going to be larger than the time decay and you end up with higher profit but this is only when the price move is in your favour AND it's big, at least big enough to cover the option cost before the option expires. If either one falls short, then you will end up with the loss. So you basically need THREE things to be in your favour to win with naked long options, price move, magnitude of the move and dte. Whereas with underlying + protective OTM options, as long as the price move is in your favour, you will make money because with the underlying delta being 1, it will always net you at least some profit even with the time decay because the hedging OTM option price will always be lower due to its delta being < 1 given the same volatility and when the volatility goes higher either with the price move going in your favour or not, it will actually play in your favour. If the volatility becomes larger when the price move is in your favour, then you will just net more of the profit with the protective options fast becoming worthless which you won't care at that moment, when the price move is not in the underlying's favour, the rising volatility will make the hedging option price rise faster to protect you against the losses on the underlying but what you need to remember is you need to close the underlying AND the hedging option at the same time when the hedging option price is increasing BEFORE the time decay sets in. That's the key. You have to cash in and lock in the losses when it's minimal or even reversed while the hedging option still has value. Do NOT wait!! The biggest mistake that traders make is wait thinking the price can reverse back. Don't ever think of the possibility of the "V-shape" curve that the price will come back up if you are long or the "reverse V-shape" curve that the price will go back down if you are short because you never know how much the price will reverse back. It may reverse back completely and go back to the direction of the original trade/investment or it may not and just taper off so you are still stuck with the losses on the underlying but the hedging option price is fast declining and expiring worthlessly because time decay has come back with a vengeance so you are stuck with double the loss, the loss on the underlying and on the hedging option. That's the worst predicament that a trader can be in and lose most of the money. Been there and done that many times and it's NOT fun. You need to think of protective OTM options as insurance policies with an adaptive expiration date. As soon as it thinks you don't need it anymore, it expires so you need to cash in when you need it the most. Don't wait!! The bottom line is saving your trade/investment NOW!!! If the price reverses back, that's for another trade another time. DON'T wait until the time decay sets in!! As long as you keep this in mind when you trade in the underlying with protective OTM options, you will be fine.
I have two questions... 1. In order to better avoid time decay, should I pick contracts with expiration >30dte? (I had previously been advised to pick 30dte contracts.) Should I plan on selling both the underlying and the option well before expiration? 2. Let's say my underlying is ESH22 (S&P e-mini future with March expiry). What would the appropriate protective option be? The futures contract expires on 3/18/22, so I will go to the 3/18/22 options chain and purchase a put.... But how far OTM do I go? Currently, the closest option to ATM is 4780. How low should I go with the protective option?
Perhaps nothing. I was going to ask that as Question #3, but I thought 90dte was far enough. I could definitely be wrong. I perhaps thought that since it was so far out, that the moves in current price wouldn't affect it as much. Do you use 180dte?
Also, how do I size the two to be in proportion? If the underlying were a stock, I believe I would buy 100 shares to every 1 option. But I can't figure out how to make the two equivalent with a futures contract.
1. From my personal experience, it's best to choose the option with the closest expiration. It's most sensitive to underlying's price move when s*** hits the fan and is the cheapest. Time decay will set in no matter what but what's more important is how much the price can move to offset the loss from the underlying. When the s*** hits the fan, like I said, I would close both the underlying and the option. If you really feel lucky you can close one before the other but you run the risk of either the underlying deteriorating further after the closing of the option if you closed the option first or the underlying bouncing back and you lose on the options if you closed the underlying first. Like I said before, it's best to minimize the loss on the current trade first and do a new trade another day. 2. How OTM you want for the protective option will depend on what your outlook of the market and how much you are willing to spend on the option. If you don't think the market will go down that much, you can go a little further out in terms of strikes to save some cost. If you feel the market is relatively weak, you might want to invest a little more in the option and choose a closer strike especially if you are able to buy it cheap. That you will have to experiment a bit and find your own comfort zone in terms of which option to choose to pair up with your underlying.
Just to make everything easy, I like to do 1:1 for the underlying vs. the option so if the option is based on an underlying that's not exactly the same as the underlying, I would buy it size it in proportion to the underlying, e.g. if the option is based on an underlying that's only 1/10 of the underlying that you are trading, I would buy 10X of the option and etc. For futures, if the option is on the same underlying that you are trading, its size should be matching that of the unit of the underlying.