The Synthetic Futures Position Goal To try to profit from a trending market using an option strategy that allows entry at a reduced cost while offering the same potential for unlimited profit (and loss) found when trading with futures contracts. Summary Though its name suggests otherwise, the Synthetic Futures Position is an option strategy that can be used in both bullish and bearish markets. In an advancing market, the bullish strategy involves buying a call option and simultaneously selling a put option in the same contract month. In a declining market, the bearish strategy involves buying a put option and simultaneously selling a call option in the same contract month. This strategy establishes a Synthetic Futures Position a position based on options only, that has the potential for both unlimited profit and unlimited loss just like an ordinary futures position. The purpose for following this strategy is that the premium collected for the option sold can offset some or all of the cost of the option purchased. How to Set Up a Synthetic Futures Position Copyright US Chart Company Page 1
Step-By-Step Instructions We will provide instructions for establishing a bullish Synthetic Futures Position. An easy adjustment in the direction of each action makes these instructions appropriate for setting up a bearish Synthetic Futures Position. 1. Find a chart pattern that is taught in the Greatest Business on Earth Course, such as a pennant, a channel, or another GBE formation. For example, here s a channel formation that shaped up in the August 2008 Soybeans market. Note: To ensure you're seeing as much historical price data on the chart as you need, scroll below the chart, select the "1024 x 768 (large)" option, and click the "Resize This Chart" button 2. Once you ve discovered the chart pattern, filter the setup by confirming the direction of the trend with Trend Seeker. In this instance, since our example is based on using a bullish strategy, we anticipate the market will be moving higher out of a bullish chart pattern and so we want Trend Seeker to confirm our desired trend by listing a Trend Rating of up. Copyright US Chart Company Page 2
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Note that this snap shot of the Trend Seeker historical page shows the July contract. This is because it was the front month contract at that time. However, on this same day the August contract also changed to the first day of an uptrend. Always use the individual Trend Seeker Trend Rating table located below each online chart to make sure the trend of the contract month you re trading is in the right direction. In a declining market showing a bearish chart pattern, we would want Trend Seeker to confirm the trend by showing a Trend Rating of down. 3. Use the breakout of the chart pattern as your signal to enter the market by setting up a Synthetic Futures Position as follows: Buy a call option and simultaneously sell a put option in the same contract month. To help you select the call option you buy, consider using the Rule of 3 s found in the GBE ToolBox at http://www.gbemembers.com. Ideally, you should buy an option that is closer-to-the-money, but this is up to you and your budget. For the put option you sell, select a strike price that is below a support level located far enough out-of-themoney that it is unlikely to be surpassed by a movement in the underlying futures market. It is best to initiate the Synthetic Futures Position with options that have 60 days or more remaining before expiration. The expectation is that the call option will appreciate and the put option will depreciate as futures prices continue to move higher. Your purpose for selling the put option is to use the premium collected to offset as much of the call option s purchase price as possible. If all goes as planned, the put option you sold will expire worthless, allowing you to keep the entire premium collected, with no further responsibility; meanwhile the call option you purchased will increase in value, providing a nice potential for unlimited profit with very little, or no initial outlay. With a proper setup, you may be able to pay for the call option s entire premium with the proceeds from the sale of the put option; it s even possible to collect a net gain if the put option s premium is more than the call option s premium. For example, if you pay $500 for the call option and receive $700 for the put option, your net gain is $200 (less exchange fees and brokerage commissions)! In a setup like this, even if both options expire worthless, you will still make $200 on the trade. 4. Enter the trade into Trade Tracker so you can follow its progress. Copyright US Chart Company Page 4
Possible Exit Strategies In a Market Moving in Our Favor In a bullish Synthetic Futures Position, the higher futures prices go, the greater the profit we make on the call option we purchased. Our profit potential is unlimited. At the same time, our position on the put option we sold becomes less and less risky, as prices are less likely to turn around and reach a strike price that is getting farther and farther out-of-the-money. Of course, markets can turn against us when we least expect them to, and even in a market moving in our favor, option value will eventually decay with time. So, as with any trade, having an exit strategy in mind when entering the trade is necessary for a workable plan. A good exit strategy with a winning Synthetic Futures Position is to set a target using points of support and resistance as they naturally develop and/or a break in the trend line on the daily chart we re trading. When our predetermined target is hit, we liquidate our profitable option. As the futures market moves in the direction we anticipated, we might consider buying back (liquidating) the option we sold while its premium has deteriorated. This may eat into our profit a bit, but doing so will eliminate our risk of unlimited loss potential should the market later move against us before the option expires. If we don t liquidate the option, and the market continues to move in our favor, the put option will simply expire worthless, and we get to keep all of the premium we collected. Note: Selecting exit points is a highly individual process. Traders may use daily, weekly, or monthly charts to find exit points, and they may read their charts differently. The best way to determine the approach you prefer is to paper trade as many setups as possible. Copyright US Chart Company Page 5
In a Market Moving Against Us A Synthetic Futures Position offers the unlimited profit potential of an actual futures position, but it also offers the potential for unlimited loss. There is no guarantee that the market will move as we hoped so that the option we sold will expire worthless. With a bullish Synthetic Futures Position, if the futures market moves lower, the call option we bought will depreciate in value and the put option we sold will appreciate. We could ultimately end up liquidating (buying back) our put option at a higher premium than we received and liquidating the call option for less than we paid for it. In fact, our potential loss on the put option, as with any sold option, is unlimited. For this reason, it is critical to embark on this kind of trade with a protective mental stop loss firmly in place. Here are three different approaches to setting a mental stop loss when trading a Synthetic Futures Position: a) Determine a specific amount of money that you are willing to risk on the trade, and set your mental stop loss based on that dollar amount. For example, if you re willing to risk $500 on the option you sold, determine the appropriate premium at which you would exit the trade. If the market moves against you and the put option s premium appreciates by $500 or more, you would liquidate it (i.e., buy it back) at the price you predetermined. b) The second stop method to help control your risk is to simply liquidate the short option (the one you wrote) if it ever becomes an at-the-money or in-the-money option. c) For the third method, once you enter a Synthetic Futures Position, choose a chartbased price level below the current futures price at which you will liquidate the put option. Ideally, this price will be at a support level on the price chart. Be careful not to pick a support level that is too far away from current prices. The lower futures prices go, the more the put option you sold will appreciate in value, and you don t want the premium of the put option you re buying back to be overly expensive. (For a bearish Synthetic Futures Position you would choose a point of resistance above the futures price at which you would liquidate the call option you sold.) Be aware that this third method requires a bit more analysis and closer monitoring of the underlying futures market, which a good full-service broker can help you perform. As mentioned above, in a Synthetic Futures Position, it s best to sell an option that is far enough out-of-the-money to place it beyond the price range you believe the market is likely to reach. This way, even if the market goes against you, you ll be better positioned to avoid a loss. And as long as the futures price stays within your forecasted range, the premium you collect on the option you sell will cover all or part of the premium of the option you buy. Copyright US Chart Company Page 6
Sample Trade On June 5, 2008, August 2008 Soybeans broke out of its sideways channel to the upside. Since Trend Seeker confirmed the trend was up, a paper trade to the upside was triggered. On the day of the breakout, prices surged and the underlying futures contract closed at 1454-2. The top of the channel was 1400, so futures closed well above our desired entry point. Since we don t like to chase markets, we waited to see if prices would pull back toward the top of the channel to give us a better entry price. This occurred on June 10, providing a possible entry on that day. (See Daily chart of August Soybeans above.) Further examination revealed that this was a very expensive market to trade. Trading a fullsized futures contract required putting up $4,725 in margin. Options in this market were also expensive. Looking at the 1540 strike call option because it fell right in line with the contract high (our potential target), we found that this call option cost $3,368.75. For many traders the sheer cost to enter this market would have put this trading opportunity out of reach, and they would have had to pass on the setup. However, a Synthetic Futures position could have been initiated that would have made the opportunity much more affordable. Here s how: We could have bought the August 1540 call option for $3,368.75, and at the same time sold (wrote) the August 1300 put for $1,875. We chose this strike price because it was just below support found on the August futures chart. Copyright US Chart Company Page 7
Our cost to get into this market would have been the difference between the amount paid for the call option and the amount received from the sale of the put option: $3,368.75 - $1,875 = $1,493.75 (plus fees and commissions). So, for around $1,500 we would have been able to secure our opportunity in this market. However, we still faced the prospect of unlimited risk. To help control our risk, we might have used method c to set a mental stop on the August chart below support at 1360. Copyright US Chart Company Page 8
As you can see by the price action on the daily chart after our entry, this market rallied toward our profit target, the contract high, and hit it on June 13. This was the day we would liquidate our Synthetic Futures Position. We could have liquidated the call option for $6,150 and liquidated (bought back) the put option for $1,000, for a difference of $5,150 ($6,150 - $1,000 = $5,150). Subtracting our cost to enter the trade from the total amount received, we arrive at our net profit: $5,150 - $1,493.75 = $3,656.25 (net profit before subtracting fees and commissions) a return of more than 240% in just four days! Copyright US Chart Company Page 9
In this example, the Synthetic Futures position would have allowed a trader to participate in this market at a reduced cost and still have unlimited profit potential (as well as unlimited loss potential). Using a good full service broker is paramount to executing this strategy, which requires careful attention and timing, as well as assistance in entering and liquidating with good fills, whether you are in a profitable or a losing position. Possible Advantages of This Strategy The benefits of trading a Synthetic Futures Position are as follows: 1. Using this strategy provides us with unlimited profit potential. 2. We can enter a position with less initial outlay. This opens markets to us that would have otherwise been far too expensive to trade. Possible Drawbacks 1. The primary drawback of this approach is that just as with a futures position, we face the potential for unlimited loss. Therefore it is necessary to put a mental stop in place and watch the market carefully. 2. A loss on a bullish position will occur if the market drops suddenly. A loss on a bearish position will occur if the market suddenly moves higher. Practice paper trading this strategy until you feel comfortable with it. Remember, there is unlimited risk with this strategy so be sure that you are 100% comfortable with the steps Copyright US Chart Company Page 10
involved to implement it. Only then should you consider using this strategy and, of course, you should only trade with risk capital money you can afford to lose. Notice: Being a successful PAPER TRADER during one time period does not mean that you will make money when you actually invest during a later time period. Market conditions constantly change. When granting options, you may lose more than the funds you invested. Option spread strategies do not necessarily limit your risk of loss. Simulated performance results have certain inherent limitations and do not represent actual trading. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. This brief statement cannot disclose all the risks and other significant aspects of the commodity markets. You should carefully study commodity trading and consider whether such trading is suitable for you in light of your circumstances and financial resources before you trade. WARNING: FUTURES AND OPTIONS trading involves high risks and YOU can LOSE a lot of money. Copyright US Chart Company Page 11