There are two kinds of participants in the futures markets; hedgers and speculators. While hedgers and speculators purchase futures contracts for slightly different reasons, both groups are attempting to maximize profits and limit losses. The best way to achieve these goals is to buy options as a hedge against potential futures contract losses.
Note the size of your futures position and buy a corresponding number of options. For example, if you have a position size of five futures contracts, purchase five corresponding options to completely hedge your position. Also, make sure the expiration month of the options you purchase matches the expiration date of the futures contracts you own.
Select a strike price that fits your accepted level of risk tolerance. When you purchase an option, you must specify a strike price. The closer the strike price is to the current futures price, the more expensive the option. An option with a strike price that’s further away from the futures price costs less, but provides less protection against an adverse price move.
Buy a put option to hedge if you are long the futures contract. A put option gives you the right to go short the underlying futures market at the option’s strike price. You will be able to offset your position at the put option’s strike price if the futures price moves against you.
Buy a call option to hedge if you are short the futures contract. The call option gives you the option to go long the underlying futures contract, so it provides a hedge for a short futures position.
Adam Parker is a writer from Virginia. He holds a Bachelor of Science from James Madison University. Parker has written articles for online sources including The Motley Fool, Gameworld Network and Glossy News.