By: Chuck Hackett, Access Futures and Options & One of The PitMaster's Resident Pro's

DISCLAIMER: No representation is being made that any account will or is likely to achieve gains or losses similar to any implied or shown. Certain events must occur for this strategy to succeed. Purchasing options may result in the entire loss of premiums and commissions paid for such options. This article is a statement of opinion by the author whose experiences are subjective and may differ sharply with the realities you may encounter when trading futures or options.

Do you think trading is easy? Some say it's like playing chess and twister at the same time with an octopus who happens to be a lawyer. Others describe it as being blindfolded while chasing a greased pig through a forest at midnight. In any case, ignoring any possible advantage can be expensive. Using futures and options together, you can wield more leverage with less risk, improving your chances for survival and success. The One-Two-Three Combo Punch technique uses two options and one futures towards reducing risk and keeping your account alive.

Traders often divide themselves into two camps: those who only trade futures, and those who only trade options, or to be precise, those who only buy options. There are excellent reasons for sticking to one or the other.

The futures-only folks point out, correctly, that a large percentage of options expire worthless and that all things being equal, an option loses its component time value while a futures does not. They say that even if the market moves in favor of an option, it is never a one to one relationship as opposed to a futures trade. Margin is a deposit you get back if things go well, while paying for option premium is a sunk cost, plus commissions. Futures traders like to be able to say "I'm in" or "I'm out" and not fiddle around waiting for an option to do something. To them, options are a gray area they feel dulls their edge.

Options buyers argue you can't tell how much you're risking when you trade futures due to slippage and changing margin requirements, among other uncertainties. They point out that when a market moves unfavorably against an option, it won't lose value as quickly as a futures contract. Option traders claim that they can sustain their positions through market moves that would have stopped them out in the futures, sometimes several times.

This division can exist as easily in the mind of one person. Reviewing an account that carries both futures and options will usually show no connection between them. Futures are traded for the sake of futures, and options are treated as individual trades or spread against themselves. The two instruments pass each other like blind ships in a foggy night, rarely coming together to work as partners within an overall strategy.

Some say that it's too complex to make futures and options work together. I disagree. There are more moving parts in the trade than just doing an option or just doing a futures, but it isn't difficult. This brings me to an important point: There are many who pound home the gospel of keeping things simple, but they do so at the expense of remembering that there is no free lunch. In fact, I have often bought someone else's lunch in exchange for their advice (worthless) on how to keep things simple. After paying for this kind of advice several times, I've come to the conclusion that some things are simply not simple, but not very difficult either. Consider that a unicycle is simpler with one wheel than a bicycle with two, but much harder to ride. Or, to put it another way, spreading peanut butter on a slice of bread is easy, but making a sandwich with all the goodies requires a flittle extra effort and tastes far better.

Both sides could argue all day and be right, but the result is a large group of traders who never combine futures and options on purpose and never know how well this strategy can work. I'm going to focus on one style of combining futures and options, but remember that there are lots more worth investigating. I call it the One-Two-Three Combo Punch, because when it works it diminishes risk and expense. The only thing left standing is the chance to make money. Here's an example showing how to set it up using a market that is trending down (reverse everything for an uptrend). 

Step One: Find a market that looks like it simply cannot go any lower and has around four months left to trade. It should be so tempting that you can barely stop yourself from calling your broker and getting long or buying a call. 

Notes on Step One: This step might be considered by many to be vague. What I want to take advantage of here is the emotional power that traders, regardless of experience, often find themselves unable to resist when they see markets making new lows. This potent emotional force causes traders to see what they think are solid formations in support of going long, or purchasing call options when really, the formations are deadly mirages. Of course, these actions are contrary to the prevailing trend, and the rationalizations begin.

One of the most popular and sexy terms a trader can use to seduce himself into believing in his choice is to say "Well, I'm a contrarian trader, so is Warren Buffet, isn't he?" Being a contrarian, in my opinion, is something you should consider in the planning stages of a trade, not a label you slap on your forehead after you get in and are searching for excuses to stay in. Here is what I think really happens, and why the often self-applied-after-you-are-in contrarian label is not all contrarian. Webster's Dictionary defines the word contrarian: 

Main Entry: con·trar·i·an

Pronunciation: kon-'trer-E-n,

Function: noun

Date: 1657

Definition: a person who takes a contrary position or attitude; specifically: an investor who buys shares of stock when most others are selling and sells when others are buying (See also Warren Buffet). 

Here's how the logic comes together. If, according to generally accepted industry statistics, approximately eight out of ten traders lose money trading in the long run then, in a downtrend, eight people will be losing by being positioned against the trend, and two will be gaining by following the trend. If being a contrarian is doing the opposite of what the crowd is doing, then, you would NOT be a contrarian by being counter-trend. An amazingly important distinction. Let me reiterate, according to the generally accepted evidence, it is impossible to follow the crowd and follow the trend at the same time. To go against the crowd, go with the trend.

The idea that the crowd is not short in a downtrending market goes against what we think must be true, namely, that there must be more sellers than buyers for a market to go down, right? Not exactly. Of the ten traders, the two who are short can be short four contracts each, one to each of the eight traders who is long. If the traders who are short are right about the trend, they will add to their positions by going short again. The eight traders who think of themselves as contrarians will believe themselves to be even greater contrarians if they buy another contract while the market is going down against their first position. At the end of the day, we have the same number of real contrarians and fake ones, but the market has gone lower, with the trend. (This scenario is a simulation meant only to show that things may not be as they appear.)

Apparently, trying to figure out when a trend will change and going against the current one is part of human nature. Trading this way has been going on for hundreds of years, and shows no sign of stopping for the next several hundred years.

However, I don't want to make it appear easy to follow the trend, you can get stopped out and make a loss even if you are trading with the trend, but if you spend your energy looking to participate in existing trends rather than entering trades against trends you think will soon turn, you should be able to increase the odds in your favor.

The strange result is that it's much harder (and much lonelier) to go with the trend, than to go against it. It's no wonder that many gurus and books about trading tell you to eliminate, to the greatest degree possible, and with extreme prejudice, your emotions when trading. They say you need to be like a machine rather than a human being, because you obviously can't trust the way you feel and still expect to succeed. Because of this, many are attracted to "system trading" as a way out from under the weight and strain of being emotionally misled by what they see in the markets. Alas, the statistics for system traders are not much different, if at all, than for traders who don't use them.

Systems are blindsided by many things, but the most often cited reason for trading system failure is curve fitting. Curve fitting happens when a system designer, using historical price data, keeps tweaking the rules that make his system buy or sell until he can't improve the results. This is also called optimizing a system's parameters. The system will work beautifully for the data used to develop it, but will often stumble badly when used with current price data. Why? Because history doesn't repeat itself, and even though it often rhymes, systems are not designed to understand poetry. The so-called contrarian ingredients used in making most systems look good on paper, are the same ingredients that trouble non-system traders. The old saying is "garbage in, garbage out."

Misunderstanding the word "contrarian," and the concept it stands for, is often at the very root of what plagues most people when they try to apply their talents towards becoming successful traders. The solution to this problem is, in my opinion, to turn your emotions into a powerful tool by experiencing them as fully as possible. The more strongly you feel about about going long in a market, the greater the chance you will make money by doing the exact opposite and going short, or buying puts. By all means, even if you don't apply the combined futures and options strategy outlined here, do your best to trade with the trend. If you do, you won't find yourself in a crowd, but more and more alone, which is how they say things are at the top.

This means, really, that you have to learn to trick yourself into doing what's good for you. In my experience, it's possible to do this, even simple, but not painless. To repeat step one, find a market that is making multi-month or multi-year lows, feel how badly you want to go long or buy calls, and if you really think you're going to miss out if you don't, go short or buy puts. It should hurt. This kind of pain is not vague, it is sharp, pointed, and specific.

Step Two: Find the put options two or three strike prices below the current price of the market. Determine how much they cost and how many days they have before they expire. If they cost around $300 or less, and they have 60 days or more of time before they expire, buy a pair. (The closer the strike prices of the options you buy to the current market price, the better.)

Notes on Step Two: Here is where you get to hold your breath. The time between now and step three is when this trade experiences maximum risk, which is everything you've spent so far, including commissions. If the market completely stops going down, and goes up, don't be too surprised. After all, you were trying to pick the bottom, and you did. However, this is a rare occurrence. Since the market can go sideways, or retrace, it's often good to wait at least two weeks before selling back the puts and getting out of the trade completely. I suggest setting a mental stop to sell back the options at around one third of what you paid for them. No need to let them dribble away to nothing and drain your confidence to trade. But remember, trends are like that battery bunny, just when you think they're over, they keep going and going, and will often revive options that are aimed in the direction of the trend. Frequently, you will not proceed to step three. Instead you will either sell back the puts and take your gain that way, or exercise them if you have come to the belief (enlightened) that the market will continue even lower.

Step Three: By now, you will have the put options either at or very close to being in money. If it has taken a lot of time to get here, consider selling back the options. Otherwise, check to see how much time remains before first notice day in the futures. If there are at least thirty days remaining, the trade is still worth doing. Place an order to buy the futures contract at or below the strike price of the options.

Notes on Step Three: When filled, you will have one covered long futures position that will not require margin except in very rare cases, and the other put option. If this put gains enough value to cover the costs of buying both puts, plus all commissions, I recommend selling it back. Now, the money you spent in the beginning for both options, plus commissions, plus the commissions you spent to initiate the futures position, is back in your account, along with the covered long futures position.

If the market keeps going down, and stays down until the expiration of the options, your account will show a purchase and sale at the same price (if you are long from the strike price of the option). Should this happen, your account will be like it was before you did the trade, except for any commissions on closing out. That's the bad news. The good news is that if you were right about the market being at a bottom, you now have a long position ready to mop up the new uptrend. And it's not just any long position, it's special because it doesn't require margin, or a stop loss, which often knocks you out just before the best part of the trade. Another benefit is that you can now afford to have terrible timing. You may miss the actual bottom by weeks and still be there to see your ship come in, turning what might have been a loser into contender, or even a winner by knockout!

Of course, if the position develops gains, you can offset it, or let the market take it out with a standard following stop order.

Don't allow the market, with its many confusing twists, to command more respect from you than it deserves. Yes, it can feel like an octopus is beckoning you, with all its tentacles, to jump in and play against the trend now, or like you are pursuing a piglet in the dark only to wind up chasing your own tail, but by learning and applying your skills it ought not to feel that way forever. In this article, I've done my best to introduce you to two exclusive clubs you may wish to consider joining, as well as some ideas on how to join them: Those who trade with trends, and those who combine futures and options on purpose.

For working examples of this and other strategies, or to execute this approach in your own account, you are invited to call or email Carmen Lopez, or myself, Chuck Hackett, at Access Futures and Options (1-888-443-6140). Ask for our free starter kit!

Disclaimer and Disclosure of Risk Statement

You should understand that trading in the futures and or options markets is not for everyone. There is substantial risk of loss when trading futures and or options. Carefully evaluate whether trading in the futures and or options markets is appropriate, as such trading is speculative in nature. When trading futures, you may sustain losses which exceed your margin deposits. Purchasing options may result in the entire loss of premiums and commissions paid for such options. Options sellers should understand that they may be at risk of assuming a long futures position in the case of selling a put or a short futures position in the case of selling a call from the respective strike prices of such options. Past results are not necessarily indicative of future results.