There are going to be times when your system is signaling the onset of a powerful and long term Trend that you will want to take advantage of. In such instances, regression betting and the scalping that is inherent in the strategy will not be the correct tool for the job.
As we discussed in Chapter 2, Futures are WMDs ready to blow your finances to smithereens, so whenever holding them you absolutely must do so with insurance, via a protective option.
This means if you are going Long, you buy a put. If you are going short you buy a call. Your maximum loss in then calculated by: A) The difference between your entry price and the strike price of the option B) The premium payment on the option.
Lets walk through an example:
3PC is in the perma-bull camp for precious metals. Of course we follow Alchymist and all of the technical signals within, so we may be positioned neutral or even net short at times, however we are always looking to position bullishly for long term exposure.
As of the time of this writing Gold is sitting at 1,280. Let's say we believe prices will be going to approx 1350-1400 by the end of the year and we want to position to take advantage of this move. Our thought process in structuring the trade is as follows:
1 - Check the Alchymist Odds tables to check seasonality trends as well as to understand the baseline moves in Gold and how the commodity has traded historically. So we learn the following information from our actuarial tables:
A - Looking at the Yearly Max Hi/ Min Low Table we see that for the last 11 years, the minimum Hi Lo spread intra year was $205, which was back in 2006. Further, during the last 3 years, post the massive crash in Gold, the average yearly Hi/Lo spread was $280.
Thus far, as of June 2017 we have seen a low price of 1,146.5 and a High of 1,294.8 for a H/L spread of $148. The historical data are telling us that this spread will most likely widen by at least $57 to match the minimum spread from 11 years ago, and if we keep trending towards the average of the prior 3 years, we would see this spread widen by another $100 to the $250 range. In the current environment this seems like the likely scenario to us.
So this means that we are forecasting either the Yearly High to go to 1,350 - 1,400 or the yearly low to drop to 1,050 - 1,100. This tells us we likely have very large moves ahead for Gold, but we don't know which way - We need other indicators to provide direction.
B - Looking at the Monthly Data tables, we can see that since 2005, the July-Sep period is seasonally bullish for Gold with winning months beating losers to the tune of 61% to 39%. Looking even further back to 1974, we can see that the Aug-Sep period sports a 64% win rate. This makes sense as large Physical buying in India occurs around this period in advance of the festival season. So we would expect higher trending prices in the quarter ahead.
2 - Looking at Wave count on a Long Term basis, we have what appears to be a Impulsive bullish movement underway, forecasting higher prices. Simply notice the pattern off higher highs and higher lows, projecting new highs.
3 - All signals are pointing for a Long position to profit on a $70-$120 rally. We now turn to our entry tools to put us into the trade. The monthly 1 Pivot High from our range report is 1,272 and our 9day Channel High is at 1,271 so these 2 indicators are in the Green and providing us with a logical stop - We will enter here@ 1,280.
Now, we don't want to short term trade this position - We want to stay in for the expected Wave 5 rally, but we need to protect our downside in the event we are wrong.
As a rule of thumb we want to set up trades with a Risk/Reward profile of 2-1 - We'll try to improve on this throughout the trade, but at initial setup, 2-1 is our minimum target.
In the above scenario, price is at 1,280 & we are looking for a minimum rally to 1,350 which = $70 in gains. Therefore we would be willing to risk $35 to earn that $70 profit. 70/35 =2/1 Risk/ Reward.
Our tactic in this situation will be to buy a protective put option for approx $35.
Options are insurance for a specific amount of time. You are paying upfront to insure your maximum loss. Some Futures have a liquid options market, while others do not. Especially when you first begin trading you only want to trade in Futures that have liquid options markets. This would be Gold/Silver, S&P/Naz100, Oil/Nat Gas/ Beans/Wheat.. Avoid copper, most currencies, and softs for now.
We discussed options back in Chapter 2, and now we want to highlight a few points for when you are shopping for cheap insurance.
1 - The longer dated the option, the more expensive it is in upfront cost to purchase it. In this example, we are looking to buy a 1,280 Put. We are willing to risk $35 on the bet because we see upside of at least $70. If we look at a 1,280 put that expires in 51 days it costs you approx $17.20. If we look at the 1,280 put that expires in 175 days. this costs you $38.20.
You should notice something about the price of these options. Although option 2 is more expensive, the cost per month is actually much cheaper. The reason is that options lose most of their value in the last month prior to expiry. They still are very valuable to hedgers and traders. So instead of paying $17 for 51 days of protection, for another $17 you not only get another 51 days, but an extra 71 days in addition to this for free!
Therefore, make it a rule, when swing or position trading, always buy the Long Dated Option at the money. (at your cost of the underlying future) Even though it is a higher outlay initially, it is actually cheaper insurance to buy.
Now, your next step is to add a additional leg to this trade by selling a call against your future position. So you will now collect the insurance premium and in return you agree to sell them your gold and some higher price. Lets see what you can earn:
As your Put is for 175 days, you should look to sell a call for 175 days. Since our analysis is targeting 1,350 - 1,400 as potential targets, these are the options you want to consider selling. The 1,350 call is trading for $25.50 while the 1,400 call is trading for $15.20.
Remember, when you sell a call, you give up all of the future upside post the strike price. So while you collect more premium by selling the 1,350, you give up the potential to profit on a move to 1,400. So this will be your judgement call here. Lets look at the risk reward scenario here.
- Long 1 Future at 1,280.
- Bot 1 Put at 1,280 for $41.20 (175 days to maturity)
- Sold 1 call at 1,350 for $24.50 (175 days to maturity)
Max Gain = 1,350 - 1,280 on the future for $70 profit.
Minus cost of insurance which is $41.20- 24.50 you collected or $16.70
Max Gain = $70-$ 16.70 = $53.3
Max Loss = 16.70 which is the net of insurance cost.
So this ends up as a trade with a Risk/Reward profile of 3.2 to 1 which is great.
- Long 1 Future at 1,280.
- Bot 1 Put at 1,280 for $41.20 (175 days to maturity)
- Sold 1 call at 1,400 for $13.90 (175 days to maturity)
Max Gain = 1,400 - 1,280 on the future for $120 profit.
Minus cost of insurance which is $41.20- 13.90 you collected or $27.3.
Max Gain = $120-$27.3 = $92.7
Max Loss = $27.3 which is the net of insurance cost
So this ends up as a trade with a Risk/Reward profile of 3.4 to 1 which is also great.
There are many variations you can have off of this play. For example, we opt to purchase the protection right away, but we wait to sell the call provided Alchymist is giving us the all Green signal. As price moves higher the 1,350 +1,400 calls become more valuable and we earn a greater premium by selling them.
A second variation, which we don't recommend until you have years experience under your belt with thousands of trades, is to treat the future and the hedge as 2 separate trades and trade them accordingly.
So we noted above that numerous indicators are signaling the 1,270 level as a support pivot. So if price traded below there we would sell the future but keep the put, making us net short Gold. On the other hand if gold rallies $20 over 1,300 we'd opt to sell the put & therefore we are now only long the future. In this case your insurance lost some value, but not too much, and you are now using $1,300 round number as your pivot point to exit your future position.
Great Risk / Reward trades can be structured by utilizing options. When you are accumulating a intermediate to Long term futures position you must buy protection to avoid catastrophic loss. By choosing a Long dated option, your cost is actually quite cheaper than buying near dated options . To further reduce the insurance expense you can choose to sell insurance on your Future - which is referred to covered writing of options.
By considering your risk and structuring your trades with a minimum R/R target of 2-1, you are laying the foundation of a profitable trading system. Provided your losses are kept at 1, and a random distribution of 50/50 wins and losses occurs, your profit will be 1 unit of risk multiplied by however many trades you can find. You will be a winner!