How to Hedge Futures Contracts With Options

Futures contracts are highly leveraged financial instruments. When the market moves against a trade, each tick is magnified by the leverage amount. A small loss can quickly overwhelm a trader’s account and could trigger a margin call. Traders can offset some of the risk by using options as an insurance policy to hedge each futures contract.

Go to your online futures account and decide which futures contract you want to trade. Use the chart feature and indicators to determine if you should open the trade as a buy or sell order. Pay particular attention to USDA crop yield and livestock forecast announcements if you are trading cattle, hogs or other agricultural products. Review the weekly Commitment of Traders report to see if the majority of futures contracts are held long or short.

Open your trade order entry window and select "futures" as the type of order you want to place. Enter the futures contract symbol and the futures contract month. Enter the number of futures contracts you want to trade followed by the action, buy or sell, to open the trade. Enter the trade and wait for confirmation that your order is filled before moving on to the option portion of the trade.

Return to the trade order entry window and click on "options" as your order selection. Pull up the option chain for the futures contract month you are trading. Decide if you want your option strike price to be in-the-money, at-the-money or out-of-the money based on the futures contract price. For example, if you bought one January 2013 gold futures contract for $1,700, you could hedge your trade with an out-of-the-money January 2013 put option with a strike price of $1,690 at a cost of $1620. Enter the trade and wait for a fill confirmation before closing out the window.

Review your trade in the account position window. You should be long one gold futures contract and long one put option. Buying the put option also reduces your margin requirement. Continuing with the above example, the margin requirement to trade one gold futures contract is $7,425. By purchasing a put option at $1,620 to hedge the trade, your margin requirement falls from $7,425 to about $2,100.