The first thing you want to do is determine what you expect a particular commodity market to do. Do you expect it to move up or down and how quickly? Knowing how far you expect a market to move also helps to determine the type of strategy to utilize.
Futures and Sell Options
One of the most common trades to use when combining futures and option contracts is to buy a futures contract and sell an option contract against it. Both contracts should be on the same market and typically on the same contract month.
An example of this trade is to buy December corn at $6.00 and sell a December $6.50 call at 20. The beauty of the trade is that a trader can make money from the long futures position and the short option position. If corn futures are less than $6.50 when the option contract expires, the option will be worthless and the trader collects the $1,000 (20 x $50 per cent).
Selling the option also protects the trader if the market moves lower. If the trader is losing on the futures position, he will most likely be making money on the option position – although it will be less than a 1 to 1 ratio.
One drawback, if you want to consider it a drawback, is the gains on the trade will be somewhat capped. In the above example, if corn moves above $6.50 the option will almost start cancelling out the gains on the futures contract.
Buy Futures and Buy Options
This strategy works well if you are expecting a large move in a commodity market, but you need to protect against a sharp adverse move. In this case, you could buy a futures contract and buy a put option to protect against a sharp move lower.
An example of this trade is to buy December gold futures at $1,600 and buy a December gold $1,600 put at $20. The cost of the option would be $2,000. This strategy works well if gold makes a sharp move higher. The trader would lose money on the put option, but would make money on the futures contract. To show a profit at expiration, the trader would need the market to trade above $1,620 to cover the cost of the put option.
The reasoning for this type of trade is to keep unlimited upside potential and minimizing downside risk. This type of strategy can work very well during periods when volatility is low and options are cheap. Then, the market a sharp move. Some traders like to use this strategy with only a couple days until option expiration when options are very cheap.
There are numerous combinations that can be used when trading options with futures. Instead of using one option contract per futures contract, you could buy or sell two or more options. For example, you could buy July silver at $30 and sell two $35 calls at 20. This strategy can work well if silver prices don’t move much above $35.
Some traders like to use a delta neutral strategy where the deltas on the options offset the delta on a futures contract. An at-the-money-option has a delta of about .500. The delta on a futures contract is always 1. In this case, you could buy a futures contract and sell two at-the-money options. The theory is that the options will typically decrease in value every day because of the time decay. The futures contract offsets the risk. This strategy can get very complicated if you want to regularly adjust positions to level out the deltas.