Stops, protective puts, and financed spread risk

How a futures stop fills

A stop-loss on a futures position is not a guaranteed fill. Once the named price is hit it becomes a market order and can be filled with slippage. A gap through a resting stop can produce large slippage.

The stop-loss is a resting order that becomes a market order when the named price is reached, so neither fill nor fill price is guaranteed through a gap or fast tape. Electronic routing can reduce typical slippage versus open outcry, but slippage can still occur in either venue.

A stop-limit is a stop that also names the worst acceptable fill. If price skips the limit, the order may never rest as protection. If price trades through the limit without a fill, the futures position is left unprotected.

The protective put overlay

The archive presents a purchased option as the structure that can define remaining risk on a futures trade when a resting stop can be gapped through. A long futures position paired with a long put replaces an open stop with a defined overlay.

That protective put is a purchased put held against a long futures or cash book so remaining loss is the gap from entry to the strike plus the premium paid. Remaining risk is the difference between futures entry and the put strike plus the premium paid.

A single long put used as a hedge can require a large premium. An at-the-money mini-Dow put with about three weeks to expiration can cost $1,000 or more.

Financing the put with an option spread

An option spread in this workflow is a multi-strike put overlay used in place of a single long put, typically to reduce cash premium while changing where residual risk sits. A one-by-two ratio put spread can reduce or eliminate the cash premium of a hedge.

The worked case bought a 10,900 put and sold two 10,300 puts for even money or a small credit. That ratio put spread can be entered near even money or a small credit, but it leaves unlimited downside below the lower intrinsic breakeven.

Where the short wing reopens

At expiration, ignoring transaction costs, that spread's intrinsic value is positive between 10,900 and 9,700, peaks at 600 points at 10,300, and then declines. Below 9,700 the short-put residual is unlimited on the spread alone.

Buying an additional 9,700 put converts the overlay into an iron butterfly and limits the hedge's own risk to entry cost plus commissions. The iron butterfly is the financed put overlay plus a still-lower long put that converts residual crash risk on the hedge into a known entry cost plus commissions.