Tag: Asset Investment Management

Explaining Put Options (Short and Long)

Put Options

A put option is the right to sell the underlying futures contract at a certain price.

Buying Puts

When traders sell a futures contract they profit when the market moves lower. A put option has a similar profit potential to a short future. When prices move downward the put owner can exercise the option to sell the futures contract at the original strike price. This is when the put will have the same profit potential as the underlying futures.

However, when prices move up you are not obligated to sell the future at the strike price, which is now lower than the futures price because that would create an immediate loss.

Why would any trader short a future instead of buying a put?

The potential to profit on a put option does not come without a cost. The “seller” or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a put option pays a premium to the seller of a put option.

As a result of the added cost of the premium, the profit potential for a put is less than the profit potential of a futures contract by the amount of premium paid. The price of the futures contract must fall enough to cover the original premium for the trade to be profitable.

The breakeven point for a put is where the profit on the futures contract that you can purchase at the strike price is equal to the premium paid for the call.

Selling Puts

For every long put option buyer, there is a corresponding put option “writer” or seller. If you have written the put option, then you receive the premium in return for the accepting the risk that you may need to buy a futures contract at a higher price than the current market price for that future.

While Put option sellers don’t have unlimited risk, the risk of writing puts can still be very large. The most a put option seller can lose is the full strike price minus the premium received. If you sell a 100 put option, and the underlying future drops to 20. You will have an 80pt loss minus the premium you took in which will only offset a small portion of the loss. In reality, most futures contracts don’t lose 80 percent of their value as in the example above, but losses on ANY short option can be substantial…so do your homework and fully understand the risks.

Put sellers will profit as long as the futures price does not fall beyond the value of the premium received subtracted from the strike price. For example, if you sell a 100 put strike and receive a premium of 6.00 pts. You will profit as long as the future is above 94 (strike minus the put premium).

The breakeven point is exactly the same for the put seller as it is for the put buyer.

Summary

Put options are the right to sell the underlying futures contract. Buyers of the put have some protection against adverse price movements in that they have limited risk (only the premium paid is at risk). On the other hand, hedgers can also use puts to protect against a declining price. Sellers of put options collect premium and accept the risk they may have the underlying “put” into their account resulting in a long futures position, a position that might be at a price much higher than is currently trading in the market.

Using our put selling example, if you sold the 100 put and the price of the underlying declined to 80 at expiration. If the buyer exercised his option, you would be assigned and have the futures put to you at 100 despite the fact it was trading fully 20 points lower in the market. While buyers have limited risk when buying puts and calls, the seller has substantial and virtually unlimited risk.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Explaining Call Options (Short and Long)

What is a Call Option?

A call option is the right to buy the underlying futures contract at a certain price.

Buying Calls

When traders buy a futures contract they profit when the market moves higher. The call option has a similar profit potential to a long futures contract. When prices move upward the call owner can exercise the option to buy the future at the original strike price. This is why the call will have the same profit potential as the underlying futures contract.

However, when prices move down you are not obligated to buy the future at the strike price, which is now higher than the futures price because that would create an immediate loss.

With this downside protection why would any trader buy a futures contract instead of call?

The potential to profit on a call option does not come without a cost. The seller or “writer” of the option will require compensation for the economic benefit given to the option owner. This payment is similar to an insurance policy premium and, is called the option premium. The buyer of a call option pays a premium to the seller of a call option.

As a result of the added cost of the premium, the profit potential for a call is less than the profit potential of a futures contract by the amount of premium paid. The price of the future must rise enough to cover the original premium for the trade to be profitable. Moreover, options premiums are impacted by time decay and changes in volatility (futures are not).

The breakeven point for a call is the strike price plus the premium paid. So if you paid 4.50 points for a 100 call option, the breakeven is 104.50. The most you could lose is the premium or 4.50 points.

Selling Calls

For every long call option buyer, there is a corresponding call option “writer” or seller. If you sell the call option, then you receive the premium in return for the accepting the risk, that you may need to deliver a futures contract, at a price lower than the current market price for that future.

Option sellers have unlimited risk if the futures price continues to rise.

Call sellers will profit as long as the futures price does not increase beyond the value of the premium received from the buyer.

The breakeven point is exactly the same for the call seller as it is for the call buyer.

Summary

Call Buyers have protection in that their risk is limited to the premium they must pay for the call option. The maximum risk of a call option is the premium paid. They can lock in the strike price and profit (should the underlying rise far enough) while risking only the upfront premium paid.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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What is Exercise Price (Strike)?

Strike Price

One key characteristic of an option contract is the agreed upon price, known as the strike price or exercise price.

The strike price is the predetermined price at which you buy (in the case of a call) or you sell (in the case of a put) an underlying futures contract when the option is exercised.

Strike Price Ranges

When trading options you can choose from a range of strike prices that are set at predefined intervals by the exchange. The interval range may vary depending on the underlying futures contract.

While futures can trade at prices in between these intervals, the exchange attempts to set the option strike intervals to meet the market’s need for liquidity and granularity.

Each option product will have a unique price interval rule that is based on the product structure and the needs of the market. Not only will products have varying intervals, but also within certain products, the intervals will change depending on the expiration month.

For example, options on corn futures have an interval of 5 cents for the two front months, of the expiring futures contract and then transition to 10 cent intervals for contracts 3 months and beyond.

The full range of strike prices, for many options products, will be determined by the previous day’s daily settlement price for the futures contract.

Over time the entire range may expand beyond the initial listed boundaries, due to large market movements. In addition, strike intervals can become more granular as options move closer to expiration.

Example Strike Price Range

In our example we are going to look at a fictional contract with a December expiration. At outset of the option contract, the price rule dictates a 10 point interval and a 40 point range. Assume the underlying futures contract is trading around 100 points, the option price range will be set at 80, 90, 100, 110, and 120.

As the price of the underlying futures contract moves, the exchange will monitor and adjust the range of strike prices.

After the first quarter the futures market fell to 83 points, therefore another strike price at 70 was made available.

In the third quarter the futures contract rallied higher. The option contracts are now much closer to expiration and have increasing trading activity. To meet demand, additional strike prices at one point intervals are made available between 80 and 100.

By the last quarter the market continued upward and additional one point intervals were needed between 100 and 110.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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What is Expiration Date (Expiry)?

Option Expiration Dates

Options do not last forever. They expire or terminate; they all have an ending date.

Options are tied to an underlying futures product and all futures products have a settlement date. If the futures contract no longer exists, then clearly an option on that contract can no longer exist either.

When do options expire?

When it comes to options on futures, there may be a variety of option expiration dates you could trade for the same futures contract.

You may find some option expirations align with the expiration of the underlying futures contract. In other cases a futures product could have a variety of shorter term options listed. These shorter term options offer traders greater precision and flexibility to expand their trading strategies.

Expiration Examples

Assume the E-mini S&P 500® futures contract (ES) has a settlement date in June.

Quarterly Options

Quarterly options contracts are offered on the E-mini S&P 500® futures contract. In this case the June quarterly option contract would expire at the same time as the futures contract.

Monthly Options

Monthly contracts are also offered for the same futures product. With a monthly option contract you can express a short term opinion on this longer dated futures contract.

For each listed month, such as May and April, you can trade an option that will expire within a month and settles into the same June ES futures contract.

Weekly Options

If your time horizon is even shorter, there are weekly options on the E-mini S&P 500 futures contract.

A rolling list of five weekly options that expire each Friday is offered on most products. After each weekly front-end contract expires, another back-end weekly is listed.

Physically Delivered Commodity Options

When it comes to physically-delivered commodities, option expirations will expire prior to the futures settlement. This happens so that traders have an opportunity to mitigate delivery of the physical product.

For example, when WTI Crude Oil futures settle in June, the WTI option will have a May expiration date. If the option is exercised into the active futures contract, the trader has time to adjust their futures position to either offset the position or make plans to take delivery.

Summary

Options can have a variety of option expiration dates, giving you the flexibility to find a product that meets your trading needs.

For more information on specific option expirations, visit the product specification pages on cmegroup.com.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Get to Know Underlying (Options on Futures)

Option contracts are written on a broad cross section of underlying futures contracts. Since 1982, when option contracts on futures were first introduced, the options market has grown significantly and now most major US futures contracts have companion option contracts. Very few new futures contracts are listed on major exchanges without an associated option contract. Hedgers and speculators alike spend a great deal of time examining price behavior unique to each underlying futures contract. Historic price data along with other statistics, such as open interest, volatility, delta, etc., are useful in choosing the strike price and time frame for an option contract.

CME Group is the world’s largest Derivatives Exchange. In 2016, average daily volume reached a record 15.6 million contracts and open interest exceeded a record 120 million contracts.

Both futures and options on futures are called derivatives because they “derive” their value from something other than themselves. For example, a corn futures contract derives its value from the actual underlying corn that can be delivered into the contract.

An option on a future is no different in this regard, but the underlier is another derivative, namely the corn future, which in turn has actual corn as its underlier.

Option contracts span a variety of asset classes, including Interest Rates, Equity Indexes, Foreign Exchange, and physical commodities.

Each option you hold is either the right to buy (call option) or the right to sell (put option) an underlying futures contract as defined by the name of the underlying commodity, index, or interest rate future on which the option is based.

For example;

If you are holding a Gold option on a commodity future, you will have the opportunity to either buy, in the case of a call, or sell, in the case of a put, a Gold futures contract at a specific price on or before the expiration of that contract.

If you are holding an S&P 500® Equity Index option, then you have the opportunity to either buy or sell a future, at a specified price, on the S&P 500®-index level for a defined period of time.

When holding a Treasury option, you have the right to buy or sell a $100,000 US Treasury bond futures contract at a specific price during a certain period of time.

In each case, the underlying contract influences the value of the option: the strike range, the premium, and the timing for each option.

Doing your homework on the underlying futures contract, may help you identify opportunities in the associated options contracts.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding Option Contract Details

Option Contract Details

Contract details refer to the terms of an option contract. How an option contract gains or loses value, and therefore creates a benefit to you as the holder of the option, is dependent on key option contract details. Understanding the key contract details is essential to determining how and when an option will meet your financial objectives. Choosing the right options contract for you is dependent on your objectives. For example, if you want to protect or hedge an asset, you will need to know the contract details to determine the best fit for your portfolio; when speculating, your trading strategy might be influenced by the contract details.

Key Option Elements

Underlying

The deliverable for every CME Group option is a futures contract. This is called the “underlying instrument” or the “underlier”. Futures contracts also have an underlying product such as an interest rate, equity index, a foreign currency rate, or some other commodity.

Expiration/Maturity Date

Each option also has its own expiration or maturity date. This is the last day on which an option can be exercised into the underlying futures contract. After the expiration or maturity date, the option contract will cease to exist; the buyer cannot exercise and the seller has no obligation.

Strike Price

This is the agreed price at which a transaction will happen, if the option is worth exercising. The strike price for the option contract will determine the value at expiration.

Option Type

Option contracts fall into two categories, call options and put options.

A call option is the right to “buy” the underlying product at a predetermined price.

A put option is the right to “sell” the underlying product at a predetermined price.

Before establishing your option position, you will need to carefully consider your financial strategy and objectives. Whether you are hedging or pursuing a trading strategy, close alignment of the contract details are important to achieving desired results from your option position.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Futures Currencies Indices Interest Rates Metals Energy

Options Educational Videos & Links

1) Option Basics

1.01) Explaining Call Options (Short and Long)
1.02) Understanding Covered Calls
1.03) Explaining Put Options (Short and Long)
1.04) Get to Know Underlying (Options on Futures)
1.05) Understanding Option Contract Details
1.06) What is Exercise Price (Strike)?
1.07) What is Expiration Date (Expiry)?
1.08) Understanding Options Expiration (Profit and Loss)
1.09) Understanding AM/PM Expirations
1.10) Learn About Exercise and Assignment
1.11) The Difference: European vs. American Style Options
1.12) Calculating Options Moneyness & Intrinsic Value
1.13) Introduction to CVOL Skew

2) Option Strategies

2.01) Option Collars
2.02) Working Example of Collaring a Position
2.03) Option Straddles
2.04) Option Strangles
2.05) Option Butterfly
2.06) Option Ratio Spreads
2.07) Option Calendar Spreads
2.08) Option Bull Spread
2.09) Option Bear Spread
2.10) Trading PR’s using CVOL and SKEW

3) Pricing

3.1) Discover Options Volatility
3.2) Introduction to Options Theoretical Pricing
3.3) Put-Call Parity
3.4) Options Delta
3.5) Options Gamma
3.6) Options Theta
3.7) Options Vega
3.8) Options Premium and the Greeks

4) Application

4.1)   Options on Futures and Diversifying Risk
4.2)   Trading Options During Economic Events
4.3) Trading Options on Stock Index Futures
4.4)   Influence of Pricing on the Option for Equity Traders
4.5)   Options on Futures vs ETFs

If you have any questions, contact me.

Peter Knight
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How Can You Measure Risk in Treasuries?

Interest Rate Education Homepage

How to Measure Risk in Treasuries

When it comes to measuring risk for fixed income (rates) traders and portfolio managers, they tend to use one or two yardsticks, value of a basis point and modified duration.

Value of a basis point (VBP), also known as basis point value (BPV), or, for U.S. dollar products, dollar-value of an 01 (DV01),is the financial effect of a 0.01% (one-basis point) change in that instrument’s yield.

For example, if a 10-Year note is current 1.30% yield to maturity with a DV01 of $859 per million par value and the yield goes up by 0.01 to 1.31%, we would expect the financial value of that note to drop by $859 per million par.

DV01

One can identify the DV01 of individual securities or an average DV01 of a whole portfolio. DV01s tend to get larger as you move out the yield curve.

For example, a 2-Year U.S. Treasury note may have a DV01 of $185 per million par while a 30-year Treasury bond may have a DV01 or $2,131 per million par.

Modified Duration

Modified duration represents the financial effect as a percentage gain or loss to a 1.0% (100 basis points) change in underlying yield.

For example, consider our previously mentioned 10-Year note: if its duration was 8.95 years and yields move higher from 1.30% to 2.30%, or by 1.0%, we would expect the value to fall by 8.95% in value.

Treasury	DV01
Ultra 30-Year	$289.34
30-Year	$213.14
Ultra 10-Year	$115.84
10-Year	$76.55
5-Year	$47.94
2-Year	$36.97

In general, the longer the maturity, the greater the price sensitivity and risk. Duration measures this risk precisely.

Traders and portfolio managers routinely refer to your position or portfolio in basis point value and modified duration terms.

Implied Basis Point Value and Implied Duration

U.S. Treasury futures can also be referred to in implied duration and implied basis point value terms.

To look more closely at the BPV and modified duration of a futures contract, we must first go back to the concept of a U.S. Treasury futures contract’s cheapest-to-deliver (CTD) security. You may recall from previous modules a U.S. Treasury futures contract’s CTD security is the eligible bond or note that is most financially efficient for the short position to deliver to the long position at contract expiration. Very few market participants go all the way to delivery, in fact the number is quite low (usually less than 5% of open interest).

The reasons we want to know about the CTD security is two-fold: contracts trade like their CTD security and we will use the CTD security and its conversion factor to arrive at that contracts implied BPV.

Once we know a U.S. Treasury’s CTD security we can determine that security’s BPV per $100,000 face value (or $200,000 face value in the case of 2-Year note futures). We use $100,000 because, with the exception of 2-year notes which have an underlying face value of $200,000 per contract, U.S. Treasury contracts have an underlying face value of $100,000 per contract.

Once we know a contract’s CTD we can determine its BPV; and using that security’s conversion factor (CF) and some simple mathematics, arrive at the implied BPV.

Assume we have a 5-Year Note futures contract and its CTD security is the 1.375% of May 31, 2021 with a BPV per $100,000 of $42.45 and a conversion factor of 0.8317.

To arrive at the BPV, we take the BPV of CTD and divide it by its conversion factor:

BPVcontract = BPV ctd ÷ CF

For our example, BPVcontract = 42.45 / 0.8317 = $51.04 per contract.

Once we have the implied BPVs for the U.S. Treasury futures contracts we can use them to calculate appropriate dollar-weighted hedge ratios versus a cash security of portfolio. We could also calculate the spread ratios between futures contracts so we can construct dollar-weighted yield curve trades.

Interest rate traders and managers of risk use basis point value and modified duration to measure their market risk. Futures contracts based on U.S. Treasury securities can also be referred to in implied basis point value and implied modified duration with a little knowledge of how the contracts price and behave and some simple math. Knowing the contract’s CTD is the starting point.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Interest Rate Education Homepage

Get to know Treasuries CTD

Get to Know Treasuries CTD (Cheapest to Deliver)

Now that you have a deeper understanding of the U.S. Treasury basis, we need to delve a little deeper into what is known as the cheapest-to-deliver (CTD) security. While each U.S. Treasury futures contract has its own basket of eligible securities for delivery generally one, or sometimes two, price out to be most efficient for the short position to deliver to the long position. This security is most efficient because it is considered cheaper or cheapest to deliver versus the other alternative securities.

Knowing which security is the CTD is important because the futures contract tends to trade like the CTD security. It is also important when calculating hedge ratios because the futures contract’s theoretical basis point value is derived from the CTD security.

What Determines the CTD?

Before we dive deeper into how to ascertain which issue is the CTD some additional background on the market forces that go into the calculation might be useful. If we take a snapshot of a typical U.S. Treasury futures contract settlement prices of quarterly contracts currently listed for trading, we will see a discernable pricing pattern.

Example

On February 10, 2017 the following were the settlement prices for the listing quarterly futures for the 10-Year Note (ZN) futures:

March 2017 = 124-250

June 2017 = 124-075

September 2017 = 123-280

Notice that as the futures contract goes out further in time, the price goes lower in value. There is a very good reason for this. Remember that the underlying product of a U.S. Treasury futures contract is a U.S. Government security that pays interest twice per year based on its coupon value established when it was originally auctioned. This means the cash Treasury is an asset. Futures contracts are not assets. They represent a price point for future delivery. Because of this opportunity cost, or time value of money, the futures prices trade at a discount or premium to cash.

The Yield Curve

On February 10 when these prices were posted, the yield curve for U.S. Treasuries was positively sloped, that is, rates at the short end of the yield curve were lower than yields further out. Generally speaking, when the yield curve is positively sloped it results in what we call positive carry. If I borrow overnight funds (short-end) and buy a long dated (long-end) U.S. Treasury security with a higher paying rate I enjoy positive carry. To account for this revenue in the underlying physical note or bond the futures contract must price at a discount and gradually converge to cash by time of delivery.

Carry can be either positive or negative depending on the level of rates and the slope of the yield curve.

Example

It might be useful to walk through the financial calculation for carry to see why this works and why it is important regarding the CTD.

Assume we buy the 1-3/4% of November 30, 2021. This issue is eligible for delivery into the March 2017 5-Year Note (ZFH7) contract. We borrow funds through the repo market to purchase this security and will be charged an interest rate known as the repo rate every day we keep this borrowed position open. Carry is defined as the difference between the coupon income and the financing cost.

Carry = Coupon Income (CI) – Financing Cost (FC)

Assume the CI = $599.45 per million face value from original trade settlement date to futures contract last delivery date. Additionally, assume the FC = $206.54 for the same terms. Therefore, Carry = 599.45 – 206.54 = $392.91. Notice the carry number is positive.

If we were to calculate the carry for all the ZFH7 futures contracts eligible securities, we could then use that number along with each security’s basis to determine each eligible security’s net basis.

Net basis = Basis – Carry

This is important because the issue with the lowest net basis tends to be the CTD issue.

Implied Repo Rate (IRR)

There is another widely accepted method for determining the CTD issue. It is called the implied repo rate (IRR). It is a theoretical yield produced by buying the cash security, selling the futures contract, lending the cash security in the repo market and finally, delivering the security into the futures contract on last delivery day. The issue with the highest IRR is generally considered CTD. What you will find if you follow these methods is they arrive at the same result. Bloomberg, for example, has a function that calculates the CTD for U.S. Treasury futures using both methods.

The point of knowing the CTD is to understand how the futures contract will behave. U.S. Treasury futures contracts trade like their CTD securities. Knowing what goes into determining the CTD issue is useful to understanding U.S. Treasury futures valuation. It can also help understand how the CTD can shift or change.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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