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Alpha

For example, assume the S&P 500 is up 10% over a particular period and an investor’s portfolio is up 12%. The additional 2 percentage points above the benchmark (12%-10% = 2%) is referred to as Alpha.

Alpha can also be negative, as would be the case if the investor’s portfolio returned less than 10% (the benchmark).

Some skillful investment managers can and do add alpha. Over the long run though, studies have shown that doing so is very difficult. In fact, most managers have a hard time matching their benchmarks, let alone exceeding it. And therein lies the reason why passive investing (where you buy every stock in an index, such as the S&P 500, in order to match the return of the market) has become so popular over the recent years.

 

FACTOID: Portable alpha strategies with equities trace their beginnings back to 1982. Shortly after the launch of the S&P 500 contract, Bill Gross, the founder of PIMCO and Myron Scholes, a PIMCO board member, got together after a board meeting and discussed how the new stock index futures contract could be combined with active fixed income management to create incremental returns above the benchmark S&P 500 index. Four years later the strategy was the linchpin of the PIMCO StocksPLUS program, a strategy designed to enhance passive returns with portable alpha strategies.Alpha is a measure of the active return on an investment, or the excess return above a benchmark such as the S&P 500.

Beta

Beta is both a measure of volatility as well as a term that describes exposure to a benchmark or index such as the S&P 500. It expresses the relative volatility of a stock relative to the market.

The market in this case is the S&P 500. If a stock has a beta of 1.20, it is 20% more volatile than the S&P 500. If the S&P 500 was up 10%, a stock with a beta of 1.20 would be expected to rise by 12%. If a stock has a beta of .80, it is only 80% as volatile as the market as a whole. If the S&P 500 advanced by 10%, a stock with a beta of .80 would be expected to rise only 8%.

An S&P 500 Index fund, which owns each of the 500 members of the index, has a beta of exactly 1.00. Hence, if an investor was buying beta, it would refer to investing in the market as a whole, usually through derivatives such as S&P 500 futures. If an investor wanted exposure to small cap beta, she might obtain this through E-mini Russell 2000 futures. Futures are a cheap and efficient way to obtain beta exposure.

Portable Alpha

The result would be a strategy known as portable alpha.

Portable Alpha, also known as alpha transport or alpha-beta separation, is a strategy that uses derivatives to gain market exposure, coupled with an investment in a separate and distinct strategy (or set of strategies designed to generate excess returns), or alpha.

The market exposure obtained using derivatives such as stock index futures is typically described as beta, while the underlying capital investment that effectively collateralizes the derivatives exposure is commonly referred to as the alpha strategy. The goal is for the combined parts, the alpha strategy and the derivatives-based beta exposure, to generate an attractive risk adjusted excess return relative to a specified benchmark, generally the market index (beta) represented by a derivatives contract such as the S&P 500 futures.

As long as the active fixed income investments returned greater than money market instruments, your returns would exceed the market or benchmark.

Passive strategies strive to match the performance of a market index. Portable alpha strategies go further by combining active management with passive market exposure to enhance returns. This is especially important in an era of low investment returns in markets such as fixed income.

Blending Alpha and Beta

A Simple Portable Alpha illustration (Assume $120,000 investment)

While the S&P 500 is a primary focus with equity portable alpha strategists, portable alpha can be done with nearly any benchmark, such as the Russell 2000, the S&P Midcap 400 as well as with fixed income portfolios and commodity investments.

Sources of Beta

• S&P 500 futures
• E-mini S&P 500 futures
• E-mini mid-cap 400 futures
• E-mini Russell 2000 futures
• Almost any benchmark that has a liquid derivative instrument.

Sources of Alpha that can be transported on top of Beta

• Fixed income securities (Treasury and agency bonds/notes, corporate bonds, mortgage-backed bonds/notes)
• Hedge funds and absolute return strategies
• Long/short strategies

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

Regards,
Peter Knight Advisor

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Trading Options During Economic Events

Economic events offer traders a unique high-volatility environment in which to place trades.

Many equity traders like to trade during earnings and have specific set ups for these news events. Traders are drawn to these high-volatility events because of the large moves that equities can make after the earnings numbers are released

Many futures contracts also have events that act much like corporate earnings announcements and can be traded in much the same way.

Use Existing Set Ups More Often

A trader who likes to trade around news events and is comfortable with trade set ups designed for volatile moves may also want to look at economic events linked to futures markets and trade using options on futures. An options on futures trader can trade around news releases like crude oil inventory reports, unemployment data, or Federal Open Markets Committee Meetings (FOMC).

Just like an equity trader may trade around an FOMC event by trading the size or volatility of the anticipated move using strategies like straddles or strangles, so too can an options on futures trader.

Example

A trader could trade various options strategies in the ZN 10-year Note futures, since FOMC will have a direct price effect on that contract. The trader can narrow in on just the earnings event using weekly Wednesday or Friday expirations.

These trade strategies can also be used to trade currency pairs during economic news events.

Example

A trader who believes that the next European Central Bank (ECB) announcement on interest rates will push the Euro lower could purchase a put in the 6E EUR/USD contract. If the EUR/USD is trading around 1.059, the trader could buy a put that expires just after the ECB rate decision. Say the rate decision is due in 15 days, the trader could buy the 1.06 put in the 6E contract that expires in 25 days for around .0112.

Trade the Size and Direction of Market Moves

As with any options strategy, trading options on futures during economic news releases offers the benefit of defining your risk and reward when you enter the trade, and allows you to create strategies that do not solely rely on the trader having to pick the correct direction of the move and the size of the move.

Options have the benefit of allowing the trader to isolate one of the variables and reduce the factors that affect the profitability of the trade, allowing the trader to isolate the factors they want to trade. Rather than having to pick direction and size of the move, the trader can pick one or the other factors to trade. This strategy gives the trader more flexibility in constructing their trading strategies. Strategies such as, straddles, strangles and selling credit far out of the money can be employed with options on futures just like they are used in equity options.

An added benefit of options on futures is that most contracts have a Wednesday and Friday expiration. This means added flexibility to traders, allowing them to fine tune expirations to events they are trading.

Example

A trader believes that the Unites States Jobless Claims report will have less of an impact on the market than what is currently being priced in by the market. The trader wants to sell volatility, meaning that they want the market to move less than expected.

The trader could sell a straddle in the ES. If the ES is currently trading for 2,264, they could sell a put and call with a strike of 2,265 that expires on Jan 27. The credit received would be around 36 points. The trade would start to lose money if at expiration the market was more than 36 points above or below 2,265.

By adding these additional events, the trader who likes volatility and large moves of news-driven trading strategies can add many more trades over the course of the year compared to simply trading corporate earnings releases.

Top Events Followed by Individual Investors

• Gross Domestic Product (GDP)
• Retail Sales Report
• Consumer Price Index (CPI)
• Producer Price Index (PPI)
• U.S. Housing Data
• U.S. Non-farm Payroll (NFP)
• European Central Bank Report (ECB)
• Federal Open Market Committee (FOMC)
• U.S. Oil Data
• Consumer Confidence Survey

Trade the 24-hour Market

Economic events occur across the globe 24 hours a day. The options on futures market allows you the flexibility to trade when these events occur in real-time instead of standard equity market hours.

After the cash market is closed, if a major event occurs, an equity trader would have to wait to participate in the move. As an options on futures trader, you can participate in that event any time of day. If the euro moves at 3 a.m. Eastern Time (ET), you can participate by trading the EUR/USD contract using strategies you may already know.

You can participate in news events like the ECB or Bank of Japan (BOJ) releases by trading the currency pair prior to the event announcement.

Example

One day before the scheduled release of BOJ interest rate decision, you can trade the volatility by selling a straddle in the 6J contract. If the 6J contract is trading for .00864, you could sell the .00865 put and call for a credit of around .0001175. If you are correct and the 6J does not move as much as expected, you will keep a portion of the credit you received when you placed the trade.

The world is a global market, and events across the globe have impacts on the markets we trade. Options on futures offer not only the opportunity to trade economic events that originate in the United States, using similar trade set ups that you already know, but expand to global news events to offer many more trade possibilities.

If you are interested in adding a global perspective to your trading portfolio, options on futures can provide that opportunity for you to trade.

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

Regards,
Peter Knight Advisor

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Diversify Risks Using Options on Futures

Options on futures can provide additional opportunities to manage risk and diversify your portfolio. While many traders are interested in trading futures, they may also want the flexibility that comes with trading options.

An advantage of options on futures is the ability to reduce risk in your portfolio in different ways. Whether you are looking to trade in an uncorrelated market to diversify risk, hedge existing positions to limit risk, or directly trade more volatile markets at a reduced cost from the futures contact alone, options on futures can be a way to do this.

Trading options on futures provides many trade set ups with varying risks and rewards depending on the strategies chosen to trade and provides many different markets to choose from. This course will look at a few examples of how risks might be managed in your portfolio by using options on futures.

Large Moves with Limited Risk

In markets like oil, gold and silver, you can see swings of over 2% in one day. These markets may offer great set ups for someone who likes to trade volatility, but may seem like too large a swing in price for other traders.

One way to participate in these markets without as much exposure is to trade the option. As an options on futures trader, you can still be involved in the same large move but risk less if the market moves against you by purchasing a put or call or trading a spread. An options buyer is only risking the amount paid for the trade, otherwise known as the premium.

 Example

If the E-mini NASDAQ 100 future (NQ) is trading at 5,022, a trader could buy a 5,020 call in NQ that expires in four days, costing around 24 points.

Assume at the time, the 14-day Average True Range (ATR) for the NQ is around 50. Using the ATR as a guide, a move of 25 points up or down each day on average is expected. Buying the NQ call would allow an options on futures buyer the ability to stay in a trade while only risking one day’s move, but with four days of possibility for the trade to profit.

Even though the futures contract might have a large move, which could potentially have unlimited risk, the options buyer of a call or put is only risking what she/he paid for their option. While the price of options is always fluctuating based on the underlying, the options on futures trader knows their risk exposure because they have only risked what they paid.

Diversification

In addition to limiting risk, options on futures can complement existing equity strategies and add diversification by allowing trades to be placed in uncorrelated markets. Markets like corn, wheat, soy, etc. will move differently than stocks or the S&P 500.

A trader who may want to have multiple trades can spread their risk out in different markets while using similar trade set ups. An equity trader might be in several equities at the same time and also trade, for example, one of the grains. In addition to diversifying by asset class, options on futures provide ease-of-access to all the major equity indexes. This allows the options trader to participate in the broad market just like an exchange traded fund (ETF) or cash-settled index.

A variety of markets can be opened up to you when you add options on futures to your trading portfolio. This range of choice offers market participants additional opportunities to diversify.

Top Options on Futures for Individual Investors

• E-mini S&P 500
• E-mini NASDAQ
• Crude Oil
• Henry Hub Natural Gas
• Gold
• Eurodollar
• 10 YR Treasury Note
• Euro FX
• Japanese Yen
• British Pound
• Soybeans
• Corn

Managing Portfolio Risk

Another unique quality of using options on futures to manage portfolio risk is to hedge specific positions against certain risks in various ways.

Because of the varied asset classes that futures contracts represent, investors can selectively hedge most, if not all, asset classes in their portfolios. From an investor who wants to hedge with the S&P 500 contract to one who wants to reduce or hedge foreign currency exposure with options on currency futures. An investor can hedge the fixed income portion of their portfolio with bond options on futures.

An added benefit of hedging with options on futures is that they allow positions in futures contracts to be hedged in the same ratio. If you own one E-mini S&P 500 futures (ES) contract, then you could potentially offset risk using one ES option contract.

Summary

For many traders, finding ways to manage risk in a trading portfolio is a priority. As you can see, options on futures provide many ways to manage risk and optimize a diversified portfolio. Whether you are looking to reduce your cost base in trades, hedge to manage portfolio risk or complement trades in equity markets, there are advantages for the options on futures trader. Take a look and see if diversification with options on futures is appropriate in your circumstance to diversify risk in your portfolio.

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

Regards,
Peter Knight Advisor

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Influence of Pricing of Options

A trader who is already familiar with how options are traded will find that the pricing of options on futures is guided by the same principles. Using factors like time, volatility and the ability to trade options in, at or out of the money gives a trader many choices and flexibility to trade. Options on futures are just like options on equities as their price is based on the price of an underlying asset; thus, the influence of option expiry will affect the trade.

Specifically, the influence of theta, or time decay and premium or intrinsic value and the flexibility to trade options at the money, out of the money and in the money are relevant and will be important for both options in equities and futures.

This course will look at how some characteristics of how an option is priced will impact your decision to trade options on futures.

Influence of Theta or Time Decay

All options traders will need to know how to leverage time to their advantage when making trades. This means having awareness of the influence of time decay on options. Just like an option in the equity market, an option on a futures contract will expire at a given time. The influence of time, or theta, decay will impact both an equity and futures option trades in the same way. Each options trade will be influenced by how much time the underlying will take to move and the value of the underlying at that given time. As an options trader, you might analyze the market and set up your trade based on factors including the amount of time you think it will take the anticipated move in the underlying to take place before the option expires.

Example – Directional

An equity options trader could analyze Apple (AAPL) and determine they want to trade a bullish assumption because they believe the stock price will increase soon. This trader might purchase a call with an option that will expire on a specific date, such as  two weeks, to take advantage of their anticipated move. This AAPL trader will want to see their expected move by the time or before the option reaches expiry.

The same is true for an options trader who analyses E-mini S&P 500 futures (ES) and determines they want to trade with a bullish assumption and anticipates the move will happen soon. The ES trader could choose to purchase a call option that expires in two weeks as well. The ES trader will want to see their expected move by the time or before the option reaches expiry.

As an added advantage, the options on futures trader can actually choose between a Monday, Wednesday or Friday expiry for some markets, giving them even more choices to trade. So, for the options on futures trader who is buying a call in ES, they can fine tune their trade with even more flexibility of time.

Example – Spread

Let’s say it’s Tuesday, and a trader wants to take advantage of the rapid time decay in the last few days of expiry. The trader has a bullish to sideways assumption for the market over the next few days, so they could sell an out of the money put credit spread to take advantage of the time decay. If the ES is trading at 2265, they could sell a 2235 put and buy a 2230 put that expired at the end of the week for 0.30 points. If the market moved sideways or up, the trader would keep the entire credit received if the ES closed above 2235 at expiry.

Influence of Premium and Intrinsic Value

Another consideration for all options traders is premium and intrinsic value. With all options, the intrinsic value and premium will change the price of the option, thus influencing a trader’s set up and ultimately the profit and loss of a trade.

Many trade set ups will be based on where to purchase the option in relation to the underlying price, taking into consideration the amount of value of the option. Trade set ups used to take advantage of premium in equity options in a stock like GOOGL, for example, will also be applicable in an options on futures market like E-mini NASDAQ (NQ). The equity options trader and the options on futures trader will consider the risks of buying or selling an option by weighing many factors including intrinsic value and the amount of premium embedded into the price of the option.

Just like equity options, a market with high and decreasing implied volatility will favor an options seller, while an options buyer will favor low and increasing implied volatility. Since an options trader will most likely be familiar with selling to take advantage of premium decay and/or buying to take advantage of larger moves in the underlying, the options trader can apply this knowledge in the same way in the options on futures market.

Example – Credit Spread

A Corn contract might have high implied volatility and a trader decides to trade by selling a spread. If they believe that Corn (ZC) might increase in value over the next few weeks, they could sell a put credit spread that expires in three weeks. If Corn is trading at 358, they could sell the 340 put and buy the 335 put creating a credit of 7/16 points in Corn. The trader would be profitable if Corn closes above 340 at the end of the month.

Flexibility to Trade Options At-the-Money, Out-of-the-Money and In-the-Money

Options on futures allow you the ability to choose to trade at, in, or out-of-the-money, all of which will vary the cost of the option and its risk/reward profile (just like an equity option). Trades can be placed at-the-money and benefit from trading at levels where price is currently hovering, or trade out-of-the-money to take advantage of collecting premium, or a big move in the underlying. The flexibility of trading in-or out-of-the-money allows the trader to adjust the risk/reward profile they prefer.

Example – Directional

A trader who thinks that Gold futures (GC) will sky rocket to new highs could buy an out-of-the-money call. If GC is trading at 1184, a trader might buy a 1280 call for around $5.50; since all the cost of the option is premium, GC must have a large move by expiry for this option to pay off. If the trader wants to better replicate the performance of the underlying futures contract, they can pay more and buy an in-the-money call. They could buy an 1170 call with the same expiry, but this might cost around $38.

As you can see, there is a balancing act between probability of the option being in-the-money at expiration and the cost to purchase the option.

Summary

Just like equity options, trades in options on futures can be placed at different levels providing flexible participation in the market. If you understand equity options pricing information, then you can put that same knowledge to use when trading options on futures.

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

Regards,
Peter Knight Advisor

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Trading Opportunities

Due to their wide acceptance as benchmarks and deep liquidity, Equity Index and Select Sector futures can be used by risk managers and traders for a variety of purposes. These flexible products can be employed in numerous trading and hedging strategies.

Possible Trading Strategies

Examples of possible trading strategies include:

Outright bull/bear directional trades

Beta replication/beta adjustment

Portable alpha

Conditional rebalancing

Spreads

Sector rotation

Index Spreads

Another possible trading strategy is an index spread. A spread is the simultaneous purchase and sale of two futures contracts. An index spread is a common and effective trading strategy. The strategy is designed to express the relative value between index contracts rather than an outright market direction bias.

How Spreads Are Used

Outright long or short positions in Equity Index futures can be easily established to reflect a trader’s point of view regarding that index’s next directional move or trend. For example, if a trader believes that the S&P 500 Index is over-valued and will trade lower soon he may sell E-mini S&P 500 futures to express that view.

Asset managers that want to use Equity Index futures to replicate exposure to an index may buy futures contracts and use the residual capital for cash management purposes or alpha producing tactical strategies.

Another possible trading strategy is an index spread. Consider an index spread, specifically, spreading the NASDAQ-100 to the S&P 500.

Advantages of Index Spreads

Because spread trades involve both a long and a short position in highly correlated contracts, they are generally viewed as less volatile and therefore less risky than an outright position in a single contract. Additionally, since spread positions generally reflect lower market risk, there are lower margin requirements.

Example of an Index Spread

Let’s look at an example of a possible equity index spread. The NASDAQ-100 Index is heavily weighted to the technology sector. The S&P 500 Index, by contrast, is recognized as having a broad, diversified constituency and represents the broad market. What makes this type of trade possible is both of these indices, while slightly different, have a high degree of price correlation. In other words, they tend to trade directionally in a similar pattern.

In order to construct this spread, we must first calculate a Spread Ratio. The spread ratio is defined as the notional value of one index future divided by the notional value of another.

In this case, we will divide the notional value of the NASDAQ-100 futures by the notional value of the S&P 500 futures.

How the Trade Might Play Out

A portfolio manager (PM) believes the tech sector is at risk versus the broad market. He is willing to express this opinion with a $100 million equivalent risk position, leading the PM to take the following actions:

The PM sells the E-mini NASDAQ-100/E- mini S&P 500 spread. First calculating the spread ratio, the notional value of the NASDAQ Index equal to 4711.50 x $20 dollars, or $94,230 per contract divided by a notional value of E-mini S&P of 2093.00 x $50 or one $104,650 per contract. Our spread ratio, then, is equal to $94,230 ÷ $104,650 per contract. This comes to 0.9004 E-mini S&P 500 futures for every one E-mini NASDAQ-100 futures.

Divide the notional value of the E-mini NASDAQ-100 futures into the $100 million dollar risk assumption, and you get 1061 NASDAQ-100 futures contracts. Applying the spread ratio of 0.9004 to 1061 results in an equivalent E-mini S&P 500 futures position of 955 contracts. Since the trader believes the tech sector is overvalued versus the broad market, he will sell 1061 E-mini NASDAQ futures and simultaneously buy 955 E-mini S&P 500 futures.

At this point, the trader believes the valuations have normalized. Now, he simply unwinds the spread by executing orders opposite to the original trade. He would do this by purchasing E-mini NASDAQ futures and selling the E-mini S&P 500 futures.

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

Regards,
Peter Knight Advisor

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Did you know: E-mini S&P 500 futures trade more average daily dollar volume than all 6,800 ETFs around the globe?

In 1997, four years after the launch of the first ETF (Exchange Traded Fund), CME Group introduced the E-mini S&P 500 futures. While futures had been trading since the mid-1800s, the launch of the E-mini was significant in two ways:

The E-mini was the first contract structured as a bite-size, investor-friendly futures contract. It was designed to be one-fifth the size of standard S&P 500 futures.

The new contract was traded exclusively, electronically on CME Globex, a trade matching system and traded nearly 24 hours a day.

Both products, futures and Exchange Traded Funds, went on to become very popular. In fact, the E-mini S&P 500 went on to become the most liquid stock index futures contract in the world, based on open interest and volume. When you compare futures like the E-mini S&P 500 with ETFs, it should come as no surprise why futures far out-trade ETFs. We created this module, so you could see the advantages of trading futures over ETFs.

A Comparison

Compare futures with ETFs and see why futures are the more compelling instrument.

Benefit	Futures	ETFs
Management fees	None, there are no annual management fees.	ETFs have annual management fees.
Capital efficiencies	Futures margin is capital-efficient with performance bond margins usually less than 5% of notional amount.	Reg T margins with stocks and ETFs are 50% of the value of the stock or ETF. This is far larger than futures.
24-hour trading access	Yes, trades nearly 24 hours, six days a week	While some firms offer after-hours trading, ETFs cannot be traded 24hours-a-day.
Liquidity	Primary futures contracts such as the E-mini S&P 500, Treasuries, Crude, Metals all far out-trade in dollar terms their ETF counterpart.	Good liquidity but not as much critical mass as futures.
Tracking to underlying	Futures track underlying very closely, with little tracking error.	Some ETFs have major tracking error.
Tax advantages	A profitable short-term trade with futures will pay less in taxes than with an ETF do to IRS Section 1256 treatment (60/40 blend of short and long term gains)	All short-term profits with ETFs pay ordinary income rates.

Average Daily Dollar Volume Comparison

Clearly, futures offer some compelling advantages to large and small investors alike. In fact, if you look at the average daily dollar volume comparisons between futures and their corresponding ETF, you will notice that futures trade multiple dollar amounts of their ETF counterpart. Treasuries, Crude oil and Gold trade 20-600 times greater dollar value than ETFs each day. The E-mini S&P 500 alone outtrades all ETFs around the world by a factor of 2.56 times.

Figure 2: Source: CME Group, Bloomberg

While it is true that both futures and ETFs are regarded as two of the most successful instruments ever introduced, futures hold the lead in many categories in a head-to-head comparison. Many leading money managers have gone on record extolling the benefits of futures when compared with ETFs.

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

Regards,
Peter Knight Advisor

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