Tag: Futures Trading

Trading Options on Stock Index Futures

Did you know that as an equity trader you can apply the same strategies to options on futures that you use with equity options? One of the benefits of being an options trader is that you can use the same trading strategy in multiple markets.

All traders have at one time or another found it difficult to consistently find new trades from their watch list; adding options on futures markets can help expand your watch list to find more trades. If you already have trade set ups for equity options, you benefit from the ability to apply those same set ups across all futures markets, thus giving you access to more trades.

Trades in options on futures can include market neutral, multi-leg and directional trades depending on your market assumption and risk/reward goals. Using the same tools you already use to create your equity market assumption about where you think the underlying will move, you can place trades to take advantage of that move. Essentially, if you already know how to trade equity options then adding options on futures becomes an easy transition and a valuable addition to your trading plan.

Take a look at some of the trade strategies you might use to trade Equity Index options that can also be used to trade options on futures.

Directional Trades

Directional trading by buying calls and puts is a common way to trade options and can be used in the same manner in options on futures. Trading options on futures by purchasing puts and calls is a way to capitalize on a fast moving market with a set amount of risk (what you pay for the option) just the same as buying a call or put in an equity option.

Other spread strategies like debit spreads can also provide a subsidized way to buy put and call options with a fixed risk and reward. Regardless of the strategy, all of the directional trades that you currently use in equities will be applicable here.

In fact, trading options on futures can, in many cases, have an advantage. Rather than trade the futures contract alone, options on futures allows a trader to make a trading assumption about the direction of price similar to trading a futures contract, but with the advantages of only risking what you paid for the option rather than the usual higher cost of the futures contract, all while taking advantage of a fast move in these markets.

Example

A trader who believes that silver is poised to move higher might buy a January $16.50 at the money call in the Silver contract for $0.38, when Silver is trading for $16.60. Their belief is that Silver will be worth more in the next month. This trader buys this call that is about one month out so that there is time for silver to rise and for him to sell the call for more than what he paid for it.

Multi-Leg Trades

Just like equities, options on futures can also be traded using multi-leg trade strategies like spreads and butterflies. Combinations can be traded as one order or add legs to existing positions to build spreads. A spread strategy can be used to take advantage of trading an expected move with a directional assumption while allowing the trader to control risk/reward at the initiation of the trade. It can also be an opportunity to trade by selling premium with less margin requirement than selling puts alone. A spread strategy will behave the same whether in equity options or options on futures.

Example One

Using E-mini Dow ($5) Futures (YM) as an example, if a trader feels that the markets are at all-time highs and are poised for a reversal, he can trade by selling an out of the money call credit spread at 20,000. The trader would sell the 20,000 call and buy the 20,050 call that expires in three weeks when the YM is trading around 19,840 and receive a credit of around 20 points. This example of taking advantage of premium from volatility is just one way a trader using multi-leg strategies can benefit from options on futures.

Example Two

If a trader believes that 30-year Treasury Bonds (ZB) are going to move down, he could sell an out of the money January weekly call spread that expires at the end of the current week. ZB is currently trading at 152’27. The trader could sell the 153 call and buy the 153’50 call creating a credit of 15/64 ($234.75) on the trade. The trader would keep the entire credit received if bonds closed below 153 at the end of the week.

Non-Directional Trades

Just like equity options, with options on futures, volatility traders and non-directional traders can use the same strategies which are already familiar. Non-directional traders can implement strategies like selling straddles and strangles to take advantage of decreasing volatility in a sideways market. Other strategies like calendar spreads are also possible just like with equity options.

Example

If a trader believes that YM is going to consolidate over the next few weeks, one of the ways he could trade is by selling a straddle. If YM is currently trading at 19,848, a trader could sell the Jan 31 19,850 put and call for 396 points. The strategy would pay off if YM moved less than 396 points by expiry of the spread.

As an experienced equity index trader, you can hedge your positions in a couple of different ways using the futures markets and your existing trading knowledge. You can consider combining any existing futures holdings and options on futures to create a perfect one-to-one hedge. For example, a trader who is net long the S&P in their stock holdings, could use short-term E-mini S&P 500 futures (ES) puts to help offset any downturns in the portfolio. The same is possible with foreign exchange (FX) contracts allowing traders to hedge any foreign currency exposure they might have.

A trader who has multiple stock holdings could help offset a downturn in the market by buying sufficient puts in the ES contract. The trader can choose between long- and short-term expiries depending on the time frame they wish to hedge. For example, ES is trading at 2,266. The trader could buy March 2017 2,270 puts for 46 points to hedge over the short term or buy September 2017 2,270 puts for 113 points to hedge over the longer term.

Summary

Next time you are searching for a new trade, consider looking at the many options on futures products available and use the knowledge you already know.

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

Regards,
Peter Knight Advisor

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Understanding the benefits of the Bid-Offer Spread

What does it mean when we say the energy complex is highly liquid with a tight bid offer spread? Is it a good thing?

One thing traders look for is the ability to get in and out of a market efficiently. A tight bid-offer spread makes that possible.

Tight Bid-Offer in Futures versus ETFs

An ETF is a security that tracks an index, a commodity, or a basket of assets like an index fund but trades like a stock on an exchange. A futures contract, on the other hand, is a contractual agreement to buy or sell a particular commodity or financial instrument at a predetermined price in the future.

Example

A Crude Oil futures contract is currently priced at $100 per barrel and one futures contract is comprised of 1,000 barrels of oil. One thousand barrels times $100 gives the trader control of a notional value of $100,000. Since the minimum price fluctuation, or tick, for this contract is $0.01 per barrel, then a one-tick change would be worth $10.

Crude Oil Futures Notional = 1,000 barrels X $100

Crude Oil Futures Notional = $100,000

If the current price of a crude oil ETF share is $38, in order for an investor to manage the same notional value of one futures contract ($100,000), the investor would need to purchase the equivalent of 2,632 ETF shares.

Assuming 1 Oil ETF share = $38

Number of ETF shares to equate to 1 oil futures contract notional = $100,000 / $38 = 2,632 shares

Assume the ETF also trades in $0.01 increments. A one-tick price movement in the ETF position would equate to a change of $26.32 while a one-tick move in the futures contract is only $10.

Conclusion

Tight bid offer spreads may lower one of the costs associated with getting into and out of a position.

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

Regards,
Peter Knight Advisor

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The Power of Leverage

Leverage can seem risky, but when used properly it is a game changer. Leverage is the ability to control a large contract value with a relatively small amount of capital. In the futures market, that capital is called performance bond, or initial margin, and is typically 3-12% of a contract’s notional or cash value.

Assume that one E-mini S&P 500 future has a value of $103,800. You initiate a position by posting an initial margin of at least $5,060. In other words, you will have exposure to $103,800, but you have only put down a small percentage of the value. This is called greater capital efficiency.

Exposure

Another benefit of leverage is gaining increased exposure. For example, if you have $10,000 with which you would like to express your opinion in the gold market. How can you maximize your $10,000? One option is to buy physical gold at $1,250 per ounce. This would afford you 8 oz. of gold.

Another option is to purchase shares of a GLD ETF. If the current price is $125 on GLD, you would be able to purchase 160 shares. That would afford you $20,000 in market exposure and you control the equivalent of 16 oz. of gold.

ETFs are subject to the Federal Regulation T requirement for 50% margin of purchase price, which means you can control $20,000 of exposure with $10,000 in capital.

A third option is to buy a Gold futures contract, which represents 100 oz. If initial margins are $4,400 you can guy two Gold futures contracts. You will have exposure to the equivalent of 200 oz. of gold.

Conclusion

Experienced futures traders understand the power of leverage, its risks and its potential benefits when used as part of a well-thought out risk management plan. Now you, too, can harness the power of leverage for greater capital efficiency and increased exposure.

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

Regards,
Peter Knight Advisor

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Benefits of 24 Hour Trading

If you are only an equity trader, when a market is closed and an opportunity arises, you cannot take advantage of it. And worse, if you need to exit a position, you have to wait until the market opens.

You are probably familiar with U.S. stock market hours. But political events and natural disasters do not wait for the market to open and in a true global economy, many markets that affect the U.S. market trade outside U.S. market hours.

Trade 24 Hours a Day

In the world of futures, you can make a move nearly 24 hours a day, 6 days a week. That means a futures trader can react as the event unfolds.

Twenty four-hour access does not mean you have to stay glued to your trading screen. Say you are long in E-mini S&P position and you are concerned that China’s manufacturing PMI report may be negative and drive the market lower. Instead of waiting for the report, you can place a stop order several hours before the report is released. It will be working while you are enjoying your evening.

You also can have an order working to take advantage of market opportunities so that you will not miss out.

Conclusion

It comes down to one question: where would you rather be to take advantage of market opportunities or to manage risk, on the sidelines waiting for the markets to open or already trading futures?

With nearly 24-hour access, futures markets give you the ability to express your opinion and manage risk around the clock.

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

Regards,
Peter Knight Advisor

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The Benefits of Futures Margins

When we talk about securities margin and futures margin, we are talking about two very different things. Understanding the difference is important.

In the securities world, margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond or ETF. This practice is often referred to as buying on margin.

In futures markets, margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.

The good news is that futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.

Margin requirements may fluctuate based on market conditions. When markets are changing rapidly and daily price moves become more volatile clearinghouse margin methodology may result in higher margin requirements to account for increased risk. In contrast, when market conditions and the margin methodology warrant, margin requirements may be reduced.

Types of Margin

There are two main kinds of margin in the futures markets: initial margin and maintenance margin.

Initial margin is the amount required by the exchange to initiate a futures position. While the exchange sets the margin amount, your broker may be required to collect additional funds for deposit.

Maintenance margin is the minimum amount that must be maintained at any given time in your account. If the funds in your account drop below this level, you may receive a margin call requiring you to add funds immediately to bring the account back up to the initial margin level.

If you do not or cannot meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account, or your position may be liquidated automatically once it drops below the maintenance margin level.

A small change in a futures price can translate into a huge gain or loss, so understanding how futures margin works is essential to maximize the capital efficiencies that futures afford.

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

Regards,
Peter Knight Advisor

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Put-Call Parity

Put-Call Parity

Individuals trading options should familiarize themselves with a common options principle, known as put-call parity.

Put-call parity defines the relationship between calls, puts and the underlying futures contract.

This principle requires that the puts and calls are the same strike, same expiration and have the same underlying futures contract. The put call relationship is highly correlated, so if put call parity is violated, an arbitrage opportunity exists.

The formula for put call parity is c + k = f +p, meaning the call price plus the strike price of both options is equal to the futures price plus the put price.

Using algebraic manipulation, this formula can be rewritten as futures price minus call price plus put price minus strike price is equal to zero f – c + p – k = 0. If this is not the case, an arbitrage opportunity exists.

For example, if the futures price is 100 minus the call price of 5, plus the put price of 10 minus the 105 strike equals zero.

Say the futures increase to 103 and the call goes up to 6. The put price must go down to 8.

Now say the future increases to 105 and the call price increases to 7. The put price must go down to 7.

As we originally said, if futures are at 100, the call price is 5 and the put price is 10. If the futures fall to 97.5, the call price is 3.5, the put price goes to 11.

If a put or call does not adjust in accordance with the other variables in the put-call parity formula, an arbitrage opportunity exists. Consider a 105 call priced at 2, the underlying future is at 100 so the put price should be 7.

If you could sell the put at 8 and simultaneously buy the call for 2, along with selling the futures contract at 100, you could benefit from the lack of parity between the put, call and future.

Market Outcomes

Look at different market outcomes demonstrating that this position allows individuals to profit by arbitrage regardless of where the underlying market finishes.

The futures price finished below 105 at expiration. Our short 105 put is now in-the-money and will be exercised, which means we are obligated to buy a futures contract at 105 from the put owner.

When this trade was executed, we shorted a futures contract at 100, therefore our futures loss is $5, given the fact that we bought at 105 and sold at 100. This loss is mitigated by the $8 we received upon the sale of the put. The put owner forfeited the $8 when he exercised his option.

Our long 105 call expires worthless, so we forfeit the $2 call premium. This brings our net profit to $1 with the loss of $5 from the futures and loss of $2 from the call and the gain of $8 from the put.

Another scenario, the futures price finished above 105 at expiration. Our long 105 call is now in-the-money allowing us to exercise the call and buy a futures contract at 105. Because we exercised the option, our $2 premium is forfeited.

When this trade was executed, we shorted a future at 100, therefore our futures loss is $5. The $8 we received from the sale of the put is now profit because it expired worthless. If you add up the $8 gain from the put, less the $5 loss from the futures and $2 loss from the call you would net a profit of $1.

If the futures end exactly at 105, both options expire worthless. We lose $5 on the futures and make net $6 in options premium, therefore, we net $1.

We stated earlier that put-call parity would require the put to be priced at 7. We have now seen that a put price of 8 created an arbitrage opportunity that generated a profit of $1 regardless of the market outcome.

Put-call parity keeps the prices of calls, puts and futures consistent with one another. Thus, improving market efficiency for trading participants.

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

Regards,
Peter Knight Advisor

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Discover Options Volatility

Understanding Options Volatility

Volatility is the bounciness of the underlying asset of an option.

There are complicated formulas for measuring realized volatility, there are complicated formulas for forecasting volatility, and there are also complicated formulas for calculating implied volatility.

Temperature Change Example

For example, we will look at temperature changes that may occur in different parts of the world. In Singapore, the temperature swings over the course of a year only vary by 15 degrees from the coldest temperature to the hottest. In Bismarck, North Dakota, those same temperatures swings can be as much as 80 degrees. Thus, the temperature volatility is much greater in Bismarck than in Singapore.

Asset Class Example

You can also compare the bounciness of natural gas prices to corn prices.

If we look at price changes in percentage terms for natural gas versus corn, we see the natural gas price change, whether up or down, is larger than the corn price change. Therefore, natural gas is bouncier than corn.

Volatility as Measure of Bounciness

Volatility as a measure of bounciness, is simply a standard deviation of the underlying asset.

In the options world, volatility is quoted as an annualized number. You can calculate a one year, one standard deviation move,by taking the volatility times the underlying price.

For example, if the underlying price was 100 and volatility was 20%, a one standard deviation move would be 20 points, up or down. This would create an expected price range of 80 to 120.

Time Horizons

If you have a different time horizon, we can calculate that as well by adjusting the volatility by using the square root of time. For a one-month period, the standard deviation would be 20% times the square root of 1/12. The square root of 1/12 is 0.289. Therefore, the range from an initial price of 100 would be 94.2 to 105.8 in one month. For a one-week period, the standard deviation would be 20% times the square root of 1/52. A one standard deviation range for a week, would be 97.2 to 102.8.

Summary

The bounciness of an asset is referred to as volatility, which is the standard deviation. In the options world, that standard deviation is always annualized. The standard deviation can be scaled to different time periods.

We have demonstrated how you could compare the bounciness, or volatility, of different underlying assets by annualizing the standard deviations of those assets.

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

Regards,
Peter Knight Advisor

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Introduction to Options Theoretical Pricing

Introduction to Theoretical Pricing Models

Option pricing is based on the unknown future outcome for the underlying asset.

If we knew where the market would be at expiration, we could perfectly price every option today. No one knows where the price will be, but we can draw some conclusions using pricing models.

When looking at call options, a higher strike will cost less than a lower strike.

If the underlying asset price has risen dramatically and you chose a higher strike price rather than a lower strike, your payoff will be less because you have foregone the first part of the upward price movement.

For Example

To get an idea of how much the premium should be at each strike, we are going to use a simple model.

Assume an asset is priced at $100 and has the characteristic of moving one dollar each month (either up or down). In this model, we will assume the price movement repeats every month over the life of the option and the option expiration will occur in four months.

What is the probability for each of the possible price outcomes after four months? In this model there are 16 possible paths that lead to each of the five price outcomes. The probability of each outcome can be calculated by aggregating the paths for each price.

The probability of reaching any one price point in this model is the number of paths in that price point divided by the total number of paths.

Now that we have the probability for each price point, we can start pricing options with different strike prices. First, you need to know the payoff for each strike price at the defined price level.

For example, the 97 call with an underlying price level of 96, would be an out of the money option. The payoff is zero.

At a price level of 98, the 97 call is now in the money, and the payoff is $1. At 100, the payoff is $3, at 102 the payoff is $5 and at 104 the payoff would be $7.

To find the probability weighted payoff, we multiply the probability for each price point by the payoff amount. The theoretical price for a 97 call would be the sum of the probability weighted payoffs. In this case the sum would be 3.0625.

Continuing the mathematics for each strike price we see the 101 strike has a theoretical price of .4375 and the 103 strike has a theoretical price of.0625.

It should be no surprise the 103 strike has less value than the 101 strike as the probability of it being in the money is much less.

Summary

Traders use proprietary models to determine if the prices in the marketplace are in line with their views. We have shown you a very simple binomial model. Which assumes that the market will move a set amount, either up or down, over each period.

Even the more advanced models still provide only estimates for the option price and are still based on assumptions about the future.

These theoretical pricing models provide options traders the ability to track and measure option prices.

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

Regards,
Peter Knight Advisor

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Understanding Options Expiration (Profit and Loss)

The profit and loss of an option position at expiration is a function of the original premium and the difference in price between the futures contract and the strike price of the option.

Selling a Call Scenario

Suppose you sell the 105 call for $2 in premium. The maximum profit potential for this trade is $2. Let’s look at a few different possible outcomes for the futures price at expiration.

To understand the profit and loss, we look at the math for each of these potential scenarios. You sold the option and collected $2 in premium. For each scenario the premium column will be $2 and the strike price is $105. This is the price at which you are obligated to sell the futures contract if you are assigned.

Sell Call Scenario One

In scenario one, the futures price at option expiry is $112. This option will be in the money and you would be assigned. You will sell the future for $105 creating an instantaneous $7 loss on the future. You collected $2 in premium and lost $7 on the future, so your net loss will be $5.

Sell Call Scenario Two

For scenario 2 we see the futures price at option expiry is $106. This option is also in the money and again you would be assigned. You will sell the future at the strike price of $105 and have a loss of $1 on the future. Since you collected $2 in premium you will have a net profit of $1.

Sell Call Scenario Three and Four

In scenario 3, the futures price at option expiry is $100. This option is out of the money and will not be exercised. There will be no loss from futures. Therefore, your $2 collected in premium will become your total profit.

Scenario 4 has the futures price at $94. This example is like scenario 3; the option will be out of the money and will not be exercised. Again, your final net position will be a profit of $2.

Buying a Call Scenario

Now let’s look at the same group of scenarios but from the buyer’s perspective.

In this case you buy a call at $105, and pay a $2 premium to the seller. We will look at your profit and loss potential using the same futures prices at option expiration.

Buy Call Scenario One

In scenario one, the futures price at option expiration will be $112. This option is in the money. You exercise the option at $105. With the futures at $112, this will result in a gain of $7. If you subtract the $2 premium paid for the option, your net profit will be $5.

Buy Call Scenario Two

For scenario two, the futures price at option expiration will be $106. Again, this option is still in the money. You exercise this option at $105 and make $1. You paid $2 in premium, so your net will be a loss of $1.

Buy Call Scenario Three and Four

Scenarios three and four are both out of the money options. In both cases you would not exercise the option. Your net loss has been capped at $2 which is the full premium paid for the option.

Summary

These scenarios show you two views of profit and loss from either side of the same transaction. When looking at profit and loss potential of an option position at expiration, you will need to consider the original premium and the difference in price between the futures contract and the strike price of the option.

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

Regards,
Peter Knight Advisor

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