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Fundamentals and Metal Futures

Fundamentals and Metals Futures

The fundamental analyst will look at certain factors to determine where the price of metals like gold and silver might move in the future

There are a few unique factors that the fundamental analyst will use to evaluate trades in the metals futures market, including investment and manufacturing demand.

Uses and Movement of Metals

Many of the metals traded in the futures market are sought after for investment purposes and industrial applications.

The supply and demand of metal futures will be influenced by people using metals as a speculative investment, and those using metals as an input in manufacturing processes. For metals like gold and silver, there is also strong demand from ETFs and other investment funds, as investor appetite for precious metals increases.

For example, gold is used as a speculative investment and in the manufacturing of goods like jewelry and electronics. Gold has always been a unique metal, used as a currency and as a store of value to combat inflation.

Contrast that to copper, where investment demand is virtually non-existent, but the industrial demand is high. The fundamental analyst in this case will look at demand coming from the construction and other industries rather than focusing on copper as an investment.

The demand from each of these sources might move in the same direction at times and in opposite directions at other times.

For example, if the economy is growing rapidly and inflation is increasing, the investment demand for gold might increase as investors buy gold to hedge against inflation. At the same time, the growing economy will most likely create increased demand for industrial gold as consumers buy more products that contain gold.

But, if the economy is contracting, demand for investment gold is likely to increase as investors purchase gold as a stable investment as the equity markets show signs of weakness. At the same time, industrial demand may decrease as consumers demand fewer products in a weakening economy.

Supply

Supply is important for metals, but typically demand is the primary driver of price. The overall supply of metals is limited, but the fact that metals can be melted and reused increases the available supply as existing metals are re-melted, lessening the reliance on new production and smoothing out the supply cycle.

For example, once corn is fed to livestock, it is removed from the supply chain and new corn must replace it. But since metals can be reused virtually forever, the metals market supply comes from existing and newly mined inventory.

Demand

The main factors effecting demand for metals are economic. Factors such as GDP, inflation and interest rates all play a factor in both industrial and investment demand for metals.

Each of these factors will affect a particular metal differently. Some metals, like gold, will be impacted by all of these economic factors, whereas other metals will not be impacted in the same way. The demand for gold will respond to different factors than the demand for platinum.

Conclusion

Fundamental analysts evaluate a variety of factors, to determine which factors hold more weight than others, and then make trading decisions based on these opinions.

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

Regards,
Peter Knight Advisor

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Fundamentals and Equity Index Futures

Fundamentals and Equity Index Futures

Fundamentals are important in the analysis of a futures contract price. Each futures market will have unique fundamental factors that will affect price.

One such contract is E-mini S&P 500 Index futures, ticker symbol ES. It is based on the S&P 500 Index, which is made up of the 500 largest U.S. companies, based on market capitalization.

A fundamental trader will review macro-economic data as well as individual conditions for specific stocks that are held within the S&P 500 Index to make decisions about whether to buy or sell the ES futures contract.

Economic Factors

Factors such as GDP, inflation, interest rates and unemployment rates are some of the influences that will affect the economy, and thus influence individual stocks, leading to the price of an equity index to either increase or decrease.

While these factors may influence on companies, and ultimately the equity indexes, they do not directly affect companies or the futures contracts, e.g. just because interest rates increase, does not mean equity index futures will decrease in price. The influence is created by the interaction of the economy, which influences a company’s financials and the price of the futures contract in the long run.

Traders will analyze available economic data and create a trading strategy based on the behaviors they expect from the data. For example, if unemployment rates are high, people are less willing to spend money on certain items, which means the companies in these sectors may see sales, and ultimately stock price, decrease. If the price of enough companies move down, the price of the index will also move down.

Stock Price

Since equity index futures are based on the price of the underlying companies, a fundamental trader will attempt to determine how a company’s current stock price will be affected by its future outlook. If the trader believes that there will be growth in the economy for the next few years they will incorporate that assumption in to their analysis of the futures contract.

Stock prices move up and down based on the financial health of a company, the stock price of a company now is based on the estimated future earnings of the company.

If the company is financially strong, they should see earnings grow over time and see their stock price increase as well. If the company expects lower earnings in the future, their stock price should move down. These are the most basic relationships, and the reactions of the futures contracts over time might be different than the model, since futures markets are complex and sometimes move in different directions than predicted.

One Factor, Multiple Outcomes

Some macroeconomic factors might have more than one effect on the equity indexes. The immediate reaction might be different than the reaction that happens over time.

For example, if GDP increases too quickly, the government might be tempted to increase interest rates to try and cool down the economy. This will lead to equity index futures decreasing in price in the long-term.

Some factors that influence ES futures in the short-term might have an opposite effect in the long-term. The analyst will tailor their projections to the timeframe they plan on holding their trade. The trader will make assumptions based on the intended length of time they plan on holding the trade. If the trade is a short-term trade of a few weeks the trader might come up with a very different assumption than if the trader is planning on holding the trade for a year or more.

Conclusion

The modern economy makes equity indices a more complex futures contract to analyze, because there are a lot of variables for a fundamental trader to incorporate in the analysis.

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

Regards,
Peter Knight Advisor

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Beta Replication and Smart Beta

Beta

Beta describes the return achieved from exposure to the overall market, e.g., via an index fund. It is also a measure of the relative volatility of a stock compared to the whole market.

Stock index futures, especially E-mini S&P 500 futures, are the institutional choice for beta replication and can allow investors large and small to achieve the elusive goal of cheap beta. Beta can now be sourced efficiently and cheaply around-the-clock in nearly any major stock index.

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 whole market. 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 whole market, usually through derivatives such as S&P 500 futures. If an investor wanted exposure to small cap beta, he might obtain this through E-mini Russell 2000 futures.

Futures are a cheap and efficient way to obtain beta exposure. In fact, investors can replicate exposure in just about any type of market.

Beta or Exposure Sought	Beta source or primary underlying index	Cheapest beta for replication
MidCap Stocks	S&P MidCap 400	S&P MidCap 400 Futures
Small Cap Stocks	Russell 2000 Index	Russell 2000 Futures
Large Cap Stocks	S&P 500 Index	S&P 500 Index Futures
Japanese Stocks	Topix or Nikkei 225 Index	Nikkei 225 futures/Topix futures

While other sources for beta replication (swaps/options/ETFs) exist, futures offer the best combination of efficiency, liquidity and low transaction costs.

Next Generation Beta — Smart Beta

The latest evolution in passive investing goes beyond plain vanilla passive investing. Smart beta is an approach that tries to enhance the return from tracking an asset class by deviating from the traditional cap-weighted approach, in which investors simply buy shares or bonds in proportion to their market value in their respective index.

Fundamental indexing, where each component stock might be weighed according to their earnings or price-to-sales ratios, are part of many smart beta strategies.

Equal-weighted indices are another strategy and can help prevent overweighting caused by the most successful stocks in an index. As time progresses, successful companies can become over-weighted in their indices. This can cause balance issues and a portfolio that is biased toward the successful larger-cap companies.

As fundamental indexing and new generations of beta appear, look for more innovative products going forward including futures contracts and derivatives on such products

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

Regards,
Peter Knight Advisor

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Transition Management using Stock Index Futures

With the exception of the very largest pension plan sponsors, endowments and foundations, the vast majority of buy side investors hire external or outside third party money managers to manage their assets. These external managers may be equity managers, fixed income managers or alternative investment managers.

For a multitude of reasons, a pension fund, for example, may wish to make a change in one of their investment managers. The process by which an institutional investor switches manager is known as transition management.

Why a pension fund might transition from one manager to another

- Change in asset allocation policy. Several years back a major automaker decided to take their allocation to commodity investing down to zero and increase their equity exposure. As a result, they had to notify the managers involved and move the assets from one manager (the commodity managers) to an equity manager that would managed the funds within the new mandate.
- Underperformance: If a manager fails to perform as expected a pension fund has every right to terminate their agreement with the manager and seek out a new manager.
- Major changes in organizational structure that causes a significant shift in their investments. For example, a large U.S. based college endowment shifted their focus from passive investing toward active managers. Such a shift might require a significant transition period from indexed based managers to active managers.
- Recently, the industry has encountered more complex transitions that involve derivatives such as swaps, options and futures necessitating the need for transition managers that have experience with derivatives trading desks. With the extraordinary growth of futures and options over recent years, many portfolios contain these products and thus require specialized attention during transition.

FACTOID: Transition managers are adding new capabilities to transfer assets in complex derivatives, futures and options, along with traditional transfers of securities. These managers increasingly are using derivatives desks to handle the complex transitions, particularly in fixed income. Ross McLellan, founder and president of transition management data analysis firm Harbor Analytics, calls it “an evolution in the industry that allows transition managers to stay relevant.” – Ross McClellan quoted in Pensions and Investments

The process by which assets or funds are moved from one asset manager to another is referred to as Transition Management. And firms that offer expertise in this area are known as transition managers.

What are the considerations and risks in transitioning a portfolio from one manager to another? Anytime you sell a portfolio and reinvest in another, you incur costs. Transactions costs, commissions and other fees can be performance killers. Moreover, there is market impact. If the portfolio contains small and/or illiquid securities, the market impact in selling/buying can be much greater than transaction costs.

However, the biggest risks during the transition period is having no exposure to the market during the process. One of the ways to combat this risk of “missing out”, is to utilize the futures markets. Say for example, an endowment was going to move their small cap exposure from an active small cap manager to a passive indexer benchmarked to the Russell 2000 index. From the time securities are sold from the legacy manager, to the purchase of the new issues by the passive small cap manager, there is the risk that the Russell 2000 might rise resulting in tracking error and underperformance. Hence, the transition manager would consider using E-mini Russell 2000 futures. See illustration in figure one below.

Whether an investor benchmarks to large cap indexes, midcap indexes, small caps, sectors or international indexes, there are literally dozens of liquid stock index futures available that replicate many key global benchmarks. The S&P 500, the S&P MidCap 400 and the Russell 2000 are primary U.S based benchmarks that have extremely liquid futures contracts and are useful in transition management. Thus, it’s no surprise that transition managers have come to rely on these instruments to transition portfolios smoothly and quickly. Other futures such as Treasury futures and commodity futures could conceivably be used in transitions that involve fixed income and commodity managers respectively.

And finally, while derivatives themselves are being transitioned as part of complex portfolios, they are primarily being used to facilitate orderly and efficient transitions from one manager to another.

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

Regards,
Peter Knight Advisor

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Cash Equitization – Cash Drag in the Cross Hairs

Cash Equitization: Cash Drag in the Cross Hairs

When it comes to equities and fixed income, both markets historically have had more periods of positive returns than periods of negative returns. Over longer-term time horizons, the effect is even more pronounced. Hence, investors, whether they be large institutional investors such as a pension plan or money manager or individual investors, have an aversion to holding too much cash in reserves.

While it is true that holding cash can be a positive in terms of protecting a portfolio in a down market, it is a major performance drag if the market should continue to advance as it has for much of recent history.

If the market were to advance even by a small amount, say 5% over the next few years, holding cash reserves will guarantee underperforming the benchmark (such as the S&P 500) as cash currently yields less than 1%. True, cash would give you reserves to invest in any potential bargains should the market decline, but in a bull market cash is not true value. In general, most portfolio managers take the long view and believe that the markets will advance. After all, why invest if you believed the market would suffer negative returns?

Cash Equitization

A pension plan or a money manager can combat cash drag by using a technique called cash equitization, which makes putting excess cash to work much easier. The primary tool for implementing a cash equitization strategy is stock index futures contracts. Their exceptional liquidity, low transaction costs, and nearly 24-hour availability makes them an excellent vehicle for equitizing cash.

Examine an illustration

A portfolio manager (PM) that runs an S&P 500 Index mutual fund (a fund that exactly duplicates the S&P 500 by buying each of the members in the index) finds out that he has $1,200,000 to invest. The portfolio manager receives this information around 2 p.m. Central Time (CT)—an hour before the market closes.

Since he runs an index fund he must be fully invested at all times or he risks underperforming his benchmark: the S&P 500. If the PM failed to invest the $1,200,000 in cash and the market were to open and subsequently close higher the next day, he runs the risk of underperforming the market since he would be invested in cash instead of the stocks that make up the S&P 500 index.

The solution: equitize the $1,200,000 in cash using E-mini S&P 500 futures contracts. Simply put, cash equitization is a strategy whereby an investor can transform his cash into an investment that will track his benchmark; in this case, the S&P 500.

Each E-mini S&P 500 futures contract is worth about $120,000 in notional value (assuming E-mini S&P 500 is priced at 2400). So, the manager would have to buy 10 futures contracts to equitize the entire $1,200,000 in cash.

Since the S&P 500 futures correlate extremely highly with the underlying index, he now has fully invested the cash and will not have to worry about tracking error relative to his S&P 500 benchmark.

Benefits of Cash Equitization

FACTOID: Since the launch of S&P 500 futures back in 1982, one of the more popular uses of stock index futures has been to manage the excess cash in equity portfolios. Since then, many large pension plans and money managers use stock index futures as their primary cash equitization tool.

Since the S&P 500 futures correlate extremely highly with the underlying index, he now has fully invested the cash and will not have to worry about tracking error relative to his S&P 500 benchmark.

Benefits of Cash Equitization

Using E-mini S&P 500 futures to manage cash can have other benefits as well. If the manager were to have redemptions (investors selling their shares in exchange for cash), he could merely sell any S&P 500 futures that were in the portfolio. By doing this, he avoids selling stocks and thereby losing any dividends.

Conclusion

Cash equitization is a very commonly used strategy by pension funds, endowments and other money managers. It can also be utilized in fixed income portfolios as well since cash drag exists in bond portfolios too.

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

Regards,
Peter Knight Advisor

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Alpha/Beta and Portable Alpha

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

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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Why Options on Futures Gives Added Benefit of Diversifying Risk

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 on the Option for Equity Traders

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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