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The following order types are supported by CME Globex for futures and options markets.Click the order type in the table for a description and examples of each type.

For message-level details for the following order types, see iLink Order Types.

Limit Order

Limit orders allow the buyer to define the maximum purchase price for buying an instrument and the seller to define the minimum sale price for selling an instrument.

Any portion of the order that can be matched is immediately executed. Limit orders submitted for buying an instrument are executed at or below the limit price. Limit orders submitted for selling an instrument are executed at or above the limit price. A limit order remains on the book until the order is either executed, cancelled, or expires.

Market-Limit Order

Market-limit orders are executed at the best price available in the market. If the market-limit order can only be partially filled, the order becomes a limit order and the remaining quantity remains on the order book at the specified limit price.

Market Order with Protection

Market orders with protection prevent market orders from being filled at extreme prices. Market orders with protection are filled within a pre-defined range of prices referred to as the protected range. For bid orders, protection points are added to the current best offer price to calculate the protection price limit. For offer orders, protection points are subtracted from the current best bid price.

CME Globex matches the order at the best available price level without exceeding the protection price limit. If the entire order cannot be filled within the protected range immediately, the unfilled quantity remains in the order book as a limit order at the limit of the protected range. Refer to the GCC Product Reference Sheet  for a list of the “no cancel” ranges for products.

Example: Offer

The following example illustrates how the client interacts with CME Globex to process a market order with protection offer.

• The client sends a Market Order to CME Globex.
• Offer, ESZ8, Market Order.
• Best Bid = 90000 and Protection Points = 600
• Protection Price Limit = 90000 – 600 = 89400
• CME Globex sends an Execution Report – Partial Fill.
• 2-Lot @ 90000
• CME sends an Execution Report – Partial Fill.
• 3-Lot @ 89900
• CME Globex sends an Execution Report – Partial Fill.
• 3-Lot @ 89650
• Next Best Bid = 89300. This value is below the protection price limit. CME Globex places the remaining quantity on the order book at a protection price limit of 89400.Protection Functionality for Market and Stop Orders

Market Order with protection:

Stop Order – Futures Only

The Stop order type is an order which, when accepted, does not immediately go on the book, but must be “triggered” by a trade in the market the price level submitted with the order. There are two types of Stop order: the Stop-Limit, which goes on the book as a Limit order when activated, and the Stop with Protection, which goes on the book as a Market order.

Stop-Limit Order

Stop-limit orders are activated when an order’s trigger price is traded in the market.

• For a bid order, the trigger price must be higher than the last traded price.
• For a sell order, the trigger price must be lower than the last traded price.

After the trigger price is traded in the market, the order enters the order book as a limit order at the order limit price. The limit price is the highest/lowest price at which the stop order can be filled. The order can be filled at all price levels between the trigger price and the limit price. If any quantity remains unfilled, it remains on the order book as a limit order at the limit price.

Stop Order with Protection

Stop orders with protection prevent stop orders from being executed at extreme prices. A stop order with protection is activated when the market trades at or through the stop trigger price and can only be executed within the protection range limit. The order enters the order book as a market order with the protection price limit equal to the trigger price plus or minus the pre-defined protection point range. Protection point values usually equal half of the Non-reviewable range. Refer to www.cmegroup.com for a list of the Non-reviewable range per product. For bid orders, protection points are added to the trigger price to calculate the protection price limit. For offer orders, protection points are subtracted from the trigger price.

CME Globex matches the order at all price levels between the trigger price and the protection price limits. If the order is not completely executed, the remaining quantity is then placed in the order book at the protection price limit.

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

Regards,
Peter Knight Advisor

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Orders for futures contracts can be submitted to an exchange with different conditions specified. The conditions are referred to as order types. These conditions allow traders to create orders that meet the criteria they set for the trade, and to define how, and at what, price the orders will be filled.

There are many order types that can be submitted through your broker, the most common being market orders, limit orders and stop orders.

Market Order

Market orders can be broken down into two types: a market limit order and a market order with protection.

A market limit order is executed at the best possible price available in the market. If the market limit order can only be partially filled, the order becomes a limit order and the remaining quantity remains on the order book at the specified limit price.

A market order with protection prevents orders from being filled at extreme prices. Market orders with protection are filled within a pre-defined range of prices, referred to as the protected range. For bid orders, protection points are added to the current best offer price to calculate the protection price limit. For offer orders, protection points are subtracted from the current best bid price.

When trading a liquid market with narrow bid-ask spreads, like the E-mini S&P 500, the trader generally gets filled quickly at the current price in the market,  which is reflected in their trading platform.

In a market with a wide bid-ask spread and low volume, the trader might find their order gets filled for a higher price if they are buying, or a lower price if they are selling.

Traders need to be aware and understand the type of market order they are submitting.

Limit Order

Limit orders allow the buyer to define the maximum purchase price for buying a future or the seller to define the minimum sale price for selling a future. A limit price cannot be filled worse than the limit price but can be filled better.

For example, if the market is 12 offer and a trader enters a 15 bid, the trader will get filled at 12 if there are sell orders still on the offer. The buy order could get filled at 12,13,14 or 15.

In a fast-moving market, the order may not be filled because the price keeps moving away from the price of their order.

Stop Order

The stop order type is an order which, when accepted, does not immediately go on the book, but must be triggered by a trade in the market at the price level submitted with the order. There are two types of stop orders: stop-limit, which goes on the book as a limit order when activated, and the stop with protection, which goes on the book as a market order.

For example, the market is trading at 11 and the trader has a sell stop-limit order at 8 to exit their long position. If the trigger price of 8 is traded, the stop order will become a limit order to sell at 8. The order remains on the order book at a limit order at 8.

A stop order with protection prevents stop orders from being executed at extreme prices. A stop order with protection is activated when the market trades at or through the stop trigger price and can only be executed within the protection range limit.

In the previous example, a sell stop order with protection was entered at 8 with 2 protection points. If triggered at 8, the stop order will attempt to sell at 8, but sell as low as 6.

Time Limits

In addition to price levels, orders placed through your broker have a time limit that they are active.

Typically, futures orders are submitted as day orders. This means that the order is only active until the end of that day’s trading session, if the order does not get filled.

Traders can also place orders that are valid until cancelled by the trader. These orders are typically called Good Till Cancel (GTC) orders and will remain active until the trader cancels the order or the order is filled.

Traders can also exit multi-contract positions at different prices. Traders can exit part of their position at one price and the remainder of their position at a different price.

For additional information regarding order types and other order qualifiers, visit:

Order Types for Futures and Options

Order Qualifiers

Order Management

Matching Algorithms

Market participants should be aware of the different order types available to them, providing price protection and greater flexibility in managing their orders.

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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Options Education Homepage

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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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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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

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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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 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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