THE OPTIONS COURSE- The Big Picture

THE OPTIONS COURSE


The Big Picture

FUTURES

To the novice, futures contracts can be quite confusing; yet they offer a unique opportunity to make money in today’s volatile markets. Futures markets consist of a variety of commodities (e.g., gold, oil, soybeans, etc.); financial trading instruments (e.g., bonds, currencies); indexes (e.g, S&P 500, Nasdaq 100); and most recently, single stock futures (Microsoft, Intel, Citigroup). A futures contract is the agreement to buy or sell a uniform quantity and quality of physical or financial commodities at a designated time in the future at a specific price. The contracts themselves are traded on the futures market.

Futures markets gave rise to two distinct types of traders: hedgers and speculators. Hedgers consist primarily of farmers and manufacturers. Futures contracts were initially used by farmers and manufacturers to protect themselves or lock in prices for a certain crop or product cycle. Hence, hedgers are primarily interested in actually selling or receiving the commodities themselves. Keep in mind that futures prices are directly driven by consumer supply and demand, which is primarily dependent on events and seasonal factors.

For example, if you are a farmer who grows wheat, soybeans, and corn, you can sell your products even though they have not yet been farmed. If the price of corn is at a level that you like, you can sell a corresponding number of futures contracts against your expected production. An oil company can do the same thing, locking in the price of oil at a level to guarantee the price it will receive. For instance, British Petroleum (BP) may sell crude oil futures one year away to lock in that specific price. To make a profit, a company has to predetermine the price of its production and plan accordingly.

The other players are the speculators. These traders play the futures markets to make a profit. Speculators do not expect to take delivery of a product or sell futures to lock in a crop price. Most contracts are now traded on a speculative basis. In other words, most people are in the futures market to try to make money on their best judgment as to the future price movement of the futures contract. For example, if you believe corn prices will rise in the next three months, you would buy—go long—the corn futures three months out. If you believe corn prices will fall during this same period, you will sell—go short—the corn futures contract three months out.

Hedgers and speculators have a symbiotic relationship. They need one another for futures trading to work. Hedgers try to avoid risk while speculators thrive on it. Together they keep the markets active enough for everyone to get a piece of the action. Unlike stocks, where profits depend on company growth, futures markets are a zero-sum game—for each buyer there is a seller and vice versa.

Physical commodities are raw materials, which are traded on futures exchanges; examples include grains, meats, metals, and energies. Financial commodities include debt instruments (such as bonds), currencies, single stock futures, and indexes. In these markets, money is the actual commodity being traded, and price depends on a variety of factors including interest rates and the value of the U.S. dollar.

Physical Commodities

A wide variety of commodities can be profitably traded. Some are seasonal in nature, such as grains, food and fiber, livestock, metals, and energies. Some fluctuate due to seasonal changes in climate. Others may change due to world events, such as an Organization of Petroleum Exporting Countries (OPEC) meeting. Each market is unique. Physical commodity markets include:

• Grains (e.g., soybeans, wheat, corn).
• Food and fiber (e.g., coffee, cocoa, sugar, orange juice, cotton).
• Livestock (e.g., feeder cattle, live cattle, lean hogs, pork bellies).
• Metals (e.g., copper, gold, silver).
• Energies (e.g., crude oil, natural gas, heating oil, unleaded gas).

Financial Commodities

Commodity trading goes beyond grains, energy, cattle, and pork bellies and includes a variety of more complex financial instruments that trade actively across the globe. These so-called financial commodities include debt instruments like government bonds as well as Eurodollars and foreign currency exchange. Entire books can be written about any of these investments. However, a basic understanding of the most important financial commodities can also help traders make sense of the daily happenings in the financial markets at home and abroad.

Debt Instruments

Just as there are instruments to trade stocks, either individually or collectively as an index, there are numerous instruments available to trade interest rates. Welcome to the world of debt instruments! The first response I usually get when I talk about trading interest rates is, “Who would want to trade interest rates?” The simple answer is banks and other lending institutions that have loans outstanding, as well as investors who have a great deal of exposure in interest rate investments.

Originally, the futures markets were primarily used to hedge—offset or mitigate—risk. Today, financial commodities, including all the interest rate instruments, are growing at a faster rate than traditional commodities. The interest rate markets have participants from all over the world trading interest rates for hedging purposes and speculation. If you have interest rate risk or you just want to speculate on the direction of interest rates, there are plenty of markets and opportunities awaiting you. These markets are also traded extensively in off-exchange markets such as those created by banks and securities trading firms, also referred to as the over-the-counter (OTC) market.

Bonds are one of the most popular forms of financial instruments. A bond is a debt obligation issued by a government or corporation that promises to pay its bondholders periodic interest at a fixed rate and to repay the principal of the loan at maturity at a specified future date. Bonds are usually issued with a value of $1,000 to $100,000, representing the principal or amount of money borrowed. Other popular financial instruments include:

• Treasury bill (T-bill). These short-term government securities have maturities of no more than one year. Treasury bills are issued through a competitive bidding process at a discount from par; there is no fixed interest rate.

• Treasury bond (T-bond). This marketable, fixed-interest U.S. government debt security has a maturity of more than 10 years. The most of-ten quoted T-bond is the 10-year bond.

• Treasury note (T-note). This is a marketable, fixed-interest U.S. government debt security with a maturity of between 1 and 10 years.

• Eurodollars. Eurodollars are dollars deposited in foreign banks. The futures contract reflects the rates offered between London branches of top U.S. banks and foreign banks.

Currency Markets

The currency markets are another very large market. Most countries have their own currencies. These currencies go up or down relative to each other based on a number of factors such as economic growth (present and future), interest rates, and supply and demand. Most major currencies are quoted against the U.S. dollar. Therefore, there will typically be an inverse relationship between the U.S. dollar and other currencies. The major currency futures traded at the Chicago Mercantile Exchange include the following:

• Euro (ECU or European currency unit).
• Swiss franc.
• British pound.
• Japanese yen.
• Canadian dollar.

If the U.S. dollar goes up, then the Japanese yen will drop along with other foreign currencies. Keep in mind that the Canadian and U.S. dollars move similarly due to their physical proximity and the closeness of their economies. Each of these currencies will then have a rate relative to each of the others. This cross-reference is referred to as the cross rate. The yen/pound, euro/dollar, and so on will have their own rates at which they may be traded.

Why are currencies traded? As you are probably aware, many products are sold across borders. A company may sell $100 million worth of computer equipment in Japan, and will likely be paid in yen. If the company prefers to be paid in U.S. dollars, it can go into the futures market or cash market—traded from bank to bank—to change its yen purchase. By selling yen futures contracts, the company can lock in its profits in U.S. dollars. Speculators are also active in the currency markets, buying and selling based on their predictions for the changes in cross rates. Trillions (yes, trillions) of dollars are traded each day in the currency markets, 24 hours a day.

Single Stock Futures

The introduction of single stock futures (SSFs) in the United States on November 8, 2002, was one of the most anticipated events in today’s financial world. Single stock futures offer wide-spread applications for both professionals and retail users. They were previously traded on the London Financial Futures and Options Exchange (which is now part of Euronext.liffe—the international derivatives business of Euronext), and the U.S. market continues to hold high promise for these unique instruments.

Single stock futures are futures contracts that are based on single stocks. As previously stated, a future is a contract to either buy or sell an underlying instrument at a predetermined price at a set date in the future. Unlike an option, the holder of the future has the obligation (as opposed to the right) to take delivery at expiration. One single stock futures contract represents 100 shares of stock, which will convert into stock if held to expiration. Like other futures contracts, SSFs have expiration months of March, June, September, and December. 

Speculators buy stock futures when they expect the share price to move higher, and sell futures when they want to profit from a move lower in the stock price. Hedgers can also use single stock futures to protect stock positions. Currently, there are approximately 115 single stock futures available to trade, including IBM, Microsoft, Citigroup, and Johnson & Johnson. Trading is done through an electronic exchange called OneChicago, which is a joint venture between the Chicago Board Options Exchange, the Chicago Mercantile Exchange, and the Chicago Board of Trade.

In addition, trades clear through the Options Clearing Corporation (OCC). There are several things to consider when looking at single stock futures as opposed to the outright stock. First, while a future could be thought of as a price discovery tool for the stock, generally the stock and future will not trade at the same price. The price of an SSF is determined according to the following formula:

                 SSF = Stock price × (1 + time to expiration × interest rate) – dividends

Since SSFs have quarterly expirations, time to expiration is based on the remaining time until the end of the quarter. Normally the single stock future will trade above the stock; this is partially due to leverage of the future. Unlike stocks, SSFs require the buyer to put up margin of only a small portion of the underlying stock value in order to purchase, right now proposed to be about 20 percent of the cash value of the underlying stock. We should recognize here that margin in futures does not represent borrowed money, as in stocks. Futures margin is the cash that the investor must put up in order to hold a position. As the futures are marked to market at the end of the day, this amount may fluctuate.

The only time the stock would trade over the future would be if there were a large dividend to be paid—investors would likely hold the stock to collect the dividend. Futures holders do not collect dividends paid by the underlying stock. As options traders, we welcome the arrival of SSFs. Not only are they easier to execute than stock, but they are also less costly. For traders who trade stock, this added leverage will increase returns, whether the stock moves higher or lower in price. Prudent risk management and carefully thought out trading strategies, as always, will carry the day.

Index Markets

As noted earlier, an index is a tool used to measure and report value changes in a specific group of stocks or commodities. There is a variety of indexes tailored to reflect the performances of many different markets or sectors. Here are some of the most popular market indexes (also known as averages or market averages):

• Dow Jones Industrial Average ($INDU). The most widely followed index, the DJIA represents 30 blue-chip stocks and is used as an overall indicator of market performance.

• Standard & Poor’s 500 Index ($SPX). A benchmark of U.S. common stock performance, this index includes 500 of the largest U.S. stocks—400 industrial companies, 40 utilities, 40 financial corporations, and 20 transportation companies.

• NYSE Composite Index. This index is composed of all the stocks traded on the New York Stock Exchange.

• Nasdaq Composite Index ($COMPQ). This index tracks the performances of all stocks traded on the Nasdaq Stock Market. The National Association of Securities Dealers Automated Quotations (NASDAQ) devised a computerized system that provides brokers and dealers with price quotations for securities traded over-the-counter as well as for many New York Stock Exchange–listed securities.

• Nasdaq 100 Index ($NDX). The top 100 nonfinancial stocks trading on the Nasdaq Stock Market.

• S&P 100 Index ($OEX). This index represents 100 of the largest U.S. stocks with listed options.

• Wilshire 5000. This market value–weighted index monitors 7,000 U.S.-based equities traded on the New York Stock Exchange, the American Stock Exchange, and the Nasdaq Stock Market, and is a popular indicator of the broad trend in stock prices.

• Commodity Research Bureau Futures Price Index (CRB Futures). This index tracks the commodity markets and is closely monitored as an indicator of economic inflation.

• DAX. Similar to the U.S. Dow Jones Industrial Average, this index tracks the performance of the top 30 German stocks. This is not a market capitalization–weighted index; each company has an equal weighting.

• Financial Times Stock Exchange (FTSE) Index. This index is composed of the top 100 companies (by market capitalization) in Great Britain.

• Euro Stoxx 50. This index tracks the top 50 stocks from the European Economic Community.

• Nikkei 225. This benchmark index is composed of 225 Japanese companies and is a popular indicator of the broad trend in stock prices.

As you can see from the wide variety of indexes listed, you can trade in virtually any type of market that interests you. Indexes like the ones listed can help to track and monitor changes not just in the U.S. market, but around the globe. However, it is important to specialize in just one index to begin with and then continue learning various risk management techniques. There is a vast amount of information that everyone needs to sort out, and that’s what makes investing so interesting.

It is exciting to find the needle in the haystack—you just need to know where to begin looking and what to look for. Buying (going long) and selling (going short) are the simplest forms of trading in futures markets. They are also the most popular strategies because many individuals are not familiar with the more creative aspects of trading. However, by learning to combine stocks with options, you can create trades that limit risk and maximize your potential profits.

Exchange-Traded Funds

Another way to play the index market is through a relatively new investment vehicle, exchange-traded funds (ETFs). Despite their relative newness, ETFs have become among the most popular trading tools in the marketplace today. For example, you have probably heard of the Nasdaq 100 QQQ Index (QQQ). Not only is it the most actively traded exchange-traded fund today, it has one of the busiest options contracts. In addition, there are a host of different ETFs available to the option strategist today. Consequently, understanding what these investment vehicles are and how they trade can open up an enormous number of trading opportunities.

The American Stock Exchange pioneered the concept of ETFs when the exchange launched the S&P Depositary Receipts (SPY), or Spiders, in 1993. In a nutshell, ETFs trade like stocks, but represent specific indexes. Therefore, exchange-traded funds offer investors a way to buy and sell shares that represent entire baskets of stocks. In the case of Spiders, the basket of stocks represents the companies included within the Standard & Poor’s 500 Index. When buying SPY shares, investors are really buying the entire S&P 500 Index. Dow Jones Diamonds (DIA), in turn, track the performance of the Dow Jones Industrial Average ($INDU) and started trading in 1998. The QQQ, also known as the Qs, is today’s most popular exchange-traded fund and made its debut in March 1999. It tracks the performance of the Nasdaq 100 ($NDX). While QQQ options have been actively traded for several years, options on DIA made their debut earlier this year and there are no options yet available on the SPY.

The American Stock Exchange, however, has not been the sole player in the ETF market. Barclay’s Global Investors introduced a series of ETFs in June 1996 called WEBs (now known as iShares). To date, the company has brought forth more than 60 of these so-called iShares, which trade on the American Stock Exchange. Holding Company Depositary Receipts (HOLDRS) are another type of exchange-traded fund. HOLDRS also trade on the American Stock Exchange and can be bought and sold in round lots of 100 shares. In addition, HOLDRS are available on a variety of different industry groups such oil service, biotechnology, semiconductors, and so on. Not all iShares and HOLDRS have options linked to their performance, however.

In order to find those that do, option traders can visit the Chicago Board Options Exchange and the American Stock Exchange, where complete product specifications are available for HOLDRS and iShares. The Nasdaq Stock Market also has plans to list its own family of exchange-traded funds. The exchange’s list of ETFs will include the first-ever fund based on the performance of the widely watched Nasdaq Composite Index ($COMPQ). In addition, the family of exchange-traded funds is expected to include companies that trade on the Nasdaq from specific industries such as telecommunications, financial services, biotechnology, and so on. Furthermore, these investment vehicles will trade on the Nasdaq Stock Market.

The launch of the new Nasdaq ETFs is expected to occur later this year. While there are a number of different ETFs available for trading to-day, there is an important distinction between these investment vehicles and the more common cash-based index products. In fact, indexes and index options date back well before the development of exchange-traded funds. Charles Dow created the first index in 1884. It was known as the Dow Jones Railroad Average (today’s Dow Jones Transportation Average [$TRAN]). Index options did not come into existence until almost a century later. To be specific, the Chicago Board Options Exchange (CBOE) was the first to list options on the S&P 100 Index ($OEX) in 1983. Since that time, options have been launched on a number of other indexes.

Some, like the OEX, reflect the performance of the entire market. For instance, traders can buy and sell options on the S&P 500 Index ($SPX) and the Dow Jones Industrial Average ($DJX). These, of course, are familiar measures of the U.S. stock market. Other indexes are designed to gauge the performance of specific sectors. These include the PHLX Semiconductor Index ($SOX), the AMEX Biotechnology Index ($BTK), and the Morgan Stanley Oil Service Index ($MGO). There are a large number of other cash-based indexes and their complete specifications can be found on the web sites of the Chicago Board Options Exchange, the American Stock Exchange, or the Philadelphia Stock Exchange.

There is an important difference between ETFs like the Nasdaq 100 QQQ and cash-based indexes. Specifically, exchange-traded funds are physical delivery options (i.e., settle for shares), but index options involve cash settlement. For instance, a call writer (seller) who is faced with assignment on his or her Diamonds must deliver DIA shares. However, a call writer of DJX options must provide cash payment (equal to the difference between the exercise settlement value and the strike price of the index option). In addition, most index options settle European-style and, therefore, exercise can only take place at expiration. By contrast, ETFs settle American-style, which means that option writers can face assignment at any time prior to expiration.

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