course, is “fungibility.” Any one futures contract for corn, or an Index, or any other commodity is substitutable for another of the same commodity. Similarly, theExchange has negated counterparty risk by placing a Clearing Corporationbetween all parties to trades. So even if the other party to a trade went broke,the Clearing Corporation would assume his liability. And, using the mechanism of daily settlement, whereby losers pay winners daily, the danger ofmajor default is avoided.Futures “margins” (or “earnest money”) are deposited with the brokeron opening a trade. The leverage obtainable is quite extreme for a stocktrader. Initial margin is usually 3–5% of the total value of the contract. Eachday thereafter margins vary according to the process described above ofmarking to market.As the reader can easily see, the purchase or sale of a Dow Future is theequivalent of a fairly large portfolio transaction, with the understanding thatit is a transaction which must be closed in the future, unlike a stock purchasewhich may be held indefinitely.
Differences between Cash and FuturesThe main two differences between the cash and the futures transactions are
AU3772_book.fm Page 341 Saturday, November 18, 2006 5:29 PM
Chapter 17.2:
Advancements in Investment Technology
341
1. In cash, the value of the portfolio must be paid up front, or financedin a stock margin account.2. The owner of the cash portfolio receives cash dividends.These are not the only differences of course. The leverage employed inthe futures transaction is a two-edged sword. If the trader has no reserves,a minor move in the index wipes him out. Such a minor move would bebarely noticed by the owner of a cash portfolio.
Dow Index FutureThe price of the future and the price of the index are closely linked (cf.Figure 199.1). Any price anomaly is quickly corrected by arbitragers. On anysignificant price difference, arbitragers will buy the underpriced and sell theoverpriced, bringing the relationship back in line. Their prices are not exactlythe same because the futures contract value must reflect the costs of shortterm financing of stocks and the dividends paid by index stocks until futuresexpiration. This is known as the “cost of carry.” The “theoretical value” ofthe future should equal the price of the index plus the carrying cost. This iswhat is called the “fair” or “theoretical” value.
Using Stock Index Futures to Control Exposure to the MarketThe owner of a cash portfolio in the Dow, or of DIAMONDS, can controlhis exposure, his risk, by using futures to hedge. If, for example, he ispessimistic about the market, or more to the point, a lot of uptrend lineshave been broken and the technical situation seems to be deteriorating, hecan sell a futures contract equivalent to his portfolio and be flat the market.Readers will immediately recognize the advantages of this strategy. Taxconsequences on the cash portfolio are avoided, as are the other negativeconsequences of trading — slippage, errors, etc. Long-term positions arebetter left alone. By flattening his position the investor has now insured thefuture value of his portfolio and the capital involved is now earning themoney market rate of return.What happens if the forecast market decline occurs? The portfolio isprotected from loss, and the capital earns the market rate of return. And theinvestor should monitor his hedge closely, lifting it when he calculates thatthe correction has run its course. Taxes will, of course, then be due on theprofits on the hedge.In monitoring the hedge, the possibility must be considered that themarket rises instead of falling. In planning the hedge in the first place, theinvestor must plan for this eventuality and determine where he will lift thehedge on the losing side. At worst, of course, the investor has surrenderedportfolio appreciation. Not considering cash flow implications, of course.It is worth emphasizing, in fact strongly emphasizing, that these techniques require knowledge, expertise, and study. Careless use of techniques
AU3772_book.fm Page 342 Saturday, November 18, 2006 5:29 PM
342
Technical Analysis of Stock Trends118
DIA LAST-Daily 02/24/2000
118
116
116
114
114
112
112
110
110
108
108
106
106
104
104
102
102100
10012000
/DI200006 LAST-Daily 02/24/2000
12000
11600
11600
11200
11200
1080010400
10800Created with TradeStation www.TradeStation.com9/1999
10/1999
11/1999
1040012/1999
00
2/2000
FIGURE 199.1. Diamonds and Futures. The 2% plus break at the arrow of an 11month trendline is an unmistakable invitation to hedge the DIAMONDS by shortingthe futures. Profits on the short would have offset losses in the DIAMONDS. Thisconvenient drill would have preserved liquidity, postponed capital gains taxes andavoided loss of equity. Notice the return to the trendline after the break. More of thefoolish virgin syndrome?
of this nature can bloody the amateur investor. So it is probably best to havea professional guide for the first several of these expeditions, and to executea number of paper transactions first.The canny investor can increase his exposure to the market and the riskto his capital by buying index futures. But the canny investor must be carefulnot to turn into a burned speculator. Futures trading, because of the extremeleverage, is an area for dedicated and experienced speculators.A Dow Futures transaction costs less than if you had to buy or sell awhole basket of stocks. Professional fund managers — as well as otherprofessionals — regularly use futures for asset allocation and reallocation.In all likelihood, they are not using the extreme leverage afforded by futures.In other words, if they have a million dollar cash portfolio, they don’t buy10 million dollars worth of futures. It is not the leverage they are interestedin, but the extreme convenience and agility offered by doing short-termallocations in futures. The ability to almost instantaneously move in and outof the market without disturbing the underlying portfolio is a powerfulfeature of these “proxy markets.”
Investment Uses of Dow Index FuturesIn the following examples, I describe the basic mechanics of using DowFutures contracts. These can be used to adjust equity exposure in anticipationof volatile market cycles and to rebalance portfolios among different asset
AU3772_book.fm Page 343 Saturday, November 18, 2006 5:29 PM
Chapter 17.2:
Advancements in Investment Technology
343
classes. The futures may also be used for other purposes not illustrated here.The following examples are not intended to be absolutely precise, but onlyto illustrate the mechanics involved. For the sake of simplicity, mark-tomarket payments and cost of carry have been eliminated from the examples.
Situation 1: Portfolio ProtectionYou are a long-term Magee-type investor and you have old and profitablepositions with which you are satisfied. But you have seen the broadeningtop of the Dow Jones (circa anno 2000) and it is almost October and youwould not be surprised to see a little bloodshed. You have $400,000 in theDow and $100,000 in money market instruments. You decide to reverse thisratio. But you don’t want to liquidate the Dow portfolio, as there is no signof a confirmed downtrend, only that of consolidation. So you sell $300,000of index futures, leaving yourself with a $100,000 kicker in case you arewrong about the market’s declining. At the time, the market is 10000 andthe futures are 10500, meaning the cost of carry is approximately 0.5%(10,500/10,000 – 1).You sell three futures contracts ($300,000/($10 ⋅ 10,000)). You now havereversed your position and are long $100,000 Dow stocks and long $400,000money market equivalents.Validating your technical analysis, the market has begun to swing inbroad undulations and, at the expiration of the futures, the Dow is at 10000.On your stocks you have a return of –0.5%, and the money market positionhas a rate of return of 0.5%.What would have been the situation had you not hedged?Stock Portfolio: $400,000 ⋅ 0.95Money Market + 100,000 ⋅ 1.005Total
$380,000$100,500$480,500
How the futures position affects the portfolio:Short 3 futures 3 ⋅ $10 ⋅ (10,000 – 9500)Total
+$15,000$495,000
Value of portfolio with reallocation of assets in cash market:Stocks $100,000 ⋅ 0.95Money market + $400,000 ⋅ 1.005Total
$95,000$402,000$497,000
By hedging in the futures market, you now have the equivalent of a$100,000 investment in Dow Future stocks and a $400,000 investment in themoney market instrument. The stock market decline now affects only$100,000 of your stock portfolio rather than $400,000; in addition, you earna money market rate of return of 0.5% on the $300,000 difference.
AU3772_book.fm Page 344 Saturday, November 18, 2006 5:29 PM
344
Technical Analysis of Stock Trends
Without the futures transaction, the portfolio is worth $480,500. The$15,000 profit on the short futures position offsets the loss on the $300,000of the portfolio that was moved out of equities by the short futures position.In brief, by selling futures, you are able to protect $300,000 of your initialportfolio value from a stock price decline, nearly breaking even, an achievement given these market conditions. Of course, had you been more confidentof the market decline, you might have completely neutralized the equity riskon the portfolio by selling more futures contracts. This would have convertedthe entire stock position to a $400,000 investment in the money market. Theamount of protection you should obtain depends on your assessment of themarket and your tolerance for risk.
Situation 2: Increasing Exposure with FuturesNow let us look at the other side of the coin. The market has come off itshighs in a predictable and controlled secondary reaction and your technicalanalysis is that the Bull Market will continue. At 10000, it appears headedfor 11000 and you want to increase your commitment. Your portfolio is aspreviously described, split 80/20 between Dow stocks and money markets.It is time to go whole hog, you decide. You are acutely aware of the marketmaxim that bulls make money and bears make money and hogs wind upslaughtered, but there is also a market maxim that no market maxim is true100% of the time, which is also true of this maxim.Rather than liquidate your money market holdings, you buy one futurescontract, which puts you long another $100,000 of stocks. The rate of returnon the money markets in your portfolio is 0.5%. To get a $500,000 exposurein blue chips, you buy the following number of contracts: $100,000/($10 ⋅10000) = 1 contract.Results: Your technical analysis of the direction of the market is correct,and the Dow Future rises to 11000 at the September expiration, or by 10%.Value of portfolio with passive management:StocksMoney market +Total
$400,000 × 1.10$100,000 × 1.005
$440,000$100,500$540,500
Value of portfolio with futures position:Long DJIA futures 1 ⋅ $10 × (11000 – 10000)Total
$10,000$550,500
Value of portfolio with reallocation of assets in cash market:Stocks $500,000 × 1.10Money marketTotal
$550,000$0$550,000
AU3772_book.fm Page 345 Saturday, November 18, 2006 5:29 PM
Chapter 17.2:
Advancements in Investment Technology
345
In buying Dow Index futures, you are able to “equitize” $100,000 of yourmoney market investment, effectively increasing your return from the moneymarket rate of 0.5% to 10%. If you had not bought futures, the total valueof your portfolio at the September expiration would have been $540,500instead of $550,500. Not only do you have a $10,000 extra gain in yourportfolio, but you have taken advantage of the market’s continuing upwardclimb without having to adjust your portfolio.
Situation 3: Using Bond and Index Futures for Asset AllocationSpeculation in bonds can be quite profitable notwithstanding DavidDreman’s assertion that long-term investments in bonds are net losers. (EN9:An oversimplification of a sophisticated thesis by an important figure.) So it is notunusual for an investor to have both bonds and stocks in his portfolio. Inthis event, the portfolio can be managed with facility by using both Indexfutures and Treasury bond futures.Many investors consider it prudent to reallocate their capital commitments based on inflation rates, interest rates, and the reported expression onAlan Greenspan’s face before Congressional testimony.An efficient and inexpensive way to reallocate assets between stocks andbonds is to put on spreads of Treasury bond futures and Dow Index futures.Analysis of recent long- and medium-term trends in the market, however, has led you to consider increasing your equity portfolio and decreasingyour bond portfolio. You have $200,000 invested in Dow stocks and $200,000invested in Treasury bonds. You would like to take advantage of the sustained market rally by increasing your equities exposure to 75% and decreasing your bond holdings to 25%.As for tactics, you can reallocate both sides of your portfolio — buying$100,000 of stocks and selling $100,000 of bonds — with the sale of Treasurybond futures and the purchase of Dow Index futures.The Treasury bonds in your portfolio have a market price of 103-20. Theprice of September Treasury bond futures is 102-20 per $100 of face value,and $100,000 of face value must be delivered against each contract. The valueof the Dow Future is 10000, and the price of the Dow Index futures contractis 10000 (ignoring the cost of carry, of course).The number of T-bond futures to sell is: short T-bond futures:$100,000/(102-20 ⋅ $1,000) = 1 (number of futures is rounded to the nearestwhole number). The number of stock index futures to buy is: long stockindex futures: $100,000/($10 ⋅ 10000) = 1 (number of futures is rounded tothe nearest whole number).Results: at the September futures expiration, the value of the Dow Futureis 11000, a rate of return of 10%, and the market value of the bonds is 10108, a rate of return of –1%.Portfolio value with no market action taken:StocksMoney marketTotal
$200,000 × 1.10$200,000 × 0.99
$220,000$198,000$418,000
AU3772_book.fm Page 346 Saturday, November 18, 2006 5:29 PM
346
Technical Analysis of Stock Trends
12000 /DI200006 LAST-Daily 02/24/2000118001160011400112001100010800106001040010200
Created with TradeStation www.TradeStation.com
1600120080040011/1999
12/1999
00
2/2000
FIGURE 199.2. Dow Jones Futures and Options. A put purchased at the arrow onthe break would have protected patiently won gains over the previous 11 months.Increase in value of put can be seen as futures track declining Dow cash. A theoreticaldrill, but theoretical drills precede actual tactics in the market.
Value of futures positions:Long Dow futuresShort bond futuresTotalGrand total
$10 × 1 × (11000 – 10000)+$1000 × 1 × (102-20 – 101-08)
$10,000$1375$11,375$429,375
Value of portfolio had transaction been done in cash market:StocksBondsTotal
$300,000 × 1.10+ $100,000 × 0.99
$330,000$99,000$429,000
By this simple maneuver you have quickly and easily changed yourmarket posture to add an additional $100,000 exposure to stocks and subtract$100,000 exposure to bonds. Having correctly analyzed market trends, youraction results in an increase in portfolio value from $418,000 to $429,375. Youcould have accomplished the same result by buying and selling bonds andstocks, but not without tax consequences and the attendant transaction headaches. The use of futures to accomplish your goals allowed you to implementyour trading plan without disturbing your existing portfolio.
AU3772_book.fm Page 347 Saturday, November 18, 2006 5:29 PM
Chapter 17.2:
Advancements in Investment Technology
347
PerspectiveWhile there can be no argument about the importance of CBOT® DJIASMIndex futures — they are markets of enormous usefulness and importance —there can also be no doubt that the futures novice should thoroughly preparehimself before venturing into these pits. In such a highly leveraged environment, mistakes will be punished much more severely than an error in thestock market. By the same token, ignorance of this vital tool is the mark ofan investor who is not serious about his portfolio, or who is less intense inhis investment goals. “They” (the infamous “they”) use all the weapons attheir disposal. So should “we.”
Options on Dow Index FuturesThe buyer of this instrument has the choice, or the right, to assume a position.It is his option to do so — unlike a futures contract in which he has anobligation once entered. There are two kinds of options: calls (the right to buythe underlying instrument) and puts (the right to sell). And options can bebought (long) or sold (short) like futures contracts.A long call option on Dow Index futures gives the buyer the right tobuy one futures contract at a specified price which is called the “exercise,”or “strike” price. A long put option on Dow Index futures gives the buyerthe right to sell one futures contract at the strike price. For example, a callat a strike price of 10000 entitles the buyer to be long one futures contractat a price of 10000 when he exercises the option. A put at the same strikeprice entitles the buyer to be short one futures contract at 10000. The strikeprices of Dow Index futures options are listed in increments of 100 indexpoints, giving the trader the flexibility to express his opinions about upwardor downward movement of the market.The seller, or writer, of a call or put is short the option. Effectively sellinga call makes the writer short the market, just as selling a put makes the writerlong the market. As in a futures contract, the seller is obligated to fulfill theterms of the option if the buyer exercises. If you are short a call, and the longexercises, you become short one futures contract at 10000. If you are short oneput and the long exercises, you become long one futures contract at 10000.Buyers of options enjoy fixed risk. They can lose no more than thepremium they pay to go long an option. On the other hand, sellers of optionshave potentially unlimited risk. Catastrophic moves in the markets oftenbankrupt imprudent option sellers.
Option PremiumsThe purchase price of the option is called the option premium. The optionpremium is quoted in points, each point being worth $100. The premiumfor a Dow Index option is paid by the buyer at initiation of the transaction.The underlying instrument for one CBOT futures option is one CBOTDJIASM futures contract; so the option contract and the futures contract are
AU3772_book.fm Page 348 Saturday, November 18, 2006 5:29 PM
348
Technical Analysis of Stock Trends
essentially different expressions of the same instrument, and both are basedon the Dow–Jones Index.Options premiums consist of two elements: intrinsic value and timevalue. The difference between the futures price and strike price is the intrinsicvalue of the option. If the futures price is greater than the strike price of acall, the call is said to be “in-the-money.” In fact, you can be long the futurescontract at less than its current price. For example, if the futures price is10020 and the strike price is 10000, the call is in-the-money and immediateexercise of the call pays $10 times the difference between the futures andstrike price, or $10 ⋅ 20 = $200. If the futures price is smaller than the strikeprice, the call is “out-of-the-money.” If the two are equal, the call is “at-themoney.” A put is in-the-money if the futures price is less than the strike priceand out-of-the-money if the futures price is greater than the strike price. Itis at-the-money when these two prices are equal.Because a Dow Index futures option can be exercised at any date untilexpiration, and exercise results in a cash payment equal to the intrinsic value,the value of the option must be at least as great as its intrinsic value. Thedifference between the option price and the intrinsic value represents thetime value of the option. The time value reflects the possibility that exercisewill become more profitable if the futures price moves farther away fromthe strike price. Generally, the more time until expiration, the greater thetime value of the option, because the likelihood of the option becomingprofitable to exercise is greater. At expiration, the time value is zero and theoption price equals the intrinsic value.
VolatilityThe degree of fluctuation in the price of the underlying futures contract isknown as “volatility” (cf. Resources, Appendix D, for formula). The greaterthe volatility of the futures, the higher the option premium. The price of afutures option is a function of the futures price, the strike price, the time left toexpiration, the money market rate, and the volatility of the futures price. Of thesevariables, volatility is the only one that cannot be observed directly. Sinceall the other variables are known, however, it is possible to infer from optionprices an estimate of how the market is gauging volatility. This estimate iscalled the “implied volatility” of the option. It measures the market’s averageexpectation of what the volatility of the underlying futures return will beuntil the expiration of the option. Implied volatility is usually expressed inannualized terms. Implied volatility is suggested as an input to stop calculation in Chapter 27. The significance and use of implied volatility is potentially complex and confusing for the general investor, professionals havinga decided edge in this area. Their edge can be removed by serious study.
Exercising the OptionAt expiration, the rules of optimal exercise are clear. The call owner shouldexercise the option if the strike price is less than the underlying futures price.
AU3772_book.fm Page 349 Saturday, November 18, 2006 5:29 PM
Chapter 17.2:
Advancements in Investment Technology
349
The value of the exercised call is the difference between the futures priceand the strike price. Conversely, the put owner should exercise the optionif the strike price is greater than the futures price. The value of the exercisedput is the difference between the strike price and the futures price.To illustrate, if the price of the expiring futures contract is 7600, a callstruck at 7500 should be exercised, but a put at the same or lower strikeprice should not. The value of the exercised call is $1000. The value of theunexercised put is $0. If the price of the expiring futures contract is 7500, a7600 put should be exercised but not a call at 7600 or a higher strike. Thevalue of the exercised put is $1000 and that of the unexercised call is $0.The profit on long options is the difference between the expiration valueand the option premium. The profit on short options is the expiration valueplus the option premium. The expiration values and profits on call and putoptions can often be an important tool in an investment strategy. Their payoffpatterns and risk parameters make options quite different from futures. Theirversatility makes them good instruments to adjust a portfolio to changingexpectations about stock market conditions. Moreover, these expectationscan range from very general to very specific predictions about the futuredirection and volatility of stock prices. Effectively, there is an option strategysuited to virtually every set of market conditions.
Using Futures Options to Participate in Market MovementsTraders must often react to rapid and surprising events in the market. Thetransaction costs and price impact of buying or selling a portfolio’s stockson short notice inhibit many investors from reacting to short-term marketdevelopments. Shorting stocks is an even less palatable option for averageinvestors because of the margin and risks involved and semantical prejudices.The flexibility that options provide can allow one to take advantage ofthe profits from market cycles quickly and conveniently. A long call optionon Dow Index futures profits at all levels above its strike price. A long putoption similarly profits at all levels below its strike price. Let us examineboth strategies.
Profits in Rising MarketsIn August, the Dow Index is 10000 and the Dow Index September future is10050. You expect the current Bull Market to continue, and you would liketo take advantage of the trend without tying up too much capital and alsoundertake only limited risk.You buy a September call option on Dow Index futures. These optionswill expire simultaneously with September futures, and the futures pricewill be the same as the cash index at expiration.Your analysis is bullish, so the 10500 call (out-of-the-money strike price)is a reasonable alternative at a quoted premium of 10.10. You pay $1,010 forthe call ($100 ⋅ 10.10).
AU3772_book.fm Page 350 Saturday, November 18, 2006 5:29 PM
350
Technical Analysis of Stock Trends
The payoff: at the September expiration, the value of the Dow Future is10610. Now, your call is in-the-money, and you exercise it and garner theexercise value less the premium, or $90 = $10 ⋅ (10610 – 10500) – $100 ⋅ (10.10)= $1,100 – $1,010. If the Dow Future stays at or below 10500, you let the callexpire worthless and simply lose the premium. This is the maximum possibleloss on the call. If the Dow Future increases by 101 points above the strikeprice, you break even.Instead of buying the call option, the trader could have invested $100,500directly in the Dow stocks. Given a value of the Dow Future of 10110 inSeptember, he would have had a gain of $3,030. If he had invested directly inthe stocks, however, an unexpected market decline would have led to a loss.
Exploiting Market ReversalsThe trader expects a reversal of the Bull Market now at 7800 and would likesome downside protection.He buys a put with a strike price of 7700 (out-of-the-money). The putpremium is 9.80, for a total cost of $980 = $100 ⋅ 9.80. If the Index decreasesto 7600, with a corresponding decrease in the futures contract in September,the put is worth $1,000. The maximum loss is the premium cost, which islost if the Dow Future is above 7700 at expiration. The trader breaks even ifthe Dow Future decreases by 98 points below the strike price.
Using Puts to Protect Profits in an Appreciated PortfolioDuring a sustained Bull Market, investors often search for ways of protectingtheir paper profits from a possible market break. Even when fundamentaleconomic factors tend to support a continued market upside, investors haveto guard against unpredictable “technical market corrections” and marketover-reactions to news.Selling stocks to reduce downside risk is costly in fees and taxwise andsacrifices potential price gains. What is desirable in a sideways market environment is an instrument that protects the value of a portfolio against amarket drop but does not constrain upside participation. This is preciselywhat put options are designed to do.
Situation 1The market is in an uptrend in August. And the market lives in anxiety thatthe Federal Reserve will tighten short-term interest rates further in the coming months. The trader has $78,000 invested in the Dow portfolio, and theDow Future is at 7800.In order to hedge his portfolio, he purchases a put option on Septemberfutures against a possible market downturn. He buys a 7600 put at a premium of 6.60, cost $100 ⋅ 6.60 = $660.Buying the put places a floor on the value of the portfolio at the strikeprice. Buying a put with a strike price of 7600 effectively locks in the value
AU3772_book.fm Page 351 Saturday, November 18, 2006 5:29 PM
Chapter 17.2:
Advancements in Investment Technology
351
of the portfolio