sale of the same orrelated contracts. Most spreads involve two legs—a purchase of one contractmonth and the sale of another, usually at a simple differential.
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Spread orders are used by traders who trade changes in price relationshipsbetween two markets as well as those who are simply rolling positions frommonth to month as they get close to first notice days or last trading days. Thespread order ensures that both sides of the trade are filled, so there is no worryof legging out and missing the market on one side. A broker cannot return theorder with a fill on one side only. The spread order is either filled on all sides ornot filled.Spreads are quoted with one contract at a premium to the other. A premiumis the difference in prices between the months or contracts being spread. Whenplacing an order, the premium nearly always goes on the higher-priced contractof the spread.For example, with April cattle futures quoted at 7475 and June cattle futuresat 7075, the premium “on the board” is 400 to the April side. “On the board” refersto the spread price based on quotes, which may not accurately reflect where thespread is trading in the pit. In open-outcry markets, it may be necessary to get aspread bid/offer from the pit to determine the true market, especially if one orboth sides of the spread are at the daily limit. For the cattle example, a sampletelephone order would be: “For account 12345, access code 6789, spread order,buy 3 June cattle, sell 3 April cattle at 400 to the April side.”This order may be used by a trader who is long 3 April cattle and is looking toroll the position to the June contract. If the order is filled, April would have to bepriced at least 410 points over the June contract, and one of the sides of the spreadprice would have to be within the day’s possible trading range. The actual priceson each leg would be determined in the pit.A few important points to note about spreads:• Although outright prices can indicate where a spread may be trading, only anactual bid/offer will provide true spread premiums.• Some markets, most notably interest rates and currencies, have pricing conventions that do not necessarily equate to the norm of premium to the higherside. As a result, some markets may utilize negative spread premiums. Consultyour broker if you are unsure as to the correct pricing convention.• Although traditional markets generally adhere to premium to the higher side,markets can invert. For instance, referring to the cattle example, supposeApril cattle trade at 7230 and June at 7170, with a premium on the board at 60to the April side. It is acceptable to place an order that reads: “Buy 2 April cattle and sell 2 June cattle, with the premium at 30 to the June side.” This ordermeans that the market would have to invert, and June would have to trade at apremium to April by at least 30 points. Because the prices are relatively closeto begin with, this order is not unusual.• Spreads can be traded at even, meaning the same price on both legs and alsoimplying “or any premium to the sell side.”• Spread premiums on listed electronic spreads are readily available.
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Option Spread OrdersOption spread orders work essentially the same as futures spread orders, with afew notable exceptions. Premiums are derived using the same premises as discussed under futures spreads. However, a greater variety of spreads is accessible with options. We will mention only the most actively traded scenarios, usingthese prices:April gold 420 calls trading at 700April gold 440 calls trading at 300April gold 410 calls trading at 1000April gold 410 puts trading at 1210A typical spread order might be: “Account 12345, access code 6789, place anoption spread order. Buy 2 April gold 420 calls, sell 2 April gold 440 calls, premium380 to the buy side.”Note the premium is 400 “on the board”; you do not double the premium to doa two-lot spread. Always use the lowest common denominator when calculatingan option spread.Conversely, an account may be long the 420 calls and may wish to roll to the440 calls. This could be accomplished by placing this spread order: “Buy 2 Aprilgold 440 calls and sell 2 April gold 420 calls, premium 410 to the sell side.”An account may wish to place an order to buy both the calls and puts, expecting a big move in the market but not sure which way. To accomplish this, youcould place this order: “Account 12345, access code 6789, option spread order.Buy 3 April gold 410 calls and buy 3 April gold 410 puts at 2200.” Again, the premium is calculated at 1:1 and is not multiplied by 3.These examples are just a few of the almost unlimited ways that optionspreads can be placed to accomplish your objectives. Keep in mind that many options are not very liquid, they may not trade frequently, and last prices may not berelevant although theoretical values revealed by an option calculator may be apretty good indicator of where these spreads may trade.
PLACING ORDERSIf you place orders online, the trading platform will pretty much direct youthrough the order process—although it won’t prevent you from making amistake such as entering “Buy” when you meant “Sell.” If you telephone yourorders, setting up a similar procedure not only will help you organize yourpaperwork but also will greatly reduce the possibility of an error due tomiscommunication.
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When using the phone, place orders in a clear and concise fashion by following the same pattern for every order. For example, with March bonds trading at110-28, you might say: “Buy 10 March bonds at 110-21.” Add GTC if applicable. Theword limit is not necessary on a telephone order; it is assumed.State other order types such as a stop at the end of the order to avoid confusion. Saying “I would like to place a stop” and then reading the order without saying “stop” for the order type may result in an error. For example, say: “Buy 10March bonds at 111-05 stop.”A market order implies no specific price, so the price field is blank when entered online. The resulting order would read: “Buy 10 March bonds at the market.”In addition, day orders are assumed, and it is not necessary to specify that.
Hints for Placing OrdersHere are some other important points to remember in placing orders:• Phone clerks are instructed to listen carefully to the order you want to placeand will read the order back to you for your okay. Make sure they have readthe exact order you intended.• Day orders with prices on markets that have daily limits must be placed withinthe day’s trading range.• Limit moves or circuit breakers may preclude orders from being filled. In addition, market and stop orders may be filled at prices that you may not expect.• Fast market conditions on open-outcry markets may lengthen the time it takesto get an order filled or canceled or to obtain a response from the floor. Government report releases and extraordinary news items are the most commoncauses of fast markets, but they can occur at any time as determined by theexchange.• Use discretion in placing orders. In markets with no limit, do not place day orders way off the market. Be especially diligent when canceling and replacingorders. Open-outcry markets are sensitive to the amount of paper going intothe pits, and every new order instruction adds to the total. It is not necessaryto chase markets by changing an order every tick or two or moving your stopevery time the market moves another two ticks.• If you are using OCOs, do not place the limit and stop orders too close together because that can cause problems for the filling brokers.• Cancel the opposite side if working both stop and limit orders. Be sure tocheck working orders constantly.• Be sure to cancel an open order stop if you decide to exit a position before thestop is elected. Stops are not canceled automatically; you must place the cancel instructions.• It is imperative to specify “open order” if, in fact, you do want a GTC order. Allorders are assumed to be day orders unless otherwise specified.
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• If products trade on more than one exchange, it is important to specify whichproduct it is that you would like to trade. In cases where there is a clear dominant product, your broker will often assume that you are trading the highly liquid, dominant product unless you specify otherwise.• Many products now trade side by side on both the floor and the computer, asis the case with currencies at the Chicago Mercantile Exchange and financials at the Chicago Board of Trade. If you are not getting input from yourbroker, it is important to specify where you would like the order to work. Totrade single-stock futures, you must stipulate the exchange, or your brokerwill ask.• The names of some months sound alike—September and December, for example. To avoid errors, many firms use “September Labor Day” and “DecemberChristmas” when reading back orders.• Numbers such as 15 and 50 or 16 and 60 also sound alike and should be readas “Fifteen, that’s one five” or “Sixty, that’s six zero” on quantities andprices.Trading online can eliminate much of the confusion that may occur with telephone order placement. All you have to do is familiarize yourself with the tradingplatform, especially the symbols. Electronic trading depends totally on choosingthe right symbol for the product you are interested in trading.For instance, if you wish to trade the yen on Globex, you must use a differentsymbol than you would if you want to trade the yen open-outcry market. If youplace a market order in the yen on Friday afternoon at 3 P.M. Central time, the order will go in a queue for Monday’s open if you use the open-outcry symbol. However, it will be filled on Friday afternoon if you use the Globex symbol! That couldmake quite a difference in the trade’s outcome. Make sure you receive an ordernumber as confirmation.Learning and becoming comfortable with the trading platform can streamlinethe order placement process and make the whole experience more enjoyable.
TIPS ABOUT TRADING MECHANICSHere are a few issues to consider before placing futures or options orders.
Margin CallsIn general, if you get a margin call, it means that the market has moved againstyour position. Many professional traders and money managers advise againstever meeting a margin call. Meeting the call means wiring the amount of moneynecessary to bring the account back to full initial margin. Other options includeoffsetting positions or a combination of both wiring money and offsetting some
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contracts. In any event, your broker will insist that you take some action to reduce the overall exposure and risk, or the position will be closed for you.If you decide to offset, your broker may want you to place stops to protect theaccount from going debit while you are still holding positions. Do not be offendedby this. The broker is merely following the firm’s fiduciary responsibility to boththe clearing member to maintain the integrity of the market and, most important,to you the client.Some strategies to reduce risk include adding positions by spreading withboth futures and options. However, these strategies are not recommended whenyou are on margin call.Another strategy to deal with adverse market movement is to simply avoid incurring a margin call by reducing the size of your positions gradually as needed.Some traders employ a strategy whereby they wire funds to hit the account beforea call is incurred. The additional funds can buy some time, and if the amount sentputs the account above the minimum maintenance margin requirement, it may beless than you would have had to send to get back to full initial margin in the eventof a margin call. Sending additional funds is okay, but it defeats the principle ofnot meeting a margin call.
DeliveriesTaking physical delivery of a commodity (where that provision applies) is not intended for individual investors, and you should avoid the delivery process. It isrelatively easy to take delivery of some products such as grains and precious metals and retender because they simply involve exchanging receipts and money.However, for other products such as livestock and coffee, the process is not easyand can involve significant expenses. Delivery expenses can include additionalcommissions, surcharges for processing the delivery, storage, interest, insurance,and replacement of product that fails inspection. Rule of thumb: If you want tomaintain a position, roll into the next active month and do so while open interestremains high.
First Notice Day and Last Trading DayContract specifications vary dramatically from product to product. Deliverableproducts may have a first notice day (FND) before the last trading day (LTD), giving traders who take delivery the option to redeliver the product and offset the position. When the FND is before the LTD, most contracts allow an offset up to thebusiness day before FND to avoid a possible delivery notice.Other deliverable products may have LTD before FND, which usually meansthat, if you are holding a position through the close on LTD, you are obligated tomake or take delivery. In this case, FND is handled by the exchange as a means ofmatching buyers and sellers, as is the case with energy contracts.
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Individual investors should avoid last trading days in futures. Clients shouldexit positions at least one day before the LTD, the sooner the better. Some products will have active liquid markets almost up to expiration, but the deeper intothe LTD session, the more volatile the price swings can be as liquidity dries up.Products with difficult deliveries are especially dangerous and should be avoidedon LTDs. This point cannot be stressed enough.
Cash SettlementFinal contract settlement in cash on expiration day has gained in popularityover the past few years as more contracts adopt that provision. Although primarily the domain of indexes, other products are cash-settled, including somephysical commodities. Cash-settled contracts can be held through expirationand do not have to be offset. At expiration, an offsetting trade is added to youraccount at the final contract settlement price. This book entry closes out thetrade, puts the money right in the account or takes it out, and completes theround turn for commission purposes.Keep in mind that the cash-settlement algorithm will vary by market and maynot be what you expect. Consult your broker for details. If you are in doubt andyou do not want to take on any perceived cash-settlement exposure, offset yourposition before it expires.
Option ExpirationsLong options on futures positions may be exercised. Short options on futurespositions may be assigned. Most U.S. options are exercised automatically ifthey are in the money by a tick, meaning that the holder of a long call becomeslong the underlying futures at the strike price and the holder of a long put becomes short the underlying futures at the strike price. Having a futures positionmay come as a surprise to those who gave up on a long option as it expired.Long options can be abandoned on the option’s last trading day, meaning thatno action is taken.Short option holders in the money by a tick or more as of expiration may beassigned—a short call may become a short position in the underlying futures atthe strike price and a short put may become long the underlying futures at thestrike price. You can never assume that an in-the-money short option will be assigned or expire worthless. Out-of-the-money short options can be assigned, so ifyou hold a short option through the close on LTD for the option, you will not knowfor certain exactly what your position will be when the next session opens. Inpractice, however, far out-of-the-money options are often assumed to be worthlessand rarely have any repercussions.Short option holders must also consider “pin risk”—that is, when the underlying futures contract settles exactly at the strike price. In this scenario, they have to
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wait until shortly before the next regular trading session to determine their position. Some traders will offset short options on LTD and spend a small premium todo so, just to ensure they know their position.If a long option holder is expecting to take an automatic exercise, the accountshould have enough funds to cover the resulting margin for the underlying futuresposition acquired. The account can use the open trade profit on the new futuresposition when making the calculation. A broker may liquidate options in accountsthat are not funded properly to hold the resulting futures positions.Early exercise is another possibility if the option is illiquid. Many optionsare thinly traded. Some traders may execute futures trades that can offset anoption position if exercised and give exercise instructions to their broker.This process will cost the trader a round-turn futures commission but maymore than compensate for a poor bid/offer on the option. The exercise onAmerican options can be done at any time up to and including the option’s lasttrading day.With the exception of serial options, cash-settled futures also means cashsettled options. The cash settlement on the option is based on the final settlementprice for the underlying futures contract, which can be confusing, especially inregard to S&P options. A quarterly cycle S&P option (March, June, September,December) is cash-settled to the futures settlement. The futures settlement is calculated the morning after the last trading day and can vary significantly from thelast traded futures price.Serial options on cash-settled futures are not cash-settled options. This is avery important point. A serial option refers to an option month that is not part ofthe regular cycle but is based on a futures month that is part of the normal cycle.For instance, a February S&P option is a serial option based on the March futurescontract. The March futures and options are cash-settled, but the February optionis not. If a February S&P option is exercised or assigned, the resulting futures position will be for the March contract.
CONNECTIVITY ISSUES AND QUESTIONSIn the age of technology, glitches can and still do occur. For a trader who has become accustomed to trading online, a computer crash or a power outage at eitherthe trader’s end or the brokerage or exchange end can be a traumatic situation, especially for the trader who has a sizable position in an actively trading market. Forthat reason, some active traders maintain redundant data feeds and brokerageconnections to give them alternatives if there is any disruption to their normaltrading setup.In the event of technological difficulties or questions about orders, youshould not hesitate to call the brokerage firm’s trade desk. Situations may arise
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that you are unsure how to handle. For instance, e-cbot, the Chicago Board ofTrade’s electronic platform, does not allow a market order before the open on anyof its products. If you place a market order on e-cbot in bonds, for example, youmay receive an error message that indicates that your order is not working. Everyelectronic platform has its own nuances, and the messages you receive may notalways be clear.When in doubt, place a call. Many brokerage firms have trade centersstaffed 24 hours a day from Sunday afternoon through Friday afternoon andmay be able to deal with your trading questions and concerns before an issuegets out of hand.
CHAPTER 8
FuturesDiverse MarketsYou Can Trade
I
nvestors have thousands of stocks from which to choose—in fact, one of thebiggest challenges that stock market investors have is that there are manymore stocks than most traders can ever hope to analyze or trade. They canspend far more time finding good candidates to trade than they do deciding how totrade them.In contrast, futures traders focus on relatively few markets and can putmore effort into their trading methods. But don’t think futures traders are lacking in markets to trade. From futures on individual stocks or stock indexes tofutures on government Treasury issues to futures on commodities, traders havehundreds of contracts from which to choose in the United States and aroundthe world.Although most American traders stick to trading products on U.S. exchanges,the advent of online trading access to electronically traded markets has expandedthe horizon. Indeed, a U.S. futures trader could make a trade somewhere in theworld anytime from Sunday afternoon, when the markets open in Australia, untilFriday afternoon, when the U.S. markets close for the week. That’s nearly 120 continuous hours of market availability.This chapter explains what types of futures contracts are listed, so you understand some of the more popular products. Broadly, all futures markets fall into oneof three categories: equity-based, financial instruments, or commodities. Until currency futures began trading in 1972, futures markets were clearly designated ascommodity markets because the products traded were mainly agricultural. However, trading in futures on financial products has boomed since the mid-1970s andnow accounts for about 75 percent of all derivatives trading volume in the world,with commodities and natural resources accounting for just 25 percent of today’svolume (see Figure 8.1, Table 8.1, and Table 8.2).115
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FIGURE 8.1 Growth of Futures Trading on U.S. Exchanges. (Source: FuturesIndustry Association)
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TABLE 8.1 Top 20 Exchanges Worldwide by Exchange Contract Volume in 2004Exchange
2003
2004
EurexChicago Mercantile ExchangeEuronext.liffeChicago Board of TradeChicago Board Options ExchangeInternational Securities ExchangeBovespaMexican Derivatives ExchangeAmerican Stock ExchangeBM&FNew York Mercantile ExchangePhiladelphia Stock ExchangePaciﬁc ExchangeOMX ExchangesDalian Commodity ExchangeNational Stock Exchange of IndiaTokyo Commodity ExchangeLondon Metal ExchangeTaiwan Futures ExchangeKorea Futures Exchange*
1,014,932,312640,209,634694,970,981454,190,749283,946,495244,968,190177,223,140173,820,944180,074,778120,785,602137,225,439112,705,59786,152,63774,105,69074,973,49343,081,96887,252,21972,308,32731,874,9342,912,894,034
1,065,639,010805,341,681790,381,989599,994,386361,086,774360,852,519235,349,514210,395,264202,680,929183,427,938161,103,746133,401,278103,262,45894,382,63388,034,15375,093,62974,511,73471,906,90164,973,4292,586,818,602
*Korea Futures Exchange ranks number one in terms of volume because of thelarge size of its KOSPI 200 futures and options contracts.Source: Futures Industry Association.
EQUITY-BASED FUTURESIt’s not surprising that some of the most popular futures contracts are related tothe equity markets, the most prevalent form of investment. Most majoreconomies with a vibrant stock market also have a futures contract on a stockindex that represents that particular economy. For example, in the United States,futures contracts are available on the Dow Jones Industrial Average as well asthe broader Standard & Poor’s (S&P) 500 Index and the technology-orientedNasdaq-100 index. Other countries have similar futures contracts, such as theFTSE-100 for the United Kingdom, the Hang Seng in Hong Kong, and the CAC 40in France; the Dow Jones Euro STOXX 50 covers selected stocks in the euroeconomy.All stock markets are influenced by news about the domestic economy, inflation, currency values, politics, interest rates, and the like, because those are thefactors that affect companies’ earning potential. Technical factors such as tick volume and breadth also come into play.
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TABLE 8.2 Top 20 Contracts Traded Worldwide (in millions—net ofindividual equities)Contracts Traded
2003
2004
3-Month Eurodollar Futures, CMEEuro-Bund Futures, EurexTIIE 28 Futures, MexDer10-Year T-Note Futures, CBOTE-mini S&P 500 Index Futures, CMEEuro-Bobl Futures, Eurex3-Month Euribor Futures, Euronext.liffe3-Month Eurodollar Options, CMEEuro-Schatz Futures, EurexDJ Euro Stoxx 50 Futures, Eurex5-Year T-Note Futures, CBOTInterest Rate Futures, BM&FE-mini Nasdaq 100 Futures, CME30-Year T-Bond Futures, CBOTDJ Euro Stoxx 50 Options, EurexCAC 40 Index Options, Euronext.liffeNo. 1 Soybeans Futures, DCE10-Year T-Note Options, CBOTKospi 200 Futures, KofexKospi 200 Options, Kofex*
208.77244.41162.08146.45161.18150.09137.69100.82117.37116.0473.7557.6467.8963.5261.7973.6760.0041.1762.202,837.72
297.58239.79206.03196.12167.20159.17157.75130.60122.93121.66105.47100.2977.1772.9571.4163.1557.3456.8855.612,521.56
*Kospi 200 options trading on the Korea Futures Exchange rank number onein terms of volume, but their rank is based on their comparatively largecontract size of KRW100,000 × the index.Source: Futures Industry Association.
Stock IndexesStock index futures contracts were introduced in the United States in 1982, nineyears after listed equity options began trading at the Chicago Board Options Exchange (CBOE), the equity options offshoot of the Chicago Board of Trade(CBOT). Interestingly, the CBOT had come up with the idea of futures on stocks inthe mid-1960s as a way to diversify its product line.The Kansas City Board of Trade launched the first stock index futures contract on the Value Line Index in February 1982, followed a few months later by theS&P 500 Index futures contract on the Chicago Mercantile Exchange (CME),which quickly became the leader and continues to dominate U.S. stock index futures trading more than 20 years later. A number of stock index futures and options contracts are now available to traders, covering all areas of the stockmarket. Here are the major indexes that you are most likely to trade.S&P 500 Index The Standard & Poor’s 500 stock index is a market valueweighted index of 500 large-capitalized stocks traded on the New York Stock
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Exchange, American Stock Exchange, and the Nasdaq National Market Execution system. Because the S&P 500 Index is capitalization-weighted, those stockswith the most shares outstanding at the highest prices will have the most influence on the index movement. The S&P 500 Index, introduced in 1957, is currently the investment industry’s standard for measuring portfolio performance.The original S&P 500 Index futures contract was valued at $500 times the index. As the stock market began to surge higher, the index more than doubled inthree years. With the index approaching the 1000 level, the value of the contractneared $500,000, and a 10-point change in the index was worth $5,000. The marginrequirement for that size contract priced many traders out of the market as therisk became too large.So the CME took two significant steps:1. Introduced an S&P 500 Index futures contract that was one-tenth the size of
the original S&P 500 contract in September 1997. At $50 times the S&P 500 Index, the value of this new E-mini contract brought the initial margin down toaround $4,000.2. Took a page out of the book of stock splits, cutting the value of the big S&P500 Index futures contract in half to $250 times the index beginning in midNovember 1997.Even with a margin requirement of only about 6 percent of the contract’svalue, the rising stock market put the initial margin at $15,000 with this $250,000contract, keeping the S&P futures contract out of the reach of many individualspeculators. The E-mini put the S&P 500 Index within the capabilities of many individual accounts.But the real innovation was letting small orders of this new E-mini markettrade entirely on an electronic platform and not in the traditional open-outcry pits.CME officials decided that trading orders could take place entirely on a tradematching computer with no human intervention, giving traders direct access tothe market without going through an order handler. Electronic trading would nolonger be limited to after-hours trading or to supplement the primary pit contract,but it became the mainstream market for the E-mini contracts as the allowablenumber of contracts was increased over time. And, as long as trading was all computer-based, the CME also decided it might as well keep the market open almost24 hours a day.The radical move caught the wave of online trading and day trading that wasrevolutionizing the stock market at the same time. Opening-day volume for theE-mini S&P 500 on September 9, 1997, totaled 7,987 contracts. That doesn’tsound like much compared to today’s volume, which sometimes tops one millioncontracts a day. But it was the best first day for any CME product, including thebig S&P 500 contract. In only a little over a year, the E-mini S&P was the thirdmost active stock index contract in the country, trailing only the big S&P 500 futures contract and options on S&P 500 futures.
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The term E-mini has come to denote any futures contract (particularly stockindexes) on any exchange whose contract value is appealing to individual investors and trades on an electronic platform. However, “E-mini” is actually atrademark of the CME and has been applied to a variety of CME markets, fromstock index to foreign exchange to livestock.Nasdaq-100 Index The Nasdaq-100 index is a modified market capitalizationindex and includes the top 100 nonfinancial stocks (both domestic and foreign)listed on the Nasdaq Stock Market. Dominated by stocks such as Microsoft, Intel,Cisco, and Dell, the index is frequently