FUTURES
THE OPTIONS COURSE
To  the  novice,  futures  contracts  can  be  quite  confusing;  yet  they  offer  aunique  opportunity  to  make  money  in  today’s  volatile  markets.  Futuresmarkets  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 uni-form quantity and quality of physical or ﬁnancial commodities at a desig-nated time in the future at a speciﬁc price. The contracts themselves aretraded on the futures market.
Futures  markets  gave  rise  to  two  distinct  types  of  traders:  hedgersand speculators. Hedgers consist primarily of farmers and manufacturers.Futures  contracts  were  initially  used  by  farmers  and  manufacturers  toprotect themselves or lock in prices for a certain crop or product cycle.Hence, hedgers are primarily interested in actually selling or receiving thecommodities themselves. Keep in mind that futures prices are directly dri-ven  by  consumer  supply  and  demand,  which  is  primarily  dependent  onevents and seasonal factors.
For  example,  if  you  are  a  farmer  who  grows  wheat,  soybeans,  andcorn,  you  can  sell  your  products  even  though  they  have  not  yet  beenfarmed. If the price of corn is at a level that you like, you can sell a corre-sponding number of futures contracts against your expected production.An oil company can do the same thing, locking in the price of oil at a levelto 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. Tomake a proﬁt, a company has to predetermine the price of its productionand plan accordingly.
The other players are the speculators. These traders play the futuresmarkets to make a proﬁt. Speculators do not expect to take delivery of aproduct  or  sell  futures  to  lock  in  a  crop  price.  Most  contracts  are  nowtraded on a speculative basis. In other words, most people are in the fu-tures market to try to make money on their best judgment as to the futureprice movement of the futures contract. For example, if you believe cornprices  will  rise  in  the  next  three  months,  you  would  buy—go  long—thecorn futures three months out. If you believe corn prices will fall duringthis same period, you will sell—go short—the corn futures contract threemonths out.
Hedgers  and  speculators  have  a  symbiotic  relationship.  They  needone another for futures trading to work. Hedgers try to avoid risk whilespeculators thrive on it. Together they keep the markets active enough foreveryone to get a piece of the action. Unlike stocks, where proﬁts depend
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on  company  growth,  futures  markets  are  a  zero-sum  game—for  eachbuyer there is a seller and vice versa.
Physical commodities are raw materials, which are traded on futuresexchanges; examples include grains, meats, metals, and energies. Finan-cial  commodities  include  debt  instruments  (such  as  bonds),  currencies,single  stock  futures,  and  indexes.  In  these  markets,  money  is  the  actualcommodity being traded, and price depends on a variety of factors includ-ing interest rates and the value of the U.S. dollar.
Physical Commodities
A  wide  variety  of  commodities  can  be  proﬁtably  traded.  Some  are  sea-sonal in nature, such as grains, food and ﬁber, livestock, metals, and ener-gies.  Some  ﬂuctuate  due  to  seasonal  changes  in  climate.  Others  maychange due to world events, such as an Organization of Petroleum Export-ing Countries (OPEC) meeting. Each market is unique. Physical commoditymarkets 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  belliesand  includes  a  variety  of  more  complex  ﬁnancial  instruments  that  tradeactively  across  the  globe.  These  so-called  ﬁnancial  commodities  includedebt instruments like government bonds as well as Eurodollars and for-eign currency exchange. Entire books can be written about any of theseinvestments.  However,  a  basic  understanding  of  the  most  important ﬁnancial  commodities  can  also  help  traders  make  sense  of  the  dailyhappenings in the ﬁnancial markets at home and abroad.
Debt Instruments Just as there are instruments to trade stocks, eitherindividually  or  collectively  as  an  index,  there  are  numerous  instrumentsavailable 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 andother lending institutions that have loans outstanding, as well as investorswho have a great deal of exposure in interest rate investments.
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Originally, the futures markets were primarily used to hedge—offsetor mitigate—risk. Today, ﬁnancial commodities, including all the interestrate  instruments,  are  growing  at  a  faster  rate  than  traditional  commodi-ties. The interest rate markets have participants from all over the worldtrading interest rates for hedging purposes and speculation. If you have in-terest rate risk or you just want to speculate on the direction of interestrates, there are plenty of markets and opportunities awaiting you. Thesemarkets are also traded extensively in off-exchange markets such as thosecreated 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. Abond  is  a  debt  obligation  issued  by  a  government  or  corporation  thatpromises to pay its bondholders periodic interest at a ﬁxed rate and to re-pay the principal of the loan at maturity at a speciﬁed future date. Bondsare  usually  issued  with  a  value  of  $1,000  to  $100,000,  representing  theprincipal  or  amount  of  money  borrowed.  Other  popular  ﬁnancial  instru-ments include:
• Treasury  bill  (T-bill). These  short-term  government  securities  havematurities of no more than one year. Treasury bills are issued througha competitive bidding process at a discount from par; there is no ﬁxedinterest rate.
• Treasury bond (T-bond). This marketable, ﬁxed-interest U.S. govern-ment 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. gov-ernment debt security with a maturity of between 1 and 10 years.• Eurodollars. Eurodollars are dollars deposited in foreign banks. Thefutures contract reﬂects the rates offered between London branchesof top U.S. banks and foreign banks.
Currency Markets The currency markets are another very large mar-ket. Most countries have their own currencies. These currencies go up ordown  relative  to  each  other  based  on  a  number  of  factors  such  as  eco-nomic  growth  (present  and  future),  interest  rates,  and  supply  and  de-mand.  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  theChicago Mercantile Exchange include the following:
• Euro (ECU or European currency unit).• Swiss franc.• British pound.
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• Japanese yen.• Canadian dollar.
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If the U.S. dollar goes up, then the Japanese yen will drop along withother foreign currencies. Keep in mind that the Canadian and U.S. dollarsmove similarly due to their physical proximity and the closeness of theireconomies. Each of these currencies will then have a rate relative to eachof  the  others.  This  cross-reference  is  referred  to  as  the  cross  rate.  Theyen/pound, euro/dollar, and so on will have their own rates at which theymay be traded.
Why  are  currencies  traded?  As  you  are  probably  aware,  many  prod-ucts are sold across borders. A company may sell $100 million worth ofcomputer equipment in Japan, and will likely be paid in yen. If the com-pany prefers to be paid in U.S. dollars, it can go into the futures market orcash market—traded from bank to bank—to change its yen purchase. Byselling yen futures contracts, the company can lock in its proﬁts in U.S.dollars.  Speculators  are  also  active  in  the  currency  markets,  buying  andselling based on their predictions for the changes in cross rates. Trillions(yes, trillions) of dollars are traded each day in the currency markets, 24hours 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 an-ticipated events in today’s ﬁnancial world. Single stock futures offer wide-spread  applications  for  both  professionals  and  retail  users.  They  werepreviously traded on the London Financial Futures and Options Exchange(which  is  now  part  of  Euronext.liffe—the  international  derivatives  busi-ness of Euronext), and the U.S. market continues to hold high promise forthese unique instruments.
Single  stock  futures  are  futures  contracts  that  are  based  on  singlestocks. As previously stated, a future is a contract to either buy or sell anunderlying instrument at a predetermined price at a set date in the future.Unlike an option, the holder of the future has the obligation (as opposedto the right) to take delivery at expiration. One single stock futures con-tract represents 100 shares of stock, which will convert into stock if heldto expiration. Like other futures contracts, SSFs have expiration monthsof March, June, September, and December. Speculators buy stock futureswhen they expect the share price to move higher, and sell futures whenthey want to proﬁt from a move lower in the stock price. Hedgers can alsouse single stock futures to protect stock positions.
Currently, there are approximately 115 single stock futures availableto  trade,  including  IBM,  Microsoft,  Citigroup,  and  Johnson  &  Johnson.Trading is done through an electronic exchange called OneChicago, which
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is  a  joint  venture  between  the  Chicago  Board  Options  Exchange,  theChicago Mercantile Exchange, and the Chicago Board of Trade. In addi-tion, trades clear through the Options Clearing Corporation (OCC).
There are several things to consider when looking at single stock fu-tures  as  opposed  to  the  outright  stock.  First,  while  a  future  could  bethought of as a price discovery tool for the stock, generally the stock andfuture will not trade at the same price. The price of an SSF is determinedaccording to the following formula:
SSF = Stock price × (1 + time to expiration × interest rate) – dividends
Since SSFs have quarterly expirations, time to expiration is based onthe remaining time until the end of the quarter. Normally the single stockfuture will trade above the stock; this is partially due to leverage of the fu-ture.  Unlike  stocks,  SSFs  require  the  buyer  to  put  up  margin  of  only  asmall  portion  of  the  underlying  stock  value  in  order  to  purchase,  rightnow proposed to be about 20 percent of the cash value of the underlyingstock. We should recognize here that margin in futures does not representborrowed money, as in stocks. Futures margin is the cash that the investormust put up in order to hold a position. As the futures are marked to mar-ket  at  the  end  of  the  day,  this  amount  may  ﬂuctuate.  The  only  time  thestock would trade over the future would be if there were a large dividendto 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 theyeasier to execute than stock, but they are also less costly. For traders whotrade stock, this added leverage will increase returns, whether the stockmoves  higher  or  lower  in  price.  Prudent  risk  management  and  carefullythought out trading strategies, as always, will carry the day.
Index  Markets As  noted  earlier,  an  index  is  a  tool  used  to  measureand  report  value  changes  in  a  speciﬁc  group  of  stocks  or  commodities.There is a variety of indexes tailored to reﬂect the performances of manydifferent markets or sectors. Here are some of the most popular marketindexes (also known as averages or market averages):
• Dow  Jones  Industrial  Average  ($INDU). The most widely followedindex, the DJIA represents 30 blue-chip stocks and is used as an over-all indicator of market performance.
• Standard & Poor’s 500 Index ($SPX). A benchmark of U.S. commonstock  performance,  this  index  includes  500  of  the  largest  U.S.stocks—400  industrial  companies,  40  utilities,  40  ﬁnancial  corpora-tions, and 20 transportation companies.
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• NYSE  Composite  Index. This  index  is  composed  of  all  the  stocks
traded on the New York Stock Exchange.
• Nasdaq  Composite  Index  ($COMPQ). This  index  tracks  the  perfor-mances of all stocks traded on the Nasdaq Stock Market. The NationalAssociation  of  Securities  Dealers  Automated  Quotations  (NASDAQ)devised  a  computerized  system  that  provides  brokers  and  dealerswith price quotations for securities traded over-the-counter as well asfor 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  7,000U.S.-based  equities  traded  on  the  New  York  Stock  Exchange,  theAmerican  Stock  Exchange,  and  the  Nasdaq  Stock  Market,  and  is  apopular 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 asan indicator of economic inﬂation.
• DAX. Similar  to  the  U.S.  Dow  Jones  Industrial  Average,  this  indextracks  the  performance  of  the  top  30  German  stocks.  This  is  not  amarket  capitalization–weighted  index;  each  company  has  an  equalweighting.
• Financial Times Stock Exchange (FTSE) Index. This index is com-posed  of  the  top  100  companies  (by  market  capitalization)  in  GreatBritain.
• 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 com-panies 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 tradein  virtually  any  type  of  market  that  interests  you.  Indexes  like  the  oneslisted 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 withand then continue learning various risk management techniques. There isa vast amount of information that everyone needs to sort out, and that’swhat makes investing so interesting. It is exciting to ﬁnd the needle in thehaystack—you just need to know where to begin looking and what to lookfor. Buying (going long) and selling (going short) are the simplest forms oftrading in futures markets. They are also the most popular strategies be-cause many individuals are not familiar with the more creative aspects of
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trading.  However,  by  learning  to  combine  stocks  with  options,  you  cancreate trades that limit risk and maximize your potential proﬁts.
Exchange-Traded  Funds Another  way  to  play  the  index  market  isthrough a relatively new investment vehicle, exchange-traded funds (ETFs).Despite their relative newness, ETFs have become among the most populartrading  tools  in  the  marketplace  today.  For  example,  you  have  probablyheard of the Nasdaq 100 QQQ Index (QQQ). Not only is it the most activelytraded exchange-traded fund today, it has one of the busiest options con-tracts. In addition, there are a host of different ETFs available to the optionstrategist today. Consequently, understanding what these investment vehi-cles are and how they trade can open up an enormous number of tradingopportunities.
The American Stock Exchange pioneered the concept of ETFs whenthe exchange launched the S&P Depositary Receipts (SPY), or Spiders, in1993. In a nutshell, ETFs trade like stocks, but represent speciﬁc indexes.Therefore,  exchange-traded  funds  offer  investors  a  way  to  buy  and  sellshares that represent entire baskets of stocks. In the case of Spiders, thebasket of stocks represents the companies included within the Standard &Poor’s 500 Index. When buying SPY shares, investors are really buying theentire S&P 500 Index. Dow Jones Diamonds (DIA), in turn, track the per-formance of the Dow Jones Industrial Average ($INDU) and started trad-ing  in  1998.  The  QQQ,  also  known  as  the  Qs,  is  today’s  most  popularexchange-traded fund and made its debut in March 1999. It tracks the per-formance  of  the  Nasdaq  100  ($NDX).  While  QQQ  options  have  been  ac-tively  traded  for  several  years,  options  on  DIA  made  their  debut  earlierthis year and there are no options yet available on the SPY.
The American Stock Exchange, however, has not been the sole playerin the ETF market. Barclay’s Global Investors introduced a series of ETFsin June 1996 called WEBs (now known as iShares). To date, the companyhas brought forth more than 60 of these so-called iShares, which trade onthe  American  Stock  Exchange.  Holding  Company  Depositary  Receipts(HOLDRS) are another type of exchange-traded fund. HOLDRS also tradeon  the  American  Stock  Exchange  and  can  be  bought  and  sold  in  roundlots of 100 shares. In addition, HOLDRS are available on a variety of differ-ent industry groups such oil service, biotechnology, semiconductors, andso  on.  Not  all  iShares  and  HOLDRS  have  options  linked  to  their  perfor-mance, however. In order to ﬁnd those that do, option traders can visit theChicago  Board  Options  Exchange  (www.cboe.com)  and  the  AmericanStock  Exchange  (www.amex.com),  where  complete  product  speciﬁca-tions 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
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fund based on the performance of the widely watched Nasdaq Composite In-dex ($COMPQ). In addition, the family of exchange-traded funds is expectedto include companies that trade on the Nasdaq from speciﬁc industries suchas  telecommunications,  ﬁnancial  services,  biotechnology,  and  so  on.  Fur-thermore, these investment vehicles will trade on the Nasdaq Stock Market.The launch of the new Nasdaq ETFs is expected to occur later this year.
While  there  are  a  number  of  different  ETFs  available  for  trading  to-day, there is an important distinction between these investment vehiclesand the more common cash-based index products. In fact, indexes and in-dex  options  date  back  well  before  the  development  of  exchange-tradedfunds. Charles Dow created the ﬁrst index in 1884. It was known as theDow Jones Railroad Average (today’s Dow Jones Transportation Average[$TRAN]). Index options did not come into existence until almost a cen-tury  later.  To  be  speciﬁc,  the  Chicago  Board  Options  Exchange  (CBOE)was the ﬁrst to list options on the S&P 100 Index ($OEX) in 1983. Sincethat  time,  options  have  been  launched  on  a  number  of  other  indexes.Some, like the OEX, reﬂect the performance of the entire market. For in-stance, traders can buy and sell options on the S&P 500 Index ($SPX) andthe Dow Jones Industrial Average ($DJX). These, of course, are familiarmeasures of the U.S. stock market. Other indexes are designed to gaugethe performance of speciﬁc sectors. These include the PHLX Semiconduc-tor Index ($SOX), the AMEX Biotechnology Index ($BTK), and the Mor-gan Stanley Oil Service Index ($MGO). There are a large number of othercash-based indexes and their complete speciﬁcations can be found on theweb  sites  of  the  Chicago  Board  Options  Exchange,  the  American  StockExchange, or the Philadelphia Stock Exchange (www.phlx.com).
There  is  an  important  difference  between  ETFs  like  the  Nasdaq  100QQQ  and  cash-based  indexes.  Speciﬁcally,  exchange-traded  funds  arephysical delivery options (i.e., settle for shares), but index options involvecash settlement. For instance, a call writer (seller) who is faced with as-signment on his or her Diamonds must deliver DIA shares. However, a callwriter of DJX options must provide cash payment (equal to the differencebetween  the  exercise  settlement  value  and  the  strike  price  of  the  indexoption). In addition, most index options settle European-style and, there-fore, exercise can only take place at expiration. By contrast, ETFs settleAmerican-style, which means that option writers can face assignment atany time prior to expiration.
OPTIONS
Options are probably the most versatile trading instrument ever invented.They  provide  a  high-leverage  approach  to  trading  that  can  signiﬁcantly
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limit the overall risk of a trade, especially when combined with stock orfutures.  As  a  result,  understanding  how  to  develop  proﬁtable  strategiesusing  options  can  be  extremely  rewarding,  both  personally  and  ﬁnan-cially. The key is to develop an appreciation about how these investmentvehicles work, what risks are involved, and the vast reward potential thatcan be unleashed with well-conceived and time-tested trading strategies.First, it is important to differentiate between futures and options. Afutures contract is a legally binding agreement that gives the holder theright  to  actually  buy  (and  take  delivery  of)  or  sell  (be  obligated  to  de-liver) a commodity or ﬁnancial instrument at a speciﬁc price. In contrast,purchasing an option is the right, but not the obligation, to buy or sell aﬁnancial  instrument  (stock,  index,  futures  contract,  etc.)  at  a  speciﬁcprice. The key here is that buying an option is not a legally binding con-tract.  In  contrast,  selling (writing  or  shorting)  an  option  obligates  theseller  to  provide  (or  buy)  the  instrument  at  the  agreed-upon  price  ifasked to do so.
So, option buyers have rights and option sellers have obligations. Op-tion buyers have the right, but not the obligation, to buy or sell a stock, in-dex,  or  futures  contract  at  a  predetermined  price  before  a  predeﬁnedexpiration date. In contrast, option sellers, sometimes called writers, havethe obligation to buy or sell the underlying stock shares (or futures con-tract) if an assigned option buyer or holder exercises the option.
There are two types of options contracts: puts and calls. A put op-tion is an options contract that gives the owner the right to sell (or put)the  underlying  asset  at  a  speciﬁc  price  for  a  predetermined  period  oftime. Call options, in contrast, give the option holder the right, but notthe obligation, to buy a stock at a predetermined price for a speciﬁc pe-riod of time.
Importantly, for every option buyer there is a seller. Buyers and sell-ers  do  not  deal  with  one  another  directly,  but  through  their  respectivebrokerage ﬁrms. If an investor sells a call and the new owner exercises
Two Types of Options
Puts: A bearish type of options contract that gives the buyer the right, butnot the obligation, to sell, or put, a speciﬁc asset (stock, index, or futurescontract) at a speciﬁc price for a predetermined period of time.
Calls: A bullish type of options contract that gives the buyer the right, butnot the obligation, to buy, or call, a speciﬁc asset (stock, index, or futurescontract) at a speciﬁc price for a predetermined period of time.
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the  call,  the  call  seller  has  the  obligation  to  deliver  the  ﬁnancial  instru-ment to the option holder at the call strike price. The call seller will getnotice from the broker that he or she must provide the stock or futurescontract  to  the  option  holder.  This  is  known  as  assignment.  Once  as-signed,  the  option  writer  is  obligated  to  fulﬁll  the  terms  of  the  optionscontract.
A put seller, in contrast, has the obligation to accept delivery of the ﬁ-nancial  instrument  from  the  option  holder.  If  the  put  seller  is  assigned,the brokerage ﬁrm will notify the put seller that he or she must buy the ﬁ-nancial instrument at the predetermined price. In Chapter 3 we explainhow to anticipate the assignment of a short option. For now, it is impor-tant to understand that a put owner has the right to exercise the optionscontract and, if so, the option seller will face assignment on the option.Therefore, if you decide to write an options contract, you must be willingto face the prospect of assignment—which, as we later see, can involvesigniﬁcant risks.
To see how options work, let’s consider an example using a stock op-tion. Say that you believe the price of IBM is going to rise over the nextthree months. But instead of buying 100 shares of IBM, you decide to buya call option. The IBM call gives you the right, but not the obligation, tobuy 100 IBM shares for a speciﬁc price until a speciﬁc point in time. Forthis right you pay a price: the option premium. Furthermore, you can exer-cise  the  right  at  any  time  until  the  option  expires—that  is,  unless  youclose the position before the option expires. You can close an option posi-tion at any time through an offsetting transaction. For example, if you buyan  IBM  call  options  contract,  you  can  close  the  position  at  any  time  byselling an identical IBM call options contract.
In  another  example,  suppose  you  do  not  own  any  options 