Limit moves usually occur as aresult of an unexpected increase in supply or demand, perhapscaused by weather (storms or droughts), cartels (OPEC), or an unexpected government crop report. The greatest fear that any futurestrader has is that he will get caught on the wrong side of a prolongedlimit move and not be able to get out of his position. If this happens,huge losses could occur.However, whenever there are listed futures options trading, thetrader can extract himself from a limit move at any time. This strategy—using options as the equivalent of the underlying—is mandatory knowledge for every futures trader, for it can allow him toremove himself from a position that is locked limit against him. Thisknowledge can keep a loss small, preventing it from ballooning out ofcontrol to the point where the account might even be wiped out.In late January of 1993, lumber had an extended move, trading up the limitseveral days in a row. March lumber futures were trading at 279 when housing starts were reported to be a very positive number. This expectedincrease in demand for lumber caused the futures to rise the five-point limitand lock there, limit up at 284, for the remainder of the day. The nextseven(!) days, lumber was also up the five-point limit with virtually no tradingtaking place. Buyers were bidding, but there were very, very few willing sellers as more bullish statistics regarding housing sales and building projectionswere released by the government. As with many commodity futures, thelimit increases if it is repeatedly hit. So after the eighth day of limit moves,the limit was increased to 10 points. Still, the demand was so great that thefutures locked limit up for two more days! It now had risen to 339, andvirtually no trades had taken place for 10 days. Short sellers were on theverge of being wiped out, since a one-point move in lumber is worth $160.
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So, the 55-point move from 284 to 339 was costing shorts $8,800per contract.Worse yet, the bull move was far from over, and the limit was raised to15 points. After trading off the limit for a few hours on the 11th day, thefutures contract locked limit up once again. Even the increased trading limitstill couldn’t stem the tide. Over the next nine days, lumber closed limit upeight times. Moreover, on five of those nine days, it was locked limit up allday. By this time March lumber was trading at 441. Thus, the loss on oneshort contract—if it was not covered during the few times that there hadbeen free trading—had now reached 157 points, or $25,120!This was a classic case where options could have saved the shorts agreat deal of money. Lumber traders who understood options could havecovered on that first day, when the futures locked limit up at 284. Theywould have paid a price of about 288 to cover their position. Thus, theycould have taken a 4-point loss, even after the series of limit moves hadbegun, as compared to the 55-point, or 157-point, losses that nonoptiontraders had to sustain. Moreover, option traders, if they didn’t cover thatfirst day, could have covered any day thereafter that they wanted to,although it got more expensive to do so each day.
Veteran futures traders can relate many horror stories of beingcaught on the wrong side of extended limit moves. A couple of others that come to mind are orange juice, in the fall of 1991, when itrose from 127 to 168 on a series of six limit moves without anychance to cover. Since orange juice is worth $150 per point, thattranslated into a $7,650 loss per contract. Also, in the spring of1995, cotton futures sustained a series of limit moves in both directions! The wildest action came when the July contract was first limitdown for five days in a row. Then, after a couple of days of free trading, it was up the limit for eight days in a row. In fact, cotton continued to be crazy all summer, with several others series of limit movestaking place.In this section, we have talked about only two equivalences: (1)long call plus short put is equivalent to being long the underlying, and(2) short call plus long put is equivalent to being short the underlying.It is these two concepts that can save the skin of any futures trader. Ifyou are trading futures and you don’t understand this concept,then stop trading futures or learn the concept. You have no other
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choice, in my opinion. Let’s use the lumber futures and their options,from the narrative, to look at just how this works.Example: On the first day that November lumber locked limit up at 285,the Nov 285 call settled at 8 and the Nov 285 put settled at 5. Now, normally, a futures put and call with the same terms would trade for the sameprice when the underlying futures settle right at their striking price. However, that is not necessarily the case when limit moves are involved, becausethe options are “predicting” where the futures should be trading, were theyallowed to trade freely.Suppose that we are viewing this situation from the viewpoint of atrader who is short the November lumber futures contract, which is nowlocked limit up. He could have bought the Nov 285 call for 8 and sold theNov 285 put for 5, a 3-point debit. By executing this simple trade, he wouldhave eliminated any further risk for himself. His option trades—long calland short put—are the equivalent of being long November lumber futures,and his futures position is short November lumber futures. Therefore, thesum of the two is a flattened position. Moreover, the price at which he hascovered the futures is equal to the striking price plus the debit of the optionposition, or 285 + 3 = 288 in this case.In order to verify this, note that if futures continue to rise, he will eventually be able to exercise his long call at expiration (or if it becomes verydeep in-the-money and loses its time value premium). The call exercisemeans he buys lumber futures at 285, no matter how high they actually areat the time of the exercise. Since he also paid the 3-point debit for theoption position, he has a net cost of 288 (285 + 3) for covering his futures.Thus, he was able to cover his short futures at 288, saving himself countlessheartaches as the ensuing bull move developed—a move that trapped theshorts who didn’t understand this concept.
Note that if the lumber futures had suddenly plunged after thetrader established his option position (long call and short put), it wouldhave made no difference to him in terms of his exit price. Althoughthis didn’t really happen, suppose that lumber futures had fallen to225 or so. Eventually, he would be assigned on his short put. Thatassignment means he would buy the futures at 285, the striking price.Again, he must add the 3-point debit that he originally paid for theoption position, so his net cost for covering the futures would againbe 288. Thus, no matter which way futures go after the option trade
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is established, he has locked himself into a buy at 288. He has no further risk or reward potential once the option trade is established; hehas equivalently covered his short at 288.Oftentimes, it’s best to take the first loss—it may be the smallestone. In the case of lumber, that first loss would have involved usingoptions to equivalently cover the short at 288. In the real-life lumberexample, things got much worse as time passed. By the time lumberhad risen the daily limit for six days in a row and had reached 335,the options were priced quite a bit higher than the market. In fact,the following prices were quoted at that time:November lumber: 335 (limit bid)Nov 335 calls: 30Nov 335 puts: 12If the short seller had waited this long to attempt to cover, hewould have had to pay a greater premium over the settlement price.In fact, if he bought the calls at 30 and sold the puts at 12, this wouldentail an 18-point debit. Thus, his eventual buy price would be thestriking price plus the debit, 335 + 18 = 353. So, you can see thatas more and more limit days piled up, the options began to get moreand more expensive. Still, covering at 353 was a bargain comparedto waiting until 460, when the bull move finally ended.This strategy would have been a welcome one for cotton tradersin the spring of 1995 when, as mentioned earlier, the futures tradedlimit down for five days and then shortly after traded limit up foreight days. Think how frustrating it would have been to be short thecotton futures and have a nice unrealized gain, only to get caught inthe limit up moves and give it all back. Cotton traders who understood options wouldn’t have worried, for on the first limit up day,they could have executed the long-call–short-put option strategy(equivalently covering their short position) and locked in their profitsat that time.Traders who are long and who get trapped in a series of downlimit moves can use the companion option strategy to extract themselves. They would buy the put and sell the call in order to establishan option position that is the equivalent of a short futures contract.This would then offset their long futures contract that they actually
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own, and the loss would be locked in. There would be no further risk(or reward either).In summary, futures traders must understand this strategy. It doesnot prevent losses from ever occurring, but it does allow one to takehis losses when he wants. He will never be “caught” by a series oflimit moves and have to stand helplessly by while his equity dissipates. As to when you should use the option strategy, I would use itwhen the futures trade through your stop price. For example, if youwere short November lumber that day and had a stop in to cover at289.25, your stop was never executed because the futures jumpedfrom 285 to 290 and no trades took place—not even at 290. I wouldthen step in and execute the option strategy because the stop pricehad been exceeded.
OPTIONS AS A PROXY FORTHE UNDERLYINGIn the first part of this chapter, we discussed how to use options tocompletely replicate a position in the underlying security. Anotheruseful option tactic is to use options as a proxy for the underlying.Generally, this is done when you want more leverage or less risk, orboth, than the underlying security itself possesses.
Option Buying as a Short-TermStock SubstituteIn Chapter 1, we dealt with buying calls as a substitute for buyingstock or futures. The idea was to use an in-the-money call option forthat purpose, for it provides leverage but also is not so subject to theravages of time decay. The in-the-money option has very little timevalue premium to begin with.The same philosophy can be applied to buying short-term, inthe-money puts as a proxy for shorting stock. This has the additionaladvantages that we described when we discussed fully equivalentpositions: the short sale proxy can be obtained without needing an
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uptick; and, in the case of common stock, there is no borrowing necessary. Moreover, since in-the-money puts generally have even lesstime value premium than in-the-money calls do, it is usually quiteeasy to find an in-the-money put that has very little time value premium. In both cases, the in-the-money option will mirror almost allof the short-term movement of the underlying. This is an especiallyattractive feature for a short-term trader.
Option Buying as a Long-TermStock SubstituteShort-term traders aren’t the only ones who can benefit from the limited-risk nature of owning a call as opposed to owning the underlyingsecurity. Investors with a longer-term viewpoint can avail themselvesof this feature as well; they could substitute a long in-the-money callfor their long stock. As long-term calls (LEAPS) have become morepopular, brokers have been advising investors of the benefits of selling the stock they own and buying LEAPS as a substitute, or buyingLEAPS instead of making an initial purchase in a particular commonstock. This strategy also increases in popularity during long bullishruns in the stock market.If an investor sells his stock and buys a call option, he hasremoved quite a bit of money from the market. He should then takethat money and buy a bank certificate of deposit (CD) or a T-billwhose maturity more or less matches the expiration date of theoption he purchased. The option gives him upside profit potential,while most of his money is safe in CDs or T-bills. Even if things goterribly awry and the stock collapses and the option expires worthless, he will still have his money in the bank, plus the interest earnedby the CD or T-bill.The costs to the stock owner who decides to use this strategy arecommissions, the time value premium of the call, and the loss of dividends. The benefits are the interest that can be earned from freeingup a substantial portion of his funds, plus the fact that there is lessdownside risk in owning the call than in owning the stock. Theregenerally is a net cost of switching; that is, the interest earned won’tcompletely offset the loss of the dividend, the time premium, and the
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commissions. The investor must decide if it is worth that cost in orderto have his downside risk limited over the life of the LEAPS options.The cost to switch may seem like a reasonably small price to payto remove a lot of downside risk. However, one detriment thatmight exist is that the underlying common stock might declare anincreased dividend or, even worse, a special cash dividend. TheLEAPS call owner would not be entitled to that dividend increase—inwhatever form—while, obviously, the common stock owner wouldbe. If the company declared a stock split or a stock dividend, it wouldhave no effect on this strategy since the call owner is entitled to astock split or stock dividend.There may be other mitigating circumstances involving tax considerations. If the stock is currently a profitable investment, the sale wouldgenerate a capital gain, and taxes might be owed. If the stock is currently being held at a loss, the purchase of the call would constitute awash sale, and the loss could not be taken at the current time.
Using LEAPS Puts instead of CallsIn the preceding strategy, the stock owner paid some cost in order tolimit the risk of his stock ownership to a fixed price. He might be ableto accomplish the same thing at a lower cost to himself. If he buys aLEAPS put against the stock that he owns, he has a position that isequivalent to owning a LEAPS call. He would still have upside profitpotential (now in the form of long stock), he would have downsideprotection (provided by the long put), he would have spent less incommissions (only the commission for the put), and he might not disturb the tax holding period of his stock.The comparison between substituting a call or buying a put is arelatively simple one. Merely compare the cost of switching with thecost of the put. If arbitrageurs are doing their job, the put will mostlikely be the better way to go. Moreover, capital gains don’t haveto be realized with this method. The purchase of a put may suspendhis holding period for tax purposes (if he is not already a long-termholder), but the LEAPS call strategy had its own tax complications.Moreover, he would remain fully represented for all dividends sincehe continues to own the common stock.
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Whether the strategist uses the put or the call, if the underlyingstock rises in value, he will want to sell the LEAPS option he ownsand buy another one with a higher strike, in order to further protectthe profits that build up as the stock rises.In my opinion, the purchase of a LEAPS put is a more efficientway to protect long stock. However, the former strategy—selling thestock and replacing it with a long call—is usually preferred by brokerage firms.
THE EFFECT OF STOCK INDEXFUTURES ON THE STOCK MARKETThe strategy of buying puts on individual equities in order to protectthem from downside loss is the simplest usage of a derivative securityto hedge a position. Another simple strategy is to sell index futuresagainst stock holdings. The main problem with doing that is that itremoves the upside potential from one’s portfolio, a distasteful alternative to almost all stockholders. There are more complex strategies,of course, most of which have to do with hedging an entire portfolioof stocks with derivatives.The idea of using derivatives to insure a portfolio of stocks firstachieved recognition in the mid-1980s when the term portfolioinsurance became widespread. At that time, the theory involved selling Standard & Poor's (S&P) 500 futures contracts against a portfolio of stocks in a particular manner. Since there are a couple of otherstrategies that also involve selling S&P 500 futures against a portfolio of stocks—index arbitrage and program trading—the variousstrategies are often confused with each other, especially by themedia. There are also theories that involve the purchase of index putoptions to protects portfolios. We explore these various strategies inthis section.First, it may be useful to spend some time clarifying the threestrategies involving futures before we actually approach the topic ofhow portfolio insurance is structured today. These futures strategiesoften have an effect on the movements of the overall stock market, soit is important for nearly all stock traders to understand these effects.
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Index ArbitrageIndex arbitrage is the easiest one to understand, for in this strategythe arbitrageur takes a position in a stock index futures contract andtakes exactly the opposite position in the stocks themselves. Forexample, an arbitraguer might sell the S&P 500 futures and more orless simultaneously buy the correct amount of each of those 500stocks, in order to set up a perfect hedge. With computerized trading, 500 stocks can be bought almost simultaneously with the pushof a button.Arbitrage, by the way, is merely the simultaneous buying andselling of the same thing in two different forms. For arbitrage tobe profitable, the arbitrageur must have at least a small positive differential in price between what he buys and what he sells. One common example involves the strategy that we have spent a great deal ofthis chapter discussing—using options to establish a position that isequivalent to the underlying security. Thus, if you buy a call and sell aput, you have a position that is equivalent to long stock. If you thenshort the underlying stock, you have an arbitrage, because youbought the stock in one form (the option equivalent form) and soldthe stock itself. Most of the time, arbitrage produces a profit that isonly a fraction of a point; however, when done repeatedly, theseprofits add up. There are countless ways in which arbitrage can bedone, but usually only member firms can trade arbitrage profitably,because commissions would wipe out the profits for a public traderor customer.Arbitrage is an ancient and widely practiced trading method. It isboth useful and necessary, especially in the derivatives markets, inorder to provide liquidity and depth to markets. If arbitrage is notpossible in a derivative contract, or if arbitrage is extremely difficult,the contract often fails within a short period of time.Now let’s return to index arbitrage, specifically. If an index arbitrage is established at favorable prices, the arbitrageur locks in aguaranteed profit on the trade. It may behoove us to spend a minuteexplaining why and when index arbitrage is profitable, for thatknowledge is necessary for any day trader of index futures contracts,particularly, the S&P 500 Index futures. On any day, the trader cancalculate the fair value of the S&P 500 futures contract. This fair
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value is a function of only four things: (1) the price of the S&P 500Cash Index, (2) interest rates, (3) the time until the contract expires,and (4) dividends on the S&P 500 stocks themselves. The actual formula isFair value of S&P futures = [SPX × (1 + r)t] – dividendswhere SPX = S&P 500 Cash Index, r = the risk-free interest rate, andt = time remaining in years.Example: Suppose the S&P 500 Cash Index is trading at 561.00. Also,there are 51 days remaining until the contract expires, short-term T-bill ratesare 6 percent, and the total of all dividends to be paid by the S&P 500 stocksduring the next 51 days is $3.23. Note that 51 days is 0.1397 year.Fair value = [561.00 × (1.06)0.1397] – 3.23= [561.00 × 1.0082] – 3.23 = 562.36Sometimes the fair value is stated strictly in terms of the premium of thefutures contract, which in this case is 562.36 – 561.00 = 1.36, premium.
The premium of the futures versus the cash index fluctuatesduring the trading day as supply and demand forces the marketaround. If the futures acquire too much premium (we’ll define toomuch shortly), they are said to be expensive; and arbitrageurs will sellthe futures and buy stocks. This action alone will force the stock market higher for a short while, until the excess premium is removedfrom the futures. Since the arbitrageurs are selling futures at thesame time that they are buying stocks, it usually only takes a shorttime before the arbitrage opportunity disappears—the arbitrageurs’own actions force the premium of the futures versus the cash indexto shrink.In a similar manner, the futures may trade down below fair value;that is, they are said to be trading at a “discount” [to fair value]. Iffutures get too cheap, then arbitrage can be done in the oppositemanner: futures are bought and stocks are sold. If the arbitrageur hasno position prior to establishing this position, then he must sell thestocks short. Since selling stocks short requires that they be sold on
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upticks, this form of arbitrage is more difficult to enact. However,many arbitrage firms will initially buy stocks and sell futures at fairvalue—meaning they have no profit in the position—in order to have“ammunition” to be able to sell stocks (long) and buy futures whenthe futures go to extreme discounts.Index arbitrage is available almost every trading day. All the arbitrageur (arb) needs in order to make money is for the futures premium to deviate from fair value by an amount large enough to coverthe arb’s transaction costs (which are low).Example: Suppose again that the fair value for the S&P 500 futures premium is 1.36, as in the previous example. Arbitrageurs have quotemachines that can display the S&P 500 Index in at least three ways: the lastsale value (which is what is widely disseminated), the bid value, and the offervalue. For example, the offer value would be the price that the arb wouldpay for the S&P 500 Cash Index if he were able to buy all 500 stocks ontheir current offering price.An arb sees that the S&P 500 Cash Index is trading at 561.00 and theIndex is offered at 561.50; that is, it would actually cost 561.50 for the arbto buy the Index in its correct composition (the proper amount of all 500stocks). Furthermore, he notes that the futures are running to the upside,and they are currently selling at 563.75. So, if he could sell futures at563.75 and buy the Cash Index on the offering at 561.50, he would haveestablished the arbitrage at a 2.25-point differential. Since fair value is only1.36, this means that he has 0.89 profit in his pocket (2.25 minus 1.36,less transaction costs, which will be quite small).
In reality, our mythical arbitrageur is not the only person in townwho sees this opportunity. In fact, every index arbitrageur sees thisopportunity on his quote machine. Therefore, they may all rush in atonce to execute the arbitrage. This causes two things to happen: (1)the arbitrage opportunity usually disappears quickly, and (2) none ofthem actually get to buy the S&P 500 Cash Index at 561.50 becausethey are all forcing prices higher.So, in reality, an index arbitrageur builds in a “fudge factor,” orslippage, to account for the fact that he may have to buy the CashIndex at a higher price than is shown on his screen. Most arbitrageurs want to see the futures at least 0.70 to 0.90 overvalued or
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undervalued before they will attempt to execute the arbitrage. Forthis reason, we do not constantly see the stock market being buffetedby buying and selling from index arbitrageurs. The futures don’t normally get that far away from fair value; but, as stated earlier, they doget far enough out of line at least once or twice a day, almost everyday, for arbitrage to be profitably established.I have noticed a very easy way to tell if buy or sell arbitrage isactively being done in the market: watch an indicator called TICKI. Itcan be quoted on all the major quote machines. It is the net upticksor downticks of the 30 stocks in the Dow Jones Industrials. Therefore, its maximum value is +30 and its minimum value is –30. IfTICKI rises to +22 or higher, you can be sure that computerized buyprograms are being executed; if TICKI falls to –22 or lower, computerized sell programs are taking place. A trading system using thisindicator is explained in Chapter 5.So, the action of index arbitrage being established causes shortterm movements in the stock market. However, it also causes thearbitrage opportunity to disappear (in theory), so index arbitragedoes not have a lasting effect on the market. It may all be over withina matter of minutes, depending on what causes the futures to be mispriced in the first place. In fact, you may wonder why the futures everget overpriced or underpriced to begin with. Usually, it is becausesomeone who is not interested in arbitrage decides to take a relatively large position in the futures. What follows is one of history’sclassic examples.In the winter of 1995, Barings Bank collapsed under the weight of a nowinfamous trader who overextended the bank’s resources. Many people stilldon’t understand what happened there, but we can summarize the debacle:the trader sold naked straddles on the Japanese stock market; and then,when the market suffered a rather severe and quick decline, he didn’t coverthe naked short straddles. Instead, he bought index futures in an attempt toforce the entire Japanese stock market higher in order to bring his positionback to profitability. Perhaps the first part of this story belongs in Chapter2, along with the discussion of selling naked straddles, but we prefer it herebecause it relates to index arbitrage as well.Once the market fell initially, it was at levels below the break-even priceof the straddles. The trader then decided to buy index futures on the
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Japanese stock market. He was able to buy these on small amounts of margin. As he bought enough of these futures, he created a large premium onthe futures. This attracted index arbitrageurs, who actually bought Japanesestocks and sold the futures. Thus, the arbitrageurs were in fact forcing theJapanese stock market higher, but only briefly. After each bout of arbitragebuying, the index futures returned to approximately fair value, and the Barings trader had to buy more futures and start the cycle all over again.By the time that Barings ran out of money, the strategy had worked toa certain degree—open interest in the Japanese index futures was at itslargest level in history, indicating that plenty of index arbitrageurs wereloaded to the gills with positions. Unfortunately, the Japanese stock marketdropped farther, due to natural market activity; and Barings was wiped out,for they not only were short straddles but now were also long massiveamounts of index futures. Add to that the fact that they had bought thosefutures at inflated prices, which added more to the losses, and you have thestory of how a long-standing institution went out of business in a very shorttime. The real problem, of course, was that the trader—or his supervisors—should have covered some or all of the short puts when the naked straddlesfirst got into trouble. This would have meant taking a loss, but they wouldhave still been in business.
Portfolio InsuranceNow let’s move on to the second of the three strategies that involveselling index futures against stocks that are owned, portfolio insurance. Many portfolio managers in the mid-1980s were attracted tothe protective quality of owning puts against their stocks, but theydidn’t like the cost of the (expensive) puts. If the market continued torise, the puts that the manager bought would expire worthless, andhis performance would suffer in comparison to both his competitorswho didn’t buy puts and the overall stock market.Despite this aversion to paying put premiums, the fast-risingmarkets of those years—which saw the Dow Jones Industrials nearlytriple between 1982 and 1987—were making stockholders nervous;and there was demand for a product that would offer downside protection without having the onerous cost of owning puts. In addition,the protection should still afford room for upside appreciation if themarket continued to rise.
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In response to this demand, a strategy was created that wastermed portfolio insurance. In essence, it worked like this: initially,the stockholder did nothing to hedge his stock position. However,if the market dropped by a certain fixed amount, then the portfoliomanager would sell futures against a portion of his holdings, perhaps10 percent to 20 percent on this first sale. Then, if the marketdropped further, more futures would be sold to provide more protection. Finally, if the market dropped far enough, enough futures wouldbe sold so that the entire portfolio would be protected. This strategyhad several attractive features. First, even though futures weren’t solduntil the market started to fall, if the strategy was executed properly,the only loss to the portfolio would be approximately the same as thetime value premium if puts had been bought in the first place. Second, if the market rallied initially, then there was no expense at allsince no futures were sold. Finally, the portfolio manager was gettingthe benefit of selling futures, which trade at a premium to the cashindex, so he eventually would be making a small profit from that premium as well. On paper, the mathematics all worked out, and thestrategy attracted several large institutions as practitioners.Unfortunately, there was one flaw in the strategy, a flaw that iscommon to many theoretical attempts at trading in the market: itassumed a relatively stable and rational market environment in whichto operate. This flaw led to disaster and was the main reason why thecrash of 1987 became a crash, rather than just a very nasty downturn in the market.The stock market had peaked at just over 2,700 in late August of 1987 (therally had begun from just below Dow 800 in August of 1982). It then fellback to about 2,500 but rallied again to 2,640 by