the sameunderlying security. However, in a broader sense, whenever we arelong one security and short another related security, we have aspread in place. Such a spread might be established with stock,futures, or options. Stock traders often call these positions "pairstrades" rather than spreads.Within this broad concept of spreads, we can divide all spreadsinto two broad categories: intermarket spreads and intramarketspreads. Intramarket spreads involve spreading futures or optionsthat have the same underlying stock or commodity. For example,going long December corn and simultaneously shorting Septembercorn would be an intramarket spread using futures. An intramarketspread using options would be any of the normal options spreads, forexample, buying the IBM Jan 100 call and selling the IBM Jan 110call. This is an intramarket spread because both sides of the spreadare options on the same underlying security, IBM.Intermarket spreads are spreads that, as the name implies,involve one market spread against another. They may be closelyrelated markets, such as T-bonds and municipal bonds, or they maybe more loosely related, such as T-bonds and utility stocks. Anintermarket spread may even be a spread between two stocks thathave a tendency to move somewhat in unison, a strategy calledpairs trading. In any case, there is normally a well-defined historical relationship between the two markets. Within that relationship,however, swings can occur. When the swings are wide enough,there are opportunities to profit by trading the two markets againsteach other.There are general relationships between many markets. The ideabehind interindex spreading is often to capitalize on your view of therelationships between the two indices without having to actually predict the direction of the stock market. Note that this is often the philosophy behind many option spreads as well. For example, have youever heard some analyst say that he expects small-cap stocks to outperform large-cap stocks? This analyst should consider using aninterindex spread between the S&P 500 Index and the Value Line
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Index (which contains many small stocks) or perhaps between theS&P and an over-the-counter index. If he buys the index that comprises smaller stocks and sells the S&P 500 Index, he will makemoney if his analysis is right, regardless of whether the stock marketgoes up or down. All he wants is for the index he is long to outperform the index he is short.Before getting into specific markets that have proven to be tradeable over time, we describe the two main strategies for implementingthe spreads: using futures or using options. The simplest way toimplement a spread is to use futures, or the equivalent position. Forexample, if we were spreading T-bonds against muni bonds, wecould use futures in both markets. However, if we were spreading Tbonds against the Utility Index, we would have to use the equivalentof futures.When you are trading an index—particularly a sector index—as part of anintermarket spread, you can’t actually buy or sell the index itself; and youcan’t normally buy or sell a futures contract on the sector, either. However,by using options and a knowledge of equivalent positions, you can establisha “futures equivalent” or “index equivalent” position. For example, if youare attempting to buy the index as part of an intermarket spread, then youwould merely buy a call and sell a put with the same terms. As you know,this is the equivalent of going long the index. Since the call and the put havetime value premium, what you actually establish is the equivalent of a futurescontract on the index. Conversely, if you want to short the index, you buy aput and sell a call.
So, whether you use futures or the equivalent thereof, you establish the intermarket or intramarket spread in its simplest form. Withthis type of position, your profit potential is straightforward—if thetwo futures move in the correct direction, you will profit; if theydon’t, you will lose money.There is, however, another way to establish these spread positions: with options. If, instead of buying (equivalent) futures on oneside of the spread, you buy an in-the-money call, you have similarprofit potential. You can make unlimited profits just as the futurescan, but you give up whatever time value premium you spent to buythe call. If the call is far enough in-the-money, that time value
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expense will be small. Thus, the profit potential between owning thefuture and owning the in-the-money call is similar. There is onemajor difference: the call can only lose a fixed amount, while the(equivalent) futures position has virtually unlimited downside risk.Similarly, if you buy an in-the-money put instead of shorting the(equivalent) futures contract, you have similar characteristics. Thus,the option intermarket spread would be constructed by buying an inthe-money call and an in-the-money put.What this means is that the option intermarket spread has anadditional chance to make money that the (equivalent) futures position does not: it can make money if prices are volatile, even if thespread between the two markets does not converge as expected. Forexample, suppose that prices fall by a great deal (in both markets),but the spread between the two markets does not converge. Thenthe intermarket spread using (equivalent) futures would not makemoney. However, the option intermarket spread would, because thecall would only lose a limited amount to the downside, whereas theput would keep making profits. Thus, with the option intermarketspread, you can make money if either (1) the markets converge asexpected, or (2) prices are volatile and move a good deal in eitherdirection. The option trader must pay time value premium for thisprivilege; but if he uses in-the-money options, he can keep the timevalue expense to a minimum.Later in this chapter, we specifically discuss intermarket spreadsusing gold futures and gold stocks, but for now we present a true-lifeexample from those markets in order to demonstrate the advantageof using options in these spreads.In late 1995, gold stocks had rallied quite a bit, while the price of gold hadnot. Thus, we thought that the two markets would converge, and we recommended that our customers buy puts on gold stocks and calls on goldfutures. The recommended prices were:Gold Stock Index ($XAU): 120April gold futures: 389
XAU Feb 125 put: 8Gold April 380 call: 10.50
An equal number of calls and puts were purchased, with each put-andcall combo costing 181⁄2 points ($1,850).
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Things didn’t work out as forecast, for gold stocks continued to outperform gold futures. However, both markets started to move higher quickly.This was the saving grace. A couple of months later, these prices existed:$XAU: 138April gold futures: 407
XAU Feb 125 put: 1Gold April 380 call: 27.00
The combo was now worth $2,800. The call’s price had increased invalue by quite a bit ($1,650), but the put could only lose a limited amount.Thus, the option strategy made a profit, whereas a straight intermarketindex hedge would not have.
European OptionsBefore discussing the intermarket spreads, it is necessary to spend amoment or two talking about some of the more intricate propertiesof European options. Most index options and sector options areEuropean-style. As you probably recall, this means that they can’t beexercised until the end of their life. As a result, their price behavior issomewhat different from the American-style option that most peopleare accustomed to.The main difference is that European options can and do tradeat discounts to parity prior to expiration. This is true for both putsand calls, although it is more prevalent with puts. This discount isstrictly a function of the mathematics of arbitrage and option pricing,and has nothing to do with how markets are made or with any typeof supply/demand situation.To understand why this is true, you need to look at the situationfrom the viewpoint of an arbitrageur. First, let’s understand whyAmerican-style options do not trade below parity. Suppose that atrader has been fortunate enough to have bought an American-styleput and then sees the underlying stock decline substantially in price,to the point where the put is 20 points in-the-money. The tradernow decides he wants to sell his put, and he can be certain that hewill obtain 20 (or maybe a small fraction of a point less) for it. Why?Because an arbitrageur or market maker can:
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1. Buy the put from the trader, and2. Buy the underlying stock, and then3. Exercise the put to remove the arbitrage position.In order to provide this “service,” the market maker will generallynot pay the full 20 points for the put but will discount it by a fractionof a point so he (the market maker) can make some money on thistransaction also. Notice that the market maker never has any risk, forhe is hedged at all times (the stock and option trades—steps 1 and2—will be executed simultaneously). The following illustrates such atrade.
Example: Assume that the trader owns an XYZ Dec 100 put and that thestock is trading at 80 in November. He wants to sell the put. The marketmaker sees that he can buy stock at 80, so he tells the trader that he will payhim 197⁄8 for his put. The trader agrees, and the trade is done. The marketmaker paid a total of 997⁄8 (80 for the stock and 197⁄8 for the put) and gotback 100 when he exercised the Dec 100 put (to sell stock at 100). Thus,the market maker made an eighth, without risk, and the trader got out of hisput at virtually parity.The following sums up the transaction from the market maker’s pointof view:Buy Dec 100 put @ 197⁄8Buy 100 shares of XYZ at 80Exercise the put tosell 100 shares of XYZ at 100Net credit:
$1,987.50 debit$8,000.00 debit$10,000 credit$12.50 credit
Since the market maker pays virtually no commissions, he has a profiton this arbitrage.
Thus, any American-style put can be sold for nearly parity at anytime during its life because of the arbitrage that can be constructed bythe market maker to whom the put is sold. The same sort of thing istrue for an American-style, in-the-money call. The trader who ownsan in-the-money call that is American-style can be certain that he can
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sell that call at any time for nearly parity. In the case of the call, themarket maker simultaneously (1) buys the call and (2) sells the stock(short exempt), and then (3) exercises the call to completely close outthe position. Again, the market maker may try to make an eighth ofa point by buying the call at a slight, fractional discount to parity.When European-style, in-the-money options are owned bytraders who want to sell them prior to expiration, the market makersare generally the ones who are going to buy them. However, thearbitrage takes on a slightly different character because the marketmaker can’t exercise the option as he could in step 3 to close out theposition. Rather the market maker, after he (1) buys the in-themoney option from the trader and (2) hedges his risk with the underlying stock, then must hold the position until expiration. This tiesup the market maker’s money for what may be a considerableamount of time, so he must make allowances for this fact by adjusting the price that he is willing to pay the trader for that in-the-moneyoption. Again, an example will clarify this concept.Example: A trader owns a Dec 100 put on a stock that is trading at 80, andthe trader wants to sell the put a month before expiration. Assume, however, that now the option is European-style. The market maker of thisoption now faces the following situation. He would still like to make a riskless eighth of a point for his trouble. However, when he now (1) buys theput from the trader and (2) buys the underlying stock, he has to wait amonth until expiration arrives before he can complete step 3: exercising theput and removing the position. Thus, the market maker will adjust his bidfor the put to reflect his “carrying cost” of the position until expiration. Heusually does this by figuring how much it would cost him to carry the striking price, $100 in this case, for the required time—a month, in this example. If his annual rate for borrowing short-term money is 12 percent, thenthat means that the market maker would have a cost of 1 percent to carrythe position for one month. That is exactly $1. Therefore, the put will tradeat a discount to parity of 1 point.The whole transaction would go like this, from the market maker’sviewpoint:•
A month before expiration:1. Buy the put from the trader for 187⁄8 (1 point less than he wouldhave paid for an American-style put): $1,887.50 debit.
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•
At expiration (a month later):3. Pay his bank $100 for the interest on the loan ($100 debit).4. Exercise the put and receive the strike price: 100 points($10,000 credit).His net profit is the same eighth of a point: $10,000 less$9,887.50 paid for the position initially, less the $100 in interest,equals $12.50 profit.
Disregarding the eighth of a point that the market maker takes asprofit, the European-style put sells for 19, while its American-stylecounterpart sells for 20 (parity). You may be thinking, “What if themarket maker doesn’t have to borrow the money from the bank.Wouldn’t that lower the cost?” Actually, that would change nothing,because if he uses his own money, then he will still “charge” for thelost opportunity cost of not being able to use his money to earn interest until expiration.The preceding example was overly simplistic in that it ignoredtwo factors that could help increase the price of the European put:(1) dividends and (2) the price of the call with the same striking priceand expiration date. The reason that dividends are important is thatthey increase the price of any put, European or American. Forexample, if the stock in the preceding example were going to pay a25-cent dividend during the remaining month of the put’s life, thenthe put would be worth about a quarter of a point more than theprices in the example.The call price figures into the equation as well, for the marketmaker or arbitrageur can reduce his overall expense by selling thatcall at the same time that he buys the trader’s put. This reduces themarket maker’s overall expense, which he can pass along to thetrader in the form of an increased put price.Let's continue with the previous example.
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Example: Suppose, again, that a trader wants to sell a Dec 100 put whenthe underlying stock is at 80, about a month before expiration. However,now we are going to incorporate one other piece of information: there is aDec 100 call selling for a half point. The arbitrageur’s actions can now besummarized as follows:ActionBuy the Dec 100 put at 193⁄8 from the traderBuy the stock at 80Sell the Dec 100 call at 1⁄2Total Debit
Cost$1,937.50 DB$8,000 DB($50 CR)$9,875.50 DB
As you can see, this is the same initial debit as in the preceding example. The market maker will then pay the $100 in interest to his banker andeventually exercise the put or be assigned on the call— collecting 100points, or $10,000, and closing out the position in either case.The difference here, though, is that the trader was paid 193⁄8 for hisput, not 187⁄8 as in the previous example. Thus, the price of the call isimportant in determining the amount of discount (if there is any discount atall) of the in-the-money European-style put.
The more time that remains in the life of an in-the-money European option, the deeper will be the discount, because the marketmaker’s borrowing costs will be larger. In the preceding example, wewere talking about the discount on a relatively short-term option—ithad only one month of life remaining. However, there are LEAPSoptions on indices that extend out two years or more. The discountson these longer-term European-style puts can be very significant.These deep discounts on longer-term European-style put optionsare something that traders should factor into their projections.The first rather widespread encounter between the reality of European-styleoption discounts and put owners occurred in the American Stock Exchange(AMEX)–based Japanese Index puts (symbol: $JPN) in the early 1990s. TheJapanese stock market, as measured by that country’s Nikkei 225 Index,had peaked out at about ¥40,000 and was in the process of falling to nearly¥15,000 in the course of the next couple of years. The Japan Index is a
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surrogate for the Japanese stock market, and it has a value that is aboutone-hundredth of the value of the Nikkei. So, roughly, the JPN Index fell tonearly 150 (the JPN index didn’t exist when the Nikkei was at ¥40,000, butit would probably have been near 400 if it had).There were European-style LEAPS puts listed on the JPN Index; andsome had strikes as high as 280, which meant they were over 100 pointsin-the-money with over a year of life remaining when the JPN Index nearedthe bottom of that bear market. Consider a Jan 280 put with a year of liferemaining and the JPN Index at 180. You can safely assume that the Jan280 call was essentially worthless, so it was of no help in increasing theprice of the put. Even at 5 percent interest, the cost of carrying $28,000(the strike price) for one year is $1,400. In option terms, that’s 14 points.So the Jan 280 put was theoretically selling for 86, when parity was 100.In reality, with index options, the discount bid by the market makersmay be even slightly deeper because it is more difficult for them to hedge anentire index—they have to buy all the stocks in the index, rather than justone stock, as in the previous examples. This increases their clearing costs,to say nothing of their having to buy lots of stocks, each one on the offeringprice. These factors caused the actual bid for that put to be about 84.There were even some minor lawsuits by investors who felt that the discount on the puts was arbitrary and unfair. Of course, it wasn’t—the putswere properly priced—but in those days, many public traders didn’t understand the concept of European options well, and so some felt that the market makers simply lowered their bids to extreme levels because they knewthat these traders were long and wanted to sell. Trader paranoia? Yes.Incorrect pricing? No.
Of course, if you were bearish when the market was much higherand bought that put for, say, 10 points, you are probably not so concerned with whether you sell it for 84 or 86, since you have a phenomenal profit in either case. However, it is important to understandthat you are not going to be able to sell it for 100 if expiration is along way off.This concept of discounts on European-style puts could also beimportant if you are buying the puts as protection for a marketdecline, since the discounted puts will not provide as much protection if the market falls quickly and there is still a great deal of timeuntil expiration.
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Do European-style calls suffer the same fate? The answer is no,unless the underlying pays a large dividend. To understand why, it isagain necessary to view things from the arbitrageur’s viewpoint.When a trader who owns a European-style, in-the-money call wantsto sell it, the market maker buys it and immediately hedges himself byselling (short) the underlying stock. This transaction creates a creditin the arbitrageur’s account, on which he can collect interest. So, heis perfectly willing to hold the position until expiration and earn interest. Thus, he will pay the trader full parity (or maybe even a littlemore) for the call.The exception would be if the underlying pays a lot of dividendsduring the remaining life of the option. Since the arbitrageur is shortthe underlying stock, he will be paying out those dividends as timepasses. Therefore, he will discount the original price that he pays thetrader for the call by the present value of all the remaining dividends.Note that in the case of an American-style option, a market makerwho is both long an in-the-money call and short the underlying stockwill merely exercise his call on the day before the stock goes exdividend, thereby saving himself the dividend expense. However,with the European-style option, the market maker cannot exerciseprior to expiration, so he is forced to pay out those dividends.A trader buys a July 60 long-term, European-style call option and subsequently has the good fortune to see the stock rise to 90. At this point,assume there is still a year of life remaining in the call, but the trader wantsto sell. Furthermore, assume that the stock pays a quarterly dividend of 50cents, or a total of $2.00 over the next year. The market maker will bid 28for the call: that is parity (30) less the 2 points for dividends that he will haveto pay out from being short the stock over the course of the next year.
In reality, the present worth of the dividend is not the full $2.00,but it’s probably more like $1.80 or something, depending on interest rates. So the exact price that the market maker pays might beslightly more than 28, but the concept is illustrated correctly in thisexample. Also, if the July 60 put is worth anything, its value mayincrease the value of the call as well.
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This feature of European-style calls can be significant if you aredealing with a high-yielding stock or index, such as the Utility Index($UTY), especially if a significant number of stocks that composethe index are about to go ex-dividend. Many stocks go ex-dividendin early February, May, August, and November. So in-the-money,European-style call options expiring in those months may trade atdiscounts even though expiration is nigh.One firsthand experience of the dividend affecting a European-style calloption occurred in a 1993 trade of the Philadelphia Stock Exchange's(PHLX’s) Utility Index ($UTY). I was long the Dec 210 calls, with the indexat about 214. The index made a nice move in my favor, rising quickly to233, by late November. Thus, the calls were 23 points in-the-money. However, when I checked the market, it was only bid at 211⁄4. The reason wasthat many of the stocks that made up the Utility Index were about to go exdividend; the total of these dividends was about two points, in UTY terms.Moreover, since there was so little time remaining until expiration, the market maker couldn’t really earn any substantial interest from being short thestocks in the index for only three weeks until expiration. However, he wasgoing to have to pay out the dividends against the short sales that hedgedhis position. Thus, his bid for the calls reflected a discount equal to the $2 individends, less a small amount for interest that he could earn over the courseof the three weeks.
If you find yourself wanting to sell a European-style option, butyou’re dubious because it’s trading at discount because of dividends,my advice would be to sell it anyway. It’s not mispriced—it’s supposed to be trading at a discount. You may be tempted to wait untilthe ex-dividend date is past before selling. First, that will gain younothing theoretically, because the underlying stock or index willdrop in price by the amount of the dividends. Thus, even if the callis then selling at parity, it will theoretically be selling at the price youare currently seeing. Second, it is generally a mistake to delay a salefor the pure reason of something like this. Taxes are another common example; many people want to sell a stock, but decide not tofor tax reasons, only to see it drop substantially in price, therebycosting them much more than they would have had to pay in capitalgains taxes.
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This concludes the discussion of European-style options. Wehave included it here because many of the intermarket spreads thatwe discuss in the remainder of this chapter involve using Europeanstyle index or sector options. If you are trading those options, youshould have a thorough understanding of the concepts just described,or you will find yourself at a disadvantage.Now, let’s turn our attention once again to the intermarketspread using options. Recall that the option spread gives the trader apossible advantage over the (equivalent) futures spread when marketsare volatile. Let’s look at some of my favorite intermarket spreads.Some of these have longer time horizons than others, but most areheld for several weeks.
The HUG/HOG SpreadNo, this doesn’t have anything to do with giving a loveable squeezeto a farm animal, even though the name might seem like it. Rather,it’s a spread between the February heating oil futures contract(symbol: HOG) and the February unleaded gas futures contract(symbol: HUG).It is a rather well-established fact that in the fall of the year,unleaded gasoline futures outperform heating oil futures. Now, thismight seem illogical at first, unless you have an understanding of theway that markets work. After Labor Day, families are no longer vacationing or traveling as much, so the demand for gasoline should slackoff, right? Right. Also, as the winter approaches, the demand forheating oil should increase, right? Right. So how in the world canunleaded gasoline futures outperform heating oil futures during thattime period? Because it is the job of the marketplace to discountfuture events.Historic price charts tell us that the futures market tends to havedone most of the discounting for these February futures contracts bySeptember of the preceding year. Moreover, a sort of worst-case scenario is often built into the discounting mechanism. So, if things are“bad” as the fall unfolds and winter develops, then the spreadbetween heating oil futures and unleaded gas futures will remainabout steady. However, if things aren’t as bad as the discounting
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allowed for—as is often the case—the unleaded gas futures will outperform heating oil futures. Thus, it is a low-risk spread to buy February unleaded gas futures and sell February heating oil futuresagainst them; the spread is usually established in September or earlyOctober and held into December.You may be saying, “Wait a minute. I hear radio ads all during the fall saying that I should buy heating oil options because winter is approaching.What’s going on here?” I would respond to that question in two ways. First,are you the only trader who knows that winter is approaching? If you aretrading based on obvious information or on information that has alreadybeen made widely public, then you can be assured that that information isalready factored into the price of whatever you are trading, and you have noedge because of that information. Second, if you are buying optionsbecause of what you hear in a media ad, then you deserve what you get asa result. Also, check out the commissions those radio guys are charging,and you’ll see who stands to make money from buying those options.
It should be pointed out that the price of heating oil may go up asthe winter approaches (or it may not), but we have no directional biasin this spread other than to want unleaded gas to outperform heatingoil. So, the spread can move favorably for us if prices of both productsmove higher or if prices of both products move lower. We don’t care.In order to see how this spread behaves in general, let’s start outwith a composite graph of the spread, covering the years 1992through 2003, which is shown in Figure 5.3. Specifically, we usedthe futures expiring in February 1992 through the futures expiring inFebruary 2003 to construct this graph. Recall that a compositegraph is constructed by averaging the data points at each day overthe 12-year period. It is possible that no one year actually behavedas the composite graph depicts, but the graph is a good guide as tothe tendencies of the futures during this time period.In this spread, we sell heating oil futures and buy unleaded gasfutures. The composite graph shows it that way—heating oil minusunleaded gas. So, when the graph is declining, profits result. Thecomposite graph only shows the spread over a five-month period—from September 1 through the end of the following January, whenthe futures expire. You can see from Figure 5.3 that the spread is
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Figure 5.3HEATING OIL/UNLEADED GAS COMPOSITE SPREAD:1992–200323 days
200150
Spread
100
Optimal entry(7 days)
500Sept
Oct
Nov
Dec
Jan
–50–100–150
Optimal exit(92 days)
rather flat in September and early October. Then it declines for mostof November before rallying again in mid-November. Once that rallytops out, the spread declines in earnest, to a low in mid-January.With Figure 5.3 as a guide, we’d want to enter the spread in September, 7 trading days into the month and exit it 92 trading dayslater, in mid-January. Realistically, though, not much happens duringSeptember, so the entry point in early October—23 trading days afterthe end of August—is nearly as good as the one in early September.Using these procedures, the position is only open for about threemonths—from early October through mid-January of each year.Both heating oil and unleaded gas futures are worth $420 perpoint of movement. The composite graph shows the spread declining from about the +2.00 area to –1.50—a distance of 3.50 points,or $1,470 at $420 per point. I usually recommend using a stopabout 2.00 points from entry, although in volatile years I may raisethat to 3.00 points. Margin requirements vary, but the N.Y. Mercantile Exchange recognizes this as a spread, and the margin is generallyless than $2,000 per contract. Check with your broker for exactmargin requirements before establishing the spread.
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Figures 5.4 through 5.8 show specifically how the spread performed in various years. We’ll comment on these, individually. Figure5.4 shows the February 1993 contracts, so the trading took place inOctober 1992 through January 1993. This was a fairly classic year,as the spread declined (i.e., made profits) from October through alow in December. I would recommend using a trailing stop of perhaps 2.00 points or so after profits