, sophisticated software, and data.There are several other things you probably ought to think about. These are:1. The majority of options traders lose.2. The professional options traders who win are those who are the writers ofoptions and professional market makers.3. Most professional traders who use options use them as a method of hedging speculative positions as well as portfolios.
CREATING SYNTHETICSOne can combine futures and options to create synthetic options or synthetic futures.For example, if you buy a call and sell a futures, you have created a synthetic put;i.e., you have limited your loss on the upside if prices rise while maintaining opportunity for significant gains if prices fall.A synthetic call would be just the opposite. If you buy a put and buy futures,you have limited your losses if prices fall, but have opportunity for unlimited gainif prices rise.Those who desire more risk and potential for greater reward in the creationof synthetic securities can institute what is called a dynamic hedging strategy. Priorto the 1987 stock market crash this was referred to as portfolio insurance. Thestrategy uses futures to create the equivalent of the cash flows associated with anoption. By utilizing the delta and gamma from an option, one can create the effectof an option. For example, suppose you had borrowed $10 million and the interest rate you paid changed every 90 days based on Eurodollar rates. To hedge thatliability with futures for 90 days, you would need to sell 10 Eurodollar contracts.That would give you full 100 percent coverage on your hedge. To convert thishedge into the equivalent of an option at the strike price equal to today’s Eurodollarrate, you would establish a futures hedge of only five contracts (equal to the delta)and then adjust a number of contracts up closer to 10 or down closer to zero as thedelta moved up from .5 toward 1, or down from .5 toward zero. In other words,adjust it according to the gamma.
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As noted, this is a risky strategy. If it works perfectly, your results will be veryclosely equivalent to the purchase of an option. However, as in most things, perfection is elusive. For one thing, the delta changes by small amounts, whereasEurodollar contracts can be traded only in full units. For another, the futures markets are sometimes discontinuous. If the market moves limit up or limit down, youmay be unable to establish a futures position at prices that move in lock-step withthe change in delta. Lastly, there is great danger of being whipsawed. If the market is very volatile, you may be able to establish your position only after a pricemove occurs, and then promptly find that the market reverses and you again areunable to remove your position until after it moves. That’s a disaster. That’s alsowhat happened to many people during the 1987 stock market crash when theyattempted to employ this technique in using the S&P futures to hedge their stockportfolios.
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Strategies for Trading Options
The trading applications of options are numerous, and motives for buying and selling options are as varied as they are for trading commodity futures contracts. Inaddition to the limited risk advantages that options offer to speculators, they alsoperform certain economic functions and can be used for hedging purposes.Commodity options contracts can serve as a risk-shifting medium for individuals and firms dealing in a cash commodity, similar to hedging with futuresmarkets. A call option, by providing its buyer the right to acquire a commodity orfutures contract at a fixed price, can provide price protection to a person who hasa short position in the cash market, e.g., one who has signed a contract to delivera product. Buying a put option also can provide the same manner of price protection to its purchaser as can a short futures position. Both of them establish a saleprice. In contrast to futures, however, options contracts provide price protection onlyto purchasers because only purchasers have the right to exercise an option. Sellersof options have a firm price for their product only if the buyer exercises the option,but they cannot require a buyer to exercise. Thus, the risk transfer is not as complete or as symmetrical in options as it is in futures.
279Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
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USING OPTIONS IN BUSINESSFollowing are some examples of how the options market might be used for hedging. Concepts apply equally well to options on “actuals” or options on futures.
Purchasing a Put to Protect Profit MarginSuppose a producer or processor of raw materials—a sugar refiner, a mine operator, or an animal feed manufacturer—wishes to secure a manufacturing marginby selling his product forward but wants the right to cancel the deal should pricesrise. He can achieve this by purchasing a put option for a forward delivery date.In the event that prices fall, he would exercise his option and thus have a securedsales contract. (If it is an option on a futures contract, he will have a short futuresposition that he can deliver on or offset as a normal hedge. If it is an option on theactual product, he will deliver the product to the seller of the option.) But if pricesrise, he could abandon the option and sell his product (either physically or througha futures hedge) at the higher level ruling in the market. The cost of this choicewould be the option premium.
Buying a Call to Protect a PriceExactly the reverse of this example would apply to someone who processes rawmaterial and needs to buy those materials forward for delivery at a future date.The use of a call option to secure the purchases allows him the choice of abandoningthe option if prices decline or of exercising the option if prices rise.
Buying a Put to Protect a Contingent RiskSuppose a firm were preparing to make a sealed bid to buy large quantities of a product but wouldn’t know for some time (perhaps weeks) whether its bid had beenaccepted or for how much. In such a situation the firm could buy a put on the product. If, in the interim between the submission of the bid and the acceptance of it,prices fall and the firm is awarded the winning bid, it will be able to exercise theput at the higher price, thus obtaining a sale price at the higher level and buyingthe needed supply at the new lower price. If, on the other hand, prices should riseand it should receive either no part of the bid or a partial fulfillment of it, the putcan be abandoned and the product sold in the open market at the higher prices. Inthis latter instance, the firm will have lost the premium paid for the put but will havegained protection from a price fall during the interim.This same concept would be applied to any firm which sells largely by catalog or by direct mail. In such a situation, the pricing on the final product must frequently be done long in advance of manufacture and of shipment. If raw material
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costs change substantially during that time, profit margins can be adversely affected. Buying a call option on the raw material in such a situation provides protection against such dramatic price increases. If prices do increase, the firm can exercise the call at the lower price. If they fall, the call can be abandoned.
Buying a Call to Protect a Short PositionSuppose a merchant sold a quantity of sugar for deferred delivery to a food processor at a fixed price, but the merchant had not yet acquired sufficient sugar to coverthe sale. The merchant faces the risk that sugar prices may rise before he can makenecessary purchases. Although he could hedge this risk with a long futures position, the merchant may be reluctant to lock in his profit margin in that mannerbecause he suspects that sugar prices are more likely to fall than to rise, in whichcase he would have to meet margin calls. By purchasing call options rather thanfutures, the merchant can protect his short cash position at the additional cost ofthe option premium, while still reserving the opportunity to take advantage oflower sugar prices should his expectations materialize.
Writing a Call Against InventoryA holder of an inventory, such as a producer or a manufacturer, may use the optionsmarket to generate income on inventory by selling a call option on that inventory,thus giving the buyer the option to purchase the inventory. If the option is abandonedby the buyer because the price falls, the seller will still carry the inventory but hisnet cost-of-carry and ownership will be reduced because he has received the optionpremium and interest on it. This is a form of price speculation, and any businessperson undertaking it should so realize. If prices rise and the option is exercised, then the seller must deliver the physical goods against the contract. This, ofcourse, is an attractive procedure only if, at the time the option is sold, the strikingprice of the option is higher than the spot price, because the option seller obtainsthis differential together with the option premium and interest.In short, options provide a businessperson:1. More flexibility in strategy than do futures contracts alone.2. More certainty in planning cash exposure than do futures.3. More control over the decision-making environment.This is particularly true when buying options, because only the buyer maydetermine when and whether to exercise. Options allow the buyer to buy time during which he can wait for the future to be revealed. If the future turns out to his advantage, he exercises the option. If not, the buyer abandons it, suffers the loss of atleast part of his premium, and makes his transaction through another channel.
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STRATEGIES FOR SPECULATING IN OPTIONSIn general, the trading of options is a complex topic. Whole books have been written on the subject. All that can be done here is to introduce you to the topic andthe language to make you aware of the rich variety of ways in which options canbe a part of your investment strategy.If you expect prices to go up, you should buy a call or sell a put. If you expectprices to go down, you should buy a put or sell a call. Those two rules of thumbseem simple enough. But beware! If you sell a put expecting prices to go up butthey actually go down, you run the risk that the put will be exercised. You do nothave that risk buying a call. The same thing is true if you sell a call expectingprices to fall. If they go up, you have the risk of being called to fulfill your contractual obligations.
Buying a Gold CallA call gives the purchaser the right to obtain a long position in the underlyingfutures contract. Hence, if you expect prices to rise, you would purchase a call, giving you the right to buy a futures contract at the strike price stated at any timebefore the call expires.Suppose on September 1 that December gold futures are trading at $470 perounce and that, after careful analysis of the market, you come to expect Decembergold to trade above the $500 per ounce level. There are two ways to take advantage of this expectation: (1) You can buy a futures contract at $470 for delivery inDecember. That will cost you approximately $2,000 in margin plus a $45 commission. If the price falls to $450 per ounce, you will have lost your entire $2,000margin plus your $45 commission. If, on the other hand, the price does rise to the$500 level, you will have made $3,000 minus commission; (2) an alternative to buying the December futures contract would have been to buy a call option on theDecember futures. Suppose you could purchase, for $20 per ounce ($2,000 = 100ounces per contract × $20), a call option with the strike price of $470. You wouldthen be potentially long December futures contract at $470 with a break-even pointof $490 ($470 + $20).1 Now if the price rises to the $500 level, the option will beworth $3,000. You can sell (offset) the option to obtain the $3,000, deduct the$2,000 cost, and you end with $1,000 profit. Or you can “exercise” (notify the
1.
Some options (e.g., cash market options) are sold with a strike price equal to the immediateprice of the future. Thus, the break-even point is closer to the current price than would be true inthe above example. In either event the break-even point is still calculated by adding the premium and commission costs to the strike price.
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other party [seller] that you wish to buy the December futures at $470 per ounce).You can sell the futures acquired by exercise and accept your profit of $30 perounce ($3,000) on the transaction for a net of $1,000. If the price fails to rise abovethe $470 level, you will simply be out the amount of your premium, $2,000, pluscommissions. If it rises to $475, the value of the option will fall to $500 and youwill suffer a $1,500 loss.The maximum loss to the call buyer can never exceed the premium cost—in this instance, $2,000 plus commissions. That maximum loss will occur only ifthe option expires worthless, which would happen if the market does not moveabove the $470 level. If the market does move above the $470 strike price butdoes not reach the $490 level before the expiration date, the loss decreases as theprice rises to the break-even point. As the price rises above the break-even point,the option becomes profitable, and the profit increases as the price continues toadvance.
Hedging a Profitable Call OptionAs noted above, the major advantage in trading options is the unlimited opportunity it provides for gains with a fixed risk of loss. Another distinct advantageoffered by options is the flexibility they provide for trading futures and optionsagainst each other at the same time. For example, if a taker has a profitable optionposition, he can “trade against it” (take an opposite position in the futures—the sameas “hedge it”), thus opening many more possible opportunities for profit than simply through the exercise of the option. The following examples show how thiscan be done.
Hedging a Profitable Call By Selling a FutureAssume that on October 15 the December gold futures contract advances to the $500level. As a buyer, you can take advantage of this advance and “lock in” your profit on the option without exercise by selling a December futures contract at the$500 level. In effect, you hedge your option position. Now, if futures fall back to$460, the option will be “out-of-the-money” (below the $470 strike price), but youwill have a $40 gain on your short futures positions. You will realize the sameprofit as if you had exercised at $500 and then immediately offset.The advantage of this technique over an immediate exercise on October 15when it reaches $500 is that the option is kept “alive” until the declaration date,thus providing you the opportunity to trade against it at a later date.If indeed the market moves lower (say to the $470 level), the short futurescontract can be covered by the purchase of a futures contract. This transaction willgenerate a profit on the futures side (remember that you went short the futures at
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the $500 level and bought it back at $470) and leave the original option positionunchanged. Now, if the price goes back up (say to the $495 level) so that on thedeclaration date the market is above the striking price, the call can be exercised ata profit. Thus, you have made a profit on your option and also on your trade againstthe option. If on the declaration date the market is below the original striking price,the option would be abandoned, causing a loss of the premium. That loss, of course,would be offset by the profit made on trading against the option.
Hedging a Profitable Call By Buying a PutEarlier, it was shown that you could “hedge” a profitable call by selling a futuresagainst it. Another way to hedge a profitable call option is with the purchase of aput option. The maximum price for this protection is the premium on the put pluscommissions. If the market does subsequently drop, the put can be profitable exercised. Even more importantly, if the market continues to rise, the maximum losson the put is still only the premium plus commissions, and the profit on the call willcontinue to accrue.Note that when you hedge a profitable call position through the sale of a futurescontract, you give up all potential benefits that might accrue from a continuation ofa price rise and, in addition, you have to meet margin calls. Not so when you hedgewith the purchase of a put. The other side of this coin, however, is that the cost of afutures hedge may be far cheaper than the cost of the premium for the put option.What happens to the call option if, on the declaration date, the futures contract is trading at a price higher than the striking price but below the break-evenmark? In such a case, it will always benefit the option holder to offset or to exercise the option even if the premium is not fully covered. In the above example, ifDecember gold is trading at $475 on the declaration date, the call should be offset or exercised. Even though a net profit will not result, the cash thus generatedwill help reduce the total loss on the option. In this instance, had the call beenabandoned, the loss would have been $20 per ounce. However, by exercising oroffsetting it, the loss is only $15 per ounce.
USING THE FUTURES TO CONVERT A CALL TO A PUTIf you sell a futures position short against the purchase of a call, it has the effectof converting the call to a put. (The opposite is also true. Buying a futures againstthe sale of a put has the same effect as buying a call.) Remember, a put gives thepurchaser the right to sell the product at a later date at a price determined today.Thus, the purchaser has unlimited (down to zero price) potential for gain if pricesfall and limited risk if prices rise.
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Using the futures to convert a call into the equivalent of a put works likethis. Assume that you buy a call for $20 with a strike price of $470 per ounce andthat later you sell a futures at $490 per ounce. At that point you have a positionequivalent to the purchase of a put; i.e., if prices rise, your call option positionwill become more valuable at the same time your short futures position becomesless valuable. They will offset each other, and you will have given up your premium.In effect, the financial result will be the same as it would have been if you hadbought a put. If, on the other hand, prices fall, you will have a loss on the optionposition and a gain on the futures position—the same as if you owned a put. To theextent the price fall exceeds the cost of the call option, you will have a net profiton the transaction. The break-even point, minus commission, will be $470, thesame as if you had bought a put for $20 per ounce and a strike price of $490. Thecost of the “put” is the premium for the call option plus interest on margins and commissions on the futures and the options.
OPTIONS ON FINANCIAL FUTURESAmong the most active on the options scene are options on financial futures suchas interest rates, stock indexes, and foreign currencies. To further illustrate the richvariety of strategies available, this section focuses on options strategies for longterm U.S. Treasury bond futures. These same strategies can be applied to currencies and stock indexes.
Rising Interest Rates—Declining Bond Pricesa. Buy put options. Assume you are anticipating an increase in long-term interest rates and a corresponding decrease in futures prices. To take advantage of yourexpectations, you could buy a put option on U.S. Treasury bond futures. Assumeyou buy a March 100 put at a premium cost of $2,000, reflecting an interest rateon long-term bonds of about 8 percent. Assume, by expiration in March, the interest rate has increased to near 8.6 percent, and the futures price has decreased to94-00, so you should be able to sell the option at a value of $6,000. Your profiton this transaction will be $4,000 ($6,000 less your $2,000 premium) minus transaction costs.If, by the time March rolled around, interest rates had decreased to approximately 7.7 percent, the contract would be selling for about 103-00 and your putoption with a strike price of 100-00 would expire worthless. You would have lostthe entire $2,000 paid for the option.In many cases, you might decide not to wait until expiration to close out yourposition. If, in the above example, interest rates started falling with expiration a
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month or so away, you might have decided to sell the option before it reached a valueof zero. By selling the option at $500, for example, you would reduce your loss toonly $1,500 ($2,000 premium minus $500) plus the transaction costs.b. Sell futures and buy call options. By selling a futures contract you can profit from
any increase in long-term interest rates because as interest rates go up, U.S. Treasurybond prices decline. The purchase of a call option in conjunction with a short futuresposition makes it possible to limit the otherwise unlimited risk involved in sellingfutures contracts. In effect, the call option provides insurance against major loss.For example, suppose you were expecting higher interest rates, and you solda September U.S. Treasury bond futures contract at the price of 100-00. At thesame time, to protect yourself against major losses that could result if futures pricesrise, you might decide to pay a $2,000 premium for the purchase of a September100-00 call option. The most that you can now lose if futures prices rise insteadof fall is the $2,000 cost of the call option. Table 27.1 shows a summary of howthis transaction could turn out under various scenarios.A major advantage of this strategy is the “staying power” it can provide.That is, these two transactions provide the ability to maintain a futures positiondespite adverse short-term price movements. One survives in order to maintainthe potential that the position may still eventually become profitable.In the absence of the protection provided by the call, you might be facedwith a large margin call on your futures position. If such a margin requirementcan’t be met, you would be forced to liquidate the futures position at a loss. Thecall protects against that because, as the futures position loses value, the call increases in value. The call acts as a hedge against major losses.c. A “bear” put spread. If you expect rising interest rates and, therefore, declin-
ing bond prices, you could profit by purchasing a put option with a high strikeprice and selling or writing a put option with a new low strike price. The maximumnet profit is the difference in the strike prices less the net cost of the two options.The maximum loss is the net cost of the two options.For example, suppose in June you expect rising interest rates through themonth of September. Assume the September futures price is at 100-00. To profitfrom your expectations, let’s say you buy a September 100 put for a premium of$2,000, and you sell a September 94 put and collect a premium of $400. Your netpremium is $1,600.If the futures price in September turns out to be 94-00 or lower, your profits will be the difference between the strike price of the options ($6,000 less thenet premium cost of the two options), or $1,600. The net profit will be $4,400. If,on the other hand, futures prices at expiration are 100-00 or above, both optionswill expire worthless and you will suffer your maximum loss of $1,600.
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Table 27.1 Summary of Sell Futures—Buy Call OptionSell Sept. T-Bond Futures @Buy Sept. 100 T-Bond Futures Call @
100-00$2,000
Profit or Loss at ExpirationFutures rise to 106-00Buy Futures @ 106-00Sell Call @ 6-00
Futures do not changeBuy Futures @ 100-00Sell Call @ 0
Futures fall to 98-00Buy Futures @ 98-00Sell Call @ 0
Futures fall to 92-00Buy Futures @ 92-00Sell Call @ 0
$6,000 Loss$4,000 Gain$2,000 Net Loss
No Gain – No Loss$2,000 Loss$2,000 Net Loss
$2,000 Gain$2,000 Loss0 Net
$8,000 Gain$2,000 Loss$6,000 Net Gain
SUMMARY OF OPTIONS STRATEGIES UNDER VARIOUSPRICE SCENARIOSAs is obvious from the foregoing, the number and variety of trading techniques thatcan be employed using options and futures, singly or in combination, is large. Ingeneral, you can now tailor a limited-risk trading strategy to almost any price trend
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(or non-trend) scenario that could occur. Table 27.2 has been compiled to help thereader better understand the variety of strategies available, and the situations inwhich they should be used. These strategies apply to price situations in all commodities, including stock index options and futures.
Table 27.2 Summary of Option Strategies under Various Price ScenariosInterest Rateand Bond PriceExpectation
PossibleStrategy
Interest Rateand Bond PriceExpectation
PossibleStrategy
Declining Prices
Buy Put Options
Rising Prices
Buy Call Options
Declining Prices
Sell Futures andBuy Call Options
Rising Prices
Buy Futures andPut Options
Declining Prices
A “Bear” CallSpread
Rising Prices
A “Bull” CallSpread
Declining Prices
A “Bear” PutSpread
Rising Prices
A “Bull” PutSpread
Steady to SlightlyLower Prices
Sell Futures andWrite Put Options
Steady toSlightly HigherPrices
Buy Futures andWrite CallOptions
Steady to SlightlyLower Prices
Write Call Options
Steady toSlightly HigherPrices
Write Put Options
Relatively FlatPrices
A “Neutral”Calendar Spread
Prices will beBuy a Put-Callhighly volatile, Straddlecould changein either direction
Relatively FlatPrices
Write a Put-CallStraddle
Note: Interest rates and prices on bonds, T-bills, GNMAs, etc., move in opposite directions. So the above strategies for rising prices (falling prices) shouldbe considered when interest rates are expected to fall (to rise).
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Declining Interest Rates—Rising Bond Pricesa. Buy-call options. If you anticipate a decrease in long-term interest rates, yourstrategy should be to purchase call options on U.S. Treasury bond futures. A calloption, as noted above, gives you, the buyer, the right to buy the underlying futurescontract at the specified strike price. You will realize a profit if the intrinsic valueof the option at expiration is greater than the premium you paid for the option. Forexample, if it is now June and you expect interest rates to be lower in September,assume you pay a $2,000 premium to buy a September 100 call option reflectingan interest rate of about 8 percent. If, when September rolls around, the interest ratehas declined to around 7.4 percent, the futures price should have increased to 10600. You should then be able to sell the call option at its intrinsic value of $6,000.Your profit would be $4,000 less the transaction costs.Suppose, however, that when September arrives, the futures price was 10000 or below. In that case your call would expire worthless and you would loseyour entire $2,000. If, on the other hand, the futures price is at 102, your call wouldbe worth the same price you paid for it. If the futures price has increased to 11000, your call should be valued at 10-00, an $8,000 profit.b. A “bull” call spread. Perhaps a more conservative approach to a situation
where you expect interest rates to decline and bond prices to rise would be oneknown as a vertical bull spread. With such a strategy, you would know in advancethe exact maximum net profit you could possibly make, and the exact maximumnet loss possible on the transaction.Like all bull spreads, bull call spreads (meaning the investor is bullish onbond prices) involves buying one option and writing or selling another option. Inthis case, you would buy a call option with a low strike price and sell a call optionwith a high strike price.Your maximum net loss potential is the net premium cost, that is, the difference between the premium you pay for the call you buy and the premium youreceive for the call you sell.The maximum net profit you can make in this transaction is the differencebetween the strike prices of the two options less the net premium cost.For example, suppose in March you expect lower interest rates and higherbond prices, and you find that the June futures price is trading at 96-00. Suppose,further, you buy a June 96 call at a premium of $2,000 and sell a June 102 call ata premium of $500. The maximum net profit would be $4,500, the strike pricedifference of $6,000 less the net premium cost of $1,500, and your maximum netloss would be $1,500, the net premium cost. In order to realize maximum profit,the futures price at expiration must be equal to or above the strike price of theoption written, in this case 102-00. If it isn’t, the investor’s resulting profit or losswill depend on whether the value of the purchase option at expiration is more or
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less than the premium cost. See Table 27.3 for a summary of such a strategy undervarious price scenarios.
WHAT OPTION TO TRADEAn important decision for an investor selecting among strike prices and maturitydates is the determination of which option to select. Which is preferable: An option
Table 27.3 Summary of Bull Spread—Call OptionsPaidBuy June 96-00 callSell June 102-00 callNet Premium
Received
$2,000$500$1,500Profit or Loss Summary
Futures @ 102-00Sell June 96 callBuy June 102 callNet Premium CostFutures @ 96-00Sell June 96 callBuy June 102 callNet Premium CostFutures @ 90-00Sell June 96 callBuy June 102 callNet Premium CostFutures fall to 99-00Sell June 96 callBuy June 102 callNet Premium Cost
+6,000 Gain0–1,5004,500 Net Gain001,5001,500 Net Loss001,5001,500 Net Gain3,00001,5001,500 Net Gain290
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with a short period of time until expiration or an option with a long period of timeuntil expiration? An option with a high strike price (an in-the-money option) or anoption with a lower strike price (an out-of-the-money option)?Generally, the premium costs will be higher the longer the time remaininguntil expiration. Such an option provides the buyer more time for his price expectations to be realized and thus, a greater likelihood of his actually earning a profit. Generally, the longer time remaining until expiration, the lower the cost of eachadditional time unit. That is, a six-month option usually does not cost twice asmuch as a three-month option.Decisions about purchasing an at-the-money or an out-of-the-money optionare equally important. The option premium is usually higher for an at-the-moneyoption than for an out-of-the-money option. An at-the-money option stands agreater chance of yielding a profit. However, an out-of-the-money