futures options, you are best served by obtaining an inexpensive source, such as Investors Business Daily newspaper, thatlists all the current options on one page. It is then an easy manner to
FUTURES AND FUTURES OPTIONS
29
observe where the strike prices are located for various futures contracts. For those traders with more sophisticated quote machines, anoption “chain” is usually available that will display all currently tradedoptions on a specific type of futures. For example, SIGNAL—a popular quote service that can be run on any computer—is one suchsource.Unit of Trading. Every futures option has one futures contractunderlying it; that is, if you exercise your futures option, it will convert into one futures contract. That is a simple concept; what is morecomplicated is remembering how many dollars are represented by aone-point movement of either the underlying future or the futuresoption. With stock and index options, a one-point move is normallyworth $100 (except in the case of stock splits, possibly). Futuresoptions are less standardized. For example, a one-point (cent) movein grain options is worth $50, while a one-point move in the S&P500 Index futures is worth $250. In every case, a one-point move infutures options is worth exactly the same number of dollars as a onepoint move in the underlying futures contract.Appendix B lists these dollar amounts for most of the majorfutures contracts. However, you can often determine this information from the newspaper listings of futures option prices. The newspaper normally lists the size of the underlying futures contract, inphysical terms. The “dollars per point” can normally be determinedby dividing the physical contract size by 100. For example, a soybean futures contract is for 5,000 bushels of soybeans, and thatinformation will be listed in the newspaper right along with theprices. Dividing by 100, you arrive at the fact that a one-point (cent)move in soybeans is worth $50.Price Quotes. Traders of stocks are accustomed to being able toquote a bid-and-asked price for any stock or option they trade. Inaddition, any broker can obtain that information on his quotemachine. Such is not the case with futures contracts nor with mostfutures option contracts. Rarely are you able to obtain a bid or offerquote for a futures contract on a quote machine. They can beobtained from the trading floor; but unless you are trading directlywith the floor, in most cases it is too time-consuming to have your
30
OPTION HISTORY, DEFINITIONS, AND TERMS
broker request a quote, for there would be several phone callsinvolved in getting it.The trading floors do supply quotes to the major quote vendors.However, they are often “stale” quotes, and one cannot really relyon them much of the time. Where options are concerned, I don’t recommend trading with market orders, so you need to know theoption’s quote. One way to speed up the quote and order-entryprocess is to place an order at a price you would accept and to askyour broker to relay the actual market to you. In this way, your orderis effective right away, and you get a quote back, too. If the actualmarket is far away from your order, then you can adjust the price onyour order.Electronic Trading. Futures can be electronically traded, but onlya few markets are actually electronic. The most popular electronicmarket is that of the S&P e-mini futures on the Chicago Merc. It is acompletely electronic market, and anyone with a quote machine cansee the actual bids and offer (although not the size of them) at anytime. These S&P e-mini contracts are worth $50 per point of movement—one-fifth the size of the “big” S&P futures contract. The bigS&P futures continue to trade at auction in the pit during the daytimehours; but at night, they, too, trade electronically on a system calledGlobex. Some other futures trade completely electronically, andmore will surely follow as time goes by.Be careful when trading with an “electronic futures broker,”though. Sometimes your electronic order merely prints out at ahuman’s desk, and then it has to be relayed to the trading floor.Because such a double order-entry process might actually cost youtime, be sure to investigate how your electronic broker is actually getting the order to the floor—especially where the actual futures pit isnot electronically enabled.Commissions. In the futures market, commissions are generallyfigured as a constant dollar amount per contract. For futures contracts, commissions are charged only when your position is closedout. Thus, if you buy a futures contract on wheat, for example, youare not charged any commission at that point. Later, when you sellthe futures contract, you will then be charged the commission. The
FUTURES AND FUTURES OPTIONS
31
nomenclature to describe this process is round turn. If your commission rate is $20 per futures contract, it is usually stated as $20 perround turn.Futures option commissions are normally a fixed amount as well,but they are charged on both the buy and the sell, just as stock commissions are. In some cases, brokers attempt to charge a percentageof the option’s price, but that is not the norm.The fact that futures and futures option commissions are normally fixed amounts means that they are more or less onerousdepending on the contract being traded. For example, if you are paying $20 per round turn and you are trading wheat (which is worth$50 per point), then the commission represents a move of 0.40point in wheat, which is a rather large commission in terms of thedistance wheat must move to make the commission back. However,if you are trading S&P 500 futures, which are worth $250 per point,then the commission only represents 0.08 point, which is less thanone tick in the futures and is almost a trivial amount in terms of thefuture’s price movement.Serial Options. Futures contracts on the same commodity donot normally expire in every month of the year. For example, S&P500 futures expire only in March, June, September, and December.Others may have five or six futures contract months per year. Experienced option traders know that most option trading takes place inthe near-term contracts, especially as the options near their expiration dates.The futures exchanges realized that activity would be lessened ifthe nearest term option had as much as two or three months of liferemaining. So they decided to introduce options that expire in themonths between the actual expiration months of the futures contractitself. These options are called serial options. They generally areonly listed for the one- or two-month expirations preceding an actualfutures expiration month. The futures contract that underlies a serialoption is the actual futures contract expiring in the next actual month.Example: S&P 500 futures expire in March, June, September, and December of each year. There are also futures options expiring in those months.Both the futures and the options are cash-settled and expire on the third Fri-
32
OPTION HISTORY, DEFINITIONS, AND TERMS
day of the month. Suppose that the current date is April 1. Then the nearestfuture expires two and a half months in the future, in the middle of June.Since the S&P 500 futures contract is a very active one, there is naturally going to be great demand for trading of short-term options. Thus, theChicago Merc (the exchange where these options are listed) began listingserial options. For example, the April S&P 500 futures options wouldexpire on the third Friday of April; but instead of receiving cash when youexercise these options, you would receive a concomitant position in JuneS&P 500 futures. Assume you are long an S&P 500 April 460 call. If youexercise it, you would be long one June S&P 500 futures contract at a priceof 460 in your account.
Serial options exist on the S&Ps, all the currencies, the grains, allthe bond and note contracts, gold, silver, platinum, live cattle, porkbellies, sugar, and orange juice. It should be noted that not everyfutures contract will have serial options. Some don’t need them; forexample, crude oil and its related products and natural gas all havefutures that expire each month of the calendar year, so serial optionsare not necessary for those futures. However, many of the othershave serial options, although not all.Remember, the easiest way to tell if serial options exist is to see ifthere are options with expiration dates that don’t match the expirationdates of the corresponding futures contracts. If there are, then thoseoptions are serial options. This can easily be determined from thenewspaper or from your quote machine, if you have access to one.There are many other nuances of futures options that are different from stock or index options, but they are addressed in the specific chapters on strategy and trading that follow.
INFLUENCES ON AN OPTION’S PRICEAs listed, but not in order of importance, there are six factors thatinfluence the price of an option:1. Price of the underlying instrument.2. Striking price of the option.3. Amount of time remaining until expiration.
INFLUENCES ON AN OPTION’S PRICE
33
4. Volatility of the underlying instrument.5. Short-term interest rates, generally defined as the 90-dayT-bill rate.6. Dividends (if applicable).Each of these six factors has an influence on the price of anoption. In some cases, the factor has a direct effect. For example,the more time remaining until expiration, the more expensive theoptions will be—both puts and calls. Conversely, as time decreases,so do option prices. Thus, option prices are directly related to thetime remaining. Volatility is also a direct factor—the higher thevolatility, the more expensive the options.However, some of the factors have different effects on calls thanthey do on puts. Take interest rates. When interest rates are high,calls will be more expensive, since arbitrageurs can pay more for thecalls that hedge their short stock. However, puts will becomecheaper when interest rates increase, since arbs will pay less forthem. Also having a diverse effect is the underlying price itself. Forexample, as the underlying’s price increases, calls get more expensive while puts get cheaper. Dividends, also, have opposite effectson puts and calls. If a company increases its dividend, calls will becheaper, and puts will get more expensive. This is because the listedoptions do not have any right to the dividend. The options’ pricesmerely reflect what the stock price will do; and if the dividend isincreased, it will drop farther when it goes ex-dividend. Thus, putsincrease in value, to account for the expected ex-dividend drop instock price, and calls get cheaper.
VolatilityWe discuss volatility at length in this book, so we want you to be clearabout what it is. Volatility is a measure of how fast the underlyingchanges in price. If the underlying stock or future has the potentialto change in price by a great deal in a short amount of time, then wesay that the underlying is volatile. For example, over-the-counterbiotech stocks are volatile stocks; orange juice futures in winter orsoybean futures in summer are volatile as well.
34
OPTION HISTORY, DEFINITIONS, AND TERMS
There are two types of volatility that are pertinent to the discussion of option pricing. One is historical volatility, which is a statistical measure of how fast the underlying security has been changing inprice. Historical volatility is quantifiable; that is, it is calculated by astandard formula, although some mathematicians disagree as to thebest exact formula for calculating historical volatility. The other typeof volatility is implied volatility. This is the volatility that is “implied”for future time periods, and the things that are doing the implying arethe listed options.The most startling example of implied volatility that I know ofoccurred during the crash of 1987. When implied volatility increases,the prices of all options increase as well. Thus, this trader received apleasant surprise, one of the few pleasant surprise stories that relateto the crash of 1987.On the Wednesday before the crash (10/14/87), OEX was trading at 295.A customer paid 11⁄8 for the Dec 320 calls. These calls were trading withan implied volatility of about 15 percent, which was actually quite low forthat era.On the following Monday (10/19/87), the market crashed, and OEXwas trading at 230. The customer figured he had lost his entire investment,and considering the large losses that others had taken, he was actually gladto have only lost a point and an eighth. He didn’t even bother getting aquote on these options until Tuesday, the day after the crash, because hefigured there wouldn’t be any bid for them if he wanted to sell them.What he didn’t realize was that implied volatility had skyrocketed tonearly 50 percent for OEX options in the wake of the crash. The Dec 320calls—now 90 points out of the money with less than two months until expiration—were trading at 1! Thus he had only lost an eighth. The power ofimplied volatility is great; it can even bail out losing trades sometimes.
Of course, most stories relating to the crash of 1987 were not sopleasant. In fact, one dogma circulating on the “street” was that “thecrash of 1987 was so bad that even the liars lost money.”Another example of the difference between implied and historical volatility occurred in the following litigation situation, where thepossible outcome of a lawsuit caused implied volatility to inflate,while the actual volatility of the underlying was quite stable.
INFLUENCES ON AN OPTION’S PRICE
35
An example from early 1994 dramatically shows the difference betweenhistorical and implied volatility. Advanced Micro Devices is a maker of semiconductor chips. So is Intel, the leader in the field. Intel had filed a lawsuitagainst Advanced Micro, claiming patent violations, and the case went totrial. The news caused Advanced Micro stock to drop in price and then stabilize in the low 20s.The resulting court decision was sure to have a large effect on the priceof Advanced Micro. If the courts decided in favor of Intel, Advanced Micro’sstock was destined to drop a lot; however, if the decision went against Intel,then Advanced Micro stock was destined to rise back into the 30s, where ithad been trading prior to the lawsuit.As the decision approached, the historical (or actual) volatility ofAdvanced Micro Devices stock was rather normal: the stock was tradingback and forth from about 19 to 22. Thus, the stock was not acting veryvolatile because no one knew what the odds were of the stock moving up ordown when the court handed down its decision; buyers and sellers wereabout in equilibrium. However, since the option prices were based on wherethe stock was going to be in the future, they were extremely expensive. Forexample, with the stock at 20, the calls expiring in one month were sellingfor over four points! This is extremely expensive for a one-month option ona $20 stock. The puts were similarly expensive. Thus, the options wereimplying that there was going to be a big change in price by AdvancedMicro Devices; or, alternatively stated, the options were trading with a highimplied volatility. As it turned out, the court decided in favor of AdvancedMicro, and the stock jumped six points higher in one day. After that, theoption prices settled back down, and historical volatility and implied volatility were once again in line.
It is often the case that historical and implied volatility on a certain underlying issue are very nearly the same. Even when they differ,the reason is not normally as obvious as in the preceding example. Inlater chapters, we discuss how to measure these volatilities, how tointerpret them, and what strategies to use when they differ.You might think that it should be a fairly easy matter to determine the “fair” value of an option, given that the price is only dependent on the six factors listed earlier. Five of the six factors are knownfor certain at any one time. We certainly know the price of theunderlying, and of course we know what the strike price is. We alsoknow how much time is left until expiration of the option. Moreover,
36
OPTION HISTORY, DEFINITIONS, AND TERMS
it is a simple matter to find out where short-term interest rates are.And, if there are any dividends, it is an easy task to find the amountand timing of the dividend. The one factor that we can’t quantify withany certainty is volatility, especially the volatility in future time periods. This, then, is the “rub” in determining the fair—or theoretical—value of an option. If we don’t know how volatile the underlyingsecurity is going to be—that is, we don’t know how much the underlying is going to change in price and how fast it’s going to do it—then how can we possibly decide how much to pay for the option?The answer to this question is not an easy one, and we spend a greatdeal of time in this book trying to shed light on it.
How the Factors Affect the Option PriceIt was shown earlier that each of the six factors has its own effect onoption prices. The following table, which shows what happens aseach factor decreases (if the factor were to increase, the result wouldbe the opposite of that shown in the table, in each case):Factor
Time
Underlying
Interest
Dividends
Volatility
Call pricePut price
DecreasesDecreases
DecreasesIncreases
DecreasesIncreases
IncreasesDecreases
DecreasesDecreases
Moreover, some of these factors are interrelated so that it is notnecessarily easy to tell which is exerting more power at any time. Forexample, if a stock or futures contract rallies, we can’t say for certainthat a call will necessarily increase in value. If the strike price is toofar above the current price of the underlying, even a rather largeshort-term rally may not help out the call much at all. This would beespecially true if there were very little time remaining.Example: Suppose a stock has been in a long bear market and is trading at20. Then a rally sets in, and the stock jumps by 5 points to 25 in a day ortwo. Furthermore, suppose this happens with only a week or so remaininguntil the nearest expiration. The following data summarize this situation.
DELTA
Stock priceFeb 35 callAug 35 Call
February 7
February 9
20⁄ 161⁄2
25⁄ 1611⁄4
1
37
1
The Feb 35 call, which is going to expire in a little more than a week,was not helped out by the stock’s jump in price; but the longer-term Aug 35call was helped because there is more time remaining for the August option.So stock price, strike price, and time are all related in determining whetherthe value of an option would increase or not when the stock makes a favorable move.
DELTAMuch more is said about the interdependence of these factors later,but first let’s define some terms that are common among optiontraders. These terms describe just how much of an effect each factorhas on the stock price. The best known such term is the delta of anoption. The delta of an option measures how much the optionchanges in price when the underlying moves one point.Example: XYZ is trading at 80, and the March 80 call is selling for 4. Weobserve that when XYZ rises one point to 81, the March 80 call now sellsfor 41⁄2. Thus, the option increased by a half point when the stock rose byone point. This option is said to have a delta of one-half, or 0.50.
The delta of a call option is a number that ranges between 0.00and 1.00. To verify this for yourself, note that if a call is way out-ofthe-money, it will not move at all, even if the stock rises by onepoint—the Feb 35 call in the prior example. Thus, the delta of a verydeeply out-of-the-money call is 0.00. On the other hand, if the stockis trading far in excess of the striking price—that is, the option is wayin-the-money—then the option and the stock move in concert. Thus,if the stock rises by one point, so will the option; hence, the delta ofsuch a deeply in-the-money option is 1.00. The delta of a put ranges
38
OPTION HISTORY, DEFINITIONS, AND TERMS
between 0.00 and –1.00, reflecting the fact that the put moves in theopposite direction from the underlying security.In between these two extremes (deeply out-of-the-money anddeeply in-the-money), the delta of a call option ranges between zeroand one. Call options that are out-of-the-money have small deltas,such as 0.25 or 0.30, meaning that they will increase by only about1⁄4 or 3 ⁄8 of a point when the underlying stock rises by a point. In asimilar manner, call options that are somewhat in-the-money willhave higher deltas, such as 0.70 or 0.80, indicating that they willmove much more like the common stock, but not quite as fast as thestock moves.Example: The following table is an example of the deltas you might expectto see for various call options on a particular stock XYZ. As you will find outlater, there are other factors that affect delta; but for now, we will justobserve how delta behaves when we view the relationship of the underlyingprice and the strike price.Underlying Price: 80
Date: February 1
Call Option
Call Delta
Put Delta
May 70 callMay 75 callMay 80 callMay 90 callMay 100 callMay 110 call
0.940.790.580.360.200.10
–0.06–0.21–0.42–0.64–0.80*–0.90*
The delta of a put and a call at the same striking price, with thesame expiration date, are related by the general formula:Put delta = Call delta – 1There is an exception to this formula when the put is deeply inthe-money (the two asterisks in the preceding table). The deltas ofstock or index puts, but not futures puts, may go to their maximum(–1.00) well in advance of expiration, even when the corresponding
DELTA
39
call option still has a positive, nonzero, delta. This has to do with theeffects of conversion arbitrage. Thus, in the preceding table, the May100 put and the May 110 put would probably have deltas of nearly–1.00, rather than –0.80 and –0.90, respectively, as shown.Did you notice that the delta of the at-the-money option is not0.50? In fact, it is generally higher than that for any type of calloption—stock, index, or futures (while it is lower for the put option).The reason for this is that stocks or futures can move farther to theupside (they can rise infinitely, in theory) than they can to the downside (they can only fall to zero). This means there is more than a 5050 chance of prices rising over any extended time period, and thusthe delta of the at-the-money call reflects this fact.Some traders also think of the delta as a simple way of tellingwhether the option will be in-the-money at expiration. While this isnot mathematically correct, it is sometimes useful. Thus, in the table,under this interpretation, we can say that there is a 20 percentchance that the stock will rise and be over 100 at May expiration,because the May call has a delta of 0.20. You may prefer to think ofdelta in this way, if it makes it clearer to you. There is really nothingwrong with this interpretation.Understanding the concept of delta is mandatory for optiontraders, for it helps them to envision just how the option is going tomove when the stock price moves. Since most traders have a feelingfor what they expect of a stock when they buy it, or even when theybuy the options, the understanding of delta can help them decidewhich option to buy.
What Affects Delta?Anyone who has traded options, or even thought seriously aboutthem, realizes that an out-of-the-money option does not gain muchvalue when the stock rises slightly; the at- or in-the-money optionwill rise faster than the out-of-the-money call option. This is true forboth puts and calls. Delta gives us a way to measure these relativemovements.For example, suppose a trader were going to buy the stock in theprevious example, and he was looking for a quick move of 3 points,from 80 to 83. How much will the May 100 call appreciate? Thedelta tells us that the May 100 will increase by about 20 cents for
40
OPTION HISTORY, DEFINITIONS, AND TERMS
each point that XYZ rises. The increase will then be 3 × 0.20, or 60cents. Between commissions and the bid-asked spread in the option,there might not be much profit left if that option were bought; it justwon’t appreciate enough for a 3-point stock move. However, buyingthe at-the-money May 80 call should work just fine: it will appreciateby 3 × 0.58, or 1.74 points (13⁄4), which is a good move and shouldleave a good profit even after commissions and the bid-asked spreadare taken into consideration.Of course, if this trader were looking for a move of 20 points bythe stock over the next three months, then the purchase of the outof-the-money calls is more feasible. The trader must therefore adjusthis option purchase with respect to his outlook for the underlyingsecurity, and the delta helps him do just that.The previous examples demonstrate the relationship betweenthe delta and the stock’s price. However, other factors can influencethe delta as well. One important factor is time. The delta of an optionis affected by the passage of time. An out-of-the-money option’sdelta will trend toward zero as time passes. This merely meansthat an out-of-the-money option will respond less and less to shortterm price changes in the underlying stock as the amount of liferemaining in the option grows shorter and shorter. Sometimes ithelps to envision things by looking at the extreme, or “end,” points.For example, on the last day of trading, any option that is more thanone strike out-of-the-money will probably have no delta at all—it isgoing to expire worthless and a one-point rise by the underlyingstock will not result in any price change in the option. On the otherhand, if an out-of-the-money option has a long time remaining (threeyears, say), then it will be responsive to movements by the underlying stock. Thus, the more time value that an out-of-the-moneyoption has, the farther its delta will be from zero.Just the opposite is true for in-the-money options: the delta ofan in-the-money option will increase to its maximum as timepasses. Again, thinking in the extreme may help. Any option that ismore than just slightly in-the-money behaves just like the underlyingon its last trading day. Thus, such a call would have a delta of 1.00,and a put would have a delta of –1.00. However, if there is a greatdeal of time remaining in the option (e.g., three years), even thoughit is in-the-money, it will have some time value premium. Conse-
DELTA
41
quently, while its movement may reflect most of the price change ofthe underlying security, it won’t reflect all of it, so its delta will be lessthan the maximum. Thus, the more time value premium that anin-the-money option has, the smaller its delta will be.The delta of an option can change swiftly, sometimes apparentlydefying the elementary mathematical definition. These concepts arediscussed in great detail in Chapter 6, but an example at this timemay be sufficient to illustrate the point.H. J. Heinz stock was the subject of takeover rumors in January 1995.Another food company had recently been acquired, and gossip swirledabout the same thing happening to Heinz. As a result, options on Heinzhad gained quite a bit of implied volatility. Takeover rumors often “heat up”on Fridays, as traders seemingly feel that there is a greater chance of a dealbeing announced over a weekend. Thus, it was not unusual that on a Friday,implied volatility reached a peak of about 50 percent. The accompanyingtable lists some of the option prices on that Friday, and then also showswhere the same options were trading on the following Monday, when thestock closed off only 3⁄8 of a point.
StockJan 40 callFeb 40 callMarch 40 call
Closing PriceFriday
Closing PriceFollowing Monday
Change
391⁄415⁄1613⁄423⁄8
387⁄83⁄815⁄1613⁄4
– 3 ⁄8– 9⁄16– 7⁄16– 5⁄8
What was going on here? Each of these slightly out-the-money optionswas down more than the underlying stock. That is, each of these threeoptions had a delta of more than 1.00! Normally, a slightly out-of-themoney option would have a delta of about 0.50 or less.The actual delta of an option after any stock move can be computed bydividing the option’s price change by the stock’s price change. This simplecalculation yields the following deltas for the preceding options:Option
Actual Delta
Jan 40 callFeb 40 callMarch 40 call
1.501.171.67
42
OPTION HISTORY, DEFINITIONS, AND TERMS
In fact, what had happened was that a negative newspaper articleappeared over the weekend. The article basically denigrated the takeoverrumors and gave evidence that the company was not “in play.” Thus, eventhough the stock itself only traded off three-eighths of a point, the optionswere crushed as implied volatility fell to about 35 percent from the 50 percent level of Friday. That is a huge change in implied volatility in one day,and it had a very harmful effect on the call prices. This is a vivid example ofhow a change in implied volatility can affect the price and the delta of anoption.
Thus, there is a relationship between price and volatility. It is awell-known fact that a change in one of these factors can affect anoption’s price. What is sometimes forgotten is that these factors canwork together to dramatically affect an option’s price, as in theHeinz example. Both volatility and stock price can change dramatically in a short period of time. The other three factors that determinean option’s price—short-term interest rates, striking price, and dividend—have little or no effect most of the time, for they don’t changemuch, and certainly not over a short time period.
TECHNICAL ANALYSISThere are two major approaches to analyzing markets—technicaland fundamental. Most investors are familiar with fundamentalanalysis, that is, the process by which analysts attempt to forecastthe future profits of a company by analyzing their market penetration, pricing structure, and other things having to do with the actualoperation of the company’s business. Technical analysis, on theother hand, has nothing at all to do with the tangible operations ofthe company. Rather, it is an analysis of the price of the company’sstock. Technicians (practitioners of technical analysis) feel that pastprice patterns leave valuable clues as to the future direction of prices.Technical analysis can be applied to any price pattern—stock, bonds,futures, and so on.There is merit in both camps, although each camp tends to viewthe other as being somewhat inferior. This is a classic example of howeach camp was “right” and yet each thought the other was wrong.
TECHNICAL ANALYSIS
43
In 1991, the market was beginning to roll to the upside after the Gulf Warwas “won.” Many brokerage firm analysts were predicting great things forbasic U.S. companies, such as Coca-Cola. Earnings were projected toincrease for each of the next few years.Technicians, however, were more interested in what the market wassaying about Coke. The