Textbook Questions
Assignment Content
1.
Top of Form
Complete the following Case Problems from Fundamentals of Investing:
o Case Problem 14.1: The Franciscos’ Investment Options, Questions A-C (page 588)
o Case Problem 14.2: Luke’s Quandary: To Hedge or Not to Hedge, Questions A-D (page 589)
o Case Problem 15.1: T.J.’s Fast-Track Investments: Interest Rate Futures, Questions A-D (page 622)
o Case Problem 15.2: Jim and Polly Pernelli Try Hedging with Stock Index Futures, Questions A-D (page 623)
Format your submission consistent with APA guidelines.
Submit your assignment.
Case Problem 14.1 The Franciscos’ Investment Options
1. LG 3
2. LG 4
Hector Francisco is a successful businessman in Atlanta. The box-manufacturing firm he and his wife, Judy, founded several years ago has prospered. Because he is self-employed, Hector is building his own retirement fund. So far, he has accumulated a substantial sum in his investment account, mostly by following an aggressive investment posture. He does this because, as he puts it, “In this business, you never know when the bottom will fall out.” Hector has been following the stock of Rembrandt Paper Products (RPP), and after conducting extensive analysis, he feels the stock is about ready to move. Specifically, he believes that within the next six months, RPP could go to about $80 per share, from its current level of $57.50. The stock pays annual dividends of $2.40 per share. Hector figures he would receive two quarterly dividend payments over his six-month investment horizon.
In studying RPP, Hector has learned that the company has six-month call options (with $50 and $60 strike prices) listed on the CBOE. The CBOE calls are quoted at $8 for the options with $50 strike prices and at $5 for the $60 options.
Questions
a. How many alternative investments does Hector have if he wants to invest in RPP for no more than six months? What if he has a two-year investment horizon?
b. Using a six-month holding period and assuming the stock does indeed rise to $80 over this time frame:
1. Find the value of both calls, given that at the end of the holding period neither contains any investment premium.
2. Determine the holding period return for each of the three investment alternatives open to Hector Francisco.
c. Which course of action would you recommend if Hector simply wants to maximize profit? Would your answer change if other factors (e.g., comparative risk exposure) were considered along with return? Explain.
Case Problem 14.2 Luke’s Quandary: To Hedge or Not to Hedge
1. LG 3
2. LG 4
A little more than 10 months ago, Luke Weaver, a mortgage banker in Phoenix, bought 300 shares of stock at $40 per share. Since then, the price of the stock has risen to $75 per share. It is now near the end of the year, and the market is starting to weaken. Luke feels there is still plenty of play left in the stock but is afraid the tone of the market will be detrimental to his position. His wife, Denise, is taking an adult education course on the stock market and has just learned about put and call hedges. She suggests that he use puts to hedge his position. Luke is intrigued by the idea, which he discusses with his broker, who advises him that the needed puts are indeed available on his stock. Specifically, he can buy three-month puts, with $75 strike prices, at a cost of $550 each (quoted at $5.50).
Questions
a. Given the circumstances surrounding Luke’s current investment position, what benefits could be derived from using the puts as a hedge device? What would be the major drawback?
b. What will Luke’s minimum profit be if he buys three puts at the indicated option price? How much would he make if he did not hedge but instead sold his stock immediately at a price of $75 per share?
c. Assuming Luke uses three puts to hedge his position, indicate the amount of profit he will generate if the stock moves to $100 by the expiration date of the puts. What if the stock drops to $50 per share?
d. Should Luke use the puts as a hedge? Explain. Under what conditions would you urge him not to use the puts as a hedge?
Case Problem 15.2 Jim and Polly Pernelli Try Hedging with Stock Index Futures
1. LG 5
2. LG 6
Jim Pernelli and his wife, Polly, live in Augusta, Georgia. Like many young couples, the Pernellis are a two-income family. Jim and Polly are both college graduates and hold high-paying jobs. Jim has been an avid investor in the stock market for a number of years and over time has built up a portfolio that is currently worth nearly $375,000. The Pernellis’ portfolio is well diversified, although it is heavily weighted in high-quality, mid-cap growth stocks. The Pernellis reinvest all dividends and regularly add investment capital to their portfolio. Up to now, they have avoided short selling and do only a modest amount of margin trading.
Their portfolio has undergone a substantial amount of capital appreciation in the last 18 months or so, and Jim is eager to protect the profit they have earned. And that’s the problem: Jim feels the market has pretty much run its course and is about to enter a period of decline. He has studied the market and economic news very carefully and does not believe the retreat will cover an especially long period of time. He feels fairly certain, however, that most, if not all, of the stocks in his portfolio will be adversely affected by these market conditions—although some will drop more in price than others.
Jim has been following stock index futures for some time and believes he knows the ins and outs of these securities pretty well. After careful deliberation, Jim and Polly decide to use stock index futures—in particular, the S&P MidCap 400 futures contract—as a way to protect (hedge) their portfolio of common stocks.
Questions
a. Explain why the Pernellis would want to use stock index futures to hedge their stock portfolio and how they would go about setting up such a hedge. Be specific.
1. What alternatives do Jim and Polly have to protect the capital value of their portfolio?
2. What are the benefits and risks of using stock index futures to hedge?
b. Assume that S&P MidCap 400 futures contracts are priced at $500 × the index and are currently being quoted at 769.40. How many contracts would the Pernellis have to buy (or sell) to set up the hedge?
1. Say the value of the Pernelli portfolio dropped 12% over the course of the market retreat. To what price must the stock index futures contract move in order to cover that loss?
2. Given that a $16,875 margin deposit is required to buy or sell a single S&P 400 futures contract, what would be the Pernellis’ return on invested capital if the price of the futures contract changed by the amount computed in question b1?
c. Assume that the value of the Pernelli portfolio declined by $52,000 while the price of an S&P 400 futures contract moved from 769.40 to 691.40. (Assume that Jim and Polly short sold one futures contract to set up the hedge.)
1. Add the profit from the hedge transaction to the new (depreciated) value of the stock portfolio. How does this amount compare to the $375,000 portfolio that existed just before the market started its retreat?
2. Why did the stock index futures hedge fail to give complete protection to the Pernelli portfolio? Is it possible to obtain perfect (dollar-for-dollar) protection from these types of hedges? Explain.
d. The Pernellis might decide to set up the hedge by using futures options instead of futures contracts. Fortunately, such options are available on the S&P MidCap 400 Index. These futures options, like their underlying futures contracts, are also valued/priced at $500 times the underlying S&P 400 Index. Now, suppose a put on the S&P MidCap 400 futures contract (with a strike price of 769) is currently quoted at 5.80, and a comparable call is quoted at 2.35. Use the same portfolio and futures price conditions as set out in question c to determine how well the portfolio would be protected if these futures options were used as the hedge vehicle. (Hint: Add the net profit from the hedge to the new depreciated value of the stock portfolio.) What are the advantages and disadvantages of using futures options, rather than the stock index futures contract itself, to hedge a stock portfolio?
Assignment Content
1.
Top of Form
Complete the following Case Problems from Fundamentals of Investing:
· Case Problem 14.1: The Franciscos’ Investment Options, Questions A-C (page 588)
· Case Problem 14.2: Luke’s Quandary: To Hedge or Not to Hedge, Questions A-D (page 589)
· Case Problem 15.1: T.J.’s Fast-Track Investments: Interest Rate Futures, Questions A-D (page 622)
· Case Problem 15.2: Jim and Polly Pernelli Try Hedging with Stock Index Futures, Questions A-D (page 623)
Format your submission consistent with APA guidelines.
Submit your assignment.
Bottom of Form
Case Problem 15.1 T. J.’s Fast-Track Investments: Interest Rate Futures
1. LG 5
2. LG 6
T. J. Patrick is a young, successful industrial designer in Portland, Oregon, who enjoys the excitement of commodities speculation. T. J. has been dabbling in commodities since he was a teenager—he was introduced to this market by his dad, who is a grain buyer for one of the leading food processors. T. J. recognizes the enormous risks involved in commodities speculating but feels that because he’s young, he can afford to take a few chances. As a principal in a thriving industrial design firm, T. J. earns more than $150,000 a year. He follows a well-disciplined investment program and annually adds $15,000 to $20,000 to his portfolio.
Recently, T. J. has started playing with financial futures—interest rate futures, to be exact. He admits he is no expert in interest rates, but he likes the price action these investments offer. This all started several months ago, when T. J. met Vinnie Banano, a broker who specializes in financial futures, at a party. T. J. liked what Vinnie had to say (mostly how you couldn’t go wrong with interest rate futures) and soon set up a trading account with Vinnie’s firm, Banano’s of Portland.
The other day, Vinnie called T. J. and suggested he get into five-year Treasury note futures. He reasoned that with the Fed pushing up interest rates so aggressively, the short to intermediate sectors of the term structure would probably respond the most—with the biggest jump in yields. Accordingly, Vinnie recommended that T. J. short sell some five-year T-note contracts. In particular, Vinnie thinks that rates on these T-notes should go up by a full point (moving from about 5.5% to around 6.5%) and that T. J. should short four contracts. This would be a $5,400 investment because each contract requires an initial margin deposit of $1,350.
Questions
a. Assume T-note futures ($100,000/contract; 32’s of 1%) are now being quoted at 103’16.
1. Determine the current underlying value of this T-note futures contract.
2. What would this futures contract be quoted at if Vinnie is right and the yield does go up by one percentage point, to 6.5%, on the date of expiration? (Hint: It’ll be quoted at the same price as its underlying security, which in this case is assumed to be a five-year, 6% semiannual-pay U.S. Treasury note.)
b. How much profit will T. J. make if he shorts four contracts at 103’16 and then covers when five-year T-note contracts are quoted at 98’00? Also, calculate the return on invested capital from this transaction.
c. What happens if rates go down? For example, how much will T. J. make if the yield on T-note futures goes down by just 3/4 of 1%, in which case these contracts would be trading at 105’8?
d. What risks do you see in the recommended short-sale transaction? What is your assessment of T. J.’s new interest in financial futures? How do you think it compares to his established commodities investment program?
Call and Put Options
1. LG 1
2. LG 2
When investors buy shares of common or preferred stock, they are entitled to all the rights and privileges of ownership such as receiving dividends or, in the case of common stock, having the right to vote at shareholder meetings. Investors who acquire bonds or convertible issues are also entitled to certain benefits of ownership such as receiving periodic interest payments. Stocks, bonds, and convertibles are all examples of financial assets. They represent financial claims on the issuing organization. In contrast, investors who buy options acquire nothing more than the right to subsequently buy or sell other, related securities. An
option
gives the holder the right to buy or sell an underlying asset (such as common stock) at a fixed price over a limited period of time.
Options are contractual instruments, whereby two parties enter into an agreement to exchange something of value. The option buyer has the right to buy or sell an underlying asset, and in exchange for this right the option buyer makes an up-front payment to the seller. The option seller receives the payment and then stands ready to buy or sell the underlying asset to the option holder according to the terms of the contract. In this chapter we’ll look at two basic kinds of options: calls and puts.
Before we get into the details of call and put options, note that there are two other types of options: rights and warrants. Rights are issued by corporations to their existing shareholders, and they entitle shareholders to buy new shares that the company plans to issue in the near future, usually at a price that is slightly below the stock’s market value. By using their rights to buy new shares, existing stockholders can avoid having their ownership stake diluted when the company issues new shares. If they do not wish to purchase new shares, existing stockholders can sell their rights on the open market. These rights typically expire within 30 to 60 days, so they hold very little investment appeal for the average individual investor.
In contrast, warrants are long-term options that grant the right to buy shares in a certain company for a given period of time (often fairly long—5 to 10 years or more). Warrants are usually created as “sweeteners” to bond issues and are used to make the issues more attractive to investors. That is, some bonds come with warrants attached, which gives bondholders the opportunity to earn higher returns if the underlying stock performs well. In essence, the buyer of one of these bonds also receives one or more warrants, and the additional upside potential that these bonds provide is called an equity kicker.
Basic Features of Calls and Puts
Stock options began trading on the Chicago Board Options Exchange in the early 1970s. Soon the interest in options spilled over to other kinds of financial assets. Today investors can trade puts and calls on common stock, stock indexes, exchange-traded funds, foreign currencies, debt instruments, and commodities and financial futures. For the most part, we will focus on options on common stock, though many of the principles that apply to stock options also apply to options on other kinds of financial assets.
As we will see, although the underlying financial assets may vary, the basic features of different types of options are very similar. Perhaps the most important feature to understand is that options allow investors to benefit from price changes in the underlying asset without investing much capital.
The Option Contract
Call and put options allow the holder to buy or sell an underlying security at a fixed price known as the strike price or exercise price. We’ll focus our attention on calls and puts that grant the right to buy or sell shares of common stock. A
call
enables the holder to buy the underlying stock at the strike price over a set period of time. A
put
, in contrast, gives the holder the right to sell the stock at the strike price within a set period of time. In most cases, calls and puts allow investors to buy or sell 100 shares of the underlying stock. Calls and puts are entitled to no voting rights, no privileges of ownership, and no interest or dividend income. Instead, calls and puts possess value to the extent that they allow the holder to benefit from price movements of the underlying asset.
Because call and put options derive their value from the price of some other underlying asset, they are known as
derivative securities
. In other words, call and put options derive their value from the price of the underlying asset. Rights and warrants, as well as futures contracts (which we’ll study later), are also derivative securities. Although certain segments of the derivative market are for big institutional investors only, there’s still ample room for the individual investor. Many of these securities—especially those listed on exchanges—are readily available for individuals to trade.
The price that an investor pays to buy an option is called the
option premium
. As we will see, an option’s premium depends on the option’s characteristics such as its strike price and expiration date and on the price and volatility of the underlying asset. However, don’t let the word premium confuse you. It’s just the market price of the option.
One of the key features of puts and calls is the attractive
leverage
opportunities they offer. Option buyers can invest a relatively small amount of capital, yet the potential return on that capital can be very large. To illustrate, consider a call on a common stock that gives an investor the right to buy a share of stock at a strike price of
$45
a share. If that stock currently sells for $45, the call option would cost just a few dollars— for the sake of illustration, let’s say $3 per option or $300 total since the option contract covers 100 shares. Next, suppose that a month or two later the underlying stock’s price has increased by
$10
to
$55
. At that point, the investor might exercise his right to buy 100 shares for $45 each. He pays $4,500 to acquire the shares and then immediately resells them at the market price for $5,500, pocketing a gain of
$1,000
. Thus, in a short period of time his $300 up-front investment grew to $1,000, a gain of 233%. The percentage increase in the stock over this period was just 22.2% ($10 ÷ $45), so the percentage gain on the option is much greater than the percentage gain on the stock. That’s the benefit of the leverage the options provide.
Seller versus Buyer
Puts and calls are a unique type of security because they are not issued by the organizations that issue the underlying stock. Instead, they are created by investors. It works like this. Suppose Abby wants to sell Carli the right to buy 100 shares of Fitbit common stock (i.e., Abby wants to sell a Fitbit call option to Carli). Abby does this by “writing a call.” More generally, the individual (or institution) writing the option is known as the
option seller
or option writer. As the option writer, Abby sells the option in the market, so she is entitled to receive the price paid by Carli for the call option. However, Abby does have an obligation. If Carli later decides that she wants to exercise her right to buy Fitbit stock, Abby must sell those shares to her. If Abby does not already own Fitbit shares, she must go into the open market to buy them. Her obligation is legally binding, so she cannot walk away from the deal if it turns out to be a money loser for her. In contrast, Carli has no obligation. She has an option. She can buy Fitbit shares if she wants to, but she is under no obligation to do so. Puts work in much the same way. If Abby sold Carli a put option, then Carli would have the right to sell Fitbit shares to Abby, but she would not be obligated to do so. Abby, on the other hand, must stand behind her promise to buy Fitbit shares from Carli if Carli chooses to sell them. It is important to note that no matter what happens in these transactions between Abby and Carli, Fitbit Inc. is not affected. They do not receive any money, nor do they issue or retire any common shares.
Investors trade calls and puts with the help of securities brokers and dealers. In fact, options are as easy to buy and sell as common stocks. A simple phone call, or a few mouse clicks, is all it takes. Investors trade options for a variety of reasons, many of which we will explore in this chapter. At this point, suffice it to say that trading options can be a viable investment strategy.
Investor Facts
American or
Euro
pean? Put and call options can be issued in either American or European form. Actually, this has absolutely nothing to do with where the options are traded but rather with when they can be exercised. An American option can be exercised on any business day that the option is traded. A European option can be exercised only on the day of expiration. Because the right to exercise is more flexible with American options than with European options, the American variety is often more desirable, and hence more valuable in the market. But that’s not always true. Having the right to exercise an option prior to its expiration date does not mean that it is optimal to do so. In many cases, an investor is better off selling the option in the open market than exercising it, and in those instances, the prices of American and European options are similar.
How Calls and Puts Work
Taking the buyer’s point of view, we will briefly examine how calls and puts work and how they derive their value. To start, it is best to look at their profit-making potential. For example, consider the call described earlier that has a $45 strike price and sells for $3. A buyer of the call option hopes for a rise in the price of the underlying common stock. What is the profit potential from this transaction if the price of the stock does indeed move up to, say, $75 by the expiration date on the call?
The answer is that the buyer will earn $30 ($75−$45)$30 ($75−$45) on each of the 100 shares of stock in the call, minus the original $300 cost of the option. In other words, the buyer earns a gross profit of $3,000 from the $300 investment. This is so because the buyer has the right to buy 100 shares of the stock, from the option seller, at a price of $45 each, and then immediately turn around and sell them in the market for $75 a share.
Could an investor have made the same gross profit ($3,000) by investing directly in the common stock? Yes, if the investor had purchased 100 shares of stock. Buying 100 shares of a $45 stock requires an initial investment of $4,500 compared to the $300 investment needed to buy the options. As a consequence, the rate of return from buying the shares is much less than the rate of return from buying the options. The return potential of common stocks and calls differs considerably. This difference attracts investors and speculators to calls whenever the price outlook for the underlying financial asset is positive. Such differential returns are, of course, the direct result of leverage, which is similar to buying a stock on margin. We learned earlier that buying stock on margin raises the potential return that an investor might earn, but it also increases the risk of the investment.
To see the downside of buying a call option, suppose that the stock price in the previous example did not increase to $75, but instead fell to
$40
.50. That represents just a 10% decline from the initial $45 stock price, but when the stock is worth $40.50, the call option will not be exercised. No investor would choose to pay the $45 strike price to buy the stock when they can simply purchase shares in the open market at a cheaper price. Therefore, if the option contract expires when the stock price is at $40.50, the option will be worthless, and the option buyer’s $300 initial investment will be worth nothing. Another way to say this is that the option buyer earns a return of −100% even though the stock price fell just 10%. Clearly call options have a lot of upside potential, but the risk of a total loss is also very real.
A similar situation can be worked out for puts. Assume that for the same stock (which has a current price of $45) an investor could pay
$25
0 to buy a put option, which gives the investor the right to sell 100 shares of the stock at a strike price of $45 each. As the buyer of a put, the investor wants the price of the stock to drop. Assume that the investor’s expectations are correct and the price of the stock does indeed drop to $25 a share. The investor goes into the market and purchases 100 shares for $25 each, and then she immediately exercises her put option by selling those shares for $45 each (note: the person who sold the put option is obligated to buy these shares at $45 each). The investor makes a gross profit of $20 per share, or $2,000 total on her initial investment of $250. That represents a rate of return of 700%! Of course, put options are risky just as call options are. If the stock price had risen to
$50
rather than falling to $25, the put option buyer’s $250 investment would be totally lost.
In some cases, investors who buy calls and puts do not actually have to trade the underlying asset to realize their profits. Instead, investors can “cash settle” their options, meaning that they receive the profits from their option in cash. This arrangement is most common when the underlying asset is difficult to trade, as would be the case when the underlying asset is a stock index rather than stock of a single company. Though most options that have a single common stock as the underlying asset are settled by exchanging the stock, to keep things simple we will illustrate the cash settlement process for a basic stock option. For example, consider once more the call option that had a strike price of $45. Suppose the underlying stock price rises to $75, so on paper at least, the call option buyer has made a gross profit of $30 per share. Rather than pay the $45 exercise price, take delivery of the shares from the call writer, and then resell the shares in the open market for $75, the call buyer may simply receive a $30 per share or $3,000 total cash payment from the call seller in exchange for the option. Settling options in cash eliminates the need for the option buyer and seller to exchange the underlying shares and the need for the option buyer to sell shares in the open market to monetize his or her profit.
Investors can trade options in the secondary market, just as they can trade other securities such as stocks and bonds. The value of both calls and puts is directly linked to the market price of the underlying common stock. For example, the secondary market price of a call increases as the market price of the underlying stock rises. Likewise, the price of a put increases as the underlying common stock price declines. Thus, another way that investors can realize their profits on options is simply to sell them in the secondary market after they have increased in value.
Advantages and Disadvantages
The major advantage of investing in puts and calls is the leverage they offer. This feature allows investors to earn large profits from relatively small movements in the underlying asset without investing a large amount of money up front. Another advantage is that options allow investors to profit whether the underlying stock price goes up or down. Investors who believe that the underlying stock price will go up can buy calls, and those who believe that the stock price will fall can buy puts.
A major disadvantage of calls and puts is that the holder enjoys neither interest or dividend income nor any other ownership benefits. Moreover, because options have limited lives, there is a limited time during which the underlying asset can move in the direction that makes the option profitable. Finally, while it is possible to buy calls and puts without investing a lot of money up front, the likelihood that an investor will lose 100% of the money that he or she does invest is much higher with options than with stocks. That’s because if the underlying stock moves just a little in the wrong direction, a call or put option on that stock may be totally worthless when it expires.
Options Markets
Although the concept of options can be traced back to the writings of Aristotle, options trading in the United States did not begin until the late 1700s. Even then, up to the early 1970s, this market remained fairly small, largely unorganized, and the almost-private domain of a handful of specialists and traders. All of this changed, however, on April 26, 1973, when the Chicago Board Options Exchange (CBOE) opened.
Conventional Options
Prior to the creation of the CBOE, options trading occurred in the over-the-counter market through a handful of specialized dealers. Investors who wished to purchase options contacted their own brokers, who contacted the options dealers. The dealers would find investors willing to write the options. If the buyer wished to exercise an option, he or she did so with the writer and no one else—a system that largely prohibited any secondary trading. Options were written on New York and American exchange stocks, as well as on regional and over-the-counter securities, for as short a time as 30 days and for as long as a year. Over-the-counter options, known today as
conventional options
, are not as widespread as they once were. Accordingly, our attention in this chapter will focus on listed markets, like the CBOE, where individual investors do most of their options trading.
Listed Options
The creation of the CBOE signaled the birth of
listed options
, a term that describes options traded on organized exchanges. The CBOE launched trading in calls on just 16 firms. From these rather humble beginnings, there evolved in a relatively short time a large and active market for listed options. Today trading in listed options in the United States is done in both calls and puts and takes place on several exchanges, the most active of which are the CBOE, the International Securities Exchange (ISE), the BATS Exchange, and the Nasdaq PHLX. Collectively those four exchanges accounted for more than half of all options trading in 2015. In total, put and call options are now traded on thousands of different stocks, with many of those options listed on multiple exchanges. In addition to stocks, the options exchanges also offer listed options on stock indexes, exchange-traded funds, debt securities, foreign currencies, and even commodities and financial futures.
Investor Facts
Know Your Options Options trading continues to be increasingly popular with investors. In 2014 trading volume reached 4.3 billion contracts, or about 17.6 million contracts per day.
(Source: The Options Clearing Corporation, 2014 annual report.)
Listed options provide not only a convenient market for calls and puts but also standardized expiration dates and exercise prices. The listed options exchanges created a clearinghouse that eliminated direct ties between buyers and sellers of options and reduced the cost of executing put and call transactions. They also developed an active secondary market, with wide distribution of price information. As a result, it is now as easy to trade a listed option as a listed stock.
Stock Options
The advent of the CBOE and the other listed option exchanges had a dramatic impact on the trading volume of puts and calls. Today 4.3 billion listed options contracts are traded each year, most of which are stock options. In 2015 about 89% of listed options contracts were stock options.
Listed options exchanges have unquestionably added a new dimension to investing. In order to avoid serious (and possibly expensive) mistakes with these securities, however, investors must fully understand their basic features. In the sections that follow, we will look closely at the investment attributes of stock options and the trading strategies for using them. Later, we’ll explore stock-index (and ETF) options and then briefly look at other types of calls and puts, including interest rate and currency options, and long-term options.
Stock Option Provisions
Because of their low unit cost, stock options (or equity options, as they’re also called) are very popular with individual investors. Except for the underlying financial asset, they are like any other type of call or put, subject to the same kinds of contract provisions and market forces. Two provisions are especially important for stock options: (1) the price—known as the strike price—at which the stock can be bought or sold, and (2) the amount of time remaining until expiration. As we’ll see, both the strike price and the time remaining to expiration have a significant bearing on the market value of an option.
Strike Price
The
strike price
is the fixed, contract price at which an option holder has the right to buy (in the case of a call option) or sell (in the case of a put option) the underlying stock. With conventional (OTC) options, there are no constraints on the strike price, meaning that two parties can agree to whatever strike price they desire. With listed options, strike prices are standardized by the exchanges on which options trade. Generally speaking, options strike prices are set as follows:
· Stocks selling for less than $25 per share carry strike prices that are set in
$2.50
increments ($7.50, $10.00, $12.50,
$15
, and so on).
· In general, the increments jump to $5 for stocks selling between $25 and $200 per share, although a number of securities in the $25 to $50 range are now allowed to use $2.50 increments.
· For stocks that trade at more than $200 a share, the strike price is set in $10 increments.
· Unlike most equity options, options on exchange-traded funds (discussed more fully later in this chapter) usually have strike prices set in $1 increments.
In all cases, the strike price is adjusted for stock splits. Strike prices are not adjusted for cash dividends (except for large “special” dividends), but they are adjusted when firms pay significant stock dividends (e.g., dividends paid in additional shares).
Expiration Date
The
expiration date
is also an important provision. It specifies the life of the option, just as the maturity date indicates the life of a bond. The expiration date, in effect, specifies the length of the contract between the holder and the writer of the option. Thus, if you hold a six-month call on Sears with a strike price of, say, $70, that option gives you the right to buy 100 shares of Sears common stock at $70 per share at any time over the next six months. No matter what happens to the market price of the stock, you can use your call option to buy 100 shares of Sears at $70 a share. If the price of the stock moves up, you stand to make money. If it goes down, you’ll be out the cost of the option.
Technically, some options can be exercised at any time up until the expiration date, while others can be exercised only on the expiration date. American options allow investors to exercise their right to buy or sell the underlying asset at any time up to the expiration date, while European options only permit investors to exercise on the expiration date. All exchange-listed options in the United States are American options, so unless otherwise noted, we will focus on those.
Expiration dates are standardized in the listed options market. The exchanges initially created three expiration cycles for all listed options:
·
January
, April, July, and October
·
February
, May, August, and November
·
March
,
June
, September, and December
Each issue is assigned to one of these cycles. The exchanges still use the same three expiration cycles, but they’ve been altered so that investors are always able to trade in the two nearest (current and following) months, plus the next two closest months in the option’s regular expiration cycle. For reasons that are pretty obvious, this is sometimes referred to as a two-plus-two schedule.
For example, if the current month (also called the front month) is January, then available options in the January cycle would be January, February, April, and July. These represent the two current months (January and February) and the next two months in the cycle (April and July). Likewise, maintaining the assumption that the current month is January, available contracts for the February cycle would be January, February, May, and August; available contracts for the March cycle would be January, February, March, and June. The expiration dates, based on the front months, continue rolling over in this way during the course of the year. The following table demonstrates the available contracts under the two-plus-two system for the months of February and June:
|
Front Month |
Cycle |
Available Contracts |
|||||
| February | January |
February, March, April, July |
|||||
|
February, March, May, August |
|||||||
| March |
February, March, June, September |
||||||
| June |
June, July, October, January |
||||||
|
June, July, August, November |
|||||||
|
June, July, September, December |
Given the month of expiration, the actual day of expiration is always the same: the third Friday of each expiration month. Thus, for all practical purposes, listed options always expire on the third Friday of the month of expiration.
Look Up an Option Chain
Put and Call Transactions
Option traders are subject to commission and transaction costs when they buy or sell an option. These costs effectively represent compensation to the broker or dealer for selling the option.
Listed options have their own marketplace and quotation system. Finding the price (or premium) of a listed stock option is fairly easy since there are lots of online sources for option quotations.
Figure 14.1
illustrates a quotation from
Nasdaq.com
for an option chain in which Facebook stock serves as the underlying asset. An
option chain
is a listing of all options (calls and puts) on an underlying asset for a given expiration period. The quotation in
Figure 14.1
shows only a small subset of the entire option chain for Facebook, seven call option contracts on the left and seven put option contracts on the right along with their strike prices and premiums for contracts that expire on August 21, 2015. Generating a quotation for all current option contracts on Facebook produces an option chain with several hundred call and put option quotes.
Each row of
Figure 14.1
provides important details about a particular option contract. Notice that in the upper left portion of the figure is a column heading that says “Calls,” indicating that the first several columns in the figure contain information about various call options on Facebook stock. Moving to the right, notice the column header, “Puts,” which indicates that the right side of the figure provides information about put options on Facebook shares. All of the options shown in
Figure 14.1
expire on August 21, 2015. The columns headed “Last” provide the most recent market price (or premium) for each option, and the columns headed “Chg” show the change in the price of each option from the previous day’s closing price. Other columns show the bid and ask prices for the options, the day’s trading volume, and the open interest, which is a measure of the number of outstanding option contracts. Notice that the column headed “Root” shows the ticker symbol for Facebook, which is the underlying asset for all of these options.
Perhaps the most salient information in
Figure 14.1
is the market price of each option. For example, on July 6, 2015, an August Facebook call with a strike price of $85 was quoted at $4.90 (which translates into a price of $490 because stock options trade in 100 share lots), and an August put option with the same strike price sold for $2.68.
Figure 14.1 Quotations for Facebook Stock Options
The quotes for calls and puts of a specified expiration period are listed down either side of the strike price. In addition to the last price the option traded at for the day and its end-of-day bid and ask price, the change from the previous day’s last transaction price is shown.
(Source: Data from
http://www.nasdaq.com
, accessed July 6, 2015.)
Concepts in Review
Answers available at
http://www.pearsonhighered.com/smart
1. 14.1 Describe call and put options. Are they issued like other corporate securities?
2. 14.2 What are listed options, and how do they differ from conventional options?
3. 14.3 What are the main investment attractions of call and put options? What are the risks?
4. 14.4 What is a stock option? What is the difference between a stock option and a derivative security? Describe a derivative security and give several examples.
5. 14.5 What is a strike price? How does it differ from the market price of the stock?
6. 14.6 Why do call and put options have expiration dates? Is there a market for options that have passed their expiration dates?
Options Pricing and Trading
1. LG 3
2. LG 4
3. LG 5
The value of an option depends to a large extent on the price of the underlying asset, but several other factors also influence option prices. Being a good options trader requires an understanding of these factors and how they influence option values. Let’s look now at the basic principles of options pricing. We’ll start with a brief review of how profits are derived from puts and calls. Then we’ll take a look at several ways in which investors can use these options.
The
Profit
Potential from Puts and Calls
Although the quoted market price of a call or put is affected by such factors as time to expiration, stock volatility, and market interest rates, by far the most important variable is the price of the underlying common stock. This is the variable that drives the most significant moves in an option’s price. When the price of the underlying stock moves up, calls do well. After all, a call option gives an investor the right to buy a stock at a fixed price, and that right is most valuable when the stock price is very high. When the price of the underlying stock drops, puts do well. Again, having the right to sell a stock at a fixed price is most valuable when the market price of the stock is far below the strike price. Clearly investors who are purchasing or selling options need to have some awareness of the potential behavior of the underlying stock.
Call Option Payoff Diagrams
Figure 14.2
illustrates how the ultimate profits that options provide depend upon the underlying stock price. By “profit” we mean the gain that an investor would receive from exercising the option just before it expires—the difference between the stock price and the strike price (as long as that difference is positive) minus the initial cost of the option. The diagram on the left depicts a call, and the one on the right depicts a put. The call diagram assumes that an investor pays $500 for a call option contract
Figure 14.2 The Valuation Properties of Put and Call Options
The payoff of a call or put depends on the price of the underlying common stock (or other financial asset). The cost of the option has been recovered when the option passes its breakeven point. After that, the profit potential of a call is unlimited, but the profit potential of a put is limited because the underlying stock price cannot go lower than $0.
(i.e., 100 calls at $5 per call) and that the call has a strike price of $50. The graph shows how the option profit increases as the stock price rises. Observe that a call provides no cash inflow unless the price of the stock advances past the stated exercise price ($50). In other words, when the underlying stock price is below $50, the call generates a net loss of $500, which is just what the investor spent on the call. If the market price of the stock is below $50, no rational investor would exercise the option and pay $50 to buy the stock—it would be cheaper to simply buy the stock in the open market, and therefore the call expires worthless in that case.
The call option does not begin to move toward profitability until the stock price starts to move above $50. Because it costs $500 to buy the call, the stock has to move up to $55 ($5 above the strike price) for the investor to recover the $500 premium and thereby reach a breakeven point. Note, however, that even if the stock price is between $50 and $55, it’s still best to exercise the option because doing so reduces the option holder’s net loss. For example, if the stock price is
$52
, exercising the option generates a cash inflow of $200, which partially offsets the $500 option premium. For each dollar by which the stock price exceeds the breakeven point ($55), the call option’s profit goes up by $100. The potential profit from the call position is unlimited because there is no upper limit on the underlying stock’s price.
The value of a put is also derived from the price of the underlying stock, except that the put value goes up when the stock price goes down and vice versa. The put diagram in
Figure 14.2
assumes you buy a put for $500 and obtain the right to sell the underlying stock at $50 a share. It shows that the profit of the put is −$500 unless the market price of the corresponding stock drops below the exercise price ($50) on the put. The further the stock price is below $50, the more the profit of the put option increases. Again, note that because the put cost $500, the put doesn’t reach a breakeven point until the stock price reaches $45. At stock prices lower than that, the put is profitable, and it becomes more profitable the further the stock price drops. However, notice an important difference between puts and calls. The put option has a maximum profit of $4,500 because the stock price cannot fall below zero. As noted, a call’s profit potential is unlimited because there is no upper limit on the stock price.
Intrinsic Value
As we have seen, the payoff of a put or call depends ultimately on the exercise price stated on the option, as well as on the prevailing market price of the underlying common stock. The relationship between an option’s strike price and the underlying stock’s market price determines the options intrinsic value.
Intrinsic value
represents the gross amount of money that an investor would receive if he chose to exercise a call option. For example, suppose a call option has a strike price of $50 and the underlying stock price is
$60
. By exercising this option an investor could receive $10 (or $1,000 for a call contract on 100 shares of stock), and that is the option’s intrinsic value. If the stock price were just $45, the investor would not choose to exercise the option (because the stock is cheaper in the open market) and the call’s intrinsic value would be zero. More specifically, the intrinsic value of a call is determined according to the following simple formula.
Intrinsic value of a call=(Stock price−Strike price)×100or 0, whichever is greaterIntrinsic value of a call=(Stock price−Strike price)×100or 0, whichever is greaterEquation14.1
In other words, the intrinsic value of a call is merely the difference between the stock’s market price and the option’s strike price times 100. When the stock price is below the strike price, the intrinsic value is zero. As implied in
Equation 14.1
, a call has an intrinsic value whenever the market price of the underlying financial asset exceeds the strike price stipulated on the call. If a call option has a strike price of $50 and the underlying stock sells for $60, then the option’s intrinsic value is $1,000.
A put, on the other hand, cannot be valued in the same way because puts and calls allow the holder to do different things. To find the intrinsic value of a put, we must change the order of the equation a bit:
Intrinsic value of a put=(Strike price−Stock price)×100or 0, whichever is greaterIntrinsic value of a put=(Strike price−Stock price)×100or 0, whichever is greaterEquation14.2
In this case, a put has intrinsic value as long as the market price of the underlying stock (or financial asset) is less than the strike price stipulated on the put.
When a call has a strike price that is less than the market price of the underlying common stock, it has a positive intrinsic value and is known as an in-the-money option. Look back at
Figure 14.1
and notice that the first three call options listed in the figure are highlighted in yellow. Those call options have strike prices of $80, $82.50, and $85, and they are highlighted in yellow because on the day that these option quotes were retrieved, Facebook stock was selling just above $87. This means that the highlighted call options in
Figure 14.1
are in the money (i.e., their strike prices are below Facebook’s stock price).
When the strike price of the call exceeds the market price of the stock, the call has no intrinsic value, in which case it is known as an out-of-the-money option. In
Figure 14.1
, the calls with strike prices of $87.50, $90, $92.50, and $95 are not highlighted because they were out of the money at the time (i.e., Facebook’s stock price was below the strike prices). However, an out-of-the-money call option is not worthless as long as there is still time before it expires because there is a chance that the stock price will rise above the strike price. In other words, when a call is out-of-the-money, its intrinsic value is zero but its market value is greater than zero. In such a case, we say that the option has no intrinsic value but it still has time value. An option’s
time value
is the difference between its market price and its intrinsic value. In
Figure 14.1
, notice that the Facebook call option with a strike price of $87.50 has a quoted price of $3.53. Because the option had more than a month left before it expired, it still had plenty of time value even though its intrinsic value was zero. In the special case when the strike price of the option and the market price of the stock are the same, we say that the call option is
at-the-money
.
As you might expect, the situation is reversed for put options. A put is in-the-money when its strike price is greater than the market price of the stock. Remember, a put option grants the holder the right to sell a stock at the strike price, so that right is most valuable when the strike price is higher than the stock’s current market price. In
Figure 14.1
, the in-the-money put options (highlighted in yellow) have strike prices of $87.50, $90, $92.50, and $95. For all four of those put options, the strike price is above the stock’s then-current market price, so the options have a positive intrinsic value. A put option is out-of-the-money when the market price of the stock exceeds the strike price, which is the case in
Figure 14.1
for the put options with strike prices of $80, $82.50, and $85. As with calls, an out-of-the-money put still has a positive market value as long as there is some time before the expiration date. For example, the put option with a strike price of $85 in
Figure 14.1
has a market price of $2.68. This put’s
Famous Failures in Finance Ethical Lapse or Extraordinarily Good Timing?
A finance professor conducting research on executive stock option grants discovered that firms awarding these grants seemed to display extraordinarily good timing, setting the exercise prices just before a large run-up in the stock price. Perhaps firms were withholding good news until after they awarded stock option grants, knowing that when they released the news, their stock prices would rise. A few years later, Erik Lie and Randall Heron solved the puzzle of executives’ remarkable timing abilities. Some firms apparently backdated their option grants, using hindsight to set the exercise price on the one date in the prior several weeks when their stock price was at its lowest point. Backdating works like this. A firm announces on June 1 that it had granted its executives stock options on April 15, using the market price of the stock that day as the option’s exercise price. In fact, the firm did not actually award the options on April 15 but rather chose that date several weeks later. That gave the firm the benefit of hindsight, meaning that the firm knew that the stock’s lowest point in the preceding month or two had in fact been April 15. By the time the firm announced the option grant on June 1, the options were already in-the-money because the stock price was much higher than it had been on the retroactively set grant date. In backdating options, firms failed to disclose the true value of the option grants they awarded, which in turn affected their reported earnings and taxes.
That research and the press coverage it generated prompted investigations of at least 257 firms’ options grants. Some firms launched their own internal investigations, but many other companies became the target of SEC investigations. Firms involved in options backdating scandals endured serious consequences. Some executives paid fines or went to prison. Other firms settled lawsuits without admitting wrongdoing, such as Broadcom, which paid $118 million to settle a shareholder lawsuit. Most of the firms investigated saw their stock prices decline by as much as 10%.
The opportunity for senior management to engage in meaningful options backdating was largely eliminated by the Sarbanes-Oxley Act, which requires companies to publicly disclose option grants within two days. Indeed, researchers verified that the unusual market timing associated with stock option grants seemed to vanish soon after the passage of Sarbanes-Oxley.
(Source: Kenneth Carow, Randall Heron, Erik Lie, and Robert Neal, “Option Grant Backdating Investigations and Capital Market Discipline,” Journal of Corporate Finance, Volume 15, Issue 5, December 2009, pages 562–572.)
intrinsic value is zero, but its time value is $2.68. Finally, a put is at-the-money when the strike price equals the stock price.
When firms grant stock options to their employees, they typically grant at-the-money options, meaning that the strike prices of the options are set equal to the price of the underlying stock on the date of the option grant. However, as the accompanying Famous Failures in Finance box explains, many companies got into trouble for using a bit of hindsight (and failing to disclose that) when selecting their option grant dates. This practice came to be known as options backdating.
Put-Call Parity
Newcomers to options are often surprised to learn that as different as put and call options are from each other, their prices are linked under certain conditions. As long as a put and call option have the same underlying asset, the same strike price, and the same expiration date, their prices do not, and in fact cannot move independently of each other without creating an arbitrage opportunity. To explain why, consider the following example.
Suppose Nick forms a portfolio containing one share of Dow Chemical common stock and one put option with an exercise price of $50 (which we will denote X=$50X=$50). The Dow put option expires in one year. Nick’s wife Nora forms a different portfolio. She purchases a Dow call option, also having an exercise price of $50 and a one-year expiration, but Nora also buys a risk-free, zero-coupon bond with a face value of $50 (which matches the option’s strike price) and a maturity of one year. Unlike Nora’s call
Excel@Investing
Table 14.1 Illustration of Put-Call Parity
|
Price of Dow Chemical Stock in One Year |
|||||||||||||||||||||||||||||
|
$35 |
$40 |
$45 |
$50 |
$55 |
$60 |
$65 |
|||||||||||||||||||||||
|
Nick’s portfolio |
|||||||||||||||||||||||||||||
|
Put with X = 50X = 50 |
$15 |
$ 10 |
$ 5 |
$ 0 |
$ 0 |
||||||||||||||||||||||||
|
Share of stock |
$35 |
$40 | $45 | $50 | $55 | $60 |
$65 |
||||||||||||||||||||||
|
Total value |
|||||||||||||||||||||||||||||
|
Nora’s portfolio |
|||||||||||||||||||||||||||||
|
Call with X = $50X = $50 |
$ 0 |
$ 5 |
$ 10 |
$ 15 |
|||||||||||||||||||||||||
|
Bond with FV = $50FV = $50 |
option, the bond is an absolutely safe investment that will pay her $50 in one year with certainty. Let’s assume that the put and call options that Nick and Nora have purchased are European options, meaning that they can only be exercised when they expire in one year.
Because Nick and Nora have invested in options on Dow common stock, the value of their portfolios will clearly depend on how Dow’s stock performs.
Table 14.1
shows what each portfolio will be worth next year, just as the options are about to expire, for a range of possible Dow stock values. Let’s look at Nick’s portfolio first. Suppose Dow stock does not perform well at all, trading at $35 next year. In that case, Nick will be fortunate to have purchased a put option. If Dow stock is trading at $35, the put option will be in the money by $15, and its market value will be $15 too since it is about to expire. Combined with the share of stock that Nick owns (which is worth $35), the total portfolio value is $50. Notice that Nick’s portfolio value is fixed at $50 as long as Dow’s stock price is $50 or lower. That should make sense because the put option guarantees that Nick can sell his Dow share for $50. If Dow stock finishes the year above $50 per share, the put option expires out of the money and will be worthless, but the share of Dow that Nick owns gives his portfolio upside potential. To summarize, one year from now, Nick’s portfolio will be worth at least $50, and it could be worth more if Dow’s stock price ends the year above $50.
Now let’s turn to Nora’s portfolio, and again let’s start by asking what happens to her portfolio when Dow’s performance is poor and the stock ends the year at $35. In that case, Nora’s call option expires out of the money and has no value. However, Nora at least receives the $50 payment from her risk-free bond, so her total portfolio value is $50. The same will be true at any Dow price of $50 or lower, because when Dow’s price is in that range, the call option will be worthless, and Nora will only receive the $50 bond payment. What happens if Dow stock ends the year higher, say at $55? In that scenario, Nora’s call option will be worth $5, and her total portfolio will be worth $55. If Dow stock ends the year even higher, then Nora’s portfolio will be worth more too because the call value will increase in step with the underlying stock. To summarize Nora’s position, her portfolio will be worth at least $50, and it could be worth more if Dow’s stock price ends the year above $50.
By now it should be clear that the portfolios that Nick and Nora created have identical future values, no matter what happens to the price of Dow stock. Both investors have guaranteed that their portfolio will be worth at least $50, and both will benefit from an even higher payoff if Dow stock ends the year above $50. In technical terms, we would say that Nick and Nora have replicating portfolios, meaning that their portfolios provide identical payoffs (i.e., Nora’s portfolio replicates Nick’s and vice versa) even though the portfolios contain different securities. This leads to an important concept in option pricing called put-call parity. Put-call parity says that the future payoffs of a portfolio containing a put option and a share of the underlying stock are the same as the payoffs of a portfolio containing a call option and a risk-free bond. Again, remember that the put and call options have to have the same underlying asset, the same exercise price, and the same expiration date. But if those conditions hold, as they do for Nick and Nora’s portfolios, then put-call parity holds.
Put-call parity is important because it tells us something about the market prices of puts and calls. To be specific, if the future payoff of a put option and a stock equals the future payoff of a call option and a risk-free bond, then the prices of those two portfolios must be the same at any moment in time. If that were not true there would be an arbitrage opportunity. Remember that arbitrage means buying and selling identical assets at different prices to earn an instant, risk-free profit. Hypothetically, if the value of the portfolio containing a put and a share of stock exceeded the value of the portfolio containing a call and a risk-free bond, the traders could sell short the first portfolio and buy the second one to earn a profit. Such transactions would put upward pressure on the prices of the call and the bond, and they would put downward pressure on the prices of the stock and the put, until the values of the two portfolios were equal again. Put-call parity says that because the portfolio containing the put and the stock is essentially the same as the portfolio containing the call and the risk-free bond, the prices of those portfolios must also be the same. We can express this mathematically as follows:
Price of a put option + Price of a stock = Price of a call option + Price of arisk-free bondPrice of a put option + Price of a stock = Price of a call option + Price of a risk-free bondEquation14.3
Example
Suppose a certain stock sells for
$71.75
. You want to know the value of a put option on this stock if the strike price is $70 and the expiration date is three months from now. A call option on the same underlying stock has a strike price of $70, and it expires in three months. That call option currently sells for
$6.74
. There is also a risk-free, zero-coupon bond available in the market with a maturity in three months and a face value of $70 (notice the bond’s face value is the same as the option’s strike price). The current risk-free rate is 2% per year, or about 0.5% for a quarter (three months). This means that the bond’s market price is just the present value of $70 discounted for three months, or $69.65 ($70/0.005). You can use put-call parity (
Equation 14.3
) to find the put option’s market price:
Price of a put + Price of a stock = Price of a call + Price of a risk-free bondPrice of a put + $71.75 = $6.74 + 69.65Price of a put = $6.74 + $69.65−$71.75 = $4.64Price of a put + Price of a stock = Price of a call + Price of a risk-free bondPrice of a put + $71.75 = $6.74 + 69.65Price of a put = $6.74 + $69.65−$71.75 = $4.64
Now we know one way to find the value of an option. If we know the price of the underlying stock, the risk-free interest rate, and the price of a call option, we can use put-call parity to find the value of a put. Or, if we know the value of the put, we can use it to find the value of a call. But what if we don’t know the value of either option? To explore that question, let’s turn our attention to the underlying forces that influence option prices.
Table 14.2 Option Price Components for Call Options
|
Stock Price |
Strike Price |
Options Expiring in One Month |
Options Expiring in Three Months |
||||||
|
Market Price |
Intrinsic Value |
Time Value |
|||||||
| $71.75 |
$65.00 |
$7.69 |
$6.75 |
$0.94 |
$9.68 |
$2.93 |
|||
|
$70.00 |
$4.28 |
$1.75 |
$2.53 |
$6.74 |
$4.99 |
||||
|
$75.00 |
$2.04 |
$0.00 |
$4.50 |
What Drives Option Prices
Excel@Investing
Option prices can be reduced to two separate components. The first is the intrinsic value of the option, which is driven by the gap between the current market price of the underlying financial asset and the option’s strike price. As we saw in
Equations 14.1
and
14.2
, the greater the difference between the market price of the underlying asset and the strike price on the option, the greater the intrinsic value of the call or put. We can summarize these relationships by saying that a call value is greater when (1) the strike price is lower or (2) the stock price is higher. Conversely, a put value is greater when (2) the strike price is higher or (3) the stock price is lower.
Time Value and Time to Expiration
The second component of an option price is the time value. It represents the amount by which an option’s price exceeds its intrinsic value.
Table 14.2
illustrates this concept by listing market prices, intrinsic values, and time values for six different call options. Three of the options expire in one month, and the other three options expire in three months. In addition, there are two call options with a strike price of $65, two with a strike of $70, and two with a $75 strike price. The current market price of the underlying stock is $71.75, so the call options with $65 and $70 strike prices are in the money, but the options with a $75 strike price are out of the money.
Look first at the call option with a strike price of $65 expiring in one month.
Table 14.2
lists its market price as $7.69. This option is in-the-money and has an intrinsic value of $6.75 because it allows the option holder to buy a stock for $65 when that stock is actually worth $71.75. The option’s market price is $0.94 higher than its intrinsic value, so $0.94 is the option’s time value. Why would investors be willing to pay $7.69 for this option when they will only earn $6.75 if they exercise it today? Because the option does not expire for another month, there is some chance that the underlying stock price will rise, and that possibility gives the option its time value. Moving to the right in
Table 14.2
, observe that the call with a $65 strike price expiring in three months has an even higher market value, $9.68. The intrinsic value of this option is also $6.75, but its time value is higher because there is more time for the stock price to move in a favorable direction.
Watch Your Behavior
Exercising Too Early Researchers have discovered that customers of discount brokers frequently make the mistake of exercising their options early rather than selling them, and they are particularly prone to this mistake when a stock hits a 52-week high. In contrast, professional options traders almost never make that mistake.
(Source: Allen M. Poteshman and Vitaly Serbin, “Clearly Irrational Financial Market Behavior: Evidence from the Early Exercise of Exchange Traded Stock Options,” Journal of Finance, February 2003, Volume 58, Issue 37, pp. 37–70.)
Now look at the options with a $75 strike price. These options are out of the money, so their intrinsic values are zero. Yet both have time value. The option expiring in one month is worth $2.04, and the option expiring in three months sells for $4.50. Investors are willing to pay for out-of-the-money options because with time left before they expire, there is still a chance that the underlying stock price will rise, and it will become profitable to exercise the options. Clearly the option expiring in three months is more valuable than the one expiring next month.
There are two important general lessons from
Table 14.2
. The first is that the market price of an option will almost always be higher than its intrinsic value. The main exception to that general rule is that an option’s price will equal its intrinsic value just before it expires. As long as an option has some time left before it expires, it will generally be worth more than its intrinsic value. The second important lesson is that an option’s price will usually be higher if the option has more time remaining before it expires.
Volatility and Option Prices
For most financial assets, higher volatility means higher risk, and higher risk means that investors demand a higher rate of return. Because an asset’s value is linked to the present value of its cash flows, if investors discount those cash flows at a higher rate of interest, the asset’s value will be lower. Think of a bond, for example. A bond’s cash flows are contractually fixed, so if investors perceive that the bond’s risk has increased, they will discount those cash flows at a higher rate, which in turn leads to a lower bond price. So in most cases, we can say that if an asset’s volatility is higher, its value will be lower, holding everything else constant.
That’s not really true with options. The reason is that options have asymmetric payoffs. Consider a call option that is near its expiration date. As the underlying stock price rises above the call’s strike price, the option’s payoff rises too. So on the upside, the call’s payoff moves in step with the stock. But when the stock falls below the call’s strike price, the option is out-of-the-money and will not be worth exercising. That is true whether the stock price is $1 below the call’s strike price or $10 below it or even $100 below the strike price. On the downside, the call’s payoff is fixed at zero no matter how the stock price goes, so there is an asymmetry between a call’s upside and its downside.
This asymmetry makes options more valuable if the underlying stock price is more volatile. To see this clearly, consider two stocks, A and B, which are both currently selling for $50 per share. Suppose we want to evaluate the investment potential of call options on these two stocks. Suppose these call options are at-the-money, so their strike prices are $50, and they expire in one year. Suppose A is not a particularly volatile stock, and you think that a year from now, the value of stock A will be in a range between $40 and $60. The following table shows how the payoff on a call option will vary depending on the price of stock A next year.
|
Price of Stock A |
$44 |
$48 |
$52 |
$56 |
||||||||||
|
Payoff of Call |
$ 0 |
$ 2 |
$ 6 |
$10 |
Now stock B is more volatile than stock A, so you believe that in one year its price will be in a range from
$32
to
$68
. The following table below how payoffs on a call option will vary depending on the price of stock B.
|
Price of Stock B |
$32 |
$36 |
$64 |
$68 |
|
Payoff of a Call |
$14 |
$18 |
Notice that the payoffs of this option are the same as the call option on stock A when the stock price ends the year below $50, but call options on stock B offer more upside. This means that the market price of a call option on stock B must be higher than the price of a call option on stock A. To say this more generally, the value of an option (call or put) is greater if the volatility of the underlying stock is greater.
Interest Rates and Option Prices
Previously we said that one way to value options is by using put-call parity, and part of that valuation process involves pricing a risk-free
Famous Failures in Finance The Volatility Index
Because the volatility of the underlying asset plays a major role in option valuation, options traders track the volatility of individual stocks and of the market as a whole very closely. In fact, there is an index, called the VIX (which stands for volatility index), which provides an estimate of the volatility of the overall market. From about 1990 to 2007, the average volatility of the U.S. stock market as measured by VIX was close to 20% per year. But in the fall of 2008, after the failure of Lehman Brothers, the VIX index peaked at nearly 90%, more than four times its long-run average! Throughout the Great Recession (December 2007 through June 2009) the VIX index spiked several times to levels above its historical average, but it has been mainly below average in recent years.
bond. In general, options prices do depend on interest rates, just as the prices of other financial assets do. The general relationship is that the value of a call rises when the risk-free rate rises, and the value of a put falls with rising interest rates. Intuitively, a call option grants the holder the right to buy something at some future date. In a sense then, part of what a call option provides is the right to defer payment for a stock. When is the right to defer paying for something most valuable? It’s when interest rates are high. With high rates, investors prefer to keep their money invested as long as possible, so having the right to defer payment for something is particularly valuable.
Puts work in just the opposite way. A put option gives the holder the right to sell something, that is, to receive cash in exchange for stock at some future date. Therefore, part of what a put option provides is a deferred receipt. Having to wait to receive money is never a good thing, but it is worse when interest rates are high. Thus, put values fall when the risk-free interest rate rises.
To summarize what we’ve learned so far, there are five major forces that influence the price of an option. They are (1) the price of the underlying financial asset, (2) the option’s strike price, (3) the amount of time remaining to expiration, (4) the underlying asset’s volatility, and (5) the risk-free interest rate. For stocks that pay dividends, the dividend yield can also influence the price of an option, with higher dividends leading to lower call values and higher put values.
Option-Pricing Models
Some fairly sophisticated option-pricing models have been developed, notably by Myron Scholes and the late Fisher Black, to value options. Options traders use these models to try to identify and trade over- and undervalued options. Not surprisingly, these models are based on the same five variables we identified above. The Black and Scholes option-pricing model prices a European call option using this equation:
Call price=SN(d1)−PV(X)N(d2)Call price=SN(d1)−PV(X)N(d2)Equation14.4
In
Equation 14.4
, S represents the market price of the underling stock, PV(X) represents the present value of the option’s strike price, and N(d1) and N(d2) are probabilities ranging from 0 to 1. Loosely speaking, these probabilities are related to the odds that the call option will expire in-the-money. In other words, as these probabilities get closer and closer to 1.0, the option is more and more likely to be exercised, and hence it is more and more valuable. The probabilities N(d1) and N(d2) depend on the numerical values of d1 and d2, which come from these equations:
d1=ln(SX)+(r+σ22)Tσ√Td1=ln(SX)+(r+σ22)TσTEquation14.4a
d2=d1−σ√Td2=d1−σTEquation14.4b
In these two equations, S and X again represent the stock price and the strike price, respectively, T represents the time remaining before the option expires (expressed in years), σ represents the annual standard deviation of the stock’s return (so σ2 represents the variance of the stock’s return), and r represents the annual risk-free interest rate. Once values for d1 and d2 are calculated, they must then be converted into probabilities using the standard normal distribution function. The normal distribution is simply the familiar bell curve, and the standard normal distribution is a bell curve with a mean of zero and a standard deviation of 1. The probabilities we need in
Equation 14.4
represent the likelihood of drawing a number less than or equal to d1 (and d2) from this distribution.
Figure 14.3
provides a graphical illustration of the probability that we seek. Suppose we use
Equation 14.4a
and find that d1 equals 0.9. To obtain N(d1) for
Equation 14.4
, we need to know the area under the curve in
Figure 14.3
to the left of the value 0.9.
Fortunately, Excel provides a useful function that makes it easy to calculate these standard normal probabilities. That function is denoted with = normsdist(0.9), and Excel reveals that the appropriate probability is 0.8159.
Figure 14.3The Standard Normal Distribution
The standard normal distribution has a 0 mean and a standard deviation of 1. The shaded area to the left of d1 represents the probability of drawing a value at random from this distribution that is less than or equal to d1.
Now we are ready to price a call option using Black and Scholes.
Example
Suppose we want to price a call option that expires in three months (one-quarter of a year). The option has a strike price of $45, and the market price of the underlying stock is currently $44. The standard deviation of this stock’s returns is about 50% per year, and the risk-free rate is 2%.
To price this option, start by solving for the quantities d1 and d2:
d1=ln(4445)+(0.02+0.5022)0.250.50√0.25=−0.0225+(0.145)0.250.25=0.0551d2=0.0551−0.50√0.25=−0.1949d1=ln(4445)+(0.02+0.5022)0.250.500.25=−0.0225+(0.145)0.250.25=0.0551d2=0.0551−0.500.25=−0.1949
Next, use Excel to find the standard normal probabilities attached to these values:
N(d1)=normsdist (0.0551)=0.5220N(d2)=normsdist (−0.1949)=0.4227N(d1)=normsdist (0.0551)=0.5220N(d2)=normsdist (−0.1949)=0.4227
Finally, plug the values for N(d1) and N(d2) into
Equation 14.4
to obtain the call price:
Call price=$44 (0.5220)−[$45÷(1.02)0.25](0.4227)=$22.97−$18.93=$4.04Call price=$44 (0.5220)−[$45÷(1.02)0.25](0.4227)=$22.97−$18.93=$4.04
In this last equation, we calculate the present value of the strike price by discounting $45 at 2% for one quarter of a year. So, according to the Black-Scholes option-pricing model, the call should be priced at $4.04.
Trading Strategies
For the most part, investors can use stock options in three kinds of trading strategies: (1) buying puts and calls for speculation, (2) hedging with puts and calls, and (3) option writing and spreading.
Buying for Speculation
Buying for speculation is the simplest and most straightforward use of puts and calls. Basically, it is like buying stock (“buy low, sell high”) and, in fact, represents an alternative to investing in stock. For example, if investors feel the market price of a particular stock is going to move up, they can capture that price appreciation by buying a call on the stock. In contrast, if investors feel the stock is about to drop in price, a put could convert that price decline into a profitable situation. Investors may buy options rather than shares due to the leverage that options provide. On a percentage basis, the gains (and losses) that investors can realize on options are typically much higher than on stocks.
Sometimes investors will argue that options offer valuable downside protection. The most an investor can lose is the cost of the option, which is always less than the cost of the underlying stock. Thus, by using options as a tool for speculation, investors can put a cap on losses and still get almost as much profit potential as with the underlying stock. It’s true that the potential dollar losses on one option are less than the potential losses on one share of stock, but don’t be fooled into thinking that options are less risky than stock. The likelihood of buying an option and earning a return of −100% (i.e., losing the entire investment) is quite high, whereas buying a share of stock and seeing its value drop to nothing is very unusual.
Watch Your Behavior
Option Buyers Chase Returns A recent study found that investors bought more call options on stocks that had recently earned high returns. This “return chasing” behavior resembles the surge in inflows to mutual funds with high past returns. There is no evidence that chasing returns, either in options or in mutual funds, benefits investors.
Speculating with Calls
To illustrate the essentials of speculating with options, imagine that you own a stock that you feel will move up in price over the next six months. What would happen if you were to buy a call on this stock rather than investing directly in the stock? To find out, let’s see what the numbers show. The price of the stock is now $49, and you anticipate that within six months it will rise to about $65. You need to determine the expected return associated with each of your investment alternatives. Because (most) options have relatively short lives, and because we’re dealing with an investment horizon of only six months, we can use holding period return to measure the investment’s performance. Thus, if your expectations about the stock are correct, it should go up by $16 a share and will provide you with a 33% holding period return: ($65−$49)÷$49 = $16÷$49 = 0.33($65−$49)÷$49 = $16÷$49 = 0.33.
But there are also some listed options available on this stock. Let’s see how they would do. For illustrative purposes, we will use two six-month calls that carry a $40 and a $50 strike price, respectively.
Table 14.3
compares the behavior of these two calls with the behavior of the underlying common stock. Clearly, from a holding period return perspective, either call option represents a superior investment to buying the stock itself. The dollar amount of profit may be a bit more with the stock, but note that the size of the required investment,
$4,900
, is a lot more too, so that alternative has the lowest HPR.
Observe that one of the calls is an in-the-money option (the one with the $40 strike price). The other is out-of-the-money. The difference in returns generated by these calls is rather typical. That is, investors are usually able to generate much better rates of return with lower-priced (out-of-the-money) options, but of course there is a greater
Excel@Investing
Table 14.3 Speculating with Call Options
|
100 Shares of Underlying Common Stock |
Six-Month Call Options on the Stock |
||||||
|
$40 Strike Price |
$50 Strike Price |
||||||
|
* The price of the calls was computed using the Black and Scholes option-pricing model, assuming a six-month expiration, 2% risk-free rate, and 40% standard deviation. |
|||||||
|
** Holding period return (HPR) = (Ending price of the stock or option − Beginning price of the stock or option) ÷ Beginning price of the stock or option. |
|||||||
|
Today |
|||||||
|
Market value of stock (at $49/share) |
$4,900 | ||||||
|
Market price of calls |
$1,100 |
$ 530 |
|||||
|
Six Months Later |
|||||||
|
Expected value of stock (at $65/share) |
$6,500 |
||||||
|
Expected price of calls |
$2,500 |
$1,500 |
|||||
|
Profit |
$1,600 |
$1,400 |
$ 970 |
||||
|
Holding Period Return |
33% |
127% |
183% |
risk that these options will expire worthless. A major drawback of out-of-the-money options is that their price is made up solely of investment premium—a sunk cost that will be lost if the stock does not move in price.
Speculating with Puts
To see how you can speculate in puts, consider the following situation. You’re looking at a stock that’s now priced at $51, but you anticipate a drop in price to about $35 per share within the next six months. If that occurs, you could sell the stock short and make a profit of $16 per share.
Alternatively, you can purchase an out-of-the-money put (with a strike price of $50) for, say, $500. Again, if the price of the underlying stock drops, you will make money with the put. The profit and rate of return on the put are summarized below, along with the comparative returns from short selling the stock. Once again, in terms of holding period return, the stock option is the superior investment vehicle by a wide margin.
|
Comparative Performance Given Price of Stock Moves from $51 to $35/Share over a 6-Month Period |
Buy 1 Put ($50 strike price) |
Short Sell 100 Shares of Stock |
|
* The purchase price of the put was computed using the Black and Scholes option-pricing model to value an identical call, then using put-call parity to value the put. Assumed 2% risk-free rate and 40% standard deviation. |
||
|
** Assumes the short sale was made with a required margin deposit of 50% ($2,550). |
||
|
Purchase price (today) |
2$ 500 |
|
|
Selling price (six months later) |
||
|
Short sell (today) |
$5,100 |
|
|
Cover (six months later) |
|
2$3,500 |
|
$1,000 |
||
|
Holding period return |
200% |
63% |
Of course, not all option investments perform as well as the ones in our examples. Success with this strategy rests on picking the right underlying common stock. Thus, security analysis and proper stock selection are critical dimensions of this technique. It is a highly risky investment strategy, but it may be well suited for the more speculatively inclined investor.
Hedging: Modifying Risks
A
hedge
is simply a combination of two or more securities into a single investment position for the purpose of reducing risk. Let’s say you hold a stock and want to reduce the amount of downside risk in this investment. You can do that by setting up a hedge. In essence, you are using the hedge as a way to modify your exposure to risk. To be more specific, you are trying to change not only the chance of loss but also the amount lost if the worst does occur. A simple hedge might involve nothing more than buying stock and simultaneously buying a put on that stock with a strike price equal to the current stock price. This strategy guarantees that you can sell the stock for at least the strike price of the option, but you might be able to sell the stock for more than the strike price if the stock performs well. Another hedge strategy might consist of selling some stock short and then buying a call. There are many types of hedges, some of which are very simple and others very sophisticated. Investors use them for one basic reason: to earn or protect a profit without exposing the investor to excessive loss.
An options hedge may be appropriate if you have generated a profit from an earlier common stock investment and wish to protect that profit. Or it may be appropriate if you are about to make a common stock investment and wish to protect your money by limiting potential capital loss. If you hold a stock that has gone up in price, the purchase of a put would provide the type of downside protection you need; the purchase of a call, in contrast, would provide protection to a short seller of common stock. Thus, option hedging always involves two transactions: (1) the initial common stock position (long or short) and (2) the simultaneous or subsequent purchase of the option.
Protective Puts: Limiting Capital Loss
Let’s examine a simple option hedge in which you use a put to limit your exposure to capital loss. Assume that you want to buy 100 shares of stock. Being a bit apprehensive about the stock’s outlook, you decide to use an option hedge to protect your capital against loss. Therefore, you simultaneously (1) buy the stock and (2) buy a put on the stock (which fully covers the 100 shares owned) with strike price equal to the stock’s current market price. This type of hedge is known as a protective put. Suppose you purchase 100 shares of the common stock at $25 a share and pay $150 for a put with a $25 strike price. Now, no matter what happens to the price of the stock over the life of the put, you can always sell the stock for at least $25. Your maximum loss is $150, which occurs if the stock price stays at $25. In that case, there is no gain on the stock and the put expires worthless too, so your loss equals your investment in the put. At the same time, there’s no limit on the gains. If the price of the stock goes up (as hoped), the put becomes worthless, and you will earn the capital gains on the stock (less the cost of the put, of course).
Table 14.4
shows the essentials of this option hedge. The $150 paid for the put is sunk cost. That’s lost no matter what happens to the price of the stock. In effect, it is the price paid for the insurance this hedge offers. Moreover, this hedge is good only for the life of the put. When this put expires, you will have to replace it with another put or forget about hedging your capital.
Excel@Investing
Table 14.4 Limiting Capital Loss with a Put Hedge
|
Stock |
Put |
||||||
|
* The put is purchased simultaneously and carries a strike price of $25. |
|||||||
|
Purchase price of the stock |
$25 | ||||||
|
Purchase price of the put |
$1.50 |
||||||
|
Sometime Later |
|||||||
|
A. Price of stock goes up to: |
|||||||
|
Value of put |
$ 0 |
||||||
|
Profit: |
|||||||
|
100 shares of stock ($50 – $25) |
|||||||
|
Less: Cost of Put |
− $ 15 0 |
||||||
|
Profit: |
$2,350 |
||||||
|
B. Price of stock goes down to: |
$10 | ||||||
| $ 15 | |||||||
|
100 shares of stock (loss $10 – $25) |
−$1,500 |
||||||
|
Value of put (profit) |
|||||||
|
Less: Cost of put |
−$ 150 |
||||||
|
Loss: |
$ 150 |
Excel@Investing
Table 14.5 Protecting Profits with a Put Hedge
|
3-month Put with $75 Strike Price |
||
|
$ 35 |
||
|
Marketprice of the stock |
$ 75 |
|
|
Market price of the put |
$2.50 | |
|
Three Months Later |
||
|
A. Price of stock goes down to: |
$ 50 |
|
|
$ 25 |
||
|
100 shares of stock ($50 – $35) |
||
|
− $ 250 |
||
| Profit |
$3,750 |
|
|
B. Price of stock goes up to: |
$100 |
|
|
100 shares of stock ($100 – $35) |
||
|
$6,250 |
||
Protective Puts: Protecting Profits
The other basic use of an option hedge involves entering into the options position after a profit has been made on the underlying stock. This could be done because of investment uncertainty or for tax purposes (to carry over a profit to the next taxable year). For example, if you bought 100 shares of a stock at $35 and it moved to $75, there would be a profit of $40 per share to protect. You could protect the profit with an option hedge by buying a put. Assume you buy a three-month put with a $75 strike price at a cost of $250. Now, regardless of what happens to the price of the stock over the life of the put, you are guaranteed a minimum profit of $3,750 (the $4,000 profit in the stock made so far, less the $250 cost of the put).
You can see this in
Table 14.5
. Note that if the price of the stock should fall to $50, you still earn a profit of $3,750. Plus, there is still no limit on how much profit can be made. For example, if the stock goes up to $100, you earn a profit of $6,250.
Unfortunately, the cost of this kind of insurance can become very expensive just when it’s needed the most—that is, when market prices are falling. Under such circumstances, it’s not uncommon to find put options trading at price premiums of 20% to 30%, or more, above their prevailing intrinsic values. Essentially, that means the price of the stock position you’re trying to protect has to fall 20% to 30% before the protection even starts to kick in. Clearly, as long as high option price premiums prevail, the hedging strategies described above are a lot less attractive. They still may prove to be helpful, but only for very wide swings in value—and for those that occur over fairly short periods of time, as defined by the life of the put option.
Although the preceding discussion pertained to put hedges, call hedges can also be set up to limit the loss or protect a profit on a short sale. For example, when selling a stock short, you can purchase a call to protect yourself against a rise in the price of the stock—with the same basic results as outlined above.
Enhancing Returns: Options Writing and Spreading
The advent of listed options has led to many intriguing options-trading strategies. Yet, despite the appeal of these techniques, the experts agree on one important point: Such specialized trading strategies should be left to experienced investors who fully understand their subtleties. Our goal at this point is not to master these specialized strategies but to explain in general terms what they are and how they operate. We will look at two types of specialized options strategies here: (1) writing options and (2) spreading options.
Writing Options
Generally, investors write options because they believe the price of the underlying stock is going to move in their favor. That is, it is not going to rise as much as the buyer of a call expects, nor will it fall as much as the buyer of a put hopes. Option writing represents an investment transaction to the writers. They receive the full option premium (less normal transaction costs) in exchange for agreeing to live up to the terms of the option.
Naked Options
Investors can write options in two ways. One is to write
naked options
, which involves writing options on stock not owned by the writer. An investor simply writes the put or call, collects the option premium, and hopes the price of the underlying stock does not move against him or her. If successful, naked writing can be highly profitable because it requires essentially no capital up front. Remember, though, the amount of return to the writer is always limited to the amount of option premium received. The catch is that there is really no limit to loss exposure. The price of the underlying stock can rise or fall by just about any amount over the life of the option and, thus, can deal a real blow to the writer of a naked put or call.
Covered Options
The amount of risk exposure is a lot less for those who write
covered options
. That’s because these options are written against stocks the investor (writer) already owns or has a position in. For example, an investor could write a call against stock he owns or write a put against stock he has short sold. The investor can use the long or short position to meet the terms of the option. Such a strategy is a fairly conservative way to generate attractive rates of return. The object is to write a slightly out-of-the-money option, pocket the option premium, and hope the price of the underlying stock will move up or down to (but not exceed) the option’s strike price. In effect, you are adding an option premium to the other usual sources of return (dividends and/or capital gains). But there’s more. While the option premium adds to the return, it also reduces risk. It can cushion a loss if the price of the stock moves against the investor.
There is a hitch to all this, of course. The amount of return the covered option investor can realize is limited. Once the price of the underlying common stock exceeds the strike price on the option, the option becomes valuable. When that happens, the investor starts to lose money on the options. From this point on, for every dollar the investor makes on the stock position, he loses an equal amount on the option position. That’s a major risk of writing covered call options—if the price of the underlying stock takes off, the call writer misses out on the added profits.
To illustrate the ins and outs of covered call writing, let’s assume you own 100 shares of PFP, Inc., an actively traded, high-yielding common stock. The stock is currently trading at $73.50 and pays quarterly dividends of $1 a share. You decide to write a three-month call on PFP, giving the buyer the right to take the stock off your hands at $80 a share. Such options are trading in the market at $2.50, so you receive $250 for writing the call. You fully intend to hold on to the stock, so you’d like to see the price of
Table 14.6 Covered Call Writing
|
3-Month Call with $80 Strike Price |
||||||
|
Current market price of the stock |
$ 73.50 |
|||||
|
Current market price of the call |
||||||
|
A. Price of the stock is unchanged: |
$73.50 |
|||||
|
Value of the call |
$0 |
|||||
|
Quarterly dividends received |
$ 100 |
|||||
|
Proceeds from sale of call |
$ 250 |
|||||
|
Total Profit: |
$ 350 |
|||||
|
B. Price of the stock goes up to: |
$80 |
Price Where Maximum Profit Occurs |
||||
|
$ 100 |
||||||
|
$ 250 |
||||||
|
Capital gains on stock ($80 – $73.5) |
$ 650 |
|||||
| $1,000 | ||||||
|
C. Price of the stock goes up to: |
$90 |
|||||
|
$10.00 |
||||||
|
Capital gains on stock ($90 – $73.5) |
$ 1,650 |
|||||
|
Less: Loss on call |
−$1,000 |
|||||
|
Net Profit: |
||||||
|
D. Price of the stock drops to: |
$ 71 |
reakeven Price |
||||
|
Capital loss on stock ($71 – $73.50) |
||||||
| $ 100 |
Excel@Investing
PFP stock rise to no more than $80 by the expiration date on the call. If that happens, the call option will expire worthless. As a result, not only will you earn the dividends and capital gains on the stock, but you also get to pocket the $250 you received when you wrote the call. Basically, you’ve just added $250 to the quarterly return on your stock.
Table 14.6
summarizes the profit and loss characteristics of this covered call position. Note that the maximum profit on this transaction occurs when the market price of the stock equals the strike price on the call. If the price of the stock keeps going up, you miss out on the added profits. Even so, the $1,000 profit you earn at a stock price of $80 or above translates into a (three-month) holding period return of 13.6% ($1,000 ÷ $7,350). That represents an annualized return of nearly 55%! With this kind of return potential, it’s not difficult to see why covered call writing is so popular. Moreover, as situation D in the table illustrates, covered call writing adds a little cushion to losses. The price of the stock has to drop more than $2.50 (which is what you received when you wrote/sold the call) before you start losing money.
Besides covered calls and protective puts, there are many ways to combine options with other types of securities to achieve a given investment objective. Probably none is more unusual than the creation of so-called synthetic securities. Here’s an example. Say you want to buy a convertible bond on a certain company but that company doesn’t have any convertibles outstanding. You can create your own customized convertible by combining a straight (nonconvertible) bond with a listed call option on your targeted company.
Spreading Options
Option spreading
is nothing more than the combination of two or more options into a single transaction. You could create an option spread, for example, by simultaneously buying and writing options on the same underlying stock. These would not be identical options; they would differ with respect to strike price and/or expiration date. Spreads are a very popular use of listed options, and they account for a substantial amount of the trading activity on the listed options exchanges. These spreads go by a variety of exotic names, such as bull spreads, bear spreads, money spreads, vertical spreads, and butterfly spreads. Each spread is different and each is constructed to meet a certain type of investment goal.
Consider, for example, a vertical spread. It would be set up by buying a call at one strike price and then writing a call (on the same stock and for the same expiration date) at a higher strike price. For instance, you could buy an August call on Facebook at a strike price of, say, $80 and simultaneously sell (write) an August call on Facebook at a strike price of $85. If you refer back to
Figure 14.1
, you will see that the first option would cost you $8.40, while the option that you sell would bring in $4.90. Therefore, the net cost of this position is $3.50. Strange as it may sound, such a position would generate a hefty return if the price of the underlying stock went up by just a few points. Suppose, for example, that when these options expire, the price of Facebook stock is $88. The call option that you purchased would pay you $8, but you’d have to pay $3 to the buyer of the option you wrote, so your net cash payoff at expiration would be $5. A $5 return on an investment of $3.50 represents a rate of return of almost 43%! Other spreads are used to profit from a falling market. Still others try to make money when the price of the underlying stock moves either up or down.
Whatever the objective, most spreads are created to take advantage of differences in prevailing option prices. The payoff from spreading is usually substantial, but so is the risk. In fact, some spreads that seem to involve almost no risk may end up with devastating results if the market and the difference between option premiums move against the investor.
How Do Straddles Work?
Option Straddles
A variation on this theme involves an
option straddle
. This is the simultaneous purchase (or sale) of both a put and a call on the same underlying common stock. Unlike spreads, straddles normally involve the same strike price and expiration date. Here the object is to earn a profit from either a big or a small swing in the price of the underlying common stock.
For example, in a long straddle you buy an equal number of puts and calls. You make money in a long straddle when the underlying stock undergoes a big change in price—either up or down. If the price of the stock shoots way up, you make money on the call side of the straddle but are out the cost of the puts. If the price of the stock plummets, you make money on the puts, but the calls are useless. In either case, so long as you make more money on one side than the cost of the options for the other side, you’re ahead of the game.
As an example, refer again to
Figure 14.1
. Imagine that you buy a Facebook call and a put, both having a strike of $87.50 and an August expiration date. The call costs $3.53, and the put costs $3.85, so the total cost of this position is $7.38. To make money on this transaction, Facebook stock would have to fall more than $7.38 below the $87.50 strike price or rise more than $7.38 above it. If Facebook stock stays within that range, your position loses money.
In a similar fashion, in a short straddle, you sell/write an equal number of puts and calls with the same underlying stock, the same strike price, and the same expiration date. You make money in this position when the price of the underlying stock goes nowhere. In effect, you get to keep all or most of the option premiums you collected when you wrote the options.
Except for obvious structural differences, the principles that underlie the creation of straddles are much like those for spreads. The object is to combine options that will enable you to capture the benefits of certain types of stock price behavior. But keep in mind that if the prices of the underlying stock and/or the option premiums do not behave in the anticipated manner, you lose. Spreads and straddles are extremely tricky and should be used only by knowledgeable investors.
Concepts in Review
Answers available at
http://www.pearsonhighered.com/smart
1. 14.7 Briefly explain how you would make money on (a) a call option and (b) a put option. Do you have to exercise the option to capture the profit?
2. 14.8 How do you find the intrinsic value of a call? Of a put? Does an out-of-the-money option have intrinsic value?
3. 14.9 Name five variables that can affect the price of options, and briefly explain how each affects prices. How important are intrinsic value and time value to in-the-money options? To out-of-the-money options?
4. 14.10 Describe three ways in which investors can use stock options.
5. 14.11 What’s the most that can be made from writing calls? Why would an investor want to write covered calls? Explain how you can reduce the risk on an underlying common stock by writing covered calls.
Stock-Index and
Other Types of Options
1. LG 6
Imagine being able to buy or sell a major stock market index like the S&P 500—and at a reasonable cost. Think of what you could do. If you felt the market was heading up, you could invest in a security that tracks the price of the S&P 500 Index and make money when the market goes up. No longer would you have to go through the process of selecting specific stocks that you hope will capture the market’s performance. Rather, you could play the market as a whole. Of course, you can do this by purchasing a mutual fund or an ETF that is indexed to the S&P 500, but you can also accomplish that goal with stock-index options—puts and calls that are written on major stock market indexes. Index options have been around since 1983 and have become immensely popular with both individual and institutional investors. Here we will take a closer look at these popular and often highly profitable investments.
Contract Provisions of Stock-Index Options
Basically, a
stock-index option
is a put or call written on a specific stock market index. The underlying security in this case is the specific market index. Thus, when the market index moves in one direction or another, the value of the index option moves accordingly. Because there are no stocks or other financial assets backing these options, settlement is defined in terms of cash. Specifically, the cash value of an index option is equal to 100 times the published market index that underlies the option. For example, if the S&P 500 is at 2,100, then the value of an S&P 500 Index option will be $100×2,100=$210,000$100×2,100=$210,000. If the underlying index moves up or down in the market, so will the cash value of the option. In addition, whereas most options on individual stocks are American options and can be exercised at any time, stock index options may be American or European options, so they may be exercisable only on the expiration date.
Today put and call options are available on more than 100 stock indexes. These include options on just about every major U.S. stock market index or average (such as the Dow Jones Industrial Average, the S&P 500, the Russell 2000, and the Nasdaq 100), options on a handful of foreign markets (e.g., China, Mexico, Japan, Hong Kong, and the Europe sector), and options on different segments of the market (pharmaceuticals, oil services, semiconductors, bank, and utility indexes). In 2015 about 10% of traded option contracts were index options, and a large percentage of these contracts were on five of the leading stock indexes:
· S&P 500 Index (SPX)
· Russell 2000 Index (RUT)
· Nasdaq 100 Index (NDX)
· S&P 100 Index (OEX)
· Dow Jones Industrial Average (DJX)
The S&P 500 Index captures the market behavior of large-cap stocks. The Russell 2000 Index measures the performance of the small-cap stocks in the United States. The Nasdaq 100 Index tracks the behavior of the 100 largest nonfinancial stocks listed on Nasdaq and is composed of mostly large, high-tech companies (such as Intel and Cisco). The S&P 100 Index is another large-cap index composed of 100 stocks, drawn from the S&P 500, that have actively traded stock options. Another popular index is the DJIA Index, which measures the blue-chip segment of the market and is one of the most actively traded index options. Options on the S&P 500 are, by far, the most popular instruments. Indeed, there’s more trading in SPX options contracts than in all the other index options combined. Among the options exchanges that currently deal in index options, the CBOE dominates the market, accounting for more than 98% of the trades in 2015.
Both puts and calls are available on index options. They are valued and have issue characteristics like any other put or call. That is, a put lets a holder profit from a drop in the market. (When the underlying market index goes down, the value of a put goes up.) A call enables the holder to profit from a market that’s going up. Also, as
Figure 14.4
shows, index options have a quotation system that is the same as for stock options, except for the fact that the strike price is an index level.
Putting a Value on Stock-lndex Options
As is true of equity options, the market price of index options is a function of the difference between the strike price on the option (stated in terms of the underlying index) and the latest published stock market index. To illustrate, consider the highly popular S&P 500 Index traded on the CBOE.
Example
Let’s say the S&P 500 Index recently closed at 2058 and the August call has a strike price of 2055. A stock-index call will have a positive value so long as the underlying index exceeds the index strike price (just the opposite for puts). The intrinsic value of this call is 2058−2053=32058−2053=3.
Suppose that the call actually trades at 49.92, which is 46.92 points above the call’s intrinsic value. This difference is the option’s time value.
If the S&P 500 Index in our example were to go up to, say, 2200 by late August (the expiration date of the call), this option would be quoted at 2200−2055=1452200−2055=145. Because index options (like stock options) are valued in multiples of $100, this contract would be worth $14,500. Thus, if you had purchased this option when it was trading at $49.92, it would have cost you $49.92×$100 = $4,992$49.92×$100 = $4,992 and, in less than a month, would have generated a profit of $14,500−$4,992 = $9,508$14,500−$4,992 = $9,508. That translates into a holding period return of a whopping 90%.
Figure 14.4 Quotations on Index Options
The quotation system used with index options is just like that used with stock options: strikes and expiration dates are shown along with option prices and volumes. The biggest differences are that the option strikes and closing values for the underlying asset are shown as index levels. The closing S&P 500 Index level on the day of this quotation was 2051.
(Source: Data from
http://www.nasdaq.com
, accessed July 9, 2015.)
Full Value versus Fractional Value
Most broad-based index options use the full market value of the underlying index for purposes of options trading and valuation. That’s not the case, however, with two of the Dow Jones measures: The option on the Dow Jones Industrial Average is based on 1% of the actual Industrial Average, and the Dow Transportation Average option is based on 10% of the actual average. For example, if the DJIA is at 11,260, the index option would be valued at 1% of that amount, or 112.60. Thus, the cash value of this option is not $100 times the underlying DJIA but $100 times 1% of the DJIA, which equals the Dow Jones Industrial Average itself: $100×112.60 = $11,260$100×112.60 = $11,260.
Fortunately, the option strike prices are also based on the same 1% of the Dow, so there is no effect on option valuation. What matters is the difference between the strike price on the option and 1% of the DJIA. For instance, suppose that the DJIA closes at 11,260, which means that the DJIA option index would close at 112.60. A call option on this index might have a strike price of 110, which would mean that the call is slightly in-the-money with an intrinsic value of 2.60. If the option were not set to expire immediately, its market price would be higher, with the difference between the market price and 2.60 being the option’s time value.
Another type of option that is traded at 10% (1 ÷ 10) of the value of the underlying index is the “mini” index option. For example, the Mini-NDX Index (MNX) is set at 10% of the value of the Nasdaq 100. “Minis” also exist for the Nasdaq composite, the S&P 500, the Russell 2000, and the FTSE 250 (an index of mid-cap stocks in the United Kingdom), among others.
Investment Uses
Although index options, like equity options, can be used in spreads, straddles, or even covered calls, they are perhaps used most often for speculating or for hedging. When used as a speculative investment, index options give investors an opportunity to play the market as a whole, with a relatively small amount of capital. Like any other put or call, index options provide attractive leverage opportunities and at the same time limit exposure to loss to the price paid for the option.
Index Options as Hedging Vehicles
Index options are equally effective as hedging vehicles. In fact, hedging is a major use of index options and accounts for a good deal of the trading in these securities. To see how these options can be used for hedging, assume that you hold a diversified portfolio of, say, a dozen different stocks and you think the market is heading down. One way to protect your capital would be to sell all of your stocks. However, that could be expensive, especially if you plan to get back into the market after it drops, and it could lead to a good deal of unnecessary taxes. Fortunately, there is a way to “have your cake and eat it, too” and that is to hedge your stock portfolio with a stock index put. In this way, if the market does go down, you’ll make money on your puts, which you then can use to buy more stocks at the lower prices. On the other hand, if the market continues to go up, you’ll be out only the cost of the puts. That amount could well be recovered from the increased value of your stock holdings. The principles of hedging with stock-index options are exactly the same as those for hedging with equity options. The only difference is that with stock-index options, you’re trying to protect a whole portfolio of stocks rather than individual stocks.
Like hedging with individual equity options, the cost of protecting your portfolio with index options can become very expensive (with price premiums of 20% to 30% or more) when markets are falling and the need for this type of portfolio insurance is the greatest. That, of course, will have an impact on the effectiveness of this strategy.
Also, the amount of profit you make or the protection you obtain depends in large part on how closely the behavior of your stock portfolio is matched by the behavior of the stock-index option you employ. There is no guarantee that the two will behave in the same way. You should therefore select an index option that closely reflects the nature of the stocks in your portfolio. If, for example, you hold a number of small-cap stocks, you might select something like the Russell 2000 index option as the hedging vehicle. If you hold mostly blue chips, you might choose the DJIA index option. You probably can’t get dollar-for-dollar portfolio protection, but you should try to get as close a match as possible.
A Word of Caution
Given their effectiveness for either speculating or hedging, it’s little wonder that index options have become popular with investors. But a word of caution is in order. Although trading index options appears simple and seems to provide high rates of return, these investments involve high risk and are subject to considerable price volatility. Amateurs should not use them. True, there’s only so much you can lose with these options. The trouble is that it’s very easy to lose all of that investment, however small it may be. These securities are not investments you can buy and then forget about until just before they expire. With the wide market swings that are so common today, you must monitor these securities daily.
Other Types of Options
Options on stocks and stock indexes account for most of the market activity in listed options. But you also can obtain put and call options on various other securities. Let’s now take a brief look at these other kinds of options, starting with options on ETFs.
Options on Exchange-Traded Funds
In addition to various market indexes, put and call options are also available on several hundred exchange-traded funds (ETFs). As you’ve already learned, ETFs are like mutual funds that have been structured to track the performance of a wide range of market indexes—in other words, ETFs are a type of index fund. They trade like shares of common stock on listed exchanges and cover everything from broad market measures, such as the DJIA, the S&P 500, and the Nasdaq 100, to market sectors like energy, financials, health care, and semiconductors.
There’s a good deal of overlap in the markets and market segments covered by index options and ETF options. In addition to their similar market coverage, they perform very much the same in the market, are valued the same, and are used for many of the same reasons (particularly for speculation and hedging). After all, an ETF option is written on an underlying index fund (for example, one that tracks the S&P 500) just like an index option is written on the same underlying market index (the S&P 500). Both do pretty much the same thing—either directly or indirectly track the performance of a market measure—so of course they should behave in the same way. The only real difference is a structural detail. Options on ETFs are operationally like stock options in that each option covers 100 shares of the underlying exchange-traded fund rather than $100 of the underlying market index, as is the case with index options. In the end, though, both trade at 100 times the underlying index (or ETF). Thus, while operationally ETF options may be closer to stock options, they function more like index options. As such, the market views them as viable alternatives to index options. These contracts have definitely caught the fancy of investors, especially those who track the major market indexes.
Interest Rate Options
Puts and calls on fixed-income (debt) securities are known as
interest rate options
. At the present time, interest rate options are written only on U.S. Treasury securities with 30-year, 10-year, 5-year, or 13-week maturities. These options are yield-based rather than price-based. This means they track the yield (rather than the price) of the underlying Treasury security. Other types of options (equity and index options) are set up so that they react to movements in the price (or value) of the underlying asset. Interest rate options, in contrast, are set up to react to the yield of the underlying Treasury security (i.e., the exercise price is an interest rate). Thus, when yields rise, the value of a call goes up, and the value of a put goes down. In effect, because bond prices and yields move in opposite directions, the value of an interest rate call option goes up at the very time that the price (or value) of the underlying debt security is going down. The opposite is true for puts.
Currency Options
Foreign exchange options, or
currency options
as they’re more commonly called, provide a way for investors to speculate on foreign exchange rates or to hedge foreign currency or foreign security holdings. Currency options are available on the currencies of most of the countries with which the United States has strong trading ties. These options are traded on several exchanges and over the counter and include the following currencies:
·
British pound
·
Swiss franc
·
Australian dollar
·
Canadian dollar
·
Japanese yen
· Euro
Puts and calls on foreign currencies give the holders the right to sell or buy large amounts of the specified currency. However, in contrast to the standardized contracts used with stock and stock-index options, the specific unit of trading in this market varies with the particular underlying currency.
Table 14.7
spells out the details. Currency options are traded in full or fractional cents per unit of the underlying currency, relative to the amount of foreign currency involved. Thus, if a put or call on the British pound were quoted at, say, 6.40 (which is read as “6.4 cents”), it would be valued at $640 because 10,000 British pounds underlie this option (that is, 10,000×0.064 = $64010,000×0.064 = $640).
The value of a currency option is linked to the exchange rate between the U.S. dollar and the underlying foreign currency. For example, if the Canadian dollar
Table 14.7 Foreign Currency Option Contracts on the Philadelphia Exchange
|
Underlying Currency * |
Size of Contracts |
Underlying Currency* |
||
|
* The British pound, Swiss franc, euro, Canadian dollar, and Australian dollar are all quoted in full cents. The Japanese yen is quoted in hundredths of a cent. |
||||
| British pound |
10,000 pounds |
Canadian dollar |
10,000 dollars |
|
| Swiss franc |
10,000 francs |
Japanese yen |
1,000,000 yen |
|
| Euro |
10,000 euros |
Australian dollar |
becomes stronger relative to the U.S. dollar, causing the exchange rate to go up, the price of a call option on the Canadian dollar will increase, and the price of a put will decline. (Note: Some cross-currency options are available in the market, but such options/trading techniques are beyond the scope of this text. Here, we will focus solely on foreign currency options (or futures) linked to U.S. dollars.)
The strike price on a currency option is stated in terms of exchange rates. Thus, a strike price of 150 implies that each unit of the foreign currency (such as one British pound) is worth 150 cents, or $1.50, in U.S. money. If you held a 150 call on this foreign currency, you would make money if the foreign currency strengthened relative to the U.S. dollar so that the exchange rate rose—say, to 155. In contrast, if you held a 150 put, you would profit from a decline in the exchange rate—say, to 145. Success in forecasting movements in foreign exchange rates is obviously essential to a profitable foreign currency options program.
LEAPS
They look like regular puts and calls, and they behave pretty much like regular puts and calls, but they’re not regular puts and calls. We’re talking about
LEAPS
, which are puts and calls with lengthy expiration dates. Basically, LEAPS are long-term options. Whereas standard options have maturities of eight months or less, LEAPS have expiration dates as long as three years. Known formally as Long-term Equity AnticiPation Securities, they are listed on all of the major options exchanges. LEAPS are available on hundreds of stocks, stock indexes, and ETFs.
Aside from their time frame, LEAPS work like any other equity or index option. For example, a single (equity) LEAPS contract gives the holder the right to buy or sell 100 shares of stock at a predetermined price on or before the specified expiration date. LEAPS give you more time to be right about your bets on the direction of a stock or stock index, and they give hedgers more time to protect their positions. But there’s a price for this extra time. You can expect to pay a lot more for a LEAPS than you would for a regular (short-term) option. That should come as no surprise. LEAPS, being nothing more than long-term options, are loaded with time value. And as we saw earlier in this chapter, other things being equal, the more time an option has to expiration, the higher the quoted price.
Concepts in Review
Answers available at
http://www.pearsonhighered.com/smart
1. 14.12 Briefly describe the differences and similarities between stock-index options and stock options. Do the same for foreign currency options and stock options.
2. 14.13 Identify and briefly discuss two ways to use stock-index options. Do the same for foreign currency options.
3. 14.14 Why would an investor want to use index options to hedge a portfolio of common stock? Could the same objective be obtained using options on ETFs? If the investor thinks the market is in for a fall, why not just sell the stock?
4. 14.15 What are LEAPS? Why would an investor want to use a LEAPS option rather than a regular listed option?
The Futures Market
1. LG 1
“Psst, hey buddy. Wanna buy some copper? How about some coffee, or lean hogs, or propane? Maybe the
Japanese yen
or Swiss franc strikes your fancy?” Sound a bit unusual? Perhaps, but these items have one thing in common. They all represent real investments. This is the more exotic side of investing—the market for commodities and financial futures—and it often involves a considerable amount of speculation. The risks are enormous, but with some luck, the payoffs can be phenomenal. Even more important than luck, however, is the need for patience and know-how. Indeed, these are specialized investment products that require specialized investor skills.
Why the Economy Needs Futures Markets
The amount of futures trading in the United States has mushroomed over the past few decades. An increasing number of investors have turned to futures trading as a way to earn attractive, highly competitive rates of return. A major reason behind the growth in futures trading has been the number and variety of futures contracts now available for trading. Today futures contracts exist for the traditional primary commodities, such as grains and metals, as well as for processed commodities, crude oil and gasoline, electricity, foreign currencies, money market securities, U.S. and foreign debt securities,
Euro
dollar securities, and common stocks. You can even buy listed put and call options on just about any actively traded futures contract. All these commodities and financial assets are traded in what is known as the futures market.
Market Structure
When a bushel of wheat is sold, the transaction takes place in the
cash market
. The bushel changes hands in exchange for the cash price paid to the seller. For all practical purposes, the transaction is completed then and there. Most traditional securities are traded in this type of market. However, a bushel of wheat can also be sold in the
futures market
, the organized market for the trading of futures contracts. In this market, the seller would not deliver the wheat until some mutually agreed-upon date in the future. As a result, the transaction would not be completed for some time. The buyer, in turn, would own a highly liquid futures contract that could be held (and presented for delivery of the bushel of wheat) or traded in the futures market. No matter what the buyer does with the contract, as long as it is outstanding, the seller has a legally binding obligation to make delivery of the stated quantity of wheat on a specified date in the future. The buyer/holder has a similar obligation to take delivery of the underlying commodity.
Futures Contracts
A
futures contract
is a commitment to deliver a certain amount of a specified item at a specified date at an agreed-upon price. Each market establishes its own contract specifications. These include not only the quantity and quality of the item but also the delivery procedure and delivery month. The
delivery month
on a futures contract is much like the expiration date on put and call options. It specifies when the commodity or item must be delivered and thus defines the life of the contract. For example, the
CME
Group’s Chicago Board of Trade specifies that each of its full-sized soybean futures contracts will involve
5,000 bu
shels of USDA No. 2 yellow soybeans; soybean delivery months are January, March, May, July, August, September, and November.
How Futures Work
In addition, futures contracts have their own trading hours. Normal trading hours for commodities and financial futures vary widely, unlike listed stocks and bonds, which begin and end trading at the same time. For example, floor trading in futures contracts for oats is Monday through Friday from 9:30 a.m. to 2:00 p.m. (all hours are
Table 15.1 Futures Contract Dimensions
|
Size of a Single Contract |
Market Value of a Single Contract |
||||
|
* Contract sizes are for CME Group futures products. |
|||||
|
** Contract values are representative of those that existed on July 9, 2015, for the next expiring futures contract. |
|||||
|
Corn |
5,000 bu |
$ 21,013 |
|||
|
Wheat |
$ 28,863 |
||||
|
Live cattle |
40,000 lb |
$ 59,500 |
|||
|
Feeder cattle |
50,000 lb |
$106,213 |
|||
|
Lean hogs |
$ 29,300 |
||||
|
Coffee |
37,500 lb |
$ 46,950 |
|||
|
Sugar |
112,000 lb |
$ 13,328 |
|||
|
Gold |
100 troy oz |
$115,910 |
|||
|
Copper |
25,000 lb |
$ 63,800 |
|||
|
Crude oil |
1,000 bbls |
$ 52,870 |
|||
| Euro |
125,000 euro |
$137,950 |
|||
| Japanese yen |
12.5 million yen |
$ 103,113 |
|||
|
10-year Treasury notes |
$100,000 |
$126,609 |
|||
|
S&P 500 Stock Index |
$250 × S&P 500 futures price$250 × S&P 500 futures price |
$515,625 |
central time); silver is from 8:25 a.m. to 1:25 p.m.; live cattle is from 9:05 a.m. to 1:00 p.m.; U.S. Treasury bonds is from 7:20 a.m. to 2:00 p.m.; and the S&P 500 Stock Index is from 8:30 a.m. to 3:15 p.m. In addition to the set of hours for open-outcry or floor trading, there is another set of hours for electronic trading. CME Globex allows traders access to futures products on any exchange nearly 24 hours a day, 5 days a week, from anywhere in the world.
Table 15.1
lists a cross section of 14 commodities and financial futures. The market value of a single contract, as reported in
Table 15.1
, is found by multiplying the size of the contract by the latest quoted price of the underlying commodity. For example, there are 37,500 pounds of coffee in a single contract, so if coffee’s trading at $1.252 a pound, then the market value of one contract is 37,500 × $1.252 = $46,95037,500 × $1.252 = $46,950. As you can see, the typical futures contract covers a large quantity of the underlying product or financial instrument. However, although the value of a single contract is normally quite large, the actual amount of investor capital required to deal in these vehicles is relatively small because all trading in this market is done on a margin basis.
Options versus Futures Contracts
In many respects, futures contracts are closely related to call options. For example, both involve the future delivery of an item at an agreed-upon price, and both are derivative securities. But there is a significant difference between a futures contract and an options contract. To begin with, a futures contract obligates a person to buy or sell a specified amount of a given commodity on or before a stated date—unless the contract is canceled or liquidated before it expires. In contrast, an option gives the holder the right to buy or sell a specific amount of a real or financial asset at a specific price over a specified period of time.
In addition, whereas call and put options specify the price at which investors can buy or sell the underlying asset, futures prices are not spelled out in the futures contract. Instead, the price on a futures contract is established through trading on the floor of a commodities exchange. This means that the delivery price is set at whatever price the contract sells for. So, if you bought a corn futures contract three months ago at $4.00 a bushel, then that’s the price you’ll pay to take delivery of the underlying product, even if the contract trades at, say, $4.50 a bushel at its date of expiration (i.e., delivery date). Equally important, the risk of loss with an option is limited to the price paid for it. A futures contract has no such limit on exposure to loss. Finally, while options have an explicit up-front cost (in the form of an option premium), futures contracts do not. The purchase of a futures contract does involve a margin deposit, but that’s nothing more than a refundable security deposit, not a sunk cost (like an option premium).
Major Exchanges
Modern futures contracts in this country got their start in the agricultural segment of the economy over 170 years ago when individuals who produced, owned, and/or processed foodstuffs sought a way to protect themselves against adverse price movements. Later, futures contracts came to be traded by individuals who were not necessarily connected with agriculture but who wanted to make money with commodities by speculating on their price swings.
The first organized commodities exchange in this country was the Chicago Board of Trade, which opened its doors in 1848. Over time, additional markets opened. There currently are more than a dozen U.S. exchanges that qualify as designated contract markets (DCM) and deal in listed futures contracts. Designated contract markets are boards of trade (or exchanges) that operate under the regulatory oversight of the U.S. Commodity Futures Trading Commission (CFTC). DCMs may list futures (or options) contracts based on any underlying commodity, index, or instrument. The majority of futures trading occurs on only a few exchanges. The Chicago Mercantile Exchange is the most active exchange, with about as much trading volume as all other futures exchanges combined. The CME is followed in size by the Chicago Board of Trade (
CBOT
) and the New York Mercantile Exchange (
NYMEX
), which includes through a previous acquisition the Commodity Exchange, Inc. (
COMEX
). Together, these four exchanges account for about 95% of the trading conducted on U.S. futures exchanges. Although the exchanges continue to operate separately, in July of 2007 the CME Group was created through a merger of the CME and the CBOT. The CME Group expanded further in August of 2008 by acquiring the NYMEX, which included COMEX.
Most exchanges deal in a number of commodities or financial assets, and many commodities and financial futures are traded on more than one exchange. Annual volume of trading on futures exchanges has surpassed three billion contracts with a total value above the trillion-dollar mark. Most exchanges now conduct trading electronically. The
open-outcry auction
method once used to conduct floor trading, which required traders to shout their orders while using elaborate hand signals (illustrated in
Figure 15.1
), has all but disappeared. As of July 2015 the CME Group continues open outcry futures trading for the S&P 500 futures contracts. The company also continues floor trading for the options on futures contracts.
In 1992 CME Globex became the first global electronic futures trading platform. Globex offers trading more than 23 hours a day, 5 days a week, and provides an international link among futures exchanges. Since 2000 electronic trading of futures contracts has grown from about 9 percent of trading volume to nearly 100 percent. Globex allowed the CME Eurodollar futures contract to become the most actively traded futures contract in the world. Indeed, the three most actively traded contracts on CME Globex (three-month Eurodollars, the E-Mini S&P 500 Stock Index, and the U.S. 10-year Treasury Note) represent more than 50% of futures trading volume on the U.S. exchanges.
Figure 15.1 The Auction Market at Work on the Floor of the Chicago Board of Trade
Traders once employed a system of open-outcry and hand signals to indicate whether they wished to buy or sell and the price at which they wished to do so. Fingers held vertically indicated the number of contracts a trader wanted to buy or sell. Fingers held horizontally indicated the fraction of a cent above or below the last traded full-cent price at which the trader would buy or sell.
Trading in the Futures Market
Basically, the futures market contains hedgers and speculators. The market could not exist and operate efficiently without either one. The
hedgers
are businesses that either produce a commodity or use it as an input to their production process. For example, a rancher might enter into a futures contract to lock in the price for his herd months before actually selling the herd. That way, the rancher’s revenues are predictable and are not affected by swings in the price of cattle. In effect, the hedgers provide the underlying strength of the futures market and represent the very reason for its existence. In the case of financial futures, hedgers are companies whose businesses are affected by swings in financial variables such as interest rates or exchange rates. Accordingly, hedgers also include financial institutions and other large corporations.
Speculators
, in contrast, trade futures contracts simply to earn a profit on expected price swings. They have no inherent interest in the commodity or financial future other than the price action and potential capital gains it can produce. However, their presence in the market benefits others because speculators’ trades help make the futures market more liquid.
Trading Mechanics
Once futures contracts are created, they can readily be traded in the market. Like common stocks, futures contracts are bought and sold through local brokerage offices and on many Internet sites. Except for setting up a special commodities trading account, there is no difference between trading futures and dealing in stocks and bonds. The same types of orders are used, and margin trading is standard practice. Any investor can buy or sell any contract, with any delivery month, as long as it is currently being traded on one of the exchanges.
Buying a contract is referred to as taking a long position. Selling one is known as taking a short position. It is exactly like going long or short with stocks and has the same connotation. A speculator who is long wants the price to rise, and the short seller wants it to drop. Investors can liquidate both long and short positions simply by executing an offsetting transaction. The short seller, for example, would cover her position by buying an equal amount of the contract. In general, only about 1% of all futures contracts are settled by delivery. The rest are offset prior to the delivery month. The total number of contracts that are open and have not been settled by delivery or by an offsetting transaction is called
open interest
. All trades are subject to normal transaction costs, which include
round-trip commissions
for each contract traded. A round-trip commission includes the commission costs on both ends of the transaction—to buy and sell a contract. Although the size of the commission depends on the number and type of contracts being traded, trades that are executed electronically usually have round-trip commissions under $10 and are much less expensive than trades that have to be routed to a pit broker.
An Advisor’s Perspective
Rob Russell CEO, Russell and Company
“Futures contracts are quite different than stocks.”
MyFinanceLab
Margin Trading
Buying on margin means putting up only a fraction of the total price in cash. Margin, in effect, is the amount of equity that goes into the deal. All futures contracts are traded on a margin basis. The margin required usually ranges from about 2% to 10% of the contract value. This is very low compared to the margin required for stocks and most other securities. Furthermore, there is no borrowing required on the part of the investor to finance the balance of the contract. The
margin deposit
, as margin is called with futures, represents security to cover any loss in the market value of the contract that may result from adverse price movements. It exists simply to guarantee fulfillment of the contract. The margin deposit is not a partial payment for the commodity or financial instrument, nor is it related to the value of the underlying product or item.
Margins and Margin Calls
The size of the required margin deposit is specified as a dollar amount. It varies according to the type of contract and depends on the price volatility of the underlying commodity or financial asset. In some cases, it also varies according to the exchange on which the commodity is traded.
Table 15.2
gives the margin requirements for the same 14 commodities and financial instruments listed in
Table 15.1
. Compared to the size and value of the futures contracts, margin requirements are very low. The
initial margin
noted in
Table 15.2
is the amount of capital the investor must deposit with the broker when initiating the transaction; it represents the amount of money required to make a
Table 15.2 Margin Requirements for A Sample of
Commodities
and
Financial Futures
Contract
Initial Margin
Maintenance Margin
Exchange
$ 1,375
$ 1,250
$ 1,925
$ 1,750
CBOT
$ 1,320
$ 1,200
$ 2,475
$ 2,250
CME
$ 1,320
$ 1,200
CME
$ 4,675
$ 4,250
$ 770
$ 700
NYMEX
$ 4,125
$ 3,750
$ 3,410
$ 3,100
COMEX
$ 5,060
$ 4,600
NYMEX
$ 3,905
$ 3,550
CME
$ 2,860
$ 2,600
CME
$ 1,485
$ 1,350
CBOT
$25,300
$23,000
CME
Note: On July 9, 2015, the CME Group specified that speculative and nonmembers initial margin requirements for all products are set at 110% of the maintenance margin requirement for a given product. Hedge and member initial margin requirements for all products are set at 100% of the maintenance margin requirement for a given product. Margins are meant to be typical of the ongoing requirements that customers are expected to live up to. Depending on the volatility of the market, exchange-minimum margin requirements are changed frequently. Thus, the requirements in this table are also subject to change on short notice. The actual margin requirements for a specific type of transaction on a given exchange are typically reported on the exchange’s website.
given investment. (The margins quoted in
Table 15.2
are for speculative transactions. Typically, the initial margin amount is slightly lower for hedge transactions.)
After the investment is made, the market value of a contract will rise and fall as the quoted price of the underlying commodity or financial instrument goes up or down, and that fluctuation triggers changes in the amount of margin on deposit. To be sure that an adequate margin is always on hand, investors are required to meet a second type of margin requirement, the
maintenance margin
. The maintenance margin, which is slightly less than the initial margin, establishes the minimum amount of margin that an investor must keep in the account at all times. For instance, if the initial margin on a commodity is $1,100 per contract, its maintenance margin might be $1,000. As long as the market value of the contract does not fall by more than $100 (the difference between the contract’s initial and maintenance margins), the investor has no problem. But if the value of the contract drops by more than $100, the investor will receive a margin call. The investor must then immediately deposit enough cash to bring the position back to the initial margin level.
An investor’s margin position is checked daily via a procedure known as
mark-to-the-market
. That is, the gain or loss in a contract’s value is determined at the end of each session. At that time the broker debits or credits the account accordingly. In a falling market, an investor may receive a number of margin calls and be required to make additional margin payments. Failure to do so will leave the broker with no choice but to close out the position—that is, to sell the contract.
Concepts in Review
Answers available at
http://www.pearsonhighered.com/smart
1. 15.1 What is a futures contract? Briefly explain how it is used as an investment vehicle.
2. 15.2 Discuss the difference between a cash market and a futures market.
3. 15.3 What is the major source of return to commodities speculators? How important is current income from dividends and interest?
4. 15.4 Why are both hedgers and speculators important to the efficient operation of a futures market?
5. 15.5 Explain how margin trading is conducted in the futures market.
a. What is the difference between an initial margin and a maintenance margin?
b. Are investors ever required to put up additional margin? If so, when?
Commodities
1. LG 2
2. LG 3
3. LG 4
Physical commodities like grains, metals, wood, and meat make up a major portion of the futures market. They have been actively traded in this country for well over a century. The material that follows focuses on commodities trading. We begin with a review of the basic characteristics and investment merits of these contracts.
Basic Characteristics
Commodities are goods for which there is demand without differentiation of supplier. In other words, a commodity is a fungible good that is qualitatively the same regardless of the supplier. For example, a Troy ounce of gold from a mine in Uzbekistan is the same as a Troy ounce of gold from a mine in Indonesia. As long as the underlying commodity meets the contractual standard, it can be traded with futures.
Table 15.3
divides the market for commodity contracts into six categories: agriculture, metals, livestock, food, energy, and other. Such segmentation does not affect trading mechanics and procedures. It merely provides a convenient way of categorizing commodities into groups based on similar underlying characteristics.
Table 15.3 Major Classes of Commodities
|
Agriculture |
Metals |
||
|
Soybean oil |
Silver |
Palladium |
|
|
Oats |
Platinum |
||
|
Soybeans |
Canola |
Iron ore |
|
|
Soybean meal |
Rice |
||
|
Livestock |
Food |
||
|
Cocoa |
|||
|
Cotton |
|||
|
Milk |
Orange juice |
||
|
Energy |
Other |
||
|
Coal |
Natural gas |
Weather |
Freight |
|
Ethanol |
Interest rates |
Environment |
|
|
Heating oil |
Electricity |
Real estate |
Lumber |
Table 15.3
shows the diversity of the commodities market and the variety of contracts available. Although the list of available contract types changes yearly, the table indicates that investors have dozens of commodities to choose from. A number of the contracts in
Table 15.3
(e.g., soybeans, wheat, and sugar) are available in several forms or grades. Not included in
Table 15.3
are dozens of commodities (e.g., butter, cheese, whey, boneless beef, and others) that are not widely traded.
Investor Facts
Weather Futures Can Be Hot or Cold! If weather is a concern, buy a futures contract on the weather and eliminate your worries. Governments, companies, or individuals can use these financial instruments, also known as weather derivatives, to manage risk associated with unexpected or adverse weather conditions. Weather futures derive their value from an underlying weather index that can be based on any weather variation, such as temperature, rain, frost, snow, or even hurricanes.
For example, energy companies can use them to hedge against shifts in demand due to unexpected temperatures, like a warm winter or cool summer. Farmers can use weather futures to hedge against poor harvests caused by drought or frost, amusement parks can use them to insure against rainy weekends during their peak summer seasons, and ski resorts can use them to protect against lost revenue due to insufficient amounts of snow. The applications are quite numerous.
The Chicago Mercantile Exchange introduced the first exchange-traded weather futures contract in 1999. The CME currently offers weather futures indexed to temperature, frost, snow, and hurricanes.
(Source: CME Group, Weather Products,
http://www.cmegroup .com
.)
A Commodities Contract
Every commodity (whether actively or thinly traded) has certain specifications that spell out in detail the amounts and quality of the product being traded.
Figure 15.2
shows the contract specifications of corn futures contracts that trade on the CBOT. You can see that a corn futures contract represents 5,000 bushels of #2 yellow corn, and its price is quoted in cents per bushel. In this case, the contract also allows for deliverable grades of either #1 or #3 yellow corn, but for a premium or discounted price, respectively. The futures contract also specifies the expiration months, trading hours, daily price limits, settlement procedures, and more. In the middle of the page of contract specifications is the exchange rule, which indicates the listing exchange and the trading rules and regulations that apply when trading the contract.
The quotation system used for commodities is based on the size of the contract and the pricing unit. Standard commodities quotations, like the one shown in
Figure 15.3
, generally report the daily last, open, high, and low prices for each delivery month. With commodities, the last price of the day, or the closing price, is known as the
settlement price
. The daily settlement price is very important since it is used to determine the daily market value of a contract and, therefore, an investor’s profit or loss for the day, as well as margin requirements. The prior settle price is the final settlement price at the end of the previous day. The quotation in
Figure 15.3
also reports the
volume
—the number of contracts traded—for the day. According to
Figure 15.3
, the settle price for December 2016 corn futures contract is 439’6. The term after the apostrophe represents a fraction in eighths. Because corn futures are quoted in cents per bushel, the six following the apostrophe means 6/8ths of a cent. According to
Figure 15.2
the minimum price fluctuation for corn futures contracts is 1/4th of one cent so 6/8ths is 3/4ths of one cent or 0.75 cents. Each contract represents 5,000 bushels of corn and each bushel is worth $4.3975, so the market value of the contract is 5,000 × $4.3975 = $21,987.505,000 × $4.3975 = $21,987.50.
Price Behavior
Commodity prices react to a unique set of economic, political, and international pressures—as well as to the weather. The explanation of the reasons that commodity prices change is beyond the scope of this text. But they do move up and down just like any other investment, which is precisely what speculators want. Because we are dealing in such large trading units (5,000 bushels of this or 40,000 pounds of that), even a modest price change can have an enormous impact on the market value of a contract and therefore on investor returns or losses. For example, if the price of corn goes up or down by just $0.20 per bushel, the value of a single contract will change by $1,000. A corn contract can be bought with a $1,375 initial margin deposit, so it is easy to see the effect this kind of price behavior can have on investor return.
Do commodity prices really move all that much? Judge for yourself. The price change columns in
Figure 15.3
show some examples of price changes that occurred from the previous day’s closing price to the current day’s last price. For example, relative to the prior day’s settle or closing price, March 2016 corn dropped $75
Figure 15.2 Contract Specifications for Corn Futures
The contract specifications for any listed futures contract are typically available online at the listing exchange website. When traders buy or sell futures contracts, they are agreeing to uphold the terms defined by the contract specifications. In this case we see that a corn futures contract calls for the delivery of 5,000 bushels of #2 yellow corn by the end of the second business day following the last trading day of the delivery month, which would be the contract’s expiration month.
(Source: Reprinted with permission, CME Group, 2015.)
Figure 15.3 Quotations on Corn Futures Contracts
Readily available online quotations quickly reveal key information about various commodities in real time (or from some sources, slightly delayed). This quotation for corn futures contracts includes the daily last, open, high, and low prices. It also provides the change in price from the previous day’s closing price to the current day’s last price and the previous day’s settlement price (or prior settle), as well as the current day’s volume, and Hi/Lo limit.
(Source: Reprinted with permission, CME Group, 2015.)
(i.e., 5,000 bushels × $0.0155,000 bushels × $0.015). The price swing is even larger if you consider the current day’s low price relative to the prior day’s settle price. In this case March 2016 corn dropped $0.02 per bushel (i.e., $4.49 − $4.47$4.49 − $4.47) or $100 per contract (i.e., 5,000 bushels × $0.025,000 bushels × $0.02). Keep in mind that these intraday price swings are on a single contract. The impact of these small changes can quickly add up to significant profits or losses depending on the number of contracts, especially relative to the small initial investment required.
Clearly, such price behavior is one of the magnets that draw investors to commodities. The exchanges recognize the volatile nature of commodities contracts and try to put lids on price fluctuations by imposing daily price limits and maximum daily price ranges. (Similar limits also are put on some financial futures.) The
daily price limit
restricts the interday change in the price (i.e., the price change from one day to the next day) of the underlying commodity. For example, a corn futures contract has an initial price limit of $0.30 per bushel and an expanded price limit of $0.45 per bushel. The
maximum daily price range
(shown in
Figure 15.3
as the difference between the Hi/Lo limits) limits the amount of intraday price movement (i.e., the price can change during the day) and is usually equal to twice the daily price limit. For example, the daily price limit on corn is $0.30 per bushel and its maximum daily range is $0.60 per bushel. In fact, the prior day’s settlement price (i.e., the settle price) plus and minus the daily price limit determines the Hi/Lo limits. Because futures prices can become extremely volatile as the contract nears expiration, there are no price limits on the current month contract on or after the second business day preceding the first day of the delivery month. Such limits, however, still leave plenty of room to turn a quick profit. Consider that the daily price limits on one corn futures contract translates into a per-day change in value of $1,500 to unlimited depending on the contract and prior pricing.
Return on Invested Capital
Futures contracts have only one source of return: the capital gains that result when prices move in a favorable direction. There is no current income of any kind. The volatile price behavior of futures contracts is one reason why high returns are possible, and the other reason is leverage. Because all futures trading is done on margin, it takes only a small amount of money to control a large investment position—and to participate in the price swings that accompany futures contracts. Of course, the use of leverage also means that an investment can be wiped out in just a matter of days.
We can measure the return on a commodities contract by calculating the
return on invested capital
. This variation of the standard holding period return formula bases the investment’s return on the amount of money actually invested in the contract rather than on the value of the contract itself. The return on invested capital for a commodities position can be determined according to the following simple formula.
Return on invested capital=Selling price of commodity contract−Purchase price of commodity contractAmount of margin depositReturn on invested capital=Selling price of commodity contract−Purchase price of commodity contractAmount of margin depositEquation15.1
We can use
Equation 15.1
for both long and short transactions. To see how it works, assume you recently bought two March 2017 corn futures contracts at 447’0 ($4.47 per bushel) by depositing the required initial margin of $2,750 ($1,375 for each contract). Your investment, therefore, amounts to only $2,750, but you control 10,000 bushels of corn worth $44,700 (i.e., 10,000 × $4.4710,000 × $4.47) at the time of purchase. Now, assume that March 2017 corn has just closed at 458, making the market value of your position equal to 10,000 × $4.58 = $45,80010,000 × $4.58 = $45,800. At this point, you decide to sell and take your profit. Your return on invested capital is:
Return on invested capital=$45,800 − $44,700$2,750=$1,100$2,750=0.40=40%Return on invested capital=$45,800 − $44,700$2,750=$1,100$2,750=0.40=40%
Famous Failures IN Finance Shady Trading at Enron
Before it was known for its financial problems, Enron, a utility firm operating pipelines and shipping natural gas, had become famous as a business pioneer, blazing new trails in the market for trading risk. In the 1980s the price of natural gas was deregulated, which meant that its price could go down and up, exposing producers and consumers to risks. Enron decided to exploit new opportunities in the commodities business by trading natural gas futures. The natural gas futures that traded on the New York Mercantile Exchange did not take into account regional discrepancies in gas prices. Enron filled this void by agreeing to deliver natural gas to any location in the United States at any time.
In addition to trading natural gas and other energy contracts, in the late 1990s Enron began trading weather derivatives for which no underlying commodities existed. These were just bets on the weather. Its weather-derivatives transactions were worth an estimated $3.5 billion in the United States alone. Thanks to its near-monopoly position in derivatives products, Enron’s trading business was initially highly profitable. At one point, the company offered more than 1,800 different contracts for 16 product categories, ranging from oil and natural gas to weather derivatives, broadband services, and emissions rights, and it earned 90% of its revenues from trading derivatives. And unlike traditional commodity and futures exchanges and brokers, Enron’s online commodity and derivative business was not subject to federal regulations.
However, Enron eventually lost its unique position as the energy business started to mature. When other firms entered the online derivatives-trading business, they competed by charging lower commissions and exploiting the same regional price discrepancies that had been Enron’s bread and butter. Enron’s trading operations became less profitable. To find new markets and products, the company expanded into areas such as water, foreign power sources, telecommunications, and broadband services. The farther it moved from its core businesses of supplying gas, the more money Enron lost.
The company sought to hide those losses by entering into more risky and bizarre financial contracts. When financial institutions began to realize that Enron was essentially a shell game, they withdrew their credit. At that point, despite rosy assurances from its founder and CEO Ken Lay, Enron went into a death spiral that ended in bankruptcy on December 2, 2001.
In July 2004 Lay was indicted on 11 counts of securities fraud and related charges. He was found guilty on May 25, 2006, of all but one of the counts. Each count carried a maximum 5- to 10-year sentence and legal experts said Lay could face 20 to 30 years in prison. However, about three and a half months before his scheduled sentencing, Ken Lay died on July 5, 2006, while vacationing in Snowmass, Colorado. On October 17, 2006, as a result of his death, the federal district court judge who presided over the case vacated Lay’s conviction.
Critical Thinking Questions
1. Could the Enron debacle have been prevented? If so, what actions should have been taken by auditors, regulators, and lawmakers?
Clearly, this high rate of return was due not only to an increase in the price of the commodity but also to the fact that you were using very low margin, or very high financial leverage. The initial margin in this transaction is only about 6% of the underlying value of the contract.
Watch Your Behavior
It is well known that individual investors are reluctant to sell stocks that have experienced a loss. Perhaps surprisingly, experiments have discovered that professional futures traders exhibit an even stronger tendency to hang onto their losing positions too long.
(Source: Michael S. Haigh and John A. List, “Do Professional Traders Exhibit Myopic Loss Aversion? An Experimental Analysis,” Journal of Finance, 2005, Vol. 60, No.)
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Trading Commodities
Investing in commodities takes one of three forms. The first, speculating, involves using commodities as a way to generate capital gains. In essence, speculators try to capitalize on the wide price swings that are characteristic of so many commodities. As explained in the accompanying Famous Failures in Finance box, this is basically what Enron was doing—until things started turning nasty.
While volatile price movements may appeal to speculators, they frighten many other investors. As a result, some of these more cautious investors turn to spreading, the second form of commodities investing. Futures investors use this trading technique as a way to capture some of the benefits of volatile commodities prices but without all the exposure to loss.
Finally, commodities futures can be used for hedging. A hedge in the commodities market is more of a technical strategy that is used almost exclusively by producers and processors to protect a position in a product or commodity. For example, a producer or grower would use a commodity hedge to obtain as high a price as possible for its goods. The processor or manufacturer who uses the commodity would use a hedge for the opposite reason: to obtain the goods at as low a price as possible. A successful hedge, in effect, means more predictable income to producers or costs to processors.
Let’s now look briefly at the two trading strategies that are most used by individual investors—speculating and spreading—to gain a better understanding of how to use commodities as investments.
Speculating
Speculators hope to capitalize on swings in commodity prices by going long or short. To see why a speculator would go long when prices are expected to rise, assume you buy a June 2021 gold futures contract at 1287.4 by depositing the required initial margin of $4,125. One gold contract involves 100 troy ounces of gold, so it has a market value equal to 100 troy ounces × $1,287.4 = $128,740100 troy ounces × $1,287.4 = $128,740. If gold goes up, you make money. Assume that one month after you purchased the June 2021 contract, its price is 1313.1. You then liquidate the contract and make a profit equal to $1,313.10 − $1,287.40 = $25.70$1,313.10 − $1,287.40 = $25.70 per ounce. That means a total profit of $2,570 on the long gold contract position with an investment of $4,125—this translates into a return on invested capital of 62.3%. Not bad for a month of speculation.
Of course, instead of rising, the price of gold could have dropped by $25.70 per ounce. On a 100-ounce contract, that amounts to $2,570 loss on the position. As a result, you would have lost a good bit of your original investment: $4,125 − $2,570$4,125 − $2,570 leaves $1,555.
But a drop in price would be just what a short seller is after. Here’s why. You sell “short” the June 2021 gold contract at 1287.4 and buy it back one month later at 1261.7. Clearly, the difference between the selling price and the purchase price is the same $25.70. But in this case it is profit because the selling price exceeds the purchase price.
Spreading
Instead of attempting to speculate on the price behavior of a futures contract, you might follow the more conservative tactic of spreading. Much like spreading with put and call options, the idea is to combine two or more different contracts into a position that offers the potential for a modest amount of profit but restricts your exposure to loss. One very important reason for spreading in the commodities market is that, unlike options, there is no limit to the amount of loss that can occur with a futures contract.
You set up a spread by buying one contract and simultaneously selling another. Although one side of the transaction will lead to a loss, you hope that the profit earned from the other side will more than offset the loss and that the net result will be at least a modest amount of profit. If you’re wrong, the spread will limit, but not eliminate, any losses.
Here is a simple example of how a spread might work. Suppose you buy contract A at 533.50 and at the same time short sell contract B for 575.50. Sometime later, you close out your position in contract A by selling it at 542, and you simultaneously cover your short position in B by purchasing a contract at 579. Although you made a profit of 8.50 points (542 − 533.50)(542 − 533.50) on the long position (contract A), you lost 3.50 points (575.50 − 579)(575.50 − 579) on the contract you shorted (B). The net effect, however, is a profit of 5 points. If you were dealing in cents per pound, those 5 points would mean a profit of $250 on a 5,000-pound contract.
All sorts of commodity spreads can be set up for almost any type of investment situation. Most of them, however, are highly sophisticated and require specialized skills.
Famous Failures IN Finance Diving Oil Prices Send Cal Dive into Bankruptcy
One of the reasons that commodity futures markets exist is the price volatility of the underlying commodity. Futures contracts give firms a way to manage that volatility, but it isn’t always possible to insulate a company from commodity price risk. Swings in oil prices, for example, have created many millionaires through the years, but they have also brought about financial ruin. The chart below illustrates the volatility in crude oil prices from 2007 to 2015. In 2007 and 2008 crude oil futures prices were reaching all-time highs of over $100 per barrel, which triggered an explosion in oil futures trading. The average daily trading volume in 2008 was about 15 times the daily world production of oil. But as the global economy turned south and began to slip into recession, demand for oil and other commodities fell off sharply. After peaking during the summer of 2008, the price of oil responded true to form, falling by almost 70% in six months and sending the stock prices of oil-related businesses into freefall. Since then, as the economy has slowly rebounded, so has the oil futures price, again surpassing $100 per barrel. Interestingly, in mid-2014 the price of oil again plummeted, this time blamed mostly on oil futures speculation and a flood of worldwide supply of oil. Even so, the drop in prices sent many oil-related businesses into bankruptcy, among them Cal Dive International, which filed for bankruptcy in March 2015.
Concepts in Review
Answers available at
http://www.pearsonhighered.com/smart
1. 15.6 List and briefly define the five essential parts of a commodities contract. Which parts have a direct bearing on the price behavior of the contract?
2. 15.7 Briefly define each of the following:
a. Settlement price
b. Daily price limit
c. Volume
d. Maximum daily price range
e. Delivery month
3. 15.8 What is the source of return on futures contracts? What measure is used to calculate the return on a commodities contract?
4. 15.9 Note several approaches to investing in commodities and explain the investment objectives of each.
Financial Futures
1. LG 5
2. LG 6
Another dimension of the futures market is
financial futures
, a segment of the market in which futures contracts are traded on financial instruments. Financial futures are an extension of the commodities concept. They were created for much the same reason as commodities futures, they are traded in the same market, their prices behave a lot like commodities, and they have similar investment merits. However, financial futures are unique because of the underlying assets. Let’s now look more closely at financial futures and see how investors can use them.
The Financial Futures Market
Although relatively young, financial futures are the dominant type of futures contract. The level of trading in financial futures far surpasses that of traditional commodities. Much of the interest in financial futures is due to hedgers and institutional investors who use these contracts as portfolio management tools. But individual investors can also use financial futures to speculate on the behavior of interest rates and to speculate in the stock market. Financial futures even offer a convenient way to speculate in the highly specialized foreign currency markets.
The financial futures market was established in response to the economic turmoil the United States experienced in the 1970s. The instability of the dollar on the world market was causing serious problems for multinational firms. Interest rates were highly volatile, which caused severe difficulties for corporate treasurers, financial institutions, and money managers. All of these parties needed a way to protect themselves from the wide fluctuations in the value of the dollar and interest rates. Thus, a market for financial futures was born. Hedging provided the economic rationale for the market, but speculators were quick to join in.
Most of the financial futures trading in this country occurs on the Chicago Board of Trade, the Chicago Mercantile Exchange and, to a much lesser extent, the New York Mercantile Exchange. Financial futures also are traded on several foreign exchanges, the most noteworthy of which is the London International Financial Futures Exchange. The basic types of financial futures include foreign currencies, debt securities (more commonly known as interest rate futures), and stock indexes.
Investor Facts
Single Stock Futures Several years ago, single stock futures (SSFs) began trading on an exchange called OneChicago. SSFs allow investors to buy or sell futures contracts written on 100-share lots of a given common stock. SSFs today are available on more than 1,500 well-known companies and ETFs. Because of their lower margin requirements (20% for SSFs versus 50% for regular stock trades), SSFs are highly leveraged investments, with substantial risk but also with very attractive return potential. Depending on their risk profiles, investors can use this futures version of a stock to support both speculative and hedging investment strategies.
(Source: OneChicago, LLC, Press Release 7/1/2015,
http://www .Onechicago.Com/?p=10392
, accessed July 11, 2015.)
Foreign Currencies, Interest Rates, and Stock Indexes
The financial futures market started rather inconspicuously in May 1972, with the listing of a handful of foreign currency contracts. Known as
currency futures
, they have become a major hedging vehicle as international trade has mushroomed. Most of the trading in this market is conducted in major market currencies such as the British pound, Swiss franc, Canadian dollar, Japanese yen, and the euro—all of which are issued by countries or regions with strong international trade and economic ties to the United States.
The first futures contract on debt securities, or
interest rate futures
, began trading in October 1975. Today trading is carried out in a variety of interest-rate-based securities, including U.S. Treasury securities, Federal Funds, interest rate swaps, Euromarket deposits (e.g., Eurodollar and Euroyen), and foreign government bonds. Interest rate futures were immediately successful, and their popularity continues to grow.
In February 1982 still another type of trading vehicle was introduced: the stock-index futures contract.
Stock index futures
are contracts pegged to broad-based measures of stock market performance. Today trading is done in most of the (major) U.S. stock indexes, including the Dow Jones Industrial Average, the S&P 500, the Nasdaq 100, and the Russell 2000, among others.
In addition to U.S. indexes, investors can trade stock index futures contracts based on the London, Tokyo, Paris, Sydney, Berlin, Zurich, and Toronto stock exchanges. Stock index futures, which are similar to the stock index options we discussed earlier, allow investors to participate in the general movements of the entire stock market.
Stock index futures, and other futures contracts, are a type of derivative security. Like options, they derive their value from the price of the assets that underlie them. In the case of stock index futures, they reflect the general performance of the stock market as a whole or various segments of the market. Thus, when the market for large-cap stocks, as measured by the S&P 500, goes up, the value of an S&P 500 futures contract should go up as well. Accordingly, investors can use stock index futures as a way to buy or sell the market—or reasonable proxies thereof—and thereby participate in broad market moves.
Contract Specifications
In principle, financial futures contracts are like commodities contracts. They control large sums of the underlying financial instrument and are issued with a variety of delivery months. The lives of financial futures contracts run from about 12 months or less for most stock index and currency futures to two to three years or more for interest rate instruments. In terms of quotations,
Figure 15.4
shows quotes for a foreign currency, an interest rate, and a stock index futures contract. Looking first at the Canadian dollars futures quotation, we see information very similar to that of commodity futures quotations. In particular, currency futures quotations provide the last, prior settle, open, high, and low prices, as well as contract trading volume. The owner of a currency futures contract holds a claim on a certain amount of foreign money, in this case 100,000 Canadian dollars. Underlying currency amounts can vary widely across currency futures contracts, such as 62,500 British pounds or 12.5 million Japanese yen.
Holders of interest rate futures have a claim on a certain amount of the underlying debt security. The contract for interest rate futures shown in
Figure 15.4
represents a claim to $100,000 worth of U.S. Treasury bonds. Recall from earlier in the text that bond quotations are expressed as a percentage of the par value, and the same is true for interest rate futures quotations.
Figure 15.4
indicates that the September 2015 contract price is 149’21 and in the case of interest rate futures contracts the value following the apostrophe refers to the number 1/32 of a percentage point. So 149’21 is 149.65625% (i.e., 149 + 21/32149 + 21/32) and that means that the contract value is $100,000 × 149.65625% =$149,656.25$100,000 × 149.65625% =$149,656.25.
Stock index futures are a bit different from most futures contracts because the seller of one of these contracts is not obligated to deliver the underlying stocks at the expiration date. Instead, ultimate delivery is in the form of cash. This is fortunate, as it would indeed be a task to make delivery of the 500 issues in the S&P 500 Index. Basically, the amount of underlying cash is set at a certain multiple of the value of the underlying stock index. Some common examples for U.S. indexes:
|
Index |
Multiple |
|
E-mini Dow ($5) |
$5 × index$5 × index |
|
E-mini S&P 500 |
$50 × index$50 × index |
|
E-mini S&P MidCap 400 |
$100 × index$100 × index |
|
E-mini NASDAQ 100 |
$20 × index$20 × index |
| S&P 500 |
$250 × index$250 × index |
Figure 15.4 Quotations on Financial Futures Contracts
These quotations for financial futures contracts include the daily last, prior settle, open, high, and low prices, as well as the change in price from the previous day’s closing price to the current day’s last price and the current day’s volume. The top panel shows euro futures contracts that trade on CME, the middle panel shows U.S. Treasury bond futures that trade on CBOT, and the bottom panel shows the E-mini Dow ($5) index futures.
(Source: Reprinted with permission, CME Group, 2015.)
Example
Consider a December 2015 E-mini NASDAQ 100 stock index futures contract, which stands at 4,407.25. The amount of cash underlying a single futures contract is $20 × 4,407.25 = $88,145$20 × 4,407.25 = $88,145. The amount of cash underlying an E-mini NASDAQ 100 futures contract is quite substantial; however, the initial margin amount for a single contract is a much more manageable $3,960.
Prices and Profits
Not surprisingly, the price of each type of financial futures contract is quoted somewhat differently.
· Currency futures. All currency futures are quoted in U.S. dollars or cents per unit of the underlying foreign currency (e.g., U.S. dollars per Canadian dollar or cents per Japanese yen). For example, the value of a September 2013 Japanese yen contract with a settlement price of 0.012774 is calculated as 12,500,000 yen ×$0.012774 = $159,67512,500,000 yen × $0.012774 = $159,675.
· Interest-rate futures. Except for the quotes on Treasury bills and other short-term securities, interest rate futures contracts are priced as a percentage of the par value of the underlying debt instrument (e.g., Treasury notes or bonds). Because these instruments are quoted in increments of 1/32 of 1%, a quote of 148’11 for the settlement price of the December 2015 U.S. Treasury bonds (in
Figure 15.4
) translates into 148–11/32, which converts to a quote of 148.34375% of par. Multiply this rate times the $100,000 par value of the underlying security, and we see that this contract is worth $148,343.75. The pricing conventions for the variety of other interest rate futures contracts are found in their contract specifications or often included with their quotations.
· Stock index futures. Stock index futures are quoted in terms of the actual underlying index. As noted above, they carry a face value of anywhere from $5 to $250 times the index. Thus, according to the settlement price in
Figure 15.4
, the December 2015 E-mini Dow ($5) contract would be worth $87,915 because the value of this particular contract is equal to $5 times the settlement price of the index or $5 × 17,583$5 × 17,583.
Example
Suppose a September 2019 S&P 500 Stock Index contract has a settlement price of 2072.80. The contract’s market value can be calculated as follows:
$250 × 2072.80 = $518,200$250 × 2072.80 = $518,200
The initial margin requirement for this position is $25,300, which is less than 5% of the total contract value.
The value of an interest rate futures contract responds to interest rates exactly as the debt instrument that underlies the contract. That is, when interest rates go up, the value of an interest rate futures contract goes down, and vice versa. The quote system used for interest rate as well as currency and stock index futures is set up to reflect the market value of the contract itself. Thus, when the price or quote of a financial futures contract increases (for example, when interest rates fall or a stock index goes up), the investor who is long makes money. In contrast, when the price decreases, the short seller makes money.
Price behavior is the only source of return to speculators. Financial futures contracts have no claim on the dividend and interest income of the underlying issues. Even so, huge profits (or losses) are possible with financial futures because of the equally large size of the contracts. For instance, if the price of Swiss francs goes up by just $0.02 against the U.S. dollar, the investor is ahead $2,500 (i.e., 125,000 Swiss francs × $0.02125,000 Swiss francs × $0.02). Likewise, a 6-point drop in the Nasdaq 100 index means a loss of $20 × 6$20 × 6 or $120 to an E-mini Nasdaq 100 futures investor. When related to the relatively small initial margin deposit required to make transactions in the financial futures markets, such price activity can mean very high rates of return—or very high risk of a total wipeout.
Trading Techniques
Investors can use financial futures, like commodity futures, for hedging, spreading, and speculating. Multinational companies and firms that are active in international trade might hedge with currency or Euromarket futures. Various financial institutions and corporate money managers often use interest rate futures for hedging purposes. In either case, the objective is the same: to lock in the best monetary exchange or interest rate possible. In addition, individual investors and portfolio managers often hedge with stock index futures to protect their security holdings against temporary market declines. Financial futures can also be used for spreading. This tactic is popular with investors who simultaneously buy and sell combinations of two or more contracts to form a desired investment position. Finally, financial futures are widely used for speculation.
Although investors can employ any of the trading strategies noted above, we will focus primarily on the use of financial futures by speculators and hedgers. We will first examine speculating in currency and interest rate futures. Then we’ll look at how investors can use futures to hedge investments in stocks, bonds, and foreign securities.
Speculating in Financial Futures
Speculators are especially interested in financial futures because of the size of the contracts. For instance, in mid-2015, euro currency contracts were worth $139,262.50 or 125,000 euros × $1.1141125,000 euros × $1.1141, 10-year Treasury note contracts were going for 125’26 or $100,000 × 125.8125 = $125,812.50$100,000 × 125.8125 = $125,812.50 and Dow Jones Real Estate futures contracts were being quoted at $100 × 288.9$100 × 288.9 or $28,890 each. With contracts of this size, even small movements in the underlying asset can produce big price swings—and therefore big profits.
Currency and interest rate futures can be used for just about any speculative purpose. For example, if you expect the dollar to be devalued relative to the euro, you could buy euro currency futures because the contracts should go up in value, right along with the appreciation of the euro. If you anticipate a rise in interest rates, you might “go short” (sell) interest rate futures, since they should go down in value. Because margin is used and financial futures have the same source of return as commodities (price appreciation), we can measure the profitability of these contracts using return on invested capital (
Equation 15.1
).
Going Long a Foreign Currency Contract
Suppose you believe that the Swiss franc (CHF) is about to appreciate in value relative to the dollar. You decide to go long (buy) three December 2017 CHF contracts at 0.9728—that is at a quote of just under $1.00 a franc. Each contract would be worth 125,000 CHF × 0.9728 = $121,600125,000 CHF × 0.9728 = $121,600, so the total underlying value of the three contracts would be $364,800. Given an initial margin requirement of, say, $5,400 per contract, you would have to deposit only $16,200 to acquire this position.
Now, if Swiss francs do appreciate and move up from 0.9728 to, say, 0.9965, the value of the three contracts will rise to $373,687.50. In a matter of months, you will have made a profit of $8,887.50. Using
Equation 15.1
for return on invested capital, we find that such a profit translates into a 54.9% rate of return. Of course, an even smaller fractional change in the other direction would have wiped out this investment. Clearly, these high returns are not without equally high risk.
Going Short an Interest Rate Contract
Let’s assume that you’re anticipating a sharp rise in long-term rates. A rise in rates translates into a drop in the value of interest rate futures. You decide to short sell two June 2016 T-bond contracts at 147’00, which means that the contracts are trading at 147% of par. Thus, the two contracts have a value of $100,000 × 1.47 × 2 = $294,000$100,000 × 1.47 × 2 = $294,000. You need only $7,560 (the initial margin deposit is $3,780 per contract) to make the investment.
Assume that interest rates do, in fact, move up. As a result, the price on Treasury bond contracts drops to 138’16 (or1381213812). You could now buy back the two June 2016 T-bond contracts (to cover the short position) and in the process make a profit of $17,000. You originally sold the two contracts at $294,000 and bought them back sometime later for $100,000 × 1.385 × 2 = $277,000$100,000 × 1.385 × 2 = $277,000. As with any investment, such a difference between what you pay for a security and what you sell it for is profit. In this case, the return on invested capital amounts to 225%. Again, this return is due in no small part to the enormous risk of loss you assumed.
Trading Stock-Index Futures
Most investors use stock index futures for speculation or hedging. (Stock index futures are similar to the index options introduced earlier in the text. Therefore, much of the discussion that follows also applies to index options.) Whether speculating or hedging, the key to success is predicting the future course of the stock market. Because you are “buying the market” with stock index futures, it is important to get a handle on the future direction of the market via technical analysis or some other technique. Once you have a feel for the market’s direction, you can formulate a strategy for stock index futures trading or hedging. For example, if you feel that the market is headed up, you would want to go long (buy stock index futures). In contrast, if your analysis suggests a drop in equity values, you could make money by going short (sell stock index futures).
Assume, for instance, that you believe the market is undervalued and a move up is imminent. You can try to identify one or a handful of stocks that should go up with the market (and assume the stock selection risks that go along with this approach), or you can buy an S&P 500 stock index futures contract currently trading at, say, 2101.60. To execute this speculative transaction, you would need to deposit an initial margin of $25,300. Now, if the market does rise so that the S&P 500 Index moves to, say, 2176.6 by the expiration of the futures contract, you earn a profit of (2,176.6 − 2,101.6) × $250 = $18,750(2,176.6 − 2,101.6) × $250 = $18,750. Given the $25,300 investment, your return on invested capital would amount to a hefty 74%. Of course, keep in mind that if the market drops by 75 points (or 3.6%), the investment will be a total loss.
Hedging with Stock Index Futures
Stock index futures are also used for hedging. They provide investors with a highly effective way of protecting stock holdings in a declining market. Although this tactic is not perfect, it does enable investors to obtain desired protection against a decline in market value without disturbing their equity holdings.
Here’s how a so-called short hedge would work: Assume that you hold a total of 2,000 shares of stock in a dozen companies and that the market value of this portfolio is around $235,000. If you think the market is about to undergo a sharp decline, you can sell all of your shares or buy puts on each of the stocks. You can also protect your stock portfolio by short selling stock index futures.
Suppose, for purposes of our illustration, that you short sell three E-mini Dow ($5) stock index futures contracts at 17672. These contracts would provide a close match to the current value of your portfolio since they would be valued at 3 × $5 × 17,672 = $265,0803 × $5 × 17,672 = $265,080. Yet these stock index futures contracts would require an initial margin deposit of only $4,290 per contract, or a total deposit of 3 × $4,290 = $12,8703 × $4,290 = $12,870 Now, if the DJIA drops, causing the value of your futures contract to drop to 17165, you will make a profit of $7,605 from this short sale. That is, because the futures contract value fell 507 points (17,672 − 17,165)(17,672 − 17,165), the total profit is 3 × $5 × 507 = $7,6053 × $5 × 507 = $7,605. Ignoring margin costs and taxes, you can add this profit to the portfolio (by purchasing additional shares of stock at their new lower prices). The net result will be a new portfolio position that will approximate the one that existed prior to the decline in the market.
Investor Facts
Triple Witching Day Watch out for the third Friday in March, June, September, and December. It’s “triple witching day,” when stock options, stock index options, and stock index futures all expire more or less simultaneously. On these days, the equities markets are more volatile than usual because speculators and traders may have to buy or sell large quantities of stock or index positions to fulfill their obligations. As a result, stock prices may fluctuate considerably, creating bargains or windfall profits.
To reduce the impact of triple witching day, the exchanges now spread the expirations of the options so that they occur throughout the day, instead of within an hour of each other. For example, the S&P 500 Index options and futures expire at the start of that business day, while individual stock options and the S&P 100 Index options expire at the close of that day.
How well the “before” and “after” portfolio positions match will depend on how far the portfolio dropped in value. If the average price dropped about $5 per share in our example, the positions will closely match. But this does not always happen. The price of some stocks will change more than that of others, so the amount of protection provided by this type of short hedge depends on how sensitive the stock portfolio is to movements in the market. Thus, the types of stocks held in the portfolio are an important consideration in structuring a stock index short hedge.
A key to success with this kind of hedging is to make sure that the characteristics of the hedging vehicle (the futures contract) closely match those of the portfolio (or security position) being protected. If the portfolio is made up mostly (or exclusively) of large-cap stocks, use something like the S&P 500 Stock Index futures contract as the hedging vehicle. If the portfolio is mostly blue-chip stocks, use the DJIA contracts. If the portfolio holds mostly tech stocks, consider the Nasdaq 100 Index contract. Again, the point is to pick a hedging vehicle that closely reflects the types of securities you want to protect. If you keep that caveat in mind, hedging with stock index futures can be a low-cost yet effective way of obtaining protection against loss in a declining stock market.
Hedging Other Securities
Just as you can use stock index futures to hedge stock portfolios, you can use interest rate futures to hedge bond portfolios. Or, you can use currency futures with foreign securities as a way to protect against foreign exchange risk. Let’s consider an interest rate hedge. If you held a substantial portfolio of bonds, the last thing you would want to see is a big jump in interest rates, which could cause a sharp decline in the value of your portfolio. Assume you hold around $300,000 worth of Treasury and agency bonds, with an average maturity of 18 years. If you believe that market rates are headed up, you can hedge your bond portfolio by short selling three U.S. Treasury bond futures contracts. (Each T-bond futures contract is worth about $100,000, so it would take three of them to cover a $300,000 portfolio.) If rates do head up, you will have protected the portfolio against loss. As noted above, the exact amount of protection will depend on how well the T-bond futures contracts parallel the price behavior of your particular bond portfolio.
There is, of course, a downside. If market interest rates go down rather than up, you will miss out on potential profits as long as the short hedge position remains in place. This is so because the profits being made in the portfolio will be offset by losses from the futures contracts. Actually, this will occur with any type of portfolio (stocks, bonds, or anything else) that is tied to an offsetting short hedge. When you create the short hedge, you essentially lock in a position at that point. Although you do not lose anything when the market falls, you also do not make anything when the market goes up. In either case, the profits you make from one position are offset by losses from the other.
Hedging Foreign Currency Exposure
Now let’s see how you can use futures contracts to hedge foreign exchange risk. Let’s assume that you have just purchased $200,000 of British government one-year notes. (You did this because higher yields were available on the British notes than on comparable U.S. Treasury securities.) Because these notes are denominated in pounds, this investment is subject to loss if currency exchange rates move against you (i.e., if the value of the dollar rises relative to the pound).
If all you wanted was the higher yield offered by the British note, you could eliminate most of the currency exchange risk by setting up a currency hedge. Here’s how: Let’s say that at the current exchange rate, 1 U.S. dollar will “buy” 0.606 of a British pound. This means that pounds are worth about $1.65 (i.e., $1.00/0.606£ = $1.65$1.00/0.606£ = $1.65). So, if currency contracts on British pounds were trading at around $1.65 a pound, you would have to sell two contracts to protect the $200,000 investment. Each contract covers 62,500 pounds; if they’re being quoted at 1.65, then each contract is worth $103,125.
Assume that one year later the value of the dollar has increased relative to the pound, so that 1 U.S. dollar will now “buy” 0.65 pound. Under such conditions, a British pound futures contract would be quoted at around 1.54 (i.e., $1.00/.065£ = $1.54$1.00/.065£ = $1.54). At this price, each futures contract would have a value of 62,500 × $1.54 = $96,25062,500 × $1.54 = $96,250. Each contract, in effect, would be worth $6,875 less than it was a year ago. But because the contract was sold short when you set up the hedge, you will make a profit of $6,875 per contract—for a total profit of $13,750 on the two contracts. Unfortunately, that’s not net profit because this profit will offset the loss you will incur on the British note investment. In very simple terms, when you sent $200,000 overseas to buy the British notes, the money was worth about £121,000. However, when you brought the money back a year later, those 121,000 pounds purchased only about 186,500 U.S. dollars. Thus, you are out some $13,500 on your original investment. Were it not for the currency hedge, you would be out the full $13,500, and the return on this investment would be a lot lower. The hedge covered the loss (plus a little extra), and the net effect was that you were able to enjoy the added yield of the British note without having to worry about potential loss from currency exchange rates.
Financial Futures and the Individual Investor
Like commodities, financial futures can play an important role in your portfolio so long as three factors apply: (1) You thoroughly understand these investments. (2) You clearly recognize the tremendous risk exposure of these investments. (3) You are fully prepared (financially and emotionally) to absorb some losses.
Financial futures are highly volatile securities that have enormous potential for profit and for loss. For instance, the September 2015 S&P 500 futures contract traded at a low of 1963.50 on January 1, 2015, and a high of 2122.00 on June 1, 2015. This range of 158.5 points for a single contract translated into a potential profit—or loss—of $250 × 158.5 = $39,625$250 × 158.5 = $39,625 and all from an initial margin investment of only $25,300. Investment diversification is obviously essential as a means of reducing the potentially devastating impact of price volatility. Financial futures are exotic investments, but if properly used, they can provide generous returns.
Options on Futures
The evolution that began with listed stock options and financial futures spread, over time, to interest rate options and stock index futures. Eventually, it led to the creation of the ultimate leverage vehicle: options on futures contracts.
Futures options
, as they are called, represent listed puts and calls on actively traded futures contracts. In essence, they give the holders the right to buy (with calls) or sell (with puts) a single standardized futures contract for a specific period of time at a specified strike price.
Such options can be found on both commodities and financial futures. Notice that each of the corn futures contracts quoted in
Figure 15.3
include an options icon under each contract delivery month, indicating that a futures option exists for that futures contract. In fact, the CME Group quotations allow you to click on the options icon to access the futures options quotations.
Figure 15.5
shows the options quotations for the July 2015 corn futures contract quoted in
Figure 15.3
. For the most part, these puts and calls cover the same amount of assets as the underlying futures contracts—for example, 112,000 pounds of sugar, 100 troy ounces of gold, 62,500 British pounds, or $100,000 in Treasury bonds. Thus, they also involve the same amount of price volatility as is normally found with commodities and financial futures.
Futures options have the same standardized strike prices, expiration dates, and quotation system as other listed options. Depending on the strike price on the option and the market value of the underlying futures contract, these options can also be in-the-money or out-of-the-money. Futures options are valued like other puts and calls—by the difference between the option’s strike price and the market price of the underlying futures contract. They can also be used like any other listed option—for speculating or hedging, in options-writing programs, or for spreading. The biggest difference between a futures option and a futures contract is that the option limits the loss exposure to the price of the option. The most you can lose is the price paid for the put or call option. With the futures contract, there is no real limit to the amount of loss you can incur.
To see how futures options work, assume that you want to trade some gold contracts. You believe that the price of gold will increase over the next four or five months from its present level of $1,160.80 an ounce. You can enter into an August 2016 futures contract to buy gold at $1,163.90 an ounce by depositing the required initial margin of $4,125. Alternatively, you can buy a futures call option with a $1,160 strike price that is currently being quoted at $9.80. Because the underlying futures contract covers 100 ounces of gold, the total cost of this option would be 100 × $9.80 = $980100 × $9.80 = $980. The call is an in-the-money option because the market price of gold exceeds the exercise price on the option. The following table summarizes what happens to both investments if the value of the gold futures contract increases to $1,182.54 an ounce by the expiration date and also what happens if the value of the gold futures contract drops to $1,139.75 an ounce.
|
Futures Contract Futures Option |
||||
|
Price Change |
Profit (or Loss) |
Return on Invested Capital | ||
|
If futures contract value increases to $1,182.54 an ounce |
$1,864 |
45.2% |
$1,274 |
130% |
|
If futures contract value decreases to $1,139.75 an ounce |
($2,415) |
−58.5% |
($980) |
−100% |
Figure 15.5 Quotations on Corn Futures Options Contracts
This quotation for call and put options on corn futures contracts includes the daily last, open, high, and low prices, as well as the prior settle and strike price. It also provides the change in price from the previous day’s closing price to the current day’s last price, the current day’s volume, and the Hi/Lo limit.
(Source: Reprinted with permission, CME Group, 2015.)
Clearly the futures option provides a superior upside rate of return but also a reduced exposure to loss since the maximum loss is limited to the price of the options. Futures options offer interesting investment opportunities. But as always, they should be used only by knowledgeable commodities and financial futures investors.
Concepts in Review
Answers available at
http://www.pearsonhighered.com/smart
1. 15.10 What is the difference between physical commodities and financial futures? What are their similarities?
2. 15.11 Describe a currency future and contrast it with an interest rate future. What is a stock index future, and how can it be used by investors?
3. 15.12 Discuss how stock index futures can be used for speculation and for hedging. What advantages are there to speculating with stock index futures rather than specific issues of common stock?
4. 15.13 What are futures options? Explain how they can be used by speculators. Why would an investor want to use an option on an interest rate futures contract rather than the futures contract itself?