Futures and Options

1
Chapter 9

• Futures and Options

2
Background

• Derivatives are investments that derive their
  value from some underlying quantity (usually a
  stock, bond or commodity price)
• Forward contractobligates the buyer to purchase
  the underlying security on a given date for a
  specified price
• Arrangements between private parties
• Not actively traded in any market
• Futures contractobligates the buyer to purchase
  a specified quantity of the underlying security
  on a given date at a specified price
• Actively traded on futures exchanges until
  delivery date
• Can earn gains/losses from simply trading the
  contract itself, without every taking delivery of
  underlying goods

3
Background

• Optionagreement between an option writer (who
  sells the option) and buyer
• Option buyer has right (but not obligation) to
  buy (call) or sell (put) underlying security at
  the pre-determined exercise price on a specified
  date
• If option is exercised, option writer must follow
  through
• Many options expire unexercised
• Options actively traded at options exchanges and
  OTC markets

4
Forward Contracts

• A forward contract is created when someone buys a
  commodity, security or other asset for future
  delivery
• Delivery price is fixed when contract is created,
  but not paid until delivery date (which may be
  months or years after the contracting date)
• Buyer and seller negotiate the
• Price
• Quantity
• Quality of goods
• Delivery location
• Delivery date
• Each forward contract is tailor-made to fit the
  needs and preferences of the buyer and seller
• Counterparty risk arises due to the risk that the
  buyer or seller may default

5
Futures Contracts

• Evolved from forward contracts
• Contain improvements designed to
• Reduce counterparty risk
• Increase liquidity
• Agricultural futures on corn and wheat traded on
  CBT in 1865
• Financial futures on stock, bonds, etc. began
  trading in 1970s

6
Futures Contracts

• Basic characteristics
• A futures contract is just a forward contract
  that has been standardized to increase its
  marketability
• Taking Delivery
• If you buy a futures contract you must
• Sell the contract prior to the delivery date
• Most common occurrence
• Or take delivery of the underlying goods upon
  expiration of contract
• Cash Settlement
• Financial futures usually provide for cash
  settlementreceiving cash rather than the
  underlying good
• Most agricultural futures allow for physical
  delivery of the underlying good

7
Futures Contracts

• Trading Futures
• Futures exchange
• Members meet on exchange trading floor and use
  open outcry method to negotiate each transaction
• Each time a futures contract is purchased and
  resold, the transaction can occur at a different
  price than the preceding transaction
• Last buyer will receive delivery upon delivery
  date
• If last seller fails to make delivery,
  clearinghouse makes delivery and sues defaulted
  seller
• Removes counterparty risk

8
Types of Futures Contracts

• Futures contracts have existed for many years for
  commodities such as
• Gold
• Silver
• Soybeans
• Corn
• Wheat
• Futures have been traded since the 1970s on
  financial products such as
• Bonds
• Foreign currencies
• Stock market indexes
• Volume of financial futures far exceeds aggregate
  trading of traditional commodities

9
Exchanges

• Chicago Board of Options
• Largest organized options exchange in the world
• http//www.cboe.com
• Chicago Mercantile Exchange
• Large organized futures exchange
• http//www.cme.com
• Chicago Board of Trade (CBOT)
• Largest, oldest futures exchange in the world
• http//www.cbot.com

10
Gains Losses in Futures Positions

• An investor long in a future may
• Wait until the contract expires and take delivery
  (or perhaps receive a cash settlement value)
• Hold position and see what happens to price
• Eliminate long position by offsetting (selling
  contract)
• An investor short in a future may
• Wait until the contract expires and make delivery
  (or make a cash payment)
• Hold position and see what happens to price
• Eliminate short position by offsetting (buying
  contract)

11
The Clearing House

• A futures contract can be executed without the
  buyer and seller having to contact each other
• Clearing house inserts itself into every
  transactionbuyer in every sale and seller in
  every purchase
• Clear and settle transactions
• Expedite the delivery process
• Guarantee performance of every contract
• Collect fees of a few pennies on every contract
• Process thousands of contracts daily
• Fees accumulate in a guarantee fund

12
Margin Requirements

• To trade futures, client must open a margin
  account
• Initial margins on futures are smallrange from
  3 to 12 of transactions value
• Most futures traders trade on margin rather than
  pay for the entire transaction
• If significant losses occur, will receive margin
  call

13
Speculating with Futures

• Speculators hope to earn profits by aggressively
  trading futures
• Example A professor has been researching a new
  strain of bacteria which caused a
  rapidly-spreading blight in Illinois, destroying
  many acres of wheat. The professor believes that
  the blight could wipe out a significant part of
  the U.S.s wheat crop if it is not contained
  before the end of May. If so, the price of wheat
  could rise rapidly. If the professor goes long
  in wheat futures, he could realize personal
  profit.

14
Speculating with Futures

• The professor buys one September wheat future at
  a price of 3.50 per bushel in early May, for a
  total cost of 17,500 (CBT wheat contracts deal
  in 5,000 bushels of wheat per contract)
• However, he is only required to put up a 10
  margin, or 1,750
• Several days later the U.S. Department of
  Agriculture announces the wheat blight and the
  price of wheat rises
• The professor sells his long position in wheat
  futures for 4.00 per bushel
• Results in profit of 0.50 per bushel times 5,000
  bushels, or 2,500
• This is a return of 2,500 ? 1,750 143

15
Leverage

• Low initial margin requirements on futures allow
  investors to make only small initial outlays on
  large amounts of contracts
• This use of leverage enhances both profits and
  losses
• Forward contracts cannot be purchased using
  leverage
• Buyers must pay cash on delivery

16
Speculating with SP500 Index Futures

• CME began trading a futures contract on the
  SP500 index in 1982
• One of the most successful futures contracts in
  the world
• Underlying quantity on which the futures contract
  is based is the market value of the SP500 index
• Mercs futures contract defines the futures price
  as
• 250 ? Market Value of SP500 index
• Index owners are not entitled to any cash
  dividends
• Futures contract is a cash settlement contract
• Cash received is based on the difference between
  most recent market value of the index future and
  the contracts purchase price

17
Speculating with SP500 Index Futures

• Example You feel bullish about the stock market
  and you decide to purchase one September futures
  contract on the SP500 Index
• You call your broker and give him a market order
  to buy one contract
• The order is executed when the SP500 index was
  trading at 651 for a total of 162,750
• You have to put up a 3 margin, or 3 x 651 x
  250 4,882.5
• Feeling satisfied with yourself you decide to go
  to lunchupon returning from lunch you learn that
  the SP500 index is now at 653

18
Speculating with SP500 Index Futures

• You call your broker and give a market order to
  sell while the index is still at 653
• You earn a profit of
• 250 x 653 163,250 - 162,750 - 100
  (commissions) 400
• This represents a return of
• 400 ? 4,882.5 8.19 for a holding period of
  several hours
• What if the market had moved in the wrong
  direction?
• Could have suffered substantial losses if the
  market had experienced a severe downturn

19
Speculating with SP500 Index Futures

• If you had bearishly sold SP500 Index futures at
  651 before lunch and the market rose to 653
  during lunch you would have lost 600
• 162,750 - 163,750 - 100 (commissions) -600

20
Hedging with Futures

• Hedgers are more interested in avoiding risk than
  speculating to maximize gains
• Selling hedgeused to avoid losses from price
  declines on physical inventory
• Protect a farmer against a loss if the market
  value of his growing crop declines
• Also limits his ability for potential profits if
  the market value of crop rises

21
Hedging with Futures

• Example Farmer Brown can profitably produce
  20,000 bushels of wheat if he can sell the crop
  for 4.50 per bushel in July
• In April, while he was planting his crops, the
  price of July wheat futures was 4.50 per bushel
• By selling 4 wheat futures contracts (5,000
  bushels each) short at 4.50 per bushel, Farmer
  Brown hedges the 20,000 bushels of physical wheat
  growing in the field
• Locks in the 4.50 per bushel selling price and
  assures Farmer Brown that he can earn his desired
  profit

22
Hedging with Futures

• Regardless of what happens to the price of wheat,
  Farmer Brown will receive a total value of
  22,500 per contract as shown below

23
Hedging with Futures

• It is now July and Farmer Brown harvests his
  wheat
• At this time, the price of wheat is 4.25 per
  bushel
• Farmer Brown sells his wheat in the cash
  (physicals) market for 4.25 per bushel
• At the same time, he offsets his positions in the
  futures market by buying 4 wheat futures
  contracts at 4.25 per bushel
• This eliminates (reverses, unwinds) his short
  futures position

24
Hedging with Futures

• Farmer Brown receives
• A net gain of 0.25 per bushel on his futures
  contract
• A 0.25 per bushel loss on his physical wheat
• Excluding brokerage commissions and taxes, Farmer
  Brown received the 4.50 per bushel he wanted

25
Perfect Hedges

• The preceding example involved a perfect hedge
• Rarely possible
• Hedges are usually imperfect due to
• The long and short positions may not coincide in
  time
• For example, best harvest time may occur after
  delivery date of futures contract
• Delivery may have to be made at an inaccessible
  location
• Chicago may be too costly for a farmer in Oregon
• The specified quality cannot be delivered
• For example, due to a blight, Farmer Browns
  wheat is discolored

26
Futures Prices and Other Trading Data

• New contracts originate every quarter, with
  expiration dates of March, June, September and
  December
• Open interest represents the number of opened
  contracts that have not yet been offset

27
Regulating Financial Futures in the U.S.

• Most futures exchanges operate their own clearing
  house
• Commodity Futures Trading Commission Act of 1974
  established an independent federal agency (CFTC)
  to oversee futures transactions in the U.S.
• Options Clearing Corporation (OCC) is owned by
  the CBOE, AMEX, PHIX and PSE and is regulated by
  the SEC

28
Characteristics of Puts and Calls on Equities

• Regardless of your view of the future price of a
  stock, it is possible to create a investment to
  take advantage of that expectation
• Profit opportunities can be constructed using
  these basic building blocks
• Buying a long position in the stock
• Selling the stock short
• Buying a call option on the stock
• Selling a call option on the stock
• Buying a put option on the stock
• Selling a put option on the stock

29
Defining a Call Option

• A call option
• Gives the owner the right (not the obligation) to
  buy the underlying stock within a specified
  period of time at a specified price (exercise
  price)
• One call deals with 100 shares of stock (a round
  lot)
• Call writer gets paid to provide the buyer with
  the opportunity to buy underlying stock if the
  buyer chooses to do so

30
Characteristics of Stock Options

• New options originate in the U.S. every month
• Options exist on the same stock with different
  expiration dates
• 3, 6, 9 and 12 months
• AMEX started listing put and call options with
  expirations as long as 30 months
• Long-term Equity Appreciation Securities (LEAPS)

31
Characteristics of Stock Options

• Prior to an options expiration date, the owner
  of a put or call option can
• Hold the option to see what happens to the
  stocks price
• Sell the option at the current market price and
  take the resulting gain or loss
• Eliminates the option position
• Exercise the option
• Eliminates the option position
• Let the option expire
• Option is then worthless
• Only about 10 of all exchange-listed options are
  exercised

32
Characteristics of Stock Options

• Parties to an option contract
• Option buyer
• Pays premium to option seller to encourage seller
  to write the option
• Said to be long options
• Option seller
• Receives premium from buyer for writing the
  option
• Said to be short options

33
Characteristics of Stock Options

• Prices associated with options
• Price of the underlying assets
• Fluctuating market price of the asset underlying
  the option contract
• Exercise price (AKA strike price, contract price)
• Price at which the option seller can be legally
  required to execute the option
• Does not fluctuate over the life of the option
• Option premium
• Price the option buyer pays the seller
• Fluctuates throughout the options life

34
Characteristics of Stock Options

• Options buyers usually do not exercise the
  options
• Because options buyers are usually price
  speculators and risk-averting hedgers
• If an option seller writes an option that is
  never exercised, he receives money (option
  premium) for simply exposing himself to the risk
  that the option would be exercised and he would
  lose money
• If options are exercised, the writer usually
  loses more than his premium income

35
Characteristics of Stock Options

• European options can only be exercised on the
  expiration date
• Trade in Europe and non-European countries
• American options can be exercised any trading day
  up to and including the expiration date
• Trade in U.S. and other countries

36
Markets for Options

• Options exchanges include
• Chicago Board Options Exchange (CBOE)
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange
• American Stock Exchange (AMEX)
• Philadelphia Stock Exchange (PHIX)
• Pacific Stock Exchange (PSE)

37
Option Quotations
38
Gain-Loss Illustrations for Call Positions

• If an investor expects a stock price increase, he
  could
• Take a long position in the stock, or
• Buy a call option on the stock
• If stock price rises above exercise price, buyer
  can exercise option to buy stock then sell stock
  at the higher market price
• If investor was wrong and stock price falls,
  buyer loses the premium paid for the option

39
Gain-Loss GraphCall Buyer
Intrinsic Value of a call Max0, (Stock price
Exercise price) If stock price is 50, the IV
is Max0, 50-40 10.
40
Example A Call Option on KO

• KO is currently selling for 30 per share. A
  call option with a strike price of 40 expires in
  six months and has a current premium of 3 per
  share
• The intrinsic value of the call is 0, or the MAX
  of 0, 30-40
• Over a range of KOs stock prices, the intrinsic
  value of the option would be

41
Illustration of Call Writers Position

• If the stocks price remains below the options
  strike price, the option will not be exercised
  and it will expire worthless
• The call writer keeps the option premium for
  doing nothing
• However, if the stock price rises above the
  exercise price, the call buyer will exercise the
  option and the call buyers gain will equal the
  call writers loss
• Thus, the intrinsic value of a call writer's
  position is the minimum of
• 0, (Exercise price Stock price)

42
Illustration of Call Writers Position

• The call writers intrinsic gain is equal to the
  premium received when the option was sold plus
  the intrinsic value of the call

43
Illustration of Call Writers Position
44
Example Intel Call Option

• In 1993 Intels price ranged from 21 to 37
• In 1993 Mr. Byer bought a call option on Intel,
  paying Ms. Rhyter a premium of 2.50
• The option had a strike price of 20 per share
  and six months until expiration
• If the value of Intel rose to 75 prior to the
  expiration date, Mr. Byer could exercise the
  option and buy Intel for 20, then immediately
  sell the stock for 75
• His profit would be 75 - 20 - 2.50 52.50
  per share
• If the value of Intel rose to 75 and Mr. Byer
  exercised the option, Ms. Rhyter would have to
  buy shares of Intel for 75 and immediately
  deliver them to Mr. Byer who would pay her 20
  for each
• Her loss would be 20 - 75 2.50 -52.50 per
  share
• Note that Mr. Byers profit exactly equals Ms.
  Rhyters loss

45
Example Intel Call Option

• If Intels price dropped below 20 a share, Ms.
  Rhyters position would become profitable while
  Mr. Byer would lose money (the call premium)

46
Put Options

• A put option
• Gives the owner the right (not the obligation) to
  sell (or put) a round lot of the underlying stock
  to the put seller within a specified period of
  time at a specified price (exercise price)
• The intrinsic value of a put is
• MAX0, Exercise price Stock price

47
Gain-Loss Graph for Put Buyer
48
Gain-Loss Graph for Put Writer
Intrinsic Value of a put writers position
is MIN0, (Stock price Exercise price)
49
Example Intrinsic Values for a Put Buyer

• You buy a put for 2 per share for Speed.Com
  Corporation with an exercise price of 45
• What is your maximum loss?
• The most you can lose is your premium of 2 per
  share
• What is your maximum gain?
• If the company goes bankrupt, youll still be
  able to sell the stock for 45thus, your gain
  would be 45-243
• What will your gain be at expiration if the stock
  rises in value to 50?
• The put would not be exercised and your loss
  would be the premium of 2
• What will your gain be at expiration if the stock
  falls in value to 40?
• You would exercise the put and sell the stock for
  45thus your gain would be 45 - 40 - 2 3

50
Perspectives on Options

• Short sellers and buyers of put options both
  benefit from a stock price decline
• Options buyers cannot lose more than the premium
  paid for the optionlimited liability
• Means that buyers of a put option are better off
  than short sellers if the stock price rises
• Means that call buyers are better off than
  investors with long positions if the stock price
  falls
• Call writers do not enjoy limited liability
• If the price of the optioned stock rises to
  infinity, the writers losses rise in tandem

51
Perspectives on Options

• Gains (Losses) for put buyers are offset by equal
  losses (gains) for the put writers
• Gains (Losses) for call buyers are offset by
  equal losses (gains) for call writers
• Counterparties in options are involved in a zero
  sum game

52
Advantages from Using Options

• If you believe a stocks price will change, you
  can either
• Go long (or short) the stock
• Buy an option on the underlying stock
• Buying an option may be better than taking a
  position in the stock itself due to
• Financial leverage
• Less money is required to invest in an option and
  each dollar invested in the option can lead to
  more dollar gains than a direct position in the
  stock
• Limited liability
• An option buyer can only lose a maximum of the
  call premium if the stock moves against
  expectations
• While this is 100 of the invested funds, the
  invested funds are much smaller than a direct
  position in the stock

53
Advantages from Using Options

• No lost interest
• A short seller must give up the use of their
  funds from the short sale and they do not earn
  interest on these funds
• Individual short sellers do not immediately
  receive the proceeds from their short sale (but
  institutional investors do)
• No cash dividend payments
• A short seller must pass along dividend payments
  to the owners of the borrowed shares whereas put
  option buyers do not
• Anytime
• Short sales cannot be made on a downtick whereas
  a put option can be purchased at any time

54
Advantages of Short Sale Over Put Option

• A short (or long) position in a stock can remain
  open for years without incurring additional
  transactions costs
• However, a put option expires within a relatively
  short time frame
• If you expect a quick movement in stock prices,
  an option may be a better choice

55
Zero Sum Game

• A zero sum game means that for every winner there
  is an offsetting loser
• A competitive advantage exists for those who have
• A superior education
• Superior information processing abilities
• Monopolistic access to valuable information

56
Determinants of Put and Call Premiums

• Six factors affect the premiums that put and call
  options trade at in the market
• The length of time remaining in the options life
• The riskiness of the underlying asset
• The market price of the underlying asset
• The exercise price
• Interest rates
• Cash dividend payments

57
The Length of Time Remaining in the Options Life

• Option writers charge a higher premium to write
  options with a longer time to expiration
• Because the probability that the option will be
  in-the-money increases with the length of time
  until expiration
• An option has both time value and intrinsic value

58
The Length of Time Remaining in the Options Life

• For a call or put option
• Time value option premium intrinsic value
• Time value may be either zero or positive, but
  never negative

59
The Riskiness of the Underlying Asset

• Stocks that fluctuate a great deal in price offer
  more opportunities for an option owner to
  exercise the option
• Option writers review the risk of the underlying
  stock
• Charge higher premiums for options written on
  riskier stocks

60
Figure 9-8Call Premiums Are Affected By Risk
61
Figure 9-8Call Premiums Are Affected By Risk
62
Figure 9-8Call Premiums Are Affected By Risk
63
Market Price of the Underlying Asset

• Options written on stocks with a higher price are
  riskier
• Because writer may suffer higher potential losses

64
Exercise Price

• Call buyers gain when stock price rises above
  exercise price
• The lower the exercise price the higher the value
  of the call
• Put buyers gain when stock price drops below
  exercise price
• The higher the exercise price, the higher the
  value of the put

65
Rate of Interest

• Impact of interest rates on option premiums is
  minimal but effect occurs because
• The discounted present value of the exercise
  price is lower the higher the level of interest
  rates
• The discounted present value of the exercise
  price is lower the longer the time until the
  option is exercised
• Call option premiums relate directly to interest
  rates
• Put option premiums move inversely to the level
  of interest rates

66
Cash Dividend Payments

• Ex-dividend date
• The first trading day after a stock pays a cash
  dividend
• The stocks price drops by the amount of the cash
  dividend
• This changes the value of stock options
• Calls (Puts) are worth less (more)

67
The Bottom Line

• A derivative derives its value from an underlying
  asset
• A forward is when someone buys an asset for
  future delivery
• Delivery price specified at time of purchase
• Does not offer the opportunity to trade on margin
• Illiquid

68
The Bottom Line

• Futures contracts are improved forward contracts
• Prices are determined by open outcry or an
  electronic limit order book system
• Counter-party risk is non-existent because a
  clearing corporation serves as a middleman
• Can be used for speculating or hedging
• Small initial margin requirements

69
The Bottom Line

• Financial futures are extremely popular
• Many are cash settleddo not provide for physical
  delivery
• Buying options rather than taking a short or long
  position has advantages
• Limited liability and financial leverage
• Options are basically a zero sum game
• Option prices move in a non-linear fashion
  relative to the price of the underlying asset

70
Appendix Warrants

• Warrants are call options to buy shares of stock
• Newly created warrants are given as attachments
  to a bond or preferred stock
• Sweeten the issue and make it easier to sell
• Exercise price
• Amount the warrant owner must pay to buy the
  specified number of shares

71
Appendix Warrants

• Intrinsic value
• MAX 0, (Stocks market price exercise price)
  ? number of shares
• Warrants are identical to call options if the
  warrant entitles owner to one share of underlying
  stock

72
Appendix Warrants

• Differences between warrants and call options
• The corporation that issues the underlying stock
  is the writer of a warrant
• External third parties write call options
• When warrants are exercised, new shares of
  outstanding common stock are created, causing
  dilution
• If warrants offer a number of shares of stock
  different from one, the relationship between a
  warrants premium and the underlying stock price
  can differ from that of a call option

73
Appendix Warrants

• Warrants can be exercised in a time frame usually
  ranging from 5 to 15 years
• Some have perpetual lives
• Some may be exercised only at specific times
• Non-detachable warrants cannot be traded
  separately while detachable warrants can be

74
Appendix Callable Bonds Have Embedded Options

• Embedded call options give bond issuer right to
  redeem the bonds prior to maturity date
• Usually detrimental to bondholders
• Usually redeemed when alternative investments
  offer low rates of interest
• Issuers usually offer interest rates that are 50
  to 100 basis points (BPs) higher than equivalent,
  non-callable bonds
• Also offer additional protective provisions to
  induce investors to buy the bonds

75
Appendix Convertible Securities

• Convertible securities allow owners to convert
  their preferred stock or bonds to another
  security
• Usually the common stock of the corporation
• Can be viewed as a combination of a
  non-convertible security and an embedded call
  option on issuers stock
• Most are also callable