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Options & Futures Markets

Finance > Options & Futures Markets
Table of Contents Abstract Keywords Overview Viewpoints Conclusion Terms & Concepts Bibliography Suggested Reading
buy are called call options. Options giving the right to sell are called put options (Faerber, 2006). Futures can be any type of financial security including stocks, bonds, stock indexes, currencies, and commodities such as oil, coffee, orange juice, soybeans, gold, silver, pork bellies and corn. Financial Exchanges Options and futures are traded at financial exchanges. Options are traded at the Chicago Board Options Exchange (CBOE) using brokers and market makers (Faerber, p. 51, 54). Market makers are firms that buy and sell stocks for their own stock inventory while brokers are companies that sell stock on behalf of financial institutions and the general public. The CBOE is the largest options market in the world. The Philadelphia Exchange is a regional exchange that lists options. The Chicago Mercantile exchange lists futures and options while the New York Mercantile Exchange lists futures. Recently, the Chicago Board of Trade (CBOT) merged with the Chicago Mercantile Exchange (CME) which presented some conflict since CBOT members had provided seed capital for the CBOE in 1973. In exchange for this capital, CBOT members were to receive certain rights and privileges at the CBOE which now conflict since the CBOT is part of a competing exchange, the Chicago Mercantile Exchange (CME) (Clary, 2007). Investment Vehicles Groz (1999) reviewed five categories of investments including stocks, mutual funds, bonds, options and futures. All have different benefits and disadvantages. Options are used to reduce portfolio risk from speculative investing. Futures are riskier than options but have the benefit of higher returns. It is also possible for investors to reduce the risk of investing in futures by using managed accounts which are similar to mutual funds and balance out the risk of investing directly in futures. However, as with any managed account, the investor has to be certain that the fees associated with the account are warranted when compared to the long term returns of the account.

Abstract
Investors have choices when choosing to invest in financial securities. The options and futures markets offer investments in securities based on the future. The investors ability to guess what might happen in the future can pay off in profits to the investor. Options are used to reduce the portfolio risk from speculative investing. Futures are riskier than options but have the benefit of higher returns. In the end, the investor may decide to reduce the risk of futures and options by using managed accounts similar to mutual funds. The knowledge of the market and risk will ultimately determine the success of the investor in futures and options. However, the ability of the investor to weather volatility, tolerate risk and invest for the long term is directly tied to whether or not success will be realized.

Overview
Futures and options are financial instruments that focus on the future. Options give an investor the right but not the obligation to purchase a financial instrument at some time in the future (Kansas, 2005). Futures are contracts between two parties that give the buyer the right and obligation to purchase a financial instrument at some time in the future. Options giving the right to

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Options & Futures Markets

Essay by Marlanda English, Ph. D.

Keywords
Arbitrage Bear Market Bull Market Derivatives Futures Futures Contract Margin Call Mark to Market Market Order National Futures Association Offer Option Contract Options Groz (1999) likens options to bonds in that they have a specific, date driven end point. For bonds, this ending point is a maturity date. For options, the ending point is expiration date. Godin (2001) stated that the seller is the party that determines the expiration date and the price at which the buyer can exercise their option called the strike price. The strike price is only valid, however, if the buyer exercises the option before the expiration date. From this example, it is easy to see how dependent options are on time and how volatile options can be. An investor can make a decision that is based on the best knowledge they have available today. Yet, in an instant as soon as the next day the buyer may find that market conditions have changed dramatically. Godin (2001) found the premium or price of options to be dependent on the market demand, current stock price and the time that remains before the option expires. Options: Pros & Cons Options have benefits and drawbacks as an investment. Godin (2001) referred to options as the right to buy or sell stock at a certain price. Godin noted that many investors arent really interested in buying or selling the stock their option is based on. Instead, they use the buying and selling of the options as the investment. The downside is option volatility or the propensity to go up and down rapidly. However, when used optimally for the investors benefit, they can be used as a hedge against risk in the investors portfolio. Making Money The way buyers make money on options depends on the decisions they make about time and selling the option. For example,

a buyer purchases an option to buy called a call option. The option is purchased at a specific expiration date and strike price. If the price of that stock goes up, the buyer has some choices to make. The buyer can exercise their right to buy shares of the stock represented by the option. They can then sell the stock they purchased at the higher price since it has gone up in the market. So the goal of purchasing call options is that the stock price will rise higher than the strike price of your option. Sell options or put options work in a similar way but in a different market direction. You may purchase a put option on a stock that you expect to fall in price. If the price of the stock falls below your strike price before the option expiration date, you can exercise your right to sell shares at a higher price, thus making a profit. Risk Options offer no advantage to investors if the underlying investment, stock for example, is at the same price as the strike price because the investor can neither buy nor sell to make a profit. When an investor closes their option position, they are selling their options back to the open market in order to make a profit (Godin, 2001). Ultimately, Godin suggests that the ability to enjoy investing in options or any risky investment vehicle is directly related to how well the investor can tolerate risk and rapid changes in the market. If the investor is fearful of bear markets when prices are decreasing and often doing so rapidly, it is likely that the investor will choose to liquidate the falling investments at a loss. Similarly, Jones (2006) described a long running bull market where prices are rising. Just as a bear market might instill fear in the investor, a bull market might instill false confidence. Knowing your own ability to tolerate risk and need to avert risk can be valuable in determining the appropriate investment strategy. Investments in stock are usually for the long term but risk averse and small investors often dont have the wherewithal or the ability to tolerate periods of downturn. The basic question investors must ask themselves about options is how confident are they that a specific situation will occur in the future. Kansas (2005) notes that options are less risky than the actual stocks themselves because the most an individual might lose in a day of market activity is the initial investment made. However, Kansas also describes options investing as complex and risky requiring the investor to have education and knowledge of risk and somewhat intricate mathematical abilities. Kansas recommends options only for seasoned investors and suggests part time investors stay on the sidelines. The most volatile period for options based on stocks is the triple witching session once a quarter on the third Friday of March, June, September and December when most stock options expire on the same day (Kansas, 2005). Volatile periods are also times to avoid for novice investors. Types of Options Options are generally purchased with expiration dates of no more than a year away and often expire monthly. Other types of options include long term options, index options and futures options.
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Options & Futures Markets

Essay by Marlanda English, Ph. D.

Long term options, as the name implies, allow the investor to purchase options with expiration dates farther into the future. Index options are based on indexes such as the Standard and Poors 500. Futures options are complex options based on futures where the option itself is not an obligation to buy, but the underlying futures contract does have the obligation. Strategies for Buying Options Groz (1999) explains that options contracts require a relationship between the buyer and the seller called a zero-sum game meaning that one person wins and the other person loses. If you profit, the other player experiences losses. However, even if a player experiences a loss, the transaction may provide value to the player by reducing risk, improving the relationship between assets and liabilities, creating a position in the market or other benefits. Groz suggests five strategies called combination strategies that investors can use for options: Buy stock and buy put: For situations when the underlying asset is declining in value and the investor wants to preserve a position in the market. Buy stock and sell call: When the investor wants to get income from the underlying asset. Buy stock, buy put, sell call: A combination of the above strategies to provide insurance to the investor against loss. Straddles and strangles: Strategies for getting profit from volatility with a straddle meaning to buy puts and calls at the same price and see which one works, strangles being to buy puts and calls at different prices. Calendar spread: To spread option positions out over time providing for options that expire in the near term and those that expire in the long term and balancing profits and losses. It is clear that these strategies are not for the novice, as great losses could come just from trying to understand how to create these positions. Futures: Pros & Cons Reduced Risk Godin (2001) called futures contracts an agreement to take delivery of a specific type of commodity at a certain price sometime in the future. These contracts date back to the time when the economy was primarily agriculture-based and speculation was often based on corn, wheat and other agriculture commodities. Farmers wanted futures contracts to ensure that they would get a fair price for their commodities regardless of the conditions at the time of harvesting the product. For example, if there ended up being a glut of a certain commodity at the end of the season, the farmer might have to take lower prices for commodities without having negotiated a futures contract. Farmers can also use these contracts to raise money now while delivering the product later.

The investor may purchase the futures contract in hopes of selling the commodity at a higher price later. Early futures markets can be traced back to 18th century Japan where rice growers sold contracts to ensure certain prices. Farmers Weekly (2007) discussed how the grain market is unpredictable and how it is becoming increasingly necessary for farmers to limit the amount of risk for their own survival. Futures provide a vehicle for reducing agricultural risk. Futures Markets The biggest difference in futures and options is that futures are a promise to actually make a transaction (Morgenson & Harvey, 2002). Futures and options are part of a class of investment called derivatives because they derive their value from an underlying investment such as a stock, commodity or precious metal. Investors can find futures traded at the four major futures exchanges: Chicago Mercantile Exchange, Chicago Board of Trade, New York Mercantile Exchange and the New York Board of Trade (Kansas, 2005). Each exchange specializes in certain kinds of futures. For example, the Chicago Board of Trade specializes in corn and wheat while the New York Mercantile Exchange specializes in gold and silver. Investors can turn to online and print publications such as the Wall Street Journal to track the daily changes in the futures market. Futures markets are essential to an economy where goods are produced, bought and sold. Futures allow someone to assume risk with the promise of some reward in the future. For example, manufacturers of food products who are dependent on certain commodities may want to reduce the fluctuation of their costs due to the regular consumption of a particular commodity. Market fluctuations in the price of the commodity may adversely affect the ability of the manufacturer to make a profit. In cases like these, it is suggested that manufacturers make purchases of commodities needed in the futures market and sell futures of their finished product (Groz, 1999). This strategy provides a means of balancing out natural fluctuations. Reasons for Futures Investment Futures investing can be done by investors for speculation, insurance or both. Financial speculation is when investors venture into various financial transactions and financial instruments with the hope of receiving profits, dividends, interest and financial value from the speculative activity. Some call speculation gambling. Speculation without forethought and knowledge can be thought of as gambling. The investment in futures may be done to protect the investor against various types of risk. Hedging strategies may involve futures because the investor is trying to protect a portfolio from market volatility. However, futures are no guarantee when an investor wants to hedge. Cotter and Hanly (2006) measured five performance metrics across seven international markets and found mixed results from hedging strategies. It seems that the performance is hard to prePage 3

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Options & Futures Markets

Essay by Marlanda English, Ph. D.

dict and can be based on whether or not the investment strategy is for short or long term hedging. An arbitrage strategy may emerge because the investor sees an opportunity with futures to make money because of price differences in different markets. Investors may see these investments as a strategy for increasing or protecting an investment, but when using these complex strategies for profit Faerber (2006) found futures to be among the riskier of investments. Futures are different from stocks because they are bought on margin. Margin is the minimum amount of money an investor must have in their account to purchase or sell a futures contract. Futures seem like a feasible investment alternative because the margin requirements are smaller than those for stock purchases. Faerber (2006) describes the stock margin as 50% of the price while futures margins vary from 2 to 10%. According to Morgenson & Harvey (2002) margin allows the investor to borrow money from the broker to purchase securities. So a margin account is a combination of a loan and cash to purchase securities. According to Groz (1999), futures contracts conclude in one of two ways. The ownership of the underlying asset is transferred or a cash settlement is made. Change of ownership is called an actual delivery while a cash transaction is called a cash settled contract. Futures based on stock indexes are usually settled with cash for convenience.

strategies used if guided by a professional. Denault, Gauthier, & Simonato (2006) described a lattice strategy that examines the correlation of options prices to the underlying stock price that minimizes bias due to option pricing. Bias is noise or error in pricing estimates when basing option pricing on the underlying stock price. Denault et al also noted changes in strategy and performance based on whether the option was U.S. or foreign based. This example continues to illustrate the complexities of options investing. Tompkins (2006) discussed equally complex options investing strategies that benefit from the volatility of the European market. Various hypotheses and analysis exist about activity in the foreign financial markets, and competing strategies have emerged as a result. However, the investor may become weary of all the analysis and want to simply make an investment decision and see results. The degree of patience the investor has can also affect the returns that are experienced. Analysis of Futures Markets Faerber (2006) discusses two ways of analyzing futures markets including fundamental analysis and technical analysis. Fundamental analysis is looking at factors that influence the physical supply and demand for commodities. This type of analysis looks at production and imports of the commodity. The price is influenced by current and projected supply and demand. Technical analysis is looking at historical movements in volume and price to determine projected volumes and price. Technical analysts look at data to isolate trends and possible investment opportunities. Financial Futures Contracts Faerber suggests having a strategy before investing in futures so that when prices rise or fall, obvious action is dictated by a sound strategy. Opportunities in futures exist in what Faerber calls a growing segment of the futures market financial futures contracts. These are futures contracts representing positions in financial securities. Interest-rate futures, interest indexes and foreign currencies are examples of financial futures contracts. Interest rate futures include treasury bonds, notes and bills as well as foreign government bonds. Currency futures contracts are based on future delivery of foreign currencies such as the Japanese yen, the Swiss franc or the Mexican peso. Stock index futures are based on the Dow Jones Industrial Average or the Standard and Poors 500 index Global futures offer opportunities if investors can capitalize on trends. For example, Mohan (2007) noted that coffee is the largest trading commodity in the world primarily because of its emphasis in developing countries. Mohan projects average exports of coffee to be around $5 12 billion in the period between 1997 and 2005.
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Viewpoint
Futures & Options Trading Strategies, Analysis & Opportunities Although risky, there is growing interest in the futures and options markets. The Chicago Board Options Exchange (CBOE) is the largest options exchange and offers options on over 1200 publicly traded stocks. The CBOE has hundreds of millions of options contracts at any one time and had a net income of $18.7 million in the second quarter of 2007 (Clary). CBOE also lists long term options, index options and financial options called interest rate options. Investing in options requires knowledge of how they work, analysis of the opportunities and the development of a personal options investing strategy. This means a lot of work and study and perhaps engaging the services of a professional options trading advisor. The advantages of options are that they require a small amount of initial investment, losses are limited and options can be used in a hedging strategy to avoid large losses from unfavorable changes in stock prices. Options investors can use options as a source of income by doing what Faerber (2006) calls writing options. Writing options are simply selling call or put options and receiving income from the premiums the buyers pay. Various strategies for profiting from options may seem more like hocus-pocus than science though much analysis is scientific and professionals use complex mathematical formulas and computer analysis programs. Some investors may not even understand the

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Options & Futures Markets

Essay by Marlanda English, Ph. D.

Managed Futures Managed futures offer investment possibilities to investors who do not want to have daily responsibilities for managing their futures account. Prior to the 1980s futures investors primarily looked to futures investing for hedging purposes. Then, managed futures came into vogue. Managed futures investors employ third party financial experts to help the investor profit from fluctuations in price. Such financial experts are called Commodity Trading Advisors (CTAs). CTAs are useful for todays futures market which is increasingly diversified including global opportunities. The advantages of managed futures are increased chances of higher returns and the reduction of risk in an investment portfolio.

31, 2007, from http://www.financialweek.com/apps/pbcs. dll/article?AID=/20070730/REG/70726014/1021/TOC Cotter, J. & Hanly, J. (2006). Reevaluating hedging performance. Journal of Futures Markets, 26(7), 677-702. Retrieved September 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20854145 &site=ehost-live Denault, M., Gauthier, G. & Simonato, J. (2006). Improving lattice schemes through bias reduction. Journal of Futures Markets, 26(8), 757. Retrieved September 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bt h&AN=21395447&site=ehost-live Faerber, E. (2006). All about investing: the easy way to get started. New York: McGraw-Hill. Godin, S. (2001). If youre clueless about the stock market and want to know more. Chicago: Dearborn Trade Books. Groz, M. M. (1999). Forbes guide to the markets: becoming a savvy investor. New York: John Wiley and Sons. Jones, G. (2006). A time to sell? Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders, 35(9), 26. Retrieved September 30, 2007, from EBSCO Online Database Business Source Complete. http://search. ebscohost.com/login.aspx?direct=true&db=bth&AN=2155 8566&site=ehost-live Kansas, D. (2005). The Wall Street Journal: complete money & investing guidebook. New York: Three Rivers Press. Learn with us how to profit from risk. (2007). Farmers Weekly, 146(13), 3. Retrieved September 30, 2007, from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bt h&AN=24823427&site=ehost-live Mohan, S. (2007). Market-based price-risk management for coffee producers. Development Policy Review, 25(3), 333354. Retrieved September 30, 2007, from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=24977055 &site=ehost-live
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Conclusion
Futures and options are risky but offer rewards. They are complex but can be managed using various strategies and financial advice. The ultimate test of whether or not an investor can profit from options and futures rests with the discipline the investor has in the approach to the market, if the investor can weather volatility storms and the consistency of strategy and investing.

Terms & Concepts

Arbitrage: Technology applied to business for processing data and transferring information. Bear Market: A financial situation where the market sees falling prices. Bull Market: A market where prices are increasing. Futures Contract: A legal contract to buy or sell a commodity in the future. Margin Call: A call to customers with brokerage accounts to require them to bring their account balance up to the required minimum. Mark to Market: A daily debiting or crediting of a margin account based on the close of the daily trading session to avoid contract default. Market Order: An order to buy or sell a futures contract at whatever price is currently available. National Futures Association: A self regulatory industry organization enacted by Congress in 1974. Offer: A willingness to sell a futures contract at a specific price. Option Contract: A contract where the buyer has the option but not the obligation to buy a futures contract at a specified time for a certain price.

Bibliography
Clary, I. (2007, July 30). As exchanges merge, Chicago options mart is in catbird seat. Financial Week. Retrieved October

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Options & Futures Markets

Essay by Marlanda English, Ph. D.

Morgenson, G. & Harvey, C. R. (2002). The New York Times dictionary of money investing. New York: Times Books. Tompkins, R. (2006). Why smiles exist in foreign exchange options markets: Isolating components of the risk neutral process. European Journal of Finance, 12(6/7), 583-603. Retrieved September 30, 2007, from EBSCO Online Database Business Source Complete http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22342966 &site=ehost-live

McMahon, C. (2007). Options on futures: At the tipping point? Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders, 36(4), 54-56. Retrieved September 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/ login.aspx?direct=true&db=bth&AN=24751952&site=bs i-live Overview of derivatives. (2007, May 1). Federal Reserve Bulletin, A3. Retrieved September 30, 2007, from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a 9h&AN=26023447&site=ehost-live Profitable futures helping farmers turn industry challenges into financial reward. (2007). Farmers Weekly, 146(26), 25. Retrieved September 30, 2007, from EBSCO Online Database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=25912098 &site=ehost-live

Suggested Reading
Colon, S. (2006). Futures and options interns get taste of the market. Bond Buyer, 357(32447), 6. Retrieved September 30, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=t rue&db=bth&AN=22032593&site=bsi-live

Essay by Marlanda English, Ph. D.

Dr. Marlanda English is president of ECS Consulting Associates which provides executive coaching and management consulting services. ECS also provides online professional development content. Dr. English was previously employed in various engineering, marketing and management positions with IBM, American Airlines, Borg-Warner Automotive and Johnson & Johnson. Dr. English holds a doctorate in business with a major in organization and management and a specialization in e-business.
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