Reference manual futures options

Level Diploma in Applied Financial Trading Introduction to Futures & Options Trading -Course Manual Introduction to Futures Markets • Definition of a futures contract • Futures market jargon Profit and Loss Profiles • Long position profile • Short position profile Closing Out • Definition • Process Futures uses • Speculation • Hedging • Arbitrage Yield Curves • Normal • Inverted • Flat 1|Page ReferenceManual–Futures&Options Futures Pricing Fair Value • Calculation of fair value • Cash and carry and Reverse cash and carry arbitrage • Concept of convergence Basis • How to calculate basis • The effect of basis strengthening and weakening on hedging strategies • Contango & Backwardation Options • The basic mechanics of options from the buyer's & seller’s viewpoint • The difference between a future and an option • Terminology surrounding options contracts • The four basic options positions • Profit and loss profiles for call & put options • Option uses – speculation, hedging & arbitrage What is a Future? A futures contract is a legally binding agreement between a buyer and seller to buy or sell a particular asset (e.g shares, bonds, FX, etc.) or an index representing such assets at some time in the future, at a price agreed today The asset is called the “underlying” If you buy a future you have entered into an agreement to buy the underlying at some time in the future, at a price agreed today If you sell a future you have entered into an agreement to sell the underlying at some time in the future, at a price agreed today Note that the terms and conditions of the future transaction (i.e price, size, quality, etc.) are agreed in advance (i.e now) All futures are exchange-traded contracts and they're standardised in terms of: • Delivery date (or “expiry”) • Amount of the underlying they relate to • Contract terms 2|Page ReferenceManual–Futures&Options Futures contracts can be cash settled or require physical delivery Most equity futures are cash settled, which means the contract requires a cash amount to be paid on the settlement day, reflecting the difference between the initial futures price and the price of the underlying share or index when the futures contract reaches maturity Futures contracts can also be freely bought and sold before the contract expires (i.e before the point at which the underlying must be delivered or the contract cash settled) The value of the contract fluctuates before the settlement date to reflect the changing price of the underlying Also note that futures are geared (or leveraged) instruments, since positions can be taken in the underlying instrument by means of a relatively small cash outlay, called the “margin” Example: FUTURES CONTRACT Buyer (Long position) Seller (Short position) I agree to buy 1,000 barrels of oil from you in months time at $100 a barrel I agree to sell 1,000 barrels of oil to you in months time at $100 a barrel Note that nothing is bought, sold or delivered today – this is simply an agreement to complete a transaction at a future date Futures Jargon Futures contract A futures contract is an agreement to buy or sell a specified quantity of a specified asset on a specified future date at a price agreed today Futures contracts are traded on derivative/futures exchanges around the world and their terms and conditions are standardised The standardised terms or contract specifications are determined by the relevant exchange (e.g CME, CBoT, etc.) Usually, a contract specification includes: • • • Quantity of the underlying Quality of the underlying Time and place of delivery Advantages • Liquidity - Since the terms and conditions of the contract are standardised, futures markets are very liquid, so futures can be easily traded by many participants and hence it's easy to open and close positions • Gearing or Leverage - You can buy exposure to price movements in a large amount of a given underlying with a relatively small outlay • Fixed contract size • Shorting - You can take long or short positions – i.e you can sell a future short with the intention of benefiting from a future fall in price 3|Page ReferenceManual–Futures&Options Disadvantages Inflexibility – The fact that futures are standardised (fixed price, expiry, etc.) means that futures are not flexible for people wanting slightly different conditions Forwards are used in these cases Long Position By taking a long futures position, you are committing to take delivery of the underlying (or its cash value at maturity) on a certain future date Taking a long position indicates you think the value of the future will increase You can close out your position at any time by selling your futures position (either for a profit or a loss, depending on the current price) Example: If you bought a futures contract at £10 and its price increased to £12, your profit is £2, but if it fell to £8 you would make a loss of £2 Note: Unlike shares, you don't pay the full price when you open the contract You only pay a small percentage of the actual value of the underlying, called “margin” In this case, £10 is simply used as a reference price to calculate your profit or loss Short Position If you think the value of the future will fall, then you should take a short position, thus committing yourself to deliver the underlying (or its cash value at maturity) on a certain future date You can close out (or “cover”) your short position at any time by buying the same number of futures contracts Depending on the movement of the price, you may realise a profit (if the future price has declined) or loss (if the price has risen) Example: If you sold short a futures contract at £10 and its price increased to £12, your loss is £2, but if it fell to £8 you would make a profit of £2 Underlying Asset The value (or price) of a future is derived from the value of the underlying asset The underlying asset is often referred to as the “underlying” or cash or spot asset Futures are derived from various underlyings, such as currencies, bonds, equities, live cattle, crude oil, etc Delivery Date The delivery date is the expiry date of the future i.e the date on which the agreed transaction will take place Contingent Liability A contingent liability transaction describes a derivative position where an investor may lose more money than they originally invested All futures transactions are contingent liability transactions 4|Page ReferenceManual–Futures&Options Basis Basis quantifies the difference between the cash price of an underlying asset and its futures price BASIS = CASH PRICE - FUTURES PRICE Basis is usually negative because the futures price is usually higher than the cash (underlying) price This is due to costs of carry (to be explained later) The calculation of basis is also referred to as “crude basis” and it is possible to “trade basis” This means an investor takes a position in both the future & the underlying (e.g long underlying, short future) to try to take advantage of fluctuations in basis Contracts for Difference (CFD’s) Many futures are physically settled, which means that the underlying asset is actually delivered at expiry E.g The Long Gilt contract on NYSE.liffe or the Natural Gas contract on ICE Futures A CFD is a term describing a cash settled derivative in which no physical delivery actually takes place Instead, the contract is settled for the difference between the agreed price and the settlement price E.g Equity index futures contracts A spread bet is a type of CFD available outside a formal exchange-based framework from companies such as FXCM, CMC Markets, City Index, IG Index and many others The concept of a spread-bet is exactly the same as a future, i.e a position is taken depending on what you think will happen to the price of the underlying, such as the FTSE Index, cricket scores or even the number of Oscars a film might win Forwards A forward transaction is similar to a futures transaction except that a forward is not dealt on an exchange It is called an over-the-counter or “OTC” transaction (as opposed to futures contracts which are always exchange-traded transactions) Forwards are individually negotiated between two parties, enabling greater flexibility Advantages • Flexibility – Forwards allow the parties to set up any contract specifications that are mutually acceptable (e.g exact size, specific expiry date, etc.) Disadvantages • Direct Counterparty Risk – Since there is no central counterparty (i.e an exchange) or collateral payment, it is vital that the creditworthiness of both counterparties is good Illiquidity – Since forwards are individually negotiated (i.e non-standardised), they are not tradable This makes them difficult to value since price information is not always available • Examples of OTC deals: • • Forward rate agreements (FRA’s): a forward applied to interest rates Swaps: a forward applied to the exchange of one series of future cash flows for another Margin Trading Futures contracts offer geared or leveraged market positions What does this mean in practice? 5|Page ReferenceManual–Futures&Options If you buy a FTSE 100 Index Future at 5922, your market exposure is £59,220 (5922 x £10), but you don't have to pay this sum to open the position Instead, you pay what's called an 'Initial Margin' effectively a deposit - which is a fixed amount per contract based on the likely maximum overnight movement in the contract's price, known as the “scanning risk” In addition to the initial margin, each night your position is "marked to market" This means that the daily change in contract value is credited to or debited from your account, so your total margin requirement is made up of two elements: TOTAL MARGIN = INITIAL MARGIN + VARIATION MARGIN Initial Margin When you buy or sell a futures contract from a broker, in practice, the broker has an agreement with the Clearing House and you have an agreement with the broker There are pre-defined formulae for how much margin the broker is liable to pay the Clearing House, but the initial margin the broker charges you is at their discretion (over and above the Clearing House requirement) Your broker will probably want to see a sum in your account in excess of the initial margin in order to cover daily margin fluctuations Since October 2000 the initial margin charge for the standard FTSE 100 Index Future has been £3,000 (or 300 points, as this contract is valued at £10 per full index point), and £1,500 for the FTSE 250 future This represents the maximum anticipated overnight change in the contract's price Variation Margin Once you've bought or sold the contract, your position is marked to market against the daily settlement price and running profits are either added to your account or must be paid out This is called Variation Margin The settlement price on an exchange is the closing price at the end of the trading day, ignoring any prices during any extension of trading, such as after-hours trading Variation margin is paid by the loser of an open position and received by the winner of another open position The payment is made by the next business day through a protected payment system like LCH.Clearnet's PPS When you come to "close out" your position (by selling if you are long, or buying back if you are short) the initial margin is refunded and the net profit or loss is realised The majority of your profit or loss will probably already be in your account with the broker, as it's been adjusted on a daily basis The balance for the day should be received the following morning Example: • • • • Two FTSE 100 Index contracts were bought at 5922 We'll assume here that the initial margin charge is £3000 per futures contract, so you've got to pay £3000 per contract to cover the risk of holding the position overnight At the end of the day, the futures price has risen to 5930 Your position is "marked to market" against the settlement price and has accrued points in profit (5930 - 5922), multiplied by two contracts This will be received into your account in the form of variation margin ACTION 6|Page CALCULATION PRICE CASHFLOW ReferenceManual–Futures&Options Buy futures 5922 (offer) Deposit initial margin -(2 x £3000) -£6000 Receive variation margin +8 x £10 per point x +£160 Let's assume that the following day, the futures price rises again, this time by 50 points to 5980 The variation margin now due to you is 50 x £10 x contracts ACTION CALCULATION PRICE Buy futures CASHFLOW 5922 (offer) Deposit initial margin -(2 x £3000) -£6000 Receive variation margin +8 x £10 per point x +£160 Receive variation margin +50 x £10 per point x +£1000 On the third day the price starts slipping and you decide to take profits at a futures price of 5960 Since this price is 20 points lower than the previous day’s settlement price, you are liable for 20 x £10 x contracts in variation margin ACTION CALCULATION PRICE Buy futures CASHFLOW 5922 (offer) Deposit initial margin -(2 x £3000) -£6000 Receive variation margin +8 x £10 per point x +£160 Receive variation margin +50 x £10 per point x +£1000 Sell futures 5960 (bid) Refund initial margin x £3000 +£6000 Pay out variation margin -20 x £10 per point x -£400 NET P/L +£760 Summing the cash flows over the holding period gives the net profit or loss on the contract, in this case +£760 Notice that you’d get the same result by simply subtracting the selling price from the buying price and multiplying by the value per point and the number of contracts (the margining system has just meant that gains/losses are received or paid out as they accrue) i.e Sold price (5960) - Bought price (5922) = 38 38 Points x £10 per point x contracts = £760 7|Page ReferenceManual–Futures&Options Assuming commissions of £10 per contract on both the buying and selling legs, total commissions in this case would be £40, so your profit after commissions is reduced to £720, a net return of just over 12% over days on your initial margin of £6000 Profit and Loss Profiles Profit and loss profiles, called “payoffs”, show graphically the gains and losses to be made by different derivative positions To demonstrate how profit and loss profiles are constructed the illustrations below use a futures contract on wheat Note the profit and loss profile on a forward would be the same In order for a futures trade to occur, two parties must have equal and opposite opinions as to what will happen to the price of the underlying Long Profile Analysis A bullish investor agrees to buy a tonne of wheat in one month's time for £160 by taking a long futures position The buyer will make profit if, on expiry, the price of wheat is more than £160 (and the higher the price at expiry, the greater the buyer’s profit) However, if the underlying is trading below £160 at expiry, then the buyer is still obliged to pay £160 for the wheat, even if it the underlying price is less than £160 Hence the buyer will make a loss However, the buyer can decide to sell their position at any time, realising a profit or loss depending on the current price of the underlying (and hence the current price of the future) Summary • • Maximum gain – unlimited Maximum loss - the price of the future itself Short Profile Analysis A bearish investor agrees to sell a tonne of Wheat in one month's time for £160 by taking a short futures position The p&l profile for the short position is the mirror image of the long position The seller will make profit if the price of wheat at expiry is less than £160 (and the lower the price of the underlying at expiry, the greater the seller’s profit) If the price is above £160 at expiry, then the seller makes a loss We assume here that the short position does not already own the cocoa (i.e an uncovered futures position) This means that, on expiry, the seller must cover their short position by buying cocoa in the cash market at the prevailing market price 8|Page ReferenceManual–Futures&Options This may sound strange, but one of the features of futures trading is the ability for an investor to agree to sell something they not yet own Also note, however, that the seller may decide to cover their position at any time, realising a profit or loss depending on the current price of the underlying (and hence the current price of the future) 9|Page ReferenceManual–Futures&Options Summary • • Maximum gain – the price of the future itself Maximum loss – unlimited Profit and Loss Profiles Summary Position Maximum Gain Maximum Loss Long futures Unlimited Limited to the price of the future Short futures Limited to the price of the future Unlimited Long & short positions are mirror images of each other Whatever amount the long position gains, the short position loses (& vice versa) This is why futures contracts are sometimes called a “zero sum game” Closing Out An investor with an open futures position, either long or short, has two choices: • • To hold the future to expiry and then take (or make) delivery of the underlying (or cash in the case of a CFD) To sell (or buy) the future before the expiry date This is known as CLOSING OUT Closing out is done by entering into an equal and opposite contract in order to offset the terms of the first Example Step 1: Trader A thinks the price of gold will rise, so agrees to buy 100 ounces of gold from Trader B, to be delivered in months' time, at $1675 per ounce (i.e Trader A buys a gold future for $1675) Trader A is now long at $1675 and Trader B is short Step 2: The price of gold rises, pushing up the future's price to $1690 Trader A has two options: a Keep his position open and run the risk of the price falling back down again, or b Cash in on his profits by closing out his position Trader A decides he wants to take profit and sells a gold future to Trader C for $1690 Trader A is now “square” since he has agreed to buy from B at $1675 and sell to C at $1690, so he’s locked in a profit of $15 per ounce and in months' time B will deliver the gold directly to C Trader A is now square, Trader B is still short at $1675 and Trader C is long at $1690 10 | P a g e ReferenceManual–Futures&Options Inverted Yield Curve An inverted yield curve is one in which the shorter-term yields are higher than the longerterm yields (i.e An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the same credit quality) This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession Partial inversion occurs when only some of the shorter term Treasuries have higher yields than the longer term Treasuries (e.g Five or 10 year yields may be higher than 30-year Treasury yields) An inverted yield curve is sometimes called a "negative yield curve" Historically, inversions of the yield curve have preceded many of the U.S recessions Due to this historical correlation, the yield curve is often seen as an accurate forecast of the turning points of the business cycle A recent example is when the U.S Treasury yield curve inverted in 2000 just before the U.S equity markets collapsed An inverted yield curve predicts lower interest rates in the future as longer-term bonds are being bought, sending the yields down Flat Yield Curve A yield curve in which there is little difference between short-term and long-term rates for bonds of the same credit quality This type of yield curve is often seen during transitions between normal and inverted curves 17 | P a g e ReferenceManual–Futures&Options When short and long term bonds are offering equivalent yields, there is usually little benefit in holding the longer-term instruments - that is, the investor does not gain any excess compensation for the risks associated with holding longer-term securities For example, a flat yield curve on U.S Treasuries would be one in which the yield on a twoyear bond is, say, 3% and the yield on a 30-year bond is 3.1% Examples of Yield Curves The following table gives UK Gilt and US Treasury rates as of 2nd December 2013: UK Gilt US Treasury month month year year year 10 year 30 year - 0.37 0.42 0.43 1.06 2.19 3.36 0.08 0.11 - 0.29 0.86 2.00 3.15 Here are the corresponding yield curves as of 2nd December 2013: 18 | P a g e ReferenceManual–Futures&Options 4.00% 3.50% 3.00% 2.50% UK Gilt 2.00% US Treasury 1.50% 1.00% 0.50% 0.00% month month year year year 10 year 30 year Futures Pricing The price of a future is not the expected price of the underlying asset in the future – it is actually strongly correlated to the cash (or spot) price of the underlying asset today The “Fair Value” of a future is actually equal to the cash price plus the costs of carry (e.g The fair value of a 3-month copper future equals the cost of copper today plus all the costs associated with holding the copper for three months, such as storage, insurance & finance charges) The fact that fair values are calculated this way is based upon an arbitrage argument called “Cash & Carry” Cash & carry (and reverse cash & carry) ensure that futures always trade at, or around, their fair values As the future reaches expiry, it follows that there will be less costs of carry, so the price of a future converges towards the cash price over time The property of convergence introduces the concept of the “Arbitrage Channel” Other terms will be defined below such as Basis, Contango and Backwardation It will also be explained how 'basis risk' is unavoidable and is likely to prevent a person from carrying out a perfect hedge 19 | P a g e ReferenceManual–Futures&Options Fair Value The fair value of a future is its theoretical value and is derived from the value of the underlying asset FUTURES FAIR VALUE = CASH PRICE OF UNDERLYING + NET COST OF CARRY Commodities Future Example: Consider a 3-month future on one tonne of wheat Assume that interest rates are currently 1% and storage and insurance costs are 80p per tonne per month Cash/spot price: £65/tonne Interest rates: Storage & insurance: 80p/tonne per month Delivery date: months 1% p.a months of lost interest = £65 x 0.01 x 3/12 = 16p Storage & insurance for months = 80p x = £2.40 Therefore, Fair Value for 3-month delivery = £65 + £2.56 = £67.56 Financial Future Example: This is considered slightly differently For a 3-month FTSE 100 index future… FTSE 100 index price: 5500 Interest rates: 1% p.a Storage & insurance: N/A Delivery date: months In this case there are no storage or insurance costs, but there will be a benefit of holding the constituent shares of the index (in the form of dividends paid out) that will not be gained by holding the future This “dividend yield” also needs to be taken into consideration (i.e subtracted) Dividend Yield: 2% p.a Fair Value calculation: Buy constituents of the Index today: 5500pts Cost of months lost interest: 5500pts x 0.01 x 3/12 = 13.75pts Benefit of holding shares for months: 5500pts x 0.02 x 3/12 = (27.5pts) So, Fair Value for 3-month delivery = 5500 + 13.75 – 27.50 = 5486.25 Note that since the FTSE100 Index future has a tick size of 0.5pts, this fair value would be rounded to the nearest half point (i.e 5486pts) The fair value is still the cost of the cash index plus the cost of carry, but really this is a net cost of carry (cost minus benefit) Notice here that since the net cost of carry is negative (as the benefit of holding the shares outweighs the cost of buying them), the theoretical fair value of the month future is below the cash index price 20 | P a g e ReferenceManual–Futures&Options Contango and Backwardation In the first example of fair value (above), the future was valued above the cash price of the asset on which it was based This is normal In this case the market is described as being in “Contango” In the second example, the future was valued below the cash price This is unusual, but not impossible In this case the market would be described as being in “Backwardation” Cash & Carry Arbitrage A cash & carry arbitrage opportunity arises when a futures contract trades above its fair value Such a situation arises because the real world does not always follow theoretical models and futures not always trade at their fair value The theoretical fair value for a three-month wheat future has been calculated (above) at £67.56 per tonne Suppose the future was actually trading on NYSE.liffe at £69 per tonne, (perhaps due to a temporary shortage of sellers, which has pushed the future price above its fair value) An arbitrageur will quickly spot an opportunity to profit by exploiting the inconsistency between the cash/spot price of the underlying and the future's price The arbitrageur will therefore buy wheat today (in the cash market) and hold it for months at a total cost of £67.56 At the same time he will sell the wheat future at £69, making a guaranteed profit of £1.34 per tonne However, as soon as the rest of the market sees this price discrepancy between the cash and future prices, the opportunity for arbitrage profits will disappear The two prices are (very quickly) brought back into line with each other and the future will once again trade at, or around, its fair value Reverse Cash & Carry Arbitrage Reverse cash & carry arbitrage opportunities arise when the future is trading below fair value This is the exact opposite of cash & carry arbitrage The arbitrageur sells the cash asset and buys the futures contract in order to exploit the differential in price In view of the complications of selling something in the cash markets that you not already own, this sort of activity is limited to institutional investors rather than private individuals 21 | P a g e ReferenceManual–Futures&Options Convergence Convergence describes the fact that at expiry the cash price of the underlying asset and the future's price will be the same As the fair value of a future is equal to the spot price plus the costs of carry, it follows that the nearer the future gets to its delivery date the less the costs of carry Therefore, as the delivery date approaches, the cash price of the underlying and the future's price will converge Eventually, at the delivery date, the costs of carry will be zero and the future's price will be the same as the cash price If we assume that the cash price of the underlying asset stays constant over time, convergence can be illustrated diagrammatically as follows: Basis: introduction Basis is the difference between the cash price of the underlying asset and the future's price As the actual price of a future is rarely equal to its fair value, it would be inaccurate to describe the difference between the future's price and the cash price as merely comprising the costs of carry However, note that, if the future IS trading at its fair value, then basis DOES equal the costs of carry BASIS = CASH PRICE – FUTURES PRICE Note that Basis is usually negative because the futures price is usually higher than the cash (underlying) price Contango Contango means that basis is NEGATIVE, i.e the cash price is less than the price of the future As the future's price indicates the costs of carry, basis is usually negative and the market is described as contango Negative basis is the norm when there is adequate supply, i.e 'far' prices (future prices) are higher than 'near' prices (spot prices) Another term for contango is PREMIUM Backwardation ('back') Backwardation means that basis is POSITIVE, i.e the cash price is greater than the price of the future This might occur, for example, if there were a temporary shortage of the underlying, which would push up the cash/spot price today and produce a BACK market Backwardation can also occur where there is an overall benefit of carry rather than a cost of carry This could arise where the dividend yield on an equity or equity index is above interest rates Another term for backwardation is DISCOUNT 22 | P a g e ReferenceManual–Futures&Options Background The value of basis is constantly changing over time Assuming a contango market, basis either WEAKENS (widens) or STRENGTHENS (narrows) Basis weakening/widening Basis weakening/widening means that the cash price of the underlying is DECREASING relative to the future's price To illustrate, consider the difference between the cash price and the futures price at two different moments in time, T1 and T2: Basis strengthening/narrowing Basis strengthening/narrowing means that the cash price of the underlying is INCREASING relative to the future's price Consider another two moments in time, T1 and T2, and the difference between the cash price and the future's price Basis risk Basis behaviour (i.e whether it strengthens or weakens) is unpredictable Unpredictability leads to uncertainty and uncertainty leads to risk Basis risk and hedging The fact that basis is constantly changing, i.e strengthening or weakening, has an effect on hedging strategies Although hedging removes most of the risk associated with changing prices, it will not eliminate basis risk For example, consider a farmer who produces wheat at £70 per tonne He enters into a short hedge by selling a wheat future at £80 Scenario 1: basis does not change (a perfect hedge) Imagine that, by the time the farmer comes to sell the wheat (T1), the cash price has fallen to £60 per tonne and the future's price has also fallen to £70 per tonne 23 | P a g e ReferenceManual–Futures&Options Scenario 2: basis weakens Consider what the situation would have been had the cash price fallen by £10 and the future's price fallen by £9 When the farmer sells the wheat and closes out the hedge, the overall position is now different 24 | P a g e ReferenceManual–Futures&Options Scenario 3: basis strengthens Consider what the situation would have been had the cash price fallen by £10 and the future's price fallen by £11 When the farmer sells the wheat and closes out the hedge, the overall position is now different again The profit on the future (£11) is greater than the £10 loss on the cash position Conclusion Basis uncertainty results in imperfect hedging strategies Basis trading Basis trading can also be used for SPECULATIVE purposes In this situation, the trader is attempting to profit from expected changes in the relationship between the futures price and the cash price For example, consider a situation where a zinc trader is expecting a strengthening basis - see table above In this circumstance, the trader would BUY cash zinc at £30 per tonne and go SHORT on a zinc future at £32 per tonne Assuming that the basis strengthens, a profit would be made when the zinc is subsequently sold and the futures position is closed out The basis trade described above is referred to as BUYING basis The name of the trade takes in itself from the cash position Conversely, if it were expected that basis would weaken, the appropriate trade would be to sell cash zinc, buy zinc future This would be called 'selling basis' 25 | P a g e ReferenceManual–Futures&Options Options At a basic level, options are really quite easy to understand To illustrate the basics of options, let’s compare it with a familiar financial product, car insurance Illustration: An insurance buyer You buy a new car and want to insure it against damage and theft You therefore pay a premium to an insurance company to protect your car The premium you pay gives you the right to call on the insurance company if your car is damaged or stolen If nothing happens to the car, then you lose the premium, so the most you can lose is the premium itself i.e The extent of your liability is capped at the premium paid However, if your car is damaged, you can get the insurance company to pay The costs can be substantial, so the upside potential of the policy can far outweigh the initial premium In effect you have bought an option from the insurance company giving you the right (but not the obligation) to call on the insurance company if required • The maximum you can lose is the premium • The maximum gain, however, may be much bigger An insurance seller The insurance company sells an insurance product and in return receives the premium Their maximum gain is the premium itself, but if there is a claim on the policy, the potential loss can be substantial, since the company is obliged to pay out any valid claims i.e the company has a contingent liability The position of the insurance company is exactly equal and opposite to you, the policy holder Option Definition An option gives the buyer the right (but not the obligation) to buy or sell a specified quantity of a specified asset at a fixed price on (or before) a specified future date Similar to futures, the terms and conditions are specified by the relevant exchange to ensure the contract has liquidity in the market Difference between Futures and Options There are a number of differences between futures and options: • Futures – Both the buyer and seller have an obligation to buy/sell the underlying • Options – The buyer has a choice, but and the seller has a (potential) obligation • An option buyer pays a premium to the seller • There is no premium to pay when buying futures Options When describing an option, the following details are required: • The underlying asset (e.g Wheat) 26 | P a g e ReferenceManual–Futures&Options • Expiry date (e.g September 2012) • Exercise price (e.g $120) • Whether the option is a call or a put This would be described as 'Wheat September 120 put' Terminology Call option - The right to BUY the underlying asset Put option - The right to SELL the underlying asset Exercise (or strike) price - The price at which the option specifies the underlying asset may be bought (or sold) Premium - The premium is the price paid for the option The holder - The buyer of an option (long position) The writer - The seller of an option (short position) Expiry date - The last day on which the holder can exercise their rights European style option - May only be exercised on the expiry date They are traded on exchange and OTC American style option - May be exercised at any time, up to and including the expiry date They are traded on exchange and OTC Due to the extra flexibility, American options tend to be more expensive than European style options The term 'American style' has no geographical significance Bermudan style option Bermudan style options may be exercised on the expiry date and on a range of specified dates before expiry This makes the option rather like a hybrid of a European style and an American style option – hence the name: Bermuda is somewhere between America and Europe These are traded OTC Asian style option Asian style is not a description of when the option can be exercised, rather it describes at what strike price they will be exercised Asian style options may be exercised at an average underlying price over a set period of time The set period of time will be specified by the exchange that they trade on, or agreed on by the counterparties involved in OTC transactions They are traded on exchange and OTC A Traded Average Price Option (TAPO) is an Asian style option traded on the London Metal Exchange Note the terms “European”, “American”, “Bermudan” and “Asian” have no geographical significance Flex contracts Flex contracts are options that provide users with the ability to negotiate the maturity, exercise price and exercise style of a contract This is an exchange traded contract that has added flexibility, thus bringing it closer in structure to an OTC option As time passes they are becoming increasing popular among investors on exchange and most exchanges are creating a flex option on their major contracts Barrier (knock-out / knock-in) option A barrier option is one where the option to exercise is activated or deactivated when the underlying reaches a pre-specified barrier This will restrict the right to exercise for the holder of the option and will consequently lower the premium on the option These are traded OTC Contingent liability transactions A contingent liability transaction is a derivative position where the investor may lose more money than originally invested 27 | P a g e ReferenceManual–Futures&Options Selling/writing option contracts are contingent liability transactions Buying/holding options are NOT contingent liability transactions as an investor's maximum loss is limited to the original premium paid Contracts for differences (CFD) A contract for difference is an option which is cash settled as opposed to there being any exchange of the underlying asset Gearing/Leverage Options (and futures) are highly geared (or LEVERAGED) products The upside effect of gearing is that you can make a much greater return on your investment by buying the derivative as opposed to buying the underlying asset This is because an option (or future) provides the ability to control a much more expensive asset for a low or nil cost For example, consider buying an option on Big Co plc for, say, a premium of £1 per share The underlying share price of Big Co plc is £10 Now assume that at expiry the share price is £11 and the option is worth £2, i.e both the underlying and option have increased by £1 If you had bought the underlying share you would have made a 10% return on your investment (£1/£10 x 100%) While a 10% return is nothing to be ashamed of, look at the return you would have made by buying the option… 100%! (£1/£1 x 100%) Of course, there is a downside to gearing It is also possible to lose much more from a geared product compared to the cash position Reconsider the above example, but this time let’s assume that both the option and the underlying share DECREASE by £1 each In this scenario, you would have lost 100% of your investment by buying the option, but only 10% of your initial investment if you had bought the underlying instead Note: The above example is not very realistic as it assumes the cash price and the option price each move by the same amount In the real world this will not necessarily be the case However, although the example above exaggerates the effect, it DOES illustrate the concept of a geared product In summary, gearing should be treated with great caution by investors It should only be undertaken by investors who fully understand the downside as well as the upside of geared products Profit and Loss Profiles There are four basic option positions that can be taken: Long call - the right to BUY the underlying Short call - the potential obligation to SELL the underlying Long put - the right to SELL the underlying Short put - the potential obligation to BUY the underlying The profit and loss (or PAYOFF) profiles described here represent uncovered positions (also called naked positions, meaning the option writer does not actually own the underlying asset The other assumption is that all options are European style (only exercisable on the expiry date) Long Calls You buy a call option if you think the price will rise 28 | P a g e ReferenceManual–Futures&Options To buy a call option, the buyer pays a premium (in this case 10p) and is then granted the right to buy the underlying asset on expiry (if they wish) For example, a call option on shares of ABC plc is bought at a premium of 10p with strike price of £1 (i.e The long has bought the right to buy a share in ABC plc for £1 and has paid 10p for this right.) If ABC shares are trading below the strike price (100p) at expiry, then the long will simply abandon the option & forfeit the premium of 10p If ABC shares are trading at, say, £1.05 at expiry, then the long will exercise the option and buy the shares at £1, but will actually lose 5p on the overall deal because they already paid a 10p premium If ABC shares are trading at £1.10 at expiry, then the long will exercise the option, but will only break even on the deal If ABC shares are trading at, say £1.40 at expiry, then the long will exercise the option, buy the shares for £1 and make a net profit of 20p The higher the share price of Alaska plc, the more profit the long will make Buying call options is a BULLISH strategy Short call positions The short call's profit and loss profile is the mirror image of the long call When the long wins, the short loses, and when the long loses, the short wins Example In the previous example, the short sold the long a call option on a share in Alaska plc at a premium of 10p and a strike price of £1 In other words, the short has the obligation to sell a share in Alaska plc for £1 should the long exercise their right to buy The profit and loss profile for the short may also be illustrated graphically Points to note The maximum gain a short call can make is the premium (in this case 10p) The maximum loss a short call can incur is unlimited The more the price of the underlying rises, the more the short call loses Being short a call option is a contingent liability position With call options (either long or short), the breakeven point is the strike price plus the premium Being short a call is a BEARISH/NEUTRAL strategy This strategy is often known as naked call writing Long put positions A long put gives the buyer the right to sell the underlying asset at an agreed price on expiry 29 | P a g e ReferenceManual–Futures&Options Example A put option on a share in Phoenix plc is bought by a long (from a short) at a premium of 60p The strike price is £2 The long now has the right to sell a share in Phoenix plc for £2 and has paid 60p for this right The profit and loss profile for such a position may be illustrated graphically Points to note The long will abandon the option if shares in Phoenix plc at the expiry date are trading above the strike price of £2 This will result in losing the 60p premium However, they cannot lose any more than 60p If, at expiry, the share price of Phoenix plc is £1.40, the long could buy the shares in the open market for £1.40 and then exercise the option to sell at £2 The 60p profit made on the share deal is offset by the 60p premium they have already paid, so in fact they break even If, at expiry, the share price of Phoenix is £nil, then the long can buy the shares for nothing and immediately exercise the option to sell at £2 (making a £2 profit minus the 60p premium) The lower the share price of Phoenix plc at expiry, the more profit the long will make However, there is a limit to the maximum profit as the share price can only go down to £nil The maximum profit a long put position can therefore make is the strike price less the premium Buying put options is a BEARISH strategy Short put positions The short put's profit and loss profile is the mirror image of the long put When the long wins, the short loses, and when the long loses, the short wins Example In the previous example, the short sold the long a put option on Phoenix plc shares at a premium of 60p and a strike price of £2 The profit and loss profile for the short can be illustrated graphically The short will have an obligation to buy a share in Phoenix plc, should the long exercise their right to sell Points to note The maximum gain a short put can make is the premium (in this case, 60p) The maximum loss a short put can incur is the strike price less the premium Although the potential loss is not unlimited, a short put is still a contingent liability transaction, as losses may keep rising should the price of the underlying continue to fall For put options, either long or short, the breakeven point is the strike price less the premium Being short a put is a BULLISH/NEUTRAL strategy Option profit and loss profiles: summary 30 | P a g e ReferenceManual–Futures&Options Position Strategy Max Loss Max Gain Breakeven Long Call Bullish Premium Unlimited Strike plus premium Short Call Bearish/Neutral Unlimited Premium Strike plus premium Long Put Bearish Premium Strike minus premium Strike minus premium Short Put Bullish/Neutral Strike minus premium Premium Strike minus premium 31 | P a g e ReferenceManual–Futures&Options ... hoped Share A futures loss: (£5.46 - £6.75) x x 1000 = (£2,580) Share B futures gain: (£4.50 - £3.44) x x 1000 = £3,180 So net profit = £600 15 | P a g e ReferenceManual Futures& Options Yield... called 'selling basis' 25 | P a g e ReferenceManual Futures& Options Options At a basic level, options are really quite easy to understand To illustrate the basics of options, let’s compare it with... (5930 - 5922), multiplied by two contracts This will be received into your account in the form of variation margin ACTION 6|Page CALCULATION PRICE CASHFLOW ReferenceManual Futures& Options Buy futures