he risk of a futures contract.
Example: The S&P 500 futures will be used for this example. Suppose that the
Chicago Mercantile Exchange determines that the required maintenance margin for
the futures is $10,000, which represents a 20-point move by the futures (recall that
S&P futures are worth $500 per point). Moreover, the exchange determines that an
"extreme" move is 14 points, or $7,000 of risk
Scenario
Futures unchanged; volatility up
Futures unchanged; volatility down
Futures up one-third of range; volatility up
Futures up one-third of range; volatility down
Futures down one-third of range; volatility up
Futures down one-third of range; volatility down
Futures up two-thirds of range; volatility up
Futures up two-thirds of range; volatility down
Futures down two-thirds of range; volatility up
Futures down two-thirds of range; volatility down
Futures up three-thirds of range; volatility up
Futures up three-thirds of range; volatility down
Futures down three-thirds of range; volatility up
Futures down three-thirds of range; volatility down
Futures up "extreme" move
Futures down "extreme" move
Long 1
Future
Potential
Pit/Loss
0
0
+ 3,330
+ 3,330
- 3,330
- 3,330
+ 6,670
+ 6,670
- 6,670
- 6,670
+ 10,000
+ l 0,000
-10,000
- 10,000
+ 7,000
- 7,000
The 16 array items are always displayed in this order. Note that since this array
is for a futures contract, the "volatility up" and "volatility down" scenarios are always
the same, since the volatility that is referred to is the one that is used as the input to
an option pricing model.
Notice that the actual price of the futures contract is not needed in order to
generate the risk array. The SPAN requirement is always the largest potential loss
from the array. Thus, if one were long one S&P 500 futures contract, his SPAN mar
gin requirement would be $10,000, which occurs under the "futures down three
thirds" scenarios. This will always be the maintenance margin for a futures contract.
Cl,apter 34: Futures and Futures Options 669
Now let us consider an option example. In this type of calculation, the exchange
uses the same moves by the underlying futures contract and calculates the option
theoretical values as they would exist on the next trading day. One calculation is per
formed for volatility increasing and one for volatility decreasing.
Example: Using the same S&P 500 futures contract, the following array might depict
the risk array for a long December 410 call. One does not need to know the option
or futures price in order to use the array; the exchange incorporates that information
into the model used to generate the potential gains and losses.
Scenario
Futures unchanged; volatility up
Futures unchanged; volatility down
Futures up one-third of range; volatility up
Futures up one-third of range; volatility down
Futures down one-third of range; volatility up
Futures down one-third of range; volatility down
Futures up two-thirds of range; volatility up
Futures up two-thirds of range; volatility down
Futures down two-thirds of range; volatility ur
Futures down two-thirds of range; volatility /o:n
Futures up three-thirds of range; volatility up
Futures up three-thirds of range; volatility down
Futures down three-thirds of range; volatility up
Futures down three-thirds of range; volatility down
Futures up "extreme" move
Futures down "extreme" move
Long 1
Dec 410 call
Potential
Ph/Loss
+ 460
610
+ 2,640
+ 1,730
- 1,270
- 2,340
+ 5,210
+ 4,540
- 2,540
- 3,430
+ 8,060
+ 7,640
- 3,380
- 3,990
+ 3,130
- 1,500
The items in the risk array are all quite logical: Upward futures movements pro
duce profits and downward futures movements produce losses in the long call posi
tion. Moreover, worse results are always obtained by using the lower volatility as
opposed to the higher one. In this particular example, the SPAN requirement would
be $3,990 ("futures down three-thirds; volatility down"). That is, the SPAN system
predicts that you could lose $3,990 of your call value if futures fell by their entire
range and volatility decreased - a worst-case scenario. Therefore, that is the amount
of margin one is required to keep for this long option position.
670 Part V: Index Options and Futures
While the exchange does not tell us how much of an increase or decrease it uses
in terms of volatility, one can get something of a feel for the magnitude by looking at
the first two lines of the table. The exchange is saying that if the futures are
unchanged tomorrow, but volatility "increases," then the call will increase in value by
$460 (92 cents); if it "decreases," however, the call will lose $610 (1.22 points) of
value. These are large piice changes, so one can assume that the volatility assump
tions are significant.
The real ease of use of the SPAN iisk array is when it comes to evaluating the
iisk of a more complicated position, or even a portfolio of options. All one needs to
do is to combine the risk array factors for each option or future in the position in
order to arrive at the total requirement.
Example: Using the above two examples, one can see what the SPAN requirements
would be for a covered wiite: long the S&P future and short the Dec 410 call.
Short 1
Long Dec 410 call
1 S&P Potential Covered
Scenario Future Pft/Loss Write
Futures unchanged; vol. up 0 460 - 460
Futures unchanged; vol. down 0 + 610 + 610
Futures up 1 /3 of range; vol. up + 3,330 - 2,640 + 690
Futures up 1 /3 of range; vol. down + 3,330 - 1,730 + 1,600
Futures down 1 /3 of range; vol. up - 3,330 + 1,270 -2,060
Futures down 1 /3 of range; vol. down 3,330 + 2,340 - 990
Futures up 2/3 of range; vol. up + 6,670 - 5,210 + 1,460
Futures up 2/3 of range; vol. down + 6,670 - 4,540 +2, 130
Futures down 2/3 of range; vol. up 6,670 + 2,540 -4, 130
Futures down 2/3 of range; vol. down - 6,670 + 3,430 -3,240
Futures up 3/3 of range; vol. up + 10,000 - 8,060 + 1,940
Futures up 3/


vol. up - 3,330 + 1,270 -2,060
Futures down 1 /3 of range; vol. down 3,330 + 2,340 - 990
Futures up 2/3 of range; vol. up + 6,670 - 5,210 + 1,460
Futures up 2/3 of range; vol. down + 6,670 - 4,540 +2, 130
Futures down 2/3 of range; vol. up 6,670 + 2,540 -4, 130
Futures down 2/3 of range; vol. down - 6,670 + 3,430 -3,240
Futures up 3/3 of range; vol. up + 10,000 - 8,060 + 1,940
Futures up 3/3 of range; vol. down + 10,000 - 7,640 +2,360
Futures down 3/3 of range; vol. up -10,000 + 3,380 -6,620
Futures down 3/3 of range; vol. down -10,000 + 3,990 -6,010
Futures up ,, extreme" move + 7,000 - 3,130 +3\870
Futures down "extreme" move - 7,000 + 1,500 -5,500
As might be expected, the worst-case projection for a covered wiite is for the
stock to drop, but for the implied volatility to increase. The SPAN system projects
that this covered wiiter would lose $6,620 if that happened. Thus, "futures down 3/3
of range; volatility up" is the SPAN requirement, $6,620.
Chapter 34: Futures and Futures Options 671
As a means of comparison, under the older "customer margin" option require
ments, the requirement for a covered write was the futures margin, plus the option
premium, less one-half the out-of-the-money amount. In the above example, assume
the futures were at 408 and the call was trading at 8. The customer covered write
margin would then be more than twice the SPAN requirement:
Futures margin
Option premium
1/2 out-of-money amount
$10,000
+ 4,000
- 1,000
$13,000
Obviously, one can alter the quantities in the use of the risk array quite easily.
For example, ifhe had a ratio write oflong 3 futures and short 5 December 410 calls,
he could easily calculate the SPAN requirement by multiplying the projected futures
gains and losses by 3, multiplying the projected option gains and losses by 5, and
adding the two together to obtain the total requirement. Once he had completed this
calculation, his SPAN requirement would be the worst expected loss as projected by
SPAN for the next trading day.
In actual practice, the SPAN calculations are even more sophisticated: They
take into account a certain minimum option margin (for deeply out-of-the-money
options); they account for spreads between futures contracts on the same commodi
ty (different expiration months); they add a delivery month charge (if you are hold
ing a position past the first notice day); ~ they even allow for slightly reduced
requirements for related, but different, futures spreads (T-bills versus T-bonds, for
example).
If you are interested in calculating SPAN margin yourself, your broker may be
able to provide you with the software to do so. More likely, though, he will provide
the service of calculating the SPAN margin on a position prior to your establishing it.
The details for obtaining the SPAN margin requirements should thus be requested
from your broker.
PHYSICAL CURRENCY OPTIONS
Another group oflisted options on a physical is the currency options that trade on the
Philadelphia Stock Exchange (PHLX). In addition, there is an even larger over-the
counter market in foreign currency options. Since the physical commodity underly
ing the option is currency, in some sense of the word, these are cash-based options
as well. However, the cash that the options are based in is not dollars, but rather may
be deutsche marks, Swiss francs, British pounds, Canadian dollars, French francs, or
672 Part V: Index Options and Futures
Japanese yen. Futures trade in these same currencies on the Chicago Mercantile
Exchange. Hence, many traders of the physical options use the Chicago-based
futures as a hedge for their positions.
Unlike stock options, currency options do not have standardized terms - the
amount of currency underlying the option contract is not the same in each of the
cases. The striking price intervals and units of trading are not the same either.
However, since there are only the six different contracts and since their terms corre
spond to the details of the futures contracts, these options have had much success.
The foreign currency markets are some of the largest in the world, and that size is
reflected in the liquidity of the futures on these currencies.
The Swiss franc contract will be used to illustrate the workings of the foreign
currency options. The other types of foreign currency options work in a similar man
ner, although they are for differing amounts of foreign currency. The amount of for
eign currency controlled by the foreign currency contract is the unit of trading, just
as 100 shares of stock is the unit of trading for stock options. The unit of trading for
the Swiss franc option on the PHLX is 62,500 Swiss francs. Normally, the currency
itself is quoted in terms of U.S. dollars. For example, a Swiss franc quote of 0.50
would mean that one Swiss franc is worth 50 cents in U.S. currency.
Note that when one takes a position in foreign currency options (or futures), he
is simultaneously taking an opposite position in U.S. dollars. That is, if one owns a
Swiss franc call, he is long the franc (at least delta long) and is by implication there
fore short U.S. dollars.
Striking prices in Swiss options are assigned in one-cent increments and are
stated in cents, not dollars. That is, if the Swiss franc is trading at 50 cents, then there
might be striking prices of 48, 49, 50, 51, and 52. Given the unit of trading and the
striking price in U.S. dollars, one can compute the total dollars involved in a foreign
currency exercise or assignment.
Example: Suppose the Swiss franc is trading at 0.50 and there are striking prices of
48, 50, and 52, representing U.S. cents per Swiss franc. If one were to exercise a call
with a strike of 48, then the dollars involved in the exercise would be 125,000 (the
unit of trading) times 0.48 (the strike in U.S. dollars), or $60,000.
Option premiums are stated in U.S. cents. That is, if a Swiss franc option is
quoted at 0. 75, its c

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf


is trading at 0.50 and there are striking prices of
48, 50, and 52, representing U.S. cents per Swiss franc. If one were to exercise a call
with a strike of 48, then the dollars involved in the exercise would be 125,000 (the
unit of trading) times 0.48 (the strike in U.S. dollars), or $60,000.
Option premiums are stated in U.S. cents. That is, if a Swiss franc option is
quoted at 0. 75, its cost is $.0075 times the unit of trading, 125,000, for a total of
$937.50. Premiums are quoted in hundredths of a point. That is, the next "tick" from
0.75 would be 0.76. Thus, for the Swiss franc options, each tick or hundredth of a
point is equal to $12.50 (.0001 x 125,000).
Chapter 34: Futures and Futures Options 673
Actual delivery of the security to satisfy an assignment notice must occur with
in the country of origin. That is, the seller of the currency must make arrangements
to deliver the currency in its country of origin. On exercise or assignment, sellers of
currency would be put holders who exercise or call writers who are assigned. Thus,
if one were short Swiss franc calls and he were assigned, he would have to deliver
Swiss francs into a bank in Switzerland. This essentially means that there have to be
agreements between your firm or your broker and foreign banks if you expect to
exercise or be assigned. The actual payment for the exercise or assignment takes
place between the broker and the Options Clearing Corporation (OCC) in U.S. dol
lars. The OCC then can receive or deliver the currency in its country of origin, since
OCC has arrangements with banks in each country.
EXERCISE AND ASSIGNMENT
The currency options that trade on the PHLX (Philadelphia Exchange) have exercise
privileges similar to those for all other options that we have studied: They can be
exercised at any time during their life.
Even though PHLX currency options are "cash" options in the most literal
sense of the word, they do not expose the writer to the same risks of early assignment
that cash-based index options do.
Example: Suppose that a currency trader has established the following spread on the
PHLX: long Swiss franc December 50 puts, short Swiss franc December 52 puts - a
bullish spread. As in any one-to-one spread, there is limited risk. However, the dol
lar rallies and the Swiss franc falls, pushing the exchange rate down to 48 cents (U.S.)
per Swiss franc. Now the puts that were wri,tten - the December 52 contracts - are
deeply in-the-money and might be subject to early assignment, as would any deeply
in-the-money put if it were trading at a discount.
Suppose the trader learns that he has indeed been assigned on his short puts.
He still has a hedge, for he is long the December 50 puts and he is now long Swiss
francs. This is still a hedged position, and he still has the same limited risk as he did
when he started (plus possibly some costs involved in taking physical delivery of the
francs). This situation is essentially the same as that of a spreader in stock or futures
options, who would still be hedged after an assignment because he would have
acquired the stock or future. Contrast this to the cash-based index option, in which
there is no longer a hedge after an assignment.
674 Part V: Index Options and Futures
FUTURES OPTION TRADING STRATEGIES
The strategies described here are those that are unique to futures option trading.
Although there may be some general relationships to stock and index option strate
gies, for the most part these strategies apply only to futures options. It will also be
shown - in the backspread and ratio spread examples - that one can compute the
profitability of an option spread in the same manner, no matter what the underlying
instrument is (stocks, futures, etc.) by breaking everything down into "points" and not
"dollars."
Before getting into specific strategies, it might prove useful to observe some
relationships about futures options and their price relationships to each other and to
the futures contract itself. Carrying cost and dividends are built into the price of stock
and index options, because the underlying instrument pays dividends and one has to
pay cash to buy or sell the stock. Such is not the case with futures. The "investment"
required to buy a futures contract is not initially a cash outlay. Note that the cost of
carry associated with futures generally refers to the carrying cost of owning the cash
commodity itself. That carrying cost has no bearing on the price of a futures option
other than to determine the futures price itself. Moreover, the future has no divi
dends or similar payout. This is even true for something like U.S. Treasury bond
options, because the interest rate payout of the cash bond is built into the futures
price; thus, the option, which is based on the futures price and not directly on the
cash price, does not have to allow for carry, since the future itself has no initial car
rying costs associated with it.
Simplistically, it can be stated that:
Futures Call = Futures Put + Futures Price - Strike Price
Example: April crude oil futures closed at 18.74 ($18.74 per barrel). The following
prices exist:
Strike April Call April Put Put + Futures
Price Price Price - Strike
17 1.80 0.06 1.80
18 0.96 0.22 0.96
19 0.35 0.61 \ 0.35
20 0.10 1.36 0.10
Note that, at every strike, the above formula is true (Call = Put + Futures -
Strike). These are not theoretical prices; they were taken from actual settlement
prices on a particular trading day.
Chapter 34: Futures and Futures Options 675
In reality, where deeply in-the-money or longer-term options are involved, this
simple formula is not correct. However, for most options on a particular nearby
futures contract, it will suffice quite well. Examine the quotes in today's newspaper
to verify that this is a true statement.
A subcase of this observation is that when the futures contract is exactly at the
striking price, the call and put


lity, where deeply in-the-money or longer-term options are involved, this
simple formula is not correct. However, for most options on a particular nearby
futures contract, it will suffice quite well. Examine the quotes in today's newspaper
to verify that this is a true statement.
A subcase of this observation is that when the futures contract is exactly at the
striking price, the call and put with that strike will both trade at the same price. Note
that in the above formula, if one sets the futures price equal to the striking price, the
last two terms cancel out and one is left with: Call price = Put price.
One final observation before getting into strategies: For a put and a call with the
same strike,
Net change call - Net change put = Net change futures
This is a true statement for stock and index options as well, and is a useful rule
to remember. Since futures options bid and offer quotes are not always disseminat
ed by quote vendors, one is forced to use last sales. If the last sales don't conform to
the rule above, then at least one of the last sales is probably not representative of the
true market in the options.
Example: April crude oil is up 50 cents to 19.24. A trader punches up the following
quotes on his machine and sees the following prices:
Option
April 19 call:
April 19 put:
Last Sale
0.55
0.31
These options conform to the abo~rule:
Net change futures = Net change call - Net change put
= +0.20 - (-0.30)
= +0.50
Net Change
+ 0.20
- 0.30
The net changes of the call and put indicate the April future should be up 50
cents, which it is.
Suppose that one also priced a less active option on his quote machine and saw
the following:
Option
April 17 call:
April 17 put:
Last Sale
2.10
0.04
Net Change
+ 0.30
- 0.02
676 Part V: Index Options and Futures
In this case, the formula yields an incorrect result:
Net change futures= +0.30 - (-0.02) = +0.32
Since the futures are really up 50 cents, one can assume that one of the last sales
is out of date. It is obviously the April 17 call, since that is the in-the-money option;
if one were to ask for a quote from the trading floor, that option would probably be
indicated up about 48 cents on the day.
DELTA
While we are on the subject of pricing, a word about delta may be in order as well.
The delta of a futures option has the same meaning as the delta of a stock option: It
is the amount by which the option is expected to increase in price for a one-point
move in the underlying futures contract. As we also know, it is an instantaneous meas
urement that is obtained by taking the first derivative of the option pricing model.
In any case, the delta of an at-the-money stock or index option is greater than
0.50; the more time remaining to expiration, the higher the delta is. In a simplified
sense, this has to do with the cost of carrying the value of the striking price until the
option expires. But part of it is also due to the distribution of stock price movements
- there is an upward bias, and with a long time remaining until expiration, that bias
makes call movements more pronounced than put movements.
Options on futures do not have the carrying cost feature to deal with, but they
do have the positive bias in their price distribution. A futures contract, just like a
stock, can increase by more than 100%, but cannot fall more than 100%.
Consequently, deltas of at-the-money futures calls will be slightly larger than 0.50.
The more time remaining until expiration of the futures option, the higher the at-the
money call delta will be.
Many traders erroneously believe that the delta of an at-the-money futures
option is 0.50, since there is no carrying cost involved in the futures conversion or
reversal arbitrage. That is not a true statement, since the distribution of futures prices
affects the delta as well.
As always, for futures options as well as for stock and index options, the delta of
a put is related to the delta of a call with the same striking price and expiration date:
Delta of put = 1 - Delta of call
Finally, the concept of equivalent stock position applies to futures opti<i>n strate
gies, except, of course, it is called the equivalent futures position (EFP). The EFP is
calculated by the simple formula:
EFP = Delta of option x Option quantity
Chapter 34: Futures and Futures Options 677
Thus, if one is long 8 calls with a delta of 0. 75, then that position has an EFP of
6 (8 x 0.75). This means that being long those 8 calls is the same as being long 6
futures contracts.
Note that in the case of stocks, the equivalent stock position formula has anoth
er factor shares per option. That concept does not apply to futures options, since
they are always options on one futures contract.
MATHEMATICAL CONSIDERATIONS
This brief section discusses modeling considerations for futures options and options
on physicals.
Futures Options. The Black model (see Chapter 33 on mathematical consider
ations for index options) is used to price futures options. Recall that futures don't pay
dividends, so there is no dividend adjustment necessary for the model. In addition,
there is no carrying cost involved with futures, so the only adjustment that one needs
to make is to use 0% as the interest rate input to the Black-Scholes model. This is an
oversimplification, especially for deeply in-the-money options. One is tying up some
money in order to buy an option. Hence, the Black model will discount the price
from the Black-Scholes model price. Therefore, the actual pricing model to be used
for theoretical evaluation of futures options is the Black model, which is merely the
Black-Scholes model, using 0% as the interest rate, and then discounted:
Call Theoretical Price = e-rt x Black-Scholes formula [r = O]
Recall that it was stated above that:
Futures call = Futures put + Future price - Strike price
The actual relationship is: ~
Futures call= Futures put+ e-rt (Futures price


for theoretical evaluation of futures options is the Black model, which is merely the
Black-Scholes model, using 0% as the interest rate, and then discounted:
Call Theoretical Price = e-rt x Black-Scholes formula [r = O]
Recall that it was stated above that:
Futures call = Futures put + Future price - Strike price
The actual relationship is: ~
Futures call= Futures put+ e-rt (Futures price - Strike price)
where
r = the short-term interest rate,
t = the time to expiration in years, and
e-rt = the discounting factor.
The short-term interest rate has to be used here because when one pays a debit
for an option, he is theoretically losing the interest that he could earn if he had that
money in the bank instead, earning money at the short-term interest rate.
The difference between these two formulae is so small for nearby options that
are not deeply in-the-money that it is normally less than the bid-asked spread in the
options, and the first equation can be used.
678 Part V: Index Options and Futures
Example: The table below compares the theoretical values computed with the two
formulae, where r = 6% and t = 0.25 (1/4 of a year). Furthermore, assume the futures
price is 100. The strike price is given in the first column, and the put price is given
in the second column. The predicted call prices according to each formula are then
shown in the next two columns.
Put Formula l Formula 2
Strike Price (Simple) ( Using e-rf)
70 0.25 30.25 29.80
80 1.00 21.00 20.70
90 3.25 13.25 13.10
95 5.35 10.35 10.28
100 7.50 7.50 7.50
105 10.70 5.70 5.77
110 13.90 3.90 4.05
120 21.80 1.80 2.10
For options that are 20 or 30 points in- or out-of-the-money, there is a notice
able differential in these three-month options. However, for options closer to the
strike, the differential is small.
If the time remaining to expiration is shorter than that used in the example
above, the differences are smaller; if the time is longer, the differences are magnified.
Options on Physicals. Determining the fair value of options on physicals such
as currencies is more complicated. The proper way to calculate the fair value of an
option on a physical is quite similar to that used for stock options. Recall that in the
case of stock options, one first subtracts the present worth of the dividend from the
current stock price before calculating the option value. A similar process is used for
determining the fair value of currency or any other options on physicals. In any of
these cases, the underlying security bears interest continuously, instead of quarterly
as stocks do. Therefore, all one needs to do is to subtract from the underlying price
the amount of interest to be paid until option expiration and then add the amount of
accrued interest to be paid. All other inputs into the Black-Scholes model would
remain the same, including the risk-free interest rate being equal to the 90-day T-bill
rate.
Again, the practical option strategist has a shortcut available to him. If one
assumes that the various factors necessary to price currencies have been assimilated
into the futures markets in Chicago, then one can merely use the futures price as the
price of the underlying for evaluating the physical delivery options in Philadelphia.
Chapter 34: Futures and Futures Options 679
This will not work well near expiration, since the future expires one week prior to the
PHLX option. In addition, it ignores the early exercise value of the PHLX options.
However, except for these small differentials, the shortcut will give theoretical values
that can be used in strategy-making decisions.
Example: It is sometime in April and one desires to calculate the theoretical values
of the June deutsche mark physical delivery options in Philadelphia. Assume that one
knows four of the basic items necessary for input to the Black-Scholes formula: 60
days to expiration, strike price of 68, interest rate of 10%, and volatility of 18%. But
what should be used as the price of the underlying deutsche mark? Merely use the
price of the June deutsche mark futures contract in Chicago.
STRATEGIES REGARDING TRADING LIMITS
The fact that trading limits exist in most futures contracts could be detrimental to
both option buyers and option writers. At other times, however, the trading limit may
present a unique opportunity. The following section focuses on who might benefit
from trading limits in futures and who would not..
Recall that a trading limit in a futures contract limits the absolute number of
points that the contract can trade up or down from the previous close. Thus, if the
trading limit in T-bonds is 3 points and they closed last night at 7 421132, then the high
est they can trade on the next day is 7721132, regardless of what might be happening
in the cash bond market. Trading limits exist in many futures contracts in order to
help ensure that the market cannot be manipulated by someone forcing the price to
move tremendously in one direction or the other. Another reason for having trading
limits is ostensibly to allow only a fixed move, approximately equal to the amount cov
ered by the initial margin, so that maintenance margin can be collected if need be.
However, limits have been applied in case~which they are unnecessary. For exam
ple, in T-bonds, there is too much liquidity for anyone to be able to manipulate the
market. Moreover, it is relatively easy to arbitrage the T-bond futures contract against
cash bonds. This also increases liquidity and would keep the future from trading at a
price substantially different from its theoretical value.
Sometimes the markets actually need to move far quickly and cannot because of
the trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points.
This makes no difference when a futures contract has risen as high as it can go for
the day, it is bid there (a situation called "limit bid") and usually doesn't trade again
as lo


stantially different from its theoretical value.
Sometimes the markets actually need to move far quickly and cannot because of
the trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points.
This makes no difference when a futures contract has risen as high as it can go for
the day, it is bid there (a situation called "limit bid") and usually doesn't trade again
as long as the underlying commodity moves higher. It is, of course, possible for a
future to be limit bid, only to find that later in the day, the underlying commodity
becomes weaker, and traders begin to sell the future, driving it down off the limit.
680 Part V: Index Options and Futures
Similar situations can also occur on the downside, where, if the future has traded as
low as it can go, it is said to be "limit offered."
As was pointed out earlier, futures options sometimes have trading limits
imposed on them as well. This limit is of the same magnitude as the futures limit.
Most of these are on the Chicago Board of Trade (all grains, U.S. Treasury bonds,
Municipal Bond Index, Nikkei stock index, and silver), although currency options on
the Chicago Mere are included as well. In other markets, options are free to trade,
even though futures have effectively halted because they are up or down the limit.
However, even in the situations in which futures options themselves have a trading
limit, there may be out-of-the-money options available for trading that have not
reached their trading limit.
When options are still trading, one can use them to imply the price at which the
futures would be trading, were they not at their trading limit.
Example: August soybeans have been inflated in price due to drought fears, having
closed on Friday at 650 ($6.50 per bushel). However, over the weekend it rains heav
ily in the Midwest, and it appears that the drought fears were overblown. Soybeans
open down 30 cents, to 620, down the allowable 30-cent limit. Furthermore, there
are no buyers at that level and the August bean contract is locked limit down. No fur
ther trading ensues.
One may be able to use the August soybean options as a price discovery mech
anism to see where August soybeans would be trading if they were open.
Suppose that the following prices exist, even though August soybeans are not
trading because they are locked limit down:
Lost Sole Net Change
Option Price for the Day
August 625 call 19 - 21
August 625 put 31 +16
An option strategist knows that synthetic long futures can be created by buying
a call and selling a put, or vice versa for short futures. Knowing this, one can tell what
price futures are projected to be trading at:
Implied Futures Price = Strike Price + Call Price - Put Price
= 625 + 19 - 31 = 613
With these options at the prices shown, one can create a synthetic futures posi
tion at a price of 613. Therefore, the implied price for August soybean futures in this
example is 613.
Chapter 34: Futures and Futures Options 681
Note that this formula is merely another version of the one previously present
ed in this chapter.
In the example above, neither of the options in question had moved the 30-
point limit, which applies to soybean options as well as to soybean futures. If they
had, they would not be useable in the formula for implying the price of the future.
Only options that are freely trading - not limit up or down - can be used in the above
formula.
A more complete look at soybean futures options on the day they opened and
stayed down the limit would reveal that some of them are not tradeable either:
Example: Continuing the above example, August soybeans are locked limit down 30
cents on the day. The following list shows a wider array of option prices. Any option
that is either up or down 30 cents on the day has also reached its trading limit, and
therefore could not be used in the process necessary to discover the implied price of
the August futures contract.
last Sale Net Change
Option Price for the Day
August 550 call 71 - 30
August 575 call 48 30
August 600 call 31 - 26
August 625 call 19 - 21
August 650 call 11 - 15
August 675 call 6 - 10
August 550 put 4 + 3
August 575 put 9 + 6
August 600 put 18 + 11
August 625 put -----------31 + 16
August 650 put 48 + 22
August 675 put 67 + 30
The deeply in-the-money calls, August 550's and August 575's, and the deeply in
the-money August 675 puts are all at the trading limit. All other options are freely trad
ing and could be used for the above computation of the August future's implied price.
One may ask how the market-makers are able to create markets for the options
when the future is not freely trading. They are pricing the options off cash quotes.
Knowing the cash quote, they can imply the price of the future (613 in this case), and
they can then make option markets as well.
682 Part V: Index Options and Futures
The real value in being able to use the options when a future is locked limit up
or limit down, of course, is to be able to hedge one's position. Simplistically, if a trad
er came in long the August soybean futures and they were locked limit down as in
the example above, he could use the puts and calls to effectively close out his posi
tion.
Example: As before, August soybeans are at 620, locked down the limit of 30 cents.
A trader has come into this trading day long the futures and he is very worried. He
cannot liquidate his long position, and if soybeans should open down the limit again
tomorrow, his account will be wiped out. He can use the August options to close out
his position.
Recall that it has been shown that the following is true:
Long put + Short call is equivalent to short stock.
It is also equivalent to short futures, of course. So if this trader were to buy a
put and short a call at the same strike, then he would have the equivalent of a short
futures position to offset his long futures position.
Using the following prices, which ar


close out
his position.
Recall that it has been shown that the following is true:
Long put + Short call is equivalent to short stock.
It is also equivalent to short futures, of course. So if this trader were to buy a
put and short a call at the same strike, then he would have the equivalent of a short
futures position to offset his long futures position.
Using the following prices, which are the same as before, one can see how his
risk is limited to the effective futures price of 613. That is, buying the put and selling
the call is the same as selling his futures out at 613, down 37 cents on the trading day.
Current prices:
Option
August 625 call
August 625 put
Position:
Buy August 625 put for 19
Sell August 625 call for 31
August Futures
at Option
Expiration Put Price
575 50
600 25
613 12
625 0
650 0
Put
P/L
+ $1,900
600
- 1,900
- 3,100
3,100
Last Sale
Price
19
31
Call Price
0
0
0
0
25
Call
P/L
+$1,900
+ 1,900
+ 1,900
+ 1,900
600
Net Change
for the Day
-21
+16
Net Profit
or loss on
Position
+$3,800
+ 1,300
0
- 1,200
- 3,700
Otapter 34: Futures and Futures Options 683
This profit table shows that selling the August 625 call at 19 and buying the
August 625 put at 31 is equivalent to - that is, it has the same profit potential as -
selling the August future at 613. So, if one buys the put and sells the call, he will
effectively have sold his future at 613 and taken his loss.
His resultant position after buying the put and selling the call would be a con
version (long futures, long put, and short call). The margin required for a conversion
or reversal is zero in the futures market. The margin rules recognize the riskless
nature of such a strategy. Thus, any excess money that he has after paying for the
unrealized loss in the futures will be freed up for new trades.
The futures trader does not have to completely hedge off his position ifhe does
not want to. He might decide to just buy a put to limit the downside risk.
Unfortunately, to do so after the futures are already locked limit down may be too lit
tle, too late. There are many kinds of partial hedges that he could establish - buy
some puts, sell some calls, utilize different strikes, etc.
The same or similar strategies could be used by a naked option seller who can
not hedge his position because it is up the limit. He could also utilize options that are
still in free trading to create a synthetic futures position.
Futures options generally have enough out-of-the-money striking prices listed
that some of them will still be free trading, even if the futures are up or down the
limit. This fact is a boon to anyone who has a losing position that has moved the daily
trading limit. Knowing how to use just this one option trading strategy should be a
worthwhile benefit to many futures traders.
COMMONPLACE MISPRICING STRATEGIES
Futures options are sometimes prone to severe mispricing. Of course, any product's
options may be subject to mispricing from time to time. However, it seems to appear
in futures options more often than it does in stock options. The following discussion
of strategies concentrates on a specific pattern of futures options mispricing that
occurs with relative frequency. It generally m{inifests itself in that out-of-the-money
puts are too cheap, and out-of-the-money calls are too expensive. The proper term
for this phenomenon is "volatility skewing" and it is discussed further in Chapter 36
on advanced concepts. In this chapter, we concentrate on how to spot it and how to
attempt to profit from it.
Occasionally, stock options exhibit this trait to a certain extent. Generally, it
occurs in stocks when speculators have it in their minds that a stock is going to expe
rience a sudden, substantial rise in price. They then bid up the out-of-the-money
calls, particularly the near-term ones, as they attempt to capitalize on their bullish
expectations. When takeover rumors abound, stock options display this mispricing
684 Part V: Index Options and Futures
pattern. Mispricing is, of course, a statistically related term; it does not infer anything
about the possible validity of takeover rumors.
A significant amount of discussion is going to be spent on this topic, because the
futures option trader will have ample opportunities to see and capitalize on this mis
pricing pattern; it is not something that just comes along rarely. He should therefore
be prepared to make it work to his advantage.
Example: January soybeans are trading at 583 ($5.83 per bushel). The following
prices exist:
Strike
525
550
575
600
625
650
675
January beans: 583
Call
Price
191/2
11
51/4
31/2
21/4
Put
Price
Suppose one knows that, according to historic patterns, the "fair values" of these
options are the prices listed in the following table.
Strike
525
550
575
600
625
650
675
Call
Price
191/2
11
53/4
31/2
21/4
Call
Theo.
Value
21.5
10.4
4.3
1.5
0.7
Put
Put Theo.
Price Value
1/2 1.6
31/4 5.4
12 13.7
28 27.6
Notice that the out-of-the-money puts are priced well below their theoretical
value, while the out-of-the-money calls are priced above. The options at the 575 and
600 strikes are much closer in price to their theoretical values than are the out-of
the-money options.
Chapter 34: Futures and Futures Options 685
There is another way to look at this data, and that is to view the options' implied
volatility. Implied volatility was discussed in Chapter 28 on mathematical applica
tions. It is basically the volatility that one would have to plug into his option pricing
model in order for the model's theoretical price to agree with the actual market price.
Alternatively, it is the volatility that is being implied by the actual marketplace. The
options in this example each have different implied volatilities, since their mispricing
is so distorted. Table 34-2 gives those implied volatilities. The deltas of the opti


ne would have to plug into his option pricing
model in order for the model's theoretical price to agree with the actual market price.
Alternatively, it is the volatility that is being implied by the actual marketplace. The
options in this example each have different implied volatilities, since their mispricing
is so distorted. Table 34-2 gives those implied volatilities. The deltas of the options
involved are shown as well, for they will be used in later examples.
These implied volatilities tell the same story: The out-of-the-money puts have
the lowest implied volatilities, and therefore are the cheapest options; the out-of-the
money calls have the highest implied volatilities, and are therefore the most expen
sive options.
So, no matter which way one prefers to look at it - through comparison of the
option price to theoretical price or by comparing implied volatilities - it is obvious
that these soybean options are out of line with one another.
This sort of pricing distortion is prevalent in many commodity options.
Soybeans, sugar, coffee, gold, and silver are all subject to this distortion from time to
time. The distortion is endemic to some - soybeans, for example - or may be pres
ent only when the speculators tum extremely bullish.
This precise mispricing pattern is so prevalent in futures options that strategists
should constantly be looking for it. There are two major ways to attempt to profit
from this pattern. Both are attractive strategies, since one is buying options that are
relatively less expensive than the options that are being sold. Such strategies, if
implemented when the options are mispriced, tilt the odds in the strategist's favor,
creating a positive expected return for the position.
TABLE 34-2.
Volatility skewing of soybean options.
Strike
525
550
575
600
625
650
675
Call
Price
19 1/2
11
53/4
31/2
21/4
Put
Price
1/2
31/4 ;
12
28
Implied Delta
Volatility Call/Put
12% /-0.02
13% /-0.16
15% 0.59/-0.41
17% 0.37 /-0.63
19% 0.21
21% 0.13
23% 0.09
686 Part V: Index Options and Futures
The two theoretically attractive strategies are:
1. Buy out-of-the-money puts and sell at-the-money puts; or
2. Buy at-the-money calls and sell out-of-the-money calls.
One might just buy one cheap and sell one expensive option - a bear spread
with the puts, or a bull spread with the calls. However, it is better to implement these
spreads with a ratio between the number of options bought and the number sold.
That is, the first strategy involving puts would be a backspread, while the second
strategy involving calls would be a ratio spread. By doing the ratio, each strategy is a
more neutral one. Each strategy is examined separately.
BACKSPREAD/NG THE PUTS
The backspread strategy works best when one expects a large degree of volatility.
Implementing the strategy with puts means that a large drop in price by the under
lying futures would be most profitable, although a limited profit could be made if
futures rose. Note that a moderate drop in price by expiration would be the worst
result for this spread.
Example: Using prices from the above example, suppose that one decides to estab
lish a backspread in the puts. Assume that a neutral ratio is obtained in the following
spread:
Buy 4 January bean 550 puts 31/4
Sell 1 January bean 600 put at 28
Net position:
13 DB
28 CR
15 Credit
The deltas (see Table 34-2) of the options are used to compute this neutral ratio.
Figure 34-1 shows the profit potential of this spread. It is the typical picture for
a put backspread - limited upside potential with a great deal of profit potential for
large downward moves. Note that the spread is initially established for a credit of 15
cents. If January soybeans have volatile movements in either direction, the position
should profit. Obviously, the profit potential is larger to the downside, where there
are extra long puts. However, if beans should rally instead, the spreader could still
make up to 15 cents ($750), the initial credit of the position.
Note that one can treat the prices of soybean options in the same manner as he
would treat the prices of stock options in order to determine such things as break
even points and maximum profit potential. The fact that soybean options are worth
Chapter 34: Futures and Futures Options 687
FIGURE 34-1.
January soybean, backspread.
60
50
40
30 .....
e 20 a..
0 10 ~ r:::
~ 550 600 625
-20
-30
Futures Price
$50 per point ( which is cents when referring to soybeans) and stock options are worth
$100 per point do not alter these calculations for a put backspread.
Maximum upside profit potential= Initial debit or credit of position
= 15 points
Maximum risk = Maximum upside Distance between strikes
x Number of puts sold short
= 15-50 X 1
= -35 points
Downside break-even point = Lower strike
- Points of risk/Number of excess puts
= 550- 35/3
= 538.3
Thus, one is able to analyze a futures option p~tion or a stock option position
in the same manner - by reducing everything to be in terms of points, not dollars.
Obviously, one will eventually have to convert to dollars in order to calculate his prof
its or losses. However, note that referring to everything in "points" works very well.
688 Part V: Index Options and Futures
Later, one can use the dollars per point to obtain actual dollar cost. Dollars per point
would be $50 for soybeans options, $100 for stock or index options, $400 for live cat
tle options, $375 for coffee options, $1,120 for sugar options, etc. In this way, one
does not have to get hung up in the nomenclature of the futures contract; he can
approach everything in the same fashion for purposes of analyzing the position. He
will, of course, have to use proper nomenclature to enter the order, but that comes
after the analysis is done.
RATIO SPREADING THE CALLS
Returning to the subject at hand - spreads that capture this particular mispricing
phenomenon of


not have to get hung up in the nomenclature of the futures contract; he can
approach everything in the same fashion for purposes of analyzing the position. He
will, of course, have to use proper nomenclature to enter the order, but that comes
after the analysis is done.
RATIO SPREADING THE CALLS
Returning to the subject at hand - spreads that capture this particular mispricing
phenomenon of futures options - recall that the other strategy that is attractive in
such situations is the ratio call spread. It is established with the maximum profit
potential being somewhat above the current futures price, since the calls that are
being sold are out-of-the-money.
Example: Again using the January soybean options of the previous few examples,
suppose that one establishes the following ratio call spread. Using the calls' deltas
(see Table 34-2), the following ratio is approximately neutral to begin with:
Buy 2 January bean 600 calls at 11
Sell 5 January bean 650 calls at 31/2
Net position:
22 DB
171/2 CR
41/2 Debit
Figure 34-2 shows the profit potential of the ratio call spread. It looks fairly typ
ical for a ratio spread: limited downside exposure, maximum profit potential at the
strike of the written calls, and unlimited upside exposure.
Since this spread is established with both options out-of-the-money, one needs
some upward movement by January soybean futures in order to be profitable.
However, too much movement would not be welcomed (although follow-up strate
gies could be used to deal with that). Consequently, this is a moderately bullish strat
egy; one should feel that the underlying futures have a chance to move somewhat
higher before expiration.
Again, the analyst should treat this position in terms of points, not dollars or
cents of soybean movement, in order to calculate the significant profit and loss
points. Refer to Chapter 11 on ratio call spreads for the original explanation of these
formulae for ratio call spreads:
Maximum downside loss = Initial debit or credit
= -4½ (it is a debit)
Chapter 34: Futures and Futures Options
FIGURE 34-2.
January soybean, ratio spread.
90
80
70
60
50
:!::
40 0 ... a.. 30
0 20 .le
C 10
~ 0
-10
-20
-30
575 625 650
At Expiration
Futures Price
Points of maximum profit = Maximum downside loss
+ Difference in strikes
x Number of calls owned
=-4½ + 50 X 2
=95½
Upside break-even price = Higher striking price
700
+ Maximum profit/Net number of naked calls
= 650 + 95½/3
= 681.8
689
These are the significant points of profitability at expiration. One does not care
what the unit of trading is (for example, cents for soybeans) or how many dollars are
involved in one unit of trading ($50 for soybeans and soybean options). He can con
duct his analysis strictly in terms of points, and he should do so.
Before proceeding into the comparisons beleen the backspread and the ratio
spread as they apply to mispriced futures options, it should be pointed out that the seri
ous strategist should analyze how his position will perform over the short term as well
as at expiration. These analyses are presented in Chapter 36 on advanced concepts.
690 Part V: Index Options and Futures
WHICH STRATEGY TO USE
The profit potential of the put backspread is obviously far different from that of the
call ratio spread. They are similar in that they both offer the strategist the opportu
nity to benefit from spreading mispriced options. Choosing which one to implement
(assuming liquidity in both the puts and calls) may be helped by examining the tech
nical picture ( chart) of the futures contract. Recall that futures traders are often more
technically oriented than stock traders, so it pays to be aware of basic chart patterns,
because others are watching them as well. If enough people see the same thing and
act on it, the chart pattern will be correct, if only from a "self-fulfilling prophecy"
viewpoint if nothing else.
Consequently, if the futures are locked in a (smooth) downtrend, the put strat
egy is the strategy of choice because it offers the best downside profit. Conversely, if
the futures are in a smooth uptrend, the call strategy is best.
The worst result will be achieved if the strategist has established the call ratio
spread, and the futures have an explosive rally. In certain cases, very bullish rumors
- weather predictions such as drought or El Nifio, foreign labor unrest in the fields
or mines, Russian buying of grain - will produce this mispricing phenomenon. The
strategist should be leery of using the call ratio spread strategy in such situations,
even though the out-of-the-money calls look and are ridiculously expensive. If the
rumors prove true, or if there are too many shorts being squeezed, the futures can
move too far, too fast and seriously hurt the spreader who has the ratio call spread in
place. His margin requirements will escalate quickly as tl1e futures price moves high
er. The option premiums will remain high or possibly even expand if the futures rally
quickly, thereby overriding the potential benefit of time decay. Moreover, if the fun
damentals change immediately - it rains; the strike is settled; no grain credits are
offered to the Russians - or rumors prove false, the futures can come crashing back
down in a hurry.
Consequently, if rumors of fundamentals have introduced volatility in the
futures rnarket, implement the strategy with the put backspread. The put backspread
is geared to taking advantage of volatility, and this fundamental situation as described
is certainly volatile. It may seem that because the market is exploding to the upside,
it is a waste of time to establish the put spread. Still, it is the wisest choice in a volatile
market, and there is always the chance that an explosive advance can turn into a quick
decline, especially when the advance is based on rumors or fundamentals that could
change overnight.
There are a few "don'ts" associated with th


le. It may seem that because the market is exploding to the upside,
it is a waste of time to establish the put spread. Still, it is the wisest choice in a volatile
market, and there is always the chance that an explosive advance can turn into a quick
decline, especially when the advance is based on rumors or fundamentals that could
change overnight.
There are a few "don'ts" associated with the ratio call spread. Do not be tempt
ed to use the ratio spread strategy in volatile situations such as those just described;
it works best in a slowly rising market. Also, do not implement the ratio spread with
Chapter 34: Futures and Futures Options 691
ridiculously far out-of-the-money options, as one is wasting his theoretical advantage
if the futures do not have a realistic chance to climb to the striking price of the writ
ten options. Finally, do not attempt to use overly large ratios in order to gain the most
theoretical advantage. This is an important concept, and the next example illustrates
it well.
Example: Assume the same pricing pattern for January soybean options that has
been the basis for this discussion. January beans are trading at 583. The (novice)
strategist sees that the slightly in-the-money January 575 call is the cheapest and the
deeply out-of-the-money January 675 call is the most expensive. This can be verified
from either of two previous tables: the one showing the actual price as compared to
the "theoretical" price, or Table 34-2 showing the implied volatilities.
Again, one would use the deltas (see Table 34-2) to create a neutral spread. A
neutral ratio of these two would involve selling approximately six calls for each one
purchased.
Buy 1 January bean 575 call at 191/z
Sell 6 January bean 675 calls at 21/4
Net position:
191/z DB
131/z CR
6 Debit
Figure 34-3 shows the possible detrimental effects of using this large ratio.
While one could make 94 points of profit if beans were at 675 at January expiration,
he could lose that profit quickly if beans shot on through the upside break-even
point, which is only 693.8. The previous formulae can be used to verify these maxi
mum profit and upside break-even point calculations. The upside break-even point
is too close to the striking price to allow for reasonable follow-up action. Therefore,
this would not be an attractive position from a practical viewpoint, even though at
first glance it looks attractive theoretically.
It would seem that neutral spreading could get one into trouble if it "recom
mends" positions like the 6-to-l ratio spread. In reality, it is the strategist who is get
ting into trouble if he doesn't look at the whole picture. The statistics are just an aid
- a tool. The strategist must use the tools to his advantage. It should be pointed out
as well that there is a tool missing from the toolkit at this point. There are statistics
that will clearly show the risk of this type of high-rati<,Yspread. In this case, that tool
is the gamma of the option. Chapter 40 covers the -Lise of gamma and other more
advanced statistical tools. This same example is expanded in that chapter to include
the gamma concept.
692 Part V: Index Options and Futures
FIGURE 34-3.
January soybean, heavily ratioed spread.
90
60
30
- 0
e 575 625 650 675 725 a. -30 0
.1!l -60 C
~
-90
-120 At Expiration
-150
-180
Futures Price
FOLLOW-UP ACTION
The same follow-up strategies apply to these futures options as did for stock options.
They will not be rehashed in detail here; refer to earlier chapters for broader expla
nations. This is a summary of the normal follow-up strategies:
Ratio call spread:
Follow-up action in strategies with naked options, such as this, generally involves
taking or limiting losses. A rising market will produce a negative EFP.
Neutralize a negative EFP by:
Buying futures
Buying some calls
Limit upside losses by placing buy stop orders for futures at or near the upside
break-even point.
Put backspread:
Follow-up action in strategies with an excess of long options generally involves
taking or protecting profits. A falling market will produce a negative EFP.
Neutralize a negative EFP by:
Buying futures
Selling some puts
Chapter 34: Futures and Futures Options 693
The reader has seen these follow-up strategies earlier in the book. However,
there is one new concept that is important: The mispricing continues to propagate
itself no matter what the price of the underlying futures contract. The at-the-money
options will always be about fairly priced; they will have the average implied volatility.
Example: In the previous examples, January soybeans were trading at 583 and the
implied volatility of the options with striking price 575 was 15%, while those with a
600 strike were 17%. One could, therefore, conclude that the at-the-money January
soybean options would exhibit an implied volatility of about 16%.
This would still be true if beans were at 525 or 675. The mispricing of the other
options would extend out from what is now the at-the-money strike. Table 34-3 shows
what one might expect to see if January soybeans rose 75 cents in price, from 583 to
658.
Nate that the same mispricing properties exist in both the old and new situa
tions: The puts that are 58 points out-of-the-money have an implied volatility of only
12%, while the calls that are 92 points out-of-the-money have an implied volatility of
23%.
TABLE 34-3.
Propagation of volatility skewing.
Original Situation
January beans: 583
Implied
Strike Volatility
525 12%
550 13%
575 15%
600 17%
625 19%
650 21%
675 23%
New Situation
January beans: 658
Strike
600
625
650
675
700
725
750
This example is not meant to infer that the volatility of an at-the-money soybean
futures option will always be 16%. It could be anything, depending on the historical
and implied volatility of the futures contract itself. However, the volatility skewing
will still persist even if the futur


625 19%
650 21%
675 23%
New Situation
January beans: 658
Strike
600
625
650
675
700
725
750
This example is not meant to infer that the volatility of an at-the-money soybean
futures option will always be 16%. It could be anything, depending on the historical
and implied volatility of the futures contract itself. However, the volatility skewing
will still persist even if the futures rally or decline.
This fact will affect how these strategies behave as the(linderlying futures con
tract moves. It is a benefit to both strategies. First, look at the put backspread when
the stock falls to the striking price of the purchased puts.
694 Part V: Index Options and Futures
Example: The put backspread was established under the following conditions:
Strike
550
600
Put
Price
Theoretical
Put Price
5.4
27.6
Implied
Volatility
13%
17%
If January soybean futures should fall to 550, one would expect the implied
volatility of the January 550 puts that are owned to be about 16% or 17%, since they
would be at-the-money at that time. This makes the assumption that the at-the
money puts will have about a 17% implied volatility, which is what they had when the
position was established.
Since the strategy involves being long a large quantity of January 550 puts, this
increase in implied volatility as the futures drop in price will be of benefit to the
spread.
Note that the implied volatility of the January 600 puts would increase as well,
which would be a small negative aspect for the spread. However, since there is only
one put short and it is quite deeply in the money with the futures at 550, this nega
tive cannot outweigh the positive effect of the expansion of volatility on the long
January 550 puts.
In a similar manner, the call spread would benefit. The implied volatility of the
written options would actually drop as the futures rallied, since they would be less far
out-of-the-money than they originally were when the spread was established. While
the same can be said of the long options in the spread, the fact that there are extra,
naked, options means the spread will benefit overall.
In summary, the futures option strategist should be alert to mispricing situations
like those described above. They occur frequently in a few commodities and occa
sionally in others. The put backspread strategy has limited risk and might therefore
be attractive to more individuals; it is best used in downtrending and/or volatile mar
kets. However, if the futures are in a smooth uptrend, not a volatile one, a ratio call
spread would be better. In either case, the strategist has established a spread that is
statistically attractive because he has sold options that are expensive in relation to the
ones that he has bought.
Chapter 34: Futures and Futures Options 695
SUMMARY
This chapter presented the basics of futures and futures options trading. The basic
differences between futures options and stock or index options were laid out. In a
certain sense, a futures option is easier to utilize than is a stock option because the
effects of dividends, interest rates, stock splits, and so forth do not apply to futures
options. However, the fact that each underlying physical commodity is completely
different from most other ones means that the strategist is forced to familiarize him
self with a vast array of details involving striking prices, trading units, expiration
dates, first notice days, etc.
More details mean there could be more opportunities for mistakes, most of
which can be avoided by visualizing and analyzing all positions in terms of points and
not in dollars.
Futures options do not create new option strategies. However, they may afford
one the opportunity to trade when the futures are locked limit up. Moreover, the
volatility skewing that is present in futures options will offer opportunities for put
backspreads and call ratio spreads that are not normally present in stock options.
Chapter 35 discusses futures spreads and how one can use futures options with
those spreads. Calendar spreads are discussed as well. Calendar spreads with futures
options are different from calendar spreads using stock or index options. These are
important concepts in the futures markets - distinctly different from an option
spread - and are therefore significant for the futures option trader.
Futures Option Strategies for
Futures Spreads
A spread with futures is not the same as a spread with options, except that one item
is bought while another is simultaneously sold. In this manner, one side of the spread
hedges the risk of the other. This chapter describes futures spreading and offers ways
to use options as an adjunct to those spreads.
The concept of calendar spreading with futures options is covered in this chap
ter as well. This is the one strategy that is very different when using futures options,
as opposed to using stock or index options.
FUTURES SPREADS
Before getting into option strategies, it is necessary to define futures spreads and to
examine some common futures spreading strategies.
FUTURES PRICING DIFFERENTIALS
It has already been shown that, for any paiticular physical commodity, there are, at
any one time, several futures that expire in different months. Oil futures have month
ly expirations; sugar futures expire in only five months of any one calendar year. The
frequency of expiration months depends on which futures contract one is discussing.
Futures on the same underlying commodity will trade at different prices. The
differential is due to several factors, not just time, as is the case with stock options. A
major factor is carrying costs - how much one would spend to buy and hold the phys-
696
Chapter 35: Futures Option Strategies for Futures Spreads 697
ical commodity until futures expiration. However, other factors may enter in as well,
including supply and demand considerations. In a normal carrying cost market,
futures that e


veral factors, not just time, as is the case with stock options. A
major factor is carrying costs - how much one would spend to buy and hold the phys-
696
Chapter 35: Futures Option Strategies for Futures Spreads 697
ical commodity until futures expiration. However, other factors may enter in as well,
including supply and demand considerations. In a normal carrying cost market,
futures that expire later in time are more expensive than those that are nearer-term.
Example: Gold is a commodity whose futures exhibit forward or normal carry.
Suppose it is March 1st and spot gold is trading at 351. Then, the futures contracts
on gold and their respective prices might be as follows:
Expiration Month Price
April 352.50
June 354.70
August 356.90
December 361.00
June 366.90
Notice that each successive contract is more expensive than the previous one.
There is a 2.20 differential between each of the first three expirations, equal to 1.10
per month of additional expiration time. However, the differential is not quite that
great for the December, which expires in 9 months, or for the June contract, which
expires in 15 months. The reason for this might be that longer-term interest rates are
slightly lower than the short-term rates, and so the cost of carry is slightly less.
However, prices in all futures don't line up this nicely. In some cases, different
months may actually represent different products, even though both are on the same
underlying physical commodity. For example, wheat is not always wheat. There is a
summer crop and a winter crop. While the two may be related in general, there could
be a substantial difference between the July wheat futures contract and the
December contract, for example, that has very little to do with what interest rates are.
Sometimes short-term demand can dominate the interest rate effect, and a
series of futures contracts can be aligned such that the short-term futures are more
expensive. This is known as a reverse carrying charge market, or contango.
INTRAMARKET FUTURES SPREADS
Some futures traders attempt to predict the relationships between various expiration
months on the same underlying physical commodity. That is, one might buy July
soybean futures and sell September soybean futures. When one both buys and sells
differing futures contracts, he has a spread. When both contracts are on the same
underlying physical commodity, he has an intramarket spread.
~
698 Part V: Index Options and Futures
The spreader is not attempting to predict the overall direction of prices. Rather,
he is trying to predict the differential in prices between the July and September con
tracts. He doesn't care if beans go up or down, as long as the spread between July and
September goes his way.
Example: A spread trader notices that historic price charts show that if September
soybeans get too expensive with respect to July soybeans, the differential usually dis
appears in a month or two. The opportunity for establishing this trade usually occurs
early in the year - February or March.
Assume it is February 1st, and the following prices exist:
July soybean futures: 600 ($6.00/bushel)
September soybean futures: 606
The price differential is 6 cents. It rarely gets worse than 12 cents, and often revers
es to the point that July futures are more expensive than soybean futures - some
years as much as 100 cents more expensive.
If one were to trade this spread from a historical perspective, he would thus be
risking approximately 6 cents, with possibilities of making over 100 cents. That is
certainly a good risk/reward ratio, if historic price patterns hold up in the current
environment.
Suppose that one establishes the spread:
Buy one July future @ 600
Sell one September future @ 606
At some later date, the following prices and, hence, profits and losses, exist.
Futures Price
July: 650
September: 630
Total Profit:
Profit/Loss
+50 cents
-24 cents
26 cents ($1,300)
The spread has inverted, going from an initial state in which September was 6
cents more expensive than July, to a situation in which July is 20 cents more expen
sive. The spreader would thus make 26 cents, or $1,300, since 1 cent in beans is
worth $50.
Chapter 35: Futures Option Strategies for Futures Spreads 699
Notice that the same profit would have been made at any of the following pairs
of prices, because the price differential between July and September is 20 cents in
all cases (with July being the more expensive of the two).
July Futures September Futures July Profit September Profit
420 400 -180 +206
470 450 -130 +156
550 530 -50 +76
600 580 0 +26
650 630 +50 -24
700 680 +100 -74
800 780 +200 -174
Therefore, the same 26-cent profit can be made whether soybeans are in a
severe bear market, in a rousing bull market, or even somewhat unchanged. The
spreader is only concerned with whether the spread widens from a 6-cent differen
tial or not.
Charts, some going back years, are kept of the various relationships between
one expiration month and another. Spread traders often use these historical charts to
determine when to enter and exit intramarket spreads. These charts display the sea
sonal tendencies that make the relationships between various contracts widen or
shrink. Analysis of the fundamentals that cause the seasonal tendencies could also be
motivation for establishing intramarket spreads.
The margin required for intramarket spread trading (and some other types of
futures spreads) is smaller than that required for speculative trading in the futures
themselves. The reason for this is that spreads are considered less risky than outright
positions in the futures. However, one can still make or lose a good deal of money in
a spread - percentage-wise as well as in dollars - so it cannot be considered conser
vative; it's just less risky than outright futures speculation.
Example: Using the soybean spread from the example above, assume the sp


s
themselves. The reason for this is that spreads are considered less risky than outright
positions in the futures. However, one can still make or lose a good deal of money in
a spread - percentage-wise as well as in dollars - so it cannot be considered conser
vative; it's just less risky than outright futures speculation.
Example: Using the soybean spread from the example above, assume the speculative
initial margin requirement is $1,700. Then, the spread margin requirement might be
$500. That is considerably less than one would have to put up as initial margin if each
side of the spread had to be margined separately, a situation that would require
$3,400.
In the previous example, it was shown that the soybean spread had the poten
tial to widen as much as 100 points ($1.00), a move that would be worth $5,000 if it
700 Part V: Index Options and Futures
occurred. While it is unlikely that the spread would actually widen to historic highs,
it is certainly possible that it could widen 25 or 30 cents, a profit of $1,250 to $1,500.
That is certainly high leverage on a $500 investment over a short time period,
so one must classify spreading as a risk strategy.
INTERMARKET FUTURES SPREADS
Another type of futures spread is one in which one buys futures contracts in one mar
ket and sells futures contracts in another, probably related, market. When the futures
spread is transacted in two different markets, it is known as an intermarket spread.
Intermarket spreads are just as popular as intramarket spreads.
One type of intermarket spread involves directly related markets. Examples
include spreads between currency futures on two different international currencies;
between financial futures on two different bond, note, or bill contracts; or between a
commodity and its products - oil, unleaded gasoline, and heating oil, for example.
Example: Interest rates have been low in both the United States and Japan. As a
result, both currencies are depressed with respect to the European currencies, where
interest rates remain high. A trader believes that interest rates will become more uni
form worldwide, causing the Japanese yen to appreciate with respect to the German
mark.
However, since he is not sure whether Japanese rates will move up or German
rates will move down, he is reluctant to take an outright position in either currency.
Rather, he decides to utilize an intermarket spread to implement his trading idea.
Assume he establishes the spread at the following prices:
Buy I June yen future: 77.00
Sell I June mark future: 60.00
This is an initial differential of 17.00 between the two currency futures. He is
hoping for the differential to get larger. The dollar trading terms are the same for
both futures: One point of movement (from 60.00 to 61.00, for example) is worth
$1,250. His profit and loss potential would therefore be:
Spread Differential
al a Later Date Profit/Loss
14.00 $3,750
16.00 - $1,250
18.00 + 1,250
20.00 + 3,750
Chapter 35: Futures Option Strategies for Futures Spreads 701
In some cases, the exchanges recognize frequently traded intermarket spreads
as being eligible for reduced margin requirements. That is, the exchange recognizes
that the two futures are hedges against one another if one is sold and the other is
bought.
These spreads between currencies, called cross-currency spreads, are so heavi
ly traded that there are other specific vehicles - both futures and warrants - that
allow the speculator to trade them as a single entity. Regardless, they serve as a prime
example of an intermarket spread when the two futures are used.
In the example above, assume the outright speculative margin for a position in
either currency future is $1,700 per contract. Then, the margin for this spread would
probably be nearly $1,700 as well, equal to the speculative margin for one side of the
spread. This position is thus recognized as a spread position for margin purposes. The
margin treatment isn't as favorable as for the intramarket spread (see the earlier soy
bean example), but the spread margin is still only one-half of what one would have to
advance as initial margin if both sides of the spread had to be margined separately.
Other intermarket spreads are also eligible for reduced margin requirements,
although at first glance they might not seem to be as direct a hedge as the two cur
rencies above were.
Example: A common intermarket spread is the TED spread, which consists of
Treasury bill futures on one side and Eurodollar futures on the other. Treasury bills
represent the safest investment there is; they are guaranteed. Eurodollars, however,
are not insured, and therefore represent a less safe investment. Consequently,
Eurodollars yield more than Treasury bills. How much more is the key, because as
the yield differential expands or shrinks, the spread between the prices of T-bill
futures and Eurodollar futures expands or shrinks as well. In essence, the yield dif
ferential is small when there is stability and confidence in the financial markets,
because uninsured deposits and insured deposits are not that much different in times
of financial certainty. However, in times of financial uncertainty and instability, the
spread widens because the uninsured depositors require a comparatively higher yield
for the higher risk they are taking.
Assume the outright initial margin for either the T-bill future or the Eurodollar
future is $800 per contract. The margin for the TED spread, however, is only $400.
Thus, one is able to trade this spread for only one-fourth of the amount of margin
that would be required to margin both sides separately.
The reason that the margin is more favorable is that there is not a lot of volatil
ity in this spread. Historically, it has ranged between about 0.30 and 1.70. In both
futures contracts, one cent (0.01) of movement is worth $25. Thus, the entire 140-
cent historic range of the spread only represent


r only one-fourth of the amount of margin
that would be required to margin both sides separately.
The reason that the margin is more favorable is that there is not a lot of volatil
ity in this spread. Historically, it has ranged between about 0.30 and 1.70. In both
futures contracts, one cent (0.01) of movement is worth $25. Thus, the entire 140-
cent historic range of the spread only represents $3,500 (140 x $25).
(
702 Part V: Index Options and Futures
More will be said later about the TED spread when the application of futures
options to intermarket spreads is discussed. Since there is a liquid option market on
both futures, it is sometimes more logical to establish the spread using options
instead of futures.
One other comment should be made regarding the TED spread: It has carry
ing cost. That is, if one buys the spread and holds it, the spread will shrink as time
passes, causing a small loss to the holder. When interest rates are low, the carrying
cost is small (about 0.05 for 3 months). It would be larger if short-term rates rose.
The prices in Table 35-1 show that the spread is more costly for longer-term con
tracts.
TABLE 35-1.
Carrying costs of the TED spread.
Month T-Bill Future
March 96.27
June 96.15
September 95.90
Eurodollar Future
95.86
95.69
95.39
TED Spread
0.41
0.46
0.51
Many intermarket spreads have some sort of carrying cost built into them; the
spreader should be aware of that fact, for it may figure into his profitability.
One final, and more complex, example of an intermarket spread is the crack
spread. There are two major areas in which a basic commodity is traded, as well as
two of its products: crude oil, unleaded gasoline, and heating oil; or soybeans, soy
bean oil, and soybean meal. A crack spread involves trading all three - the base com
modity and both byproducts.
Example: The crack spread in oil consists of buying two futures contracts for crude
oil and selling one contract each for heating oil and unleaded gasoline.
The units of trading are not the same for all three. The crude oil future is a con
tract for 1,000 barrels of oil; it is traded in units of dollars per barrel, so a $1 increase
in oil prices from $18.00 to $19.00, say - is worth $1,000 to the futures contract.
Heating oil and unleaded gasoline futures contracts have similar terms, but they are
different from crude oil. Each of these futures is for 42,000 gallons of the product,
and they are traded in cents. So, a one-cent move - gasoline going from 60 cents a
gallon to 61 cents a gallon - is worth $420. This information is summarized in Table
35-2 by showing how much a unit change in price is worth.
Chapter 35: Futures Option Strategies for Futures Spreads
TABLE 35-2.
Terms of oil production contract.
Contract
Crude Oil
Unleaded Gasoline
Heating Oil
Initial
Price
18.00
.6000
.5500
Subsequent
Price
19.00
.6100
.5600
The following formula is generally used for the oil crack spread:
Crack= (Unleaded gasoline + Heating oil) x 42 - 2 x Crude
2
(.6000 + .5500) X 42 - 2 X 18.00 =
2
= (48.3 - 36)/2
= 6.15
703
Gain in
Dollars
$1,000
$ 420
$ 420
Some traders don't use the divisor of 2 and, therefore, would arrive at a value
of 12.30 with the above data.
In either case, the spreader can track the history of this spread and will attempt
to buy oil and sell the other two, or vice versa, in order to attempt to make an over
all profit as the three products move. Suppose a spreader felt that the products were
too expensive with respect to crude oil prices. He would then implement the spread
in the following manner:
Buy 2 March crude oil futures @ 18.00
Sell 1 March heating oil future @ 0.5500
Sell l March unleaded gasoline future @ 0.6000
Thus, the crack spread was at 6.15 when he entered the position. Suppose that
he was right, and the futures prices subsequently changed to the following:
March crude oil futures: 18.50
March unleaded gas futures: .6075
March heating oil futures: .5575
The profit is shown in Table 35-3.
704
TABLE 35-3.
Profit and loss of crack spread.
Contract
2 March Crude
1 March Unleaded
1 March Heating Oil
Net Profit (before commissions)
Initial
Price
18.00
.6000
.5500
Part V: Index Options and Futures
Subsequent
Price
18.50
.6075
.5575
Gain in
Dollars
+ $1,000
- $ 315
- $ 315
+ $ 370
One can calculate that the crack spread at the new prices has shrunk to 5.965.
Thus, the spreader was correct in predicting that the spread would narrow, and he
profited.
Margin requirements are also favorable for this type of spread, generally being
slightly less than the speculative requirement for two contracts of crude oil.
The above examples demonstrate some of the various intermarket spreads that
are heavily watched and traded by futures spreaders. They often provide some of the
most reliable profit situations without requiring one to predict the actual direction of
the market itself. Only the differential of the spread is important.
One should not assume that all intermarket spreads receive favorable margin
treatment. Only those that have traditional relationships do.
USING FUTURES OPTIONS IN FUTURES SPREADS
After viewing the above examples, one can see that futures spreads are not the same
as what we typically know as option spreads. However, option contracts may be use
ful in futures spreading strategies. They can often provide an additional measure of
profit potential for very little additional risk. This is true for both intramarket and
intermarket spreads.
The futures option calendar spread is discussed first. The calendar spread with
futures options is not the same as the calendar spread with stock or index options. In
fact, it may best be viewed as an alternative to the intramarket futures spread rather
than as an option spread strategy.
CALENDAR SPREADS
A calendar spread with futures options would still be constructed in the familiar
manner - buy the May call, se


ndar spread is discussed first. The calendar spread with
futures options is not the same as the calendar spread with stock or index options. In
fact, it may best be viewed as an alternative to the intramarket futures spread rather
than as an option spread strategy.
CALENDAR SPREADS
A calendar spread with futures options would still be constructed in the familiar
manner - buy the May call, sell the March call with the same striking price. However,
Chapter 35: Futures Option Strategies for Futures Spreads 705
there is a major difference between the futures option calendar spread and the stock
option calendar spread. That difference is that a calendar spread using futures
options involves two separate underlying instruments, while a calendar spread using
stock options does not. When one buys the May soybean 600 call and sells the March
soybean 600 call, he is buying a call on the May soybean futures contract and selling
a call on the March soybean futures contract. Thus, the futures option calendar
spread involves two separate, but related, underlying futures contracts. However, if
one buys the IBM May 100 call and sells the IBM March 100 call, both calls are on
the same underlying instrument, IBM. This is a major difference between the two
strategies, although both are called "calendar spreads."
To the stock option trader who is used to visualizing calendar spreads, the
futures option variety may confound him at first. For example, a stock option trader
may conclude that if he can buy a four-month call for 5 points and sell a two-month
call for 2 points, he has a good calendar spread possibility. Such an analysis is mean
ingless with futures options. If one can buy the May soybean 600 call for 5 and sell
the March soybean 600 call for 3, is that a good spread or not? It's impossible to tell,
unless you know the relationship between May and March soybean futures contracts.
Thus, in order to analyze the futures option calendar spread, one must not only ana
lyze the options' relationship, but the two futures contracts' relationship as well.
Simply stated, when one establishes a futures option calendar spread, he is not only
spreading time, as he does with stock options, he is also spreading the relationship
between the underlying futures.
Example: A trader notices that near-term options in soybeans are relatively more
expensive than longer-term options. He thinks a calendar spread might make sense,
as he can sell the overpriced near-term calls and buy the relatively cheaper longer
term calls. This is a good situation, considering the theoretical value of the options
involved. He establishes the spread at the following prices:
Soybean Trading
Contract Initial Price Position
March 600 call 14 Sell 1
May 600 call 21 Buy 1
March future 594 none
May future 598 none
The May/March 600 call calendar spread is established for 7 points debit.
March expiration is two months away. At the current time, the May futures are trad
ing at a 4-point premium to March futures. The spreader figures that if March
706 Part V: Index Options and Futures
futures are approximately unchanged at expiration of the March options, he should
profit handsomely, because the March calls are slightly overpriced at the current
time, plus they will decay at a faster rate than the May calls over the next two months.
Suppose that he is correct and March futures are unchanged at expiration of the
March options. This is still no guarantee of profit, because one must also determine
where May futures are trading. If the spread between May and March futures
behaves poorly (May declines with respect to March), then he might still lose money.
Look at the following table to see how the futures spread between March and May
futures affects the profitability of the calendar spread. The calendar spread cost 7
debit when the futures spread was +4 initially.
Futures Calendar
Futures Prices Spread May 600 Call Spread
March/May Price Price Profit/Loss
594/570 -24 4 -3 cents
594/580 -14 61/2 _1/2
594/590 -4 10 +3
594/600 +6 141/2 +71/2
Thus, the calendar spread could lose money even with March futures
unchanged, as in the top two lines of the table. It also could do better than expected
if the futures spread widens, as in the bottom line of the table.
The profitability of the calendar spread is heavily linked to the futures spread
price. In the above example, it was possible to lose money even though the March
futures contract was unchanged in price from the time the calendar spread was
initially established. This would never happen with stock options. If one placed a
calendar spread on IBM and the stock were unchanged at the expiration of the near
term option, the spread would make money virtually all of the time ( unless implied
volatility had shrunk dramatically).
The futures option calendar spreader is therefore trading two spreads at once.
The first one has to do with the relative pricing differentials (implied volatilities, for
example) of the two options in question, as well as the passage of time. The second
one is the relationship between the two underlying futures contracts. As a result, it is
difficult to draw the ordinary profit picture. Rather, one must approach the problem
in this manner:
1. Use the horizontal axis to represent the futures spread price at the expiration of
the near-term option.
Chapter 35: Futures Option Strategies for Futures Spreads 707
2. Draw several profit curves, one for each price of the near-term future at near
term expiration.
Example: Expanding on the above example, this method is demonstrated here.
Figure 35-1 shows how to approach the problem. The horizontal axis depicts
the spread between March and May soybean futures at the expiration of the March
futures options. The vertical axis represents the profit and loss to be expected from
the calendar spread, as it always does.
The major difference between this profit graph and stan


ng on the above example, this method is demonstrated here.
Figure 35-1 shows how to approach the problem. The horizontal axis depicts
the spread between March and May soybean futures at the expiration of the March
futures options. The vertical axis represents the profit and loss to be expected from
the calendar spread, as it always does.
The major difference between this profit graph and standard ones is that there
are now several sets of profit curves. A separate one is drawn for each price of the
March futures that one wants to consider in his analysis. The previous example
showed the profitability for only one price of the March futures - unchanged at 594.
However, one cannot rely on the March futures to remain unchanged, so he must
view the profitability of the calendar spread at various March futures prices.
The data that is plotted in the figure is summarized in Table 35-4. Several things
are readily apparent. First, if the futures spread improves in price, the calendar
spread will generally make money. These are the points on the far right of the figure
and on the bottom line of Table 35-4. Second, if the futures spread behaves miser-
FIGURE 35-1.
Soybean futures calendar spreads, at March expiration.
gj
20
16
12
.3 8
::.:
0
ct 4
0
-8
March/May Spread
March =604
March =594
March= 614
March =584
March= 574
708 Part V: Index Options and Futures
ably, the calendar spread will almost certainly lose money (points on the left-hand
side of the figure, or top line of the table).
Third, if March futures rise in price too far, the calendar spread could do poor
ly. In fact, if March futures rally and the futures spread worsens, one could lose more
than his initial debit (bottom left-hand point on figure). This is partly due to the fact
that one is buying the March options back at a loss if March futures rally, and may
also be forced to sell his May options out at a loss if May futures have fallen at the
same time.
Fourth, as might be expected, the best results are obtained if March futures
rally slightly or remain unchanged and the futures spread also remains relatively
unchanged (points in the upper right-hand quadrant of the figure).
In Table 35-4, the far right-hand column shows how a futures spreader would
have fared if he had bought May and sold March at 4 points May over March, not
using any options at all.
TABLE 35-4.
Profit and loss from soybean call calendar.
All Prices at March Option Expiration
Futures Future
Spread Calendar Spread Profit Spread
(May-March) March Future Price: 574 584 594 604 614 Profit
-24 -5.5 - 4.5 -3 -4.5 -11.5 -28
-14 -4.5 3 -0.5 -1 -7 -18
-4 -2.5 0 +3 +3.5 -1 - 8
6 0 + 3 +7.5 +9 +5.5 + 2
16 +7 + 11 +17 +19 +13 +12
This example demonstrates just how powerful the influence of the futures
spread is. The calendar spread profit is predominantly a function of the futures
spread price. Thus, even though the calendar spread was attractive from the theo
retical viewpoint of the option's prices, its result does not seem to reflect that theo
retical advantage, due to the influence of the futures spread. Another important
point for the calendar spreader used to dealing with stock options to remember is
that one can lose more than his initial debit in a futures calendar spread if the spread
between the underlying futures inverts.
There is another way to view a calendar spread in futures options, however, and
that is as a substitute or alternative to an intramarket spread in the futures contracts
themselves. Look at Table 35-4 again and notice the far right-hand column. This is
Chapter 35: Futures Option Strategies for Futures Spreads 709
the profit or loss that would be made by an intramarket soybean spreader who bought
May and sold March at the initial prices of 598 and 594, respectively. The calendar
spread generally outperforms the intramarket spread for the prices shown in this
example. This is where the true theoretical advantage of the calendar spread comes
in. So, if one is thinking of establishing an intrarnarket spread, he should check out
the calendar spread in the futures options first. If the options have a theoretical pric
ing advantage, the calendar spread may clearly outperform the standard intramarket
spread.
Study Table 35-4 for a moment. Note that the intramarket spread is only better
when prices drop but the spread widens (lower left comer of table). In all other
cases, the calendar spread strategy is better. One could not always expect this to be
true, of course; the results in the example are partly due to the fact that the March
options that were sold were relatively expensive when compared with the May
options that were bought.
In summary, the futures option calendar spread is more complicated when
compared to the simpler stock or index option calendar spread. As a result, calendar
spreading with futures options is a less popular strategy than its stock option coun
terpart. However, this does not mean that the strategist should overlook this strate
gy. As the strategist knows, he can often find the best opportunities in seemingly
complex situations, because there may be pricing inefficiencies present. This strate
gy's main application may be for the intramarket spreader who also understands the
usage of options.
LONG COMBINATIONS
Another attractive use of options is as a substitute for two instruments that are being
traded one against the other. Since intermarket and intramarket futures spreads
involve two instruments being traded against each other, futures options may be able
to work well in these types of spreads. You may recall that a similar idea was pre
sented with respect to pairs trading, as well as certain risk arbitrage strategies and
index futures spreading.
In any type of futures spread, one might be able to substitute options for the
actual futures. He might buy calls for the long side of the spread instead of actually
buying futures. Likewise,