284 Technical Analysis of Stock Trends
of the futures price.  Of these variables, volatility is the only one that cannot be observed 
directly. Considering all the other variables are known, however, it is possible to infer from 
option prices an estimate of how the market is gauging volatility. This estimate is called the 
“implied volatility” of the option. It measures the market’s average expectation of what the 
volatility of the underlying futures return will be until the expiration of the option. Implied 
volatility is usually expressed in annualized terms. The significance and use of implied 
volatility is potentially complex and confusing for the general investor, professionals having 
a decided edge in this area. Their edge can be removed by serious study.
Exercising the option
At expiration, the rules of optimal exercise are clear. The call owner should exercise the 
option if the strike price is less than the underlying futures price. The value of the exercised 
call is the difference between the futures price and the strike price. Conversely, the put 
owner should exercise the option if the strike price is greater than the futures price. The 
value of the exercised put is the difference between the strike price and the futures price.
To illustrate, if the price of the expiring futures contract is 7 ,600, a call struck at 7 ,500 
should be exercised, but a put at the same or lower strike price should not. The value of the 
exercised call is $1,000. The value of the unexercised put is $0.00. If the price of the expiring 
futures contract is 7 ,500, a 7 ,600 put should be exercised but not a call at 7 ,600 or a higher 
strike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00.
The profit on long options is the difference between the expiration value and the option 
premium. The profit on short options is the expiration value plus the option premium. 
The expiration values and profits on call and put options can often be an important tool 
in an investment strategy. Their payoff patterns and risk parameters make options quite 
different from futures. Their versatility makes them good instruments to adjust a portfolio 
to changing expectations about stock market conditions. Moreover, these expectations 
can range from general to specific predictions about the future direction and volatility of 
stock prices. Effectively, there is an option strategy suited to virtually every set of market 
conditions.
Using futures options to participate in market movements
Traders must often react to rapid and surprising events in the market. The transaction 
costs and price impact of buying or selling a portfolio’s stocks on short notice inhibit many 
investors from reacting to short-term market developments. Shorting stocks is an even 
less palatable option for average investors because of the margin and risks involved and 
semantical prejudices.
The flexibility that options provide can allow one to take advantage of the profits from 
market cycles quickly and conveniently. A long call option on Dow Index futures profits 
at all levels above its strike price. A long put option similarly profits at all levels below its 
strike price. Let us examine both strategies.
Profits in rising markets
In August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You 
expect the current Bull Market to continue, and you would like to take advantage of the 
trend without tying up too much capital and also undertake only limited risk.