Single-Stock Futures Part 17

Pairs Trading

A popular strategy among many hedge funds and institutional traders is one called "pairs trading." The concept of pairs trading is very simple and is, in many ways, a variation of our fair value course during section 3. To implement pairs trading, you find two stocks that move together in predictable fashions. As we learned in the last course, this means finding stocks with high correlations.

You may be wondering how that's possible. After all, aren't stock price changes random? Yes, that's true. However, that does not mean that two stocks cannot move in similar fashions. This will be especially true if they are in the same industry, although that is not a prerequisite. For instance, if Dell Computer is expected to rise over the next year, then it's probably safe to say that IBM could be expected to rise as well. Likewise, if computer sales are soft, we could expect both Dell and IBM to decline. This expectation is captured by the fact that you will see the price of a stock rise when positive news is released about a competitor. If you see a headline that says Home Depot's sales are expected to double for the next quarter, you could expect to see the price of Lowe's stock to rise on that news as well.

Once a pair of stocks is identified as being highly correlated, the trader determines a range for that correlation. After all, the two stocks will never move perfectly together, no matter how close they may be. The trader attempts to determine when the spread between the two stocks is average, high, or low. When it is to the high side, the trader buys the one whose price is low and sells the one that's high. The idea is that the two prices can be expected to revert back to the average. If they do, the trader will make money from both sides, meaning he profits on the long and short positions. Because the trader is long and short, this strategy is also known as "long-short" and "market neutral."

The reason it is also called market neutral is because the trader is long and short stocks that are expected to move together. If the market rallies hard, both stocks may rise but the trader may be about neutral on profits or losses. This is because the profits on the long stock will be about equally matched on the losses from the short stock (this assumes the trader has equal dollars in both stocks). Likewise, if the markets plunge, the trader can again expect to be about at breakeven levels. Because the trader is indifferent to the market rising or falling, he is "market neutral." The only thing that matters to the pairs trader is the spread -- the difference in prices -- between the two chosen securities.

Law of One Price

Pairs trading is based on an economic principle called the "law of one price," which states that identical goods should cost the same across countries. Sometimes this law is loosely called the "Big Mac" law after a classic example asserting that a McDonald's Big Mac should cost the same in the U.S. as it does abroad. If it does not, then arbitrage is possible as people could buy it cheap in one country and sell it for more in another country. Of course, in the real world, risk, taxes, government regulations, import tariffs (not to mention transportation costs) will make it so that they are not exactly equal. However, you should get the idea that there is no reason for identical goods to cost different amounts across countries.

We can extend that reasoning to the stock market. If two stocks have the same payoffs in all states of the economy (i.e., they move together), then there is no reason for their prices to deviate. If they do, one can perform a "statistical arbitrage" between them by pairs trading. What do we mean by statistical arbitrage? That simply means that you are arbitraging probabilities and you will most likely make money. Notice how this is different from the standard use of the word arbitrage where the trader is guaranteed to make money.

In most cases, pairs trading is easier said than done. Most hedge funds use advanced statistical techniques to find pairs that truly are highly correlated over time and then will perform the pairs trading according to some rule such as when the spread increases by two standard deviations. However, this does not mean that it cannot be used on a simpler basis.

For example, you may notice two stocks in similar industries fluctuating around a fixed price. For example, you can see in Figure 1 that Pharmacia (PHA) and Medimune (MEDI), both in the healthcare/drug sector, fluctuated around $40 between 7/26/01 and 12/1/01. In this case, $40 is the "mean" and the highs and lows are fluctuations around that mean.

If this trend had persisted, you could have purchased MEDI and sold PHA around the time period shown by arrow A. This was a time when MEDI was cheap and PHA expensive with the expectation that they would revert to the mean of $40. You could then have sold the position at time period B, thus capturing a profit. It's also possible that you could have sold at time B and then repurchased at time C. In fact, active pairs traders will constantly flip back and forth with the market. They may buy at A, sell and simultaneously go short at B, buy and simultaneously go long at C. Remember too that futures traders can close a position and then change directions with one trade. If you were long five contracts of MEDI and short five PHA at time A, you could then sell 10 MEDI and buy 10 PHA at time B thus making you long five PHA and short five MEDI at time B. One execution, one commission, and you've instantaneously closed and changed directions. Because of the ease with which futures traders can go long and short, you can see where single-stock futures are a remarkable trading tool for pairs traders.

General Strategies

We've covered some specific strategies that are well suited for futures. At this point, we want to bring to your attention some general advantages of futures over stocks. While the following strategies are not specific, they are equally, if not more, important than the previous strategies since they get you to think of the various ways futures can be used to your benefit.

Diversification

Because of the low initial margin requirement, it should be obvious that futures can allow for safer investing through diversification. For instance, say you have $30,000 to invest in the stock market. If you buy quality companies, there's a good chance their share price will be high and you may not be able to afford many different stocks, which is key to diversification. Without going into the math, the bulk of company-specific risk (called unsystematic risk) is washed away once you hold a properly balanced portfolio of about 16 to 22 stocks in different industries in your portfolio. In other words, if you own a little bit of tech, financials, automotive, healthcare, food and beverage, etc, you will end up with minimum risk for a given level of return, or conversely, a maximum return for a given level of risk. With only $30,000, however, you may not be able to obtain this optimal amount. But with single-stock futures, you have access to a tool that may be a key to smarter investing.

If you wish to buy a stock and hold it for a long time, such as five or 10 years, there's probably no doubt that purchasing the stock is your best bet. But what if you generally hold a stock for one year or so? Would you rather have two or three stocks or a basket of 20 one-year contracts? After all, we've shown there's no difference between the two positions in terms of price movement. You're better off with a larger basket; and futures contracts give you this opportunity. Keep in mind if you do this that you may have to periodically send in money if a position goes against you. It may not be the best idea to invest all of your money so that you have some set aside to meet potential margincalls.

In addition, commodity futures are often highly uncorrelated with stocks. This simply means that there is no systematic association between commodities and stocks rising or falling together. The fact that many futures contracts are uncorrelated is a key to creating a properly diversified portfolio. We said earlier that unsystematic risk is nearly eliminated if you hold a properly balanced portfolio. Having low correlation between assets is what we mean by properly balanced -- and futures can be important for achieving this quality as demonstrated by the following facts:

• Stocks plunged 48% in 1973 and 1974 while the Goldman Sachs Agricultural Commodity Index rose 491%.

• Over the past 25 years, if you compare the major advances of the S&P 500 to futures, there were corresponding positive returns in futures as well. However, during all the largest S&P 500 stock declines, futures were positive. In all but one decline in the S&P 500, advances in futures completely offset losses in the S&P 500.

• Currently, the correlation between the S&P 500 and Barclay CTA Traders Index is .02[1] -- virtually non-existent.

Futures contracts can be your most effective source of portfolio balance. While nobody says you need to be 100% invested in futures, it is a mistake to completely ignore them.

Day-Trading

The diversification concept can be carried over to those who day-tradestocks. Day-traders are those who attempt to capture small price movements, up or down, during the day and close all positions by the end of the day. Most day-traders pick a stock they are comfortable with that they think will make a small move in a short time. Most of their expectations of these movements are based on technical analysis. Then they go for leverageby purchasing as many shares as they can with the money in their account. They hope to capture a sizeable profit on a small move many times through the day.

The problem with this approach is, once again, no diversification. The chances that a day-trader consistently picks a winning stock are slim to none. One or two losing trades quickly offset the winners. Futures contracts offer the leverageand diversification that day-traders seek. In fact, we can even carry it out one step further and buy the stocks we think will rise and short the ones we think will fall. Yes, this can be done with stocks too but it is far more expensive to meet the Reg Trequirements. The end result is that you cannot get the same diversification with stocks as you can with futures and will therefore not have the same performance.

In fact, on February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to NASD Rule 2520. These amendments make some significant changes to the margin requirements for those who day-trade stocks. First, if you buy and sell a stock on the same day in a margin account and you do so at least four times in a rolling five-day business period, you will be required to have a minimum equity balance of $25,000 before any more day-trades can be placed. On the good side, your "buying power" will be increased to a maximum of four times your excess margin. Regardless of this benefit, if you wish to actively day-trade stocks and do not keep a minimum balance of $25,000, then single-stock futures will be your only way to continue day trading.

Fine-Tuning and Rebalancing Your Portfolio

Futures are perfect for fine-tuning your existing positions. Say you have a long position that has fallen significantly but you are still bullish on it. You wish to purchase more shares to reduce you cost basis, which will allow you to reach breakeven sooner. Rather than spending a lot of money (and possibly being wrong), you can throw a relatively small amount toward a futures contract and gain the additional exposure without using all of your capital.

You can also use them to fine-tune your portfolio. Say you have a large blue-chip portfolio, but you think a couple of other sectors that you don't own are about to make a run. For just a little bit of money, you now have exposure to those sectors and can enhance your returns if you are correct without needing a lot of money to do so.

Hedging 401(k)Accounts

You may have a 401(k)or other tax advantaged account that does not allow sales except within certain time periods. If a stock in that account has made a nice run, you may not be able to do anything about if you're in a restricted time period. However, with futures contracts, you can short the contract covering the same stock in another account and that will offer you a hedgeand basically lock in a selling price. For example, say your company stock has run from $30 to $70 but you are not allowed to make a sale because it is a restricted time period. You can, instead, sell one futures contract in another account for every hundred shares of stock you own. If the stock continues to rise, the gain in the shares will offset the losses on the futures. If the stock falls, the gain in the futures contracts will offset the losses in the 401(k). Keep in mind this is one case where shorting stocks may not even work for you since many companies do not allow employees to short company stock. Futures may be your only tool.

Granted, if the stock falls, those gains on the futures contracts will be outside of your 401k but at least the money is not gone for good. It has merely been effectively transferred from your 401(k) to your personal account.

Please remember about marking-to-marketthough. If you short the futures contract and the stock continues to rise, you may get maintenance calls from your broker and will need to meet those. Even though you are effectively hedged with the long positions in the 401(k), you cannot access those funds until you sell those shares! So if you use futures in one account to hedgeanother account that you can't immediately access, make sure you have additional funds to meet potential maintenance calls.

Futures contracts can be used in nearly all the same ways as stock. There will be minor differences, for example, you won't receive dividends or voting rights with futures; but for the most part, all strategies for stocks can easily be replaced with futures. However, there are many strategies for futures that cannot be made with stocks. Because of this quality, futures contracts become an important trading tool for you to understand as the financial markets become increasingly complex.

[1]The Barclay CTA Traders Index is a portfolio of professionally managed futures.

Risks and Rewards

Single-stock futures are a new and exciting tool for hedgers and speculatorsalike. Despite their benefits, I often hear people criticize that adding one more investment class only adds to the confusion among the seemingly infinite number of choices already available. They insist there is no reason to learn about them, as they are perfectly happy with their stocks, bonds, and options.

Before you accept that way of thinking, we're going to show how market participants respond to any financial investment. It does not matter if it is new, such as single-stock futures, or an existing one, such as stocks and bonds. The method of pricing all assets depends on risk and return. To demonstrate how this is done, we're going to look at some gambling games just to make it fun. As we will find out, even games of chance are priced according to risk.

How Much Would You Pay?

Assume two games are offered, and in order to play you must bid on a ticket for that game. Only the top 100 bids will be accepted. If you win one of the top 100 spots, you are allowed to play that game. The following two games are offered:

Game 1: A coin is flipped. If the coin lands heads, each player wins $10. If it lands tails, they lose the price they paid for the ticket.

Game 2: A six-sided die is rolled and, if it lands on the number six, each player wins $10, otherwise they lose the price they paid for the ticket.

Also assume there are hundreds of thousands of people willing to play but that only 100 people can play at a time and that they are free to compete on price. Only the 100 highest bidders are allowed to play the game at any one time.

What can we expect to see happen with the prices of these two games?

Take a close look at the two games above and think about them for a moment. Which would you prefer to play? How will this preference affect its price?

First of all, we see that both have the same $10 payoff. However, each is subject to a different set of risks. Even if you do not have an understanding of probabilities, you should be able to conceive that you would win far more often playing the first game. On average, you would win every other time with the first game and every sixth time with the second. In other words, the second carries more uncertainty -- it is riskier. Because the frequency of wins is higher in the first, everybody prefers to play that game over the second one for any given cost.

While the fair price of this game can be found mathematically, we are going to assume that the gamblers have no such knowledge and must learn by trial and error.

Let's say that the first several rounds of the game are played with each gambler paying $1 for the ticket. On average, the gamblers will pay $1 every time but win $10 every other time. In other words, the gamblers will pay $2 to win $10, on average. This makes for a net gain of $8 every two games or $4 per game.

We can show this same result mathematically by looking at what are called expected values, which are nothing more than the sum of the gains and losses multiplied by their probabilities. Using expected values, we can show that half the time the gamblers will lose their dollar and half the time they will make $9 (pay $1 to play and receive $10):

-$1 (1/2) = -$.50

+$9 (1/2) = +$4.50

Net = +$4 per game

Regardless of how you look at it, the gamblers can expect an average gain of $4 per game. Because they expect net profits, they continue to play. The other gamblers not playing this game will see the profits mounting and become eager to play, but they cannot because all 100 seats are all filled. In order to play, they must bid higher than the going rate of $1. If the game is now bid to $2.00, the expected return to the gamblers becomes:

-$2 (1/2) = -$1

+$8 (1/2) = +$4

Net = +$3 per game

The additional dollar bid is countered by an additional dollar less of expected profit. The expected gain falls from $4 to $3. Still, the spectator gamblers see the profits continuing, although not as fast, so they continue to bid up the price to play. Eventually, the price will be bid to $5 to the point where gamblers can expect to break even, on average:

-$5 (1/2) = -$2.5

+$5 (1/2) = +$2.5

Net = $0 per game

At a bid of $5 per game, the gamblers are expected to neither win nor lose in the long run. If they bid $5 to play, they will lose $5 half the time and gain $5 half of the time. If the bids rise above this amount, even to just $5.01, the house will start to earn money per game (the gamblers would lose), on average, and the gamblers will learn to reduce their bets. So we find that, in the long run, the first game will be bid to a value of $5 and stay in equilibrium at that level. There is no incentive for gamblers to bid higher and no room to bid lower. If one gambler bids less than $5, another gambler will be willing to bid $5 to take his place.

What happens to the price of the second game? At some point through all of this bidding in the first game, some gamblers will try out the second game but will never bid more than the price of the first game. Remember, the first game is preferred for any given price because of the reduced risk. Therefore, the second game will never have a value greater than the first. However, this does not mean it will have no value; and gamblers will, at some point, give it a try.

Let's assume gamblers are able to participate by only paying one dollar. The gamblers who bid $1 will lose, on average, every five out of six games. Every sixth game, on average, they will pay their $1 fee but win $10 for a net gain of $9.

-$1 (5/6) = -$0.83

+ $9 (1/6) = +$1.50

Net = +$0.67 per game

This net expected gain is small but still positive, so gamblers will continue to bid up its price. From what we learned in the first game, we know that if there is a net expected gain, the gamblers will continue to bid higher. How much room is left for them to bid? Exactly the amount of the net expected gain. Because an expected gain of 0.67 remains after bidding $1, they will eventually bid this game to a price of $1.67. At that price, there will be no incentive to bid it higher and no room to bid it lower:

-$1.67 (5/6) = -$1.3916

+ $8.33 (1/6) = +$1.3883

Net = $0.0033 per game, which is approximately zero.[1]

When the price is in equilibrium, no gambler will bid it higher and, if someone bids lower, another gambler will quickly take his place by bidding higher. The end result is that the first game will be bid to a value of $5 and the second to a value of $1.67. We could also understand the rationale another way. The second game would take three times as long to win, on average, than the first. In the first game, gamblers could expect to win every two turns while those playing the second game could expect to win every six turns, which is exactly one-third as often. Because both games pay out $10, the value of the second game must be one-third that of the first or $5/3 = $1.67.

Efficient Market Theory

What we just demonstrated is a variation of a well-known financial theory called the Efficient Market Theory (EMT). While there are three different forms of EMT, the one we demonstrated is known as the semi-strong form and states that all publicly available information is priced into each and every asset just as was done with our gambling games. We can demonstrate EMT with a simpler version too by asking a simple question: Is it better to own a Porsche Boxster or a Ford Taurus? Although I'm sure you have an immediate answer, the correct answer may surprise you.

Many people are tempted to answer that the Porsche is clearly the better choice.

To find out if that's true, let's start by assuming that both the Ford Taurus and Porsche Boxster are both priced the same. With both cars priced the same, few would disagree that you are better off with the Porsche. If so, people will buy the Porsche over the Taurus. This will put buying pressure on the Porsche and raise its price relative to the Taurus. Say the Porsche is now bid up to a price $3,000 above the Taurus. Most would agree that it is still a better deal and continue to buy it. This action will continue until the markets are not so sure that an additional $1 is worth jumping from the Taurus to the Boxster. If it were worth it, they would do it.

While it may go against your intuition, as long as there is no net bidding up or down of prices between the two cars, you are equally well off with either one. While the Porsche may be faster and have higher quality and resale value (not to mention it just looks cooler), it also comes with higher repair bills, insurance rates and theft occurrences. The car market will reflect all pros and cons in the prices of the two cars. Similarly, the financial markets will price all assets to reflect their risks. Quality assets are bid up and riskier assets are sold off. This is why a government T-bill yielding 5% is equal to a more risky bond priced to yield 10%. The government bond is of higher quality but also has a lower yield. The markets realize that, all else constant, you are better off with the T-bill, so they continue to bid that price up until there is no net difference between the two bonds. If there were an advantage, the markets would continue taking action and reflect it in the price.

The important point to draw from this is that all markets, whether stocks, bonds, options, futures, real estate, coins, art -- even casinos -- will be priced according to risk. Granted, the financial markets are not as easy to price as the two gambling games we presented that offer a precise payout with exact probabilities. Nonetheless, the principle is the same and investors will bid the price up if they feel there is more reward (or less risk) and bid the price down if there is less reward (or more risk) as was done with these two gambling games.

Single-stock futures are just one of many investment markets, and they are priced according to risk. Do not be fooled by people who say they are too risky or that they are not worth learning. Just as with our gambling games, even though the second game was riskier did not mean that gamblers would not play it. They will for the right price. Whatever that price may be is up to the market to decide. The same holds true for single-stock futures. They have a unique set of risks and rewards that are unavailable with any other asset. Consequently, they will carry a price to reflect those risks and rewards.

Single-stock futures are simply another investment "game" from which to choose. If you choose to not allow single-stock futuresinto your investment portfolio, or to not even entertain the idea of learning about them, you are essentially blocking out the advantages they may offer for a particular situation. What's worse is that you will probably substitute them with a less efficient product to accomplish the same task. If you refuse to learn about them you will be limiting these new and innovative tools that were designed to efficiently help you control risk.

As the famous psychologist, Abraham Maslow, once said, "To the man who only has a hammer in the toolkit, every problem looks like a nail." Without single-stock futuresin your "toolkit," the investor who only uses stocks, bonds, or optionswill see those particular assets as the solution to every financial problem. If that were the case, then the other assets in the market would never have come into existence. Single-stock futures are the answer to a long-term problem of hedging risk. They allow us to quickly spread that risk off to speculators who are willing to accept it. They allow the investor or speculator to custom tailor risk and reward profiles in ways that cannot be done as efficiently without them. They are not a pointless product designed by brokers to sell, nor were they created under political pressures of the wealthy as a means to legally gamble for the fun of it.

The markets created them out of necessity. Single-stock futures can be used to hedge risk conservatively, speculate wildly, or any shade of gray in between. The choice of how to use them is up to you -- assuming you decide to use them. If you choose not to, you will leave behind an invaluable tool that allows you to be more proficient at maneuvering through the volatile conditions and uncertainties that exist in today's complex markets. I am convinced that using futures is essential for intelligent and successful investing.

I hope you are convinced, too.

[1] The reason it is not exactly zero is due to rounding. If we could assume that gamblers could split cents and pay amounts such as $1.6666667, we could then get the expected payout to exactly balance to zero.

Single-Stock Futures Part 16

Spreads

Spreads are strategies that involve the buying of one contract and the selling of another one. The term "spread" is used because the trader attempts to profit from a change in the spread -- the price difference between the two contracts -- as opposed to an overall rise or fall in the underlying. For example, if a January Microsoft contract is $60 and a March contract is $60.75 then the spread is 75 cents to the March side. Let's assume that you buy the January contract and sell the March. If the price of the January contract rises faster than the March contract, you will make money. This is because the amount you make on your long position is greater than the amount you lose on the short position.

To see why, assume that the January contract rises to $61 and the March contract rises to $61.50. Notice that the spread has shrunk from 75 cents to 50 cents, which is a gain of 25 cents. We can also find this 25-cent profit by considering the individual contracts rather than the spread. The January contract rose $1 (from $60 to $61) while March only rose 75 cents (from $60.75 to $61.50). Therefore, you gained $1 on the long position and lost 75 cents on the short for an overall gain of 25 cents, which is exactly the same answer we got by just looking at the difference in the spreads between the opening and closing trades. We can see these effects in the following table:

Prices do not necessarily need to rise in order for the above trader to make money either. For instance, it is possible for the January contract to fall from $60 to $59.70 while the March contract falls from $60.75 to $60.25. If so, the trader loses 30 cents on the long contract but gains 50 cents on the short contract for a net gain of 20 cents. A profit was made here because the short position fell by a larger amount than the long position. The next table shows how the same trader can make money if prices fall:

Please don't interpret this to mean that spreads will make money if prices rise or fall. We constructed both of the tables so that the trader either made more money on the long position than he lost on the short (Table 1) or that he lost less money on the long position than gained on the short (Table 2). Obviously there are other scenarios. If prices rise on both contracts as in Table 1, but the short contract rises by a larger amount, then an overall loss will occur. Similarly, if prices fall as in Table 2, we could have shown the long position falling more than the short position, which would result in an overall loss as well.

Spreads on futures contracts are a little different from spreads with options because options have strike prices and time premiums. With strike prices, there are arbitrage rules that definitively state which contract will be more valuable. For example, we know that a May $50 call will always be more valuable than a May $55 call. Similarly, we know a July $50 call will be more valuable than a May $50 call since there is more time remaining on the July option. Likewise, time premiums can determine whether the strategy is bullish or bearish. If a trader buys a May $50 call and sells a May $55 call, we know that it will result in a net debit as the time premium on the $50 call will be higher than the $55. Because this spread is paid for (net debit) we know that money must be recouped in order for it to be profitable and the strategy of buying a $50 call and selling a $55 call is therefore bullish.

However, this is not so for futures. We may think a more distant contract should be more valuable but there are no guarantees it must be so, as we learned with inverted markets. Also remember that futures contracts do not contain "time premium" above their cost of carry, so it is impossible to tell if a futures spread trader is actually bullish or bearish just by looking at the position.

If you are using spreads on futures, you need to determine the pricing relationship between the two contracts; that is, which one will move higher or lower relative to the other?

Spreads are a lower risk, lower reward strategy. In most cases, your broker will require smaller initial margin deposits if you are entering a spread order because of the reduced risk. Bear in mind that we say "in most cases." This is because your broker will want to see some type of correlation between the two assets. A high correlation simply means that the price movements are "tied together" by economic forces. Obviously buying a June Microsoft contract and selling a May Microsoft is highly correlated. If we see one Microsoft contract rise, we can be pretty sure that most of them have moved in the same direction.

Likewise, buying an airline contract and selling an oil contract is a highly correlated spread position. If oil prices rise, you can be pretty sure that airline prices will fall. Correlation does not mean that they must move in the same direction but only that we can be reasonably sure how they will move. In the case between airline stocks and oil stocks we would say the two are negatively correlated. So if you wish to enter a spread with no correlation such as purchasing a Microsoft contract and selling lean hogs, don't expect your broker to have a lower initial margin requirement!

Why Use Spreads?

While spreads are less risky, they are actually more complex for the trader to carry out profitably, which is not so for the spreads using options. The reason is that the trader must determine which contract will rise or fall relative to the other. If you think a surge in demand will occur soon, you may buy a nearby month and sell a more distant month, which is referred to as a bull spread. On the flip side, if you think there will be a fall in demand (or an increase in supply for commodities) causing the price to fall in the near term, you may sell the near-term contract and buy a more distant contract, which is a bear spread.

Key Points

The strategies of "bull spread" and "bear spread" are in relation to the near-term month. If you think the near-term month will rise relative to more distant months, you would buy the near term and sell the longer term, which is a bull spread. If you think the near term will fall faster than the longer term, you sell the near term and buy the longer term, which is a bear spread.

The Mathematical Effects of Spreads

Diversification is key to reducing the risk of any portfolio. The reason diversification helps is that the variability in any portfolio is largely caused by assets having positive correlation. In other words, when the stock market is up, most of the stocks in your portfolio will be up. When the market is down, most stocks will be down, too. Stocks tend to move in the same direction of other stocks. In order to reduce these tandem up and down swings, we need assets that pull in the opposite direction of other assets -- we need negative correlation.

Correlation is a statistical measure that shows the degree to which to variables move together. A "correlation coefficient" can be calculated and is between -1 and +1 inclusive. A correlation value of +1 means that the two assets are perfectly predictable. A move in one asset is matched by the other in exactly the same direction (because of the plus sign) and magnitude. Any stock therefore has a correlation of +1 with itself. A correlation coefficient of zero means there is no consistent way to predict the movement of one asset based on the other. In other words, the two assets move independently of each other; they are random. A correlation of -1 means the two assets are perfectly predictable, but the minus sign tells us they move in the opposite direction. If one asset is up 2%, the other is down 2%.

If you are new to investing this may be a new concept for you, so we're going to demonstrate it with an example. Say you own a small engine manufacturing factory and produce nothing but lawn mowers. If so, your sales will be up in the spring and summer months when everybody buys lawn mowers. Conversely, sales will be way down in the fall and winter months. Your business would be exposed to seasonal swings, which can hurt cash flows, profitability and growth. To guard against this, you could manufacture snowmobile engines, too. When lawn mower sales are high, snowmobile sales will be low and vice versa -- negative correlation -- and the variability of your cash flows are smoothed out.

Any time we enter a spread order or add negatively correlated positions to our portfolio, we are adding a little bit of negative correlation to the portfolio and therefore eliminating some of the fluctuations just as when snow mobile engines were added to the lawn mower factory.

We can use negative correlation easily with futures contracts. We can buy a futures contract for one particular month and sell a different month, which is called an intramarket spread. We can even buy one contract of one company and sell another contract of a different company, which is called an intermarket spread. Regardless of which type is used, the sale of the second contract creates a negative correlation for the two positions because we're selling a positively correlated asset. The risk-reducing effects can be tremendous.

For example, in the next class, we will talk about a strategy called "pairs trading," which is simply an intermarket spread. Under this strategy, the investor simultaneously buys and sells contracts of related companies such as IBM and Dell Computer. What does this accomplish? First, let's look at what happens to an investor who purchases both stocks. The effects of this purchase of two related securities can be shown mathematically with the addition of a couple more statistical measures: variance and covariance.

Variance simply describes how much variability there is between prices. The exact meaning or calculation is not important for our purposes. Let's assume that the daily variance over the past year for IBM is 0.10% and 0.12% for Dell. If Dell and IBM were independent of each other (that is, no correlation) the total variance of these two positions would be 0.10 + 0.12 = 0.22. However, because they are in the same industry, they will tend to behave similarly. We can even test this with another statistical measure called the covariance, which is similar in concept to correlation and measures how strongly the two assets move together. Again, the formula or exact interpretation of it is not necessary to understand the benefits of spreads or diversification. Let's assume the covariance between these two stocks is 0.09% per day. Once we have this information, we can determine the total variance for the two stocks combined. It will be equal to the sum of the two variances plus an additional term, which is 2 * covariance between them. The total variance is therefore 0.10 + 0.12 + (2 * 0.09) = 0.40.

Notice how the variability has risen dramatically from 0.22 to 0.40 -- nearly double -- by purchasing both stocks. This is similar to waves moving across an ocean. If waves meet in any kind of synchronized way (positively correlated), they will get bigger. Only when they are moving opposite of each other (negative correlation) will they diminish in size.Positively correlated stocks combined in a portfolio only add to the variability; they don't reduce it.

While the investor who buys both stocks may have put their money in two separate stocks, there is very little diversification benefit here since both companies are highly correlated and will tend to rise and fall together. Figuratively speaking, they have put their eggs in separate baskets but loaded those baskets onto the same truck (the computer industry). One of the biggest myths in the investment world is the belief that the idea behind diversification is to buy different stocks across the same industry. The idea is not only to have different stocks but, specifically, different stocks that are negatively correlated.

Let's see what happens with a matched pair trade and assume an investor buys IBM and sells Dell. If so, the formula is now changed and we must subtract the covariance between the two. The new variance for this investor in IBM would be 0.10 + 0.12 - (2 * 0.09) = .04%, which is less than half the amount of original variability.

The idea of creating short positions, whether for a spread or just to add to a portfolio, is one of the biggest advantages of single-stock futures for all investors. Even if you believe that shorting stocks or futures is too risky for you, it can be shown mathematically that the right contracts in the right amounts will actually reduce the variability of your portfolio -- without reducing the returns. While this may sound counterintuitive, the concept is the foundation of modern portfolio theory, which gives a broad foundation for understanding market risk and reward.

There is no easier or more cash-efficient way to reduce the overall risk of your portfolio than with futures contracts. In fact, one of the founding reasons for the creation of the broad-based futures contracts, such as the S&P 500, was so institutional traders could gain perfect negative correlation with the market by simply shorting that contract. There is no simpler way to do it. As we've said throughout the course, futures contracts were not developed for speculation even though that's the purpose for which many traders use them. Single-stock futures provide methods of hedging and speculating that are not available through any other means.

Futures Spreads

Trading market "relationships" rather than market direction.

This is a great short course in futures spreads that shows how effectively they can be used in the commodities markets. This content was supplied by our friends at Opportunities in Options (OIO), which is one of the largest and most reputable futures firms. If you have any questions about OIO, commodity or single-stock futures, please feel free to contact Greg Mitchell at 1-800-926-0926 (ext. 259) for more information.

Seasonal Futures Spreads : A Quick Introduction

1. Seasonal Spreads are simply a simultaneous buy and sell in different futures contracts. The trader is only concerned with the relationship between the prices of the different contracts involved and not with the direction each individual contract may move.

2. If a trader thinks the difference between the contracts will increase, it would be possible to win on the trade as long as the contract he buys goes up more than the one he sold, or even if the one he sold goes down more than the one he bought.

3. If a trader thinks the difference between the contracts will decrease, it would be possible to win on the trade as long as the contract he buys goes up less than the one he sold, or even if the one he sold goes down less than the one he bought.

4. These trades can involve either the same commodity with different delivery months (i.e. buy July Wheat and sell December Wheat), or different commodities (i.e. buy December Wheat and sell December Corn). We look for Seasonal Spreads that have a strong historical pattern of consistency. Although past performance does not insure future results, we sure do like to have a strong historical tendency in our favor during the time of the trade.

5. Upon entering the trade, we usually set an initial profit objective and we always have a predetermined risk level. To help establish these levels, again we find it helpful to research the history of each Seasonal Spread over the past 15 years.

Seasonal Spreads: A Detailed Explanation

The idea of "seasonal trading" in individual futures markets and futures "spreads" is based on the repetitive price patterns that many markets can exhibit throughout the year. Evaluating different known repetitive trading opportunities every month may be one of the oldest uses of a "systematic trading strategy."

For example, in physical commodity markets such as the grains, price patterns from lows to highs may be based on the normal planting and growth schedules, combined with weather cycles and demand factors. Prices may make seasonal peaks just as supplies from old crops are dwindling, before new-crop supplies are assured and hit the market. In the financial and stock markets, there are also rhythms based on institutional or government buying and selling. Annual investment patterns in the equity markets have made the six-month period from November to April far more profitable than the other six months of the year.

These "seasonal" patterns of supply and demand and the associated price patterns can be an important criteria for evaluating trading opportunities,and all traders should be "aware" of any strong seasonal tendencies normally associated with a market they are considering trading. In addition, seasonal trading and futures spreads can provide unique profit opportunities for traders willing to study this under-appreciated resource in the trading world.

One example of how a trader might use the knowledge of seasonal trading patterns in an inter-market spread can be seen in a trade in August Soybean Meal futures versus Soybean Oil in the 2000 contracts. This classic spread can often start to make a move in favor of the Soymeal starting in the spring, when the market anticipates continued strong demand for the last of the old-crop supplies of Soybean meal while recognizing a normal demand peak for Soybean Oil in May.

Historical price pattern analysis provided by Moore Research showed that entries in this spread near the end of April have a good chance of generating profits if held into the middle of July.

Well, right at the time that a trader might want to consider this spread, it was clearly in a multi-week downtrend, and most traders would want to wait for a sign that the normal seasonal pattern might actually take hold in this particular year. Spread traders know that "counter-trend" moves can be very powerful, and blindly following a seasonal trading pattern can lead to disaster.

So how might you approach a trade in this spread? Well, this is where "the art of trading" comes into play to establish a plan. In the "Winning In Futures" trading letter, the plan was to either buy the spread if it moved down to a potentially strong support area and started to recover, or broke out of its existing downtrend pattern. Here's how the trade was setting up at the time:

Excerpt from the "Winning In Futures" trading letter, April 20, 2000.

The long August Soybean Meal/ short Soybean Oil futures spread is entering a period of seasonal strength. Watch the spread for favorable price action and consider entries.

This is a classic seasonal spread, driven by the normal supply/demand dynamics between these two members of the soy complex. The market can start anticipating continued demand for the end of old-crop meal supplies, while also seeing a demand peak for soybean oil that can come in May. Technically, the spread is in a very defined downward correction channel within a longer-term uptrend.

Since the two contracts in this inter-market spread (some might say inter-commodity) trade at different point values, the spread is charted and tracked as an equity spread. This involves calculating the dollar value of each contract, and subtracting the short from the long. In this case, the last closing price for the spread was $5,542. To get that number, first calculate the value of the 100 ton soymeal contract (100 x $170.20/ton = $17,020). Then subtract the value of the 60,000 pound soyoil contract (60,000 x 19.13 cents/lb = $11,478). This gives you 17,020 minus 11,478 = 5,542.

Use either of two entry triggers for this trade:

Consider entries in this spread if it moves down further to test support in the 5400-5200 area (lateral support at the October '99 top at 5390, and a 62% retracement of the November-February rally is down at about 5228). If this support area is tested, consider an entry after the first positive close.

Also consider entries in this spread if it breaks out above the two-month downtrend line. Currently, a close at about 5800 or higher would trigger entries. The trendline is moving down at a rate of about $50 per trading day, so adjust accordingly.

The floor should accept orders based on the actual equity difference, the way the spread is charted. I have conflicting information on the margin requirements, but I believe that this spread is not given a margin break by the CBOT, so figure about $1,150 for margin per spread. Considering that it can move two or three times that amount within just a few weeks, it's still reasonable.

If entries are taken, the initial suggested risk is about $500 on a closing basis.

So, the spread was in a prime "seasonal" set-up period, and a trading plan with risk suggestions was established. It turned out that the trade entry was triggered by the market posting a bullish breakout above the downtrend line, almost right on schedule with the seasonal pattern expectation. Within just four weeks, traders had a good opportunity to take profits on this spread.

Excerpt from "Winning In Futures" trading letter, May 18, 2000.

Long August Soybean Meal/ short Soybean Oil futures spread. This trade was featured four weeks ago, and triggered entries when it broke out above the downtrend. It easily reached $2000 in profit since the breakout, and partial profits were suggested for multiple positions. It's tracked as an equity spread because the contracts trade at different point values.

The seasonal pattern can be favorable all the way into July, and another "optimal" seasonal entry point comes near the end of May. Move the trailing profit stop up to a close below $7,000 meal premium. Traders with single positions should also consider taking profits at about the $8,500 level, if reached.

Another Example of trading an "intra-market" spread is shown in the Heating Oil market. Since futures markets often "look ahead," the heating oil market often responds in the summer to anticipated demand for winter supplies. One way to play this tendency in this volatile market is buy buying a mid-winter contract (potentially the peak usage period), and selling one more deferred.

Excerpt from the "Winning In Futures" trading letter, July 13, 2000.

General Trade Comments:This week a new futures spread in the energy market is featured. We're nearing a good seasonal entry point for bull spreads in heating oil that are long a mid-winter winter contract and short one more deferred. These spreads often start working in July, as the market anticipates winter demand and starts to build inventory for the winter season. The January/March spread has already traded to very high January premiums, but the trend is up and we've seen many of the individual energy contracts and spreads challenge or exceed all-time historic extremes during the past year. As of yet, there is no convincing evidence that the bullish global supply/demand picture for energies is about to change.

It's time to start thinking about bull spreads in winter heating oil, as the industry looks to build inventory during the summer and fall.

Consider the long January/short March heating oil spread on a pullback to about 450 points January premium or lower. Limit orders are suggested in this market.The trading idea is to enter the spread near the top of the May-June consolidation, and near the rising trendline. The margin should be about $550. Suggested risk is about 100 points from entry ($420), below the bottom of the sideways consolidation from mid-May to mid-June. The high of that trading range was at 435 points January premium on May 19 and May 25, and the low in mid-June was at 375. Heating oil trades in 42,000 gallon contracts, and 100 points = 1 cent/gallon = $420. Favorable historical seasonal patterns can run into September for these spreads.

This classic seasonal spread is also featured in the July issue of the Moore Research Monthly Report. For more information and a free trial of their extensive resources on the Web, give them a call at 800-927-7259, and tell them you're one of our readers.

This spread then moved down into a strong support area and gave traders good entry opportunities in this classic "seasonal spread."

Excerpt from the "Winning In Futures" trading letter, August 31, 2000:

Long January Heating Oil/ short March futures spread. Suggested 7 weeks ago below 450 points January premium. The dip to support at the lows of the May-June consolidation provided great entries in the last half of July. The idea is that bull spreads with a long mid-winter contract in heating oil start to work as the industry builds inventory for the winter. Additional supply concerns about potential shortages have "fueled" this spread to its highest level at this time of year, and it's third-highest in at least 15 years. Normal seasonal price patterns for the spread are often favorable until the end of September, just due to the inventory building. Smaller accounts should have been taking profits near current levels, and multiple positions taken partial profits. Or, move a trailing profit stop up to 700 points January premium. From the entry area, the spread is up easily over 400 points ($1680+). In HO, 100 points = $420.

Seasonal Spreads: Questions and Answers

Which markets is this strategy used in?
We monitor numerous futures markets for seasonal strategies that fit our criteria. These markets include: grain markets (corn, wheat, soybeans, etc.), metals markets (gold, silver, copper etc.), and financial markets (stock index futures, bonds, currencies, etc.).

Does this strategy use options or futures contracts?
Futures contracts are used for many trades, but options may also be used if they can provide us with an edge.

What is the maximum risk on this strategy?
Risk levels on each trade will vary but every trade will have a pre-determined exit strategy at a specified level of loss. If left unattended, seasonal spreads could have unlimited risk.

What is the maximum profit potential of this strategy?
Seasonal spreads have unlimited profit potential but we normally suggest pre-determined profit objectives for at least part of the position.

How much of my time will it take to use this strategy?
It is up to you how closely you wish to follow each trade. Most traders who work with us stay in touch once or twice a week. (Stop) orders and profit objective orders can be taken at the same time as the entry order. This would allow you to continue trading even when you are busy or on vacation. There is no need to be glued to a quote screen all day.

How often is this strategy used?
Sometimes good opportunities seem plentiful and other times we simply wait for a nice looking trade setup. Generally speaking, with all the different market combinations, there is usually a good seasonal spread available on a regular basis.

How much trading capital does this strategy require?
Some spreads have as little as a few hundred dollars margin requirement. Others have substantially more. We recommend at least five to ten thousand dollars be made available for seasonal spread trading.

Seasonal Spreads: Summary of Benefits

1. Lower margin requirements than straight futures positions.

2. A wide variety of trading situations to choose from.

3. Not dependent on calling the correct market direction of individual contracts.

4. May be easier to predict market relationship patterns than price direction.

Single-Stock Futures Part 15

Creating Your Own Index

In the last course, we saw how a long or short futures positions in a single stock or index can be used to make money in rising and falling markets respectively. We can now take it one step further and use futures to actually modify an index to our expectations.

For example, what if you were bullish on the Nasdaq 100 with the exception of one of the stocks in it? That's easy to fix with futures. You can simply buy the NDX contract and short the contract of the company you do not like, which effectively spins that company out of the index and creates your very own Nasdaq 99. The possibilities are endless, and there is no other vehicle that allows it to be done so easily and efficiently as futures contracts.

It is possible to "delete" stocks from an index by shorting them; however, the initial 50% Reg T deposit makes it much more costly. If there are several stocks you wish to spin out of the index, you will not be able to do so if you cannot meet the margin requirements. Futures contracts make the strategy far more efficient because of the small initial margin requirement.

There is one thing you need to be aware of if you choose to remove a stock from an index by shorting a futures contract. You need to make sure you properly match the number of short futures contracts with the number of long contracts.

For example, the top ten holdings (by percent) in the Nasdaq 100 are as follows:

Microsoft	12.405
Intel Corp	6.366
Cisco Systems Inc.	4.757
Amgen Inc.	3.724
Qualcomm Inc.	3.574
Dell Computer Corp.	3.295
Oracle Corp.	3.084
Maxim Integrated Products	2.352
Concord EFS Inc.	2.040
Applied Materials Inc.	1.893

Let's assume you buy one NDX futures contract, which is currently around $940. This means the total contract value is $94,000. Of that dollar amount, 12.405% is in Microsoft, or $11,660. Because Microsoft is currently trading around $44 per share, you are effectively controlling $11,660/$44 = 265 shares.

If you buy the NDX contract and short the Microsoft single-stock futures contract, you will still be long 165 shares. If you short two contracts, you will be long only 65 shares, but still long nonetheless. If you short three contracts, you will effectively be short 35 shares (300 shares short -- 265 shares long). Remember, in order to effectively remove a stock from an index, you need to have zero exposure in the stock -- not slightly positive or negative. So, in this example, shorting less than three contracts leaves you with a positive bias while shorting three contracts leaves you with a slight negative bias. If you wish to exactly remove the risk, you'd have to combine futures with stock and short two futures contracts and then short 65 shares of stock. Still, this will be much cheaper than shorting 265 shares of stock. Just be aware that the simple act of shorting one futures contract is not necessarily enough to fully remove it from an index. In fact, in some cases, shorting one contract may even be too much if the stock has a small presence in the index. In these cases though, you must question if it's worth taking out.

Narrow-Based Indices

In addition to many of the broad-based indices that you may choose, many of the exchanges will offer their own narrow-based indices, which are basically the same idea as sector mutual funds. The big difference is that the narrow-based futures can be traded continuously throughout the day whereas mutual funds are generally only executed at one time in the evening. OneChicago plans to offer the following narrow-based indices:

Energy

• Natural gas
• Utilities
• Transmission
• Extraction services
• High technology companies

Personal computer makers

• Computer storage
• Database software
• Security
• Online markets

Health care providers

• HMOs
• Pharmaceuticals
• Hospital operators

Telecommunications

• Wireless
• Networking
• Infrastructure

If you wish to learn more about their narrow-based indices, you can do so at this link: http://www.onechicago.com/030000_products/oc_030201.aspx

These indices provide investors with some diversification while still providing strong exposure to a particular sector. In the past, if you thought computer makers would do well in the next year, you would most likely pick one or two stock in that sector. What if they were the worst performers in the group? You can see where the narrow-based indices can help to take the guesswork out of investing. If you think computer makers will do well, it only makes sense to invest in computer makers rather than a specific company.

While mutual funds offer this same benefit with sector funds, that is only if you are bullish on that sector. This is because you cannot short a mutual fund whereas you can short the narrow-based futures contracts. In addition, many mutual funds have high minimum requirements and also charge hefty fees for those who actively switch between funds -- even within the same fund family.

As with the broad-based indices, you can spin off individual stocks from a narrow-based index, but you must be sure to match up the proportions. One really nice feature about the narrow-based indices at OneChicago is that they are dollar-weighted to the nearest hundred shares (with a minimum of 100 shares each). This means they attempt to invest the same dollar amount in each stock and then round up or down to the nearest hundred shares. The main point is that they will be in lots of 100 shares, so it's very easy to take stocks out of the index.

Key Points

Narrow-based indices will hold shares in even lots of 100. They will be very easy to custom tailor and will be one of your most effective trading tools!

You can be sure that these will be very popular with investors, and that more sectors will likely be created as their recognition increases. It is therefore a good idea to keep up-to-date with the current narrow-based indices the exchanges are offering, as they are one of the best and most efficient investment tools you can use.

Covered Calls

Covered call writing is a strategy where the investor buys the underlying asset, usually stock, and then sells a call against that stock. For example, if you buy 100 shares of Intel at $28 and then sell a $30 Intel call, that is a covered call position. Which strike price to use is a matter of preference. If the investor writes a $30 call, there will be more premium than if a higher strike, such as a $35, is written. The higher premium allows for more downside protection while the higher strikes allow for more potential gains in the stock. The reason the strategy is considered "covered" is because the investor will always be able to deliver the shares if the long call owner decides to exercise his right and demand the stock. In other words, the risk of higher and higher stock prices is eliminated since the investor already owns the shares. If the stock rises though, the investor can only make a limited amount of money since he has "sold off" all rights above the strike price. In exchange for this, the investor receives a premium (cash credit) to his account, which is his to keep regardless of what happens to the underlying.

This is not to say that the covered call strategy is without risk. The risk is to the downside since the covered call investor owns the stock. If the stock falls substantially, the investor will lose that value but can only gain a fixed amount from the sale of the call. Once that premium is depleted, the strategy heads into losing territory.

Because you can only make a limited amount yet are still exposed to all of the downside risk (less the premium received), the covered call strategy should only be used if you are neutral to slightly bullish in your outlook on the underlying. If you think the underlying will run to the moon, you're better off buying the call, not selling it. Likewise, if you think the underlying will fall substantially, you're better off selling the call by itself (naked call) or buying a put.

Using Covered Calls

For example, let's assume an investor buys Intel stock at $28 and sells a two-month $30 call for $1.25. If so, the investor's cash outlay is reduced by the amount of the premium, which gives a new cost basis of $28 - $1.25 = $26.75. There are three important rates of return to compare. First, if the stock is exactly the same price at expiration, the investor profits by the $1.25 premium and the gain is $1.25/$26.75 = 4.7%. Another method is to realize that the investor paid $26.75 for a stock now worth $28, which is a 4.7% increase. Regardless of which method you use, it is important to annualize that rate since it was earned after only two months rather than one year. Because there are 12/2 = 6 groups of two-month periods in a year, we need to multiply the 4.7% return by 6 for an annualized rate of about 28%. This is called the "static" rate of return since it assumes the stock has not moved.

Another rate we want to look at is the "return if called" rate. As the name implies, this is the rate if the stock is called away (the investor is assigned on the short call). If the investor is assigned, they must give up the stock and receive the strike price of $30 in exchange. If this happens, the covered call writer nets a gain of $3.25 (bought at $26.75 and sells for $30) for a rate of 12.15%, or nearly 73% on an annualized basis.

As stated earlier, the risk of the covered call is that the underlying stock falls. If the stock falls, the investor may lose money but will not lose as much as another investor who just holds the stock. This is because the $1.25 premium provides some cushion to hedge the long stock position. So a third rate we need to look at is the "breakeven" rate, which is simply the percent fall the stock can sustain and still break even. In this example, we are assuming the investor paid $28 for the stock, which means it can fall to a level of $28 - $1.25 = $26.75, which is about a 4.5% fall. We do not need to annualize this rate, as we're only concerned with the actual percentage drop we can sustain and still break even. If the stock falls 4.5%, we just break even on our investment. Notice how a stockowner at $28 would be down 4.5% while the covered call writer would be down 0%. This shows that covered calls provide some downside protection.

Depending on which month and strike you choose, all of the above rates of return will change. If you find a set that suits your particular needs, that is the month and strike you want to write. Higher strike calls will bring in less money but provide a higher "return if called" rate while lower strike calls will bring in more money and provide a higher "breakeven" rate.

Using this covered call analysis for stocks, we can carry it over to futures. Once again, the only difference you will find is that the leverage will be about five times greater due to the low 20% initial margin rates on single-stock futures.

For example, let's assume this investor instead buys a single-stock futures contract on Intel at $28 and then sells the $30 call. The total contract value is $2,800 and the initial margin requirement, assuming it's 20%, will be $560. The futures buyer is required to put $560 down but receives $125 from the sale of the call for a net deposit of $435.

To find the static returns, we assume the futures contract can be sold for $28, which is the same as the purchase price, so it nets no gain or loss to the buyer. The futures buyer effectively invests $435 and collects $560 at expiration for a net gain of about 28.7%, or 172% annualized. With $125 credit from the call option sitting in the account, the single-stock futures position can drop to a level of $435 before breaking even.

There are some important points to consider with covered calls on futures. First, remember that the above calculations are assuming all else constant. In the real world, we are exposed to basis risk so the above calculations will sometimes be improved and sometimes not. Second, we are assuming the sale of an equity option -- an option on stock -- and not on futures. This is perfectly okay to do and may be more advantageous for you in some circumstances. Just be aware that you should probably sell the option contract that expires at the same time as the futures contract. That way, if you are assigned on the call and the stock is way up, you simply take deliver of stock from your futures contract. There is also the risk you could get assigned early on the calls, although this usually does not happen as it is not in the call owner's best interest. However, if you are assigned on the call option early you cannot take delivery from your futures contract early. But you could always short sell the stock to make delivery and use the futures as a hedge.

There are many combinations of covered calls from which to choose. Now with single-stock futures -- and eventually options on them -- you will be able to utilize them more efficiently and with greater leverage.

Single-Stock Futures Part 14

What's the Best Strategy?

We're gearing up for strategies now that we have the basics of futures and options behind us. But before we do that, it's important to understand that strategies are tools just like futures and options. There will be times when one strategy is better than another and other times when it isn't. Likewise, sometimes futures will be your best choice and other times, options may be the better choice. This is so important to understand, and that's why we are presenting this course now. Many new traders start with futures or options and look for the "best" strategy as if one is always better than another.

You may have already heard many opinions as to which option strategies are the best: Covered calls are best because they reduce the risk but still allow for a profit. Naked puts are the best because you're getting paid to buy stock. Straddles are the best because they allow you to make money whether the market is going up or down.

If you've been trading options for a while, you have probably heard many others. But when you hear comments such as these, all you're hearing are opinions of one trader's preference for a particular risk-reward profile. In order to really understand options and futures trading, you need to understand that each comes with its own set of risks and rewards and the market will price them accordingly. Be careful of someone who tells you that one particular strategy is superior to another; he either does not fully understand options or he is trying to sell you something.

Traders who tout superior option strategies focus on one aspect of the strategy -- either the risk or reward side -- and completely neglect the counterpart. They will make comments such as, "Calls are superior to stock because the return on investment is much higher." It's easy to make them consider the risky side by replying, "Sure, but lottery tickets are superior to calls because the return on investment is even higher."

The best option strategy is the one that directly matches your set of risk and reward tolerances for a given outlook on the underlying asset. This is the level of option trading you want to achieve. Learn to dissect a position into its component parts and see if you are willing to accept the associated risks. Learn the various strategies and how you can further tailor them to better match your needs. Don't spend your time looking for the superior option strategy. It doesn't exist.

Understanding Risk and Reward

To fully understand the relationships between risk and reward with options, we need to look at profit and loss diagrams.

If you compare the profit and loss diagrams of any two strategies, there will always be a part of the diagram where each strategy shows its strength.

For example, let's revisit an earlier comment. Are call options superior to stock? Assume one investor buys stock for $50 and another buys the $50 call for $5.

We can plot the profit and loss, at expiration, for each position and we will get the following diagram:

For example, the trader who buys stock at $50 will make $5 profit if the stock is trading for $55. If you look at the above chart, you can see that the profit and loss line (red) crosses the $5 profit line for a stock price of $55. Likewise, if the stock is trading for $45, the trader will incur a $5 loss.

The diagram also shows that the long $50 call buyer (blue) will lose $5 if the stock is $50 or below and will break even if the stock is $55. At a stock price of $60, the $50 call buyer will make $5 profit (the call option will be worth $10 but the trader paid $5).

Notice the profit and loss diagram for stock (red). It is superior to (lies above) the profit and loss line for the long call (blue) for all stock prices above $45. This is because the call option buyer is effectively paying $55 for the stock ($50 strike for a cost of $5). If the stock stays above $45, the long stock position is the better strategy (the red line is above the blue line.) But if the stock falls below $45, the call option becomes the better strategy (the blue line is above the red line), as the most the long call will lose is the premium. It should be evident that one strategy is not better than the other; it depends on your outlook of the stock and the amount of risk you are willing to accept.

An investor who believes the stock will stay above $50 is better off buying stock. Of course, there is a tradeoff of accepting a potential $50 maximum loss. Conversely, an investor who believes the stock is heading higher but doesn't want the exposure to the downside is better off buying the call. The tradeoff is that he will pay $55 for the stock instead of $50, but in return, he'll only be subjected to a $5 maximum loss.

If traders are more concerned with the downside risk, they will bid up the price of the call. If they feel the price of the call is too high relative to the stock, they will sell the call (either naked or covered). These actions will price the call fairly with respect to investors' opinions, and neither strategy will be superior to the other.

What about naked puts? They must be better than stock because you are actually getting paid to buy the stock, right?

Let's look at the profit and loss diagram between stock purchased for $50 and a naked $50 put sold for $5:

Again, in some areas of the chart, the long stock position dominates and others it does not. The long stock position is better for stock prices above $55. With the stock above $55, the long stock investor will realize unlimited profits while the naked put will profit only by the premium received from the sale of the put.

However, if the stock is below $55, the naked put is the better strategy. Below a $50 stock price, both investors lose but the naked put seller is ahead by the premium.

Maybe a long call is better than a naked put? Some may reason that the long call position makes more money than the short put if the stock rises and loses less if it falls so it is a better strategy. Let's assume a long $50 call and short $50 put are each traded for $5:

Looking at the above chart we see that the long call position (red) does dominate for all stock prices above $60 and below $40. But, if the stock stays between these prices, the naked put is clearly the better choice. Your outlook on the stock and tolerance for risk will determine which strategy is best for you.

Pick any two strategies and look at their profit and loss diagrams. You will always see that each strategy will dominate over a given range of stock prices. Try switching one position from long to short. Try changing strike prices. You will soon see that it does not matter; one strategy cannot dominate another for all stock prices.

Strategies come in all shapes and sizes. Now you should have a better understanding why that is true. Different strategies alter the risk-reward relationships and it is up to you, the trader, to decide which is best. Do not be afraid to alter the strategy to meet your taste -- that is what good trading is all about. If you accept somebody's strategy as the "best," you are, by default, accepting his or her risk tolerances too. If those tolerances are not in line with yours, you will eventually learn, the expensive way, that no strategy is superior to another.

As you read through the next sections on the various strategies, try to identify which ones sound like you, rather than trying to find the "best" strategy. Likewise, don't spend time looking for the strategy that provides the most reward for the least risk -- you won't find it. I only mention this because these are frequently asked questions, but they represent the wrong approach to understanding strategies. If you think about it, strategies must offer tradeoffs between risk and reward; otherwise there would only be one strategy, and everybody would use it. There would be no reason to learn others. Every time you adjust a strategy, even if only a little bit, you are altering the risk-reward profile (the profit and loss chart). Look for the strategies that appeal to you and those will be your best choices.

Basic Strategies

Of all the strategies that are available, two of the most basic will probably be the most utilized. Those strategies are the long futures position and the short futures position. You should know by now that the long position makes money if the underlying rises, and the short position makes money if it falls. So these two strategies are basically substitutes for long and short stock positions. If you want to invest longer term, futures contracts can provide a means to invest with less money. If you wish to speculate, you can buy if you think the underlying will rally or sell if you think it will fall. Using futures, you can speculate for much smaller margin requirements and can change directional biases much quicker, too.

Let's look at some examples of how these basic strategies can benefit you.

Long Futures Position

One of the most basic uses of futures is for speculation. If you think a stock is going to move higher, you now have the choice of buying a futures contract instead of the stock. As we've shown, this revolutionary new asset can provide significant leverage. Long positions can be established on individual stocks or even an index. Let's say you think the Nasdaq will move higher over the next three months.

The Nasdaq 100 (NDX) is a cash-settled index, which means it only settles in cash. You cannot take delivery of the 100 stocks in the index. Their contracts trade at the Chicago Mercantile Exchange (CME) and have a value of $100 times the level of the NDX. Currently the NDX is currently 1204, which means the total value of that contract is 1204 * $100 = $120,400, yet the initial margin is only $15,000 with maintenance margin set at $12,000. The $15,000 initial margin represents slightly more than 12% of the contract value.

The September contract is currently trading at 1216 with 140 days to expiration. By purchasing the contract, you are agreeing to pay the cash value of the index at a price of 1216 * $100 = $121,600. To do so though, you only need to put $15,000 down to control that contract.

Let's assume you are correct and the NDX rallies to a level of 1300, which is up 96 points, or 7.97%. At that point, the futures contract can be sold for at least 1300 for a profit of (1300 - 1216) * $100 = $8,400. We say the contract can be sold for "at least" 1300 because there will likely be some cost of carry associated with it just as when we purchased the contract for 1216, even though the index was trading for 1204. Assuming a price of exactly 1300, your account would move from $15,000 equity to $23,400 ($15,000 + $8,400 gain), or a 56% increase. Notice the leverage at work here. The index moves up 7.97% yet you gain 56%. Because your initial margin deposit represented about 12.5% (and not the usual 20% for single-stock futures), that means you should get leverage of about 1 / 0.125 = 8 times higher than the move in the underlying index. We can see that 56% / 7.97% = roughly 7%. The reason it doesn't match exactly is because the initial margin was not exactly 12%, but slightly higher. Why don't they require a 20% initial margin? The reason is because the Nasdaq100 is a broad-based index and carries a great deal of diversification. Because it's less risky compared to just picking an individual stock, the requirements are correspondingly lower.

Ready to see some real leverage at work? Figure 1.1 shows the Nasdaq 100 Index between October 1999 and May 2002. Between October 1999 and late March 2000 (shown between the first two vertical bars), the Nasdaq 100 climbed from 2334 to 4816, representing more than a 100% increase in less than 160 days. While this may sound rare, it can and does happen with volatile indices more often than you may think. If you had purchased the contract for about 2340 (2334 plus some cost of carry) and sold for 4816, that would net a profit of (4816 - 2340) * $100 = $247,600 for $15,000 down and virtually no maintenance calls along the way. Of course, it would be unlikely that you'd catch the index at the start of a great run and sell it at the peak; however, this example shows that aggressive movements occur in the markets and that a lot of money can be made for very little invested. Even if you only caught a fraction of that move you could have easily doubled your money in virtually no time at all.

Figure 1.1

E-Mini Nasdaq 100 Contracts

Incidentally there are a series of "e-mini" contracts traded at the CME. The "e" stands for "electronic" and the "mini" represents the fact that they are reduced in size. The e-mini Nasdaq contracts are one-fifth the size of the regular contract, which means their multiplier and initial margin requirements are reduced by one-fifth. Rather than posting $15,000 for a regular Nasdaq 100 contract, as in the previous example, only $3,000 is required to take a position in the e-mini contracts. Of course, for a given move in the Nasdaq 100, your profit (or loss) on the e-minis will only be one-fifth as large as compared to the regular contracts as they have a multiplier of $20 instead of $100. E-mini contracts trade virtually 24 hours throughout the day so you can participate in market moving events before the stock market even opens for business. There are even e-mini versions of the S&P 500, S&P 400, Russell 2000 and others. You can read more about these contracts by going to the following link:

http://www.cme.com/products/index/index.cfm

How many other assets allow you instant access to a basket of 100 stocks or more and allow point-for-point profit and loss (unlike most options) for only $3,000 down? There aren't any. In fact, most index mutual funds require an investment of at least $2,500 to even buy into them but will only execute at that evening's closing price. You will not be able to trade them during the day as you can a futures contract. In addition, many mutual funds have minimum required holding periods and will not let you even trade out of it the next day without a penalty of some kind. Hopefully you are starting to see that there are just some things that can't be done with anything but a futures contract.

Short Futures Position

Opposite the long futures position is the short futures position. If you think a stock or index is going to fall, you can simply sell a futures contract as your opening trade and you will profit if you are correct. Remember, there is no need for an uptick and no 50% Reg T requirement. You simply post your initial margin requirement as the long position does and you are short the contract. As with the previous long position example, this would require a $15,000 initial margin deposit. Looking back to Figure 1.1, the NDX fell from 4816 in late March 2000 to 2897 in late May 2000. This 61-day period is shown between the second two vertical bars in that chart. A short contract at 4816 purchased at 2897 would yield (4816-2897) * $100 = 191,900 with virtually no maintenance calls during this short period. Using the e-mini contracts would have only required $3,000 initial margin and would have yielded over $38,000.

Additional Advantages of Short Futures over Short Stocks

We mentioned earlier that single-stock futures offer big advantages to speculators in that it is easier to enter short positions because there is no uptick requirement and no need for your broker to take time to call their stock loan department. While the process of shorting stocks is usually quite fast, it can become time consuming if shares are hard to locate. If so, you may be put on a waiting list while your brokerage firm tries to locate shares at other firms, which is known as "shopping the street," to see if they have shares available to borrow.

By the time they locate the shares, which is not even certain, the trading opportunity may have already passed. This can be further complicated if the stock is "restricted," which is usually designated by an "R" next to the live quote (this used to be designated by the code "UPC 71" named after the rule). If a security is restricted, that means that it represents an aggregate clearing short position of 10,000 or more shares that is greater than or equal to one half of one percent of the total shares outstanding. In these cases, your broker will likely have a tough time finding those shares and charge you a higher corresponding margin requirement.

There is a hidden danger in short stock positions, especially in restricted shares, that many traders do not know about. It is possible, although unlikely, that you could be forced to close a short stock position if the long position wishes to sell his shares and the brokerage firm cannot find another short position to take your place.[1] This will not happen with a futures contract, as there are no limits to the amount of open interest that can exist. The open interest solely depends on how many people wish to enter contracts to buy and sell the underlying stock in the future.

You may be thinking that, despite these benefits, short stocks have a distinct advantage since there is no time limit on them. However, futures contracts can easily be rolled forward, thus keeping you in the short position until you decide to close it out. For example, say it is now January and you are short a March contract. Once March expiration nears, you can then buy March back and sell another distant month such as June. This process can continue indefinitely.

In addition to the speed, ease, and confidence that single-stock futures offer short sellers, there is yet another advantage. It will usually be much cheaper from a net interest standpoint to enter a short futures contract than to post the Reg T amount for a traditional short sale.

For example, say you wish to short 500 shares of Microsoft at $60. The total value of that position is 500 * $60 = $30,000, which means you must post 50% of that for Reg T, or $15,000 of your own money. However, if you sell five futures contracts at $60, you would only need to post 20%, or $6,000. The futures seller will earn the risk-free rate over time since the value of the futures contract must be today's spot price plus the cost of carry. The short stock trader will pay interest on the $30,000 loan but earn interest on the $45,000 in proceeds. Depending on those rates, the futures contract will usually come out the clear winner in terms of net interest charges.

The net interest advantage is often cited as one of the reasons for the holdup of the introduction of single-stock futures. Because it is faster and more efficient to short futures than stocks, brokerage firms are afraid of losing significant interest income from the lending of securities.

Once again, futures offer all of the advantages with none of the disadvantages in using stocks. Hopefully you are starting to see why it is so important to understand these powerful trading tools.

Losing More Than Your Initial Investment

Some of you may be wondering how we can say that futures offer all of the advantages with none of the disadvantages. After all, can't you lose more than your initial margin deposit on a futures contract? Yes, you can. But remember, on a total dollar basis, the loss on the futures contract and on the stock will be exactly the same. On a leveraged basis, the loss on the futures contract is much greater. But that stems from the fact that you only place a fraction of the total value as an initial deposit. If you deposited the full purchase price of the stock (total contract value) the losses would be exactly the same.

For example, if you buy 1,000 shares of stock at $50 and it falls to $40, that's a $10,000 loss. If you had, instead, bought the futures contract, you would only deposit $50 * 1,000 * 20% = $10,000 with maintenance margin of $8,000. This means that your equity is allowed to fall $2,000 before sending in variation margin. As the stock falls to $40, there will be five times you need to send in margin, which will be when the stock hits: $48, $46, $44, $42, and $40. When it's at $40, you will have sent in a total of $10,000 just to maintain your initial margin level of $10,000. The money you sent in is now gone, but your account is still worth $10,000. If you close out the position, you have lost $10,000 just as if you had purchased the stock. However, on a leveraged basis, it will feel like you lost 100% of your initial deposit.

Another way to look at this is rather than sending your broker $10,000 initial margin, you could send in the total contract value of $50,000. Now you know you will never have a maintenance call and will be out $10,000 when the futures contract is closed at $40. So be careful when people talk about the great risk in futures of losing far more than your initial deposit. That is on a leveraged comparison. In terms of total dollars lost, both the stock and the futures position will have lost exactly the same amount.

Moving from Long to Short

We've mentioned this in another course but it certainly doesn't hurt to say it again. One of the distinct advantages that futures have over stocks is the quickness at which a trader can switch from long to short. Assume you are long 300 shares of stock and think it is near a short-term top and wish to go short 300 shares. To do so, you must contact your broker to make sure shares are available to short. Assuming they locate the shares, you must then place two separate orders. The first would be to sell your 300 shares. The second would be to sell short 300 shares. Keep in mind that the sell short order must execute on an uptick, so there may be a delay in getting a fill. Now let's compare this situation is you were, instead, long three futures contracts and wanted to go short three contracts. You would simply enter one order to sell six contracts and that would leave you short three contracts on a net basis. There's no need for an uptick, and it's almost with instantaneous speed that you can change directions with the market.

[1] Nasdaq UPC 11830 and NYSE Rule 282.