Single-Stock Futures Part 13

Using Options to Exit a Futures Contract

You should remember from earlier courses that single-stock futures are not bound by daily price limits. Remember, on most commodities, the futures price is only allowed to fluctuate only so much in a given day. This is done mainly to protect people from accruing unmanageable losses, and this daily accrual of gains and losses adds to the stability of the futures markets.

In many cases, if the underlying stock or futures contract is halted (temporarily stops trading) then so is trading in options. In other words, the options are not allowed to trade unless the underlying asset is trading.

However, there many futures contracts, especially commodities, where this is not the case. For example, the live cattle futures contract on the CME cannot trade at a price of more than $.015 per pound above or below the previous day's settlement price. If this futures contract settles at 80 cents per pound today, it cannot trade above 81.50 or below 78.50 tomorrow. While this may not seem like a large price fluctuation, keep in mind that the contract is for 40,000 pounds of cattle so a $.015 move is equal to 40,000 * .015 = $600 in either direction. But if those boundaries are broken and the commodity is locked limitfor the day, the optionson that commodity will continue to trade.

Then there are some contracts that are mixed and will have no price limit in the spot month (current month) but will have price limits for subsequent months. In addition, the price limits can sometimes be altered during the contract's life, which is called an expandable price limit. For example, the Lumber 110 futures contract[1] on the CME has the following rule for price limits:

Daily Price Limits for Lumber 110 Contract: There shall be no price limit in the spot month. There shall be a daily price limit of $10.00 per thousand board feet above or below the previous day's settlement price. If the contract nearest to expiration that is subject to a daily limit settles on the limit bid for two successive days or on the limit offer for two successive days, then the price limit shall be raised to $15.00 per thousand board feet for all contracts subject to a daily limit. If the contract nearest to expiration that is subject to a daily price limit of $15.00 does not settle at a limit bid or limit offer, without regard to market direction, the price limits shall revert to $10.00 per thousand board feet on the next business day.

Regardless of what type of futures contracts you may end up trading, it is crucial to understand how to exit one through the optionsmarket in the event the futures are locked limitbut the options are still trading. Because the single stock futureswill not have daily price limits doesn't mean that you don't need to understand how to enter or exit a futures position through the options market. You may trade into a commodity at some time that does impose price limits and find yourself in a situation where this technique can save your portfolio. Further, each futures contract has a different set of rules regarding limit moves so it is certainly possible that a particular volatile stock may have trading limits imposed on it, even if only on a temporary basis, once options on single stock futures begin trading.

This is invaluable information if you are trading futures contracts. If a situation should arise where you need to enter or exit a futures contract through the optionsmarket, you will need to understand how to do it before that time. Having your broker explain the strategy (assuming they can) during a distressful time will only lead to rushed, uninformed, and potentially disastrous decisions.

Example:
Let's assume you are short the live cattle futures contract at 78. Because you are short the contract, you will incur losses as the underlying rises. You may, for example, set a "mental stop" limit of 80. That just means that you are going to exit the contract by purchasing the same contract if it were to trade at 80 or higher.

Let's say a government report comes out (which is usually what drives commodity prices) that is favorable to this market (remember the movie Trading Places?) Order flow indicates that the value of the contract should be 83 cents but the market cannot exceed 81.50. Trading therefore would open up lock limit at 81.50, and no trades for that day could occur above this price. So while you may have planned to buy the contract back at 80, if it's limit up, you may find that you cannot buy it back. What's worse, it may trade limit up for days, leaving you in a potentially dangerous situation.

While trades are allowed to occur at or below that price, there is often a lack of sellers since the long positions are hoping for another increase the following day. Speculators, of course, are not willing to short the contracts, at least in great numbers, since everyone is expecting another increase for the following day. The result is that there just aren't that many sellers and liquiditycan be a real problem.

While new information can resume trading below this lock limit range in a hurry, what can you do in those times where it doesn't? Must you be forced to stay in your futures contract, possibly day after day, only to watch it continue trading against you?

Unfortunately, that is the only thing you can do -- unless you know how to hedgeagainst this risk in the optionsmarket. In order to understand this strategy, we need to use our knowledge of syntheticoptions from the last course.

Synthetic Long and Short Positions

In the last course, we found that using stock, calls, and puts, a specific combination of any two will produce the syntheticequivalent of the third. Of all the combinations of synthetics we looked at, the most important one for our purposes will be the synthetic long position. As a quick refresher, let's go through them again.

We can replicate a long stock (or futures) position by simply buying the call and selling the put.

Key Points

Synthetic long futures = Long call + short put

We can also prove that a long futures contract is the same as a long $50 call plus a short $50 put at expiration by plotting the profit and loss diagram and observing that it is exactly a straight line, just as a long futures position:

Figure 1

You can see in Figure 1 that the profit and loss diagram for a long $50 call plus a short $50 put is exactly the same as that of a long futures contract.

Now let's take a look at a short futures contract. Logically, we could expect that the short futures profit and loss will be the exact opposite of the long position. Additionally, the synthetic short position should be exactly the opposite of the synthetic long. This is correct and stems from the fact that futures, as well as options, are a zero-sum game.

Figure 2

Key Points

Synthetic short futures =Long put plus a short call

Exiting a Futures Contract Using Options

How can we use this information to hedgeenter or exit futures positions? If you are long a futures contract and wish to exit a position that is locked limitfor the day, you simply enter the opposite long or short position synthetically in the optionsmarket. This isn't difficult to remember if you just think about how you would normally exit the futures contract with an offsetting position. Remember that an offsetting position is a reversing trade. If you are long the futures contract you enter an order to short that same contract -- a reversing position -- and you are effectively out of the contract.

Key Points

• If you are long a futures contract and wish to exit through the optionsmarket:
  Enter a syntheticshort in the optionsmarket: Buy the put and sell the call

• If you are short a futures contract and wish to exit through the optionsmarket:
  Enter a synthetic long in the optionsmarket: Buy the call and sell the put

If you cannot access the futures markets because they are locked limittrading for the day, you can quickly reverse your position by entering the opposite -- or reversing -- trade in the optionsmarket. If you were long the futures contract, you would want to short the futures synthetically in the options market to reverse your obligations. The cheapest way to accomplish this is to buy a put and sell the call with the same strike as the synthetic current level of the commodity.

For example, the underlying futures contract may be limit upat 70 but we can determine where they are trading in the minds of the investors by simply looking at the optionsmarket. We may see a 72 strike for calls and puts trading at the same price. If so, we know the futures are trading synthetically at 72.

How much will this cost? Theoretically, it should be very close to zero (with the exception of commissions) if you can find strikes that are closely matched to the current level of the underlying futures contract. We talked a little about this in the last course and we're not going to shed more light on the topic.

How do we know it will cost close to zero, assuming we can find the proper strikes? While this is often confusing to many people at first, it's very easy to understand. But first, it will help to think about the following analogy.

Assume you buy an item at a store for 70 cents. If you give the cashier 70 cents, you owe nothing and you also get no change back. That shows that the item was "trading for" exactly 70 cents. However, if you give the cashier a $1 bill, you get the item with additional 30 cents cash back (credit). Paying one dollar with a credit of 30 cents shows the item was "trading for" 70 cents. In other words, you've overpaid by giving one dollar so, in order to make the trade fair, the cashier owes you a credit of 30 cents.

Likewise, if you give the cashier 50 cents, he would not sell the item unless you pay another 20 cents (debit). If you pay 50 cents with an additional debit of 20 cents then that also shows the item is "trading for" 70 cents. Keep this example in mind as we work through the syntheticversions and we can easily see where the futures market is trading, even though we're looking at the optionsmarket.

Figure 3 shows a brief list of April option quotes for live cattle, which had about twenty-five days remaining on them.

Figure 3

Live Cattle Futures Options
Strike	Apr Calls	Apr Puts
70	1.675	.05
71	.775	.15
72	.225	.600
73	.075	1.45
74	.025	2.40

We assumed that a short futures position was held and that we wanted to exit the position by purchasing the contract synthetically through the optionsmarket. Because we must buy the syntheticversion, it may seem obvious that we want to pay as little as possible, such as with the 70 strikes. Remember that a $70 call gives us the right to purchase the underlying asset for 70 and many assume that it must be the best strike to purchase since it allows us to pay the least. We know we must enter a synthetic long futures contract so we need to buy the call and sell the put. Using the quotes in Figure 3 we see we must pay $1.675 for the call and will receive .05 for the put for a net debit (payment) of $1.625. In other words, in order to buy the contract for 70, we must ante up some more money, just as we did when we tried to buy the 70-cent item in the store for 50 cents. This implies that the futures contract is trading for 70 + 1.625 = 71.625.

What if, instead, we opted for the 74 strikes on the calls and puts? Now we would pay .025 for the call but receive 2.40 for the put for a net credit of 2.375. Many traders think this is the ideal trade since a large credit is received. However, this large credit implies that we paid too much just as when we paid $1 for the item in the store. Since we got $2.375 change back (a credit), the value of the futures contract must be 74 - 2.375 = 71.625, which is exactly the same answer we got when we used the 70 strikes.

You can work through other examples and will see that it really doesn't matter which strike we use, just as it doesn't matter whether we try to buy the item in the store for 50 cents, 70 cents, or $1. The net debits and credits that follow will balance it out to the actual value of the contract, which is shown in Figure 4:

Figure 4

Live Cattle Futures Options
Strike	Apr Calls	Apr Puts	Net credit/debit to buy call and sell put	Effective purchase price
70	1.675	.05	-1.625	71.625
71	.775	.15	-0.625	71.625
72	.225	.600	+0.375	71.625
73	.075	1.45	+1.375	71.625
74	.025	2.40	+2.375	71.625

So it appears that the futures contract should be trading for 71.625, and a quick check on the settlement price on that day, April 3, 2002, shows it was exactly 71.625. And no, these numbers were not made up. They are all actual quotes taken on the same day. The markets are just very efficient at pricing things fairly.

The quickest way to determine where the futures are trading synthetically is to find the same strike options that are trading the closest in value to each other. Using Figure 4 we can see that, although none are the same price, the 72 strike calls and puts are the closest in price (.225 and .600). That alone tells you the futures are trading synthetically close to 72. That's because whether we are entering a synthetic long or short position, we either buy the call and sell the put, or do the reverse, and we'll owe nothing nor receive "change" back, which means that must be the value of the commodity.

If we wish to zero-in on an exact price, we see that buying the 72 strike calls and selling the same puts results in a net credit of +0.375, which means we pay 72 - 0.375 = 71.625. Locating the pair of options that are close to the same price is the fastest way to determine where the futures are trading synthetically. In other words, if the futures were not locked limit, then 71.625 is where we would expect them to be trading.

So if this really were a short futures contract that you were trying to buy back synthetically, which strike should you use? Although it doesn't really matter mathematically, I would probably look for the contract that is most liquid (highest volume) and that requires the smallest debit or credit. The reason you probably do not want a large debit or credit is because, although, these may seem like small amounts, remember that contract sizes can be quite large. For the cattle futures in this example, the contract size is 40,000 pounds, which means a net debit of 0.625 will cost 0.625 * 40,000 = $25,000. Now you may be tempted to, instead, take a small credit, such as 0.375. However, you will have to pay 72 (the strike) to take delivery of the long futures contract even though they were trading for 71.625 at the time you bought the contract synthetically. Once again, it doesn't really matter mathematically; you can either pay now or pay later. And don't think you can beat the market by opting to pay later. If there is significant time remaining, the cost of carrywill be priced in as well.

Now you should understand what we said earlier in the "How much will this cost?" box. If we can locate a pair of calls and puts that are trading for the same price, we know that strike price is where the futures are trading synthetically. At that price, you will not pay any debits nor receive any credits. In other words, you owe nothing and you get no change back -- you're paying the exact value. So ideally, most traders who use this strategy try to find the syntheticlong or short version that nets a zero debit or credit. Another reason to look for the "net zeros" is because they are more likely to get filled if the trader doesn't have to give any cash back. While it shouldn't make difference mathematically, it does make a difference to traders who rely on large cash positions to fill orders -- and not to float loans for other traders. Further, with the underlying futures market locked limitup, the floor traders (called "locals") are taking huge order flow from others trying to do the same thing, yet the floor traders are unable to hedgeoff the risk like they normally do since the futures are locked. Because of this, they will likely provide a tighter market (smaller bid-ask spreads) on the optionsthat require no cash outlay.

Another View of Synthetic Positions

We said it didn't matter mathematically, which strike you used to enter a synthetictrade. Some people are still tempted, though, to take the synthetic version that nets a credit. In the above example, they may be tempted to use the 73 strikes for a 1.375 credit thinking that if the market rises, they will use the call but if it falls, they'll just keep the credit. After all, it is the rising market they are trying to hedgein this example so if they don't need the call, they will be left with a nice fat credit.

The reason this doesn't work is because you have effectively guaranteed the purchase at 73 by entering the syntheticlong position at 73.

Key Points

• Buying a call and selling a put guarantees a purchase by the trader
• Selling a call and buying a put guarantees a sale by the trader

So this is another view of synthetics: They provide ways to guarantee purchases and sales!

If the futures market rises, the call optiongains value and you would certainly exerciseat expiration, which means you would buy it for 73. But if the market falls, you can't just walk away with your credit. That's because you are short the put option, which gives you the obligation to buy at the strike price if the long put position exercises. So whether the market rises or falls, you're buying at 73! Entering into a synthetic long futures contract guarantees the purchase at the strike, which is why the strategy works in the first place. If it were not a guaranteed purchase, you couldn't say this is a way to exit the contract.

Of course, it is possible to not exerciseyour call, in this example, but rather just sell it in the open market to offset your losses on the short futures contract if the market rises. In this sense, the purchase of a call acts as a hedgejust as we saw in the beginning of the course how a long futures contract acts as a hedge for the spot market. The sale of the put just reduces your cost of the call to nearly nothing. Similarly, if the market falls, we could buy back the put in the open market for a loss, which will offset the gain in the short futures position. So whether you use the optionsto buy the futures contract or just close the options in the open market, the gain or loss is effectively locked in at the time you enter the syntheticfutures position.

Please don't think that using synthetics is a way to beat the market at the futures game. They're not. However, syntheticoptionsdo provide a way to get out of a futures contract if the futures market is locked limitand the options continue to trade. So while synthetics may not provide a cheaper way out, at least they provide a way out. Take the time to understand the process in the event you should find yourself in need of using them; it will be too late to learn it at that time.

[1] This is called the Lumber 110 contract since it controls 110,000 board feet of random length 2x4s.