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.