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.