Futures For You
| INSIDE THE FUTURES
WORLD
Want to find out how the futures markets really work?
Carley Garner, a senior analyst for Alaron who also writes the company's
Dow/NASDAQ Report and the Bond Report newsletters, responds to your questions
about today's futures markets. To submit a question, post your question
at http://Message-Boards.Traders.com. Answers will be posted there, and
selected questions will appear in a future issue of S&C. |
Carley Garner |
BUY OR SELL?
Is it better to buy or sell options?
My favorite college finance professor used to answer questions with the phrase, "It depends." In trading and finance alike there are no black and white answers. The answer is based on your personal risk and reward profile as well as market conditions, and not necessarily my judgment. However, since you asked, I will give you my opinion.
A successful long option trader must be exceptionally patient and have excellent timing; there is little room for error. Anyone can get lucky from time to time, and in some cases, a long option can seem like a lottery ticket to the fortunate holder; however, those stories are few and far between. Most option buyers are forced to watch helplessly as the values of their options tank. Conversely, during times of low volatility, option buyers drastically increase their odds of making a profit because the potential of a subsequent explosion in volatility will have the same impact on their long option trade.
Option sellers, on the other hand, can make money even if they are wrong in their speculation or are a bit off on the timing. Out-of-the-money short option traders are providing the luxury of having room for error. In fact, more options than not expire worthless. Thus, by simply selling premium instead of paying for it, you are already ahead of the odds.
However, there is a catch. Option sellers face unlimited risk and limited profit potential, and this can be a recipe for disaster. This shouldn't scare you, though; it should entice you. After all, it is the same premise that an insurance company relies on. They are constantly selling premiums in hopes that the policy will expire without a claim but knowing that a calculated percentage of the policies will result in claims, and at times, the losses will be enormous.
That said, insurance companies tend to be relatively stable in the long run. Keep in mind that insurers are experienced and highly familiar with the statistics involved; therefore, they are taking calculated risks and are likely much more efficient at running an insurance firm than we are at accurately predicting price changes.
Nevertheless, the insurers are proof that the model of premium collection can work. In a nutshell, as long as you are willing to accept the risks involved and can control your emotions enough to prevent panic liquidation or analysis paralysis, option selling may be the optimal strategy for you.
MINI-DOW ASSETS
What exactly is the underlying asset of the mini-sized Dow futures listed on the Chicago Board of Trade?
We all know that the mini-Dow is based on the value of the Dow Jones Industrial Average (DJIA), but it may not be clear as to what the underlying asset is in the futures market. Most futures contracts are based on the theory that the futures price of any given asset will converge at expiration with the cash market value of the asset. This is possible because the futures contract ensures delivery of the underlying asset, should the holder of the contract choose to accept delivery of the commodity.
However, in the case of stock indexes, it is unrealistic to expect that the stocks that make up the index itself will be delivered. Thus, stock index futures contracts are cash-delivered. This simply means that should a contract be held to expiration, the client's trading account will be adjusted higher or lower based on the entry price of their futures position and the final settlement of the futures contract.
Please note, however, that the settlement price isn't the closing price on the day of expiration. The cash settlement occurs on the third Friday of the contract month and, according to the Chicago Board of Trade (CBOT), the final settlement price is $5 times a special opening quotation of the index. This means that the exchange undergoes a cumbersome equation that incorporates the futures price and the cash index value in order to determine the official settlement price of the contract, which is used in the cash settlement process.
Another important piece of information is that the expiring futures contract does not trade on the day of expiration. Therefore, traders who hold positions into the official open of trade on the third Friday of the contract month will be subject to cash settlement. Such an event shouldn't create panic, but you must realize that you are now at the mercy of the settlement price.
I have found that it isn't a good idea to hold a stock index futures contract into expiration. Instead, the position should be completely offset or rolled into the next contract month on the Thursday before expiration at the latest. It is difficult enough to make money in the markets; the last thing you should want to gamble on in this adventure is a calculation in which you have no control over the outcome.
Originally published in the November 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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