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More about Futures Trading
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- Lemon Quarter
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More about Futures Trading
Hi everyone,
Don't get be wrong I don't want to get involved but I'm just eager to learn more on the subject (Dear Mod. if this is in the wrong board pls feel free to move). Basically I've just read This book about Fischer Black and I'm now reading this one about the fall of LTCM called When Genius Failed. They have kind of aroused a curiosity in how options and futures work.
To enquire further I did a bit of reading an existing generic financial markets book and some googling about forwards contracts e.g. with producers/farmer and consumers/miller where they, for example, strike up a contract where the farmer agrees to sell (short) a ton of wheat for £60 and the miller agrees to buy (long) this amount at that price in 3 months.
To provide security to either party, we have each of them, maintaining a margin of £6 (10% of initial spot price), and topping up the account accordingly. However if at the end of the contract wheat is now at spot price £80, the miller, who turned out to be a speculator, can settle with the farmer for £60 (initial margin + £54), and immediately sell the wheat on the market at £80, and hence make a profit of £20 on the initial margin of £6,
which results in a profit margin of 333%, i.e. 200/6. It's clear that the forward with it's lower initial margin gives the possibility of levering up the final profit.
However, how exactly does this extend onto the modern day futures market regarding leverage increasing profit margin? For example when one buys a future on a MSFT stock, is the contract on the price of the stock at some time in the future?
e.g. now MSFT is at $221, would one have a MSFT 3 month contract (long) with a predicted SP at that date of $230?
Does the speculator by buying the future today, for example, just pay the price of the contract (i.e. not the full $230 predicted value)? And is the price of the contract in some way equivalent to the earlier example of wheat, i.e. is the price of the contract just the value of the initial margin plus a fee?
So assuming that there is no fee, and the speculator purchases the future MSFT contract, and in 4 weeks the price hits $240. Then am I right that if the speculator settles the contract now he is
$230 long
$240 short
meaning $10 profit and if the cost of the contract (i.e. the initial margin) was $5, then the speculator's profit margin is 200%?
thanks Matt
Don't get be wrong I don't want to get involved but I'm just eager to learn more on the subject (Dear Mod. if this is in the wrong board pls feel free to move). Basically I've just read This book about Fischer Black and I'm now reading this one about the fall of LTCM called When Genius Failed. They have kind of aroused a curiosity in how options and futures work.
To enquire further I did a bit of reading an existing generic financial markets book and some googling about forwards contracts e.g. with producers/farmer and consumers/miller where they, for example, strike up a contract where the farmer agrees to sell (short) a ton of wheat for £60 and the miller agrees to buy (long) this amount at that price in 3 months.
To provide security to either party, we have each of them, maintaining a margin of £6 (10% of initial spot price), and topping up the account accordingly. However if at the end of the contract wheat is now at spot price £80, the miller, who turned out to be a speculator, can settle with the farmer for £60 (initial margin + £54), and immediately sell the wheat on the market at £80, and hence make a profit of £20 on the initial margin of £6,
which results in a profit margin of 333%, i.e. 200/6. It's clear that the forward with it's lower initial margin gives the possibility of levering up the final profit.
However, how exactly does this extend onto the modern day futures market regarding leverage increasing profit margin? For example when one buys a future on a MSFT stock, is the contract on the price of the stock at some time in the future?
e.g. now MSFT is at $221, would one have a MSFT 3 month contract (long) with a predicted SP at that date of $230?
Does the speculator by buying the future today, for example, just pay the price of the contract (i.e. not the full $230 predicted value)? And is the price of the contract in some way equivalent to the earlier example of wheat, i.e. is the price of the contract just the value of the initial margin plus a fee?
So assuming that there is no fee, and the speculator purchases the future MSFT contract, and in 4 weeks the price hits $240. Then am I right that if the speculator settles the contract now he is
$230 long
$240 short
meaning $10 profit and if the cost of the contract (i.e. the initial margin) was $5, then the speculator's profit margin is 200%?
thanks Matt
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- Lemon Half
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Re: More about Futures Trading
TheMotorcycleBoy wrote:Hi everyone,
Don't get be wrong I don't want to get involved but I'm just eager to learn more on the subject (Dear Mod. if this is in the wrong board pls feel free to move). Basically I've just read This book about Fischer Black and I'm now reading this one about the fall of LTCM called When Genius Failed. They have kind of aroused a curiosity in how options and futures work.
thanks Matt
Matt,
There are two boards where this discussion goes on, although TLF is not where many of these types hang out. One is this board, so feel free to continue to post here. The other is Trading My Way viewforum.php?f=7 so you might want to try there with the same question and we can see which thread gets traction and then lock the other with a redirect notice.
You might also want to read practical options discussions wrt TSLA at https://teslamotorsclub.com/tmc/threads ... la.191290/ . A few particular caveats about TSLA - 1) you tend to only hear the success stories, not the losers, and (imho) options can very much be a zero sum or negative sum game (house always skims); and 2) overall esp reading TSLA on TMC you will be reading winners in a rising market, and it can be even more brutal if one does not switch in a falling market. For sure the practitioners know that, but see 1).
regards, dspp
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- Lemon Quarter
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Re: More about Futures Trading
dspp wrote:TheMotorcycleBoy wrote:Hi everyone,
Don't get be wrong I don't want to get involved but I'm just eager to learn more on the subject (Dear Mod. if this is in the wrong board pls feel free to move). Basically I've just read This book about Fischer Black and I'm now reading this one about the fall of LTCM called When Genius Failed. They have kind of aroused a curiosity in how options and futures work.
thanks Matt
Matt,
There are two boards where this discussion goes on, although TLF is not where many of these types hang out. One is this board, so feel free to continue to post here. The other is Trading My Way viewforum.php?f=7 so you might want to try there with the same question and we can see which thread gets traction and then lock the other with a redirect notice.
You might also want to read practical options discussions wrt TSLA at https://teslamotorsclub.com/tmc/threads ... la.191290/ . A few particular caveats about TSLA - 1) you tend to only hear the success stories, not the losers, and (imho) options can very much be a zero sum or negative sum game (house always skims); and 2) overall esp reading TSLA on TMC you will be reading winners in a rising market, and it can be even more brutal if one does not switch in a falling market. For sure the practitioners know that, but see 1).
regards, dspp
Thanks dspp,
I might repost there if ness. I think GoSeigen and lootman know more about this kind of stuff.
I just wanted to know more details from a knowledge perspective, I certainly have zero interest in being a practitioner. My life is complicated enough already.
Matt
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Re: More about Futures Trading
TheMotorcycleBoy wrote:dspp wrote:TheMotorcycleBoy wrote:Hi everyone,
Don't get be wrong I don't want to get involved but I'm just eager to learn more on the subject (Dear Mod. if this is in the wrong board pls feel free to move). Basically I've just read This book about Fischer Black and I'm now reading this one about the fall of LTCM called When Genius Failed. They have kind of aroused a curiosity in how options and futures work.
thanks Matt
Matt,
There are two boards where this discussion goes on, although TLF is not where many of these types hang out. One is this board, so feel free to continue to post here. The other is Trading My Way viewforum.php?f=7 so you might want to try there with the same question and we can see which thread gets traction and then lock the other with a redirect notice.
You might also want to read practical options discussions wrt TSLA at https://teslamotorsclub.com/tmc/threads ... la.191290/ . A few particular caveats about TSLA - 1) you tend to only hear the success stories, not the losers, and (imho) options can very much be a zero sum or negative sum game (house always skims); and 2) overall esp reading TSLA on TMC you will be reading winners in a rising market, and it can be even more brutal if one does not switch in a falling market. For sure the practitioners know that, but see 1).
regards, dspp
Thanks dspp,
I might repost there if ness. I think GoSeigen and lootman know more about this kind of stuff.
I just wanted to know more details from a knowledge perspective, I certainly have zero interest in being a practitioner. My life is complicated enough already.
Matt
Check the caveat in this post
https://teslamotorsclub.com/tmc/threads ... st-5239925
regards,
dspp
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Re: More about Futures Trading
dspp wrote: (imho) options can very much be a zero sum or negative sum game (house always skims)
The "house" in this case is the exchange where options are listed. And the skim is the bid-to-offer spread.
So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38. The same date and price put options are currently 41/44. For a less liquid underlying the spreads could be higher, and very illiquid shares may not have an option listed at all.
Some of the most active options contracts, with the lowest spreads, are for ETFs like SPY (S&P 500) and GLD (spot gold).
If you are going to play options then I personally would stick to the most active ones. Given that Tesla shares are currently about $715 a share then the options (which are for a standard 100 shares in the US, 1,000 in the UK) are controlling $71,500 in Tesla shares. Given also the volatility of Tesla stock, even the options are very expensive to trade. But potentially less risky than owning the equivalent shares, unless you naked short a call option and your broker probably won't let you do that.
There used to be an options and futures board on TMF with a few regulars but most of them (Terrapin and Speso to name two) appear to have not made it over to TLF so I guess a derivatives board here isn't really warranted.
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Re: More about Futures Trading
Lootman wrote:dspp wrote: (imho) options can very much be a zero sum or negative sum game (house always skims)
The "house" in this case is the exchange where options are listed. And the skim is the bid-to-offer spread.
So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38. The same date and price put options are currently 41/44. For a less liquid underlying the spreads could be higher, and very illiquid shares may not have an option listed at all.
Some of the most active options contracts, with the lowest spreads, are for ETFs like SPY (S&P 500) and GLD (spot gold).
If you are going to play options then I personally would stick to the most active ones. Given that Tesla shares are currently about $715 a share then the options (which are for a standard 100 shares in the US, 1,000 in the UK) are controlling $71,500 in Tesla shares. Given also the volatility of Tesla stock, even the options are very expensive to trade. But potentially less risky than owning the equivalent shares, unless you naked short a call option and your broker probably won't let you do that.
There used to be an options and futures board on TMF with a few regulars but most of them (Terrapin and Speso to name two) appear to have not made it over to TLF so I guess a derivatives board here isn't really warranted.
Hi Lootman
Thanks for your reply. However my curiosity was regarding futures not options, and also I don't actually want to trade them. I just wanted to see if someone could help me, with the question I posed in my OP. That is, how the leverage concept in the form of the profit on the ton of wheat ($20) divided by the initial margin ($6) is extended to that of future contracts on shares. IOW, does the leverage bit come from the price of the contract and does that relate to a similar concept of a margin, i.e. security for the house, as opposed to that of the farmer and the miller in the wheat example?
Matt
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Re: More about Futures Trading
Lootman wrote:dspp wrote: (imho) options can very much be a zero sum or negative sum game (house always skims)
The "house" in this case is the exchange where options are listed. And the skim is the bid-to-offer spread.
So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38. The same date and price put options are currently 41/44. For a less liquid underlying the spreads could be higher, and very illiquid shares may not have an option listed at all.
Some of the most active options contracts, with the lowest spreads, are for ETFs like SPY (S&P 500) and GLD (spot gold).
If you are going to play options then I personally would stick to the most active ones. Given that Tesla shares are currently about $715 a share then the options (which are for a standard 100 shares in the US, 1,000 in the UK) are controlling $71,500 in Tesla shares. Given also the volatility of Tesla stock, even the options are very expensive to trade. But potentially less risky than owning the equivalent shares, unless you naked short a call option and your broker probably won't let you do that.
There used to be an options and futures board on TMF with a few regulars but most of them (Terrapin and Speso to name two) appear to have not made it over to TLF so I guess a derivatives board here isn't really warranted.
That would be unusual.
The providers of the bids, and offers, wouldn't be the exchange. Rather they would be liquidity providers to the exchange. The exchange would take its "skim" from amongst other things transaction fees and settlement fees, and the ability to earn interest on posted margins etc. (at least when there was such a thing as positive interest rates).
I could be wrong, I've never traded US equities, or futures, or options on such an exchange, professionally or otherwise.
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Re: More about Futures Trading
TheMotorcycleBoy wrote:Hi everyone,
Don't get be wrong I don't want to get involved but I'm just eager to learn more on the subject (Dear Mod. if this is in the wrong board pls feel free to move). Basically I've just read This book about Fischer Black and I'm now reading this one about the fall of LTCM called When Genius Failed. They have kind of aroused a curiosity in how options and futures work.
To enquire further I did a bit of reading an existing generic financial markets book and some googling about forwards contracts e.g. with producers/farmer and consumers/miller where they, for example, strike up a contract where the farmer agrees to sell (short) a ton of wheat for £60 and the miller agrees to buy (long) this amount at that price in 3 months.
To provide security to either party, we have each of them, maintaining a margin of £6 (10% of initial spot price), and topping up the account accordingly. However if at the end of the contract wheat is now at spot price £80, the miller, who turned out to be a speculator, can settle with the farmer for £60 (initial margin + £54), and immediately sell the wheat on the market at £80, and hence make a profit of £20 on the initial margin of £6,
which results in a profit margin of 333%, i.e. 200/6. It's clear that the forward with it's lower initial margin gives the possibility of levering up the final profit.
However, how exactly does this extend onto the modern day futures market regarding leverage increasing profit margin? For example when one buys a future on a MSFT stock, is the contract on the price of the stock at some time in the future?
e.g. now MSFT is at $221, would one have a MSFT 3 month contract (long) with a predicted SP at that date of $230?
Does the speculator by buying the future today, for example, just pay the price of the contract (i.e. not the full $230 predicted value)? And is the price of the contract in some way equivalent to the earlier example of wheat, i.e. is the price of the contract just the value of the initial margin plus a fee?
So assuming that there is no fee, and the speculator purchases the future MSFT contract, and in 4 weeks the price hits $240. Then am I right that if the speculator settles the contract now he is
$230 long
$240 short
meaning $10 profit and if the cost of the contract (i.e. the initial margin) was $5, then the speculator's profit margin is 200%?
thanks Matt
Broadly speaking when trading derivatives you only have to post margin up front to cover the (credit) risk with your counterparty of the price move of the contract.
So if something has a price of $100, and a likely volatility of 10% (don't take this literally), the derivative provider, let's call it an exchange might request $10 to be lodged.
As prices move to say $95, or $105, you will need to post a further $5, or receive back $5. And so on until settlement. Settlement could be anywhere say between $80 and $120, so you might have been staking up to $30 or as little as $0 over the life. The reward will be $20, or a loss of $20. So you have "gambled" (or invested depending how you see it) with a small stake and potentially profited (or lost) a similar size.
If you invested in the underlying you would be required to "stake" $100 for that same potential $20 profit (or loss).
Not all exchanges are the same, some will physically settle, rather than cash settle, not all will daily margin, many won't be accessible to retail clients directly, but broadly speaking yes it works as you initially describe.
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Re: More about Futures Trading
dealtn wrote:Lootman wrote:dspp wrote: (imho) options can very much be a zero sum or negative sum game (house always skims)
The "house" in this case is the exchange where options are listed. And the skim is the bid-to-offer spread.
So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38. The same date and price put options are currently 41/44. For a less liquid underlying the spreads could be higher, and very illiquid shares may not have an option listed at all.
Some of the most active options contracts, with the lowest spreads, are for ETFs like SPY (S&P 500) and GLD (spot gold).
If you are going to play options then I personally would stick to the most active ones. Given that Tesla shares are currently about $715 a share then the options (which are for a standard 100 shares in the US, 1,000 in the UK) are controlling $71,500 in Tesla shares. Given also the volatility of Tesla stock, even the options are very expensive to trade. But potentially less risky than owning the equivalent shares, unless you naked short a call option and your broker probably won't let you do that.
There used to be an options and futures board on TMF with a few regulars but most of them (Terrapin and Speso to name two) appear to have not made it over to TLF so I guess a derivatives board here isn't really warranted.
That would be unusual.
The providers of the bids, and offers, wouldn't be the exchange. Rather they would be liquidity providers to the exchange. The exchange would take its "skim" from amongst other things transaction fees and settlement fees, and the ability to earn interest on posted margins etc. (at least when there was such a thing as positive interest rates).
I could be wrong, I've never traded US equities, or futures, or options on such an exchange, professionally or otherwise.
It is a little different for options than for shares. For shares the issuer is the company and the exchange provides a listing and a marketplace.
But for options the exchange is the issuer as well as the listing. In other words listed options are a direct product of the exchange: CBOE in the case of equity options and CME in the case of futures and options on futures. Those exchanges decide which options to list i.e. the underlying, the strikes, the expiry dates etc., and they add and withdraw supply according to the open interest at any time.
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Re: More about Futures Trading
TheMotorcycleBoy wrote:Lootman wrote:dspp wrote: (imho) options can very much be a zero sum or negative sum game (house always skims)
The "house" in this case is the exchange where options are listed. And the skim is the bid-to-offer spread.
So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38. The same date and price put options are currently 41/44. For a less liquid underlying the spreads could be higher, and very illiquid shares may not have an option listed at all.
Some of the most active options contracts, with the lowest spreads, are for ETFs like SPY (S&P 500) and GLD (spot gold).
If you are going to play options then I personally would stick to the most active ones. Given that Tesla shares are currently about $715 a share then the options (which are for a standard 100 shares in the US, 1,000 in the UK) are controlling $71,500 in Tesla shares. Given also the volatility of Tesla stock, even the options are very expensive to trade. But potentially less risky than owning the equivalent shares, unless you naked short a call option and your broker probably won't let you do that.
There used to be an options and futures board on TMF with a few regulars but most of them (Terrapin and Speso to name two) appear to have not made it over to TLF so I guess a derivatives board here isn't really warranted.
Hi Lootman
Thanks for your reply. However my curiosity was regarding futures not options, and also I don't actually want to trade them. I just wanted to see if someone could help me, with the question I posed in my OP. That is, how the leverage concept in the form of the profit on the ton of wheat ($20) divided by the initial margin ($6) is extended to that of future contracts on shares. IOW, does the leverage bit come from the price of the contract and does that relate to a similar concept of a margin, i.e. security for the house, as opposed to that of the farmer and the miller in the wheat example?
Matt
Funnily enough I remember under-impressing the World Bank at interview a long time ago (easy for me), sufficiently so that it was a very short interview. They pitched me what they thought would be a real easy peasy options proposal to do with steel between Argentina and Brazil. Problem was I'd worked in Argentina and I was thinking to myself, "but you could never get enforcement" and so got in an awful tangle. They, comfortable that they had very little time value of money, were prepared to wait for infinite time to rule in their favour. Me, thinking practically, figured that "in the long run we are all dead", i.e. the point is to get it whilst we are still alive. The bond markets have been pursuing Argentina ever since, so I think I won the argument even if I didn't get the gig. (A classic example of one of the many ways interviews can go wrong). Anyway, serious point: enforceability matters. The exchange often does that, so my comment that the exchange skims is not entirely fair, as the exchange has real costs to meet, which in many circumstances may involve aspects of enforcement.
I was speaking with a local grain (corn & wheat) farmer a while back. He sells 1/3 of his crop forwards, straight after planting. He sells another 1/3 for cash, straight on harvesting. He sells a further 1/3 after harvesting, out of his grain stores, playing the market as/when he does so. What he is achieving by this is spreading his time-series risk. In the plain vanilla sense he is doing this unleveraged, i.e. no amplification of his 'stake' because he own his farm and is not a net borrower (unusual perhaps, not for the richer ones around here). He settles 1:1. If on the other hand he was farming on borrowed money, then he would be leveraged.
I think it may be worth you reading up on the background to these situations before trying to get into modern complexities. I think one of the TMC links I gave you it gives further links to those origins at CBOT etc.
regards, dspp
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Re: More about Futures Trading
dspp wrote:I was speaking with a local grain (corn & wheat) farmer a while back. He sells 1/3 of his crop forwards, straight after planting. He sells another 1/3 for cash, straight on harvesting. He sells a further 1/3 after harvesting, out of his grain stores, playing the market as/when he does so. What he is achieving by this is spreading his time-series risk. In the plain vanilla sense he is doing this unleveraged, i.e. no amplification of his 'stake' because he own his farm and is not a net borrower (unusual perhaps, not for the richer ones around here). He settles 1:1. If on the other hand he was farming on borrowed money, then he would be leveraged.
Actually the guy who built our house was a farmer. His son and grandson survive and live a couple of houses down the road.
They also have to debate the futures vs spot price game.
In addition to time risk diversification, I imagine the reason for forwarding only 1/3 is because its probably the only way to hedge poor yield. Our neighbours lost a lot of wheat a few years back when lack of water prevented it "filling" adequately.
Matt
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Re: More about Futures Trading
Lootman wrote:So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38..
Where does the leverage component in the speculators bottom line come from then?
I assume its due to the "stake" being the contract price, i.e. In the case of buying $0.38. So if MSFT rises to $222, then the profit margin is
(222-220)/0.38 = 526%
So is that 0.38 contract price based on MSFTs volatility and various macroeconomics factors? IOW what is at heart of the Black-scholes-merton model?
Matt
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Re: More about Futures Trading
TheMotorcycleBoy wrote:Lootman wrote:So taking the January Microsoft 220 call options as an example, you can currently sell that contract for 0.36 and buy it for 0.38.
Where does the leverage component in the speculators bottom line come from then?
I assume its due to the "stake" being the contract price, i.e. In the case of buying $0.38. So if MSFT rises to $222, then the profit margin is
(222-220)/0.38 = 526%
So is that 0.38 contract price based on MSFTs volatility and various macroeconomics factors? IOW what is at heart of the Black-scholes-merton model?
Actually it was $3.80 and not 38 cents. I misread the number. So you are paying about 1.7% of the share price to make your bet.
Yes, the key is the idea that for the small cost of the option ($380) you get the return of 100 shares of MSFT, worth $22,000. So just a small move upwards in the share price gives you a large percentage move in the option price. But of course you need that move to happen within (in this case) 2 weeks otherwise the option expires worthless and you lose the entire outlay.
Anyone taking the other side of that trade is doing the reverse of speculating. In fact options sellers can be regarded as selling insurance. They collect premium and assume the risk of having to cover a large move in the price. They are betting that your house won't catch fire.
The price of an options contract is set by supply and demand in the market. However the theoretical price of that option can be computed to indicate if the quoted price is accurate. The variables for equity options pricing are the price of the underlying, the strike price, whether a put or a call, the time to expiry, prevailing interest rates, whether any dividends are due to be paid by the underlying and the expected volatility of the underlying security.
I'm afraid I don't know much about futures and so cannot help there.
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Re: More about Futures Trading
Lootman wrote:
Anyone taking the other side of that trade is doing the reverse of speculating. In fact options sellers can be regarded as selling insurance. They collect premium and assume the risk of having to cover a large move in the price. They are betting that your house won't catch fire.
They might also own the underlying, and be prepared to "miss out" on a large upward move, but benefit from a smaller upward move (depending on where the strike price relative to the underlying price is), and the receipt of the option premium.
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Re: More about Futures Trading
dealtn wrote:Lootman wrote:Anyone taking the other side of that trade is doing the reverse of speculating. In fact options sellers can be regarded as selling insurance. They collect premium and assume the risk of having to cover a large move in the price. They are betting that your house won't catch fire.
They might also own the underlying, and be prepared to "miss out" on a large upward move, but benefit from a smaller upward move (depending on where the strike price relative to the underlying price is), and the receipt of the option premium.
Yes, often called "covered calls" or "buy write", that is a low-risk way of adding income to a long position. It is possible in my experience to get an annual return of 10% to 12% if you roll them over every month. But the risk there is that the share goes up sharply and then you either have to have your shares called away from you, or you take a loss in buying back the short calls.
For practical purposes, owning shares and selling calls against them is equivalent to a short put position, except that the latter requires margin and the former does not.
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