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Stop Orders
A stop order is an order, placed with your broker, to buy or
sell a particular futures contract at the market price if
and when the price reaches a specified level. Stop orders
are often used by futures traders in an effort to limit the
amount they. might lose if the futures price moves against
their position. For example, were you to purchase a crude
oil futures contract at $21.00 a barrel and wished to limit
your loss to $1.00 a barrel, you might place a stop order to
sell an off-setting contract if the price should fall to,
say, $20.00 a barrel. If and when the market reaches
whatever price you specify, a stop order becomes an order to
execute the desired trade at the best price immediately
obtainable. There can be no guarantee, however, that it will
be possible under all market conditions to execute the order
at the price specified. In an active, volatile market, the
market price may be declining (or rising) so rapidly that
there is no opportunity to liquidate your position at the
stop price you have designated. Under these circumstances,
the broker's only obligation is to execute your order at the
best price that is available. In the event that prices have
risen or fallen by the maximum daily limit, and there is
presently no trading in the contract (known as a "lock
limit" market), it may not be possible to execute your order
at any price.
In addition, although it happens infrequently, it is
possible that markets may be lock limit for more than one
day, resulting in substantial losses to futures traders who
may find it impossible to liquidate losing futures
positions. Subject to the kinds of limitations just
discussed, stop orders can nonetheless provide a useful tool
for the futures trader who seeks to limit his losses. Far
more often than not, it will be possible. for the broker to
execute a stop order at or near the specified price. In
addition to providing a way to limit losses, stop orders can
also be employed to protect profits. For instance, if you
have bought crude oil futures at $21.00 a barrel and the
price is now at $24.00 a barrel, you might wish to place a
stop order to sell if and when the price declines to $23.00.
This (again subject to the described limitations of stop
orders) could protect $2.00 of your existing $3.00 profit
while still allowing you to benefit from any continued
increase in price.
Spreads
Spreads involve the purchase of one futures contract and the
sale of a different futures contract in the hope of
profiting from a widening or narrowing of the price
difference. Because gains and losses occur only as the
result of a change in the price difference--rather than as a
result of a change in the overall level of futures
prices--spreads are often considered more conservative and
less risky than having an outright long or short futures
position. In general, this may be the case. It should be
recognized, though, that the loss from a spread can be as
great as--or even greater than--that which might be incurred
in having an outright futures position. An adverse widening
or narrowing of the spread during a particular time period
may exceed the change in the overall level of futures
prices, and it is possible to experience losses on both of
the futures contracts involved (that is, on both legs of the
spread).
Options on Futures Contracts
What are known as put and call options are being traded on a
growing number of futures contracts. The principal
attraction of buying options is that they make it possible
to speculate on increasing or decreasing futures prices with
a known and limited risk. The most that the buyer of an
option can lose is the cost of purchasing the option (known
as the option "premium") plus transaction costs. Options can
be most easily understood when call options and put options
are considered separately, since, in fact, they are totally
separate and distinct. Buying or selling a call in no way
involves a put, and buying or selling a put in no way
involves a call.
Buying Call Options
The buyer of a call option acquires the right but not the
obligation to purchase (go long) a particular futures
contract at a specified price at any time during the life of
the option. Each option specifies the futures contract which
may be purchased (known as the "underlying" futures
contract) and the price at which it can be purchased (known
as the "exercise" or "strike" price). A March Treasury bond
84 call option would convey the right to buy one March U.S.
Treasury bond futures contract at a price of $84,000 at any
time during the life of the option. One reason for buying
call options is to profit from an anticipated increase in
the underlying futures price. A call option buyer will
realize a net profit if, upon exercise, the underlying
futures price is above the option exercise price by more
than the premium paid for the option. Or a profit can be
realized it, prior to expiration, the option rights can be
sold for more than they cost. Example: You expect lower
interest rates to result in higher bond prices (interest
rates and bond prices move inversely). To profit if you are
right, you buy a June T-bond 82 call. Assume the premium you
pay is $2,000. If, at the expiration of the option (in May)
the June T-bond futures price is 88, you can realize a gain
of 6 (that's $6,000) by exercising or selling the option
that was purchased at 82. Since you paid $2,000 for the
option, your net profit is $4,000 less transaction costs. As
mentioned, the most that an option buyer can lose is the
option premium plus transaction costs. Thus, in the
preceding example, the most you could have lost--no matter
how wrong you might have been about the direction and timing
of interest rates and bond prices--would have been the
$2,000 premium you paid for the option plus transaction
costs. In contrast if you had an outright long position in
the underlying futures contract, your potential loss would
be unlimited. It should be pointed out, however, that while
an option buyer has a limited risk (the loss of the option
premium), his profit potential is reduced by the amount of
the premium. In the example, the option buyer realized a net
profit of $4,000. For someone with an outright long position
in the June T-bond futures contract, an increase in the
futures price from 82 to 88 would have yielded a net profit
of $6,000 less transaction costs. Although an option buyer
cannot lose more than the premium paid for the option, he
can lose the entire amount of the premium. This will be the
case if an option held until expiration is not worthwhile to
exercise.
Buying Put Options
Whereas a call option conveys the right to purchase (go
long) a particular futures contract at a specified price, a
put option conveys the right to sell (go short) a particular
futures contract at a specified price. Put options can be
purchased to profit from an anticipated price decrease. As
in the case of call options, the most that a put option
buyer can lose, if he is wrong about the direction or timing
of the price change, is the option premium plus transaction
costs. Example: Expecting a decline in the price of gold,
you pay a premium of $1,000 to purchase an October 320 gold
put option. The option gives you the right to sell a 100
ounce gold futures contract for $320 an ounce. Assume that,
at expiration, the October futures price has--as you
expected-declined to $290 an ounce. The option giving you
the right to sell at $320 can thus be sold or exercised at a
gain of $30 an ounce. On 100 ounces, that's $3,000. After
subtracting $1,000 paid for the option, your net profit
comes to $2,000. Had you been wrong about the direction or
timing of a change in the gold futures price, the most you
could have lost would have been the $1,000 premium paid for
the option plus transaction costs. However, you could have
lost the entire premium.
How Option Premiums are
Determined
Option premiums are determined the same way futures prices
are determined, through active competition between buyers
and sellers. Three major variables influence the premium for
a given option: * The option's exercise price, or, more
specifically, the relationship between the exercise price
and the current price of the underlying futures contract.
All else being equal, an option that is already worthwhile
to exercise (known as an "in-the-money" option) commands a
higher premium than an option that is not yet worthwhile to
exercise (an "out-of-the-money" option). For example, if a
gold contract is currently selling at $295 an ounce, a put
option conveying the right to sell gold at $320 an ounce is
more valuable than a put option that conveys the right to
sell gold at only $300 an ounce. * The length of time
remaining until expiration. All else being equal, an option
with a long period of time remaining until expiration
commands a higher premium than an option with a short period
of time remaining until expiration because it has more time
in which to become profitable. Said another way, an option
is an eroding asset. Its time value declines as it
approaches expiration. * The volatility of the underlying
futures contract. All rise being equal, the greater the
volatility the higher the option premium. In a volatile
market, the option stands a greater chance of becoming
profitable to exercise.
Selling Options
At this point, you might well ask, who sells the options
that option buyers purchase? The answer is that options are
sold by other market participants known as option writers,
or grantors. Their sole reason for writing options is to
earn the premium paid by the option buyer. If the option
expires without being exercised (which is what the option
writer hopes will happen), the writer retains the full
amount of the premium. If the option buyer exercises the
option, however, the writer must pay the difference between
the market value and the exercise price. It should be
emphasized and clearly recognized that unlike an option
buyer who has a limited risk (the loss of the option
premium), the writer of an option has unlimited risk. This
is because any gain realized by the option buyer if and when
he exercises the option will become a loss for the option
writer.
Reward Risk
Option Buyer Except for the premium, an option buyer has the
same profit potential as someone with an outright position
in the underlying futures contract. An option maximum loss:
is the premium paid for the option
Option Writer
An option writer's maximum profit is premium received for
writing the option An option writer's loss is unlimited.
Except for the premium received, risk is the same as having
an outright position in the underlying futures contract.
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