Trading Options in Futures Contracts

[bingk6]

Hi all,

I just came across an article in the latest YTE which compared stock options and futures options. In there, it mentioned that options in futures had lower margins, higher premiums and higher liquidity.

They gave an example of an investor selling a ATM Call on stock XYZ for a premium of $200, and the need to post a margin of $1500 to $2000, yielding a ROI of approx 10%.

However with futures, assuming coffee futures is at $1.03 per pound, a trader could write the call at $1.40 (Deep OTM) for $400 and needing to only post a margin of $800, yielding a ROI of 50%.

The interesting thing to note is that coffee futures write option is OTM by inexcess of 25%, and yet able to generate an attractive ROI. With stock options, unless you are writing options ATM, or 1 - 2 strikes OTM, you will end up with premiums that are worth, literally, peanuts (unless the stock has some incredible IV) .

My question is how does this happen??? If what the article says is true, all us stock option writers are trading the wrong instrument. I simply cannot understand how the futures options valuation do not follow the same valuation methodology as stock options

Surely if we are to apply stock option valuation to the coffee futures example above, the IV would fly off into the stratosphere. But off course, it is possible to measure the historical volatility of coffee and it would be nowhere near the IV for the futures contract. Can somebody please explain this discrepancy to me

 

[wayneL]

Hi all,

I just came across an article in the latest YTE which compared stock options and futures options. In there, it mentioned that options in futures had lower margins, higher premiums and higher liquidity.

Indeed margins are lower because they use SPAN (same method as on the underlying contract) and stocks use a formula that amounts to more or less 20% of the underlying value.

Premiums are not necessarilly higher there are lot a variable here

Liquidity is much higher than ASX stocks, but not US stocks. (depending on the contract

They gave an example of an investor selling a ATM Call on stock XYZ for a premium of $200, and the need to post a margin of $1500 to $2000, yielding a ROI of approx 10%.

However with futures, assuming coffee futures is at $1.03 per pound, a trader could write the call at $1.40 (Deep OTM) for $400 and needing to only post a margin of $800, yielding a ROI of 50%.

Thats true, but I would never get too caught up in ROI. You will need cash reserves in excess of investment for defence purposes. I would use Return on risk. Have a look at historical coffee charts to see where this puppy can spike too... all on lock limit moves too. !!!caution!!!

BTW What was the time till expiry in the example used?

The interesting thing to note is that coffee futures write option is OTM by inexcess of 25%, and yet able to generate an attractive ROI. With stock options, unless you are writing options ATM, or 1 - 2 strikes OTM, you will end up with premiums that are worth, literally, peanuts (unless the stock has some incredible IV) .

My question is how does this happen??? If what the article says is true, all us stock option writers are trading the wrong instrument. I simply cannot understand how the futures options valuation do not follow the same valuation methodology as stock options

Surely if we are to apply stock option valuation to the coffee futures example above, the IV would fly off into the stratosphere. But off course, it is possible to measure the historical volatility of coffee and it would be nowhere near the IV for the futures contract. Can somebody please explain this discrepancy to me

This is due to the volatility skew for OTM options where there is risk of black swan events (fat tails). As mentioned above, coffe is prone to extreme price spikes

The return only looks good because of the margin expended. $400 premium is not a lot compared to the face value of the contract.

Writing futures option IMO IS far superior to writing stock options, but not without risks for the unwary.

I would cautiously encourage people to look at this, but proceed with extreme caution.

A great book to read on writing futures options is "Trading Options to Win" by Stuart Johnston.

http://www.moneybags.com.au/default.asp?d=0&t=1&id=4747&c=0&a=74

Here is the mean IV chart for coffee (this is dynamic and will update daily )

 

[wayneL]

Here's a taste of how coffee can move

104 ===>>> 320 in 5 months

 

[wayneL]

Current option chain on Dec coffee

A somewhat different story

http://www.futuresource.com/quotes/options.jsp?s=KCZ06&r=KC&style=Adjacent

 

[NettAssets]

Current option chain on Dec coffee

A somewhat different story

Do ya gotta go messin up a good yarn with FACTS

 

[wayneL]

Do ya gotta go messin up a good yarn with FACTS

OOOOPs Sorry!

LOL

 

[bingk6]

Greetings Wayne,

Unfortunately for the example in the article, they did not provide any expiry periods. However, assuming that they did provide the expiry, we should then be able to calculate the IV. One would reasonably expect this calculated IV value to bear some resemblance to the historical volatility for the commodity (coffee, in this case).

To write a stock option that is OTM by 25% and still generate a "reasonable" premium would have required one hell of an IV, and whilst the chart that you attached showed that coffee is a volatile creature, would it come anywhere near its calculated IV ??

I don't trade futures options and so have no real example to do some calculations with, but would welcome anybody providing a real life example, with the full set of numbers so that we can examine a specific example.

Bingk6

 

[wayneL]

Going by the numbers provided expiry would most likely be in excess of 60 days.

Just to clarify one point. IV/SV relationship is the same for futures and stocks. IV skews may be different because of the perception of where likely fat tail events might be.

The only structural differences lie in margin (as discussed) and in the cost of carry component of option pricing. (the option is an option on a contract rather than on an asset, therefore the cost of carry is mostly priced into the future)

As much as I really do prefer futures options over stock options, it looks as though there was a bit of shenanigans in the article.

Like I said, do consider, but be aware of ALL the risks.

 

[wayneL]

Here is the chart of the current dec contract with SV below.

Compare with the IV mean chart I posted above...

Opportunity But I want to keep stressing the risks and having the skills to manage them

 

[CanOz]

I'm just spending my lazy Saturday night trying to learn about options on futures. If i want to play the bearish break on CC, can i buy a march put (CC FOP (CO) Mar'15 2850 PUT @ Nybot)? This gives enough time to expiry, my risk is limited to like 322.00 odd USD, the reward is unlimited.

Really a noob at this one, just playing on the IB Sim.

I was looking for a way to trade my directional biases on Futures without needing a 100k account to do so, trying to keep my risk to less than 1%.

CanOz

 

[hhse]

The return only looks good because of the margin expended. $400 premium is not a lot compared to the face value of the contract.

I've never traded options on futures. So to clarify, are you saying that options on futures are highly leveraged products when compared to normal options, and thus you get a better ROI, but taking on board significantly more risk.