From the January 01, 2007 issue of Futures Magazine • Subscribe!

Choosing the right option

One of the main differences between futures and equity products is that a futures contract is an obligation to buy or sell an underlying instrument at a pre-set price and date while equities are actual securities. That being said, several of the other properties are similar.

Both futures and equities can be bought and sold daily. Options on futures and equities both have put and call options that expire every month. Three Russell products in particular — the Russell 2000 E-Mini futures (ticker ER2), the Russell 2000 Index (ticker RUT) and the Russell 2000 ETF (ticker IWM) — have additional similarities in that the charts mirror one another.

WHICH RUSSELL?

In terms of composition, the same 2,000 stocks are in the ER2 and RUT but the IWM differs slightly. The price for the IWM is also lower by a factor of 10. The ER2 and RUT are similar in price, but the ER2 is slightly higher because it includes a cost-of-carry factor. This factor amounts to the dividend that would be paid by the 2,000 stocks as well as any interest on margin. The cost of carry prevents arbitrage between ER2 and the cash RUT Index. However, the ER2 and RUT indexes are identical at expiration.

Some brokerage firms with integrated technology permit both equity and future products to be displayed and traded from the same screen. For a real-world look at prices and possible trades, we’ll use the margin rates and fees from Interactive Brokers, a broker that allows this practice. The margin required to purchase futures and to sell either futures or equity options is set aside and earns interest. Margin is not borrowed money like stock margin.

Although brokers differ in the formula they use to calculate the margin required for futures contracts, the most frequently used method is SPAN (standardized portfolio analysis of risk). Margin for equities is most often calculated by a separate formula that each brokerage firm publishes.

Because futures are contracts with set durations, it is important to note the expiration date of products you are interested in. The ER2 follows the March quarterly cycle (March, June, September and December).

COMPARING RETURNS

So if an investor wants to go long and bet that the market will rally throughout the next few months (say 5% by the December expiration), which vehicle should be used? This simple strategy permits a comparison because there is a fixed time limit for the investment.

The Russell 2000 Index (RUT) is immediately eliminated because direct shares of the RUT cannot be bought (although indexes do have options that can be used as a proxy trade).

In “Going Long” (below) the price snapshot was taken on Oct. 10, 2006, with a planned exit on the December expiration. Indexes and futures usually have multipliers. ER2 is listed on the Chicago Mercantile Exchange (CME); the margin ($3,375) and the multiplier (100) can be found at the CME Web site.

Because ER2 has a multiplier of 100, the real value of the December 750 future is $75,000. However, only $3,375 is required as margin. The margin will increase by $100 for every point the ER2 drops. Therefore, to cover a 5% drop (about 40 points), $8,000 is kept in reserve.

For comparison, an equivalent cash outlay is used to buy 107 shares of the IWM. A much larger profit can be made on the ER2 if the Russell rises 5%. However, if the Russell drops by 5%, the long ER2 position loses $4,000 while the long IWM position only loses $428. The worst-case loss for the IWM position is limited to $8,000, but the ER2 position can exceed the $8,000. For the same cash outlay, there certainly is more risk/reward with the ER2 futures product.

We also can compare buying December calls on all three products. Again, the investor is hoping for a rally by Christmas with about $3,000 as the risk capital. No margin is required because calls are being purchased (see “Options assist,” below). Here, the gain and the worst-case loss are basically the same for all three products. However, only the cost of purchasing the call options can be lost while the futures can give back more than the initial investment.

Next, let’s consider a strategy where an investor wants to collect the time premium in the put options. The investor is hoping the Russell will not drop more than 10% by the December expiration, so naked put options are sold 10% out-of-the-money (see “Short with puts,” below).

When you sell naked you must keep reserve funds available in case the margin increases.Therefore, the adjusted potential profit = premium / (initial margin + reserve margin). This is shown in the last two columns. Because far less margin is required for the futures product, a greater return on investment is realized. The loss is the same for all three products. For every point the Russell closes below the naked put strike there is a $1,000 loss (minus the premium received).

Some firms, IB included, require only half the required futures margin during the day’s trading hours. It is a perk for day traders. If you are not a day trader, overnight margin is the figure to use. The overnight margin figure was the one used in this example.

MAKING THE CALL

We can say three things about the similar Russell trading vehicles:

1. The future (ER2) has more risk/reward than going long the underlying product.

2. There is little difference in buying monthly Russell options on the futures or equities.

3. Selling monthly futures or equity options has the same risk but because the margin is much less for the Russell futures, the ER2 has a much better return on investment.

As these examples have shown, choosing the right vehicle can have a large impact on how the trade plays out. Of course, which vehicle you decide to use will depend on your specific situation at that moment in time. What’s important is you recognize the qualities of each so you are equipped to make the right call when it can make a difference.

Tony Elenbaas and David Tsou are software engineers and independent option traders.

E-mail them at elenbaas@verizon.net and d_tsou@hotmail.com.

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