All options share certain attributes. The characteristics and most mechanics of options are universal. For example, both options on stocks and options on futures are derivatives and they both have strike prices, expiration dates and their payoff diagrams are mathematically identical.
Yet, there are two critical differences, and both fundamentally affect how you trade these instruments. These are the nature of the underlying vehicle and the logistics of market execution. In addition to these primary factors, there also are peripheral differences that warrant consideration: tax treatment, regulators and available trading tools.
These details challenge what most retail traders think they know about options — or at least the relative importance of what you do know. And as any experienced trader can tell you, large losses often can be traced to missing small details.
UNDERLYING DIFFERENCES
Options provide leverage to the buyer; however, options on futures are derivatives of a leveraged vehicle.
In other words, an option on a stock is a leveraged trading vehicle; an option on a futures contract leverages an already leveraged vehicle. Therefore an option on futures involves greater leverage, and leverage is a double-edged sword.
A typical stock option has the potential to control 100 shares of stock should the option come into-the-money. Even if a share price is trading at $100, which is relatively high, the option has the potential to mimic the profit potential of holding approximately $10,000 of the underlying equity.
An option on a futures contract has the potential to fluctuate in price similarly to the underlying futures contract. Consider corn. The value of a corn option, if in-the-money, would oscillate similarly to the underlying futures contract, which represents the future delivery of 5,000 bushels of corn. With corn trading around $4.00 per bushel in mid-April, that means an in-the-money option controlled approximately $20,000 of the underlying commodity — now that is leverage.
More extreme examples would be a bond future, which represents the future delivery of $100,000 of the underlying, or S&P 500 futures, which represent more than $350,000 with the S&P 500 at 1430.
SALIENT VARIATIONS
As with any trading vehicle, it’s important to understand the basic structure of the instrument you’re buying and selling.
Expiration: Both stock and futures options have an expiration date. Unlike a stock, however, which has no finite life span, an underlying futures contract does. Depending on the futures market that you are trading, the contract may expire on the same date as the option, or a couple of weeks later.
Carry charge or contango: Commodities have a carry charge, or cost to carry. This equals the cost of storing the physical commodity until it is sold. Such costs include warehousing, insurance and the potential interest lost on the money tied up in the physical commodity.
For this reason, it is reasonable to expect that the futures contract price of a commodity with a distant delivery month to be higher than that of a nearby delivery month. This scenario is called contango.
Contango is a term that you will only hear in terms of the futures industry. Contango is the occurrence, and amount, by which, the price of a commodity for futures delivery is higher than the spot price. It also can be used to describe a situation in which a distant delivery contract is trading at a premium to a nearer contract.
The opposite situation, when a nearer contract is trading at a premium to a more distant contract, is called backwardation.
Dividends: This is obvious, but it’s often overlooked. Unlike stocks, commodities pay no dividends. The only cash flow that occurs for a commodity trader is upon exit of the trade.
Standardized point value: The most difficult aspect of trading commodity options is becoming familiar with how each contract is quoted. Unlike stock and stock option prices, which are standardized, each commodity contract has a different multiplier and format. This includes the number of digits in the strike price, the premium paid or collected and the multiplier.
In the case of bond options, the futures and the options are quoted differently. Bond futures are quoted in terms of 32nds of a full point, while the options are in 64ths. This can be confusing for those in the industry, let alone a beginning trader.
Stock splits: Firms issuing stocks have the option to issue splits, or reverse splits, to keep their share prices near what they believe to be an attractive level based on their market capital. In other words, if a firm wanted to cut its share price in half, it could issue another share for each outstanding share. This doesn’t decrease the value of the firm, just each individual share.
In theory, this could be done with commodities. For example, you could cut the contract size of corn to 2,500 bushels from 5,000, but in the eyes of the futures exchange it isn’t worth the headache. Instead of changing the parameters of a contract, exchanges will often offer a mini-sized version of the original.
Product availability: The Chicago Board Options Exchange (CBOE) alone lists more than 1,300 stock options and options on more than 40 indexes, along with more than 50,000 listed series. There are far fewer commodity options offered (fewer than 100), and even fewer have enough liquidity to be efficiently traded.
INTANGIBLES
While some differences are as clear as the spec sheets for the contracts themselves, other differences between stock options and futures options are not. One is liquidity.
While most people have some exposure in the stock market, commodity markets are more exclusive. While the futures markets do not see the type of volume that stock traders enjoy, some contracts are extremely liquid — even surpassing the vast majority of individual stocks. It’s vital to understand, though, that trading distant month contracts and less liquid markets will most likely involve slippage.
This popularity shows up in volumes. There are more than one million options contracts traded daily on the CBOE alone, totaling a value of more than $25 billion. The liquidity in the options on futures markets can be spotty. It is important to know which markets have enough participants to actively trade.
Although they are traded by a larger population of traders, however, the average investor will spend eight to 10 years trading stocks before they step into equity options, according to Terry Haggerty, a senior staff instructor at the Options Institute. By contrast, new traders in the options on futures markets tend to be less experienced.
The nature of price movement in the underlyings is also different. By nature, the stock market tends to gain in value over time while commodity prices tend to trade in price envelopes (see “Two tribes,” below). In the case of agricultural commodities, supply and demand work together to find an equilibrium price, but prices will fluctuate far above and below it. Such a cycle may take months, or even years, to develop; however, in theory the price action will be sideways in the long term.
TECHNOLOGY MATTERS
Well above 50% of the daily stock options volume is executed electronically. This means that the trade takes place with little human intervention. It takes literally a matter of seconds between the time an order is placed online, executed by the exchange and then confirmed to the customer.
Some futures exchanges, namely the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange, have made valiant efforts to provide electronic option markets, but the majority of options on futures are still traded in an open-outcry environment.
Because most stock options are traded electronically, quote vending also is purely electronic. This means that bid/ask spreads are readily available to retail traders at little or no cost. While electronic quotes on options on futures are available, price discovery, for the most part occurs in the pits.
Stock options traders also benefit from equity options being listed on more than one exchange. It is possible to buy an equity option on CBOE and offset it on a different exchange, such as the Philadelphia Stock Exchange. While there are some futures exchanges that provide similar products, they are not interchangeable. If you buy a gold option on Comex, you wouldn’t be able to offset it at the CBOT.
TAXES AND REGULATION
The tax code can be extremely complicated, especially when it comes to paying taxes on investment income. While you should consult with a tax professional for details, it’s still possible to get an idea of the key differences in tax consideration between equity option trading and options on futures trading.
First of all, realized gains and losses for security traders are categorized as short-term capital gains, unless they are held for longer than 12 months. This is important because short-term gains are taxed at a higher rate than long term. Domestic futures markets receive 60/40 tax treatment, allowing 60% of profits and losses to be taxed as long-term gains despite the holding period of the trade. Thus, assuming that you traded profitably, you would be subject to a lower tax liability as a futures trader than you would as an equity trader on positions held for less than a year.
To add salt to the wound, stock traders must report a detailed trade-by-trade account of the activity. For active traders, this can be quite complex. Futures traders enjoy the simplicity of reporting a lump sum profit or loss on their Schedule D.
The regulatory structure for options on equities and options on futures also vary. Equity-based options are regulated by the Securities Exchange Commission (SEC), along with the National Association of Security Dealers (NASD). The NASD is a self-regulatory body subject to SEC oversight. Both bodies work diligently to assure that proper protocol is being exercised by market participants.
All domestic futures exchanges are regulated by the Commodity Futures Trading Commission (CFTC), along with the self-regulatory arm of the industry, the National Futures Association (NFA). Like the SEC and equities, these two agencies work together to assure proper conduct in the futures industry.
On the surface, these regulatory structures appear similar, but there is one key difference. The CFTC requires that futures commission merchants (FCM) hold customer funds in an account that is segregated from their own. A futures brokerage firm is not allowed to co-mingle customer funds with company funds. If a broker blows up or is involved in misconduct, this distinction can be the very important. Also, the SEC has a strict rules based philosophy whereas the CFTC has moved towards principle-based regulation.
TRADING TOOLS
Many stock options traders swear by a group of mathematical equations known simply as the “Greeks.” The Greeks are used to mathematically estimate things such as the sensitivity in option value relative to price changes in the underlying, or the value of time in option contracts. These values are referred to as delta, gamma, theta, vega and rho.
While these are important analysis tools for stock options traders, the Greeks are far less reliable in the arena of options on futures.
There is no harm in looking at the figures in your analysis, but trading solely on your findings would prove to be financially destructive.
There are a few characteristic flaws behind this. A primary shortcoming is a lack of liquidity in many of the commodity options. Options on futures are not always fluidly traded, causing intraday calculations of the Greeks to be unreliable and difficult to figure. In theory, you could determine the theoretical price value using an options pricing model, but this is hardly something you’d want to risk real money on.
“Volume spread thin,” (below) shows how the liquidity of commodity options differs greatly between contracts. It illustrates an option chain in the June Australian dollar, which is a low-volume futures option.
The column titled “Last” denotes the last trade. This screen shot was taken within the last hour of the trading day, and only a handful of options had actually traded. So, the Greeks in this chain are theory, not reality.
The column titled “Th Value” denotes the theoretical value based on the established Black and Scholes option pricing model. Aside from calling the floor for a bid/ask spread, this is the most accurate quote available in the world of commodities.
As you will see in “No guessing necessary” (below), stock option traders enjoy a readily available bid/ask spread regardless of the liquidity of the contract. Also note the column titled “OpnInt,” which indicates more trader interest than the example commodity option.
The problem with the bid/ask spread doesn’t necessarily occur in option contracts that are heavily traded, such as the S&P, grains and interest rate products. However, if you are interested in buying or selling options in markets that don’t have a lot of speculators, such as copper, lumber or rough rice; the Greeks are a far less reliable tool.
Although options pricing models can’t be relied on to generate Greeks in the absence of real market prices, they are still important to all options traders. Despite downfalls due to the assumptions behind the structure of the models, the results tend to be close enough to the actual market price to be useful. Indeed, the lack of a real-time quote feed can make them even more helpful to futures options traders.
When it comes to stock options relative to futures options, one isn’t necessarily better than the other. They simply are different. Most important, they should be approached and traded according to these differences and the recognition that option trading, like any investing involves risk.
Carley Garner and Paul Brittain are brokers at Alaron, where they provide free online trading seminars through www.CommodityTradingSchool.com. They can be contacted at cgarner@alaron.com.
