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

Opportunity found: 2007’s stand-out contracts

How do chickens and eggs relate to futures contracts? Besides providing the original underlyings for the Chicago Butter and Egg Board, which eventually grew into the Chicago Mercantile Exchange (CME), the classic question of which came first is directly applicable to the success (or lack thereof) of new futures and options products.

Without liquidity, traders and hedgers won’t trade the product and generate volume. And, of course, without volume, you have no liquidity.

But like chickens and eggs, there are numerous viable contracts out there, proving that hurdle can be overcome.

Rarely do contracts succeed quickly. Even the E-mini S&P 500 futures, often thought of as an overnight success, took several years to develop. Others take more time like the second-coming of milk futures at the CME. Most often, however, new products fail to live up to expectations. When exchanges get it right, though, these new, liquid markets can provide some excellent trading vehicles for the early adopters.

Because one way to get an edge in trading is to find opportunity where others see none — or simply haven’t bothered to look— it’s a good idea to make a frequent assessment of the current trading landscape to see if you’re leaving such opportunity on the table.

These contracts, some launched in the previous 12 months and some of which have just risen above the also-rans, have made a big splash in 2007. If you haven’t yet looked into trading them, maybe it’s time to take notice.

THE VIX IS IN

If liquidity is the ability to take advantage of a financial opportunity, volatility is perhaps the best gauge of that opportunity itself.

In 2004, the Chicago Board Options Exchange (CBOE) attempted to cash in on that measure directly with futures on the Volatility Index, a benchmark of market volatility that the exchange had been tracking since 1993. However, the futures were listed on the CBOE Futures Exchange. In February 2006, CBOE itself jumped into the VIX trading game with options on the index. Those options have been, in the exchange’s own words, “the most successful new product launch in CBOE history.”

Most of that growth has occurred in 2007. VIX futures volume has been up almost 150% this year, but the real barnburner has been the options. Through September 2007, more than 16 million VIX options contracts had been traded for the year, an increase of 400% over 2006 (see “Market in volatility,” right).

Several factors have contributed to this growth. One is simply the increase in volatility itself. On Aug. 16, the VIX hit 37.5, a level that the index hadn’t seen since October 2002. Another reason is that the contract is a direct hedge for that volatility. By buying and selling options and the futures themselves, traders have considerable flexibility for offsetting — or assuming — a range of volatility exposure. Finally, volatility is a great diversification tool, demonstrating over the years a negative correlation to the rise and fall in equity prices.

Like any good entrepreneur, CBOE isn’t resting on its success. In September 2007, the exchange launched volatility index options based on the Nasdaq 100, the Russell 2000 and is currently working on a new VIX index based on the CBOE S&P 500 three-month VIX benchmark.

WORLD CURRENCY OPTIONS

Of course, volatility has been around since the advent of markets themselves. Another breakout market in 2007 is also a new twist on an old underlying.

Philadelphia Stock Exchange (PHLX) world currency options are dollar-settled options that reflect the U.S. dollar’s fluctuations relative to the British pound, the euro, the Australian dollar, the Canadian dollar, the Japanese yen and the Swiss franc.

According to Dan Carrigan, vice president of new product development at the PHLX, world currency options, or WCOs, are designed with retail securities traders in mind. They represent 10,000 foreign currency units (1 million in the case of the yen) and settle in U.S. dollars, making it a simple process to calculate profit and loss.

“Retail securities traders see on the news each day the closing prices for the Dow, gold and the euro. [Previously, they were] able to express their trading views on these asset classes with the exception of foreign exchange,” Carrigan says. “Retail investors now have the ability to position trading strategies on the direction of foreign currencies and these positions can be held in their securities account along with shares of IBM and Google stock.”

Unlike plays in currency futures or OTC retail forex accounts, Carrigan says investors in WCOs are taking longer-term positions. Also, for non-U.S. investors, they provide a tool for hedging the forthcoming currency conversion of their home currencies. “A U.K.-based investor holding U.K. stocks who seeks to liquidate in six months and convert the resulting British pounds proceeds into dollars, bears the risk of a lower pound,” Carrigan says. “Accordingly, he or she can protect overall notional account value with a fully transparent PHLX exchange-traded options product.”

CURRENCY ETFs

Another recent development in the world of forex has been currency exchange-traded funds (ETF). The Rydex family of funds now offers ETFs on the euro, the British pound, the Canadian dollar, the Mexican peso, the Australian dollar, the Swiss franc and the Swedish krona.

According to Ashraf Laidi, chief FX analyst at CMC Markets US, currency ETFs are “for the faint of heart—that is, the total opposite of margin FX. While they do track the moves in FX, the magnitudes of their moves is rather small.”

The peso and krona ETFs are quoted in how many dollars it takes to purchase 1,000 units of the listed currency. The euro, pound, Canadian dollar, Aussie dollar and Swiss franc are quoted in how many dollars it takes to purchase 100 units of the listed currency.

In many ways, the currency ETFs can be described as foreign exchange money market funds. They are not held on margin, like futures or cash forex, and they earn a yield equal to the overnight interest rates of the currency’s home country. The funds all have expense ratios of 0.4%.

Of course, considering they are based on currencies, they naturally depict the extended, slow-moving price trends for which currency markets are known (see “Big, slow loonie,” above).

OLD CONTRACT, NEW TRICKS

There is nothing new about the Chicago Board of Trade’s grain complex or for that matter the New York Mercantile Exchange (Nymex) energy products, its Comex division’s metals contracts or the former New York Board of Trade’s softs contracts but all of those markets have seen huge growth and have been opened to new market participants thanks to their electronic listing during regular trading hours.

New doesn’t have to mean new to the world. It can mean simply new to you. And how you use a “new” contract doesn’t have to adhere strictly to the process of buying and selling it.

Theseus Trading’s Robert Steelman found that out when he went in search of ways to solve certain problems he has had with trading pit-traded options.

“Trading the pit-traded options is comparable to walking in a pitch-dark room filled with furniture. You just walk really carefully trying to avoid hits,” Steelman says. “We used to trade them based on end-of-the-day pricing and calculating the movements in there; however, it was rather imprecise.”

Recently, Steelman has discovered the electronically traded options based on the E-mini S&P 500 and Russell 2000. Although the E-mini S&P options have been around since 1997 and the E-mini Russell options since 2005, for Steelman, they represented a different way to look at an established market.

“I was looking into finding a source for the large S&P options data and somehow stumbled on the ES and ER2 options, and then discovered they are electronic, and my broker gives me a real-time quote matrix,” Steelman says. “They have been around, especially ES [options], but the volume used to be low. Early this year I discovered they are priced pretty much in tandem with the large contract options.”

Although Steelman will trade the electronically traded options, especially the ER2, which he says is more liquid than the big Russell 2000 options, one of his favorite uses is as a data proxy for the large S&P 500 options.

“The benefit [for the electronically traded options] is that prices are real-time unlike for the large contract option prices,” he says. “The electronic nature means instant changes in the quotes. That allows me to use the ES real-time option prices as a guide to the [pit-traded] S&P options.”

So, as you scan the trading landscape for new markets, don’t be afraid to look at contracts that have been around for a few years, as well as those that have just come onto the trading scene. And keep an open mind. Either as an indicator or as an effective data source for another listing altogether, futures contracts can be more than just trading vehicles.

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