Roger G. Clarke TSA Capital Management Options and Futures: A Tutorial The Research Foundation of The Institute of Chartered Financial Analysts Options and Futures: A Tutorial Options and Futures: A Tutorial O 1992 The Research Foundation of the Institute of Chartered Financial Analysts. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the copyright holder. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee ofPublishers. ISBN 10-digit: 0-943205-83-2 ISBN 13-digit: 978-0-943205-83-0 Printed in the United States of America December 1992Rev. August 1996 Mission The mission of the Research Foundation is to identify, fund, and publish research material that: expands the body of relevant and useful knowledge avadable to practitioners; assists practitioners in understanding and applying this knowledge; and enhances the investment management com- munity's effectiveness in serving clients. THE FRONTIERS OF INVESTMENT KNOWLEDGE GAININ('. VALIDITY AN0 ACCEPTANCE IDEAS WHOSE TIME nrs NOT YET COME The Research Foundation of The Institute of Chartered Financial Analysts P. 0. Box 3668 Charlottesville, Virginia 22903 u.S.A. Telephone: 8041977-6600 Fax: 8041977-1103 Table of Contents Errata ................................................ v ... Acknowledgments ....................................... vm Foreword ............................................. ix Chapter 1. Overview of Derivative Securities and Markets ..... 1 Chapter 2 . Futures Contracts: Pricing Relationships .......... 5 Chapter 3. Risk Management Using Futures Contracts: Hedging ................................... 15 Chapter 4 . Option Characteristics and Strategies: Risk and Return ............................. 29 Chapter 5. Option Contracts: Pricing Relationships ........... 41 Chapter 6. Short-Term Behavior of Option Prices: Hedging Relationships ......................... 57 Exercises for Futures and Options .......................... 69 Appendix A. Contract Specifications for Selected Futures and Options ................................. 95 Appendix B . Interest Rate Concepts ........................ 99 Appendix C . Price Behavior of Fixed-Income Securities ......... 105 Appendix D . Cumulative Normal Distribution ................. 111 References ............................................ 113 Glossary .............................................. 117 Acknowledgments I owe a debt of gratitude to those who have taught me about options and futures over the years. Through the material presented in this volume, I hope to share their efforts with others, although responsibility for any errors herein is solely mine. I also want to acknowledge the funding for this project by the Research Foundation of the Institute of Chartered Financial Analysts. Much of the material presented here has been presented to participants in seminars and conferences sponsored by the Association for Investment Management and Research and has benefitted from their feedback. A special thanks goes to Barbara Austin, who typed the original manuscript, and to Mindy Cowen, Hadas Perchek, and Lisa Adam, who generated earlier versions of the graphics and illustrations. Finally, an extra special thanks to my family, among others, who waited patiently for me to finally bring this project to a close. Roger G. Clarke TSA Capital Management viii Foreword Interest in derivative securities has been growing rapidly since 1973-the year ex- change-traded options were introduced in Chicago. The success of the Chicago Board Options Exchange contributed to the proliferation of derivative contracts based on a variety of underlying factors. Options on individual stocks, equity indexes, interest rates, and foreign exchange, for example, are now traded all over the world. Many of the most popular contracts are trading in volumes exceeding those of the underlying elements. With the growth in derivatives comes a need for all investment practitioners to understand the valuation of these securities and why, how, and when to use them as tools of portfolio management. In response to this need, many books and articles have been published on derivatives and their markets. Some of these publications are textbooks, addressing the fundamentals of the options and futures markets, valuation models, and strategies; others are quite technical, as befits the subject matter. Clarke adds to this literature a tutorial that provides practical information. It addresses topics that investment practitioners need to know about derivative securities, including what they are, how they trade, how they are priced, and how they are used in portfolio management. The tutorial also discusses the operational advantages and disadvantages of trading in options and futures when compared to trading the underlying securities. Clearly, one of the biggest contributions of derivative securities is their ability to limit risk (or transfer it to those willing to bear it). Clarke focuses on the risk-control capabilities of options and futures in financial markets, outlining risk-management strategies for each type and explaining the differences among them. He also describes some of the techniques used to monitor option positions and manage exposure in a portfolio. He provides a virtual cookbook on how to fashion such strategies as a covered call, protective put, straddle, and bull call spread. To give the reader hands-on practice with these techniques, Clarke includes a set of exercises, complete with answers. A glossary provides a handy reference resource for the terms used in this field. Among the appendixes are additional reference materials in the form of a table listing contract specifications for a wide variety of futures contracts, futures options, and index options. The Research Foundation is proud to publish this, its first, tutorial. We wish to thank Roger Clarke for his important contribution to understanding this complex area of financial analysis and for his assistance in the editorial process. As Clarke notes in his overview of derivative securities and markets, many investors lack the understanding and experience to use futures and options effectively. We hope this tutorial provides an aid in learning to use these securities. Katrina F. Sherrerd, CFA 1. Overview of Derivative Securities and Markets The growth in trading of financial options and arbitrage linking the options to their underlying futures began subsequent to the Chicago Board of security is referred to as putlcall parity. Both of Trade's 1973 organization of the Chicago Board these arbitrage relationships are discussed in de- Options Exchange (CBOE) to trade standardized tail in later chapters, option contracts on individual stocks. The success Futures and options share some common char- of this market contributed to the growth of other acteristics but also have some important differ- options and futures contracts to the point that ences. The common features of futures and op- many of the most popular contracts are now traded tions include (1) standardized contract features, on several different exchanges and in volumes (2) trading on organized exchanges, (3) limited exceeding those of the underlying securities them- maturity, (4) risk-management capability, and (5) selves. In addition to options trading on individual operational efficiencies. stocks, options are also traded in equity indexes, A futures contract is an agreement between a interest rates, and foreign exchange. Table 1.1 buyer and a seller to trade a security or cornrnod- shows some of the more popular futures, options, ity at a future date. The most popular futures and options on futures contracts. Specifications for contracts are traded on organized exchanges and selected futures and options contracts are pre- have standardized contract specifications relating sented in Appendix A. to how much of the security is to be bought or Options and futures contracts are derivative sold, when the transactions will take place, what instruments-derivative because they take their features the underlying security must have, and value from their connected underlying security. how delivery or transfer of the security is to be The relationships between the underlying cash handled. To encourage both buyer and seller to security and its associated options and futures are follow through with the transaction, a good faith illustrated in Figure 1.1. In addition, as shown, deposit, called margin, is usually required from options may be tied to a future, but all options and both parties when the contract is initiated. futures ultimately derive their value from an un- As the price of the underlying security changes derlying cash security. from day to day, the value of the futures contract The links pictured in Figure 1.1 keep the also changes. The buyer and seller recognize this security and its options and futures tightly cou- daily gain or loss by transferring the relative gain pled. The link between the future and the cash