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S&P 500 Options On Futures: Profiting From Time-Value Decay

One way to trade S&P futures with limited risk is to write put credit spreads using S&P
500 futures options. A bull put credit spread is my preferred trade, for reasons that will
become clear below. Among other advantages, these deep out-of-the-money put spreads
can be combined with bear call credit spreads. By using both of these in conjunction, a
trader can maximize mileage from margin requirements and minimize downside
exposure. (For a full explanation of bear and bull credit spreads, see Vertical Bull and
Bear Credit Spreads. You can also read about S&P 500 futures options in Becoming
Fluent in Options on Futures.)
The best time to write deep out-of-the-money put credit spreads is when the S&P 500
gets oversold. These positions will profit if the market trades higher, trades moderately
lower, or remains the same - this versatility is a major advantage over option-buying
strategies, which, to be profitable, require a major move in the correct direction within a
set time frame.
Credit spreads profit if they expire out of the money or if they are in the money by less
than the original amount of the premium collected when the spread is established (minus
commissions). The time premium (net options value) that you collect when you establish
a spread will fall to zero if the spread remains out of the money upon expiration. The
premium initially collected is thus retained as profit. Keep in mind that these spreads can
be closed early for a partial profit.They can also be closed at a loss should they get too
close to the money, and they can be placed farther out of the money, where they can
hopefully expire worthless.
There are two ways to apply S&P put spreads. One way involves some degree of market
timing, and the other approach is simply a quarterly system that ignores the trend in the
market (we will not discuss the latter method here). The trade I present below is one
based on identifying an oversold zone for the broad market (S&P 500), which implies
some degree of market timing. To be successful with either of these approaches, you
absolutely must practice rigorous money management techniques.
I like to establish a put spread when the market is oversold (the selling has gone too far)
because this gives my deep out-of-the-money spread lots of wiggle room if my opinion
on the market is wrong. And since the market is oversold when we establish the spread,
we collect maximum premium. Premiums tend to be pumped up due to increased implied
volatility during sell offs, a function of rising fear and increasing demand by put buyers.
Basically, the idea is to establish the deep out-of-the-money put spread when we are near
a technical market bottom, where we have a higher probability of success. Let's take a
look at an actual example of an S&P 500 futures options put credit spread.
Selling Pumped-Up Premium
In my opinion, when the equity markets are in a sell-off and an exact bottom is anyone's
guess, there could nevertheless be enough indicators flashing a technical bottom to
warrant establishing a put credit spread. One of the indicators is the level of volatility.

When implied volatility rises, so do the prices of options: writing a spread has an
advantage at such a time. The premium on the options is pumped up to higher-thannormal levels, and, since we are net sellers of the option premium when we establish a
put credit spread, we are consequently net sellers of overvalued options. With sentiment
indicators like CBOE put/call ratio indicators screaming oversold, we can now look at
some possible strike prices of S&P 500 put options to see if there is a risk/reward picture
we can tolerate.
Our example will focus on the conditions of July 2002 for the September S&P 500
futures, which closed at 917.3 in trading session on July 12, 2002, after three consecutive
down days and six out of preceding seven weeks were down. Since there was this much
selling (the S&P 500 fell by more than 10% since March), we could be confident that we
had some degree of cushion once we got into our put spread. Before establishing a deep
out-of-the-money put spread, I generally like to see the CBOE put/call ratios well into the
oversold zone. Since I am satisfied that these conditions are fulfilled, I prefer to go about
12% out of the money to establish my put spread. My rule of thumb is to aim to collect
$1,000 (on average) for each spread, which I write three months before expiration. The
amount of spreads you establish will depend on the size of your account.
The margin required to initiate this type of trade usually runs between $2,500 and $3,500
per spread, but it can increase substantially if the market moves against you, so it is
important to have sufficient capital to stay with the trade or make adjustments along the
way. If the market moves lower by another 5% once I am in the trade, I look to close the
trade and roll it lower, which means to take a loss on the spread and write it again for
enough premium to cover my loss. I then look to write one more spread to generate a new
net credit. Rolling can lower margin demands and move the trade out of trouble. This
approach requires sufficient capital and should be done with the help of a knowledgeable
broker who can work the trade for you using "fill or kill" and limit orders.
An S&P 500 Bull Put Spread
If you look at the September 2002 put options on S&P 500 futures, you will see there
were some very fat premium to sell at that point. We could have establish a put spread
using the 800 x 750 strike price, which is about 12% out of the money. Exhibit 1 below
contains the prices for such a spread, which are based on settlement of September futures
on July 12, 2002, at 917.30.

Bear in mind that the amount of premium collected is for one spread only. Each point of

premium is worth $250. We were selling the September put at the 800 strike for $3,025
and buying the September put at the 750 strike for $1,625, which left a net credit in our
trading account, or a net options value equal to $1,400. If we had done nothing and this
trade expired fully in the money (September futures at or below 750), the maximum risk
would have been $12,500 minus the initial premium collected, or $11,100. If the spread
had expired worthless, we would've been able to keep as profit the entire premium
amount collected. Keep in mind this example is exclusive of any commissions or fees
since they can vary by account size or brokerage firm.
For the spread to have expired worthless (and thus been a full winner), the September
S&P futures would've had to be above 800 at expiry on September 20, 2002. If in the
meantime the futures move lower by more than 10% or the spread doubles in value, I will
generally look to remove the spread and place in lower and sometimes to a more distant
month to retain the initial potential profitability. The risk/reward profile of this spread
size (50 points) only makes sense if you limit your losses and do not let the position get
in the money.
While just one example, this deep out-of-the-money put spread illustrates the basic setup,
which has several key advantages:

By using a spread instead of writing naked options, we eliminate the unlimited


loss potential.

Since we are writing these when the market is oversold and the spreads are deep
out of the money, we can be wrong about market direction (to a degree) and still
win.

When the market establishes a technical bottom and rallies higher, we can at the
right time leg into a call credit spread to collect additional premium. Because
futures options use the system known as SPAN margin to calculate margin
requirements, there is usually no additional charge for the second spread if the
risk is equal or less. This is because the call and put spreads cannot both expire in
the money.

By writing these at technically oversold points, we are collecting inflated


premium caused by heightened investor fear during market downturns.

The Bottom Line


It is worth noting that deep out-of-the-money put spreads can, as an alternative, be placed
on Dow futures options. Dow spreads require less margin than S&P futures options and
would be better for those investors with smaller trading accounts. Whether you are
trading Dow or S&P futures options, you require solid money management and the
ability to diligently monitor the net options value and the daily price of the underlying
futures to determine if adjustments are needed to rescue a trade from potential trouble.

John Summa
Contact | Author Bio

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If you've ever studied a second language, you know how hard it can be. But once you
learn, say, Spanish as a second language - learning Italian as a third would be much easier
since both have common Latin roots. To get facility with Italian as a third language, you
would need only to grasp minor changes in word forms and syntax. Well, the same could
be said for learning options. (To learn the basics, read our Options Basics Tutorial.)
For most people, learning about stock options is like learning to speak a new language,
which requires wrestling with totally unfamiliar terms. But if you already have some
experience with stock options, understanding the language of options on futures becomes
easy. In fact, basic concepts such as delta, time value and strike price apply the same way
to futures options as to stock options, except for slight variations in product
specifications, essentially the only hurdle to get passed.
In this article, we provide an introduction to the world of S&P 500 futures options that
will reveal to you how easy it is to make the transition to options on futures (also known
as commodity or futures options), where a world of potential profit awaits.
Stock Index Options on Futures
The first thing that probably throws a curve ball at you when initially approaching
options on futures is that you may not be familiar with a futures contract, the underlying
instrument upon which options on futures trade. Recall that for stock options, the
underlying is the equity issue (e.g. IBM call options trade on IBM stock). Since most
investors understand how to interpret stock prices, figuring out the underlying is easy.
When learning futures options, on the other hand, traders new to any particular market
(bonds, gold, soybeans, coffee or the S&Ps) need to get familiar not only with the option
specifications but also with the product specifications of the underlying futures contract.
These, however, are insignificant obstacles in today's online environment, which offers so
much information just a click away. This article will hopefully interest you in exploring
these exciting markets and new trading opportunities. (For more background knowledge,
read Understanding Option Pricing.)
S&P Options on Futures
To illustrate how options on futures work, I will explain the basic characteristics of S&P
500 options on futures, which are the more popular in the world of futures options.
Although these are cash-based futures options (i.e. they automatically settle in cash at
expiration), the logic of S&P futures options, like all futures options, is the same as that

of stock options. S&P 500 futures options, however, offer unique advantages; for
example, they can allow you to trade with superior margin rules (known as SPAN
margin), which allow more efficient use of your trading capital.
Perhaps the easiest way to begin getting a feel for options on futures is simply to look at a
quotes table of the prices of S&P 500 futures and the prices of the corresponding options
on futures. Essentially, the principle of the pricing of S&P futures is the same as that of
the price behavior of any stock. You want to buy low and sell high. In other words, if the
S&P futures rise, the value of the contract rises and vice versa if the price of S&P futures
fall.
Important Differences and Characteristics
There is, however, a key difference between futures and stock options. A $1 change in a
stock option is equivalent to $1 (per share), which is uniform for all stocks. With S&P
futures, a $1 change in price is worth $250 (per contract), and this is not uniform for all
futures and futures options markets. While there are other issues to get familiar with such as the fair value of S&P futures and the premium on the futures contract - these
related concepts are insignificant in practice and for what you need to understand for
most option strategies.
Aside from the distinction of price specification, there are some other important
characteristics of S&P options that are important. Since these options trade on the
underlying futures, the level of S&P futures, not the S&P 500 stock index, is the key
factor affecting prices of options on S&P futures. Volatility and time-value decay also
play their part, just like they affect a stock option.
Let's take a closer look at S&P futures and option prices, particularly at how changes in
the price of futures affect changes in the prices of the option. First let's look at S&P
futures product specifications, which are presented in Figure 1.

Futures Contract
Contract Value

S&P 500
Figure 1S&P
Futures
Product
Specifica
tions

Tick Size

.10 (a
$250 x price
'dime') =
of S&P 500
$25

Delivery
Months

Last Trading Day

Type of
Settlemen
t

March, June, Thursday prior to the third


Cash
Sept. and Dec. Friday of the contract month

S&P futures trade in "dime-sized" ticks (the minimum price change intervals), worth $25
each, so a full point ($1) is equal to $250. The active month is known as the "front-month
contract", and it is the first of the three delivery months listed in Figure 2. The last trading
day for all S&P futures contracts is on the Thursday before expiration, which is on the
third Friday of the contract month. By looking at Figure 2 below, we can see some actual
prices for the S&P 500 futures, taken from the close of daily trading (pit-session) on Jun
12, 2002.

Contract

High

Low

Settlement

Point Change

June '02

1022.80

1002.50

1020.20

+6.00

Sept. '02

1023.80

1003.50

1021.20

+6.00

Dec. '02

1025.00

1007.00

1023.00

+6.00

Figure 2 Settlement prices


for June 12,
2002

The Jun S&P futures contract in Figure 2, for example, settled at 1020.20 on this
particular day. The point change of +6.00 is equivalent to a gain of $1,500 per single
contract (6 x $250 = $1,500). It is worth noting that the S&P futures and the S&P 500
stock index will trade nearly identically, but the S&P futures will trade with a slight
premium attached.
Understanding S&P Futures Options
Now let's turn to some of the corresponding options. Like for nearly all options on
futures, there is a uniformity of pricing between the futures and options. That is, the value
of a $1 change in premium is the same as a $1 change in the futures price. This makes
things easy. In the case of S&P 500 futures options and their underlying futures, a $1
change is worth $250. To provide some real examples of this principle, I have selected in
Figure 3 the 25-point interval strike prices of some out-of-the-money puts and calls
trading on the Jun S&P futures.
Just as we would expect for stock put and call options, the delta in our examples below is
positive for calls and negative for puts. Therefore, since the Jun S&P futures rose by six
points (at $250 per point, or dollar), the puts fell in value and the calls rose in value. The
strikes farthest from the money (925 put and 1100 call) will have the lower delta values,
and those nearest the money (1000 put and 1025 call) have higher delta values. Both the
sign and the size of the change in dollar value for each option make this clear. The higher
the delta value the greater the option price change will be affected by a change of the

underlying S&P futures.

Figure 3 - S&P option prices at settlement on June 12, 2002

For example, we know that the Jun S&P futures rose six points to settle at 1020.20. This
settlement price is just shy of the Jun call strike price of 1025, which increased in value
by $425. This near-the-money option has a higher delta (delta = 0.40) than options farther
from the money, such as the call option with a strike price of 1100 (delta = 0.02), which
increased in value by only $12.50. Delta values measure the impact further changes in the
underlying S&P futures will have on these option prices. If, for instance, the underlying
Jun S&P futures were to rise 10 more points (provided there is no change in time-value
decay and volatility), the S&P call option in figure 3 with a strike price of 1025 would
rise by four points, or gain $1,000.
The same but reverse logic applies to the S&P put options in Figure 3. Here we see the
put option prices declining with a rise in the Jun S&P futures. The nearest-the-money
option has a strike price of 1000, and its price fell by $600. Meanwhile, the farther-fromthe-money put options, such as the option with a strike price of 925 and delta of -0.04,
lost less, a value of $225.
Conclusion
While there are many ways to trade using these options, many traders prefer to be a net
seller of options. Whether you prefer to buy or write (sell) stock options using either
simple spreads or more complex strategies, you can, with the basics presented here, easily
adapt many of your favorite strategies to S&P options on futures. (For more, read How to

Profit from Time-Value Decay.)


As for other options on futures markets, you'll need to get familiar with their product
specifications - such as trading units and tick sizes - before doing any trading. Having
said that, however, I am sure you will find that becoming fluent in a second options
language is not as difficult as you might initially have thought.

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