An Introduction to Futures and Options

Presented by Dan Dooley

NYSE Euronext. All Rights Reserved.

Course Objectives
This course provides an introduction to Futures & Options and to products traded on the NYSE Liffe Exchange The objective of this course is to give NYSE Liffe staff, who have little or no experience of Futures & Options, an introduction to the 'business side' of derivatives and derivatives trading

Course Content
Course Objectives What are Derivatives
o o

Product Groups
o o o o o

Futures Options

Derivatives compared to Spot Market Why Trade Derivatives Derivatives Exchange

o o o o o

Equities STIRs Bonds Commodities Indices

Regulated Market Liquidity Standardised Contract Guaranteed Clearing Exchange v OTC

Contract Specifications Trading

o o o o

Profit & Loss Life Cycle of a Trade Options Strategies

What are Derivatives

A Derivative is a financial instrument which derives its value from another financial instrument sometimes referred to as the underlying instrument For example: o The FTSE 100 Index Future derives its value from the FTSE 100 index o The Vodafone Equity Option derives its value from the Vodafone stock

What are Derivatives - Futures

A futures contract is a contract to buy/sell a specific underlying instrument at a specific time in the future, for a specific price. Futures are exchange-traded contracts and they're standardised in terms of delivery date, amount and contract terms.

What are Derivatives - Options

Options give an investor the right to buy or sell a quantity of a product (underlying) at a fixed price (exercise price) before a specific date (expiry). CALL Options
o

The buyer of a CALL option acquires the right, but not the obligation, to buy the underlying asset at a fixed price (exercise price). Call options generally rise in value if the price of the underlying asset rises. The buyer of a PUT option acquires the right, but not the obligation to sell the underlying asset at a fixed price (exercise price). Put options generally rise in value if the price of the underlying asset falls.

PUT Options
o

Derivative Market compared to Spot Market

Derivative Market Spot Market
Underlying asset is bought at an agreed price for Asset is bought at the current market price for immediate future ownership ownership Underlying asset is sold at an agreed price for future delivery Asset is sold at the current market price for immediate delivery

On expiry, underlying asset delivered at contracted Not applicable future date Derivatives can be bought and sold without ownership of the underlying asset Delivery of the underlying asset is optional You must own the asset to sell it

Delivery of the asset is contracted

Derivatives have Expiries and Strikes

Spreads and Strategies Matching Algorithms & Order Prefrencing Implied Pricing

Not applicable
Not applicable Not applicable Not applicable

Why Trade Derivatives?

HEDGING o Futures were originally introduced as an insurance mechanism for farmers and manufacturers who wanted to fix a price for crops at a future date. The farmer wanted to be able to make plans knowing the price he would get for his crops. For the manufacturer, fixing the price meant that he could ensure consistency in the prices he charged. RISK MANAGEMENT o Financial futures and options were originally developed in order for investors to protect their investments and manage their risks. Prices can change drastically over time and investors are able to use futures and options markets to protect themselves from uncertainty in price movements. Price can be locked-in. SPECULATION o The uses of derivative products have broadened over time, and now investors also use these products for profit by forecasting which way the market will move.

Derivatives Exchange NYSE Liffe

NYSE Liffe is the international derivatives business of Euronext, comprising the Amsterdam, Brussels, LIFFE, Lisbon and Paris derivatives markets and the New York Stock Exchange. It was formed following the purchase of LIFFE (the London International Financial Futures and Options Exchange) by Euronext in 2001 and the subsequent purchase by NYSE in 2007. NYSE Liffe is the worlds leading exchange for euro short-term interest rate derivatives and equity options. NYSE Liffe offers a greater choice of derivatives products than any other exchange: it offers futures and options on short- and long-term interest rate products, on equities, indices, government bonds and commodities. NYSE Liffe is creating a single market for derivatives, by bringing all its derivatives products together on a single electronic trading platform, LIFFE CONNECT. Trading on LIFFE was originally conducted by what's known as "open outcry". Traders would physically meet in the Exchange building to transact their business. Each product was traded in a designated area called a pit, where traders would stand and shout the price at which they were willing to buy or sell.

Derivative Exchange
Regulated market Liquidity Standardised contract Guaranteed settlement Exchange v OTC

Derivative Exchange - Regulated Market

Under current legislation, NYSE LIFFE is categorised as a Recognised Investment Exchange (RIE) under the Financial Services Act. In order to maintain this status, LIFFE works to ensure that: Trading is conducted in an orderly and fair manner Effective systems are maintained to report market activity and prices Efficient and secure clearing arrangements are in place Compliance with rules is monitored and enforced.

Derivative Exchange - Liquidity

The Exchange brings together different parties - such as financial institutions, corporate treasury departments and commercial investors, as well as private individuals - some of whom want to offset risk, hedgers, and others who are prepared to take on risk in the search for profit.

Derivative Exchange Standardised Contract

All futures are exchange-traded contracts and they are standardised in terms of: o Delivery date o Amount of the 'underlying' to which they relate o Contract terms

Derivative Exchange Guaranteed Clearing

Contracts traded on the Exchange and held overnight are "cleared" by LCH.Clearnet, a Recognised Clearing House. LCH.Clearnet guarantees the performance of all contracts, protecting against any party defaulting on their obligations. LCH.Clearnet are able to provide this partly through calling for a deposit from all buyers and sellers, known as "margin", and are also backed by sizeable reserves.

Derivative Exchange versus OTC

In contrast, off-exchange contracts are individually negotiated contracts, which may deal in non-standardised sizes, or be a structured product specifically designed for a particular purpose. The fact that they are tailormade means that they are not as widely quoted or as liquid as exchangetraded contracts.

Product Groups
Equities STIRs Bonds Commodities Indices

Product Groups - Equities

Equities - Stock or any other security representing an ownership interest e.g. o Vodafone o BT

Product Groups - STIRs

STIRs Short Term Interest Rate products e.g. o Euribor o Short Sterling

Product Groups - Bonds

Bonds - A debt investment with which the investor loans money to an entity (company or government) that borrows the funds for a defined period of time at a specified interest rate e.g. o Treasury Bonds o Japanese Government Bond (JGB) o German Government (Bund) o Gilts

Product Groups - Commodities

Commodites (aka Non Financials). Some traditional examples of commodities include grains, gold, beef, oil and natural gas. Examples on NYSE Liffe: o Coffee o Sugar o Wheat o Potato

Product Groups - Indices

An index is a number that measures changes in the economy or financial markets. Some indexes are used as benchmarks that economic or financial performance is measured against. Some well-known market indexes include: o FTSE 100 o S&P 500 o CAC 40 o DAX o Dow Jones Industrial Average o Nasdaq o AEX o Nikkei Dow o Hang Seng

Contract Specifications
NYSE Liffe futures contracts are legally binding agreements that have standard parameters such as size, expiry, exercise and settlement. Euronext LIFFE futures therefore have standardised contracts or product specifications. This improves liquidity and the ease of trading between buyers and sellers. Unit of Trading. This gives you a precise definition of the quantity and quality of the instrument to be bought or sold Delivery Months & Delivery Days. A futures contract consists of monthly cycles when delivery will occur. Contractual obligations of the contract must be met on the given day. In practice, most futures contracts are "closed out" before delivery day Last Trading Day. This is the day when trading in a particular contract will stop.

Contract Specifications
Quotation / Tick Size & Value The quotation specifies how a price is calculated and is affected by interest rates and the tick value of the contract. A "tick" represents the smallest amount a price can change. Exchange Delivery Settlement Price (EDSP) This is calculated to confirm the final value at a fixed time on the last trading day. Initial margin Margin requirements are funds or collateral that must be lodged with your broker in order to meet any obligations under the terms of the contract. Trading Hours All futures contracts have fixed times when futures can be traded. See individual contract specifications for details

FTSE 100 Index Futures

Unit of trading Contract Valued at 10 per index point (e.g. value 65,000 at 6500.0) Delivery months March, June, September, December (nearest four) Quotation Index points (eg 6500.0) Minimum price movement 0.5 (5.00) (tick size and value) Last trading day Trading shall cease as soon as reasonably practicable after 10:15 (London time) once the Expiry Value of the Index has been determined. Third Friday in delivery month1 Delivery day First business day after the Last Trading Day Trading hours 08:00 - 17:30

Three Month Sterling (Short Sterling) Futures

Unit of trading 500,000 Delivery months March, June, September, December, and two serial months, such that 23 delivery months are available for trading, with the nearest three delivery months being consecutive calendar months. Quotation 100.00 minus rate of interest Minimum price movement 0.01 (12.50) (Tick size and value)

Last trading day 11:00am Third Wednesday of the delivery month. Delivery day First business day after the Last Trading Day. Trading hours 07:30 - 18:00

Long Gilt Futures

Unit of trading 100,000 nominal value notional Gilt with 6% coupon Delivery months March, June, September, December, such that the nearest three delivery months are available for trading. Quotation Per 100 nominal Minimum price movement 0.01 (10) (tick size and value) Last trading day 11.00am Two business days prior to the last business day in the delivery month Delivery day Any business day in delivery month (at sellers choice)

Trading hours 08:00 - 18:00

Trading
Trading on LIFFE CONNECT takes place by submitting an order, via a trading application (front-end software), into the LIFFE CONNECT central order book. Having received the orders, the LIFFE CONNECT Trading Host then matches them in the central order book (this is an electronic representation of the market place) where the criteria for determining trade priority is dependent on the contract being traded. As a trader, you have the ability to revise your orders and orders may be withdrawn at any time, either individually or as a block.

Trading
Opening and closing positions Derivatives provide the opportunity to profit from the upward and downward turns in the prices of underlying assets. For a view that market prices will rise, you would buy futures. This is a LONG futures position. Conversely, for a view that market prices will fall, you would sell futures. This is a SHORT futures position. If the view held materialises, the position can be closed by undertaking an equal and opposite position in the same market in order to profit from the price difference. To close a long position you would sell futures and to close a short position you would buy futures.

Trading - Life Cycle of a Trade

Place order Order matched Trade Trade allocated to clearing account Overall Trade position calculated Long or Short Margining Clearing Expiry Delivery?

Trading
How the market works Bids/Offers/Trades/Depth Central order book Host matching/Algorithms Clearing

Trading - Profit & Loss (P&L)

Profit/loss = tick value x movement (ticks) x quantity (lots)

Trading - P&L Calculation

Buy 5 FTSE MAR07 contracts (lots) price of 6180.0 Sell 5 FTSE MAR07 contracts (lots) at a price of 6230.0 Sell price is higher than buy price, therefore it is a profit. 5 multiplied by 100 ticks (6230.0 6180.0, tick size = 0.5) multiplied by 5 lots (quantity) Profit = 5 x 100 x 5 = 2,500.

Trading - Futures & Options

A FUTURES contract is a contract to buy/sell a specific underlying instrument at a specific time in the future, for a specific price. An OPTION gives the investor the right, but not the obligation, to buy or sell a quantity of a product (underlying) at a fixed price (exercise price) before a specific date (expiry). o Options on Stocks o Options on Futures

Trading - Options versus Futures

Investors pay a premium for an Option which gives them the right, but not the obligation to buy or sell a particular asset. Investors pay the full price for a Future which gives them the obligation to buy or sell a particular asset. Futures give the owner unlimited risk Options give the owner limited risk

Trading - Options
The buying of options involves limited risk - that is to say you cannot lose any more than the premium paid at outset. It is also possible for you to write or sell options. The writing of call options, although having a wide range of uses, is a potentially high-risk strategy requiring a high degree of product knowledge. Since exercise can involve the writer in a substantial financial commitment, option writers are required to deposit margin with the broker to ensure the obligation of the contract can be met in full if required.

Trading - Options
Premium - The premium is the amount that you pay up front for the option. This amount is once-off and non-refundable. Exercise Price - The exercise or strike price is the amount that you agree to pay for the stock at a later date. Underlying Stock - The underlying stock is the stock for which you are purchasing the option. Exercising Options - By exercising an option, you are using your right to buy, and actually purchasing the underlying stock. Expiration Date - The expiration date is the last day for you to exercise your option. If you don't exercise it by then, your option will expire worthless. American Options - American style options are options that allow you to exercise the options at any time until the expiration date. European Options - European style options are options that allow you to exercise the options at only the expiration date.

Trading - Options
There are two types of options - CALLS and PUTS. The buyer of a CALL option acquires the right, but not the obligation, to buy the underlying asset at a fixed price (exercise price). Call options generally rise in value if the price of the underlying asset rises. The buyer of a PUT option acquires the right, but not the obligation to sell the underlying asset at a fixed price (exercise price). Put options generally rise in value if the price of the underlying asset falls.

Trading - Options
An Options Fair Value is calculated using o Current price of underlying asset o Strike price o Time until expiration o Cost of money o Volatility

Trading - Options
An Options price or premium can be considered as the sum of two specific elements: o Intrinsic value o Time value

Trading - Options
Intrinsic value o The intrinsic value of an option is the amount an option holder can realise by exercising the option immediately. Intrinsic value is always positive or zero. An out-of-the-money option has zero intrinsic value. o Intrinsic value of in-the-money call option = underlying product price strike price o Intrinsic value of in-the-money put option = strike price - underlying product price Time value o The time value of an option is the value over and above intrinsic value that the market places on the option. It can be considered as the value of the continuing exposure to the movement in the underlying product price that the option provides. The price that the market puts on this time value depends on a number of factors: time to expiry, volatility of the underlying product price, risk free interest rates and expected dividends.

Trading - Options
A CALL Option is: o in-the-money when the underlying price is higher than the options exercise price o out-of-the-money when the underlying price is lower than the options exercise price A PUT Option is: o in-the-money when the underlying price is lower than the options exercise price o out-of-the-money when the underlying price is higher than the options exercise price An option is at-the-money when the underlying price is equal to the options exercise price In practice, the option with the exercise price nearest to the prevailing underlying price is called the at-the-money option.

Trading - Options
Contract Specification o Eg. Stock/Equity options o Option trading is carried out in numbers of contracts. One contract equates to x underlying shares. If you buy one call option contract, you are buying the right to buy x shares of the underlying stock

Trading - Options
Volatility o The volatility of an option is a measure of the spread of the price movements of the underlying instrument. The more volatile the underlying instrument, the greater the time value of the option will be. This will mean greater uncertainty for the option seller who, will charge a high premium to compensate. Option prices increase as volatility rises and decrease as volatility falls.

Trading - Options
Option sensitivities. These sensitivities are commonly referred to as the Greeks: o Delta o Gamma o Theta o Vega

Trading - Options
Delta o Measures the change in the option price for a given change in the price of the underlying and thus enables exposure to the underlying to be determined. The delta is between 0 and +1 for calls and between 0 and -1 for puts (thus a call option with a delta of 0.5 will increase in price by 1 tick for every 2 tick increase in the underlying).

Trading - Options
Gamma o Measures the change in delta for a given change in the underlying. (e.g. if a call option has a delta of 0.5 and a gamma of 0.05, this indicates that the new delta will be 0.55 if the underlying price moves up by one full point and 0.45 if the underlying price moves down by one full point).

Trading - Options
Theta o Measures the effect of time decay on an option. As time passes, options will lose time value and the theta indicates the extent of this decay. Both call and put options are wasting assets and therefore have a negative theta. Note that the decay of options is nonlinear in that the rate of decay will accelerate as the option approaches expiry. o The theta will reach its highest value immediately before expiry.

Trading - Options
Vega o Measures the effect that a change in implied volatility has on an options price. Both calls and puts will tend to increase in value as volatility increases, as this raises the probability that the option will move in-the-money. Both calls and puts will thus possess a positive vega.

Trading - Strategies
What is a strategy? Why trade strategies? Strategy examples, futures & options Strategy pricing Implied Pricing

Exercises
Name one STIR option & one Index Option traded on LIFFE Connect If you purchase a CALL option, do you receive premium or pay it? If you purchase a PUT option, do you receive premium or pay it? What is a strike? If you buy a call option and the underlying price increases, what will happen to the value of your call option? If an options volatility is high, is there more or less probability the strike will end up in the money? A call option is priced at 8 and has a delta of 10. The underlying increases in value by 60, what would the value of the call option be? Name two reasons why people trade options? What would the underlying be of an Equity Option contract? Time value of an option is known as Gamma or Theta?

Futures & Options

Questions Summary

Other
Standing data API Settlements Clearing