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 PremiumIn 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-than-normal 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 SpreadIf 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 LineIt 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 SummaContact | Author Bio document.write(''); 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 FuturesThe 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 FuturesTo 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 CharacteristicsThere 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 Tick Size Delivery Months Last Trading Day Type of Settlement S&P 500 $250 x price of S&P 500 .10 (a 'dime') = $25 March, June, Sept. and Dec. Thursday prior to the third Friday of the contract month Cash Figure 1- S&P Futures Product Specifications

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 LowSettlementPoint ChangeJune '021022.801002.501020.20+6.00Sept. '021023.801003.501021.20+6.00Dec. '021025.001007.001023.00+6.00Figure 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 OptionsNow 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-from-the-money put options, such as the option with a strike price of 925 and delta of -0.04, lost less, a value of $225.

ConclusionWhile 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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