Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today’s futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C.
SIDE-BY-SIDE TRADING
What is “side-by-side” trading and what does it mean to me as a speculator?
A majority of futures contracts now offer side-by-side trading in which speculators have a choice between open outcry and electronic execution venues. If you are unfamiliar with these terms, “open outcry” is the original method of execution for the futures and options industry and is also referred to as pit trading. Pit traded contracts are bought and sold by traders in a tiered area, normally shaped in an octagon, waving and yelling orders to buy or sell an instrument. You’ve probably seen glimpses of the process on television or in movies. Do you remember the orange juice trading pit in the movie Trading Places? The practice is loud and exciting and best described as organized chaos.
“Electronic execution,” on the other hand, doesn’t involve a physical and centralized location. Instead, it is the exchanges’ method of matching buy and sell orders via electronic means with little or no human intervention.
Markets that offer side-by-side trading such as the Cme Group’s Chicago Board of Trade (Cbot) grains and New York Mercantile Exchange (Nymex) energies can be bought or sold in either environment during the official day session but can only be traded electronically in the afterhours session. A corn trader could buy a futures contract in the electronic market in overnight trade and offset his position by selling the contract back in the open outcry session during the day. Similarly, the same trader could opt to sell his contract in the electronic market, knowing that the open outcry session is there if he chooses to use it. Which method of execution a given trade will undergo depends on the commodity symbol used. In the case of Cbot products, the electronic version is typically denoted by the prefix Z.
Keep in mind that most retail clients use the electronic market to facilitate their futures contract trading. However, it is comforting to know that should the exchange experience a computer failure (it does happen), there is another means of entering and exiting a position.
Conversely, options on futures can also be traded electronically next to (that is, side by side) an open outcry version, but traders can often achieve more efficient execution in the form of tighter bid and ask spreads through open outcry trading. For this reason, it is important that the broker you are working with has access to option brokers located directly on the exchange floor. While the use of an open outcry execution specialist may cost you a few extra dollars in transaction costs, it might save you much more when it comes to fill quality. Don’t trip over dollars trying to save pennies in transaction costs!
OPTION DELTA USES
What is an option delta and how can I use it in my trading?
The delta of an option is the rate of change that the option value will experience for every point of price movement in the futures market. For instance, a trader who is long a crude oil call option with a delta of 0.20, or 20%, will experience an increase or decrease in option value equal to 20 cents for every $1 that the futures price moves up or down.
Many view the delta value as the approximate probability of that particular option expiring in-the-money. Knowing this, it seems logical that an at-the-money option has a delta value of 0.50 and it is easy to imagine that options with low deltas are nothing more than lottery tickets.
As simple as the definition of delta and this example of how it works is, things can become much more complicated. Specifically, the delta value of a particular option is dynamic rather than static. Not only is the value of the option changing as the underlying futures price fluctuates, so does the delta value. Traders who are long options in an exploding market enjoy the benefit of increasing deltas. However, traders who are short options in similar circumstances will pay the price.
Dramatic changes in option delta have a profound impact on the risk and reward potential that comes with being exposed to a particular call or put position. A trader who is short an option with a delta of 0.10 is probably comfortable knowing that they are, in essence, net short 0.10 futures contracts. However, following an adverse and volatile price move, the same option could quickly have a new delta of 0.40. There is a notable difference in risk between being short 0.1 futures and short 0.4 futures.
In addition, the delta value doesn’t incorporate the bid/ask spread into its calculation. If you recall, at any given time a market has two prices; one with which you can purchase an instrument and one with which you can sell it. As a retail trader, you will always pay the higher price (ask) and sell at the lower price (bid). In illiquid markets, this can create a scenario in which a given move in the futures price has a much smaller or larger impact on the price at which you can offset the option due to the difference in the bid and ask prices.
A trader who is long a call option in a market that doesn’t experience a great deal of volume such as copper may have calculated a delta value of 0.25, but after a two-cent move in the futures price, the option likely wouldn’t have gained $0.50 in premium as the delta suggests. Instead, the wide bid/ask spreads may have eaten most or all of the price move. In liquid option markets such as the S&P and Treasuries, this is less of a concern but will always have an impact on reality as opposed to the calculation on paper.