Options and Futures Term Paper

Excerpt from Term Paper :

Futures Trading

The purpose of this project was to gain experience in the area of options and futures trading. For the purposes of this project, the values were obtained from various sources. The dates covered were 2/11/2002 to 05/10/2002. The company chosen for this project was the TJX Corporation, Inc. which is in the Retail sector of the S & P. 500. It was chosen primarily because it has been showing a bullish trend for 5 years and would be a good example of bull market trading. The stock was compared to the S & P. 500 Index (Symbol SPX). The final portion of the project required the use of a futures commodity. I chose Corn (Symbol CO (e)). It has been bearish since February.

All tests were ran in a bull market environment. Various trading strategies were tested on this option. The methods tested were a Bull market Strategy, Butterfly Strategy, and Strap strategy were and the results analyzed in the "Results" section of this report. All calculations were performed using and Excel spread sheet. Graphs were generated using Excel, except where cited as coming from another source.

The purpose of this project was to become familiar with options trading. Options offer an excellent opportunity for small funded investors to buy stocks that they normally would not have been able to due to funding, while minimizing their risk at the same time. Options trading reacts much differently in a bear market. For the purposes of this study, all options chosen were in a general uptrend. It may be noted that TJX was in a bull trend during the dates of the study, but immediately after turned into a bear trend. This may effect the accuracy of my future trend predictions, as compared to the actual. All options in this study had an exercise date of June 20, 2002.

The first section of this research paper examines a stock (SPXDF), which is an S & P. 500 index share. Data was obtained for the period from 2/11/2002 to 5/10/2002. The actual price of the index was 1192 on 2/11/2002. One share would have made $28.00 if sold on May 11, 2002. The actual share price for and index option in approximately the composite divided by 100. Therefore if the price was 1192, you could purchase a share of this stock for $11.00.

The hedge ratio of TJX was measured against the price at the beginning of the measurement period and showed a general bullish trend. This means that it was showing a positive change over the course of the period. The Hedge ration is sometimes called the Delta, or change over time in price. The hedge ratio was plotted in a way so that all other prices were measured against the beginning price.

To demonstrate the effects of the Bull strategy I chose to buy two options, one with a strike price of $5.00 and the other with a strike price of $7.50. The option used for the sell portion of this experiment has a strike price of $25.00. For simplicity I only bought and sold one share of each. The calculations for multiple shares are easy to calculate. This was done to get a clear comparison between the three options strategies. These transactions would have made a net total of $28.02. It may also be noted that the put option was the highest possible and the calls were the lowest possible. This was to emphasize the results of the transactions.

The next strategy explored was the butterfly strategy. Four options were chosen, two buys and two sells. This method netted $13.68 total. The profits from the put were almost equal to the expenses for the call. They had the effect of canceling each other out. This was the least profitable and most subject to volatility of the three strategies explored.

The last strategy was the strap strategy. This is a good measurement of the effect of time on option profits. In this strategy two calls and one put are exercised, which all have the same strike price. This method netted $20.61. The call and put cancel each other out, as in the butterfly method. Had the two calls been exercised at different time, this would not have been the case. In a bull market, it would cause a higher profit. However in bear conditions, it could have possibly caused a loss. There are many variables as to the timing of the execution of the exercises in this method and all would have an effect on the results. If the put were exercised early and the calls exercised late, the results would be a greater gain or loss depending on the direction of the market. However if one call and the put were exercised relatively close together they could be used to minimize a risk in the case of a bear market. In a bull market, this would minimize the profits and the put should be exercised early and both calls exercised later for maximum profits.

Of the three options methods studied in this paper, the bull strategy is the most profitable and least risky. This would be the preferred method, especially if the bull trend were expected to continue. In the case of a bear market.

The timing of the puts and calls could be adjusted. Placing the puts and calls early would be the preferred method here, in an atmosphere of falling prices. This method is predictable and easy to control, compared to the other two strategies. The butterfly strategy is weak due to the canceling effect of the puts and calls. The strap method is subject to too much market volatility. It is easy to control the final result using the bull method.

As TJX has been in a bullish trend, the breakeven points for the lower strike prices occurred before the scope of this report. The strike price of $20.00 had a break-even point of 1.06 shares. This is close to the end price of the option at the end of this study. This option shows a slow, but steady upward slope. The June break-even point will be approximately 1.33 shares. Because this is a bullish stock and the higher prices occur at the end of the cycle, the lower strike prices have higher maximums and minimums. At a strike price of $20.00, it is possible to suffer a slight loss. The stock price will simply not climb that rapidly, In a bear market, this trend would be the exact opposite,

The stock price, as calculated using trend analysis on Excel is expected to be $28.00. In this case a long-term contract will increase the hedge ratio and therefor increase profits. This is making a dangerous assumption that this stock will continue on a bullish trend. During the time period examined, it was on an upward trend, however, just after the time period used for this study the stock took a downward trend. Whether this trend will continue or not, will have to be determined at a later date. Caution should be used and if this were real money transaction, it would have to be closely monitored for he emergence of a bearish trend.

In the final problem, we were asked to sell one option of the Index stock that we have chosen. In this case, we will use TJX. We were to buy one T-Bill, and one commodity, I chose the 91-day T-Bill. This is the closet to the risk free interest rate used by the U.S. Government. The 91-day T-bill is also the one least likely to suffer from market volatility. By comparison, a 5-year T-bill could see a variety of economic conditions before it comes to maturity. The commodity used was corn.

Profits for this trade were $63,074.00. This was primarily due to the good selection of the stock option of TJX, which rose to $11.84 above the strike price. The corn futures had no intrinsic value, and the strike and actually price were the same. The T-bill showed a small profit of 554 dollars. The effects of the bull market were demonstrated in the first exercise, where TJX show profit on one share. When one has the money to purchase 1621 shares the profits are multiplied by this amount, but one must always remember that the risk is multiplied by the same amount. The bullish trend of this stock held up the other stocks, which did not do as well.

The primary focus of this study was the stock TJX and its option chain. Compared to the index, and its own sector, TJX performed better than its it sector and the S & P. 500 in general. This is a good indicator that the bull trend will continue. In order to make an accurate assessment of the predicted trend, we must compare its performance to its own Index and sector. If it were performing below its sector, and were on an uptrend, then we might expect the trend is not…

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