At times, simplest is best in the trading of options on CBOT mini-sized Dow futures. For example, when an economic report is due out in a day or two, and you have reason to believe that the consensus prediction is wrong, you can buy a call or a put, depending on how you expect the market to react.

Suppose that a purchasing managers report will come out the next day and that you have noticed a recent surge in the prices of industrial commodities, especially copper and aluminum. This might indicate that estimates of what the purchasing number will be are low. It seems reasonable that if the actual number is significantly higher than the estimated number, the stock market will react with an upward bounce. Of course, if the estimates are on target, the market may react only slightly or not at all.

One way to trade a situation of this kind is to buy a call on CBOT mini-sized Dow futures. If your prediction is on target and the market rallies, the option will increase in value. If the market does not react, the loss will be limited to the price of the option.

Which Option? How Much Time?

One way to trade this situation is to buy an out-of-the-money call on CBOT mini-sized Dow futures that has only a short time until expiration. By choosing such an option, you limit the amount of trading capital that is at risk, and you magnify the potential bang for the buck.

Assume that on the day before the report, the futures are trading at 10490 and that you have a choice of two option expirations. The regular quarterly expiration (the futures trade on a March, June, September, December quarterly cycle) is 48 days away, but there is a serial expiration that is 20 days away.

Exhibit 1a shows how the quarterly 10500 through 10800 strike price calls would be priced assuming the 10490 futures price, 48 days to expiration, and 14% implied volatility. Exhibit 1b shows the option pricing for the serial expiration of the same four calls with the only difference being that the serials have 20 days to expiration.

Exhibit 1a: Pricing Calls on CBOT mini-sized Dow Futures (quarterly expiration)

Futures Price	10490
Days to Expiration	48
Implied Volatility	14%
Strike Price	Option Price       (Index Points)	Option Price   (Dollars)	Delta
10500	207	1,035	0.50
10600	163	815	0.43
10700	126	630	0.36
10800	95	475	0.29

Exhibit 1b: Pricing Calls on CBOT mini-sized Dow Futures (serial expiration)

Futures Price	10490
Days to Expiration	20
Implied Volatility	14%
Strike Price	Option Price       (Index Points)	Option Price   (Dollars)	Delta
10500	132	660	0.50
10600	90	450	0.38
10700	58	290	0.28
10800	36	180	0.19

Notice that all of these options are out of the money on the initial day of this strategy. That is, the futures price is lower than any of the strike prices. Because of this, the entire option price is time value. It follows that the more time to expiration, the greater the price.

The first reason to prefer the shorter-dated serial expiration in a case like this one is that these options cost less. The quarterly 10800 call at 95 index points costs 164% more than the serial 10800 call at 36 index points. The serial call exposes far less trading capital to risk of loss.

A rule of thumb that some option traders use for choosing a strike price in this kind of situation is to buy options with deltas in the 0.20 to 0.30 range. Of the four strike prices shown, the serial 10700 and 10800 strike prices qualify for consideration but only the 10800 strike price of the quarterlies does.

Evaluating Possible Outcomes 

To see why the serial 10700 or 10800 calls might be the best choices, consider what can happen to all of these calls if the number does come in high and the index gains 125 points, to 10615, in 2 days while volatility remains the same. These outcomes are shown in Exhibits 2a and 2b.

Exhibit 2a: Ending Call Prices and Results (quarterly expiration)

Futures Price	10615
Days to Exp.	18
Implied Vol.	14%
Strike Price	Option Price (Index Points)	Option Price (Dollars)	Result    (Index Points)	Result (Dollars)	Return on Investment
10500	271	1,355	64	320	0.31
10600	218	1,090	55	275	0.34
10700	171	855	45	225	0.36
10800	132	660	37	185	0.39

Exhibit 2b: Ending Call Prices and Results (serial expiration)

Futures Price	10615
Days to Exp.	18
Implied Vol.	14%
Strike Price	Option Price (Index Points)	Option Price (Dollars)	Result    (Index Points)	Result (Dollars)	Return on Investment
10500	196	980	64	320	0.48
10600	139	695	49	245	0.54
10700	94	470	36	180	0.62
10800	60	300	24	120	0.67

In Exhibits 2a and 2b, the result columns are the differences between these option price values and the option price values shown in Exhibits 1a and 1b. For example, the 24 index point result for the serial 10800 call is the difference between 60 and 36.

Notice that the best return on investment (result divided by initial price) comes from the serial 10800 call in this case. In buying this option and given these assumptions, you risk $180 to make $120 for a 67% return on investment. Granted, the longer-dated options make more in dollar terms as do the nearer-the-money strike prices. But these options also expose far more capital to risk of loss and earn much smaller returns on investment.

It is also important to consider what could happen if the stock market goes down when you expect it to go up. The most you can lose in the case of the serial 10800 is the $180 initial price. A buyer of the quarterly 10800 could lose $475, 164% more. The question of which option to buy comes down to whether the extra $65 of profit is worth risking $295 more. This risk-reward trade-off seems to favor the serial 10800 call.

In Sum

Keep in mind that this kind of option trade is only appropriate when you have sound reasons to believe that the event in question will surprise the market. When the market has correctly forecast the number or has already priced in the variation from forecast, this kind of trade is unlikely to generate a positive result.

However, if you have any reason to believe a surprise is in the offing, buying a short-dated, fairly far-out-of-the-money option can be a useful way to trade your opinion for small cost. When you do turn out to be right, this option choice will magnify the bang for the buck.

 

The information in this publication is taken from sources believed to be reliable. However, it is intended for purposes of information and education only and is not guaranteed by the Chicago Board of Trade as to accuracy, completeness, nor any trading result, and does not constitute trading advice or constitute a solicitation of the purchase or sale of any futures or options. The Rules and Regulations of the Chicago Board of Trade should be consulted as the authoritative source on all current contract specifications and regulations.

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