Options Trading Strategies

Key Points to Remember:

• ALL options eventually lose ALL of their "time value."
• ALL "Out-Of-The-Money" options expire worthless.
• Markets only "trend" 1/3 of the time; they move sideways the other 2/3.

LIFFE STRATEGIES

BULLISH Market Strategies

Option Spread Strategy	Description	Reason to use	When to use
Buy a Call	Strongest bullish option position.	Loss limited to premium paid.	Undervalued option with volatility increasing.
Sell a Put	Neutral bullish option position.	Profit limited to premium received.	High volatility, bullish trending market.
Buy Vertical Bull Call Spread	Buy Call & sell Call of higher strike price.	Loss limited to debit.	Small debit, bullish market.
Sell Vertical Bear Put Spread	Sell Put & buy Put of lower strike price.	Loss limited to strike price difference less premium received.	Large credit, bullish market.

 

BEARISH Market Strategies

Option Spread Strategy	Description	Reason to use	When to use
Buy a Put	Strongest bearish option position.	Loss limited to premium paid.	Undervalued option with increasing volatility.
Sell a Call	Neutral bearish option position.	Profit limited to premium received.	Option overvalued, market flat to bearish.
Buy Vertical Bear Put Spread	Buy at the money Put & sell out of the money Put.	Loss limited to debit.	Small debit, bearish market.
Sell Vertical Bull Call Spread	Sell Call & buy Call of higher strike price.	Loss limited to strike price difference minus credit.	Large credit, bearish market.

 

NEUTRAL Market Strategies

Option Spread Strategy	Description	Reason to use	When to use
Strangle	Sell out of the money Put & Call.	Maximum use of time value decay.	Trading range market with volatility peaking.
Arbitrage	Buy & sell similar options simultaneously.	Profit certain if done at credit.	Any time credit received.
Calendar	Sell near month, buy far month, same strike price.	Near month time value decays faster.	Small debit, trading range market.
Butterfly	Buy at the money Call (Put) & sell 2 out of the money Calls(Puts) & buy out of the money Call (Put).	Profit certain if done at credit.	Any time credit received.
Guts	Sell in the money Put & Call.	Receive large premium.	Options have time premium & market in trading range.
Box	Sell Calls & Puts same strike price.	Profit certain if done at credit.	Any time credit received.
Ratio Call	Buy Call & sell Calls of higher strike price.	Neutral, slightly bullish.	Large credit & difference between strike price of option bought & sold.
Conversion	Buy futures & buy at the money Put & sell out of the money Call.	Profit certain if done at credit.	Any time credit received.

 

Special Market Situations

Option Spread Strategy	Description	Reason to use	When to use
Straddle Purchase	Buy Put & Call.	Options will lose time value premium quickly.	Options under-valued & market likely to make a big move.
Covered Call	Buy future & sell Call.	Collect premium on Calls sold.	Neutral to slightly bullish.
Covered Put	Sell future & sell Put.	Collect premium of Puts sold.	Neutral to slightly bearish.
Synthetic futures position.	Buy Call (Put) & Sell Put (Call).	Neutral, slightly trending market.	Receive credit, option sold far out of the money.

 

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CERTIFICAT DE VALEUR GARANTIE (CVG)
En anglais:CONTINGENCY VALUE RIGHT
Dans le cadre d'une OPE, le CVG permet aux actionnaires de la société
absorbée de recevoir des titres dont la valeur ne baissera pas en dessous
d'un certain montant, en deçà duquel ils seraient indemnisés.

CVG : certificat de valeur garantie. Instrument financier attribué gratuitement
aux actionnaires lors d'une OPA pour les inciter à céder leurs actions.
CVG : certificat de valeur garantie. Instrument financier attribué gratuitement aux actionnaires lors d'une OPA pour les inciter à céder leurs actions.

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Les certificats

Les certificats nouvellement apparus sur le marché des produits dérivés se définissent comme des valeurs mobilières cotées en continu. Ils s’acquièrent comme toute autre valeur au comptant, à l’aide d’un code sicovam qui leur est attribué dès leur émission. Une échéance leur est donnée au terme de laquelle ils perdent toute valeur.

A l’instar des warrants, les émetteurs leur assurent la tenue d’un marché de sorte que l’acquéreur puisse à tout moment trouver une offre et surtout une contrepartie. Les certificats permettent de répliquer un indice, une action, voire un panier d’actions réunies généralement autour d’une thématique. Ils offrent des avantages certains, notamment par le fait qu’à la différence des sicav indicielles, ils ne supportent pas de frais de gestion.

Les seuls frais qu’ils subissent sont ceux liés à leur acquisition et à leur cession. Un investisseur qui voudrait jouer l’évolution d’un indice se dispense, par l’acquisition d’un certificat, de l’appréhension avec les frais afférents de l’ensemble des valeurs qui composent cet indice.

L’imagination des émetteurs est fertile. Ils proposent différents certificats avec des mécanismes d’évaluation divers qui peuvent ou non bénéficier d’un effet de levier et permettre d’accompagner des mouvements de hausse ou de baisse. Certains certificats n’intègrent pas dans la composition de leur prix une valeur temps. D’autres, en revanche se nourrissent de celle-ci, dans un sens d’ailleurs positif, à la différence des warrants, lesquels, nous l’avons vu dans nos précédentes éditions, en pâtissent.

L’investisseur ne doit pas se fier uniquement au nom du certificat pour savoir à quel type appartient celui qu’il acquiert. En effet, certains certificats d’appellations différentes répondent aux mêmes définitions. C’est le cas des certificats discount ou stars.

Nous pourrons ainsi voir chacun d’eux et d’ écrire leurs mécanismes.

ConvertibleBonds

A convertible bond is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities.

Convertible bonds are bonds. They have a coupon payment and are legally debt securities, which rank prior to all equity securities in a default situation. Their value, like all bonds, depends on the level of prevailing interest rates and the credit quality of the issuer.

The exchange feature of a convertible bond gives the right for the holder to convert the par amount of the bond for common shares a specified price or "conversion ratio". For example, a conversion ratio might give the holder the right to convert $100 par amount of the convertible bonds of Ensolvint Corporation into its common shares at $25 per share. This conversion ratio would be said to be " 4:1" or "four to one".

The share price affects the value of a convertible substantially. Taking our example, if the shares of the Ensolvint were trading at $10, and the convertible was at a market price of $100, there would be no economic reason for an investor to convert the convertible bonds. For $100 par amount of the bond the investor would only get 4 shares of Ensolvint with a market value of $40. You might ask why the convertible was trading at $100 in this case. The answer would be that the yield of the bond justified this price. If the normal bonds of Ensolvint were trading at 10% yields and the yield of the convertible was 10%, bond investors would buy the bond and keep it at $100. A convertible bond with an "exercise price" far higher than the market price of the stock is called a "busted convertible" and generally trades at its bond value, although the yield is usually a little higher due to its lower or "subordinate" credit status.

Think of the opposite. When the share price attached to the bond is sufficiently high or "in the money", the convertible begins to trade more like an equity. If the exercise price is much lower than the market price of the common shares, the holder of the convertible can convert into the stock attractively. If the exercise price is $25 and the stock is trading at $50, the holder can get 4 shares for $100 par amount that have a market value of $200. This would force the price of the convertible above the bond value and its market price should be above $200 since it would have a higher yield than the common shares.

Issuers sell convertible bonds to provide a higher current yield to investors and equity capital upon conversion. Investors buy convertible bonds to gain a higher current yield and less downside, since the convertible should trade to it bond value in the case of a steep drop in the common share price.

Investors traditionally use "breakeven" analysis to compare the coupon payment of the convertible to the dividend yield of the common shares. Modern techniques of option analysis examine the convertible as a bond with an equity option attached and value it in this manner.

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Brief Review of Convertible Security Types
I. Convertible Bond. A convertible bond provides the performance attributes of common stock and a bond. These securities typically pay a semi-annual coupon of 4.00% to 5.00%. The security is typically a subordinated debenture with a fixed principal amount and time to maturity with a right to convert into common stock based on its conversion ratio. The upside of the convertible comes from its common stock component, while the downside protection comes from the cash coupon, fixed maturity, and status in the capital structure which is senior to common and preferred stock. II. Convertible Preferred. A convertible preferred also has features similar to a convertible bond. However, convertible preferred stock is subordinated to debt of the issuing company. It typically offers a coupon of 6.00% to 7.00%. A convertible preferred typically pays a cash coupon on a quarterly basis, and is also perpetual or with a long maturity. Valuation: For equity oriented investors, convertibles can be viewed as either a Stock plus Put, or Bond plus Call. A. Stock plus Put. A convertible security can be viewed as a stock plus a put. The upside of the convertible comes from the underlying stock. The higher the price of the underlying stock goes, the higher the convertible price should go. The downside protection of the convertible comes from its higher yield, fixed maturity value, and status in the capital structure, which all combine to give the security downside protection. B. Stock Alternative. At very high prices, the convertible still should provide a higher current yield than its underlying common stock and have a low premium. The combination of the higher yield and low premium results in a low breakeven time. The breakeven time is the time it would take a buyer of a convertible to recover the premium paid for it. Low breakeven convertibles typically have the most equity sensitivity, and given the yield advantage, it is not unusual for a convertible with this characteristic to outperform the common on a total return basis. C. Bond plus Call. A convertible can also be viewed as a bond plus a call. In this case the upside of the convertible comes from the call represented by the conversion feature. Moreover, the downside protection also comes from the bond attributes of the security, including the generally higher yield, fixed maturity value, and place in the capital structure. III. Mandatory Convertibles (PEPS). PEPS, or Participating Equity Preferred Shares, are a type of convertible security that is designed to provide investors with high current income along with high equity-like participation in the underlying stock. PEPS usually provide a coupon of 6.00% to 8.00% and are issued with relatively low premiums of 18% to 23%. The PEPS coupon is usually paid quarterly. These securities typically mature in 3 to 5 years, are typically listed, and are usually call protected for most of their life. IV. PHONES, ZONES and ZENS. These securities are usually issued at the same price as the common with an exchange premium of 5.26%. They typically have a yield that is 1.50% to 2.00% greater than the common dividend, and in most cases this coupon is subject to any additional common stock dividend distribution. PHONES typically have maturities of 30 years. These securities can be exchanged at any time into a cash value equal to 95% of an average price of the underlying common stock over a period of trading days. For taxable investors, these securities do have a negative phantom tax implication. These securities are typically callable at any time at a call price equal to the higher of the issue price or the market value of the underlying common stock, plus a coupon make whole that gives holders any unpaid coupons for the first three years of the security’s term.

Convertible Style Investments Convertibles give investors the benefits of regular income combined with the ability to participate in equity upside. We have divided convertibles into two sections; Income Style Equity Style Income Style convertibles behave like a bond, they have very little, if any, sensitivity to movements in the underlying share price. They should be traded on the basis of their yield. Equity Style convertibles behave more like a share. They are quite sensitive to movements in the underlying equity. If the ordinary shares go up, equity style convertibles are likely to go up as well. If the ordinary shares go down the convertibles will also go down but to a smaller extent. Convertibles both income and equity style come in different forms; the two main ones are outlined below Convertible bonds are debt instruments which can be converted into equity in the underlying company in the form of shares They are sometimes described as a combination option and bond. They have a fixed maturity date and pay a coupon throughout the life of the product .As long as the company stays in business you can convert either to the underlying shares on a one for one basis or cash at maturity. A convertible bond has the ability to rally if the stock rallies (the option ),but if the stock falls the convertible will not fall as aggressively and starts performing in the same way as a bond. Converting Preference Shares are similar to the convertible bond in that the holder may convert into the underlying share at a specified time if they so desire, it is at maturity that they differ. Whereas the bond is redeemable for cash or convertible into a share, the preference shares must be redeemed for an amount of shares. These shares are issued to you at a discount. The dollar value of the shares you receive at maturity is set, the number of shares you receive will depend on the price of the ordinary shares at maturity of the prefs. A preference share in the event of a company wind-up ranks higher than ordinary shares in regard to both dividend and repayment.

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Convertible Bonds:
Debt, Equity or a Hybrid?

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Educational Objectives:

• Discuss a layer of financing that may be attractive to a firm at times.
• Discuss the use of convertible securities as an alternative to an equity investment vehicle
• Discuss the use of a call feature to force conversion
• Discuss an arbitrage situation
• This discussion is not intended to present technical insight on convertible pricing but rather to show how a firm might use convertibles to take advantage of the ups and downs associated with the capital markets. Pricing of convertibles can be much more complex than presented in this discussion.
  

The interest rate on convertible bonds is usually much lower than the rate on similar quality and maturity issues. Convertible bonds are issued at a low coupon rate because the company is offering investors an option to acquire common shares (sometimes something other than shares) in a firm. This option has value and the firm does not have to pay a high interest rate since the firm is offering something else of value (the conversion feature) along with the bond. Often a convertible issue is just a delayed equity offering.

• The convertible security has some dimensions of a bond and some of a stock. They can tend to trade in relation to the stock. Let's offer an example:
  
  Example: Convertible Bonds - Use of a derivative issue to facilitate capital acquisition in the capital markets.
  The common stock of WTR Inc. has ranged between $40 and $50 for the last year. The firm pays no dividend. WTR Inc. has just issued a 8% (BBB) rated subordinated debenture due in 2019. Other BBB rated 20 year issues were priced in the market at around 8%. Now, WTR's stock drops to $27 due to a general market decline related to a global financial crisis. WTR needs external funding to grow and its financial managers would like to not load the firm's capital structure with too much long-term debt. Equity issuance does not seem like a great scenario due to the depressed stock price. Therefore the CFO talks to the firm's investment bankers and they proposes a convertible issue to the firm. Note: The conversion price might increase as maturity is approached in some issues.
  

The issue will have a par value of $1,000, plans are for the bond to be issued at par, a 3.4% coupon (annual payment), and it will be due in 2019. Also, the firm can call the bond at a price of $1,060 after five years have passed from issuance (most bonds are callable). Notice that the firm is able to issue a bond with a 3.4% coupon at a time when other firms with a similar risk profile are paying 8%. This is due to the conversion feature. Let's say that the bonds are convertible at $50 per share beginning immediately at issuance. This implies a conversion ratio of 20 ($1,000 / $50 = 20). Each share of stock is convertible into 20 shares of stock. Today the stock is currently selling for $16 per share so the conversion value is $320 (20 * $16 = $320). For example purposes I used a simplistic way to illustrate the conversion value of the bond. Investment bankers may use more sophisticated means of pricing this piece; methods such as options pricing models are used.

The value of a 3.4% annual payment bond due in 20 years is approximately $548. How did I arrive at this number?

The convertible is worth approximately $548 + $320 = $868.

We added the value of the bond piece and value of the convertible piece. Now these two pieces do not add to the bond's issue price of $1,000. This is because there may be a premium that investors will be willing to pay due to instrument offering the possibility of investors participating in the stock's upside and at the same time offering a payment stream not offered by stock ownership (because of no dividend payout). The firm's investment bankers will try to take advantage of situations like this as they can. One should examine option pricing models to learn about other aspects of the security's structure that may influence the premium.

Market Example:

Check out the ALZA - 5% CONVERTIBLE SUBORDINATED DEBENTURES DUE 2006. These bonds are trading at a premium to their conversion value. The conversion rate is 26.18 shares per $1,000 principal amount of debentures. Alza (NYSE - Ticker AZA) is trading around $53 per share and the bonds are trading at a quote of 147.5 per $1,000 face amount. This quote is a percentage of par so the price is $1,475.00 per $1,000 face amount. The conversion value of the bonds is approximately $53 * 26.18 = $1,397.17. The convertible is trading somewhat above this value. This indicates that investors are willing to pay a premium for the bond in excess of the conversion value. Why? Can you value the interest piece of the paper? Does the interest piece when combined with the convertible piece add to the market price? What is going on?
Check out the SEC database for information on the Alza 5% convertibles due 2006 . Check out the details of teh Alza issue by reading the prospectus. Is the indenture in the prospectus?

A convertible may be appropriate for a middle layer of financing if a firm is in a situation where it cannot pay a higher interest rate, and, where there exists investors that may want a piece of equity. This layer of financing is frequently referred to as mezzanine financing.

According to an article in Corporate Financing Week the FASB has recently endorsed a method for valuing hybrid investments such as convertible bonds. A discussion of this method may be found in Corporate Financing Week, Vol. XXV, No. 4, Page 6.

Scenarios:

One year later:
The firm's stock sells at $30 and interest rates have remained the same. Should the investor convert the bond into stock.
$30 * 20 conversion ratio = $600. So do not convert. Remember that the interest stream stops upon conversion so this stream has no value.

What might the bond be worth if the stock is trading at $30 and interest rates are at 8% on similar bonds.

Value of Conversion piece = $600

Value of bond piece approximately $558. The bond cannot be converted profitably so the bond piece has some value at this point. One can continue to hold the bond receiving coupons with the possibility of converting the bond into stock at a later date.

Total theoretical value of the two pieces = $1,158. The bond may be selling at a price lower than $1,158 because even though the conversion piece has value, if converted, the bond piece loses all value. The bond may be selling at a value greater than $1,158 due to demand for a piece of paper that offers the possibility of a stream of coupon payments with the possibility to convert some day.

The prices of the two pieces of the convertible are changing relative to the conversion price of the stock.

So the bond may have increased in value and interest rates have remained the same. This is due to the conversion feature. Remember that a bond's price in the market place is determined by supply and demand forces.

What might the bond be worth if the stock is trading at $60.

Value of Conversion piece = $60 * 20 = $1,200

Value of bond piece approximately $558. But the market is not going to value the bond piece because it is worth nothing if the bond is converted. The stock is trading above the conversion parity price ($1,000 / 20 = $50) so the bond can be profitably converted.

Total theoretical value of the two pieces = $1,758. But you aren't going to realize this value.

The bond will probably be selling at discount to this value.

If the bond is converted you own 20 shares of stock valued at $1,200 but if you convert you give up the payment stream. So the bond's coupon has virtually no value. The bond may be trading at around $1,200, probably above, due to the right to convert and the right to the coupon payments.

As the stock price rises the bond piece loses value and as the stock price falls the stock piece loses value.

What might the bond be worth if the stock is trading at $10 and market yields are still at 8% and 19 years to maturity.

This is what may be called a busted convertible. Its conversion value, and probability of conversion are both very low. $10 * 20 = $200.

In this kind of situation relative to the conversion price a bond will trade closer to the price of the true bond piece. This offers the possibility for a floor price for the bond. This floor price is the value of a pure bond discounted at the yield to maturity of similar quality and maturity issues. In this case the value of a 3.4% annual payment straight bond discounted at an 8% annual rate is approximately $558.23 (floor price). The conversion piece has a theoretical value of $200 but can this be realized (what is the probability that the stock price will rise from $10 to conversion parity price of $50, it's low).

Well, looks like many ways to examine convertible pricing. Not exactly straight forward! This is why arbitrage opportunities can arise with these types of securities and why one should always contact professional help when dealing with securities such as these.

A Convertible-Bond Arbitrage Example:

(this might help explain a short sale)

Suppose one year following the bond's issue that the stock is trading $70 and the bond is offered for sale at $1,200. The financial markets move very fast. Situations can happen in a few minutes. That's why you see people watching computer monitors; to try and find these situations.

Step 1: Buy the bond for $1,200.

Step 2) Immediately arrange to borrow stock and sell 20 shares of the stock short for $70 per share. 20 * $70 = $1,400.

Step 3) Over the next few days arrange to convert the bond into stock. You now own 20 shares of stock so deliver this stock to cover the borrowed stock.

$1,400 - $1,200 = $200 per bond in arbitrage profit.

Now you would think that a situation this obvious would not take place and you are correct. I just gave this situation for explanatory purposes.

Forced Conversion:

The call feature of a bond is frequently used to force conversion. In the previous arbitrage example assume that the stock is at $70 and conversion value is at $1,400. The bonds are callable at $1,060. So the firm can force conversion by calling the bond. How? Investors will convert the bond into $1,400 (20 shares of stock) rather than receive $1,060 from the company.

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Credit Spreads:

Something investors examine periodically are credit spreads in the market. Credit spreads refer to yield differences between various debt securities. In general, the credit spreads of Treasuries, corporates, and high yield debt instruments are compared. It basically works like this. Generally, if investors are concerned about the economy or the financial markets they will bid up Treasury prices (this means that the yield goes down). Treasuries are bid up because they are risk-free in terms of default risk. Corporates, especially high yield junk bonds, are vulnerable to the business cycle's ups and downs. Therefore, it is reasonable to assume that yield spreads between Treasuries and high yield corporates will widen if investors perceive business downturn. The firms behind the high yield bonds may go under in a bad economic downturn and this default risk may not be worth the higher coupon so investors sell.

Remember in the first Finance class that we indicated that there are many different yield curves. Each yield curve illustrates the yield associated with the maturity structure relating to a bond belonging to a particular default risk class.

One reason bond traders buy and sell bonds is due to their perceptions of changes in the yield curves associated with bonds having different credit risk.

Definition: A basis point is 1/100^th of 1%. So a 100 basis point move represents a full 1% move in rates.

Credit Spreads:

Spreads are presented in basis points.

Credit spreads were much wider in August 1998 when the financial markets were going through their problems. Following the FED moves in the fall notice how in November the spreads narrowed. Why is the spread between Treasuries and high yield securities remaining at a high level here in February? The reason for the spread aside, bond traders see situations like this and, based on their view of the markets, position their portfolios to reflect their views.

This information looks at one range on the yield curve kind of in the intermediate sector.

I hope this table comes out correctly. Formatting tables for Internet use is one thing I have not mastered.

Example: 9.2% - 5.55% = 3.65%. This is 365 basis points.

                               8/25/1998               11/12/1998              2/3/1999
Junk Treasury Spread            365BP                    277BP                  454BP

10 Year Treasuries              5.55 %                   6.7%                   5.45%

Corporate AAA/AA                6.34                    7.28                    6.27

Corporate A/BBB                 6.74                    7.49                    6.78

Corporate High Yield            9.2                     9.47                    9.99

Muni 7-12 year                  4.42                    4.9                     4.07

BP - Basis Points

Why are the Municipal yields at approximately the same maturity much lower?

 
Source The Wall Street Journal

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Bears are putting forth the fundamental argument that the gold market bulls had already factored in all the bullish news events-namely world geopolitical uncertainties-and now that the bull can't be fed new bullish inputs on a regular basis, prices have dropped. Remember the old market saying that a bull market needs to be fed every day.

Educational Feature: 10 More Valuable Trading Rules

By Jim Wyckoff

Many of you have seen my "Top 10" Trading rules. (If you have not, just send me an email at jim@jimwyckoff.com and I will email them to you.) Below are 10 more important trading rules that traders can add to their trading toolbox, or to their trading plans of action. These rules are not exclusive ones that I have discovered myself, but ones that I have picked up through the years by talking to successful traders and from reading informative books by successful traders. These rules are in no particular order of importance.

Don't trade markets about which you know very little. This is not to imply you have to be a fundamental expert on every market you wish to trade. However, you should know about what fundamentals are impacting, or could impact, a market you are contemplating trading. For example, a person who has only traded grains would not want to jump right into a Treasury Bond futures trade without first doing a bit of homework on how the bond market trades-in what price increments (dollar amount per tick), trading hours, on what exchange the market trades, etc. A trader could pick up a Wall Street Journal and read the "Credit Markets" section for a week or so to become familiar with fundamental factors that influence the bond market. Also, consider this: Most traders enjoy the process of trading. If they did not, they would likely just hand their money over to a "fund manager" and give the manager discretionary control over their money. Learning and knowing what fundamental factors are impacting or could impact a market a trader is contemplating trading is part of the process (enjoyment) of trading.

Don't trade on "tips." I have been involved in the futures industry and trading for around 20 years and have never heard a good trading tip. Reason: There are not any-at least not any that are any good for "regular guys" like you and me. Markets are way too big and too tightly regulated to be impacted by any tips or inside information. Any legitimate "early information" has almost certainly already been factored into the market price structure by the time off-floor traders could ever benefit from it. Don't confuse tips with rumors. Markets do move on rumors more than just occasionally. Rumors are a part of futures trading, but still fall into the category of "not of much use" to off-floor traders. Besides, many rumors are never confirmed as fact and are often self-serving to those who try to start them. When I was a reporter on the trading floors I would occasionally have traders walk up to me and try to plant a rumor with me, to try to get me to report it on the news wires. It never worked.

Don't get too fancy with your market orders. Entering a trade "at the market" with a market order may be the best way to enter a trading position-especially in markets that are liquid (have high open interest). It's certainly the easiest way to enter. Fiddling around with limit or stop-limit, or other multi-step orders to save a tick or two or three can cost a trader a good entry point or even a missed trade altogether. I must admit that I have been guilty of this offense. I don't mean to imply that limit or stop-limit or other types of orders are not useful in certain circumstances, because indeed they are. However, the majority of entries into trades are best made "at the market." I compare this situation to pitchers in Major League baseball who "nibble" with their pitches around home plate. Most wind up with a walk instead of an out.

Don't form a new market opinion during trading hours. This rule goes hand in hand with the rule that says you need to stick to your trading plan of action. Day-to-day market "noise," or the minor up-and-down price fluctuations of a market, can be at least distracting to a trader and at most prompt the trader to make a hasty and not well-founded trading decision.

Don't force trades; if you don't see a trade, stand aside. I won't chase a market just to put on a trade. I try to exhibit the patience and discipline in trading. So should you. Patience and discipline have not been easy virtues for me to learn. I fit into the description of a typical futures trader: "Type A" personality, competitive nature, and I hate to wait in lines. (Just ask my wife!) However, I learned early on that if I wanted even a chance at success in this fascinating business, I had to control my impatience. If you happen to miss a trading opportunity because you waited too long, there will be other trading opportunities. Don't chase markets.

A good trade is usually profitable right from the beginning. This is more an observation than a rule, but it is still useful. If the market price moves "your way" in the first couple days after you've executed the trade, then odds are significantly higher that your trade will be a winner. This rule reinforces the notion that tight protective stops are an important part of trading success. I wrote a feature a while back entitled, "Don't Hold Your Breath Too Long While Under Water" that also addressed clinging to losing positions. If a straight futures trade is under water after two or three days, more times than not it's prudent to take a small loss and move on.

Watch open interest in future contracts, and especially in options. In any futures contract or futures options strike price you are contemplating trading, make sure to first check the open interest for that specific contract or strike price. If a futures contract or options strike price has a low open interest total, it is probably best to seek out a more liquid contract. Fills on both entry and exit can be tough and produce more slippage than is desired. Lumber futures and options have very low open interest totals. The U.S. Dollar Index options market also has low open interest.

Know what you can and cannot control. You can control the market you want to trade. You can control the type of market order you want to give your broker. You can control when you want to enter the market. You can control the amount of contracts you wish to trade, and you can control when you want to exit the market. But you can't control the market. Knowing and prudently managing the market factors you can control and knowing that you cannot control the market gives you a trading edge.

Make the market's action confirm your opinions. If you've got a particular market on your "radar screen" for a trade, don't just jump in based on a hunch or a "gut feeling," or because you want to get a fill right away. Make the market first confirm your opinion. Make the market show you some strength if you want to be long, or make it show you some weakness if you want to be short.

Do not overtrade. Trying to trade too many markets, or too many contracts in one market, can create problems for a trader. There is no set rule for how many markets one trader should trade at one time. Some traders can trade many markets at one time and not have a problem. But if a trader is feeling stress or can't keep up with what's going on in all the markets he or she is trading, then the trader is likely over-trading. For those traders who are really not sure how many markets to trade at one time, or how many contracts to trade for each position, it's always better to take a conservative approach.

That's it for now. Next time I'll examine another important topic on your road to more trading success. I hope you enjoy my features as much as I enjoy producing them for you.

USES AND APPLICATIONS OF EXCHANGE FOR PHYSICALS - EFPs

 

1.0 Introduction

Exchange for physical transactions (EFP’s) have been part of the futures industry since the early 1900’s when they were first used to manage risk on trades involving commodities such as wheat, corn and soybeans.

Today, EFP’s are an established feature not only of commodity markets but also of the financial futures market. For large financial institutions such as banks and fund managers, EFP’s provide an important and convenient tool for portfolio management. Their flexibility, ease of execution and limited risk makes them a popular choice amongst investors who need to hedge large portfolio exposures or to switch positions between the cash and futures markets.

As the use of EFP’s in financial futures is not yet common in Malaysia, the purpose of this paper is to explain what EFP’s are and how they can be used. The paper looks at how MME Members and their customers can use EFP’s for risk management and how in the process, this will help to improve the liquidity and pricing efficiency of the markets in which these are done. The paper also looks at the ways in which EFP’s are used in international futures markets and reviews the documentation and regulatory issues surrounding their use.

2.0 What Is An EFP ?

An exchange for physical (EFP) is created when two parties agree to exchange a commodity or financial instrument (ie: a bond, bank bill etc) and then simultaneously agree to also take out an equal and opposite futures hedge.

An example of an EFP could be where an American bank agrees to sell a parcel of U.S treasury bonds to an Insurance company. At the same time as this occurs the bank and the Insurance company both agree to enter into an opposite hedge position. to cover the full value of the bonds that are exchanged. In this instance, the bank will be the buyer of U.S Treasury Bond futures while the Insurance company will be the seller.

Unlike normal futures transactions that are traded either on the floor or on the screen dealing system of a futures exchange, an EFP’s is purely an off-market transaction. This means that the full details of the trade (ie. the value, volume and prices) of the commodity and futures contracts being exchanged can be privately negotiated between the two parties to the deal. The EFP is registered with the Exchange only after, these details have been agreed.

A key feature of an EFP is that the futures leg of the deal can be done at any price that is agreed upon and need not be the same as the prevailing market price. The exact volume of contracts is also negotiated and the one price is used to cover the entire transaction.

3.0 Benefits of EFP’s

The primary benefit of an EFP is that it allows large institutional investors such as banks, discount houses and fund managers to exchange large parcels of physical securities at a known futures price and volume.

Often, due to the liquidity constraints it is very difficult (if not impossible) for an institutional investor to obtain a futures hedge in the open market for the full volume and required.

In many cases, an investor who needs to buy or sell a large amount of futures contracts to hedge their physical portfolio can often not do so because there is simply not enough liquidity in the market to absorb the transaction. As a result, large cash market transactions have to be cancelled which further damages the liquidity and price efficiency of both the futures and underlying market.

With an EFP however, a large investor can know with certainty that they will receive both the full volume and price needed for their futures hedge. In so doing this allows both the physical and futures transactions to occur. In so doing, it creates new open positions which are often liquidated at a later date in the open market. EFP’s can therefore promote liquidity and volume in the markets in which they operate - a fact which was acknowledged in the Catalyst Institute study on EFP’s conducted last year.

 

4.0 The Catalyst Institute Study

In January 1997 the Chicago based thinktank, the Catalyst Institute published a report entitled " The role of EFP’s in futures markets". The report was authored by Ms Sharon Brown-Hruska (Tulane University) and Mr Paul Laux (Case Western Reserve University).

In the report, the authors looked at the history and role that EFP’s have played in the futures market. Amongst the key findings made in the 109 page report were:

• To date, there was no evidence to suggest that market quality has been negatively affected by EFP trading. (some market users had asserted this). Further, the volume of exchange trading has not declined, liquidity has not been reduced and price volatility has not increased as a result of EFP trading.

• A sophisticated market model suggests that the availability of EFP’s increases total trading volume (on exchange plus EFP trading) as existing traders make more and larger trades

• In many circumstances, all market participants do have access to EFP trading information. If not corrected, as EFP volume grows beyond current levels, this lack of transparency may lead to decreased market liquidity, increased transactional risk and increased hedging costs.

Overall, the report concluded that EFP’s had a favourable impact on the markets in which they operated. These findings provide academic evidence of the need for such a facility to begin in Malaysia and of the likely role it will play in the development of Malaysia’s capital and derivative markets.

 

5.0 An Example of An EFP

To fully understand how EFP’s are used. It is beneficial to look at the two main types of EFP’s traded in the market and the rationale for using them.

The first type of EFP is the traditional type of "basis trade" . This is where an EFP is used to lock in a firm "basis " for a future transaction involving a commodity product such as wheat, corn or palm oil.

The goal of a "basis" EFP is to provide both parties with the certainty that they will be able to exchange a physical commodity in the future, at a fixed margin or "basis" to the corresponding futures contract. This principle is illustrated in the following example which uses the wheat contract traded on the Chicago Board of Trade (CBOT).

5.1 An EFP Using Wheat

Assume it is now August and a farmer has 100,000 bushels of wheat which he intends to sell in November, to a local cereal company.

The farmer faces two price risks on this intended transaction. The first is that the price of wheat may fall between now (August) and when the time when the wheat is to be sold (November). This risk can be managed by selling futures contracts against the position. As a November delivery month contract is not available, the farmer decides to sell December futures in the open market to gain protection from any price fall that may occur. The farmer therefore sells December futures at the market price of $3.94 per bushel.

While the farmer has largely hedged his price risk, he is still exposed to "basis risk". This is risk that the futures price may not behave in the same way as that of the wheat that the farmer intends to sell.

Should the basis weaken, (ie. the price differential between the cash and futures price widens) the farmer may not be fully protected should wheat prices fall. This is because due to the deterioration in the basis, the profit made on the futures hedge will not be sufficient to offset the loss made on the wheat that the farmer owns.

To guard against this risk the farmer (in August) makes an agreement with the cereal company to do an EFP in November.

Under the terms of the EFP the farmer agrees to sell 100,000 bushels of wheat to the cereal company and to simultaneously buy from them December wheat futures. These futures will be used to close out the sold contracts taken out in August. The important part of the EFP is that the two parties agree to exchange the wheat at a fixed basis of 10 cents under the prevailing December futures wheat price.

5.2 The Result in November

From August to November, the wheat price falls as the farmer feared. As a result, the December futures price falls by 44 cents per bushel going from $3.94 to $3.50.

The farmer and the cereal company transact their EFP at these levels with the futures leg of the EFP being done at the current futures price of $3.50. The wheat itself is exchanged at $3.40 per bushel which is equal to the fixed basis of 10 cents agreed upon under the terms of the EFP.

The transactions undertaken by the farmer and the Cereal company are shown in the table below.

 

Cash Market - August	Futures Market - August
Farmer has 10,000 bushels of wheat to sell in November	Farmer hedge price risk by selling December wheat futures in the open market at the current price of $3.94 per bushel.   At the same time, the farmer makes an agreement with a cereal company to exchange wheat in November at a fixed basis of 10 cents under the December wheat futures price
Cash Market - August	Futures Market - August
The farmer sells his wheat to the cereal company at $3.40 per bushel (10 cents under the December futures price). The farmers effective selling price is $3.40 + hedge profit of 0.44 = $3.84.	Farmer closes futures hedge by buying December wheat futures under the EFP at $3.50. A futures hedge profit of 44 cents per bushel is made.

The benefit of doing the EFP to both the farmer and the cereal company was that it allowed them to determine in August exactly what the price basis would be when the wheat was exchanged in November.

Had this had not been done, both parties would have been vulnerable to either a strengthening or weakening in the cash / futures basis. Under the EFP the farmer knew that his effective selling price would be $3.84 per bushel as this was 10 cents lower (ie. the agreed basis) than the futures price he locked in in August.

The use of EFP’s to remove basis risk has substantial economic benefits as it allows producers and end users of commodities to better plan their future expenditure. By not exposing them to the volatility of the cash / futures basis users of basis EFP’s can generate considerable savings which in turn can be passed on to their customers.

5.3 EFP’s For Portfolio Hedging

In addition to facilitating business in commodity markets, EFP’s are also widely used in interest rate, equity and currency futures markets.

Large financial institutions often use EFP’s to manage risk on portfolios of securities held or to set firm buying or selling prices on future cash market transactions. EFP’s are also used by arbitrageurs and professional traders to exploit short term pricing anomalies that can occasionally arise between the cash and futures markets. The following examples, illustrate just two of the many ways in which EFP’s can be used in interest rate markets.

5.4 EFP’s Using KLIBOR Futures

Assume it is now May and a Malaysian bank (Bank AAA) has a large holding of bank bills which it is using as a hedge against transactions made with its customers.

For balance sheet reasons, Bank AAA would like to transfer their physical bank bill position into the KLIBOR futures contract traded at MME. To do this they will need to liquidate their physical bank bill holdings and buy an equivalent amount of KLIBOR futures contracts).

Bank AAA is very concerned that if they have to do the cash and futures transactions independently of one another, poor prices will be received owing to the lack of liquidity in the market.

Accordingly, Bank AAA tries to find another bank or large financial institution who is willing to take on both their cash and futures position. After contacting a few potential counterparties, another bank (Bank BBB) agrees to buy the physical bills from Bank AAA and to sell KLIBOR futures to them so as to hedge their interest rate risk..

After negotiating the cash / futures basis, Bank AAA and Bank BBB transact an EFP. The details of the transactions made are shown in the table below.

Cash Market	Futures Market
Bank AAA sells RM 100 million of 90- Day Bank Bills to Bank BBB at a yield of 8.75%	Bank AAA buys 100 KLIBOR futures from Bank BBB at 91.28 (8.78 %)

This example illustrates how EFP’s can be used by large financial institutions to transfer positions from the cash market to the futures market. This can be done with total price certainty and in sufficient volume to satisfy the needs of both parties.

While in this example an EFP was used to transfer a position from the cash to the futures market, it is also possible to do the opposite type of transaction.

For example, if a bank held a bought position in KLIBOR futures they could use an EFP to turn this position into an equivalent holding of short term securities such as treasury bills or negotiable certificates of deposits (NCD’s. Such a transaction may be useful when a bank has a KLIBOR futures position which is due to soon expire.

Rather than having the position go to cash settlement and then needing to do a separate cash market transaction, the bank could transfer their KLIBOR position into the physical market by doing an EFP. This could be done instantaneously, in volume and at a fully negotiable price.

5.5 EFP’s With Khazanah

Another common type of EFP is one which is done using physical bonds and bond futures.

Assume it is now February and a bank (Bank CCC) is intending to buy a large amount of Khazanah bonds when they are auctioned in one months time (ie. in March).

Bank CCC is concerned about a fall in interest rates between now and when the Khazanah bonds are auctioned. Should this occur, it will increase the price of the Khazanah bonds Bank CCC wishes to buy.

To hedge against this risk, Bank CCC decides to buy Khazanah bond futures in the open market (for the purposes of this example assume that this contract is available). Bank CCC does this so as to lock in a purchase price for the bonds it expects to receive when the bonds are auctioned in March.

Over the next month, interest rates fall as Bank CCC feared, thereby pushing up the cost of the Khazanah bond purchase.

On the day the bonds are auctioned, Bank CCC does an EFP with Khazanah whereby it agrees to simultaneously buy bonds from Khazanah and simultaneously sell bond futures to them.

The sold futures leg on this EFP is matched out against the bought futures position that Bank CCC already holds. Bank CCC is therefore left with the bought Khazanah bond position it originally wanted.

The transactions done by both Bank CCC and Khazanah are illustrated in the table below.

 

Cash Market - February	Futures Market - February
Bank CCC intends to buy RM 50 million 3-Year Khazanah bonds when they are auctioned in March. They are concerned interest rates may fall. Current interest rates are 8.50%.	Bank CCC buys 500 Khazanah bond futures in the open market. An effective yield of 8.50% is established.
Cash Market - March	Futures Market- March
Bank CCC buys RM 50 million of 3-Year Khazanah bonds under an EFP with Khazanah. Bond yields have fallen from 8.50% to 8.00% making the bonds more expensive.	Bank CCC closes their futures hedge by selling 500 Khazanah futures to Khazanah at a yield of 8.00% A futures profit of 0.50% is made.

By using the EFP, Bank CCC was able to acquire the bonds it needed for its portfolio. It was also able to use the EFP to close its futures hedge. By using this strategy, Bank CCC was able to by the bonds at a yield which was 50 basis points better than the auction price.

5.6 EFP’s With Khazanah

In the example given, Khazanah itself was shown as being a party to the EFP trade. This poses the question as to why an issuer of bonds like Khazanah would want to do this ?

The answer to this question is that by using the EFP facility, issuers of bonds like Khazanah have the potential to substantially lower their borrowing costs.

As Khazanah has a fixed timetable for issuing bonds into the market (ie. at the end of each quarter month) it would be entirely possible for Khazanah to use bond futures to lower their borrowing costs. This would involve it selling futures in the months leading up to an auction so as to synthetically lock in its future borrowing rate.

When the time of auction arrives, Khazanah can then close its futures positions by issuing its bonds on an EFP basis. Ie. it would do EFP’s whereby it sells physical bonds and buys Khazanah futures. The futures contracts obtained under the EFP would be matched out against the previous sold positions undertaken in the open market.

This use of EFP’s as a tool for bond issuance is routinely done by Semi-Government borrowing authorities in Australia. In the lead up to a bond tender, these authorities will take sold positions in SFE bond futures to lock in their borrowing costs. These are then closed out via EFP when the bonds are auctioned to the market.

The use of EFP’s as a tool for bond issuers has several advantages.

Firstly and most importantly, it allows the issuer to set a firm yield on bonds which they intend to auction in the future. This means the issuer doesn’t have to speculate as to what interest rates might be on the day when the bonds are due to be auctioned.

Secondly, by using EFP’s the issuer knows they are likely to get a much better price for their bonds. This is because banks will be more willing to bid aggressively for the bonds if they are done on an EFP basis due to the lower risks involved.

Finally, through adopting an active portfolio management approach, bond issuers such as Khazanah and Corporates can use futures to substantially lower their borrowing cots. This is because they can sell bond futures during periods when interest rates are low and then roll these positions forward until they are needed. The profits from these transactions can then be used to offset the higher borrowing costs incurred during other periods when interest rates are higher.

 

6.0 EFP Usage in International Futures Markets

As was mentioned earlier in this paper, EFP’s are widely used throughout the futures industry.

At the world’s largest futures exchange, the Chicago Board of Trade (CBOT) substantial EFP business is traded not only in the agricultural products but also in financial products such as Treasury bond and note contracts. This business is sourced from bond dealers, portfolio managers and arbitrageurs who use EFP’s to trade the price differential "or basis" between physical bonds and notes and their related contracts traded on CBOT.

At London’s LIFFE exchange (the world’s second largest exchange) a special EFP trading facility known as BTF (basis trading facility) is also in place. This has been designed to accommodate the needs of bond dealers and institutional users who use EFP’s to switch exposures between the cash and futures markets. A similar facility is also in place at the Deutsche Terminborse Exchange (Europe’s second largest exchange).

In Australia, EFP’s have for many years, been a feature of the futures market. While they were initially used to facilitate after hours trading (ie. before the launch of the Exchange’s screen dealing system, SYCOM) they are now being used to hedge transactions involving the full range of money market and fixed interest securities as well as OTC derivatives.

Listed below is a table which shows EFP volume in SFE’s four major contracts during 1996.

SFE - EFP Volume Traded In 1996

Contract	Floor Volume	EFP Volume	% of Floor
90 Day Bills	4,338,720	33,114	0.76%
3-Yr Bonds	5,928,935	1,788,557	30.0%
10-Yr Bonds	3,527,318	748,840	21.22%
SPI	2,357,870	24,786	1.05%

As is clear from the table, the volume of EFP business traded in the Exchange’s bond contracts is substantial.

This stems from the popularity that EFP’s have with government bond price makers and other institutions involved in trading bonds in the secondary market.

Such is the popularity of EFP’s that prices for Commonwealth and Semi Government bonds are mostly quoted on interdealer broker screens on an EFP, rather than an outright basis. This is because fund managers and market makers like to use EFP’s for portfolio management purposes.

Spread traders also like EFP’s as they use them to trade yield spreads between Commonwealth bonds and Semi-Government bonds. To do this, they will do an EFP whereby bond futures are bought or sold (as a proxy for Commonwealth bonds) and then an opposite trade will be done using Semi-Government bonds.

Swap dealers also like to use EFP’s to hedge the interest rate risk on their swap books. Ie: fixed rate payers will buy futures to guard against a fall in rates while fixed rate receivers will sell futures to guard against a rise in rates. EFPs’ are popular as they offer a cheaper hedge than using physical bonds both in terms of capital and transaction costs.

 

7.0 Documentation Requirements For EFP’s

As EFP’s are the only type of futures contract that can be traded "off-market", most Exchange’s have very strict documentation requirements to ensure that all EFP’s accepted are bona fide.

Typically when an EFP is registered, the Exchange will require documentary evidence that shows the following.

• The exact date, time and location of where the EFP was done.

• The identities of the two parties to the deal.

• Full details of the cash instrument or commodity that is being exchanged (Amount, grade etc).

• The futures contract being used to hedge (including delivery month and the volume of contracts traded). This must be "substantially similar" to the commodity or cash instrument that is being exchanged and the volume traded should be of equivalent economic value.

• Confirmation that only two parties are involved and that they are taking opposite cash and futures positions (ie. the seller of futures is the buyer of the cash instrument and vice a versa).

In most cases, the documentation supporting an EFP will take the form of a contract note, fax, telex or standard ISDA style agreement.

This documentation is usually attached to a pro-forma EFP form which outlines the names of the brokers and clearing members in whose name the futures contracts are to be registered. The responsibility for completing this form usually lies with the broker or Clearing Member whose clients are the parties to the EFP.

When an EFP is lodged with the Exchange, it is usually given to the Surveillance or Compliance division for their approval. Staff from these departments have the responsibility of ensuring that each EFP received is in compliance with the Exchange’s business rules. Should this be the case and the EFP is accepted, it will then be registered. For record keeping purposes, the Exchange will usually assign a specially prefix or identifier to the EFP so that separate EFP records and statistics can later be compiled.

 

  

 

Single Stock Futures and Exchange for Physicals

Does anyone know what an exchange for physical ("EFP") is?  How about "Versus Cash"?  According to the glossary of terms on the CBOT web site the definition of Versus Cash is:

Versus Cash: A transaction generally used by two hedgers who want to exchange futures for cash positions. Also referred to as "against actuals" or "exchange for physicals."

One aspect of Single Stock Futures is that they could represent the largest single increase in the potential users of EFPs or Versus Cash or Against Actuals that the futures industry has ever seen.  Not everyone who trades corn has cash corn, or any other type of grain of even physical commodity for that matter.  However, traders of Single Stock Futures have a much higher chance of being owners of cash equities.  Because of this, I believe it is vitally important for the Single Stock Futures exchanges to offer EFP services.  It will not be easy to integrate into the functionality of the electronic marketplace, but it will be important.

Let me offer an example of how this could work.

Trader A owns $100,000 of IBM stock.  Trader A needs to increase available cash, but still wants to own $100,000 of IBM.  Trader A enters into an EFP contract through Brokerage ABC.  Trader A agrees to deliver $100,000 of IBM stoke to Brokerage XYZ in return for $100,000 in cash and a long futures position in IBM Single Stock Futures.  Brokerage XYZ pays the $100,000 and receives the $100,000 in IBM stock and is given a short futures position in IBM.  Assuming a 20% margin, Trader A would have $20,000 in margins for his long IBM futures positions and $80,000 in excess cash.  Trader A would receive the $100,000 cash and deliver the $100,000 in IBM to brokerage XYZ the same day the trade was made through the DTC.  The stock would need to be held in a "street name."

Another way to do the same transaction would be for Trader A to sell the cash IBM securities on a securities exchange.  Trader A could sell his $100,000 of IBM on the New York Stock Exchange and have the $100,000 in 4 days, the trade day plus 3 days.  Once the money was received and moved to Trader A's futures account, Trader A could buy the equivalent of $100,000 of IBM stock and would have $80,000 in excess cash and $20,000 in margins.

Another way to do the same transaction would be for Trader A to put his IBM on margin, thus freeing up 50% of the value.  He could send the $50,000 to his futures account and then buy the $100,00 worth of IBM futures while selling his margined IBM shares at the same time.  Trader A would receive the net receipts of his shares after the margin loan and any associated costs were paid in 4 days, the trade day plus 4 days.

As you can see, it would be most efficient for a trader who wanted to convert a cash securities position to a futures position by doing so using an EFP transaction.  I am not sure I am smart enough to figure out the subtleties for the regulatory or tax implications, or even the operations requirements for the various entities registered to trade Single Stock Futures, but I do believe EFPs will be an important component in the success of this new product.

The EFP allows traders to move large chunks of a commodity in a private transaction while not exposing its position to any pit or bid-offer spread risk.  In some ways an EFP is used just like a Block Trade, except in the case of an EFP the physical commodity or forward contracts for the physical commodity are included in the transaction.  A Block Trade on a future exchange would just include futures contracts.  The CBOT does not allow Block Trades, but it does allow Versus Cash.

Where I think the EFP/ Versus cash has particular value is for the unwinding of arbitraged positions prior to delivery.  If I have bought IBM shares on Instinet and sold IBM futures contracts on OneChicago in a price arbitrage, an  EFP transaction will allow me to quickly capture those arbitrage profits.  Since a long cash and short futures position should be a margin-less position, the unwinding of the position in a back office transaction would have no negative impact on market and the price discovery process.  The position held to delivery accomplishes the same  thing as an EFP, save for the difference in time.

One element of the EFP is that it could essentially make different futures contracts for the same security fungible despite trading on different exchanges.  If I own IBM shares and am short futures on One Chicago and then buy NQLX IBM futures contracts and short IBM shares on the NYSE, I could offset each trade through an EFP, thus eliminating the need to hold the positions to maturity or be lucky enough to find the opposite trades to overcome the bid-ask and transaction costs.  In one sense I am long IBM on One Chicago and Short IBM on NQLX.  I am long IBM in my futures account, but short IBM shares in my securities account.  Essentially, the positions are fungible by the use of the EFP.

The Single Stock Futures exchanges have expressed various opinions about the fungibility.  I think it is important for them to be fungible.  If the contracts were fungible from exchange to exchange, then some of the EFP transactions would not be necessary.  In some ways it is the same thing.  Fungibility means the contracts are offset in a back office procedure in conjunction with the clearing house, in this case the OCC.

Thus, we may not see EFPs offered when Single Stock Futures start trading because exchanges are trying to avoid the fungibility issue.  I think that would be a mistake.  There is a basic economic function that is provided in the EFP transaction and to not offer EFPs would leave the product flawed in my mind.  That does not mean they won't work, but they would work better with EFPs.

Now if the exchanges start trading 5000 EFPs to 304 other contracts traded in competitive transparent markets, I will have a problem.  I actually think EFPs could be standardized and offered right on the matching engine.  I am sure there are some holes in my logic, or regulatory hurdles too onerous to overcome, but I believe EFPs should be part of the product design.

 

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