- 2000: Volume 9, No. 2 Puts & Calls: Dr. Option Looks Under the Hood

Henry Ford's innovation democratized the automobile. But at a price. Ford was noted for saying, "People can have the Model T in any color-so long as it's black."

Trading in index products used to be a limited choice proposition as well. First came index futures, then index options. More recently, index tracking stocks debuted. So, which is better? That depends on your risk tolerance, capitalization, and your profit objectives. A look at products based on the Nasdaq-100 index illustrates the point.

Index

NASDAQ-100 (NDX), representing 100 of the largest over-the-counter stocks, was set at an initial value of 250 in 1985. The index has been on a tear recently-advancing through the mid to upper 4,000-level.

Products

Nasdaq-100 futures-traded on the Chicago Mercantile Exchange, under symbol 'ND'.

Nasdaq-100 (cash) options-offered as 'NDX' on the Chicago Board Options Exchange.

Nasdaq-100 shares-'QQQ', traded on the American Stock Exchange, are long term trust units initialized in 1999 with a base value of 100 approximating 1/20th of NDX; QQQ has since split 2:1.

Nasdaq-100 share options-also traded on the American Stock Exchange using the base QQQ.

Liquidity

Traders are naturally attracted to more liquid markets. Liquidity signifies the facility by which you can enter and exit a trade close to the last sale price. Liquidity is made manifest in the metrics of volume, open interest, and spread. Volume, of course, is the total number of contracts or shares changing hands. Open interest, applicable only to derivatives contracts, represents outstanding contracts awaiting liquidation. And a spread is the difference between simultaneous bids and offers for an instrument, which can be reduced for comparison to a percentage of the total transaction value. A recent day's activity in Nasdaq-100 products paints the picture of relative liquidity shown in Table 1.

Table 1

Market	Volume*	Open Interest	Spread**
QQQ shares QQQ options NDX options NDX futures	16,008,600 6,991 521 22,748	n/a 11,334 5,537 37,182	0.12% 0.59% 0.87% 0.24%
* Derivative volumes represent contracts; QQQ options' multiplier is 100 shares; NDX options' and NDX futures' multiplier is $100. Volumes for QQQ and NDX options are front-month, at-the-money (within 5% of current market) strike prices only. ** Spreads are based on margined long positions: for QQQ shares, a Regulation T purchase of 100 shares; for QQQ and NDX options, a one-contract at-the-money synthetic long in the nearby month; for NDX futures, a single long contract in the nearby month. Spreads for NDX futures should be viewed cautiously. Unlike securities markets, there is no requirement for locals to maintain a two-way market in futures. The ability to actually capture the futures spread shown may, therefore, be compromised.

QQQ share volume, equivalent to 160,086 derivative contracts, clearly outdistances options and futures, as well as exhibiting the tightest apparent spread. NDX futures lead all the derivatives, while QQQ options outshine those based upon NDX.

So does that mean you should trade QQQ shares? Maybe, but we haven't looked at the relative costs of establishing these positions yet.

Capital Requirements

Suppose you were bullish on Nasdaq-100, expecting a 10 percent rise over the next two weeks. Let's also suppose you're risk tolerant enough to use a leveraged position. How much out-of-pocket capital would you need to put on the table? We need to compare apples to apples here in risk/reward terms, so the option trade employed should be a synthetic long (a call purchase, financed with a put sale) rather than just an outright long call. We'll use the more liquid QQQ options for comparison in Table 2.

Table 2

Spot Nasdaq-100 index (NDX) @ 4292.00 Nasdaq-100 shares (QQQ) @ 214 1/4
Long 100 QQQ @ 214 1/4 (50% margin)		Initial margin:	$ 10,713
Long 1 synthetic QQQ		Initial margin:	$ 3,214
Long 220 nearby call @ Short 220 nearby put @ Net credit	6 1/2 11 5/8 5 1/8	Less credit Net	513 $ 2,701
Long 1 NDX nearby future		Initial margin:	$ 31,250

It's obvious the option trade requires the least amount of trading capital to initiate. Proof, however, is in the pudding. How would these positions perform if your expectation played out?

Performance

Modeling a 10 percent gain in Nasdaq-100 over two weeks at current volatility rates, could make your positions look like those in Table 3.

Table 3

Spot Nasdaq-100 index (NDX) @ 4721.00 Nasdaq-100 shares (QQQ) @ 235 1/2
Long 100 QQQ @ 235 1/2		Gross gain Less spreads Less interest Net gain Return	$ 2,125 25 27 $ 2,073 19.35%
Long 1 synthetic QQQ
Long 220 nearby call @ Short 220 nearby put @ Net credit	23 5/8 6 5/8 17	Gross gain Less spreads Net gain Return	$ 1,187 88 $ 1,099 40.68%
Long 1 NDX nearby future @ 4721.00		Gross gain Less spread Net gain Return	$42,900 150 $42,750 136.80%

A mixed bag, isn't it? While options afford the lowest leveraged entry cost, they produce middling results when compared against futures and the cash shares. Still, a 40 percent return is nothing to sneeze at. But don't juggle your investment strategy on the basis of this cursory analysis alone. Each of the instruments we examined has a unique set of characteristics to bear in mind.

NDX Futures

The spread between the futures price and the cash index, known as basis, eventually dissipates over time. That's normally a drag on long futures positions going into the delivery month. In this example, however, we held basis constant. That may not be a realistic expectation. Keep in mind, too, that trading futures requires a commodities account, carried by a futures commission merchant (FCM). Your existing securities account won't do. So, if your brokerage firm isn't also an FCM, you'll have to go broker shopping.

Futures positions, too, are marked-to-market daily in cash. Maintenance calls can be particularly unforgiving, since you'll be called to initial requirements, rather than to maintenance levels as in a securities account. Don't forget that you're dealing with a cash-settled index here-there's no physical delivery of securities. And, since these are futures, the position's short-lived. Liquidation of the position is inevitable on or before the delivery date.

QQQ Options

American style QQQ options can be exercised on any trading day, resulting in delivery of Nasdaq-100 shares. Covered strategies, like those of other equity options, are therefore permissible. Still, you'll need approval for naked option writing in your securities account to trade the synthetic long. At best, you can hope to avoid the position's margin requirement entirely if you have a free credit balance at least equal to the aggregate exercise price of the short put (220 x $100 = $22,000).

Options, like futures, too are limited life instruments. You have only the time until expiration to see your market expectations realized or you must abandon your position.

QQQ Shares

Nasdaq-100 shares are the most forgiving of the instruments examined. If your objectives are not reached in the time you expect, you have the luxury of time to wait it out. The cost, of course, is the accrual of interest expense if you've bought on margin. There's no basis or time decay to contend with either, so trading this way requires less mathematical horsepower. Nor do QQQ shares require a special account. An existing securities brokerage account will suffice to trade the units, subject to margin account approval if leverage is to be employed or if short selling is anticipated.

In the end, the best instrument to use depends entirely on you-your tolerance for risk, the capital available to you, and your minimum profit requirements. At least now you should be better prepared to make an informed investment decision. And as the Model T's inventor once said, "Before everything else, getting ready is the secret of success."

Dr. Option (Brad Zigler) welcomes your questions. He can be reached at dr_option@hotmail.com. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax implications or other transaction costs which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone.