5.1.4.1. Conversions and Limit Moves
One use of conversions is to close out a futures position when it is limit locked and unable to trade. Recall from Chapter One that a futures contract cannot fluctuate in price on any given day beyond certain trading limits. If it reaches those limits and has unfilled orders at the limit price, trading is halted, and the contract is said to be limit locked.
Sample Question
The September Red Winter wheat futures contract closed the day before at 420’0, but a severe summer storm seriously damaged the Midwest crop, and prices opened that morning at its price limit and locked at 455’0. Short 10 September wheat futures, you are fearful that prices will limit up again the next day. You received a variation margin call of $17,500, and another day of that will totally wipe you out. You cannot liquidate your futures contract, because no one is buying at the lock limit price.
You respond by buying 10 September wheat calls at 15’0 and shorting 10 September wheat puts at 23’0, both at the same 460’0 strike. The next day, the September futures contract locks limit up again at 490’0. What is your mark-to-market gain or loss for the day?
Answer: $1,500 gain. The futures contract lost another $17,500, with wheat futures locking in at $4.90. The 10 calls at $0.15 per bushel cost an additional $7,500, while the short puts earned a premium of $11,500. The price rise brought the call, $0.30, into the money ($4.90 – $4.60) for a mark-to-market gain of $15,000. Together, the forward conversion leaves your portfolio margin account with a mark-to-market variation call of $2,500, which is a far cry from the $17,500 loss you were otherwise facing. The $4,000 you earn in net premium completely covers the loss, leaving you $1,500 to the good for the day.
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SUMMARY TABLE Synthetic Option Positions |
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Synthetic |
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