Fundamental Investment Positions

April 11, 2018 version

This Teaching Note supplements textbook Chapter 15

LEARNING OBJECTIVES CHAPTER OUTLINE

1. Master the buy-and-hold investment 1. The Long Position
position
2. Understand how to profit from declining 2. The Short Position
prices
3. Discover how to invest borrowed funds 3. Trading on Margin
4. Learn how to buy and sell in the future 4. Forward Contracting
5. Find out about commodity exchanges 5. Futures Contracts
6. Learn how to earn arbitrage profits 6. Hedging and Arbitrage
7. Learn the definitions of put and call options 7. Put and Call options
8. Summarize and conclude 8. The Bottom Line

This chapter reviews long positions, short positions, margined positions, forward contracts,

futures contracts, hedging positions, arbitrage positions, and call and put options are

considered. Each of these fundamental investment positions provides a different way to invest

in a stock, bond, commodity futures contract, foreign exchange, or other asset. Knowledge of

many different investment positions prepares the investor or speculator to deal adeptly with

continually changing market conditions.

An optimistic investor who thinks that the market price of one or more market assets will

rise is called a bullish investor. When many optimistic investors are simultaneously bidding

up market prices, a bull market exists. A pessimistic investor who expects the market price

of a market asset to decline is called a bear. When many pessimistic investors are selling at

falling prices a bear market exists. If a diversified market index like the Dow-Jones

Industrial Average (DJIA) or Standard & Poors 500 Index (S&P 500) drops more than ten

percent, a market correction occurred. If the market continues downward until the DJIA or
Fundamental Investment Positions – Professor Jack Clark Francis – Page 1
S&P 500 Index falls more than twenty percent, a market crash is underway. Not all stocks’

prices fall during a market crash. Ms. Bull may have an optimistic position about a particular

marketable asset and, at the same time, Ms. Bear may have a pessimistic view about the same

marketable asset, and these folks can both continue to co-exist during whatever market

conditions prevail.

1 - THE LONG POSITION

A long position is a buy and hold position. When a person, company, or other organization

buys a stock, bond, futures contract, foreign exchange, put or call option, or any other

financial instrument, the buyer assumes a long position in the asset. Long positions can have

holding periods that last seconds, minutes, days, months, years, or decades. The long

position ends when the asset is sold.

Three characteristics of long positions are noteworthy. First, long positions must be

purchased before they can be sold. Second, there is a one-to-one correspondence between

the market value of a long position and the wealth of the investor. This gain-loss relationship

is illustrated in Figure 1A; note that the slope of the gain-loss line is +1. Third, long positions

are usually profitable when bullish conditions prevail.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 2

FIGURE 1 - Gain-Loss Graphs for (A) Long and (B) Short Positions

A. Long Position B. Short Position

SUMMARY: The portion of the vertical axis above the origin measures gains. The portion of
the vertical axis below the origin measures losses. (A) The buyer of a long position obtains a
dollar of gain for every dollar of price rise and a dollar of loss for every dollar of price decline.
(B) In a short sale, which is the inverse of a long position, the short seller gains a dollar for
each dollar of price decline.
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EXAMPLE 1: JUDY’S FIRST LONG POSITION

Judy’s family gifted her $2,000 when she graduated from high school. She opened a cash

account at Merrill Lynch and invested her $2,000 in Coca-Cola common stock. After one

year Judy liquidated her long position and received a check from Merrill for $2,135, which

included $2,100 for the appreciated Coke stock plus $35 of accumulated cash dividend

income.

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------------------------------Top of Think Question 1 ----------------------------------------------------
THINK QUESTIONS ABOUT JUDY’S NUMERICAL EXAMPLE

Fundamental Investment Positions – Professor Jack Clark Francis – Page 3

1. What was the holding period for Judy’s investment?

2. What was the holding period return (HPR) from Judy’s investment?

ANSWERS: #1- Judy’s holding period is one year. #2- Her holding period return is 6.75%.

𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑒𝑛𝑑 𝑜𝑓 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑,

( )−( )+( )
ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑, $2,100 𝑝𝑖𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒, $2,000 $35
𝐻𝑃𝑅 =
𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑
( )
𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒, $2,000

$135
= = 6.75%
$2,000

------------------------------Bottom of Think Question 1 -------------------------------

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THINK QUESTION ABOUT GAIN-LOSS GRAPH FOR LONG POSITION

QUESTION: What are the upper and lower limits for the gain-loss line for the long position

in Figure 1A?

ANSWER: For a long position, the upper limit is infinity because a stock’s price can,

theoretically, rise endlessly. The lower limit equals the purchase price of the marketable

asset, because the buyer cannot lose more than what was paid for the stock. 1

--------------------------- Bottom of Think Question2 -------------------------------------

An MIT finance professor named Andrew Lo suggested the adaptive markets hypothesis

(AMH), which combines economics and psychology into a theory that is more descriptive

1
An investor buying a stock or bond cannot lose more than what was paid for the security because
U.S. law grants stock and bond investors limited liability. Stated differently, if a bankrupt
corporation owes millions of dollars of debt, investors owning the bankrupt corporation’s stock or
bonds are not liable for the debts of their bankrupt corporation. Limited liability laws increase the
popularity of investing.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 4

of reality than economics or psychology alone.2 Professor Lo reports that his investment

conclusions rest on the following five research findings.

1. To the extent an investment’s relationship between riskiness and its rates of return may
exist, that relationship is unlikely to be stable over time.

2. Contrary to classic economic theory, profitable arbitrage opportunities will exist from
time to time.

3. Various investment management strategies - - based on quantitative, fundamental

security analysis, and technical theories - - exist and will yield profits during some periods
of time and will be unprofitable at other times.

5. Survival is the only objective that matters. Profit maximization, utility maximization, and
achieving equilibrium are important and relevant, but only to the extent that they contribute
to survival.

4. Innovation is the key to survival, and investment managers are more likely to survive if
they can switch between different trading positions adeptly.

Professor Lo’s adaptive markets hypothesis implies that an investor who can adapt to

continual changes and utilize many different investment positions is more likely to survive

and flourish than an investor that is only able to buy and hold long positions. The

remainder of this chapter suggests sixty different investment positions (see Table 9 for the

list) that can help an investor flourish in the face of continual change.

2 - SHORT POSITIONS

A fungible asset can be freely exchanged or replaced, in whole or in part, for another

equivalent asset. The $1, $5, and $10 U.S. dollar bills are three well-known examples of

fungible assets. Every share of common stock listed on the New York Stock Exchange

2
Andrew W. Lo, “The Adaptive Markets Hypothesis,” Journal of Portfolio Management, 30th
Anniversary Issue, Volume 30, No. 5, pages 15-29. Also see A. W. Lo, “Adaptive Markets
Hypothesis in the New World Order,” Financial Analysts Journal, Vol,. 68, No. 2, March-April
2012, pages 18-29.
Fundamental Investment Positions – Professor Jack Clark Francis – Page 5
(NYSE) and every U.S. Treasury Bond is a fungible asset. Real estate provides examples of

unique assets that are not fungible. Fungible assets are more liquid and easier to trade than

assets that are not fungible.

Millions of shares of fungible securities are sold short every day. A short sale occurs when

a marketable asset that is not owned by the seller is sold with the hope that, at some later

date, an equal quantity of a fungible asset can be purchased at a price below the price at

which the asset was previously sold short. Short sales allow people to profit from price

declines. A unique characteristic of a short position is that the short seller sells the asset

before purchasing it. The short sale will yield a loss instead of a gain if the short stock is

purchased (the short position is covered) at a price above its previous selling price. Short

sales provide a trading mechanism that permits bearish investors to profit if their

pessimism is correct.

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EXAMPLE 2 – STEVE SHORTS COKE STOCK

A New Yorker named Steve is bearish about Coke stock at $40 per share. To profit from his

pessimistic forecast Steve borrows 200 shares of Coke stock from his stock brokerage firm

and immediately sells the borrowed shares to the investing public. Securities brokerage

firms are eager to loan shares to short sellers because they earn a sales commission plus

they earn fees for lending shares held in the brokerage’s safe. Coincidently, a Seattle

investor named Susan is bullish about Coke stock at the same time Steve is bearish. Steve’s

broker sells the 200 borrowed shares of Coke to Susan’s broker for $40 per share and

Susan pays her broker (200 shares times $40 equals) $8,000. Thus, Steve sells a stock he

Fundamental Investment Positions – Professor Jack Clark Francis – Page 6

does not own. Susan and Steven never learn each other’s identity. After the short sale,

Susan is long 200 shares of Coke stock, and Steve is short 200 shares. Stated differently,

Steve owes his brokerage firm 200 shares of Coke stock. To provide for the possibility that

Steve disappears while he is short the stock, U.S. securities law requires Steve to deposit at

least $4,000 of guarantee money, which equals the 50 percent minimum initial margin

requirement for all stock transactions.

Steve holds his short position open for six months. When the price of Coke stock falls to $35

per share he instructs his stock broker to buy 200 shares of Coke stock to cover (offset,

repay) his short position. Within two minutes Steve’s broker calls him to report that he

executed Steve’s buy order at the current market price of $35 per share (or 200 shares

times $35 equals $7,000), and, that Steve’s short position (of 200 shares times $40 equals

$8,000) has been extinguished (fully covered) by that purchase of 200 shares of Coke. Since

Steve bought the Coke stock for $35 per share after previously selling it for $40 per share,

he earned a capital gain of ($40 less $35 equals) five dollars per share (or $8,000 less

$7,000 equals $1,000) from his short sale.3 Steve’s $1,000 gain will be reduced by

brokerage commissions of about one percent and by income taxes on capital gains of

several percent.

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3
If, instead of falling, the price of Coke stock had risen to $45, Steve would have suffered a loss
of ($45 less $40 equals) five dollars per share for 200 shares (or, equivalently, $9,000 less $8,000
equals -$1,000).

Fundamental Investment Positions – Professor Jack Clark Francis – Page 7

2A. Securities Held in the “Street Name”

It is easy for short sellers to borrow shares from their securities brokerage house because

most investors keep their long positions stored in their broker’s safe rather than keep the

fungible securities in their home. Brokerage houses typically hold the customers’ shares in

the brokerage house’s street name rather than in the clients’ names, except for those

unusual clients that ask to receive delivery of the physical securities. The phrase street

name refers to securities registered in the brokerage firm’s name while they are being

stored for the clients that owns them. Free storage of clients’ securities is a brokerage

service that makes it easy for brokers to lend shares to short sellers and, also, a

convenience most investors appreciate.

Clients are never aware that their long position stored at their broker’s office might be

loaned to a short seller, because the shares are held in the brokerage’s safe in the

brokerage’s street name. Since brokerage safes contain many clients’ securities, short sales

can usually be held open indefinitely because fungible securities with street names can be

transferred to short sellers and between other clients’ accounts whenever needed. In an

unusual circumstance in which the brokerage house was unable to find shares to loan to a

short seller, the short seller would be forced to cover his short position by purchasing

shares from the investing public and immediately turning the shares over to the brokerage

house to cover the client’s uncovered short position.4

4
Small individual short sellers do not immediately receive the cash proceeds paid by the buyer
of the securities. The short seller's brokerage house usually hold the immediate cash proceeds
from short sales and, in addition, require the short seller to make an initial margin deposit as
collateral for the borrowed securities. When the short seller closes (pays off) the short position
Fundamental Investment Positions – Professor Jack Clark Francis – Page 8
2B. Gains, Losses and Expenses from Short Sales

Stocks, bonds, commodity futures contracts, foreign currencies, options, and other

marketable assets are routinely sold short every day. In each case, the relationship between

the market price of the marketable asset and the investors gain or loss is illustrated in Figure

1B; note that the slope of that gain-loss line is -1. The gain-loss graphs for the long and short

positions in Figures 1A and 1B are mirror images of each other.

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EXAMPLE 3 - Holding Period Returns (HPRs) From Long & Short Positions

Examples of holding period returns (HPRs) from hypothetical long position and short

positions in unrelated stocks are defined by Eqns.(1a) and (1b).

𝐵𝑢𝑦 𝑎𝑡 𝑙𝑜𝑤 𝑆𝑒𝑙𝑙 𝑎𝑡 ℎ𝑖𝑔ℎ𝑒𝑟 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑,

( )+( )+( )
r = (𝐻𝑃𝑅 𝑓𝑟𝑜𝑚 𝑙𝑜𝑛𝑔) =
𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒,−$25 𝑒𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒,+ $28 +$2
𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 (1a)
𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛, 20% (𝑝𝑟𝑖𝑐𝑒, $25)

𝑆𝑒𝑙𝑙 𝑠ℎ𝑜𝑟𝑡 𝑎𝑡 ℎ𝑖𝑔ℎ 𝐵𝑢𝑦 𝑎𝑡 𝑙𝑜𝑤𝑒𝑟 𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑,

( )+( )+( )
𝑟 = (𝐻𝑃𝑅 𝑓𝑟𝑜𝑚 𝑠ℎ𝑜𝑟𝑡 ) =
𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒,+$40 𝑒𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒,− $29 −$1
𝑆ℎ𝑜𝑟𝑡 𝑠𝑎𝑙𝑒 (1b)
𝑝𝑜𝑠𝑖𝑡𝑖𝑜𝑛, 25% (𝑝𝑟𝑖𝑐𝑒, $40)

If a shorted stock pays cash dividends, the short seller must reimburse an equivalent

amount of cash to the lender of the shares to compensate for the cash dividends that were

not received by the lender while the shares were lent. Note that the same variables

determine the investor’s gain or loss in Eqns.(1a) and (1b), only the signs differ.

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and returns the borrowed securities to their lender/owner, the brokerage returns the short seller's
margin money plus the cash proceeds from the short sale. The arrangements of every short sale
vary with the short seller's position. Unlike the small individual non-professional investors,
when institutional investors (like brokerage houses and banks) sell short they immediately
receive the cash proceeds from their short sales. These different arrangements make short selling
easier and more profitable for institutional investors than for small individual investors.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 9

---------------------------------------------- Top of Think Question ----------------------------------------
THINK QUESTION ABOUT THE GAIN-LOSS GRAPH FOR A SHORT POSITION

QUESTION: What are the upper and lower limits for the gain-loss line for the short position
in Figure 1B?

ANSWER: For a short position, the upper limit for gains equals the price of the stock that
was shorted, since negative stock prices are not permitted. The lower limit for losses is
unlimited because the stock’s price can rise to infinity.
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Trading is not free. Brokerage houses are in business to collect commissions from buy

orders, sell orders, and securities lending. Investors should not trade too frequently or they

will enrich the broker at their own expense.

3 - Trading on Margin

Investors that open margin accounts instead of cash accounts at their brokerage house

may buy a security with some of the investor’s own cash (called the margin), and the rest

of the needed funds can be borrowed from the investor’s broker (called the debit balance).

The purchased securities remain in the broker’s safe to serve as collateral for the investor’s

loan. In its role as the nation’s credit supervisor, the Federal Reserve requires that the

minimum initial margin requirement investors must put down for an initial purchase of

common stock is 50 percent of the purchase price.

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EXAMPLE 4 – Jana’s Buys on Margin

Jana buys one share of stock for $40. U.S. securities law requires her broker to collect and
hold an initial minimum margin requirement of at least $20. Jana decides to pay for the
investment with $25 of her own money, and borrow $15 from her broker. After her
purchase, the equity value in Jana’s brokerage account equals the market value of Jana’s
share minus the borrowed amount, or $25 [equals (stock $40) less ($15 loan)], as shown in
the statement below that her brokerage sends her each month.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 10

 Jana’s Initial Account Balance
-------------------------------------------------------------------------------------------
Assets | Liabilities & Net Worth
-------------------------------------------------------------------------------------------
Market value $40 | $15 Debit balance (Borrowed funds)
| $25 Jana’s equity
|--------------------------------------------
| $40 Total
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3A. A Margin Call

After securities have been purchased, the minimum equity value in an investor’s account

must remain above the minimum maintenance margin requirement, which is slightly

less than the minimum initial margin requirement. The purpose of the maintenance margin

is to protect the broker against a fall in the price of the securities (the collateral) to the

point that the investor might be unable to repay the loan (debit balance). Assume the

minimum maintenance margin requirement for common stock purchases is 40 percent.

Brokerage houses and securities exchanges, not the Federal Reserve, set the minimum

maintenance margin requirements.

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EXAMPLE 5 – Jana Gets a Margin Call

If the market price of Jana’s $40 stock falls to $20, the equity value remaining in her
account drops to $5 [equals (stock $20) less (loan $15)]. The $5 of equity in Jana’s account
is insufficient because it is less than the legally required minimum maintenance margin of
$8 [equals (stock $20) times (40 percent maintenance margin)]. So, Jana’s broker gives her
a margin call and tells her that she will either have to sell her shares or pay some additional
cash to reduce her loan so that the equity value in her account remains above $8. Note that
Jana’s $15 debit balance remains unchanged because her debt is not altered by the stock’s
price fluctuations.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 11

 Jana’s Account Balance, After the Price Falls to $20
-------------------------------------------------------------------------------------------
Assets | Liabilities & Net Worth
-------------------------------------------------------------------------------------------
Market value $20 | $15 Debit balance
| $5 Jana’s equity
|-------------------------------
| $20 Total
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--------------------------------- Top of Think Question -------------------------------
THINK QUESTION ABOUT JANA’S MARGIN CALL

QUESTION: Reconsider Jana’s case above. If the maintenance margin is 40 percent and Jana
borrows d dollars per share to buy a stock priced at p dollars per share, at what market
price can Jana expect to get a margin call from her stock broker?

ANSWER: If the stock’s price per share is p = $40 and Jana’s debt is d = $15 per share, her
equity per share equals $25 = ($40 - $15) = (p – d). Stated as a percentage of the security’s
price, the formula for Jana’s initial margin equals:
62.5% = .625 = (p – d)/p = ($40 - $15)/$40.
Resetting this equation to the maintenance margin of 40 percent yields: (p - $15)/p = .4.
Solving this latter equation for p yields p = $25. This means Jana should expect a margin
call when the price of her stock declines to $25 per share.
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3B. Buying on Margin Increases the Investor’s Risk

In contrast to the 50 percent minimum initial margin requirement on common stock, the

minimum initial margin requirement on U.S. Treasury bonds is much lower, only ten

percent, because T-bonds are safer investments than common stock. This means that the

maximum initial amount investors are allowed to borrow is 90 percent of the initial

purchase price of U.S. Treasury bonds. To make meeting margin requirements easier

brokerage houses are always pleased to loan their client’s money at an interest rate called

Fundamental Investment Positions – Professor Jack Clark Francis – Page 12

the brokers call rate, plus a service fee.5 Brokerage houses like to loan their client’s money

because the more money investors have to invest, the more commission income the

brokerage houses can earn; and, in addition, because the brokerage profits from the

interest income.

Buying on margin increases the investor’s variability of return. Variability of return is the

definition of risk throughout this book. For proof that margining is risky, reconsider Jana’s

$40 investment. Assume there is a 50-50 chance that the market price of Jana’s stock rises

or falls by $10 per share. And, to keep the arithmetic simple, assume the stock pays no cash

dividends while Jana owns it. If Jana pays cash for the stock (so her margin is 100 percent),

her unmargined holding period returns (HPRs) from the high (H) and low (L) prices are 25

percent and -25 percent.

𝐻𝑖𝑔ℎ 𝑒𝑛𝑑𝑖𝑛𝑔 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒

( )−( 𝑝𝑟𝑖𝑐𝑒 ) $50−$40 $10
𝑝𝑟𝑖𝑐𝑒
𝑟𝐻 = = = = 25% = HPR from high $50 price.
(𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒) $40 $40

𝐿𝑜𝑤 𝑒𝑛𝑑𝑖𝑛𝑔 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒

( )−( 𝑝𝑟𝑖𝑐𝑒 ) $30−$40 −$10
𝑝𝑟𝑖𝑐𝑒
𝑟𝐿 = = $40 = $40 = −25 = HPR from low $30 price.
(𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑝𝑟𝑖𝑐𝑒)

In margined transactions the leverage factor equals 1/(percent margin). The leverage

factor means that if the margin is 50 percent, for instance, the investor can buy twice as

much stock, because 1/(0.5) equals two. Leverage also increases the investor’s risk by

increasing the investor’s variability of return. For example, if Jana makes a 50 percent cash

5
For details about margin requirements, see John P. Geelan and Robert P. Rittereiser, Margin
Requirements and Practices, 4th ed. (New York: New York Institute of Finance, 1998). The
brokers call rate is usually about one percent below the prime interest rate.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 13

down payment on the same $40 stock and borrows $20 from her broker, her margined

outcomes are riskier, as shown below.

𝐻𝑖𝑔ℎ 𝑒𝑛𝑑𝑖𝑛𝑔 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒

( )−( 𝑝𝑟𝑖𝑐𝑒 ) $50−$40 $10
𝑝𝑟𝑖𝑐𝑒
𝑚𝑟𝐻 = 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 50% = ($40)(.5) = = 50% = Margined HPR from $50 price.
( 𝑝𝑟𝑖𝑐𝑒 )(𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑒 ) $20

𝐿𝑜𝑤 𝑒𝑛𝑑𝑖𝑛𝑔 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒

( )−( 𝑝𝑟𝑖𝑐𝑒 ) $30−$40 −$10
𝑝𝑟𝑖𝑐𝑒
𝑚𝑟𝐿 = 𝑃𝑢𝑟𝑐ℎ𝑎𝑠𝑒 50% = ($40)(.5) = = −50% = Margined HPR from $30 price.
( 𝑝𝑟𝑖𝑐𝑒 )(𝑚𝑎𝑟𝑔𝑖𝑛 𝑟𝑎𝑡𝑒 ) $20

Table 1 summarizes the high and low holding period returns (HPRs) Jana would earn from

her $40 investment with and without the use of margin. Interest expense was not deducted

from Jana’s margined HPRs to keep the explanation simple, and because deducting interest

would not change our conclusion. In conclusion, buying on margin increases the investor’s

variability of return (risk) because it magnifies both the investor’s gains and losses.

TABLE 1 - Jana’s High (H) and Low (L) HPRs from a Margined Long Position
Beginning Ending price Holding Period Return HPR With 50%
price (HPR) Without Margin Margin
$40 $50 = High price rH = 25% mrH = 50%
$40 $30 = Low price 𝑟𝐿 = -25% 𝑚𝑟𝐿 = -50%
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THINK QUESTION ABOUT RISK AND LEVERAGE

QUESTION: What is the relationship between risk and financial leverage?

ANSWER: Let the leverage factor be denoted L=1/(percent margin), and the holding period
return from an unmargined long position is denoted HPR. Risk equals variability of return, or the
standard deviation of the HPRs, SD(HPR) = √𝑉𝑎𝑟(𝐻𝑃𝑅). The HPR from a margined long
position equals (L)[SD(HPR)] = √𝑉𝑎𝑟(𝐿 𝑥 𝐻𝑃𝑅) = √𝐿2 𝑉𝑎𝑟(𝐻𝑃𝑅)]. Summarizing, risk varies
inversely with the percent margin and directly with leverage factor, as shown in Table 1.
----------------------------------------- Bottom of Think Question ----------------------------------------

4 – FORWARD CONTRACTING

A forward contract, called a forward, is a simple contract between a buyer and a seller.

Forwards have been used thousands of years. For example, suppose that 1,000 years ago a
Fundamental Investment Positions – Professor Jack Clark Francis – Page 14
bread baker promised to pay a wheat farmer $2 per bushel for 10 bushels of wheat when

the wheat is delivered. Forward contracts are cash transactions in which the seller

promises to make delivery at some future date and the buyer promises to pay an

appropriate pre-arranged amount of cash on delivery (COD). The buyer and the seller in a

forward contract each bear counter-party risk. The buyer takes the risk that the wheat

farmer may not deliver the goods as promised. And, the farmer assumes the risk that the

buyer might not pay the promised amount of cash on delivery. A forward contract may or

may not be written on paper. However, if a disagreement ever goes to court, it is much

easier to enforce a written agreement that is signed by both counterparties and a witness.

In this example, the wheat farmer is said to be short wheat because he is the wheat seller

and he will benefit if the price of wheat declines. The bread baker is long wheat because the

baker is the wheat buyer and he will benefit if the price of wheat rises. The short forward

contract protects the wheat farmer from selling at a price below $2 per bushel, as the gain-

loss graph Figure in 1B illustrates. And, if the market price of wheat rises, the long position

in the forward contract protects the baker from paying more than $2 per bushel, as shown

in Figure 1A. If the market price of wheat rises to $3 per bushel after the forward contract

is consummated, the lucky baker still gets to buy the wheat at the below-market contract

price of $2 per bushel. This $1 per bushel lower price increases the baker’s wealth by $1

per bushel.

The simplicity of the forward contract and its usefulness in resolving uncertainty motivate

small farmers and family-owned bakeries to use forwards. But, large commercial farms that

Fundamental Investment Positions – Professor Jack Clark Francis – Page 15

sell huge harvests to interstate and international bakers (like Pepperidge Farms) usually

prefer to deal in futures contracts.

5 – FUTURES CONTRACTS

Although forward contracts and futures contracts have similarities, these two financial

instruments differ significantly.

Contracting location. Forward contracts are simple structures that can be consummated

in an office, the back seat of a taxi, or numerous other places. In contrast, most futures

contracts are only traded at organized exchanges. Table 2 lists a few of the largest futures

exchanges in the world.

TABLE 2 – Largest Futures Exchanges, January – June 2012

Rank Exchange Volume of

Contracts Traded
1 in CME Group was created in 2007 by merger of 1,555,139,920
U.S. Chicago Mercantile Exchange (the “Merc”) and
Chicago Board of Trade (CBOT). The Merc acquired
the New York Mercantile Exchange (NYMEX) and
COMEX in 2008. The Merc, CBOT, NYMEX and
COMEX are now four large futures markets owned
by the CME Group.
2 in Intercontinental Exchange (ICE) headquartered in 197,611,922
U.S. Atlanta, Georgia owns ICE Futures Europe, ICE
Futures U.S., ICE Futures Canada, etc. And, ICE owns
the New York Stock Exchange (NYSE).
1 in Eurex is the largest futures exchange in Europe; 1,262, 493, 530
Europe Eurex is owned by Deutsche Börse.
Source: www.futuresindustry.org

Regulatory authority. Futures contracts are governed by the Commodity Futures Trading

Commission (CFTC), a U.S. federal government agency that is devoted to regulating the

Fundamental Investment Positions – Professor Jack Clark Francis – Page 16

trading of futures and options. The CFTC is analogous to the Securities and Exchange

Commission (SEC), which regulates the trading of stocks and bonds.

Price. The price in a forward contract is written into the contract when it is consummated,

and that price that cannot be changed without renegotiating the contract. This price

rigidity makes it difficult to buy and resell a forward contract as market prices fluctuate.

Unlike forward contracts, each futures contract is a marketable instrument that can be

purchased and resold any number of times. The successive prices at which a futures

contract is bought and resold fluctuate continuously to reflect market prices that change

continuously.

Contract specifications. The buyer and seller in a forward can specify any arrangements

they wish, as long as no laws are violated. For instance, the forward contract could say a

farmer should deliver the wheat to a bread baker’s place of business. Alternatively, the

forward contract could say the bread baker will pick up the wheat from the farm. Futures

contracts do not possess this flexibility. One of the reasons futures contracts are fungible is

because they are standardized. Table 3 lists the aspects of futures contracts that cannot be

changed.

TABLE 3 - Standardized Aspects of Every Futures Contract

1. Quality 4. Minimum price fluctuations, ie, Tick size

2. Delivery date 5. Trading days and hours
3. Delivery arrangements

Only the delivery date, price and quantity are determined when a futures contract is

consummated.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 17

Cancelling. If both counterparties to a forward contract want out of the deal at mutually

agreeable terms, the forward contract could be dissolved (cancelled). More likely, if either

the buyer or the seller do not want to dissolve (cancel) the deal, the resulting disagreement

could easily escalate into a costly law suit. In contrast, liquid futures contracts can be freely

bought or sold by either counterparty at any time, because every transaction creates the

occasion to write a new and different futures contract.

Before the delivery date arrives, over 90 percent of all futures contracts are extinguished

(closed, cancelled). A trader can easily close out a futures position by reversing out of the

position. Futures buyers reverse out of (eliminate, erase) a long position by selling short a

futures contract before the delivery date of the long contract arrives. A short seller reverses

out of a short position by buying a long position in a fungible contract that is identical to

the contract that was shorted. Table 4 shows that these reversing trades leave the trader

with no remaining futures positions.

TABLE 4 – Reversing Out of Positions

4A. REVERSING A PURCHASE 4B. REVERSING A SHORT SALE

First, buy a long futures position. First, sell a futures contract short.

Plus: Before delivery date, sell (short) an Plus: Before delivery date, buy an identical
identical position. long position.
Equals: No remaining futures positions. Equals: No remaining futures positions.

In addition to reversing out of a position, a futures trader can roll out a long or short

position (extend its time horizon) by trading the position for an identical position that has a

Fundamental Investment Positions – Professor Jack Clark Francis – Page 18

later delivery date. The counter-parties to a forward contract cannot easily alter, cancel,

reverse out of, or extend the life of their agreement.

Financial leverage. Forward contracts almost always require 100 percent cash on

delivery (COD). But, if desired, the buyer of a futures contract enjoys the opportunity to

make only a small down payment (say, five or ten percent of the market value of the

contract) to initially bind a futures contract. These down payments are called margin

requirements.

Commodities traded. Forward contracts can be created that cover the purchase and sale

of any commodity that is legal to buy and sell. Table 5 provides the much shorter list of

commodities that organized futures exchanges choose to list and trade. The older contracts

are listed first and successively newer types of contracts follow in Table 5.

TABLE 5 – Categories of Futures Contracts Traded

Agriculture contracts are the oldest futures contracts. These contracts include the
following underlying commodities: wheat, soybeans, corn, cattle, hogs, oats, orange juice,
sugar, et al.
Metals contracts cover gold, silver, copper, platinum, et al.
Energy contracts cover oil, gasoline, electricity, propane, natural gas, et al.
Currency contracts include the Euro, British pound, Japanese yen, Canadian dollar, and
U.S. dollar.
Interest rate futures include U.S. Treasury bonds, U.S. Treasury notes, U.S. Treasury
bills, federal funds rate, LIBOR, British government bonds, Canadian government bonds,
et al.
Equity indexes are the newest futures category. Cash settlement contracts are available
on the following stock market indexes: S&P 500 Index, NASDAQ 100, Russell 2000,
Nikkei 225, FTSE Index, et al.

The Clearing House guarantee. A clearing house is an organization within an organized

exchange which acts as a middleman that inserts itself between every buyer and every

Fundamental Investment Positions – Professor Jack Clark Francis – Page 19

seller in each transaction. Clearing houses remove counterparty risk from all futures

transactions by guaranteeing the fulfillment of every futures contract. Since clearing houses

do not guarantee forward contracts (because forwards are only traded outside futures

exchanges), forward contracts involve considerable counterparty risk.

Counter-party risk. Counterparty risk arises when a buyer fails to make a timely full

payment or a seller does not make a satisfactory delivery. Clearing houses insure both

counterparties against such losses by becoming a default-free buyer in every sale and a

default-free seller in every purchase. In other words, a clearing house is a centralized

organization in a futures exchange that guarantees the validation, delivery, and settlement

of all futures contracts originated in that exchange. Clearing houses deduct a few cents

from every transaction and accumulates these pennies in a clearing house fund that grows

to become a multi-billion dollar insurance fund guaranteeing that every transaction will be

executed in full and on time. The important result is that futures exchange transactions

involve no counter-party risk. Figure 2 depicts a series of transactions passing through the

Clearing House of an organized exchange.

---------------------------------- Insert Figure near here -------------------------

FIGURE 2 – Series of Transactions through an Exchange’s Clearing House

Fundamental Investment Positions – Professor Jack Clark Francis – Page 20

 First seller sells to first buyer - - the Clearing House.
First buyer becomes second seller.

Buyer #2 becomes
Seller #3

Buyer #4 becomes The Clearing House is the buyer in every sale and
Seller #5 the seller in every purchase. It is buyer 1, 3, 5, 7
and seller 2, 4, 6, 8.

Buyer #6 becomes
Seller #7

The eighth buyer takes delivery from the Clearing House. None of the counter-
parties communicate. If a counter-party defaults the Clearing House fully executes
on time and settles with the defaulted counter-party later.

--------------------------------- Bottom of Figure -----------------------------------

Table 6 summarizes the important differences between forwards and futures.

TABLE 6 - Contrasting the Characteristics of Futures and Forward Contracts

Characteristic Forwards Futures
1. Location of contracting Any place Organized exchange
2. Regulatory authority Contract law CFTC
3. Price Fixed Fluctuates
4. Contract specifications Tailored Standardized
5. Cancelling Uncommon Routine and easy
6. Financial leverage None, COD Through low margins
7. Commodities traded Any commodity Listed commodities
8. Clearing house guarantee None Blanket coverage
9. Counter-party risk Yes None

Fundamental Investment Positions – Professor Jack Clark Francis – Page 21

6 – HEDGING AND ARBITRAGE

Hedging is a popular risk-reduction strategy that also provides the basis for arbitrage.

6A - Perfect Hedges

Suppose you buy a long position of 100 shares of Coca-Cola’s common stock. At the same

time, you sell 100 shares of Coke stock short. Regardless of whether the market price of

Coke’s stock goes up or down, the gains and losses from your long and short positions will

cancel each other out so that it will be impossible for your two-position portfolio to gain or

lose money. A long position and a short position undertaken at the same price establish a

perfectly hedged portfolio. A perfectly hedged portfolio resembles a portfolio of cash.

FIGURE 3 - Gain-Loss Diagram for a Perfectly Hedged Position in Coke Stock

SUMMARY: A long position in Coca-Cola stock is purchased at $44 per share. At the same
time, the investor also sells Coke’s stock short at $44 per share. Suppose Coca-Cola goes
bankrupt and its stock price falls to zero. The long position will suffer a $44 per share loss.
Fundamental Investment Positions – Professor Jack Clark Francis – Page 22
The simultaneous gain from the short position will be $44 per share. Thus, if Coke's market
price falls to zero, the value of the perfectly hedged portfolio remains unchanged.

Figure 3 combines the long position from Figure 1A and the short position from Figure 1B in

the same asset at identical purchase and sale prices.

----------------------------------------- Top of numerical example -----------------------------------------

EXAMPLE 6 - Mr. Tandon Sells Short Against the Box

After years of saving, Mr. Tandon managed to accumulate 400,000 shares of the Coca-Cola

stock. Now, he has compelling new information that makes him fear that the price of the

stock will soon drop substantially. How can Mr. Tandon avoid losses on the stock he owns

without selling his ownership position and being forced to pay income taxes on the capital

gains he has accumulated from years of investing? Solution: Mr. Tandon can sell short

400,000 shares of the stock to establish a perfect hedge that will remove (hedge away,

eliminate) the possible price losses he fears. If the stock’s price falls, the losses on Mr.

Tandon's long position will be exactly offset by gains on his short position. As a result, he

completely avoids the feared loss. If Mr. Tandon kept the long position shares in his safe-

deposit box, he is doing what is called selling short against the box.6

----------------------------- Bottom of numerical example ---------------------------

6B - Imperfect Hedges

An imperfect hedge occurs when either the physical quantities of the long and the short

positions are not identical, or, the short sale’s price per unit is not equal to the purchase price

per unit for the long position. Figure 4 illustrates two imperfect hedges. The size of the dollar

6
If Mr. Tandon was a Coca-Cola executive, he would be legally prohibited from selling Coke
stock short against the box because in the U.S. insiders are not allowed to use inside information
to gain from trading in their employer’s securities.
Fundamental Investment Positions – Professor Jack Clark Francis – Page 23
commitments to the long and the short positions cannot be illustrated in a gain-loss graph;

so, for simplification, we will assume they are equal. The two hedges in Figure 4 are imperfect

because short sales price, denoted Ps, differs from the purchase price for the long position,

denoted Pp.

FIGURE 4 - Two Imperfect Hedges with Fixed (A) Losses and (4) Gains

SUMMARY: The unprofitable position in Figure A should be avoided. The imperfect hedge in
Figure B is highly desirable because it earns arbitrage profits. Suppose the law of one price
is broken because the Coca-Cola common stock is simultaneously selling for $40 per share
in Chicago and $41 at the NYSE. Arbitrageurs would buy Coke stock in the market where it
is cheapest; the long positions they acquired would tend to bid up the low purchase price of
PL = $40 in Chicago. Simultaneously, arbitrageurs sell short in the market where it the
security is over-priced; their short selling tends to drive down the high NYSE price of P S =
$41. The short sale price and the price paid for the long position are thus driven toward each
other until the price difference (PS – PL) quickly shrinks to zero, the law of one price prevails
(PS = PL), and, arbitrage is no longer profitable.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 24

The imperfect hedge in Figure 4B will yield an invariant profit equal to the excess of the

short sale price over the purchase price. The imperfect hedge in Figure 4B will earn a gain

of (PS – PL) dollars per share regardless of whether the price of the underlying stock rises

or the Coca-Cola Corporation goes bankrupt and its stock price falls to zero. In contrast,

Figure 4A illustrates a case in which the short sale price is less than the purchase price for

the long position (Ps < Pp); this type of imperfect hedge guarantees a loss.

6C – Arbitrage Profits

Arbitrage involves buying a long position and selling a short position in the same asset, or

different but related assets, to profit from unusual price differentials. If the arbitrager is an

institutional investor (eg, Merrill Lynch), that institution can open a short position before

buying the offsetting long position and immediately receive the cash proceeds from the

short sale. That cash can then be used to purchase the offsetting long position. As a result,

the institution has no money invested in the arbitrage position. If this example does not

excite you, consider how you would feel if you owned a riskless multi-million dollar

profitable arbitrage position which required no money investment and guaranteed a sure

profit.

The Law of One Price: Any time the same good is selling at different prices, arbitrage

profits are available. Profit-seeking arbitrageurs enforce the economic law of one price by

buying in the market where the price is low and selling in another market where the price

is higher. Arbitrageurs buy and bid up the low price and, simultaneously, sell at the higher

price and drive that price down, until the prices are the same in all markets. The price may

never be exactly identical in all markets because of transaction costs such as brokers’
Fundamental Investment Positions – Professor Jack Clark Francis – Page 25
commissions, foreign exchange fees, governmental foreign exchange controls, telephone

costs, and other economic frictions that slow arbitrage and erode arbitrage profits.

However, with the exception of minor transaction costs and shipping costs, every fungible

security should sell for the same price around the world.

Everyone Benefits From Arbitrage: As they pursue arbitrage profits, arbitrageurs

enforce the law of one price. Arbitrage makes the prices of a security traded around the

world continually respond rationally, efficiently, and uniformly to new information. This is

desirable because, in a free market society, market prices determine how resources are

allocated. Those who have a desperate need for something will be willing to bid its price

higher, and, as a result, things that have high prices are conserved and used carefully.

Plentiful goods tend to sell at low prices and, so, they are more likely to be used than

conserved with care.

7 - PUT AND CALL OPTIONS

Puts and calls are standardized option contracts. The following five features fully describe

an option contract.

(1) Call or put?

(2) The name of the underlying stock, bond, price index, commodity, interest rate or other
asset.
(3) The striking price, or, synonymously, the strike price, contract price, or the exercise
price.
(4) The contract’s expiration date, or maturity date.
(5) Is it a European or an American option?

Most exchange-listed options on common stocks expire in less than three years, but a

smaller number of tailor-made options have lives spanning longer periods.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 26

If you think the price of a stock is going to rise, you would usually be better off to buy a call

option on the stock than to buy a long position in the stock. Similarly, if you think the price

of a stock is going to fall, you would usually be better off if you bought a put option on that

stock than if you sought to profit from a short sale. In either case, if your forecast is correct,

you would be better off because options offer more leverage opportunity than long or short

positions in the underlying asset.

7A - Call Options

A call option is a financial contract that gives its owner the right, but not the obligation, to

buy the underlying asset. Suppose the underlying asset is a common stock. In this case, one

call grants the call buyer the option to purchase one round lot (100 shares) of a specific

stock within a pre-specified period of time at a fixed exercise price. A buyer that wants an

option to buy 200 or 300 shares of stock must purchase two or three calls. A call on 500

shares of Microsoft stock with a $40 exercise price that matures in July is called five MSFT

July 40 calls.

Figure 5A - Gain-Loss Graph for a Call Buyer

Fundamental Investment Positions – Professor Jack Clark Francis – Page 27

Figure 5B - Gain-Loss Graph for a Call Writer

----------------------------- Top of numerical example ---------------------------

Fundamental Investment Positions – Professor Jack Clark Francis – Page 28

EXAMPLE 7 - A JULY 40 CALL ON COKE

Suppose Coca-Cola’s stock price is $37 per share and a call on Coke stock maturing in July

has an exercise price of $40 per share. Table 7 shows that this call has a per share intrinsic

value of zero when the stock’s price is $37. Figure 5 illustrates the option market data in

Table 7.

Table 7 – Data for the Long July 40 Call on Coca-Cola, Illustrated in Figure 5A, dollars
per share*

Coke’s Underlying Cost of a Coke Call’s Intrinsic Call’s Time Value

Common Stock July 40 Call (CC), Value (IV) in (TV),
Price CC = IV + TV Figure 5A TV = CC - IV
$30 50¢ 0 50¢
$33 $1 0 $1
$35 $2 0 $2
$37 $3 0 $3
$40 = Exercise $5 0 $5
price
$43 $7 $3 $4
$45 $8 $5 $3
$47 $9 $7 $2
$50 $10.50 $10 50¢
* The cost of the Coke July 40 Call (CC) and its time value (TV) are not shown in
Figures 5A and 5B; only the option’s the intrinsic value (IV) is illustrated in
these Figures.

----------------------------- Bottom of numerical example ---------------------------

Every call and put option has three different prices associated with it.

1. The price of the underlying is the fluctuating market price of the optioned asset.

2. The exercise price, strike price, or contract price is the price at which the option
writer can be legally required to execute the option. The exercise price never changes
during the life of an option.

3. The option's premium is the price the option buyer pays the option writer to provide
(write, sell) the option. The option may be resold any number of times at different
premiums that are determined by the current conditions in the secondary market for
options.
Fundamental Investment Positions – Professor Jack Clark Francis – Page 29
 Figure 6 illustrates how various factors interact to determine a call’s premium. The three

curves trace the appropriate premiums (market prices) for a call that has eight, four or two

months until it expires. The vertical arrows to the right of the exercise price show that:

(Call premium) = (Intrinsic value of call) + (Call’s time value).

Figure 6 – The Determinants of the Value of a Call

Call’s price, or, call premium, $

Three options’
total values
(3 curves)

Months
before
Three time values
expiration: 8
4
2
Intrinsic value
Exercise
price

Out of the At the In the Deep in

money market money the money

Market price of the optioned asset, $

The owner of a put or call may choose from among the following four actions.

1. Hold it: Keep the option a while longer to see what happens to the price of the
underlying asset.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 30

2. Sell it: Sell the option to someone else at the option’s current market price and take the
resulting gain or loss. This eliminates the option position.

3. Exercise it: Convert the option to the underlying asset at the contracted strike price
and, thereby, eliminate the option. Exercising will result in a realized (taxable) gain or loss.

4. Let it expire: Let the option expire, remembering that expired options are null, void,
and worthless, even if the option was “in the money” when it expired.

7B - Put Options

A put option gives its buyer (investor) the right, but not the obligation, to sell (put) one

round-lot of the underlying stock to the put seller (writer). The buyer of a put must

exercise the option at a pre-specified exercise price within a stipulated period or the option

expires and is worthless. Figures 7A and 7B illustrate the gains and losses for the buyer and

writer of a put.

Figure 7 - Gain-Loss Graphs for a Put (A) Buyer and (B) Writer

See next page.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 31

 FIGURE 7 - Gain-Loss Graphs: (A) Put Buyer; (B) Put Writer

A. Put Buyer
Gain, $
Intrinsic value of
$40 put, or, Gross
$37 gain or loss

Exercise
Premium
price, $40
0
Price of the
-$3 Break-even underlying
point, $37 asset, $
Premium paid, $3
Net gain
or loss

Loss, $

B. Put Writer
Gain, $

Net gain
Break-even or loss Premium income, $3
point, $37
+$3
0
Price of the
Exercise underlying
Premium price, $40 asset, $

Intrinsic value
-$37 of put, or
-$40 Gross gain or
loss

Loss, $

Fundamental Investment Positions – Professor Jack Clark Francis – Page 32

The two curves in Figure 8 illustrate what determines the market prices of two puts with

differing expiration dates. Puts become more valuable as the prices of the underlying asset

decreases toward zero. Since a put option cannot be worth more than its exercise price, the

maximum value line for a put equals the horizontal line at the put’s exercise price.

Figure 8 - - Price Determinants Graph for a Put Option

7C. Facts About Puts and Calls

Table 8 is an excerpt from a financial newspaper showing trading data that was published

one day for options on General Motors (GM) stock.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 33

Table 8 –Newspaper Excerpt of Market Data on GM Options in Dollars Per Share

GM’s Price: $38.50 Call Put

Expiration Strike Last Vol Last Vol
Aug 201X 35 3.50 321 0.01 43
Sept 201X 35 3.54 216 0.02 23
Aug 201X 40 0.06 11 1.39 164
Sept 201X 40 0.25 35 1.45 35
SUMMARY: Consider a hypothetical call option expiring in August 201X while GM common
stock is selling at a market price of $38.50 per share. The data in the top row of Table 8
shows that if the exercise price of a call option is $35 per share, the most recent (the Last)
call option transaction earned a gain of [(Sell GM stock at $38.50) less (Purchase call
premium, $35) equals a gain of] $3.50 before taxes and transactions costs. The trading
volume (Vol) of 321 call options suggests the call is trading in a liquid market.

Contrary to what their name suggests, European options are traded around the world.

European options can only be exercised on their expiration date. In contrast, American

options can be exercised on any trading day of their life, up to and including the day they

expire. Like the European options, American options are traded around the world. In the

U.S. put and call options are actively traded in the following option exchanges.

1) The Chicago Board Options Exchange (CBOE) lists and trades options that can be
traded from computers around the world.

2) The International Securities Exchange (ISE), headquartered in New York City, lists
and trades securities and options.

3) The NYSE Amex Options market trades put and call options on some common
stocks listed on the New York Stock Exchange and NASDAQ.

4) Philadelphia Stock Exchange, now known as NASDAQ OMX PHLX, is owned by The
NASDAQ OMX Group. Options and stocks are traded.

5) The Pacific Stock Exchange (PSE) is a stock exchange and an options market. It is
owned by NYSE.

6) Many stock exchanges around the world also trade options.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 34

Futures contracts, call options, and put options are called derivative instruments, because

their market values are derived from the price of some underlying asset, interest rate, or

market index. Derivatives are profitable for banks to create and trade, and, expensive for

investors to trade, because derivatives involve higher commission rates than common

stocks.

Price speculators should consider puts and calls instead taking long or short positions

directly in the underlying asset for two main reasons. First, options provide a price

speculator more financial leverage than can be obtained from buying the underlying stock

directly. If the speculator’s forecast is correct, leverage will magnify the speculator’s gains.

Second, puts and calls offer the investor limited liability. In other words, if the price

speculator’s forecast is wrong, the unfortunate speculator’s option losses will be limited to

only the premium (purchase price) paid for the option, which is usually three to fifteen

percent of the market price of the optioned asset. The losses from option premiums are

usually much smaller than what would be lost if an unprofitable long or short position were

taken directly in the stock.

-------------------------------- Top of Think Question ------------------------------------

THINK QUESTION: Are call and put options superior to the long and short positions? (Note

that the vertical axis of Figure 9 below measures positive and negative rates of return, not

dollar amounts.)

Fundamental Investment Positions – Professor Jack Clark Francis – Page 35

FIGURE 9 – Contrasting the Returns from a Long (or Short) Position with Returns
from a Call (or Put)

ANSWER: Options are usually preferred over the long and short positions because options
provide (A) limited liability, and, (B) more financial leverage.
---------------------------- Bottom of Think Question ------------------------------------

8 – THE BOTTOM LINE

The long position is the most popular position for investors buying a security. Only a small

percent of all investors employ alternative positions. The small percent of investors that

employ alternative positions have a large impact on the markets because they are

institutional investors who are professional traders. Numerous different alternative

positions were explored above because they enable the investor to trade profitably during

whatever market conditions might transpire. Table 9 enumerates the 60 different positions

that, either directly or indirectly, were suggested in this chapter.7

7
A study of profit maximization opportunities showed short selling was used in forty percent of
the value-based investing strategies and half of the momentum-based investing strategies. See
Ronen Israel and Tobias J. Moskowitz, “The Role of Shorting, Firm Size, and Time on Market
Anomalies,” Journal of Financial Economics, Vol. 108, Issue 2, May 2013, pages 275-301.

Fundamental Investment Positions – Professor Jack Clark Francis – Page 36

TABLE 9 - Matrix of 60 Different Investment Positions

5 Asset Classes: 1. 2. 3. 4. 5.
Twelve Stocks Bonds Commodities Financial Foreign
fundamental futures currency
positions:
1. Long 1 2 3 4 5
2. Short 6 7 8 9 10
3. Hedge 11 12 13 14 15
4. Arbitrage 16 17 18 19 20
5. Long forward 21 22 23 24 25
6. Short forward 26 27 28 29 30
7. Long future 31 32 33 34 35
8. Short future 36 37 38 39 40
9. Buy call 41 42 43 44 45
10. Write call 46 47 48 49 50
11. Buy put 51 52 53 54 55
12. Write put 56 57 58 59 60

TABLE OF CONTENTS - FUNDAMENTAL INVESTMENT POSITIONS

1 - THE LONG POSITION ...................................................................................................................... 2

FIGURE 1 - Gain-Loss Graphs for (A) Long and (B) Short Positions .............................................................. 3

EXAMPLE 1: JUDY’S FIRST LONG POSITION .................................................................................................... 3

2 - SHORT POSITIONS........................................................................................................................... 5

EXAMPLE 2 – STEVE SHORTS COKE STOCK ...................................................................................................... 6

2A. Securities Held in the “Street Name” .......................................................................................................... 8

2B. Gains, Losses and Expenses from Short Sales ........................................................................................... 9

EXAMPLE 3 - Holding Period Returns (HPRs) From Long & Short Positions ............................................... 9

3 - TRADING ON MARGIN .................................................................................................................. 10

Fundamental Investment Positions – Professor Jack Clark Francis – Page 37
EXAMPLE 4 – Jana’s Buys on Margin ............................................................................................................... 10

3A. A Margin Call ............................................................................................................................................... 11

EXAMPLE 5 – Jana Gets a Margin Call ............................................................................................................. 11

3B. Buying on Margin Increases the Investor’s Risk .................................................................................... 12

TABLE 1 - JANA’S HIGH (H) AND LOW (L) HPRS FROM A MARGINED LONG POSITION
................................................................................................................................................................... 14

4 – FORWARD CONTRACTING ......................................................................................................... 14

5 – FUTURES CONTRACTS ................................................................................................................. 16

TABLE 2 – Largest Futures Exchanges, January – June 2012.............................................................................16
TABLE 3 - Standardized Aspects of Every Futures Contract..............................................................................17
TABLE 4 – Reversing Out of Positions .................................................................................................................18
TABLE 5 – Categories of Futures Contracts Traded ...........................................................................................19

FIGURE 2 – Series of Transactions through an Exchange’s Clearing House ............................................... 20

TABLE 6 - Contrasting the Characteristics of Futures and Forward Contracts ......................................... 21

6 – HEDGING AND ARBITRAGE ....................................................................................................... 22

6A - Perfect Hedges........................................................................................................................................... 22
FIGURE 3 - Gain-Loss Diagram for a Perfectly Hedged Position in Coke Stock .......................................22

EXAMPLE 6 - Mr. Tandon Sells Short Against the Box .................................................................................. 23

6B - Imperfect Hedges ...................................................................................................................................... 23

FIGURE 4 - Two Imperfect Hedges with Fixed (A) Losses and (4) Gains ..........................................................24

6C – Arbitrage Profits ....................................................................................................................................... 25

7 - PUT AND CALL OPTIONS ............................................................................................................. 26

7A - Call Options................................................................................................................................................ 27
Figure 5A - Gain-Loss Graph for a Call Buyer ......................................................................................................27
Figure 5B - Gain-Loss Graph for a Call Writer .....................................................................................................28

EXAMPLE 7 - A JULY 40 CALL ON COKE .......................................................................................................... 29

Table 7 – Data for the Long July 40 Call on Coca-Cola, Illustrated in Figure 5A, dollars per share* ..................29

Figure 6 – The Determinants of the Value of a Call ...................................................................................... 30

7B - Put Options ................................................................................................................................................ 31

Figure 7 - Gain-Loss Graphs for a Put (A) Buyer and (B) Writer .......................................................................31

Fundamental Investment Positions – Professor Jack Clark Francis – Page 38

Figure 8 - - Price Determinants Graph for a Put Option ............................................................................... 33

7C. Facts About Puts and Calls ........................................................................................................................ 33

Table 8 –Newspaper Excerpt of Market Data on GM Options in Dollars Per Share ............................................34
FIGURE 9 – Contrasting the Returns from a Long (or Short) Position with Returns from a Call (or Put) .....36

8 – THE BOTTOM LINE ....................................................................................................................... 36

TABLE 9 - Matrix of 60 Different Investment Positions ...............................................................................37

Fundamental Investment Positions – Professor Jack Clark Francis – Page 39