Option Volatility and Pricing Advanced Trading Strategies and Techniques, 2nd Edition by Sheldon Natenberg

Option Volatility and Pricing Advanced Trading Strategies and Techniques, 2nd Edition by Sheldon Natenberg

1 Financial Contracts
My friend Jerry lives in a small town, the same town in which he was born and 
raised. Because Jerry’s parents are no longer alive and many of his friends have 
left, he is seriously thinking of packing up and moving to a larger city. However, 
Jerry recently heard that there is a plan to build a major highway that will pass 
very close to his hometown. Because the highway is likely to bring new life to 
the town, Jerry is reconsidering his decision to move away. It has also occurred 
to Jerry that the highway may bring new business opportunities. 
For many years, Jerry’s family was in the restaurant business, and Jerry 
is thinking of building a restaurant at the main intersection leading from the 
highway into town. If Jerry does decide to build the restaurant, he will need to 
acquire land along the highway. Fortunately, Jerry has located a plot of land, 
currently owned by Farmer Smith, that is ideally suited for the restaurant. Because 
the land does not seem to be in use, Jerry is hoping that Farmer Smith might 
be willing to sell it.
If Farmer Smith is indeed willing to sell, how can Jerry acquire the land 
on which to build his restaurant? First, Jerry must find out how much Farmer 
Smith wants for the land. Let’s say $100,000. If Jerry thinks that the price is 
reasonable, he can agree to pay this amount and, in return, take ownership of 
the land. In this case, Jerry and Farmer Smith will have entered into a spot or 
cash transaction.
In a cash transaction, both parties agree on terms, followed immediately 
by an exchange of money for goods. The trading of stock on an exchange is 
usually considered to be a cash transaction: the buyer and seller agree on the 
price, the buyer pays the seller, and the seller delivers the stock. The actions 
essentially take place simultaneously. (Admittedly, on most stock exchanges, 
there is a settlement period between the time the price is agreed on and the 
time the stock is actually delivered and payment is made. However, the settle-

ment period is relatively short, so for practical purposes most traders consider 
this a cash transaction.)
However, it has also occurred to Jerry that it will probably take several 
years to build the highway. Because Jerry wants the opening of his restaurant 

to coincide with the opening of the highway, he doesn’t need to begin con-

struction on the restaurant for at least another year. There is no point in tak-

ing possession of the land right now—it will just sit unused for a year. Given 
his construction schedule, Jerry has decided to approach Farmer Smith with 
a slightly different proposition. Jerry will agree to Farmer Smith’s price of 
$100,000, but he will propose to Farmer Smith that they complete the transac-

tion in one year, at which time Farmer Smith will receive payment, and Jerry 
will take possession of the land. If both parties agree to this, Jerry and Farmer 
Smith will have entered into a forward contract. In a forward contract, the parties 
agree on the terms now, but the actual exchange of money for goods does not 
take place until some later date, the maturity or expiration date.
If Jerry and Farmer Smith enter into a forward contract, it’s unlikely that 
the price Farmer Smith will want for his land in one year will be the same price 
that he is asking today. Because both the payment and the transfer of goods are 
deferred, there may be advantages or disadvantages to one party or the other. 
Farmer Smith may point out that if he receives full payment of $100,000 right 
now, he can deposit the money in his bank and begin to earn interest. In a for-

ward contract, however, he will have to forego any interest earnings. As a result, 
Farmer Smith may insist that he and Jerry negotiate a one-year forward price that 
takes into consideration this loss of interest.
Forward contracts are common when a potential buyer requires goods in 
the future or when a potential seller knows that a supply of goods will be ready 
for sale in the future. A bakery may need a periodic supply of grain to support 
operations. Some grain may be required now, but the bakery also knows that 
additional grain will be required at regular intervals in the future. In order to 
eliminate the risk of rising grain prices, the bakery can buy grain in the forward 
market—agreeing on a price now but not taking delivery or making payment 
until some later date. In the same way, a farmer who knows that he will have 
grain ready for harvest at a later date can sell his crop in the forward market to 
insure against falling prices.
When a forward contract is traded on an organized exchange, it is usually 
referred to as a futures contract. On a futures exchange, the contract specifications 
for a forward contract are standardized to more easily facilitate trading. The 
exchange specifies the quantity and quality of goods to be delivered, the date 
and place of delivery, and the method of payment. Additionally, the exchange 
guarantees the integrity of the contract. Should either the buyer or the seller 
default, the exchange assumes the responsibility of fulfilling the terms of the 
forward contract.
The earliest futures exchanges enabled producers and users of physical 
commodities—grains, precious metals, and energy products—to protect them-

selves against price fluctuations. More recently, many exchanges have intro-

duced futures contracts on financial instruments—stocks and stock indexes, 
interest-rate contracts, and foreign currencies. Although there is still significant 
trading in physical commodities, the total value of exchange-traded financial 
instruments now greatly exceeds the value of physical commodities.
Returning to Jerry, he finds that he has a new problem. The government 
has indicated its desire to build the highway, but the necessary funds have not 

Option Volatility and Pricing Advanced Trading Strategies and Techniques, 2nd Edition by Sheldon Natenberg