Strategies, analysis, and news for futures and options traders.
June 2007 • Volume 1, Issue 3
OPENING GAP STRATEGY:
Rare opportunities, quick profits p. 8
DEFENSIVE OPTIONS TRADING:
Puts vs. put spreads p. 20
ALL ABOUT OIL:
Short-term price behavior insights p. 12
KAMA RANGE-TRADER SYSTEM:
Adaptive moving average technique p. 28
CREDIT SPREADS:
Profiting in different market conditions p. 24
YEHUDA BELSKY:
Focusing on call spreads p. 34
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Futures Trading System Lab KAMA range trader |
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By Volker Knapp |
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Options Trading System Lab Trading iron condors with the ADX |
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By Steve Lentz and Jim Graham |
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Trader Interview Yehuda Belsky: |
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A market marker’s perspective |
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This fund manager’s market-making skills help him manage the risk of trading call spreads in the S&P 500 futures. By David Bukey |
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Options News CME, ICE sweeten their bids for CBOT . . . . . . . . . . . . . . . . . |
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After a counteroffer by the Chicago Mercantile Exchange, the IntercontinentalExchange responded with one of its own.
Dollar index trading goes electronic
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The New York Board of Trade’s U.S. dollar index futures contract will trade side-by-side with the pit-traded contract beginning June 15.
CBOE suit vs. ISE continues
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A judge denied a motion by the International Securities Exchange to end a lawsuit brought upon it by the Chicago Board Options Exchange.
continued on p. 4
June 2007 • FUTURES & OPTIONS TRADER
CONTENTS
USFE has new name, game
The United States Futures Exchange, formerly known as Eurex U.S., is again trying to gain a foothold in the U.S. derivatives market. By Jim Kharouf
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Futures Snapshot |
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Momentum, volatility, and volume statistics for futures. |
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Option Radar |
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Notable volatility and volume in the options market. |
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Key Concepts |
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References and definitions.
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Pattern analysis identifies a buying opportunity that captures some, but not all, of the May bounce in crude oil. |
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Options Trade Journal |
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Ignoring the Greeks leads to tragedy.
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June 2007 • FUTURES & OPTIONS TRADER
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CONTRIBUTORS CONTRIBUTORS
Jim Graham (advisor@optionvue.com) is the product man- ager for OptionVue Systems and a registered investment advisor for OptionVue Research.
Steve Lentz (advisor@optionvue.com) is executive vice pres- ident of OptionVue Research, a risk-management consulting company. He also heads education and research programs for OptionVue Systems, including one- on-one mentoring for intermediate and advanced traders.
Editor-in-chief: Mark Etzkorn metzkorn@futuresandoptionstrader.com
Managing editor: Molly Flynn mflynn@futuresandoptionstrader.com
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Volume 1, Issue 3. Futures & Options Trader is pub- lished monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright © 2007 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher.
The information in Futures & Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trad- ing idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.
Charlie Santaularia is managing director of Parrot Trading Partners, LLC (CPO/CTA). He holds a bachelor of arts in eco- nomics from the University of Kansas and has been actively trad- ing for the past four years. He has a NASD series 3 license and is charge of marketing, market research, and client contact, and
actively assists with trading decisions. In addition to writing a monthly newslet- ter for the firm’s investors, he has been published in industry magazines, http://www.stockweblog.com, and http://www.commoditytrader.com.
Thom Hartle (http://www.thomhartle.com) is director of marketing for CQG and a contributing editor to Active Trader mag- azine. In a career spanning more than 20 years, Hartle has been a commodity account executive for Merrill Lynch, vice president of financial futures for Drexel Burnham Lambert, trader for the
Federal Home Loan Bank of Seattle, and editor for nine years of Technical Analysis of Stocks & Commodities magazine. Hartle also writes a daily market blog called hartle & flow (http://www.hartleandflow.com).
Volker Knapp has been a trader, system developer, and researcher for more than 20 years. His diverse background encompasses positions such as German National Hockey team player, coach of the Malaysian National Hockey team, and pres- ident of VTAD (the German branch of the International
Federation of Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc. (http://www.wealth-lab.com), which he is still running.
Jim Kharouf is a business writer and editor with more than 10 years of experience covering stocks, futures, and options worldwide. He has written extensively on equities, indices, commodities, currencies, and bonds in the U.S., Europe, and Asia. Kharouf has covered international derivatives exchanges, money managers, and traders for a variety of publications.
John Larsen is the president of Wizetrade for Options trend recognition software and the chief options strategist for Wizetrade TV. His career as a trad- er and educator spans more than two decades, and he has traded equities and stock indices, fixed income and derivatives, currencies, futures, commodities and options. Larsen earned Series 3, 7, and 63 licenses and is a former member of the Chicago Board of Trade.
Advanced Option Pricing Models details specific conditions under which current option pricing models fail to provide accurate price estimates and then shows option traders how to construct improved models for better pricing in a wider range of market conditions.
The Bible of Options Strategies is the definitive reference to contemporary options trading: the one book you need by your side whenever you trade.
Stock Index Futures & 0ptions provides you with the professional know-how and critical overview both individual investors and pro- fessional traders need to break into trading indexes on every major stock market in the world.
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TRADING STRATEGIES
Opening gap short selling strategy
Trading the equity market from the short side requires skill. Keeping trades brief and small can pay off if you use an appropriate strategy.
BY FOT STAFF
G iven the stock market’s implacable upward drift, selling the stock mar- ket short is a tricky game. If you’re conservative, disciplined, and adept,
you can augment the more significant returns the long side of the market provides, but if you’re too aggressive or too complacent, you can decimate your trading account. The following analysis outlines an interesting idea for an intraday short-selling strategy that trades relatively infrequently (29 signals in the past three years) and uses the size of the opening gap to determine whether to take a trade. The study spans May 14, 1997 to May 16, 2007 and uses S&P 500 index (SPX) daily and intraday data.
TABLE 1 — INTRADAY PRICE ACTION AFTER OPEN 0.129 PERCENT OR MORE BELOW PREVIOUS CLOSE
When the S&P 500 opened 0.129 percent or more below the previous day’s close, the index closed below the open approximately 70 percent of the time.
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No. |
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patterns |
O - C |
Down/up |
C < O |
% C < O |
O - L |
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5-14-97 to 5-16-07 |
87 |
61 |
70.11% |
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Average |
7.51 |
4.01 |
1.16% |
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Median |
7.39 |
1.79 |
1.04% |
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Max. |
48.58 |
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Min. |
-21.55 |
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5-14-97 to 12-31-03 |
60 |
42 |
70.00% |
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Average |
8.90 |
4.59 |
1.34% |
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Median |
9.94 |
1.97 |
1.17% |
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Max. |
48.58 |
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Min. |
-21.55 |
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1-1-04 to 5-16-07 |
27 |
19 |
70.37% |
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Average |
4.41 |
2.33 |
0.74% |
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Median |
2.90 |
0.66 |
0.72% |
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Max. |
19.84 |
13.89 |
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Min. |
-8.06 |
0.31 |
Down but not out
If you come into each trading day flat and you want to take advantage of the day’s intraday trend, you need to determine the probabilities the market will move far enough in your direction after the open to make a trade worthwhile. Is there any way to determine from the size of the opening move when the S&P is most likely to trade lower during the ses- sion? There are any number of trade setups based on the size and direction of the move from yesterday’s close to today’s open — the “opening gap.” For example, depending on the approach, a large open- ing gap (given certain prevailing market conditions) might indicate the market has overextended itself on the open and is like- ly to reverse. In this case, we’ll analyze opening gaps to see whether down gaps — when the S&P 500 index opens below the previous
day’s close — offer any clues about the current day’s trend.
Eye on the opening
Given the stock market’s upward bias, it should come as no surprise that — despite the 2000-2002 bear market — only 1,202 of the 2,516 trading days from May 14, 1997 through May 16, 2007 (47.7 percent) closed lower than they opened. Similarly, of the 847 more recent trading days from Jan 2, 2004 through May 16, 2007, only 379 (44.7 percent) had clos- ing prices below the opening prices. Also, the S&P 500 opened below the previous close only 621 times (25 percent) in the May 1997 to May 2007 period. In other words, most of the time the S&P closed above its open — 52.1 percent of the time between May 14, 1997 to May 16, 2007, and 55.1 percent of the time from Jan. 2, 2004 to May 16, 2007 — and it opened above the previous close 75 percent of the time. Now consider what happens after a lower open. From Jan 2, 2004 through May 16, 2007, the S&P closed below its open 52.5 percent of the time when it opened below the pre- vious day’s close. This suggests that a lower open increases the odds of the S&P closing below that open for the day, although not dramatically. However, given the overwhelm- ing upward skew of the S&P’s day-to-day behavior, a sim- ple pattern with any correlation to downward price move- ment is worth investigating.
Comparing opening gap size
These statistics leave out a key consideration, though: the
size of the opening gap — that is, how far today’s opening price is below the previous close. Are downward opening gaps of a certain size — either large or small — more likely to be associated with larger intraday price moves, higher probabilities of certain price moves, or both? (The fact that electronically traded stock index futures do not have the same opening gaps as their corresponding cash indices will be addressed later.) Downward opening moves in the S&P ranged from -0.10 to -21.89 points over the 10-year analysis period. Because the S&P index more than doubled over this time span (mak- ing point-value comparisons from one period to the next misleading), Figure 1 translates these point values into per- centages of the previous closing price and charts them in an unusual way: The horizontal axis shows the size of the opening gaps (as positive numbers). The vertical axis shows the difference between the number of these days that closed higher minus the number of these days that closed lower. The smaller gap sizes correspond to a greater number of up-closing days before giving way to mixed results and, eventually, a clear prevalence of lower-closing days as the opening-gap size exceeds 0.129 percent. Table 1 details the intraday price moves that occur when the S&P 500 opens 0.129 percent or more below the previ- ous day’s close. The results are shown for the entire study period as well as for two sub-periods. From left to right, the columns in the table show:
continued on p. 10
• The number of patterns (no. patterns).
• The difference between the day’s open and its close
(O - C).
• The day’s ratio of down movement to up movement (down/up), which is the difference between the open and the low divided by the difference between the high and the open. This shows how much of the
day’s price action occurred in favor of a short trade on the open, and how much was against it.
• The number of times the close was below the open
(C < O).
The numbers show these lower opens offer potential intraday shorting opportunities — if you could enter at the day’s opening price. The S&P closed lower 70 percent of the time in all three observation periods and, with the excep- tion of the most recent January 2004 to May 2007 period, the average and median open-to-low moves were larger than 1 percent. The most recent period’s average and median open-to- low moves of 0.74 percent and 0.72 percent — along with a 0.66 median down/up ratio — hint the pattern has weak- ened.
• The percentage of times the close was below the open (% C < O).
• The move from the day’s open to its low, expressed as a percentage of the opening price (O - L).
Practical trading
Breaking down the statistics for days that open a certain amount lower than the previous close in the S&P 500 indi- cate favorable probabilities for intraday down
moves. There are more things to consider, how- ever, including potential slippage that would occur applying the pattern in the S&P futures or the S&P 500 index tracking stock (SPY). The futures, especially, may already have sold off before the cash market opens, which means the entry price might already be too low to capture further downside price action (which raises the possibility of buying these down moves in cer- tain circumstances). Also, this analysis did not consider the context in which this pattern appeared — e.g., the nature of the preceding price action, whether a signifi- cant piece of news accompanied any of the pat- tern days that were studied, and so on. Finally, only the simplest application of the pattern was considered, and no attempt was made to filter or otherwise improve the trade sig- nals (entries or exits), or explore different ways to take advantage of the information the study sup- plied. A basic way to trade the pattern might be:
Related reading
“Morning reversal strategy,” Active Trader, May 2003. Historical tests reveal the tendency of the major stock indices to revert to the previous day’s closing price in the early minutes of the trading session.
“Trading the overnight gap,” Active Trader, March 2001. With increasingly reactionary markets comes the higher risk of open- ing gaps. Learn how to spot the early warning signs and how to take advantage of them.
“Trading the opening gap,” Active Trader, December 2004. Watching pre-market volume is a good way to determine whether to trade or fade the opening move.
“Trading system lab: gap closer (stocks),” Active Trader, May 2003. Historical testing of a gap-based system.
“Trading system lab: gap closer (futures),” Active Trader, May 2003. The gap-based system summarized above is tested on a portfolio of futures markets.
(Note: The five preceding articles are included in the discounted arti- cle collection “Gap trading techniques: Five-article set.”)
“Filling in the gap picture,” Active Trader, November 2005. This article probes what happened after gaps in the S&P 500 tracking stock (SPY) over a 12-year period. (Note: This article is also part of the discounted article collection “Market Pulse: Stock market patterns and tendencies, Vol. 1.”)
“Gauging gap opportunities,” Active Trader, January 2007. “Filling In the Gap Picture” studied price gaps in the S&P 500 tracking stock (SPY) to see whether the market tends to continue to rally after up gaps and drop after down gaps. The S&P 500’s tendency to reverse direction following down gaps within downtrends leads to a new question: How does the market react after price gaps get filled?
You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm
1. Sell the S&P futures short when the S&P 500 index opens 0.129 percent or more below the previous day’s close.
2. Enter a buy stop-loss order x percent above the [open/previous close/previous high (etc.)].
3. Exit x percent below today’s open.
4. Exit any open positions at the close.
To see the realities of this strategy and its per- formance in the futures market, see “Intraday gap short” in the August 2007 issue of Active Trader (http://www.active- tradermag.com) and next month’s issue of Futures & Options Trader. As we shall see, trans- lating analysis from a cash index to a futures market changes results significantly.
TRADING STRATEGIES
Short-term crude oil tendencies
Crude can be a wild market, but understanding the typical price behavior of both the pit and electronically traded sessions will sharpen your trading strategies and skills.
BY FOT STAFF
T he crude oil market plays a pivotal role in
today’s trading world. No trader in any mar-
ket — stocks, bonds, or forex — starts out the
Although most people are aware of crude oil’s historic rise in recent years, few understand its day-to-day behavior. And considering the typical news story about the energy markets being driven higher by ongoing global economic expansion, continued Middle East tensions, and lack of refining capacity, just to name a few factors, oil has had quite a ride over the 12 months of this analysis. Crude oil futures rallied from around $65.00 in April 2006 to above $77.50 in July 2006, dropped to $50.00 in January 2007, and rallied back above $65.00 in
late March 2007. To understand the typical behavior of crude oil, we will analyze daily price action of the pit-traded NYMEX crude oil futures (CL) for the 12 months (248 trading days) beginning in April 2006 and ending in March 2007. Also, the study compares the pit-traded session to the electronic session (traded through the Chicago Mercantile Exchange’s Globex network) from September 2006 through March 2007, illustrating why it is critical for traders to pay attention to this market on a 24- hour basis. The price characteristics we will analyze include the size of daily ranges and daily net changes, the low- est the market tends to drop on days that close higher, and the highest the market tends to rally on days that close lower. Intraday analysis of crude oil prices (using the Globex contract) will identify the times of day crude offers
day without first checking the action in the
crude oil market. With electronic contracts at the New York Mercantile Exchange (NYMEX) and the IntercontinentalExchange (ICE) augmenting the NYMEX’s longstanding pit-traded crude oil futures, oil is tradable nearly 24 hours a day.
the most volatility. Figure 1 is a daily chart of the pit-traded crude oil contract (which trades from 10:00 a.m. to 2:30 p.m. ET) during the review period. Let’s look at what the daily ranges can tell us about how this market behaves.
Daily bar statistics
Figure 2 shows the daily ranges of the pit session, sorted from the smallest to largest. The smallest range was $0.50 and the largest was $3.10. The aver- age was $1.41 and the median was $1.31. The dif- ference between the average range and the median range indicates outliers — in this case, a relatively small number of exceptionally wide-range days — pulled the average range up. Next, frequency distribution analysis is applied to the daily ranges to determine how often ranges of different sizes occurred. Figure 3 displays the number of times the daily ranges fell within certain categories. In Figure 3, the horizontal axis repre- sents categories of daily ranges of different sizes. For example, the category labeled $1.10 (the third column from the left) is the number of daily ranges that were greater than $0.90 up to and including $1.10 (i.e., between $0.91 and $1.10). In this case, there were 42 daily ranges that met those criteria. Sixty-six percent of ranges fell into the $1.10 through $1.70 categories, which includes ranges from $0.91 through $1.70. The most occurrences (47) were in the $1.50 category, which contains daily ranges from $1.30 through $1.50. The daily range for the pit-traded session exceeded $1.90 only 15- percent of the time.
Close-to-close changes
Figures 2 and 3 give you an idea of what to expect within a given trading session. Figure 4 looks at what happens from session to session — that is, from close to close. This chart shows the distribu- tion of the pit session’s net closing changes. Sixty-one percent of the daily net changes were between a net loss of -$0.99 and a gain of $1.00 (the
continued on p. 14
Crude oil price behavior
Insights from analyzing crude oil futures from April 3, 2006 through March 30, 2007:
• The average daily range for the crude oil pit-traded session was
$1.41. Sixty-six percent of the daily ranges were between $0.91 and $1.70. The daily range exceeded $1.90 only 15-percent of the time.
• Sixty-one percent of the daily close-to-close changes in the pit- traded contract were between -$0.99 and $1.00. The contract
posted a close-to-close gain larger than $2.00 only five times (2 percent) and a close-to-close loss larger than -$2.00 12 times (5 percent).
• From Sept. 1, 2006 through March 30, 2007, 67 percent of the
time the Globex session’s low was between unchanged and a $0.69 loss for up-closing sessions. The market traded more than
-$1.00 down and still recovered to close up for the session only seven times (10 percent).
• On days the Globex session closed down, the high was between
$0.01 and $0.60 above the previous close 62 percent of the time
and was more than $1.00 above the previous close only five times (7 percent).
• In the Globex session from Sept. 1, 2006 through March 30,
2007 the 10 a.m. ET hour had the largest hourly range. This was driven by the release of the weekly crude inventories report each
Wednesday. The average hourly range for all 10 a.m. hours was $0.66 (median $0.64), while the 10 a.m. hours on Wednesdays produced hourly ranges with a low of $0.61 and a high of $1.26.
-$1.00 to $1.00 categories). The market closed with a gain greater than $2.00 only five times (2 percent) and closed with a loss of more than -$2.00 12 times (5 percent). The next sections analyze how far crude tends to decline intraday on days it closes higher and how much it tends to rally on days it closes lower. They paint a picture of a volatile market, prone to wide swings and intraday reversals.
Intraday lows on up-closing days
Knowing how much a market is likely to trade below its previous closing price but still close high- er on the day is useful information for a trader with an upside bias: If the market is initially down on the day, there may be a certain price level that rep- resents a low-risk entry point for a long trade. The market closed up 129 of the 248 pit sessions in the review period; the market was unchanged two times. Figure 5 shows the bars (pit sessions) of all up- closing days adjusted so each bar’s opening price is matched to the previous day’s closing price, which is represented by the zero line. There are several days when crude oil traded as much as $1.00 below the previous close but rallied to end the session in positive territory. However, there are also days when the low for the day was more than $1.00 above the previous day’s close. Figure 6 shows the frequency distribution analy- sis of the data from Figure 5. On up-closing days, the market trade in the red intraday before advanc- ing to close higher 82 times (63 percent). Crude oil was down $1.00 or more and recovered to close higher only nine times. On the other hand, the pit- session low was more than $0.50 above the previ- ous day’s close 10 times.
Electronic trading
Comparing the electronically traded crude oil mar- ket’s behavior is revealing. NYMEX products start- ed trading on Globex June 12, 2006. Crude oil futures trade on Globex from 6:00 p.m. ET Sunday
through 5:15 p.m. Friday, with a 45-minute break each day between 5:15 p.m. and 6:00 p.m. Figure 7 shows the adjusted daily ranges for up-closing sessions in Globex crude from Sept. 1, 2006 through March 30, 2007. The statistics change using the nearly 24-hour Globex trading data. Crude oil closed up 70 of the 145 sessions in the review period. The market traded below the previous
continued on p. 16
TRADING STRATEGIES continued
day’s close on 86 percent of up-closing days (60 times). A closer inspection of Figure 7 reveals an interesting phe- nomenon. The high for the day three from the right was more than $5.00 above the previous day’s close but the mar- ket fell back to close up only $0.02 for the session. This trading is not apparent in Figure 5 — it occurred only on the Globex session. This trading session was driven by rumors of escalating confrontations between Iran and the U.S. during the British soldier hostage crisis in late March. Figure 8 shows the frequency distribution for Figure 7’s data. The lows for up-closing Globex sessions are concen-
trated (67 percent) between unchanged and a loss of -$0.69 (the -$0.70 to $0.00 categories). Crude traded more than -$1.00 down and still recovered to close in positive territory just 10 percent of the time. Figure 9 is a chart of the Globex-traded crude oil. It underscores the importance of monitoring positions on a 24-hour basis.
Intraday highs on down-closing days
Figure 10 is the adjusted daily chart of the 12 months of pit-
session trading for down-closing days. Here we are analyzing the relationship between intraday highs to the previous day’s close. The market closed down 119 sessions. Fifty- seven percent of the time the market traded in positive territory, reversed, and then closed down. The market traded more than $1.00 above the previous close and still closed lower on the day only five times (4 percent). Figure 11 is the frequency distribution of the data from Figure 10. The two highest categories represent days with highs that were between $0.11 and $0.30 (the $0.20 and $0.30 categories) above the previous close that reversed and closed lower. This happened 26 times (22 percent of down-closing days). Figure 12 shows the adjusted bars for down- closing days using the Globex session price data from Sept. 1, 2006 through March 30, 2007. During these six months, the market closed down 74 times and the high was above the previ-
ous day’s close 68 times (91 percent of the time). Figure 13 is the frequency distribution of Figure
12.
On down-closing days, high was between $0.01 up to and including a gain of $0.60 (the $0.10 to $0.60 categories) 62 percent of the time. The high exceeded a gain of $1.00 and still closed down only five times (7 percent).
Intraday analysis
The intraday analysis uses 60-minute bars based on a 24-hour clock. The NYMEX crude oil con- tract on Globex trades from 6:00 p.m. ET Sunday through 5:15 p.m. Fridays, with a 45-minute break each day between 5:15 p.m. and 6:00 p.m. Figure 14 charts the 60-minute bars from the Feb. 1, 2007 through March 30, 2007 review peri- od. Figure 15 shows the average and median ranges for each hour. The Globex session’s hourly ranges expand noticeably when the pit session is
continued on p. 18
TRADING STRATEGIES continued
open. When the pit session is closed, the hourly ranges shrink by more than half. There is a steady climb to the 10 a.m. hour, at which point
the hourly ranges decrease for two hours, climb for the final two hours of the pit session, then steadily decline again for the rest of the Globex session. The hour with the largest range is 10 a.m., with an average range of $0.66 (median $0.64). Why is this hour, rather than the first hour of the pit session, the most volatile of the day? Every Wednesday at 10:30 a.m., the U.S. Energy Information Administration announces the weekly crude oil inventories and other key petroleum statis- tics. This report plays a big role in how traders view the current demand-supply equation driving the price of crude oil. Figure 16 shows the 10 a.m. hours for February
and March 2007. The red histogram bars are the Wednesdays of each week. These hourly bars ranged from $0.61 to $1.26; recall the average range for all hourly bars was $0.66 and the median was $0.64. This weekly inventory report can drive the hour range to nearly twice the average hourly range.
24-hour markets need watching
In addition to the summary provided in “Crude oil price behavior patterns” (p. 14), there are a few key points to take from this analysis. First, the review period was marked by a downtrend — something many pundits likely did not foresee. The point is, any market can go down. Performing this kind of analysis on a regular basis will help keep you on top of changing market environments and allow you determine whether the market is behaving within expectations. Also, it is helpful to look behind the numbers and understand what is causing certain market patterns, such as the spike in the 10 a.m. hour volatility trig- gered by the release of the weekly inventory report. Finally, like other markets, the coming of nearly 24-hour electronic trading is a very positive step by allowing traders to managing positions around the clock.
TRADING STRATEGIES
Playing defense:
Long puts vs. bear put spreads
Buying puts to protect a stock portfolio can be expensive. Instead, consider a bear put spread, which cuts costs and adds flexibility.
BY CHARLIE SANTAULARIA
I f you own a house or car, you (hopefully) own insur- ance to protect these assets. Buying insurance is a prudent decision, so why do most investors fail to protect their stock market portfolio, one of their
largest assets? Long-term investors assume the stock market will climb over time, so few plan to protect against losses in bear mar- kets. The buy-and-hold approach is reasonable over decades, but withstanding a 20-percent correction can be quite painful. To avoid losses, you can diversify by buying stocks in dif- ferent sectors so gains in one area of the market may offset
losses in another. This is helpful, but it won’t completely protect you against a widespread downturn. Options can insure your stock portfolio in a variety of ways. In theory, you could buy puts on all your individual stocks, but that can be tedious and expensive. Alternately, puts on stock indices can hedge an entire portfolio in one shot. The following discussion compares two protective put
strategies: long puts and bear put spreads (long put + short same-month, lower-strike put). Both approaches protect against loss without completely limiting potential upside gains. Buying puts can completely hedge a portfolio, but it isn’t cheap. A bear put spread is less expensive,
but it only protects against moderate losses. These examples use puts on E-Mini S&P 500 futures, but you can apply the same
principles to options on other stock index futures or standard indices. Try to use the
underlying sector or index that contains a
Strategy snapshot
Strategy: Portfolio hedging with long puts and bear put spreads.
Market: Options on major indices, stock index futures, or exchange-traded funds.
Rationale: Protect stock portfolio with index options. Balance risk and reward.
Market bias: Long put: Protect against steep decline.
Bear put spread: Protect against defined selloff.
Components: Long ATM or OTM put. To create spread, sell same-month put below long put. Downside protection increases as the distance between long and short strikes widens.
Maximum profit: Limited to a long portfolio’s gain minus the options’ cost. A long put costs more than a spread.
Maximum risk: Long put: Limited to market’s current value minus strike price. Protects completely below the strike.
Bear put spread: Limited to market’s current value minus long strike price. Additional losses possible if market drops below the short strike.
majority of your holdings.
Buying puts outright
The easiest and most popular way to pro- tect a portfolio is to buy puts on a major
stock index such as the S&P 500. This
sounds simple, but a few questions arise:
What are the costs and risks involved? What is the best strike price and expiration month? If the puts expire worthless, should
you buy more? To answer these questions, let’s first
assume you want to protect a portfolio of
stocks worth less than $100,000 against a market decline in the next 30 days. To sim- plify the math, these stocks will be repre- sented by the E-Mini S&P 500 June futures contract (ESM7), which traded around 1,450 on April 12. Therefore, the portfolio’s value is $72,500 (1,450 * $50 multiplier).
If you want to fully protect these stocks until May 18 expiration, you could buy an at-the-money (ATM) May 1,450 put. However, on April 12 it traded at $15 for a total dollar cost of $760 ($15 * $50 multiplier + $10 com- mission). To lower the cost, you could buy an out-of-the-money (OTM) put instead, which only protects against larger losses. Let’s assume you can handle losses of up to five percent but want protec-
tion if the market drops further. In this case, you would buy one 1,375 May put for $4.50 that is roughly 5 percent OTM and expires in 36 days. Including commissions, the put costs $235 ($4.50 * $50 multiplier + $10 com- mission). Note: In the futures mar- ket, always make sure you
trade options that are appro- priate to the underlying posi- tion’s contract month. For example, because there is no May E-Mini S&P 500 futures contract, May options are matched to the next available futures contract — June 2007. This example assumes your portfolio is worth $72,500, so you buy one put. In reality, you need to calcu- late how many puts to buy
for protection. To do this, divide the amount to be hedged ($72,500) by the S&P 500’s nominal value:
TABLE 1 — LONG PUT VS. BEAR PUT SPREAD
A bear put spread costs $52.50 less than simply buying the 1,375 long put, because the premium collected from the short 1,300 put offsets some of this cost.
|
No. of contracts |
Long/short |
Position |
Price |
Commission |
Cost |
|
Protective put: |
|||||
|
1 |
Long |
May 1,375 put |
-$4.50 |
-$10.00 |
-$235.00 |
|
Totals: |
-$4.50 |
-$10.00 |
-$235.00 |
||
|
Bear put spread: |
|||||
|
1 |
Long |
May 1,375 put |
-$4.50 |
-$10.00 |
-$235.00 |
|
1 |
Short |
May 1,300 put |
$1.25 |
-$10.00 |
$52.50 |
|
Totals: |
-$3.25 |
-$20.00 |
-$182.50 |
||
month, and car insurance can cost 0.66 percent of a car’s value per month.
$72,500 / $72,500 [1,450* $50 multiplier] = 1
Figure 1 compares the potential gains and losses of a portfolio that is protected with a long May 1,375 put (pur- ple line) to an unprotected portfolio (green line). If the mar- ket rallies in the next month, either scenario continues to profit; however, you give up the premium paid for the put ($235). If the market drops more than five percent, the pro- tected portfolio’s losses are limited to $3,985 (75 point drop * $50 multiplier + $235 put cost). But an unprotected port- folio could lose much more. Essentially, you have used 0.32 percent of the portfolio ($235/$72,500) to hedge a drawdown of more than five per- cent in the next 36 days. That premium seems reasonable compared to typical insurance costs. For example, home insurance can cost 0.05 percent of a home’s value per
To summarize, the steps for protecting your portfolio with puts are:
1. Calculate the total portfolio amount and the portion you want to protect. Then, calculate how many puts to buy.
2. Select the put’s strike price. If you want to completely protect your stock, buy ATM puts. If you can handle 5 (or 10) percent losses, buy puts 5 (or 10) percent below the market’s current value. Lower-strike puts cost less, but offer incomplete protection.
3. Determine how long you want to protect the port- folio (e.g., 30, 60, 100, or 150 days). Longer-dated options cost more.
continued on p. 22
Buying longer-term puts might be a better idea, because time decay doesn’t have an immediate effect on the put’s value. You will pay more initially, but longer-dated puts (i.e., nine months out) offer more bang for the buck and could benefit from a spike in volatility.
Bear put spread: lower cost, less protection
Entering a bear put spread is a cheaper way to hedge your
portfolio. The trade-off is the spread only offers partial downside protection. To add a bear call spread, sell a same- month put below the long one, which offsets some of the protection
costs. If the market continues to rally, your portfolio will gain more because of these lower costs. But if the market falls, the spread only pro- tects within a defined range between its long and short strikes. For instance, let’s assume you think the market could fall five to 10 percent within two months. You can handle a five-percent decline, and you don’t expect the market to drop more than 10 percent during this period. Buy the same May 1,375 put that is five percent OTM for $4.50 and sell a May 1,300 put that is 10 percent OTM for $1.25. Selling the 1,300 put lowers the entire position’s cost to $3.25 ($4.50 long put - $1.25 short put), or $182.50 total ($3.25 * $50 multiplier + $20 commissions). Table 1 compares the total costs of both protective strategies and shows the spread costs $52.50 less. Figure 2 compares the potential gains and losses of a portfolio with a bear put spread (blue line) to an unpro-
tected portfolio (red line) at May 18 expiration. This strategy limits potential gains and losses. If the market continues to rally, the portfolio’s gains are reduced by the spread’s cost ($182.50). In a bull market, a protected portfolio will lag the E-Mini S&P 500 futures by 0.25 percent ($182.50/$72,500), but that cost protects the portfolio from a drop of five to 10 percent in the next 36 days. If the market drops up to 10 percent to the 1,300 short strike, losses are lim- ited to $3,932.50 (75 point drop *
If the put expires or is exercised, should you buy more protection? It is a good idea to insure a stock portfolio on an ongoing basis, because a sell-off such as Feb. 27’s 3.94-per- cent drop in the E-Mini S&P 500 futures could form any time. Buying front-month puts can be useful, because you can adjust risk by selecting different strikes each month. However, this approach is expensive, because short-term puts include a large amount of time premium, which decays quickly.
TABLE 2 — LONG PUT DETAILS (AT MAY EXPIRATION)
Buying puts outright can protect a portfolio against large losses. The May 1,375 put costs $52.50 more than entering a 1,375/1,300 bear put spread, so it is only preferable if you expect a downturn of more than 10 percent.
|
Portfolio value |
Compare |
|||
|
S&P 500 |
Portfoilo |
Put |
(with put |
to bear |
|
move |
gain/loss |
profit |
protection) |
call spread |
|
10% |
$7,250.00 |
Expires worthless |
$79,515.00 |
-$52.50 |
|
5% |
$3,625.00 |
Expires worthless |
$75,890.00 |
-$52.50 |
|
0% |
$0.00 |
Expires worthless |
$72,265.00 |
-$52.50 |
|
-5% |
-$3,625.00 |
Expires worthless |
$68,640.00 |
-$52.50 |
|
-10% |
-$7,250.00 |
$3,500.00 |
$68,515.00 |
-$105.00 |
|
-15% |
-$10,875.00 |
$7,125.00 |
$68,515.00 |
$3,322.50 |
|
-20% |
-$14,500.00 |
$10,750.00 |
$68,515.00 |
$6,947.50 |
TABLE 3 — BEAR PUT SPREAD DETAILS (AT MAY EXPIRATION)
Adding a May 1,375/1,300 bear put spread to a portfolio is better than simply buying puts unless you want to protect against a large selloff.
|
Bear |
Portfolio value |
Compare |
||
|
S&P 500 |
Portfoilo |
put spread |
(with spread |
to put |
|
move |
gain/loss |
profit |
protection) |
protection |
|
10% |
$7,250.00 |
Expires worthless |
$79,567.50 |
$52.50 |
|
5% |
$3,625.00 |
Expires worthless |
$75,942.50 |
$52.50 |
|
0% |
$0.00 |
Expires worthless |
$72,317.50 |
$52.50 |
|
-5% |
-$3,625.00 |
Expires worthless |
$68,692.50 |
$52.50 |
|
-10% |
-$7,250.00 |
$3,552.50 |
$68,620.00 |
$105.00 |
|
-15% |
-$10,875.00 |
$3,750.00 |
$65,192.50 |
-$3,322.50 |
|
-20% |
-$14,500.00 |
$3,750.00 |
$61,567.50 |
-$6,947.50 |
ware, check out Schaeffer Research’s portfolio protection calculator in the Market Tools section (http://www.schaef- fersresearch.com). Although this Web tool uses the S&P 100 index (OEX) as the underlying asset, the same principles apply.
For information on the author see p. 6.
Related reading
Article by Charlie and Jes Santaularia:
“Another look at diagonal spreads,” Options Trader, March 2007. This position combines bullish and bearish diagonal spreads and is quite flexible if you’re willing to adjust its components.
Other articles:
“The collar trade,” Options Trader, March 2007. Collars offer low-cost protection for new or existing long positions.
“Using options instead of stops,” Options Trader, January 2007. Buying options in a volatile market limits risk and offers more flexibility than simply placing a stop order.
“The simplicity of debit spreads,” Options Trader, February 2006. Using spreads instead of buying options outright can reduce risk and increase opportunity. This discussion of “debit” spreads highlights their versatility.
“Controlling risks with spreads,” Options Trader, July 2005. Tired of fighting time decay and volatility fluctuations? Here’s a look at an option spread trade that was a much lower-risk alternative to an outright purchase.
“Hedging risk with collar trades,” Options Trader, April 2005. Collar trades can help reduce the risk of a stock or futures position — and lock in gains without wiping out additional profits.
You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.
$50 multiplier + $182.50 spread cost).
Which is the better hedge?
If you compare Figures 1 and 2, you will notice the trade-off between simply buying a long put and adding a bear put spread. The long put costs $52.50 more, because the spread lowers costs by selling a further OTM put. However, the
spread does not protect a portfolio completely if the market drops below its 1,300 short strike. You can modify both strike prices according to how much risk you are willing to take and how much you are willing
to pay for protection. This bear put spread offers 75 points of protection from 1,375 to 1,300, but you can protect from a steeper decline by selling puts below 1,300. As the distance between strikes widens, the spread offers more protection, but it costs more.
Dozens of software programs and Web-based tools can model theoretical positions, which is the best way to bal- ance risk and reward. The process resem- bles an insurance agent adjusting home- insurance premiums based on a home’s value, amount of protection, credit histo- ry, etc. Tables 2 and 3 compare both protec- tive strategies’ potential gains and losses at expiration, based on different percent- age moves in the E-Mini S&P 500 futures. Table 2 shows the long put limits losses to $3,985 if the market drops more than five percent. By contrast, Table 3 shows the bear put spread is only preferable if the market doesn’t decline more than 10 percent. Both strategies can be adjusted to pro- vide more or less protection, depending on which strikes you select. When just buying a put, pick the strike based on your risk tolerance. When adding a bear put spread, the level of protection depends upon the short put’s strike. The spread costs more when the short strike is further OTM. In both cases, the more you pay, the more protected your portfo- lio will be. The key to hedging a portfolio with options successfully is to research each position before you jump in. You don’t necessarily need software, but it helps. If your brokerage firm doesn’t offer soft-
TRADING STRATEGIES
The debit spread option
If some credit spreads are too high risk or not allowed by your options trading level, a debit bull call spread is a good alternative.
BY JOHN C. LARSEN
D ebit spreads, such as a bull call spread (buy- ing one call option and selling a higher-strike call option against it), are typically used by traders with an intermediate time horizon —
usually somewhere from 60 days to six months until expi- ration. The high premium paid for the long side of the spread, a strike at the money or slightly in the money, is par- tially offset by the credit received from the short side of the trade, an out-of-the-money strike. This creates a spread between the two strike prices, with the ultimate price objective for the underlying security being a move to or above the higher strike (over the next couple weeks or months, but well before the expiration date). The maximum gain for the spread is the difference
between the two strikes minus the net debit (cost) of the spread. As a rule of thumb, traders should look for spreads that cost around one-third of the difference between the two strike prices. The remaining two-thirds is the maximum profit potential at expiration if the stock is trading at or above the upper strike. This one-third, two-thirds relation-
ship offers an initial risk-to-reward ratio of approximately
2-to-1.
If the stock moves slowly higher over time, the long option appreciates and goes deeper in the money as its
intrinsic value increases, thereby driving its delta higher as well. The short option will also gain, but at a slower rate with the passage of time; it could maintain its value or even decrease in value as time decay, a change in perceived risk, or implied volatility puts a damper on any out-of-the- money options. This is a lower-risk way to trade higher- priced stocks that have higher volatility and higher-priced options. Some traders, however, will avoid this scenario because the options that make the most sense for it are too expen- sive. Naturally, the thinking would be that if these options are too expensive, they should be sold for some premium (i.e., a credit spread). Perhaps that is a better approach. However, some traders may not have the necessary level of options trading authorization from their broker to capitalize on credit spreads. Or, they might be intimidated by what is sometimes described as a higher-risk strategy. Here is the interesting part: Options traders
can and do capitalize on time decay, even though they are not implementing higher-risk strategies such as a front-month bull call spread. Being long premium (i.e., buying options) means the stock must move the trad- er’s way for the trade to profit. It would only make sense that a debit spread, such as the bull call spread, would also need directional price movement in the trader’s favor. However, front-month bull call spreads offer short-term swing traders opportunities to profit from an up move, a non-directional (sideways) move, or even a modest decline in the price of the stock.
Strategy Snapshot
Strategy: Bull call spread.
Market: Options on individual stocks, exchanged-traded funds, indices, and futures contracts.
Rationale: To benefit from time decay and offset the cost of buying an in-the-money call.
Time frame: 20 days until expiration.
Components: Long front-month in-the-money call.
Short front-month call with higher strike.
To select short strike, subtract weekly average true range (ATR) from current price. Buy call one strike below it.
Max. profit: Difference between the two strikes minus the spread’s cost.
Max. risk: The spread’s cost.
Options 101
All call option premiums are made up of two components: intrinsic value and time value. The intrinsic value of the call option is the pos- itive difference between the strike price of the
call and the current underlying stock price. For example, with the underlying stock trading at $39, a $35 call option has $4 of intrinsic value. This call may have, depending on its expiration date, a total premium of, say, $5.50. The other $1.50 is the time value component. The more days until expiration, the more time for the underly- ing stock to move, and the higher the option’s time value will be.
The intrinsic value of the call option is the positive difference between the strike price of the call and the current underlying stock price.
As time passes, the option may gain intrinsic value if the trader was correct about the direction of the market. However, some of its time value will be slowly eroding and that erosion will accelerate as expiration approaches. The rate of decay (theta) is not linear. The closer expira- tion draws near, the faster time value shrinks — typically, the final two to three weeks prior to expiration are the worst for time decay. At expiration, when there is no more time for the stock to move, the time value of the expiring option will be zero. However, that can be a good thing.
The front-month bull call spread
In this strategy, the trader buys a deep-in-the-money call option and sells a call one strike above it. Ideally, both are front-month options with less than 20 days remaining until expiration. The long call should contain very little time value (or at least less than the short option), so it needs to be deeper in the money. The short call is closer to the money, so it will contain more time value in its premium and there- fore have more to lose. The difference between those two amounts of time value is the potential profit for the trade. Determining which strike prices are best is a simple process. Calculate the average true range (ATR) for the stock on a weekly basis (i.e., the last five trading sessions). Subtracting this ATR from the current stock price should produce the short call’s strike price. The strike price one strike below the sell strike is the one to buy. The deeper in- the-money call option will have a higher premium, but it will also contain less time value than the cheaper short call
with a higher strike. As expiration draws near, the spread will move toward its maximum value. This occurs as time decay erodes both options. The long option will lose less value than the time- value-heavy short option, and therefore will produce the profit. A limit order to exit at a net credit 10 to 20 cents below the maximum value of the spread can result in an early exit with a tidy gain.
Basically, three things can happen with this trade:
The stock rallies and both call options move deeper into the money. As this occurs, both options will con- tinue to increase in intrinsic value and lose their time value. This is not because of the passage of time (loss of time value is, by definition, a function of the passage of time), but a result of moving deeper in the money. Deep in-the-money options inherently contain mini- mal time value, especially within the current expira- tion month. (While all options in a chain with the same expiration do not contain the same time value, ATM options contain the greatest amount, and as you go deeper in and deeper out it gets smaller.) The limit order to exit may be filled at this point, negating the need to hold the trade until expiration. If held until expiration, with the current stock price above both call strikes, both options would expire in the money. Assignment on the short side is offset by the long posi- tion, and a small assignment fee could be incurred from the broker. The spread at this point can be worth only the difference between the two strikes, and the debit to enter the trade was considerably less than that amount. This scenario results in a profit.
The stock trades sideways and both call options remain in the money. Both strikes did not change with respect to their intrinsic value, but they have lost all their time value because of time decay. The long call had less to erode than the short call. This is also a prof- itable scenario, by the same amount as the first sce- nario; it just takes a little longer.
The stock drops in value. The stock price can drop to the short call’s strike price and the spread would still realize its maximum profit as long as the stock remains
continued on p. 26
Related reading
“The hidden cost of credit spreads,” Options Trader, May 2006. Credit spreads are a popular way to collect premium, but traders often overpay for the long option part of the spread. However, it’s possible to find debit spreads with the same characteristics that offer less risk and more potential profit.
“The simplicity of debit spreads,” Options Trader, February 2006. Using spreads instead of buying options outright can reduce risk and increase opportunity. This discussion of “debit” spreads highlights their versatility.
“A lower-risk way to generate trading capital” Options Trader, November 2005. If you trade with limited capital, placing low-cost, low-risk option spreads could improve your odds of success. Bull put and bear call spreads, strangles, and butterflies help you take advantage of the market without excessive risk.
“Controlling risks with spreads,” Options Trader, July 2005. Tired of fighting time decay and volatility fluctuations? Here’s a look at an option spread trade that was a much lower-risk alternative to an outright purchase.
“Reducing risk with vertical spreads,” Options Trader, June 2005. Vertical spreads can help you sidestep the complications of changes in implied volatility.
You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm
“The hidden cost of credit spreads” article can be downloaded free at the International Securities Exchange’s Web site:
ference of $10. Their intrinsic value did not increase, as in the first scenario, but their time value eroded to zero as expiration drew near. So, no movement in the stock price also resulted in the spread going out to $10 and producing a $1 per contract gain — again, an 11-per- cent return.
above this level at expiration. The short strike was found by subtract- ing the five-day ATR from the cur- rent stock price; this should provide plenty of wiggle room for the stock. The stock can actually dip below that strike and the trader will still see some profit. The breakeven for the front-month bull call spread is the long strike price plus the debit or cost of the spread.
Trade example
Google (GOOG) is trading at $471.44 per share. The ATR on a weekly basis is a lit- tle less than $25 a week. There are 15 cal- endar days until the front-month options expire. Subtracting the $25 ATR from the cur- rent stock price of just more than $470 per share identifies $440 as the strike price for the front-month short call. The current premium of $35.10 indicates $3.66 of time value (440 + 35.10 - 471.44 = 3.66), which will continue to erode right up until expi- ration. The next-lowest strike is the 430 call, which becomes the long side of the spread. This option is quoted at $44.10, $2.66 of which is time value. The differ-
ence between the two time value compo- nents is $1. Subtracted from the spread, this creates a $9 value for the spread (Figure 1). The $1 difference is the maximum profit on the trade and will be realized at expiration as long as the stock is any- where above $440 (the short call’s strike). That represents a rate of return of more than 11 percent.
Scenario review:
The stock rallies into expiration. Both options have moved deeper in the money, lost all of their time value, and are now worth their intrinsic value only. The 430 call will naturally be worth $10 more than the 440 call, so the spread has unwound to $10. The long option lost only $2.66 to time but the short option lost $3.66. At expiration, regardless of how high the stock has gone in price, the spread will only be worth $10, but the trader paid $9 and therefore realized the maximum profit of $1 per contract, or 11 percent.
The stock trades in a range until expiration. After 15 days the stock price is basically unchanged. The two options are still in the money and will only be worth their remaining net intrinsic value, which will be a dif-
The stock drops. A $31 per share decline in the stock price still puts the stock just above the $440 strike and still offers the same return as the first two scenarios. A move below $440 is not the end of the world, as the real breakeven for the spread is its cost — $9 plus the long strike of $430. So any stock settlement on expiration Friday above $439 means some profit, just not the max- imum. A move below $439 should set off warning bells. It may be time to admit defeat and look for an exit.
The front-month bull call spread is a way for traders with a lower level of options trading approval to capitalize on time decay. It can be profitable if the stock goes up, down, or sideways.
For information on the author see p. 6.
FUTURES TRADING SYSTEM LAB
KAMA range trader
Market: Futures.
System concept: Like last month’s Futures Trading System Lab (“ADX Consolidation Breakout 1,” Futures & Options Trader, May 2007), this system focuses on trading the least interesting type of the market activity — the trad- ing range. It does this by executing short-term trades with a price pattern after a combination of indicators has identified suitable range-bound price action. Kaufman’s Adaptive Moving Average (KAMA) is a dynamic indica- tor developed by Perry Kaufman and described in his books New Trading Systems and Methods (Wiley, 2005). The KAMA adapts to market conditions by adjusting the moving average length when volatility increases or decreases. It is based on the premise that a noisi- er, more volatile market should be traded with a longer moving average length (a slower “trend speed”) to avoid unnecessary penetrations of the moving average. When volatility is lower, a shorter moving average length can be used. This system uses the rec- ommended initial look-back period of 10 for the KAMA. Figure 1 highlights one of the distin- guishing characteristics of the KAMA. While it effectively tracks trend moves, it also tends to flatten when price enters a consolidation. The exponential moving average (EMA) included for comparison in the chart is less stable when the market consolidates. A second indicator, rate of change (ROC), is applied to the KAMA to find its percentage change over the look-
PERIODIC RETURNS
|
Percentage |
Max |
Max |
|||||
|
Avg. |
Sharpe |
Best |
Worst |
profitable |
consec. |
consec. |
|
|
return |
ratio |
return |
return |
periods |
profitable |
unprofitable |
|
|
Monthly |
0.60% |
0.18 |
13.09% |
-9.94% |
55.83 |
7 |
6 |
|
Quarterly |
1.81% |
0.29 |
30.14% |
-11.19% |
60.49 |
7 |
3 |
|
Annually |
6.84% |
0.74 |
23.90% |
-10.35% |
76.19 |
5 |
2 |
back period. When the ROC of the KAMA is low (between -0.50 and +0.50), it indicates a pause in the trend. When these conditions are in place, the system attempts to enter long on short-term weakness or enter short on short-term strength. (The entry signal is derived from the “Oops!” method- ology made famous by Larry Williams.) Trades are closed when price penetrates the two-day high or low.
Strategy rules: If the five-day rate of change (ROC) of the 10-day KAMA is between -0.5 percent and +0.5 per- cent:
1. Enter long tomorrow with a stop at yesterday’s high if yesterday’s opening price was below the previous day’s low.
2. Enter short tomorrow with a stop at yesterday’s low if yesterday’s opening price was above the previous day’s high.
3. Exit long position with a stop at the lowest low of the past two days.
4. Cover short with a stop at the highest high of the past two days.
Figure 2 shows several representative trades.
continued on p. 30
STRATEGY SUMMARY
|
Profitability |
Trade statistics |
||
|
Net profit ($): |
2,720,860.15 |
No. trades: |
3,178 |
|
Net profit (%): |
272.09 |
Win/loss (%): |
37.35 |
|
Profit factor: |
1.191 |
Avg. profit/loss (%): |
0.15 |
|
Payoff ratio: |
2.00 |
Avg. holding time (days): |
3.85 |
|
Recovery factor: |
4.99 |
Avg. profit (winners) %: |
2.45 |
|
Exposure (%): |
2.23 |
Avg. hold time (winners): |
6.44 |
|
Drawdown |
Avg. loss (losers) %: |
-1.22 |
|
|
Max. DD (%): |
-22.00 |
Avg. hold time (losers) : |
2.30 |
|
Longest flat period: |
1,290 days |
Max consec. win/loss: |
10/17 |
LEGEND:
Avg. hold time — The average holding period for all trades. 
|
|
Avg. hold time (losers) — The average holding time for losing trades. 
|
|
Avg. hold time (winners) — The average holding time for winning trades. 
|
|
Avg. loss (losers) — The average loss for losing trades. 
|
|
Avg. profit — The average profit for all trades. 
|
|
Avg. profit (winners) — The average profit for winning trades. 
|
|
Avg. return — The average percentage for the period. 
|
Best return — Best return for the period. 
|
|
Exposure — The area of the equity curve exposed to long or short positions, as opposed to cash. 
|
|
Longest flat period — Longest period (in days) between two equity highs. 
|
|
Max consec. profitable — The largest number of consecutive profitable periods. 
|
|
Max consec. unprofitable — The largest number of consecutive unprofitable periods. 
|
|
Max consec. win/loss — The maximum number of consecutive winning and losing trades. 
|
Max. DD (%) — Largest percentage decline in equity. 
|
|
Net profit — Profit at end of test period, less commission. 
|
|
No. trades — Number of trades generated by the system. 
|
|
Payoff ratio — Average profit of winning trades divided by average loss of losing trades. 
|
|
Percentage profitable periods — The percentage of periods that were profitable. 
|
Profit factor — Gross profit divided by gross loss. 
|
|
Recovery factor — Net profit divided by max. drawdown. 
|
|
Sharpe ratio — Average return divided by standard deviation of returns (annualized). 
|
|
Win/loss (%) — The percentage of trades that were profitable. 
|
Worst return — Worst return for the period.
FUTURES TRADING SYSTEM LAB continued
Money management: Risk 1 percent of account equity per position.
Starting equity: $1,000,000 (nominal). Deduct $8 com- mission and 0.1 percent slippage per trade.
Test data: The system was tested on the Futures & Options Trader Standard Futures Portfolio, which contains the following 20 futures contracts: British pound (BP), soybean oil (BO), corn (C), crude oil (CL), cotton #2 (CT), E-Mini Nasdaq 100 (NQ), E-Mini S&P 500 (ES), five-year T-note (FV), euro (EC), gold (GC), Japanese yen (JY), coffee (KC), wheat (W), live cattle (LC), lean hogs (LH), natural gas (NG), sugar #11 (SB), silver (SI), Swiss franc (SF), and T- Bonds (US). The test used ratio-adjust- ed data from Pinnacle Data Corp. (http://www.pinnacledata.com).
Test period: May 1987 to April 2007.
Test results: The system generated a net profit of 272.1 percent — an annu- alized gain of 6.8 percent. Considering the extended (20-year) test period, the performance suggests the system is sta-
ble. Figure 3 shows the long and short components comple- mented each other, resulting in steady equity growth; the individual long and short maximum drawdowns occurred at different times (not shown). And at -22 percent, the sys- tem’s overall maximum drawdown was relatively moderate (Figure 4). The equity curve was very stable for the first 10 years of the test. There were only five losing years, and only two con- secutive losers (Figure 5). However, there were some weak points. The number of trades (3,178) was quite large, which means higher transac- tion costs could significantly degrade system performance. Also, although the average trade size (0.15 percent) was not too small, the low percentage of the winning trades (37.4 percent) weighed on performance and raises questions of trade efficiency. Figure 6 shows profits were not overly concentrated in a single market, although five of the portfolio’s 20 markets did account for the bulk of gains. Figure 7 shows the individual equity curve of the top-performer, live cattle (LC).
Bottom line: The system’s weak points (high number of trades and low winning percentage) were offset by steady
performance and low exposure (only 2.23 percent). Traders should certainly experiment with fine-
tuning the system’s entries and exits; doing so could make the system more appealing from a psychological stand- point. Another avenue to explore is using this system to complement a main- stream trend-following strategy — that is, to pick up the slack when the latter system is experiencing one of its inevitable extended drawdowns.
— Volker Knapp of Wealth-Lab
For information on the author see p. 6.
Futures Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see tested, please send the trading and money-management rules to editorial@activetra- dermag.com.
Disclaimer: The Futures Lab is intended for edu- cational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guar- antee future results; historical testing may not reflect a system’s behavior in real-time trading.
OPTIONS TRADING SYSTEM LAB
Trading iron condors with the ADX
Market: Options on the S&P 500 (SPX) and Russell 2000 (RUT) indices. The strategy could also be applied to other indices, ETFs, and stocks with liquid options contracts.
System concept: Over the past year, several Options Labs have tested market-neutral strategies such as iron con- dors, iron butterflies, calendars, and double diagonal spreads on the S&P 500. Although these strategies have been profitable since 2001, the positions were always in the mar- ket, a potential drawback for trades that attempt to capture time decay in flat markets. This system tests non-directional iron condors with a dif- ferent approach. Instead of entering positions in any market, it uses the Average Directional Movement Index (ADX) to find flat markets. The ADX is an oscillator that ranges between 0 and 100 and is designed to measure whether a price is trending without regard to the direction of the trend. Last month’s Futures Lab used the ADX to find price breakouts. Here, the system only places iron condors on the S&P 500 and Russell 2000 indices whenever the ADX drops below 20, a low reading that points to a sideways market. The goal: Stay out of trending markets to reduce the possi- bility of losses. An iron condor contains two vertical credit spreads: a bear call spread (short out-of-the-money [OTM] call + long, high- er-strike call) and a bull put spread (short OTM put + long, lower-strike put). This position tries to exploit the short options’ time decay and collect premium if the market stays
Trade rules:
within one standard deviation of its entry price by expiration. The OTM short call and put have strikes that are one standard deviation above and below the market’s current price, and the long protective options are 10 points further OTM. All four options are entered in the first available expira- tion month with at least 24 days until expiration. The entire position is a credit spread, because you receive more premium for selling options closer to the money than it costs to buy further OTM options to pro- tect them. This trade has defined risk, so you can only lose a certain amount even if the markets are volatile. The spread requires margin, which varies among bro- kers. Most brokers require only the maxi- mum possible loss (strike-price difference - credit received) as margin, but some bro- kers require twice as much capital.
Figure 1 shows the potential profits and losses of an iron condor entered on the S&P 500 index on Dec. 26, 2006 and held until Feb. 16, 2007. The figure’s shad- ed area represents the first standard deviation of the S&P 500 index’s expected moves, which means the S&P 500 should trade within this price range 68 percent of the time by the Feb. 16 expiration date. Although this iron condor has a 66-percent chance of gains, it has an unfavorable risk-reward ratio. Its maximum potential loss (and required gross margin) is $806, but its maximum potential gain is just $206 if held until Feb. 16 — a risk/reward ratio of nearly 4:1.
Entry 1. Enter an iron condor on the close if the 14-day ADX drops below 20.
2. To create an iron condor:
A. Sell an OTM call and put at the first strike price above and below the first standard deviation. This standard deviation is calculated using the implied volatility of the second month’s at-the-money (ATM) call, which is the nearest call with the highest time premium.
B. Buy a call and put 10 points further OTM than the short strikes.
STRATEGY SUMMARY
|
S&P 500 |
Russell 2000 |
||
|
Overall |
only |
only |
|
|
Net gain ($): |
2,256.00 |
858.00 |
1,398.00 |
|
Percentage return (%): |
75.2 |
||
|
Annualized return (%): |
12.4 |
||
|
No. of trades: |
37 |
21 |
16 |
|
Winning/losing trades: |
26/11 |
14/7 |
12/4 |
|
Win/loss (%): |
70 |
67 |
75 |
|
Avg. trade ($): |
60.97 |
40.86 |
87.38 |
|
Largest winning trade ($): |
276.00 |
276.00 |
236.00 |
|
Largest losing trade ($): |
-338.00 |
-338.00 |
-283.00 |
|
Avg. profit (winners): |
190.08 |
196.36 |
182.75 |
|
Avg. profit (losers): |
-244.18 |
-270.14 |
-198.75 |
|
Avg. hold time (winners): |
39 |
39 |
38 |
|
Avg. hold time (losers): |
27 |
28 |
25 |
|
Max consec. win/loss: |
6/2 |
4/2 |
4/1 |
LEGEND:
Net gain – Gain at end of test period, less commission
Percent return – Gain or loss on a percentage basis. 
|
|
|
Annualized return – Gain or loss on an annualized percentage basis. 
|
|
|
No. trades – Number of trades generated by the system 
|
|
|
No. of winning trades – Number of winners generated by the system 
|
|
|
No. of losing trades – Number of losers generated by the system 
|
|
|
Win/loss (%) – The percentage of trades that were profitable 
|
|
|
Avg. trade – The average profit for all trades 
|
|
|
Largest winning trade – Biggest individual profit generated by the system 
|
|
|
Largest losing trade – Biggest individual loss generated by the system 
|
|
|
Avg. profit (winners) – The average profit for winning trades 
|
|
|
Avg. loss (losers) – The average loss for losing trades 
|
|
|
Ratio avg. win/ avg. loss – Average winner divided by average loser 
|
|
|
Avg. hold time (winners) – The average holding time for winning trades 
|
|
|
Avg. hold time (losers) – The average holding time for losing trades 
|
|
Max consec. win/loss – The maximum number of consecutive winning and losing trades
C. All options are the same month with at least 24 calendar days until expiration.
Exit the entire position if price touches one of either short strike. Otherwise, let all four options expire worthless.
Test details:
• The test account began with $3,000 in capital.
• Daily closing prices were used.
• Trades were executed between the bid and ask, when available. Otherwise, theoretical prices were used.
• Commissions were $5 base fee plus $1 per option.
Test data: The system was tested using cash-settled S&P 500 (SPX) and Russell 2000 (RUT) index options at the CBOE.
Test period: Jan. 18, 2001 to Feb. 16, 2007.
Test results: Figure 2 shows the iron condor’s per- formance, which gained $2,256 (75.2 percent) over the five-year test period. The system had an unfavorable risk-reward ratio and didn’t consider the effect of volatility when placing trades. However, it still gained ground because 70 percent of all trades were winners. The Strategy Summary table shows overall test results and also breaks down profits by market. The Russell 2000 accounted for more than two-thirds of all profits, while the S&P 500 gained just $858. The ADX system only entered iron condors on the S&P roughly four times per year but its performance was similar to the standard approach (see the January 2007 issue of Options Trader).
Bottom line: The system’s average loser (-$244.18) was larger than its average winner ($190.08). However, this strategy had a definite trading edge, especially in the Russell 2000. Finally, this test included minimal commissions, but larger fees and bad fills will likely affect performance.
— Steve Lentz and Jim Graham of OptionVue
Option System Analysis strategies are tested using OptionVue’s BackTrader module (unless otherwise noted).
If you have a trading idea or strategy that you’d like to see tested, please send the trading and money-management rules to Advisor@OptionVue.com.
TRADER INTERVIEW
Yehuda Belsky:
A market maker’s perspective
This options trader explains why call spreads may offer better opportunities than put spreads.
BY DAVID BUKEY
Y ehuda Belsky understands how options behave. After starting his career as a stock broker at Prime Charter in 1993, he took a job as a clerk for Timber Hill Group (now
Interactive Brokers), one of the largest options market-mak- ing firms. In 1995 Belsky, 35, bought a seat on the American Stock Exchange (AMEX) and became an independent
options market maker, taking the other side of retail cus- tomer trades while trying to hedge his positions quickly and efficiently. The experience was invaluable, because it taught Belsky to offset risk, and it also helped him realize that markets placing directional bets could lead to trouble. “As a market marker, I traded around an option’s fair value,” he says. “I didn’t have any directional opinion.” This mindset was much different from investors who got
caught up in the tech bubble in the late 90s and lost money when stocks fell sharply in 2000 and 2001. But he has used different approaches over the past six years. Belsky left the options pit and became a commodity trading advisor (CTA) in May 2001. Initially, he used a directional, momentum-based approach to trading stocks, but the results were mixed. After a 12-percent drawdown in 2003, Belsky revamped his strategy and traded various options spreads for Tradewise Associates, a commodity pool that gained 14.94 percent from March 2004 to April
2005.
“I vowed to stick to what I know and what makes more sense — profiting from [spreads with] favorable probabili- ties,” he says.
In December 2005, Belsky founded Innovative Capital, a managed futures program. He began trading iron condors, a market-neutral position that combines bear call and bull put spreads and gains
ground if the underlying market doesn’t move sharply in either direction by expi- ration. The fund traded options profitably on S&P 500 futures (Figure 1). However, Belsky soon focused on call credit spreads, because the calls’ implied volatility skew helped him capture pre- mium as expiration neared. He sells calls with higher implied volatility and buys further out-of-the-money (OTM) calls with lower implied volatility to protect them. He then hedges any directional risk with a debit spread in later-expiring calls. Innovative Capital recently began trad- ing a combination of call credit and debit spreads exclusively and no longer trades puts, so there is no downside risk. Although you won’t find this unusual approach in textbooks, it gained 9.89 per- cent from January to April 2007 (Figure 2). We spoke with Belsky in late May about his previous role as an options market
n’t time to research the best solution. Hedging delta (directional risk) by buying or selling stock was the first task. A better way to hedge is to trade a similar option. For example, if you buy an out-of-the-money call with X deltas, it is more effective to sell a call two or three strikes above or below it to create a vertical spread. Both options share common characteristics — implied volatilities
maker and his program’s approach.
FOT: Could you describe your role as an options market maker in the late 90s? I assume you were trying to buy at the bid and sell at the offer while hedging your directional risk. How did you do that? YB: At the American Stock Exchange, market makers assist a specialist who trades specific products — individual stocks and their options. Specialists are obligated to provide a two-sided market (bid and offer) in any option on their assigned stocks. A broker can walk into the pit with an order of any size on any strike. Also, many multi-contract positions — vertical spreads, straddles, and strangles — are quoted at one price. There are more exotic combinations, from buying one option and
selling another to buying a pair and selling
a third one. The possibilities are almost
limitless. Market makers stand in the pit and also make a two- sided market. We helped the specialist accommodate larger orders. Sometimes we thought a specialist’s price was too high or low, and we traded against him. For instance, if a specialist quotes a bid at $2.00 and an offer at $2.25 and I felt that was too cheap, I could quote $2.25 (bid) and $2.50 (offer).
FOT: Did you focus on specific stocks? YB: I moved around, but I traded options on Philip Morris (MO), Lucent Technologies (now Alcatel-Lucent, ALU), America Online (AOL), and the Nasdaq 100 tracking stock (QQQQ), all of which traded heavily. I worked at the height of the technology bubble when the Qs traded above $200 per share. That was exciting.
FOT: Let’s talk a bit more about the mechanics of being a market maker. For instance, if you bought calls at the bid, would you sell stock to hedge the directional risk and then sell calls above the long strike to neutralize the risk of the Greeks (delta, gamma, theta, vega, rho)? YB: At any time, a market maker needs to buy or sell a sig- nificant amount of contracts, which was an invaluable learning experience. The options aren’t always the same — deeply in-the-money or out-of-the-money, front month or far month. You constantly have to be on your toes and understand the sensitivities of each option.
Of course, there is always delta risk. If you bought a call
it has long delta, and if you sell a call it has short delta. But
there are minute differences, especially between expiration months. Also, skews appear when the option is in- or out- of-the-money. These trades weren’t planned, so hands-on hedging was required. Suddenly a broker could offer a two-year option that was far out-of-the-money, and I could trade 25, 50, or 100 contracts. I had to hedge appropriately, and there was-
As a market marker, I traded around an option’s fair value — I didn’t have any directional opinion.
and time to expiration. The busiest time was when there was “two-way paper.” A broker would hit our bid, and another broker was taking an offer, which fit us perfectly. We bought one and sold the other to create the best type of hedge — a spread instead of trading the stock. That spread would also offset the delta risk, which is the main reason market markers trade stock.
FOT: When you first started as a market maker, were there times when an option’s behavior surprised you? YB: There were two events. First, in 1997, the government was suing Phillip Morris (to recoup health-care costs related to tobacco use), and the stock was very sensitive to verdicts. An adverse ruling would send the stock down a lot. In April 1997, we got orders to sell Philip Morris calls, which looked cheap. Brokers were willing to sell to us even below our bid, which seemed great. Usually, they try to sell between the bid and ask, and we often paid a few ticks more than our bid. But no one was buying calls, so we couldn’t
continued on p. 36
TRADER INTERVIEW continued
offset risk with a spread. We could have sold stock, but the stock fell sharply when the jury handed down its verdict. Many market makers were left with unhedged long calls. Lucent Technologies was another example of a one-way market. After it went public in 1998, Lucent’s stock price nearly doubled in a short amount of time. Market makers sold calls they thought were overpriced, but they couldn’t create a spread (i.e., buy higher-strike calls) or buy stock as a hedge at a decent price. Acting as a market marker in a one- sided environment isn’t always fun and games.
Selling options seems easier than it is. It might take a long time, but you’ll eventually get hurt by an extraordinary market move.
FOT: Did the market downturn that began in 2000 take you by surprise? YB: No. Technology stocks were shooting higher and high- er, but I thought they would eventually run out of steam. From a mathematical standpoint, market makers empha- size the theory of efficient markets: At any given time, the market is priced efficiently. If you consider time and volatil- ity, markets have probabilities of where they can move. But we don’t expect any specific direction. As stock moved more wildly in the late 90s, our volatili- ty assumptions increased, but we were neither bullish nor bearish. We considered each day’s closing price as an effi- cient absolute value. Stocks surged and then fell sharply in 2001, but we just took that in stride. That attitude plays a big role in how I trade today. When clients ask where the market is going, the best answer I can give is “I don’t know, because it’s efficiently priced.” That [neutral] mindset and my skills in offsetting risk help me most when trading now.
FOT: Why did you decide to become a CTA in 2001? YB: Exchange seats on the AMEX lost more than 90 percent of their value that year when all equity products were “dually listed” and traded simultaneously on all four national options exchanges (AMEX, the Chicago Board Options Exchange, the Philadelphia Stock Exchange, and the International Securities Exchange). Also, stocks and options began trading in decimals, and retail interest fell as technology stocks collapsed. At that point, two-way markets that were easy to hedge became one-way markets of professional orders that market makers couldn’t benefit from.
FOT: I noticed you had some losses in 2003 after you start-
ed trading your own account. Did that experience lead to any changes in your strategy? YB: I wasn’t trading options spreads then. One popular strategy involved finding stocks with momentum — I was [trading directionally]. I succeeded for awhile, but I found that when you are wrong on direction, you can be very wrong.
FOT: Did you start trading options spreads again when you joined Tradewise Associates as a CTA in 2004? YB: Actually, I began trading ratio spreads (long one option, short multiple further-OTM options). These spreads were attractive because you receive premium while keeping the position balanced. But they have risk on one side, and I grew uncomfortable with the risk of an extreme move. After founding Innovative Capital in December 2005, I traded iron condors on the S&P 500 futures. The strategy combines a bull put spread below the market and a bear call spread above the market. In January, I began to focus on trading call spreads only. There were more opportuni- ties trading calls above the market than trading puts below it.
FOT: Why did you stop trading puts and focus on call spreads? YB: Further out-of-the-money puts have higher implied volatilities, so put credit spreads (short put, long lower strike put in same month) offer less premium. You sell a put at one implied volatility and buy a lower-strike (and cheaper) put. However, the long put has a higher implied volatility than the one you sell. In other words, the long protective put’s cost is closer to the short put’s premium, which is a prob- lem. Also, I don’t want downside risk. Investors have enough downside risk in other investments. My fund doesn’t par- ticipate in a downward market. If the market goes down one, five, or 50 percent, it doesn’t matter to us. But on the call side, implied volatilities drop as you look further out-of-the-money and as the front-month expira- tion nears. You can enter a call credit spread by selling one out-of-the-money strike and buying higher-strike call at a lower volatility. The goal is to capture the discrepancy between both calls’ implied volatility. But that spread has upside direc- tional risk, so I enter a call debit spread (long call, short high- er-strike call) in the next month where the skew hasn’t appeared yet. Ideally, I can sell a front-month credit spread for the same amount that the next-month’s debit spread costs. Both call spreads move in tandem and are near delta- neutral. The position is hedged directionally and provides positive theta (i.e., time decay helps). That’s very similar to an ideal market marker position.
FOT: I thought puts had the largest implied-volatility skew
in the S&P 500 because investors are willing to pay more for downside protection. By contrast, S&P 500 calls have seemed relatively underpriced. Has that dynamic changed? YB: No. That’s true. I’m just exploiting volatility in a better way. Calls are underpriced, but to varying degrees. I’m sell- ing a slightly underpriced call and buying a much more underpriced one. Let’s assume all September options in the S&P 500 futures trade at 15 percent implied volatility. When expira- tion is within 30 days, at-the-money calls might trade at 15 percent implied volatility, and calls that are three and five percent out-of-the-money might trade at 12 and 10 percent implied volatility. When entering the front-month spread, the higher-strike calls I buy have already lost more volatili- ty than the lower-strike ones I sell.
FOT: And how does the next-month debit spread protect it? YB: I enter the entire position at no cost. The credit spread pays for the next-month’s debit spread. Then, if the short- term spread expires worthless, you can sell the debit spread, which is pure profit.
FOT: The S&P 500 has rallied sharply and is flirting with record highs. Are your call spreads vulnerable? YB: The goal is for both spreads to move in tandem until the front month expires and I exit the next-month’s debit spread.
FUTURES & OPTIONS TRADER • June 2007
The value of an option is exactly what traders are willing to pay for it. You’re not getting any free lunches.
Overall, the position has positive theta. The front-month credit spread loses value each day. The later-expiring debit spread also decays a little bit, but not as much because of the extra time. At a certain point — usually when the market moves above the near-term spread’s strikes — they still move together, and I haven’t lost any money. When a front-month spread goes into the money, theta will work against me, which means I pay a debit on a daily basis. That’s when I want to get out. I exit when the overall position’s theta turns from positive to negative; its risk- reward ratio has shifted.
FOT: Is that a good stop-loss point? YB: It doesn’t always avoid losses. But the overall spread is usually trading near its entry price, which means I can get out near the break-even point.
FOT: How do you select strikes for both spreads? Are the back-month’s debit spread’s strikes above the correspon- ding credit spread’s strikes? YB: They often are. But both spreads aren’t always a spe- cific distance above the market, and the distance between each spread’s short and long strike isn’t always the same.
FOT: I read that you focus on statistics to pick strikes. Is that simi- lar to saying, “Okay, the market trades within three standard devia- tions of the current price, so let’s try to sell strikes far above the market?” YB: No. That works if you want to sell uncov- ered calls and you want to feel safe the market isn’t going to climb to that point. But that’s not our approach. We focus on the combined posi- tion. What are the odds
continued on p. 38
37
TRADER INTERVIEW continued
Related reading
“Trading against the pros,” Options Trader, November 2006. Understanding how market makers manage risk may help you get better fills.
“The hidden cost of credit spreads,” Options Trader, May 2006. Credit spreads are a popular way to collect premium, but traders often overpay for the long option part of the spread. However, it’s possible to find debit spreads with the same characteristics that offer less risk and more potential profit.
You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.
The credit spread article can be downloaded free at the International Securities Exchange’s Web site: http://www.iseoptions.com/education/ise_education.asp
traded at 1,510, and we sold the June 1,540/50 credit spread (short 1,540 calls, long 1,550 calls). We also entered a debit spread in July calls with higher strikes. By May 21, the S&P 500 rose from 1,510 to 1,534, and both spreads rose in value (hurting the June credit spread and helping the July debit spread). So the position was still flat (Figure 3). We weren’t betting on the market running out of steam. If the market rallies past 1,550, that would probably trigger an exit, and the position would likely break even.
of the front-month spread expiring profitably? Selling options seems easier than it is. To just establish parameters and say the market is not likely to get there is dangerous. It’s fine as long as the mar- ket doesn’t move to that point. It might take a long time, but you will eventual- ly get hurt by an extraordinary market move. The value of an option is exactly what traders are willing to pay for it. You are not getting any free lunches.
FOT: What is an ideal market for this
strategy — bullish, bearish, or flat? YB: The program’s largest profits occur when the S&P 500 is flat or rising slightly. The front- month credit spread should expire worthless, and the next- month debit spread should be worth as much as possible. However, a down market doesn’t hurt the strategy. The debit spread won’t be worth as much, but it will always have some value.
FOT: Can you give an example of a recent trade? YB: A few weeks ago, the S&P 500 June futures contract
INDUSTRY NEWS
Disagreements in the ranks
CME, ICE sweeten their bids for CBOT
C hicago Board of Trade (CBOT) Chairman
Charles Carey was confident the CBOT’s “merg-
er” with the Chicago Mercantile Exchange
(CME) was all but wrapped up after the CME raised its bid in May. However, while the new proposal was endorsed by the CBOT’s board of directors, many CBOT shareholders may not be so easily persuaded. The new bid increases the CME’s offer to about $9.9 billion — about a billion dollars more than its original bid, but still more than a billion dol- lars less than the bid made by the IntercontinentalExchange (ICE) in March. And, the ICE sweetened the pot in late May when it struck a deal with the Chicago Board Options Exchange (CBOE) that would give CBOT members $500,000 in exchange for their CBOE trading rights. CBOT claims its members are eligible to benefit from the upcoming CBOE IPO because members have always had trading rights at the CBOE. (The CBOE was originally a spin-off from the CBOT.) The CBOE claims that when the CBOT enters a merger deal with the Merc, it no longer exists in its original form and therefore cannot participate in the CBOE IPO. The ICE-CBOE agreement, which will only occur if the CBOT takes the ICE offer, could end any angst CBOT members have about trading rights. Still, Carey says he and the board of directors believe there is more security in an all-Chicago deal and the Merc is better-equipped than the ICE to handle such an enormous merger. Also, the CME and the CBOT already use the same clear- inghouse. The ICE uses the New York Board of Trade clear- inghouse, and there is some question regarding the NYBOT system’s capacity. Nonetheless, there is still considerable opposition to the deal outside the boardroom. For starters, some CBOT members aren’t convinced the CME and CBOT have completely resolved issues with the Department of Justice (DOJ), which announced it was investigating the merger and had some concerns about clearing. However, CME and CBOT executives say they are
not worried about interference from the DOJ. Regardless, the opinion of the CBOT board of directors — members who have been with the exchange for years and see the merger as a way to keep Chicago as the premier derivatives marketplace in the world — won’t mean much to a hedge fund manager in Connecticut who owns several thousand shares of CBOT stock and is only concerned with which deal will provide the higher price. Plus, some CBOT members who are also shareholders believe the CME is vastly undervaluing the exchange. In April, Eurex paid an almost 50-percent premium to buy the International Securities Exchange. The offer presented by the CME is nowhere near that much of an upgrade from the current CBOT stock price. “The word on the floor is that they are trying to low-ball us again,” says one CBOT member. “People are upset that not only is the Merc not paying market price, but they are paying below market. So they’ve not endeared themselves to the people who have the most amount of votes.” Another longtime member says the Merc has annoyed many CBOT shareholders by taking measured steps in countering the ICE bid, rather than coming back strong with an offer of a share ratio around 0.40 CME shares per CBOT share. “The burden is on the Merc to get the votes because it’s a political issue now,” he says. “The political issue is going to rise or fall on the ratio and how that translates into the stock price. The general tone is that the current ratio at 0.35 is just not enough.” The CBOT has a member and shareholder meeting sched- uled for July 9, and a vote will take place on the CME offer. For its part, the CME added another carrot to sharehold- ers, offering to buy back up to $3.5 billion of stock, or 12 percent of outstanding shares, for $560 per share. CME shareholders and current CBOT shareholders who would become CME shareholders under the deal would be eligible to sell their stock under the tender offer. The buyback offer replaces a $3 billion feature of the orig- inal proposal that offered some CBOT shareholders cash instead of CME stock.
Less holler for the dollar
Dollar index trading goes electronic
T he electrification of the New York Board of Trade
(NYBOT) by its new owners, the Intercon-
able electronically over the next few months. NYBOT soft commodity futures — cocoa, coffee, cotton, orange juice, and sugar — began trading side-by-side in early February. About 60 percent of the NYBOT’s soft con- tracts trade electronically.
Right vs. right
CBOE suit vs. ISE continues
T he Chicago Board Options Exchange (CBOE)
scored a victory over the International Securities
Exchange (ISE) in May when a state court refused
to dismiss the CBOE’s lawsuit against its rival.
The CBOE filed suit against the ISE in 2006 when the lat- ter began trading S&P 500 and Dow Jones Industrial Average index options. The CBOE claimed the ISE’s action violated the exclusive agreement the CBOE
had with the two index providers. The ISE sought to have the suit dis-
missed, but an Illinois court sided with the CBOE.
“ We believe the attempt to trade these
products without a license — essentially to free ride on CBOE’s enormous investment in creating these products — is a disincen-
tive to innovation,” said CBOE Chairman
and CEO William J. Brodsky in a statement.
“We are prepared to vigorously defend our
contractual rights with the owners of these
indices, Standard & Poor’s and Dow
Jones.”
The CBOE filed the lawsuit in Illinois
state court, but the ISE had it moved to
Illinois federal court. However, the federal
court ruled the case should be moved back
to state court, because there is no federal jurisdiction over the claims. “It has been CBOE’s firm view that Illinois state court is the appropriate forum in which to litigate this dispute, and we are gratified by today’s decision,” Brodsky says.
tinentalExchange (ICE) continues.
The ICE announced it would begin trading certain index futures contracts — including U.S. dollar index futures (DX) — electronically beginning June 15. Russell 1000 futures stock index futures, both full-sized and mini, will also trade electronically on the ICE platform. Electronic trading hours will begin at 8 p.m. ET and end at 4:15 p.m., allowing these futures to trade side-by-side with their pit-traded counterparts. The electronic trading has been in beta mode since March 16, with brokers, software and data vendors, and algorith- mic traders testing the system. Tom Farley, president and COO of the NYBOT, says there has been strong interest in trading the dollar index and the Russell 1000 futures electronically, and the exchange expects to increase the number of financial products avail-
MANAGED MONEY
Top 10 option strategy traders ranked by April 2007 return (Managing at least $1 million as of April 30, 2007.)
|
2007 |
|||||
|
April |
YTD |
$ under |
|||
|
Rank Trading advisor |
return |
return |
mgmt. |
||
|
1. CKP Finance Associates (LOMAX) |
14.21 |
11.58 |
7.4M |
|
|
2. Financial Comm Inv (Option Selling) |
7.10 |
8.72 |
14.1M |
|
|
3. Quiddity (Earnings Diversification) |
7.00 |
-1.39 |
23.2M |
|
|
4. Welton Investment (Alpha Leveraged) |
6.58 |
1.86 |
15.0M |
|
|
5. Nantucket Hedge Fund |
4.17 |
10.43 |
2.0M |
|
|
6. Oxeye Capital Mgmt. (Crude Oil) |
3.75 |
3.32 |
9.5M |
|
|
7. Trading Concept (TC Chronos K ) |
3.65 |
-4.93 |
1.0M |
|
|
8. Welton Investment (Alpha) |
3.44 |
1.73 |
15.0M |
|
|
9. Daniel J. Bennett (S&P Options) |
3.36 |
7.96 |
31.0M |
|
|
10. Raithel Inv. (Target Volatility) |
1.96 |
-3.95 |
6.3M |
||
Source: Barclay Trading Group (http://www.barclaygrp.com)
Based on estimates of the composite of all accounts or the fully funded subset method. Does not reflect the performance of any single account. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
Trying again
USFE has new name, game
BY JIM KHAROUF
W ith new ownership and a different outlook, the U.S. Futures Exchange (USFE) launched its first contract in April.
The USFE, which was formerly known as Eurex U.S., entered the U.S. market space in 2003 intent on competing with the Chicago Board of Trade (CBOT) in U.S. treasury futures, but flamed out spectacularly. The USFE is now majority owned (70 percent) by Man Group and began trading binary futures contacts on the outcome of the CBOT/Chicago Mercantile Exchange (CME)/IntercontinentalExchange (ICE) merger. A binary contract pays a fixed amount if the event happens or zero if the trader is incorrect. “One idea that came up months earlier was on mergers — would a merger take place by a certain date after it was announced, especially if something was surrounding the merger such as Department of Justice issues or other things,” says Satish Nandapurkar, CEO of the USFE, who held the same title with Eurex U.S. “When we saw ICE’s announcement, it became a two-way play on CBOT. The opportunity was there relatively quickly. “We thought this would be interesting because this is the type of risk in the marketplace that is very hard to hedge.” Essentially, traders are “predicting,” through the pur- chase of the contracts, who they think will ultimately gain control of the CBOT. The contract has traded lightly over its
first several weeks with just a few dozen contracts bought and sold, but Man is serious about building a new exchange with a new focus. It invested in upgrades to the Eurex trading platform and is reconnecting former Eurex U.S. member firms. The next step is to bring on more partner firms. In time, USFE execu- tives expect to be innovators in the derivatives space. “We definitely aim to be a changing dynamic market- place, focused on the needs of customers and innovation,” Nandapurkar says. “So it is new asset classes or new ways to trade within asset classes, new events you couldn’t trade until now that are binary in nature. You will see us with a wide range of products a few years from now, in a wide range of asset classes.” However, the USFE is not alone in this product space. In late May, HedgeStreet, which is partly owned by the Chicago Board Options Exchange, launched its own set of binary options on several possible mergers and acquisition deals. Among the contracts listed were contracts on tie-ups between Deutsche Boerse and the International Securities Exchange, as well as NYSE-ISE and Nasdaq-Philadelphia Stock Exchange. The USFE, though, hooked up with research firm Morningstar in late May to offer futures contracts on 16 of Morningstar’s indices. The contracts are expected to begin trading in the third quarter of 2007.
Three good tools for targeting customers
— CONTACT —
Bob Dorman
Ad sales East Coast and Midwest bdorman@activetradermag.com (312) 775-5421
Allison Ellis
Ad sales West Coast and Southwest aellis@activetradermag.com (626) 497-9195
Mark Seger
Account Executive mseger@activetradermag.com (312) 377-9435
FUTURES SNAPSHOT (as of May 30)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and may not reflect total volume for all contract months. Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
|
Pit |
E- |
10-day |
% |
20-day |
% |
60-day |
% |
Volatility |
||||
|
Market |
Sym |
Sym |
Exch |
Vol |
OI |
move |
Rank |
move |
Rank |
move |
Rank |
ratio/rank |
|
S&P 500 E-Mini |
ES |
CME |
1.16 M |
2.03 M |
1.69% |
89% |
2.76% |
40% |
9.92% |
99% |
.17 / 5% |
|
|
10-yr. T-note |
TY |
ZN |
CBOT |
1.15 M |
2.49 M |
-0.99% |
64% |
-1.77% |
97% |
-1.93% |
98% |
.52 / 85% |
|
5-yr. T-note |
FV |
ZF |
CBOT |
504.8 |
1.56 M |
-0.91% |
75% |
-1.04% |
97% |
-1.76% |
98% |
.46 / 82% |
|
Eurodollar* |
ED |
GE |
CME |
410.7 |
1.85 M |
-0.01% |
30% |
-0.03% |
40% |
-0.02% |
46% |
.09 / 0% |
|
30-yr. T-bond |
US |
ZB |
CBOT |
359.0 |
835.2 |
-1.12% |
42% |
-1.97% |
94% |
-3.55% |
99% |
.56 / 85% |
|
Nasdaq 100 E-Mini |
NQ |
CME |
300.6 |
449.3 |
2.07% |
69% |
1.95% |
16% |
10.17% |
96% |
.25 / 15% |
|
|
Crude oil |
CL |
NYMEX |
213.4 |
305.4 |
0.51% |
0% |
-1.41% |
37% |
5.69% |
44% |
.29 / 25% |
|
|
2-yr. T-note |
TU |
ZT |
CBOT |
203.1 |
977.3 |
-0.76% |
95% |
-0.83% |
97% |
-0.90% |
98% |
.32 / 53% |
|
Russell 2000 E-Mini |
ER |
CME |
189.5 |
495.9 |
3.34% |
100% |
2.96% |
62% |
11.37% |
99% |
.48 / 71% |
|
|
Eurocurrency |
EC |
6E |
CME |
152.3 |
221.1 |
-1.25% |
100% |
-1.51% |
83% |
2.37% |
36% |
.13 / 8% |
|
Mini Dow |
YM |
CBOT |
130.0 |
119.5 |
1.62% |
35% |
3.63% |
49% |
11.80% |
99% |
.11 / 2% |
|
|
Japanese yen |
JY |
6J |
CME |
84.6 |
256.1 |
-1.28% |
50% |
-1.86% |
67% |
-3.99% |
93% |
.18 / 10% |
|
Gold 100 oz. |
GC |
NYMEX |
76.5 |
199.0 |
-3.17% |
80% |
-3.57% |
56% |
2.17% |
6% |
.20 / 3% |
|
|
British pound |
BP |
6B |
CME |
75.2 |
133.1 |
-0.48% |
24% |
-1.19% |
58% |
2.39% |
49% |
.26 / 27% |
|
Corn |
C |
ZC |
CBOT |
70.6 |
252.0 |
2.91% |
60% |
4.03% |
70% |
-7.32% |
21% |
.23 / 28% |
|
Swiss franc |
SF |
6S |
CME |
48.8 |
83.0 |
-0.92% |
50% |
-1.17% |
59% |
0.02% |
1% |
.13 / 2% |
|
Natural gas |
NG |
NYMEX |
45.6 |
74.1 |
0.98% |
19% |
2.89% |
22% |
9.47% |
54% |
.27 / 43% |
|
|
RBOB gasoline |
RB |
NYMEX |
45.4 |
54.4 |
-4.46% |
67% |
-2.04% |
0% |
19.21% |
51% |
.26 / 82% |
|
|
Sugar |
SB |
NYBOT |
43.4 |
341.4 |
8.32% |
100% |
2.52% |
56% |
-12.10% |
62% |
.42 / 95% |
|
|
Soybeans |
S |
ZS |
CBOT |
42.8 |
138.5 |
3.88% |
40% |
9.04% |
67% |
10.26% |
25% |
.23 / 43% |
|
Canadian dollar |
CD |
6C |
CME |
41.5 |
145.2 |
2.24% |
85% |
3.33% |
71% |
9.62% |
98% |
.31 / 43% |
|
S&P 500 index |
SP |
CME |
34.8 |
612.5 |
1.69% |
89% |
2.76% |
40% |
9.93% |
99% |
.17 / 7% |
|
|
Australian dollar |
AD |
6A |
CME |
32.1 |
111.9 |
-1.18% |
71% |
-0.70% |
36% |
6.16% |
86% |
.09 / 0% |
|
Heating oil |
HO |
NYMEX |
29.6 |
48.9 |
-0.87% |
14% |
-0.48% |
15% |
8.64% |
42% |
.20 / 3% |
|
|
Gold 100 oz. |
ZG |
CBOT |
28.9 |
25.1 |
-3.20% |
80% |
-3.60% |
59% |
1.08% |
1% |
.19 / 0% |
|
|
Wheat |
W |
ZW |
CBOT |
21.7 |
105.4 |
1.71% |
44% |
4.55% |
53% |
11.14% |
67% |
.72 / 80% |
|
Soybean oil |
BO |
ZL |
CBOT |
21.1 |
99.1 |
2.77% |
25% |
6.50% |
64% |
20.75% |
97% |
.17 / 7% |
|
S&P MidCap 400 E-Mini |
ME |
CME |
20.2 |
90.8 |
2.17% |
100% |
2.63% |
40% |
10.83% |
99% |
.23 / 35% |
|
|
Silver 5,000 oz. |
SI |
NYMEX |
19.5 |
53.7 |
-0.71% |
5% |
-0.19% |
2% |
3.69% |
10% |
.24 / 28% |
|
|
Soybean meal |
SM |
ZM |
CBOT |
19.2 |
50.9 |
4.13% |
33% |
9.44% |
70% |
1.55% |
1% |
.21 / 43% |
|
Mexican peso |
MP |
6M |
CME |
15.1 |
91.3 |
0.43% |
11% |
1.73% |
72% |
3.43% |
94% |
.22 / 32% |
|
Crude oil e-miNY |
QM |
NYMEX |
14.5 |
6.1 |
0.51% |
11% |
-1.41% |
42% |
5.69% |
45% |
.30 / 25% |
|
|
Live cattle |
LC |
LE |
CME |
13.6 |
75.9 |
-2.60% |
57% |
-3.38% |
53% |
-7.07% |
100% |
.29 / 48% |
|
Cotton |
CT |
NYBOT |
12.1 |
119.5 |
5.51% |
78% |
4.48% |
100% |
-5.03% |
36% |
.27 / 46% |
|
|
Coffee |
KC |
NYBOT |
9.7 |
70.4 |
3.77% |
43% |
6.20% |
75% |
-0.13% |
0% |
.23 / 40% |
|
|
Nikkei 225 index |
NK |
CME |
9.4 |
56.0 |
1.03% |
58% |
2.22% |
61% |
4.67% |
56% |
.25 / 15% |
|
|
Copper |
HG |
NYMEX |
8.5 |
29.4 |
-6.61% |
42% |
-8.63% |
91% |
24.29% |
35% |
.14 / 3% |
|
|
Fed Funds** |
FF |
ZQ |
CBOT |
8.2 |
63.3 |
-0.01% |
0% |
-0.01% |
0% |
-0.01% |
4% |
.74 / 100% |
|
Cocoa |
CC |
NYBOT |
5.9 |
62.3 |
-1.21% |
60% |
2.40% |
18% |
5.56% |
3% |
.24 / 37% |
|
|
Lean hogs |
LH |
HE |
CME |
5.8 |
22.9 |
0.97% |
100% |
-1.02% |
16% |
15.81% |
85% |
.07 / 0% |
|
Mini-sized gold |
YG |
CBOT |
5.7 |
5.9 |
-3.20% |
80% |
-3.60% |
59% |
1.08% |
1% |
.19 / 0% |
|
|
Silver 5,000 oz. |
ZI |
CBOT |
5.2 |
7.3 |
-0.72% |
10% |
-1.05% |
8% |
2.66% |
4% |
.25 / 31% |
|
|
Dow Jones Ind. Avg. |
DJ |
ZD |
CBOT |
5.2 |
45.9 |
1.62% |
35% |
3.63% |
49% |
11.80% |
99% |
.11 / 2% |
|
Nasdaq 100 index |
ND |
CME |
4.2 |
57.3 |
2.07% |
69% |
1.95% |
16% |
10.17% |
96% |
.25 / 15% |
|
|
Natural gas e-miNY |
QG |
NYMEX |
3.5 |
3.1 |
0.98% |
13% |
2.89% |
24% |
9.64% |
50% |
.20 / 20% |
|
|
New Zealand dollar |
NE |
6N |
CME |
2.4 |
25.2 |
-0.88% |
55% |
-1.31% |
40% |
7.04% |
84% |
.11 / 30% |
|
U.S. dollar index |
DX |
NYBOT |
2.2 |
33.3 |
0.84% |
94% |
1.13% |
69% |
-1.98% |
45% |
.08 / 0% |
|
*Average volume and open interest based on highest-volume contract (December 2007) **Average volume and open interest based on highest-volume contract (August 2007)
Legend Vol: 30-day average daily volume, in thou- sands (unless otherwise indicated). OI: Open interest, in thousands (unless other- wise indicated). 10-day move: The percentage price move from the close 10 days ago to today’s close. 20-day move: The percentage price move from the close 20 days ago to today’s close. 60-day move: The percentage price move from the close 60 days ago to today’s close. The “% Rank” fields for each time window
(10-day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the “% Rank” for 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “% Rank” field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the “% Rank” field shows how the most recent 60-day move compares to the past one-hundred-twenty 60-day moves. A reading
of 100 percent means the current reading is larger than all the past readings, while a read- ing of 0 percent means the current reading is smaller than the previous readings. These fig- ures provide perspective for determining how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the short- term volatility (10-day standard deviation of prices) divided by the long-term volatility (100- day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.
This information is for educational purposes only. Futures & Options Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Futures & Options Trader assumes no responsibility for the use of this information. Futures & Options Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.
OPTIONS RADAR (as of May 31)
MOST-LIQUID INSTRUMENTS*
|
Options |
Open |
10-day |
% |
20-day |
% |
IV/SV |
IV/SV ratio — 20 days ago |
|||
|
Indices |
Symbol |
Exchange |
volume |
interest |
move |
rank |
move |
rank |
ratio |
|
|
Nasdaq 100 index |
NDX |
CBOE |
626.6 |
307.3 |
1.94% |
57% |
2.04% |
16% |
15.6% / 13% |
14.4% / 12.1% |
|
S&P 500 index |
SPX |
CBOE |
159.7 |
1.21 M |
1.09% |
47% |
2.32% |
16% |
11.4% / 9.4% |
11.3% / 9.6% |
|
E-Mini S&P 500 |
ES |
CME |
26.7 |
148.5 |
1.04% |
53% |
2.18% |
13% |
10.3% / 10% |
11.2% / 9.8% |
|
S&P 100 index |
OEX |
CBOE |
24.8 |
140.6 |
0.93% |
25% |
2.33% |
18% |
10.9% / 9% |
11.2% / 9.3% |
|
S&P 500 futures |
SP |
CME |
17.2 |
176.8 |
1.05% |
58% |
2.19% |
13% |
10.1% / 9% |
11.1% / 9.2% |
|
Stocks |
||||||||||
|
3M Company |
MMM |
8.49 M |
212.4 |
2.27% |
15% |
4.19% |
40% |
17.3% / 17% |
15.8% / 16.6% |
|
|
Neurochem |
NRMX |
3.05 M |
802.7 |
1.56% |
0% |
-35.50% |
62% |
178.2% / 147.5% 161.4% / 110.2% |
||
|
Elan Corp ADS |
ELN |
1.23 M |
241.2 |
30.77% |
100% |
39.17% |
100% |
45.7% / 52.7% |
54.3% / 35.2% |
|
|
MasterCard |
MA |
1.22 M |
145.5 |
9.81% |
50% |
18.36% |
60% |
32.1% / 38.3% |
27.9% / 20% |
|
|
American Intl Group |
AIG |
1.22 M |
274.5 |
-0.17% |
25% |
2.73% |
34% |
12.6% / 11.8% |
14.7% / 12.4% |
|
|
Futures |
||||||||||
|
Eurodollar |
ED-GE |
CME |
500.2 |
10.08 M |
-0.01% |
30% |
-0.03% |
40% |
9.1% / 1.1% |
11.9% / 3% |
|
10-yr. T-note |
TY-ZN |
CBOT |
115.1 |
1.58 M |
-1.03% |
80% |
-1.79% |
97% |
3.8% / 3.5% |
3.7% / 3.5% |
|
Crude oil |
CL |
NYMEX |
61.4 |
730.5 |
2.67% |
22% |
0.85% |
15% |
26.6% / 24.5% |
27.3% / 26.8% |
|
5-yr. T-note |
FV-ZF |
CBOT |
38.1 |
405.0 |
-0.93% |
100% |
-1.05% |
97% |
2.7% / 2.3% |
2.7% / 2.4% |
|
Corn |
C-ZC |
CBOT |
36.2 |
964.4 |
3.78% |
73% |
4.89% |
83% |
40.7% / 30.3% |
39.8% / 41.7% |
|
VOLATILITY EXTREMES** |
||||||||||
|
Indices — High IV/SV ratio |
||||||||||
|
Dow Jones index |
DJX |
CBOE |
8.7 |
151.2 |
1.04% |
5% |
3.15% |
29% |
11.2% / 9.1% |
10.8% / 10.2% |
|
S&P 500 index |
SPX |
CBOE |
159.7 |
1.21 M |
1.09% |
47% |
2.32% |
16% |
11.4% / 9.4% |
11.3% / 9.6% |
|
S&P 100 index |
OEX |
CBOE |
24.8 |
140.6 |
0.93% |
25% |
2.33% |
18% |
10.9% / 9% |
11.2% / 9.3% |
|
Nasdaq 100 index |
NDX |
CBOE |
626.6 |
307.3 |
1.94% |
57% |
2.04% |
16% |
15.6% / 13% |
14.4% / 12.1% |
|
S&P 100 index |
XEO |
CBOE |
5.2 |
33.8 |
0.93% |
25% |
2.33% |
18% |
10.6% / 8.9% |
10.9% / 9.8% |
|
Indices — Low IV/SV ratio |
||||||||||
|
Oil service index |
OSX |
PHLX |
3.2 |
53.5 |
3.40% |
32% |
5.90% |
27% |
26.2% / 29.7% |
25.8% / 24% |
|
Russell 2000 Index |
RUT |
CBOE |
12.9 |
402.0 |
3.29% |
93% |
2.26% |
44% |
16% / 16.5% |
16.2% / 11.2% |
|
Stocks — High IV/SV ratio |
||||||||||
|
Kraft Foods |
KFT |
4.2 |
218.3 |
3.27% |
90% |
1.68% |
25% |
22.5% / 12.7% |
18.8% / 22.8% |
|
|
Bristol-Myers Squibb |
BMY |
4.6 |
653.6 |
0.76% |
24% |
5.61% |
65% |
27.8% / 16.6% |
23.9% / 29.9% |
|
|
Rambus |
RMBS |
1.3 |
118.8 |
-0.94% |
0% |
-4.65% |
18% |
41.5% / 25.8% |
42.4% / 31.5% |
|
|
Penwest Pharmas |
PPCO |
1.9 |
66.0 |
3.01% |
35% |
7.53% |
24% |
69.8% / 45.7% |
73.1% / 70.9% |
|
|
MGIC Investment |
MTG |
4.8 |
116.5 |
-1.02% |
100% |
4.30% |
28% |
31.1% / 20.8% |
26.6% / 34.1% |
|
|
Stocks — Low IV/SV ratio |
||||||||||
|
Alltel |
AT |
1.7 |
211.1 |
4.40% |
50% |
7.87% |
83% |
10.8% / 18.1% |
28.5% / 19.7% |
|
|
Fremont General |
FMT |
3.3 |
124.3 |
87.68% |
100% |
67.93% |
100% |
63% / 98.9% |
90.4% / 95.2% |
|
|
Foster Wheeler |
FWLT |
1.2 |
6.8 |
10.38% |
40% |
51.77% |
98% |
39.5% / 57.6% |
NA |
|
|
GameStop |
GME |
1.3 |
33.0 |
4.91% |
31% |
9.41% |
57% |
31.5% / 44.3% |
31.9% / 31.3% |
|
|
ValueClick |
VCLK |
3.9 |
21.7 |
14.68% |
22% |
6.89% |
44% |
49.7% / 69.4% |
NA |
|
|
Futures — High IV/SV ratio |
||||||||||
|
Eurodollar |
ED-GE |
CME |
500.2 |
10.08 M |
-0.01% |
30% |
-0.03% |
40% |
9.1% / 1.1% |
11.9% / 3% |
|
Japanese yen |
JY-6J |
CME |
4.8 |
72.1 |
-1.00% |
30% |
-1.64% |
51% |
6.3% / 4.1% |
7.4% / 6.7% |
|
Soybeans |
S-ZS |
CBOT |
16.6 |
213.7 |
1.72% |
10% |
9.81% |
75% |
24.5% / 16.5% |
22.1% / 21% |
|
Coffee |
KC |
NYBOT |
10.0 |
134.1 |
1.78% |
13% |
6.64% |
77% |
29.2% / 21.5% |
27.3% / 22.6% |
|
Lean hogs |
LH |
CME |
1.3 |
20.8 |
-0.69% |
36% |
-0.66% |
12% |
18.7% / 13.8% |
18.8% / 17.5% |
|
Futures — Low IV/SV ratio |
||||||||||
|
Sugar |
SB |
NYBOT |
19.6 |
415.8 |
7.03% |
83% |
1.64% |
22% |
25.8% / 37.5% |
26.2% / 26% |
|
Gold 100 oz. |
GC |
NYMEX |
9.0 |
120.5 |
0.79% |
100% |
-1.24% |
16% |
12.9% / 15.8% |
13.9% / 15.1% |
|
Silver 5,000 oz. |
SI |
NYMEX |
4.5 |
31.3 |
4.18% |
100% |
1.01% |
5% |
18.8% / 22% |
23.4% / 26.1% |
|
Cotton |
CT |
NYBOT |
9.4 |
155.0 |
3.68% |
60% |
4.90% |
100% |
22.7% / 26% |
21.3% / 24.1% |
* Ranked by volume
LEGEND:
Options vol: 20-day average daily options volume (in thousands unless otherwise indicated). Open interest: 20-day average daily options open interest (in thousands unless otherwise indicated). IV/SV ratio: Overall average implied volatility of all options divided by statistical volatility of asset. 10-day move: The underlying’s percentage price move from the close 10 days ago to today’s close. 20-day move: The underlying’s percentage price move from the close 20 days ago to today’s close. The “% Rank” fields for each time window (10-day moves, 20-day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For exam- ple, the “% Rank” for 10-day moves shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “% Rank” field shows how the most recent 20-day move compares to the past sixty 20-day moves.
** Ranked based on high or low IV/SV values.
GLOBAL FUTURES ECONOMIC & OPTIONS CALENDAR CALENDAR
JUNE/JULY MONTH
Legend
CPI: Consumer Price Index
ECI: Employment cost index
First delivery day (FDD):
The first day on which deliv- ery of a commodity in fulfill- ment of a futures contract can take place.
First notice day (FND): Also known as first intent day, this
is the first day a clearing-
house can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillment of a futures contract. The clearing- house also informs the seller.
FOMC: Federal Open Market Committee
GDP: Gross domestic product
ISM: Institute for supply man- agement
LTD: Last trading day; the first day a contract may trade or be closed out before the delivery of the underlying asset may occur.
PPI: Producer price index
Quadruple witching Friday:
A day where equity options,
equity futures, index options,
and index futures all expire.
|
JUNE 2007 |
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27 28 |
29 |
30 |
31 |
1 |
2 |
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34 |
5 |
6 |
7 |
89 |
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10 |
11 |
12 |
13 |
14 |
15 |
16 |
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17 |
18 |
19 |
20 |
21 |
22 |
23 |
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24 |
25 |
26 |
27 |
28 |
29 |
30 |
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JULY 2007 |
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1 |
234 |
567 |
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8 |
9 |
10 |
11 |
12 |
13 |
14 |
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15 |
16 |
17 |
18 |
19 |
20 |
21 |
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22 |
23 |
24 |
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27 |
28 |
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29 |
30 |
31 |
1 |
2 |
3 |
4 |
The information on this page is subject to change. Futures & Options Trader is not responsible for the accuracy of calendar dates beyond press time.
|
June |
20 |
LTD: June T-bond futures (CBOT); July crude oil futures (NYMEX); July platinum options (NYMEX) |
||||
|
1 |
May unemployment LTD: July cocoa options (NYBOT); June live cattle options (CME) FDD: June T-bond futures (CBOT); June coal, natural gas, and crude oil futures (NYMEX); June aluminum, palladium, copper, platinum, silver, and gold futures (NYMEX) |
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|
21 |
FND: July coffee futures (NYBOT) |
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|
22 |
LTD: |
July T-bond options (CBOT); July rice, wheat, corn, soybean |
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|
oats, |
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products, and soybean options (CBOT) |
||||||
|
FND: |
July crude oil futures (NYMEX) |
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23 |
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2 |
||||||
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24 |
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3 |
||||||
|
25 |
FND: |
July cotton futures (NYBOT) |
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|
4 |
FND: June propane, gasoline, and heating oil futures (NYMEX); June live cattle futures (CME) |
26 |
LTD: July coal futures (NYMEX); July natural gas, gasoline, and heating oil options (NYMEX); July aluminum, copper, silver, and gold options (NYMEX) |
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|
5 |
||||||
|
6 |
FDD: June propane futures (NYMEX) |
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|
7 |
FDD: June live cattle futures (CME) |
27 |
FOMC meeting LTD: July natural gas futures (NYMEX); June aluminum, palladium, copper, silver, and gold futures (NYMEX) FND: July coal futures (NYMEX) |
|||
|
8 |
April trade balance LTD: June currency options (CME); June U.S. dollar index options (NYBOT); July sugar and coffee options (NYBOT) FDD: June gasoline and heating oil futures (NYMEX) |
|||||
|
28 |
Q1 GDP (final) FOMC meeting LTD: June platinum futures (NYMEX); June milk options (CME) FND: July natural gas futures (NYMEX) |
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|
9 |
||||||
|
10 |
||||||
|
11 |
29 |
LTD: July propane, gasoline, and heating oil futures (NYMEX); July sugar futures (NYBOT); June live cattle futures (CME) FND: July aluminum, palladium, copper, platinum, silver, and gold futures (NYMEX); July oats, rice, wheat, corn, soybean products, and soybean futures |
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|
12 |
||||||
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13 |
||||||
|
14 |
May PPI LTD: All June equity options and futures; June S&P futures and options (CME); |
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|
June Nasdaq futures and options (CME); June Russell futures and options (CME); June Dow Jones futures and options (CBOT); June lean hog futures and options (CME) |
(CBOT) |
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|
30 |
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|
31 |
||||||
|
15 |
May CPI Quadruple witching Friday LTD: July crude oil options (NYMEX); July orange juice options (NYBOT); July |
JULY |
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1 |
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|
2 |
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cotton options (NYBOT); July Goldman Sachs commodity index options (CME) |
3 |
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4 |
Markets closed — Independence Day |
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16 |
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5 |
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17 |
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6 |
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18 |
LTD: June currency futures (CME) FND: July cocoa futures (NYBOT) |
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19 |
||||||
June unemployment LTD: July currency options (CME); July U.S. dollar index options (NYBOT); August cocoa options (NYBOT); July pork belly options (CME)
NEW PRODUCTS AND SERVICES
The National Futures Association (NFA) has published a new investor education booklet entitled “Scams and Swindles: An Educational Guide to Avoiding Investment Fraud.” The guide describes common charac- teristics of investment scams and outlines how to avoid them. Single copies of “Scams and Swindles” are offered free of charge. Individuals may order a copy of the publi- cation by calling NFA’s Information Center toll-free at (800) 621-3570 or by e-mailing the NFA at information@nfa.futures.org. It can also be downloaded from the Investor Learning Center of the NFA’s Web site (http://www.nfa.futures.org). The NFA offers several other educational brochures and programs, including “Opportunity and Risk: An Educational Guide to Trading Futures and Options on Futures” and “Trading in the Off- Exchange Foreign Currency Markets: What Investors Need to Know.” For more information, visit the Investor Learning Center section of the NFA’s Web site.
NinjaTrader released the sixth major version of its trading platform. NinjaTrader 6 is free to use and features advanced charting, market analytics, system development, and trade simulation for futures, forex, and stock traders. New features include: trading system development and backtesting; chart-based order entry for placing, modifying, and canceling orders directly within a chart; advanced charting including more than 100 indicators, powerful vol- ume analysis indicators, new visualization options, and bar interval types of any compression; a turbo-charged quote sheet with multi-instrument real-time scanning and analy- sis with access to more than 100 pre-built indicators and data columns; and increasing third-party vendor support including KwikPop, MTPredictor, Jurik Research, ShadowTraders, Advanced Trading Workshop, Final, eMiniMaster and more. NinjaTrader 6 is available for download at http://www.ninjatrader.com.
eSignal has enhanced its Web-based global financial portal Quote.com and has launched an upgrade of Mobile Quote.com. Quote.com now offers users an optional inter- national start page for Australia, Canada, China, France, Germany, Hong Kong, India, Singapore, or Spain in addi- tion to the existing choices of a U.S. or UK start page. These country-specific financial portals are designed to give active investors access to each country’s major domestic markets and deliver region-specific financial news supplied by COMTEX, AFX, and RTT News. Mobile Quote.com offers stock, futures, forex, and mutual fund quotes, includ- ing world market data, business news, and charts using any cell phone, PDA, or Smartphone with access to the Internet.
This new version enables users to select and maintain five “Watchlists” of up to 10 trading symbols each and to use a chart-interval feature for economic analysis. A currency cal- culator allows users to make foreign exchange rate calcula- tions using Quote.com forex currency rates. The calculator includes the seven most-traded currencies: U.S. dollar, Canadian dollar, euro, British pound, Swiss franc, Australian dollar, and Japanese yen, and also includes the Mexican peso, Russian ruble, Hong Kong dollar, and Singapore dollar. Quote.com offers data from major world- wide exchanges including the Australian Stock Exchange, Toronto Stock Exchange, Shanghai Stock Exchange, Euronext Paris, Xetra, Hong Kong Stock Exchange, National Stock Exchange of India, Stock Exchange of Singapore, Madrid Stock Exchange, London Stock Exchange, and many more, as well as news, commentary, analyst recommendations, alerts and free newsletters. For additional information, http://www.Quote.com or call (800) 833-1228.
The MetaQuotes Software Corp. has released the new mobile terminal MetaTrader 4 Mobile Smartphone Edition (SE). The mobile terminal represents a program for trading using mobile devices. It allows traders to give quick responses to all changes in the market and make trades worldwide. MetaTrader 4 Mobile SE is intended for man- aging a trade account using smartphones working under MS Windows Mobile 2003 SE or later versions of OS. MetaTrader 4 Mobile SE terminal is a full-scale trading tool allowing users to get real-time quotes, view charts, utilize technical indicators, and make trades. MetaTrader 4 Mobile SE is compatible with Online Trading Platform MetaTrader 4. The cost is $45, a one-time fee that distinguishes this ter- minal among those produced by other developers. There are no subscription payments. For more information, visit http://www.metaquotes.net.
Patsystems now provides connectivity to Hong Kong Exchanges and Clearing (HKEx). In the past few months, Patsystems has also connected to the Dubai Mercantile Exchange, the Chicago Futures Exchange, and the Mexican Derivatives Exchange. For more information, visit http://www.patsystems.com.
Note: The New Products and Services section is a forum for industry businesses to announce new products and upgrades. Listings are adapted from press releases and are not endorsements or recommen- dations from the Active Trader Magazine Group. E-mail press releas- es to editorial@futuresandoptionstrader.com. Publication is not guar- anteed.
KEY CONCEPTS
Account equity: Value of account, which includes cash and investments.
American style: An option that can be exercised at any time until expiration.
Assign(ment): When an option seller (or “writer”) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option.
At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price.
Average directional movement index (ADX):
Measures trend strength, regardless of direction. The high- er the ADX value, the stronger the trend, whether the mar- ket is going up or down. The indicator can be applied to any time frame, although it is typically used on daily charts. Although the ADX concept is straightforward, its calcu- lation is rather lengthy. The indicator was designed by Welles Wilder and is described in detail in his book New Concepts in Technical Trading Systems (Trend Research 1978).
Calculation:
1. Calculate the positive or negative directional move-
ment (+DM and -DM) for each bar in the desired look- back period. Bars that make higher highs and higher lows than the previous bar have positive directional movement. Bars that make lower highs and lower lows than the previous bar have negative directional move- ment. If a bar has both a higher high and a lower low than the previous bar, it has positive directional movement if its high is above the previous high more than its low is below the previous low. Reverse this criterion for negative directional movement. An inside bar (a bar that trades within the range of the previous bar) has no directional movement, and nei- ther does a bar whose high is above the previous high by the same amount its low is below the previous low.
2. If a bar has positive (negative) directional move-
ment, the absolute value of the distance between today’s high (low) and yesterday’s high (low) is added to the running totals of +DM (-DM) calculated over a given lookback period (i.e., 20 bars, 30 bars, etc.). The absolute value is used so both +DM and -DM are pos- itive values.
3. Calculate the sum of the true ranges for all bars in
the lookback period.
4. Calculate the Directional Indicator (+DI and -DI) by
dividing the running totals of +DM and -DM by the sum of the true ranges.
5. Calculate the directional index (DX) by taking the
The option “Greeks”
Delta: The ratio of the movement in the option price for every point move in the underlying. An option with a delta of 0.5 would move a half-point for every 1-point move in the underlying stock; an option with a delta of 1.00 would move 1 point for every 1-point move in the underlying stock.
Gamma: The change in delta relative to a change in the underlying market. Unlike delta, which is highest for deep ITM options, gamma is highest for ATM options and lowest for deep ITM and OTM options.
Theta: The rate at which an option loses value each day (the rate of time decay). Theta is relatively larger for OTM than ITM options, and increases as the option gets closer to its expiration date.
Rho: The change in option price relative to the change in the interest rate.
Vega: How much an option’s price changes per a one- percent change in volatility.
absolute value of the difference between the +DI value
|
and |
the -DI value, dividing that by the sum of the +DI |
|
and |
-DI values, and multiplying by 100. |
6. To create the ADX, calculate a moving average of the
DX over the same period as the lookback period used
throughout the other calculations.
Bear call spread: A vertical credit spread that consists of a short call and a higher-strike, further OTM long call in the same expiration month. The spread’s largest potential gain is the premium collected, and its maximum loss is lim- ited to the point difference between the strikes minus that premium.
Bear put spread (call credit spread): A bear debit spread that contains puts with the same expiration date but different strike prices. You buy the higher-strike put, which costs more, and sell the cheaper, lower-strike put.
Beta: Measures the volatility of an investment compared to the overall market. Instruments with a beta of one move in line with the market. A beta value below one means the instrument is less affected by market moves and a beta value greater than one means it is more volatile than the overall market. A beta of zero implies no market risk.
Bull call spread: A bull debit spread that contains calls with the same expiration date but different strike prices. You buy the lower-strike call, which has more value, and sell the less-expensive, higher-strike call.
Bull put spread (put credit spread): A bull credit spread that contains puts with the same expiration date, but different strike prices. You sell an OTM put and buy a less- expensive, lower-strike put.
Butterfly: A non-directional trade consisting of options
with three different strike prices at equidistant intervals:
Long one each of the highest and lowest strike price options and short two of the middle strike price options.
Calendar spread: A position with one short-term short option and one long same-strike option with more time until expiration. If the spread uses ATM options, it is mar- ket-neutral and tries to profit from time decay. However, OTM options can be used to profit from both a directional move and time decay.
Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price.
Carrying costs: The costs associated with holding an investment that include interest, dividends, and the oppor- tunity costs of entering the trade.
Covered call: Shorting an out-of-the-money call option against a long position in the underlying market. An exam- ple would be purchasing a stock for $50 and selling a call option with a strike price of $55. The goal is for the market to move sideways or slightly higher and for the call option to expire worthless, in which case you keep the premium.
Credit spread: A position that collects more premium from short options than you pay for long options. A credit spread using calls is bearish, while a credit spread using puts is bullish.
Deep (e.g., deep in-the-money option or deep out-of-the-money option): Call options with strike prices that are very far above the current price of the under- lying asset and put options with strike prices that are very far below the current price of the underlying asset.
Delta-neutral: An options position that has an overall delta of zero, which means it’s unaffected by underlying price movement. However, delta will change as the under- lying moves up or down, so you must buy or sell shares/contracts to adjust delta back to zero.
Diagonal spread: A position consisting of options with different expiration dates and different strike prices — e.g., a December 50 call and a January 60 call.
Double diagonal spread: A double diagonal resembles an iron condor (call credit spread + put credit spread), but the long side of each spread expires in a later month. This position combines two diagonal spreads on either side of the market and tries to exploit the time decay of the short, near-term options. It collects the most profit if the market trades sideways by expiration. To construct a double diagonal, enter two spreads simul- taneously: a call spread, which consists of a short out-of- the-money call and a long, higher-strike call in a further month; and a put spread, which consists of a short OTM put and a long, lower-strike put in a more-distant month. Both spread’s short options share the same expiration month, and the long options expire together at least one month later.
European style: An option that can only be exercised at expiration, not before.
Exercise: To exchange an option for the underlying instrument.
Expiration: The last day on which an option can be exer- cised and exchanged for the underlying instrument (usual- ly the last trading day or one day after).
Exponential moving average (EMA): The simple moving average (SMA) is the standard moving average cal- culation that gives every price point in the average equal emphasis, or weight. For example, a five-day SMA is the sum of the most recent five closing prices divided by five. Weighted moving averages give extra emphasis to more recent price action. Exponential moving average (EMA) weights prices using the following formula:
EMA = SC * Price + (1 - SC) * EMA(yesterday) where SC is a “smoothing constant” between 0 and 1, and EMA(yesterday) is the previous day’s EMA value.
You can approximate a particular SMA length for an EMA by using the following formula to calculate the equiv- alent smoothing constant:
SC = 2/(n + 1) where n = the number of days in a simple moving average of approximately equivalent length.
For example, a smoothing constant of 0.095 creates an exponential moving average equivalent to a 20-day SMA (2/(20 + 1) = 0.095). The larger n is, the smaller the constant, and the smaller the constant, the less impact the most recent price action will have on the EMA. In practice, most soft- ware programs allow you to simply choose how many days you want in your moving average and select either simple, weighted, or exponential calculations.
In the money (ITM): A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instru- ment’s price.
Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24.
Iron condor: A market-neutral position that enters a bear call spread (OTM call + higher-strike call) above the market and a bull put spread (OTM put + lower-strike put) below the market. Both spreads collect premium, and profit when the market trades between the short strikes by expiration. All options share the same expiration month.
Kaufman’s Adaptive Moving Average (KAMA):
continued on p. 48
KEY CONCEPTS continued
This dynamic moving average technique was developed by Perry J. Kaufman and described in his books Smarter Trading (McGraw-Hill, 1995) and New Trading Systems and Methods (Fourth Edition, John Wiley & Sons, 2005). Its underlying concept is that a “noisy” market requires a longer-term moving average than one with less noise — i.e., in choppy market conditions, price will repeatedly pene- trate a too-short moving average. The KAMA uses an exponential smoothing formula to adjust the moving average length (which the author limits to two periods at the shortest on 30 periods at the longest):
KAMA t = KAMA t-1 + sc t * (Price - KAMA t-1 )
where KAMA t = the new adaptive moving average value KAMA t-1 = the previous adaptive moving average value Price = the current price (for period t) sc t = the smoothing constant, calculated each period as:
sc t = [ER t * (fastest - slowest) + slowest] 2
and
fastest = 2/(fastest moving average period +1) slowest = 2/(slowest moving average period + 1)
ER t = |Price t - Pricet t-n |
t-n
∑ |Price i - Price i-n |
i=1
“Fastest” and “slowest” refer to the shortest and longest look-back periods allowed for the average, by default set to two and 30 periods, respectively.
Lock-limit: The maximum amount that a futures contract is allowed to move (up or down) in one trading session.
Long-Term Equity AnticiPation Securities (LEAPS): Options contracts with much more distant expi- ration dates — in some cases as far as two years and eight months away — than regular options.
Market makers: Provide liquidity by attempting to prof- it from trading their own accounts. They supply bids when there may be no other buyers and supply offers when there are no other sellers. In return, they have an edge in buying and selling at more favorable prices.
Momentum (or “price momentum”): A generic term used to describe the rate at which price changes as well the name of a specific calculation. Rate of change (ROC) is simply an alternate version of this basic indicator. The implications and interpretations of these two studies are identical. Momentum/ROC are similar to oscillators, such as the relative strength index (RSI) and stochastics, in that they are generally intended to highlight shorter-term price momen-
tum extremes (overbought or oversold points). The most common calculation for momentum is simply today’s price (typically the closing price) minus the price n days ago:
(Ptoday – Pn days ago). The most basic ROC formula is today’s price divided by the price n days ago:
(Ptoday/Pn days ago). Alternate calculations for rate of change are 100*(Ptoday /Pn days ago) or (Ptoday – Pn days ago)/Pn days ago. Except for scaling, the resulting momentum and ROC indi- cators are the same; momentum simply expresses price change as the difference between two prices, while ROC expresses price change as a percentage or ratio.
Naked (uncovered) puts: Selling put options to collect premium that contains risk. If the market drops below the short put’s strike price, the holder may exercise it, requiring you to buy stock at the strike price (i.e., above the market).
Open interest: The number of options that have not been exercised in a specific contract that has not yet expired.
Out of the money (OTM): A call option with a strike price above the price of the underlying instrument, or a put option with a strike price below the underlying instru- ment’s price.
Parity: An option trading at its intrinsic value.
Premium: The price of an option.
Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price.
Put spreads: Vertical spreads with puts sharing the same expiration date but different strike prices. A bull put spread contains long, higher-strike puts and short, lower-strike puts. A bear put spread is structured differently: Its long puts have higher strikes than the short puts.
Ratio spread: A ratio spread can contain calls or puts and includes a long option and multiple short options of the same type that are further out-of-the-money, usually in a ratio of 1:2 or 1:3 (long to short options). For example, if a stock trades at $60, you could buy one $60 call and sell two same-month $65 calls. Basically, the trade is a bull call spread (long call, short higher-strike call) with the sale of additional calls at the short strike. Overall, these positions are neutral, but they can have a directional bias, depending on the strike prices you select. Because you sell more options than you buy, the short options usually cover the cost of the long one or provide a net credit. However, the spread contains uncovered, or “naked” options, which add upside or downside risk.
Straddle: A non-directional option spread that typically consists of an at-the-money call and at-the-money put with
the same expiration. For example, with the underlying instrument trading at 25, a standard long straddle would consist of buying a 25 call and a 25 put. Long straddles are designed to profit from an increase in volatility; short strad- dles are intended to capitalize on declining volatility. The strangle is a related strategy.
Strangle: A non-directional option spread that consists of an out-of-the-money call and out-of-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a long strangle could consist of buying a 27.5 call and a 22.5 put. Long strangles are designed to profit from an increase in volatility; short stran- gles are intended to capitalize on declining volatility. The straddle is a related strategy.
Strike (“exercise”) price: The price at which an under- lying instrument is exchanged upon exercise of an option.
Time decay: The tendency of time value to decrease at an accelerated rate as an option approaches expiration.
Time spread: Any type of spread that contains short near-term options and long options that expire later. Both options can share a strike price (calendar spread) or have different strikes (diagonal spread).
Time value: The amount of an option’s value that is a function of the time remaining until expiration. As expira-
tion approaches, time value decreases at an accelerated rate,
a phenomenon known as “time decay.”
True range (TR): A measure of price movement that accounts for the gaps that occur between price bars. This calculation provides a more accurate reflection of the size of
a price move over a given period than the standard range
calculation, which is simply the high of a price bar minus the low of a price bar. The true range calculation was devel- oped by Welles Wilder and discussed in his book New
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Concepts in Technical Trading Systems (Trend Research, 1978). True range can be calculated on any time frame or price bar — five-minute, hourly, daily, weekly, etc. The following discussion uses daily price bars for simplicity. True range is the greatest (absolute) distance of the following:
1. Today’s high and today’s low.
2. Today’s high and yesterday’s close.
3. Today’s low and yesterday’s close.
Average true range (ATR) is simply a moving average of the true range over a certain time period. For example, the five-day ATR would be the average of the true range calcu- lations over the last five days.
Vertical spread: A position consisting of options with the same expiration date but different strike prices (e.g., a September 40 call option and a September 50 call option).
Volatility: The level of price movement in a market. Historical (“statistical”) volatility measures the price fluctu- ations (usually calculated as the standard deviation of clos- ing prices) over a certain time period — e.g., the past 20 days. Implied volatility is the current market estimate of future volatility as reflected in the level of option premi- ums. The higher the implied volatility, the higher the option premium.
Volatility skew: The tendency of implied option volatil- ity to vary by strike price. Although, it might seem logical that all options on the same underlying instrument with the same expiration would have identical (or nearly identical) implied volatilities. For example, deeper in-the-money and out-of-the-money options often have higher volatilities than at-the-money options. This type of skew is often referred to as the “volatility smile” because a chart of these implied volatilities would resemble a line curving upward at both ends. Volatility skews can take other forms than the volatil- ity smile, though.
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FOREX FUTURES DIARY TRADE JOURNAL
Exiting too early from a well-placed crude oil trade.
TRADE
Date: Thursday, May 10, 2007.
Entry: Long July mini crude oil futures (QMN07) at 63.375.
Reasons for trade/setup: July crude sold off nearly $6 from the April 30 high to the May 9 low, and testing a price pattern at this juncture (includ- ing the establishment of a 20-day low and at least a three-point drop over the previous four days) showed favorable odds for an up move — with the caveat that a notable portion of the past examples reversed after the mar- ket had bounced one or two days.
Initial stop: 62.23, which is 0.17 below the May 9 low.
Source: TradeStation
Initial target: 65.00, which is the next round-number price more than a full point away. Take partial profits and raise stop.
RESULT
Exit: 64.40.
Profit/loss: +1.025 (1.6 percent).
Trade executed according to plan? No.
Outcome: There was a lot more potential upside to this trade, but we bailed out early after a volatile, down-closing day (May 14) in the market shook our confidence in the
position. We decided it was better to take a one-point prof- it and end the risk of being subjected to one of this market’s famously sharp reversals. We felt smart for exactly one day, because July oil dropped below our entry price the day after we exited. However, it immediately reversed to the upside and soon traded above 67 — more than two points above the initial target price. The desire to avoid any risk whatsoever resulted in miss- ing out on the best up move in this market in two months. In retrospect, we were influenced by the pattern exam- ples we had found that reversed after only a day or two of gains. However, if we had studied our analysis more close- ly, we would have discovered that positions that were in the money after three days had greater odds of continuing to profit.
|
TRADE SUMMARY |
||||||||||||
|
Date |
Futures |
Entry |
Initial |
Initial |
IRR |
Exit |
Date |
P/L |
LOP |
LOL |
Trade |
|
|
stop |
target |
length |
||||||||||
|
5/10/07 |
QMN07 |
63.375 |
62.23 |
65.00 |
1.42 |
64.40 |
5/15/07 |
+1.025 (1.6%) |
1.30 |
0.15 |
3 days |
|
Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).
OPTIONS TRADE JOURNAL
Selling puts on Whole Foods leaves us holding the bag.
|
TRADE SUMMARY |
||
|
Entry date |
May 8 
|
|
Underlying security: |
Whole Foods Market (WFMI) 
|
|
Position: |
10 short May 40 puts 
|
|
Initial capital required: |
$4,865 
|
|
Initial stop: Exit trade if WFMI drops below $38.89 — |
||
|
two percent below breakeven ($39.67). 
|
|
|
Initial target: WFMI trades above $40 short strike |
||
|
until May 19 expiration. 
|
|
|
Initial daily time decay: |
$47.36 
|
|
Trade length (in days): |
7 
|
|
P/L: |
-$950 (19.5 percent) 
|
|
LOP: |
$60 
|
|
LOL: |
-$1,035 
|
|
LOP — largest open profit (maximum available profit during |
||
|
lifetime of trade); LOL — largest open loss (maximum poten- |
||
|
tial loss during life of trade). |
||
TRADE
Date: Tuesday, May 8.
Market: Options on Whole Foods Market (WFMI).
Entry: Sell 10 May 40 puts at $0.33 each.
Reasons for trade/setup:
Whole Foods Market (WFMI) has been quite volatile after past quar- terly earnings reports, so it was no surprise that May options were trading with inflated implied volatilities (IV) ahead of WFMI’s second-quarter earnings release on May 9. However, testing showed some of its options may have been overpriced, which means selling
premium before earnings are released could be profitable. Whole Foods has traded in a fairly wide range in the two weeks after quarterly earnings were released since May 1997, but that range has had a bullish bias. The aver- age up move was 10.24 percent and the average down move was -6.56 percent. The plan: sell May puts more than
7 percent out-of-the-money (OTM) with the expectation they will expire worthless May 19.
continued on p. 52
TRADE STATISTICS
|
Date |
May 8 |
May 15 |
|
|
Delta |
119.2 |
803 |
|
|
Gamma |
37.29 |
-620.6 |
|
|
Theta |
47.36 |
19.52 |
|
|
Vega |
-16.17 |
-8.47 |
|
|
Probability of profit |
98 percent |
30 percent |
|
|
Breakeven points: |
$37.67 |
$37.67 |
||
position’s vega (16.17) was so low that it didn’t help much. However, Whole Foods bounced 3.78 percent off its low by May 11, and the short puts could have been bought back at $0.27 each for a $60 unrealized gain. At this point, the short puts still could have expired worthless, so we contin- ued to hold the trade, which was a mistake. On May 14, Whole Foods turned lower again and the short puts moved into the money and doubled in price. The stop-loss was hit the next morning, and the puts were bought back at $1.28 — a total loss of $950 (19.5 percent). What went wrong? According to Mike Tosaw, director of education at optionsXpress, the position should have been delta and gamma neutral to help eliminate directional risk. “I’m not a fan of selling naked options before a big event, because if [the market] goes against you, it could really hurt,” he says. Tosaw explains the trade correctly anticipated a drop in implied volatility, but its deltas climbed as the short puts moved near the money, which caused problems. For instance, position delta rose from 119 at trade entry to 345 after Whole Foods gapped down on May 10, meaning the trade’s directional risk resembled 119 “shares” initially but then tripled to 345 “shares” as gamma also moved from -37 to -187. When the stop-loss was triggered, position delta had surged to 803, which is similar to holding 803 shares of Whole Foods as it sold off — a bad idea.
On May 8, WFMI was trad-
ing around $45.26 and May 40
puts, which were 11.6 percent
OTM, cost $0.33. These puts had IV of 65 percent, while all puts on Whole Foods had an
IV of 50 percent. Although
WFMI could drop in response to earnings, we sold May 40
puts for $0.33 each because
the stock was unlikely to fall
enough to hurt the position
by expiration. Also, IV will
likely plummet after the release, which will help the trade. Figure 1 shows the posi-
tion’s potential gains or losses
on three dates: trade entry
(May 8, dotted line), halfway until expiration (May 14, dashed line), and expiration
(May 19, solid line). The shad-
ed area represents WFMI’s
possible trading range in the
seven trading days between its May 9 earnings release and May 19 expiration. The red and blue bars (below) show the first and second standard deviations, respectively. The trade has a 98-percent chance of gains because the short puts are nearly 12 percent below the market. The short 40 puts will be held until they expire on May 19. Normally, an exit is triggered if Whole Foods hits the breakeven point ($39.67), but this method has caused unnecessary losses in past trades. Instead, the stop-loss is loosened to $38.89 — two percent below breakeven, which offers WFMI a chance to recover if it does drop below the short strike.
Initial stop: Buy back puts if WFMI drops to $38.89 — two percent below the breakeven point of $39.67.
Initial target: WFMI trades above $40 until May 18 (last trading day).
RESULT
Outcome: Figure 2 shows Whole Foods opened 11.63 per- cent lower May 10 after it released earnings after the previ- ous day’s close. Although the short 40 puts didn’t initially move into the money, the trade was in trouble. As expected, implied volatility fell to 29 percent from 65 percent, but the
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