fot200809

September 2008 • Volume 2, No. 9

PROFITING FROM OPENING GAPS at key price levels p. 6

CRUSHES AND CRUNCHES:Implications for grain futures p. 12

STRATEGIC STOCK TRADING — with options p. 24

HEDGING A PORTFOLIO with bear put spreads p. 18

TRADING ICHIMOKU signals with options p. 28

2 September 2008 • FUTURES & OPTIONS TRADER

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .5

Trading StrategiesFading the opening gap . . . . . . . . . . . . . . .6This intraday system captures brief reversals

that often follow extreme highs and lows.

By Art Collins

From crunch to crush . . . . . . . . . . . . . . . .12The credit crunch might be making its

presence felt in the unlikeliest of places —

the grain market. Traders should prepare

themselves for a volatile season.

By Keith Schap

Hedging with bear put spreads . . . . . . . .18Adding a bear put spread to a stock portfolio

creates a more efficient hedge than simply

buying puts.

By Tristan Yates

Trading stocks with short options . . . .24Short options provide a useful alternative for

traders who want to enter the underlying market

at more advantageous price points.

By Mark D. Wolfinger

Options Trading System Lab

Ichimoku and vertical spreads . . . . . . . . . .28By Steve Lentz and Jim Graham

Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .30Momentum, volatility, and volume

statistics for futures.

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . . .31Notable volatility and volume

in the options market.

Futures & Options WatchCOT extremes . . . . . . . . . . . . . . . . . . . . . . .32A look at the relationship between commercials

and large speculators in 45 futures markets.

Options: Health care ETF components . . . . . . . . . . . . . . . . . . . . .32

CONTENTS

continued on p. 4

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Member NYSE, FINRA, NFA and SIPCSTOCKS OPTIONS FUTURES FOREX

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NewsCME shareholders approve NYMEX acquisition . . . . . . . . . . . . . . . . . .34The CME-NYMEX deal enters its final stages.

CBOE, CBOT reach settlement . . . . . . . .34The settlement of the exchange-rights issue

opens doors for the CBOE’s future.

GLD options take off . . . . . . . . . . . . . . . . .35New gold ETF options trade fast out of the gate.

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .36References and definitions.

Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40

Futures & Options Calendar . . . . . . . . . . . .42

New Products and Services . . . . . . . . . . . . .43

Futures Trade Journal . . . . . . . . . . . . . . .44Trying to squeeze a little more out of a pop in

gold.

Options Trade Journal . . . . . . . . . . . . . . .45Buying SPY calls on a 20-day high.

Have a question about something you’ve seen

in Futures & Options Trader?

Submit your editorial queries or comments to [email protected].

Looking for an advertiser?

Click on the company name below for a direct link to the ad

in this month’s issue of Futures & Options Trader.

eSignal

OptionsMentoring

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PFGBEST.com

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CONTENTS


Editor-in-chief: Mark [email protected]

Managing editor: Molly Flynn [email protected]

Senior editor: David Bukey [email protected]

Contributing editor:Keith Schap

Associate editor: Chris Peters [email protected]

Editorial assistant andWebmaster: Kesha Green

[email protected]

Art director: Laura [email protected]

President: Phil [email protected]

Publisher,Ad sales East Coast and Midwest:

Bob [email protected]

Ad sales West Coast and Southwest only:

Allison [email protected]

Classified ad sales: Mark [email protected]

Volume 2, Issue 9. Futures & Options Trader is pub-lished monthly by TechInfo, Inc., 161 N. Clark Street,Suite 4915, Chicago, IL 60601. Copyright © 2008TechInfo, Inc. All rights reserved. Information in thispublication may not be stored or reproduced in anyform without written permission from the publisher.

The information in Futures & Options Trader magazineis intended for educational purposes only. It is notmeant to recommend, promote or in any way imply theeffectiveness of any trading system, strategy orapproach. Traders are advised to do their ownresearch and testing to determine the validity of a trad-ing idea. Trading and investing carry a high level ofrisk. Past performance does not guarantee futureresults.

For all subscriber services:www.futuresandoptionstrader.com

A publication of Active Trader®

CONTRIBUTORSCONTRIBUTORS

� Art Collins ([email protected]) is the author of Beating The

Financial Futures Market: Combining Small Biases Into Powerful Money Making

Strategies (Wiley Publishing, 2006).

� Mark Wolfinger ([email protected]) has been in the options

business since 1977. After more than 20 years as a market maker, he left the

Chicago Board Options Exchange (CBOE) in 2000 and began helping indi-

vidual investors understand how to use options profitably (and safely). He

has written three books and numerous magazine articles. As an educator, he

stresses the conservative methods detailed in his newest book, The Rookie’s

Guide to Options (W&A Publishing, 2008). Wolfinger offers group seminars

and private consultation via telephone or e-mail. His Web site is

http://blog.mdwoptions.com/options_for_rookies/.

� Tristan Yates researches and writes about enhanced indexing strate-

gies using derivatives for publications including Futures & Options Trader,

SeekingAlpha, Investopedia, and Trader’s Journal. His articles are distributed

through Yahoo! Finance, Forbes, Kiplinger, and MSN Money. He is currently

working on a book on enhanced indexing for the Wiley Trading Series.

� Keith Schap is a freelance writer specializing in risk man-

agement and trading strategies. He is the author of numerous

articles and several books on these subjects, including The

Complete Guide to Spread Trading (McGraw-Hill, 2005). He was

a senior editor at Futures magazine and senior technical mar-

keting writer at the CBOT.

� Steve Lentz ([email protected]) is a well-estab-

lished options educator and trader and has spoken all over the

U.S., Asia, and Australia on behalf of the CBOE’s Options

Institute, the Options Industry Council, and the Australian

Stock Exchange. As a mentor for DsicoverOptions.com, he

teaches select students how to use complex options strategies and develop a

consistent trading plan. Lentz is constantly developing new strategies on the

use of options as part of a comprehensive profitable trading approach. He

regularly speaks at special events, trade shows and trading group organiza-

tions.

� Jim Graham ([email protected]) is the product

manager for OptionVue Systems and a registered investment

advisor for OptionVue Research.

FUTURES & OPTIONS TRADER • September 2008 5

http://blog.mdwoptions.com/options_for_rookies/

mailto:[email protected]




Fading the opening gap

Spotting a market’s tops and bottoms seemseasy in hindsight, but it is nearly impossible inreal-world trading. One of the problems ismany false signals are generated before the

market eventually reverses direction. After hitting an all-time high or low, the market will often continue in the samedirection, if only briefly.

Crude oil is a good example. As the price of oil surged

this year, analysts knew it would peak at some point. Butwhen? Several turning points seemed to emerge as itclimbed 53 percent from Jan. 2 to July 11, but crude oilfutures kept surging higher.

Figure 1 shows a daily chart of August crude oil futures(CLQ08) that highlights two all-time highs that closedlower and seemed to act as reversals. First, crude oil hit arecord high at the open on May 22 before dropping to closenear its daily low. But the market exceeded that peak 10days later. Then, oil climbed to another high on June 30, butclosed lower on the day. That high was exceeded the nextday.

A few days later, crude oil also formed an island top — aday in which the low was higher than the highs of both sur-rounding days. These one-day patterns can act as reversalsignals, but price hit a new high five days later. Clearly,price wasn’t going to surrender easily. How can you trade amarket like this?

One way is to trade in the opposite direction of openinggaps. As markets reverse direction, price often opens at anextreme n-day high (or low) before dropping (or climbing)by the close. Instead of trying to identify major trend rever-

sals, this short-term strategy simply pin-points the best times to fade extremelylarge opening gaps and exit at the close.

Behind extreme highs and lowsInvestors tend to panic when markets climbto historic highs or drop to all-time lows.And as emotions rise, markets becomevolatile and bid-ask spreads expand aseven seasoned traders hesitate before tak-ing a position. As a result, the daily range(high-low) often widens.

In addition, markets tend to open atextreme highs or lows and then pull backby the end of the day. These moves seem tobe driven by nervous traders stampeding inor out of a market they think is going tocontinue to rise or plummet. Large openinggaps often form after dramatic news hitsthe market before it opens.

By the close, however, the market has

Instead of trying to identify long-term market reversals,

this intraday system trades the opening gaps that tend to accompany them.


TRADING STRATEGIES

Crude oil seemed to peak several times during its 53-percent climb from Jan. 2to July 11. But each record high was exceeded within 10 days.

FIGURE 1 — WAITING FOR A REVERSAL – CRUDE OIL

Source: TradeStation

BY ART COLLINS

Strategy snapshot

Strategy: Fading opening gaps.

Market: Futures.

Logic: Markets often reverse direction after opening much higher or lower than the previous close. To exploit this pattern, buy markets that open at historic lows and sell those than open at historic highs.

Timing: Exit at the close or within a few days of entering the market. Don’t expect the market to reverse its long-term trend.


often moved significantly away from its opening price. Ifthis move is big enough, it doesn’t matter where priceclosed in relation to its previous close. There are no morenaïve traders to buy new highs or sell new lows, and the bignews is all but forgotten.

Trade examplesFigure 2’s daily chart showsNovember soybean futures (SX93)peaked in the summer of 1993, whenthe market had been rallying sharplybecause of heavy flooding in theMidwest. On July 19, the marketopened 30 cents higher, which was alimit up move at the time. Soybeansthen fell 20 cents by the close. Thatopening gap up represented a majormarket top — soybeans didn’t climbback to July 19’s high for three years.

Figure 3 shows a similar market topin March T-bond futures (USH08) onJan. 22. The market opened 65 tickshigher than its previous close — upmore than two full points. However, itdropped 44 ticks by the close.

Meanwhile, Figure 4 shows theMarch S&P 500 futures (SPH08)opened 63 points lower beforerebounding 44 points by the close.Both markets have tended to moveinversely at market extremes.

After setting multi-year extremes at

the open, however, T-bonds and the S&P 500 reversed direc-tion by the close. Each of the opening gaps in Figures 2 to 4were reversed by the close, suggesting that you should fadethese opportunities, not chase them.

One simple idea is to trade in the opposite direction of anopening gap if its open exceeds the last n days of highs or

Soybeans opened limit up on July 19, 1993, but fell 20 cents by the close.Selling soybeans after it gapped higher at the open would have been profitable.That opening gap represented a major market top as soybeans didn’t climbback to July 19’s high for three years.

FIGURE 2 — BEARISH REVERSAL — SOYBEANS


On Jan. 22, March T-bond futures (USH08) opened 65 ticks — more than two full points — higher than its previous close.But the market fell sharply by the close. Again, selling this opening gap up would have been profitable.

FIGURE 3 — ISLAND REVERSAL — T-BONDS


continued on p. 8

lows. Then, exit at the close. Let’s test this idea and deter-mine if an opening gap’s size influences the results.

Trade rules1. Go long if price opens below the lowest low of the

past 10, 20, 30…100 days.

2. Sell short if price opens above the highest high of the past 10, 20, 30…100 days.

3. Exit at the close.

Test results — S&P 500 futuresThe strategy tested opening gaps that exceeded previoushighs and lows of 10 different look-back periods. The testsranged from 10 to 100 in 10-day increments from Jan. 1,1990 to July 14, 2008. Table 1 lists the 10 sets of performanceresults for the S&P 500 futures, ranked by return on account(net profit / maximum drawdown * 100). All 10 look-backperiods were profitable.

The most profitable technique was fading opening gapsthat rose to new 30-day highs or fell to new 30-day lows,according to Table 1. Return on account (ROA) represents

the percentage by which your accountwould have increased if your startup cap-ital equaled the largest drawdown. The30-day example (first row) assumes yourinitial capital was $17,050 — the test’sbiggest intraday loss. Therefore, the netprofit of $130,337.50 represents a 764.44-percent increase of this initial amount.

Return on account is a better statisticfor comparison than simple net profit,because it shows relative performance. Asyou add criteria to a trading system, thenumber of instances drops, and its netprofit often falls accordingly. But this isn’ta bad sign if the profit-to-drawdown ratioimproves.

For example, a system that has a netprofit of $25,000 with a $5,000 drawdownis preferable to one that has a net profit of$80,000 with a $45,000 drawdown. Thefirst system should let you confidentlytrade multiple contracts and still achievegreater profit with less risk.


TRADING STRATEGIES continued

For the S&P 500 futures (SP), the most profitable technique is fading openinggaps that rose to new 30-day highs or fell to new 30-day lows. The return onaccount is 764.44 percent.

TABLE 1 — PERFORMANCE RESULTS — S&P 500 FUTURES

Max intraday Return onNumber Net Total % Avg. drawdown account of days profit ($) trades Profitable trade ($) ($) (%)

30 130,337.50 201 56.22 648.45 -17,050.00 764.44

20 145,162.50 235 57.02 617.71 -19,400.00 748.26

40 120,875.00 178 55.62 679.07 -16,525.00 731.47

10 178,287.50 331 57.10 538.63 -27,200.00 655.47

50 116,775.00 159 56.60 734.43 -23,175.00 503.88

60 112,950.00 149 57.05 758.05 -23,175.00 487.38

100 102,137.50 116 55.17 880.50 -23,050.00 443.11

80 95,787.50 125 55.20 766.30 -21,850.00 438.39

70 104,962.50 135 54.81 777.50 -24,075.00 435.98

90 98,187.50 118 55.08 832.10 -22,950.00 427.83


March S&P 500 futures (SPH08) opened 63 points lower on Jan. 22, but rebounded sharply by the close.

FIGURE 4 — BULLISH REVERSAL — S&P 500 INDEX FUTURES



The 100-day look-back period is profitable in all markets, except Japanese yen. In the stock-index futures, it earned averageper-trade profits of between $414 and $1,124 with minimal market exposure.

TABLE 2 — TESTING DIFFERENT MARKETS — 100-DAY HIGHS AND LOWS

Net Total % Avg. Max intraday Return on Market profit ($) trades Profitable trade ($) drawdown ($) account (%)

S&P 500 futures (SP) 105,963.00 118 55.93 897.99 -16,800.00 630.7

Nasdaq 100 futures (ND) 120,345.00 107 56.07 1,124.72 -23,300.00 516.5

Russell 2000 futures (RL) 107,750.00 147 52.38 732.99 -10,500.00 1026

Dow Jones futures (DJ) 20,730.00 50 66.00 414.60 -3,470.00 597.4

30-year T-bond futures (US) 10,906.00 124 57.26 87.95 -3,594.00 303.5

10-year T-note futures (TY) 8,375.00 139 56.83 60.25 -2,469.00 339.2

5-year T-note futures (FV) 8,570.00 152 53.95 56.38 -1,172.00 731.3

Japanese yen futures (JY) (525.00) 311 45.34 (1.69) -14,638.00 N/A

Euro futures (EC) 6,263.00 123 48.78 50.91 -4,375.00 143.1

Swiss franc futures (SF) 4,212.00 218 48.17 19.32 -7,163.00 58.8

Crude oil futures (CL) 3,360.00 172 48.26 19.53 -9,640.00 34.85


Adding a filter that waited for larger opening gaps improved performance in half of the markets shown.

TABLE 3 — FILTERED TEST RESULTS

Net Total % Avg. Max intraday Return on Market profit ($) trades Profitable trade ($) drawdown ($) account (%)

S&P 500 futures (SP) 95,125.00 39.00 71.79 2,439.10 -5,350.00 1,778.00

Nasdaq 100 futures (ND) 48,600.00 32.00 62.50 1,518.75 -11,395.00 426.50

Russell 2000 futures (RL) 93,350.00 56.00 64.29 1,666.96 -3,750.00 2,489.00

Dow Jones futures (DJ) 12,550.00 16.00 75.00 784.38 -2,380.00 527.30

30-year T-bond futures (US) 8,719.00 47.00 59.57 185.51 -2,063.00 422.60

10-year T-note futures (TY) 10,906.00 68.00 69.12 160.39 -2,031.00 537.00

5-year T-note futures (FV) 5,672.00 76.00 57.89 74.63 -1,453.00 390.40

Japanese yen futures (JY) -1,500.00 274.00 45.62 -5.47 -13,963.00 N/A

Euro futures (EC) 6,800.00 95.00 49.47 71.58 -2,688.00 253.00

Swiss franc futures (SF) 963.00 172.00 48.26 5.60 -7,263.00 13.25

Crude oil futures (CL) 1,790.00 81.00 48.15 22.10 -5,500.00 32.55


Testing different marketsWhen you test this strategy in different markets, no singlelook-back period will stand out as a consistent winner.Therefore, the challenge is to pick a value that is robustacross a wide range of markets.

You don’t want to custom fit the best numbers to eachmarket, because that increases the likelihood that thoseresults are random. A specific look-back period should per-form similarly across all markets.

Gaps that exceed 100-day highs and lowsTable 2 lists the strategy’s performance with a 100-day look-back period in 11 futures markets in the past 18 years. Thesystem is profitable in all markets, except with the Japaneseyen (JY), which posted a total loss of $525.

In the stock-index futures, the technique earned averageper-trade profits of between $414 and $1,124, despite being

in the markets less than one percent of the time. That ismore than enough to overcome commissions and slippage.Each stock index gained about $6,000 annually.

Also, the stock-index futures’ ROA percentages areamong the highest in Table 2. System equity climbed from516.5 percent to 1,026 percent in 18 years in these four mar-kets.

Finally, the system has a percentage of winners that ishigher than 50 percent most of the time. In the Dow futures(DJ), the strategy was profitable 66 percent of the time.

Adding a filterTo boost performance, let’s add the following filter: Enter atrade only if the distance between today’s open and yester-day’s close is at least 50 percent of the 20-day average range(high-low). The idea is that market tops and bottoms shouldbe accompanied by relatively wide daily ranges. Also, such

continued on p. 10


large opening gaps suggest fairly volatile markets.Table 3 lists the filtered system’s performance results for

100-day highs and lows. The ROA percentages improved inonly half the markets, but notice how much the winning

markets outpace the lagging ones. Forexample, eight of 11 markets haveROA percentages of at least 253 per-cent, while markets at the bottom ofthe list — crude oil and Swiss franc —have ROA percentages of just 32.55and 13.25 percent, respectively.

Also, the average profit per tradeimproved in nine of the 11 marketsshown. Without the filter, only thefour stock-index futures have averageprofits of at least $100. With the filter,six of the 11 markets exceed thisthreshold. In addition, the percentageof winning trades increased in 10 ofthe 11 markets; the S&P 500 and Dowfutures have winning percentages of72 and 75 percent, respectively.

Fine-tuning the exit rulesThis intraday system simply exits atthe close, but most of these marketscontinued to move in the oppositedirection as the opening gap, especial-ly the stock-index futures.

Tables 4 and 5 show the results ofholding the filtered system’s tradesfrom three to seven days in the S&P500 and Dow futures. Performancesare ranked by ROA percentages. These

numbers aren’t perfect, but they show that waiting for abigger reversal might improve profitability.��

For information on the author see p. 5.


Related reading: Art Collins articles

“Turning systems upside down” Active Trader, February 2007.Inverting the rules of two popular trading techniques produces much better results than their standard applications.

“The six-signal composite indicator” Active Trader, November 2006. Take a half-dozen trading rules, rate them as either buy orsell signals, then add them together to create a market biasfor each day.

Other articles

“E-Mini morning reversal and afternoon breakout patterns”Active Trader, January 2006.Two simple ideas provide the basis for an intraday tradingapproach. System analysis sheds light on how the strategiesperform and what you can do to get the most out of them.

“Morning reversal strategy”Active Trader, May 2003.Historical tests reveal the tendency of the major stockindices to revert to the previous day’s closing price in theearly minutes of the trading session. This strategy takes its cue from that bit of market behavior.

“Twice as nice: The two-bar reversal system”Active Trader, March 2003.

The simplicity and effectiveness of the two-bar reversal pattern prove that in the markets, as in the rest of life, goodthings often come in small packages.

“Bottom or bounce?” Active Trader, February 2002.“Bottom fishing” tempts many traders who want to get in at the absolute low, but it’s very dangerous. Here’s how to tell the difference between a real bottom and a temporaryreversal.

You can purchase and download past articles athttp://store.activetradermag.com.

Holding S&P 500 trades up to seven days boosted the system’s net profit.

TABLE 4 — WAITING TO EXIT — S&P 500 FUTURES


1 167,475.00 110 57.27 1,522.50 -20,550.00 814.96

3 138,800.00 94 56.38 1,476.60 -29,250.00 474.53

2 131,625.00 103 54.37 1,277.91 -29,250.00 450.00

4 98,387.50 89 47.19 1,105.48 -38,925.00 252.76

5 113,587.50 85 56.47 1,336.32 -64,925.00 174.95


Like the S&P 500, holding trades in the Dow futures a few more days improvedthe system’s net profit.

TABLE 5 — WAITING TO EXIT — DOW FUTURES


2 26,100.00 47 61.70 555.32 -8,450.00 308.88

1 25,620.00 47 65.96 545.11 -12,250.00 209.14

3 19,180.00 44 54.55 435.91 -10,250.00 187.12

4 23,090.00 40 55.00 577.25 -16,800.00 137.44

5 24,420.00 37 56.76 660.00 -19,700.00 123.96


http://store.activetradermag.com

4ARTICLECOLLECTIONSActive Trader Trading System Labs: 2007

Futures Trading System Labs: 2007

Options Strategy Labs: 2007

Currency System Analysis, Vol. 2

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BIG



From crunch to crush

T he ongoing credit crunch that wasoriginally thought to be containedin the sub-prime mortgage markethas spread to places the average

trader might not suspect. Although the seepagefrom sub-prime to prime mortgages and theproblems with bank funding are now commonknowledge, the way the credit situation canaffect the grain and oilseed markets is less wellknown.

Because of the credit issues the grain elevatorcommercials seem to be having, the unfolding2008 harvest season could be a perilous time forcorn and soybean traders because the spread sig-nals that ordinarily reflect the supply-demandfundamentals could be misleading.

Further, the country elevator problem seemslikely to set off a chain reaction. Elevator activityis likely to adversely affect the long-only com-modity index funds, and the reactions of thesevery large traders could make the markets diceyfor individual traders. Reactions through thischain may temporarily override market funda-mentals.

Grain elevator credit issues could victimize soybeans — and soybean traders, if they’re not careful.


TRADING STRATEGIES

BY KEITH SCHAP

Intermonth usually offer a quick-and-easy way to gauge amarket’s supply-demand situation. Successively higherprices produced the positive spreads shown here, whichis the futures market indicating supplies are plentiful.

Contract Price ($/bu) Spread ($/bu)

January 6.0925

March 6.2450 0.1525

May 6.3625 0.1175

July 6.4625 0.1000

Successively lower prices and negative spreads mean thefutures market is telling you a supply shortage — or fearof one — exists.

TABLE 2 — “INVERTED” SPREADS SIGNALA SHORTAGE OF SOYBEANS


January 7.9775

March 7.8400 -0.1375

May 7.5000 -0.3400

July 7.3150 -0.1850

For much of this summer soybean futures prices seem tobe indicating plentiful supplies: These positive spreadsare at or near “full carry.”

TABLE 3 — BEWARE A FALSE SIGNAL


November 11.8050

January 11.9925 0.1875

March 12.1375 0.1450

May 12.2700 0.1325

July 12.3975 0.1275

In contrast to Table 3, the supply-demand data from the U.S. Department of Agriculture (USDA) indicated soybeans were in very short supply.

TABLE 4 — USDA NUMBERS INDICATE SOYBEAN SHORTAGE

2007-08 2008-09

Total supply 3,169 3,135

Total usage 3,044 2,995

Ending stocks 125 140

Stocks/usage 4.1% 4.7%

The spread between the November 2008 and January 2009 soybean contracts is shown at the bottom of the chart.

FIGURE 1 — NOVEMBER-JANUARY SOYBEAN SPREAD


TABLE 1 — “CARRY” SPREADS SIGNAL PLENTIFULSUPPLIES OF SOYBEANS


Intermonth spreads usuallyindicate supply-demand relationshipsMonth-to-month commodity spreads(the difference between the prices oftwo different contract months) typical-ly provide a quick and easy way togauge a market’s supply-demand situ-ation.

Look at the soybean (S) futuresprices in Table 1. Successively higherprices lead to the positive spreads inthis table, which is the futures markettelling you supplies are plentiful. Thehigher “deferred prices” of the moredistant back months prompt farmersand elevators to store soybeans againstfuture needs.

At other times, you might see theprice relationships displayed in Table2. When successively lower prices leadto negative spreads such as these, thefutures market is telling you a supplyshortage exists, or there is the fear ofone. These higher nearby prices moti-vate immediate delivery rather thanstorage for later delivery.

For much of summer 2008, soybeanfutures prices were like the ones inTable 1. Figure 1 shows November2008 and January 2009 soybeanfutures, along with the intermonthspread. In early August, futures priceswere similar to those in Table 3. Thepositive spreads were at (or close to)“full carry,” which defines the limit forpositive spreads. Full carry includesthe costs of storage, taxes, insurance,financing, and a shrinkage allowance.Normally, spreads at full carry indicatethe market believes soybean suppliesare adequate.

However, the supply-demand tablesissued by the U.S. Department ofAgriculture (USDA) tell a differentstory about the soybean situation.Table 4 abbreviates the information forthe 2007-2008 and 2008-2009 cropyears contained in the July USDAreport. For practical purposes, any“ending stocks” number under 200million is effectively zero.

These values are given in millions ofbushels, so the 3,169 total supply for2007-2008 indicates 3.169 billionbushels. Whether these figures arecompletely accurate or not, soybeansare in very short supply; the futuresspreads of Table 3 result from some-thing other than just the supply-demand dynamic.

This conflict between the two sets ofdata calls for explanation.

Credit blight hits the elevatorsOrdinarily, farmers sell grains or soy-beans in increments throughout thegrowing season. Grain elevators buythis grain and immediately go shortfutures to protect against falling prices.Later, when the elevators sell the soy-beans they have bought, they buythese futures back to unwind theirhedges.

A typical elevator line of creditallows financing of approximately 84percent of these purchases; the eleva-tor must pay cash for the other 16 per-cent. When soybeans are trading at$6.00 per bushel, this 16 percentamounts to $4,800 per contract, or$960,000 for one million bushels. Asoybean price of $16.00 per bushelboosts this working capital require-ment to $12,800 per contract, or $2.56million for one million bushels.

Apparently, large numbers of coun-try elevators lack this kind of workingcapital. As a result, banks, already suf-fering from the credit crunch of the lastyear, decline to lend to the elevators.

The only way elevators can buymore soybeans (or corn or wheat) is to

continued on p. 14

A rising futures market often generates a large enough gain on the futuresposition to overcome the cost of rolling over the position.

A. 2/28/90 Futures Contract No. of Position value

price ($/bu) value ($) contracts ($ millions)

Buy SK90 5.8075 29,037.50 6,000 174.225

4/30/90

Sell SK90 6.3250 31,625.00 6,000 189.750

Buy SN90 6.4850 32,425.00 6,000 194.550

Roll result -4.800

Futures result 15.525

Net result 10.725

B. 12/30/04 Futures Contract No. of Position value


Buy SH05 5.4725 27,362.50 6,000 164.175

2/28/05

Sell SH05 6.1550 30,775.00 6,000 184.650

Buy SK05 6.2200 31,100.00 6,000 186.600

Roll result -1.950

Futures result 20.475

Net result 18.525

TABLE 5 — WHEN FUTURES GAINS OVERCOME THE COST OF THE ROLL

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liquidate inventory. This response to thecredit situation will tend to widen theintermonth futures spreads. Also, as adelivery month approaches, the nearby-first-deferred spread (e.g., duringOctober, this is the November-Januaryspread) will tend to reach full carry.

The strongly positive spreads of Table3 most likely reflect the elevators’response to tight credit and insufficientworking capital rather than an amplesupply of soybeans.

The plight of the long-onlyindex fundsA long-only commodity index fund goeslong all the contracts in whichever com-modity index it tracks. Unlike stocks,which you can hold practically withoutlimit, futures contracts expire on a regu-lar schedule — in soybeans, every twomonths, except for the extra August con-tract. This means a long-only fund man-ager must periodically roll forward thefund’s soybean futures positions — thatis, if the fund is long January soybeanfutures, it must sell the January contractsand buy March futures. It will usually dothis at or near the end of the month priorto the delivery month (in this case, onone of the last trading days inDecember).

When the spreads are positive, as inTables 1 and 3, the roll will be expensive,because the fund will be selling low andbuying high. Of course, when thespreads are negative, as in Table 2, theroll will generate incremental income,but this is a relatively rare situation inthe grain and oilseed markets.

A rising futures market often gener-ates a large enough gain on the futuresposition to overcome the cost of the roll.Table 5 shows two such cases. Tables 5through 10 assume 6,000-contractfutures positions and rollovers thatoccur on the last day of the roll month(e.g., April for the May-July roll in Table5). The “Futures result” values are theprice differences between the relevantcontracts (in Table 8, the May and July2004 contracts, SK04 and SN04) from thelast day in the prior roll month to the lastday of the current roll month, multipliedby 30,000,000 bushels (5,000 bushels percontract times 6,000 contracts). The6,000-contract position size, incidentally,is slightly less than the average longindex position based on the CommodityFutures Trading Commission’s data



The combination of positive spreads and falling futures prices results in negative rollovers and futures results — and an even larger negative net result.

A. 8/31/90 Futures Contract No. of Position value


Buy SX90 6.1375 30,687.50 6,000 184.125

10/31/90

Sell SX90 5.9200 29,600.00 6,000 177.600

Buy SF91 6.0925 30,462.50 6,000 182.775

Roll result -5.175

Futures result -6.525

Net result -11.700

B. 12/30/05 Futures Contract No. of Position value


Buy SH06 6.1350 30,675.00 6,000 184.050

2/28/06

Sell SH06 5.8025 29,012.50 6,000 174.075

Buy SK06 5.9400 29,700.00 6,000 178.200

Roll result -4.125

Futures result -9.975

Net result -14.100

TABLE 7 — THE ROLL COST CAN TURN A LOSS INTO A BIGGER LOSS

Positive rolls can augment a positive futures result, but they rarely occur.

2/27/04 Futures Contract No. of Position valueprice ($/bu) value ($) contracts ($ millions)

Buy SK04 9.3700 46,850.00 6,000 281.100

4/30/04Sell SK04 10.3400 51,700.00 6,000 310.200Buy SN04 10.1300 50,650.00 6,000 303.900Roll result 6.300Futures result 29.100Net result 35.400

TABLE 8 — A ROLL GAIN CAN AMPLIFY A FUTURES GAIN

On rare occasions, the rollover cost will be greater than the futures gain. The net result is then a loss.

2/28/95 Futures Contract No. of Position valueprice ($/bu) value ($) contracts ($ millions)

Buy SK95 5.6475 28,237.50 6,000 169.425

4/28/95Sell SK95 5.6700 28,350.00 6,000 170.100Buy SN95 5.8000 29,000.00 6,000 174.000Roll result -3.900Futures result 0.675Net result -3.225

TABLE 6 — THE ROLL COST CAN TURN A GAIN INTO A LOSS

from June through Aug. 5, 2008. Only rarely does the roll cost overwhelm the futures

gain. When it does, the net result is negative even thoughthe futures result is positive, as illustrated in Table 6. Here,positive spreads caused a loss on the roll, and rising Mayprices caused a small gain in the futures position. The com-bination led to a loss for that two-month period.

Frequently, the combination of positive spreads andfalling futures prices causes negative roll and futuresresults and, of course, an even larger negative net result, asillustrated in the two examples in Table 7. The rare positiveroll results can greatly enhance a positive futures result, asillustrated in Table 8.

No doubt, the situations of Tables 5 and 8 are what thelong-only managers hope for when they make these trades.Unfortunately, the situation illustrated in Table 7 is morecommon.

Table 9 distills 20 years of soybean rollovers: Each rollresult was either a cost (-) or a gain (+). The futures pricelosses and gains are similarly denoted, as are the net resultscombining roll and futures results. To avoid the complica-tions surrounding old crop-new crop transitions, this studyanalyzed only the November-January, January-March,March-May, and May-July rolls for each crop year exam-ined.

To summarize, 71 of the 80 rolls generated a cost, and 31of those had a futures gain large enough to generate a netgain (as in Table 5). Twice, the futures result was positivebut not large enough to result in a positive net result (as inTable 6).

A negative roll result combined with a negative futuresresult occurred 38 times (as in Table 7). Seven times bothroll and futures results were positive (as in Table 8). Twotimes the roll result was positive, but the futures and netresults were negative.

During these 20 years, a long-only soybean positionwould have been singularly unprofitable. Table 9 showspositive results for 38 of these 80 roll periods. A search ofresults for each crop year shows only seven of 20 generatedpositive results, while looking at five-year intervals (1-5, 6-10, 11-15, and 16-20) shows only the last one produced a netgain. In dollar terms, a 6,000-contract position would havelost $50.7 million for the entire 20-year period.

ImplicationsAmong other things, this survey — which starts manyyears before these long-only funds were even a twinkle inanyone’s eye — demonstrates the difficulty of generatingconsistently positive results using such a strategy.

The most recent five-year period includes the years dur-ing which these funds emerged and produced strongly pos-itive results. This look at the past might constitute a cau-tionary note about what to expect in the future, not only forfund investors but especially for individual traders in thesemarkets.

From the vantage points of any of the first three rolls ofthe 2008-2009 crop year, 2008 would have looked like a verygood year. The November-January roll, based on theassumptions used throughout, would have netted $33.525million, and the January-March and March-May rolls would

have netted $47.4 million and $87.975 million, respectively. But consider what happened next. Table 10 shows the

data for the May-July, July-September, and September-November rolls (note, however, the early cutoff for theSeptember-November roll, which could still play out some-what differently). This is stormy weather indeed.

Looking aheadMost funds have some kind of exit rule. When the fund suf-fers a drawdown greater than some specified magnitude, it


continued on p. 16

During the 20-year review period, a long-only soybeanposition would not have been profitable. There were positive results for 38 of the 80 roll periods, and only seven of 20 crop years were profitable. Only one five-year period (the last one) produced a net gain.

Roll Futures Net Roll Futures Netresult result result result result result

1 - + + 41 - - -2 - - - 42 + + +3 - - - 43 - + +4 - + + 44 + + +5 - + + 45 - + +6 - + + 46 - - -7 - + + 47 - - -8 - + + 48 + - -9 - - - 49 - + +10 - + + 50 - - -11 - - - 51 - - -12 - - - 52 - + +13 - - - 53 - - -14 - - - 54 - - -15 - - - 55 - + +16 - + + 56 - + +17 - - - 57 - - -18 - - - 58 - + +19 - + - 59 - - -20 - - - 60 - - -21 - - - 61 - - -22 - - - 62 - - -23 - + + 63 - + +24 - - - 64 - + +25 - + + 65 - + +26 - + + 66 + + +27 - + + 67 + + +28 - + + 68 - + +29 - - - 69 - + +30 - + + 70 - - -31 - - - 71 + + +32 + - - 72 + + +33 - - - 73 - - -34 - - - 74 + + +35 - - - 75 - + +36 - + - 76 - - -37 - + + 77 - - -38 - + + 78 - + +39 - - - 79 - - -40 - + + 80 - - -

TABLE 9 — SUMMARIZING 20 YEARS OF SOYBEAN ROLL RESULTS


must liquidate the position. The com-bination of positive spreads and aplunging soybean market leads to verylarge losses for the periods endingwith the May-July and September-November rolls. These two results,taken in isolation, make it difficult tobelieve such outcomes wouldn’t tripthe liquidation signal. In fact, thisseems to have happened during thefirst week in August, although details

remain sketchy.No one can know exactly how the

soybean situation will play out fromharvest into 2009. One analyst head-lined a mid-August report, “BeansNeed Good Finish.” A plentiful cropcould drive prices lower yet. A scantycrop could improve the situationsomewhat.

But these fundamentals may notmatter as much as they usually do.These falling futures prices and per-haps misleading wide spreads couldconceivably lead a number of long-only commodity funds to have to, orwant to, liquidate their soybean posi-tions. This would widen the spreadsmore and drive prices even lower thanthe usual post-harvest plunge.

During the harvest season and for ashort while afterwards, the soybeanand corn markets are unlikely to tradein terms of fundamentals. The funda-mental factors will still be there, butthe credit-related phenomena mayoverride them. Traders approachingthese markets will need to exercisegreat caution and have risk controlsfirmly in place.

Sometime after the beginning of2009, this furor should subside, andthe grain markets should trade inaccord with the fundamentals onceagain. For the short term, though,these are “trader beware” marketsbecause of the credit issues.��



The first three rolls (Nov.-Jan., Jan.-March, and March-May) of the 2008-09crop year might have made 2008 look like a good year, but the May-July, July-Sept., and Sept.-Nov. rolls tell a different story (although the Sept.-Nov. rollcould still play out differently).

A. 2/29/08 Futures Contract No. of Position valueprice ($/bu) value ($) contracts ($ millions)

Buy SK08 15.3650 76,825.00 6,000 460.950

4/30/08Sell SK08 13.0175 65,087.50 6,000 390.525Buy SN08 13.1400 65,700.00 6,000 394.200Roll result -3.675Futures result -70.425Net result -74.100

B. 4/30/08 Futures Contract No. of Position valueprice ($/bu) value ($) contracts ($ millions)

Buy SN08 13.1400 65,700.00 6,000 394.200

6/30/08Sell SN08 16.0500 80,250.00 6,000 481.500Buy SU08 15.8400 79,200.00 6,000 475.200Roll result 6.300Futures result 87.300Net result 93.600

C. 6/30/08 Futures Contract No. of Position valueprice ($/bu) value ($) contracts ($ millions)

Buy SU08 15.8400 79,200.00 6,000 475.200

8/14/08Sell SU08 12.7750 63,875.00 6,000 383.250Buy SX08 12.8400 64,200.00 6,000 385.200Roll result -1.950Futures result -91.950Net result -93.900

TABLE 10 —A VERY GOOD YEAR OR STORMY WEATHER?

Related reading

“Speculators in crude oil? Where?”Active Trader, October 2008.There’s been a lot of talk lately aboutspeculators in the crude oil market. Ittakes more than a little digging to findsome useful numbers — but the even-tual implications are interesting.

“When value is uncertain, sell volatility”Active Trader, September 2008.Wild conditions in commodity futuresopen the door for option trades.

“The liquidity crunch trade”Active Trader, August 2008.A futures-spread strategy practiced byinstitutional traders can be used to takeadvantage of gyrations in the creditmarket.

“The credit crisis: Investor anguish, trader opportunity”Active Trader, April 2008.Despite the actions taken by centralbanks and other institutions, the sub-prime mess and credit crisis might befar from over. Astute traders might beable to use spread relationships to prof-it from the market’s upcoming swings.

“A season for volatility trades in the grains”Futures & Options Trader, July 2007.Implied volatility extremes help uncoverstraddle and strangle opportunities inthe soybean and corn futures.

Note: Some of the above articles are part of “Keith Schap: Futures Strategy collection, Vol. 1,” which is a discountedset of articles in PDF format.You can purchase past articles at http://store.activetradermag.com


ads0908 7/15/08 1:28 PM Page 39


Hedging with bear put spreads

Investors have had a tough time so far in 2008 as theS&P 500 index fell 18.3 percent from Jan. 2 to July 15.You could have minimized the impact of this declineby hedging a portfolio of stocks with long puts. But

buying puts can be expensive, especially during down-trends when market volatility spikes. As the cost of buyingputs rises, their effectiveness as a hedge wanes, and poten-tial profits from a stock portfolio can suffer.

Instead of buying puts for protection, you can add a bearput spread (long put + short same-month, lower-strike put)to your portfolio. Both strategies protect against market

declines, but a bear put spread is much cheaper because thelower-strike put you sell helps offset the higher-strike putyou buy.

The trade-off is bear put spreads offer less downside pro-tection than straight long puts. But as long as the marketdoesn’t completely crash, these spreads offer several advan-tages over buying puts.

Buying puts as a hedgeTo compare these two strategies, let’s track their hypotheti-cal performance. The S&P 500 index closed at 1,375.93 onMay 23. For simplicity, let’s assume the long portfolio isworth $137,593, or 100 times the index’s value.

One way to hedge this portfolio is to buy puts at slightlyout-of-the-money (OTM) strikes that expire in roughly oneyear. For example, you could buy a 1,300-strike June 2009put for $91.60, or $9,160 in dollar terms ($91.60 * $100). Table1 shows this trade’s details, and Figure 1 compares itspotential gains and losses at expiration (brown line) to theunprotected index (pink line).

Figure 1 shows the hedged position’s (stock + long put)losses are limited to $16,600 if the S&P 500 drops to 1,300 orbelow by expiration on June 19, 2009. But if the marketclimbs, its upside breakeven point rises by the put’s cost;any potential gains are reduced by the same amount. TheS&P 500 must jump 6.6 percent to 1,467.53 just to cover theput’s cost by expiration.

The bear put spread advantageYou can reduce this cost by selling a same-month put at alower strike, which creates a bear put spread. After buyinga 1,300-strike put on May 23, you could then sell a 1,150-strike put for $47.10 ($4,710 in dollar terms). This step low-ers the protective position’s cost to $44.50 ($4,450 in dollarterms).

Table 1 shows this trade’s details, and Figure 2 comparesits potential gains and losses at expiration to the unhedged

Are you paying too much to hedge a long portfolio?

Find out why bear put spreads act as better hedges than long puts.


TRADING STRATEGIES

BY TRISTAN YATES

Strategy snapshot

Strategy: Hedging with bear put spreads

Components: Long stock portfolio +

1 long put with a strike price 10 percent below the market’s current value.

+1 short put with a strike price 10 percent below that.

Logic: Protect a stock portfolio against 10- to 30-percent losses for less than the cost of buying puts outright.

Best-case Market rallies sharply and spread’s cost scenario: is a small percentage of overall portfolio

profits.

Worst-case Market drops below bear put spread’s short scenario: strike and spread protects against only a

portion of that loss (strike-price difference - spread’s cost).

Possible Exit spread after six months and replace it adjustments: with higher-strike puts that expire in

18 months.


index (green and blue lines,respectively). Figure 2 shows thespread’s maximum losses are lim-ited to $12,210, but only if the mar-ket trades between the two strikeprices at expiration.

Below the 1,150 short put, lossescontinue to mount, but they are105.5 points (150 strike-price dif-ference minus 44.50 spread cost)smaller than the unprotectedindex.

In theory, a bear put spread is atrisk of early exercise, assumingAmerican-style options are used.In reality, however, the short putholder is unlikely to exercise itunless the underlying dropssharply and the put loses all of its timevalue. Even if this happened, the long1,300 put would retain its full intrinsicvalue, so you could exercise it and thespread would be worth 150 points — itsmaximum value.

Estimated costs and benefitsHedging with bear put spreads costs lessand offers more benefits than simplybuying puts. To demonstrate, let’s firstassume a hypothetical index trades at 100that also represents a portfolio of stocks.As a hedge, you can buy 12-month putswith a strike price of 90, or you can entera spread by buying 90-strike puts andselling 80-strike puts.

Table 2 compares the costs and benefits of both positionsto the unprotected index. The expected returns and proba-bilities of different-sized losses (i.e., at at least 5, 10, 15, or 20percent) are also shown. To estimate these values, the tableassumes the index climbs 10 percent annually with a 15-per-cent historical volatility and uses a normal distribution ofthose returns; for simplicity, dividends are ignored.

The bear put spread costs 1.77 vs. 2.88 points annually forbuying puts outright. The spread is less expensive becauseselling a lower-strike put offsets the long put’s cost, and theposition offers limited downside protection. Also, lower-strike puts have higher implied volatilities (IVs) than high-

er-strike ones, which helps lower the spread’s overall cost.Given Table 2’s assumptions, buying puts can help avoid

an average loss of 0.57 points each year at a cost of 2.88points. If the index rises 10 points annually, the hedgingstrategy earns a median 7.12 points and an average 7.69points. Therefore, this hedge’s cost is nearly 25 percent itsexpected annual profits.

By contrast, the bear put spread costs only 1.77 pointswith an expected benefit of 0.49 points. In one year, theindex hedged with a put spread would earn a median 8.23points and an average 8.72 points — much better than sim-

Long puts will completely protect a portfolio below the strike price, but they can beexpensive. One 1,300 put cost $9,160 on May 23, which means losses are capped at$16,600 if the S&P 500 drops sharply (brown line). However, the portfolio’s upsidebreakeven point is raised to 1,467.53, and any potential gains are reduced.

FIGURE 1 — PORTFOLIO + LONG PUTS

Source: OptionVue

continued on p. 20

As a hedge, bear put spreads are cheaper than long puts. But they offer limitedprotection if the market drops below the short put’s strike.

TABLE 1 — LONG PUTS VS. BEAR PUT SPREAD

S&P 500 index closed at 1,375.93 on May 23.

Hedge 1 - buy puts

Long or short? Strike Expiration IV Cost Dollar cost

Long 1,300 June 2009 24.51% -$91.60 -$9,160.00

Hedge 2 - buy bear put spread

Long or short? Strike Expiration IV Cost Dollar cost

Long 1,300 June 2009 24.51% -$91.60 -$9,160.00

Short 1,150 June 2009 27.07% $47.10 $4,710.00

Total debit: -$44.50 -$4,450.00

ply buying puts, especially if this performance is applied toa large portfolio and compounded over five or 10 years.

Adding a bear put spread doesn’t eliminate the likeli-hood of catastrophic loss, it just reduces it. Table 2 shows

the underlying index has a five-percent chance of dropping15 percent in one year. The bear put spread reduces thispossibility to about 1.5 percent in one year. Essentially, thespread cuts the probability of sharp losses in half.

Time decay and rolling the spreadTable 3 lists the time decay of eachposition at 30-day intervals in a 12-month period and uses the sameassumptions as Table 2. Admittedly,the passage of time and the underly-ing’s steady gains take their toll on thespread. However, the spread’s shortput decays faster than its long put,which helps the spread maintain itsvalue.

After six months, the bear putspread still retained 40 percent of itsvalue, even when the underlying ral-lied significantly. The long 90 put wasworth $0.87, but the short 80 put wasworth only $0.17. The position stillhad value as a hedge and could beheld until it expires in six months.

Or you can exit the spread andreplace it with options at higherstrikes that don’t expire for another 12months, a technique called “rolling.”Table 4 shows you can sell the 90-80spread for $0.70 and use the proceedsto buy a 95-85 spread that expires sixmonths later.

The cost of rolling a spread dependson the underlying’s price and impliedvolatility. In general, it is better to rolla position when volatility is low andthe market has dropped. However, it’stough to set solid rules, because allfour puts have different volatilitiesand strike prices.

Estimates show that the costs ofrolling the original 90-80 spread upfive points and out 12 months rangedfrom $1.10 to $1.50; it cost $1.35, onaverage.

Different market scenarios Table 5 shows how the 90-80 bear putspread’s value is affected by the pas-sage of time, gains or losses in theunderlying, and changes in volatility.



The bear put spread costs 1.77 vs. 2.88 points annually for buying puts outright.And the spread earns more than long puts, assuming the index climbs 10 percent each year.

TABLE 2 — WHICH IS THE BETTER HEDGE?

No hedge Bear put spread Long putAnnual cost 0 1.77 2.88Expected benefit 0 0.49 0.57Expected loss (cost-benefit) 0 1.28 2.31

Expected annual return 10 8.72 7.69Median return 10 8.23 7.12Probability of >= 5% loss 16% 19% 21%Probability of >= 10% loss 10% 12% 13%Probability of >= 15% loss 5% 2% 0%Probability of >= 20% loss 3% 0.6% 0%

Assumptions: Market price = 100, long put strike = 90, short put strike = 80,12-month bear put spread, 90-strike put IV =22%, 80-strike put IV = 22% (volatility skew of 1%), expected annual return = 10 %, volatility = 15%, interest rate = 3.75%, no dividends.

Adding a bear put spread to a stock portfolio limits the position’s maximum lossto $12,210, but only if the market trades between the two strike prices at expira-tion. Below the 1,150 short put losses continue to mount, but they are smallerthan if the index was unhedged.

FIGURE 2 — PORTFOLIO + BEAR PUT SPREAD

Source: OptionVue


The passage of time and the underlying’s steady gains take theirtoll on both hedging strategies. But after six months the spread stillretained 40 percent of its value.

TABLE 3 — TIME DECAY

Days to Market Long Short Time expiration price put put Spread decay

365 100.00 2.88 1.11 1.77

335 100.80 2.53 0.92 1.61 8.7%

304 101.60 2.18 0.73 1.45 18.0%

274 102.41 1.84 0.56 1.27 27.8%

243 103.23 1.50 0.41 1.09 38.2%

213 104.05 1.18 0.28 0.90 49.0%

183 104.88 0.87 0.17 0.70 60.2%

152 105.72 0.59 0.09 0.50 71.5%

122 106.56 0.35 0.04 0.31 82.3%

91 107.41 0.16 0.01 0.15 91.6%

61 108.27 0.04 0.00 0.04 97.9%

30 109.13 0.00 0.00 0.00 99.9%

0 110.00 0.00 0.00 0.00 100.0%

Assumptions: Market price = 100, long put strike = 90, short put

strike = 80, annual gain = 10%, 12-month bear put spread, 90-strike

put IV =22%, 80-strike put IV = 22% (volatility skew of 1%), expected

return = 10 % and volatility = 15%, interest rate = 3.75%, no

dividends.

After six months you could have rolled the 90-80 spread to higherstrikes and later expirations for just $1.38.

TABLE 4 — ROLLOVER AFTER SIX MONTHS

Original bear put spreadValue after

Type Expiration Entry cost six monthsLong 90 put June 2009 -$2.88 $0.87Short 80 put June 2009 $1.11 -$0.17

Total debit: $1.77 $0.70Index rises from 100 to 104.88 in six months.*

Rolling the spreadType Expiration Entry costLong 95 put December 2009 -$4.17Short 85 put December 2009 $2.09

Total debit: -$2.08Total rolling costs: -$1.38

* The rest of Table 2's assumptions remain unchanged.

The spread initially cost 1.77 and its largest possiblevalue is $10, which represents a 660-percent gain.But you won’t capture the spread’s maximum gainunless the underlying falls 25 percent in 12 monthsand you wait until expiration to exit the trade.

However, you can still make money in a varietyof situations. For instance, the spread gains groundif the underlying drops 10 percent or more or ifimplied volatility rises. If the index drops 10 percentin the first six months, the spread could double invalue as the OTM 90-strike put moves closer to themoney. And when markets drop, implied volatilitytends to rise, which also boosts the trade’s value.

Bear put spreads often benefit from IV increases,because the long put’s value rises further than theshort put’s value. But it doesn’t always work thisway.

If, for example, the underlying falls sharply totrade near the short put’s lower strike, the spreadbecomes vega neutral, which means changes in IVno longer affect it. And if the market falls further,the position will lose value if implied volatilityincreases. This happens because the short put’sextrinsic value rises, reducing the spread’s overallvalue.

A scenario in which the underlying falls 20 pointscan be frustrating, because the bear put spreadmight be worth only $5 or $6 instead of its maxi-mum value of $10. In this case, the short put mayhave a large amount of time value left. And theshort put will increase in value if volatility contin-ues to rise, eroding the spread’s profit further.Fortunately, this situation should only be tempo-rary, because the short put’s value will drop as timepasses and volatility declines.

It’s tempting to try to time the market and hedgewith a bear put spread only when you think stockscould decline. This approach might be profitable,but it misses the point of a hedge — security. By con-trast, the spread’s costs and benefits are more pre-dictable if you maintain the position by rolling itevery six months.

Which market to hedge?The strategy works best on broad and highly liquidindices such as the S&P 500 (SPX), Dow JonesIndustrial Average (DJIA), Nasdaq 100 (NDX), orRussell 2000 (RUT). On other indices, the bid-askspreads and transaction costs may be too large tobenefit from selling puts or from rolling the spreadevery six months.

continued on p. 22


However, you can apply this strate-gy to liquid, but more volatile indicessuch as distressed sectors or foreignmarkets. The caveat is that these posi-tions cost more because impliedvolatility is higher and traders arewilling to pay more to protect againstsharp declines.

In September 2007, for example, thegold/silver producer index (XAU)traded at an implied volatility of 38. Atthose prices, a 10-point bear putspread cost more than 3.5 percent ofthe index’s price, which seemed high.But XAU jumped from 171 on Sept. 20,2007 to 206 on March 14 — a 20-per-cent gain that would have paid for the

hedge’s cost multiple times (Figure 3).In addition, a 160-150 September 2008bear put spread retained some valuebecause it didn’t expire for another sixmonths and the market’s volatilitywas still elevated.

At that point, exiting the spread androlling it to higher-strike puts thatexpired later would have been a goodidea. The gold/silver producer indexthen fell 20.9 percent from March 14 toMay 1. If you had rolled the spread inmid-March, that hedge would haveprotected you from roughly half ofthat loss. ��


TRADING STRATEGIES continued Related reading:Tristan Yates articles

“Exploiting the fear factor” Futures & Options Trader, February 2008.What’s the best way to profit fromhigh-volatility forecast? Comparingthe performance of covered calls, dif-ferent option spreads, and LEAPSshines some light on the subject.

“Long-term diagonal call spreads”Futures & Options Trader, November 2007.This detailed look at diagonalspreads shows how to trade themwith a long-term perspective.

“Rolling leaps calls” Futures & Options Trader, September 2007.Holding LEAPS calls instead of theunderlying shares can pay off — butonly if you know when to roll themforward.

Other articles

“Optionality: Why options are better than insurance” Active Trader, November 2007.Getting the most out of an optionstrade requires looking beyond theclichés and understanding how thesetools really work.

“Playing defense: Long puts vs. bear put spreads” Futures & Options Trader, June2007. Protecting a portfolio from amarket downturn doesn’t have to becomplicated. Find out which defen-sive strategy offers the most bang foryour buck.

“The simplicity of debit spreads”Options Trader, February 2006.Using spreads instead of buyingoptions outright can reduce risk andincrease opportunity. This discussion of "debit" spreads highlights their versatility.

You can purchase and download past articles at http://store.activetradermag.com.

XAU jumped 20 percent from September 2007 to March 2008, but then gave backthose gains within six weeks. But you could have made money if you entered abear put spread back in September and then replaced it with higher-strike, later-expiring puts in March.

FIGURE 3 — HEDGING IN THE GOLD/SILVER PRODUCER INDEX

Source: eSignal

The spread gains ground if the underlying drops 10 percent or more or impliedvolatility rises. But you won’t capture its maximum value of $10 unless the indexdrops 25 percent and you wait until both puts expire in 12 months.

TABLE 5 — EFFECTS OF TIME, DIRECTION, AND VOLATILITY

Scenario Today 3 months 6 months 9 months 12 months later later later later

Flat 1.77 1.56 1.22 0.63 0.00

10% gain 0.86 0.65 0.37 0.08 0.00

25% gain 0.25 0.14 0.04 0.00 0.00

10% loss 3.27 3.23 3.12 2.78 0.39

25% loss 6.40 6.83 7.43 8.41 10.00

Higher volatility (IV=31) 2.76 2.56 2.20 1.49 0.00

Lower volatility (IV=11) 0.41 0.30 0.17 0.03 0.00


ads1008 8/12/08 6:15 PM Page 47

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Trading stocks with short options

In the quest to learn complexoptions strategies, newer tradersoften miss some of their simpleand practical advantages. For

example, you can use options to buy orsell stock at your target price — a tech-nique that has certain benefits over sim-ply entering a limit order in the stockitself. You may need to wait a week or twolonger than usual, but the odds of execut-ing orders at ideal prices are improved,even when the stock never trades as lowor high as you wish.

The trick lies in selling options instead

Shorting puts and calls can be risky, but if you want to own the underlying instrument,

it can help you trade more efficiently.


TRADING STRATEGIES

Instead of entering a buy limit order in the stock, you could sell August 165 putson Apple, which obligates you to buy the stock if it trades below the strike priceat expiration.

FIGURE 1 — TRADE EXAMPLE

Source: eSignal

Strategy snapshot

Strategy: Selling puts or calls.

Logic: Collect premium. Wait to buya stock at a reduced price (short puts).

Criteria: Use front-month options whenIV is low. Use second- or third-month options when IV is high.

Max. risk: Stock price – premium collected.

Best-case Puts — underlying drops scenario: below short strike, stock

is bought and then climbs sharply. Calls — underlying drops to short strike at expiration.

Worst-case scenario: Underlying falls to zero.

BY MARK D. WOLFINGER

When you sell August 165 puts on Apple, you collect 8.00 in premium,which lowers your purchase price to $157. But if the short puts aren’t exercised and you don’t get assigned, you still keep that premium.

TABLE 1 — SELLING PUTS ON APPLE

Apple Inc. (AAPL) traded at $174 on June 24.

Dollar amount No. of Long or (price * 100 puts short? Strike Expiration Cost multiplier)

3 Short 165 August 2008 $8.00 $800.00

Total premium: $24.00 $2,400.00

Net cost: $157.00

FUTURES & OPTIONS TRADER • September

of buying them. When you buy an option, you purchase theright to buy or sell the underlying at the strike price beforeit expires. But when you sell an option, you accept the obli-gation to buy or sell stock at the strike price. Selling optionscan be risky, but if you already own the underlying shares— or plan to buy them — it can be a smart move.

For example, if you want to buy a stock but think it’soverpriced, you could sell a put with a strike price belowthe current stock price. Then you buy the stock only if it isbelow the strike price when expiration arrives. You alwayskeep the premium.

Alternately, if you own stock but want to sell it at a high-er price, you could sell a call with astrike above its current value. Then, yousell the stock only if it rallies andremains above the strike at expiration;again, you keep the short option’s pre-mium.

Buying stock below the marketFigure 1 shows that Apple (AAPL) trad-ed at $174 on June 24. Let’s assume youwant to buy 300 shares, but you don’twant to pay more than $158 per share.One method is to place a good till can-celled (GTC) order with your broker,bidding $158. If AAPL drops that far,that order will be executed. But if Applenever falls that low, the order won’t beexecuted, and you will eventually can-cel it.

Another approach is to sell AAPLputs. On June 24, you could have soldthree AAPL August 165 puts thatexpired in 38 days. By selling those putsand collecting the cash premium, youare accepting an obligation to buy 300shares at the strike price. That obliga-tion remains until the options expire oryou buy them back to close the position.If Apple is below the strike price whenexpiration arrives, you will receive anexercise notice and be required to buy300 shares.

How aggressive do you want to bewhen buying the stock? This is animportant decision, because manytraders who use this strategy actuallyhope to collect the option premiumrather than buy the shares.

First, let’s assume you are very bull-ish and hope a brief drop will providean opportunity to buy stock at a lowerprice. Aggressive buyers could sell threeAugust AAPL 165 puts for 8.00 ($800)

each on June 24 (Table 1). You collect 24 in premium — atotal of $2,400 — and wait. If you are eventually assignedthat exercise notice, you pay $165 per share. If, however,you subtract the 8.00 premium from each short put, yournet cost drops to $157 per share — lower than your targetprice of $158.

Managing the tradeThere are several issues to consider when using this strate-gy. For instance, you buy stock when you are assigned, andthat will happen only if it is below the 165 strike price at the

continued on p. 26

http://www.thewizard.com

close of trading on the third Friday ofAugust. (Less-experienced tradersoften believe you automatically buystock if AAPL drops to 165 at anytime, but that’s not the case.)

You may repurchase the optionsyou sold at any time; you are not obli-gated to hold your position until expi-ration. If you change your mind aboutthe trade, you can buy back the putsand cancel your obligation, althoughyou may lose money depending onhow much you pay for them. If theshort puts drop in value, it’s often agood idea to buy them back cheaply.

This method contains some risks.The idea of buying Apple for $157might have been very attractive onJune 24, but the stock might be trad-ing lower by the time August expira-tion rolls around and you would owna losing position. Or, you could miss asubstantial profit. If AAPL drops to$158 before Aug. 16 expiration andthen rallies much higher, your profitis limited to the $2,400 premium youcollected for the three puts. However,if you entered a buy limit order at$158, you would have bought Appleand been able to sell those shares at ahigher price.

A less-aggressive approachLet’s assume you are less bullish onApple. In this scenario, your mainobjective is to simply collect the pre-mium from selling puts. Your odds ofsuccess will increase when you sellputs with lower strikes that are fur-ther out-of-the-money (OTM). Thistactic significantly reduces yourchances of buying AAPL, but youdidn’t really want to buy it. If you dobuy stock, its price will be even lower.

Instead of selling August 165 putsfor 8.00 each, you could sell August160 puts for 6.00 or sell August 155puts for 4.50. Obviously, you collectless premium for these options, whichreduces your profit if they expireworthless. But if AAPL declines andyou are forced to buy it, your pur-



Mark D. Wolfinger articles:

“Synthetic solutions,” Futures & Options Trader, March 2008.Any options strategy has at least one other synthetic alternative, which could bea better choice for a trade. Learn how to find an identical position with less riskand greater profit potential.

“Options for swing traders,” Options Trader, November 2005.New options traders must understand how leverage and time decay could affecta trade’s performance. We compare buying stock, buying calls, and sellingnaked puts to illustrate how these two factors influence the outcome.

Other articles:“Putting the put-write right,” Active Trader, August 2008.Unlike the venerable covered call strategy, short puts, despite their bad reputation, have a built-in advantage.

“Buying stocks at a discount with puts”Futures & Options Trader, July 2008.Attention discount shoppers: Puts and put ratio spreads can be used to buystocks at reduced prices.

“Covered calls vs. cash-secured puts,” Futures & Options Trader, July 2007.These positions are similar, but one offers a slight edge.

“Gad Grieve: Putting a premium on put premium”Options Trader, November 2005.This options trader’s expertise in selling premium has helped his Finvest Primerfund profitably navigate the U.S. options market — and outperform its peers —since 2001.

“Naked puts: An option-income alternative”Options Trader, September 2005.Although trading “naked” is rarely recommended, selling puts can be a way togenerate income if you pick the appropriate underlying market.

“A new look at naked puts,” Active Trader, August 2002.Shorting puts can be a limited-risk strategy that behaves the same way as selling a covered call — with potentially lower costs.

“Selling naked puts,” Active Trader, April 2001.The average trader or investor may think of buying a call to profit from anuptrending stock, but selling puts is an alternate technique with a number of key advantages for traders who can manage risk.

You can purchase and download past articles at http://store.activetradermag.com.

Selling calls can help you sell a stock you already own at an advantageous price.When you collect 10.00 for selling each August 180 call, that premium helps youreach a target selling price of $190 even if Apple never trades that high.

TABLE 2 — SELLING CALLS ON APPLE

Apple Inc. (AAPL) traded at $174 on June 24.

Dollar amount No. of Long or (price * 100 calls short? Strike Expiration Cost multiplier)

3 Short 180 Aug. 2008 $10.00 $1,000.00

Total premium: $30.00 $3,000.00


FUTURES & OPTIONS TRADER • September 2008

chase price also drops accordingly. With theAugust 160 put, the purchase price falls to$154 (160 strike - 6.00 premium), and withthe August 155 put, the purchase pricedeclines to $150.50 (155 strike - 4.50 premi-um).

Selling OTM puts is an effective way tocollect premium or buy stocks at a reducedprice. But if the stock tanks, you could facelarge losses. You may lose less money thansomeone who simply buys 300 shares thetraditional way, but that’s not much conso-lation.

Selling stock above the marketYou can use a similar technique to sell stockyou already own at advantageous prices.Let’s assume you own 300 shares of Appleand your target selling price is $190. Youcan enter a sell limit order at $190 with yourbroker. Or you can sell three August 180 calls for 10.00 each — a total of $3,000(Table 2).

If AAPL trades above 180 at expiration,you will be assigned an exercise notice andsell your shares. Add the 10.00 premium tothe $180 you will collect later, and the effec-tive selling price rises to $190, even if Applenever trades that high.

However, AAPL could drop in price andyour 180 calls would expire worthless. Ifthis happens, keep in mind you already col-lected $10 per share, which lowers your tar-get selling price to $180. After expiration,you may decide to sell three September 170calls or three October 175 calls, dependingon where Apple currently trades and howmuch premium you can collect for thosecalls.

The point is you already have earnedcash to apply toward the sale price. As youcontinue to sell calls with strikes belowyour target sale price and collect more pre-mium, the chances of meeting your originalgoal increase. There’s no guarantee you willeventually sell the stock, but your chancesof doing so — and reaching the original$190 target — are much better than whenyou simply hold stock and hope it rallies toyour target price.��


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OPTIONS STRATEGY LABOPTIONS TRADING SYSTEM LAB

Market: Options on the S&P 500 index (SPX). This strate-gy could also be applied to other broad-based indices andstocks or ETFs with liquid options contracts.

System concept: Ichimoku analysis is a Japanese chart-ing approach that combines trend-following and support-resistance components. The method has been used in Japanfor years and has caught on quickly in the West, especiallyin the forex market. Its exotic terms mask common chartingtools that are relatively easy to understand and analyze.

In the following test Ichimoku analysis identifies tradesignals and the system enters vertical debit spreads in thedirection of each trade. The system isn’t always in the mar-ket, so there may be long periods of time between each sig-nal. You can use software to scan for these entry signals; thedefinitions for this test were written in MetaStock code.

When a bullish signal appears, the system enters a bullcall spread. When a bearish signal emerges, the systementers a bear put spread. Each trade is held until the optionsexpire, and no money management rules or stops are used.

Figure 1 shows the potentialgains and losses of a bear putspread entered on Feb. 4 when theS&P 500 index traded at 1380.80.Both puts expire in March and theirstrikes are 25 points apart. Thespread has a reward-risk ratio of1.75: Its maximum potential loss is$892 (its cost) and its maximumpotential gain is $1,596. The tradewill be profitable if SPX tradesbelow 1366.02 by March 21 expira-tion and it has a 45-percent proba-bility of profit.

Trade rules:

Bullish signal: 1. The S&P 500 crosses above

the trendline (kijun).2. The index trades above the

cloud (kumo).3. The index trades above its

value 26 days ago (chikou confirmation).

Bull call spread:1. Buy the call with the most time premium in the first

expiring month that has over 21 days remaining and a strike price divisible by 25.

2. Sell a same-month call with a strike 25 points higher.3. Hold until expiration.

Bearish signal:1. The S&P 500 crosses below the trendline (kijun).2. The index trades below the cloud (kumo).3. The index trades below its value 26 days ago

chikou confirmation).

Bear put spread:1. Buy a put with the most time premium in the first

expiring month that has over 21 days remaining and a strike evenly divisible by 25.

2. Sell a same-month put with a strike 25 points lower.


Ichimoku and vertical spreads

The 1350-1375 bear put spread has a 42-percent probability of profit and will makemoney if the SPX closes below 1366.02 by March 21 expiration.

Source: OptionVue

FIGURE 1 — RISK PROFILE: BEAR PUT SPREAD

Net gain: $10,436.00

Percentage return: 209.0%

Annualized return: 29.3%

No. of trades: 23

Winning/losing trades: 15/8

Win/loss: 65%

Avg. trade: $453.74

Largest winning trade: $1,696.00

Largest losing trade: -$1,132.00

Avg. profit (winners): $1,099.60

Avg. profit (losers): -$757.25

Avg. hold time (winners): 39

Avg. hold time (losers): 42

Max consec. win/loss: 8/3


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

[email protected].

STRATEGY SUMMARY

3. Hold until expiration.

Starting capital: $5,000.

Execution: When possibleoption trades were executed atthe average of the bid and askprices at the daily close; other-wise, theoretical prices wereused. At-the-money (ATM)options are defined here as thecalls with the largest time value.Each spread held one contractper leg. Commissions were $5 base fee plus $1 percontract.

Test data: Options on the S&P 500 index (SPX).

Test period: Jan. 5, 2001 to March 21, 2008.

Test results: Figure 2 shows the system’s per-formance, which gained $10,436 (209 percent) overthe seven-year test period. However, the systemmight perform better with added steps to managerisk instead of simply holding each spread until itexpires.

The strategy’s largest winning trade ($1,696) ishigher than its largest losing trade (-$1,132.00).Combined with a win-loss ratio of 65 percent, thestatistics suggest this system has adefinite trading edge.

— Steve Lentz and Jim Graham of OptionVue

The system gained 209 percent since January 2001.

Source: OptionVue

FIGURE 2 — ICHIMOKU SYSTEM PERFORMANCE

LEGEND: Net gain – Gain at end of test period.Percentage return – Gain or loss on a percentage basis.Annualized return – Gain or loss on a annualized percentage basis.No. of trades – Number of trades generated by the system.Winning/losing trades – Number of winners and 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.Avg. hold time (winners) – The average holding period for winning trades (in days).Avg. hold time (losers) – The average holding period for losing trades (in days).Max consec. win/loss – The maximum number of consecutive winning and losing trades.



The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitutetrade 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 andmay 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 futuresis based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).

LegendVolume: 30-day average daily volume, inthousands (unless otherwise indicated).OI: Open interest, in thousands (unless other-wise indicated). 10-day move: The percentage price movefrom the close 10 days ago to today’s close.20-day move: The percentage price movefrom the close 20 days ago to today’s close.60-day move: The percentage price movefrom 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 per-centile rank of the most recent move to a cer-tain number of the previous moves of thesame size and in the same direction. Forexample, the rank for 10-day move showshow the most recent 10-day move comparesto the past twenty 10-day moves; for the 20-day move, the rank field shows how the mostrecent 20-day move compares to the pastsixty 20-day moves; for the 60-day move, therank field shows how the most recent 60-daymove compares to the past one-hundred-twenty 60-day moves. A reading of 100 per-

cent means the current reading is larger thanall the past readings, while a reading of 0 per-cent means the current reading is smaller thanthe previous readings. These figures provideperspective for determining how relativelylarge or small the most recent price move iscompared to past price moves.Volatility ratio/rank: The ratio is the short-term volatility (10-day standard deviation ofprices) divided by the long-term volatility (100-day standard deviation of prices). The rank isthe percentile rank of the volatility ratio overthe 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 & OptionsTrader 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 buyor 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.

FUTURES SNAPSHOT (as of Aug. 27)

E- Pit 10-day move/ 20-day move/ 60-day move/ VolatilityMarket symbol symbol Exchange Volume OI rank rank rank ratio/rankE-Mini S&P 500 ES CME 1.91 M 2.40 M -0.19% / 29% -0.21% / 0% -6.93% / 33% .18 / 2%10-yr. T-note ZN TY CME 885.4 1.70 M 1.03% / 63% 2.00% / 70% 1.99% / 44% .24 / 12%5-yr. T-note ZF FV CME 583.1 1.47 M 0.87% / 42% 1.74% / 75% 1.05% / 28% .19 / 2%E-Mini Nasdaq 100 NQ CME 390.3 323.9 -2.05% / 33% 2.45% / 30% -5.89% / 61% .37 / 76%Eurodollar* GE ED CME 314.5 1.20 M 0.21% / 61% 0.33% / 55% 0.28% / 24% .21 / 25%30-yr. T-bond ZB US CME 290.9 828.4 1.92% / 84% 3.49% / 81% 3.45% / 69% .33 / 20%Crude oil CL NYMEX 276.1 239.0 1.85% / 67% -6.80% / 28% -3.39% / 17% .24 / 48%2-yr. T-note ZT TU CME 265.4 846.9 0.13% / 42% 0.87% / 67% 0.87% / 36% .21 / 33%Eurocurrency 6E EC CME 223.2 151.9 -1.42% / 10% -5.39% / 69% -4.78% / 72% .20 / 2%E-Mini Russell 2000 ER2 CME 220.9 594.3 -2.13% / 0% 1.88% / 36% -1.56% / 25% .50 / 49%Mini Dow YM CME 197.1 114.1 -0.22% / 0% -0.72% / 0% -7.31% / 31% .16 / 2%Japanese yen 6J JY CME 114.4 172.4 -0.19% / 0% -1.53% / 33% -4.15% / 50% .19 / 27%Natural gas NG NYMEX 89.0 81.7 1.80% / 100% -6.92% / 11% -30.46% / 76% .14 / 17%British pound 6B BP CME 87.5 101.4 -2.03% / 30% -7.30% / 100% -6.31% / 97% .32 / 5%Swiss franc 6S SF CME 64.8 57.1 -1.09% / 5% -4.99% / 66% -5.42% / 89% .17 / 2%Gold 100 oz. GC NYMEX 60.5 81.1 0.30% / 0% -8.06% / 62% -6.08% / 59% .33 / 30%Corn ZC C CME 58.5 231.1 7.12% / 14% -3.99% / 16% -5.03% / 39% .28 / 23%Australian dollar 6A AD CME 49.2 83.2 -2.01% / 5% -8.76% / 73% -10.59% / 100% .22 / 22%Sugar SB ICE 44.2 332.9 -1.88% / 20% 1.42% / 7% 39.96% / 99% .23 / 25%Canadian dollar 6C CD CME 43.0 100.3 1.37% / 50% -2.28% / 55% -2.99% / 69% .35 / 37%Wheat ZW W CME 40.3 106.5 -5.60% / 89% 1.90% / 6% 6.96% / 43% .53 / 87%S&P 500 index SP CME 33.3 540.0 -0.19% / 38% -0.20% / 2% -8.77% / 51% .18 / 2%Silver 5,000 oz. SI NYMEX 32.4 53.3 -9.26% / 45% -22.87% / 76% -20.48% / 89% .27 / 12%Heating oil HO NYMEX 32.1 40.0 4.15% / 75% -7.35% / 29% -8.01% / 17% .22 / 28%RBOB gasoline RB NYMEX 29.9 46.4 4.60% / 100% -2.17% / 17% -4.00% / 15% .33 / 85%E-Mini S&P MidCap 400 ME CME 23.4 103.8 -0.42% / 29% -0.55% / 6% -7.44% / 56% .25 / 22%Crude oil e-miNY QM NYMEX 23.1 6.7 1.85% / 67% -6.80% / 28% -3.39% / 6% .24 / 52%Mexican peso 6M MP CME 21.6 99.6 0.38% / 20% -0.63% / 62% 1.58% / 19% .13 / 5%Soybeans ZS S CME 17.3 26.7 5.53% / 17% -3.30% / 7% -0.84% / 10% .37 / 40%Soybean oil ZL BO CME 14.9 24.7 3.34% / 20% -6.93% / 36% -11.17% / 55% .33 / 37%Soybean meal ZM SM CME 14.5 27.0 3.52% / 0% -2.80% / 10% 6.05% / 34% .30 / 33%Nikkei 225 index NK CME 13.3 76.7 -3.28% / 80% -3.90% / 48% -9.81% / 69% .20 / 2%Copper HG NYMEX 12.7 44.8 3.57% / 20% -4.79% / 39% -2.07% / 17% .42 / 45%Coffee KC ICE 12.6 72.8 9.26% / 100% 7.67% / 67% 11.77% / 78% .87 / 100%Fed Funds** ZQ FF CME 10.4 137.1 0.02% / 5% 0.14% / 49% 0.05% / 17% .04 / 0%Lean hogs HE LH CME 9.6 47.3 -7.51% / 58% -10.62% / 100% -7.27% / 88% .42 / 83%Live cattle LE LC CME 8.8 38.0 0.58% / 18% 6.03% / 70% 10.02% / 78% .32 / 40%Cocoa CC ICE 7.9 59.9 10.22% / 100% 5.63% / 37% 5.66% / 28% .64 / 100%Gold 100 oz. ZG CME 6.8 3.2 0.31% / 0% -8.06% / 59% -6.29% / 61% .33 / 29%U.S. dollar index DX ICE 6.3 33.9 1.06% / 5% 5.06% / 69% 5.02% / 80% .20 / 0%Nasdaq 100 ND CME 4.2 30.1 -2.05% / 33% 2.45% / 30% -5.89% / 61% .37 / 77%Dow Jones Ind. Avg. ZD DJ CME 4.1 31.4 -0.22% / 0% -0.72% / 0% -7.31% / 32% .16 / 2%Natural gas e-miNY QG NYMEX 3.9 2.5 1.80% / 100% -6.92% / 11% -30.46% / 76% .14 / 20%Mini-sized gold YG CME 2.6 2.1 0.31% / 0% -8.06% / 59% -6.29% / 61% .33 / 28%Russell 2000 index RL CME 1.5 32.0 -2.13% / 0% 1.88% / 36% -1.56% / 25% .50 / 50%Feeder cattle FC CME 1.4 6.8 -2.48% / 88% -1.16% / 45% -2.24% / 56% .19 / 41%Silver 5,000 oz. ZI CME 1.3 2.0 -9.14% / 45% -22.70% / 74% -19.92% / 90% .27 / 12%*Average volume and open interest based on highest-volume contract (June 2009). **November 2008


LEGEND:Options volume: 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 underlying instrument.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 example,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 showshow the most recent 20-day move compares to the past sixty 20-day moves.

OPTIONS RADAR (as of Aug. 27)

MOST-LIQUID OPTIONS*Indices Symbol Exchange Options Open 10-day move / 20-day move / IV / IV / SV ratio —

volume interest rank rank SV ratio 20 days agoS&P 500 index SPX CBOE 221.6 2.29 M -0.32% / 29% -0.20% / 2% 19% / 19% 19.9% / 23.5%Russell 2000 index RUT CBOE 97.5 966.6 -1.97% / 0% 1.96% / 24% 24.2% / 22% 24.3% / 30.8%S&P 500 volatility index VIX CBOE 86.1 1.02 M -8.31% / 47% -6.84% / 21% 137.2% / 95.8% 66.1% / 114.1%Nasdaq 100 index NDX CBOE 30.7 252.6 -2.15% / 50% 2.56% / 42% 22.6% / 22.6% 24.5% / 26.9%E-Mini S&P 500 futures ES CME 30.2 133.0 -0.19% / 29% -0.21% / 0% 18.8% / 21% 20% / 25.3%

StocksApple Inc. AAPL 193.7 1.02 M -2.58% / 50% 9.25% / 81% 33.7% / 34.1% 38.2% / 51.4%Kraft Foods KFT 168.5 1.47 M -2.37% / 100% 0.22% / 4% 21.7% / 20.8% 22.5% / 23.6%Bank of America BAC 164.6 3.10 M 2.74% / 11% -11.78% / 11% 60.4% / 71.1% 72.3% / 133.2%Citigroup C 155.3 3.83 M 1.74% / 20% -3.67% / 3% 58.1% / 66.2% 59.5% / 106.7%Wells Fargo WFC 124.3 1.75 M -1.30% / 31% -7.34% / 12% 52.7% / 56% 55.1% / 95.2%

FuturesEurodollar ED-GE CME 283.5 7.83 M 0.02% / 23% -0.01% / 0% 28.7% / 9.1% 30.6% / 19%10-year T-notes TY-ZN CBOT 56.6 562.7 1.03% / 63% 2.00% / 70% 7.2% / 4.5% 6.4% / 7.7%Corn C-ZC CBOT 51.5 633.7 7.12% / 14% -3.99% / 16% 37.9% / 50.1% 35.8% / 45.5%Crude oil CL NYMEX 42.3 422.2 1.85% / 67% -6.80% / 28% 47.2% / 41.3% 44.6% / 44.3%30-yr T-bonds US-ZB CBOT 38.4 364.8 1.92% / 84% 3.49% / 84% 8.9% / 6.7% 10.1% / 9.8%

VOLATILITY EXTREMES**Indices - High IV/SV ratio

S&P 500 volatility index VIX CBOE 86.1 1.02 M -8.31% / 47% -6.84% / 21% 137.2% / 95.8% 66.1% / 114.1%Japanese yen index XDN PHLX 1.7 45.9 0.05% / 0% -1.25% / 34% 10.6% / 8.4% 10% / 9%British pound index XDB PHLX 1.2 18.1 -3.01% / 45% -7.05% / 97% 10.2% / 8.5% 8.6% / 6.1%Mini Dow YM CBOT 1.7 7.4 -2.00% / 89% 0.34% / 17% 18.8% / 16% 18.8% / 16.6%Eurodollar index XDE PHLX 1.5 45.3 -1.24% / 5% -5.44% / 66% 10.8% / 9.3% 7.8% / 7.4%

Indices - Low IV/SV ratioGold/Silver index XAU PHLX 4.0 38.0 1.46% / 0% -11.91% / 53% 43.2% / 59.3% 41.7% / 50.4%Housing index HGX PHLX 4.9 68.2 4.05% / 25% 8.29% / 29% 45.3% / 57.1% 51.3% / 75.3%Banking index BKX PHLX 4.4 99.4 0.00% / 0% -5.89% / 13% 52.5% / 61.9% 58.2% / 99.6%Morgan Stanley Retail index MVR CBOE 4.8 67.1 1.63% / 24% 7.59% / 52% 37.9% / 42.5% 41.4% / 54.1%E-mini S&P 500 futures ES CME 30.2 133.0 -0.19% / 29% -0.21% / 0% 18.8% / 21% 20% / 25.3%

Stocks - High IV/SV ratioAnheuser Busch BUD 42.5 737.9 -0.19% / 0% 0.15% / 2% 17.1% / 4.2% 15.3% / 11.3%Dendreon DNDN 26.2 1.59 M -1.04% / 67% 0.70% / 3% 168.3% / 52.8% 143.8% / 69.5%Huntsman HUN 23.4 522.5 -7.68% / 100% -3.96% / 6% 105.2% / 42.7% 101.3% / 76.8%Tivo Inc. TIVO 1.8 49.6 3.38% / 75% 3.65% / 20% 80.6% / 38.8% 71.1% / 59.1%E-Trade Financial ETFC 6.3 298.7 -1.64% / 20% -0.33% / 0% 80.2% / 41.6% 92.4% / 159.1%

Stocks - Low IV/SV ratioAmbac Financial ABK 29.8 351.3 32.99% / 32% 124.89% / 58% 116.8% / 253.8% 146% / 270.5%Fording Canadian Coal FDG 4.1 93.7 2.96% / 25% 2.34% / 7% 15.4% / 25.4% 26.8% / 87.4%Radian Group RDN 1.5 27.4 -2.17% / 100% 73.08% / 44% 157.8% / 254.7% 197.2% / 391.2%Teck Cominco Ltd. TCK 2.5 40.8 3.60% / 20% -14.58% / 80% 48% / 76.9% 51.4% / 57.3%Goodrich Petroleum GDP 1.7 33.2 8.00% / 42% 12.62% / 14% 82.8% / 131.6% 93.3% / 131.5%

Futures - High IV/SV ratioEurodollar ED-GE CME 283.5 7.83 M 0.02% / 23% -0.01% / 0% 28.7% / 9.1% 30.6% / 19%5-year T-notes FV-ZF CBOT 27.6 229.2 0.87% / 42% 1.74% / 75% 5.6% / 3.4% 6.2% / 5.7%10-year T-notes TY-ZN CBOT 56.6 562.7 1.03% / 63% 2.00% / 70% 7.2% / 4.5% 6.4% / 7.7%Australian dollar AD-6A CME 1.3 6.9 -2.01% / 5% -8.76% / 73% 14.6% / 9.7% 9.2% / 7.5%Japanese yen JY-6J CME 2.3 63.5 -0.19% / 0% -1.53% / 33% 10.2% / 6.8% 9.7% / 6.6%

Futures - Low IV/SV ratioSilver 5,000 oz. SI NYMEX 5.8 41.8 -9.26% / 45% -22.87% / 76% 39.3% / 66.7% 31.8% / 39.3%Sugar SB NYBOT 16.8 516.1 -1.88% / 20% 1.42% / 7% 40.6% / 58.9% 39.6% / 50.6%Gold 100 oz. GC NYMEX 4.9 59.9 0.30% / 0% -8.06% / 62% 25.7% / 34.3% 23.4% / 26.1%Corn C-ZC CBOT 51.5 633.7 7.12% / 14% -3.99% / 16% 37.9% / 50.1% 35.8% / 45.5%Wheat W-ZW CBOT 7.7 86.6 -5.60% / 89% 1.90% / 6% 43.2% / 56.8% 38% / 35.4%

* Ranked by volume ** Ranked based on high or low IV/SV values.


Options Watch: Health Care ETF components (as of Aug. 25) Compiled by Tristan YatesThe following table summarizes the expiration months available for the top components of the health care exchange-traded fund (XLV). It also showseach index's average bid-ask spread for at-the-money (ATM) August options. The information does NOT constitute trade signals. It is intended onlyto provide a brief synopsis of potential slippage in each option market.

Option contracts traded

2008 2009 2010 Bid-ask spreads

Bid-askspread as %

Closing of underlyingStock Symbol Exchange price Call Put pricePfizer PFE NA X X X X X X 19.51 0.02 0.02 0.09%Bristol Meyers Squibb BMY NA X X X X X X 21.98 0.02 0.03 0.10%Amgen AMGN NA X X X X X 63.96 0.07 0.09 0.12%Johnson and Johnson JNJ NA X X X X X 70.80 0.10 0.09 0.13%Abbott Laboratories ABT NA X X X X X X 57.76 0.11 0.09 0.17%Genzyme GENZ NA X X X X 78.20 0.14 0.16 0.19%Gilead Sciences GILD NA X X X X X X 53.21 0.10 0.11 0.20%Baxter International BAX NA X X X X X X 68.15 0.14 0.14 0.20%Medtronic MDT NA X X X X X X 55.43 0.13 0.10 0.20%Eli Lilly LLY NA X X X X X 47.52 0.10 0.13 0.24%Celgene CELG NA X X X X X 71.45 0.21 0.14 0.24%WellPoint WLP NA X X X X X X 52.56 0.13 0.14 0.25%Merck MRK NA X X X X X 35.00 0.09 0.09 0.25%MedcoHealth Solutions MHS NA X X X X X 47.37 0.13 0.11 0.25%Unitedhealth Group UNH NA X X X X X X 29.31 0.10 0.08 0.30%Wyeth WYE NA X X X X X 42.25 0.11 0.15 0.31%Covidien COV NA X X X X X 54.03 0.16 0.19 0.32%Becton Dickinson BDX NA X X X X 87.53 0.18 0.58 0.43%Schering-Plough SGP NA X X X X X X 19.40 0.09 0.10 0.48%Thermo Fisher Scientific TMO NA X X X X X 60.01 0.33 0.33 0.54%Healthcare Select SPDR XLV NA X X X X X X 32.77 0.14 0.24 0.57%As of Aug. 25Legend:Call: Four-day average difference between bid and ask prices for the front-month ATM call.Put: Four-day average difference between bid and ask prices for the front-month ATM put.Bid-ask spread as % of underlying price: Average difference between bid and ask prices for front-month, ATM call, and put divided by the underlying's closing price.

Aug

.

Sep

t.

Oct

.

Nov

.

Dec

.

Jan.

Feb.

Mar

.

Jan.

The Commitment of Traders (COT) report is published eachweek by the Commodity Futures Trading Commission(CFTC). The report divides the open positions in futuresmarkets into three categories: commercials, non-commer-cials, and non-reportable.

Commercial traders, or hedgers, tend to operate in thecash market (e.g., grain merchants and oil companies, thateither produce or consume the underlying commodity).

Non-commercial traders are large speculators (“largespecs”) such as commodity trading advisors and hedgefunds — professional money managers who do not deal inthe underlying cash markets but speculate in futures on alarge-scale basis. Many of these traders are trend-followers.The non-reportable category represents small traders, or thegeneral public.

Figure 1 shows the relationship between commercialsand large speculators on Aug. 19. Positive values mean netcommercial positions (longs - shorts) are larger than net speculator holdings,based on their five-year historical relationship. Negative values mean large spec-ulators have bigger positions than the commercials.

In U.S. dollar index futures (DX), the difference between commercials and largespeculators is near a five-year low, a bearish relationship. However, in Britishpound futures (BP), this relationship is near a five-year high, a bullish sign. Theseextremes don’t act as stand-alone trade signals, but they sometimes precede majorprice reversals.

Last month, for example, gold futures (GC) generated a bearish signal on July22, and gold fell 18.4 percent by Aug. 15. Also, lumber futures triggered a bullishsignal on the same date, and lumber rallied 9 percent during the same period. �– Compiled by Floyd Upperman

The largest positive readings represent markets in which net commercialpositions (longs - shorts) exceed net fund holdings in August. By contrast,the largest negative values represent markets in which net fund holdingssurpass net commercial positions.

FIGURE 1 — COT REPORT EXTREMES

For a list of contract names, see “Futures Snapshot.” Source: http://www.upperman.com

COT extremes

Legend: Figure 1 shows the difference between net commer-cial and net large spec positions (longs - shorts) for all 45 futuresmarkets, in descending order. It is calculated by subtracting thecurrent net large spec position from the net commercial positionand then comparing this value to its five-year range. The formu-la is:

a1 = (net commercial 5-year high - net commercial current)b1 = (net commercial 5-year high - net commercial 5-year low)

c1 = ((b1 - a1)/ b1 ) * 100

a2 = (net large spec 5-year high - net large spec current)b2 = (net large spec 5-year high - net large spec 5-year low)

c2 = ((b2 - a2)/ b2 ) * 100

x = (c1 - c2)

FUTURES & OPTIONS WATCH

http://www.upperman.com

http://www.currencytradermag.com

I n August, members of the Chicago Board OptionsExchange (CBOE) and the Chicago Board of Trade,now part of the CME Group (CME), reached an agree-

ment over their two-year-old exercise rights issue. TheCBOT launched the CBOE in 1973, and through the yearssome CBOT members have retained CBOE trading rights— a benefit the CBOE in recent years (as it pursued the pathto demutualization and becoming a publicly traded com-pany) has claimed is no longer valid.

After attempts to work out an agreement failed, theCBOT sued the CBOE, claiming their trading rights repre-sented ownership in the latter exchange. When the CMEbought the CBOT, however, the CBOE considered the claimnull and void. In January the SEC weighed in on the issueand sided with the CBOE.

With the case still pending in the Delaware court system,the two exchanges reached their agreement. A shareholdervote to approve the agreement will be held on Sept. 17. Thenew settlement awards former CBOT members whoclaimed CBOE trading rights and who hold more than10,251 shares in the CME Group an 18-percent stake in thetotal common stock to be issued by the CBOE when it goespublic. This group will also share a $300 million cash poolwith a second set of former CBOT members who haveCBOE trading rights but own fewer shares than those in thefirst group.

A CBOE membership traded at a record $3.3 million inJune amid signs of a pending agreement. In July, the CBOEconducted 34.4 percent of all options volume in the U.S.,averaging 5.7 million contracts per day.

The settlement now opens the way for the CBOE to offerstock or pursue some form of acquisition or merger. So far

this year, however, exchange stocks haven’t fared well.From the beginning of 2008 through July 15, CME stock fellmore than 50 percent (Figure 1), and had recovered little asof early September. The IntercontinentalExchange (ICE) fell48 percent on the year through July, and NYSE Euronext,thought to be a potential suitor for the CBOE, fell 46 per-cent.�

T he CME Group’s long-contested bid to acquire theNew York Mercantile Exchange (NYMEX) wasapproved by shareholders on Aug. 18. The acqui-

sition completed on Aug. 22.The merger will create a nearly all-encompassing futures

exchange, trading everything from stock indices, interestrates, and currencies to energy, metals, and agriculturalcommodities. In the first half of 2008, the two exchangesaveraged a combined 14.2 million contracts per day withtotal revenue of 2.7 billion in 2007.

Through the merger agreement NYMEX shareholderswill receive cash, stock, or a combination of the two.NYMEX stock (NMX), which was valued at $81.16 for thedeal, had traded as low as $64.34 in July, 48.3 percent lowerthan in July 2007.

The integration, including integration of the NYMEX andCOMEX (the metals division of the NYMEX) trading floors,is expected to complete by the third quarter of 2009. Theplan proposes to save $60 million through expected “costsynergies.” Although there haven’t been any concrete num-bers so far regarding exchange staffing, 380 people initiallylost their jobs when the CME bought the CBOT last year.

NYMEX members, however, did secure a pledge from theCME Group to keep the NYMEX’s Manhattan trading flooropen until at least 2012. Afterward, the CME Group claimsthey will “maintain a trading floor in the New York Citymetropolitan area as long as profitability and revenuethresholds are met,” according to a customer Q&A sheetreleased by the group.�


INDUSTRY NEWS

Moving forward

CME shareholders approve NYMEX acquisition

Exchange stocks have fared poorly in 2008. CME Groupshares have fallen steadily throughout the year.

FIGURE 1 — CME GROUP

Source: eSignal

Burying the hatchet

CBOE, CBOT reach settlement


O nly two months after being released, the CBOE’s optionson SPDR Gold Shares (GLD) have established themselvesas a top trader. On Aug. 5, volume totaled 188,841 con-

tracts, or 3.7 percent of all contracts traded on the exchange that day.By comparison, options on the CBOE’s Volatility Index (VIX) traded99,138 contracts, while SPDR options (SPY) traded 243,700 contracts.

GLD options track the SPDR Gold Trust, which began trading onthe New York Stock Exchange in November 2004. Unlike other sim-ilar exchange traded funds (ETFs), the GLD holds actual gold bullionas opposed to securities. This has led to confusion over who hasjurisdiction rights over these instruments. Funds such as this one,and issues surrounding instruments such as Credit Default Swaps,prompted an agreement in March between the SEC and theCommodity Futures Trading Commission (CFTC) to enhance theircooperation and transparency. Previously, the agencies had enteredinto a Memorandum of Understanding to deal with the oversight ofsecurities futures products. Following the agreement, the agenciesbegan the approval process for offering options and futures based onthe GLD fund.

GLD steadily gained 89 percent from 2005 through 2007. In 2008the fund hit an all-time high of 100.44 on March 17, but fell 22.7 per-cent to a nine-month low of 77.63 on Aug. 15 (Figure 1).�

Source: Barclay Hedge (http://www.barclayhedge.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.

Top 10 option strategy traders ranked by July 2008 return.

(Managing at least $1 million as of July 31, 2008.)

July YTD $ under

Rank Trading advisor return return mgmt.

1. Welton Investment (Alpha Leveraged) 10.05 25.19 4.0M

2. CKP Finance Associates (LOMAX) 9.51 29.89 6.2M

3. Aksel Capital Mgmt (Growth & Income) 9.02 109.00 11.6M

4. Golden West 6.01 13.64 1.5M

5. UNISystems Research (5D Option) 5.75 28.84 1.1M

6. Eickelberg & Associates (Option) 5.55 1.03 2.0M

7. Kingdom Trading (Short Option) 5.49 24.12 1.2M

8. Parrot Trading Partners 5.18 38.39 23.6M

9. Kawaller Fund 5.03 24.74 1.6M

10. Welton Investment (Alpha) 4.91 12.32 4.0M

MANAGED MONEY

There’s gold in them thar options

GLD options take offOptions on the SPDR Gold Trust (GLD) rivaledthe volume of some of the CBOE’s key instru-ments after only two months. The ETF has fall-en since hitting an all-time high in March.

FIGURE 1 — SPDR GOLD TRUST

Source: eSignal

http://www.barclayhedge.com

http://www.optionsmentoring.com

American style: An option that can be exercised at anytime until expiration.

Assign(ment): When an option seller (or “writer”) isobligated to assume a long position (if he or she sold a put)or short position (if he or she sold a call) in the underlyingstock or futures contract because an option buyer exercisedthe same option.

At the money (ATM): An option whose strike price isidentical (or very close) to the current underlying stock (orfutures) price.

Bear call spread: A vertical credit spread that consistsof a short call and a higher-strike, further OTM long call inthe same expiration month. The spread’s largest potentialgain is the premium collected, and its maximum loss is lim-ited to the point difference between the strikes minus thatpremium.

Bear flag: Flags are short-term consolidation patterns.They are sometimes referred to as “continuation patterns”because they are often pauses in price trends and imply thecontinuation of those trends. Flags are essentially short-term trading ranges that last approximately three to 15 bars(roughly one to three weeks on a daily chart), althoughsome people argue flags should consist of no more than 10price bars.

A bear flag pattern represents a time when the market istaking a “breather” — pausing before resuming a down-trending move.

Bear put spread: A bear debit spread that contains putswith the same expiration date but different strike prices.You buy the higher-strike put, which costs more, and sellthe cheaper, lower-strike put.

Beta: Measures the volatility of an investment comparedto the overall market. Instruments with a beta of one movein line with the market. A beta value below one means theinstrument is less affected by market moves and a betavalue greater than one means it is more volatile than theoverall market. A beta of zero implies no market risk.

Box spread: A hedged position in which the profit isdetermined in advance. A box contains one long call andone short put that share the same strike. Also, the spreadcontains one short call and one long put that share a higherstrike price. All four options expire at the same time.

Bull call spread: A bull debit spread that contains callswith the same expiration date but different strike prices.You buy the lower-strike call, which has more value, andsell the less-expensive, higher-strike call.

Bull put spread (put credit spread): A bull credit

spread that contains puts with the same expiration date, butdifferent strike prices. You sell an OTM put and buy a less-expensive, lower-strike put.

Calendar spread: A position with one short-term shortoption and one long same-strike option with more timeuntil 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 directionalmove and time decay.

Call option: An option that gives the owner the right, butnot the obligation, to buy a stock (or futures contract) at afixed price.

Carrying costs: The costs associated with holding aninvestment that include interest, dividends, the opportuni-ty costs of entering the trade, and, in the case of physicalcommodities, storage.

Collar: An options spread with three components — anunderlying long position, a short call, and a long put thatexpires in the same month. It is a conservative, flexible strat-egy that profits if the underlying trades within a certainrange by expiration. The strategy’s goal is to improve a longposition’s odds of success by adding low-cost downsideprotection without limiting potential upside profits exces-sively.

The Commitments of Traders report: Publishedweekly by the Commodity Futures Trading Commission(CFTC), the Commitments of Traders (COT) report breaksdown the open interest in major futures markets. Clearingmembers, futures commission merchants, and foreign bro-


KEY CONCEPTSThe option “Greeks”

Delta: The ratio of the movement in the option price forevery point move in the underlying. An option with adelta of 0.5 would move a half-point for every 1-pointmove in the underlying stock; an option with a delta of1.00 would move 1 point for every 1-point move in theunderlying stock.

Gamma: The change in delta relative to a change in theunderlying market. Unlike delta, which is highest fordeep ITM options, gamma is highest for ATM optionsand lowest for deep ITM and OTM options.

Rho: The change in option price relative to the changein the interest rate.

Theta: The rate at which an option loses value each day(the rate of time decay). Theta is relatively larger forOTM than ITM options, and increases as the option getscloser to its expiration date.

Vega: How much an option’s price changes per a one-percent change in volatility.


kers are required to report daily the futures and optionspositions of their customers that are above specific report-ing levels set by the CFTC.

For each futures contract, report data is divided into three“reporting” categories: commercial, non-commercial, andnon-reportable positions. The first two groups are thosewho hold positions above specific reporting levels.

The “commercials” are often referred to as the largehedgers. Commercial hedgers are typically those who actu-ally deal in the cash market (e.g., grain merchants and oilcompanies, who either produce or consume the underlyingcommodity) and can have access to supply and demandinformation other market players do not.

Non-commercial large traders include large speculators(“large specs”) such as commodity trading advisors (CTAs)and hedge funds. This group consists mostly of institution-al and quasi-institutional money managers who do not dealin the underlying cash markets, but speculate in futures ona large-scale basis for their clients.

The final COT category is called the non-reportable posi-tion category — otherwise known as small traders — i.e.,the general public.

Covered call: Shorting an out-of-the-money call optionagainst a long position in the underlying market. An exam-ple would be purchasing a stock for $50 and selling a calloption with a strike price of $55. The goalis for the market to move sideways orslightly higher and for the call option toexpire worthless, in which case you keepthe premium.

Credit spread: A position that collectsmore premium from short options thanyou pay for long options. A credit spreadusing calls is bearish, while a credit spreadusing puts is bullish.

Debit: A cost you must pay to enter anyposition if the components you buy aremore expensive than the ones you sell. Forinstance, you must pay a debit to buy anyoption, and a spread (long one option,short another) requires a debit if the pre-mium you collect from the short optiondoesn’t offset the long option’s cost.

Debit spread: An options spread thatcosts money to enter, because the long sideis more expensive that the short side.These spreads can be verticals, calendars,or diagonals.

Deep (e.g., deep in-the-moneyoption or deep out-of-the-moneyoption): Call options with strike prices

that are very far above the current price of the underlyingasset and put options with strike prices that are very farbelow the current price of the underlying asset.

Delivery period (delivery dates): The specific timeperiod during which a delivery can occur for a futures con-tract. These dates vary from market to market and are deter-mined by the exchange. They typically fall during themonth designated by a specific contract - e.g. the deliveryperiod for March T-notes will be a specific period in March.

Delta-neutral: An options position that has an overalldelta of zero, which means it’s unaffected by underlyingprice movement. However, delta will change as the under-lying moves up or down, so you must buy or sellshares/contracts to adjust delta back to zero.

Diagonal spread: A position consisting of options withdifferent expiration dates and different strike prices — e.g.,a December 50 call and a January 60 call.

European style: An option that can only be exercised atexpiration, not before.

Exercise: To exchange an option for the underlyinginstrument.

continued on p. 38

http://www.esignal.com/offer/ot


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).

Float: The number of tradable shares in a public company.

Ichimoku analysis: The Ichimoku Kinko Hyo chartingtechnique was reportedly developed by Goichi Hosoda, aJapanese newspaper writer, prior to World War II, althoughhe did not publish the method until 1968. The phrase loose-ly translates to “one-glance balance chart” or “equilibriumchart at-a-glance technique.” Most traders refer to themethod simply as “Ichimoku.”

The technique combines trend-following tools similar tomoving averages with other calculations that define sup-posed support and resistance areas. (See Table 1.)

First, chart the shorter-term tenkan sen, which is the “sig-nal line,” and then the kijun sen, which is the longer-term“base line.” Basically, the tenkan sen represents a short-term moving average, the kijun sen represents an interme-diate-term moving average, and the kumo functions as alonger-term moving average, or support- resistance zone.

The chikou span basically provides a convenient way tocontrast today’s closing price to the closing price 26 barsago by comparing the end point of the chikou span to theclose of the bar directly above or below it The senkou linesare the longer-term support-resistance pieces of theIchimoku puzzle.

Intermonth (futures) spread: A trade consisting oflong and short positions in different contract months in thesame market — e.g., July and November soybeans orSeptember and December crude oil. Also referred to as afutures “calendar spread.”

In the money (ITM): A call option with a strike pricebelow the price of the underlying instrument, or a putoption with a strike price above the underlying instru-ment’s price.

Intrinsic value: The difference between the strike priceof an in-the-money option and the underlying asset price. Acall option with a strike price of 22 has 2 points of intrinsicvalue if the underlying market is trading at 24.

Leverage: An amount of “buying power” that increasesexposure to underlying market moves. For example, if youbuy 100 shares of stock, that investment will gain or lose$100 for each $1 (one-point) move in the stock.

But if you invest half as much and borrow the other halffrom your broker as margin, then you control those 100shares with half as much capital (i.e., 2-to-1 buying power).At that point, if the stock moves $1, you will gain or lose$100 even though you only invested $50 — a double-edgedsword.

Limit up (down): The maximum amount that a futurescontract is allowed to move up (down) in one trading ses-sion.

Lock-limit: The maximum amount that a futures contractis allowed to move (up or down) in one trading session.

Long call condor: A market-neutral position structuredwith calls only. It combines a bear call spread (short call,long higher-strike further OTM call) above the market anda bull call spread (long call, short higher-strike call). Unlikean iron condor, which contains two credit spreads, a callcondor includes two types of spreads: debit and credit.

KEY CONCEPTS continued

TABLE 1 — THE ICHIMOKU KINKO HYO CHARTING TECHNIQUE

Line name Calculation Comparable to: MetaStock formula

Tenkan sen (Highest high of past 9 bars A short-term moving average. (HHV(H,9) + (signal line) + lowest low of past 9 bars) / 2 LLV(L,9))/2

Kijun sen (Highest high of past 26 bars + A medium-term moving average. (HHV(H,26) + (base line) lowest low of past 26 bars) / 2 LLV(L,26))/2

Chikou span Today’s closing price plotted (lagging span) 26 bars back

Senkou (Tenkan sen + kijun sen) / 2, Forward-adjusted moving average. Ref((( Fml( “Ichi Signal span A offset 26 bars ahead Upper boundary of support area, Line”)+ Fml( “Ichi Trend

lower boundaryof resistance area Line”))/2),-26)(cloud, or kumo).

Senkou (Highest high of past 52 bars Forward-adjusted moving average. Ref(((HHV(H,52) + span B + lowest low of past 52 bars) / 2, Lower boundary of support area, LLV(L,52))/2),-26)

offset 26 bars ahead upper boundary of resistance (cloud, or kumo).

Long-Term Equity AnticiPation Securities(LEAPS): Options contracts with much more distant expi-ration dates — in some cases as far as two years and eightmonths away — than regular options.

Market makers: Independent traders who attempt toprofit by trading their own accounts. They supply bidswhen there may be no other buyers and supply offers whenthere are no other sellers. In return, they have an edge inbuying and selling at more favorable prices.

Moving average convergence-divergence (MACD):Although it is often grouped with oscillators, the MACD ismore of an intermediate-term trend indicator (although itcan reflect overbought and oversold conditions).

The default MACD line (which can also be plotted as ahistogram) is created by subtracting a 26-period exponen-tial moving average (EMA) of closing prices from a 12-peri-od EMA of closing prices; a nine-period EMA is thenapplied to the MACD line to create a “signal line.”

MACD = EMA(C,12)-EMA(C,26)Signal line = EMA(MACD,9)

Naked option: A position that involves selling an unpro-tected call or put that has a large or unlimited amount ofrisk. If you sell a call, for example, you areobligated to sell the underlying instrumentat the call’s strike price, which might bebelow the market’s value, triggering a loss.If you sell a put, for example, you are obli-gated to buy the underlying instrument atthe put’s strike price, which may be wellabove the market, also causing a loss.

Given its risk, selling naked options isonly for advanced options traders, andnewer traders aren’t usually allowed bytheir brokers to trade such strategies.

Naked (uncovered) puts: Selling putoptions to collect premium that containsrisk. If the market drops below the shortput’s strike price, the holder may exerciseit, requiring you to buy stock at the strikeprice (i.e., above the market).

Near the money: An option whosestrike price is close to the underlying mar-ket’s price.

Open interest: The number of optionsthat have not been exercised in a specificcontract that has not yet expired.

Opportunity cost: The value of anyother investment you might have made ifyour capital wasn’t already in the market.

Outlier: An anomalous data point or reading that is notrepresentative of the majority of a data set.

Out of the money (OTM): A call option with a strikeprice above the price of the underlying instrument, or a putoption with a strike price below the underlying instru-ment’s price.

Parity: An option trading at its intrinsic value.

Physical delivery: The process of exchanging a physicalcommodity (and making and taking payment) as a result ofthe execution of a futures contract. Although 98 percent ofall futures contracts are not delivered, there are market par-ticipants who do take delivery of physically settled con-tracts such as wheat, crude oil, and T-notes. Commoditiesgenerally are delivered to a designated warehouse; T-notedelivery is taken by a book-entry transfer of ownership,although no certificates change hands.

Premium: The price of an option.

Put option: An option that gives the owner the right, but


continued on p. 40


not the obligation, to sell a stock (or futures contract) at afixed price.

Put ratio backspread: A bearish ratio spread that con-tains more long puts than short ones. The short strikes arecloser to the money and the long strikes are further from themoney.

For example, if a stock trades at $50, you could sell one$45 put and buy two $40 puts in the same expiration month.If the stock drops, the short $45 put might move into themoney, but the long lower-strike puts will hedge some (orall) of those losses. If the stock drops well below $40, poten-tial gains are unlimited until it reaches zero.

Put spreads: Vertical spreads with puts sharing the sameexpiration date but different strike prices. A bull put spreadcontains short, higher-strike puts and long, lower-strikeputs. A bear put spread is structured differently: Its longputs have higher strikes than the short puts.

Ratio spread: A ratio spread can contain calls or puts andincludes a long option and multiple short options of thesame type that are further out-of-the-money, usually in aratio of 1:2 or 1:3 (long to short options). For example, if astock trades at $60, you could buy one $60 call and sell twosame-month $65 calls. Basically, the trade is a bull callspread (long call, short higher-strike call) with the sale ofadditional calls at the short strike.

Overall, these positions are neutral, but they can have adirectional bias, depending on the strike prices you select.Because you sell more options than you buy, the shortoptions usually cover the cost of the long one or provide anet credit. However, the spread contains uncovered, or

“naked” options, which add upside or downside risk.

Rollover: The process of maintaining an open futuresposition beyond the expiration of the current contractmonth and into the next contract month. A position is“rolled forward” (or “rolled over”) by liquidating the posi-tion in the current contract and simultaneously re-establish-ing it in the new contract. For example, if you were long theSeptember E-Mini S&P 500 futures and wanted to remainlong past the expiration of the September contract, youwould simultaneously sell the September contract and buythe December contract.

Simple moving average: A simple moving average(SMA) is the average price of a stock, future, or other mar-ket over a certain time period. A five-day SMA is the sum ofthe five most recent closing prices divided by five, whichmeans each day’s price is equally weighted in the calcula-tion.

Strike (“exercise”) price: The price at which an under-lying instrument is exchanged upon exercise of an option.

Support and resistance: Support is a price level thatacts as a “floor,” preventing prices from dropping belowthat level. Resistance is the opposite: a price level that actsas a “ceiling;” a barrier that prevents prices from risinghigher.

Support and resistance levels are a natural outgrowth ofthe interaction of supply and demand in any market. Forexample, increased demand for a stock will cause its priceto rise, creating an uptrend. But when price has risen to acertain level, traders and investors will take profits and

KEY CONCEPTS continued


EVENTS

Event: Forex Trading ExpoDate: Sept. 12-13Location: Mandalay Bay Resort & Casino, Las VegasFor more information:http://www.moneyshow.com/msc/lvfx/main.asp

Event: Real Trading with Dan SheridanDate: Sept. 24Location: CBOE Options Institute, ChicagoFor more information: http://www.cboe.com

Event: The Options Intensive Two-day SeminarsDates: Oct. 23, Dec. 4Location: CBOE Options Institute, ChicagoFor more information: http://www.cboe.com

Event: Traders Expo Las VegasDate: Nov. 19-22Location: Mandalay Bay Resort & Casino, Las VegasFor more information: http://www.tradersexpo.com

Event: The Options Initiative Two-day SeminarsDate: Nov. 20Location: CBOE Options Institute, ChicagoFor more information: http://www.cboe.com

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short sellers will come into the market, creating “resistance”to further price increases. Price may retreat from andadvance to this resistance level many times, sometimeseventually breaking through it and continuing the previoustrend, other times reversing completely.

Support and resistance should be thought of more as gen-eral price levels rather than precise prices. For example, if astock makes a low of 52.15, rallies slightly, then declinesagain to 52.15, then rallies again, a subsequent move downto 52 does not violate the “support level” of 52.15. In thiscase, the fact that the stock retraced once to the exact pricelevel it had established before is more of a coincidence thananything else.

Time decay: The tendency of time value to decrease at anaccelerated rate as an option approaches expiration.

Time spread: Any type of spread that contains shortnear-term options and long options that expire later. Bothoptions can share a strike price (calendar spread) or havedifferent strikes (diagonal spread).

Time value (premium): The amount of an option’svalue that is a function of the time remain-ing until expiration. As expirationapproaches, time value decreases at anaccelerated rate, a phenomenon known as“time decay.”

TRIX indicator: A percent rate-of-change indicator of a triple smoothed expo-nential moving average (EMA). The TRIX isa momentum indicator that can identifytrend changes. The calculation is as follows:

1. Take an n-period exponential movingaverage of price.2. Take an n-period EMA of the value from#1.3. Take an n-period EMA of the value from#2.

Positive values typically indicate anuptrend, while negative values indicate adowntrend. Traders also calculate a signalline of the TRIX by taking a shorter-termsimple moving average of it. When its sig-nal line crosses above the TRIX, marketconditions are bullish, and when the signalline crosses below the TRIX, market condi-tions are bearish.

Vertical spread: A position consistingof options with the same expiration date

but different strike prices (e.g., a September 40 call optionand 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 20days. Implied volatility is the current market estimate offuture volatility as reflected in the level of option premi-ums. The higher the implied volatility, the higher the optionpremium.

Volatility skew (“smile”): The tendency of impliedoption volatility to vary by strike price. Although, it mightseem logical that all options on the same underlying instru-ment with the same expiration would have identical (ornearly identical) implied volatilities. For example, deeperin-the-money and out-of-the-money options often havehigher volatilities than at-the-money options. This type ofskew is often referred to as the “volatility smile” because achart of these implied volatilities would resemble a linecurving upward at both ends. Volatility skews can takeother forms than the volatility smile, though.


MONTH

Legend

CPI: Consumer price index

ECI: Employment cost index

FDD (first delivery day):The first day on which deliv-ery of a commodity in fulfill-ment of a futures contractcan take place.

FND (first notice day): Alsoknown as first intent day, thisis the first day a clearing-house can give notice to abuyer of a futures contractthat it intends to deliver acommodity in fulfillment of afutures contract. The clear-inghouse also informs theseller.

FOMC: Federal OpenMarket Committee

GDP: Gross domestic product

ISM: Institute for supplymanagement

LTD (last trading day): Thefirst day a contract maytrade or be closed out beforethe delivery of the underlyingasset may occur.

PPI: Producer price index

Quadruple witching Friday:A day where equity options,equity futures, index options,and index futures all expire.

September

1 FDD: September crude oil and natural gas futures (NYMEX); September sugarfutures (ICE)

2 FDD: September copper, gold, silver, palladium, and platinum futures (NYMEX); September corn, rough rice, oats, soybeans, soybean products, T-bonds, silver, and gold futures (CME);September wheat futures (KCBT); September wheat futures (MGEX)FND: September OJ futures (ICE)

3 FND: September gasoline and heating oil futures (NYMEX)

4 U.S.: EIA natural gas storage report

5 LTD: September live cattle options (CME); October cocoa options (ICE)

6

7

8

9 FDD: September gasoline and heating oil futures (NYMEX); September OJ futures (ICE)

10 LTD: September OJ futures (ICE)U.S.: Petroleum status report

11 U.S.: EIA natural gas storage report

12 LTD: September corn, oats, rough rice, soybeans, soybean products, and wheat futures (CME); September wheatfutures (KCBT); September wheat futures (MGEX); October coffee, cotton,and sugar options (ICE)U.S.: Crop production

13

14

15 LTD: September lumber futures (CME),September cocoa futures (ICE)

16 FDD: September lumber futures (CME)FND: September lumber futures (CME)

17 LTD: October crude oil and platinum options (NYMEX)U.S.: Petroleum status report

18 LTD: September coffee futures (ICE),September index futures (CME), September equity optionsU.S.: EIA Natural gas storage report

19 LTD: September index and T-bond options (CBOE); September T-bonds and E-mini index futures (CME); October OJ options (ICE); September single stock futures (OC); September

equity optionsU.S.: Cattle on Feed report

20

21

22 LTD: October crude oil futures (NYMEX)

23

24 FND: October cotton futures (ICE)U.S.: Petroleum status report

25 LTD: September feeder cattle futures (CME); September feeder cattle options(CME); October gold, silver, copper, gasoline, heating oil, and natural gas options (NYMEX)

26 LTD: September copper, gold, silver, palladium, platinum, and October natural gas futures (NYMEX); September gold and silver futures (CME); October wheat futures (KCBT); October corn, rice, soybeans, soybean products, wheat, and T-note options (CME); October wheat options (MGEX);October wheat options (KCBT)U.S.: EIA natural gas storage report; hogs and pigs report

27

28

29 FND: October natural gas futures (NYMEX)

30 FND: October copper, gold, silver, palladium, and platinum futures (NYMEX); October gold, silver, and soybean products futures (CME); October wheat futures (KCBT); Octoberwheat futures (MGEX)LTD: September T-bond futures (CME);October gasoline and heating oil futures(NYMEX); October sugar futures (ICE); October lumber options (CME)

October

1 FDD: October crude oil, gasoline, natural gas, palladium, platinum, cotton,gold, and silver futures (NYMEX); October gold, silver, and soybean products (CME)FND: October sugar futures (ICE)U.S.: Petroleum status report

2 FND: October gasoline and heating oil futures (NYMEX)U.S.: EIA natural gas storage report

3 LTD: October live cattle options (CME);November cocoa (ICE)

SEPTEMBER/OCTOBERFUTURES & OPTIONS CALENDAR

OCTOBER 2008

28 29 30 1 2 3 4

5 6 7 8 9 10 11

12 13 14 15 16 17 18

19 20 21 22 23 24 25

26 27 28 29 30 31 1

The information on this page issubject to change. Futures &Options Trader is not responsiblefor the accuracy of calendar datesbeyond press time.

SEPTEMBER 2008

31 1 2 3 4 5 6

7 8 9 10 11 12 13

14 15 16 17 18 19 20

21 22 23 24 25 26 27

28 29 30 1 2 3 4



Bob DormanAd sales East Coast and [email protected]

(312) 775-5421

Allison CheeAd sales West Coast and Southwest

[email protected](626) 497-9195

Mark SegerAccount Executive

[email protected](312) 377-9435

Three good tools for targeting customers . . .

— CONTACT —

� Charles Schwab has launched an online community for its active trad-er clients called the Schwab Trading Community. Clients can participate in dis-cussions on investing, exchange ideas and experiences, and gain access toSchwab and other trading experts using blogs, tutorials, live webinars, and moreinformal methods. Users can customize their home pages. The online communi-ty is only available to Schwab active trading clients. Visithttp://www.schwab.com for more details.

� TheOptionsInsider.com released Options Insider Mobile, a new webapplication for the iPhone. Options Insider Mobile is a customized Web applica-tion. You can get options headlines delivered straight to your iPhone or iPodTouch, and read the latest articles from Options Insider’s network of optionsexperts. You can also listen to the latest episodes of Options Insider Radio, andreview the latest questions, comments, and insights from Options Insider com-munity.

Note: The New Products and Services section is a forum for industry businesses to announcenew products and upgrades. Listings are adapted from press releases and are not endorsementsor recommendations from the Active Trader Magazine Group. E-mail press releases to [email protected]. Publication is not guaranteed.

NEW PRODUCTS AND SERVICES

Trading Option GreeksBy Dan PassarelliBloomberg Press, 2008Hardcover, 330 pages$59.95

Passarelli explains his options-trad-ing methodology using the fiveGreeks — delta, gamma, theta,vega, and rho. Chapters coveroptions basics, spreads, put-callparity and synthetic options, tradingvolatility, and advanced optionstrading.

http://www.schwab.com



FUTURES TRADE JOURNAL

TRADE SUMMARY

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profitduring lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

Late to the party, but no harm done.

Initial Initial

Date Contract Entry stop target IRR Exit Date P/L LOP LOL Length

8/21/08 YGZ08 837.20 835.60 844 4.25 838.40 8/21/08 1.20 (.14%) 3.00 -0.20 23 min.

839.50 841.60 827 5.95 839.30 .20 2.90 -1.40 30 min.

TRADE

Date: Thursday, Aug. 21, 2008.

Entry: Long December mini gold futures(YGZ08) at $837.20, and short at $839.50.

Reasons for trade/setup (long trade):Initial research conducted the day before thetrade had indicated that gold was ready fora bounce after selling off from nearly $1,000on July 15 to below $800 on Aug. 15. We did-n’t expect the move to be so sudden and sodramatic, however. Before we had a chanceto complete testing, the market (along withvirtually every other physical commodity)was up big.

The December gold contract hit $844.70 in the morningbut sold off steadily until a sharp down move brought it aslow as $836.40. Although we believed we had missed thetrade opportunity the analysis had indicated, we thoughtthe market had at least one more push in it as it had not yettested the day’s high. We entered as price stabilized afterthe initial pullback to $836.40.

This is intended only as a very short-term trade, as webelieve the market is, in the long term, headed lower. Wewill carry only part of the position overnight, and then onlyif the market remains above the initial target price.

Initial stop: $835.60.

Initial target: $844, a little below the intraday high.

RESULT

Exit: $838.40 (first trade); $839.30 (second trade).

Profit/loss: +1.20 (first trade); +0.20 (second trade).

Trade executed according to plan? No.

Outcome: These trades represented a reassessment of the

original trade idea. The market failed to show much upsidemomentum after the long entry, even though it did movehigher overall. With other commodities (led by crude oil)flagging, it appeared the day might be setting up to be aspike with a weak close. Given our longer-term bias wasbearish, anyway, we took profits early (at 838.40) and thenshorted at $839.50 (with a stop at $841.60).

The turnabout appeared to be the right move, as the mar-ket soon pushed back below $837 again. We expected adown move, though, and didn’t take any profits. When themarket crept higher again, we lowered the stop to justbelow breakeven, and got taken out of the market shortlythereafter.

The chart shows the rest of the day was a somewhatchoppy trading range, so there were no big moves to cap-ture either way.

Although the trading was essentially fruitless, tight trademanagement minimized risk and prevented either positionfrom losing money. (Gold did, however, move sharplylower the next day, reaching $821.60.)�

Note: Initial targets for trades are typically based on things such as thehistorical performance of a price pattern or trading system signal.However, individual trades are a function of immediate market behav-ior; initial price targets are flexible and are most often used as points atwhich a portion of the trade is liquidated to reduce the position’s openrisk. As a result, the initial (pre-trade) reward-risk ratios are conjec-tural by nature.



OPTIONS TRADE JOURNAL

TRADE

Date: Wednesday, Aug. 6.

Market: Options on the S&P 500 tracking stock (SPY).

Entry: Buy one September 125 call at $6.25.

Reasons for trade/setup: SPY climbed to a 20-dayhigh on Aug. 6 and was poised to close within the upper 20percent of its daily range. Historical testing shows the mar-ket climbed roughly 1 percent in the week after this pattern(see “Follow-through or fake-out: Testing 20-day highs andlows,” Active Trader, April 2006).

September 125 calls are four points in-the-money (ITM)with a delta of 68 and seem ideal for a short directionalmove. In addition, the calls won’t expire for six weeks, so

time decay shouldn’t be a problem. To capitalize on a bull-ish move, we bought these calls for $6.25 each when SPYtraded around 129.00 at the Aug. 6 close.

Figure 1 shows the call’s potential gains and losses onthree dates: trade entry (Aug. 6, dotted line), halfway toexpiration (Aug. 29, dashed line), and expiration (Sept. 20,solid line).

Initial stop: Exit if call loses one-third of its value.

Initial target: Exit if SPY climbs 1 percent within oneweek.

RESULT

Outcome: Figure 2 shows SPY opened 0.9 percent lowerthe next day and dropped another 0.8 percent by the close.

At that point, the trade lost itsvalidity, and we just hoped themarket would rebound so wecould minimize losses.

The market bounced back andposted a 2.2-percent gain on Aug.8. We could have exited that after-noon, but we waited to see if SPYwould push higher. Instead, weexited the next morning as SPYapproached 130. The calls weresold for $6.70 each — a profit of$0.45.

The trade was profitable, butmistakes were made. Figure 2shows we exited too soon: SPYclimbed an additional 0.5 percentto 131.50 before dropping in thelate afternoon. Instead of takingsuch a small profit, we could haveplaced a trailing stop to capture a

A bullish trade turns profitable after a shaky start, but a clumsy exit leaves money on the table.

This long call has a delta of 68, so it will make money if SPY successfully breaksabove its 20-day high.

FIGURE 1 — LONG CALL RISK PROFILE

Source: OptionVuecontinued on p. 46

larger gain. In hindsight, we tied up unnecessary capital by buy-

ing September calls that didn’t expire for six weeks. Bycontrast, August 125 calls cost $1.70 less and gained thesame amount ($0.45) during the trade. When buyingoptions, time works against you, but it wasn’t a factorhere because the trade lasted only five days.�

The trade went negative immediately, but the market bounced back within a couple of days. After exiting with a small profiton the morning of Aug. 11, SPY climbed an additional 0.5 percent by the close.

FIGURE 2 — TAKING PROFITS TOO SOON

Source: eSignal

TRADE SUMMARY

Entry date: Aug. 6, 2008

Underlying security: S&P 500 tracking stock (SPY)

Position: 1 long September 125 call

Initial capital required: $625

Initial stop: Exit if trade loses one-third of its value.

Initial target: Exit if SPY rallies 1 percent in one week.

Initial daily time decay: -$4.41

Trade length (in days): 5

P/L: $45 (7.2%)

LOP: $45

LOL: -$140

LOP — largest open profit (maximum available profit during life of trade).

LOL — largest open loss (maximum potential loss during life of trade).

TRADE STATISTICS

Aug. 6 Aug. 11

Delta: 68.09 70.84

Gamma: 3.93 3.82

Theta: -4.41 -4.97

Vega: 16.44 15.11

Probability of profit: 42% 45%

Breakeven point: 131.25 131.25


OPTIONS TRADE JOURNAL continued

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