FOT200811

November 2008 • Volume 2, No. 11

OPTIONS TRADER STUDYoffers strategy clues p. 18

OIL’S slippery slope p. 39

SPREAD TRADINGwith the A-D line p. 22

PROFITABLEdelta-neutral trading p. 14

BASICS:The put-call ratio p. 24

FUTURES:Trading multiple systems p. 10

2 November 2008 • FUTURES & OPTIONS TRADER

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

Market Movers . . . . . . . . . . . . . . . . . . . . . . . .6Futures markets are down across the board

as traders and investors divest themselves

of holdings.

Trading Strategies

Two systems are better than one . . . . . . .10Combining multiple trading systems can

improve the performance of your portfolio.

By Richard Weissman

Gamma scalping . . . . . . . . . . . . . . . . . . . . . .14Find out how to build delta-neutral positions

and trade them profitability, regardless of

which way the market moves.

By Dan Passarelli

Who trades options? . . . . . . . . . . . . . . . . . .18A recent academic paper analyzing who trades

different types of options strategies offers clues

for successful trading.

By George Hoekstra

Options Trading System Lab

Spread trading with the

advance-decline line . . . . . . . . . . . . . . . . . .22This credit-spread system takes directional cues

from a market-breadth indicator.

By Steve Lentz and Jim Graham

Trading Basics

Put-call ratio . . . . . . . . . . . . . . . . . . . . . . . . .24This widely watched indicator compares the

activity in put options to call options.

Learn about its variations and uses.

By Chris Peters

NewsMore exchanges move toward

electronic platforms . . . . . . . . . . . . . . . . . . .26The CBOE and the MGEX move toward

all-electronic platforms as open outcry gets even

quieter.

CME Group offerings expand with

plastics, swaps contracts . . . . . . . . . . . . . .27Merc keeps the new-contract spigot open.

CONTENTS

continued on p. 4

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IMPORTANT INFORMATION: No offer or solicitation to buy or sell securities, securities derivative or futures products of any kind, or any type of trading or investment advice, recommendation or strategy, is made, given or in any manner endorsed by TradeStation Securities, Inc. or any of its affiliates. • Past performance, whether actual or indicated by historical tests of strategies, is no guarantee of future performance or success. • Active trading is generally not appropriate for someone of limited resources, limited investment or trading experience, or low-risk tolerance. • There is a risk of loss in futures trading. Options and Security Futures trading is not suitable for all investors. Please visit our Web site for relevant risk disclosures. • System access and trade placement and execution may be delayed or fail due to market volatility and volume, quote delays, system and software errors, Internet traffic, outages and other factors. • All proprietary technology in TradeStation is owned by TradeStation Technologies, Inc., an affiliate of TradeStation Securities, Inc. • Trading foreign exchange carries a high level of risk and may not be suitable for all investors. There is a possibility that you may sustain a loss equal to or greater than your entire investment; therefore, you should not invest or risk money that you cannot afford to lose. You should be aware of all risks associated with foreign exchange trading. Barron’s awards are based on a review of TradeStation’s brokerage products and services by a Barron’s journalist. Barron’s is a registered trademark of Dow Jones & Company. Leader in Rule-Based Trading tag line based on industry awards and reviews. © 2008 TradeStation Securities, Inc. All rights reserved.

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Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .28Momentum, volatility, and volume

statistics for futures.

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . . .29Notable volatility and volume

in the options market.

Futures & Options WatchCOT extremes . . . . . . . . . . . . . . . . . . . . . . . .30A look at the relationship between commercials

and large speculators in all 45 futures markets.

Options Watch:Consumer Staples ETF components . . . . . . . .30

Futures & Options Calendar . . . . . . . . . . . .31

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .32References and definitions.

Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

New Products and Services . . . . . . . . . . . . .38

Futures Trade Journal . . . . . . . . . . . . . . .39Adventures in the crude market.

Options Trade Journal . . . . . . . . . . . . . . .40Buying puts on IBM as the stock

market crashes.

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.

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CONTENTS


FUTURES & OPTIONS TRADER • November 2008 5

CONTRIBUTORS

Editor-in-chief: Mark [email protected]

Managing editor: Molly [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 11. 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 implythe effectiveness 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®

CONTRIBUTORS

� George Hoekstra is a research engineer in the

petroleum refining business. He started trading options 30

years ago while studying under Myron Scholes who was

his professor at the University of Chicago. Hoekstra holds

degrees in chemical engineering from Purdue University and an MBA

from the University of Chicago. He can be contacted via his Web site,

http://hoekstratrading.com/default.aspx.

� Richard L. Weissman is the author of Mechanical

Trading Systems: Pairing Trader Psychology with Technical

Analysis. He has more than 20 years experience as a deriv-

atives trader and has provided training and consultation

services on technical analysis, risk management, and

derivatives trading to traders and risk managers for 15 years. Currently,

he provides training for the Energy Management Institute

(http://www.energyinstitution.org), a training solution provider to the

CME Group and IntercontinentalExchange, and can be reached at

[email protected].

� Dan Passarelli is the author of Trading Option Greeks

(Bloomberg, 2008) and the founder of Market Taker

Mentoring. For more information and a free excerpt from

his book, please visit http://markettaker.com. Passarelli

can be reached at [email protected].

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

established 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 con-

stantly developing new strategies on the use of options as part of a com-

prehensive profitable trading approach. He regularly speaks at special

events, trade shows, and trading group organizations.

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

manager for OptionVue Systems and a registered invest-

ment advisor for OptionVue Research.

http://hoekstratrading.com/default.aspx

http://www.energyinstitution.org

http://markettaker.com

mailto:[email protected]




Metals

The big story inprecious metalfutures has been

the lack of story:Gold refused to budge as thestock market disintegrated. Itlooked like it might make a runon Oct. 10 when the Decembercontract (GCZ08) pushed above$935 (topping the Septemberhigh), but the move turned out tobe a feint: The contract closed down and over the next three weeks droppedas low as 681. Silver and copper also wallowed near long-term lows asNovember trading began.

The rationalization for gold’s weakness has been lack of inflationary pres-sures in the market. However, this argument handily sidesteps the lack of theexpected “safe-haven” move into gold as stocks collapsed — something goldbugs had been anticipating.

MARKET MOVERS

The Great Sell-off continues

October expanded on September’s liquidation theme, with the financial crisis triggering selling across the board.

Instead of directing money into different markets as they took it out of the crumbling stock market, money managers

put it in cash (the U.S. dollar has been one of the few beneficiaries of the market panic).

Two wit: the lack of bullish activity in U.S. Treasuries and gold — two markets that conventional wisdom dictates

should rally in “flight-to-quality” situations. Apparently, traders and investors perceived little quality anywhere.

Preliminary data showed volume dropping significantly in both the futures and equity markets.

One interesting note: Futures of all kinds were up across the board on election day in the U.S. (Nov. 4).

Energy

Last monthcrude oil fell wellbelow half its

July all-time high,with the December futures(CLZ08) hitting $61.30 on Oct. 27.After a small bounce that tookthe market up to $70, crudeopened November on a weaknote, turning back below $65before leaping back above $70 onelection day, Nov. 4.

The selling was imitated in the other major energy futures — gasoline(RB), natural gas (NG), and heating oil.

Grains

Grains, like all com-modities, were downacross the board, withwheat (W) showing themost signs of life — attempting tospike higher on a few days in lateOctober and early November — as themarkets stabilized.


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Treasuries

Like gold, T-notes failed toproduce the

perhaps-antici-pated rally in October. However,as discussed in “The flight-to-quality trade” (Active Trader,October 2008), the sell-stocks,buy-treasuries phenomenon does-n’t occur as often as people think.

December 10-year T-notefutures (TYZ08) fell from a high above 119 in mid-September to a low of 111-12.5/32 in mid-October. By Nov. 4, the market had rebounded to around 115.

MARKET MOVERS continued

Softs and fibers

Coffee, sugar, and cocoa all sold off sharply in October, withDecember coffee (KCZ08) and March 2009 sugar (SBH09)rallying a little toward the end of the month while cocoa con-tinued to trade sideways to lower.

Stockindices

Stock index futureswent on a wild ride in

October, posting huge intraday swingsand lurching higher and (mostly) lowerfrom day to day. After the spike low onOct. 10, the E-Mini S&P 500 futures zig-zagged crazily before slightly exceedingthat low on Oct. 27 and 28. The marketrallied the next few days, closing strong-ly on Nov. 4.

Detailed coverage of the stock marketand the financial crisis can be foundin the current issue of Active Trader(http://www.activetradermag.com).

Currencies

The big story in the forex world was the dollar’s renewedstrength as the financial panic deepened. The buck gainedagainst all major currencies except the Japanese yen.

The dollar index (DXY) pushed to its highest level since 2006. (For currencystrategies, news, and analysis, go to http://www.currencytradermag.com).


Meats

Toward the end ofOctober, live cattle(LC) managed tostage a small rally offits lows while lean hogs(LH) continued to push to new lows.December live cattle (LCZ08) traded ashigh as 93.80 on Nov. 3 — the highestlevel in nearly three weeks.

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TRADING STRATEGIES

BY RICHARD WEISSMAN

Most investors understand the logic behinddiversifying their assets. One asset class orindustry may perform well as another oneloses ground, so if you place capital in dif-

ferent areas you can smooth your overall returns.The same logic applies to diversifying trading systems.

Instead of focusing on only one system, traders can use twoor more systems that aren’t highly correlated to offset weak-nesses and improve a portfolio’s reward-risk profile. Theidea is to mix trading styles to make sure the systems willcomplement each other: trend-following vs. countertrend,short-term vs. long-term, and so on.

The following strategy examines two different intermedi-

ate-term approaches — a trend-following system and amean-reverting system with a trend filter. The systems arethen combined to show how total performance can beimproved when they are traded simultaneously.

Bollinger Band breakout systemThe first system enters long trades when price closes abovethe upper Bollinger Band and enters short trades whenprice closes below the lower Bollinger Band. The systemexits when price reaches the 20-day simple moving average(SMA).

Trade rules:

1. Go long if price closes above theupper Bollinger Band (using a 20-daySMA and two-standard-deviationbands).

2. Sell short if price closes below the lower Bollinger Band.

3. Exit all trades with a stop-loss order when price reaches the 20-day SMA.

Figure 1 shows a daily chart of theOctober natural gas contract (NGV08) andhighlights a profitable short trade. The sys-tem sold short when natural gas closedbelow the lower Bollinger Band on July 8,and closed the trade when price hit the 20-day SMA on Aug. 27.

Table 1 shows back-test results for adiversified portfolio of futures contractsfrom Sept. 1, 1998 to Sept. 1, 2008 (including$50 round-trip commission and slippagefees). First, the average trade lasted just 12days, significantly shorter than many trend-

Taking trade signals from multiple systems can help smooth out a portfolio’s equity curve.

The trick is to pick the right strategies.

Two systems are better than one

The trend-following Bollinger Band strategy caught a major down move inOctober natural gas futures from July 8 to Aug. 27. The system sold shortwhen price closed below the lower Band and exited after it reached a 20-daysimple moving average.

FIGURE 1 — TRADE EXAMPLE IN NATURAL GAS

Source: CQG, Inc.



following systems, and therefore morepsychologically palatable to mosttraders. One of the biggest advantagesof shorter trades is per-trade losses areoften smaller.

Table 1 shows that gains from indi-vidual markets add to the portfolio’sprofits, while the individual maximumdrawdowns don’t add to the portfo-lio’s overall drawdown. For example,the profit-to-maximum-drawdownratio (P:MD) for the portfolio is 4.2 —larger than the P:MD ratio of any singlemarket. This is typical of a diversifiedportfolio and suggests profits in onemarket offset drawdowns in others.

Like most trend-following systems,the portfolio’s percentage of winningtrades is well below 50 percent. Thesystem is still profitable overall, how-ever, because its average wins are sig-nificantly larger than its average losses.

System developers understand thesedifferences, and some simply choose to omit certain mar-kets from trend-following system portfolios and othersfrom mean-reversion, or countertrend, portfolios. If wetraded the Bollinger Band breakout strategy, for example,we would likely not use it to trade stock-index futures. Thatsaid, there is no guarantee trending markets of the past 10years will continue to trend in the future, and previouslychoppy markets could become trending markets in thefuture, which is why the E-Mini S&P 500 was included.

Countertrend RSI systemA straightforward way to complement the Bollinger Bandsystem is to add a countertrend system with no bias towardthe dominant market trend. Instead, let’s test a coun-tertrend system that uses the relative strength index (RSI)with a 200-day SMA to prevent taking trade signals that areagainst the long-term trend.

The countertrend RSI system bought Euro futures after the RSI closed below 35on May 2 and exited after the RSI climbed above 65 on May 22.

continued on p. 12

Source: CQG, Inc.

The overall system’s profit-to-maximum-drawdown ratio (4.2) is larger than in any individual market, which is typical of a diversified portfolio.

TABLE 1 — BOLLINGER BAND SYSTEM

Avg. Percentage trade Avg. Max. time

Total No. of Trades length Avg. annual Max. consecutive P:MD Winning in the Market net profit trades per year (days) trade profit drawdown* losers ratio percentage market

British pound futures (BP) $5,267 98 9.8 12 $53.74 $526.70 -$14,862 9 0.35 35.71 44.46

Euro futures (EC) $30,328 96 9.6 14 $315.92 $3,032.80 -$18,250 8 1.66 32.29 48.83

Japanese yen futures (JY) $18,736 93 9.3 14 $201.46 $1,873.60 -$16,300 5 1.15 37.63 47.89

Natural gas futures (NG) $108,770 94 9.4 14 $1,157.13 $10,877.00 -$50,990 7 2.13 36.17 47.28

Crude oil futures (CL) $25,890 93 9.3 13 $279.35 $2,589.00 -$23,030 12 1.12 39.78 45.44

Gold futures (GC) -$11,510 106 10.6 13 -$108.58 -$1,151.00 -$23,300 10 -0.5 31.13 49.22

Sugar futures (SB) $872 94 9.4 14 $9.28 $87.20 -$8,341 10 0.1 31.91 47.75

Soybean futures (S) $43,324 84 8.4 15 $515.76 $4,332.40 -$11,062 6 3.92 46.99 46.89

Wheat futures (W) -$7,985 106 10.6 12 -$75.33 -$798.50 -$19,837 10 -0.4 26.42 46.86

10-year T-note futures (TY) $14,196 88 8.8 15 $161.32 $1,419.60 -$9,406 7 1.51 43.18 49.08

E-Mini S&P 500 futures (ES) -$33,724 98 9.8 12 -$344.12 -$3,372.40 -$38,362 9 -0.88 27.55 41.1

Portfolio $194,164 1,050 105 12 $184.92 $19,416.40 -$46,261 18 4.2 35.14 NA

*17 months — beginning of drawdown to new equity high (10/06-3/08)Longest drawdown was 26 months (10/98-12/00), but drawdown was -$45,566

Source: CQG, Inc.

FIGURE 2 — TRADE EXAMPLE IN EURO FUTURES

Trade rules:

1. Go long if the nine-day RSI is below 35, price closes above its 200-day SMA, and today’s volume is less than yesterday’s volume.

2. Exit long trade if RSI closes above 65, or with a $7,500 stop-loss.

3. Sell short if the nine-day RSI is above 65, price closes below the 200-day SMA, and today’s

volume is less than yesterday’s volume.

4. Exit short trade if the RSI closes below 35 or with a $7,500 stop-loss.

Figure 2 shows a daily chart of Eurocurrency futures (EC)with a profitable long trade. On May 2 the RSI fell below 35and price remained above its 200-day SMA, triggering along trade. The RSI closed above 65 on May 22 and thetrade was exited the next day.

Table 2 shows back-test results for the same futures mar-kets over the past 10 years. Unlike the Bollinger Bandbreakout system, the countertrend RSI system had a highwinning percentage — 67.65 percent. In addition, the E-Mini S&P 500 futures, which was the trend-following strat-egy’s poorest performer, was profitable and had a 0.65P:MD ratio ($7,252 net profit/$11,212 maximum draw-down). Finally, the countertrend system had only six con-secutive losing trades compared to 18 for the BollingerBand system.

Of course, the RSI strategy had its own weaknesses, espe-cially a lengthy 43-month drawdown before hitting a newequity high and a mediocre 1.78 P:MD ratio. If traded alone,these weaknesses would be troublesome, but the goal is tocombine it with the Bollinger Band system. Therefore, thestrengths of the latter system will offset the weaknesses ofthe former.


TRADING STRATEGIES continued

This countertrend RSI system had a winning percentage of 67.65 percent and only 6 consecutive losses. On the other hand,it took 43 months to recover from its largest drawdown.

TABLE 2 — COUNTERTREND RSI SYSTEM

Avg. Percentage trade Avg. Max. time

Total No. of Trades length Avg. annual Max. consecutive P:MD Winning in the Market net profit trades per year (days) trade profit drawdown* losers ratio percentage market

British pound futures (BP) $33,466 34 3.4 25 $984.29 $3,346.60 -$11,631 2 2.88 82.35 32.63

Euro futures (EC) $20,410 23 2.3 25 $887.39 $2,041.00 -$15,212 2 1.34 69.57 22.41

Japanese yen futures (JY) -$527 27 2.7 28 -$19.52 -$52.70 -$20,625 2 -0.03 59.26 28.87

Natural gas futures (NG) -$10,800 40 4 20 -$270.00 -$1,080.00 -$57,560 4 -0.19 45 29.87

Crude oil futures (CL) $22,430 28 2.8 25 $801.07 $2,243.00 -$15,800 1 1.42 71.43 26.87

Gold futures (GC) $14,810 27 2.7 29 $548.52 $1,481.00 -$10,350 2 1.43 74.07 30.58

Sugar futures (SB) -$118 25 2.5 32 -$4.72 -$11.80 -$5,958 2 -0.02 72 31.15

Soybean futures (S) -$27,900 24 2.4 39 -$1,162.50 -$2,790.00 -$32,350 2 -0.86 56.52 34.59

Wheat futures (W) $11,417 30 3 25 $380.57 $1,141.70 -$12,625 2 0.9 76.67 28.74

10-year T-note futures (TY) $6,541 27 2.7 30 $242.26 $654.10 -$12,350 2 0.53 66.67 30.89

E-Mini S&P 500 futures (ES) $7,252 21 2.1 32 $345.33 $725.20 -$11,212 1 0.65 71.43 26.03

Portfolio $76,981 306 30.6 25 $251.57 $7,698.10 -$43,203 6 1.78 67.65 NA

*43 months — beginning of drawdown to new equity high (12/00-6/04)

Source: CQG, Inc.

Related reading

“Multi-system testing”Active Trader, December 2008.This Trading System Lab shows there is more to tradingmultiple systems than first meets the eye.

“Allocating capital to multiple trading signals” Active Trader, November 2006.Find out how a multi-signal system performed usingthree different capital-allocation techniques.

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

http://store.activetradermag.com

Combining low-correlationsystemsTable 3 shows the results of combiningthe systems. The combined portfoliohad a higher winning percentage thanthe Bollinger Band strategy (42.33 per-cent vs. 35.14 percent) and a shorterpeak-to-valley drawdown than the

countertrend RSI system (24 monthsvs. 43 months). More importantly, thecombined system had a 5.39 P:MDratio, which is superior to either of thecomponent strategies.

One disadvantage to trading mul-tiple systems is you might have toopen additional subaccounts with

your broker to prevent one strategy’slong positions from offsetting anoth-er’s short positions.��

For information on the author see p. 5.


The combined system performed better than either standalone system. It had a profit-to-maximum-drawdown ratio of 5.39,which is superior to either strategy.

TABLE 3 — COMBINING THE SYSTEMS

Avg. trade Avg. Max.

Total No. of Trades length Avg. annual Max. consecutive P:MD Winning Market net profit trades per year (days) trade profit drawdown* losers ratio percentage

British pound futures (BP) $38,733 132 13.2 15.35 $293.43 $3,873.30 -$13,100 7 2.96 47.73

Euro futures (EC) $50,738 119 11.9 16.13 $426.37 $5,073.80 -$17,362 7 2.92 41.18

Japanese yen futures (JY) $18,209 120 12 17.15 $151.74 $1,820.90 -$16,901 5 1.08 41.67

Natural gas futures (NG) $97,970 134 13.4 15.79 $731.12 $9,797.00 -$56,520 7 1.73 38.06

Crude oil futures (CL) $48,320 121 12.1 15.78 $399.34 $4,832.00 -$17,390 12 2.78 47.11

Gold futures (GC) $3,300 133 13.3 16.25 $24.81 $330.00 -$16,090 9 0.21 39.85

Sugar futures (SB) $754 119 11.9 17.78 $6.34 $75.40 -$5,946 6 0.13 40.34

Soybean futures (S) $15,424 108 10.8 20.33 $142.81 $1,542.40 -$14,314 4 1.08 50

Wheat futures (W) $3,432 136 13.6 14.87 $25.24 $343.20 -$11,188 7 0.31 37.5

10-year T-note futures (TY) $20,737 115 11.5 18.52 $180.32 $2,073.70 -$11,732 7 1.77 48.7

E-Mini S&P 500 futures (ES) -$26,472 119 11.9 15.53 -$222.45 -$2,647.20 -$33,492 10 -0.79 35.29

Portfolio $271,145 1,356 135.6 14.93 $199.96 $27,114.50 -$50,351 16 5.39 42.33

*24 months — beginning of drawdown to new equity high (1/01-1/03)

CQG programming code

Bollinger Band system:

Long Entry: Close(@)[-1] > BHI(@,Sim,20,2.00)[-1]

Short Entry: Close(@)[-1]< BLO(@,Sim,20,2.00)[-1]

Long & Short Exit (set price field to): BMA(@,Sim,20)[-1]

Counter-trend RSI system:

Long Entry: RSI(@,9)[-1] < 35 AND Close(@)[-1] > MA(@,Sim,200)[-1] ANDVol(@)[-2] > Vol(@)[-1]

Long Exit: RSI(@,9)[-1] > 65 OROpenPositionAverageEntryPrice(@,ThisTradeOnly) - Dollar2Price(@,7500)/ OpenPositionSize(@,ThisTradeOnly)

Short Entry: RSI(@,9)[-1] > 65 AND Close(@)[-1] < MA(@,Sim,200)[-1]AND Vol(@)[-2] > Vol(@)[-1]

Short Exit: RSI(@,9)[-1] > 65 OR OpenPositionAverageEntryPrice(@,ThisTradeOnly) -Dollar2Price(@,7500) / OpenPositionSize(@,ThisTradeOnly)

Source: CQG, Inc.

http://www.optionsmentoring.com

TRADING STRATEGIES

BY DAN PASSARELLI

Given the recent stock-market rout, volatilityseems like a dirty word. But it doesn’t haveto be. Volatility simply means opportunity inthe options markets.

Every opportunity to make money includes the potentialfor risk. In highly volatile markets, you really need skills tohave a fighting chance.

The problem is many traders focus solely on predictingthe market’s direction, a foolish task in such an uncertainenvironment. Instead, sophisticated traders try to takeadvantage of rising volatility regardless of which directionthe markets are headed.

One way to exploit a jump in volatility is to buy anoptions straddle (long call, long same-strike put). Straddlebuyers make money if the underlying market moves farenough in one direction to offset the position’s cost.

Another way to make money with a long straddle is tobuy or sell the underlying market each time it moves a cer-tain amount. The idea is that if you buy stock after it dropsand sell after it climbs, you can offset the straddle’s time

decay — a strategy known as “gamma scalping.”

Understanding the GreeksBefore trading this strategy, you need to understand theGreeks, which measure different components of an option’sprice — delta, gamma, theta, and vega.

Delta is the rate of change of an option’s value relative toa change in the underlying’s price. Delta is also consideredthe equivalent to shares held in the underlying. Gamma is

Gamma scalping

In August, QQQQ’s close-to-close price change (up ordown) was $0.50. If you think its daily price moves couldrise to $0.90 in six weeks, you could buy an Octoberoptions straddle to take advantage of increased volatility.

TABLE 1 — NASDAQ 100 TRACKING STOCK (QQQQ) PRICES

Date Closing price Daily change

8/1/08 44.88

8/4/08 44.43 -0.45

8/5/08 45.93 1.5

8/6/08 46.63 0.7

8/7/08 46.27 -0.36

8/8/08 47.32 1.05

8/11/08 47.75 0.43

8/12/08 47.8 0.05

8/13/08 47.7 -0.1

8/14/08 48.25 0.55

8/15/08 48.16 -0.09

8/18/08 47.6 -0.56

8/19/08 47.01 -0.59

8/20/08 47.09 0.08

8/21/08 46.87 -0.22

8/22/08 47.49 0.62

8/25/08 46.49 -1

8/26/08 46.43 -0.06

8/27/08 46.73 0.3

8/28/08 47.11 0.38

8/29/08 46.12 -0.99

Avg. daily change (up or down): 0.50


Strategy Snapshot

Strategy: Gamma scalping with straddles

Components: Long at-the-money (ATM) calls+

Long same-strike puts

Logic: Create a delta-neutral position by buying options and offsetting their deltas by trading an appropriate number of shares. To keep the trade direction neutral, buy when position delta gets negative and sell when position delta gets positive.

Criteria: Use options that expire within one or two months.

Best-case The profits from buying low and selling scenario: high exceed any time decay from the long

options. Implied volatility spikes.

Worst-case Time decay from the long options exceed scenario: any gains from buying low and selling

high. Implied volatility tanks. Transaction costs add to losses.

In uncertain times smart traders focus on volatility, not market direction.


the rate of change of an option’s deltarelative to a change in the underlying’sprice. Theta is the rate of change of anoption’s value relative to the passageof time. And vega is the rate of changeof an option’s value relative to achange in implied volatility (IV).

If these terms are new to you, that’sokay. But keep in mind strategies thatrely heavily on the Greeks are oftenmore complex. Let’s examine a longstraddle example to see how these con-cepts work together.

Buying volatility with straddlesTable 1 lists the daily closing prices ofthe Nasdaq 100 tracking stock (QQQQ)in August. Disregarding direction, theaverage close-to-close price changewas $0.50. Let’s assume you thoughtdaily change could climb to $0.90 inthe next six weeks.

On Sept. 4, QQQQ closed at $43.66, and you could havebought 10 October 43-strike calls for 2.05 each and 10October 43 puts for 1.33 each — a total of 3.38 ($338) each.When you buy this straddle, you acquire Greeks risk,meaning the position is vulnerable to changes in the under-lying’s price (delta), delta’s value (gamma), time (theta),and implied volatility (vega). Table 2 lists the long strad-dle’s cost and Greeks values.

Figure 1 shows the long straddle’s potential gains andlosses on three dates: trade entry (Sept. 4, dotted line),halfway until expiration (Sept. 26, dashed line), and expira-tion (Oct. 18, solid line). The position will typically makemoney if QQQQ either rallies or falls, but it must moveenough to offset the negative effect of time decay. As timepasses, the straddle’s value drops, and the Nasdaq 100tracking stock must move further in either direction to beprofitable.

However, the goal here isn’t simply to hold the straddleand wait for the underlying to make a large move. Instead,we plan to capture small profits as QQQQ fluctuates eachday, which requires monitoring the position’s Greeks closely.

Tracking delta and gamma The straddle has a delta of 1.73, meaning its directional riskis similar to 173 QQQQ shares. If the Nasdaq 100 trackingstock climbs by $1, the straddle will gain $1.73 ($173). Butconsidering you are holding 20 contracts, representing 2,000underlying shares, this is a fairly flat position at this point.

Gamma tracks delta’s rate of change as the underlyingmoves. Therefore, if QQQQ rises $1 from $43.66 to $44.66,the straddle’s delta will climb by 1.87 — gamma’s value —to 3.60. At that point, the straddle will resemble 360 shares

of the Nasdaq 100 tracking stock. And as QQQQ rallieshigher, the delta will rise further.

On the other hand, if QQQQ falls, the straddle’s deltawill drop by gamma’s value. So if the Nasdaq 100 trackingstock drops $1 to $42.66, the straddle’s delta slips from 1.73to -0.14 by the gamma value of 1.87. Now, the straddle’sdelta resembles 14 short shares. And as QQQQ falls lower,the delta will become more negative. If the underlyingdrops $1 further to $41.66, the straddle’s gamma (1.87) willcause the delta to change to -2.01 from -0.14. As QQQQ’sdecline intensifies, the more the straddle will earn for each$1 drop.

Creating a delta-neutral positionIdeally, the long straddle will have a delta of zero, but theOctober 43 straddle has a long delta bias (1.73). If QQQQfell from $43.66, the only benefit positive gamma offers is to

Long straddles make money if the underlying moves far enough in either directionto offset the negative effect of time decay. On Sept. 4, this long 43-strike straddlewill become profitable if QQQQ either drops to $41.42 or climbs to $44.06.

FIGURE 1 — RISK PROFILE – LONG STRADDLE

Source: OptionVue

continued on p. 16

When QQQQ closed at $43.66 on Sept. 4, you could havebought Oct. 43-strike calls for 2.05 each and Oct. 43-strikeputs for 1.33 each — a total cost of 3.38. The position is vul-nerable to changes in the underlying’s price (delta), delta’svalue (gamma), time (theta), and implied volatility (vega).

TABLE 2 — OPTION GREEKS

10 Oct. 10 Oct. 10 Oct. 43 calls 43 puts 43 straddles

Value (per contract) 2.05 1.33 3.38

Delta 5.88 -4.15 1.73

Gamma 0.93 0.94 1.87

Theta -0.2 -0.18 -0.38

Vega 0.58 0.58 1.16



Related reading

Dan Passarelli articles:

“Fighting the options battle with the Greeks”Futures & Options Trader, February 2008.Paying attention to options Greeks is vital for nearly anyoptions trader. Tracking an option’s delta, gamma, theta,and vega might save your neck in today’s volatile market.

“Trading against the pros”Options Trader, November 2006.Understanding how market makers manage risk mayhelp you get better fills.

“Calendar spreads: Taking time out of the market”Options Trader, February 2006.Trading time spreads offers a way to take advantage oftime decay and volatility changes while limiting risk.

Other articles:

“Shifting into neutral” Futures & Options Trader, June 2008.You don’t always have to forecast market direction cor-rectly to make money-trading options. This non-direction-al approach will gain ground if you buy options beforevolatility picks up or sell them before it declines.

“Valuing options with ‘gamma rent’”Active Trader, August 2007.Deciding whether an option is cheap enough to buy orexpensive enough to sell can be tough. This simple for-mula uses implied volatility to find out what the marketsthink.

“Swing with the market: Vega and rho”Options Trader, February 2007.Vega and rho are lesser-known “Greeks,” but they meas-ure the effect of two critical option-pricing components:implied volatility and interest rates.

“Know your theta”Options Trader, January 2007. Time eats away at every options position, so it pays toknow time decay affects option prices.

“Get on the fast track with gamma”Options Trader, November 2006.Gamma digs digger into explaining how underlying pricemoves affect an option’s price.

“Delta for the rest of us” Options Trader, October 2006.A few simple concepts shed light on delta and how optionprices change.

Several of these articles are included in “OptionsBasics Collection, Volume 1,” a set of nine pastOptions Trader and Active Trader articles. The collectionencompasses options terminology, fundamental tradingconcepts and simple strategies, as well as practical con-siderations such as margin. This is a series designed forthose new to options trading, whether in stock or futures,available now for a 30-percent discount.


At first, the straddle had a delta of 1.73, but it fell to zero afterwe sold short 173 shares. Notice that delta is the only Greekvalue that changes when you trade the underlying stock.

TABLE 3 — DELTA-NEUTRAL STRADDLE

10 Oct. 10 Oct. 10 Oct. 10 straddles,43 43 43 short

calls puts straddles 173 shares

Value (per contract) 2.05 1.33 3.38 3.38

Delta 5.88 -4.15 1.73 0

Gamma 0.93 0.94 1.87 1.87

Theta -0.2 -0.18 -0.38 -0.38

Vega 0.58 0.58 1.16 1.16

reduce delta’s value, meaning the position loses less as theunderlying falls.

To trade volatility instead of direction, the first step is toeliminate the straddle’s directional (delta) bias by sellingshort 173 shares of QQQQ. Table 3 shows the position is nowdelta neutral. After this adjustment, all the Greek valuesremain unchanged except for delta, because 100 underlyingshares have a delta of 1.0, but a gamma, theta, and vega ofzero.

Now that the straddle’s directional bias has been eliminat-ed, you can begin to trade based solely on the underlying’svolatility — the more volatile QQQQ becomes, the morechances you’ll have to make money. After the Nasdaq 100tracking stock rises or falls, you can neutralize its delta bybuying or selling underlying shares, locking in profits witheach trade. This process is called gamma scalping, becausepositive gamma creates the opportunity to trade stock favor-ably.

If, for example, QQQQ climbs $1 to $44.66, the position’sdelta rises to 1.87 from zero, and you can sell short 187 sharesto lower its delta back to zero. Then if QQQQ drops backdown to $43.66, you can buy back the short 187 shares, lock-ing in a $187 profit. Again, as volatility climbs, the strategy’spotential profit increases.

In theory, this technique sounds good, and it works well ifthe underlying is volatile enough. But when volatility wanes,the position is punished by the passage of time.

The trade-off between gamma and thetaThe success of a long straddle depends on the trade-offbetween gamma, which drives the strategy, and theta, whicherodes the position’s value. Time decay, or theta, takes its tollon the straddle’s value as time passes; the October 43 straddleloses $38 each day, including weekends. Therefore, you mustearn $266 in gamma scalps each week to cover the position’scarrying costs.

If the Nasdaq 100 tracking stock moves roughly $1 eachday, this isn’t a problem, but remember it was only moving$0.50 each day when we entered the position on Sept. 4. IfQQQQ rises $0.50 to $44.16, delta will climb to 0.94, similar to94 long shares. At that point, you can sell 94 shares to neu-tralize delta. And if QQQQ drops $0.50 the next day, you canbuy back 94 shares to neutralize delta again. This trade earnsjust $47 in two days, which isn’t enough to cover theta’s cost.


Don’t forget IV (vega)If trading volatility is so easy, then whydon’t clever traders just buy straddles onthe most volatile stocks? They do, and theprice of straddles rises because of this buy-ing pressure, posing two problems forstraddle buyers. First, because a straddlecosts more, theta is higher, inflating theposition’s daily carrying cost. Also, the IV ofthe options increases.

Implied volatility is the relative price ofan option based on the market’s expecta-tions of future volatility. When the marketthinks volatility will climb in the future,which benefits long straddles, optionsprices rise and vice versa.

How IV affects your trade depends onthe difference between your view of futurevolatility compared to the market’s assess-ment. Is the straddle’s cost worth it? Theproblem appears when the market adjustsits view of future volatility, causing IV tofall and your straddle to be worth less.

You can track IV’s effect on your positionusing vega: In the October 43 straddleexample, IV is 28 percent. However, iftraders suddenly felt volatility in QQQQ ispoised to rise and bought more options, IVcould climb, boosting the straddle’s valueby its vega. For example, if IV advances onepercentage point to 29, the straddle’s costwill jump 1.16 ($116). By contrast, if themarket’s opinion of volatility fell by onepercentage point to 27, the straddle will losethe same amount. Note that this vega’svalue is based on a 10-contract straddle; thestraddle’s per-contract vega value is 0.116($11.60).

The realities of gamma scalpingIn the past, only market makers and otherprofessional traders could make moneyscalping gamma on delta-neutral positions,because commissions took a big chunk ofany profits. These days, low commissionsand portfolio margining allow retail tradersto use this technique too.

However, trading based on the Greeks iscomplex, and this example should beviewed as only the first step in learning thenuances of this approach. ��


FUTURES & OPTIONS TRADER • November 2008

http://www.pfgbest.com/link/?go=challenge&LSD=Futures%20and%20Options%20Trader%20Newsletter%20Ad%20Jun08&LSC=3rd%20Party%20Newsletter&BID=&CID=

Who trades options?An academic study of who trades what in the options markets finds that traders

prefer to keep their strategies simple.


TRADING STRATEGIES

Non market makers traded calls almost exclusively from1990 to 2001. By contrast, only 20 percent of all tradesused puts (short or long).

FIGURE 1 — TYPES OF POSITIONS

Full-service customers — hedge funds and retailtraders — held 70 percent of the short-call open inter-est, meaning they often sold covered calls.

FIGURE 2 — WHO SELLS CALLS?

Source: Option Market Activity

BY GEORGE HOEKSTRA


Whenever you trade an option, someonetakes the other side of your trade. Haveyou ever wondered who that person is?Professional market makers, whose job is

to provide a market in the options on that stock, often do.But who else trades options and how can you use this infor-mation?

A recent academic study of option market activity ana-lyzed 12 years of trading data for options listed at theChicago Board Options Exchange (CBOE) to see who tradesoptions and why they do it. The conclusions are summa-rized in a paper titled Option Market Activity by professorsJosef Lakonishok, Inmoo Lee, Neil Pearson, and AllenPoteshman of the University of Illinois.

These researchers uncovered some interesting detailsabout option market activity from 1990 to 2001 that debunk

some myths about how options markets work and offerclues about how to trade options more effectively.

Call options are big businessFirst, the researchers broke down the CBOE data into fourdifferent groups of non market makers: firm proprietarytraders, discount customers, full-service customers, andother public customers. These four investor groups trademany more calls than puts. Figure 1 breaks down theirtrades according to open interest during the 12-year period.

Open interest in calls was four times as large as openinterest in puts (80 percent vs. 20 percent). The most popu-lar trade among non market makers was to sell calls, main-ly as part of popular covered call positions (long stock,short call).


Who sells calls? Figure 2 shows who sold calls from1990 to 2001. Customers of full-servicebrokerage firms held 70 percent of theshort-call open interest. These cus-tomers include hedge funds and retailinvestors who often use more sophisti-cated investment strategies. Most oftheir positions hedge long stock posi-tions — i.e., covered calls.

Another interesting conclusion issome advanced strategies that get agreat deal of attention in trading litera-ture and textbooks weren’t usedmuch.

The following strategies weren’t aspopular as you might think:

Straddles, strangles, and butterflyspreads. Options educators often focuson ways options can be used to specu-late on changes in stock volatility.Straddles, strangles, and butterfliesare volatility-based strategies. Butthe study’s data reveals “volatilitytrading through straddles, stran-gles, and butterflies — whether forspeculative or hedging purposes —explains at most a small fraction ofoption trading.” Traders may enjoydiscussing these positions, but fewuse them in real-world situations.

Protective puts. Another high-pro-file strategy is buying puts to hedgelong stock positions. This is a sensi-ble strategy that resembles buyinginsurance on the underlying stock.However, the study shows thatvery few traders use protectiveputs. Indeed, traders rarely boughtputs for any reason; Figure 1 showsonly 9 percent of total open interestwas long puts.

Dot-com bubble fueled callbuyingThe study also found discount customers bought more callsas the technology bubble inflated in the late 1990s. Beforereaching this conclusion, researchers analyzed the averagevolume of opening purchases in four time periods: pre-

bubble (1990-1994), early-bubble (1994-1997), peak-bubble(1998-March 2000), and post-bubble (April 2000-2001).

Figure 3 shows that call buying by discount customers

Discount customers bought more calls as the technology bubble inflated in thelate 1990s.

FIGURE 3 — CALL-BUYING VOLUME SURROUNDING TECH BUBBLE

Trading volume tends to pick up as interest grows and the contract moves closerto expiration.

FIGURE 4 — SHERWIN WILLIAMS SEPTEMBER 60 CALL

continued on p. 20


Source: OptionsXpress

doubled from the initial pre-bubble period to the early-bub-ble period (1990-1994 vs. 1994-1997). Then, as the bubblepeaked from 1998 to March 2000, discount customersbought nearly 2.5 times as many calls than before the bub-ble began. After the bubble, discount customers boughtonly one-third as many calls as they did during the peak.

Clearly, the technology boom attracted discount cus-tomers who speculated that stocks would continue to rise.And many of them were probably new options traders.Volume was concentrated in long calls on large growthstocks. By contrast, the study didn’t find increased call buy-ing among other types of investors.

(Click here to download the full Option Market Activityarticle.)

Lessons from this studyFirst, most options traders use simple strategies such asbuying calls and selling covered calls. It makes sense tokeep things simple. Don’t get caught up in the idea that youshould trade complex strategies, which usually require agreat deal of capital to execute consistently and add totransaction costs.

Also, the study contradicts a common myth that mostretail option traders are wide-eyed, unsophisticated gam-blers who buy calls to make short-term, high-leverage betson stocks. To some extent, this caricature was likely accu-rate during the dot-com bubble, but even then, call buyingwas only a small part of the total picture, and it has driedup since 2000.

A corollary to this myth is that selling covered calls is asmart way to take advantage of the overabundance of callbuyers who bid up option prices to excessive levels to payfor high-leverage bets. However, the study’s data suggeststhe supply-demand balance among non market-makers istilted toward an oversupply of call sellers. If more traderswant to sell calls than buy them, prices will tend to be driv-en down. Therefore, that bias may work to call buyers’advantage.

Dig into trading dataCan you benefit from studying trading data on options thatseem attractive? The Options Market Activity authors usedsome clever analysis, along with available data, to learnwhen and how options trades took place. This kind of datais increasingly available to anyone.

Many options are thinly traded, meaning only a fewtrades are executed each day. These contracts usually havewide bid-ask spreads. Today, it is possible to study how aday’s trading unfolds, tick-by-tick. If you are consideringbuying or selling options on a stock, it makes sense to diginto that data and see what you can learn.

For example, Figure 4 shows a daily chart of a SherwinWilliams (SHW) September 2008 60 call. Charts of individ-ual options are available on most brokers’ Web sites. TheSHW September 60 call began trading in February 2008.



The more an option contract trades, the more likely youwill be able to get a better filled price on a limit order.

TABLE 1 — TIME AND SALES DATA

Date Time Exchange Size Price

9/4/08 9:31:12 10 2.3

9/4/08 9:45:45 CBOE 5 2.39

9/4/08 11:09:25 48 2.15

9/4/08 11:09:25 46 2.15

9/4/08 11:09:25 53 2.15

9/4/08 11:09:25 84 2.15

9/4/08 11:09:25 19 2.15

9/4/08 11:11:35 2 2.15

9/4/08 11:11:36 9 2.15

9/4/08 11:11:37 5 2.15

9/4/08 11:11:43 123 2.15

9/4/08 11:11:44 CBOE 2 2.15

9/4/08 11:11:44 111 2.15

9/4/08 11:13:29 47 2.25

9/4/08 11:13:29 PSE 15 2.25

9/4/08 11:13:29 PSE 11 2.25

9/4/08 11:13:29 CBOE 78 2.25

9/4/08 11:13:29 30 2.25

9/4/08 11:13:29 PSE 6 2.25

9/4/08 11:13:29 10 2.25

9/4/08 11:13:40 CBOE 9 2.25

9/4/08 11:14:23 21 2.2

9/4/08 11:14:23 9 2.2

9/4/08 11:59:43 10 2

9/4/08 15:07:08 4 1.6

9/4/08 15:07:41 11 1.6

9/4/08 15:28:26 CBOE 10 1.6

9/4/08 15:28:26 10 1.6

9/4/08 15:37:14 12 1.6

9/4/08 15:37:17 4 1.6

9/4/08 15:37:18 8 1.6

9/4/08 15:37:22 4 1.6

9/4/08 15:37:23 4 1.6

9/4/08 15:39:10 6 1.6

9/4/08 15:39:10 54 1.6

Source: OptionsXpress

http://www.business.uiuc.edu/poteshma/research/lakonishokLeePearsonPoteshman22May2006.pdf

Price and volume data is shown fromits initial offering in February to Sept.5, two weeks before it expired on Sept.19.

Trading volume was sparse inFebruary and March as the call didn’ttrade at all on most days. But volumepicked up in July and August as expi-ration drew closer. The first time itsdaily volume exceeded 100 contractswas July 18. By August the contracttraded nearly every day, and inSeptember, its expiration month, vol-ume increased considerably, includingone day with 900 contracts traded.This pattern of gradually increasingtrading volume is typical as interestgrows and the contract moves closer toexpiration.

Gleaning insight from time and sales dataAnother way to examine an option’strading activity is to use its time andsales data available in the quotes sec-tion of most brokers’ Web sites.

Table 1 shows the time and salesdata for the SHW September 60 call on

Sept. 4. There were a couple of smalltrades at 9:31 a.m. and 9:45 a.m., butthen no trades occurred until the five-minute interval from 11:09 a.m. to11:14 a.m. when volume exceeded thetotal number of contracts traded so far.What does this mean? One clue iswhether the trades are filled at the bidprice, ask price, or in between. You canfind other clues by examining otherSherwin Williams options. For exam-ple, did volume climb in same-strikeputs or calls with different strikes orexpirations?

The idea is to study the trades inattractive options to find patterns. If,for example, you see volume spurtsoccasionally either at the bid or askprice, you might be able to enter alimit order and wait for it to get filledat a more attractive price. If a contractnever trades, you probably won’t beable to buy it much below the askprice. But if a contract trades more fre-quently, you might get a better fill on alimit order if you are patient. ��



“The quest for cheap options” Futures & Options Trader, August 2008.This option-buying strategy builds on a recent academic studythat found a compelling edge in the options market from 1996to 2005.

“Getting a handle on volatility”Options Trader, September 2006.Want to understand volatility? Before you dive into option-pric-ing models and complex math, do some basic price compari-son. You’ll be surprised how much you can learn.

“Focusing on volatility,” Options Trader, August 2005. To hone in on options with the most favorable odds, structurea search that focuses on a certain stock price, exercise price,and expiration date, and then use a simple analysis approachto identify options that are the most underpriced.

“The option pricing edge,” Options Trader, October 2005. Buying options at a 10- to 20-percent discount can be the dif-ference between making and losing money over time. A pop-ular trading approach is to buy options on a stock you expectto have more volatility than the level implied by the price of itsoptions. Higher volatility translates into higher option prices,so if your assessment of future volatility is correct, suchoptions give you an advantage in that higher actual volatilityincreases the chance of a profitable trade.

“Bargain hunting options,” Active Trader, January 2005. If you get the willies every time you read “standard deviation,”take heart: This volatility analysis approach and option tradingstrategy takes the mathematical sting out of finding inexpen-sive options.


Related reading: George Hoekstra articles


http://rsofhouston.com

OPTIONS STRATEGY LABOPTIONS TRADING SYSTEM LAB

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

System concept: This system trades credit spreadsbased on signals generated by the advance-decline (A-D)line, which is a day-to-day running total of the number ofstocks that have closed higher on the day (advancing)minus the number of stocks that have closed lower on theday (declining). The indicator is applied to the S&P 500index, but it can be calculated on any market index forwhich daily advancing and declining issues are reported.

Trade signals are triggered when the underlying’s pricediverges from the A-D line. For example, a bullish signal istriggered when the S&P 500 forms a lower low but the A-Dline doesn’t. A bearish signal occurs when the S&P 500makes a higher high but the A-D line doesn’t.

Depending on the type of signal, the system enters a bullput spread or a bear call spread. Each spread is held eitheruntil it expires worthless or an opposite signal appears. Thesystem isn’t always in the market, so there are long periodsof inactivity.

To enter a vertical credit spread, you sell an option witha strike that is closer to the money than the one bought toprotect it. The spread tries toexploit the short option’s timedecay and collects the mostprofit if the underlying doesn’treverse beyond the short strikeprice by expiration. Bothoptions share the same expira-tion month, and when strikesare 10 points apart, a 10-contractposition requires a $10,000 mar-gin. The spread is entered at anet credit, which you keep ifboth options expire worthless.

Figure 1 shows the potentialgains and losses of an October1135/1145 bull put spreadentered on Sept. 5 when the S&P500 closed at 1242.30. The tradewould be profitable if the S&P500 closes above 1143.94 on Oct.17 (expiration). The spread’smaximum gain is $1,070, a 12-percent potential yield (104 per-cent annualized). The positioncan lose up to $8,960 if the S&P500 drops to 1135 or below atexpiration.

Trade rules:

Bullish signalThe S&P 500 forms a lower low than yesterday, but the A-D line doesn’t.Enter the trade at the close on the first day the S&P500 posts a gain.

Entering bull put spreads1. Sell 10 puts with a strike located one standard

deviation out-of-the-money (OTM).2. Buy 10 puts at a strike 10 points below the short

put.3. Use the first expiration month with more than 21

days left until expiration.4. The spread’s minimum yield must be at least 5

percent (premium received / net margin required).

Bearish signal1. The S&P 500 forms a higher high than yesterday,

but the A-D line doesn’t.


Spread trading withthe advance-decline line

This 1135-1145 bull put spread has an 88-percent probability of profit and will makemoney if the S&P 500 index closes above 1143.94 at Oct. 17 expiration.

Source: OptionVue

FIGURE 1 — RISK PROFILE: BULL PUT SPREAD

Net gain: $4,350.00

Percentage return: 29.0%

Annualized return: 4.0%

No. of trades: 20

Winning/losing trades: 15/5

Win/loss: 75%

Avg. trade: $192.50

Largest winning trade: $1,870.00

Largest losing trade: $3,060.00

Avg. profit (winners): $1,003.33

Avg. loss (losers): -$2,240.00

Avg. hold time (winners): 38

Avg. hold time (losers): 2

Max consec. win/loss: 13/2


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

2. Enter the trade at the close on the first day the S&P 500 posts a loss.

Entering bear call spreads1. Sell 10 calls with a strike

located one standard deviation OTM.

2. Buy 10 calls at a strike price 10 points above the short call.

3. Use the first expiration month with more than 21 days left until expiration.

4. The spread’s minimum yield must be at least 5 percent (premium received / net margin required).

ExitClose either spread if the S&P 500touches the short strike.Otherwise, allow the position to expire worthless.

Starting capital: $15,000.

Execution: When possible, option trades were executed atthe average of the bid and ask prices at the daily close; oth-erwise, theoretical prices were used. Standard deviation wascalculated using the implied volatility (IV) of the at-the-money (ATM) call. Each spread held 10 contracts per “leg.”Commissions were $1.50 per contract.

Test data: The system was tested using options on theS&P 500 index (SPX).

Test period: July 8, 2001 to Sept. 18, 2008.

Test results: Figure 2 shows the system’s performance,which gained $4,350 (29 percent) since July 2001. The strate-gy’s average winning trade ($1,003.33) is lower than its aver-age losing trade (-$2,240), but it alsohas a high percentage of winningtrades (75 percent). However, theannual return of 4 percent is less thanideal.

—Steve Lentz and Jim Grahamof OptionVue

Trading credit spreads with the A-D line gained 29 percent since July 2001.

Source: OptionVue

FIGURE 2 — 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.


Put-call ratio

There are two types of options: calls and puts.Call options give the owner the right to buy astock or futures contract at a predeterminedprice for a set amount of time. Put options give

the owner the right to sell a stock or futures contract at apredetermined price for a set amount of time. Investorsgenerally buy puts when they feel the price of a particularinstrument will decline. The opposite is true for calls.

The put-call ratio compares the volume of put and calloptions and is often used to determine market sentiment.The indicator is traditionally used in contrarian fashion:Typically, a high level of put-option volume relative to call-option volume is considered potentially bullish, while theopposite condition is considered potentially bearish.

An important aspect of interpreting put-call ratios is thatthe public is more likely to buy options while professionalsare more likely to sell them. Thus, high put volume is takenas a sign of bearishness on the part of the uninformed andreactionary public as opposed to the more-sophisticatedprofessionals. When put volume reaches a certain highlevel relative to call volume, the typical interpretation is the

market might be nearing a bearish sentiment extreme and ispoised for a reversal. The opposite is true for very high callactivity relative to put activity.

Put-call ratios can be calculated for any single stock orgroup of stocks. Two of the largest options exchanges —Chicago Board Options Exchange (CBOE) and theInternational Securities Exchange (ISE) — publish compre-hensive put-call ratios for stocks and indices. Unlike theCBOE ratios, the ISE ratios distinguish between marketmakers and broker/dealers and include only opening longtrades, which is meant to show the direction in which retailinvestors are leaning.

These examples use daily values, but put-call ratios canbe calculated on any time interval from intraday (tick andminute) to weekly periods or longer.

CalculationPut-call ratios are usually calculated by dividing total put-option volume by total call-option volume:

Put-call ratio = put-option volume/call-option volume

Although a 1.00 put-call ratio value might seem tosuggest neutral market sentiment, historically callactivity in stocks has outweighed put activity onstocks because of the overall bullish trend in the equi-ty market. As a result, the equity put-call ratio’s “neu-tral” level is actually closer to about 0.70. For example,the CBOE’s total equity put-call ratio’s five-year aver-age (as of Oct. 17) is roughly 0.66.

However, the CBOE’s total index put-call ratioreflects a different dynamic. The index ratio’s averageis about 1.62 over the past five years, which indicatesput volume has outnumbered call volume in thesemarkets by more than 50 percent. One reason is insti-tutional investors, such as hedge funds, in addition toretail investors, tend to buy index put options as away to hedge against price drops in their portfolios.

For comprehensive put-call ratios on stocks, how-ever, readings of less than 0.50 or more than 1.0 tendto be considered bearish and bullish extremes,although such thresholds aren’t set in stone; traderstypically look for relative spikes and dips in the ratio.

Figure 1 compares the S&P 500’s monthly closingprices to the CBOE index and equity put-call ratiosfrom November 2003 to October 2008. Notice how theequity put-call ratio dips below 0.5 in October 2007,indicating a peak in bullish sentiment just before themarket begins to drop.

BY CHRIS PETERS

Tracking the volume and open interest of put options vs. call options

can highlight investor sentiment extremes.


TRADING BASICS

Relative peaks and troughs in the CBOE’s equity and index put-call ratios sometimes accompany market reversals. For example,the equity put-call ratio fell below 0.50 in October 2007 as retailinvestors traded more than twice as many calls than puts, bullishsentiment that suggested a market top.

FIGURE 1 — CBOE PUT-CALL RATIOS

Source: CBOE


The put-call ratio’s daily calculations are fairlyvolatile, so a moving average is often used to smooththe indicator’s readings.

A recent Active Trader Market Pulse article exam-ined how the S&P 500 tracking stock (SPY) behavedafter a 10-day exponential moving average (EMA) ofthe CBOE equity and index put-call ratios hit bullishand bearish extremes, defined as 120-day lows andhighs, respectively (see “Related reading”).

Overall, the market behaved more predictablyafter high/low extremes in the equity ratio than itdid following its index-ratio counterparts. SPYclimbed an average 1.57 percent in the 10 days afterthe equity put-call ratio hit bearish extremes.However, the market was basically flat in the 10 daysafter the equity put-call ratio hit bullish extremes.

Volume vs. open interestTraditionally put-call ratios have been calculatedusing option volume, but you can also use optionopen interest, which represents the number of openpositions (unclosed trades). The number of outstand-ing contracts can also indicate market sentiment,depending on option type (puts or calls). A daily put-call volume ratio offers a snapshot of a single day’sactivity, but the open-interest ratio can show chang-ing sentiment over time, because it builds upon pre-vious days as open contracts are held into the nextday.

Figures 2 and 3 show put-call ratios for SPY basedon volume and open interest, respectively. As withFigure 1’s CBOE index ratio, both put-call calcula-tions show significantly more puts than calls in themarket.

Overall, both put-call ratios moved lower in thepast couple of years, but the volume ratio was muchchoppier than the open-interest ratio. While stillprone to a few wild swings, the put-call open-interestratio provides a much smoother representation of themarket sentiment (bearish to less bearish). ��

Put-call ratios based on daily volume can produce choppy results ifnot smoothed by a moving average.

FIGURE 2 — VOLUME PUT-CALL RATIO

Source: Schaeffers Research

A put-call ratio based on open interest tends to show clearer trendsin market sentiment than the traditional volume ratio

FIGURE 3 — OPEN INTEREST PUT-CALL RATIO

Source: Schaeffers Research

“Getting sentimental about options” Active Trader, March 2002.Successful option trading depends on a number of variables, butone many traders overlook is sentiment analysis. Find out whatdifferent sentiment tools represent and how they can round outyour trading.

“Put-call inversions: Separating the smart money from the dumb,” Active Trader, June 2002.Contrary to popular belief, there’s more than one put-call ratio,and looking at the wrong one at the wrong time can give you amisleading picture of the market.

“CBOE put-call ratio,” Active Trader, October 2007.This Trading System Lab tests extreme put-call ratio readings asmechanical buy and sell signals on individual stocks and index-based exchange-traded funds.

“The put-call ratio as a contrarian indicator”Active Trader, March 2006.Many traders believe the put-call ratio’s extremes signal marketturning points, but interpreting this indicator isn’t that simple. The following analysis shows how the S&P 500 tracking stock(SPY) behaved in the two weeks after extreme daily highs andlows in both OEX and equity put/call ratios since 1997.

“Going against the crowd,” Active Trader, November 2000.The put-call ratio has long been used as a measure of marketsentiment. Here’s a new twist on an old approach that can helpyou catch turning points based on short-term put-call extremes.


Related reading


T he Chicago Board Options Exchange (CBOE)announced an initiative to open an all-electronicoptions exchange sometime in 2009. Currently

dubbed “C2,” the new exchange would operate under a sepa-rate exchange license than the CBOE and have a separateaccess structure and fee schedule.

According to information released by the exchange, the newexchange will have its own Board of Directors, rules, connec-tivity, and systems architecture, with its primary data center inthe New York metropolitan area.

The exchange expects the endeavor’s initial capital invest-ment will be approximately $25 million with the in-house sys-tem development expected to be completed this year.

The CBOE currently operates what it calls a “hybrid” systemthat consists of both open-outcry and electronic trading, allow-ing investors to choose where to rout their orders.

In 2000 the International Securities Exchange (ISE) openedthe first all-electronic options exchange in the U.S. While theCBOE has ruled the roost when it comes to index options,accounting for 88 percent of total index options trading inSeptember alone, the ISE took the lead in equity options vol-

ume. The gap has been closing in recent months, however. Figure 1 displays each exchange’s equity options volume as

a percentage of all equity options traded on U.S. exchanges, asrecorded by the Options Clearing Corporation. While the two

exchanges’ equity option market share hasremained fairly close, the ISE’s lead has dwindled.Overall, total equity options volume has increasedby nearly 300 percent since 2005, and was up 33percent year-to-date through August 2008 vs. thesame period last year.

Also in October, the Minneapolis GrainExchange (MGEX) announced it will close its trad-ing pits and switch to an electronic platform onDec. 19. Beginning on Nov. 1 and running throughthe final date of the transition, the exchange willwaive all open outcry transaction fees for floortraders initiating trades on their own behalf as wellas fees for electronic trading permit (ETP) holdersas an incentive to continue trading the MGEX mar-ket. Formed in 1881, the MGEX futures andoptions exchange is known primarily for its hardred spring and winter wheat futures contracts.

For more information about the ongoing shift toelectronic exchanges, see “The shrinking tradingfloor” in the November 2008 issue of ActiveTrader.�

INDUSTRY NEWS

More exchanges move toward electronic platformsCBOE develops electronic alter ego and Minneapolis does away with its pits.

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 September 2008 return. (Managing at least $1 million as of Sept. 30, 2008.)

September YTD $ underRank Trading advisor return return mgmt.

1. Elk River Trading 12.08% 28.61% 54.02. Reynoso Asset Mgmt. (Options Arb.) 10.68% 11.76% 1.63. Harbor Assets 2.56% 19.44% 2.64. Chicago Capital Mgmt (Strat Option) 2.10% 27.95% 2.45. Hyman Beck (Volatility) 1.38% 3.32% 106.26. Conservative Concept (Athena Inst) 0.62% 9.73% 271.57. Zenith Resources II LP - A 0.56% 8.86% 78.48. Conservative Concept (Athena Ret) 0.49% 9.74% 271.59. K4 Capital Management (MVS) 0.43% 9.77% 18.010. Diamond Capital Management 0.42% -7.83% 16.6

MANAGED MONEY

The CBOE and ISE have dominated the equity optionsmarket in the U.S., with the ISE holding a slight lead forthe past few years.

FIGURE 1 — EQUITY OPTIONS VOLUME


http://www.barclayhedge.com

The CME Group announced thelaunch of two plastics futurescontracts for trade on NYMEX’s

ClearPort platform in November.Polypropylene (P1) and polyethylene(P6) contracts will initially be listed for24 consecutive months beginning withJanuary 2009 contracts.

The London Metals Exchange (LME)has offered contracts for both polypropy-lene and polyethylene since 2005, includ-ing global and regional contracts. Figure1 shows the continuous closing priceaction in the polypropylene (PP) futuresdenominated in U.S. dollars. Price rosethroughout much of 2008, but the marketwas not immune to the bursting of thecommodity bubble. In October alone thecontract dropped nearly 40 percent.

The Dubai Gold and CommoditiesExchange (DGCX) also plans to launchsimilar contracts.

The CME Group launched a slew ofnew swaps contracts on the ClearPortplatform. Eighteen natural gas basis,

index, and swing swaps futuresbegan trading on Oct. 20, includ-ing the Algonquin Citygate natu-ral gas basis swap (B4) and theTennessee Zone 0 natural gasindex swap (Q4). Seventeen petro-leum based swaps began tradingon the platform on Oct. 27, andfive natural gas liquid swaps con-tracts began trading on Nov. 3.

Swaps contracts are quoted asdifferentials between two differentpricing points. In the case of thenatural gas contracts, differentmarket centers are priced againstthe Henry Hub pricing point. Thecontracts are used to hedgeagainst specific price risks in theirrespective markets.

Through these contracts, whichare usually traded on an over-the-counter (OTC) basis, the CMEhopes to lure OTC traders seekinga safer exchange haven for theirtransactions.�

CME Group offerings expand with plastics, swaps contractsCME Group unleashes new contracts through their newly acquired ClearPort platform.

Although new to the CME, plastics futureshave traded for a few years on the LME.Polypropylene (PP) prices peaked in July, but have significantly fallen off since.

FIGURE 1 — POLYPROPYLENE FUTURES

Source: eSignal



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 Oct. 30)

10-day move/ 20-day move/ 60-day move/ VolatilityMarket Symbol Exchange Volume OI rank rank rank ratio/rankE-Mini S&P 500 ES CME 3.62 M 2.74 M 2.18% / 50% -14.50% / 59% -25.33% / 89% .33 / 42%10-yr. T-note TY CBOT 735.4 1.45 M 0.94% / 22% -1.75% / 65% -0.88% / 29% .67 / 62%E-Mini Nasdaq 100 NQ CME 516.7 357.0 2.19% / 50% -9.32% / 14% -28.96% / 89% .27 / 7%5-yr. T-note FV CBOT 509.9 1.39 M 0.87% / 25% -0.02% / 0% 1.90% / 63% .35 / 45%Mini Dow YM CBOT 305.0 96.0 2.90% / 50% -12.61% / 59% -20.68% / 90% .38 / 56%2-yr. T-note TU CBOT 263.9 726.7 0.06% / 20% 0.05% / 10% 1.79% / 83% .18 / 32%30-yr. T-bond US CBOT 262.2 778.0 -0.03% / 0% -4.22% / 81% -0.10% / 9% .66 / 67%Crude oil CL NYMEX 260.1 236.1 -5.57% / 5% -29.81% / 85% -44.38% / 92% .16 / 0%Eurodollar* ED CME 229.4 989.56 0.03% / 13% 0.46% / 67% 1.09% / 70% .22 / 40%E-Mini Russell 2000 TF CME 214.5 489.3 -2.88% / 10% -19.39% / 57% -28.78% / 84% .38 / 12%Eurocurrency EC CME 198.0 154.3 -3.54% / 20% -6.38% / 72% -15.82% / 91% .31 / 32%Japanese yen JY CME 131.7 139.7 2.27% / 17% 6.22% / 75% 11.23% / 91% .78 / 78%Corn C CBOT 124.6 486.2 6.50% / 0% -9.82% / 36% -19.41% / 43% .14 / 7%Soybeans S CBOT 95.8 143.4 7.73% / 50% -6.97% / 23% -23.47% / 57% .11 / 8%Gold 100 oz. GC NYMEX 89.9 147.3 -8.20% / 56% -12.53% / 63% -15.96% / 92% .36 / 28%British pound BP CME 68.1 103.2 -4.93% / 45% -6.92% / 63% -15.48% / 94% .47 / 58%S&P 500 index SP CME 67.8 594.3 2.18% / 50% -14.49% / 64% -24.17% / 88% .33 / 39%Natural gas NG NYMEX 63.8 81.8 -4.06% / 18% -14.04% / 61% -26.70% / 31% .11 / 43%Swiss franc SF CME 48.3 39.3 -0.14% / 0% -0.29% / 2% -6.74% / 67% .21 / 28%Sugar SB ICE 45.2 315.2 6.18% / 0% -9.40% / 47% -16.49% / 59% .39 / 58%E-Mini S&P MidCap 400 ME CME 38.0 102.8 1.60% / 100% -17.71% / 59% -30.85% / 87% .31 / 35%Canadian dollar CD CME 35.7 92.8 -2.22% / 5% -11.18% / 82% -13.65% / 87% .43 / 38%Australian dollar AD CME 35.5 54.7 0.24% / 100% -12.22% / 73% -25.16% / 72% .29 / 30%Wheat W CBOT 35.3 161.4 -3.10% / 0% -15.41% / 51% -29.73% / 78% .17 / 2%RBOB gasoline RB NYMEX 28.5 39.2 -9.56% / 5% -34.94% / 87% -50.26% / 95% .15 / 2%Heating oil HO NYMEX 25.7 30.6 -4.94% / 5% -26.77% / 87% -38.72% / 79% .16 / 5%Silver 5,000 oz. SI NYMEX 25.5 59.6 1.56% / 100% -12.01% / 32% -39.81% / 83% .11 / 2%Soybean oil BO CBOT 24.9 64.0 -2.74% / 0% -19.27% / 72% -33.02% / 72% .18 / 3%Nikkei 225 index NK CME 22.8 62.5 3.35% / 100% -17.72% / 68% -31.73% / 85% .37 / 38%Soybean meal SM CBOT 19.9 47.8 12.42% / 83% 5.16% / 86% -15.18% / 40% .15 / 2%Crude oil e-miNY QM NYMEX 15.3 6.9 -5.57% / 10% -29.81% / 88% -44.65% / 92% .17 / 0%Copper HG NYMEX 13.6 47.2 -9.35% / 5% -28.05% / 83% -44.78% / 95% .25 / 10%Mexican peso MP CME 12.5 47.7 3.46% / 100% -12.26% / 67% -22.23% / 78% .27 / 15%Fed Funds FF CBOT 12.2 70.5 0.43% / 60% 0.81% / 97% 1.69% / 100% .27 / 60%Coffee KC ICE 10.2 81.1 -1.73% / 11% -11.52% / 53% -19.51% / 84% .23 / 7%Lean hogs LH CME 9.3 52.3 0.04% / 100% -15.09% / 73% -33.65% / 100% .12 / 2%Live cattle LC CME 9.1 32.6 2.24% / 100% -4.44% / 31% -10.65% / 90% .27 / 48%Cocoa CC ICE 7.3 56.3 -1.88% / 0% -14.97% / 83% -24.38% / 88% .20 / 3%U.S. dollar index DX ICE 6.3 43.4 3.77% / 35% 6.52% / 81% 14.95% / 93% .38 / 45%Mini-sized gold YG CBOT 6.2 2.9 -8.32% / 56% -12.91% / 65% -16.06% / 93% .36 / 25%Nasdaq 100 ND CME 5.7 25.7 1.66% / 0% -10.96% / 24% -29.07% / 90% .26 / 2%Dow Jones Ind. Avg. DJ CBOT 4.5 25.9 2.90% / 50% -12.61% / 59% -20.68% / 90% .38 / 57%E-Mini eurocurrency ZE CME 4.1 2.0 -3.54% / 20% -6.38% / 72% -15.82% / 91% .31 / 32%New Zealand dollar NE CME 2.2 19.2 -2.80% / 11% -9.68% / 87% -17.25% / 88% .46 / 77%Natural gas e-miNY QG NYMEX 2.1 2.8 -4.06% / 18% -14.04% / 63% -26.70% / 31% .11 / 37%Soybeans E-mini YK CBOT 1.6 12.0 8.77% / 50% -6.08% / 21% -22.28% / 51% .12 / 8%Feeder cattle FC CME 1.0 4.5 0.23% / 50% -2.04% / 8% -13.54% / 80% .22 / 41%*Average volume and open interest based on highest-volume contract (February 2009).


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 Oct. 30)

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 277.4 1.13 M 0.81% / 0% -14.38% / 0% 55.4% / 91.9% 41.4% / 36.2%Russell 2000 index RUT CBOE 123.9 471.2 -4.17% / 0% -19.37% / 0% 61.8% / 87.7% 47.3% / 37.3%S&P 500 volatility index VIX CBOE 86.2 501.9 -6.97% / 0% 38.97% / 0% 229.5% / 310.5% 250% / 136.6%Mini Nasdaq 100 index MNX CBOE 35.5 288.8 1.59% / 0% -10.54% / 0% 57.2% / 93.6% 46.8% / 40%Nasdaq 100 index NDX CBOE 33.5 163.4 1.60% / 0% -10.54% / 0% 57.9% / 86.7% 47.8% / 38.1%

StocksApple Inc AAPL 281.4 983.0 8.98% / 0% 10.93% / 0% 66% / 118% 92.6% / 73.5%Citigroup C 250.9 3.64 M -17.55% / 0% -41.73% / 0% 100.2% / 159% 92.9% / 117.8%Bank of America BAC 188.3 2.41 M -6.06% / 0% -37.37% / 0% 83.7% / 159.9% 77% / 110.6%Microsoft MSFT 187.5 2.12 M -6.45% / 0% -13.79% / 0% 56.6% / 98.4% 47.9% / 47.2%General Electric GE 161.4 1.54 M -2.71% / 0% -12.64% / 0% 75.5% / 105.9% 68.8% / 83.6%

FuturesEurodollar ED-GE CME 594.6 7.91 M 0.44% / 0% 1.06% / 0% 69.2% / 73.6% 63.7% / 47.1%Crude oil CL NYMEX 47.8 317.5 -6.01% / 0% -30.14% / 0% 76.9% / 87.1% 56.5% / 60.3%Corn C-ZC CME 40.4 426.0 6.50% / 0% -9.82% / 0% 51.3% / 56.5% 39.3% / 39%10-year T-notes TY-ZN CME 35.6 348.7 0.97% / 0% -1.72% / 0% 10.2% / 11.2% 11% / 10.6%E-mini S&P 500 futures ES CME 24.6 106.1 2.02% / 0% -14.63% / 0% 56.4% / 99.5% 43.6% / 40.6%

VOLATILITY EXTREMES**Indices - High IV/SV ratio

Swiss franc index XDS PHLX 1.7 12.6 0.11% / 0% -0.19% / 0% 21.4% / 13.4% 14.8% / 14%Euro index XDE PHLX 1.7 13.3 -3.72% / 0% 3.72% / 0% 28% / 18.7% 14.5% / 14%

Indices - Low IV/SV ratioOil service index OSX PHLX 1.8 10.1 6.54% / 0% -24.41% / 0% 87.3% / 161.9% 74.1% / 65.6%E-mini S&P 500 futures ES CME 24.6 106.1 2.02% / 0% -14.63% / 0% 56.4% / 99.5% 43.6% / 40.6%S&P 500 Index SPX CBOE 277.4 1.13 M 0.81% / 0% -14.38% / 0% 55.4% / 91.9% 41.4% / 36.2%Mini SPX index XSP CBOE 3.3 81.2 0.81% / 0% -14.38% / 0% 56.8% / 93.2% 42.6% / 36.5%Mini Nasdaq 100 index MNX CBOE 35.5 288.8 1.59% / 0% -10.54% / 0% 57.2% / 93.6% 46.8% / 40%

Stocks - High IV/SV ratioSavient Pharma SVNT 3.0 146.6 -65.53% / 0% -69.69% / 0% 197.9% / 133.4% 109.5% / 90.7%HSBC Holdings HBC 10.5 320.9 -11.27% / 0% -23.46% / 0% 86.9% / 69.4% 47.1% / 51.6%General Motors GM 66.1 1.28 M -5.16% / 0% -32.78% / 0% 193.4% / 180.5% 139.2% / 132.6%

Stocks - Low IV/SV ratioNational City NCC 52.8 617.8 -21.57% / 0% -23.57% / 0% 90% / 323.6% 245.1% / 200.5%Wachovia WB 56.0 845.7 -8.37% / 0% 51.15% / 0% 71% / 211.5% 202.3% / 273.1%Sovereign Bancorp SOV 7.0 140.4 -10.39% / 0% -47.43% / 0% 93.7% / 276.2% 216% / 150.7%Rohm & Haas ROH 1.6 21.7 -0.24% / 0% 2.14% / 0% 32.4% / 88.4% 31.6% / 26%SLM Corp SLM 12.6 297.3 -9.17% / 0% 9.68% / 0% 112.4% / 299% 139% / 110.3%

Futures - High IV/SV ratioMilk DA CME 1.8 12.8 -8.40% / 0% -7.31% / 0% 23.6% / 14.9% 8.8% / 13.8%Wheat W-ZW CME 8.2 72.1 -3.10% / 0% -15.41% / 0% 50.7% / 47% 43.6% / 38.4%30-year T-bond US CME 20.6 223.1 0.20% / 0% -5.00% / 0% 17.5% / 16.6% 14% / 14.4%Lean hogs LH CME 3.6 36.6 0.04% / 0% -15.09% / 0% 27.5% / 27.2% 28.2% / 22.9%

Futures - Low IV/SV ratioE-mini S&P 500 futures ES CME 24.6 106.1 2.02% / 0% -14.63% / 0% 56.4% / 99.5% 43.6% / 40.6%Cotton CT ICE 4.7 57.0 -9.04% / 0% -22.84% / 0% 48.7% / 80.4% 37.5% / 49.8%Sugar SB ICE 12.8 402.9 6.18% / 0% -9.40% / 0% 40.7% / 58.6% 33.5% / 55%Gold GC NYMEX 8.1 60.4 -8.20% / 0% -12.53% / 0% 49% / 68.8% 41.9% / 51%Silver SI NYMEX 3.8 18.4 1.56% / 0% -12.01% / 0% 76.5% / 100% 58.5% / 77.9%

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


Options Watch: Consumer Staples ETF components (as of Oct. 29) Compiled by Tristan YatesThe following table summarizes the expiration months available for the top components of the Consumer Staples exchange-traded fund (XLP). It also shows each stock’s average bid-ask spread for at-the-money (ATM) October options. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of potential slippage in each option market.

Option contracts traded

Bid-askspread as %

Closing of underlyingStock Ticker price Call Put priceAltria Group Inc MO X X X X X X 19.14 0.03 0.04 0.18%Wal-Mart Stores Inc WMT X X X X X X 55.02 0.10 0.11 0.19%Coca-Cola Co KO X X X X X X X 43.85 0.15 0.18 0.37%General Mills Inc GIS X X X X X X 66.81 0.26 0.30 0.42%HJ Heinz Co HNZ X X X X X X 42.59 0.19 0.23 0.48%Kimberly-Clark Corporation KMB X X X X X X 59.09 0.30 0.29 0.50%Costco Wholesale Corp COST X X X X X X 56.88 0.28 0.30 0.51%Kellogg Co K X X X X X X 50.02 0.25 0.28 0.52%Colgate-Palmolive CL X X X X X X X 60.00 0.38 0.29 0.55%Pepsico Inc PEP X X X X X X 55.00 0.38 0.24 0.56%Kraft Foods Inc KFT X X X X X X 28.47 0.16 0.16 0.57%Philip Morris Intl Inc PM X X X X X X 41.55 0.26 0.23 0.59%Walgreen Co WAG X X X X X X 23.74 0.15 0.14 0.61%Archer-Daniels-Midland ADM X X X X X X X 21.42 0.13 0.15 0.64%Kroger Co KR X X X X X X 26.50 0.18 0.18 0.66%CVS Caremark Corp CVS X X X X X X X 26.31 0.18 0.18 0.67%Sysco Corp SYY X X X X X X X 24.86 0.18 0.16 0.68%Proctor & Gamble Co PG X X X X X X 61.33 0.55 0.46 0.83%UST Inc UST X X X X X 67.74 0.66 0.48 0.84%Anheuser-Busch Companies BUD X X X X X X 59.83 0.48 0.60 0.90%Select Sector SPDR Consumer Staples XLP X X X X X X 23.29 0.31 0.25 1.21%Legend: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.

Nov

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Dec

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Jan.

Feb.

Mar

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Apr

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May

June

Jan.

Jan.

The Commitment of Traders (COT) report is publishedweekly by the Commodity Futures Trading Commission(CFTC). The report divides the open positions in futuresmarkets into three categories: commercials, non-commeri-cals, 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 Oct. 21. Positive values mean net commercial positions(longs - shorts) are larger than net speculator holdings, based on their five-yearhistorical relationship. Negative values mean large speculators have bigger posi-tions than the commercials.

In Japanese yen (JY) and U.S. dollar index futures (DX), the difference betweencommercials and large speculators is ranked lowest among all futures markets,which is a bearish sign. But in oats (O) and lumber futures (LB), this relationshipis near a five-year high, a bullish indication. These extremes aren’t trade signals,but they sometimes appear before price reversals. �

– Compiled by Floyd Upperman

The largest positive readings represent markets in which net commer-cial positions (longs - shorts) exceed net fund holdings in October. Bycontrast, the largest negative values represent markets in which netfund holdings surpass 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

2008 2009 2010 2011 Bid-ask spreads

http://www.upperman.com

November 2008 • FUTURES & OPTIONS TRADER 31

GLOBAL ECONOMIC CALENDAR MONTH

Legend

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

CPI: Consumer price index

ECI: Employment cost index

FOMC: Federal OpenMarket Committee

GDP: Gross domestic product

ISM: Institute for supplymanagement

PPI: Producer price index

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

November1 FDD: November crude oil and natural

gas futures (CME)

23 FND: November orange juice futures

(ICE)FDD: November soybeans, gold, silver, copper, platinum, aluminum, and palladium futures (CME)Crop progress report

4 FND: November heating oil, propane, and RBOB gasoline (CME)

5 Petroleum status report

6 LTD: November orange juice futures (ICE)FDD: November propane futures (ICE)EIA natural gas storage report

7 LTD: November live cattle options (CME); December cocoa and cotton options (ICE)

8 FDD: November gasoline and heating oil futures (CME)

910 FDD: November orange juice futures

(ICE)Crop production reportCrop progress reportWorld agricultural production

11 LTD: December coffee (ICE)

1213 FND: December cocoa futures (ICE)

Petroleum status report

14 LTD: November lumber, rice, and soybeans futures (CME)EIA natural gas storage reportNOPA soy crush

151617 FND: November lumber futures (CME)

LTD: December crude oil options (CME); December sugar options (ICE)FDD: November lumber futures (CME)Crop progress report

18 FND: December coffee futures (ICE)

19 LTD: December platinum options (CME)Petroleum status report

20 FND: November feeder cattle futures (CME); December cotton futures (ICE)LTD: December feeder cattle and crudeoil futures (CME); December feeder cattle, gold, silver, and copper options (CME)EIA natural gas storage report

21 LTD: November single stock futures (OCX); November T-bond options(CME); November equity options;December corn, oats, rice, wheat, soybeans, soybean products, and natural gas options (CME); December orange juice options (ICE)Cattle on feed report

222324 FND: December crude oil futures

(CME)LTD: December natural gas futures (CME); December copper futures (CME); December gasoline and heatingoil options (CME)Crop progress report

25 LTD: November gold, silver, copper, platinum, aluminum, and palladium futures (CME)

26 FND: December natural gas futures (CME)Petroleum status reportEIA natural gas storage report

2728 FND: December T-bonds, corn, oats,

wheat, soybean products, gold, silver, copper, aluminum, platinum, and palladium futures (CME); December wheat futures (MGX); December wheat futures (KCBOT)LTD: December heating oil and RBOB gasoline futures (CME); December lumber options (CME)U.S. agricultural prices

2930

December1 FDD: December T-bonds, corn,

soybean products, gold, silver, copper, palladium, aluminum, platinum, crude oil, and natural gas futures (CME); December cocoa and coffee

2 FND: December heating oil and RBOB gasoline

3 Petroleum status report

4 EIA natural gas report

5 LTD: December live cattle options (CME); January cocoa options (ICE)

NOVEMBER/DECEMBERFUTURES & OPTIONS CALENDAR

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

DECEMBER 2008

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 2 3

NOVEMBER 2008

26 27 28 29 30 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 5 6

Advance-decline line: A breadth indicator that meas-ures aspects of supply and demand not always reflecteddirectly in price. The indicator is a day-to-day running totalof the number of stocks that have closed higher on the day(advancing) minus the number of stocks that have closedlower on the day (declining). A version using the week-to-week figures can also be used as a longer-term indicator.

The most commonly referenced A-D line is the one calcu-lated on New York Stock Exchange (NYSE) stocks, but theindicator can be calculated on any index or exchange. Calculation A-D line = [AS(today) – DS(today)] + AD(prev)

where

AS(today) = the number of advancing stocks (those that

closed higher than the previous day’s close)

DS(today) = the number of declining stocks (those that

closed lower than the previous day’s close)

AD(prev) = previous day’s A-D line value

That is, add the difference between the number ofadvancing stocks and declining stocks today to yesterday’sA-D number, which is the running total of all previousdays. A nominal value is often used to begin the A-D calculation.

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 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.

Bollinger Bands: Bollinger Bands are a type of trading“envelope” consisting of lines plotted above and below amoving average, which are designed to capture a market’stypical price fluctuations.

The indicator is similar in concept to the moving averageenvelope, with an important difference: While movingaverage envelopes plot lines a fixed percentage above andbelow the average (typically three percent above and belowa 21-day simple moving average), Bollinger Bands use stan-dard deviation to determine how far above and below themoving average the lines are placed. As a result, while theupper and lower lines of a moving average envelope movein tandem, Bollinger Bands expand during periods of risingmarket volatility and contract during periods of decreasingmarket volatility.

Bollinger Bands were created by John Bollinger, CFA,CMT, the president and founder of Bollinger CapitalManagement (see Active Trader, April 2003, p. 60). Bydefault, the upper and lower Bollinger Bands are placedtwo standard deviations above and below a 20-period sim-ple moving average.

Upper band = 20-period simple moving average + 2 stan-

dard deviations

Middle line = 20-period simple moving average of closing

prices


KEY CONCEPTS

The 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.


Lower band = 20-period simple moving average - 2 stan-

dard deviations

Bollinger Bands highlight when price has become high orlow on a relative basis, which is signaled through the touch(or minor penetration) of the upper or lower line.

However, Bollinger stresses that price touching the loweror upper band does not constitute an automatic buy or sellsignal. For example, a close (or multiple closes) above theupper band or below the lower band reflects strongerupside or downside momentum that is more likely to be abreakout (or trend) signal, rather than a reversal signal.Accordingly, Bollinger suggests using the bands in conjunc-tion with other trading tools that can supply context andsignal confirmation.

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 withthe same expiration date, but differentstrike prices. You sell an OTM put and buya less-expensive, lower-strike put.

Calendar spread: A position with oneshort-term short option and one longsame-strike option with more time untilexpiration. If the spread uses ATM options,it is market-neutral and tries to profit fromtime decay. However, OTM options can beused to profit from both a directional moveand time decay.

Call option: An option that gives theowner the right, but not the obligation, tobuy a stock (or futures contract) at a fixedprice.

The Commitments of Traders

report: Published weekly by theCommodity Futures Trading Commission(CFTC), the Commitments of Traders(COT) report breaks down the open inter-est in major futures markets. Clearingmembers, futures commission merchants,

and foreign brokers are required to report daily the futuresand options positions of their customers that are above spe-cific reporting 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-continued on p. 34

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


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 goal is for the marketto move sideways or slightly higher and for the call optionto expire worthless, in which case you keep the premium.

Credit spread: A position that collects more premiumfrom short options than you pay for long options. A creditspread using calls is bearish, while a credit spread usingputs is bullish.

Debit: A cost you must pay to enter any position if thecomponents you buy are more expensive than the ones yousell. For instance, you must pay a debit to buy any option,and a spread (long one option, short another) requires adebit if the premium you collect from the short option does-n’t offset the long option’s cost.

Debit spread: An options spread that costs money toenter, because the long side is more expensive that the shortside. These spreads can be verticals, calendars, or diagonals.

Deep (e.g., deep in-the-money option or deep

out-of-the-money option): Call options with strikeprices that are very far above the current price of the under-lying asset and put options with strike prices that are veryfar below 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.

Double calendar spread: A calendar spread involvespurchasing an option and selling a shorter-term, same-strike option of the same type (call or put) against it. Doublecalendars have two strikes: one put calendar spread belowthe current underlying price and one call calendar spreadabove it. The goal is to collect premium and capture thetafrom the shorter-term sold options as expiration approach-es. Single calendars only profit in a fairly narrow range ofunderlying prices, so the double calendar widens this rangeand increases its chances of success.

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

Exercise: To exchange an option for the underlyinginstrument.

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).

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.

Iron condor: A market-neutral position that enters a bearcall spread (OTM call + higher-strike call) above the marketand a bull put spread (OTM put + lower-strike put) belowthe market. Both spreads collect premium, and profit whenthe market trades between the short strikes by expiration.All options share the same expiration month.

Logarithm: The exponent by which a certain base, such as10, is raised to produce another number. For example, thelogarithm of 10,000 is 4 because 10 to the 4th power equals10,000.

KEY CONCEPTS continued

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 are obligated to sellthe underlying instrument at the call’s strike price, whichmight be below the market’s value, triggering a loss. If yousell a put, for example, you are obligated to buy the under-lying instrument at the put’s strike price, which may be wellabove the market, also causing a loss.

Given its risk, selling naked options is only for advancedoptions traders, and newer traders aren’t usually allowedby their brokers to trade such strategies.

Naked (uncovered) puts: Selling put options to collectpremium that contains risk. If the market drops below theshort put’s strike price, the holder may exercise it, requiringyou to buy stock at the strike price (i.e., above the market).

Near the money: An option whose strike price is closeto the underlying market’s price.

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

Out of the money (OTM): A call optionwith a strike price above the price of theunderlying instrument, or a put optionwith a strike price below the underlyinginstrument’s price.

Parity: An option trading at its intrinsicvalue.

Physical delivery: The process ofexchanging a physical commodity (andmaking and taking payment) as a result ofthe execution of a futures contract.Although 98 percent of all futures contractsare not delivered, there are market partici-pants who do take delivery of physicallysettled contracts such as wheat, crude oil,and T-notes. Commodities generally aredelivered to a designated warehouse; T-note delivery is taken by a book-entrytransfer of ownership, although no certifi-cates change hands.

Premium: The price of an option.

Put option: An option that gives the owner the right, butnot 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 spread


continued on p. 36


contains 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.

Relative strength index (RSI): Developed by WellesWilder, the relative strength index (RSI) is an indicator inthe “oscillator” family designed to reflect shorter-termmomentum. It ranges from zero to 100, with higher read-ings supposedly corresponding to overbought levels andlow readings reflecting the opposite. The formula is:

RSI = 100 – (100/[1+RS])

where

RS = relative strength = the average of the up closes over

the calculation period (e.g., 10 bars, 14 bars) divided by the

average of the down closes over the calculation period.

For example, when calculating a 10-day RSI, if six of thedays closed higher than the previous day’s close, subtractthe previous close from the current close for these days, addup the differences, and divide the result by 10 to get the up-close average. (Note that the sum is divided by the totalnumber of days in the look-back period and not the numberof up-closing days.)

KEY CONCEPTS continued


EVENTS

Event: SIFMA’s OFAC Compliance SymposiumDate: Nov. 6Location: AXA Equitable Conference Center, NYCFor more information: http://www.sifma.org/events

Event: 23rd Annual Futures & Options ExpoDate: Nov. 10-12Location: Hyatt Regency ChicagoFor more information: Go to http://www.futuresindustry.org and click on “Conferences”

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

Event: Middle East Investor ConferenceDate: Nov. 20Location: The Monarch Dubai Hotel, Dubai, U.A.E.For more information:http://dubai.nasdaqinvestorprogram.com

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

Event: TradeStation ETF SymposiumDate: Dec. 4-6Location: Delray Beach Marriott, Delray, Fla.For more information:http://www.TradeStation.com/Strategy

Event: Dynamic Hedging of Long Volatility StrategiesDate: Dec. 4-5Location: Sheraton Suites on the Hudson, New YorkFor more information: http://www.marcusevans.com

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

Event: TradeTech Foreign Exchange 2009Date: Feb. 9-11Location: Bridgewaters, NYCFor more information:http://www.TradeTechForeignExchange.com

http://www.sifma.org/events

http://www.futuresindustry.org

http://www.tradersexpo.com

http://dubai.nasdaqinvestorprogram.com

http://www.cboe.com

http://www.TradeStation.com/Strategy

http://www.marcusevans.com

http://www.cboe.com

http://www.TradeTechForeignExchange.com


For the four days that closed lower than the previousday’s close, subtract the current close from the previouslow, add these differences, and divide by 10 to get thedown-close average. If the up-close average was 0.8 and thedown close average was 0.4, the relative strength over thisperiod would be 2. The resulting RSI would be 100 -(100/[1+2]) = 100 - 33.3 = 66.67.

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.

Straddle: A non-directional option spread that typicallyconsists of an at-the-money call and at-the-money put withthe same expiration. For example, with the underlyinginstrument trading at 25, a standard long straddle wouldconsist of buying a 25 call and a 25 put. Long straddles aredesigned to profit from an increase in volatility; short strad-dles are intended to capitalize on declin-ing volatility. The strangle is a relatedstrategy.

Strangle: A non-directional optionspread that consists of an out-of-the-money call and out-of-the-money putwith the same expiration. For example,with the underlying instrument trading at25, a long strangle could consist of buyinga 27.5 call and a 22.5 put. Long stranglesare designed to profit from an increase involatility; short strangles are intended tocapitalize on declining volatility. Thestraddle is a related strategy.

Strike (“exercise”) price: The priceat which an underlying instrument isexchanged upon exercise of an option.

Time decay: The tendency of timevalue to decrease at an accelerated rate asan option approaches expiration.

Time spread: Any type of spread thatcontains short near-term options and longoptions that expire later. Both options can

share a strike price (calendar spread) or have differentstrikes (diagonal spread).

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

Vertical spread: A position consisting of options withthe same expiration date but different strike prices (e.g., aSeptember 40 call option and a September 50 call option).

Volatility: The level of price movement in a market.Historical (“statistical”) volatility measures the price fluctu-ations (usually calculated as the standard deviation of clos-ing prices) over a certain time period — e.g., the past 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.


� CQG, Inc., the charting, analytics, and trade-routing plat-form for global electronically traded futures markets, hasadded SEB Futures to its list of Futures Commission Merchant(FCM) partners. CQG has teamed with SEB to connect tradersto Euronext, Globex, ICE, and Eurex. Traders clearing throughSEB have access to CQG’s market analysis tools and advancedorder execution software.

� CME Group and BM&FBOVESPA announced the orderrouting of BM&F derivatives products on CME Globex. Theorder routing linkage enables customers using the CME Globexelectronic trading platform to trade BM&FBOVESPA productsdirectly, including futures and options on one-day Inter-BankDeposits, the Bovespa Stock Index (pending regulatoryapproval), and commodities such as Arabica coffee, live cattle,and corn. BM&FBOVESPA customers will have the ability totrade CME Group products directly through theirBM&FBOVESPA connections, including CME Group futuresand options on interest rates, equity indices, foreign exchange,commodities, and energy and metals products. More informa-tion on the agreement can be found at http://www.cmegroup-bmfbovespa.com. CME Group also has launched the latestversion of CME E-quotes, a real-time streaming market dataapplication offering quotes, charting, advanced analytics, andnews on CME Group-traded products, including interest rates,equity indices, foreign currencies, commodities, energy, metals,and alternative investments. It also offers access to prices forproducts listed on the Minneapolis Grain Exchange and theKansas Board of Trade, which are available for electronic trad-ing on CME Globex. For more information and a free two-weektrial, visit http://www.cmegroup.com/e-quotes.

� Option-industry denizen and author Dan Passarellilaunched a new mentoring company designed to educateoption traders. Market Taker Mentoring (http://market-taker.com) offers an educational service to do-it-yourselftraders as well as seasoned professionals. Passarelli’s neworganization takes a personal approach to mentoring. In thesix-week course, students receive one-on-one time withPassarelli in a program tailored to their specific educationallevels. For more information and a free excerpt fromPassarelli’s book Trading Option Greeks, click here.

� Adaptrade Software’s Market System Analyzer (MSA)version 3 is available. MSA software for futures and stocktraders applies position sizing, Monte Carlo analysis, depend-ency analysis, equity curve crossover trading, and othermoney-management methods. Version 3 includes full portfolioanalysis, portfolio optimization, correlation analysis, supportfor non-US traders, and more. The software works with anytrading system or method and requires only a list of profits andlosses as input. An EasyLanguage interface to TradeStation isincluded. A 30-day trial can be downloaded fromhttp://www.Adaptrade.com.

� Wave59 Technologies released Wave59 RT 3.0, anupdate of its real-time technical market analysis program.Version 3.0 includes the ability to design, backtest, optimize,and automate custom trading systems using Wave59’s QScript

language. Wave59 RT is a charting and analysis programdesigned around versions of classical technical tools, as well asa suite of proprietary algorithms. For additional information onWave59 RT 3.0, contact Jonn Millarkie at (866) 494-7613 or visithttp://www.wave59.com to download a 30-day free trial.

� Vhayu Technologies has partnered with Alphacet,Inc., a developer of software for quantitative analysts, portfo-lio managers, and traders, to provide customers with an inte-grated tick database and alpha generation solution. It enablesquants to create, backtest, and analyze multi-layer models inhours-to-days instead of weeks-to-months. This partnershipcombines Vhayu Velocity, which can process, analyze, andstore tick and bar data, with Alphacet Explorer, a codeless his-torical backtesting engine designed specifically for VhayuVelocity for use across asset classes and instrument types.

� Dow Jones has signed a strategic alliance with AgenciaEFE to develop a joint Spanish-language news service — EFEDow Jones News — to serve financial professionals, corpora-tions, media, institutions, and private investors in Spain. Thenew real-time newswire will draw upon coverage of Spanishcompanies and policy-making in EFE’s economic service, EFE-COM, and the international financial and market reporting ofDow Jones en Español to offer clients expanded coverage ofSpanish business, including regional reporting and analysis ofsmall- and mid-cap stocks. For more information about DowJones Newswires, visit http://www.dowjonesnewswires.com.

� HedgeCo Networks, LLC has launched its online ana-lytical and reporting tool, the Hedge Fund Calculator. Availableas a monthly or annual subscription service, the Hedge FundCalculator was designed for hedge funds and funds of hedgefunds, and facilitates the computation of quantitative statistics,net performance numbers, and the creation of branded market-ing materials. Key features of the Hedge Fund Calculatorinclude: online access, branded and customized tearsheets, acontact manager, and benchmark analysis. To view a demo orsign up for a free Webinar visit http://www.hedgefundcalcu-lator.com.

� BarclayHedge and Global Fund Technologies,LLC announced the launch of http://www.myfund-finder.com, a capital introduction platform designed to matchhedge fund managers with institutional and high net worthinvestors. MyFundFinder.com is a web-based platformdesigned to provide hedge-fund managers with a capital-rais-ing tool and to provide investors free access to search onlinethrough more than 1,900 hedge funds, funds of funds, andmanaged futures funds (CTAs) to discover, match, and connectwith those that meet their investment needs. Additional plat-form features include industry discussion forums, geographi-cal mapping, and new fund launches, all centered on a com-munity-driven site.

Note: The New Products and Services section is a forum for industry busi-nesses to announce new products and upgrades. Listings are adapted frompress releases and are not endorsements or recommendations from theActive Trader Magazine Group. E-mail press releases to [email protected]. Publication is not guaranteed.

NEW PRODUCTS AND SERVICES


http://www.cmegroup-bmfbovespa.com

http://www.cmegroup.com/e-quotes


http://www.Adaptrade.com

http://www.wave59.com

http://www.dowjonesnewswires.com

http://www.hedgefundcalculator.com

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http://markettaker.com/FREE_Book_Excerpt_.html




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).

TRADE

Date: Tuesday, Oct. 14, 2008.

Entry: Long December mini crude oilfutures (QMZ08) at 80.875.

Reasons for trade/setup: Crudefutures have been cut nearly in halfsince their July high around $150.Having flushed most of the longs whoexpected strong support at $100, themarket is showing signs of stabilizing after the recent pushbelow the round-number price of $80, and the time appearsright for an attempt at a long position.

We actually captured a small (approximately $1) profitduring yesterday’s uptrend, then turned around and wentshort for what we expected to be a small scalp. However,the market turned higher once again and we scratched theshort and reverted to our long position.

Initial stop: $79.125.

Initial target: $82.125. Take partial profits and raise stop.

Second target: 85.125.

RESULT

Exit: $74.20 (first trade).

Profit/loss: -6.675 (8.2 percent).

Trade executed according to plan? No.

Outcome: Rarely have we been so satisfied with a tradeentry — holding back from chasing the market and buyingas the market tested the day’s low — and had such imme-diately disastrous results.

No point in dressing up this one. It was simply a case ofnot being able to take a loss. Adhering to the initial stopwould have resulted in this trade essentially giving backthe previous day’s profit instead of turning into the disasterit was. The fact the market was so volatile and had tendedto bounce back from its drops led us to believe it would doit one more time … as the market sank and sank. The factthe market never really rebounded and eventually tradedas low as 61.30 by Oct. 27 was small comfort.�

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.

Blown stop is oldest story

in the trading world.

Source: TradeStation

Initial Initial

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

10/14/08 QMZ08 80.875 79.125 82.125 0.71 $74.20 10/15/08 -6.675 (8.2%) +0.10 -6.675 1 day

FOREX DIARY


OPTIONS TRADE JOURNAL

TRADE

Date: Tuesday, Oct. 7.

Market: Options on IBM Corp.(IBM).

Entry: Buy one October 105 putfor $8.50.

Reasons for trade/setup:IBM Corp. was downgraded from“overweight” to “equal weight”by Barclays Capital before thestock market opened on Oct. 7.

Historically, downgraded Dowstocks fall an average 1.40 percentovernight, so we were surprisedwhen IBM opened flat that morn-ing. Downgraded stocks also tendto drop an additional 0.45 percentby the close, suggesting that IBMwas likely to drop, at least briefly (see “Playing the ratingsgame,” Active Trader, September 2007). Moreover, the S&P500 slid 3.8 percent on Oct. 6 as traders continued to panic,so further weakness in the broader market also seemedlikely.

The easiest way to benefit from a market decline is to buyputs. As a result, we bought October 105 puts for 8.50 whenIBM traded at $100 at 10 a.m. on Oct. 7. We entered just afterIBM dropped roughly 1 percent within two or threeminutes, and the goal was to ride this quick down moveand exit by the close.

From a directional standpoint, the 105 put seemedideal. It was in-the-money by roughly 5 points with a -71 delta.

However, IBM’s implied volatility doubled in the past

month, climbing from 22.6 percent on Aug. 29 to 50 percentby Oct. 7. For instance, the 105 put had a $3.50 extrinsicvalue, reflecting skyrocketing volatility estimates. In short,this trade could backfire quickly if IBM began to rally andIVs fell. But because this was such a short-term trade, wewere prepared to take this risk.

Figure 1 shows the trade’s potential gains and losses onOct. 7. The risk profile resembles an outright short trade —

This in-the-money October 105 put is poised to make money if IBM drops by the close.

FIGURE 1 — RISK PROFILE — LONG PUT

Source: OptionVue

TRADE STATISTICS

Oct. 7 10 a.m. 10:08 a.m.

Delta: -71.20 -72.03

Gamma: 2.49 2.86

Theta: -22.61 -18.35

Vega: 6.60 6.10

Probability of profit: 34% 40%

Breakeven point: 98.36 99.21

TRADE SUMMARY

Entry date: Oct. 7, 2008

Underlying security: IBM Corp. (IBM)

Position: 1 long Oct. 105 put

Initial capital required: $850

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

Initial target: Hold until close.

Initial daily time decay: $22.61

Trade length (in days): 1

P/L: $0.40 (4.7%)

LOP: $0.40

LOL: $0

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

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

Profits on this bearish position are limited by a hasty exit.

profits will accumulate if IBMdrops below $99 and losseswill mount if the stock jumps,although the trade can’t losemore than $850. Again, weplan to hold this bearish posi-tion until the close, but we’llexit if the put loses a third ofits value.

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

Initial target: Hold untilclose.

RESULT

Outcome: Figure 2 showsIBM continued to decline afterwe entered the trade. Within10 minutes, IBM fell 1.2 per-cent to 98.76, and we sold the October 105 puts for $8.90 —a $0.40 (4.7 percent) profit. Exiting the trade at a decentprice wasn’t easy because the put’s bid-ask spread widenedto $0.70 as the stock tanked.

We managed to exit near a short-term low, and IBMbounced back above $101 within 20 minutes. However, IBMdropped another 2.8 percent by the close, and we gave upanother $200 in profits by not sticking to the original plan.�

IBM fell 1.25 percent to $98.76 within 10 minutes and we sold the puts for a $0.40 (4.7percent) profit. However, if we had simply followed our plan, we could have cashed in asIBM dropped another 2.8 percent by the close.

FIGURE 2 — EXITING TOO SOON

Source: eSignal


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