FOT200911

November 2009 • Volume 3, No. 11

OPTION LABp. 22

PENNY PILOT gets new wings p. 28

STOCHASTIC breakout system p. 8

THE NOB FUTURES SPREAD is back p. 12

COVERED CALLS VS. COLLARS p. 16

CREDIT SPREAD basics p. 24

2 November 2009 • FUTURES & OPTIONS TRADER

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

Market Movers . . . . . . . . . . . . . . . . . . . . . . . .6Futures market roundup.

Trading Strategies

Stochastic breakout . . . . . . . . . . . . . . . . . . .8A system that fades stochastic signals produces

profits over the long run in across a futures

portfolio.

By Volker Knapp

The return of the NOB spread . . . . . . . .12An old favorite of futures spreaders is enjoying

renewed life.

By Keith Schap

To hedge or not to hedge? . . . . . . . . . . .16A historical look at simple options-hedging

techniques sheds light on the debate between

covered calls and collars.

By Mark D. Wolfinger

Options Trading System Lab

Credit spreads and the directional

movement index . . . . . . . . . . . . . . . . . . . . .22This simple indicator-based system has

generated robust performance since 2001.

By Steve Lentz and Jim Graham

Options Basics

Bull put spread . . . . . . . . . . . . . . . . . . . . . .24Looking under the hood of this vertical options

spread.

By FOT Staff

Industry News

A penny for your lots . . . . . . . . . . . . . . . . .28The SEC’s options Penny Pilot Program has just

doubled in size. But not everyone is celebrating.

By FOT Staff

CONTENTS

continued on p. 4

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45 futures markets.

Options Watch . . . . . . . . . . . . . . . . . . . . . .29Technology sector ETF components

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

statistics for futures.

Options Radar . . . . . . . . . . . . . . . . . . . . . . . . .31Notable volatility and volume

in the options market.

Futures & Options Calendar . . . . . . . . . . . .32

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .33References and definitions.

Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35

New Products and Services . . . . . . . . . . . . .36

Options Trade Journal . . . . . . . . . . . . . . .38This covered call wins with a bounce from RIMM.

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CONTENTS


mailto:[email protected]

FUTURES & OPTIONS TRADER • November 2009 5

CONTRIBUTORS

Editor-in-chief: Mark [email protected]

Managing editor: Molly [email protected]

Senior editor: David Bukey [email protected]

Contributing writers: Keith Schap,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 3, Issue 11. Futures & Options Trader is pub-lished monthly by TechInfo, Inc., 161 N. Clark St.,Suite 4915, Chicago, IL 60601. Copyright © 2009TechInfo, 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

� Keith Schap is a freelance writer specializing in risk

management and trading strategies. He is the author of

numerous articles and several books on these subjects,

including The Complete Guide to Spread Trading (McGraw-Hill,

2005). He was a senior editor at Futures magazine and senior

technical marketing writer at the CBOT.

� Volker Knapp has been a trader, system developer, and

researcher for more than 20 years. His diverse background

encompasses positions such as German National Hockey

team player, coach of the Malaysian National Hockey team,

and president of VTAD (the German branch of the

International Federation of Technical Analysts). In 2001, he became a part-

ner in Wealth-Lab Inc. (www.wealth-lab.com), which he still runs.

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

professionally since 1977. For the past nine years, he has educated individ-

ual investors, stressing the idea of using options to reduce the risk of invest-

ing. His latest book is The Rookie’s Guide to Options (W&A Publishing, 2008).

He writes a blog (http://blog.mdwoptions.com/Options_for_Rookies/)

dedicated to options education.

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

manager for OptionVue Systems and a registered investment

advisor for OptionVue Research.

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

lished options educator and trader and has spoken all over

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

Institute, the Options Industry Council, and the Australian

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

teaches select students how to use complex options strategies and develop

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

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

He regularly speaks at special events, trade shows, and trading group

organizations.

http://www.futuresandoptionstrader.com











http://www.wealth-lab.com


http://blog.mdwoptions.com/Options_for_Rookies/




MARKET MOVERS

Grains

Most grains futurespulled back in lateOctober, but theynonetheless remainednear their highest lev-

els since August.December wheat (WZ09), which had been

decimated from June through September,reached 574.75 on Oct. 23 before retreatingbelow 500 by the end of the month. Decembercorn (CZ09) mirrored the move, pushing above400, then retracing its steps back to around 360.

January soybeans (SF10) rallied above 1000fairly early in October beforeconsolidating between rough-ly 9750 and 1010.

January rice (RRF10) wasby far the hottest grain inOctober, jumping more than12 percent over the 20 daysending Nov. 2.

A mostly bullish October for commodity futures was led by an unlikely sector — meats, specifically lean hog futures, whichrallied despite renewed interest in the H1N1 (“don’t call me swine”) flu story that had battered the market for months.

After breaking out above the June and August highs, the RogersInternational Commodity Index TRAKRS (RCTY) turned lower inlate October, but in the first few days of November had not deeplypenetrated the roughly 18-22 congestion of the past six months.Energies and grains — markets that had been notably weak inSeptember — helped lead the bullish charge in October, while pre-cious metals reversed their previous upside momentum.

Stock-index futures, which surprised many by failing to com-pletely unravel in October, nonetheless began to slide lower in thelatter of the month. U.S. interest-rate futures pulled back from anearly five-month high in early October before bouncing.

For momentum, volatility, and volumedata for the top U.S. futures contracts, seethe Futures Snapshot.

Energies, grains — and meats — hold bullish ground

Energy

Crude oil, gasoline, and heating oil all jumped higher in October, breaking out oftheir nearly four-month consolidations. December crude oil (CLZ09) came up just

a penny short of $82/barrel on Oct. 21 before pulling back. Meanwhile, December natural gas (NGZ09) perpetuated its con-

trarian ways, tumbling some 15 percent in the 20 trading days endingNov. 2 after having outperformed its energy compatriots the previousmonth.

Metals

After hitting a newrecord high inOctober, Decembergold (GCZ09) trad-ed as high as 1072on Oct. 14 beforeconsolidating andcorrecting late inthe month. Themarket jumpedhigher on the firsttrading day inNovember, push-ing back above$1050.

December silver(SIZ09) pulled offmuch more sharply — fallingfrom above 18 to around 16.

December copper (HGZ09)didn’t match gold and silver forexcitement, but into earlyNovember it had done a better jobof hanging around its recent highs.

Source for all: TradeStation

Softs

December coffee (KCZ09),which had zigzagged wildlysince June, thrust upward outof the top of its loose triangu-lar pattern.

Both January sugar (SBF10),which had been the most con-sistently bullish soft commod-ity into late summer, extendeda mildly bearish trading rangeinto early November.

December cocoa (CCZ09)has picked up where sugarleft off, extending its multi-month rally and pushingabove 3,400 — its highest levelsince 2008.

Meats

After a mid-September feint,December lean hogs (LHZ09)continued to rebound inOctober, trading to their high-est level since July and rack-ing up a 22-percent gain overthe 20 days ending Nov. 2 —the biggest gain of any U.S.commodity. February porkbellies (PBG10) also remainedin the bullish column, albeitwith much more choppiness.

And although the marketbounced in early October,December live cattle (LCZ09)failed to embrace the rally,pulling back after tradingabove 87.00 on Oct. 22.

Wood and fiber

January lumber (LBF10)jumped more than 16 per-cent from Oct. 8 to Nov. 2.

December cotton(CTZ09) paused in lateOctober after pushing outof a trading range and trad-ing above 68.50.

Treasuries

Treasury futures slumped quietlythroughout most of October beforebouncing late in the month. TheDecember 10-year T-note contract

( T Y Z 0 9 ) ,which trad-ed to around 120 early in themonth, pulled back to 117before making anotherswing to the upside.

Stock indices

The December E-Mini S&P500 (ESZ09) declined in thelatter half of October. Afterrallying to 1099, the market

began to driftlower, ulti-mately falling to 1026 by Nov. 2, putting itwithin striking distance of theOct. 2 low of 1012.

Currencies

December U.S. dollar indexfutures (DXZ09) regained theirfooting — somewhat — afterfalling to a multi-month lowaround 75 in October.

For more coverage of the for-eign exchange market, go toCurrency Trader magazine.


www.currencytradermag.com

OPTIONS STRATEGY LABTRADING STRATEGIES


Stochastic breakout

Note: A version of this article originally appeared in the October 2004

issue of Active Trader magazine.

The typical oscillator-based trading system goeslong when the indicator is oversold and sells onthe opposite condition. This system does theopposite: It goes short on very low stochastic

readings and long on very high readings, based on thepremise that extremely strong upward or downwardmomentum is more likely to immediately continue thanreverse. This application transforms the oscillator from acountertrend to a trend-following tool.

Indicator and rulesIn this case, the indicator is the stochasticoscillator, which compares the currentprice to the high-low range over a givenlook-back period (see “Stochastic oscilla-tor” for background information on thistool). Trade signals are based on the basicstochastic calculation, referred to as %K.The entry rules are:

1. Long entry: Buy on the next open if the 25-day %K crosses above 98.

2. Short entry: Sell short on the next open if the 25-day %K reading crosses below 2.

The profit-taking and stop-loss rulesexit trades when price either moves by acertain volatility-adjusted amount, orwhen a signal in the opposite directionoccurs:

3. Long exit: Place a stop at the closing price of the day before entry minus the 12-day average true range (ATR) multiplied by four. This stop should be recalculated every day based on

the new closing price. If the stop is not hit, exit on the next open if %K crosses below 2.

4. Short exit: Place a stop at the closing price of the day before entry plus the 12-day ATR multiplied by four. This stop should be recalculated every day based on the new closing price. If the stop is not hit, exit on the next open if %K crosses above 98.

Figure 1 shows some representative trades in corn

Inverting the standard oscillator overbought-oversold rules produces profits,

but not without some pain.

FIGURE 1 — SAMPLE TRADES

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

The stochastic breakout system caught a big up move in corn in 2004, butfailed to sell before the market had given back much of the profit — a com-mon problem with trend-following systems. The dots represent the stop level.

BY VOLKER KNAPP

http://www.wealth-lab.com


futures (C). Notice the sell signaltoward the end of the chart occursaround the point a typical downsidebreakout signal would have takenplace, upon the penetration of the April2004 lows.

Other system parametersIn historical testing, we will risk a max-imum of 2 percent of total equity basedon the ATR stop. For example, if on aday a long trade is triggered the marketcloses at 50, the stop is set at 40, and thepoint value of the contract is $25, thetheoretical risk would be 10 points *$25 = $250. If the account value on theentry day is $150,000, you could risk atotal of $150,000 * .02 = $3,000). Thenumber of contracts you could pur-chase is $3,000/$250 = 12.

The longer the position stays open,the greater the likelihood the ATR willexpand and the stop will move awayfrom the original calculation. As aresult, most trades will be stopped outby the %K-based rule.

Nonetheless, the ATR method will pre-vent any trade from chewing up morethan 2 percent of total equity. Futurescontracts have different values, and thismethod allows us to adjust them to a spe-cific risk level and treat them all thesame. The starting account equity will be$200,000, $20 slippage/commission willbe deducted per contract (for everyround-turn trade).

The system will tested on the follow-ing 19 futures contracts: DAX30 (AX),corn (C), crude oil (CL), Euro bund (DT),Eurodollar (ED), Euro (FX), gold (GC),copper (HG), Japanese yen (JY), coffee(KC), live cattle (LC), lean hogs (LH),Nasdaq 100 (ND), natural gas (NG), soy-

continued on p. 10

FIGURE 2 — EQUITY CURVE

The system returned 356 percent over nine years, but often stagnated forextended periods.

FIGURE 3 — DRAWDOWN

Source: CBOE

Using the 2-percent money management rule, the system produced anacceptable drawdown relative to profit.

Source: CBOE


TRADING STRATEGIES

The stochastic oscillator (or, simply “stochastics”) isa technical tool designed to highlight shorter-termmomentum and so-called “overbought” and “over-sold” levels — points at which a price move has, the-oretically at least, temporarily exhausted itself and isripe for a correction or reversal.

The stochastic oscillator consists of two lines: %Kand a moving average of %K called %D. The basicstochastic calculation compares the most recentclose to the price range (high of the range - low of therange) over a particular period. For example, a 10-day stochastic calculation (%K) would be the differ-ence between today’s close and the lowest low of thepast 10 days divided by the difference between thehighest high and the lowest low of the past 10 days;the result is multiplied by 100. The formula is:

%K = 100*((Ct-Ln)/(Hn-Ln))

where:

Ct is today’s closing priceHn is the highest price of the most recent n days (the default value is five days)Ln is the lowest price of the most recent n days

For example, if today’s close was 58, the highest high of thepast 10 days was 60, and the lowest low of the past 10 dayswas 45, the day’s %K reading would be 100*(58-45)/(60-45) =100*(13-15) = 86.67. The second line, %D, is a three-periodsimple moving average of %K. The resulting indicator fluctu-ates between 0 and 100.

Fast vs. slow: The preceding indicator formula is sometimesreferred to as “fast” stochastics. Because it is very sensitive,an additionally smoothed version of the indicator –– where theoriginal %D line becomes a new %K line and a three-periodmoving average of this line becomes the new %D line –– ismore commonly used, and is referred to as “slow” stochastics,or simply “stochastics.”

Any of the parameters –– either the number of periods usedin the basic calculation or the length of the moving averagesused to smooth the %K and %D lines — can be adjusted tomake the indicator more or less sensitive to price action. Theshorter the number of days in the calculation, the more sensi-tive the indicator will be.

Horizontal lines are used to mark overbought and oversoldstochastic readings. These levels are discretionary; readingsof 80 and 20 or 70 and 30 are common, but different marketconditions and indicator lengths will result in different over-bought and oversold levels. Because fixed indicator parame-ters may be useful in certain conditions and not in others, ana-lysts sometimes create dynamic versions of indicators so theybetter adjust to changing market volatility.

Typically, tools such as stochastics are interpreted as short-er-term momentum indicators: relatively high readings areintended to alert traders to a market that is overextended to theupside, while relatively low readings suggest the opposite.However, in a strongly trending market, such indicators tend toremain overbought or oversold for extended periods. Also, veryhigh or low readings are signs of strong momentum in thatdirection — a concept that provides the counterintuitive appli-cation for the system in this article.

STRATEGY SUMMARY (2% RISK)

Avg. Sharpe Best Worst Percentage Max. Max.return ratio return return profitable consec. consec.

periods profitable unprofitable

Weekly 0.35% 0.76 10.08% -15.76% 54.98% 8 7

Monthly 1.54% 0.71 24.97% -20.52% 57.85% 5 5

Quarterly 4.40% 0.76 36.34% -25.42% 60.98% 6 2

Annually 15.48% 1.16 40.42% -2.50% 90.91% 7 1

LEGEND: Avg. return — The average percent-age for the period • Sharpe ratio — Averagereturn divided by standard deviation of returns(annualized) • Best return — Best return for theperiod • Worst return — Worst return for theperiod • Percentage profitable periods — Thepercentage of periods that were profitable • Max.consec. profitable — The largest number of con-secutive profitable periods • Max. consec.unprofitable — The largest number of consecu-tive unprofitable periods

10-DAY STOCHASTIC OSCILLATOR

Source: TradeStation

SSttoocchhaassttiicc oosscciillllaattoorr


beans (S), sugar (SB), silver (SI), S&P 500 (SP) and 10-year T-notes (TY). Data source: Ratio-adjusted data from PinnacleData Corp. The test period was August 1994 to August 2004.

System resultsOverall, the equity curve (Figure 2) shows a steady increasethat stays close to the linear regression line (magenta).However, short trades (red line) were not very helpful inthe long run — after August 2003, they became net losersand by the end of the test period were in the red $200,000.Short trades were very profitable, however, in 1998 and 1999when the long trades were going through an extended flatperiod.

Figure 3 shows the drawdown, while Figure 4 shows theflat period. The drawdown was stable during the test peri-od, but the biggest loss came in 2004. In a short period oftime, the system lost more than 33 percent from its equityhigh.

System traders often overlook the flat period, but it is animportant indicator since it tells ushow long it took the strategy torecover from its lows and producenew profits. Most of the time the sto-chastic %K system recovered after100 days, but on one occasion it tookthe strategy 600 days to recover fromits losses.

Overall, the system had one downyear (1997) and turned $200,000 into

more than $912,000 in 10 years — a net profit of 356 percent.Out of the 446 trades, only 36 percent were winners.However, they produced a per-trade profit of $1,598.

The system looks promising with the chosen portfolio ofmarkets, starting equity, and money management. Theresults may also surprise some people, given the systemstands the typical rules of an oscillator system on theirhead. Of course, further studies should include additionalmarkets, different time frames (weekly data showed verygood results too), and money management settings. �

For information on the author see p. 5.

STRATEGY SUMMARY (2% RISK)

Profitability Trade statistics

Net profit: $712,744.71 No. trades: 446

Net profit: 356.37% Win/loss: 36.55%

Exposure: 32.47% Avg. trade: 0.77%

Profit factor: 1.31 Avg. winner: 12.94%

Payoff ratio: 2.07 Avg. loser: -6.25%

Recovery factor: 1.75 Avg. hold time: 73.91

Drawdown Avg. hold time (winners): 138.18

Max. DD: 33.32% Avg. hold time (losers): 36.89

Longest flat days: 605 Max. consec. win/loss: 7/11

LEGEND: Net profit — Profit at end of test period, less commission •Exposure — The area of the equity curve exposed to long or short positions,as opposed to cash • Profit factor — Gross profit divided by gross loss •Payoff ratio — Average profit of winning trades divided by average loss oflosing trades • Recovery factor — Net profit divided by max. drawdown •Max. DD (%) — Largest percentage decline in equity • Longest flat days— Longest period, in days, the system is between two equity highs • No.trades — Number of trades generated by the system • Win/Loss (%) — Thepercentage of trades that were profitable • Avg. trade — The average prof-it/loss for all trades • Avg. winner — The average profit for winning trades• Avg. loser — The average loss for losing trades • Avg. hold time — Theaverage holding period for all trades • Avg. hold time (winners) — Theaverage holding time for winning trades • Avg. hold time (losers) — Theaverage holding time for losing trades • Max. consec. win/loss — The max-imum number of consecutive winning and losing trades

FIGURE 4 — FLAT PERIOD

The spike in the middle of the testing period represents a peri-od of more than 600 days without a new portfolio equity high.

www.tradewithvolume.com



The return of the NOB spread

Reunions with friends warmour hearts. Especially sweetis the return of a friend whohas been missing from our

lives for a long time. So it’s a joy to seethe CME Group offer the NOB spread(“notes over bonds,” as in 10-year T-notes and 30-year T-bonds) as a singletransaction, along with the FYT (“fivesand tens”) spread and several others.

A long-time favorite of interest-ratetraders, the NOB spread died a suddendeath when the U.S. Treasury stoppedissuing 30-year Treasury bonds (US) inmid-February 2002. Granted, T-bondfutures continued to trade (a little), but

the 10-year T-note (TY) took over asthe long-term interest-rate benchmark,and the NOB faded along with theissue of new T-bonds.

Curiously, the resumption of T-bondissuance in early 2006 didn’t immedi-ately revive this trade. But now theNOB is back. A big part of the resur-gence seems to result from how simplethe exchange has made it for the aver-age trader.

Simplicity illustratedThe simplicity starts with how youspecify these new spread trades fororder entry. Say you want to buy theNOB — going long 10-year T-notefutures and short T-bond futures.Rather than “legging” into the trade(placing two orders, one in each mar-ket, to establish the spread), you nowsimply specify the spread in terms ofname, number of contracts in each leg,contract month, and year. For exam-ple, to buy the December 2009 NOB,you enter “NOB 05:03 Z9,” whichmeans long five T-note contracts andshort three T-bond contracts; “Z” des-ignates the December contract monthand “9” represents 2009. Individualvendor codes may vary slightly, butthe idea is the same.

Establishing a spread price requiresthree bits of information: the 10-year T-note and T-bond price changes (in32nds) and the “price ratio” (the num-ber of 30-year contracts divided by thenumber of 10-year contracts, in thiscase 5 / 3 = 1.6667). A word of caution:Both the price ratio and the “leg quan-tity ratio” (the number of contractsneeded in each leg of the spread to ren-der it approximately neutral to parallelyield shifts) can change if the cheapest-to-deliver (CTD) changes, although

they won’t necessarily change. (TheCTD Treasury issue for any maturity isthe issue the short will find mostadvantageous to deliver into thefutures contract; as yields shift, differ-ent issues can become CTD.) Forexample, for the June NOB the priceratio was 1.8001 and the leg quantityratio was 9:5. But for the SeptemberNOB, the price ratio was 1.6668 whilethe leg quantity ratio shifted to 5:3.Currently, the December ratios are thesame as September’s ratios. The ratiosfor the NOB and the other interest-ratespreads are available on the CMEGroup Web site. (For different contractmonths, replace “December” in theWeb address with the month of yourchoice.)

Assume you bought the NOB on aday when the December 10-year T-note traded at 121-18, the December T-bond traded at 125-21+, and the pricesat unwinding were 122-17 for the T-note and 126-08+ for the T-bond —that is, during the life of the trade theT-note price rose 31/32 while the T-bond price rose 19/32. (Note: “+”refers to half-ticks — 21.5/32nds and8.5/32nds in the preceding example.)

The December price ratio is 1.6668.To find the spread value for this trade,divide the T-bond price change by theprice ratio and subtract this result fromthe T-note price change:

Spread value = 31 – (19/1.6668) = 31 – (11.3990) = 19.6009, which rounds to 19.5/32, or 19+

To determine the dollar gain or lossfor this trade, multiply the spreadvalue by the dollar value of 1/32($31.25) and by the number of front-

Technology has made spreading easier than ever for futures traders.

BY KEITH SCHAP

Spread liquidity

New contracts often struggle tobuild enough liquidity to makethem feasible for traders, espe-cially those who want to trade insize. One of the best features ofthe CME Group spread designaddresses this issue. The answerto the liquidity question comes intwo parts. First, the liquidity poolbehind each leg of the spreadconsists of everyone who is trad-ing the NOB and everyone who istrading the 10-year T-note and theT-bond. Second, given a tradespecification, the CME will createan implied spread to take theother side of your trade. Yourcounterpart could be anotherspread trader, but you could justas easily have two separate coun-terparties. It makes no difference.There is a vast pool of liquidityunderlying your trade.

www.cmegroup.com/trading/interest-rates/files/ICS_Ratios__December_2009_Contracts.pdf


leg contracts (for the NOB, the numberof 10-year T-note contracts):

19.5 * $31.25 * 5 = $3,046.88

Leaving money on the tableYou sometimes hear traders sayspreaders “leave money on the table.”Granted, a typical description of aspread trade indicates spread tradersexpect one leg of the trade to gain, theother to lose. The hope is the gain willbe bigger than the loss.

This might be true, but it also miss-es a crucial point. The gains don’talways come from the same leg of thetrade. Consider a pair of hypotheticalsituations.

First, take the previous example,where the spread earned $3,046.88. Atrader who had bought five DecemberT-note contracts outright would haveearned $4,843.75 on the 31/32 pricemove:

31 ticks * $31.25 * 5 contracts = $4,843.75.

A spread skeptic would point outthat this leaves almost $1,800 on thetable. No question — that’s a lot.

Second, assume the T-note traded at122-13 and the T-bond at 125-21 when

you bought the NOB. Say the T-notetraded at 121-21+ and the T-bond at123-26 at unwinding. On these pricedrops, the T-note price change is -23.5/32 while the T-bond pricechange is -59/32. Based on the 1.6668price ratio and the 5:3 leg quantityratio, this trade would have earned$1,796.88. The spread value calculationis:

-23.5 – (-59/1.6668) = 11.8972, rounded to 11.5

The gain or loss calculation is:

11.5 * 31.25 * 5 = $1,796.88

Admittedly, this is a modest gain,but contrast it with the situation of aspread skeptic who simply bought fiveDecember T-note contracts. On thesame T-note price move, he wouldhave lost $3,671.88 (-23.5 ticks * $31.25* 5 = $3,671.88). The spread trader inthis case ends up $5,468.76 better offthan the spread skeptic. This demon-strates an important motive for trad-ing the NOB spread, or any otherspread.

Realities of the NOB spread Among the worst bits of trading folk

wisdom is the notion spreads are safe.Forget it — spreads are speculativetrades, although the focus of the spec-ulation shifts to whether the spreadwill widen or narrow rather thanwhether the outright price will rise orfall. You can predict spread directionincorrectly, just as you can outrightmarket direction. In cases where oneleg gains and the other loses, and youare on the wrong side of the spread,the gaining leg may soften the blow,but when both legs lose, being wrongcan be ugly.

A better reason for trading spreadsconcerns how many ways a spread cansatisfy your trading goal. When yousimply buy the 10-year T-note futuresoutright, for example, you have onlyone way to be right: You need the priceto rise. But if you go long the NOBspread in anticipation of a widening

continued on p. 14

FIGURE 1 — THE NOB SPREAD

The easiest way to track the NOB spread is in terms of yield difference. TheNOB was an active spread between early 2008 and July 2009.

www.rsofhouston.com


spread, you have at least five ways to be right:

1. Both yields fall, but the 10-year yield falls more.2. Both yields rise, but the 30-year yield rises more.3. The 10-year yield falls, and the 30-year yield rises.4. The 10-year yield remains stable, and the 30-year

yield rises.5. The 10-year yield falls, and the 30-year yield

remains stable.

Of course, the fourth and fifth possibilities are really justspecial cases of the second and first possibilities. A parallelset of situations applies to short NOB spreads. Whicheverview you take on the NOB relationship, trading the NOBgives you more ways to be right than are available to atrader long or short just the 10-year T-note or just the T-bond.

The various shapes of NOB trading opportunityAlthough you evaluate NOB spread trades in futures priceterms, the easiest way to track this spread is in terms of theyield difference. Figure 1 displays the NOB from the begin-ning of 2008 through mid-July 2009. Even the quickestglance shows this to have been an active spread duringthese months. And active translates into opportunity totrade.

Table 1 identifies 18 spread-buying opportunities (inexpectation of a widening spread) that occurred in 2008and the first half of 2009. The numbers in the “nature ofspread change” column refer to the five spread-wideningpossibilities.

Locating the opportunitiesFigure 1 and Table 1 illustrate the abundance of opportu-nities to buy the NOB, and Figure 1 shows at least an equalnumber of places where you could have sold the NOB.However, knowing how to identify these places in realtime confronts traders with an interesting challenge.

In principle, any tool you use to analyze an outrightprice series should work with spreads. Many of the morecommonly used tools are easy to construct. Simple chartanalysis works the same way as with an outright series.Moving averages, Bollinger bands, and some of themomentum indicators take only minutes to develop givena spreadsheet.

How you determine when to trade when looking at out-right futures should govern your trading decisions withthese spreads. Will you always be right? Of course not. Butare you always right in your other trading? The trick, asalways, is to control your losses and, more importantly, tomaximize your winners.�


TRADING STRATEGIES

TABLE 1 — NOB SPREAD WIDENING EVENTS

The numbers in the “nature of spread change” columnrefer to the five ways a spread can widen.

NOB 10-year 30-year Nature ofspread yield yield spread (in bps) (%) (%) change

1/2/08 44 3.91 4.351/23/08 72 3.51 4.23Change 28 -0.40 -0.12 11/28/08 68 3.61 4.292/6/08 76 3.61 4.37Change 8 0.00 0.08 41/29/08 65 3.69 3.342/15/08 82 3.76 4.58Change 17 0.07 0.24 22/20/08 72 3.93 4.653/7/08 99 3.56 4.55Change 27 -0.37 -0.10 15/2/08 68 3.89 4.575/9/08 76 3.77 4.53Change 8 -0.12 -0.04 17/2/08 52 3.99 4.517/16/08 62 3.97 4.59Change 10 -0.02 0.08 310/14/08 19 4.08 4.2710/21/08 44 3.76 4.20Change 25 -0.32 -0.07 110/30/08 30 4.00 4.3011/18/08 61 3.53 4.14Change 31 -0.47 -0.16 112/10/08 40 2.69 3.0912/16/08 49 2.37 2.86Change 9 -0.32 -0.23 11/2/09 37 2.46 2.831/13/09 67 2.33 3.00Change 30 -0.13 0.17 31/16/09 53 2.36 2.891/28/09 73 2.71 3.44Change 20 0.35 0.55 22/9/09 62 3.07 3.692/19/09 83 2.85 3.68Change 21 -0.22 -0.01 12/10/09 64 2.90 3.542/18/09 80 2.74 3.54Change 16 -0.16 0.00 53/6/09 67 2.83 3.503/18/09 106 2.51 3.57Change 39 -0.32 0.07 34/21/09 80 2.94 3.744/28/09 92 3.05 3.97Change 12 0.11 0.23 25/5/09 86 3.20 4.065/11/09 101 3.17 4.18Change 15 -0.03 0.12 36/8/09 74 3.91 4.656/17/09 82 3.68 4.50Change 8 -0.23 -0.15 16/24/09 72 3.72 4.447/9/09 87 3.44 4.31Change 15 -0.28 -.013 1

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BY MARK D. WOLFINGER

To hedge or not to hedge?

The 2008 market rout taught everyone that a tra-ditional buy-and-hold approach to investing hasflaws. However, finding a practical alternativeisn’t as simple as you might think.

Options traders have three fairly straightforward choices— buying puts (too costly to be a reasonable choice), sellingcalls against an underlying position (covered calls), and amore conservative version that combines covered calls withlong puts for additional downside protection (collars). Thelatter two positions help hedge an underlying portfolio, butthey aren’t free. In exchange for this protection, both strate-gies limit potential upside profits.

Is hedging with covered calls or collars worthwhile, andif so, which position is preferable? A recent academic studysummarized in the December 2009 issue of Active Tradersuggests collars beat a buy-and-hold approach, especiallywhen their strike prices are adjusted based on current mar-ket conditions (see “Related reading”). But that studyignores covered calls.

This analysis weighs the benefits and drawbacks of thesetechniques by examining three indices that track the stockmarket, covered calls, and collars over the past 21 years.

MethodologyThe study compares three methods of investing from June1988 to October 2009.

Buy and hold. The approach matches the S&P 500 TotalReturn index (SPTR), which reinvests all dividends.

Writing covered calls. The technique owns the same index,but sells front-month, at-the-money (ATM) call options. TheChicago Board Options Exchange’s (CBOE) BuyWrite Index(BXM) tracks this portfolio’s performance, with all divi-dends and option premium reinvested.

Options collars. A collar is essentially a covered call with along put. The CBOE introduced a new collar index (CLL) inSeptember 2008 that tracks the performance of an S&P 500portfolio for which the investor sells a front-month call 10percent out-of-the-money (OTM) and buys a three-monthput 5 percent OTM. Note: This is referred to as the 95-110collar because the long puts have a strike price that is 95percent of the S&P 500’s value and the short calls have astrike price that is 110 percent of its value.

When the CBOE launched BXM on June 1, 1988, theindex’s value was set at 100.00. Later, index values were cal-culated another 23 months back to allow comparisons withthe October 1987 crash.

For comparison purposes, SPTRand CLL values are normalized sothey were worth 100.00 on June 1,1988. Thus, the data shown here isdifferent than the actual daily val-ues for the S&P 500 Total Returnand collar indices.

Figure 1 compares the normal-ized daily values of each indexfrom June 1, 1988 to Oct. 15, 2009.On the study’s final day, the nor-malized index values were:

BXM: 677.58SPTR: 588.16CLL: 469.49

The BuyWrite Index seems to bethe clear winner, but before we

Options offer plenty of alternatives to the traditional buy-and-hold approach.

But is hedging your bets with options worth the inevitable trade-offs?

FIGURE 1 — STRATEGY SHOWDOWN

Source: CBOE

The BuyWrite Index has been less volatile than buy-and-hold, and it performed better than the Collar Index.


draw any hasty conclusions, let’sexamine each strategy in depth.

Hold or hedge?The buy-and-hold approach hasone advantage — it provides thebest opportunity for earning sub-stantial profits. All dividends arereinvested for maximum growth,and the possibility of a raging bullmarket makes this method so pop-ular. But hope is not a strategy anddownside risk is real and too oftenignored.

Many investors came to believethey were entitled to double-digitreturns, especially as the technolo-gy bubble was building during the1990s, and they invested according-ly. They discovered there was noneed to manage their portfolios.The bull market rewarded thosewho simply added to investmentswith no exit strategy. But whenthose double-digit returns disap-peared, many investors were hurt.Although there have been somedecent rallies, the market has gonenowhere over the past decade;SPTR has increased by less than 5percent since the end of 1998.

Given the pain involved in a pas-sive buy-and-hold approach, is it agood idea to hedge, or reduce therisk of owning, an investment port-folio and possibly accept lowerprofits? The two hedging strategies— covered calls and collars — areconsidered next.

Covered calls What conclusions can we draw from the BuyWrite Index’s21 years of performance in Figure 1? As expected, BXMlagged the market when it surged as the technology bubblegrew in the late 1990s, and more recently, in the middle halfof 2009. But the market also declined dramatically in 2000and 2008, years in which the BuyWrite Index more thanmade up for lost ground (Figures 2 and 3).

Because surging markets are unusual, a longer-termstrategy that includes covered calls could be suitable formost investors, especially those willing to trade part-timeunderperformance for a higher expectancy of superiorlong-term results.

When the market rallies strongly, BXM disappoints. Butdon’t misunderstand — the BuyWrite Index gained groundduring bullish years. And it should because the portfoliohas a bullish bias. But the dream of (too) many investors isto own stocks during one of those surges. Hoping to makean immediate fortune (or quickly recover losses), theseinvestors refuse to hedge risk.

We believe those very bullish markets occur too infre-quently to base an investment portfolio on that hope. Butlet’s also consider psychology. If you must achieve the bestpossible result every time, then it may be tough to acceptany investment that limits potential profits, as covered callsdo.

continued on p. 19

FIGURE 2 — TECH WRECK, 2000-2002

The S&P 500 Total Return Index falls further than the BuyWrite Index after thetechnology bubble burst in 2002. The Collar Index held more of its value, but wasslow to rebound.

FIGURE 3 — RECENT FINANCIAL MELTDOWN, 2008-2009

Source: CBOE

Losses in SPTR in the fall of 2008 were much more dramatic than in either hedgedstrategy.

Source: CBOE


TRADING STRATEGIES

Professional investors know a perfect hedgedoesn’t exist — you always give up some-thing to protect a stock portfolio. Two ways topartially hedge a portfolio are with coveredcalls and options collars.

A covered call is arguably the most well-known options position: Simply buy an under-lying instrument and sell a higher-strike call togenerate income. In a bullish or neutral mar-ket, this trade could produce consistent gains.However, few traders focus on the strategy’sdownside risk: If the instrument tanks, youcould lose nearly all of your investment. Inshort, a covered call is an imperfect hedge.

An option collar is a similar position thatsolves this dilemma by buying puts to limitlosses. A collar is a conservative, flexiblestrategy that profits if the underlying remainsabove a certain price level when expirationarrives. The strategy’s goal is to add low-costdownside protection. It reduces the odds ofsuccess, but that’s the cost of adding protec-tion. Insurance is not free.

To demonstrate the potential gains andlosses of covered calls and collars, let’s startby purchasing 100 shares of the S&P 500 tracking stock(SPY) at 110 on Oct. 21. We can now create a covered call by

selling one November 110-strike call for $2.30 per share. Thisstep lowers the position’s overall cost (and risk) by $2.30 to107.70. But it also limits potential upside profits to $2.30 if

SPY closes above the 110 strike at Novemberexpiration.

Figure A compares the potential gains andlosses (at expiration) of a long SPY positionwith a covered call (green and blue lines,respectively). The covered call earns moreprofit from 107.70 to 112.30. Owning theunderlying is more profitable above 112.30,but below 112.30, the covered call eitherearns more or loses slightly less money.

To create an option collar, you could buy aNovember put option with, say, a 105 strike for$0.88. Figure B compares the collar to thecovered call at the November options expira-tion (red and blue lines, respectively).Purchasing a put lowers the position’s poten-tial upside profit to $1.42 ($2.30 short call pre-mium - $0.88 put cost). The collar’sbreakeven point rises by the same amount.

However, this collar can lose only $3.58 (5-point difference in strikes - 1.42 credit) if themarket tanks. By contrast, the covered call isvulnerable to large downside losses.

— FOT Staff

FIGURE A — LONG UNDERLYING VS. COVERED CALL

Source: OptionVue

A covered call is preferable if the underlying closes below the call’sshort strike, but if the market skyrockets, this position will limit yourgains. Also, covered calls reduce downside losses, but that won’t helpmuch if the underlying plummets.

FIGURE B — COVERED CALL VS. COLLAR

Source: OptionVue

A collar gives up potential profits for downside protection. A coveredcall offers a slightly higher potential profit, but is more vulnerable tomajor down moves.

CCoovveerreedd ccaallllss aanndd ccoollllaarrss

The cash collected from sellingcalls, or premium, protects the overallposition modestly in case the marketfalls. Covered call traders lose nothingunless the market drops further thanthat premium, which provides somecomfort.

However, BXM is a bullish strategyand its followers can get clobberedduring rapid market declines. That’swhy more conservative investorsshould consider the collar strategy.

Protect investments with a collarCollars provide complete, or almostcomplete, protection against down-side loss, but they cost more than cov-ered calls. A collar strategy fares lesswell when markets rally and much bet-ter when they fall.

continued on p. 20

Related reading:Mark D. Wolfinger articles:

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

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

Other articles:

“Collaring your portfolio,” Active Trader, December 2009.Standard option collars can boost risk-adjusted returns, but the best-performingcollars take cues from market trends.

“Covered calls vs. cash-secured short puts” Futures & Options Trader, July 2007.A comparison of two strategies uncovers some guidelines about how to choosebetween them.

BuyWrite Index methodology: www.cboe.com/micro/BuyWrite/introduction.aspx

Collar Index methodology: www.cboe.com/micro/cll/collarindexpaper.pdf

http://www.cboe.com/micro/BuyWrite/introduction.aspx

http://www.cboe.com/micro/cll/collarindexpaper.pdf

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Collars are flexible and you canchoose among many different puts tobuy and calls to sell. The specific collarchosen by the CBOE for its CLL indexis not ideal for this discussion. Again,its collar index uses strikes that are 95and 110 percent of the S&P’s price, butwe prefer an index that uses the samecall strike as BXM (i.e., 95 and 100 per-cent of the S&P 500).

When the market rallied, CLL sig-nificantly underperformed buy-and-hold and BXM, as Figure 1 shows. Butwhen the market declined, CLL pro-tected its portfolio in an outstandingfashion. Insuring a stock portfolio issimilar to insuring a home or othervaluables. It provides wonderfulpeace of mind, but there is a financialcost. The real question is how much are you willing to payfor this insurance policy?

Assuming the past 21 years can be accepted as normal,then after the occasional downturn, SPTR and BXM willcatch up with CLL by declining to its level. Collar perform-ance might look far better — when compared with BXMand SPTR — if higher-priced call options were sold (i.e.,selling ATM calls rather than 10-percent OTM calls).

Digging into the detailsTable 1 lists normalized values for the three indices at mar-ket tops and bottoms since October 1987. The followingconclusions can be drawn from Figure 1 and Table 1:

• Black Monday, Oct. 19, 1987 highlights the collar strategy’s power. Data for the S&P 500 Total Return Index is not available, but with BXM worth only 77 percent of its baseline value, CLL significantly outperformed.

• As the market recovered from the 1987 crash, the BuyWrite Index caught up to the collar index by June 1, 1988.

• At its 2000 market peak, SPTR was 21 percent higher than BXM and 57 percent higher than CLL. This is why bullish investors don’t like to limit profits. As much as we recommend the collar strategy to conservative investors, this fact is hard to ignore. Indeed, the collar index was essentially flat in 1998 and 1999, which is disturbing. In theory, selling calls 10 percent OTM should have allowed for growth.

• When the S&P 500 Total Return Index bottomed in October 2002, it dipped more than 8 percent below the BuyWrite Index and was only 6.5 percent higher than the collar index. SPTR had declined 46 percent and CLL declined 20 percent from their 2000 peaks. At this point, BXM was the clear winner.

• At the 2007 market top, the S&P 500 Total Return Index had regained the lead and collars lagged.

• SPTR again fell well below BXM at the November 2008 low. But this decline was enough to push it below CLL too.

• During the strong 2009 rally, the S&P 500 Total Return index surpassed the collar index, but still lagged behind the BuyWrite Index.

The covered-call compromiseThere are three obvious conclusions here: In rising markets,SPTR outperforms and collars trail behind; in falling mar-kets, collars easily outperform the other indices; and cov-ered calls are a compromise between maximum hedgingand no hedging, and perform best over extended periods.

Covered calls seem appropriate for most investors,because they offer a less volatile ride, and surging marketsare fairly rare. Collars are suitable for more conservativeinvestors, although selling ATM (as opposed to 10-percentOTM) call strikes makes more sense.�


TRADING STRATEGIES

The S&P 500 Total Return Index (middle column) was cut in half from July 2007to November 2008, while the BuyWrite and Collar indices lost only 36 and 27percent, respectively. However, the S&P also recovered more rapidly over thenext 11 months.

TABLE 1 — MAJOR MARKET TOPS AND BOTTOMS

CBOE BuyWrite S&P 500 Total Return CBOE Collar Date Index (BXM) Index (SPTR) Index (CLL)

10/19/87 77.47 104.13

6/1/88 100 100 100

6/19/00 627.87 758.74 482.8

10/9/02 446.88 409.26 383.77

7/13/07 850.34 891.77 628.57

11/20/08 544.39 445.11 457.18

10/15/09 727.05 663.92 518.91

Source: CBOE

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OPTIONS STRATEGY LABOPTIONS TRADING SYSTEM LAB

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

System concept: Previous Options Labs have testedcredit spreads with different types of trend-following andcountertrend signals. The most successful systems rely onthe directional movement index (DMI), which Wells Wilderdeveloped in 1978.

The DMI indicator gauges the trend from the magnitudeof daily upward and downward price moves. This credit-spread system focuses on the index’s core components: pos-itive directional movement (DM+) and negative directionalmovement (DM-).

A bullish signal begins when the DM+ line crosses abovethe DM- line. The system triggers a bullish position afterprice exceeds that day’s high. At that point, the systementers a bull put spread by selling a put option at the firststrike that is one standard deviation lower and buying a putat a strike 10 points farther out-of-the-money (OTM).

A bearish signal begins when the DM+ line crosses belowthe DM- line. The system triggers a bearish position afterprice falls below that day’s low. At that point, the strategyenters a bear call spread by selling a call option at the firststrike that is one standard deviation higher and buying acall at a strike 10 points farther OTM.

These vertical credit spreads attempt to exploit the shortoptions’ time decay and collect the most profit if the under-lying doesn’t reverse beyond the short strike price by expi-ration. Both options share the same expiration month, and

when strikes are 10 points apart, a five-contract position requires gross margin of$5,000. The spread is entered at a net cred-it, which you keep if both options expireworthless.

Figure 1 shows the potential gains andlosses of an October 1090/1100 bear callspread entered on Sept. 2, 2009 when theS&P 500 traded at 994.70. The trade will beprofitable if the S&P 500 closes below1094.20 at Oct. 16 expiration. The spreadcollected premium of $600, which repre-sents its maximum gain and potentialyield of 13.6 percent (113 percent annual-ized). However, the trade will lose $4,400— the maximum amount — if the S&P 500finishes at 1100 or above at expiration.

Trade rules:

Bullish signal1. DM+ line crosses above DM- line.2. Enter market after price exceeds that

day’s high.

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

deviation OTM.2. Buy five puts at a strike 10 points below the

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

21 days left until expiration.

Bearish signal1. DM+ crosses below DM- line.2. Enter market after price falls below that day’s low.

Entering bear call spreads1. Sell five calls with a strike located one standard

deviation OTM.2. Buy five 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.

ExitClose either spread if the underlying index touches theshort strike. Otherwise, allow the position to expireworthless.

Starting capital: $10,000.


FIGURE 1 — BEAR CALL SPREAD ON S&P 500

We entered this bearish vertical credit spread on Sept. 2, 2009 when the S&P500 traded at 994.70. It had a maximum potential profit of $600.

OPTIONS TRADING SYSTEM LAB

Credit spreadsand the directional movement index

Source: OptionVue

Execution: When possible, optiontrades were executed at the averageof the bid and ask prices at the dailyclose; otherwise, theoretical priceswere used. Standard deviation wascalculated using the implied volatilityof the ATM call. Each spread held fivecontracts per “leg.” Commissionswere $20 per trade.

Test data: The system was testedusing options on the S&P 500 index(SPX).

Test period: Jan. 17, 2001 to Oct. 14,2009.

Test results: Figure 2 tracks thesystem’s performance, which gained$25,365 (254 percent, 29 percent annu-alized) since January 2001. The strate-gy’s average winning trade ($501.00)is much lower than its average losingtrade (-$1,337.73), reflecting the rela-tively poor risk-reward ratio (about 7-1) of these credit spreads. However,the high percentage of winning trades(88 percent) shows this system has adefinite trading edge.

— Steve Lentz and Jim Grahamof OptionVue


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.

Trading vertical credit spreads with the DMI gained 254 percent since January 2001.

Source: OptionVue

FIGURE 2 — SYSTEM PERFORMANCE

Net gain: $25,365.00Percentage return: 254.0%Annualized return: 29.0%No. of trades: 91Winning/losing trades: 80/11Win/loss: 88%Avg. trade: $276.74Largest winning trade: $1,230.00Largest losing trade: -$2,015.00Avg. profit (winners): $501.00Avg. loss (losers): -$1,337.73Avg. hold time (winners): 36Avg. hold time (losers): 24Max. consec. win/loss: 29/1

Directional movement indexDirectional movement index (DMI): Measures trend strength, regardless of direction.The higher the value, the stronger the trend, whether the market is going up or down.

Calculation:1. Calculate the positive or negative directional movement (+DM and -DM) for

each bar in the desired lookback period. Bars that make higher highs and higher lows than the previous bar have positive directional movement. Bars that make lower highs and lower lows than the previous bar have negative directional movement. If a bar has both a higher high and a lower low than the previous bar, it has positive directional movement if its high is above the previous high more than its low is below the previous low. Reverse this criterion for negative directional movement.

2. If a bar has positive (negative) directional movement, the absolute value of the distance between today’s high (low) and yesterday’s high (low) is added to the running totals of +DM (-DM) calculated over a given lookback period (i.e., 20 bars, 30 bars, etc.). The absolute value is used so both +DM and -DM are positive values.

3. Calculate the sum of the true ranges for all bars in the lookback period.

4. Calculate the directional indicator (+DI and -DI) by dividing the running totalsof +DM and -DM by the sum of the true ranges.

Option System Analysis strategies aretested using OptionVue’s BackTradermodule (unless otherwise noted).

If you have a trading idea or strategy thatyou’d like to see tested, please send thetrading and money-management rules [email protected].

STRATEGY SUMMARY



OPTIONS BASICS

Instead of buying or selling options outright, tradersoften buy one option and sell another with the sameexpiration month — a “vertical spread” that reducesthe risk of an outright position in exchange for limit-

ed profits. It’s a trade-off many traders might be willing tomake after watching the financial markets implode in 2008.

There are two types of vertical spreads: credit and debit.When the option you sell costs more than the option youpurchase, you receive cash (“premium”) in your account,hence the name credit spread. On the other hand, when theoption you buy costs more than the option you sell, youmust pay cash to trade it — a debit spread.

Each type of spread has bullish and bearish versions.Despite some claims, one spread isn’t inherently better thanthe others. Whether you choose to trade a credit or debitspread — and how you structure it — depends on your risktolerance, expectations for profit, and market dynamics.

For simplicity, let’s focus on a bullish credit spread usingputs, one of the four types of vertical spreads (Table 1). Theposition is a fairly conservative way to profit from uptrendsby selling puts while keeping downside risk to a minimum.Unlike outright positions, credit spreads can make moneyeven when the underlying market doesn’t behave exactly asexpected.

Bull put spreadIf you are extremely bullish on a stock, it makes sense tobuy the underlying shares or purchase calls outright. But ifyour bullish forecast is less enthusiastic, entering a bull putspread may be preferable. These spreads often contain out-of-the-money (OTM) puts with strike prices below theunderlying market. After selling one or more puts, you thenbuy an equal number of cheaper, lower-strike puts to pro-tect them.

If the underlying closes above the highest strike atoptions expiration, you keep the credit received upon entry,which represents the spread’s maximum profit. If the mar-ket falls below that threshold, losses depend on the distancebetween both strike prices; the further apart the short andlong strikes are, the bigger the maximum loss.

Figure 1 shows a daily chart of Northern Trust (NTRS), aMidwest bank that specializes in wealth management. Afterbouncing 22 percent off its June 17 low, Northern gave backmuch of that gain throughout August. However, the bankhalted its slide around 56, a possible support level, in earlySeptember. The support level held again in early October asNTRS continued to trade in a wide range from 56 to 61.Clearly, Northern hasn’t been nearly as strong as its biggercompetitors such as J.P. Morgan Chase (JPM). But NTRSseems likely to continue trading above support over thenext several weeks.

Given this lukewarm forecast, a vertical spread is moreappropriate than simply buying the underlying stock orpurchasing calls outright. When Northern traded at $59.17,you could have sold a November 55-strike put and boughta 50-strike put to help protect it. Remember you receivecash for entering this spread, which you will keep ifNorthern trades above the short 55 strike when optionsexpire on Nov. 21. The short strike’s location — 7 percentbelow the market — acts as a cushion if Northern Trustdeclines.

Picking the right priceHow much can you collect from selling this spread? Table 2lists the details of the spread’s components. The 55-strikeput had a bid price of $0.80 and an ask price of $0.95 pershare, while the 50-strike put had a bid of $0.20 and an askof $0.25 per share. With a market order, you would sell the

TABLE 1 — GETTING VERTICAL

Name Type Components Risk Reward

Bull put spread Credit Sell one or more puts, buy an equal Strike price difference - Limited to credit number of puts at a lower strike price credit received received

Bear call spread Credit Sell one or more calls, buy an equal Strike price difference - Limited to credit number of calls at a higher strike price credit received received

Bear put spread Debit Buy one or more puts, sell an equal Amount paid Strike-price difference - number of puts at a lower strike price amount paid

Bull call spread Debit Buy one or more calls, sell an equal Amount paid Strike-price difference - number of calls at a higher strike price amount paid

Traders use vertical options spreads because they limit risk and are often less expensive than buying options outright. Butprofits are also capped, making them more conservative trades.

BY FOT STAFF

Bull put spreadSelling out-of-the-money puts is like skydiving — fun, but dangerous. This spread is a less-risky alternative.


55 put at the bid and buy the 50 put atthe ask for a total credit of $0.55 ($0.80- $0.25).

This might be acceptable if you needto execute a trade immediately, butbuyers of this spread (i.e., long 55 put,short 50 put) were willing to pay $0.75(Figure 2, right). A better idea is toplace a limit order halfway betweenthe spread’s bid and ask prices, say,$0.65 per share. There’s no guaranteethe order will be filled, but you canprobably get a better price (as opposedto selling the bid and paying the ask, atactic that really adds up when trading spreads with multi-ple “legs”).

Managing the tradeFigure 3 shows the November 55-50 bull put spread’spotential gains and losses according to Northern’s price onthree dates: trade entry (Oct. 14, dotted line), halfway untilexpiration (Nov. 3, dashed line), and expiration (Nov. 21,solid line).

The best-case scenario is both puts expire worthless andyou keep the premium. Collecting $0.65 in premium for thespread lowers its breakeven point to $54.35 (short 55-strike- 0.65 premium). Below that point, the position can lose upto $4.35 (5 strike-price difference - 0.65) if NTRS dropsbelow the long 50 strike by expiration.

What happens if Northern drops below the spread’sshort strike? At that point, the 55-strike put’s holder mightexercise it, forcing you to buy NTRS at $55 and sell it at alower price. In reality, anyone who holds the 55 put proba-

bly won’t exercise it unless it trades close to its intrinsicvalue (strike price - current market price) near expiration.Otherwise, they will lose money by exercising it too early.

The easiest way to avoid risk of assignment is to buy backthe spread at a loss. If assigned, you can exercise the long 50put, buying Northern at 50, delivering it to the 55 put hold-er, and locking in a loss (55 short strike - underlying marketprice - remaining extrinsic value of 50 put).

Location, location, locationFigure 3 reveals this bull put spread risks $4.35 to gain just$0.65, an unfavorable risk-reward ratio. However, the posi-tion has a 79-percent chance of success because its shortstrike is 7 percent below the market. When trading creditspreads, you balance profit with the odds of making money.Spreads with strikes closer to the market may offer higherpremiums, but they have lower odds of success.

For example, the November 60-55 bull put spread tradedcontinued on p. 26

TABLE 2 — BULL PUT SPREAD EXAMPLE

NTRS closed at $59.17 on Oct. 14.

Long/ Bid Ask Trade price Dollar Components short price price (credit/debit) cost

1 November 55-strike put Short 0.80 0.95 0.90 $90.00

1 November 50-strike put Long 0.20 0.25 -0.25 -$25.00

Total premium collected: 0.65 $65.00

Total risk: 4.35 $435.00

Breakeven point: 54.35

Probability of profit: 79%

This OTM bull put spread on Northern Trust was sold for $0.65 per share on Oct. 14.

FIGURE 1 — BULLISH ON BANKS

Source: eSignal

Given a moderately bullish forecast of Northern Trust, a 55-50 bull put spread could have been entered on Oct. 14. Ideally,NTRS will trade above support until November options expire worthless in five weeks.


around $1.80 — almost three times asmuch as the 55-50 spread (Figure 2).However, that spread had only a 56-percent chance of success, because its60 short strike was actually in-the-money by almost one point. In short,credit spreads with close-to-the-money strike prices leave less roomfor error.

Choosing the width between shortand long strikes involves similartrade-offs. For example, if we enteredthe 55-45 spread on Northern, we mayhave collected another $0.20 in premi-um, but is that worth the additional $5risk?

Most individual stocks have strikeprices at intervals of 2.5 or 5, whileindex-based exchange-traded funds(ETFs) such as the S&P 500 (SPY) andNasdaq 100 tracking stocks (QQQQ)list options with strikes at one-pointintervals, which offer more spreadingopportunities. ��

OPTIONS BASICS continued

FIGURE 2 — DON’T SETTLE FOR LESS

Source: Schwab.com

FIGURE 3 — POTENTIAL GAINS AND LOSSES – NTRS

Source: OptionVue

The November 55-50 bull put spread on Northern Trust was selling for $0.55, but buyers were willing to pay $0.75. You probablycould have gotten a better fill using a limit order for, say, $0.65.

This bull put spread risks $4.35 to earn $0.65 per share. Its risk-reward ratio isn’tgreat, but it has a 79-percent chance of success because the short 55 strike is 7percent below the market.

“Options 101” Options Trader, April 2005.Options can seem complex, but learning a few basic concepts will remove much of the mystery and intimidation.Here’s what you need to know to get started in the world ofputs and calls.

“Vertical spreads: Credit vs. debit” Futures & Options Trader, April 2008.Picking the right kind of spread requires considering volatility and time decay in light of how much your positionis in or out of the money.

“Putting time on your side with credit spreads” Futures & Options Trader, May 2008.If you pick appropriate strike prices, a credit spread will payyou to wait for the underlying market to move.

“(Extra) credit spreads,” Active Trader, February 2002.A look at trading credit spreads.

“Stepping into options,” Active Trader, April 2001.When trading options, you have to walk first and run later.Taking things one step at a time will give you the confidence to use these tools more effectively.

“Spreading your charting options” Active Trader, July 2000.To trade options efficiently, you need to know which strategygoes with which market condition.

Related reading:

ads1009 8/7/09 9:16 PM Page 77

www.moneyshow.com


O n Nov. 2, the option Penny Pilot Program, whichallows penny-increment trading in options oncertain stocks and exchange-traded funds

(ETFs), grew to include options on 75 more equities. The expansion is the first in a series of four quarterly

additions that should increase the number of stocks andETFs with options trading in pennies by 300. Before theNov. 2 change, options on only 63 equities traded in pen-nies.

The Penny Pilot Program was launched by the Securitiesand Exchange Commission (SEC) in January 2007 on 13participating securities. Designed to tighten bid-askspreads and lower transaction costs, the program com-

pelled market makers to quote options priced below $3 inpennies and those priced above $3 in nickels.

Although the program has been successful in tighteningspreads, not everyone is happy with the results. Bid-askspreads have narrowed and options volume has climbed inparticipating stocks and ETFs, according to July and Augustreports from the Chicago Board Options Exchange (CBOE)and the SEC. However, liquidity at the best bid-offer pricessuffered, according to CBOE’s analysis from early 2009.

Several brokerage-firm executives voiced their concernsabout the program’s liquidity impact at the October FuturesIndustry Association (FIA) conference in Chicago.

“The SEC needs to measure not just market width, butliquidity,” OptionsHouse CEOGeorge Ruhana said.

Pricing in pennies doesn’t necessar-ily impact top-volume options, butthe program may reduce liquidity inless-popular stocks and ETFs, accord-ing to Ruhana. At some point, “slight-ly tighter markets with no liquidityare worse for retail customers” thanthose with wider spreads with moreavailable contracts to trade, Ruhanasaid. If the program causes an optionto change from a bid-ask spread of0.10 with 25 contracts available to aspread of 0.08 with just two contracts,it won’t be helping customers,Ruhana said.

Jon Schlossberg, product managerat Lime Brokerage, shares those wor-ries.

“I like the idea of going to pennies,”he said. “[But] I’m absolutely con-cerned about the implications for liq-uidity.”

The SEC has extended the PennyPilot Program until Dec. 31, 2010 andplans to introduce a second set of 75symbols on Jan. 25, 2010.�

INDUSTRY NEWS

Source: Barclay Hedge (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 2009 return.

(Managing at least $1 million as of September 30, 2009.)

Sept 2009 YTD $ underRank Trading advisor return return mgmt.

1. CKP Finance Associates (Masters) 13.08% 210.51% 3.9

2. ACE Investment Strategists (DPC) 7.53% 76.80% 19.2

3. LJM Partners (Aggr. Premium Writing) 4.05% 26.85% 25.0

4. JPS Capital Mgmt (JPS Fund) 3.56% -17.38% 2.8

5. White River Group (Diversified) 3.21% 40.41% 1.0

6. Censura Futures Mgmt. (TEOW) 3.20% 16.67% 21.9

7. Oak Investment Group (Ag Options) 2.89% 51.60% 4.3

8. Kingdom Trading (Short Option) 2.58% 28.51% 2.4

9. Crescent Bay Capital (BVP) 2.39% -10.06% 1.6

10. LJM Partners (LJM Fund Ltd) 2.25% 21.89% 6.2

MANAGED MONEY

A penny for your lotsSpreads tighten, but some decry dispersed liquidity.

BY FOT STAFF

http://www.barclayhedge.com


Options Watch: Technology sector ETF components (as of Nov. 3) Compiled by Tristan Yates

The following table summarizes the expiration months available for the 20 top holdings of the S&P 500 technology sector ETF (XLK). It alsoshows each stock’s average bid-ask spread for at-the-money (ATM) November options. The information does NOT constitute trade signals. It isintended only to provide a brief synopsis of potential slippage in each option market.

spread as %Stock of underlying

Stock Ticker price Call Put priceInternational Business Machines IBM X X X X X X 120.30 0.05 0.04 0.04%Google Inc. GOOG X X X X X X 535.49 0.25 0.23 0.04%Microsoft Corp. MSFT X X X X X X 27.48 0.02 0.01 0.05%Apple Inc. AAPL X X X X X X 187.95 0.08 0.10 0.05%Intel Corp. INTC X X X X X X 18.43 0.01 0.01 0.05%Qualcomm Inc. QCOM X X X X X X 41.99 0.02 0.02 0.05%Verizon Communications Inc. VZ X X X X X X 29.03 0.01 0.02 0.05%AT&T Inc. T X X X X X X 25.35 0.01 0.02 0.05%Cisco Systems Inc. CSCO X X X X X X 22.80 0.01 0.02 0.06%Texas Instruments Inc. TXN X X X X X X 23.41 0.02 0.02 0.07%Hewlett Packard Co. HPQ X X X X X X X 47.65 0.05 0.03 0.08%EMC Corp. EMC X X X X X X 16.35 0.02 0.01 0.08%Ebay Inc. EBAY X X X X X X 22.38 0.02 0.02 0.09%Yahoo Inc. YHOO X X X X X X 15.73 0.02 0.02 0.10%Dell Corp. DELL X X X X X X X 14.42 0.02 0.02 0.10%Oracle Corp. ORCL X X X X X X 20.77 0.03 0.03 0.13%Motorola Inc. MOT X X X X X X 8.94 0.02 0.02 0.18%ADP Inc. ADP X X X X X X X 40.34 0.09 0.06 0.19%Adobe Systems Inc. ADBE X X X X X X 32.63 0.08 0.08 0.23%Corning Inc. GLW X X X X X X X 14.51 0.05 0.05 0.34%

Legend:Call: Three-day average difference between bid and ask prices for the front-month ATM call.Put: Three-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

ch

Apr

il

May

June

Jan.

Jan.

2009 2010 2011 2012

The Commitments of Traders (COT) report is published eachweek by the Commodity Futures Trading Commission(CFTC). The report divides the open positions in futures mar-kets into three categories: commercials, non-commercials,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 (“large specs”)such as commodity trading advisors and hedge funds — pro-fessional money managers who do not deal in the underlyingcash markets but speculate in futures on a large-scale basis.Many of these traders are trend-followers. The non-reportable category represents small traders, or the generalpublic.

Figure 1 shows the relationship between commercials and large speculators onOct. 27. Positive values mean net commercial positions (longs-shorts) are largerthan net speculator holdings based on their five-year historical relationship.Negative values mean large speculators have bigger positions than the commer-cials.

In October, commercial positions were larger than speculator positions in nat-ural gas futures (NG). But this bullish dynamic has eased since September.Meanwhile, speculators dominated in heating oil (HO), platinum (PL), and pal-ladium (PA), a bearish sign. The bearish situation in platinum has existed for atleast three months, while the relationship in heating oil has recently heated up.�

— Compiled by Floyd Upperman

The largest positive readings represent markets in which commercialpositions (longs-shorts) exceeded speculator holdings in October. Andthe largest negative values represent the opposite relationship — specu-lator positions exceeded commercial positions.

FIGURE 1 — COT REPORT EXTREMES

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

Natural gas and heating oil near 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 formula 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)

Option contracts traded

FUTURES & OPTIONS WATCH

Bid-ask

http://www.upperman.com


LegendVolume: 30-day average daily volume, in thou-sands (unless otherwise indicated).OI: Open interest, in thousands (unless other-wise indicated). 10-day move: The percentage price move fromthe close 10 days ago to today’s close.20-day move: The percentage price move fromthe close 20 days ago to today’s close.60-day move: The percentage price move fromthe 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 certainnumber of the previous moves of the same sizeand in the same direction. For example, therank for 10-day move shows how the mostrecent 10-day move compares to the past twen-ty 10-day moves; for the 20-day move, the rankfield shows how the most recent 20-day movecompares to the past sixty 20-day moves; forthe 60-day move, the rank field shows how themost recent 60-day move compares to the pastone-hundred-twenty 60-day moves. A readingof 100 percent means the current reading is

larger than all the past readings, while a read-ing of 0 percent means the current reading issmaller than the previous readings. These fig-ures provide perspective for determining howrelatively large or small the most recent pricemove is compared to past price moves.Volatility ratio/rank: The ratio is the short-termvolatility (10-day standard deviation of prices)divided by the long-term volatility (100-day stan-dard deviation of prices). The rank is the per-centile rank of the volatility ratio over the past60 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)

The following table summarizes the most actively traded U.S. futures contracts. The information does NOT constitute trade signals. It is intendedonly to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the dif-ferent fields. Volume figures are for the most active contract month in a particular market and may not reflect total volume for all contract months. Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based onpit-traded contracts.

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 2.01 M 2.36 M -4.53% / 100% 1.10% / 7% 3.82% / 4% .31 / 86%10-yr. T-note TY CME 826.1 1.19 M 0.14% / 22% -0.73% / 58% 2.57% / 83% .36 / 85%5-yr. T-note FV CME 401.1 773.8 0.72% / 45% -0.05% / 12% 1.72% / 80% .34 / 62%Crude oil CL CME 315.5 272.7 -1.95% / 50% 10.08% / 63% 7.03% / 14% .29 / 35%E-Mini Nasdaq 100 NQ CME 308.2 314.8 -3.81% / 86% 0.20% / 2% 4.01% / 1% .31 / 92%Eurodollar* ED CME 286.8 838.3 0.23% / 83% 0.09% / 17% 0.91% / 93% .26 / 50%Eurocurrency EC CME 238.6 166.3 -1.15% / 86% 0.95% / 24% 2.67% / 16% .33 / 78%30-yr. T-bond US CME 218.7 737.8 0.73% / 17% -1.67% / 72% 4.30% / 78% .38 / 78%2-yr. T-note TU CME 210.0 870.9 0.08% / 58% 0.05% / 26% 0.21% / 74% .37 / 65%E-Mini Russell 2000 TF CME 151.2 375.7 -8.55% / 89% -2.90% / 80% -1.25% / 100% .45 / 100%Mini Dow YM CME 147.9 65.3 -2.62% / 83% 2.43% / 45% 3.64% / 5% .21 / 68%Gold 100 oz. GC CME 131.9 346.0 -1.06% / 40% 3.59% / 27% 8.05% / 74% .24 / 28%British pound BP CME 130.0 99.1 0.56% / 8% 3.32% / 93% -1.98% / 57% .49 / 68%Natural gas NG CME 128.8 115.0 5.52% / 36% 6.93% / 11% 37.32% / 83% .31 / 7%Corn C CME 123.1 514.8 -1.61% / 33% 9.78% / 53% 10.11% / 35% .42 / 100%Japanese yen JY CME 95.7 118.2 0.95% / 38% -0.45% / 19% 6.03% / 91% .29 / 30%Soybeans S CME 91.2 188.1 -0.10% / 0% 10.33% / 97% -9.54% / 50% .16 / 23%Australian dollar AD CME 82.6 111.1 -1.70% / 100% 4.27% / 59% 7.31% / 18% .24 / 65%Canadian dollar CD CME 70.9 90.7 -3.87% / 83% 0.29% / 8% -0.11% / 0% .48 / 92%Sugar SB ICE 53.1 364.6 -4.60% / 64% -4.08% / 36% 15.20% / 4% .22 / 20%Swiss franc SF CME 48.1 51.0 -0.71% / 67% 0.90% / 23% 3.96% / 28% .31 / 67%Wheat W CME 43.2 194.6 -0.88% / 20% 12.01% / 61% -1.20% / 9% .57 / 97%E-Mini S&P MidCap 400 ME CME 40.0 106.8 -6.67% / 100% -0.62% / 0% 0.97% / 1% .37 / 93%Soybean oil BO CME 33.2 91.4 -1.46% / 67% 6.84% / 44% -1.54% / 6% .39 / 50%Heating oil HO CME 33.1 43.3 -1.21% / 0% 11.60% / 58% 3.54% / 7% .25 / 32%RBOB gasoline RB CME 33.0 50.3 -1.00% / 50% 12.56% / 56% -4.91% / 23% .26 / 33%Silver 5,000 oz. SI CME 31.3 94.3 -6.69% / 71% 0.15% / 0% 10.99% / 50% .38 / 53%Soybean meal SM CME 25.1 60.9 0.78% / 0% 10.90% / 88% -12.52% / 50% .12 / 10%Copper HG CME 22.7 88.2 3.87% / 31% 10.22% / 55% 7.39% / 5% .15 / 8%Mexican peso MP CME 21.0 66.3 -0.69% / 43% 3.62% / 64% -1.44% / 62% .54 / 60%S&P 500 index SP CME 20.2 376.2 -4.53% / 100% 1.11% / 9% 2.64% / 1% .31 / 88%Crude oil e-miNY QM CME 12.5 5.3 -1.95% / 50% 10.08% / 63% 8.56% / 18% .29 / 30%U.S. dollar index DX ICE 10.7 32.1 0.93% / 83% -0.96% / 25% -3.32% / 19% .29 / 88%Nikkei 225 index NK CME 10.2 31.4 -4.65% / 50% 0.05% / 0% -6.84% / 100% .55 / 93%Coffee KC ICE 9.9 66.3 -5.15% / 100% 4.47% / 33% 0.59% / 5% .47 / 48%Lean hogs LH CME 9.6 45.1 4.81% / 31% 15.13% / 82% 11.01% / 78% .28 / 77%Mini-sized gold YG CME 8.4 5.3 -0.79% / 40% 4.18% / 38% 8.37% / 74% .24 / 27%Live cattle LC CME 8.3 34.0 1.87% / 10% 3.29% / 69% 2.97% / 55% .39 / 62%Cocoa CC ICE 8.0 57.7 0.73% / 6% 9.86% / 89% 17.33% / 55% .12 / 0%Fed Funds** FF CME 7.9 65.3 0.04% / 94% 0.05% / 49% 0.25% / 83% .13 / 63%New Zealand dollar NE CME 5.5 24.2 -2.78% / 100% 0.42% / 2% 7.12% / 5% .34 / 100%Natural gas e-miNY QG CME 4.4 4.9 5.52% / 36% 6.93% / 11% 37.32% / 82% .30 / 8%E-Mini eurocurrency ZE CME 3.6 2.5 -1.15% / 86% 0.95% / 24% 3.91% / 24% .33 / 80%Mini-sized silver YI CME 2.8 2.9 -6.64% / 88% 0.88% / 5% 12.16% / 50% .38 / 51%Nasdaq 100 ND CME 2.0 18.9 -3.81% / 86% 0.20% / 2% 4.01% / 1% .31 / 92%Feeder cattle FC CME 1.0 4.6 0.26% / 10% 1.34% / 100% -6.23% / 48% .18 / 15%Dow Jones Ind. Avg. DJ CME 0.8 12.0 -2.62% / 83% 2.43% / 47% 4.71% / 6% .21 / 57%*Average volume and open interest based on highest-volume contract (December 2010). **Average volume and open interest based on highest-volume contract (February 2010).


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-daymoves) 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 shows how the mostrecent 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 189.9 1.63 M -4.73% / 100% 1.07% / 7% 26.4% / 16.5% 25.5% / 17.3%S&P 500 volatility index VIX CBOE 110.1 2.09 M 43.21% / 100% 7.01% / 64% 79.4% / 82.8% 65.4% / 81.6%Russell 2000 index RUT CBOE 49.5 436.4 -8.67% / 89% -3.00% / 70% 33.5% / 22.5% 31.3% / 24%E-Mini S&P 500 futures ES CME 32.8 136.4 -4.53% / 100% 1.10% / 7% 26.4% / 19.6% 25% / 19.6%Nasdaq 100 index NDX CBOE 15.5 169.2 -4.15% / 100% 0.28% / 2% 26.3% / 16.8% 26.6% / 18.3%

StocksCitigroup C 278.6 8.94 M -10.89% / 78% -9.51% / 85% 56.2% / 47.8% 67.9% / 73.1%Bank of America BAC 197.2 3.48 M -15.53% / 91% -10.77% / 96% 59.6% / 42.6% 52.2% / 40.2%Apple Inc. AAPL 117.0 799.3 0.24% / 0% 1.95% / 7% 34.1% / 22.3% 34.6% / 26%Microsoft MSFT 94.6 2.04 M 4.64% / 29% 11.10% / 98% 29% / 23.5% 29% / 21.6%Comp Vale do Rio Doce VALE 86.3 770.7 -4.10% / 50% 11.21% / 36% 55.1% / 46.6% 43.2% / 40%

FuturesEurodollar ED CME 76.8 4.81 M 0.05% / 84% 0.05% / 14% 116.2% / 39.2% 116.7% / 139%Corn C CME 55.7 696.5 -1.61% / 33% 9.78% / 53% 38.6% / 44.8% 31.5% / 47.3%E-Mini S&P 500 futures ES CME 32.8 136.4 -4.53% / 100% 1.10% / 7% 26.4% / 19.6% 25% / 19.6%10-year T-notes TY CME 31.6 473.9 0.14% / 22% -0.73% / 58% 6.8% / 5.1% 7.5% / 5.9%Soybeans S CME 23.8 135.1 -0.10% / 0% 10.33% / 97% 29.3% / 31.5% 27.4% / 34.3%

VOLATILITY EXTREMES**Indices - High IV/SV ratio

S&P 100 index OEX CBOE 76.8 4.81 M -4.09% / 100% 1.44% / 9% 116.2% / 39.2% 116.7% / 139%S&P 500 index SPX CBOE 1.9 43.5 -4.73% / 100% 1.07% / 7% 2.1% / 1% 1.7% / 1%S&P 100 index (European style) XEO CBOE 2.7 61.4 -4.09% / 100% 1.44% / 9% 5.3% / 2.8% 4.8% / 2.5%Nasdaq 100 index NDX CBOE 4.2 21.3 -4.15% / 100% 0.28% / 2% 11.1% / 6.2% 9.7% / 7.5%Dow Jones index DJX CBOE 11.8 113.8 -2.83% / 86% 2.37% / 36% 13.4% / 8.4% 12.3% / 24.3%

Indices - Low IV/SV ratioS&P 500 futures SP CME 9.9 59.1 -4.53% / 100% 1.11% / 9% 16.1% / 16.9% 25.5% / 17.9%S&P 500 volatility index VIX CBOE 110.1 2.09 M 43.21% / 100% 7.01% / 64% 79.4% / 82.8% 65.4% / 81.6%

Stocks - High IV/SV ratioGTX Inc. GTXI 4.3 58.5 -12.48% / 60% -18.44% / 68% 154.7% / 47.5% 141.6% / 58.2%Human Genome Sciences HGSI 19.4 232.5 -6.36% / 83% 2.69% / 13% 204.1% / 68% 136.8% / 62.4%Sun Microsystems JAVA 16.8 367.0 -10.31% / 92% -8.71% / 95% 47.4% / 19.6% 17.1% / 8.9%Arena Pharmaceuticals ARNA 3.2 114.0 -19.95% / 83% -13.05% / 68% 104.5% / 50% 94.6% / 106.2%Chimera Invest. Corp. CIM 3.6 64.9 -10.51% / 92% -9.35% / 94% 79.9% / 39.1% 66.8% / 56.1%

Stocks - Low IV/SV ratioStarent Networks STAR 3.2 52.5 -0.35% / 33% 34.64% / 87% 13.8% / 32.1% 50.9% / 56.1%Harvest Energy Trust HTE 1.1 34.5 29.26% / 65% 51.67% / 96% 19.4% / 42.2% 62.2% / 55.6%Fed Home Loan Bank FRE 3.9 333.9 -28.49% / 89% -25.90% / 70% 66.1% / 111.6% 106.7% / 99.9%NCI Building Systems NCS 10.3 221.1 -37.18% / 78% -27.41% / 50% 108% / 149.9% 216.2% / 100.9%

Futures - High IV/SV ratioEurodollar ED CME 76.8 4.81 M 0.05% / 84% 0.05% / 14% 116.2% / 39.2% 116.7% / 139%2-year T-notes TU CME 1.9 43.5 0.08% / 58% 0.05% / 26% 2.1% / 1% 1.7% / 1%5-year T-notes FV CME 2.7 61.4 0.72% / 45% -0.05% / 12% 5.3% / 2.8% 4.8% / 2.5%Eurocurrency EC CME 4.2 21.3 -1.15% / 86% 0.95% / 24% 11.1% / 6.2% 9.7% / 7.5%30-yr T-bonds US CME 11.8 113.8 0.73% / 17% -1.67% / 67% 13.4% / 8.4% 12.3% / 24.3%

Futures - Low IV/SV ratio**Wheat W CME 12.8 134.5 -0.88% / 20% 12.01% / 61% 35.6% / 52.5% 27.6% / 38.5%Soybean meal SM CME 2.8 58.3 0.78% / 0% 10.90% / 88% 29.7% / 35.5% 26.6% / 39.8%Corn C CME 55.7 696.5 -1.61% / 33% 9.78% / 53% 38.6% / 44.8% 31.5% / 47.3%Sugar SB ICE 18.6 288.1 -4.60% / 64% -4.08% / 36% 49% / 54.8% 49.9% / 49.7%Cotton CT ICE 9.5 75.0 -0.84% / 40% 11.51% / 87% 29.3% / 32% 29.6% / 29%

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


MONTH

Legend

CPI: Consumer price index

ECI: Employment cost index

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

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

FOMC: Federal OpenMarket Committee

GDP: Gross domestic product

ISM: Institute for supplymanagement

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

PPI: Producer price index

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

November1 FDD: November crude oil and natural

gas futures (NYMEX)

2 FND: November propane futures (NYMEX); November orange juice futures (ICE)FDD: November gold, silver, copper, aluminum, platinum, and palladium futures (NYMEX); November soybeans and rough rice futures (CME)U.S.: Crop progress report

3 FND: November heating oil and RBOB gasoline futures (NYMEX)U.S.: Weekly weather report

4 U.S.: Petroleum status report

5 FDD: November propane futures (NYMEX)U.S.: Natural gas storage report

6 LTD: December cocoa and U.S. dollar index options (ICE)

7 FDD: November heating oil and RBOB gasoline futures (NYMEX)

89 FDD: November orange juice futures

(ICE)LTD: November orange juice futures (ICE)U.S.: Crop progress report

10 U.S.: Crop production report; world agricultural production; weekly weather report

1112 LTD: December coffee options (ICE)

U.S.: Petroleum status report

13 LTD: November soybeans, rough rice, and lumber futures (CME); December cotton options (ICE)U.S.: Natural gas storage report

141516 FND: December cocoa futures (ICE);

November lumber futures (CME)FDD: November lumber futures (CME)LTD: December sugar options (ICE)U.S.: Crop progress report

17 LTD: December crude oil options (NYMEXU.S.: Weekly weather report

18 LTD: December platinum options (NYMEX)U.S.: Petroleum status report

19 FND: December coffee futures (ICE)U.S.: Natural gas storage report

20 FND: December crude oil futures (NYMEX)LTD: December crude oil futures

(NYMEX); November single stock futures (OC); December T-bonds, corn, wheat, soybean products, and oats options (CME); December orange juice options (ICE); November index and equity optionsU.S.: Cattle on feed

212223 FND: December cotton futures (ICE)

LTD: December natural gas options (NYMEX); December gold and silver options (NYMEX)U.S.: Crop progress report

24 LTD: December natural gas futures(NYMEX); December heating oil, RBOBgasoline options, copper, and aluminum optionsU.S.: Weekly weather report

25 FND: December natural gas futures (NYMEX)LTD: November gold, silver, copper, aluminum, and palladium futures (NYMEX)U.S.: Petroleum status report; natural gas storage report

2627282930 FND: December gold, silver, copper,

aluminum, platinum, and palladium futures (NYMEX); December T-bond, corn, wheat, soybean products, and oats futures (CME)LTD: December heating oil, RBOB gasoline, and propane futures (NYMEX)U.S.: Crop progress report; agricultural prices

December1 FDD: December crude oil, natural gas,

gold, silver, copper, aluminum, platinum,and palladium futures(NYMEX); December T-bonds, corn, wheat, soybean products, and oats futures (CME); December coffee, Cocoa, and cotton futures (ICE)U.S.: Weekly weather report

2 FND: December heating oil, RBOB gasoline, and propane futures (NYMEX)U.S.: Petroleum status report

3 U.S.: Natural gas storage report

4 FDD: December propane futures (NYMEX)LTD: December live cattle options (CME); January cocoa and U.S. dollar index options (ICE); December forex options

NOVEMBER/DECEMBER FUTURES & OPTIONS CALENDAR

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

NOVEMBER 2009

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

DECEMBER 2009

29 30 1 2 3 4 5

6 7 8 9 10 11 12

13 14 15 16 17 18 19

20 21 22 23 24 25 26

27 28 29 30 31 1 2


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.

Backspreads and ratio spreads are leveraged posi-tions that involve buying and selling options in differentproportions, usually in 1:2 or 2:3 ratios. Backspreads con-tain more long options than short ones, so the potentialprofits are unlimited and losses are capped. By contrast,ratio spreads have more short options than long ones andhave the opposite risk profile.

Note: These labels are not set in stone. Some tradersdescribe either position as option trades with long andshort legs in different proportions.

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.

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

Calendar spread: A position with one short-term shortoption and one long same-strike option with more timeuntil expiration. If the spread uses ATM options, it is mar-ket-neutral and tries to profit from time decay. However,OTM options can be used to profit from both a directionalmove and time decay.

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

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

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

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

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

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

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

Covered call: Shorting an out-of-the-money call optionagainst a long position in the underlying market. An exam-ple would be purchasing a stock for $50 and selling a calloption with a strike price of $55. The 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 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.

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.

continued on p. 34

KEY CONCEPTS


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.

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

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

Exercise: To exchange an option for the underlyinginstrument.

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).

Extrinsic value: The difference between an option'sintrinsic value and it's current price (premium). For exam-ple, with the underlying instrument trading at 50, a 45-strike call option with a premium of 8.50 has 3.50 of extrin-sic value.

Front month (or “nearest month”): The contractmonth closest to expiration.

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.

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 options that have notbeen exercised in a specific contract that has not yet expired.

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

Parity: An option trading at its intrinsic value.

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

Premium: The price of an option.

Put option: An option that gives the owner the right, 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 spreadcontains short, higher-strike puts and long, lower-strikeputs. A bear put spread is structured differently: Its longputs have higher strikes than the short puts.

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 declining volatility. Thestrangle is a related strategy.

Strangle: A non-directional option spread that consists of


an out-of-the-money call and out-of-the-money put withthe same expiration. For example, with the underlyinginstrument trading at 25, a long strangle could consist ofbuying a 27.5 call and a 22.5 put. Long strangles aredesigned to profit from an increase in volatility; short stran-gles are intended to capitalize on declining volatility. Thestraddle is a related strategy.

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

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

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

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

True range (TR): A measure of price movement thataccounts for the gaps that occur between price bars. Thiscalculation provides a more accurate reflection of the size ofa price move over a given period than the standard rangecalculation, which is simply the high of a price bar minus

the low of a price bar. The true range calculation was devel-oped by Welles Wilder and discussed in his book NewConcepts in Technical Trading Systems (Trend Research,1978).

True range can be calculated on any time frame or pricebar — five-minute, hourly, daily, weekly, etc. The followingdiscussion uses daily price bars for simplicity. True range isthe greatest (absolute) distance of the following:

1. Today’s high and today’s low.2. Today’s high and yesterday’s close.3. Today’s low and yesterday’s close.

Average true range (ATR) is simply a moving average ofthe true range over a certain time period. For example, thefive-day ATR would be the average of the true range calcu-lations over the last five days.

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.

EVENTS

Event: Lawrence G. McMillan’sIntensive Options Seminar Date: Nov. 7Location: New York City, Marriott MarquisFor more information: Go to www.optionstrategist.com and click on “Seminars”

Event: The Fifth Middle East Forex Trading Expo andConference 2009Date: Nov. 17-18Location: Jumeirah Emirates Towers Hotel, DubaiFor more information: www.meforexexpo.com

Event: International Traders ExpoDate: Nov. 18-21Location: Mandalay Bay Resort & Casino, Las VegasFor more information: www.tradersexpo.com

Event: TradeStation Futures SymposiumDate: Dec. 10-12 Location: Naples, Fla.

For more information: Visitwww.tradestation.com/strategy

Event: International Traders ExpoDate: Feb. 13-16Location: Marriott Marquis Hotel, New York, N.Y.For more information: www.tradersexpo.com

Event: 26th Annual Risk Management ConferenceDate: March 7-9Location: The Ritz-Carlton Golf Resort, Naples, Fla.For more information: Visit www.cboe.com/rmc

Event: The World MoneyShow Vancouver 2010Date: April 6-8Location: Hyatt Regency VancouverFor more information: Go to www.moneyshow.comand click on “Events.”

http://www.optionstrategist.com

http://www.meforexexpo.com

http://www.tradersexpo.com

http://www.tradestation.com/strategy

http://www.tradersexpo.com

http://www.cboe.com/rmc

http://www.moneyshow.com

36 November 2009 • OPTIONS TRADER

� CQG (www.cqg.com) has released CQG Integrated

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TRADE

Date: Friday, Oct. 2., 2009

Market: Options and under-lying stock of Research inMotion (RIMM).

Entry: Buy 100 shares of RIMM at $66.13.Sell 1 October 65-strike put for $2.81.

Reasons for trade/setup:After missing second-quarterearnings estimates, BlackBerrymanufacturer Research inMotion got punished on Sept.25 as it fell 15 percent overnight. Such a large drop in ahigh-profile technology company with attractive funda-mentals is an opportunity to enter a conservatively bullishtrade.

RIMM has been an ideal candidate for covered calls (longunderlying stock, short calls) in 2009, according to an arti-cle in the November 2009 issue of Active Trader. BlackBerrycontrols 30 percent of the smartphone market and RIMMhas a beta of 2.15, a sign of a volatile stock with high optionpremiums.

A 15-percent drop implies investor sentiment in RIMMhas clearly shifted. But Research in Motion’s competitiveposition and the overall strength of technology stocks sug-gest a short-term bounce is likely. But if the stock keepssinking, the premium we collect from selling a call optionwill help protect us.

Getting the details right is the key to making moneywith a covered call. Specifically, we need to pick the cor-rect strike price and expiration month. One rule of thumbis to select in- or at-the-money calls with 20 to 40 days leftuntil expiration. Moreover, the short call should have anextrinsic value of at least $2.50.

Figure 1 shows that we entered a covered call on Oct. 2by purchasing 100 shares of RIMM for $66.13 and sellingone October 65-strike call for $2.81 — a total cost of $63.32.

This cost represents the trade’s maximum loss, so we won’tlose money unless RIMM drops more than 4 percent byexpiration on Oct. 15.

Figure 2 shows the covered call’s potential gains andlosses on three dates: trade entry (Oct. 2, dotted line),halfway until expiration (Oct. 10, dashed line), and expira-tion (Oct. 17, solid line). The position is somewhat protect-ed on the downside, but profits are limited to a mere $1.68per share if RIMM closes above the 65 strike at expiration.

By selling calls, our directional exposure is more than cutin half. The trade has a 67-percent chance of success with atotal delta of roughly 40 vs. 100 if we had simply bought theunderlying shares.

TRADE STATISTICS

Date: Oct. 2 Oct. 9Delta: 39.76 11.68Gamma: -8.10 -4.08Theta: 7.06 5.91Vega: -5.19 -2.21Probability of profit: 67% 96%Breakeven point: $63.32 $63.32

TRADE SUMMARY

Entry date: Oct. 2, 2009

Underlying security: Research in Motion (RIMM)

Position: Long 100 sharesShort 1 October 65 call

Initial capital required: $6,332

Initial stop: Exit if RIMM drops below $63.32

Initial target: Sell if RIMM hits $70. Otherwise, wait for expiration.

Initial daily time decay: $7.06

Trade length: 7 days

P/L: $150 (2.4%)

LOP: $150

LOL: -$20

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

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

OPTIONS TRADE JOURNAL

We timed the market well and collected a large portion of the covered call’s maximumprofit. However, we would have earned twice as much by owning the underlying outright.

FIGURE 1 — PROFITS HAMPERED BY SELLING CALLS

Source: eSignal

This hedged position is

ill suited for a strong rally

in Research in Motion.


Initial stop: Exit if RIMM drops belowbreakeven price of 63.32 before expiration.

Initial target: Sell before expiration ifRIMM jumps to 70. Otherwise hold untilexpiration and let shares get called away.

RESULT

Outcome: We entered the trade after apullback in the broader market, and Figure 1shows it moved in the right direction almostimmediately. At first, RIMM stumbled, butthe position never lost more than $0.20 pershare. This hedge was reassuring, but asRIMM began to climb, we realized how lim-ited profits were.

We sold the covered call at a profit of$1.50 per share (2.4 percent) when Researchin Motion hit $70 on Oct. 9. When we exitedthe trade, it had already gained $1.50 of its$1.68 maximum profit. Waiting a week tocollect another $0.18 per share wasn’t worththe risk.

Even though it made money, this trade lacked bite. Byselling a call, we gave up the opportunity to earn twice asmuch profit.

We reestablished this position later in October just before

RIMM fell below its $60 support level. As RIMM tanked, thecovered call lost more than we thought because the shortcall’s value didn’t shrink as fast as we had hoped. In theo-ry, short call’s value should shrink as the underlying falls,but premiums often remain inflated, held higher by spikingvolatility.�

A covered call is a conservative position that limits upside profits for somedownside protection.

FIGURE 2 — RISK PROFILE — COVERED CALL

Source: OptionVue

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FOT200911

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