Futures and Options Trader, May 2008, Vol. 2 no.5

May 2008 • Volume 2, No. 5

TRADING FUTURES volatility breakouts p. 8 RIDING THE CANADIAN DOLLAR BULL with credit spreads p. 13 THE OPTIONS COLLAR as market hedge p. 18

BETTING AGAINST the oil gusher p. 38 POTENTIAL CME-NYMEX merger snag p. 24

CONTENTS

Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .20 Momentum, volatility, and volume statistics for futures.

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . . .21 Notable volatility and volume in the options market.

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Trading Strategies Trading volatility breakouts . . . . . . . . . . . . .8 This strategy identifies lulls in market volatility before trying to profit from price breakouts. By Sherwood Tucker

Futures & Options Watch What’s new in the COT report . . . . . . . . .22 A look at the relationship between commercial traders and large speculators in all 45 futures markets.

Tracking option bid-ask spreads on high-volume ADRs . . . . . . . . . . . . . . . .22

Putting time on your side with credit spreads . . . . . . . . . . . . . . . . . . .13 Vertical credit spreads aren’t always better than debit spreads, but they can provide an edge, assuming you know how to pick the right one. By Jason Ayres

continued on p. 4

Options Trading System Lab Optimizing an options collar . . . . . . . . . . .18 By Steve Lentz and Jim Graham

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May 2008 • FUTURES & OPTIONS TRADER

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CONTENTS

News . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 NYMEX-CME deal hits potential snag Falling stock prices and rising seat prices may make approval of the NYMEX-CME deal more difficult than anticipated.

Ex-exchange director pleads guilty to fraud Former NYMEX official Steven Karvellas and three others admitted to front-running customer orders.

Trading Basics Options order execution . . . . . . . . . . . . . .25 A behind-the-scenes look at how options orders are filled. By Chris Peters

Futures & Options Calendar . . . . . . . . . . . .34 Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35 New Products and Services . . . . . . . . . . . . .36 Futures Trade Journal . . . . . . . . . . . . . . .38 A gusher — of blood — in the oil market.

Options Trade Journal . . . . . . . . . . . . . . .40 Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .28 References and definitions.

A bull call spread in JPMorgan Chase catches a short rally before the Bear Sterns buyout.

Have a question about something you’ve seen in Futures & Options Trader? Submit your editorial queries or comments to [email protected].

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Page 39

CONTRIBUTORS CONTRIBUTORS

A publication of Active Trader ®

For all subscriber services: www.futuresandoptionstrader.com


Sherwood Tucker is a financial consultant specializing in probability theory and trading strategies with Manduca Trading LLC in Chicago (http://www.manducatrading.com).

Editor-in-chief: Mark Etzkorn [email protected] Managing editor: Molly Flynn Goad [email protected]

He is the author of multiple articles for Futures magazine and a newsletter on these subjects, titled The Matrix Futures Report.

Senior editor: David Bukey [email protected] Contributing editors: Jeff Ponczak [email protected], Keith Schap


Jason Ayres has been an independent trader and investor

for the last 10 years. He has been teaching technical analysis of price charts and the application of options strategies for the last

Associate editor: Chris Peters [email protected] Editorial assistant and Webmaster: Kesha Green [email protected]

five years. More recently, he and his partners founded, designed, and developed OptionSource.net, a Web site where they host in-class and on-line educational programs and offer stock and options trading insight.

Art director: Laura Coyle [email protected] President: Phil Dorman [email protected] Publisher, Ad sales East Coast and Midwest: Bob Dorman [email protected] Ad sales West Coast and Southwest only: Allison Ellis [email protected] Classified ad sales: Mark Seger [email protected]


Jim Graham ([email protected]) is the product manager for OptionVue Systems and a registered investment advisor for OptionVue Research.


Steve Lentz ([email protected]) is executive vice president of OptionVue Research, a risk-management consulting company. He also heads education and research programs for OptionVue Systems, including one-on-

Volume 2, Issue 5. Futures & Options Trader is published monthly by TechInfo, Inc., 161 N. Clark Street, Suite 4915, Chicago, IL 60601. Copyright © 2008 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher.

one mentoring for intermediate and advanced traders.

The information in Futures & Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

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May 2008 • FUTURES & OPTIONS TRADER

TRADING STRATEGIES

Trading volatility breakouts This simple breakout approach enters calm markets in hopes that volatility will pick up.

BY SHERWOOD TUCKER

H

uptrend accelerates, and the January correction causes a noticeable bump in ATR. As the market peaks and sells off in March and daily ranges increase significantly, the indicator pushes higher again; by early April, the indicator is more than twice as high as it was at the end of 2007. Volatility can be viewed as a reflection of the emotions and attitudes of the traders and investors in a market at a given time. When volatility is low, the market can be considered complacent — i.e., the market’s fundamentals are essentially in line with the expectations and percepFIGURE 1 — VOLATILITY IN SOYBEAN FUTURES tions of the traders and Volatility in soybean futures more than doubled from late December 2007 to early April 2008. investors in that market at that moment in time. In contrast, high volatility accompanies uncertain market conditions that cause price to swing up and down, or is a reaction to a specific event that causes traders to put significant money into the market, which pushes price to extremes. The key to the following strategy is understanding that high volatility typically follows low volatility, and vice versa. In his book, Option Volatility & Pricing (McGraw-Hill, 1994), Source: eSignal Sheldon Natenberg writes

istoric volatility (HV), sometimes called statistical volatility (SV), is a measure of the amount of price movement over a specific time period. Historical volatility is typically represented by the standard deviation of closing prices, although other measures of price movement, such as average true range (ATR), can also be used. Figure 1 shows May 2008 soybean futures (ZSK08) with a 14-day ATR calculation. Volatility increases steadily as the

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May 2008 • FUTURES & OPTIONS TRADER

that volatility is “mean reverting,” while this is not necessarily true of price. Essentially, this means that, after moving to a high or low extreme, volatility will tend to move back in the opposite direction. This mean-reverting tendency is the key to capitalizing on volatility.

Identifying low-volatility setups Comparing volatility over different time periods is a method you can use to avoid trendless, choppy markets and identify situations when price is ready to move. For example, comparing a short-term HV reading to a long-term HV reading allows you to determine whether recent volatility is high or low relative to the market’s longer-term (mean) volatility level. In this case, we will compare the six-day HV to the 100day HV reading. Volatility is defined here as the standard deviation of daily closing prices. When the six-day HV reading drops to less than half the 100-day HV, it means the short-term volatility is low relative to the longterm volatility. When this HV signal is generated, the market is indicating it is ready to make a move. Figure 2 shows the 14-day ATR and the sixday/100-day HV ratio, which dropped below 0.50 six times during this period (highlighted red).

a stop order to buy or sell more than 50 percent of the ATR (in this case, 16 1⁄2 cents) above or below the previous day’s close. A more conservative approach would be to use a higher percentage — e.g., 68 percent of ATR, which in this example would require a move of 22 1⁄2 cents or more above or below the previous close. Requiring the market to push beyond its expected range of movement increases the odds the market is making a significant move out of a low-volatility condition. When a trade is entered, place a protective stop-loss 50 percent of the ATR away from your entry price. In this case, with a 33-cent ATR at entry you would place a stop-loss order 16 1⁄2 cents away from the entry price ($825.00 per concontinued on p. 10

Entering positions Once a low-HV signal occurs, an entry is triggered when price moves above or below the previous day’s closing price by more than a certain percentage of the ATR. The goal is to enter outside the range of the market’s normal, “random” fluctuations. For example, when the final HV signal in Figure 2 was generated, the 14-day ATR was approximately 33 cents, which means you could expect soybeans to trade in an approximately 33-cent daily range. To avoid most of the market noise, you would place FUTURES & OPTIONS TRADER • May 2008

9

TRADING STRATEGIES continued

FIGURE 2 — LOW-VOLATILITY TRADE SET-UP A long trade was triggered on Feb. 13 as volatility fell and price climbed to a buy stop of 13.69 1⁄2.

tract) before transaction costs. The basic trade rules can be summarized as follows: Setup — If the six-day HV is less than half the 100day HV:

Source: eSignal

FIGURE 3 — ADDING TO A LONG POSITION After buying three soybean contracts, we placed a trailing stop below the position and two progressively smaller add-on orders above it. This approach lets you build positions with open profit and account for volatility with a trailing stop.

Buy when price moves more than 50 percent of the 14-day ATR above the opening price. Sell short when price moves more than 50 percent of the 14-day ATR below the opening price. Exit with a loss when price moves 50 percent of the ATR below (for longs) or above (for shorts) the entry price. In Figure 2’s trade example, the entry order was filled at 13.69 1⁄2 — 22 1 ⁄2 cents above the Feb. 13, 2008 close of 13.47. Now let’s look at how to structure a multiple-contract trade and exit positions with a profit.

Position sizing and trade management

Source: eSignal

10

Overtrading and trading too large are two of the biggest reasons traders fail. At most, a trader should risk 2 percent of total account equity on any trade. This needs to be factored in before you May 2008 • FUTURES & OPTIONS TRADER

place your initial entry order. With this strategy, the initial position size should be a minimum of three contracts (300 shares for a stock trade). By starting with a relatively small position size, you can add to the position if the market moves in your direction — as it did after the Feb. 14 trade entry in Figure 2. One way to do this is to add to the position in 0.5-ATR increments. Given an ATR of 33 cents, you would add to the position at 16 1⁄2-cent increments. For example, after getting filled on three long soybean contracts at 13.69 1⁄2, you would enter an initial protective stop 16 1⁄2 cents lower at 13.53 while simultaneously entering an order to buy two additional contracts at 13.86, which is 16 1⁄2 cents above the original entry (see Figure 3). If you are filled on the add-on order, you would raise the protective stop to the original entry price of 13.69 1 ⁄2 for a total of five contracts and place a final add-on order for one contract at 14.02 1⁄2, which is 16 1⁄2 cents above the previous add-on price. The reason for adding progressively fewer contracts as the market moves in your favor is because the additional contracts raise your position’s cost basis (average price). Increasing the total position size by smaller amounts reduces the additional risk and raises the cost basis at a slower pace than would be the case if you continued to add the same number of contracts or shares (or progressively more) at each interval. This allows you to build your position with open profit and place a trailing stop far enough below the market to account for volatility.

$11,175.00 (before transaction costs), and the stop is 6 1⁄2 cents above the position’s average cost. What about taking profits on the position? Using profit targets goes against one of the oldest trading adages around: “Cut your losses and let your winners ride.” If you use profit targets you are, in effect, cutting profits short. At this point in the trade, you need to focus on protecting your profits with trailing stops, which is the tool that will ultimately exit the trade. A short-term (e.g., seven-day) exponential moving average (EMA) can be used as a simple trailing stop: exit when price closes below (for a long trade) or above (for a short trade) the EMA. In a runaway market you can use a volatility surge to exit continued on p. 12

Trailing stops and exits After the final add-on order is filled, you will be long a total of six contracts at an average price of 13.80 1⁄2, with a protective trailing stop at 13.86 1⁄2 (the second add-on price). After adding the last contract at 14.02 1⁄2 on Feb. 15, soybeans closed at 14.17 3⁄4. At this point, the trade has an open profit of FUTURES & OPTIONS TRADER • May 2008

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TRADING STRATEGIES continued

FIGURE 4 — EXIT TRIGGERED BY TRAILING STOP This long trade example was exited on the March 6 close when price closed below its 7-day EMA.

— i.e., getting out within two to four days after HV increases 75 to 100 percent. This is a red flag there is too much risk and the market may be ready to reverse. Most trades, however, will be exited using the seven-day EMA trailing stop. Figure 4 shows this trade example would have been stopped out at 14.58 3⁄4 on the March 6 close with a realized profit of $23,475.00 (before commissions and slippage).
For information on the author see p. 6.

Source: eSignal

Related reading “Indicator insight: True range” Active Trader, January-February 2001. A closer look at true range. “Low volatility and inside days” Active Trader, June 2006. Inside days are simply periods of low volatility and don’t necessarily lead to predictable market behavior. However, adding a few guidelines to this pattern uncovered consistent (and surprising) short-term market tendencies. “Staying on top of volatility” Active Trader, May 2004. No matter what or how you trade, you need to keep abreast of volatility changes to get the most out of your trading approach. “Volatility-based currency trading” Currency Trader, February 2005. Market volatility can be a complex subject, but understanding a few basic principles can help you implement strategies to capitalize on volatility extremes.

12

“The good, the bad, and the volatility” Active Trader, August 2002. In a perfect world, there would be a way to distinguish between good volatility that occurs in the direction of your trade and bad volatility that moves against it. The Volatility Quality Index (VQI) can help you make this distinction and plan your trades accordingly. “Putting the squeeze on volatility” Active Trader, November 2001. Volatility is essential for profitable short-term trading. The BandWidth Indicator can help you identify points at which a market is poised to switch from a low-volatility to a high-volatility phase. “Putting volatility to work” Active Trader, April 2001. Who’s afraid of volatility? Not anyone who wants a true edge in his or her trading, that’s for sure. Get a handle on the essential concepts and learn how to improve your trading with practical volatility analysis and trading techniques.

May 2008 • FUTURES & OPTIONS TRADER

TRADING STRATEGIES

Putting time on your side with credit spreads If you pick appropriate strike prices, a credit spread will pay you to wait for the underlying market to move. BY JASON AYRES

A

vertical spread is a hedged options strategy that combines one short option and one long option of the same type and expiration, but with a different strike price. The rationale behind the strategy is to make money if the underlying market moves in the anticipated direction or trades sideways, and also to restrict the overall risk if it moves against you. Credit spreads deposit money in your account upon entry as opposed to debit spreads, which cost money to enter. In addition, all options lose part of their value as time passes, and credit spreads can benefit from this characteristic. The idea is to sell an option that has the highest probability of expiring worthless and buy a cheaper one to identify and minimize potential losses. If constructed properly, a credit spread will profit from both time decay and a directional move in the underlying. The following example focuses on a front-month, out-of-the-money (OTM) credit spread in currency options at the International Securities Exchange (ISE).

the anticipated direction. Also, if the short option remains OTM, you won’t have to pay a commission to close the trade, which saves money. Credit spreads can help you take advantage of a directional move without having to combat the time decay associated with buying options outright. There are two types of continued on p. 14

The credit spread advantage Credit spreads have two significant advantages. First, if the underlying trades above (puts) or below (calls) the short strike, both options will expire worthless, and you keep the initial credit, which is also the spread’s maximum profit. Therefore, you will earn its largest possible gain if the underlying either goes nowhere or moves in FUTURES & OPTIONS TRADER • May 2008

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TRADING STRATEGIES continued

TABLE 1 — CURRENCY INDEX OPTIONS You can trade options on each of these six currency indices that are quoted in credit spreads: bear call and bull U.S. dollars based on each pair’s current spot values. put spreads. To construct either position, you would sell a strike Underlying rate = rate * modifier closer to the money and buy a Currency Currency ISE further OTM strike. name pair symbol Modifier Example Suppose a hypothetical index traded at 100 on March 14. If you Canadian dollar USD/CAD CDD 100 98.395 (.9839 * 100) want to sell an at-the-money Yen USD/JPY YUK 1 104.06 (104.06 * 1) (ATM) option and collect its preEuro* USD/EUR EUI 100 65.50 (.6550 * 100) mium, you could sell an April Pound* USD/GBP BPX 100 50.19 (.5019 * 100) 100-strike call or put. But when you sell a “naked” option, you Australian dollar* USD/AUD AUX 100 107.12 (1.0712 * 100) have an obligation to either sell Swiss franc USD/CHF SFC 100 103.67 (1.0367 * 100) (call) or buy (put) the underlying * Chart will appear inverse to spot-market values because the index is based in U.S. dollars. security at the strike price. Source: International Securities Exchange Therefore, either position faces unidentified losses if the index EMA, and price seemed to consolidate in a lower range. rallies (call) or plummets (put) by expiration. To offset this risk, you must buy a call at a higher strike Finally, a bear flag pattern formed, which could signal a or a put at a lower strike than the one you sold. Losses are continued price drop from Feb. 20’s high (point D). The Canadian dollar index might trade in a range capped at the difference between the strike prices minus the between support and resistance (97.50 and 98.80, respeccredit received. For instance, selling a 100-strike call has unidentifiable tively). Or CDD could drop below that support level and upside risk, which you can limit by purchasing a cheaper April call at a higher strike of 105. Although the trade’s Strategy snapshot credit is reduced, you will still collect premium since the short 100 call costs more than the long 105 call that protects Strategy: Bear call spread it. This bear call spread will make money if the underlying doesn’t trade much above the 100 strike, and losses are Components: One short call capped at the difference between the strike prices minus the One long higher-strike call credit received.

Bearish forecast on the U.S. dollar Table 1 lists the six currency pairs available to trade using the ISE’s currency options. These indices are quoted in U.S. dollars based on each pair’s current spot values. On March 14, for example, the USD/CAD rate was $0.9839 (0.9839 Canadian dollars for 1 U.S. dollar), and the underlying ISE Canadian dollar index (CDD) was 98.39. Table 1 also includes examples of how each currency index is calculated (i.e., spot value * modifier). Figure 1 shows the technical rationale behind a bearish directional outlook on the Canadian dollar index. Because the Canadian dollar index is denominated in U.S. dollars, this forecast calls for a drop in the U.S. dollar against the Canadian dollar. First, CDD formed a downward channel, starting from its Jan. 22 high of 103.63 (point A). Next, the Canadian dollar bounced off a short-term support level (point C) on Feb. 26 and tested its 50-day exponential moving average (EMA) several times, forming short-term resistance around 99.80 (point B). This resistance level also coincides with the index’s early February lows. In early March, the 8-day EMA traded below the 21-day 14

Logic: The underlying trades at (or below) the short strike at expiration. Keep initial credit as both options expire worthless. Criteria: Use front-month options. Max. risk The difference between the strike prices (margin): minus premium received. Best-case Underlying remains below the spread’s scenario: short strike at expiration. Max. profit equals initial premium received. Break-even point: Short strike + credit Worst-case Underlying climbs above the spread’s higher scenario: long strike by expiration. Max. loss equals the difference between the strike prices minus premium received.

May 2008 • FUTURES & OPTIONS TRADER

FIGURE 1 — BEARISH ON THE CANADIAN DOLLAR INDEX In 2008, several technical signals suggested that the ISE’s Canadian dollar index could drop further in the following weeks, including a downward channel (A), resistance at 99.80 (B), and a bear flag (D) that began to form in late February.

Source: optionsXpress

TABLE 2 — BEAR CALL SPREAD

firmly backed by exports and business and consumer spending trends. [And] global demand for raw materials boosted the commodity CDD traded at 98.39 on March 14. appeal of the Canadian dolApril 100-100.50 bear call spread lar.” Dollar amount In 2008, however, the Bank Position Long or short? Price (price * 100 multiplier) of Canada has cut interest 1 April 100 call Short $0.97 $97.00 rates by 0.50 percent, which 1 April 100.50 call Long -$0.88 -$88.00 brought USD/CAD closer to parity (i.e., a one-to-one relaTotal credit (max. profit): $0.09 $9.00 tionship). Meanwhile, the Max. loss: $0.41 $41.00 U.S. Federal Reserve lowered its fed funds rate another 0.75 Breakeven point: 100.09 percent to 2.25 percent on Return on capital: 22% March 18 as the U.S. economy continued to weaken and test a new support level between 95.50 and 96. Either fore- commodities such as oil, gold, and grains hit new highs. cast presents an ideal opportunity for a bear call spread to “With the first Bank of Canada (BoC) rate cuts out of the profit. way, it will be easier for [the BoC] to follow up with further easing – putting further downward pressure on the loonie,” Fundamental background says Kicklighter. While additional Canadian interest-rate So far this forecast is based on technical analysis, but let’s cuts could threaten a bear call spread’s profitability, the also consider the current economic relationship between the Bank of Canada isn’t scheduled to meet until April 22, the U.S. and Canada. In the past six months, the U.S. dollar has week after front-month April options will expire. fallen sharply against the Canadian dollar as the U.S. Federal Reserve continues to cut interest rates in an effort to Bear call spread example stimulate a suffering economy. Let’s assume you had a short-term bearish or neutral outCurrency analyst John Kicklighter at FXCM suggests that look on the U.S. dollar/Canadian dollar currency pair “Canadian fundamentals at the end of 2007 were clearly (USD/CAD), and you plan to enter a bear call spread in supportive of a strong loonie. Economic expansion was continued on p. 16 This 100-100.50 bear call spread in the Canadian dollar index’s April options risked $41 to earn $9 within a month. You’ll keep that $9 if CDD continues to trade below 100 by April 18 expiration.

FUTURES & OPTIONS TRADER • May 2008

15

TRADING STRATEGIES continued

Related reading “Trading credit spreads with the MACD” Futures and Options Trader, December 2007. This Options Lab compares the performance of credit spreads triggered by two technical indicators - new 20-day highs and lows and Moving Average Convergence Divergence (MACD) readings. “ADX credit spread system” Futures and Options Trader, August 2007. This system uses the Average Directional Movement Index (ADX) to trade breakouts with credit spreads. The idea is to spot a flat market and enter a spread in the direction of a new trend. “Options spreads: A lower-risk way to generate trading capital” Options Trader, November 2005. If you trade with limited capital, placing low-cost, low-risk option spreads could improve your odds of success. Bull put and bear call spreads, strangles, and butterflies help you take advantage of the market without excessive risk. “Forex options” Currency Trader, March 2005. Most stock and futures traders are at least familiar with basic optiontrading concepts, but options are a much different beast in the forex world. “Weekly currency options” Currency Trader, November 2004. Futures options that expire each week give traders greater flexibility in designing strategies that capitalize on short-term price action. “Options spreads: The reinsurance approach” Active Trader, July 2004. The probabilities of options trading are not so different from those in the insurance and gaming industries. To make money, it helps to play the odds the way insurers and casinos do. Credit spreads are one way to do it. “Diagonal put spreads” Active Trader, March 2005. Expanding the conventional "vertical" credit spread to incorporate different expiration months results in a position with enhanced profit potential. “Extra credit (spreads)” Active Trader, February 2002. Option credit spreads allow you to trade directional moves is stocks and indices with well-defined risk. Find out how they can help your trading. You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm and download them to your computer.

16

April options. The idea behind the following trade is that CDD will remain at (or below) 100 by April 18 expiration. Front-month options are ideal for credit spreads, because the rate of time decay occurs more rapidly in the final month before expiration. It also shortens the amount of time the underlying has to move against the trade. The ISE Canadian dollar index traded at 98.39 on March 14, and you could have sold an April 100-strike call for $97 and bought a 100.50-strike call in the same month for $88. This represents a total credit of $9 per spread, while the credit spread’s maximum loss is $41 (50 strike-price difference - $9 initial credit). The bear call credit spread’s break-even price is 100.09 (short strike + credit). Table 2 lists this trade’s details, and Figure 2 shows its potential gains and losses at expiration on April 18. This bear call spread will profit if the underlying index drops, trades flat, or even rallies 1.6 percent to its short strike (100). Ideally, a bear call spread’s short strike will be slightly above a resistance level (see Figure 1), which helps minimize the risk of closing the trade early at a loss. Or if you enter a bull put spread, you should sell the strike just below an established support level.

Risk and margin requirements Before entering a credit spread, make sure there are no big upcoming events that could rattle the underlying market or cause the implied volatility of its options to spike. If, for example, you’re trading credit spreads on stocks, you should probably avoid periods surrounding earnings reports, which can trigger erratic moves in either direction. When trading forex options, the monetary policy of each country can have a similar impact on a currency pair. Again, entering the bear call spread in April options is logical because they expire before the BoC meets on April 22. And as the underlying fluctuates in price, the options’ value will adjust accordingly. In the short term, the spread may lose ground if market volatility picks up and offsets the rate of time decay. In this example, each spread requires you to post $41 in margin. If the trade moves against you, you will incur losses when the short option increases in value, although the spread’s long option’s value will rise to help offset this loss. If your losses climb to 50 percent of the collected May 2008 • FUTURES & OPTIONS TRADER

FIGURE 2 — RISK PROFILE — BEAR CALL SPREAD This bear call spread will profit if the Canadian dollar index drops, trades flat, or even rallies 1.6 percent to its short strike (100). The trade will be profitable as long as CDD closes below its break-even point (100.09) at expiration, but it could lose $41 if the index trades at (or above) the long 100.50 strike.

Source: optionsXpress

premium ($20), you should consider closing the position. More importantly, check the distance between the market and the short strike. A spread may lose ground due to

FUTURES & OPTIONS TRADER • May 2008

volatility even if the short strike remains out-of-the-money. But as long as the underlying does not rally above the short strike, the options will still expire worthless and you will keep the entire premium. After you place the trade, you should monitor the distance between the Canadian dollar index and the 100 short strike. As long as CDD trades below 100, the probability of all options expiring worthless still remains in your favor, which is why selling strikes just above a resistance level is so important. The credit spread’s maximum risk (and margin) depends on the distance between both strikes. The closer the strikes, the less capital is required; but a short distance between strikes also lowers the spread’s profit potential. Despite this limitation, however, markets that offer smaller strike increments such as the ISE’s FX options let small account holders trade them. And trades with smaller risk offer a higher possible percentage return. While a credit spread’s profit potential is limited to the credit collected, the strategy is a good choice, assuming time decay and the underlying’s directional moves work in your favor.
For information on the author see p. 6.

17

OPTIONS TRADING SYSTEM LAB

Optimizing an option collar Market: Nasdaq 100 tracking stock (QQQQ) and its options, or any broad-based exchange-traded fund (ETF) or index with liquid options.

Long puts – 1. For every 100 underlying shares, buy a one-year put option that is 5 percent OTM. 2. On the options’ last trading day: a). if they are OTM, let them expire worthless. b). if they are in-the-money (ITM), exit at the closing bid price. 3. Replace expiring puts by

System concept: Options are one way to protect a stock portfolio against volatile market swings. Investors and traders often buy puts to hedge against downside losses, but this approach can be pricey. A recent Options Lab compared the effectiveness of purchasing puts expiring in three months vs. puts expiring in 12 months (“Hedging with long FIGURE 1 — RISK PROFILES - HEDGING STRATEGIES puts,” Futures & Options Trader, March 2008). The OTM collar offers more potential profit if the market rallies above $57, but The 12-month puts outperformed the threethe ATM collar mitigates downside losses below that point (pink and brown lines, month puts and lowered the stock portfolio’s respectively). volatility. This test expands upon this approach by selling calls to help offset the cost of the long puts, which converts the position into an options collar (long stock, long put, short call). The goal is to determine which call strike price to select when creating a collar in this situation. The first step is to buy the underlying market and the appropriate number of puts. On Jan. 2, 2001 the system bought 4,300 shares of the Nasdaq 100 tracking stock (QQQQ) and purchased 43 put options with strike prices five percent out-of-the-money (OTM) that expired in 12 months (the optimal time frame found in the March 2008 test). Finally, the system sold two different types of call options expiring in three months — at-the-money (ATM) and OTM. All options were rolled forward, or replaced, on their last trading day. In this test, QQQQ is completely hedged with QQQQ puts. However, if you hedge a customized portfolio with index options, the proSource: OptionVue tection won’t be as precise because you will likely hold several stocks that won’t always FIGURE 2 — PERFORMANCE - COLLARS VS. BUY-AND-HOLD move in line with the index. Instead of simply Both collared portfolios were less volatile than simply buying stock, and they selling calls (as tested here), you would need to also gained more ground by the end of the seven-year test period. But the sell call credit spreads to minimize risk and the ATM collar was the clear winner (yellow line). margin required, because you would not actually have a position in the underlying index. Figure 1 shows the potential gains and losses of three strategies at March 2001 expiration: long stock only, collar with ATM calls, and collar with OTM calls (blue, brown, and pink lines, respectively). The OTM collar beats the ATM collar above $57, while the ATM collar provides larger gains or smaller losses below that level. Trade rules: Stock – 1. Buy 4,300 shares of QQQQ on Jan. 2, 2001 at $58. 18

May 2008 • FUTURES & OPTIONS TRADER

STRATEGY SUMMARY

purchasing new ones that expire in one year at 5 percent OTM. Short ATM calls – 1. For every 100 underlying shares, sell one ATM call (i.e., the call with the highest time premium) expiring in 90 days. 2. On the options’ last trading day: a). if they are OTM, let them expire worthless. b). If they are ITM, buy them back at the closing ask price. 3. Replace the expiring ATM calls by selling new ones that expire in 90 days.

Net gain or loss ($): Percentage return (%): Annualized return (%): No. of trades: Winning/losing trades: Win/loss (%): Avg. trade ($): Largest winning trade ($): Largest losing trade ($): Avg. profit (winners): Avg. loss (losers): Avg. hold time (winners): Avg. hold time (losers): Max. consec. win/loss :

Short OTM calls – 1. For every 100 underlying shares, sell one OTM call expiring in 90 days at one-half of one standard deviation from the current price as defined by a probabilitycalculator. 2. On the options’ last trading day: a). If they are OTM, let them expire worthless. b). If they are ITM, buy them back at the closing ask price. 3. Replace the expiring OTM calls by selling new ones that expire in 90 days. Test data: Nasdaq 100 tracking stock (QQQQ) and its options. Test period: Jan. 2, 2001 to Jan. 2, 2008. Starting capital: $300,000. Execution: When possible, option trades were executed at the average of the bid and ask prices at the daily close; otherwise, theoretical prices were used. Commissions were $5 plus $1 per option trade, $8 per stock trade. Dividends were not included. Note: Larger fees and bad fills will negatively affect performance. Test results: The QQQQ position was closed on Jan. 2, 2008 at $51.23 for a total loss of $29,127, including commissions. Figure 2 compares both collar strategies to the stock-only portfolio (blue line) and the portfolio hedged by one-year puts (green line) since 2001. Both collar strategies outperformed the hedged and unhedged methods, with less volatility. The collar with short ATM calls gained $40,845 in the test period, compared to just $22,739 for the position with short OTM calls (yellow and red lines, respectively). Although both type of collars generated additional income, in the long run the ATM-call version performed better than the OTM-call version. The ATM collar performed better because of FUTURES & OPTIONS TRADER • May 2008

Stock portfolio -29,127 -9.7 -1.4 1 0/1 0 -29,127 N/A -29,127 N/A -29,127 N/A 2,556 0/1

Portfolio with long puts -30,725 -10.2 -1.5 8 2/6 25 -3,840.63 24,414.00 -29,127.00 21,404.00 -12,255.50 372 728 1/5

ATM collar 40,845 13.6 1.9 37 20/17 54 1,103.92 32,928.00 35,012.00 11,189.70 -10,761.71 115 316 4/3

OTM collar 22,739 7.6 1.1 37 25/12 68 614.57 32,928.00 -29,127.00 6,101.32 -10,816.17 110 409 6/2

unusual conditions from January 2001 to January 2003. The market dropped sharply and implied volatility was very high. Bottom line: This test and the March 2008 Options Trading System Lab offer valuable information for both investors and traders: First, the optimal time frame for buying protective puts was one year, while a collar using ATM calls outperformed a simple buy-and-hold strategy by $69,972 (22.48 percent). — Steve Lentz and Jim Graham of OptionVue LEGEND: Net gain or loss – Gain or loss 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. Option System Analysis strategies are tested using OptionVue’s BackTrader module (unless otherwise noted). If you have a trading idea or strategy that you’d like to see tested, please send the trading and money-management rules to [email protected].

19

FUTURES SNAPSHOT (as of April 30) The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and may not reflect total volume for all contract months. Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic). EPit 10-day move/ 20-day move/ 60-day move/ Volatility Market symbol symbol Exchange Volume OI rank rank rank ratio/rank E-Mini S&P 500 ES CME 1.83 M 2.04 M 1.09% / 17% 1.09% / 10% 0.53% / 5% .13 / 3% 10-yr. T-note ZN TY CBOT 852.1 2.07 M -0.80% / 25% -1.60% / 46% -1.60% / 80% .24 / 38% 5-yr. T-note ZF FV CBOT 560.2 1.83 M -0.85% / 44% -1.51% / 64% -1.69% / 90% .25 / 60% Eurodollar* GE ED CME 359.3 1.38 M 0.04% / 100% -0.21% / 20% 0.33% / 11% 0.09 / 57% E-Mini Nasdaq 100 NQ CME 333.5 310.9 3.28% / 50% 3.28% / 20% 5.28% / 62% .15 / 24% Crude oil CL NYMEX 280.1 286.6 -1.28% / 0% 8.23% / 43% 28.33% / 79% .19 / 2% 30-yr. T-bond ZB US CBOT 274.9 901.8 -0.61% / 13% -0.73% / 11% -2.49% / 79% .29 / 17% E-Mini Russell 2000 ER CME 210.1 645.3 0.50% / 13% 0.74% / 12% 1.51% / 61% .18 / 19% Eurocurrency 6E EC CME 199.9 170.8 -1.91% / 100% -0.01% / 0% 5.40% / 47% .30 / 28% 2-yr. T-note ZT TU CBOT 174.0 857.6 -0.13% / 37% -0.16% / 17% -0.84% / 100% .18 / 40% Mini Dow YM CBOT 149.9 83.3 1.21% / 37% 1.49% / 21% 1.55% / 50% .14 / 0% Gold 100 oz. GC NYMEX 129.2 222.4 -8.77% / 92% -3.90% / 41% -2.83% / 50% .44 / 88% Japanese yen 6J JY CME 118.2 180.2 -2.19% / 50% -1.61% / 39% 2.68% / 25% .17 / 28% Corn ZC C CBOT 107.1 300.0 -0.53% / 0% 0.77% / 4% 17.59% / 23% .18 / 50% British pound 6B BP CME 86.5 100.0 1.05% / 90% 0.30% / 26% 0.70% / 42% .37 / 85% Natural gas NG NYMEX 75.3 99.1 3.93% / 16% 10.28% / 45% 36.53% / 86% .21 / 2% Soybeans ZS S CBOT 70.6 130.0 -3.20% / 50% 4.71% / 33% -1.84% / 50% .36 / 55% Swiss franc 6S SF CME 56.5 58.0 -3.34% / 92% -2.29% / 73% 5.20% / 33% .30 / 63% Sugar SB ICE 53.0 263.0 -6.64% / 89% 0.34% / 0% -2.96% / 60% .27 / 33% Canadian dollar 6C CD CME 42.0 91.5 -0.23% / 25% 1.37% / 51% -1.03% / 24% .31 / 37% S&P 500 index SP CME 40.6 546.2 1.10% / 17% 1.10% / 10% 0.52% / 5% .13 / 3% Australian dollar 6A AD CME 40.2 84.6 0.98% / 11% 3.90% / 69% 3.92% / 28% .23 / 3% RBOB gasoline RB NYMEX 36.6 53.5 -1.11% / 100% 4.78% / 24% 28.33% / 91% .20 / 2% Silver 5,000 oz. SI NYMEX 33.1 55.2 -9.45% / 92% -3.42% / 23% 1.52% / 1% .33 / 70% Soybean oil ZL BO CBOT 30.8 73.9 -6.27% / 83% 4.76% / 10% 3.43% / 2% .26 / 23% Wheat ZW W CBOT 29.2 81.3 -14.84% / 95% -15.93% / 50% -19.10% / 100% .36 / 27% Heating oil HO NYMEX 28.5 46.2 -3.81% / 67% 7.01% / 36% 29.08% / 80% .17 / 7% Soybean meal ZM SM CBOT 24.0 43.0 -1.00% / 14% 1.69% / 13% -4.62% / 80% .53 / 90% E-Mini S&P MidCap 400 ME CME 21.7 91.2 1.58% / 11% 3.73% / 34% 5.22% / 77% .23 / 20% Crude oil e-miNY QM NYMEX 20.0 7.5 -1.28% / 0% 8.23% / 45% 28.33% / 79% .19 / 2% Mexican peso 6M MP CME 18.6 130.6 0.03% / 0% 1.20% / 24% 3.26% / 85% .17 / 0% Cotton CT ICE 15.2 88.6 -3.22% / 45% 1.41% / 15% 3.34% / 8% .22 / 8% Gold 100 oz. ZG CBOT 14.1 7.0 -8.77% / 92% -3.32% / 37% -4.39% / 100% .43 / 88% Fed Funds ZQ FF CBOT 14 44.5 0.24% / 0% 0.21% / 2% 0.98% / 50% .10 / 57% Coffee KC ICE 12.7 60.4 0.52% / 15% 5.29% / 28% -5.08% / 97% .25 / 33% Nikkei 225 index NK CME 12.7 75.3 3.11% / 37% 4.70% / 50% 1.05% / 27% .17 / 5% Copper HG NYMEX 10.9 36.8 -0.61% / 0% 1.46% / 16% 22.48% / 54% .08 / 0% Live cattle LE LC CME 8.4 36.5 3.80% / 62% 8.44% / 100% 3.26% / 73% .67 / 77% Cocoa CC ICE 8.1 42.6 3.35% / 13% 24.48% / 100% 18.33% / 62% .14 / 3% Mini-sized gold YG CBOT 5.9 3.2 -8.77% / 92% -3.32% / 37% -4.39% / 100% .43 / 88% U.S. dollar index DX ICE 5.4 39.3 1.50% / 100% 0.07% / 8% -4.67% / 60% .27 / 27% Lean hogs HE LH CME 4.1 13.0 2.82% / 10% 32.64% / 97% 23.38% / 72% .23 / 0% Nasdaq 100 ND CME 4.0 30.6 3.28% / 50% 3.28% / 23% 7.75% / 90% .15 / 25% Dow Jones Ind. Avg. ZD DJ CBOT 3.8 26.5 1.21% / 37% 1.49% / 21% 3.95% / 91% .14 / 3% Natural gas e-miNY QG NYMEX 3.7 1.8 3.93% / 16% 10.28% / 46% 37.79% / 90% .21 / 0% Silver 5,000 oz. ZI CBOT 2.6 2.2 -10.00% / 92% -3.98% / 27% -1.79% / 0% .34 / 69% Russell 2000 index RL CME 1.6 34.4 0.50% / 13% 0.74% / 12% 1.51% / 61% .18 / 18% *Average volume and open interest based on highest-volume contract (December 2008).

Legend Volume: 30-day average daily volume, in thousands (unless otherwise indicated). OI: Open interest, in thousands (unless otherwise indicated). 10-day move: The percentage price move from the close 10 days ago to today’s close. 20-day move: The percentage price move from the close 20 days ago to today’s close. 60-day move: The percentage price move from the close 60 days ago to today’s close. The “rank” fields for each time window (10-

day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the rank for 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20day move, the rank field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the rank field shows how the most recent 60-day move compares to the past one-hundredtwenty 60-day moves. A reading of 100 per-

cent means the current reading is larger than all the past readings, while a reading of 0 percent means the current reading is smaller than the previous readings. These figures provide perspective for determining how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the shortterm volatility (10-day standard deviation of prices) divided by the long-term volatility (100day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.

This information is for educational purposes only. Futures & Options Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Futures & Options Trader assumes no responsibility for the use of this information. Futures & Options Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.

20

May 2008 • FUTURES & OPTIONS TRADER

OPTIONS RADAR (as of April 28) MOST-LIQUID OPTIONS* Indices

Symbol Exchange Options volume SPX CBOE 195.7 VIX CBOE 86.0 RUT CBOE 64.9 NDX CBOE 28.9 OEX CBOE 27.1

Open interest 1.51 M 828.3 595.0 180.3 87.6

10-day move / rank 5.12% / 88% -17.55% / 84% 5.73% / 87% 7.39% / 88% 5.27% / 94%

20-day move / rank 5.57% / 89% -23.31% / 82% 5.44% / 72% 7.93% / 74% 4.92% / 85%

IV / SV ratio 18.6% / 17.2% 89.8% / 76.5% 22.2% / 23.1% 22.4% / 22.9% 17.7% / 17.2%

IV / SV ratio — 20 days ago 24.4% / 27.4% 57.3% / 134.4% 30.1% / 33.8% 27.9% / 29% 23.6% / 26.2%

Stocks Apple Inc. Citigroup Yahoo! Microsoft Clear Channel Comm.

AAPL C YHOO MSFT CCU

262.3 195.8 141.5 141.3 116.6

977.1 2.42 M 1.96 M 1.16 M 1.29 M

16.55% / 89% 19.10% / 88% -4.93% / 88% 3.31% / 46% 4.52% / 83%

20.03% / 68% 25.16% / 96% -8.64% / 88% 2.15% / 25% 2.81% / 14%

38.9% / 45.5% 39% / 56.8% 57.9% / 26.1% 27.2% / 31.2% 75.7% / 43.6%

44.9% / 46.9% 65.7% / 79.2% 46.8% / 34.1% 33.1% / 29.8% 74.7% / 79.1%

Futures Eurodollar 10-yr T-notes Crude oil Corn 30-yr T-bonds

ED-GE TY-ZN CL C-ZC US-ZB

CME CBOT NYMEX CBOT CBOT

659.6 66.0 46.1 41.7 28.3

7.13 M 591.6 321.9 575.6 347.9

-0.31% / 50% -1.86% / 95% 6.25% / 35% 1.42% / 25% -2.59% / 93%

-0.55% / 47% -2.70% / 95% 16.90% / 92% 5.78% / 35% -1.90% / 66%

34.1% / 36.7% 6.3% / 7.7% 36.4% / 34.1% 44.2% / 30.3% 12.4% / 10.9%

41.9% / 40.5% 8.3% / 8.8% 38.2% / 38.2% 42.8% / 37% 12.9% / 19.4%

Indices - High IV/SV ratio Canadian dollar index Mini Dow S&P 500 volatility index Eurodollar index Japanese yen index

XDC YM VIX XDE XDN

PHLX CBOT CBOE PHLX PHLX

1.3 1.2 86.0 2.4 1.1

36.4 4.6 828.3 22.7 45.1

0.58% / 54% 4.57% / 95% -17.55% / 84% -1.13% / 80% -2.95% / 83%

1.36% / 54% 5.07% / 90% -23.31% / 82% -0.89% / 40% -4.28% / 86%

11.1% / 8.7% 16.7% / 13.9% 89.8% / 76.5% 10.1% / 9.1% 12.4% / 11.2%

NA 22.3% / 19.7% 57.3% / 134.4% 11.8% / 9% NA

Indices - Low IV/SV ratio Banking index Semiconductor index Mini-Nasdaq 100 Index E-Mini Nasdaq 100 futures E-mini S&P 500 futures

BKX SOX MNX NQ ES

PHLX PHLX CBOE CME CME

1.7 1.0 19.3 1.1 26.4

80.3 16.7 524.1 5.3 119.0

11.47% / 86% 10.70% / 100% 7.39% / 88% 7.25% / 89% 4.98% / 89%

6.73% / 50% 13.48% / 93% 7.94% / 74% 7.60% / 74% 5.55% / 86%

32.4% / 44.6% 29.5% / 38.9% 22% / 26.1% 22.6% / 26.7% 18.1% / 19.6%

53% / 66.5% 32.8% / 35.7% 27.5% / 33% 28.3% / 35.4% 24.4% / 30.3%

S&P 500 index S&P 500 volatility index Russell 2000 index Nasdaq 100 index S&P 100 index

VOLATILITY EXTREMES**

Stocks - High IV/SV ratio Gemstar Intl. Yahoo! Take-Two Interactive Clear Channel Comm. IndyMac Bancorp

GMST YHOO TTWO CCU IMB

2.8 141.5 4.5 116.6 3.1

18.2 1.96 M 189.1 1.29 M 86.8

-14.88% / 100% -4.93% / 88% 2.88% / 75% 4.52% / 83% -12.18% / 37%

-13.62% / 100% -8.64% / 88% 3.72% / 32% 2.81% / 14% -31.65% / 67%

99.1% / 28.8% 57.9% / 26.1% 37.6% / 20.8% 75.7% / 43.6% 160.6% / 97.8%

142.5% / 38.1% 46.8% / 34.1% 48.7% / 27.4% 74.7% / 79.1% 122% / 149.8%

Stocks - Low IV/SV ratio National City Washington Mutual Cheniere Energy Jefferies Group Regions Financial

NCC WM LNG JEF RF

26.7 76.3 7.0 2.6 5.5

182.2 746.6 131.9 35.1 88.8

-14.02% / 12% 21.74% / 91% -33.42% / 65% 31.25% / 100% 20.04% / 100%

-34.67% / 49% 22.33% / 52% -45.96% / 85% 17.42% / 100% 12.81% / 61%

51% / 101.7% 52.5% / 96.9% 114.4% / 203.6% 47.1% / 83.4% 37.2% / 65%

135.3% / 129.1% 126.7% / 156.9% 68.9% / 74.9% 79.6% / 85.7% 56.5% / 74%

Futures - High IV/SV ratio Corn Canadian dollar Live cattle Soybeans Soybean oil

C-ZC CD-6C LC S-ZS BO-ZL

41.7 2.1 4.4 14.0 9.6

575.6 17.3 67.2 152.2 81.5

1.42% / 25% 0.88% / 86% 5.16% / 82% -6.48% / 75% -6.10% / 67%

5.78% / 35% 1.73% / 62% 7.23% / 100% 7.20% / 58% 12.18% / 66%

44.2% / 30.3% 10.7% / 8.2% 18.5% / 14.7% 50.2% / 40.4% 42.3% / 34.4%

42.8% / 37% 13% / 9.8% 16.2% / 15.4% 47.8% / 42.2% 31.4% / 41.1%

43.7 62.5 158.0 591.6 680.7

-4.37% / 42% -3.57% / 54% 2.59% / 45% -1.86% / 95% -2.51% / 33%

-1.72% / 13% -2.26% / 24% 5.57% / 31% -2.70% / 95% 3.17% / 6%

34.9% / 49.1% 22.7% / 29.4% 31% / 38.1% 6.3% / 7.7% 37.8% / 44.1%

40.7% / 58.3% 26% / 29.7% 36% / 47.7% 8.3% / 8.8% 36% / 48.8%

CBOT CME CME CBOT CBOT

Futures - Low IV/SV ratio Silver 5,000 oz. SI NYMEX 4.5 Gold 100 oz. GC NYMEX 5.0 Coffee KC NYBOT 6.7 10-yr T-notes TY-ZN CBOT 66.0 Sugar SB NYBOT 25.1 * Ranked by volume ** Ranked based on high or low IV/SV values.

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, 20day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For example, the “rank” for 10-day moves shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “rank” field shows how the most recent 20-day move compares to the past sixty 20-day moves.

FUTURES & OPTIONS TRADER • May 2008

21

FUTURES & OPTIONS WATCH FIGURE 1 — COT REPORT EXTREMES The difference between commercials and speculators in gasoline futures (RB) reached a five-year low on April 22, while this relationship remains near a five-year high in the Nikkei 225 futures (NK).

What’s new in the COT report

Each week, the Commitment of Traders (COT) report, published by the Commodity Futures Trading Commission (CFTC), lists the number of open positions in each futures market according to three key players: commercials, large speculators, and nonreportables, or smaller retail traders. Commercial traders either produce or use commodities and operate in the cash market, so they tend to hedge by selling or buying futures contracts to reduce their risk. Large speculators, however, are investment funds that trade only to make money. For a list of contract names, see “Futures Snapshot.” Source: http://www.upperman.com Figure 1 shows the relationship between commercials and large speculators on April 22. Positive values Legend: Figure 1 shows the difference between net commercial mean that net commercial positions (longs - shorts) are larger than and net fund positions (longs - shorts) for all 45 futures markets, in net fund holdings, based on their five-year historical relationship. descending order. It is calculated by subtracting the current netfund position from the net-commercial position and then comparing Negative values mean that large funds have bigger positions than this value to its five-year range. The basic formula is: the commercials. a1 = (net commercials’ 5-year high - net commercials’ current) In gasoline futures (RB), for example, the difference between comb1 = (net commercials’ 5-year high - net commercials’ 5-year low) mercials and funds reached a five-year low, while this relationship c1 = ((b1 - a1)/ b1 ) * 100 remains near a five-year high in the Nikkei 225 futures (NK). These a2 = (net funds’ 5-year high - net funds’ current) b2 = (net funds’ 5-year high - net funds’ 5-year low) types of historical extremes sometimes precede major price reverc2 = ((b2 - a2)/ b2 ) * 100 sals.
x = (c1 - c2) – Compiled by Floyd Upperman

Options Watch: High-volume ADRs (as of April 29)

Stock

Symbol Exchange

Compahnia Vale do Rio Doce* Baidu.com Petroleo Brasileiro Teva Pharmaceutical Garmin Ltd. America Movil, S.A.B. Nokia Corp. Marvell Technology Group Ltd. Suntech Power Holdings Focus Media Holding Ltd. Cemex, S.A.B. LDK Solar Co. Ltd. SAP AG Banco Itau Holding Financeira Gold Fields Ltd. JA Solar Holdings Co. Ltd. Banco Bradesco Solarfun Power Holdings Co. Taiwan Semiconductor Mfg. BHP Billiton Ltd. Alacatel-Lucent

RIO BIDU PBR TEVA GRMN AMX NOK MRVL STP FMCN CX LDK SAP ITU GFI JASO BBD SOLF TSM BHP ALU

NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA

X X X X X X X X X X X X X X X X X X X X X

X X X X X X X X X X X X X X X X X X X X X

X X X

X X X

X X

X X

X

X

X

X X

X X

X X

X X X

X X X X

X X X X

X X X X

X X X X

X

X X

X

Jan.

Jan.

Dec.

Nov.

Oct.

Sept.

Aug.

July

June

May

Compiled by Tristan Yates The following table summarizes the expiration months available for high-volume ADRs. It also shows each index’s average bid-ask spread for at-the-money (ATM) May options. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of potential slippage in each option market. Option contracts traded 2008 2009 2010

X X X X X X X X X X X X X

X X X X X X X X X X X X X

X

X

X X X X X

X X X X X

Bid-ask spreads

Closing price

Call

Put

Bid-ask spread as % of underlying price

36.84 373.81 116.79 45.74 46.44 57.12 29.88 13.04 44.06 39.00 27.31 31.59 52.45 25.77 13.32 23.16 21.00 13.18 10.83 79.40 7.06

0.04 0.45 0.18 0.15 0.18 0.23 0.09 0.06 0.18 0.21 0.19 0.23 0.33 0.19 0.09 0.24 0.16 0.10 0.13 1.10 0.09

0.06 0.58 0.23 0.14 0.13 0.15 0.13 0.06 0.28 0.21 0.11 0.15 0.30 0.16 0.10 0.14 0.20 0.14 0.09 1.18 0.13

0.13% 0.14% 0.17% 0.31% 0.32% 0.33% 0.36% 0.48% 0.51% 0.54% 0.55% 0.59% 0.60% 0.68% 0.70% 0.81% 0.86% 0.90% 0.98% 1.43% 1.50%

*Penny pilot program participant

Legend: Call: Four-day average difference between bid and ask prices for the front-month ATM call. Put: Four-day average difference between bid and ask prices for the front-month ATM put. Bid-ask spread as % of underlying price: Average difference between bid and ask prices for front-month, ATM call, and put divided by the underlying's closing price. 22

May 2008 • FUTURES & OPTIONS TRADER

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INDUSTRY NEWS Hold everything

NYMEX-CME deal hits potential snag

T

he hardest part of a mega-merger isn’t always getting the initial agreement between the two firms. It’s often finalizing the deal as shareholders of one company hold up the process because they don’t think they’re getting enough money. The $9.3-billion agreement between the New York Mercantile Exchange and the Chicago Mercantile Exchange may have reached that point in late April. A seat at the NYMEX sold for $640,000, an increase from the $612,000 in the original deal. Two different sets of NYMEX shareholders say they have enough votes to block the deal. The seat sale comes a few days after NYMEX shareholders forced a special meeting sparked by a change in stock prices that saw the deal lose almost $2 billion in value since January, when the two sides first admitted they were talking about a merger. The meeting will occur on June 3, and NYMEX shareholders could force the CME to raise its offer. The CME is interested in buying NYMEX memberships

because, under NYMEX rules, members are entitled to 10 percent of revenues for any product that shifts to electronic trading. Although the deal requires the NYMEX trading floor to remain open until at least 2012, the NYMEX in late April provided specifics on what would cause a shift off the floor and said such payments could begin as early as next year. The NYMEX sent a letter to members and to the SEC that payments will begin “following the end of two consecutive fiscal quarters in which, during each quarter, the average quarterly electronic trading volume has equaled or exceeded 90 percent of the contract volume in such product.” Once those levels are reached, NYMEX members are entitled to the payments forever. Heating oil already trades electronically 86.4 percent of the time, while palladium, at 63.7 percent, is the least electronically traded product. There are 816 trading-rights holders at the NYMEX, and 75 percent of them must approve the merger before it becomes official.


The mighty have fallen

Ex-exchange director pleads guilty to fraud

F

or 10 years, Steven Karvellas served the New York Mercantile Exchange (NYMEX) as a director. In April, he pled guilty to charges he defrauded customers making trades in NYMEX products. An investigation conducted by New York prosecutors and

the Commodity Futures Trading Commission (CFTC) found that Karvellas placed his own orders in natural gas products ahead of those of his customers, an illegal technique known as front-running. Floor broker Thomas Maloney and two others pled guilty along with Karvellas, while three others are still pending trial. MANAGED MONEY Karvellas, the owner of Steven J. Karvellas and Co., Top 10 option strategy traders ranked by March 2008 return. a natural gas trading company, was also found to (Managing at least $1 million as of March 31, 2008.) have destroyed order tickets in order to conceal his illegal activities. He admitted to illegal trading March YTD $ under between September 2002 and May 2003 and will Rank Trading advisor return return mgmt. serve five months in prison plus five years probation, 1. Aksel Capital Mgmt (Growth & Income) 26.38 39.87 6.8M and pay $850,000 in fines. 2. Parrot Trading Partners 11.49 17.64 17.4M “In using the trade practice scheme, both Karvellas 3. Censura Futures Mgmt. 10.62 -9.03 54.0M and Maloney deprived their customers of the oppor4. Oxeye Capital Mgmt. (FTSE 100) 10.52 14.49 16.5M tunity to profit,” the CFTC said in a statement. 5. Crescent Bay Capital (Stock Index) 8.78 13.35 1.8M Karvellas and Maloney were both barred from the trading industry for life. Maloney was sentenced to 6. LJM Partners (Neutral S&P Option) 7.04 7.83 171.4M probation and a $75,000 fine, while the two others 7. LJM Fund Ltd 6.91 6.50 8.4M received either jail time or probation. 8. ACE Investment Strat (ASIPC INST) 6.76 -3.87 1.6M In a statement, NYMEX president and CEO James 9. Crescent Bay Capital (BVP) 5.50 15.59 1.0M Newsome said, “Today's action should serve as an 10. ACE Investment Strategists (DPC) 4.72 0.76 4.5M unmistakable notice to our market participants that Source: Barclay Hedge (http://www.barclayhedge.com) NYMEX will not hesitate to work with law enforceBased on estimates of the composite of all accounts or the fully funded subset method. ment authorities, or take whatever steps are otherDoes not reflect the performance of any single account. wise necessary, to protect the integrity of our marPAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. kets.”
24

May 2008 • FUTURES & OPTIONS TRADER

TRADING BASICS

Options order execution Electronic trading has simplified the order-execution process, but it still pays to know what happens after you submit an order BY CHRIS PETERS

FIGURE 1 — FROM ORDER TO EXECUTION

B

In the past, an option order passed through many hands, wasting time and leaving room for error. Now, some electronic platforms can access the floor directly, which eliminates several steps.

efore placing a trade, options traders make several decisions about the underlying market’s direction, timing, and volatility (among other factors). Therefore, when it’s time to place a trade, submitting an order seems like the easiest step in the process. However, you shouldn’t take order execution for granted, because an option order’s journey to get filled includes more steps than other instruments. Unlike stocks that can be traded off the exchange floor, all option orders must be executed on one of the six U.S. options exchanges (see Table 1 for a list). An increasing number of trades are now handled electronically, and no exchange relies solely on physical “open outcry” trading pits anymore. Understanding how an option order gets filled — and how that process has evolved — is an essential part of becoming a successful trader.

The basic steps Although the Internet allows many traders to skip some steps of the order-execution process, option orders still follow a standard route from you to a broker to a market maker and back. Years ago, the process involved several middlemen. Before placing a trade, you first called your broker who relayed the order’s details to a phone clerk on the floor of FUTURES & OPTIONS TRADER • May 2008

an exchange. Brokers chose the exchange on which they thought you would get the best price. Then, a phone clerk handed the order to a runner who took it to a floor broker. At that point, the floor broker tried to fill your order by working with a market maker. Market makers are professional traders who provide liquidity by posting both bid and ask prices for each option. They create both sides of a two-sided market by buying at the bid price, selling at the ask price, and trying to profit from the spread, or difference between them. Let’s look at an example. On March 14, General Electric (GE) traded at $33.76 as its near-the-money, 34-strike March put was $0.67 (bid) and $0.72 (ask). That means market markers were willing to buy the March 34 put at $0.68 and sell it at $0.73. To calculate these prices, market makers first use an option-pricing model such as the Black-Scholes formula to derive an option’s theoretical price. According to this formula, the March 34 put was worth $0.71. If market markers buy it at a bid of $0.68 or sell it at an ask of $0.73, they earn $0.02 or $0.03 for each contract. After buying or selling an option, a market maker tries to continued on p. 26

25

TRADING BASICS continued

hedge their risk by immediately placing an offsetting trade. If there is an imbalance between buyers and sellers, a market maker is required to buy or sell the corresponding orders from his own account to facilitate liquidity and keep the market moving. Market makers often compete with each other on exchange floors by offering different bid-ask prices. Floor broker sometimes work with multiple market makers if one can’t fill a large order from their inventory. After floor brokers fill orders, they hand them back to the runner who returns to the phone clerk. Finally, your broker is notified and you receive a trade confirmation.

Semi-automatic When you submit an order via the Web, you are basically sending an e-mail message to your broker who then passes it along. Just because you trade over the Internet doesn’t mean any steps are eliminated. If, however, an order is placed through a direct-access brokerage firm, it is sent directly to a floor trader’s computer and skips the retail broker, phone clerk, and runner. The floor trader then deals with the market makers, executes the order, and inputs it back into the computer, which gets passed along to you. Figure 1 breaks down the orderexecution process and highlights the steps that can be elim-

inated (in blue). These days, electronic orders can be sent directly to a market maker’s computer or into an exchange’s order book to be matched up with other incoming orders. In the past, a market maker could handle, at most, a few dozen underlying instruments, but now they manage hundreds simultaneously. Most option orders now bypass the pit and trade automatically over electronic exchanges. Only the largest institutional orders go to the floor, where it’s easier to auction off a big order in smaller pieces with discretion. Because large or complex orders are better handled via the openoutcry method, some exchanges host both physical and electronic pits — a “hybrid” system. Table 1 shows a list of the six U.S. options exchanges and how each handles their orders. The basic mechanics of executing options of different underlying instruments remains the same across the board. Unlike stock options, options on futures and indices typically only trade on one exchange. But the process remains similar to the steps shown in Figure 1.

Order routing Ultimately, your broker decides how to route an order, although you sometimes have a choice. Some brokerage

TABLE 1 — U.S. OPTIONS EXCHANGES None of the six U.S. options exchanges rely solely on the open-outcry trading method. But half of them use a hybrid system, which uses open outcry for large, complex orders. Exchange CBOE ISE PHLX PCX / NYSE Arca AMEX BOX

Avg. daily volume (March 2008) 4,647,680 4,244,888 1,938,937 1,811,318 798,762 612,995

Percentage of total 33.0% 30.1% 14.1% 12.8% 5.7% 4.3%

Exchange type Hybrid* Electronic Hybrid* Electronic Hybrid* Electronic

Website http://www.cboe.com http://www.iseoptions.com http://www.phlx.com http://www.nyse.com http://www.amex.com http://www.bostonoptions.com

Total daily volume: 14,099,714 *Combination of physical and electronic trading

26

May 2008 • FUTURES & OPTIONS TRADER

Related reading “Yehuda Belsky: A market maker's perspective” Futures and Options Trader, June 2007. This options trader explains why call spreads may offer better opportunities than put spreads.

firms’ trading platforms show the bid-ask prices of different market makers across different markets. Many brokerages have started using smart routers, which automatically direct orders to specific exchanges based on criteria such as bid-ask spread, order size, the time of the last quote, and the availability of auto-execution. Auto-execution is the fastest way to complete an order and eliminates everyone between you and a market maker. Or this method might even bypass a market maker and match your order with an opposing one. Option trades can be executed automatically if they are less than a certain size, which differs among exchanges. An exchange can also suspend auto-execution, such as in times of increased volatility.


FUTURES & OPTIONS TRADER • May 2008

“Trading the maximum-pain effect” Options Trader, January 2007. We unravel the "mystery" behind market-markers’ tactics before options expire and show how retail traders can benefit. “Trading against the pros” Options Trader, November 2006. Understanding how market makers manage risk may help you get better fills. “Order up: 2007” Active Trader, November 2007. Most traders know the difference between market and limit orders, but there are many other order types. Learn which do what and how to use them to your advantage. You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm.

27

KEY CONCEPTS American style: An option that can be exercised at any time until expiration. Arbitrage: The simultaneous purchase and sale of similar or identical instruments (often in different geographical locations) to take advantage of short-term price discrepancies. For example, gold trades in several major financial centers around the world — New York, London, Paris, Hong Kong, and Tokyo. If gold were trading in New York for $780 per ounce and $782 per ounce in London, you could, in effect, buy gold in New York and immediately sell an equal amount in the London market and profit $2 per ounce. Why would the metal be $2 higher in London? Shortterm supply and demand fluctuations: Perhaps a European jeweler or metal fabricator placed a large order in the London market. This short-term demand may cause the price to rise in London relative to New York or other financial centers. Assign(ment): When an option seller (or “writer”) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. Average directional movement index (ADX): Measures trend strength, regardless of direction. The higher the ADX value, the stronger the trend, whether the market is going up or down. The indicator can be applied to any time frame, although it is typically used on daily charts. Although the ADX concept is straightforward, its calculation is rather lengthy. The indicator was designed by Welles Wilder and is described in detail in his book New Concepts in Technical Trading Systems (Trend Research 1978). Calculation: 1. Calculate the positive or negative directional 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. An inside bar (a bar that trades within the range of the previous bar) has no directional movement, and nei28

The option “Greeks” Delta: The ratio of the movement in the option price for every point move in the underlying. An option with a delta of 0.5 would move a half-point for every 1-point move in the underlying stock; an option with a delta of 1.00 would move 1 point for every 1-point move in the underlying stock. Gamma: The change in delta relative to a change in the underlying market. Unlike delta, which is highest for deep ITM options, gamma is highest for ATM options and lowest for deep ITM and OTM options. Rho: The change in option price relative to the change in the interest rate. Theta: The rate at which an option loses value each day (the rate of time decay). Theta is relatively larger for OTM than ITM options, and increases as the option gets closer to its expiration date. Vega: How much an option’s price changes per a onepercent change in volatility. ther does a bar whose high is above the previous high by the same amount its low is below the previous low. 2. If a bar has positive (negative) directional 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 totals of +DM and -DM by the sum of the true ranges. 5. Calculate the directional index (DX) by taking the absolute value of the difference between the +DI value and the -DI value, dividing that by the sum of the +DI and -DI values, and multiplying by 100. 6. To create the ADX, calculate a moving average of the DX over the same period as the lookback period used throughout the other calculations. Bear call spread: A vertical credit spread that consists of a short call and a higher-strike, further OTM long call in the same expiration month. The spread’s largest potential gain is the premium collected, and its maximum loss is limited to the point difference between the strikes minus that premium.

May 2008 • FUTURES & OPTIONS TRADER

Bear flag: Flags are short-term consolidation patterns. They are sometimes referred to as “continuation patterns” because they are often pauses in price trends and imply the continuation of those trends. Flags are essentially short-tem trading ranges that last approximately three to 15 bars (roughly one to three weeks on a daily chart), although some people argue flags should consist of no more than 10 price bars. A bear flag pattern represents a time when the market is taking a “breather” — pausing before resuming a downtrending move. Bear put spread: A bear debit spread that contains puts with the same expiration date but different strike prices. You buy the higher-strike put, which costs more, and sell the cheaper, lower-strike put. Beta: Measures the volatility of an investment compared to the overall market. Instruments with a beta of one move in line with the market. A beta value below one means the instrument is less affected by market moves and a beta value greater than one means it is more volatile than the overall market. A beta of zero implies no market risk. Black-Scholes formula: A formula developed by Fischer Black, Robert Merton, and Myron Scholes that estimates an option’s value from six variables: underlying price, strike price, days until expiration, implied volatility, dividends, and interest rates. The formula was first published by Robert C. Merton in 1973, and Scholes and Merton received the Nobel Prize in Economics in 1997 for their contributions. For an explanation of the BlackScholes pricing formula, visit http://en.wikipedia.org/wiki/BlackScholes. Box spread: A hedged position in which the profit is determined in advance. A box contains one long call and one short put that share the same strike. Also, the spread contains one short call and one long put that share a FUTURES & OPTIONS TRADER • May 2008

higher strike price. All four options expire at the same time. Bull call spread: A bull debit spread that contains calls with the same expiration date but different strike prices. You buy the lower-strike call, which has more value, and sell the less-expensive, higher-strike call. Bull put spread (put credit spread): A bull credit spread that contains puts with the same expiration date, but different strike prices. You sell an OTM put and buy a less-expensive, lower-strike put. Calendar spread: A position with one short-term short option and one long same-strike option with more time until expiration. If the spread uses ATM options, it is market-neutral and tries to profit from time decay. However, OTM options can be used to profit from both a directional move and time decay. Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price.

open interest in major futures markets. Clearing members, futures commission merchants, and foreign brokers are required to report daily the futures and options positions of their customers that are above specific reporting levels set by the CFTC. For each futures contract, report data is divided into three “reporting” categories: commercial, non-commercial, and non-reportable positions. The first two groups are those who hold positions above specific reporting levels. The “commercials” are often referred to as the large hedgers. Commercial hedgers are typically those who actually deal in the cash market (e.g., grain merchants and oil companies, who either produce or consume the underlying commodity) and can have access to supply and demand information other market players do not. Non-commercial large traders include large speculators (“large specs”) such as commodity trading continued on p. 30

Carrying costs: The costs associated with holding an investment that include interest, dividends, and the opportunity costs of entering the trade. Collar: An options spread with three components — an underlying long position, a short call, and a long put that expires in the same month. It is a conservative, flexible strategy that profits if the underlying trades within a certain range by expiration. The strategy’s goal is to improve a long position’s odds of success by adding low-cost downside protection without limiting potential upside profits excessively. The Commitments of Traders report: Published weekly by the Commodity Futures Trading Commission (CFTC), the Commitments of Traders (COT) report breaks down the 29

KEY CONCEPTS continued advisors (CTAs) and hedge funds. This group consists mostly of institutional and quasi-institutional money managers who do not deal in the underlying cash markets, but speculate in futures on a large-scale basis for their clients. The final COT category is called the non-reportable position category — otherwise known as small traders — i.e., the general public. Covered call: Shorting an out-of-the-money call option against a long position in the underlying market. An example would be purchasing a stock for $50 and selling a call option with a strike price of $55. The goal is for the market to move sideways or slightly higher and for the call option to expire worthless, in which case you keep the premium. Credit spread: A position that collects more premium from short options than you pay for long options. A credit spread using calls is bearish, while a credit spread using puts is bullish. Debit: A cost you must pay to enter any position if the components you buy are more expensive than the ones you sell. For instance, you must pay a debit to buy any option, and a spread (long one option, short another) requires a debit if the premium you collect from the short option doesn’t offset the long option’s cost. Debit spread: An options spread that costs money to enter, because the long side is more expensive that the short side. These spreads can be verticals, calendars, or diagonals. Deep (e.g., deep in-the-money option or deep out-of-the-money option): Call options with strike prices that are very far above the current price of the underlying asset and put options with strike prices that are very far below the current price of the underlying asset. Delivery period (delivery dates): The specific time period during which a delivery can occur for a futures contract. These dates vary from market to market and are determined by the exchange. They typically fall during the month designated by a specific contract - e.g. the delivery period for March T-notes will be a specific period in March. Delta-neutral: An options position that has an overall delta of zero, which means it’s unaffected by underlying price movement. However, delta will change as the underlying moves up or down, so you must buy or sell shares/contracts to adjust delta back to zero. Diagonal spread: A position consisting of options with different expiration dates and different strike prices — e.g., a December 50 call and a January 60 call.

30

Exponential moving average (EMA): The simple moving average (SMA) is the standard moving average calculation that gives every price point in the average equal emphasis, or weight. For example, a five-day SMA is the sum of the most recent five closing prices divided by five. Weighted moving averages give extra emphasis to more recent price action. Exponential moving average (EMA) weights prices using the following formula: EMA = SC * Price + (1 - SC) * EMA (yesterday) where SC is a “smoothing constant” between 0 and 1, and EMA (yesterday) is the previous day’s EMA value. You can approximate a particular SMA length for an EMA by using this formula to calculate the equivalent smoothing constant: SC = 2/(n + 1) where n = the number of days in a simple moving average of approximately equivalent length. For example, a smoothing constant of 0.095 creates an exponential moving average equivalent to a 20-day SMA (2/(20 + 1) = 0.095). The larger n is, the smaller the constant, and the smaller the constant, the less impact the most recent price action will have on the EMA. In practice, most software programs allow you to simply choose how many days you want in your moving average and select either simple, weighted, or exponential calculations. European style: An option that can only be exercised at expiration, not before. Exercise: To exchange an option for the underlying instrument. Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after). Fair value: An option’s theoretical, or “fair,” value is based on six interrelated variables — strike price, price of the underlying market, days until expiration, volatility, interest rate, and dividends. Although many traders simply rely on the standard Black-Scholes pricing model to estimate option values, it’s important to understand how each element may affect an option’s price. An option’s premium has two main parts: Intrinsic value, which represents the amount an option is in-the-money (i.e., the difference between the strike price and the underlying’s current price), and time value, which is often used to describe the combination of the four other May 2008 • FUTURES & OPTIONS TRADER

factors that influence its probability of profit by expiration. For a detailed explanation of the Black-Scholes pricing formula, visit http://en.wikipedia.org/wiki/BlackScholes.

it from trading their own accounts. They supply bids when there may be no other buyers and supply offers when there are no other sellers. In return, they have an edge in buying and selling at more favorable prices.

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

Naked option: A position that involves selling an unprotected call or put that has a large or unlimited amount of risk. If you sell a call, for example, you are obligated to sell the underlying instrument at the call’s strike price, which might be below the market’s value, triggering a loss. If you sell a put, for example, you are obligated to buy the underlying instrument at the put’s strike price, which may be well above the market, also causing a loss. Given its risk, selling naked options is only for advanced options traders, and newer traders aren’t usually allowed by their brokers to trade such strategies.

Intermonth (futures) spread: A trade consisting of long and short positions in different contract months in the same market — e.g., July and November soybeans or September and December crude oil. Also referred to as a futures “calendar spread.” In the money (ITM): A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instrument’s price. Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Leverage: An amount of “buying power” that increases exposure to underlying market moves. For example, if you buy 100 shares of stock, that investment will gain or lose $100 for each $1 (one-point) move in the stock. But if you invest half as much and borrow the other half from your broker as margin, then you control those 100 shares with half as much capital (i.e., 2-to-1 buying power). At that point, if the stock moves $1, you will gain or lose $100 even though you only invested $50 — a double-edged sword. Limit up (down): The maximum amount that a futures contract is allowed to move up (down) in one trading session. Lock-limit: The maximum amount that a futures contract is allowed to move (up or down) in one trading session.

Naked (uncovered) puts: Selling put options to collect premium that contains risk. If the market drops below the short put’s strike price, the holder may exercise it, requiring you to buy stock at the strike price (i.e., above the market). Near the money: An option whose strike price is close to the underlying market’s price. Open interest: The number of options that have not been exercised in a specific contract that has not yet expired. Opportunity cost: The value of any other investment you might have made if your capital wasn’t already in the market. Outlier: An anomalous data point or reading that is not representative of the majority of a data set. Out of the money (OTM): A call option with a strike price above the price of the underlying instrument, or a put option with a strike price below the underlying instrument’s price. Parity: An option trading at its intrinsic value.

Long call condor: A market-neutral position structured with calls only. It combines a bear call spread (short call, long higher-strike further OTM call) above the market and a bull call spread (long call, short higher-strike call). Unlike an iron condor, which contains two credit spreads, a call condor includes two types of spreads: debit and credit. Long-Term Equity AnticiPation Securities (LEAPS): Options contracts with much more distant expiration dates — in some cases as far as two years and eight months away — than regular options.

Physical delivery: The process of exchanging a physical commodity (and making and taking payment) as a result of the execution of a futures contract. Although 98 percent of all futures contracts are not delivered, there are market participants who do take delivery of physically settled contracts such as wheat, crude oil, and T-notes. Commodities generally are delivered to a designated warehouse; t-note delivery is taken by a book-entry transfer of ownership, although no certificates change hands. Premium: The price of an option.

Market makers: Provide liquidity by attempting to profFUTURES & OPTIONS TRADER • May 2008

continued on p. 32

31

KEY CONCEPTS continued

Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. Put ratio backspread: A bearish ratio spread that contains more long puts than short ones. The short strikes are closer to the money and the long strikes are further from the money. 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 the money, but the long lower-strike puts will hedge some (or all) of those losses. If the stock drops well below $40, potential gains are unlimited until it reaches zero. Put spreads: Vertical spreads with puts sharing the same expiration date but different strike prices. A bull put spread contains short, higher-strike puts and long, lower-strike puts. A bear put spread is structured differently: Its long puts have higher strikes than the short puts. Ratio spread: A ratio spread can contain calls or puts and includes a long option and multiple short options of the same type that are further out-of-the-money, usually in a ratio of 1:2 or 1:3 (long to short options). For example, if a stock trades at $60, you could buy one $60 call and sell two same-month $65 calls. Basically, the trade is a bull call spread (long call, short higher-strike call) with the sale of additional calls at the short strike. Overall, these positions are neutral, but they can have a directional bias, depending on the strike prices you select. Because you sell more options than you buy, the short options usually cover the cost of the long one or provide a net credit. However, the spread contains uncovered, or “naked” options, which add upside or downside risk. Simple moving average: A simple moving average (SMA) is the average price of a stock, future, or other market over a certain time period. A five-day SMA is the sum of the five most recent closing prices divided by five, which means each day’s price is equally weighted in the calculation. Strike (“exercise”) price: The price at which an underlying instrument is exchanged upon exercise of an option. Support and resistance: Support is a price level that acts as a “floor,” preventing prices from dropping below that level. Resistance is the opposite: a price level that acts as a “ceiling;” a barrier that prevents prices from rising higher. 32

Support and resistance levels are a natural outgrowth of the interaction of supply and demand in any market. For example, increased demand for a stock will cause its price to rise, creating an uptrend. But when price has risen to a certain level, traders and investors will take profits and short sellers will come into the market, creating “resistance” to further price increases. Price may retreat from and advance to this resistance level many times, sometimes eventually breaking through it and continuing the previous trend, other times reversing completely. Support and resistance should be thought of more as general price levels rather than precise prices. For example, if a stock makes a low of 52.15, rallies slightly, then declines again to 52.15, then rallies again, a subsequent move down to 52 does not violate the “support level” of 52.15. In this case, the fact that the stock retraced once to the exact price level it had established before is more of a coincidence than anything else. Time decay: The tendency of time value to decrease at an accelerated rate as an option approaches expiration. Time spread: Any type of spread that contains short near-term options and long options that expire later. Both options can share a strike price (calendar spread) or have different strikes (diagonal spread). Time value (premium): The amount of an option’s value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as “time decay.” True range (TR): A measure of price movement that accounts for the gaps that occur between price bars. This calculation provides a more accurate reflection of the size of a price move over a given period than the standard range calculation, which is simply the high of a price bar minus the low of a price bar. The true range calculation was developed by Welles Wilder and discussed in his book New Concepts in Technical Trading Systems (Trend Research, 1978). True range can be calculated on any time frame or price bar — five-minute, hourly, daily, weekly, etc. The following discussion uses daily price bars for simplicity. True range is the greatest (absolute) distance of the following: 1. Today’s high and today’s low. 2. Today’s high and yesterday’s close. 3. Today’s low and yesterday’s close. Average true range (ATR) is simply a moving average of the true range over a certain time period. For example, the May 2008 • FUTURES & OPTIONS TRADER

five-day ATR would be the average of the true range calculations over the last five days. Variance and standard deviation: Variance measures how spread out a group of values are — in other words, how much they vary. Mathematically, variance is the average squared “deviation” (or difference) of each number in the group from the group’s mean value, divided by the number of elements in the group. For example, for the numbers 8, 9, and 10, the mean is 9 and the variance is: {(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = 0.667 Now look at the variance of a more widely distributed set of numbers: 2, 9, and 16: {(2-9)2 + (9-9)2 + (16-9)2}/3 = (49 + 0 + 49)/3 = 32.67 The more varied the prices, the higher their variance — the more widely distributed they will be. The more varied a market’s price changes from day to day (or week to week, etc.), the more volatile that market is. A common application of variance in trading is standard deviation, which is the square root of variance. The standard deviation of 8, 9, and 10 is: .667 = .82; the standard deviation of 2, 9, and 16 is: 32.67 = 5.72.

Vertical spread: A position consisting of options with the same expiration date but different strike prices (e.g., a September 40 call option and a September 50 call option). Volatility: The level of price movement in a market. Historical (“statistical”) volatility measures the price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period — e.g., the past 20 days. Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums. The higher the implied volatility, the higher the option premium. Volatility skew: The tendency of implied option volatility to vary by strike price. Although, it might seem logical that all options on the same underlying instrument with the same expiration would have identical (or nearly identical) implied volatilities. For example, deeper in-the-money and out-of-the-money options often have higher volatilities than at-the-money options. This type of skew is often referred to as the “volatility smile” because a chart of these implied volatilities would resemble a line curving upward at both ends. Volatility skews can take other forms than the volatility smile, though.

Three good tools for targeting customers . . .

— CONTACT — Bob Dorman

Allison Ellis

Mark Seger

Ad sales East Coast and Midwest [email protected] (312) 775-5421

Ad sales West Coast and Southwest [email protected] (626) 497-9195

Account Executive [email protected] (312) 377-9435

FUTURES & OPTIONS TRADER • May 2008

33

FUTURES & OPTIONS CALENDAR GLOBAL ECONOMIC CALENDAR May 1

Legend CPI: Consumer price index ECI: Employment cost index First delivery day (FDD): The first day on which delivery of a commodity in fulfillment of a futures contract can take place. First notice day (FND): Also known as first intent day, this is the first day a clearinghouse can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillment of a futures contract. The clearinghouse also informs the seller.

2

3 4 5

FOMC: Federal Open Market Committee GDP: Gross domestic product ISM: Institute for supply management LTD: Last trading day; the first day a contract may trade or be closed out before the delivery of the underlying asset may occur.

MAY 2008 27 28 29 30

1

2

3

4

8

9

10

5

6

7

11 12 13 14 15 16 17 18 19 20 21 22 23 24

JUNE 2008 1

2

3

4

5

6

8

9

10 11 12 13 14

7

29 30

1

2

3

4

The information on this page is subject to change. Futures & Options Trader is not responsible for the accuracy of calendar dates beyond press time.

34

5

April unemployment LTD: May pork belly options (CME); June cocoa options (ICE) FND: May propane and heating oil futures (NYMEX)

April ISM non-manufacturing index FND: May pork belly futures (CME)

28

April durable goods LTD: June natural gas and gasoline futures (NYMEX); May aluminum, copper, palladium, platinum, silver, and gold futures (NYMEX)

29 30

Q1 GDP (prelim)

FDD: May heating oil futures (NYMEX); May orange juice futures (ICE) LTD: June sugar and coffee options (ICE); May orange juice futures (ICE)

April retail sales April CPI LTD: May oats, rice, wheat, corn, soybean, and soybean products futures (CBOT); May lean hog futures and options (CME); May cocoa futures (ICE)

15

LTD: June crude oil options (NYMEX); May lumber futures (CME)

16

LTD: All May equity options; May S&P options (CME); May Nasdaq options (CME); May Russell options (CME); May Dow Jones options (CBOT); June orange juice options (ICE) FND: May lumber futures (CME) FDD: May lumber futures (CME)

15 16 17 18 19 20 21 22 23 24 25 26 27 28

LTD: June T-bond options (CBOT)

LTD: May cotton futures (ICE)

25 26 27 28 29 30 31

April PPI LTD: June crude oil futures (NYMEX)

23 24 25 26 27

7 8

10 11 12 13 14

LTD: May coffee futures (ICE)

LTD: June platinum options (NYMEX)

FDD: May propane futures (NYMEX); May pork belly futures (CME))

9

17 18 19 20 21 22

6

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

April ISM manufacturing index FND: May orange juice and sugar futures (ICE) FDD: May natural gas, gasoline, and crude oil futures (NYMEX); May aluminum, copper, platinum, palladium, silver, and gold futures (NYMEX); May oat, rice, wheat, corn, soybean, and soybean product futures (CBOT); May cocoa, sugar, and coffee futures (ICE); May cotton futures (ICE)

MAY/JUNE MONTH

LTD: May feeder cattle futures and options (CME) FND: June crude oil futures (NYMEX)

LTD: June natural gas, gasoline, and heating oil options (NYMEX); June aluminum, copper, silver, and gold options (NYMEX); May pork belly futures (CME)

LTD: June propane and heating oil futures (NYMEX) FND: June T-bond futures (CBOT); June natural gas and gasoline futures (NYMEX); June aluminum, copper, platinum, palladium, silver, and gold futures (NYMEX)

31 June 1 FDD: June gasoline, natural gas, and crude oil futures (NYMEX)

2

May ISM FDD: June T-bond futures (CBOT); June aluminum, copper, platinum, palladium, silver, and gold futures (NYMEX)

3

FND: June propane and heating oil futures (NYMEX)

4 5 6

FDD: June propane futures (NYMEX) May unemployment LTD: June currency options (CME); June live cattle options (CME); July cocoa options (ISE) May 2008 • CURRENCY TRADER

EVENTS Event: 30th Annual Law & Compliance Division

Event: Real Trading with Dan Sheridan

Workshop

Date: July 24

Date: May 7-9

Location: CBOE Options Institute, Chicago

Location: Renaissance Harborplace Hotel, Baltimore

For more information: Call (877) THE-CBOE

For more information: Call (202) 466-5460 Event: TradeStation’s Two Day Futures Symposium Event: Capital Markets BootCamp

Date: June 26-28

Date: May 12-13

Location: Wyndham Drake, Oak Brook, Ill.

Location: New York City

For more information: Call (800) 808-3241

For more information: http://www.fmwonline.com Event: Forex Trading Expo Event: The Options Intensive Two-day Seminars

Date: Sept. 12-13

Dates: May 22, Oct. 23, Dec. 4

Location: Mandalay Bay Resort & Casino, Las Vegas

Location: CBOE Options Institute, Chicago

For more information: http://www.tradersexpo.com

For more information: Call (877) THE-CBOE Event: Traders Expo Las Vegas Event: DiscoverOptions’ “High Probability” Options

Date: Nov. 19-22

Seminar

Location: Mandalay Bay Resort & Casino, Las Vegas

Date: May 29

For more information: http://www.tradersexpo.com

Location: Maison Dupuy Hotel, New Orleans, La. For more information: http://www.DiscoverOptions.com Event: Third Annual Capital Markets Compliance Conference: Harnessing Technology for Compliance

Date: June 4-5 Location: New York City For more information: http://www.fmwonline.com Event: Electronic Trading: Securities Industry Structure and Trends

Date: June 11-12 Location: London For more information: http://www.fmwonline.com Event: The Options Initiative Two-day Seminars Dates: July 17, Nov. 20 Location: CBOE Options Institute, Chicago For more information: Call (877) THE-CBOE Event: Traders Expo Los Angeles Date: June 18-21 Location: Ontario Convention Center For more information: http://www.tradersexpo.com

FUTURES & OPTIONS TRADER • May 2008

35

NEW PRODUCTS AND SERVICES
Eurex is set to introduce 13 new equity options on Belgian, Dutch, French, and Spanish underlyings. The Belgian equity options suite will be extended with six new options on Belgacom S.A., Delhaize Group S.A., INBEV S.A., KBC NV, UCB S.A., and Umicore S.A. The French segment will grow by two options on Essilor and Unibail-Rodamco SIIC, and the Dutch segment by an option on Corio N.V. Four new Spanish options will be based on Acerinox S.A., ACS, Banco Popular Español S.A., and Industria de Diseño Textil S.A. The contract specifications of the new options are analogous to existing equity options. As of June 1, the new options will also be included in the Eurex market-making program in place for all existing equity options. In addition, Eurex expanded its equity index derivatives with futures and options on the DivDAX index. In offering the additional index product, Eurex continues to expand its German index derivatives product range, currently consisting of DAX, MDAX, and TecDAX futures and options. The DivDAX index, introduced by Deutsche Börse in March 2005, comprises 15 DAX constituents with the highest dividend yield. Components are capped at 10 percent, and the index is weighted according to market capitalization. The contract size of the DivDAX futures is around a factor of six times smaller than the DAX futures. Eurex launched five other German equity options on stocks from the MDAX index as of March 25. The new options are based on Bilfinger Berger, Fraport, Klöckner & Co., SGL Carbon, and Wacker Chemie, and are included in Eurex’s market-making program, giving market makers an incentive to quote these equity options on a permanent basis to ensure liquid screen-based trading. The contract specifications resemble existing equity options.
IntercontinentalExchange and globalCOAL announced an agreement to develop and launch two new coal futures contracts at ICE Futures Europe. The contracts will consist of financially settled NEWC coal futures to be launched mid-2008, and physically settled ARA coal futures to be launched later in the year. The globalCOAL NEWC index is based on bids, offers, and trades on the globalCOAL trading platform with delivery in Newcastle, Australia, which is the leading reference point for over-the-counter trading in Asian coal markets. ICE and globalCOAL will also work with the market to develop a physically delivered coal futures contract with delivery points in the Antwerp-Rotterdam-Amsterdam (ARA) region, the main European hub for oil and coal trading. The new contracts will be complementary to the existing financially settled coal futures contract currently listed by ICE Futures Europe, API2 and API4, as published in Argus/McCloskey’s Coal Price Index Report.
eSignal announced the release of Nasdaq LiveQuotes Pro, an upgrade to Nasdaq LiveQuotes. Nasdaq LiveQuotes Pro is a browser-based, professional-level workstation that requires no software download and features customizable charting, streaming real-time market data from more than 125 exchanges worldwide, Nasdaq Level II access, custom workspaces, detailed quotes windows, wide-ranging business news feeds, and comprehensive market research and analysis tools. Users can examine detailed quotes and global data on all asset classes. 36

Searchable news is available from Dow Jones, AFX, COMTEX, and other news providers. The product also includes intraday and historical charts with studies and drawing tools, dynamic time-and-sales viewing, and a Market Depth order book with bid/ask quotes from Nasdaq TotalView, NYSE OpenBook, and others. LiveQuotes Pro also includes evaluations and corporate actions from Interactive Data Pricing and Reference. For additional information, visit http://www.esignal.com or call 800.833.1228.
NinjaTrader, LLC released an enhanced version of their NinjaTrader trading platform. This release strengthens NinjaTrader’s feature set while remaining free to use for advanced charting, market analytics, strategy development, and trade simulation. There are over 160 enhancements, including: TD Ameritrade equities support; the addition of Interactive Brokers, MB Trading, and IQFeed for forex trading and analysis; event-driven strategy development; charting improvements including range bars, candlestick pattern recognition, and enhanced drawing tools; the ability to create, save, and work with multiple workspaces simultaneously; and more third party add-ons. NinjaTrader 6.5 is available for download from http://www.ninjatrader.com.
Saxo Bank has launched a free educational Web site, www.saxoeducation.com, to facilitate a better understanding of the fundamentals of the online forex markets. The initiative was developed in response to the popularity and impressive growth of online retail forex trading. The site provides flexible and comprehensive learning materials and is designed to help those who want to successfully manage their own finances and trading needs. A variety of learning methods are offered, including webinars, videos, a course curriculum, and offline regional seminars. The site offers a thorough overview of all aspects of online trading and caters to all levels of expertise. Market instruments and investment tools are explained in detail alongside guidance notes on creating complex trading strategies. Participants can decide their own starting point and gain an advanced knowledge of online trading. Initially, Saxo Bank will offer education in forex trading, but courses on stocks, futures, and portfolio management will be added. Online tutorials will be offered in multiple languages, starting with English.
The new Million Dollar Challenge board game (two to

four players, ages 12 and up) features the teachings of Larry Williams, with contributions from Jake Bernstein, Tom DeMark, and Welles Wilder. The game promotes organized decision making by utilizing aspects of technical analysis in the game play. The board game equips players with the basics before advancing them onto the Million Dollar Challenge, where they compete for $1,000,000. (Although the prize is not monetary, the bragging rights are priceless.) For more information, visit http://www.thehalllight.com. Note: The New Products and Services section is a forum for industry businesses to announce new products and upgrades. Listings are adapted from press releases and are not endorsements or recommendations from the Active Trader Magazine Group. E-mail press releases to [email protected]. Publication is not guaranteed. May 2008 • FUTURES & OPTIONS TRADER

FUTURES TRADE JOURNAL Greed results in bad money thrown after good. TRADE Date: Monday, March 31. Entry: Short May mini crude oil futures (QMK08) at 104.90. Reasons for trade/setup: On March 17, May futures peaked to a new high above 110.00 and tumbled as low as 101.80 the same day. The subsequent rally off the March 20 low of 98.60 took oil back above 108.00 on March 27, but the market closed lower and continued to sag the next day. Believing the March 27 high represented an unsuccessful challenge to the March 17 high, we went short on March 31 as an intraday sell-off accelerated. We expect a move to challenge the March 20 low. Initial stop: 109.61, which is approximately 1.40 above the March 27 high.

Source: TradeStation

Initial target: 99.10, which is 0.50 above the March 20 low. Take partial profits and lower stop to protect remainder of position.

RESULT Exit: 100.875 (initial position); 105.675 (one-third of reestablished position); 112.475 (two-thirds of re-established position). Profit/loss: +4.025 (initial position); +0.225 (one-third of re-established position); -6.575 (one third of re-established position); -11.875; (one-third of re-established position). Trade executed according to plan? No. Outcome: The Trade Summary table shows we added on to this position in the worst way possible, and destroyed an initially profitable trade. The market dropped so fast after the initial entry, we decided to cash out with a 4-point profit before the day ended. That should have been the end of the story. The next day price dropped to 99.575 before rallying back above the century mark. Kicking ourselves for exiting pre-

maturely when it appeared the market would not be able to remain above support, we re-entered at 100.60. The session closed a little above our entry price. The next day the market screamed back above $105.00, and instead of taking our lumps, we dug in our heels, convinced oil’s dance above $100 was over for the near future: We tripled the size of the short position at 105.90, although we thought better of it and exited one-third of the position on 105.675 for a scratch trade. The chart tells the rest of the story. Oil marched higher, and instead of limiting the damage we kept waiting for the market to bail us out — convincing ourselves every intraday down swing was the beginning of a significant reversal. Basically, after the initial big profit, we decided — like gamblers — we were going to parlay the profits into something really big. Greed, lack of discipline, stubbornness — you always have to be on guard.
Note: Initial targets for trades are typically based on things such as the historical performance of a price pattern or trading system signal. However, individual trades are a function of immediate market behavior; initial price targets are flexible and are most often used as points at which a portion of the trade is liquidated to reduce the position’s open risk. As a result, the initial (pre-trade) reward-risk ratios are conjectural by nature.

TRADE SUMMARY Date

Contract

Entry

Initial stop

Initial target

IRR

Exit

Date

P/L

LOP

LOL

Trade length

3/31/08 4/1/08 4/3/08

QMK08

104.90 100.60 105.90

109.61

99.10

1.23

100.875 112.475 (1/3rd) 105.675 (1/3rd) 112.475 (1/3rd)

4/1/08 4/14/08 4/4/08 4/14/08

+4.025 (3.8%) -11.875 (11.8%) +0.225 (0.2%) -6.575 (6.2%)

5.325 — — 2.70

-0.275 -11.875 — -6.575

1 day 10 days — 7 days

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade). 38

May 2008 • FUTURES & OPTIONS TRADER

OPTIONS TRADE JOURNAL

An analyst upgrade of JPMorgan Chase triggers a winning bull call spread.

TRADE Date: Tuesday, March 11.

ing much higher. In addition, the broad U.S. market indices jumped roughly 2.1 percent at the open, a strong bounce

Market: Options on JPMorgan Chase (JPM).

after dropping to new monthly lows on March 10.

Entry: Buy 2 JPM April 37.50 call for $3.03.

April 37.5/40 bull call spread to profit from this bullish pat-

When JPMorgan Chase fell below its open, we entered an Sell 2 JPM April 40 call for $1.78.

tern. We bought April 37.50 calls for $3.03 each and sold April 40 calls for $1.78 each when JPM traded at $38.50 at

Reasons for trade/setup: JPMorgan Chase (JPM)

11:30 a.m. ET.

jumped 5.3 percent after investment bank Fox-Pitt Kelton

The goal was to limit risk without giving up too much

upgraded it before the open on March 11. Historical

potential profit. The spread’s price of $1.25 was roughly

research shows Dow components such as JPM continued to

$0.10 more than its fair value; the reward-risk ratio was 1:1,

climb for two days after analyst upgrades, even after open-

meaning each spread risked $1.25 to earn $1.25. Figure 1 shows the April bull call

FIGURE 1 — RISK PROFILE — BULL CALL SPREAD

spread’s possible gains and losses on

This bull call spread will profit if JPMorgan Chase trades above $38.75 by April 19 expiration. The position will earn $250 if JPM closes above $40 at expiration, but it could lose the same amount if the stock falls below $37.50.

three dates: trade entry (March 11, dotted line), halfway to expiration (March 31, dashed line), and expiration (April 19, solid line). If JPMorgan Chase rallies 3.9 percent to $40 at expiration, the trade will gain $2.50; however, much of the trade’s profit will emerge in the final two weeks before expiration as the calls lose their time value. Therefore, this spread may not be the best way to profit from a shortterm price move. Despite this caveat, we plan to hold the spread until tomorrow’s close. Initial stop: Exit trade if spread’s value drops to $0.65 from $1.25.

Source: OptionVue

40

Initial target: Hold two days. May 2008 • FUTURES & OPTIONS TRADER

FIGURE 2 — A QUICK BOUNCE We entered an April bull call spread on JPMorgan Chase after it was upgraded by Fox-Pitt before March 11’s open. Although the spread made money, simply buying calls would have been more profitable.

RESULT Outcome: After we entered the trade, JPMorgan Chase sank another 3.5 percent, but the position lost just $0.40 by midday

(see

Figure

2).

Fortunately, JPM rebounded in the afternoon to close 0.94 percent above its open. On March 12, the market continued to climb, rising 3.6 per-

Source: eSignal

cent to $40.23 by 11 a.m. As JPMorgan Chase rallied that morning, we entered a limit order of $1.50 per spread, which was filled around lunchtime. Admittedly, a gain of $0.25

TRADE SUMMARY

Entry date:

Tuesday, March 11, 2008

per spread (5 percent) is modest, and we could

Underlying security:

have earned twice that amount by simply buying

Position:

ITM calls without placing a vertical spread.

2 long April 37.50 calls

Although we chose the wrong position, JPM still moved in the right direction, and we sold at a weekly high.
TRADE STATISTICS

JPMorgan Chase (JPM) Bull call spread -$6.06

2 short April 40 calls

$3.56

Initial capital required:

$962

Initial stop:

Exit if spread’s value drops in half

Initial target:

Close spread at tomorrow’s close

Date:

Entry date

Exit date

Initial daily time decay:

0.42

Delta:

33.10

30.98

Trade length (in days):

2

Gamma:

-0.22

-1.79

P/L:

Theta:

-0.42

-0.14

LOP:

$50

Vega:

0.11

-0.68

LOL:

-$40

Probability of profit:

48%

57%

Breakeven point:

40.42

40.32

FUTURES & OPTIONS TRADER • May 2008

$50 (5 percent)

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

41

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