FOT200912

December 2009 • Volume 3, No. 12

IMPROVING STRATEGY PERFORMANCE with money management p. 6 BETTER BREAKOUT trading p. 10

OPTIONS STRATEGIES: Gamma scalping p. 12 PLAYING RESISTANCE in treasuries p. 28 TRADING THE parabolic SAR with credit spreads p. 17 COMMERCIAL TRADERS forego gold rush p. 21

CONTENTS

Options Trading System Lab Parabolic SAR with credit spreads . . . .17 Trading credit spreads when this indicator changes direction. By Steve Lentz and Jim Graham

Futures & Options Calendar . . . . . . . . . . . .19 Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .5

New Products and Services . . . . . . . . . . . . .20

Trading Strategies

Futures & Options Watch:

Trading with maximum portfolio risk . . . .6

COT extremes . . . . . . . . . . . . . . . . . . . . . . .21

Using a dynamic position-sizing approach turns a

A look at the relationship between

so-so system into a significant winner.

commercials and large speculators in all 45 futures markets.

Tuning up the Turtle . . . . . . . . . . . . . . . . .10 After two decades, traders are still intrigued by

Options Watch . . . . . . . . . . . . . . . . . . . . . .21

the trend-following strategy followed by the

Vanguard Value ETF components

Turtles in the 1980s. Does it still work? By Anthony Garner

Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .22 Momentum, volatility, and volume

The options straddle battle . . . . . . . . . . .12

statistics for futures.

Can two traders succeed if they make completely opposite bets on market volatility? By Dan Keegan

continued on p. 4

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December 2009 • FUTURES & OPTIONS TRADER

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CONTENTS

Options Radar . . . . . . . . . . . . . . . . . . . . . . . . .23 Notable volatility and volume in the options market.

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .24 References and definitions.

Managed Money . . . . . . . . . . . . . . . . . . . . .25 Top 10 option strategy traders ranked by

Futures Trade Journal . . . . . . . . . . . . . . .28 Resisting the temptation to fade resistance.

August 2009 return.

Options Trade Journal . . . . . . . . . . . . . . .29 Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26

Trading gaps in a range-bound holiday market.

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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December 2009 • FUTURES & OPTIONS TRADER

CONTRIBUTORS CONTRIBUTORS

A publication of Active Trader ®

For all subscriber services: www.futuresandoptionstrader.com

Editor-in-chief: Mark Etzkorn [email protected]

 After Oxford University, Anthony Garner spent a few formative years as a solicitor with Slaughter and May, a London commercial law practice. He joined Swiss Bank Corporation International in the mid-1980s and spent several years as an investment analyst, with postings in Tokyo, Hong Kong, Singapore, and Zurich. He left conventional employment in 1995 and began working for himself. Garner now designs, tests, and trades simple mechanical investment strategies. He recently published A Practical Guide to ETF Trading Systems (Harriman House). Together with his colleague Roeland Phillippe, Garner provides Zurich-based fund manager IFIT Advisory AG with mechanical trading strategies. The firm uses Garner’s strategies in its Cardio Angels Fund.  Dion Kurczek ([email protected]) is a private trader, software engi-

Managing editor: Molly Goad [email protected] Senior editor: David Bukey [email protected] Contributing writers: Keith Schap, Chris Peters [email protected] Editorial assistant and webmaster: Kesha Green [email protected] 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 Chee [email protected] Classified ad sales: Mark Seger [email protected]

Volume 3, Issue 12. Futures & Options Trader is published monthly by TechInfo, Inc., 161 N. Clark St., Suite 4915, Chicago, IL 60601. Copyright © 2009 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Futures & Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote, or in any way imply the effectiveness of any trading system, strategy, or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

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neer and trading system researcher. In 2000 he founded Wealth-Lab Inc. and launched an interactive trading system development laboratory on the Web (www.wealth-lab.com). He is currently vice president of Wealth-Lab Product Development at Fidelity Investments.  Volker Knapp has been a trader, system developer, and researcher for more than 20 years. His diverse background encompasses positions such as German National Hockey team player, coach of the Malaysian National Hockey team, and president of VTAD (the German branch of the International Federation of Technical Analysts). In 2001, he became a partner in Wealth-Lab Inc. (www.wealth-lab.com), which he still runs.

 Dan Keegan is from Rochester, New York and earned an economics degree from Marquette University in 1977. After graduation, Keegan moved to Chicago and soon began working at the Chicago Board Options Exchange (CBOE). The CBOE was only four years old when Keegan began working at a series of several jobs both on and off the trading floor. In 1982, Keegan began trading on the CBOE floor with backing from legendary adventurer Steve Fossett who made his fortune backing young traders like Keegan. After more than 20 years as an independent floor trader, Keegan has become an options educator and advisor. He frequently guest lectures in options at Marquette University, is an advisor for i2i Analytics, and a regular contributor to financial trade publications. Keegan is the co-founder and director of options for the Chicago School of Trading. He and his wife Lesly live in Hinsdale, Ill. with their three children.  Jim Graham ([email protected]) is the product manager for OptionVue Systems and a registered investment advisor for OptionVue Research.

 Steve Lentz ([email protected]) is a well-established options educator and trader and has spoken all over the U.S., Asia, and Australia on behalf of the CBOE’s Options Institute, the Options Industry Council, and the Australian Stock Exchange. As a mentor for DiscoverOptions.com, he teaches select students how to use complex options strategies and develop a consistent trading plan. Lentz is constantly developing new strategies on the use of options as part of a comprehensive profitable trading approach. He regularly speaks at special events, trade shows, and trading group organizations. December 2009 • FUTURES & OPTIONS TRADER

TRADING STRATEGY STRATEGIES OPTIONS LAB

Trading with maximum portfolio risk A basic price pattern with mediocre results when tested on a single-contract basis takes off when a dynamic money-management regime is introduced. FIGURE 1 — SAMPLE TRADES

Note: A version of this article originally appeared in the November 2003 issue of Active Trader magazine.

This cross section of long and short trades in natural gas (NG) illustrates how the system rides short trends nicely, but exits at the first sign of a reversal.

he two-bar breakout (2BB) system attempts to capture short trends by going long or short based on the behavior of the two most recent price bars. It trades frequently and has a very brief average holding period — typically one or two bars on average (six or seven bars when a good trend move materializes). Also, it uses a very tight stop to limit losses. Many traders would likely be skeptical that such a basic price pattern could produce useful results. However, such traders might overlook the role money Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com) management — specifically, adjusting the number of contracts accordb. the high is greater than the previous bar’s high; ing to current account equity — can play in making the c. the close is greater than the open. most of a strategy. 2. Cover short using a trailing stop at the current The 2BB essentially looks for a reversal of the immedibar’s high. ate directional momentum, buying if price exceeds yesterday’s high if yesterday was a down day, and selling if Figure 1 shows sample trades in natural gas (NG). The price falls below yesterday’s low if yesterday was a down system was relatively active, triggering around 20 trades day. The rules are: during this roughly two-month period. Losing trades are stopped out quickly. Long trades: To start, we’ll test the system trading only one contract 1. Go long with a stop order on the next bar per position, then evaluate other position-sizing strategies (at the current high plus one tick) if: later in the article. The initial account equity was set to $1 a. the low is less than the previous bar’s low; million, and $20 was deducted per round-turn trade for b. the high is less than the previous bar’s high; slippage and commissions. Testing was conducted on c. the close is less than the open. daily data on the following 19 markets: DAX30 (AX), corn Exit long using a trailing stop at the current bar’s low. (C), crude oil (CL), German bund (DT), Eurodollar (ED), Eurocurrency (FX), gold (GC), copper (HG), Japanese yen Short trades: (JY), coffee (KC), live cattle (LC), lean hogs (LH), Nasdaq 4. Go short with a stop order on the next bar 100 (ND), natural gas (NG), soybeans (S), sugar (SB), sil(at the current low minus one tick) if: ver (SI), S&P 500 (SP) and 10-year T-notes (TY). The test a. the low is greater than the previous bar’s low;

T

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December 2009 • FUTURES & OPTIONS TRADER

FIGURE 2 — STATIC POSITION SIZE EQUITY CURVE

spanned September 1993 until December 2002.

Trading one contract per market produced a very low-key equity curve. However, both the long and short sides of the system were profitable.

Fixed position test results The system returned a 45-percent profit over the test period, but was somewhat hobbled by the one-contract-per-trade position-sizing rule and the large starting capital in the test account. As a result, the system sat in cash for most of the test period. Nonetheless, the equity curve showed steady increases in both the long and the short sides of the system (Figure 2). Another interesting characteristic of the equity curve is that on three occasions (1995, 1998, and 2002) the account ratcheted up sharply, followed by longer periods of much more moderate volatility. Because the system traded one contract per trade, very large markets have a far greater impact on the overall results than small ones. Although the system’s annualized return over the test period was a meager 3.93 percent, the maximum drawdown was only -6.56 percent (Figure 3). Once again, the very conservative position sizing limited the system’s potential during the test run. Let’s see if using a more dynamic position-sizing approach might extract more value from the trade rules.

Dynamic position sizing with maximum portfolio risk

TABLE 1 — ADJUSTING THE RISK LEVEL Reducing the risk per trade also decreased the system’s maximum drawdown. Maximum risk (%)

APR (%)

Net profit (%)

Maximum drawdown (%)

1.00 28.65 1,052.00 -30.82 One of the most important aspects — some would argue the most important aspect — of futures trading is position siz0.75 22.82 635.00 -27.84 ing. Intelligent position sizing can produce much0.50 14.95 286.00 -23.89 improved returns even on simple trend-following systems. 0.25 5.65 70.00 -13.14 One approach is called “maximum portfolio risk,” which establishes the position size so if the initial stop-loss is hit, the amount of money lost will FIGURE 3 — DRAWDOWN equal a certain percentage of the total account The average drawdown was -3-percent and the maximum drawdown was equity. only -6 percent. A second test of the two-bar breakout system used a maximum portfolio risk level of 1 percent, along with a filter that required the number of contracts to not exceed 1 percent of the total trading volume for that day. Finally, two ticks of slippage were added to both the entry and the exits for each trade. Figure 4 shows the results of this test. The difference between it and Figure 2 is clear. The equity curve’s ascent is much sharper, although also more volatile, and the ending profit much higher. However, in this case the increased reward seems worth the higher risk. continued on p. 8

FUTURES & OPTIONS TRADER • December 2009

7

TRADING STRATEGIES

FIGURE 4 — DYNAMIC POSITION SIZE EQUITY CURVE

Table 1 shows the relationship between maximum risk, annualized return, and maximum drawdown. Net profit increased to an annual rate of 28.65 percent, but maximum drawdown also increased dramatically to -30.82 percent. However, the system still boasts a healthy recovery factor (net profit/maximum drawdown) of 2.58. The drawdown can be reduced by reducing the maximum portfolio risk.

Normalizing the position size for all contracts by risking 1 percent of account equity increased returns significantly.

Sizing matters up An intelligent position sizing strategy can help minimize losses and extract the full potential out of the strategy. Although the trade setup only uses the most recent two bars of market data, it proved to be robust — and quite profitable when combined with dynamic position sizing.  —Submitted by Vetri Vel —Compiled by Dion Kurczek and Volker Knapp of Wealth-Lab Inc. For information on the author see p. 5. STRATEGY SUMMARY LEGEND: Net profit — Profit at end of test period, less commission • Exposure — The area of the equity curve exposed to long or short positions, as opposed to cash • Profit factor — Gross profit divided by gross loss • Payoff ratio — Average profit of winning trades divided by average loss of losing trades • Recovery factor — Net profit divided by max. drawdown • Max. DD (%) — Largest percentage decline in equity • Longest flat days — Longest period, in days, the system is between two equity highs • No. trades — Number of trades generated by the system • Win/Loss (%) — The percentage of trades that were profitable • Avg. trade — The average profit/loss for all trades • Avg. winner — The average profit for winning trades • Avg. loser — The average loss for losing trades • Avg. hold time — The average holding period for all trades • Avg. hold time (winners) — The average holding time for winning trades • Avg. hold time (losers) — The average holding time for losing trades • Max. consec. win/loss — The maximum number of consecutive winning and losing trades

Profitability

Trade statistics

Net profit:

$453,934.00

Net profit:

45.39%

Exposure:

1.86%

No. trades: Win/loss: Avg. gain/loss:

Profit factor:

1.21

Avg. hold time:

Payoff ratio:

1.77

Avg. profit (winners):

Recovery factor:

4.67

Avg. hold time (winners):

Drawdown

Avg. loss (losers):

Max. DD: Longest flat days:

4,884 38.74% 0.08% 2.44 2.08% 3.78 -1.18%

-6.56%

Avg. hold time (losers):

1.60

388

Max. consec. win/loss:

10/14

STRATEGY SUMMARY (2% RISK)

8

Avg. return

Sharpe ratio

Best return

Worst return

Percentage profitable periods

Max. Max. consec. consec. profitable unprofitable

Weekly

0.08%

0.70

7.90%

-3.11%

49.11%

Monthly

0.33%

0.77

7.02%

-3.24%

55.93%

7

5

Quarterly

0.97%

0.76

10.42%

-3.13%

65.00%

7

2

Annually

4.01%

0.58

20.20%

-2.68%

70.00%

6

2

7

6

LEGEND: Avg. return — The average percentage for the period • Sharpe ratio — Average return divided by standard deviation of returns (annualized) • Best return — Best return for the period • Worst return — Worst return for the period • Percentage profitable periods — The percentage of periods that were profitable • Max. consec. profitable — The largest number of consecutive profitable periods • Max. consec. unprofitable — The largest number of consecutive unprofitable periods

December 2009 • FUTURES & OPTIONS TRADER

TRADING STRATEGIES

Tuning up the turtle After two decades, traders are still intrigued by the trend-following strategy followed by the Turtles in the 1980s. This preview of an article in the February 2009 issue of Active Trader tests their strategy and suggests how to improve it. BY ANTHONY GARNER TABLE 1 — MARKETS TRADED BY TURTLES o markets change? Is it necessary to undertake continued research and The original trend-following strategy traded by the Turtles included 21 development and adapt a trend-folfutures markets. This test replaces the Deutsche mark and French franc with the Euro and excludes the 90-day T-bill contract. lowing system to maintain its profitability over the years? Market To attempt to answer these questions, the folBonds: 30-year T-bonds (US), 10-year T-note (TY), Eurodollar lowing study tracks the strategy of the “Turtles,” a (ED) group trained by legendary traders Richard Softs: Coffee (KC), cocoa (CC), sugar #11 (SB), cotton (CT) Dennis and Bill Eckhart in the 1980s. The Turtles Currencies: Swiss franc (SF), Euro (EC), British pound (BP), were used to conduct an experiment about Japanese yen (JY), Canadian dollar (CD) whether it was possible to teach people to become Stock indices: S&P 500 (SP) successful traders. Metals: Gold (GC), silver (SI), copper (HG) One trading system salesmen recently argued Energy: Crude oil (CL), unleaded gas (RB), heating oil (HB) that it is “nonsense” and a “specious argument” to Source: Way of the Turtle: The Secret Methods that Turned Ordinary People into suggest trend-following rules must adapt to Legendary Traders (McGraw-Hill, 2007). changing market conditions. Others argue a trend-following FIGURE 1 — TRADE EXAMPLES — TURTLE SYSTEM system does not simply self-adapt The original Turtle strategy sold short in cocoa futures in January 1970 and exited at a but needs continued monitoring profit in March. and refining. Some well-known trend-followers have indeed stated they still trade the same system as when they started out 30 or 40 years ago. But what do those managers really mean?

D

Testing the Turtle By back testing the original Turtle strategy, we can ascertain whether this one particular system, which was highly profitable back in the early 1980s, has stood the test of time or needs updating. At its core, the Turtle strategy is a trend-following system that attempts to capture short- and medium-term trends in a portfolio of futures markets (Table 1). For example, Turtles bought the market after 20-day highs and sold Source: Trading Blox short after 20-day lows. Figure 1 shows trade examples in cocoa futures (CC), which shows the effect of pyramiding: Units

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were entered short on Jan. 6 and 7, 1970, and all units were exited at the same time on March 5, 1970 as the market pen-

December 2009 • FUTURES & OPTIONS TRADER

FIGURE 2 — EQUITY CURVE After impressive growth in the 1980s, the equity curve flattened in the early 1990s,

etrated the 10-day high. suggesting the system has broken down. We tested the Turtles’ strategy on 21 futures markets from Table 1 from Jan. 1, 1970 to Sept. 23, 2009. These were the markets traded by the original Turtles. Note: French francs and the 90-day U.S. T-Bill were omitted from the original portfolio, and the Euro was substituted for the Deutsche mark. Figure 2 shows its equity curve. The strategy was highly profitable before and during the Turtle experiment, which spanned from 1983 to 1988. Average trade length was relatively short: 43 calendar days for winning trades and 13 days for losing trades. Source: Trading Blox However, since the early 1990s, the system has essentially been unprofitable. Large drawdowns of up to 66 percent would (instead of 20-day thresholds). Similarly, wait to exit long have made this system difficult to trade unless you had (short) trades at longer-term lows (highs) instead of just 10exceptionally strong nerves. The original Turtle system day extremes. These changes produce a longer-term system needs considerable updating in the light of current market that is more likely to avoid some of the increased noise in today’s markets. conditions.

Rethinking the strategy

For information on the author see p. 5.

Let’s stick with the basic approach, but wait to buy the market at longer-term highs and sell short at longer-term lows

Read the full article in the February 2010 issue of Active Trader, on newsstands in January.

TRADING STRATEGY STRATEGIES OPTIONS LAB

The options straddle battle Traders on opposites sides of the market aren’t necessarily locked into a battle for success, as this comparison of options straddles in corn futures shows. BY DAN KEEGAN an two traders both make money trading volatil- The long-short debate ity if one of them is short while the other is long? A common approach to trading volatility is the options At first glance, that seems unlikely because options trading is a zero-sum FIGURE 1 — DECEMBER CORN FUTURES game. When you place a trade, someone takes the By entering a long options straddle on December corn futures, other side and only one of you will succeed at expiyou are betting corn either rallies above the upper breakeven ration. point or below the lower breakeven point by expiration. Traders of However, both traders might be profitable if they the opposite position — a short straddle — will benefit if corn adjust the position correctly. Establishing a trading trades in between these thresholds. However, either position can position with an edge is always helpful, but properultimately be profitable if adjusted correctly. ly managing that position is more important. The following examples use options straddles (samestrike, same-month puts and calls) on corn futures to demonstrate this point.

C

Historical and implied volatility When deciding whether to buy or sell options, traders often use the relationship between historical and implied volatility (HV and IV) as a guide. Historical volatility is the realized volatility of the underlying over a given time period. Generally, this measure is calculated by the standard deviation of returns in a given period. HV is empirically based. By contrast, implied volatility is the reverse engineering process in which the current option prices imply the underlying’s volatility. A wide divergence between HV and IV can mean one of two things. Either the relationship is out of line with past levels, suggesting it might soon revert Source: eSignal back to normal, or the relationship has changed and may stay that way. For example, implied volatility may increase before TABLE 1 — CORN STRADDLE DETAILS an expected announcement while hisStraddle buyers pay to enter this spread and will profit if December corn torical volatility holds steady. Or IV exceeds one of the breakeven points. Straddle sellers get paid to open the may drop well below HV as traders spread and hope the underlying doesn’t move much. anticipate a calm market. If you December corn (CZ09) traded at 372 on Oct. 16. believe extremely high or low IV will eventually move back toward HV, you Position Total price per bushel Dollar amount could sell high-IV “expensive” options 10 December 3750-strike calls $1.78750 $8,937.50 or buy low-IV “cheap” options. 10 December 3750-strike puts $1.98750 $9,937.50 But the wide divergence could also remain intact, and any attempts to Total cost (risk): $3.7750 $18,875.00 exploit a move toward their historical Lower breakeven point: 412.75 relationship could result in losses. Upper breakeven point: 337.25 Unfortunately, there is no crystal ball. 12

December 2009 • FUTURES & OPTIONS TRADER

straddle. If you believe the underlying is poised to move sharply (in either direction), widening the spread between IV and HV, you could enter a long straddle by purchasing at-the-money (ATM) calls and buying ATM puts in the same expiration month. However, if you believe the underlying will trade in a range, narrowing the IV-HV spread, you could take the opposite position by selling those same calls and puts. If one trader buys a straddle and another sells the opposite position, only one will make money if they don’t adjust those positions before they expire. But if both traders adjust the strategies based on underlying moves, each lowers risk and increases their odds of success.

FIGURE 2 — LONG STRADDLE The easiest way to make money with a long straddle is with a large underlying move in either direction. But there are other ways to profit if a significant move doesn’t materialize.

Implied volatility in corn The first step is to examine IVs of individual options on corn futures. One corn futures contract represents 5,000 bushels, and a strike price of 3750 represents $3.75 per bushel. Figure 1 shows December 2009 corn futures closed at 372 on Oct. 16, and the December 3750-strike call had a 41-percent IV. By contrast, the March 2010 and May 2010 3900-strike calls had IVs of 35 and 32 percent, respectively. And the ATM call IVs for July, September, and December 2010 and March 2011 were roughly 32 percent. Why was the highest IV at the nearest month? This could mean traders expect corn futures to break out in either direction. Over the past six months, near-term IVs swung between 34 and 38 percent, with a few exceptions touching 30 and 40 percent. If you believe corn futures could move sharply in either direction, you could buy a straddle in December ATM options.

Source: OptionVue

Straddling stalks of corn To enter a long straddle on Oct. 16, you could buy 10 December 3750-strike calls for 17 7/8 ($0.17875 per bushel) each and purchase 10 same-month, same-strike puts for 19 7/8 ($0.19875 per bushel). At expiration, you will be long 10 December corn futures if the calls finish in-thecontinued on p. 14

FUTURES & OPTIONS TRADER • December 2009

13

TRADING STRATEGIES

FIGURE 3 — SHORT STRADDLE The short straddle can only lose money on one side of the market at expiration. However, potential losses are large.

Source: OptionVue

money (ITM) or short 10 December corn futures if the puts finish ITM. This long-volatility position costs 37 6/8 ($0.3775 per bushel, Table 1). Figure 2 shows the trade’s potential gains and losses on three dates: Trade entry (Oct. 16, dotted line), halfway until expiration (Nov. 3, dashed line), and expiration (Nov. 21, solid line). There are three ways to make money on this position. First, do nothing and hope December corn finishes above 412 6/8 or below 337 2/8. Second, the uncertainty surrounding the corn crop could increase, inflating implied volatility. If this happens, the straddle will climb in value and you can exit the position. But what if December corn never breaches either of the straddle’s breakeven points and implied volatility stays flat or decreases? You still have opportunities to make money on the trade, but it won’t be easy. If December corn drops lower, the long puts are more likely to expire ITM, boosting the odds of a short futures position. (Long put holders have the right to sell the underlying at the strike price.) In response, you can buy the underlying futures contracts to reduce the risk of holding a short position. At that point, if the underlying bounces back, you can sell the underlying contracts at a profit. If December corn rallies, the long calls are more likely to expire ITM, which could result in a long futures position. (Long call holders have the right to buy the underlying at the strike price.) You can then sell the underlying to lower the risk of holding a long position. And if December corn slips, you can buy back the underlying at a profit. You will make money with this technique if the profit earned from these underlying trades exceeds the decay in the option’s time value. This “scalping” approach works best when the underlying is range-bound, not when it moves in a straight line.

Short straddle example Let’s compare a long straddle with a short one in December corn options on Oct. 16. The position includes the same 14

December 2009 • FUTURES & OPTIONS TRADER

options, but they were sold instead FIGURE 4 — CORN VOLATILITY of bought. The short straddle’s risk-profile Implied volatility of options on corn futures (blue line) climbed from Oct. 16 to Nov. 12. graph is shown in Figure 3. Note the risks and rewards are reversed: By selling those options, the maximum profit is 37 6/8 and the total possible loss is nearly limitless. And unlike the long straddle, the short one is profitable if December corn trades within the upper and lower breakeven points. The short straddle can only lose money on one side of the market at expiration. If the short calls move into the money, they will convert into a short underlying position; if the short puts move ITM, they will convert into a long underlying position. If you do nothing until expiration, and December corn never Source: OptionVue exceeds the upper or lower breakeven points (412 6/8 and 337 2/8), the position will make money. Another way to profit is to buy back the position after the underlying trades sideways and the options’ time value drops. But what happens if December corn exceeds one of the breakeven points? As the underlying declines, the short puts will act more like long underlying futures. To hedge against this directional risk, you can sell the underlying after it declines. This step essentially converts the position’s short puts into short calls. The position is now somewhat hedged against market declines. If December corn increases, then you can buy futures contracts, which converts the short calls into short puts and mitigates the pain of further market rallies. If the underlying market is choppy, these trades may lose money. But that’s fine as long as the short options’ daily time decay exceeds the losses from trading the underlying.

Adjusting the position Figure 4 shows implied volatility of options on corn futures climbed from Oct. 16 to Nov. 12 — two weeks before expiration. The December 3750-strike call continued on p. 16

FUTURES & OPTIONS TRADER • December 2009

15

TRADING STRATEGIES

TABLE 2 — AND THE VERDICT IS… The straddle lost value since Oct. 16, suggesting straddle sellers made money while straddle buyers lost money. However, a long straddle could have been profitable if you traded the underlying futures against it, selling after rallies and buying after declines.

IV increased to 47 percent. Does that spell disaster for the short straddle? Not necessarily. Those calls now trade at 19 5/8 ($0.19625 per bushel) and have a 75-percent chance of expiring ITM. The puts now trade at 4 5/8 ($0.04625 per bushel) with a 25-percent chance of finishing ITM (Table 2). A position of 10 short calls with a 75-percent chance combined with 10 short puts with a 25-percent chance adds up to holding five short futures contracts at expiration [(10 * 75 percent) + (10 * 25 percent)]. To flatten those probabilities, you could have purchased five futures contracts along the way. Thus, you are now short 15 puts and five calls. The overall short position has a -500 delta; you could buy five futures (+100 deltas each) to lower its total delta to zero. If you had originally bought the straddle for 37 6/8, it has since shrunk to 24 2/8. To offset that unrealized loss, you could trade the underlying. For example, December corn opened at 392 on Nov. 12 and hit a high of 398 2/8. Suppose you sell three futures at 395 before the underlying drops to a low of 382 4/8 and you buy them back. Then you buy another futures contract at 383 and three more at 385. Finally, you sold this long underlying position at 390. The profit earned from scalping corn futures combined with a rise in corn above the 3750 strike means you could have made money overall. How frequently should you trade the underlying? The answer depends on your risk tolerance, but some traders use the overall position’s delta as a guide. For example, the original short straddle had a basically flat delta (-38) at entry. However, it fell to -500 after the underlying gained 6.9 percent within a week. At that point, you could have bought five futures to bring delta back down to zero, which lowers directional risk. But you don’t have to wait that long. Other traders might be more comfortable adjusting the position after delta moves by 200 or 300 in either direction. For information on the author see p. 5. 16

December corn (CZ09) traded at 390 4/8 on Nov. 12. Total price Position per bushel 10 December 3750-strike calls $1.96250 10 December 3750-strike puts $0.46250 Short straddle gain (without adjustments) Long straddle loss (without adjustments)

$2.4250 -$2.4250

Dollar amount $9,812.50 $2,312.50 $6,750 -$6,750

Related reading: Corn futures: “A season for volatility in the grains,” Futures & Options Trader, July 2007. Implied volatility extremes help uncover straddle and strangle opportunities in the soybean and corn futures. “Corn: The new crude oil?” Futures & Options Trader, April 2007. Corn – it’s not just for dinner any more. This commodity’s expanding economic importance could make this an exciting year for the July-December futures spread trade.

Options straddles: “Searching for the short-straddle edge” Futures & Options Trader, December 2008. The difference between implied and actual volatility offers an advantage for selling straddles on the S&P 500. “Straddling the COT report,” Futures & Options Trader, September 2007. Tracking shifts in large-trader sentiment can signal trade opportunities. This long straddle was triggered by an extreme reading in the S&P 500 futures. “Straddles vs. strangles, round two,” Options Trader, January 2007. To choose between the two, calculate points at which both strategies generate identical returns and compare them to your underlying price target. “Seasonal straddles,” Options Trader, December 2006. Long straddles can profit from a price move in either direction, assuming the market moves enough to overcome the trade’s cost. Finding low-implied volatility markets with strong seasonal price tendencies may be your best bet for this trade. “Long straddles and strangles,” Futures & Options Trader, July 2006. They are popular trades that offer limited risk and unlimited reward, but long straddles and strangles require large underlying price moves in order to profit. Learn the differences between these positions and discover when they are most appropriate to trade. “Long straddles: The importance of buying time” Options Trader, July 2005. Buying options has a bad reputation in some trading circles because you're always fighting time decay. But knowing how to find options with the best volatility characteristics and tapping into LEAPS can allow you to construct higher-probability long straddles. “Straddles vs. strangles,” Options Trader, December 2005. It's the volatility-spread decision: Do you trade a straddle or a strangle? You might be surprised by the clear advantages one strategy has over the other in most situations.

December 2009 • FUTURES & OPTIONS TRADER

OPTIONS TRADING LAB OPTIONS STRATEGY TRADING SYSTEM SYSTEM LAB OPTIONS LAB FIGURE 1 — PARABOLIC SAR CHART

Parabolic SAR with credit spreads

The parabolic SAR works best during strong trending periods, which developer Welles Wilder estimated occur roughly 30 percent of the time.

Market: Options on the S&P 500 index (SPX). System concept: The most profitable options lab we have tested used the directional movement index, developed by Wells Wilder in 1978. This lab tests another of Wilder’s indicators — the parabolic SAR. Sometimes known as the stop-andreverse system, the parabolic SAR is a calculation that acts as a stop-loss point underSource: MetaStock neath long trades and above short trades (Figure 1). The parabolic SAR is often used FIGURE 2 — BULL PUT SPREAD RISK PROFILE to determine the direction of an asset’s A November 1030-825 bear call spread was entered on Oct. 26, 2009 when momentum and when momentum has a the market closed at 1067. higher-than-normal probability of switching directions. If the parabolic SAR lies below the current price, the market could be bullish, and if it is above price, the market may be bearish. In this lab, all transactions are placed when price crosses the parabolic SAR calculation. Bullish signals are triggered at the close after price crosses above yesterday’s parabolic SAR value. Bearish signals are triggered at the close after price crosses below yesterday’s parabolic SAR value. (Standard settings were used: an acceleration factor of 0.02 with a maximum of 0.20.) When signals appear, the system enters credit spreads by selling an option (a put for bullish signals, a call for bearish ones) at the first strike beyond one standard deviation. The system also buys a same-type option 10 Source: OptionVue points farther OTM — far enough out-ofthe-money (OTM) to ensure the credit is sufficient. Note: This distance varies depending on the under- Trade rules: lying and current market conditions. Ideally, credit spreads make money as time passes. If the Bullish signal underlying’s price goes nowhere or moves away from the When price crosses above yesterday’s parabolic SAR short strike, the spread’s value will decline toward zero as value, enter a bull put credit spread as follows: the likelihood of the short strike finishing in-the-money (ITM) decreases. 1. Sell five puts at the first strike that is beyond one Figure 2 shows the potential gains and losses of a standard deviation. November 1030-825 bear call spread entered on Oct. 26, 2. Use the first expiration month with 21 or more days 2009 when the S&P 500 index closed at 1067. The trade will remaining. be profitable if the S&P 500 closes below 1130.89 at Nov. 20 3. Buy five puts at a strike price 10 points farther OTM. expiration. continued on p. 18 FUTURES & OPTIONS TRADER • December 2009

17

OPTIONS TRADING SYSTEM LAB Exit: Let the spread expire worthless unless a bearish trade is triggered.

FIGURE 3 — SYSTEM PERFORMANCE The parabolic SAR system gained 133 percent since January 2004.

Bearish signal When price crosses below yesterday’s parabolic SAR value, enter a bear call credit spread as follows: 1. Sell five calls at the first strike that is beyond one standard deviation. 2. Use the first expiration month with 21 or more days remaining, 3. Buy five puts at a strike price 10 points further OTM. Exit: Exit if underlying touches the short option’s strike. Otherwise, allow the credit spread to expire worthless.

Source: OptionVue

months, the winning percentage dropped to 70 percent, reducing the overall win rate to 85 percent.

Starting capital: $10,000.

— Steve Lentz and Jim Graham of OptionVue

Execution: All entries occur at the close when price crosses yesterday’s parabolic SAR value. The system may hold both bullish and bearish positions at the same time. However, duplicate signals are ignored until a position closes. Option trades were executed at the average of the bid and ask prices at the daily close, if available; otherwise, theoretical prices were used. The standard deviation was calculated with a probability calculator using the implied volatility (IV) of the at-the-money call in the relevant month. Each spread held five contracts per “leg.” Commissions were $5 per trade plus $1 per option ($20 per spread). No commissions were included when a spread expired worthless. Test data: The system was tested using options on the S&P 500 index (SPX). Test period: Jan. 12, 2004 to Nov. 20, 2009. Test results: Figure 3 shows the performance of the system, which gained $13,250 (133 percent) in six years, a 22.6percent annual return. In the test’s first four years, the strategy had a winning percentage of 93 percent. But in the final 18 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]. 18

STRATEGY SUMMARY Initial capital: Net gain: 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:

$10,000 $13,250 133% 22.6% 82 70/12 85% $161.59 $1,580.00 -$2,340.00 447.93 -1,508.75 36 19 29/2

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

December 2009 • FUTURES & OPTIONS TRADER

FUTURES & OPTIONS CALENDAR December 1 FDD: December crude oil, natural

Legend

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

CPI: Consumer price index ECI: Employment cost index FDD (first delivery day): The first day on which delivery of a commodity in fulfillment of a futures contract can take place. FND (first notice day): 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. FOMC: Federal Open Market Committee GDP: Gross domestic product

LTD (last trading day): The first day a contract may trade or be closed out before the delivery of the underlying asset may occur.

DECEMBER 2009 29 30

1

2

3

6

8

9

10 11 12

4

5

13 14 15 16 17 18 19 20 21 22 23 24 25 26 1

1

2

3

8

9

7

17 18 19 20 21 22 23 24 25 26 27 28 29 30 2

3

4

FND: January sugar futures (ICE) U.S.: Petroleum status report LTD: January soybeans, soybean products, and rough rice options (CME) U.S.: Natural gas storage report

3 4

U.S.: Natural gas storage report

25 26 27 28

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

5 6 7 8

LTD: January natural gas futures (NYMEX); December gold, silver, copper, aluminum, platinum, and palladium futures (CME) U.S.: Weekly weather report

30

FND: January natural gas futures

FND: December live cattle futures

9 10

5

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

FDD: December heating oil and RBOB gasoline futures (NYMEX) LTD: December cotton futures (ICE) U.S.: Weekly weather report U.S.: Petroleum status report

(NYMEX)

U.S.: Agricultural prices and petroleum status report

31

FDD: December live cattle futures U.S.: Crop production, world agricultural production, and natural gas storage report

11 12 13 14

LTD: January coffee options (ICE)

LTD: December corn, wheat, soybean products, and oats futures (CME); December U.S. dollar index (ICE); December currency futures

15

17 18

FND: December U.S. dollar index futures (ICE) LTD: December cocoa futures (ICE) U.S.: Weekly weather report FDD: December U.S. dollar index (ICE); December currency futures LTD: January crude oil and platinum options (NYMEX) U.S.: Petroleum status report U.S.: Natural gas storage report LTD: December coffee futures (ICE); December single stock futures (OC); December index futures; January orange juice and cotton options (ICE); December index and equity options U.S.: Cattle on feed

6

19 20

December 2009 • CURRENCY TRADER

LTD: January natural gas, heating oil, RBOB gasoline, gold, silver, copper, and aluminum options (NYMEX)

29

LTD: January sugar options (ICE)

10 11 12 13 14 15 16

31 1

23 24

16

27 28 29 30 31 6

LTD: January sugar futures (ICE) U.S.: Weekly weather report

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

2

JANUARY 2010 5

22

(CME)

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

4

FND: January crude oil futures (NYMEX) LTD: January crude oil futures (NYMEX); December T-bonds futures (CME)

2

PPI: Producer price index

27 28 29 30 31

21

(CME)

ISM: Institute for supply management

7

DECEMBER/JANUARY MONTH

FND: January gold, silver, copper, aluminum, platinum, and palladium futures (NYMEX); January soybeans, soybean products, and rough rice futures (CME) LTD: January heating oil, RBOB gasoline, and propane futures (NYMEX); December live cattle futures (CME) U.S.: Natural gas storage report

January 1 FDD: January crude oil and natural gas futures (NYMEX); January sugar futures (ICE)

2 3 4

FND: January orange juice futures (ICE) FDD: January gold, silver, copper, platinum, and palladium futures (NYMEX); January soybean, soybean products, and rough rice futures (CME)

5

FND: January heating oil and RBOB gasoline futures (NYMEX)

6 7 8

U.S.: Petroleum status report U.S.: Natural gas storage report LTD: January orange juice futures (ICE); February coffee and U.S. dollar index options (ICE); January currency options 19

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 Fidelity Investments (www.fidelity.com) has launched a new online stock research center to help investors identify trading and investment ideas by delivering independent expert insights about emerging opportunities, popular stock screening strategies, stocks most frequently bought and sold online by Fidelity customers, and emerging topics on the Web. These new enhancements, combined with Fidelity’s current research offering, allow customers to understand what is happening in real-time across a wide variety of sources, including some top financial blogs. The research center can be used to find emerging trends and opportunities among the most active stocks in the market; set predefined expert stock screening criteria that customers can fine-tune, save, and use; read expert analysis; track financial events such as earnings and splits; track upgrades and downgrades; and search for investment topics on the Web. The stock research center is available to all investors while expanded lists and intraday trading data are available only to Fidelity customers. Fidelity offers access to premium content on a subscription basis, and will be adding additional providers on an ongoing basis.  CQG, the order execution, charting, and analytics provider for global electronically traded futures markets, has expanded its direct market access to include the Australian Securities Exchange (ASX), an operator of electricity and natural gas futures and options markets in Australia and New Zealand. CQG customers will have access to trade ASX’s Australian feed barley, Australian sorghum, Australian milling wheat, and western Australian wheat contracts and the Mini S&P/ASX 50, 200, and 200 Property Trust indexes. These contracts are available on both the CQG Trader and CQG Integrated Client advanced trading platforms. In addition, CQG has launched a Certified API Partner Program. CQG API Partner Certification provides programmers, developers, and vendors the opportunity to become Certified API Partners with CQG. CQG certification indicates the partner has demonstrated expertise in working with either the CQG Data API or the CQG Trading API. Certified CQG API Partners will enjoy a host of benefits including joint marketing exposure, discounts on CQG systems, membership in a private social network, and access to Level III support and CQG developers. For more information, visit www.cqg.com.  Futures Truth Magazine and Chicago-based Trader Kingdom have partnered, sharing viable content such as access to Webinars, articles, newsletters, podcasts, and blogs to enhance subscriber experiences. Futures Truth Magazine subscribers are now able to access Trader Kingdom Webinars from the Futures Truth Web site (www.futurestruth.com). Systems trading experts now have greater reach to present strategies to education seekers. Trader Kingdom (www.traderkingdom.com) is an 20

interactive trading tool; traders of all abilities are welcome to access the site with a valid email address. Visitors find valuable information, endorsed by major exchanges, and presented by veteran educators. Articles, research reports, podcasts, live and archived Webinars, newsletters, blogs, RSS news feeds, and special offers are regularly updated.  Trading software provider NinjaTrader has announced a partnership with Steve Nison’s Candlecharts.com. Nison has selected NinjaTrader (www.ninjatrader.com) as his preferred trading platform for the Nison Candle Scanner (NCS). The scanner allows traders to use NinjaTrader to uncover candlestick patterns in real time in any market. NCS users can apply Nison’s custom candlestick filter conditions in NinjaTrader’s powerful Market Analyzer. NCS provides updated condition alerts to traders in real time to identify intraday and daily trade setups. NinjaTrader makes it easy for traders to react quickly to these trade setups through its SuperDOM and chart-based order execution features. The orders can be submitted to NinjaTrader’s worldwide network of supporting brokerages for futures, forex, and equities markets.  TopCommodityBrokers.com — an interactive commodity/futures broker directory and educational and social networking Web site — is now up and running. This Web site gives commodity brokers the ability to upload a profile photo and video, include a professional bio, connect instantly with potential clients via Skype, link to their company Web site and external blog, add detailed information about their organization, services and specialties, upload their company logo, and allow potential clients and fellow brokers to follow them on Twitter and Facebook. Registered companies will be listed within the Top Commodity Brokers searchable database. TopCommodityBrokers.com is targeted to commodity brokers as well as investors. The site also has a Community Blogosphere with a variety of topics including interviews with commodity brokers, broker commissions, commodity broker trade shows, career classifieds, and weekly commentaries.  United-ICAP — a leader in technical analysis-based price risk assessment for institutional hedgers and professional energy traders — has launched new product offerings and a revamped Web site (www.united-icap.com). The new site offers a suite of customizable tools and technical analysis including daily, weekly, and monthly reports and emails, larger in-depth topical reports, live daily and weekly Webcasts, and full analyst support to discuss any of the report contents, investment ideas, or methodologies. 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.

December 2009 • FUTURES & OPTIONS TRADER

FUTURES & OPTIONS WATCH FIGURE 1 — COT REPORT EXTREMES

Is gold hot? The commercials think not

The commercials in November were overwhelmingly short in gold futures (GC).

The Commitments of Traders (COT) report is published each week by the Commodity Futures Trading Commission (CFTC). The report divides the open positions in futures markets into three categories: commercials, non-commercials, and non-reportable. Commercial traders, or hedgers, tend to operate in the cash market (e.g., grain merchants and oil companies that either produce or consume the underlying commodity). Non-commercial traders are large speculators (“large specs”) such as commodity trading advisors and hedge funds — professional money managers who do not deal in the underlying cash markets but speculate in futures For a list of contract names, see “Futures Snapshot.” Source: www.upperman.com on a large-scale basis. Many of these traders are trend-followers. The non-reportable category represents small traders, or the general public. Legend: Figure 1 shows the difference between net commercial and net large spec positions (longs minus shorts) for all 45 Figure 1 shows the relationship between commercials and large speculators on futures markets, in descending order. It is calculated by subtractNov. 24. Positive values mean net commercial positions (longs minus shorts) are ing the current net large spec position from the net commercial larger than net speculator holdings, based on their five-year historical relationposition and then comparing this value to its five-year range. ship. Negative values mean large speculators have bigger positions than the The formula is: commercials. a1 = (net commercial 5-year high - net commercial current) In November, commercial positions in gold futures (GC) were overwhelmingb1 = (net commercial 5-year high - net commercial 5-year low) ly short, a bearish dynamic that has recently intensified. Similar relationships c1 = ((b1 - a1)/ b1 ) * 100 existed in platinum (PL) and palladium (PA) futures. On the other side, coma2 = (net large spec 5-year high - net large spec current) mercial long positions have outnumbered speculator long holdings in natural b2 = (net large spec 5-year high - net large spec 5-year low) gas futures (NG) for several months.  c2 = ((b2 - a2)/ b2 ) * 100 — Compiled by Floyd Upperman

x = (c1 - c2)

Options Watch: Vanguard value ETF components (as of Nov. 30)

Compiled by Tristan Yates

The following table summarizes the expiration months available for the 20 top holdings of the Vanguard Value ETF (VTV). It also shows each stock’s average bid-ask spread for at-the-money (ATM) December 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

Jan.

X

Jan.

X

July

June

2011 2012

May

April

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

March

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

Feb.

Ticker XOM KO PG CVX VZ JNJ JPM GS COP T WFC INTC BAC MRK PFE GE UTX MMM DIS C

Jan.

Stock Exxon Mobil Corp. Coca Cola Co. Proctor & Gamble Co. Chevron Corp. Verizon Communications Inc. Johnson & Johnson JP Morgan Chase Goldman Sachs Group Inc. ConocoPhilips AT&T Inc. Wells Fargo & Co. Intel Corp. Bank of America Merck & Co. Pfizer Inc. General Electric Co. United Technologies 3M Co. Walt Disney Co. Citigroup Inc.

2010

Dec.

2009

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

Stock price 75.07 57.20 62.35 78.04 31.46 62.84 42.49 169.66 51.77 26.94 28.04 19.20 15.85 36.21 18.17 16.02 67.24 77.44 30.22 4.11

Call 0.03 0.03 0.03 0.03 0.02 0.03 0.03 0.10 0.04 0.02 0.02 0.02 0.01 0.04 0.02 0.02 0.10 0.13 0.08 0.02

Put 0.03 0.03 0.03 0.05 0.02 0.05 0.03 0.14 0.04 0.03 0.02 0.01 0.02 0.03 0.02 0.02 0.09 0.11 0.09 0.01

Bid-ask spread as % of underlying price 0.04% 0.05% 0.05% 0.05% 0.06% 0.06% 0.07% 0.07% 0.07% 0.08% 0.08% 0.08% 0.09% 0.09% 0.10% 0.11% 0.14% 0.15% 0.27% 0.33%

Legend: Call: Three-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.

FUTURES & OPTIONS TRADER • December 2009

21

FUTURES SNAPSHOT (as of Nov. 27) The following table summarizes the most actively traded U.S. 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.

Market E-Mini S&P 500 10-yr. T-note 5-yr. T-note Crude oil E-Mini Nasdaq 100 Eurodollar* 30-yr. T-bond Eurocurrency 2-yr. T-note Gold 100 oz. Mini Dow E-Mini Russell 2000 Corn British pound Natural gas Japanese yen Australian dollar Soybeans Canadian dollar Swiss franc Wheat Sugar Silver 5,000 oz. E-Mini S&P MidCap 400 Heating oil RBOB gasoline Soybean oil Soybean meal Copper Mexican peso S&P 500 index U.S. dollar index Live cattle Lean hogs Coffee Crude oil e-miNY Mini-sized gold Nikkei 225 index Cocoa Fed Funds** New Zealand dollar E-Mini eurocurrency Natural gas e-miNY Nasdaq 100 Mini-sized silver Feeder cattle Dow Jones Ind. Avg.

Symbol Exchange ES CME TY CME FV CME CL CME NQ CME ED CME US CME EC CME TU CME GC CME YM CME TF CME C CME BP CME NG CME JY CME AD CME S CME CD CME SF CME W CME SB ICE SI CME ME CME HO CME RB CME BO CME SM CME HG CME MP CME SP CME DX ICE LC CME LH CME KC ICE QM CME YG CME NK CME CC ICE FF CME NE CME ZE CME QG CME ND CME YI CME FC CME DJ CME

Volume 2.02 M 863.5 436.9 341.2 310.4 276.4 268.8 262.1 259.1 158.4 152.3 146.0 142.3 127.3 113.1 94.0 93.6 91.9 76.9 55.4 51.2 43.9 39.9 38.8 36.7 35.8 35.2 28.4 26.7 23.8 19.4 15.8 14.5 13.3 12.5 11.2 9.6 9.3 8.2 6.9 5.6 3.5 3.4 2.3 2.3 1.1 0.7

OI 2.49 M 1.20 M 756.3 288.9 323.5 841.7 690.8 166.4 938.4 296.2 64.6 387.7 397.8 97.7 115.2 118.2 113.9 194.4 90.2 53.1 128.9 361.1 73.0 107.2 49.2 49.6 77.4 55.6 68.6 84.0 387.8 36.0 65.8 53.0 59.4 5.2 5.1 31.6 50.5 50.0 22.6 2.5 4.0 20.7 2.4 7.5 14.4

*Average volume and open interest based on highest-volume contract (December 2010).

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-

10-day move/ rank -0.18% / 0% 2.31% / 100% 1.53% / 100% -0.39% / 0% -1.62% / 29% 0.22% / 35% 4.03% / 100% 0.65% / 36% 0.11% / 35% 6.11% / 71% 0.49% / 7% -2.00% / 25% 1.74% / 23% -0.46% / 40% 18.21% / 80% 4.06% / 100% -1.59% / 50% 6.36% / 64% -0.74% / 11% 0.92% / 30% 3.20% / 8% 0.35% / 25% 6.01% / 38% -2.35% / 30% -0.20% / 6% 0.52% / 57% 4.51% / 47% 8.47% / 73% 4.95% / 46% 2.08% / 54% -0.17% / 0% -0.51% / 17% 0.42% / 17% 8.40% / 92% 5.30% / 80% -0.39% / 0% 6.59% / 82% -5.73% / 94% 6.48% / 83% 0.04% / 0% -3.13% / 62% 0.45% / 33% 18.21% / 83% -1.62% / 29% 6.33% / 38% -0.48% / 8% 1.01% / 7%

20-day move/ 60-day move/ rank rank 5.47% / 89% 8.76% / 32% 3.24% / 100% 2.55% / 85% 2.43% / 94% 0.87% / 40% -1.23% / 22% 11.90% / 32% 5.63% / 86% 9.68% / 23% 0.53% / 84% 0.65% / 55% 4.09% / 97% 1.66% / 34% 0.78% / 12% 4.82% / 52% 0.86% / 93% 0.11% / 37% 12.14% / 97% 20.00% / 93% 6.50% / 98% 9.29% / 40% 2.12% / 24% 1.04% / 6% 4.69% / 30% 24.44% / 92% -0.32% / 4% 1.31% / 17% 2.91% / 11% 90.32% / 98% 5.44% / 100% 6.19% / 89% -0.93% / 100% 8.38% / 26% 6.86% / 58% 10.73% / 30% 0.33% / 5% 4.07% / 30% 1.10% / 30% 5.33% / 64% 8.94% / 54% 12.97% / 80% -0.18% / 7% -3.84% / 40% 9.89% / 58% 19.11% / 57% 3.56% / 64% 4.50% / 11% -2.14% / 17% 13.10% / 38% -1.70% / 12% 7.44% / 35% 6.88% / 61% 16.91% / 92% 10.57% / 93% 8.72% / 32% 2.11% / 17% 9.47% / 22% 1.11% / 28% 5.39% / 82% 5.47% / 87% 7.46% / 20% -1.88% / 75% -4.00% / 42% -3.56% / 61% -4.12% / 71% 3.19% / 13% 20.89% / 71% 1.88% / 9% 14.28% / 84% -1.23% / 21% 11.81% / 34% 12.33% / 97% 20.05% / 93% -8.26% / 98% -10.00% / 88% -0.76% / 14% 11.94% / 24% 0.19% / 73% 0.28% / 46% -3.45% / 92% 5.20% / 3% 1.59% / 47% 4.55% / 46% 2.91% / 11% 90.32% / 98% 5.63% / 86% 9.68% / 23% 9.77% / 57% 19.03% / 56% -2.22% / 39% -6.19% / 46% 3.93% / 80% 10.94% / 60%

Volatility ratio/rank .17 / 24% .49 / 95% .41 / 73% .23 / 23% .23 / 58% .18 / 10% .55 / 88% .24 / 32% .33 / 50% .29 / 33% .13 / 8% .35 / 82% .25 / 43% .43 / 52% .45 / 62% .40 / 82% .20 / 43% .35 / 72% .31 / 47% .25 / 43% .35 / 52% .20 / 23% .20 / 13% .29 / 67% .26 / 50% .21 / 13% .24 / 30% .31 / 78% .23 / 68% .36 / 12% .17 / 24% .24 / 38% .23 / 13% .31 / 88% .14 / 0% .23 / 27% .29 / 30% .55 / 87% .40 / 82% .07 / 13% .32 / 90% .24 / 28% .43 / 60% .24 / 60% .20 / 14% .14 / 0% .12 / 8%

**Average volume and open interest based on highest-volume contract (May 2010).

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

larger than all the past readings, while a 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 short-term volatility (10-day standard deviation of prices) divided by the long-term volatility (100-day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.

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

22

December 2009 • FUTURES & OPTIONS TRADER

OPTIONS RADAR

(as of Nov. 30)

MOST-LIQUID OPTIONS* Indices S&P 500 index S&P 500 volatility index Russell 2000 index E-Mini S&P 500 futures Nasdaq 100 index Stocks Bank of America Citigroup Apple Inc Microsoft Research in Motion

Symbol Exchange Options volume SPX CBOE 143.4 VIX CBOE 142.2 RUT CBOE 43.0 ES CME 34.1 NDX CBOE 19.0

BAC C AAPL MSFT RIMM

Futures Eurodollar 10-year T-notes Corn E-Mini S&P 500 futures Sugar

Open interest 1.74 M 2.40 M 524.9 161.8 191.5

10-day move / rank 0.20% / 0% 4.92% / 14% -1.12% / 40% 0.30% / 7% -1.18% / 14%

20-day move / rank 5.74% / 89% -20.14% / 97% 3.01% / 40% 5.98% / 93% 6.02% / 88%

IV / SV ratio 21.6% / 17.1% 105.5% / 112.5% 30.6% / 24.1% 21.7% / 20% 23.2% / 17.6%

IV / SV ratio — 20 days ago 21.6% / 19.1% 80.6% / 100.9% 29.1% / 25.3% 21.9% / 21.3% 22.8% / 19%

135.7 124.4 83.3 73.8 72.7

4.20 M 9.14 M 998.0 1.85 M 792.7

-0.81% / 0% 1.48% / 30% -2.22% / 43% -0.74% / 100% -7.66% / 33%

8.71% / 100% 0.49% / 9% 6.05% / 42% 6.06% / 53% -1.43% / 2%

43.1% / 39.5% 50.9% / 35.9% 32.2% / 24.3% 24.9% / 19.2% 55.8% / 46.3%

46.5% / 47.3% 51.7% / 53.2% 29.9% / 29.9% 24.8% / 25.5% 45.1% / 35.8%

ED TY C ES SB

CME CME CME CME ICE

190.1 58.5 41.6 34.1 21.1

4.94 M 665.8 583.2 161.8 377.8

-0.01% / 0% 0.84% / 39% 6.92% / 100% 0.30% / 7% -0.35% / 7%

0.03% / 9% 0.93% / 45% 14.04% / 79% 5.98% / 93% -0.75% / 21%

115.7% / 51.8% 6.4% / 4.5% 35.4% / 44.8% 21.7% / 20% 43.4% / 39.6%

110.9% / 38.8% 7.7% / 6% 40.2% / 50.3% 21.9% / 21.3% 46.5% / 50.2%

Indices - High IV/SV ratio S&P 100 index Nasdaq 100 index Russell 2000 index S&P 500 index Dow Jones index

OEX NDX RUT SPX DJX

CBOE CBOE CBOE CBOE CBOE

11.0 19.0 43.0 143.4 5.5

92.1 191.5 524.9 1.74 M 205.7

0.52% / 0% -1.18% / 14% -1.12% / 40% 0.20% / 0% 0.73% / 7%

5.89% / 93% 6.02% / 88% 3.01% / 40% 5.74% / 89% 6.51% / 98%

21% / 15.9% 23.2% / 17.6% 30.6% / 24.1% 21.6% / 17.1% 19.3% / 15.6%

20.7% / 16.5% 22.8% / 19% 29.1% / 25.3% 21.6% / 19.1% 18.7% / 16.9%

Indices - Low IV/SV ratio Mini Nasdaq 100 index S&P 500 volatility index

MNX VIX

CBOE CBOE

5.8 142.2

223.6 2.40 M

-1.19% / 14% 4.92% / 14%

6.02% / 88% -20.14% / 97%

22.1% / 47.3% 105.5% / 112.5%

22.6% / 42.2% 80.6% / 100.9%

Stocks - High IV/SV ratio Fed Home Loan Bank Burlington Northern Chimera Invest Apollo Group Fannie Mae

FRE BNI CIM APOL FNM

1.3 5.3 1.1 8.1 2.8

284.8 175.2 96.1 170.8 682.1

-8.85% / 67% 0.34% / 6% 4.13% / 43% 5.96% / 100% -12.00% / 89%

-16.26% / 49% 30.51% / 100% 15.47% / 100% -0.05% / 0% -18.52% / 53%

298.1% / 68.6% 11.4% / 5% 77.5% / 34.5% 57.3% / 29.7% 98.7% / 57.3%

48.8% / 113.1% 31.6% / 32.5% 81% / 43.5% 49.2% / 49.4% 117.7% / 108.1%

Stocks - Low IV/SV ratio 3Com LDK Solar Co. Ambac Financial Group

COMS LDK ABK

4.7 5.3 2.6

46.2 174.6 149.6

-1.86% / 14% 22.07% / 11% 0.00% / 0%

43.39% / 100% 15.04% / 93% -33.04% / 76%

15.2% / 22.2% 74.4% / 106.2% 152.1% / 195.8%

54.8% / 45.5% 81.4% / 54% 138.2% / 92.4%

Futures - High IV/SV ratio Eurodollar 2-year T-notes 5-year T-notes Japanese yen 10-year T-notes

ED TU FV JY TY

CME CME CME CME CME

190.1 2.2 4.4 1.0 58.5

4.94 M 54.1 86.7 12.9 665.8

-0.01% / 0% -0.65% / 100% 0.68% / 21% 3.94% / 95% 0.84% / 39%

0.03% / 9% 0.04% / 15% 0.81% / 39% 4.30% / 85% 0.93% / 45%

115.7% / 51.8% 1.5% / 0.8% 4.1% / 2.5% 16% / 11.1% 6.4% / 4.5%

110.9% / 38.8% 2% / 1.1% 5% / 3.4% 13.9% / 13.3% 7.7% / 6%

Futures - Low IV/SV ratio Corn Soybean meal Wheat Soybean oil 30-year T-bonds

C SM W BO US

CME CME CME CME CME

41.6 2.8 9.7 4.0 13.5

583.2 60.8 135.2 111.2 132.0

6.92% / 100% 4.68% / 56% 9.20% / 77% 5.10% / 47% 2.59% / 92%

14.04% / 79% 6.13% / 70% 19.10% / 97% 11.48% / 90% 1.82% / 75%

35.4% / 44.8% 29.1% / 36% 38.8% / 44.4% 29% / 30.4% 11.4% / 11.7%

40.2% / 50.3% 30.4% / 37% 37% / 55.6% 29.7% / 29.6% 13.2% / 12.2%

VOLATILITY EXTREMES**

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

FUTURES & OPTIONS TRADER • December 2009

23

KEY CONCEPTS American style: An option that can be exercised at any time until expiration. Assign(ment): When an option seller (or “writer”) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. Backspreads and ratio spreads are leveraged positions that involve buying and selling options in different proportions, usually in 1:2 or 2:3 ratios. Backspreads contain more long options than short ones, so the potential profits are unlimited and losses are capped. By contrast, ratio spreads have more short options than long ones and have the opposite risk profile. Note: These labels are not set in stone. Some traders describe either position as option trades with long and short legs in different proportions. 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. 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. 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 lessexpensive, 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. The Commitments of Traders report: Published weekly by the Commodity Futures Trading Commission (CFTC), the Commitments of Traders (COT) report breaks down the open interest in major futures markets. Clearing 24

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.

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 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 spread: An options spread that costs money to enter, because the long side is more expensive that the short December 2009 • FUTURES & OPTIONS TRADER

side. These spreads can be verticals, calendars, or diagonals.

allowed by their brokers to trade such strategies.

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.

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).

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. 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). Extrinsic value: The difference between an option's intrinsic value and it's current price (premium). For example, with the underlying instrument trading at 50, a 45strike call option with a premium of 8.50 has 3.50 of extrinsic value.

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. 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. Parabolic SAR (stop-and-reverse): The parabolic stop is a trailing stop technique developed by Welles Wilder and explained in his book New Concepts in Technical Trading (Trend Research, 1978). It is the primary component of what he called the “Parabolic Time/Price” trading system. The basic principle behind the parabolic stop is a calculation that automatically raises (in the case of a long trade) or lowers (in the case of a short trade) a stop-loss order that protects existing profits in a trade. For simplicity, the following discussion is given in terms of long trades. The rules are inverted for short trades. The formula for calculating the parabolic stop level (P) for

Front month (or “nearest month”): The contract month closest to expiration. 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-themoney 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. 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 FUTURES & OPTIONS TRADER • December 2009

continued on p. 26

MANAGED MONEY Top 10 option strategy traders ranked by October 2009 return. (Managing at least $1 million as of Oct. 31, 2009.)

Rank Trading advisor

Oct. return

1. CKP Finance Associates (Masters) 14.87%

2009 YTD return

$ under mgmt.

256.69%

4.3

2. Zephyr Investment (Defined Risk)

13.30%

-9.71%

2.5

3. Carter Road

12.00%

49.52%

2.1

4. ACE Investment Strategists (DPC)

9.86%

94.24%

24.2

5. Financial Comm Inv (Option Selling) 7.45%

28.73%

12.8

6. Kingsview Capital Ptnrs

5.48%

8.76%

2.0

7. JPS Capital Mgmt (JPS Fund)

3.96%

-14.11%

2.9

8. Oak Investment Group (Ag Options) 3.75%

57.29%

4.6

9. Washington (Singleton Fund)

2.83%

35.99%

56.9

10. Reynoso Asset Mgmt. (Options Arb.) 2.63%

-4.42%

1.8

Source: Barclay Hedge (www.barclayhedge.com) Based on estimates of the composite of all accounts or the fully funded subset method. Does not reflect the performance of any single account. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.

25

KEY CONCEPTS

tomorrow’s trading day (when using daily price bars) is: Ptomorrow = Ptoday + AF(EPtrade - Ptoday) where: Ptoday = Today’s parabolic stop value. AF = Acceleration factor, the default value of which begins at 0.02 and increases in 0.02 increments (for each bar that establishes a new high during the trade) to a maximum of 0.20. The greater the acceleration factor, the more “tightly” the stop follow prices. EP = The extreme price since the trade was initiated (highest high if long, lowest low if short). Assume a long trade was established yesterday in stock XYZ at 25, with an initial stop-loss of 23 that is still in effect today. Today’s high of 26.50 was higher than yesterday’s high, which means it is the extreme price (EP in the previous formula) since the trade began. The calculations for tomorrow’s parabolic stop level are then: Ptomorrow = Ptoday + AF(Htoday – Ptoday) where: Ptoday = Today’s parabolic stop value AF = Acceleration factor Htoday = Today’s high (the extreme price) Because this is the first day of the calculation, there is no parabolic stop level for today. This means we must use the initial stop for the trade (23) as Ptoday in the formula. Plugging in the hypothetical values results in: Ptomorrow = 23 + 0.02(26.50 - 23) Ptomorrow = 23 + 0.07 = 23.07 If tomorrow the stock rallies to a new high of 28, the parabolic stop level for the following day would be: Ptomorrow = 23.07 + 0.04(28 - 23.07) Ptomorrow = 23.07 + 0.1972 = 23.27

Note that the acceleration factor increased from 0.02 to 0.04, and that the previous day’s parabolic value is now used in the formula. The AF increases by 0.02 only for a bar that establishes a new EP (high price) in the trade. If the stock had not made a new high, the previous high of 26.50 would have been used as the EP and the AF would have remained at 0.02. Parity: An option trading at its intrinsic value. 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. 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

EVENTS Event: International Traders Expo Date: Feb. 13-16 Location: Marriott Marquis Hotel, New York, N.Y. For more information: www.tradersexpo.com Event: 26th Annual Risk Management Conference Date: March 7-9 Location: The Ritz-Carlton Golf Resort, Naples, Fla. For more information: Visit www.cboe.com/rmc Event: 35th Annual International Futures Industry Conference Date: March 10-13 Location: Boca Raton Resort & Club, Fla. For more information: Go to www.futuresindustry.org

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Event: The 17th Forbes Cruise for Investors Date: March 18-30 Location: Crystal Symphony, Sydney to Auckland For more information: Go to www.moneyshow.com/events/Investment_Cruises.asp Event: The World MoneyShow Vancouver 2010 Date: April 6-8 Location: Hyatt Regency Vancouver For more information: Go to www.moneyshow.com/events/World_MoneyShows.asp Event: FIA/FOA International Derivatives Expo Date: June 8-9 Location: The Brewery, Chiswell Street, London For more information: Go to www.idw.org.uk December 2009 • FUTURES & OPTIONS TRADER

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. 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. Straddle: A non-directional option spread that typically consists of an atthe-money call and at-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a standard long straddle would consist of buying a 25 call and a 25 put. Long straddles are designed to profit from an increase in volatility; short straddles are intended to capitalize on declining volatility. The strangle is a related strategy. Strangle: A non-directional option spread that consists of an out-of-themoney call and out-of-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a long strangle could consist of buying a 27.5 call and a 22.5 put. Long strangles are designed to profit from an increase in volatility; short strangles are intended to capitalize on declining volatility. The straddle is a related strategy. Strike (“exercise”) price: The price at which an underlying instrument is exchanged upon exercise of an option.

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 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:

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

{(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = 0.667

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).

Now look at the variance of a more widely distributed set of numbers: 2, 9, and 16:

Time value (premium): The amount of an option’s value that is a function of the time remaining until

The more varied the prices, the higher their variance — the more widely distributed they will be. The more var-

{(2-9)2 + (9-9)2 + (16-9)2}/3 = (49 + 0 + 49)/3 = 32.67

FUTURES & OPTIONS TRADER • December 2009

27

ied 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: sq. rt. 0.667 = .82; the standard deviation of 2, 9, and 16 is: sq. rt. 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.

FUTURES TRADE JOURNAL

Resistance fails to repel market. TRADE Date: Wednesday, Nov. 18. Entry: Short December 10-year T-notes

(TYZ09) at 119-14/32. Reason for trade/setup: This paper trade

was based on the simple premise of resistance — in this case, the October high of 119-29. The market came up just a couple ticks short of that level on Nov. 17 before sagging intraday on Nov. 18. We want to give the trade enough room to pop above the prior high without getting stopped out prematurely. Although the market could ultimately move higher, we look for a retracement into the previous congestion (below 119) before the contract rallies significantly.

Source: TradeStation

mate level of the October high for a couple days after entry and closed down on Nov. 20 after trading to 120. The trade looked okay until the market recovered intraday from the sharp drop on Nov. 23 to close near the top of the day’s range. Strong follow-through the next two trading days brought price to within a dozen ticks of the stop on Nov. 25. Ultimately, though, the resistance was nothing more than a chart mirage — even though the market paused for a few days around that level, price soon blasted through it on its way to a new high above 121.

Initial stop: 120-26. Initial target: 118-09. Secondary target: 117-04.

RESULT Exit: 120-26/32. Profit/loss: -1-12/32. Outcome: The market bumped up against the approxi-

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 P/L Date

Contract Entry price Initial stop Initial target

11/182/09 TYZ09

119-14

120-26

118-09

IRR

Exit

Date

Point

%

LOP

LOL

Length

.84

120-26

11/26/09

-1-12

-1.15%

10/32

-1-12

6 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).

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December 2009 • FUTURES & OPTIONS TRADER

OPTIONS TRADE JOURNAL

FIGURE 1 — MORNING JOLT We bought ITM calls after SPY opened 1.2 percent higher on Nov. 23. We exited at a small profit before the market cooled down.

Catching the last stage of a bullish open with long calls. TRADE Date: Monday, Nov. 23. Market: Options on the S&P 500 tracking stock (SPY). Entry: Buy two December 110 calls for 2.71 each. Source: eSignal Reasons for trade/setup: When SPY gapped higher by 1.2 percent on Nov. 23, it was unclear where the market might be headed Figure 1 shows we bought two December 110-strike calls (Figure 1). for $2.71 each at 9:35 a.m. ET when SPY traded at 111.07. Historical testing shows opening gaps tend to be filled, Figure 2 shows the position’s potential gains and losses on meaning price will likely drop to yesterday’s high. On the the entry date (Nov. 23). The trade’s risk profile is compaother hand, the stock market has been unusually bullish rable to 100 shares of SPY, but we can only lose $2.71 per since March, and buying dips has been a profitable strategy. share. SPY fell 2.4 percent in the four days before today’s gap The goal is to capture a quick, small gain, and we plan to higher, so this bounce might continue, if only briefly. exit if SPY climbs 0.6 percent to its Nov. 16 high. Otherwise, Moreover, the week surrounding the Thanksgiving has we plan to hold the trade up to a week. been historically bullish as the S&P 500 gained a median 0.6 continued on p. 30 percent from 1983 to 2007. In 2008, the S&P jumped 11.6 percent on Thanksgiving week as the financial panic began TRADE SUMMARY to subside. Buying in-the-money (ITM) calls is one of the easiest Entry date: Monday, Nov. 23, 2009 ways to take a bullish stance. Their directional exposure, Underlying security: S&P 500 tracking stock (SPY) measured by delta, is similar to buying the underlying outPosition: 2 long December 110 calls right. If SPY climbs, ITM calls should increase in value Initial capital required: $542 accordingly and time value is less of a problem, especially with short-term trades. Initial stop: Exit if SPY drops below 110.71.

Initial target: TRADE STATISTICS Time: Delta: Gamma: Theta: Vega: Probability of profit: Breakeven point:

9:25 a.m. 117.5 15.52 -8.62 23.4 39% $112.71

FUTURES & OPTIONS TRADER • December 2009

9:50 a.m. 126.6 14.9 -8.55 23.2 42% $112.71

Hold one week or until SPY hits 111.69.

Initial daily time decay:

$8.62

Trade length:

1 day

P/L:

$28 (5.2%)

LOP:

$28

LOL:

$0

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

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TRADING STRATEGIES

Initial stop: Exit if SPY falls below today’s low of 110.71.

FIGURE 2 — RISK PROFILE — LONG CALLS Buying ITM calls is an easy and cheap way to exploit brief rallies.

Initial target: Hold over Thanksgiving week unless SPY hits its Nov. 16 high of 111.69.

RESULT Outcome: Figure 2 shows SPY continued to rally after we entered, but we had second thoughts as the market climbed above Nov. 19’s high. SPY stalled around 111.50 last week, and holding a long position near this resistance level made us nervous. We sold the calls at a per-share profit of 0.14. In hindsight, the trade didn’t make much sense, but exiting early helped us avoid losses.

Source: OptionVue

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December 2009 • FUTURES & OPTIONS TRADER