Options Trader 0605

JUNE 2005 Volume 1, No.
L s t A i f C D: pro I T e A r R u E t E p V PR ca E , S k H s i L r T L ze A i l a C utr
Ne
OPTION BASICS:
Matching strategy with market conditions
EXOTIC TRADING:
FX options
NEW: OPTIONS
TRADE JOURNAL Diary of a trade
USING OPTIONS AS
market insurance policies
NEW: OPTIONS
SYSTEM ANALYSIS
CONTENTS
Forex options . . . . . . . . . . . . . . . . . . . . . . . . .16 Explore the different forex options becoming available to individual traders. By Boris Schlossberg Option spreads: The reinsurance approach . . . . . . . . . . . . . .20 An analysis of the credit spread provides a departure point for investigating the balance between risk, reward, and probability of profit in options trading. By Don Fishback Matching option strategy to market conditions . . . . . . . . . . . . . . . . . .24 To trade options efficiently, you need to know which strategy goes with which market condition. By Thomas Stridsman
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . .4 Letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Options News

By Carlise Peterson Options traders savvy, becoming mainstream . . . . . . . . . . . . . . . . . . .8 An Options Industry Council survey showed differences between those who trade options and those who dont. By Jim Kharouf CME bolsters options trading . . . . . . . . . . . .8 The Merc aligns firms to provide liquidity in options contracts. By Options Trader staff SEC mulls execution requirements, penny trading, for option brokers . . . . . . . . .9 Options traders might get access to firms orderexecution statistics. By Carlise Peterson
Options Basics . . . . . . . . . . . . . . . . . . . . .28

Options: Market insurance policies Intimidated by options? Think of as them as insurance policies. By Bill McLean
Option Strategy Lab . . . . . . . . . . . . . . .30

Using a long straddle to trade the monthly employment report.
Options Resources . . . . . . . . . . . . . . . . .32

Software, Web sites, and new products and services.
Options Trade Journal . . . . . . . . . . . . . .34 Options Expiration Calendar and Events . . . . . . . . . . . . . . . . . . . . . . . . .36 Key concepts and definitions . . . . . .38
Options Strategies
Reducing risk with vertical spreads . . . . .10 Vertical spreads can reduce volatility exposure and help you profit from short-term price moves. By James Bittman
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June 2005 OPTIONS TRADER
CONTRIBUTORS CONTRIBUTORS
James Bittman is the author of Options for the Stock Investor (McGraw-Hill, 1996) and Trading Index Options (McGraw-Hill, 1998). He teaches courses for public and institutional investors and has presented several custom courses throughout the U.S., Europe, South America, and Southeast Asia. In 1980 Bittman began his trading career as an equity options market maker at the Chicago Board Options Exchange. From 1983 to 1993 he was a commodity options member of the Chicago Board of Trade where he traded options on financial and agricultural futures. Boris Schlossberg is a senior currency strategist at Forex Capital Markets in New York, the largest retail forex market maker in the world. He is also a guest lecturer at www.fxstreet.com, covering proper risk management, trader psychology, and true market structure. Schlossberg is a frequent commentator for Reuters and Dow Jones/CBS Marketwatch currency and bond market sections. Schlossberg has been an independent trader since 1999, trading a variety of instruments including, stocks, options, futures, and currencies. Don Fishback is president of Lexington, Ky.-based Fishback Management & Research Inc. (www.donfishback.com), an advisory firm that offers services and software products for option traders. Before starting his own company, he was head of research at Schaeffer Investment Research Institute. Thomas Stridsman is a systems researcher and designer. Formerly a technical analyst and systemstrading expert for both Active Trader and Futures magazines, Stridsman is the author of Trading Systems that Work (McGraw-Hill, 2000) and Trading Systems and Money Management (McGraw-Hill, 2003). William McClean is a managing partner for EMAC Trading, where he has implemented technology and trading strategies while overseeing the design, development, and deployment of trading and risk management systems. He is the principal of the F100 Tool Company, a trading-software and consulting firm that provides trading strategies and tools for proprietary trading companies and hedge funds. McLean was formerly a member of the Chicago Board Options Exchange. Steve Lentz is executive vice president of OptionVue Research and is the chief trader for the companys CTA managed futures program called the Swing 500. Jim Graham is the product manager for OptionVue Systems and a Registered Investment Advisor for OptionVue Research. Jim Kharouf is a business writer and editor with more than 10 years of experience covering stocks, futures, and options worldwide. He has written extensively on equities, indices, commodities, currencies, and bonds in the U.S., Europe, and Asia.
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Editor-in-chief: Mark Etzkorn metzkorn@optionstradermag.com Managing editor: Molly Flynn mflynn@optionstradermag.com Associate editor: Carlise Peterson cpeterson@optionstradermag.com Associate editor: David Bukey dbukey@optionstradermag.com Contributing editor: Jeff Ponczak jponczak@optionstradermag.com Editorial assistant and Webmaster: Kesha Green kgreen@optionstradermag.com Art director: Laura Coyle lcoyle@optionstradermag.com President: Phil Dorman pdorman@optionstradermag.com Publisher, Ad sales East Coast and Midwest: Bob Dorman bdorman@optionstradermag.com Ad sales West Coast and Southwest only: Allison Ellis aellis@optionstradermag.com Classified ad sales: Mark Seger mseger@optionstradermag.com
Volume 1, Issue 3. Options Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2005 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 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.
LETTERS
Options online
just wanted to thank you for developing Options Trader magazine. I author a blog on trading options and have pointed my readers in your direction: www.galatime.com/archives/2005/05/options_trader_2.html and www.galatime.com/archives/2005/04/options_trader_1.html. We greatly value such resources in the options trading area, and would love to hear about your future plans. Kaushik Dear Sir/Madam, In the May 2005 issue of the Options Trader magazine, Kevin Lund describes how a strategy called slingshot strangle (a.k.a., a gut strangle) can be used to catch market bottoms. As Im sure every serious options trader knows, understanding synthetics is a key part of options trading. In this case, a slingshot strangle is nothing more than a synthetic alternative of the normal strangle, which uses OTM options. In fact, theres absolutely no difference between the two, other than the fact that an ITM (i.e., slingshot) strangle requires a greater capital outlay since a trader pays for the intrinsic value in addition to the time value. In other words, the two alternatives have exactly the same position Greeks and the same amount of time value, so the amount of capital at risk is exactly the same i.e., the time value portion of the premium. To use the example from the article, a March 25/35 slingshot strangle on QCOM was trading at 12.30 on the Feb. 21 close; so without even looking at historical prices one can be fairly certain that an OTM strangle (25 put and 35 call) was trading at 2.30. Certainly, it is possible the slingshot strangle can sometimes be bought for $0.05-0.1 less due to the bid-ask spread, but then you have to take into account the opportunity cost of the extra capital that is being tied up in the trade. A. Fain
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OPTIONS NEWS
Survey says
Options traders savvy, becoming mainstream

An Options Industry Council survey shows differences between those who trade options and those who dont.
BY JIM KHAROUF
ho are you guys? Thats what the Option Industry Council (OIC) aimed to find out in its Profile of the Options Investor study released in April. The survey, conducted every five years by the organization, covered a wide variety of aspects regarding options traders vs. non-options traders. The survey of 569 investors in options and stocks showed that options traders are more likely to have an annual income of more than $100,000 and hold more liquid assets than non-options traders. Not surprisingly, options traders also were more active and held a more diverse portfolio than non-options traders. The survey found that options traders are four times more likely than their counterparts to make more than 50 trades in a year. Options investors also are much more diversified and more likely to own over-the-counter stocks, exchange traded funds, gold, and futures, the study said. The survey also indicated a shift in the reasons people do not trade options. The 2005 study said lack of knowledge about options was the top reason, while prior surveys showed that traders avoided options because they thought they were too risky. Options industry professionals say this is an important shift because it indicates options trading is gaining acceptance as an investment tool. Im gratified to see lack of education is the reason people are not investing in options, rather than saying its a bad
product, says Hank Nothnegel, senior vice president at Wachovia Securities. Nothnagel also believes options are on their way to becoming a mainstream product. I dont think were very far away from being widely accepted, Nothnagel says. Other retail options firm executives were not so certain, however. Joe Sellitto, director of derivatives products at E*Trade, says options trading at E*Trade has grown steadily. The company has also advertised its options-trading capabilities for the first time. Still, Sellitto says there is a long way to go for the product. I dont think its mainstream at all because there are so many investors who dont choose options and [arent] educated about [them], Sellitto says. Retail executives say there is a tremendous amount of information about options trading, especially via the education efforts of the OIC. But some retail options brokers say at the firm level, options are not considered a high priority in terms of marketing and resources. Firms continue to promote stock trading, ETFs, and other products, but budgets are limited for options promotion. The study also found the Internet is the primary source for trading and information. According to the survey, 83 percent of all options traders trade online while only 63 percent of non-options investors do.
Support your local options contract
CME bolsters options trading

BY CARLISE PETERSON
A
8
s part of its initiative for increasing the volume of electronic trading for options on foreign exchange, equity indexes and interest rates, the CME has introduced the Certified Options Partner Program. The program promotes collaboration between the exchange and the market-making firms to provide liquidity in new options contracts. The CME also plans to integrate the Enhanced Options System for Eurodollar options into the Globex electronic trading platform.
The following firms have committed to supporting the CME electronic options enhancements: Actant, Credit Suisse First Boston, Catus Technologies, FfastFill, GL TRADE, NYFIX, Orc Software, Prime Analytics, RTS Realtime Systems, Photon Trader, Random Walk Consulting, and TradingScreen. Only about three percent of the CMEs options volume is done electronically, compared with 70 percent of overall volume.
Show me the numbers
SEC mulls execution requirements, penny trading, for option brokers

BY CARLISE PETERSON
he U.S. Securities and Exchange Commission may require options brokers to compile and publish data on how efficiently customer orders are executed, a top official has says. The SEC is considering a proposal to extend the so-called execution quality rules in place for stock brokerages to the options market, says Elizabeth King, SEC associate director of market regulation, in a news release. King says extending the rule would give brokers more information to help them meet their obligations to their clients. The SEC is also considering whether to reduce the options markets present trading increments of five cents or 10 cents, depending on the contract price, to one cent. King says penny quotes would narrow bid-ask spreads. Penny-increment trading was introduced in the stock markets more than four years ago and has helped reduce payment for
order flow, the SEC says. Payment for order flow occurs when brokerages are paid by trading specialists or exchanges to steer orders their way. The practice raises questions about brokers duty to get the best price for clients, say critics of the current system. But traders also say options markets generate so much data that penny price points could present a capacity problem for electronic systems.
OPTIONS STRATEGIES
Reducing risk with vertical spreads

Vertical spreads can help you sidestep the complications of changes in implied volatility.
Traditional approach
First, consider the hypothetical example in Table 1. Its first column contains the names of the six necessary inputs (stock price, days to expiration, volatility, interest rate, dividends, and strike price) to a standard option pricing formula and the resulting price and delta for the 70 call option. A comparison of the second and third columns shows how each variables value changes as the stock price rises from $68.50 to $71.25 in eight calendar days. Initially, the call has 40 days to expiration, implied volatility of 60 percent, no dividends, a strike price of 70, and a 2-percent interest rate. Given this information, the price of the 70 call is $4.80, and its delta is 0.50. Table 1s second section shows the 70 call increases from $4.80 to $5.70, and its delta climbs from 0.50 to 0.58. With a delta of 0.50, a $2.75 stock price rise suggests a rise in the price of the call of approximately $1.37 (2.75 * 0.50 = 1.375). Looking only at the original delta, one might expect the price of the 70 call to rise from $4.80 to roughly
T
BY JAMES BITTMAN
rading options can be frustrating because the behavior of option prices is sometimes counterintuitive. For example, assume a companys earnings announcement met (or exceeded) expectations and its stock price rose from $68.50 to $71.25. The price of a call option with a strike price of $70, however, declined from $4.80 to $4.00. What happened? Implied volatility, thats what. Changes in implied volatility can affect an options price more than changes in its underlying stock price. Well explain how a drop in implied volatility caused the 70 call to drop despite a rallying stock price and show how a vertical spread (buying a call and selling another call with a higher strike price) can mitigate the effect of implied volatility.
10
TABLE 1 UNCHANGED VOLATILITY Implied volatility holds steady at 60 percent in this scenario, which means the 70 call gains $0.90 as the stock rallies to $71.25 from $68.50.
Inputs Stock price Days to expiration Volatility Interest rates Dividends Strike price Outputs Price of 70 call Delta of 70 call
Initial $68.50 40 60% 2% 0 70
Eight days later $71.25 32 60% 2% 0 70
$4.80 0.50
$5.70 0.58
TABLE 2 DROPPING VOLATILITY Here, the original 70 call drops $0.80 even though it moves in the money as the underlying stock rises 4.01 percent. Declining implied volatility is the culprit.
$6.17. However, Table 1 shows the option only climbed to $5.70. Table 1s pricing formula calculation ($5.70) is different from the delta-only estimate ($6.17) for two reasons: First, time decay has a negative impact on option prices. There are eight days of time decay in this example, which represent 20 percent of the time left until expiration a significant factor in this situation. Second, the delta changes as the stock price changes. In this case, the delta rose from 0.50 to 0.58, which helped the 70 call gain ground. The negative impact of time decay, however, was greater than the positive impact of rising delta. However, something is missing from Table 1: The original example description showed the 70 call declining from 4.80 to 4.00 instead of rising to 5.70.
Inputs Stock price Days to expiration Volatility Interest rates Dividends Strike price Outputs Price of 70 call Delta of 70 call
Initial $68.50 40 60% 2% 0 70
Eight days later $71.25 32 40% 2% 0 70
$4.80 0.50
$4.00 0.59
The missing link volatility

If the price of the 70 call did not change as Table 1 forecasted, then one of the six variables that affect options prices (besides stock price and days to expiration) must have changed. Although
OPTIONS TRADER June 2005
any of the other four factors could have changed, it is extremely unlikely interest rates or dividends could have changed enough to account for the $1.70 difference between $5.70 and $4.00. Table 2 shows the contributing factor is a change in volatility. As volatility drops from 60 to 40 percent, the 70 call falls to $4.00. This scenario raises two questions: Why would volatility drop from 60 to 40 percent and what can a trader do about it? To answer the first question, you must understand what volatility is. In its simplest form, volatility means
movement. Although there is an exact mathematical explanation of how much movement a specific level of volatility indicates, you dont have to be a mathematician to understand the impact of volatility on an options price.
Historical vs. implied volatility

There are three important concepts you should know about volatility. First, there are at least two types of volatility historical (statistical) and implied. Historical volatility is a measure of a
continued on p. 12
11
OPTIONS STRATEGIES continued
FIGURE 1 VERTICAL SPREADS RISK PROFILE The vertical spreads maximum risk is limited to $4.20 at expiration, which is lower than the original 70 calls cost ($4.80). The tradeoff is that your potential profit is now capped at $5.80.
-5 65 66 67 68 69 70 71 72 73 74 75 Stock price
markets actual past price fluctuations. Assume stocks A and B both trade at approximately $100 per share. If stock A fluctuates $0.50 per day on average, and stock B fluctuates $2 per day on average, then stock B is more volatile than stock A. Implied volatility, in contrast, is the volatility component in an options
TABLE 3 VERTICAL SPREAD
price. Essentially, implied volatility is the markets expectation of how much stock price volatility there will be between now and option expiration. Historical and implied volatility can be very different. Just because a stocks price has fluctuated at one level historically doesnt mean the market will expect it to continue moving at the
This vertical spread minimizes exposure to implied volatility so you can profit from the same underlying price move as in Tables 1 and 2. Notice that the spread rises to $5.40 from $4.20 in eight days, which is close to its maximum gain ($5.80) at expiration.
Inputs Stock price Days to expiration Volatility Interest rates Dividends Outputs Price of 65 call Delta of 65 call Price of 75 call Delta of 75 call Price of 65-75 spread Delta of 65-75 spread
Initial $68.50 40 60% 2% 0
Eight days later $71.25 32 40% 2% 0
same level. Thus, it is possible for a stock to have a historical volatility of 30 percent and an implied volatility of 40 percent at the same time. Finally, implied volatility can change. It can change slowly over several weeks or suddenly and dramatically in response to an event such as an earnings report or a news announcement. A change in implied volatility means the market has changed its expectation about the size of stock price fluctuations in the future. Table 2s scenario a sharply changing stock price and a decrease in implied volatility is not uncommon. Before an anxiously anticipated earnings report, it is reasonable to expect that the pending announcement could cause the market to forecast a big price move (in either direction). Therefore, option prices could contain a high level of implied volatility. After the announcement, however, the option market could expect little stock price movement going forward regardless of whether or not the stock price changed as the news hit the Street. This means the implied volatility would be significantly lower than before the event. Table 2 shows the 70 calls price change has three influences: the rise in stock price, time decay, and the decrease in implied volatility. The rising stock price has a positive impact, but the passing of time and declining implied volatility both have a negative effect, which outweigh it.
Profit/loss at expiration
The vertical spread solution

You can protect against an implied volatility drop by trading a vertical spread instead of an outright option. Instead of simply buying the 70 call, buy a 65 call and simultaneously sell a 75 call. This strategy is known as a vertical spread because the 75 strike price is higher than (vertical to) the 65 strike price. Figure 1 shows a profit-and-loss diaJune 2005 OPTIONS TRADER
$7.30 0.65 $3.10 0.36 $4.20 0.29
$7.30 0.80 $1.90 0.36 $5.40 0.44
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Estimating an options theoretical value
n options fair value involves six interrelated variables strike price, price of the underlying market, days until expiration, volatility, interest rate, and dividends. Although many traders simply rely on the standard Black-Scholes pricing model to estimate option values, its important to understand how each element may affect an options price. An options premium has two main parts: Intrinsic value, which represents the amount an option is in-the-money (i.e., the difference between the strike price and the underlyings current price), and time value, which is often used to describe the combination of the four other factors that influence its probability of profit by expiration. For example, on May 6 a Dupont (DD) May 2005 call with a strike price of $47.50 cost roughly $0.87, based on its $48.05 closing price. The call has an intrinsic value of $0.55 ($48.05 - $47.50) and the remaining $0.32 is time value, or the premium charged for the time left until expiration, its implied volatility, the risk-free short-term interest rate (i.e., 90-day T-bill rate), and dividends. Calculating intrinsic value is straightforward, but deriving time value can be tough because its difficult to figure out which of its four variables are affecting an options price at any given point. Overall, time and volatility are the most significant factors, especially in the short term. Options with more time until expiration typically cost more because theres a better chance they might move into the money. Similarly, options on more volatile stocks have high implied volatility levels, which reflect the markets heightened expectation of future stock price fluctuations. The effect of interest rates and dividends can be best understood by viewing their impact on an underlying security. For example, when interest rates rise, call prices also increase and put values drop because the borrowing costs of holding a stock position are higher. Larger dividends lead to cheaper calls and more expensive puts because a stock price drops by the dividend amount on its ex-dividend date, or the first day it trades without its dividend (i.e., you must own it before this date to receive the dividend). To test how these six variables can alter an options value, you can modify default inputs used by one of the many free Web-based options pricing calculators (www.ivolatility.com/calc/) or standalone tools (www.cboe.com/ LearnCenter/Software.aspx).
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Options Trader Staff

Sources: Michael T. Burke, Getting Started Trading Options (Omega Research Inc., 1999). Lawrence G. McMillan, McMillan on Options (John Wiley & Sons, 2004, second edition). Jim Graham, Hedging risk with collar trades, Options Trader, April 2005.
gram for this vertical call spread at expiration. The long 65 call costs $7.30 and the short 75 call has a premium of $3.10, so the strategys net cost (i.e., its maximum risk) is $4.20. The maximum profit potential of the spread is $5.80. The maximum loss will occur if the
underlying stock price is at or below $65 and both options expire worthless. If the stock is above $75 at expiration, exercise the 65 call; the short 75 call will be assigned. The exercise allows you to buy stock at $65, and the assignment forces you to sell stock at $75 a profcontinued on p. 14
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OPTIONS STRATEGIES continued
Related reading
Option spreads: The reinsurance approach Active Trader, July 2004. An analysis of option credit spreads from the perspective of playing the odds the way insurers and casinos do. Controlling risk with spreads Active Trader, March 2003. Trading the bull call-option spread. Easing the pain: Repair strategies for a losing options trade Options Trader, May 2005. How to salvage an unprofitable long put with additional legs that help reduce risk and lower the trades breakeven point. Diagonal put spreads: Beyond the basic credit spread Active Trader, March 2005. An explanation of how diagonal put spreads can take advantage of increasing volatility, which gives them an edge over standard vertical put credit spreads. Timing events with the calendar spread Active Trader, October 2003. The calendar spread offers a way to capitalize on aspects of time, market direction, and volatility. Extra credit (spreads) Active Trader, February 2002. Another look at trading credit spreads. You can purchase past Active Trader articles at www.activetradermag.com/purchase_articles. htm and download them to your computer.
it of $10 per share. Because the spread cost $4.20 per share to establish, the resulting net profit is $5.80, excluding commissions and taxes. However, holding the spread until expiration is not the goal of the trade.
result is significantly better for the 65/75 call spread than for buying the 70 call outright.
The tradeoff
Comparing the performance of a vertical spread to an outright option purchase is an important step in the tradeselection process. As with any strategy choice, theres a tradeoff what are you getting and what are you giving up? The long 70 calls maximum risk is $4.80, and its profit potential is unlimited. In contrast, the call spread has a lower maximum risk of $4.20, but its profit potential is limited to $5.80. If you intend to close the trade shortly after an earnings announcement, however, the tradeoff between maximum risk and profit potential at expiration shouldnt be your primary concern. If you have a shorter time frame than expiration, focus on a strategys delta, its exposure to time decay, and its exposure to changing implied volatility. The delta of the purchased 70 call (0.50) is higher than the 65/75 call spreads delta (0.29). But a comparison of Tables 2 and 3 shows the original 70 calls exposure to time decay and declining implied volatility is significantly greater than the vertical spreads. In this situation, therefore, a prudent trader might choose to purchase the 65/75 call spread rather than the single 70 call.
A vertical call spread has a lower maximum risk than an outright call position, but the tradeoff is that its profit potential is limited.
Table 3 shows an estimate of how the spreads value changes given Table 2s forecast a stock price increase from $68.75 to $71.25 in eight days and an implied volatility decrease from 60 percent to 40 percent. Table 3 shows the long 65 call remains at $7.30 while the short 75 call decreases from $3.10 to $1.90, which means the vertical spreads value rises from $4.20 ($7.30 - $3.10) to $5.40 ($7.30 - $1.90). The vertical spreads gain is larger than you might expect (given its delta of 0.29), despite the decrease in implied volatility. For example, a $2.75 stock gain multiplied by a delta of 0.29 equals roughly $0.80, but the spread climbed $1.20 in our scenario. The vertical call spread performs better than the outright call position because it is less exposed to implied volatility. The spreads long 65 call is negatively impacted by the decrease in implied volatility, but the short 75 call profits from lower volatility levels because you can buy it back at a lower price ($1.90) eight days later. The net
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Neutralizing volatility
Your expectations play an important role in determining which strategy is most desirable for a given forecast. In a trading environment for which a sharp decrease in implied volatility is a potential hazard, buying a vertical spread instead of an outright option can be an excellent way to neutralize volatility risk while still capitalizing on directional movement.
For information on the author see p. 4. Visit the CBOE at www.cboe.com.
TRADING STRATEGIES
Forex options
Forex options are a breed apart. Traders used to standard calls and puts will need to familiarize themselves with some new concepts and terminology before trading these exotic instruments.
BY BORIS SCHLOSSBERG
ost vanilla options strategies involve simultaneously buying and selling put and call options at different strike prices and sometimes different expiration months. Although the permutations are virtually endless, ultimately all option trades fall into two categories: high-volatility (extensive price movement) or low-volatility (little price movement). Options can be used to trade directional moves, but it is their ability to earn profits from bets on volatility rather than just direction that makes them unique instruments. The forex market takes these special properties further and simplifies the traders ability to trade volatility through a set of specific exotic options. Until recently, exotics have only been available to large corporate and institutional accounts, but now retail accounts can trade these products as well.
16
Exotic details
Unlike plain vanilla options with single strike prices and standard expiration dates (e.g., an IBM 100 call option expiring the third Friday in July), exotic options incorporate conditional scenarios regarding both price and time. The most common forex exotics are:
strike price. For example, if the price of a certain exotic option is 30 percent of payout, the option buyer would pay $30 for the option and receive $100 if the currency pair reached the priced designated in the options terms. Analyzing the different exotic options will illustrate the payout process.
Until recently, exotic options have only been available to large corporate and institutional forex traders, but now retail accounts can trade these products as well.
one-touch, no-touch, double one-touch (also known as a barrier option), and digital options. Exotic options are always priced as percent of payout, which is calculated in increments of $100 per option if the trade turns out to be correct i.e., if the currency reaches the designated
One-touch options
As one of the most popular exotics, the one-touch option is profitable if the price of the currency pair touches a specified price within a certain period of time. Lets say the Euro/U.S. dollar pair
(EUR/USD) is trading at 1.2900. A trader could buy a 1.3000 one-touch option expiring in two days for 45 percent of payout. In this case a trader would pay $45 and if price reached 1.3000 he would receive $100, or a 122-percent return on his trade ($100 payout - $45 premium = $55; $55/$45= 122 percent). Timing is especially critical with exotic options. You must know the exact time of expiration, and each broker may have different cutoff conventions. Typically, exotic options are timed against the New York cutoff, which is 10 a.m. ET. However, some brokers will set the cutoff time at 24:00 GMT (4 a.m. ET), so confirm the time before making a trade. One-touch options are suited for conditions when you have a strong opinion about the direction of a currency pair and you are convinced the move will happen soon. A one-touch option with a far-away target (perhaps 200 pips away) and a very short time span (24 to 48 hours) will have a very high reward-risk ratio (typically 3:1 or less) precisely because the payout on such a trade will be rare.
profit. The currency pair simply has to stay relatively stationary in order for the trader to collect a payout.
Double one-touch
The double one-touch option allows you to select two strike-price barriers and provides a payout if either one is touched. If the Euro/U.S. dollar (EUR/USD) spot was trading at 1.3000, you could buy a double one-touch with 1.2900 and 1.3100 strikes expiring 48 hours forward. If EUR/USD either rose to 1.3100 or declined to 1.2900, you would make a profit. The double onetouch is similar to a standard long strangle or straddle option trade in that
trader will walk away with a profit. One-touch and no-touch options are highly time sensitive. A one-touch will be significantly cheaper the less time there is to expiration because the odds of reaching the target will be greatly reduced, while a no-touch will be priced in opposite fashion because the chances of not touching the target will diminish the more time is left on the contract. However, the double one-touch and double no-touch options will have the same pricing parameters in terms of time but will vary greatly with respect to the width of the barriers. Double one-touch options, for example, will
During certain news announcements when the forex market becomes extremely volatile, dealers often widen their spreads and trade execution can be problematic. This is when exotic options are especially useful instruments.
it is a good tool to use when you have no strong opinion about direction but you expect volatility to explode. become progressively more expensive as the barriers narrow. Recent pricing in double one-touch options in the U.S. dollar/Japanese yen rate (USD/JPY) with 10 days to expiration and the spot rate trading at 104.75 were as follows: For strike barriers between 103.50 and 105.50 (meaning price had to hit either one of those points for the option to pay out), price was an eye-popping 95 percent of payout, offering the trader only a potential 5-percent gain against a 95 percent loss. Expanding the boundaries to 102.50 and 106.50 reduced the premium to only 41 percent of payout. Conversely, the double no-touch options would have the exact opposite properties, offering much higher payouts as the strike prices narrowed.
continued on p. 18
No-touch options
No-touch options are profitable if the price of a currency pair does not reach the target by a specified time. For example, a 10-day no-touch option of GBP/USD at 1.9200 when the pound is trading at 1.9100 may be priced at 40 percent of payout. This means you will pay $40 and receive $100 after 10 days if price does not decline to 1.9100. A no-touch option offers better payout odds when the strike price is closer to the market price and the expiration date is farther away because the chances the currency will not touch the strike price diminish considerably the longer the trader has to wait. One interesting property of the notouch is the fact the underlying currency pair does not have to move in the traders direction (that is, away from the strike price) in order to produce a
Double no-touch
The double no-touch option is the opposite of the double one-touch. It is appropriate for situations in which you anticipate a range-bound market and expect volatility to be low. Large trend moves are often followed by periods of consolidation; the double no-touch can be a profitable trade to use in these cases. Assume the EUR/USD makes a strong up move from 1.2400 to 1.3400 over several weeks, but price then pauses and starts to weaken a bit. A trader could buy a double no-touch from 1.3200 to 1.3600 with expiration in a week. If the market remains within these boundaries, the
17
TRADING STRATEGIES continued
Digital options
Digital options produce a payout if the spot price meets or exceeds the selected barrier price at expiration. Lets imagine you buy a digital option for 105.00 USD/JPY that expires 10 days forward when spot is trading at 104.00. In the next nine days, USD/JPY may be trading comfortably above the 105.00 barrier between 105.50 and 105.90. However, if on expiration day USD/JPY slips below 105.00 and ends the day at 104.99, the trader would forfeit the entire premium. Accordingly, digital options are less expensive than one-touch options with the same strike and expiration date. Digital premiums can be half the price of no-touch options premiums with the exact same strike price and expiration dates, but the trader has to weigh the advantage of lower cost against the risk price will settle even 1 pip below the target at expiration. In certain respects digital options resemble the vertical spread in vanilla options, where the trader buys a put or a call and offsets it by selling a cheaper put or call a strike higher/lower. In that scenario, the maximum payout to the trader would be the difference between the strike prices minus the premium paid. The key difference is digital options will pay maximum payout as long as the target level is met or exceeded, while the vertical spread will only pay out the maximum return if price exceeds the outer strike zone. The vertical spread will pay out partially if price settles somewhere between the two strike prices.
trade execution can become problematic. Spot traders who are often trading highly leveraged positions expose themselves to tremendous slippage and potentially devastating losses if they are on the wrong side of the market. It is during this time that exotic options can be especially useful instruments. The release of U.S. Non-Farm Payroll report at 8:30 a.m. ET on the
electronic order entry. Regardless of individual dealing practices, the process is rife with danger, especially for heavily leveraged traders. Thats why news events such as Non-Farm Payroll numbers, Central Bank rate announcements, current account reports, and inflation data can be traded with more flexibility and far better risk control using exotic options rather than spot.
By sifting through possible scenarios and analyzing the probabilities of each trade, the exotic option trader engages in a more rigorous intellectual process than the reactive spot trader.
first Friday of every month presents a notoriously difficult environment to trade the EUR/USD will often rise or fall more than 100 points in a manner of seconds. While this can be a maddening time for spot traders, option traders can profit handsomely. Because exotic forex options predetermine entry and exit points ahead of time, buyers of a one-touch option dont need to worry about entering the market as liquidity suddenly disappears and many brokers widen their spreads to five times their usual size. Nor do they need to worry about slippage on stops if their positions are wrong. They know if their analysis is correct and the currency pair trades through their price, they will profit; if they are wrong their risk is limited to the cost of premium. The spot trader enjoys no such assurances. During these volatile times orders often slip hundreds of pips as dealers try to cope with order imbalances. Furthermore, because volume often spikes to 10 times the normal level, simply accessing dealable quotes can be difficult. Some dealers provide phone access, while others only offer
Preparation
Of course, you cannot simply pull up your trading screen five minutes before an event and expect to obtain a reasonable price on an exotic option. At that point volatility is likely to have increased to such an extent that most trades will be unattractive from reward/risk point of view. However, traders who do their analysis and plan trades a week in advance of an event will be in a much better position to find favorable opportunities. The operative word here is plan. Planning may be the greatest benefit of option trading. By sifting through possible scenarios and analyzing the probabilities of each trade strategy, the option trader engages in a far more rigorous intellectual process than the reactive spot trader. And we all know impulse trades often generate the worst losses. Have a hunch bet a bunch may be fine for a few harmless dollars on lottery tickets, but it is not a good strategy for trading success.
For information on the author see p. 4. Questions or comments? Click here.
Exotic options and trading news events

Although forex is the largest and most liquid market in the world, during certain news announcements it can become extremely volatile, as dealers try to adjust to new information and millions of traders attempt to enter or exit the market at the same time. Dealers often widen their spreads and
18
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TRADING STRATEGIES
Option spreads: The reinsurance approach

The probabilities of options trading are not so different from those in the insurance and gaming industries. To make money, it helps to play the odds the way insurers and casinos do. Credit spreads are one way to do it.
BY DON FISHBACK
ne of the biggest advantages of options is the flexibility they offer. With sufficient study, you can create a strategy that meets your personal criteria for risk, reward and probability of success. Understanding and managing the relationship between these three factors is one of the most important skills option traders must master. The following discussion illustrates this by analyzing a well-known option spread. The credit spread is an option strategy that involves selling an option while simultaneously purchasing the same type of option, with the short option being more expensive than the long option. A vertical credit spread indicates the options have the same expiration month. For instance, a credit spread on stock ABC, which is trading at 16, would consist of selling the June 12.50 put (bid at 0.90) and simultaneously buying the June 10 put (offered at 0.40). The June 12.50 put is more expensive than the June 10 put, so the position provides a net credit of $0.50. The maximum profit potential for this trade is the net credit received, or
20
$50 per spread. The maximum loss is $200 per spread, which means the risk is quadruple the potential reward. Why
would anyone want to take on risk four times the maximum possible reward? The answer is probability how fre-
FIGURE 1 SHORT PUT OR CREDIT SPREADS? With the stock trading around $100 in June 2003, a trader could sell July 80 puts because of the low probability of a 20-point drop in the next month. However, the risk on such a trade is unlimited. By also purchasing July 75 puts, the risk on the trade is dramatically reduced.
eBay (EBAY), daily 140 130 120 110 Profit zone 100 90 80 Loss zone 70 60
24 3 10 March 17 24 31 April 7 14 21 28 May 5 12 19 27 2 June
Source: Reuters Metastock
Profit/loss ($)
quently you get to make the $50 profit vs. how frequently you take the $200 loss. In this case, the prior historical price action of the stock indicated the probability of keeping the $50 i.e., the strategys winning percentage was nearly 90 percent. Implementing high-probability trades such as this is the opposite of what the majority of beginning traders do in the options market. When most people speculate with options (as opposed to using them to hedge a position in the underlying instrument) they tend to buy cheap options, hoping to hit a home run and make a huge profit with relatively small risk. The credit spread strategy is a substantially different approach. Its not that buying options outright is a bad idea. But realistically, if you are simply buying them hoping to hit the jackpot, you should know your odds of winning are about equal to playing the tables at a casino. And casinos dont go out of business too often because of gambling losses. Thats because casinos (and even state lottery commissions) know and manage the risk, reward and probability of profit for the games of chance they run. Its similar to the insurance business, although the risk, reward and probability model in this area is far more complex. However, individual investors can use the same principles in the options market.
collecting a premium and keeping it as long as the stock does not move adversely. Lets look at what happens when
FIGURE 2 NAKED PUT SALE
Figure 1). The net credit for the put sales was $1,700, which was the positions maximum profit. You would get to keep that credit as long as the stock
Selling a put outright has fixed profit and potentially disastrous risk.
Profit/loss of put sale (at expiration) 20,000 Profit/loss ($) 0 -20,000 -40,000 -60,000 -80,000 -100,000 -120,000 -140,000 -160,000 9 39 69 99 EBAY share price 129 159 189
Source: chart Excel; data oddsonline.com
FIGURE 3 CREDIT SPREAD
Adding long options to the short put position creates a credit spread, which has a smaller potential profit than a naked put, but also limits downside risk.
Profit/loss of credit spread (at expiration) 2,000 0 -2,000 -4,000 -6,000 -8,000 -10,000 69.00
Risk and reward: Naked options

In the insurance business, you make money when something does not happen. Insurance companies collect premiums, which they get to keep if you dont get sick, you dont get into an automobile accident, your house does not catch fire, etc. Individual traders can replicate this concept with the credit spread, essentially turning themselves into insurance companies, by selling an option,
79.00
89.00
99.00 EBAY share price
109.00
119.00
129.00
you sell an option. Back in June 2003, prior to eBays stock split when the price was $100, lets say you sold 20 of the eBay July 80 puts at 0.85 (see
was above the 80 strike price at expiration. Based on the one-year historical
continued on p. 22
21
volatility of the stock at the time (42 percent), the odds of the stock being below 80 at July expiration were less than 7 percent, which means there was a 93-percent chance the stock would not be below 80. In other words, the odds were great a loss would not occur. The problem is the maximum risk on this trade is $80 per share (the strike price of the put sold) multiplied by 100 (number of shares each option represents) multiplied by 20 (the number of puts sold): $160,000! So while this trade has a great probability of profit, and a decent possible reward, it carries with it potentially catastrophic risk (see Figure 2). Selling naked, or uncovered, options in this manner has ruined more than one financial company in the past several years. The centuriesold Barings Bank is one institution that suffered the consequences of a solitary trader who sold a huge number of options in the expectation a big move would not occur in the Japanese market over a short period of time. But it did, and Barings collapsed as a result. In effect, selling a naked option (particularly a call) is very similar to selling an insurance policy with no limit to the size of the claim. Lloyds of London used to sell this kind of policy. Unfortunately, all it takes is one bad
claim to bring catastrophe. In the case of Lloyds, it was asbestos.
The reinsurance option

If unlimited liability is the problem, then limiting the liability is the solu-
With reinsurance, the company that wrote the policy takes a portion of the premium collected from the policyholder and buys coverage for part of the policys risk. However, this seemingly simple and effective solution has
FIGURE 4 SIDE-BY-SIDE COMPARISON Overlaying the profit/loss profiles of the naked put sale and the credit spread highlights the credit spreads risk control a form of resistance for the short put position.
Put sale vs. credit spread (at expiration) 10,000 0 -10,000 -20,000 Profit/loss ($) -30,000 -40,000 -50,000 -60,000 -70,000 -80,000 -90,000 39 59 79 99 EBAY share price 119 139 159 Put sale Credit spread
tion. Insurance companies have two ways to do that. First, they can set a limit on the amount the policy will pay. The second solution is to buy reinsurance.
Gauging probability
he probability figures are derived from standard volatility models and the probability assumptions in the Black-Scholes option pricing formula. Basically, if a distribution of values (such as prices or price changes over a period of time) is normal, it takes the shape of a bell curve, and one standard deviation will contain approximately two-thirds of all the values in the data set. Two standard deviations will contain 95 percent of all the numbers in the set. By definition, volatility is equal to one standard deviation of an asset's price returns. As a result, because of the implications of the bell curve, volatility produces a standard deviation, which in turn produces a probability. For a more in-depth discussion of these issues, visit www.oddsonline.com/ probability.
a downside: By capping the loss in this fashion, you also reduce the profit. Thats the trade-off. Traders can do the same thing with options. Returning to the eBay example, taking $800 of the $1,700 premium and buying 20 July 75 puts at 0.40 would establish a credit spread and effectively reinsure the original naked put position. The net credit (and maximum possible profit) is now $900, but the maximum risk is now much lower, as well. The long put option provides coverage for the risk that eBay would trade below $75. The total risk on a vertical credit spread is the difference in strike prices minus the net credit. In this case, the difference in strike prices is 5. The net credit is 0.45 (0.85 - 0.40 = 0.45). Thus, the trades maximum risk is 4.55 (5.00 - 0.45 = 4.55), or $455 per spread. With this trade consisting of 20 spreads, the
22
total risk has dropped from $160,000 to just $9,100 (see Figure 3). To some traders these numbers still might not look very good. Comparing the put credit spread to the naked put sale, the profit potential on the spread dropped by almost half from $1,700 to $900. And although the maximum risk is down to $9,100 much lower than before its still 10 times higher than the potential reward. Figure 4 compares the naked put sale directly to the credit spread. The key to the success of this trade is probability. The probability of any loss is less than 7 percent, and the probability of reaching the maximum loss is less than 3 percent. When you quantitatively balance these probability numbers with risk and reward, you find the trade has a positive expected outcome. (See the Gauging probability sidebar)
Games of chance: The probability factor

The options industry doesnt like the comparison, but the analytics of options trading are not too far removed from the analytics of games of chance. Casinos offer games that almost exclusively have expected outcomes that are positive for the casino, negative for the player. Nevertheless, for the casino operator, the risk in each incremental game is substantially larger than the rewards. With every pull of the slot machine lever, someone has the opportunity to win a jackpot. Thats what keeps people coming back. If there was no jackpot, there would be no players. The question for the casino is, how many times does someone put money in the slot machine and lose it before they hit a winning combination? Lottery commissions depend upon games where the reward potential to
the lottery board is just $1, and the potential risk could be a massive $80 million. The question is, how many of those $1 lottery tickets get sold before a player collects the $80 million jackpot? Insurance companies depend upon people making claims for losses. After all, if there were no losses, insurance would be needless. For insurers, the questions are: How much money can we collect before we have to pay a claim? How likely is it that a claim will be filed? How big will that claim be? In the end, the analysis is the same with options. How much can the spread trader collect? How likely is it that the trader will lose? How big will the loss be?
For information on the author see p. 4. Questions or comments? Click here. A version of this article previously appeared in Active Trader magazine.
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TRADING STRATEGIES
Matching option strategy to market conditions

One way to trade options more effectively is to analyze chart patterns to determine the best option strategy to use in a particular situation.
BY THOMAS STRIDSMAN
FIGURE 2 A MODIFIED VERTICAL DEBIT CALL SPREAD
ne basic disadvantage to only trading stocks from the long side, or by using futures for selling short, is the limited risk protection and decreased ability to tailor a position to suit your specific needs. One way to customize your positions is to use a set of basic and easy-to-implement option strategies that complement a few equally basic technical analysis chart patterns. Of course, if you believe the market will go up you could simply buy a call option and limit your risk to the amount paid, or buy a put option if you believe the market will go down. But what if you could weigh the possibilities of a certain scenario actually happening say on a three-grade scale (e.g., unlikely, likely, very likely)
and then tailor an options position to fit the scenario and the potential risk-reward ratio youre willing to take on? The probabilities of chart-pattern analysis can help you choose an appropriate option strategy for a given trading situation.
A modified vertical debit call spread: The position is established with two long calls and two short calls; one of the short options is bought back when the market moves up, increasing the positions upside bias.
Profit Two long calls Vertical debit call spread, minus one short call Price of stock One short call
Vertical jump
Consider a situation in which you think the marLoss ket may rise, but you still want some protection against a potential drop. Instead of just buying a call option, you could buy one call option and sell one call option with a higher strike price to limit your risk. This position is called FIGURE 1 THE VERTICAL DEBIT CALL SPREAD a vertical debit call spread. The vertical debit call spread consists of a long call The green line in Figure 1 and a short call at a higher strike price. (left) shows what the profit potential for this Profit Long call position looks like. (Debit means it will cost money to put on one Vertical debit of these spreads; you call spread cannot lose more money than the cost of the posiPrice of stock tion.) Granted, the profit potential will also be limShort call ited, but why aim for a Loss higher profit and thereby also take on
more risk than your market analysis deems reasonable? To establish a similar position in anticipation of falling prices you could put on a vertical debit put spread, consisting of one long put option and one short put option with a lower strike. To implement a vertical debit call spread you should choose the strike for the short option to be at or slightly above (below for a put spread) the targeted price for the underlying stock. The two options should not be more than two strikes apart because options too far out-of-the-money tend to become very illiquid. The advantage of a strategy like a vertical debit spread is that you dont have to hold it until expiration. Depending on how the market unfolds, you can get rid of one half of the position or add even more options to either
24
side of the strategy. For instance, if you place a vertical debit call spread in anticipation of the penetration of a resistance line, you can easily buy back the previously shorted option once the market has moved in your favor, ending up with an outright long call position (the blue line in Figure 1.) Or, if the market goes against you, sell the long option to end up with a short call position that will allow you to take a small profit out of the declining market (the red line in Figure 1.) Because it doesnt matter how many total options the spread consists of, as long as it has an equal number on both sides, buying and selling more than one option only adds to the positions flexibility. For example, say you bought two call options and sold two call options with a higher strike. Figure 1 shows that a vertical debit call spread will become profitable earlier than an outright long option. Once your position has moved into profitable territory, you could then buy back one of the short options to end up with the position defined by the green line in Figure 2. As you can see, this position will not be as profitable as an outright long call position if the market moves very strongly in your favor. However, because it becomes profitable sooner, it will take a substantial move by the underlying stock before the outright long position will start to outperform this modified vertical debit call spread. Further, if and when this happens, you can always buy back the last remaining short option and end up with two outright longs.
Straddling volatility
A vertical debit spread is a useful position when you have a fairly clear opinion about what the market will do next. But what about when youre not so sure when you think it can take off in either direction? Thats when a long straddle would come in handy. A long straddle consists of one or more long calls and an equal number of long puts with the
same strike price. (See FIGURE 3 THE LONG STRADDLE Trading volatility, The long straddle consists of a call and put with Active Trader, June p. 52 ). the same strike price and expiration. The green line in Figure 3 shows what this position Profit will look like compared Long put with the performance of Long call an individual long put and long call. As you can see, the straddle will make money if the marPrice of stock ket makes a substantial move in either direction, but will lose money if volatility decreases and Loss Long straddle the market drifts in a narrow trading range As with the vertical FIGURE 4 A MODIFIED STRADDLE WITH TWO debit spread, the stradLONG CALLS AND ONE LONG PUT dle allows you to get rid of the side of the position This modified straddle performs more favorably if the market moves higher. that loses money once the market takes off; the more options you use for Profit Two long calls the initial position the more flexibility youll One long put have as the price action unfolds. Figure 4 shows Price what a long straddle (iniof stock tially consisting of two call options and two put options) would look like after selling one of the put options. As you can Loss Long straddle, minus one long put see, its now slightly easier to earn a profit on the potential is very limited, unless youre long side than the short side. Now lets take a look at the kinds of a trader who specializes in volatility chart patterns that offer trading oppor- plays without any regard to the actual tunities for the option strategies weve price of the underlying market. Among the patterns that favor discussed. strong moves in a certain direction are Chart patterns and directional top and bottom formations like headbias and-shoulders, double tops and botWhen you get right down to it, there toms, and wedges. In Figure 5 (left), are only four types of chart patterns: the formation during the fall of 1998 is those that favor a strong move either an example of a double bottom with its up or down; those that favor a more most important resistance (often modest move up or down; those that referred to as the neckline) at point 1 imply a strong move in either direc- (the relative high between the two tion; and those that dont favor a move lows of the pattern, which also hapin either direction (i.e., price will con- pens to coincide with the bottom of a tinue to move sideways). consolidation pattern preceding the Most traders are probably better off double bottom). avoiding the last type. The profit continued on p. 26
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FIGURE 5 CHARTING YOUR OPTIONS STRATEGIES The various support and resistance levels that developed over an 18-month period in the S&P 500 provide clues to the direction and magnitude of price moves. This information can then be used to select appropriate option strategies at different points.
S&P 500 ($SPX), daily 8 10 9a
1550 1500 1450
7 4 3 2c 2b 2a 1 6
9b
1400 1350 1300 1250 1200 1150 1100
5 April July Oct. Jan. April July Oct. Jan. April Source: TradeStation 2000, Omega Research (Data: CSI Unfair Advantage)
1050
An upward sloping wedge, which implies a potential top and trend reversal, consists of two upward sloping, converging trendlines. In Figure 5,
FIGURE 6 OPTION STRATEGY MAP
this pattern is forming between trendlines 5 and 8. A downward sloping wedge formed between trendlines 4 and 7.
Other patterns with a strong directional bias are consolidation patterns within trends, such as flags and pennants (See Waving the pennant, Active Trader, May p. 60). Because these occur within the context of an established uptrend, the consolidation patterns at points 2a, 2b and 2c in Figure 5 all favor a break (continuation) to the upside in the direction of the previous trend. (Such patterns are, in fact, often referred to as continuation patterns.) For these patterns, the magnitude of the subsequent move depends not only on other support and resistance levels present in the market, but also on the move leading into the pattern. To get a rough estimate, look for the move out of the pattern to be similar in size to the move leading into the pattern. That turned out to be fairly accurate for the patterns in Figure 5. The patterns on this chart all represent support or resistance of one degree or another. The next step is to consider which option strategies to use to capitalize on the price action they imply.
Combining pattern and strategy

The way to trade these patterns is to place a vertical debit spread in anticipation of the move through the support or resistance line in question, then liquidate the losing half of the position after the breakout has occurred. Ideally, though, you should wait until the market pulls back slightly from the breakout before eliminating the losing half. However, because the market sometimes takes off without looking back, waiting might prevent you from getting out of the unprofitable side. As a result, its a good idea to consider working with a total of four options. This way, you can get rid of half the losing position as the breakout begins giving you a position looking like the one in Figure 2 and the other half at the pullback, giving you two outright long options. In the event of a failed breakout, you
A breakdown of different options strategies based on the expected price direction and level of volatility.
Higher volatility expected Long Put (You expect the market to explode to the downside.) Vertical Debit Put Spread (You expect a breakout to the downside.) More Bearish Vertical Credit Call Spread (You expect a modest move to the downside.) Short Call (You firmly expect the market NOT to go up.) Lower volatility expected Short Straddle (You expect the market to stay within a trading range.) Long Straddle (You expect the market to take off in either direction.) Vertical Debit Call Spread (You expect a breakout to the upside.) More Bullish Vertical Credit Put Spread (You expect a modest move to the upside.)
Long Call (You expect the market to explode to the upside.)
Short Put (You firmly expect the market NOT to go down.)
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TABLE 1 MATCHING UP: CHART PATTERNS AND OPTION STRATEGIES Different chart patterns and the option strategies to use to capitalize on them.
Volatility
Higher volatility expected
Strategy
Long call: Vertical debit call spread: Long straddle:
Implementation
Buy one or more calls with the same strike price. Buy one or more calls, and sell an equal number of calls with a higher strike price. Buy one or more calls, and an equal number of puts with the same strike price and expiration. Buy one or more puts, and sell an equal number of puts with a lower strike price. Buy one or more puts with the same strike price. Sell one or more puts with the same strike price. Buy one or more puts, and sell an equal number of puts with a higher strike price. Sell one or more calls, and an equal number of puts with the same strike price and expiration. Buy one or more calls, and sell an equal number of calls with a lower strike price. Sell one or more calls with the same strike price.
Suggested chart patterns

After breaking through a neckline and (preferably) also after a test of support In anticipation of breaking through a neckline or consolidation pattern. In anticipation of a breakout of a horizontal consolidation area or symmetrical triangle (either direction), or a test of a major trendlines. In anticipation of breaking through a neckline or consolidation pattern. After breaking through a neckline and (preferably) also after test of resistance. After breaking through a neckline and (preferably) also after test of support. In anticipation of breaking through a neckline or consolidation pattern. When moving into (or when expecting to stay within) a horizontal consolidation area or symmetrical triangle. In anticipation of breaking through a neckline or consolidation pattern. After breaking through a neckline and (preferably) also after test of resistance.
Vertical debit put spread: Long put: Short put: Lower volatility expected Vertical credit put spread: Short straddle:
Vertical credit call spread: Short call:
have two choices: Stay with your recently modified position, or scale it back further so it consists of one long and one short option, which you can sit on in anticipation of a second breakout attempt. When the market is about to test a major trendline or support or resistance level without any other kind of formation (such as any of the ones mentioned above) to indicate possible direction, price is equally likely to take off in either direction and usually in a rather swift move with large, shortterm profit potential for the correctly positioned trader. The magnitude of the move is usually limited to previously defined support or resistance levels and the other extreme of the price channel, such as the ones marked by trendlines 9a and 9b in Figure 5. Another directionally unbiased patOPTIONS TRADER June 2005
tern is the (preferably symmetrical) triangle, which forms with the intersection of two major trendlines, such as trendlines 5 and 10. Directionally neutral patterns like this are opportunities to put on straddles. One excellent opportunity to place a long straddle occurred in October 1999, when the market attempted to test both support at about 1,300, and trendlines 4 and 5. It also would have been possible to add a vertical debit call spread to this position in anticipation of a breakout through the resistance at trendline 6 and the wedge at trendline 7. No matter how you might have handled the outcome and modified the positions as the market unfolded, these two strategies would have positioned you to profit from sizable moves. Given the apparent longer-term
wedge developing between trendlines 5 and 8, it could (at the time this was written) be a good place for a vertical debit put spread in anticipation of a breakthrough of trendline 5 and a move back to support at 1,350. This would be an acceptable move if the market continued down over the next couple of days. But if this test failed the first time, the market would be very close to the meeting point of trendlines 5 and 10 a more neutral pattern that would call for a long straddle. Figure 6 and Table 1 give you a quick overview of how and when to place these and a few other basic option strategies.
For information on the author see p. 4. Questions or comments? Click here. A version of this article previously appeared in Active Trader magazine.
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OPTIONS BASICS
Options: Market insurance policies

Just as auto insurance protects you in the event of a car crash, options can protect you in the event of a stock market crash. Take the first step toward trading options by learning how they function as trading instruments and risk hedges.
BY WILLIAM MCLEAN
ptions can be a daunting subject for beginners for many reasons, not the least of which is the jargon surrounding them. It sometimes seems as if trading options hinges upon learning a new language, with terms such as calls, puts, assignment, parity, intrinsic, at-the-money, in-the-money and out-of-the-money sounding like one thing but meaning another. Even common words, such as strike, exercise, American and European, turn out to have surprising definitions. Option language even contains some Greek, just to keep things interesting, although terms such as Delta, Gamma, Theta, Vega and Rho have meanings no Greek dictionary will help you understand. Luckily, the underlying concepts governing option behavior and pricing unlike the language are intuitive. For example, even if you dont know what a put option is, youll find the concept behind put easy to grasp. In fact, you probably already understand it because of the auto or home insurance policies you own. For instance, if you crash your car or your house burns down, you effectively get to sell that property to your insurance company at a specific price, typical28
ly a predetermined replacement value. A put option performs a similar insurance role for a stock position. If your stock crashes and you own a put option on it, you get to sell the stock to the option writer (seller) at a previously agreed upon price (the strike, or exercise price). In other words, you put the stock in the custody of the writer, which is where the word comes from. An option writer is, in effect, a seller of insurance. The insurance concept extends to call options as well. A call option performs the same function as a put, except that it protects against upward price movement in a stock (or futures market, etc.) rather than downward price movement.
Burning down the house: Expanding on the insurance model

Understanding that call and put options are nothing more than insurance policies leads to the next topic: how these instruments are priced. Conveniently, calls and puts are priced just like regular insurance policies. (Appropriately, option prices are typically referred to as premiums.) Its pretty simple: Figure out the fair value of a proposition or scenario and tack on a little bit of profit.
Assume a neighborhood has 100 houses, each worth $399,000. Lets further say there is a 10-percent chance one of the houses will burn to the ground in the next year. So, 10 percent of the time the insurance company will pay out $399,000, and 90 percent of the time they will pay out $0. The expected value of this proposition is the sum of the probabilities of these two possible scenarios multiplied by their respective values, or in this case: (.10 x $399,000 = 39,000) + (.90 x 0 = 0) = $39,000. This means the fair value for home insurance on one of these houses is $39,000 divided by 100 households, or $390 per year. By charging each household more than $390 per year, the insurance company is likely, over time, to make a profit. Now consider a situation in which you could buy an insurance policy on something you didnt own. For example, say a municipal zoning committee is meeting to decide the fate of a piece of vacant land in their community. There is a 60-percent chance the property will be zoned commercial, which will bring a price of $600,000. There is a 40percent chance the land will be zoned residential, in which case the value will be only $300,000. Your company (which has no interest in residential property) decides the
property is strategically important to its business development plan. The current property owner, sensing an eager buyer, offers to sell you the right to buy the property tomorrow at a price of $400,000. Acquiring this insurance policy is perfect for your company. If you can secure the right but not the obligation to buy the property, you can effectively block any competitors from taking the location. You are, in effect, buying a call option on this piece of real estate. Using the previously described equation, you determine the fair value of the property to be (.60 x $600,000) + (.40 x $300,000) = 360,000 + 120,000 = $480,000. That means the right to buy the property for $400,000 tomorrow is worth $80,000 today. The statistics would indicate that in a situation like this you would, over time, break-even if you paid $80,000 for the option to buy this property. Sometimes you would lose your $80,000 and sometimes you would gain the $120,000 savings on the property ($600,000 $80,000 $400,000 = $120,000). The problem, of course, is that in this instance you are only playing once. This is akin to the difference between a one-spin roulette player and the casino. Your decision is whether or not to risk $80,000 to lock in the property price. A smart businessman in this situation would realize there are many decisions (i.e., many spins of the wheel) over the course of a career and would choose to buy this protection for $80,000 or less. By purchasing this option insurance policy, you would have the ability to call away the property from the current owner.
Understanding the statistics

An important aspect of the kinds of statistical propositions weve been discussing is that they work over the long term. Any individual outcome will be much more uncertain. One implication of this is that, as in the real estate example, you would have to be in a position to lose $80,000. To take advantage of the long-term statistical edge in opportunities such as this, you cant allow the inevitable
individual losses to put you out of business. In other words, you need to make many of these bets to reap the expected long-term payoff. A general rule is the more money you have to trade, the more sense a statistical proposition makes. So lets talk about the real world. Insurance, in the form of options, exists on a multitude of traded instruments, including stocks and bonds. You can insure virtually any holding you have, long or short, through buying an option. In addition, you can speculate in the option market, both buying and writing (selling) options and combinations of options. Option pricing is governed by the probability the price of the underlying instrument will be above or below a particular strike price at a certain point in the future (typically, expiration). These probabilities are largely predicted by the underlying instruments volatility (the degree of price movement). In a higher volatility climate, option prices should be higher, because it is less certain where a stock price will be at a certain point in the future. The opposite applies for a lower volatility climate. In practice, the option markets are extremely efficient. In the equity arena alone, there are now five national option exchanges soon to be six with competing market makers vying for your option business. If you are a lowvolume option user, primarily using options to hedge risk or trade outright (as opposed to arbitrage), you can simply enter the marketplace and get your insurance. For example, if youre worried about CSCO closing below 15 in the next month, you can buy some put options with a strike price of 15 and an expiration date roughly 30 days away. If your broker is any good, youll get the best bid or offer available.
at-the-money OEX options. Look at the readings over the past one, three, 12 and 24 months to get a good indication of where volatility has been. In periods when the VIX is very low relative to its own history, theres a reasonably good chance option prices, in general, are fair to underpriced, which makes it a good time to buy them. When the VIX is high relative to its past levels, be careful buying options because their values may be inflated, possibly making it a better time to sell options. However, use extreme vigilance when selling options, as the seller is obligated to cover all losses the underlying may experience. (Remember youre the insurance company when you sell an option.) Use caution when trading individual stock options based on relative VIX levels, though. Remember, VIX is calculated on a basket of index options and does not speak to specific equity option prices.
Its all the same game

For the beginner, options may appear to be somewhat esoteric or difficult to use. However, once you get past all the language, theyre nothing more than insurance policies for a stock position. If you understand how insurance works, you can begin to understand how options are priced, and thus be able to know when and how to use them to protect positions in an underlying instrument or trade them outright. For information on the author see p. 4. Questions or comments? Click here.
A version of this article previously appeared in Active Trader magazine.
Additional reading
Options for beginners: Getting started in options, Active Trader, April 2001, p. 82 Stepping into options, Active Trader, April 2001, p. 64 Volatility Putting volatility to work, Active Trader, April 2001, p. 42
The volatility-value relationship

Given the importance of volatility in determining option value, a quick parting trick of the trade is to watch the VIX, the Chicago Board Options Exchanges (CBOE) volatility index, which reflects the implied volatility of
29
OPTIONS STRATEGY LAB
Using a long straddle to trade the monthly employment report

System concept: The first FIGURE 1 EMPLOYMENT ANNOUNCEMENT DAYS installment of our monthly Option Strategy Lab, which The 10-year T-note futures (TY) have been quite volatile when they digested the Bureau of Labor Statistics monthly jobs report. studies the potential profitability of specific trade strateTen-year T-note (TY), 60 days gies based on historical option 118 prices, examines whether 116 options can be used to profit from a predictable event the 114 Bureau of Labor Statistics (BLS) release of the employ112 ment report, which typically hits the Street on the first 110 Friday of every month. 108 This report explains the U.S. employment situation in detail 106 and includes non-farm payrolls and the unemployment 104 March April May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. March April rate two closely watched 2004 2005 indicators as well as average workweek and average ity (IV). For instance, a drop in implied volatility will cause hourly and weekly statistics. Because the report plays a big role in helping the Federal both the long call and put to drop in value, while an Reserve decide whether to change its Fed Funds target rate increase will have the opposite effect. or the interest rate banks charge each other for overnight loans, its release often precedes large moves in the Treasury Trade rules: 1. Purchase an at-the-money straddle in the nearest market. The T-notes (i.e., maturities of two, three, five, and option-expiration month at Thursdays close when the 10 years) price range on announcement days can be several BLS plans to release the jobs report the following day times their average daily price movement. (Friday). Purchase one of the closest-to-the-money calls Figure 1 shows the 10-year T-note 60-day forward conand one of the closest-to-the-money puts at the last price tract (TY) from March 2004 to May 2005; the arrows reprequoted. (Commissions and slippage are not included.) sent announcement days over the past 14 months. It seems there should be a way to use options to take advantage of 2. Sell the straddle at the next days closing price. large price moves. However, we ruled out a directional strategy (i.e., betting on whether prices will move up or down) because Treasury Test data: The system was tested on nearest-month prices dropped eight times and climbed seven times after options of the 10-year T-note futures contract. jobs releases since March 2004. So how would an options Test period: March 2004 to May 2005. Option System trader go about exploiting this pattern? One possibility is a long straddle, which involves simul- Analysis strategies were tested using OptionVues taneously buying a call and put option at the same strike BackTester module. price in the same month. This strategy offers profit potential no matter which way price moves. Other variables that Test results: Figure 2 shows a detailed breakdown of affect the value of a long straddle (besides the direction of each trade over the past 15 months. This strategy lost a total of $875 (excluding commissions). According to the Strategy the underlying) are volatility and time. Long straddles are vulnerable to time decay, which Summary, individual straddle performance varied from a means both options value erodes a little bit each day. The 22.9-percent gain to 26.7-percent loss. These rules produced a profit only one out of every three position is also very sensitive to changes in implied volatil30 June 2005 OPTIONS TRADER
FIGURE 2 STRADDLE RESULTS
times, on average. There appears to be no tradable edge to this strategy since its average winner ($228.12) was about the same as the average loser ($204.56). However, Figure 1 shows Treasury prices made substantial moves after nearly every job announcement so what went wrong? When a major event approaches, the markets heightened anxiety level is reflected in higher-than-normal option prices (as measured by IV). Once the event occurs, however, IV levels drop back to normal. Because IV always moves up prior to jobs announcements, the system bought expensive options each time. When IV declined sharply after the news hit the Street, both the long call and put lost value.
Only five of the 15 straddles were profitable, and the strategy lost $875 between March 2004 and May 2005.
Bottom line: Applying straddles to the Treasury market this way raises the question whether the markets move will be enough to overcome the subsequent decline in IV levels. If so, the straddle will become profitable; if not, it will lose money. Commissions and slippage will likely add to this strategys losses, so you should always include accurate brokerage fees and consider the effect possible bad fills would have before actually trading. In next months issue, well examine a completely differ-
ent approach that may be more profitable selling a strangle or shorting both an out-of-the-money call and out-ofthe-money put with different strike prices but the same expiration month after the report had already been released. - Steve Lentz and Jim Graham of OptionVue
STRATEGY SUMMARY
Net loss ($): No. of trades: No. of winning trades: No. of losing trades: Win/loss (%): Average trade ($): Hold time (winners and losers): Largest winning trade ($): Largest losing trade ($): Avg. profit (winners) $: Avg. loss (losers) $: Ratio avg. win/avg. loss: Max. consec. win/loss:
-875.01 15 5 10 33 -58.33 1 day 437.50 -500.00 228.12 -201.56 1.13 2/5
LEGEND: Net loss Loss at end of test period, less commission. No. trades Number of trades generated by the system. No. of winning trades. Number of winners generated by the system. No. of losing trades Number of losers generated by the system. Win/loss (%) The percentage of trades that were profitable. Avg. trade The average profit for all trades. Hold time (winners and losers) The holding period for all trades (in days). Avg. profit (winners) The average profit for winning trades. Avg. loss (losers) The average loss for losing trades. Ratio avg. win/ avg. loss Average winner divided by average loser. Max consec. win/loss The maximum number of consecutive winning and losing trades.
If you have a strategy youd like to see tested, please send the trading and money-management rules to Advisor@OptionVue.com.
31
OPTIONS RESOURCES
Hoadley.net
Lots of free and reasonably priced analysis tools for option traders.
eter Hoadley might not be a household name in ing dividend payouts. the options world, but the Australian traders Web Certain features of this spreadsheet work better with the site (www.hoadley.net/options/options.htm) con- add-in sheet (e.g., the add-in allows you to download price tains several helpful tools for option traders everywhere. FIGURE 1 STRATEGY EVALUATOR The site has a Derivatives Add-In The Strategy Evaluator plots a profit/loss chart after you enter various Excel spreadsheet that allows you to parameters for an option trade. build applications that can price options, calculate Greeks and historical and implied volatility, identify optimal exercise points, determine value at risk, and perform a host of other functions. The spreadsheet costs 66 Aussie dollars (a little more than $50 U.S. as of early May) and can be downloaded instantly upon purchase. Also, buying the spreadsheet gives you the opportunity to use a handful of other spreadsheets (including an Open Positions Manager and a Portfolio Optimizer) that are available for free on the site. The add-in spreadsheet adds premium features to the Options Strategy Evaluation Model, which can be Source: Hoadley.net downloaded for free. The model provides what-if scenarios for various FIGURE 2 ALTERNATE VIEW combinations of puts, calls, and the The graphical information from the chart in Figure 1 is here displayed in a table. underlying instrument. Although it downloads as an Excel file, the Evaluation Model is quite extensive. It allows users to input various aspects of an option (strike price, days until expiration, American or European options, etc.) and see the profit/loss potential of various scenarios (Figure 1). It includes a strategy payoff chart that shows at a glance the profit/loss of a trade depending on the price of the underlying instrument, and displays the positions Greeks as well. You have the choice of viewing all this information in table form (Figure 2). The spreadsheet also features probability analysis, a tool for establishing an early exercise threshold, an implied volatility calculator, and a place to Source: Hoadley.net record underlying positions, includ32 June 2005 OPTIONS TRADER
Two products Trade Secrets DVD Series offered through www.traderslibrary.com:
data from the Internet; without it you must enter this information by hand), and some wont work at all without it (e.g., the Strategy Dissection, which charts the profit/loss for all trades on one chart). Nonetheless, the Evaluation Model is a handy tool to have around. While the spreadsheets are rather large and, in some cases, a bit advanced, Hoadley offers more than an hours worth of online demos and tutorials to help users with them. Hoadleys site also features nine
FIGURE 3 PRICE CALCULATOR
Two others use a binomial or trinomial tree models to graphically show how options prices are derived, and another uses a trinomial lattice to show how barrier options are priced (the site has explanations for all the calculators). The remaining calculators feature a convergence analysis, a dividend impact analysis and comparison of European and American options, a stock price distribution analysis, and a stock price probability analysis.
Bull and Bear Spreads: Advanced Option Strategies for Any Market By Marc Allaire Marketplace Books, 2005 DVD $99 The right approach to options trading depends on how well it fits your investment style, according to Allaire. His DVD, targeted for the intermediate trader, explains several options-trading techniques, including bull and bear options, calendar spreads, and stockpurchase leveraging.
The Black-Scholes calculator shows how an options price changes based on stock price, volatility, time until expiration, and interest rates.
Source: Hoadley.net
financial calculators, all free and ready for immediate use. Two of them show how changes in stock price, volatility, time until expiration, and interest rates affect option price, time value, Greeks, and probability the option will close in the money (Figure 3). One calculator takes dividends into account, the other does not.
Hoadley also includes a rather lengthy section on option pricing with detailed explanations of the BlackScholes model, the Binomial model, and a small section on the Greeks. Hoadleys goal is to sell his spreadsheet, but that doesnt diminish the fact that the sites free tools can be very useful.
Option Spreads: Generating Exceptional Returns By Tony Ciccone Marketplace Books, 2005 DVD $99 Ciccone uses real-world examples in his DVD presentation on options trading. He covers how to leg in and out of combination trades, recognize certain factors that cause volatility shifts, exploit time decay, and use calendar spreads.
33
OPTIONS TRADE JOURNAL

We try to catch a breakout from the Australian dollars trading range with a long strangle.
FIGURE 1 LOW IMPLIED VOLATILITY The Australian dollars volatility (statistical and implied) dropped below 10 percent in March from a three-year high (14 percent) in May 2004, which suggests buying options in anticipation of an upcoming volatility spike could be a profitable strategy.
TRADE
Date: Friday, May 20, 2005. Position: Long 1 July 77 call option at 0.35. Long 1 July 75 put option at 1.06. Reasons for trade/setup: The Australian dollar futures statistical and implied volatilities have dropped to 18-month lows over the past six months, and front-month futures have traded between roughly 74 and 79. We constructed a long strangle by buying a July 77 call option and July 75 put in anticipation of a breakout (up or down) from the Aussie dollars consolidation between the entry date (May 20) and the options expiration date (July 9). A move above 78.48 or below 73.52 would put the strangle in the money, but an increase in the markets currently low implied volatility also will narrow the positions breakeven points and help boost its potential profitability. Figure 1 shows the currencys average weekly statistical and implied volatilities over the past six years. Implied volatility (IV) spiked from late 2003 to June 2004 as the Australian dollar first rose to a seven-year high (79.00) in February 2004 before plummeting more than 15 percent over the following four months. However, IV has dropped steadily to 9.7 percent on May 20 from 14.8 percent on May 21, 2004 as the currency rallied late last year and then consolidated throughout 2005. Figure 2 shows the long strangles risk profile, which plots
Source: OptionVue 5
TRADE SUMMARY Entry Date 5/20/05 Underlying security ADU05 Position: Long 1 July 77 call ($): 0.35 Long 1 July 75 put ($): 1.06 Total position cost ($): 1.41 Capital required ($): $1,480 Initial stop: If AD is trading between 75.35 and 76.30 with no increase in IV a 50-percent loss by June 14, or twenty five days before expiration (July 9). Initial targets: Above 78.25 or below 74.00 Initial daily time decay ($): -18.44 One week later Date 5/27/05 Exit (MTM) 1.05 Trade length: 5 days P/L -0.36 (24%) LOP n/a LOL -0.36 (24%)
LOP Largest open profit (Maximum available profit during lifetime of trade); LOL largest open loss (maximum potential loss during life of trade); MTM marked to market price.
TRADE STATISTICS Date Delta Gamma Theta Vega May 20, 2005 -22.83 29.68 -18.44 195.50 May 27, 2005 0.03 33.79 -21.34 181.70 10.3% 10.0% 10.5% 22% 73.90 / 78.10
Average IV 10.0% Calls IV 9.9% Puts IV 10.1% Probability of profit by expiration (July 9) 26% Breakeven points 73.52 / 78.48
34
FIGURE 2 RISK PROFILE This long strangle will be profitable if the Australian dollar trades below 73.52 or above 78.48 by expiration (July 9, solid brown line).
the positions potential profitability based on the Aussie dollars price on three dates: trade entry (May 20, orange line), 25 days until expiration (June 14, dashed brown), and expiration (July 9, solid brown). The strangle is more likely to profit from a sell-off below its lower breakeven point because the currencys distance from the May 20 close to this boundary (1.46) is less than half as far as its required move above the upper threshold (3.50). Initial stop: Well exit the position if the Aussie dollar futures are trading between 75.35 and 76.30 with unchanged volatility (i.e., a 50-percent loss) by June 14 halfway between our trade entry and the July options expiration date. Initial target: Well take profits when the underlying currency falls below 73.50 or climbs above 78.25 by June 14. Both scenarios will result in a gain of roughly 11 percent. However, these estimates exclude a rise in implied volatility, which could double these profits if IV climbed nearly 2 percent from 9.7 to 11.5 percent its 18-month average (see Figure 1).
Source: OptionVue 5
FIGURE 3 PROFITABILITY A big move (up or down) in the Australian dollar over the next 50 days can help overcome the strangles time decay and lead to gains.
RESULT
Source: OptionVue 5 Lessons: The Australian dollar gained 1.11 percent during the trades first week, which erased 24 percent of the strangles value. Although the Australian dollars implied volatility rose slightly (see Trade Statistics), this increase wasnt nearly enough to offset the rallys negative effect on our position. Figure 3 shows Australian dollar futures (AD). The green and red sections (right side) represent the positions profitability zones. The September futures closed at 74.98 on May 20, but then rose towards the middle of the strangles unprofitable area by May 27.
Our hopes have dimmed somewhat, especially since the trades sensitivity to implied volatilitys changes (vega) dropped as its daily time decay (theta) continued to rise. Also, the strangles probability of profit sank to 22 from 26 percent not a great sign. However, July options wont expire for another six weeks, and the strangles breakeven points have narrowed. Overall, the trade could still end in the black if the Australian dollar makes a significant move (up or down) and its options revert to more normal levels of implied volatility.
35
OPTIONS EXPIRATION CALENDAR & EVENTS GLOBAL ECONOMIC CALENDAR

Monday Tuesday Wednesday Thursday Friday
JUNE MONTH
Saturday
Legend
CBOT: Chicago Board of Trade CME: Chicago Mercantile Exchange CPI: Consumer Price Index FOMC: Federal Open Market Committee GDP: Gross Domestic Product
LTD: The final day a contract may trade or be closed out before delivery of the underlying asset must occur. NYBOT: New York Board of Trade NYMEX: New York Mercantile Exchange PPI: Producer Price Index
2
LTD: May milk options (CME)
3
LTD: June currencies options (CME); June U.S. dollar index options (CME); July live cattle options (CME); July cocoa options (NYBOT) Employment for May
10
LTD: July sugar and coffee options (NYBOT); July cotton options (NYBOT)
11
13
14
PPI for May LTD: June lean hogs options (CME)
15
CPI for May LTD: July platinum options (NYMEX); June Goldman Sachs Commodity Index options (CME)
16
LTD: All June equity options and futures; June S&P options and futures (CME); June Nasdaq options and futures (CME); June Dow Jones options and futures (CBOT); July crude oil options (NYMEX)
17
LTD: Quadruple witching Friday; July orange juice options (NYBOT)
20
21
22
23
24
LTD: July T-bond options (CBOT); July corn, wheat, rice, oats, soybean, and soybean products options (CBOT)
25
27
LTD: July natural gas, gasoline and heating oil options (NYMEX); July aluminum, copper, silver, and gold options (NYMEX)
28
29
GDP (final) for Q1 FOMC meeting
30
FOMC meeting LTD: July lumber options (CME); June milk options (CME)
Event: Linda Raschkes 9th Annual Trading Seminar Date: June 10-12 Location: Orlando World Center Marriott Resort & Convention Center For more information: Contact Laura Meek at laura@lbrgroup.com or (888) 546-4836 Event: Ag options workshop instructed by options author and speaker Jay Sorkin Date: June 15 Location: Chicago Board of Trade
Cost: $275 For more information: E-mail educationandtraining@cbot.com or call (312) 435-3478 Event: Expo Trader Brazil International Asset Managers and Traders Conference. Speakers include John Bollinger, Larry Williams, and Frank Tirado. Date: June 23-24 Location: Sofitel Hotel, Rio de Janeiro, Brazil For more information: www.expotrader.com.br/
Event: The Traders Expo Chicago Date: July 13-16 Location: Hyatt Regency Chicago For more information: www.tradersexpo.com or call (800) 9704355 Event: Fibonacci Trader workshops Date: July 16-18 (Orlando) and Sept. 11-13 (Denver) Presenters: Dennis Bolze and Yuri Shramenko For more information: Visit www.fibonaccitrader.com
The information on this page is subject to change. Options Trader is not responsible for the accuracy of calendar dates beyond press time.
36
KEY CONCEPTS AND DEFINITIONS
Options glossary
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. 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. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. 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 instruments price. 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 instruments price. Deep (e.g., deep in-the-money option or deep out-of-the money option): Call options with strike price that are very far above the current price of the underlying asset and put options with strike prices that are very far below the current price of the underlying asset. Exercise: To exchange an option for the underlying instrument. American style: An option that can be exercised at any time until expiration. European style: An option that can only be exercised at expiration, not before. 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). Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Premium: The price of an option. Strike (exercise) price: The price at which an underlying stock is exchanged upon exercise of an option. Time value: The amount of an options value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as time decay. 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.
Three good tools for targeting customers . . .
CONTACT
Bob Dorman
Ad sales East Coast and Midwest bdorman@activetradermag.com (312) 775-5421
38
Allison Ellis
Ad sales West Coast and Southwest aellis@activetradermag.com (626) 497-9195
Mark Seger
Account Executive mseger@activetradermag.com (312) 377-9435
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JUNE 2005 Volume 1, No.

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . .4 Letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Options News

Options Basics . . . . . . . . . . . . . . . . . . . . .28

Option Strategy Lab . . . . . . . . . . . . . . .30

Options Resources . . . . . . . . . . . . . . . . .32

Have a question about something youve seen in Options Trader?

For how-to instruction on viewing the magazine

Looking for an advertiser?

CBOE TradersExpo Investorflix

NetPicks Expo Trader Brazil ChoiceTrade

A publication of Active Trader

For all subscriber services:

HIT YOUR MARK!

Contact Bob Dorman

June 2005 OPTIONS TRADER

Options traders savvy, becoming mainstream

Support your local options contract

CME bolsters options trading

Show me the numbers

SEC mulls execution requirements, penny trading, for option brokers

Reducing risk with vertical spreads

Initial $68.50 40 60% 2% 0 70

Eight days later $71.25 32 60% 2% 0 70

Initial $68.50 40 60% 2% 0 70

Eight days later $71.25 32 40% 2% 0 70

The missing link volatility

Historical vs. implied volatility

OPTIONS STRATEGIES continued

Initial $68.50 40 60% 2% 0

Eight days later $71.25 32 40% 2% 0

The vertical spread solution

$7.30 0.65 $3.10 0.36 $4.20 0.29

$7.30 0.80 $1.90 0.36 $5.40 0.44

Estimating an options theoretical value

~NOW~ Trade Options for as low as

Unmatched service and support

Options Trader Staff

Come visit us at: www.choicetrade.com

OPTIONS STRATEGIES continued

June 2005 OPTIONS TRADER

TRADING STRATEGIES continued

Exotic options and trading news events

Send Options Trader to a friend

Visit www.optionstradermag.com for more information.

Option spreads: The reinsurance approach

Source: Reuters Metastock

June 2005 OPTIONS TRADER

Source: chart Excel; data oddsonline.com

FIGURE 3 CREDIT SPREAD

Risk and reward: Naked options

99.00 EBAY share price

Source: chart Excel; data oddsonline.com

TRADING STRATEGIES continued

claim to bring catastrophe. In the case of Lloyds, it was asbestos.

The reinsurance option

Source: chart Excel; data oddsonline.com

Games of chance: The probability factor

Sign u p no for a w subsc

Matching option strategy to market conditions

TRADING STRATEGIES continued

1400 1350 1300 1250 1200 1150 1100

Combining pattern and strategy

Long Call (You expect the market to explode to the upside.)

Short Put (You firmly expect the market NOT to go down.)