January 2008 Volume 2, No.

1

CRUDE OIL pullback pattern p. 8 BREAKOUT ANTICIPATION SYSTEM p. 22 SHORT INTEREST: Trading investor sentiment p. 18 THE TIME DECAY vs. delta trading edge p. 12 FUNDAMENTALS and grain futures p. 26

CONTENTS

Futures Trading System Lab . . . . . . . .22 Bollinger Band breakout-anticipation system
By Volker Knapp

Options Trading System Lab . . . . . . . .24 Covered calls on the Diamonds
By Steve Lentz and Jim Graham

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Trading Strategies Oil driller strategy . . . . . . . . . . . . . . . . . . . . .8
It doesn’t trigger often, but this signal has the potential to identify favorable buying opportunities in the oil market. By FOT staff

Trading Basics Rain, soil, and sun: Grain futures fundamentals . . . . . . . . . . .26
Grains are the oldest futures markets, but that doesn’t make them the simplest. There’s a great deal of information to digest before dipping your toes into the grain futures pool. By FOT staff
continued on p. 4

The theta-vega relationship . . . . . . . . . . .12
Focusing on these option “Greeks” can help you avoid missteps when trading calendar spreads. By Darren Chu

Short interest and relative strength . . . .18
This contrarian approach combines relative strength and short interest to identify stocks that are poised for a “short-squeeze” rally. By Bernie Schaeffer and Beth Gaston Moon

2

January 2008 • FUTURES & OPTIONS TRADER

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CONTENTS

News NYMEX hopes it’s easy being Green . . .30
The New York Mercantile Exchange will enter the emissions trading market with the launch of the Green Exchange. By Jim Kharouf

Senate moves CFTC reauthorization forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 The Commodity Futures Trading Commission moves one step closer to
reauthorization and picks up some additional power along the way. By Jim Kharouf

Futures Snapshot . . . . . . . . . . . . . . . . . . . .34
Momentum, volatility, and volume statistics for futures.

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .35
Notable volatility and volume in the options market.

OneChicago offers remedy to credit squeeze . . . . . . . . . . . . . . . . . . . . .31
Single-stock futures on the Nasdaq 100 and Russell 2000 ETFs are now available at OneChicago. By Jim Kharouf

Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36 Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .38
References and definitions.

Futures & Options Calendar . . . . . . . . . . . .41 Futures Trade Journal . . . . . . . . . . . . . . .42
Managing a trade during a market shock.

Options Watch: Financial sector ETF components . . . . . . . . . . . . .32
Tracking bid-ask spreads on financial sector stock options.

Options Trade Journal . . . . . . . . . . . . . . .43
Another stock-split trade profits modestly with long ATM calls.

New Products and Services . . . . . . . . .33

Have a question about something you’ve seen in Futures & Options Trader?
Submit your editorial queries or comments to webmaster@futuresandoptionstrader.com.

Looking for an advertiser?
Click on the company name below for a direct link to the ad in this month’s issue of Futures & Options Trader. eSignal ISE New York Expo OptionsMentoring OptionVue RS of Houston TradeStation Zecco

4

January 2008 • FUTURES & OPTIONS TRADER

CONTRIBUTORS CONTRIBUTORS

Bernie Schaeffer is chairman and CEO of Schaeffer’s Investment Research, Inc. and author of The Option Advisor:
A publication of Active Trader ®

Wealth-Building Techniques Using Equity and Index Options. Schaeffer has edited the Option Advisor newsletter since its inception in 1981. He focuses on equity and index options, investor sentiment, and market timing. He can be reached at http://www.SchaeffersResearch.com. Darren Chu is a corporate relations manager for the Montreal Exchange, servicing institutional and retail traders/brokers and the buy-side. Chu’s prior role at the Montreal Exchange involved educating retail investors, financial industry professionals, students, and business groups on exchange-traded derivatives. Previously, Chu worked at CMC Markets, where he developed and taught courses on CFD and forex trading. While at CMC Markets, Chu also served as a market analyst, providing market commentary to clients from the perspective of an active trader in the oil and gold markets. Chu is currently a member of the Canadian Securities Institute’s Derivatives Board. Volker Knapp has been a trader, system developer, and researcher for more than 20 years. His diverse background encompasses positions such as German National Hockey team player, coach of the Malaysian National Hockey team, and president of VTAD (the German branch of the International Federation of Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc. (http://www.wealth-lab.com), which he is still running. Jim Graham (advisor@optionvue.com) is the product manager for OptionVue Systems and a registered investment advisor for OptionVue Research. Steve Lentz (advisor@optionvue.com) is executive vice president of OptionVue Research, a risk-management consulting company. He also heads education and research programs for OptionVue Systems, including one-on-one mentoring for intermediate and advanced traders.

For all subscriber services:
www.futuresandoptionstrader.com

Editor-in-chief: Mark Etzkorn metzkorn@futuresandoptionstrader.com Managing editor: Molly Flynn mflynn@futuresandoptionstrader.com Senior editor: David Bukey dbukey@futuresandoptionstrader.com Contributing editors: Jeff Ponczak jponczak@futuresandoptionstrader.com, Keith Schap Editorial assistant and Webmaster: Kesha Green kgreen@futuresandoptionstrader.com Art director: Laura Coyle lcoyle@futuresandoptionstrader.com President: Phil Dorman pdorman@futuresandoptionstrader.com Publisher, Ad sales East Coast and Midwest: Bob Dorman bdorman@futuresandoptionstrader.com Ad sales West Coast and Southwest only: Allison Ellis aellis@futuresandoptionstrader.com Classified ad sales: Mark Seger mseger@futuresandoptionstrader.com

Volume 2, Issue 1. Futures & Options Trader is published monthly by TechInfo, Inc., 161 N. Clark Street, Suite 4915, Chicago, IL 60601. Copyright © 2007 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Futures & Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

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. Kharouf has covered international derivatives exchanges, money managers, and traders for a variety of publications.

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January 2008 • FUTURES & OPTIONS TRADER

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billed exchange fees for any real-time exchange or premium services which you choose to receive. $14.95 fee applies for option exercises or assignments. Prices, fees, costs and terms are subject to change. • No offer or solicitation to buy or sell securities, securities derivative or futures products of any kind, or future performance or any type of trading or investment advice, recommendation or strategy, is made, given or in any manner endorsed by TradeStation Securities, Inc. or any of its affiliates.• Past performance, whether actual or indicated by historical tests of strategies, is no guarantee of future performance or success. • Active trading is generally not appropriate for someone with limited resources, limited investment or trading experience, or low-risk tolerance. • There is a risk of loss in futures trading. Options and Security Futures trading is not suitable for all investors. Please visit our web site for relevant risk disclosures.
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TRADING STRATEGIES

Oil driller strategy
A weekly bar pattern offers a good — if rare — entry point for traders willing to hold a position for several weeks.
BY FOT STAFF

T

rading oil can sometimes feel like trying to grab a meteor by the tail — and 2007 was the market’s biggest year in more than a decade. Crude has essentially been in a nine-year bull market (Figure 1), and many believe the market can only go up in the long run, given oil is a finite resource and unending turmoil in the Middle East always threatens (at least in the minds of traders) global supplies. Even if it seems like crude oil never pulls back, there are signals when the market has finished up a downside move and is ready to move higher. The following weekly bar pat-

tern has not occurred very often in the past 24 years, but when it has, the upside follow-through has often been significant.

Definition of simplicity

The pattern consists of a weekly bar in which the opening and closing prices are relatively near each other and are also in the upper 25 percent of the week’s range. In a nutshell, during such a week crude sells off at some point after trading opens, and then rallies to climb near or above where it started the week, and in the upper end of the week’s trading. FIGURE 1 — ONE-WAY STREET The implication is easy to grasp: Whatever catalysts or sentiment pushed Crude oil has been in a powerful uptrend for nearly nine years, and topped $100 for the first time in early January. the market lower earlier in the week have either dissipated or been offset by the end of the week. If this pattern formed on a daily, hourly, or 10-minute bar, this implication might seem to be progressively inconsequential. During any 10-minute period, for example, the market might be pushed down and recover for any number of reasons, or just randomly. It is the longer-term weekly time frame that offers the possibility the implication has significance. To find out if this concept has any merit, let’s consider the following pattern rules: 1. Both the open and close prices must be in the upper 25 percent of the week’s range.

Source: TradeStation

8

January 2008 • FUTURES & OPTIONS TRADER

2. The difference between the open and close prices must be 0.064 percent or less of the previous week’s closing price. As formulas the pattern rules are:
1. (CLOSE-LOW)/(HIGH-LOW) >= 0.75 and (OPEN-LOW)/(HIGH-LOW) >= 0.75 and 2. ABS(OPEN-CLOSE) <= 0.0064*PREVCLOSE where All prices are the most recent week’s prices, except PREVCLOSE, which is the previous week’s close ABS = absolute value

FIGURE 2 — WEEKLY BUY BARS Four of the weekly buy patterns occurred in 2007.

Source: TradeStation

FIGURE 3 — BULLISH WEEKLY CRUDE PATTERN The pattern outperformed the typical market gain by a wide margin in the bullish 1998-2007 period, but its advantage was muted between 1983 and 1997. The pattern is definitely a bull-market phenomenon.

Figure 2 shows four recent examples of the pattern. However, this pattern has a notable weakness — its infrequency. There were only six instances of the pattern between April 1983 and the end of 1997 (with the first example in this period coming in 1990) and 16 from 1998 to October 2007. In addition to this being a small sample from which to extrapolate, there is also the practical matter of how infrequently the signal would trigger in the future — a common problem with patterns based on longer-term data. Nonetheless, the results are fairly consistent. Let’s look at the 1998-2007 period, since most of the signals occurred then — not surprising, since
continued on p. 10

FUTURES & OPTIONS TRADER • January 2008

9

TRADING STRATEGIES continued

Understanding Table 1
Table 1 summarizes the price behavior for one- to 10-week periods, showing the average, median, maximum, and minimum price changes from: 1. The pattern’s closing price to the closing price of the next day (week 1, 2, etc.). 2. The pattern’s closing price to the next week’s highest high (largest up move, or “LUM”). 3. The pattern’s closing price to the next week’s lowest low (largest down move, or “LDM”). Also included are the standard deviations (StD) for the close-to-close changes and the percentage of times the close-to-close change was positive (“% > 0”). Figure A shows the close-to-close moves, LUMs, and LDMs from the initial bar to the two subsequent bars.

this was the more dynamic period for crude, which increased nearly tenfold. Figure 3 compares the median performance in the 10 weeks after the patterns to the average performance for all one- to 10-week periods in the analysis window. The gains after the pattern far outstrip crude oil’s typical gains — by two, three, or nearly four times. Table 1 shows the details of the 1998-2007 patterns. One of the most salient statistics is the probability of gains from week to week — always above 50 percent, and usually significantly higher. The results from the six 1983-1997 patterns were not as bullish (the market itself was less bullish during this period, but the patterns also outperformed the market during this period). See “Understanding Table 1” for more information about the figures in Table 1.

TABLE 1 — 1998-2007 PATTERN DETAILS The probability of higher closes for the first 10 weeks after the pattern was always at least 50 percent, and usually much higher. +1 Avg Med Max Min StD %<0 0.98 0.73 4.34 -1.40 1.47 68.75% +6 Avg Med Max Min StD %<0 4.13 3.06 15.31 -2.86 4.71 85.71% LUM 5.68 3.86 1.36 4.77 LDM -2.17 -2.82 -4.03 1.40 LUM 1.61 1.39 4.86 0.00 1.27 LDM -1.30 -0.82 0.00 -3.33 1.24 +2 0.74 0.67 7.16 -5.13 3.24 62.50% +7 4.63 3.74 19.65 -4.21 5.99 85.71% LUM 6.21 5.26 20.17 1.36 5.01 LDM -2.31 -2.82 -0.26 -4.83 1.57 LUM 2.67 1.70 8.33 0.52 2.31 LDM -1.93 -1.19 0.00 -5.19 1.61 +3 1.46 0.48 12.07 -5.56 4.40 50.00% +8 4.62 4.07 18.57 -4.48 5.63 71.43% LUM 7.50 5.50 20.17 1.36 5.73 LDM -2.34 -2.82 -0.26 -5.17 1.61 LUM 3.61 2.22 12.21 0.99 3.32 LDM -2.26 -1.37 -0.26 -7.64 1.92 +4 3.19 1.57 16.14 -2.57 4.86 75.00% +9 5.19 5.79 23.48 -5.45 6.81 78.57% LUM 8.25 7.75 23.62 1.36 6.23 LDM -2.57 -2.82 -0.26 -6.66 1.96 LUM 4.45 2.80 16.21 0.99 4.36 LDM -2.28 -1.52 -0.26 -7.64 1.92 +5 3.16 1.86 16.53 -4.68 5.32 75.00% +10 5.50 4.93 27.55 -8.77 8.22 71.43% LUM 8.84 7.75 27.62 1.36 6.96 LDM -3.18 -2.82 -0.81 -10.16 2.33 LUM 5.05 3.28 18.31 1.20 4.79 LDM -2.80 -2.27 -0.26 -14.12 3.29

18.31 -0.26

10

January 2008 • FUTURES & OPTIONS TRADER

Again, some traders may be thrown by the pattern’s infrequency, but trade opportunities are trade opportunities. Furthermore, if these patterns coincide with more frequent signals, there is more reason to pay attention to their bullish implications.

Related reading
“Futures Insight: Crude oil” Active Trader, July 2004. A broad analysis of the crude oil market helps highlight its seasonal patterns and its tendency to make runs. “Short-term crude oil tendencies” Futures & Options Trader, June 2005. Crude can be a wild market, but understanding the typical price behavior of both the pit and electronically traded sessions will improve your trading strategies and sharpen your skills. “Using spreads to find back-month crude oil trades” Futures & Options Trader, October 2007. A practical approach to analyzing spread relationships can be used to locate outright trade opportunities in crude oil. You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.

Not a bear pattern
In the past 20 years crude oil has made only a couple of significant, extended bear moves — 1997 to 1999 and late 2000 to late 2001 (and only two patterns formed during these four years). Nonetheless, downtrending market conditions would likely negatively affect this pattern — that is, signal a long trade when the market is likely to continue lower — or erase it altogether, as the 1997-1999 and 2000-2001 periods suggest. While many traders have come to believe the crude oil market is destined to remain in an uptrend, such broad assumptions have a way of unraveling when you least expect. Markets change, and strategies must change with them.

TRADING STRATEGIES

The theta-vega relationship
Profiting from a drop in implied volatility with calendar spreads isn’t as easy as you might think. The trick is to keep your eye on theta and vega.
BY DARREN CHU

M

TABLE 1 — VEGA AND THETA A long options position is long vega and short theta, which means its value increases if IV climbs while time works against it. This relationship is reversed for short options. Options position Long Short Vega + Theta +

ost traders understand options decay in value over time, but many fail to realize how the relationship between time decay and implied volatility (IV) can influence an option’s price. The option “Greeks” measure different ways an option’s price can change: Theta tracks its time decay and vega gauges its sensitivity to IV changes. Although many traders can define these terms, few can profit from how they interact. Retail traders often enter calendar spreads if the nearmonth option’s IV seems inflated and they expect it to drop. However, these spreads can backfire if the longer-term option’s IV is also higher than usual. The trick is to measure a position’s total vega and theta to see how it might react to changes in implied volatility and the passage of time. The following examples use calendar spreads (short option, long same-strike option that expires later) to illustrate how individual options and more complex strategies may be impacted by changes in theta, vega, and implied volatility.

Defining theta

Theta estimates the rate at which an option loses value as time passes, assuming all other option-pricing TABLE 2 — CALENDAR CALL SPREAD ON MERRILL LYNCH factors remain constant. This Merrill Lynch calendar spread costs $4.60 and has a positive vega, which means it will Traders often refer to benefit from an increase in IV. theta as an annualized or daily value. For instance, Per-share numbers if an option’s annualized Components Long/short Vega Theta Cost Dollar cost theta value is -3.5, its 1 April 55 MER call Long 0.134 -0.0284 -$7.20 -$720.00 value should drop by 1 December 55 MER call Short -0.059 0.0606 $2.60 $260.00 $3.50 in 365 calendar Totals: 0.075 0.0322 -$4.60 -$460.00 days (if nothing else changes).
12

Always remember to adjust theta’s value to match a trade’s holding period. If, for example, you expect to hold an at-the-money (ATM) option for 14 calendar days, you could multiply its annualized theta by 14/365 to calculate theta for this period. However, time decay accelerates for ATM options, particularly in the month before they expire. Therefore, predicting time decay with this method only provides an estimate. Time decay is more linear for out-of-the-money (OTM) and in-the-money (ITM) options, and it actually decelerates in the final days before expiration. The reason is that OTM and ITM options have less time value, which decays rapidly toward expiration. Because time decay of OTM and ITM options slows as expiration approaches, options sellers tend to exit earlier than if they had sold ATM options.

January 2008 • FUTURES & OPTIONS TRADER

FIGURE 1 — MERRILL LYNCH Merrill’s implied volatility (blue line) remained below 40 percent for much of 2007 before it jumped to historically high levels in November. Selling this seemingly high IV is tempting, but traders have bid up MER’s IV for a reason.

Both long calls and puts have negative thetas because they lose value as time passes. Short options, on the other hand, have positive thetas and benefit from time decay. To calculate the combined theta of a strategy with multiple options, just add each option’s theta value. Calculating a position’s total theta can help ensure it benefits from the passage of time. You can also determine its total delta or vega with the same approach.

Defining vega
Most options traders know that an option’s value is boosted, or Source: OptionVue at least supported, by higher implied volatility. The option Greek vega measures an option’s sensitivity to IV changes and represents the theoretical amount the option’s value will change if IV climbs or falls one percentage point. Suppose a front-month option on Research in Motion (RIMM) was near the money with an IV of 75 percent and a vega of 0.120. If IV climbed to 76 percent, you could expect the option’s value to increase by roughly $0.12, assuming all other option-pricing factors remain constant. Conversely, if IV fell to 74 percent, the option’s premium should drop by $0.12. ATM vegas tend to be roughly equal for calls and puts (regardless of time to expiration) and differ more as options become deeper OTM or ITM.

Relationship between vega and theta
To better appreciate volatility, think of it as time. Long options benefit from an increasingly volatile underlying, because they are more likely to move into the money and be profitable at expiration. With more time to expiracontinued on p. 14

FUTURES & OPTIONS TRADER • January 2008

13

TRADING STRATEGIES continued

TABLE 3 — VOLATILITY DROPS, SPREAD LOSES VALUE This Barrick Gold calendar spread seems poised to profit from an IV drop. However, the spread lost $0.07 even though both options’ IV fell, because its total vega was positive. Barrick Gold (ABX) closed at $32.39 on Aug. 16: Components 1 Sept. 34 call 1 Oct. 34 call Long-short Short Long Spread cost: Bid-ask $1.10-$1.17 $1.46-$1.62 $0.52 IV 42.46% 39.06% Vega comments October 34 vega is higher than September 34 vega, as the October call has more time to expiration.

Barrick Gold (ABX) climbed to $34.48 by Aug. 23: Components 1 Sept. 34 call Long-short Short Bid-ask $1.44-$1.55 IV 31.88% Vega comments Call vegas benefit from the calls being closer to ATM, but suffer from time to expiration falling; October 34 vega remains higher than September 34 vega, as the October call has more time to expiration.

1 Oct. 34 call

Long Spread cost: Gain/loss:

$1.99-$2.10 $0.45 -$0.07

31.38%

tion, an option has more extrinsic time value, and therefore more vega. Short options, however, lose value as both time and volatility diminish. Options sellers want to avoid assignment, and this process becomes less likely as these two pric-

Calendar spreads
A calendar, or time, spread contains one long call (put) option and another short call (put) on the same underlying instrument with the same strike price, but with a shorter term to expiration. The spread reaches its maximum gain when the underlying closes at the strike when the shorterterm option expires. Calendar spreads work with any strike price as long as both options share the same strike. If, for example, a stock traded at $101, you could sell a front-month call with a 100 strike and buy a four-month, same-strike call to protect it. If the stock falls to $100 by the first expiration, you will keep the short call’s premium. At that point, the long call will still have some time value, and you could either sell it or hold it (if you believe the underlying will rebound sufficiently by the second expiration). At-the-money (ATM) calendar spreads are most profitable in flat markets and exploit the short option’s time decay. However, out-of-the-money (OTM) calendars are ideal if you expect the market to climb (or drop) to the shared strike price at the front-month expiration.

ing factors fall. Table 1 shows a long options position is long vega and short theta, while a short options position is short vega and long theta. ATM options typically have the largest time value; theta is highest at these strikes, because they have the greatest potential for time decay. Vega is also highest in ATM strikes, which makes sense if you think of volatility as synthetic time. Using the same reasoning, the more volatile the underlying asset, the greater theta’s value. Meanwhile, deep ITM options trade close to their intrinsic values and contain little time value, resulting in low thetas and vegas. Deep OTM options lack intrinsic value and have very little time value. Therefore, theta and vega on these options are also low.

Position vega
Calculating the Greeks for multi-legged positions is important, because their net totals (position Greeks) reveal how these trades may react to specific changes in the underlying’s price, time to expiration, volatility, and so on. To calculate a position’s overall vega or theta, simply add each option’s values together. Let’s assume you were either neutral or somewhat bearish on Merrill Lynch (MER) when it closed at $53.54 on Nov. 23. Therefore, you decided to enter a call calendar spread by selling a December 55 call for $2.60 and buying an April 2008 55 call for $7.20 (Table 2). This trade will offer the largest profit if MER trades below the 55 strike until the first
January 2008 • FUTURES & OPTIONS TRADER

14

expiration on Dec. 15 and then trades higher by the second expiration on April 19, 2008. Traders often buy calendar spreads to take advantage of short-term options’ greater rate of time decay. This position is also called a horizontal, or time, spread and contains all calls or puts at the same strike, but different expiration months. For more details about calendar spreads, see “Calendar spreads.” The first step in measuring position vega is to identify each option’s vega. The short December call’s vega is 0.059, while the long April call’s vega is 0.134. Simply add these values and then multiply by the number of shares each call represents (100): Short December 55 call’s vega = 0.059 * 100 shares * -1 contract = -5.9 Long April call’s vega = 0.134 * 100 shares * 1 contract = 13.4 Net vega = 13.4 + -5.9 = 7.5 Remember that longer-dated options have higher vegas than short-term options, so calendar spreads always have positive vegas, which means they will benefit from an increase in implied volatility. When each of these two calls’ IV climbs by one percentage point, the calendar’s dollar value should appreciate by $7.50, assuming all other variables remain constant. In reality, however, implied volatility rarely changes uniformly across different contracts. For instance, the December 55 call’s IV may fall by 1 percentage point, while the April 55 call’s IV may drop by 0.5 percentage points. For simplicity, however, let’s assume options’ implied volatilities change by the same amount.

could be “expensive.” Figure 1 shows a daily chart of Merrill Lynch and compares SV and IV levels since October 2006 (brown and blue lines, respectively). In November MER’s implied volatility spiked to historically high levels as the December and April 55 calls’ IVs were 54.5 percent and 53 percent, respectively. By contrast, Merrill’s IV and SV were below 40 percent during most of 2007. If you believe the long December/April calendar’s vega risk is too high, you could sell the same calendar spread instead by buying the December call and selling its April 2008 counterpart. But selling the April call is very risky because it will sit uncovered after the long December call expires. New options traders often assume calendar spreads are a sure thing. Their logic is as follows: If you sell a near-month call to capture its high IV and buy a longer-term call with a lower IV, you should make money. But IVs trade at certain
continued on p. 16

The elusive volatility trade
Before buying options or entering a position with positive vega, you should compare the underlying’s overall current IV to its statistical volatility (SV). In addition, you should compare current IV levels to past values. If current implied volatility is below these levels, an option IV might be “cheap,” and if current IV is higher, an option
FUTURES & OPTIONS TRADER • January 2008 15

TRADING STRATEGIES continued

Related reading
“Directional calendars on the S&P 500” Futures & Options Trader, May 2007. This system compares two strategies with similar profiles: a horizontal calendar spread and a butterfly spread. Both positions try to collect premium from short options and protect them with long options, but they protect against large losses differently. “Calendar spreads surrounding earnings news” Options Trader, March 2007. More versatile than you might think, these calendar spreads profit from changes in volatility rather than the time decay. “Swing with the market: Vega and rho” Options Trader, February 2007. Vega and rho are lesser-known “Greeks,” but they measure the effect of two critical option-pricing components: implied volatility and interest rates. “Know your theta” Options Trader, January 2007. Time eats away at every options position, so it pays to know time decay affects option prices. “Calendar spreads after earnings releases” Options Trader, September 2006. The system placed an at-the-money (ATM) horizontal debit (calendar) spread on stocks after quarterly earnings were announced. “Calendar spreads on the S&P 500” Options Trader, August 2006. This system tested an at-the-money (ATM) horizontal (calendar) debit spread strategy on the cash-settled options of the S&P 500. “Death, taxes, and time decay” Options Trader, March 2006. Markets that go nowhere can be frustrating, but call calendar and diagonal spreads can generate respectable profits in these situations by taking advantage of time decay. “Calendar spreads: Taking time out of the market” Options Trader, February 2005. Trading time spreads offers a way to take advantage of time decay and volatility changes while limiting risk. Many of these articles are included in “Options Trading System Labs, Volume 2,” a collection of 12 articles that show historical performance of different options positions. These strategies are rarely back-tested, but Futures & Options Trader showcases back-tested option-trading systems in each issue. This collection contains all the monthly Options Trading System Lab articles from 2006, exploring event-based strategies, sentiment plays, and non-directional techniques. These articles are designed to show good and bad trade ideas. As a result, back-testing results in some articles may indicate a system or trade idea is likely to be unprofitable. You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.

levels for a reason. Before you decide to buy “low” volatility and sell “high” volatility, you must understand the fundamental and technical factors behind these numbers. Remember, the markets are efficient, especially with liquid options classes.

Position theta
You can calculate a position’s total theta in the same way you calculate its vega: Identify each option’s value and add them together. For example, on Nov. 24 Merrill Lynch’s December 55 call had a theta of 0.0606, and its April 2008 55 call had a theta of 0.0284. This means the spread benefited from time decay, because the December call was decaying from time passing at more than twice the rate of the April call. The position’s theta was: Short December 55 call’s theta = -0.0606 * 100 shares * -1 contract = 6.06 Long April call’s theta = -0.0284 * 100 shares * 1 contract = -2.84 Net theta = 6.06 + -2.84 = 3.22 The MER December/April 55 call calendar’s net theta was positive, and the spread was gaining $3.22 per day (as of Nov. 24). Remember theta increases notably in the final 30 days before an ATM option expires. Therefore, calendarspread traders typically sell the short leg in the front month. Once the short call expires, the spread becomes an outright long call position, which remains long vega, but becomes short theta (see Table 1).

Don’t ignore vega and implied volatility
The next example in Barrick Gold Corp. (ABX) highlights the relationship between vega and implied volatility by describing how a poorly constructed calendar spread can sufJanuary 2008 • FUTURES & OPTIONS TRADER

16

fer from a drop in implied volatility. (Although ABX and its options trade on U.S.-based exchanges, the following example uses underlying prices from the Toronto Stock Exchange and option prices from the Montreal Exchange.) Barrick Gold dropped 5.4 percent on Aug. 16 to close at $32.39, and its implied volatility rose on the pullback. The September 34 call’s IV was 42.46 percent, while the samestrike October call’s IV was only 39.06 percent. When stocks fall, their near-term options’ IVs are often pushed higher than IVs of longer-dated options of the same strike. Markets expect implied volatility to gradually subside after it spikes, eventually reverting to its mean. Without paying attention to either call’s vega, let’s assume you decide to buy the September /October 34 calendar spread. The logic: You expect the September 34 call’s IV to decline further than the October call’s IV. Table 3 shows the spread costs $0.52 if you sell the September 34 call for $1.10 (bid) and buy the October 34 call at $1.62 (ask). As with all long calendar positions, this spread is long vega and long theta. ABX gained 6.4 percent by Aug. 23 and closed at $34.48, above the spread’s strike. Table 3 shows the short September 34 call’s bid-ask climbed to $1.44-$1.55, reflecting about $1 in intrinsic value; its IV fell to 31.88 percent, a drop of more than 10 percentage points. The October 34 call’s bid-ask rose to $1.99$2.10 as its IV declined to 31.38 percent, a decline of nearly 8 percentage points. As expected, the September call’s IV fell further than the October call’s, which would seem to benefit the calendar spread (if you ignore vega). If, however, you sold the spread on Aug. 23, you would have collected only $0.44 ($1.99 - $1.55), a loss of 8.5 percent [(0.44 - 0.52)/0.52] in one week.

spread to boost its odds of success? The trade would have worked better if only the September call’s IV had climbed — not the October call’s. However, the back-month contract’s IV also rose, which suggested it was more vulnerable to a similar-size IV decline in both contracts. Traders typically buy calendar spreads when they expect IV to stay relatively low and stable until the short-term leg expires. Ideally, the short option will expire worthless, and the underlying will move in the right direction afterwards. In addition, traders rarely construct calendar spreads with options in two back-to-back months, as in the Barrick Gold example. Instead, it’s better to enter a calendar spread with at least three months between its short and long legs. For example, you could buy an option that expires in more than three months and sell the front-month contract. There are no set rules, however — the number of months between the calendar’s short and long legs depends on your IV forecasts and the underlying’s direction as well as your tolerance for risk.
For information on the author see p. 6.

What went wrong?
Calendar spreads are always net long vega, so you should never buy one if you expect both options’ IVs to drop. In a calendar spread, the short option’s vega is always lower than the long call’s vega. (Remember that laterexpiring options have higher vegas.) Even though the short call’s IV fell further than the long call’s IV, the long call had a higher vega, which indicates it was more sensitive to IV changes. How could you have revised this
FUTURES & OPTIONS TRADER • January 2008 17

TRADING STRATEGIES

Short interest and relative strength
Short sellers aren’t always right about a stock’s future direction. This technique identifies opportunities to buy calls on stocks that are popular with the short-selling crowd.
BY BERNIE SCHAEFFER AND BETH GASTON MOON

S

hort interest is the number of shares investors have sold short on any given stock or exchange traded fund (ETF). When a stock is sold short, shares are borrowed, sold, and then bought back (covered) to close the trade. Despite these added steps, selling short is simply the opposite of buying stock, because price must decline for the trade to become profitable. At first glance, a large amount of short interest seems negative, because traders are betting on the stock to fall. From a contrarian viewpoint, however, this pessimism isn’t necessarily a bearish sign, especially if the stock has outperformed on a technical basis. Historically, stocks that recently outperformed the broader market despite a large amount of short interest were more likely to trade higher within two weeks. In these cases, short interest can

be a bullish signal. The reason: Short sellers lose money when the underlying price rises, and the more price climbs, the more likely they will cut losses and buy their positions back — a “short-covering” rally. This analysis suggests one way to find potentially bullish stocks by combining short interest and relative strength.

If a stock’s short interest climbs substantially and price advances, short sellers might get “squeezed” and be forced to exit, boosting price further and perpetuating the cycle.

Historical patterns
Short interest can also help you find a bullish options trade. For an aggressive options trade to truly succeed, it has to subscribe to the “FAR” concept by moving fast, aggressively, and in the right direction. Stocks that are heavily shorted tend to be more volatile after two-day gains of at least eight percent, which can help options buyers. Also, high-short-interest stock prices tend to advance after these rallies as short sellers throw in the towel. Table 1 breaks down short interest on NYSE and Nasdaq stocks into four categories — less than 5 percent, 5 to 10 percent, 10 to 20 percent, and more than 20 percent of a stock’s float, or the number of tradable shares, sold short. The table shows how stocks performed from 2005 to 2007 following two types of up moves: Five-percent gains in one day (columns 1 to 3), and 8-percent gains in two days (columns 4 to 6). Table 1 also lists the number of signals in each category and the percentage of stocks that gained 10 percent within 10 days, respectively. Table 1’s statistics support the theory that stocks with large short-interest values will hit this target most often. After two-day jumps of eight percent (or more), mid-cap and large-cap stocks were 50 percent more likely to

Short interest as fuel
Generally, a high volume of short interest indicates investors have a negative outlook for a stock (although heavy short interest can also be created from arbitrage situations such as mergers and the release of convertible bonds). But contrarians believe this pessimism could be bullish if the stock is in an uptrend. Assuming other bullish factors exist, stocks with high short-interest values are prone to rally, because short sellers act as potential buyers on the sidelines.

Strategy snapshot
Strategy: Contrarian short-interest trade. Market: Options on individual stocks. Components: Long near-the-money, front-month calls. Logic: Stocks with high relative strength and large short-interest
values are more likely to jump in the next 10 days.

Criteria: Has outperformed S&P 500 by 20 percent in the past 60
days, short interest of at least 1 million shares, and a shortinterest ratio of 7.

Historical High-short-interest stocks were 62 percent more likely tendency: to gain 10 percent in 10 days.
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January 2008 • FUTURES & OPTIONS TRADER

TABLE 1 — SHORT-INTEREST STATISTICS High-short-interest stocks were 62 percent more likely to gain 10 percent within two weeks than their low-short-interest counterparts (column 6, 12.87 percent vs. 7.96 percent, respectively). Moved 5% in 1 day Signals Reached 10% in 10 days Moved 8% in 2 days Signals Reached 10% in 10 days

SI % range

SI % range

> 5% 5% - 10% 10% - 20% > 20% Grand total

5,403 3,752 2,701 1,765 13,621

8.05% 8.66% 9.14% 12.18% 8.97%

> 5% 5% - 10% 10% - 20% > 20% Grand total

2,814 2,041 1,466 1,010 7,331

7.96% 9.11% 9.14% 12.87% 9.19%

Source: http://www.schaeffersresearch.com

gain at least 10 percent within two weeks if they had more than 10-percent short interest (not shown). This was an even more dramatic signal when stocks had at least 20 percent of their float sold short, regardless of their size (small-, mid-, and large-cap stocks). For example, high-short-interest stocks were 62 percent more likely to gain 10 percent within two weeks than their low-short-interest counterparts (see Table 1’s column 6, 12.87 percent vs. 7.96 percent, respectively).

ment, the short-interest ratio is the number of days needed to close all shorted shares at the stock’s average daily volume, assuming each trade represents short sellers covering their positions. The ratio effectively reveals the extent of short-covering potential. Contrarians view large ratio values as bullish. Minimum stock price: $10. Several Web sites and software programs let you scan for stocks that meet these criteria. These thresholds are merely suggestions and can be altered. Twenty-six stocks met all of these specifications. The top relativestrength stock was American Oriental Bioengineering (AOB), which outperformed the S&P 500 by 61 percent in the last 60 days. However, Open Text (OTEX) had the largest short-interest ratio of 22.1. The remaining stocks had solid momentum, strong price action, and short-covering potential. However, there are additional factors you can use to select candidates. One way is to focus on recent price action — just because a stock outperformed the S&P 500 in the past three months doesn’t necessarily mean it gained ground in the last several weeks. Other sentiment factors are relevant, including analysts’ ratings (to determine the potential for upgrades or downgrades on the underlying stock) and options activity. Additionally, fundamental variables such as earnings momentum are important to check,
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particularly if an earnings report is imminent.

Narrowing the list to one stock
One of the better selections from a fundamental, technical, and sentiment perspective is BioMarin Pharmaceuticals (BMRN). BMRN is a biopharmaceutical company with two “orphan drugs” under its umbrella, meaning BioMarin has exclusive marketing rights to these medications for
continued on p. 20

The relative-strength, short-interest filter
One way to find these potentially bullish stocks is to scan the universe of stocks for a combination of high relative strength and short interest. On Oct. 31 the following criteria were used as a filter: Relative-strength look-back period: 60 trading days Stocks must outperform the S&P 500 index for roughly 3 months. Minimum relative strength: 1.2 Stocks must outperform the S&P 500 index by at least 20 percent during this period. Minimum short interest: 1,000,000 Stocks must have at least 1 million open shorted shares. Minimum average daily volume: 500,000 Minimum short-interest ratio: 7.0 Arguably the most important ele-

FUTURES & OPTIONS TRADER • January 2008

TRADING STRATEGIES continued

FIGURE 1 — BIOMARIN PHARMACEUTICALS (BMRN), MONTHLY BioMarin (BMRN) jumped 358 percent from Feb. 1, 2005 to Oct. 31, 2007, and traded above its 10- and 20-month SMAs for most of this three-year period.

Source: Thompson/ILX

FIGURE 2 — BIOMARIN PHARMACEUTICALS (BMRN), DAILY Although BioMarin pulled back below its 10- and 20-day SMAs in mid-October, it crossed above them just before reaching a new yearly high on Oct. 27.

seven years. Its fundamentals appear strong — although biopharmaceutical companies are always at risk of volatile price swings. Figure 1’s monthly chart shows BMRN jumped 358 percent from Feb. 1, 2005 to Oct. 31, 2007, and traded above its 10- and 20-month simple moving averages (SMA) for most of this three-year period. In the last three months, BioMarin gained 53.5 percent and reached a new seven-year high of $28.50. On a short-term basis, Figure 2’s daily chart shows BMRN has traded above its 10-day and 20-day SMAs since early August. Although BioMarin pulled back below these moving averages in mid-October, it crossed above them just before reaching a new yearly high on Oct. 27. There were roughly 16.7 million BMRN shares sold short in October. This represents 17.4 percent of BioMarin’s float and a short-interest ratio of 9.4. In other words, it would take 9.4 trading days — at the stock’s average daily volume — to buy back all of these short positions (assuming only short sellers were trading to close their positions on those days). In the past two months, the number of short BMRN shares has dropped nearly 15 percent, which suggests short sellers were already exiting, a process that helps boost its price.

Options hold clues about sentiment
Options sentiment boded well for BioMarin from a contrarian perspective. For example, the Schaeffer’s put/call open interest ratio (SOIR) was 1.38 on Oct. 31, which means there were 138 open puts for every 100 open calls — a bearish preference from the options crowd. This SOIR reading was higher than 88 percent of daily values in the last year, meaning the indicator neared an annual extreme.
January 2008 • FUTURES & OPTIONS TRADER

Source: Thompson/ILX

20

The majority of open calls were in-the-money (ITM, below the stock’s current price), reducing the threat of options-related resistance. Alternately, put open interest offered a layer of structural support, as most of BMRN’s open short-term puts were out-of-the-money (OTM, below the stock’s current price).

Related reading by Bernie Schaeffer
“Three types of debit spreads: Bullish, bearish, and neutral” Futures and Options Trader, July 2007. Paying to enter an option spread may not be popular, but it can help control risk. Learn how to match your market forecast with the right spread. “Option pair trading expands profit horizon” Options Trader, February 2007. Buying a call in one stock and a put in another is a simple strategy that can benefit from overlooked relationships between the stocks. “Getting sentimental about options” Active Trader, March 2002. Successful option trading depends on a number of variables, but one many traders overlook is sentiment analysis. Find out what different sentiment tools represent and how they can round out your trading.

Buying calls on BioMarin
At the end of October, BioMarin traded in a strong uptrend that could accelerate amid short-covering activity. How can you take advantage of a possible short-term rally such as a 10percent underlying gain in two weeks? One way is to simply buy BRMN stock, but the leverage inherent in options can produce even bigger and better gains. Because a call costs less than buying stock, you can earn a large return on margin even if the underlying climbs only modestly. The more aggressive the call (in terms of its time value and ITM or OTM status), the higher its leverage ratio will be. (Leverage is simply defined as option return divided by stock return.) For example, a near-the-money, front-month option might earn 150 percent or more if BioMarin moved 10 percent (up or down). However, short-term OTM options offer the biggest bang for your buck. These options are cheap, but can offer large profits if the underlying stock moves quickly and aggressively in the right direction. If you’re more conservative, consider buying an ITM option or one with more time until expiration. Remember, a sharp upward move in the underlying stock will benefit all long option positions. The difference in profit depends upon the long option’s leverage.
For information on the author see p. 6.
FUTURES & OPTIONS TRADER • January 2008

Other articles:
“Short selling basics” Active Trader, December 2007. From a regulation standpoint, selling short is easier now that it was a year ago, — but there are still things to consider before shorting a stock. “Indicator insight: Relative strength” Active Trader, June 2002. An overview of the ways in which relative strength can be measured and interpreted. “Short-term trading with relative strength” Active Trader, August 2001. How do you find the best trading opportunities from day to day? Compare a stock’s performance to the rest of the market. Relative strength analysis can alert you to stocks with great momentum potential. “Relative strength bands” Active Trader, March 2001. This system uses a mix of relative strength (not RSI) analysis and Bollinger Bands to identify markets that are about to break out of congestion areas. “A walk on the short side” Active Trader, July 2000. There are benefits and risks to short selling, but working both sides of the market is a key trading survival skill. You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.

21

FUTURES TRADING SYSTEM LAB

Bollinger Band breakout-anticipation system
FIGURE 1 — SAMPLE TRADES Entries occur when a Bollinger Band “squeeze” occurs. The top panel shows the Bollinger BandWidth indicator, with the red dots marking the lowest low of the past 100 days. Market: Futures. System concept: Bollinger Bands consist of a moving average (20 days by default) and two lines, one two standard deviations above the average and the other two standard deviations below it. The bands expand as volatility increases and contract as it decreases. The formula for the Bollinger “BandWidth” indicator, which represents the distance between the upper and lower bands as a percentage of the indicator’s moving average, is: BandWidth = (upper band - lower band )/SMA where, SMA is the length of the simple moving average used to create the Bollinger Bands.
Source: Wealth-Lab Pro 5.0

FIGURE 2 — EQUITY CURVE The system produced most of its profits in the second half of the test period.

A low BandWidth reading reflects a temporary balance of buyers and sellers. When the bands tighten significantly, sharp volatility expansions — and trends — are possible. The following system attempts to capitalize on this idea. Strategy rules: If the Band Width is the lowest it’s been in 100 days and the absolute distance between the upper and lower Bollinger Bands is less than 2.5 times the 10-day average true range (ATR): 1. Go long tomorrow with a stop loss order at today’s high plus one tick, or go short tomorrow with a stop-loss order at today’s low minus one tick, whichever comes first. 2. After 10 bars in a position, exit tomorrow at market. 3. Alternately, exit on a penetration of the five-day low (for a long position) or the five-day high (for a long position). Standard Bollinger Band parameters are used: 20-day simple moving average and bands set two standard deviaJanuary 2008 • FUTURES & OPTIONS TRADER

Source: Wealth-Lab Pro 5.0

22

PERIODIC RETURNS Percentage profitable periods 51.67 56.10 54.55 Max consec. profitable 7 8 4 Max consec. unprofitable 5 5 2

Avg. return Monthly Quarterly Annually 1.07% 3.11% 12.09%

Sharpe ratio 0.44 0.46 0.42

Best return 33.38% 26.79% 41.28%

Worst return -9.36% -11.71% -13.36%

tions above and below the average. Figure 1 shows some sample trades. Money management: Risk 2 percent of account equity per trade. Starting equity: $1,000,000. Deduct $8 commission and one tick slippage per trade.

STRATEGY SUMMARY

Profitability
Net profit: Net profit: Profit factor: Payoff ratio: Recovery factor: Exposure: $2,103,341.26 210.33% 1.35 1.86 2.55 3.42%

Trade statistics
No. trades: Win/loss: Avg. profit/loss: Avg. hold time (days): Avg. win: Avg. hold time (winners): Avg. loss: Avg. hold time (losers): Max consec. win/loss: Total commission: 453 43.27% 0.34% 7.36 2.67% 10.29 -1.44% 5.13 5/8 $7,248

Test data: The system was tested on the Futures & Options Trader Standard Drawdown Futures Portfolio, which contains the folMax. DD: -29.80% lowing 20 futures contracts: British Longest flat period: 534 bars pound (BP), soybean oil (BO), corn (C), crude oil (CL), cotton #2 (CT), E-Mini Nasdaq 100 (NQ), E-Mini S&P 500 (ES), 5-year T-note (FV), LEGEND: euro (EC), gold (GC), Japanese yen (JY), coffee (KC), wheat Avg. hold time — The average holding period for all trades. (W), live cattle (LC), lean hogs (LH), natural gas (NG), sugar Avg. hold time (losers) — The average holding time for losing trades. #11 (SB), silver (SI), Swiss franc (SF), and T-Bonds (US). Data Avg. hold time (winners) — The average holding time for winning source: ratio-adjusted data from Pinnacle Data Corp. trades. (http://www.pinnacledata.com).
Avg. loss (losers) — The average loss for losing trades. Avg. profit/loss — The average profit/loss for all trades. Avg. profit (winners) — The average profit for winning trades. Avg. return — The average percentage for the period. Best return — Best return for the period. Exposure — The area of the equity curve exposed to long or short positions, as opposed to cash. Longest flat period — Longest period (in days) between two equity highs. Max consec. profitable — The largest number of consecutive profitable periods. Max consec. unprofitable — The largest number of consecutive unprofitable periods. Max consec. win/loss — The maximum number of consecutive winning and losing trades. Max. DD — Largest percentage decline in equity. Net profit — Profit at end of test period, less commission. No. trades — Number of trades generated by the system. Payoff ratio — Average profit of winning trades divided by average loss of losing trades. Percentage profitable periods — The percentage of periods that were profitable. Profit factor — Gross profit divided by gross loss. Recovery factor — Net profit divided by maximum drawdown. Disclaimer: The Futures Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading. Sharpe ratio — Average return divided by standard deviation of returns (annualized). Win/loss — The percentage of trades that were profitable. Worst return — Worst return for the period.

Test period: December 1997 to November 2007. Test results: On the whole, the system’s performance could be described as decent. The system returned 210.3 percent on 453 trades over the 10-year test period (12-percent annualized return). A payoff ratio close of 1.86 compensated for the low number of winning trades (43 percent). The equity curve was unspectacular in the first five years of the test period, but picked up its pace noticeably in the second half (Figure 2). Both the long and short sides of the system contributed to its profitability. (In fact, although the short side had fewer trading opportunities, it was a vast benefit to the overall returns.) For more details on this system — including its performance on intraday stock data — see the March 2008 issue of Active Trader magazine (http://www.activetradermag.com). — Volker Knapp of Wealth-Lab
For information on the author see p. 6.
Futures Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform.

FUTURES & OPTIONS TRADER • January 2008

23

OPTIONS TRADING SYSTEM LAB

Covered calls on the Diamonds
Market: Dow Jones tracking stock, or Diamonds, (DIA) and its options. These strategies could also be applied to options on other indices, ETFs, and stocks. System concept: New options traders often trade covered calls (long underlying, short call) on stocks they own. A covered call is relatively easy to understand, collects income immediately, and seems as safe as buying stock. However, capturing gains can be tough, because it’s hard to know which calls to sell and how to manage the position. A covered call contains a long underlying position (e.g., 100 shares of stock) and a short call — one call per 100 shares (or one futures contract). The short call is “covered” by the underlying, because if the price of the underlying climbs above the call’s strike, you already own the shares of stock needed to meet your obligations if you are assigned. To enter a covered call, you can either sell a call against stock you already own or place both trades simultaneously. Covered-call traders often sell calls repeatedly on a stock they already own by buying them back (or letting them expire worthless) and then selling calls in later-expiring months, a process called “rolling.” This test compares two different ways of rolling the position’s short call vs. a simple buy-and-hold strategy on the Diamonds over the past five years. The first “seasonal” approach simply rolls the short call on the second Friday of every month. The second managed approach checks closing prices each day and rolls if the short call’s time premium falls by two-thirds of its value. (Note: The system doesn’t sell the original 100 shares of DIA — only calls are sold and bought back during the test period.) Figure 1 shows the potential gains and losses of a covered call — long
24

FIGURE 1 — COVERED CALL — RISK PROFILE The managed covered-call strategy entered this position on Nov. 8. Its upside gains were limited, while its downside risk was much larger (although the position posted gains for all DIA prices shown here).

Source: OptionVue

FIGURE 2 — COVERED CALLS — SEASONAL, MANAGED, AND BUY-AND-HOLD All three strategies gained from 32.5 percent to 38.9 percent during the test period. The two covered call methods (green and pink lines) had less volatile returns, but the buy-and-hold strategy (blue line) earned roughly 6 percent more.

January 2008 • FUTURES & OPTIONS TRADER

STRATEGY SUMMARY

DIA at 132.56, short December 132 call — that was opened on Nov. 8. It illustrates the covered call strategy’s downside risk and limited profit potential. (Note: The trade will be profitable at all prices shown by Dec. 21 expiration, because the system bought 100 shares of DIA in June 2002 when it traded at a multi-year low.)
Trade rules: Seasonal: 1. Buy 100 shares of DIA on June 14, 2002 and sell the call with the most time premium in the second expiration month. 2. Buy back the short call on the second Friday of each month. Sell another call with the most time premium in the second expiration month.

Buy and hold Net gain: $3,867 Percentage return: 38.9% Annualized return: 7.1% No. of trades: 1 Winning/losing trades: 1/0 Win/loss: 100% Avg. trade: N/A Largest winning trade: N/A Largest losing trade: N/A Avg. profit (winners): $3,867 Avg. loss (losers): N/A Avg. hold time (winners): 1,995 Avg. hold time (losers): N/A Max. consec. win/loss: 1/0

Seasonal $3,233 32.7% 6.0% 66 34/32 52% $48.98 $4,110 -$617 $258.94 -$174.09 88 30 4/6

Managed $3,058 32.5% 6% 134 67/67 50% $22.82 $4,045 -$389 $171.43 -$125.79 44 16 4/6

Managed: 1. Buy 100 shares of DIA on June 14, 2002 and sell the call with the most time premium in the second expiration month. 2. Buy back the short call if its time premium falls to one-third of its original value. Sell the call with highest time premium in the first month with at least 14 days until expiration.
Test details: • All three test accounts began with $10,000 in capital. • Dividends were not included. • No margin was used when buying stock. • Daily closing prices were used. Trades were executed at the bid and ask, when possible. Otherwise, theoretical prices were used. • Commissions were $6 per option, $8 per 100 shares of stock. Test data: Dow Jones tracking stock, or Diamonds, and its options. Test period: June 14, 2002 to Nov. 30, 2007. Test results: Figure 2 compares the performance of all three strategies over the five-year test period. The managed approach gained $3,058 (32.5 percent), slightly less than the seasonal method. Because the managed approach requires more effort, traders may prefer the seasonal method. Bottom line: In contrast to options’ reputation as risky investments, a covered call reduces directional risk somewhat. Selling calls against existing underlying shares lowers the overall variance of returns, thus minimizing risk in the traditional sense. But while traders are drawn to the income covered calls
FUTURES & OPTIONS TRADER • January 2008

generate, it also has one major shortcoming: It has nearly the same downside risk as owning stock, but limits potential upside profits. Note: This test included minimal commissions, but larger fees and bad fills will likely affect performance. — Steve Lentz and Jim Graham of OptionVue

LEGEND: Net gain – Gain at end of test period, less commission. Percentage return – Gain or loss on a percentage basis. Annualized return – Gain or loss on an annualized percentage basis. No. of trades – Number of trades generated by the system. Winning/losing trades – Number of winners/losers generated by the system. Win/loss (%) – The percentage of trades that were profitable. Avg. trade – The average profit for all trades. Largest winning trade – Biggest individual profit generated by the system. Largest losing trade – Biggest individual loss generated by the system. Avg. profit (winners) – The average profit for winning trades. Avg. loss (losers) – The average loss for losing trades. Avg. hold time (winners) – The average holding time for winning trades. Avg. hold time (losers) – The average holding time for losing trades. Max consec. win/loss – The maximum number of consecutive winning and losing trades.
Option System Analysis strategies are tested using OptionVue’s BackTrader module (unless otherwise noted). If you have a trading idea or strategy that you’d like to see tested, please send the trading and money-management rules to Advisor@OptionVue.com.

25

TRADING BASICS

Rain, soil, and sun: Grain futures fundamentals
Several fundamental factors determine the prices of agricultural futures, but their relationships aren’t as simple as you might think.
BY FOT STAFF
n the legendary movie “Trading Places,” Louis Winthorpe III (Dan Akroyd) and Billy Ray Valentine (Eddie Murphy) make their fortune by stealing a crop report from the Duke brothers (who stole it from the government) and cashing in on that inside information. Winthorpe and Valentine knew ahead of time the weather would likely lead to a successful orange crop harvest, keeping the supply of frozen concentrated orange juice high and demand low. In addition, the protagonists fed a false crop report — which indicated the harvest would not go so

I

Accurately predicting a product’s supply base (or at least having an educated guess) is the first step in successfully trading agricultural futures.
well — to the Duke brothers, who thus bid up the market in anticipation of higher prices. The truth emerged when the official report was released, and the Duke Brothers went bankrupt at the expense of Winthorpe and Valentine. While the movie focused on frozen concentrated orange juice, the concept is the same for grains — corn, wheat, rice, oats, and soybeans futures traded at the Chicago Board of Trade. The weather leading up to the harvest of these crops is a big determinant in where prices will wind up. The prices of agricultural futures are ultimately determined by the same economic forces that set the price of stocks, rare pieces of art, real estate, or the 32-ounce fountain drink at your local convenience store — supply and demand. Speculation would be much easier if traders were able to accurately predict one side of the supply-demand equation. However, this is obviously easier said than done. If Company X is six months away from announcing it has
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discovered a drug that will help reduce cancer, a wise investment move would be to buy large quantities of Company X’s stock in anticipation of the price being significantly higher once the news became public. However, without some (likely illegal) insider information, it would be difficult if not impossible to take advantage of this situation. On the other hand, diligent agricultural futures traders who know where to look and what to search for might be able to gain an informational edge. Accurately predicting a product’s supply base (or at least having an educated guess) is the first step in successfully trading agricultural futures.

Talking ‘bout the weather
To oversimplify the concept, certain crops will have more bountiful harvests when temperature and precipitation amounts are at a certain level than when those conditions are abnormal (Figure 1). More bountiful harvests lead to greater supply, which leads to lower prices. Diminished harvests produce less of the crop, which gives the farmer a reason to sell the product at a higher price. Of course, nothing is perfect — x precipitation and y temperature may result in corn that sells around z price one year, but the same weather conditions may produce a different price the next year because of different macroeconomic conditions, advances in crop production, etc. Nonetheless, watching and studying pre-harvest weather conditions can provide a better idea of what prices might do in a few months. The important thing is to study the right information. Agriculture professors, CTAs, and other professional groups (such as ones hired by large agribusinesses) generally consider three things when evaluating what the upcoming crop harvest will produce: precipitation, temperature, and soil condition. “We focus on crop moisture average, weekly average temperatures, and weekly average precipitation,” says Oscar Vergara, agricultural risk-modeling consultant at AIR Worldwide, a risk-management firm that analyzes crop
January 2008 • FUTURES & OPTIONS TRADER

FIGURE 1 — BIG AND BOUNTIFUL Because of ideal weather conditions and advancements in harvesting, corn (top), wheat (middle), and soybean (bottom) futures traded at the Chicago Board of Trade all set or challenged record highs in 2007.

Wisconsin, South Dakota, Michigan, Missouri, Kansas, Ohio, and Kentucky also produce significant amounts, and a few other states are minor producers. Two other heavily traded agricultural commodities, wheat and soybeans, have similar production patterns — i.e., total production is spread across several states. So, how much emphasis can you put on a particular unusual weather pattern in one of the high-production areas? It’s easy to understand that temperatures 20 degrees above normal for two straight weeks in Illinois are bad for the corn crop, but what weather is normal in the other corn-growing areas? How much emphasis should you put on Illinois’ weather woes? This is where many traders fall into a trap. “It’s important not to hone in on a headline about a drought affecting
continued on p. 28

Source: eSignal

insurance and reinsurance programs. AIR has finished first or second each of the last four years at the FACTSim Futures and Options Trading Competition. “We use 15-, 30-, and 45-day models,” Vergara says. “We don’t go much longer because the weather fluxes too much.”

Location, location, location
If a crop were grown in only one part

of the country, the effects of weather would be easier to understand. A prolonged drought would lead to a lessthan-stellar crop, which would lead to higher prices. Unfortunately, the situation is much more complex. Take corn, for example. Corn is the most commonly grown crop in the U.S. More than 50 percent of U.S. corn production comes from Iowa, Illinois, Nebraska, and Minnesota. However, Indiana,
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FUTURES & OPTIONS TRADER • January 2008

TRADING BASICS continued

FIGURE 2 — BETTER THAN A NEWSPAPER The Weekly Weather and Crop Bulletin released every week by the United States Department of Agriculture provides detailed reports on the weather across the U.S. and how it might affect certain crops.

the dead vegetation around it. At this point, it can be determined how tall the plants are compared to past year, the condition of the plant, the size of the kernels/pods, etc. Harvesting. This is the final stage, when yield is determined and the overall quality of the crop can be accurately assessed. The entire process takes several months, and the listing of corn futures at the CBOT reflects this — there are contracts expiring in March, May, July, September, and December. Soybeans have a similar schedule — they also have January and August contracts, and their final contract of the year is November, not December.

Getting help
This is a lot of information to consider before trading. However, there is a pair of user-friendly, information-heavy Web sites traders can consult. The first is the United States Department of Agriculture site (http://www.usda.gov), which, among other things, provides detailed reports on every commodity tradable on a U.S. futures market, as well as detailed weather reports (Figure 2). The second is the National Agricultural Statistics Service site (http://www.nass.usda.gov). The NASS is a division of the USDA and offers more in-depth info than the USDA site. “The maps we’re using are the same ones you can find on the USDA site, although ours are a little more detailed,” Vergara says. You can find the seeding, planting, flowering, and harvesting stages of each crop on these sites. This information changes from year to year. Vergara says the AIR team took second in the latest competition because its trading system included strategies that weren’t weather related — what was happening in China and India, the price of the U.S. dollar vs. the euro, etc. However, Vergara says he has since learned that while macroeconomic factors are important, from June to August, weather is the key element. Also consider that if 2008 produces the exact same weather conditions as 2003 or 1998, the yield will be greater because farmers have better technology, better machinery, better seeds, and better farm management.
January 2008 • FUTURES & OPTIONS TRADER

Source: http://www.usda.gov

somebody,” says AIR senior manager Jack Seaquist. “Examine it and see how it’s affecting the entire country.” It’s also important to remember there are myriad seeds for each crop, each are planted at various times of the season, and each responds to precipitation/temperature in a different way.

A marathon, not a sprint
Measuring the quality, or lack thereof, of a crop is not a linear exercise. There are four things to consider: Seed. What is the quality of the seed? Was there a problem with the storage facility that damaged some seeds and left others useless? Planting. Was the soil in ideal shape for planting? Was it too hard or too soft? Were there any major delays in the process? Tasseling/flowering. After the plant emerges from the ground, it needs to be manicured to remove some of
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INDUSTRY NEWS
Climate competition

NYMEX hopes it’s easy being Green
BY JIM KHAROUF
he New York Mercantile Exchange (NYMEX) announced plans to launch a new emissions exchange in the first quarter, bringing another entry into an increasingly crowded field. The new market, called the Green Exchange, partners NYMEX with Evolution Markets, Morgan Stanley, Credit Suisse, JPMorgan, Merrill Lynch, Tudor Investment Corp., ICAP, and Constellation Energy. NYMEX Chairman Richard Schaeffer says the partnership structure was designed to build liquidity quickly, and more equity partners from European institutions are expected to sign on as well. “When you have the people actually doing the trading and they’ve made commitments to actually put volume on a regulated exchange, it surely gives that exchange a much better jumpstart at building and growing,” Schaeffer says. The Green Exchange will offer a slate of U.S. and international emissions and renewable energy credit (REC) contracts starting in the first quarter of 2008 with trading on the CME’s Globex platform and clearing on NYMEX’s ClearPort. Paul Ezekiel, head of environmental trading at Credit Suisse, says the emissions market is coming at the right time with the right mix of market participants. “The exchange-traded futures contracts continue to build liquidity and depth,” Ezekiel says. “We’re seeing CER futures trading now but it’s still [in the] early stages in this market. And as the market is expected to grow, there is enormous opportunity to create another exchange that can

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“ We’re truly trying to build a global
exchange and tackle a global environmental issue. We won’t be judged on the success of this exchange merely by the number of contracts we trade, but by the lasting legacy for the environment — how big business can contribute to a sustainable planet.”
– Andrew Ertel, Evolution Markets

add other products over time.” Among the contracts announced, the Green Exchange will offer global carbon contracts such as EU allowances (EUAs) under the current European Union Emissions Trading Scheme, certified emission reduction credits (CERs) under the UN Clean Development Mechanism, and voluntary emission reductions called VERs. The exchange also plans to offer U.S.-based emissions trading on sulfur dioxide (SO2) and nitrogen oxide (NOx). Options are being developed as well. Evolution Markets President and CEO Andrew Ertel says the market is designed to create a global market that helps lower global greenhouse gas emisMANAGED MONEY sions. “We’re truly trying to build a global exchange Top 10 option strategy traders ranked by November 2007 return. and tackle a global environmental issue,” Ertel (Managing at least $1 million as of Nov. 30, 2007.) says. “We won’t be judged on the success of this 2007 exchange merely by the number of contracts we October YTD $ under trade, but by the lasting legacy for the environRank Trading advisor return return mgmt. ment — how big business can contribute to a 1. Oxeye Capital Mgmt. (FTSE 100) 18.60 23.44 17.0M sustainable planet.” 2. Parrot Trading Partners 13.98 44.40 14.1M The new exchange will bring a lower and 3. Solaris Market Neutral Fund LP 13.13 39.60 1.8M more competitive fee structure to the sector and 4. Optrize Traders House (Option) 11.49 6.37 4.1M allow for cross-margining on the NYMEX clear5. CKP Finance Associates (LOMAX) 11.41 12.90 6.1M ing platform. Also, firms who are not part of the 6. Ascendant Asset Adv. (Strategic2) 10.00 60.38 42.5M founding partner group will have a chance to 7. ACE Investment Strategists (DPC) 9.07 -24.41 4.3M earn equity in the exchange through participa8. Aksel Capital Mgmt (Growth & Income) 8.05 -16.11 4.4M tion. 9. Censura Futures Mgmt. 7.71 11.51 56.0M The new exchange brings more competition to 10. Ascendant Asset Adv. (JLDeVore) 6.00 86.36 7.8M the exchange-traded emissions space currently dominated by the Climate Exchange, which runs Source: Barclay Hedge (http://www.barclayhedge.com) the European Climate Exchange (ECX) and the Based on estimates of the composite of all accounts or the fully funded subset method. Chicago Climate Exchange (CCX). ECX is Does not reflect the performance of any single account. responsible for about 80 percent of the exchangePAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
30 January 2008 • FUTURES & OPTIONS TRADER

traded volume in carbon emissions contracts and CCX is the largest U.S. voluntary emissions market. That space is becoming increasingly crowded as NYSE Euronext breaks into the emissions market in the first quarter and Eurex pushes European Energy Exchange emissions contracts on its trading platform. That doesn’t faze the NYMEX. “We watched what other people did and we don’t think they’ve gotten it right yet,” Schaeffer says. The Green Exchange brings in a new level of competition, made up in large part of over-the-counter players such as Evolution, ICAP, and others. “They’ve looked at the OTC market as their partners, not their competitors,” Ertel says. “I think a lot of the other exchanges see it differently and that has really been a

strength at the NYMEX and the Green Exchange.” ECX CEO Patrick Birley says the competition will help the overall market, which is estimated between $60 and $70 billion in 2007 and expected to grow to $100 billion in 2008, according to the World Bank. “ECX volumes have continued to rise to over one billion tonnes of CO2 allowances traded this year despite a number of other exchanges making plans to get involved in the emissions space,” Birley says. “We have good relationships with our members who recognize our long-term commitment to the business and support our continued central position. We expect that new exchange entrants into the emissions space will have a positive overall impact on trading activity in line with the predicted growth in this new asset class.”

Now with greater authority

Senate moves CFTC reauthorization forward
BY JIM KHAROUF
he U.S. Senate passed the farm bill in December, a move that will give the Commodity Futures Trading Commission (CFTC) greater oversight of over-the-counter (OTC) and forex markets. The bill, which reauthorizes CFTC until fiscal year 2013, provides a number of new powers for the regulator including increased authority to oversee forex trading and to monitor so-called Exempt Commercial Markets (ECMs), which are essentially OTC markets. The CFTC has gone without authorization since 2005. The measure will now go to the House floor, although no date for a vote has been set. Much of the focus of reauthorization has been on certain ECMs. The provisions in the latest bill mean the CFTC will have greater oversight of the OTC energy markets, which have been a hot political topic in Washington after the recent hedge fund blow up by Amaranth and charges of price manipulation of natural gas. It also closes the “Enron

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loophole,” which kept the CFTC and other regulators from fully monitoring the OTC market. Senators say the new powers will help prevent price distortions and manipulation of energy markets and provide more transparency to OTC energy markets such as the Intercontinental Exchange (ICE). The CFTC Reauthorization Act of 2007 also closes the socalled Zelener loophole, allowing for better oversight of forex markets. The CFTC was dealt a blow in 2004 when a Circuit Court judge ruled in favor of Michael Zelener, president of British Royal Group. The CFTC charged that Zelener was defrauding forex customers, but the judge ruled that the types of trades Zelener was providing customers did not fall under CFTC jurisdiction. It also clarified the agency’s anti-fraud authority to pursue fraud cases involving principal-to-principal transactions. The measure also increases civil penalties for violations of the Commodity Exchange Act.

Still trying to catch on

OneChicago offers remedy to credit squeeze
BY JIM KHAROUF

S

ingle-stock futures exchange OneChicago launched single-stock futures (SSFs) on two ETFs in December and is aggressively trying to take advantage of the current credit squeeze. OneChicago now offers SSFs on the Nasdaq 100 (QQQQ) and Russell 2000 (IWM) ETFs. The contracts complement OneChicago’s SSF on the S&P 500 (SPY) ETF, which was
FUTURES & OPTIONS TRADER • January 2008

launched in October. The exchange also offers an SSF on the Dow Jones (DIA) ETF. David Downey, who took over as CEO in January 2007, says these ETF products are attractive to traders looking for better capital efficiencies with equity positions. “Customers can trade this very highly correlated product
continued on p. 32

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INDUSTRY NEWS continued

OneChicago continued from p. 31 that is a security future and is eligible for portfolio margining and subject to the offsets,” Downey says. “I really believe that the customer volume will follow.” OneChicago volumes for the first 11 months of 2007 rose 13 percent from last year to 7.72 million contracts, but SSFs still continue to struggle to find traction among mainstream investors. Downey has spent much of his time trying to break though major barriers that have prevented SSFs from succeeding in the U.S. The biggest obstacle for OneChicago is to get prime brokers to offer SSFs. Those large firms have resisted offering the product because it would cut into their extremely profitable stock-lending business. “We’re up against the profit centers for these firms,” Downey admits, although he believes the current credit squeeze in the wake of the sub-prime lending meltdown is providing the exchange the opening it needs. “The credit squeeze is pushing everyone to reevaluate their trading. All they have to do is rethink what they are doing.” Securities trading firms looking to free up capital on their books in this tight credit market can lower the risk on their stock positions by using exchange for physicals on OneChicago. That allows firms to hold the same equity position in SSFs and enables firms to carry the position as a futures position and an “off balance sheet” item, Downey says. “You have longs and shorts out there with bloated balance sheets carrying these positions,” Downey says. “We’re just trying to find them to bring them in. Everyone understands this is going to solve their balance sheet problem. That’s where we’re seeing some volume growth.” Downey added that it’s an educational process, but one that is coming at the right time. “We’re forcing them to rethink single stock futures, not as a trading vehicle to hedge or speculate, but as a method to participate at preferential financing rates that are much better than they are getting from their broker,” Downey says. Whether OneChicago can succeed is still a question mark for the exchange, which is backed by the Chicago Board Options Exchange, the CME Group and Interactive Brokers Group. Not only is OneChicago competing with prime brokers

Options Watch: Financial Sector ETF Components (as of Dec. 20)
Compiled by Tristan Yates The following table summarizes the expiration months available for options on the financial sector exchange-traded fund (XLF) and its top 15 components. It also shows each index's average bid-ask spread for at-the-money (ATM) January options. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of potential slippage in each option market.

Option contracts traded 2008 March June April Aug. Feb. Jan. July May

2009 2010 Jan. Jan. Bid-ask spreads Bid-ask spread as % of underlying Put price 0.15 0.02 0.20 0.18 0.10 0.09 0.10 0.09 0.13 0.09 0.11 0.09 0.11 0.14 0.20 0.16 0.41% 0.08% 0.13% 0.19% 0.20% 0.23% 0.23% 0.23% 0.24% 0.24% 0.25% 0.29% 0.31% 0.35% 0.37% 0.46%

Index

Sym

Exchange NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X X

Closing price 29.02 29.89 202.67 91.89 41.41 48.91 56.74 51.03 60.61 31.60 43.33 30.37 38.66 51.37 54.50 35.65

Call 0.09 0.03 0.33 0.18 0.06 0.14 0.16 0.15 0.16 0.06 0.10 0.09 0.13 0.23 0.20 0.16

Financial Sector SPDR XLF Top 15 XLF components: Citigroup C Goldman Sachs Group GS Prudential PRU Bank of America BAC Bank of New York Mellon BK American International Group AIG American Express AXP Met Life Ins MET US Bancorp USB J.P. Morgan Chase JPM Wells Fargo WFC Wachovia WB Morgan Stanley MS Merrill Lynch MER Fannie Mae FNM

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

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January 2008 • FUTURES & OPTIONS TRADER

but it now finds itself battling with other non-U.S. exchanges such as Eurex, which plans to offer SSFs on the S&P 500 in U.S. dollars. The advantage Eurex currently has over OneChicago is that Eurex and other futures markets offer portfolio margining on SSFs. OneChicago is saddled with strategy-based margining. Downey says he is trying to convince U.S. regulators to change that margining policy to allow U.S. exchanges to

remain competitive with others. For retail traders, the problem with SSFs goes beyond firms not wanting to undercut their own profitable stockloan businesses. Downey says few securities firms have the necessary technology to offer portfolio margining on SSFs. He says OneChicago is attempting to solve that issue by working with SunGard, which has new products that allow for management of positions from multiple asset classes.

NEW PRODUCTS AND SERVICES
Barchart.com has launched its new AgriCharts division. AgriCharts provides a full suite of agricultural information and technology services. AgriCharts’ Web site services offers a solution for developing and managing an agri-business Web site. Users may customize their service to meet their specific needs, choosing from a wide variety of features, including: Web site hosting, Web development and site management, market quotes and charts, agricultural industry news, market commentary and analysis, and cash-basis calculation tools. AgriCharts also offers real-time quotes, charts, news, and weather. In addition, AgriCharts provides data feed solutions, including real-time, delayed and end-of-day market data to agribusinesses for front, middle, and back-office systems. For more information on Barchart and its new AgriCharts division, please visit http://www.agricharts.com. eSignal has launched Quote.com 2.0, an upgrade to its Web-based global financial portal. Quote.com 2.0's new interactive stock charts feature has timeline tracking, integrated chart studies, news, and export features. The updated portfolio manager allows users to track multiple financial portfolios, customize watch lists, filter news, and set up mobile stock and fund alerts. A new personal finance section has added content to help manage real-estate information, college and tax planning, and debt management. Quote.com 2.0 is still the source for individual stock and market index information, including stocks with the highest volume for the day, the largest percentage gainers and losers, stocks reaching new yearly highs or dropping to new yearly lows, or stocks with unusual volume. Specific hot lists for U.S. stocks include the very short-term high and low, and stocks with the greatest trading range. Market indices are also available with hot lists for the U.S. highest percentage gainers and losers. For more information, visit http://www.eSignal.com. Alyuda Research has released a new version of its AmpleSight Trader software, which enables traders to combine traditional technical analysis techniques with conceptions of intermarket and relative strength analysis. Users can analyze interdependencies on financial markets and react to even small
FUTURES & OPTIONS TRADER • January 2008

market movements. Key features in the new edition include integration of eSignal and IQfeed datafeeds, market beacons and indicator strips which signal every market movement, an influence map and relativity panel for correlation analysis, customizable watch lists, trade order visualization, and enhanced charting. More information is located at http://www.amplesight.com. Online discount broker TradeKing is now offering its clients access to portfolio management capabilities from Portfolio Director Inc. (http://www.portfoliodirector.com). TradeKing clients can upload their TradeKing account data for both equities and options to the Portfolio Director software to see time-weighed returns, compare their performance to key benchmarks, produce end-of-year gain/loss information and other flexible reports, re-balance holdings instantly according to model portfolios, view asset allocation by symbol, investment type, or Morningstar category, and other useful portfolio management capabilities. Additional information can be found at http://www.tradeking.com. CQG Inc. has added the Chicago Futures Exchange (CFE) and the European Energy Exchange (EEX) to its list of direct trading connections. CQG has connected its hosted trading gateways to CFE, giving customers the ability to trade exchange contracts including the CBOE S&P 500 BuyWrite Index, CBOE S&P 500 12-Month Variance, CBOE S&P 500 3Month Variance, CBOE Volatility Index (VIX), and CBOE DJIA Volatility Index (VXD); and EEX, allowing customers to trade the Second Period European Carbon contract. CQG’s list of tradable exchanges includes Globex, eCBOT, Eurex, Montreal, Euronext, NYBOT, ICE, DME, and NYMEX/COMEX. Visit http://www.cqg.com for more information. Note: The New Products and Services section is a forum for industry businesses to announce new products and upgrades. Listings are adapted from press releases and are not endorsements or recommendations from the Active Trader Magazine Group. E-mail press releases to editorial@futuresandoptionstrader.com. Publication is not guaranteed.

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FUTURES SNAPSHOT (as of Dec. 27)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and may not reflect total volume for all contract months. Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic). EPit 10-day % 20-day % 60-day % Volatility Market sym sym Exch Vol OI move rank move rank move rank ratio/rank E-Mini S&P 500 ES CME 1.69 M 1.83 M -0.03% 0% 1.31% 21% -4.17% 70% .43 / 46% 10-yr. T-note ZN TY CBOT 1.20 M 2.16 M -0.21% 33% -0.94% 47% 2.71% 20% .28 / 58% 5-yr. T-note ZF FV CBOT 696.0 1.66 M -0.16% 27% -0.16% 17% 2.66% 43% .24 / 55% Eurodollar* GE ED CME 400.6 1.49 M -0.01% 0% 0.55% 85% 0.64% 87% .13 / 10% E-Mini Nasdaq 100 NQ CME 386.5 352.2 1.13% 33% 1.72% 11% -0.19% 0% .41 / 85% 30-yr. T-bond ZB US CBOT 382.5 898.2 -0.93% 31% -1.86% 44% 2.62% 20% .37 / 67% 2-yr. T-note ZT TU CBOT 300.4 861.7 -0.05% 27% 0.00% 0% 1.08% 30% .16 / 15% Crude oil CL NYMEX 262.7 304.0 2.36% 40% 6.62% 40% 20.70% 78% .25 / 50% E-Mini Russell 2000 ER CME 230.3 569.6 1.04% 50% 1.14% 30% -6.54% 77% .65 / 97% Mini Dow YM CBOT 156.3 80.0 -0.92% 67% 1.14% 15% -4.59% 98% .37 / 24% Eurocurrency 6E EC CME 137.9 170.0 -0.58% 0% -1.50% 36% 2.67% 46% .24 / 57% Gold 100 oz. GC NYMEX 106.1 233.7 1.59% 80% 3.94% 32% 12.97% 59% .21 / 32% Japanese yen 6J JY CME 99.1 142.1 -1.58% 53% -2.72% 67% 1.69% 16% .28 / 38% Corn ZC C CBOT 79.6 314.3 4.94% 45% 17.41% 98% 30.41% 100% .22 / 25% Soybeans ZS S CBOT 74.4 210.9 5.30% 70% 10.56% 89% 28.49% 96% .24 / 57% British pound 6B BP CME 60.2 89.8 -2.37% 67% -4.24% 90% -2.40% 89% .64 / 73% S&P 500 index SP CME 57.6 500.1 -0.03% 0% 1.31% 21% -4.17% 73% .43 / 46% Natural gas NG NYMEX 51.4 80.8 -2.81% 37% -3.82% 5% -3.06% 2% .10 / 0% Sugar SB ICE 45.2 434.5 6.50% 50% 13.09% 98% 8.08% 65% .67 / 85% Canadian dollar 6C CD CME 41.4 85.6 3.35% 100% 0.46% 3% 1.03% 6% .37 / 83% Australian dollar 6A AD CME 41.3 55.9 -0.42% 28% -1.76% 32% -1.94% 62% .24 / 27% Swiss franc 6S SF CME 38.6 64.0 -0.57% 6% -2.23% 60% 2.53% 48% .20 / 7% Heating oil HO NYMEX 33.1 55.2 1.40% 8% 4.14% 36% 23.96% 83% .13 / 3% Wheat ZW W CBOT 30.9 105.0 -2.70% 100% 6.52% 27% -0.80% 33% .22 / 47% RBOB gasoline RB NYMEX 30.5 48.9 3.46% 20% 9.69% 60% 25.89% 98% .32 / 43% E-Mini S&P MidCap 400 ME CME 28.9 94.9 -0.18% 0% 1.75% 41% -4.00% 66% .48 / 57% Soybean oil ZL BO CBOT 23.5 41.3 4.39% 87% 5.66% 55% 28.16% 96% .25 / 45% Gold 100 oz. ZG CBOT 23.1 12.5 1.60% 81% 3.96% 31% 13.03% 57% .21 / 34% Silver 5,000 oz. SI NYMEX 21.4 58.0 -0.05% 0% 3.37% 27% 10.17% 54% .30 / 38% Soybean meal ZM SM CBOT 21.3 34.1 4.16% 18% 14.96% 98% 27.77% 90% .18 / 50% Mexican peso 6M MP CME 17.4 74.4 -0.33% 50% 0.08% 5% 0.14% 0% .11 / 10% Fed Funds ZQ FF CBOT 16.8 132.6 0.01% 7% 0.03% 2% 0.50% 48% .04 / 33% Crude oil e-miNY QM NYMEX 16.5 6.7 2.36% 40% 6.62% 40% 20.70% 78% .25 / 48% Cotton CT ICE 15.1 111.3 5.69% 87% 5.25% 65% 4.10% 16% .26 / 53% Nikkei 225 index NK CME 12.6 65.4 -3.62% 71% -0.71% 3% -9.74% 86% .34 / 42% Coffee KC ICE 9.5 81.9 -1.27% 100% 4.94% 12% 2.45% 15% .11 / 3% Lean hogs HE LH CME 9.2 58.4 -4.01% 67% 8.02% 63% 1.85% 75% .10 / 8% Cocoa CC ICE 7.3 76.4 -1.05% 0% 6.60% 64% 1.77% 3% .26 / 33% Live cattle LE LC CME 7.2 31.0 2.83% 100% 1.24% 72% 0.47% 1% .81 / 100% Nasdaq 100 ND CME 5.7 43.6 1.13% 33% 1.72% 11% -0.19% 0% .41 / 83% Copper HG NYMEX 5.5 13.4 3.85% 89% 4.19% 19% -15.60% 92% .45 / 68% U.S. dollar index DX ICE 4.4 27.9 0.58% 11% 1.99% 47% -2.37% 40% .21 / 43% Dow Jones Ind. Avg. ZD DJ CBOT 4.0 32.7 -0.92% 67% 1.14% 15% -4.59% 98% .38 / 27% Mini-sized gold YG CBOT 4.0 3.9 1.60% 67% 3.96% 31% 13.03% 62% .21 / 33% Silver 5,000 oz. ZI CBOT 3.9 4.0 -0.05% 7% 3.37% 26% 10.25% 55% .30 / 39% 10-year interest rate swap SR NI CBOT 3.4 48.2 -0.92% 42% -1.68% 54% 1.95% 10% .36 / 67% Russell 2000 index RL CME 3.0 33.4 1.04% 50% 1.14% 30% -6.54% 79% .64 / 97% *Average volume and open interest based on highest-volume contract (December 2008).
Legend Vol: 30-day average daily volume, in thousands (unless otherwise indicated). OI: Open interest, in thousands (unless otherwise indicated). 10-day move: The percentage price move from the close 10 days ago to today’s close. 20-day move: The percentage price move from the close 20 days ago to today’s close. 60-day move: The percentage price move from the close 60 days ago to today’s close. The “% rank” fields for each time window (10-day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the “% rank” for 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20day move, the “% rank” field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the “% rank” field shows how the most recent 60-day move compares to the past one-hundred-twenty 60-day moves. A reading of 100 percent means the current reading is larger than all the past readings, while a reading of 0 percent means the current reading is smaller than the previous readings. These figures provide perspective for determining how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the shortterm volatility (10-day standard deviation of prices) divided by the long-term volatility (100day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.

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

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January 2008 • FUTURES & OPTIONS TRADER

OPTIONS RADAR (as of Dec. 27)
MOST-LIQUID OPTIONS*
Indices S&P 500 index Mini Nasdaq 100 index Nasdaq 100 index S&P 500 volatility index Russell 2000 index Stocks Microsoft Citigroup Yahoo! Apple Inc. Cisco Systems Futures Eurodollar 10-year T-notes Crude oil Sugar Corn Options Open Symbol Exchange volume interest SPX CBOE 632.4 2.20 M MNX CBOE 117.5 871.4 NDX CBOE 92.3 302.2 VIX CBOE 76.2 751.0 RUT CBOE 65.3 726.6 MSFT C YHOO AAPL CSCO 431.3 372.4 324.8 252.4 251.1 3.06 M 2.81 M 1.94 M 1.22 M 1.61 M 10-day move -0.69% 0.22% 0.23% -9.84% 0.23% 4.35% -6.07% -3.38% 4.04% -3.51% % rank 22% 0% 0% 53% 25% 43% 29% 38% 18% 13% 20-day move 0.49% 0.51% 0.51% -15.97% 0.45% 6.74% -8.45% -9.50% 10.18% -0.93% % IV/SV IV/SV ratio — rank ratio 20 days ago 7% 18.7% / 19.6% 23.6% / 20.8% 5% 20.3% / 24.9% 26.9% / 28.8% 5% 20.6% / 23.6% 27.4% / 27% 37% 154.3% / 107.2% 87.7% / 154.8% 7% 24.9% / 27.4% 29.4% / 26.2% 52% 22% 47% 12% 5% 25.3% / 30.2% 40.8% / 51.3% 43.2% / 36.2% 51.7% / 44.3% 32.8% / 32.6% 29.2% / 31.6% 49.6% / 65.6% 46% / 64.6% 42.7% / 59.7% 35.5% / 39.6%

ED-GE TY-ZN CL SB C-ZC

CME CBOT NYMEX ICE CBOT

188.0 63.4 49.1 30.2 21.5

5.96 M 326.2 446.3 637.0 398.9

-0.01% -0.21% 2.36% 6.50% 4.94%

0% 33% 40% 50% 45%

0.55% -0.94% 6.62% 13.09% 17.41%

85% 50% 36% 98% 98%

24.3% / 14.7% 7% / 8.1% 30.3% / 36.3% 26% / 23.7% 27.2% / 21.9%

22.4% / 12.7% 6.8% / 5.2% 31.6% / 35.4% 20.5% / 16.4% 24.9% / 21.1%

VOLATILITY EXTREMES**
Indices — High IV/SV ratio Euro index S&P 500 volatility index Airline index British pound index Morgan Stanley Retail index Indices — Low IV/SV ratio E-mini S&P 500 futures Mini Nasdaq 100 index Nasdaq 100 index S&P 100 index Broker/Dealer index Stocks — High IV/SV ratio Advantage Energy Income King Pharmaceuticals UT Starcom Crystallex Intl. Altera Stocks — Low IV/SV ratio Fed Home Loan Bank First Marblehead Grant Prideco Fed National Mortgage Force Protection Inc. Futures — High IV/SV ratio Soybeans Soybean oil Eurodollar Soybean meal Canadian dollar Futures — Low IV/SV ratio Heating oil E-mini S&P 500 futures 30-year T-bonds Crude oil 10-year T-notes LEGEND: * Ranked by volume XDE VIX XAL XDB MVR ES MNX NDX XEO XBD AAV KG UTSI KRY ALTR FRE FMD GRP FNM FRPT S-ZS BO-ZL ED-GE SM-ZM CD CBOT CBOT CME CBOT CME PHLX CBOE AMEX PHLX CBOE CME CBOE CBOE CBOE AMEX 6.4 76.2 2.0 3.1 16.3 17.9 117.5 92.3 13.0 3.7 1.9 2.8 6.7 1.6 4.9 35.5 8.4 4.7 53.3 8.8 13.6 3.6 188.0 2.7 1.9 63.0 751.0 14.0 23.8 63.8 113.3 871.4 302.2 123.2 16.0 27.5 34.5 122.1 112.3 119.5 246.3 61.5 29.2 404.3 85.0 104.5 47.1 5.96 M 24.6 13.5 -0.56% -9.84% -4.72% -2.50% -5.53% -0.03% 0.22% 0.23% -0.69% -1.32% -11.83% -0.10% 2.96% -5.63% 0.57% 10.78% 7.82% 14.24% 23.32% -2.61% 5.30% 4.39% -0.01% 4.16% 3.35% 0% 53% 7% 93% 67% 0% 0% 0% 38% 33% 95% 0% 67% 5% 17% 44% 100% 89% 70% 0% 70% 86% 0% 12% 100% 17% 0% 31% 40% 33% -1.44% -15.97% -12.22% -4.15% -5.71% 1.31% 0.51% 0.51% 0.54% -2.92% -15.20% 2.30% -3.81% -14.51% 0.83% 14.55% -44.38% 17.31% 22.63% -66.85% 10.56% 5.66% 0.55% 14.96% 0.46% 4.14% 1.31% -1.86% 6.62% -0.94% 36% 8.9% / 6.1% 9.7% / 5.4% 37% 154.3% / 107.2% 87.7% / 154.8% 65% 56.6% / 43.7% 50.8% / 60.6% 95% 8.8% / 7.4% 8% / 7.1% 56% 34.6% / 31% 32.6% / 35.5% 21% 5% 5% 4% 25% 58% 47% 12% 37% 38% 18.1% / 22.7% 20.3% / 24.9% 20.6% / 23.6% 17.7% / 19.7% 37.4% / 41.4% 40.2% / 23.8% 65.6% / 39% 101% / 60.7% 120% / 78.3% 31.6% / 20.8% 23.5% / 23.6% 26.9% / 28.8% 27.4% / 27% 22.2% / 20.8% 38.7% / 52.8% 36.2% / 36.3% 45.7% / 42.7% 93.3% / 86% 141.4% / 76.5% 33.7% / 29.8%

64% 60.2% / 111.9% 75.8% / 102.6% 74% 96.9% / 174.8% 77.8% / 65.8% 76% 24.7% / 43.4% 42.7% / 48.3% 80% 63.5% / 109.3% 85.3% / 122.5% 98% 146.5% / 244.7% 92% / 100.9% 91% 55% 85% 98% 3% 36% 21% 44% 36% 50% 27.9% / 16.6% 21.1% / 12.7% 24.3% / 14.7% 32.8% / 22.3% 11.6% / 8.4% 27.5% / 35.9% 18.1% / 22.7% 10.7% / 13.2% 30.3% / 36.3% 7% / 8.1% 23.7% / 17.7% 21.9% / 16.2% 22.4% / 12.7% 26.6% / 19.1% 14.1% / 11.3% 29.1% / 30.3% 23.5% / 23.6% 9.7% / 6.6% 31.6% / 35.4% 6.8% / 5.2%

Options volume: 20-day average daily options volume (in thousands unless otherwise indicated). Open interest: 20-day average daily options open interest (in thousands unless otherwise indicated). IV/SV ratio: Overall average implied volatility of all options divided by statistical volatility of underlying instrument. 10-day move: The underlying’s percentage price move from the close 10 days ago to today’s close. 20-day move: The underlying’s percentage price move from the close 20 days ago to today’s close. The “% rank” fields for each time window (10-day moves, 20-day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For example, the “% rank” for 10-day moves shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “% rank” field shows how the most recent 20-day move compares to the past sixty 20-day moves.

HO NYMEX 2.1 6.5 1.40% ES CME 17.9 113.3 -0.03% US-ZB CBOT 7.9 103.4 -0.93% CL NYMEX 49.1 446.3 2.36% TY-ZN CBOT 63.4 326.2 -0.21% ** Ranked based on high or low IV/SV values.

FUTURES & OPTIONS TRADER • January 2008

35

EVENTS

Event: MTA Mid-Winter Retreat Date: Jan. 24-26 Location: Don CeSar Beach Resort at St. Pete Beach (outside Tampa, Fla.) For more information: Call (646) 652-3300 Event: The World Money Show Date: Feb. 6-9 Location: Gaylord Palms Resort and Convention Center, Kissimmee, Fla. For more information: http://www.worldmoneyshow.com Event: Traders Expo New York Date: Feb. 16-19 Location: Marriott Marquis Hotel, New York For more information: http://www.tradersexpo.com Event: Options Seminar hosted by Steve Lentz Date: Feb. 28

Location: Las Vegas For more information: Call (800) 733-6610 Event: 24th Annual Risk Management Conference Date: March 9-11 Location: Hyatt Regency Coconut Point Resort and Spa, Bonita Springs, Fla. For more information: http://www.cboe.com/rmc Event: Day Trading Seminar: Presented by Joe Ross and Rogerio Kirchbaum Date: March 23-24 Location: Sao Paulo, Brazil For more information: E-mail info@tradingeducators.com.br Event: Traders Expo Los Angeles Date: June 23-26 Location: Ontario Convention Center For more information: http://www.tradersexpo.com

KEY CONCEPTS
American style: An option that can be exercised at any time until expiration. Assign(ment): When an option seller (or “writer”) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. Bear call spread: A vertical credit spread that consists of a short call and a higher-strike, further OTM long call in the same expiration month. The spread’s largest potential gain is the premium collected, and its maximum loss is limited to the point difference between the strikes minus that premium. Bear put spread: A bear debit spread that contains puts with the same expiration date but different strike prices. You buy the higher-strike put, which costs more, and sell the cheaper, lower-strike put. Beta: Measures the volatility of an investment compared to the overall market. Instruments with a beta of one move in line with the market. A beta value below one means the instrument is less affected by market moves and a beta value greater than one means it is more volatile than the overall market. A beta of zero implies no market risk. Bull call ladder: A variation of the bull call debit spread that profits if the underlying market doesn’t rally too far. To enter a bull call ladder, buy an ATM or ITM long call and sell two calls at different, higher strike prices. The goal is to profit from a moderately bullish outlook without too much upside risk. Ideally, the market will rally and close between the two short strikes at expiration. But if the market jumps far above the highest short strike, potential losses could be unlimited. Bull call spread: A bull debit spread that contains calls with the same expiration date but different strike prices. You buy the lower-strike call, which has more value, and sell the less-expensive, higher-strike call. Bull put spread (put credit spread): A bull credit spread that contains puts with the same expiration date, but different strike prices. You sell an OTM put and buy a lessexpensive, lower-strike put. Calendar spread: A position with one short-term short option and one long same-strike option with more time until expiration. If the spread uses ATM options, it is market-neutral and tries to profit from time decay. However, OTM options can be used to profit from both a directional move and time decay. Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price.

The option “Greeks”
Delta: The ratio of the movement in the option price for every point move in the underlying. An option with a delta of 0.5 would move a half-point for every 1-point move in the underlying stock; an option with a delta of 1.00 would move 1 point for every 1-point move in the underlying stock. Gamma: The change in delta relative to a change in the underlying market. Unlike delta, which is highest for deep ITM options, gamma is highest for ATM options and lowest for deep ITM and OTM options. Rho: The change in option price relative to the change in the interest rate. Theta: The rate at which an option loses value each day (the rate of time decay). Theta is relatively larger for OTM than ITM options, and increases as the option gets closer to its expiration date. Vega: How much an option’s price changes per a onepercent change in volatility. Carrying costs: The costs associated with holding an investment that include interest, dividends, and the opportunity costs of entering the trade. Correlation: The correlation coefficient can tell us the type and strength of the relationship between two data series. The correlation coefficient ranges from +1, which indicates perfect, positive correlation between two data sets (i.e., they move in the same direction, in tandem) and -1, which indicates the sets are directly inverted; zero indicates no discernible relationship between the two data sets. Covered call: Shorting an out-of-the-money call option against a long position in the underlying market. An example would be purchasing a stock for $50 and selling a call option with a strike price of $55. The goal is for the market to move sideways or slightly higher and for the call option to expire worthless, in which case you keep the premium. Credit spread: A position that collects more premium from short options than you pay for long options. A credit spread using calls is bearish, while a credit spread using puts is bullish. Debit: A cost you must pay to enter any position if the components you buy are more expensive than the ones you sell. For instance, you must pay a debit to buy any option, and a spread (long one option, short another) requires a debit if the premium you collect from the short option doesn’t offset the long option’s cost. Deep (e.g., deep in-the-money option or deep out-of-the-money option): Call options with strike prices that are very far above the current price of the underlying asset and put options with strike prices that are very far below the current price of the underlying asset. Delta-neutral: An options position that has an overall delta of zero, which means it’s unaffected by underlying
January 2008 • FUTURES & OPTIONS TRADER

38

price movement. However, delta will change as the underlying moves up or down, so you must buy or sell shares/contracts to adjust delta back to zero. Diagonal spread: A position consisting of options with different expiration dates and different strike prices — e.g., a December 50 call and a January 60 call. European style: An option that can only be exercised at expiration, not before. Exercise: To exchange an option for the underlying instrument. Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after). Float: The number of tradable shares in a public company. Intermonth (futures) spread: A trade consisting of long and short positions in different contract months in the same market — e.g., July and November soybeans or September and December crude oil. Also referred to as a futures “calendar spread.” In the money (ITM): A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instrument’s price. Intrinsic value: The difference between the strike price of an in-the-money option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Leverage: An amount of “buying power” that increases exposure to underlying market moves. For example, if you buy 100 shares of stock, that investment will gain or lose $100 for each $1 (one-point) move in the stock. But if you invest half as much and borrow the other half from your broker as margin, then you control those 100 shares with half as much capital (i.e., 2-to1 buying power). At that point, if the stock moves $1, you will gain or lose $100 even though you only invested $50 — a double-edged sword. Limit up (down): The maximum amount that a futures contract is allowed to move up (down) in one trading session. Lock-limit: The maximum amount that a futures contract is allowed to move (up or down) in one trading session. Long call condor: A market-neutral position structured with calls only. It combines a bear call spread (short call, long higher-strike further OTM call) above the market and a bull call spread (long call, short higher-strike call). Unlike an iron condor, which contains two credit spreads, a call condor includes two types of spreads: debit and credit. Long-Term Equity AnticiPation Securities (LEAPS): Options contracts with much more distant expiration dates — in some cases as far as two years and eight months away — than regular options.
FUTURES & OPTIONS TRADER • January 2008

Market makers: Provide liquidity by attempting to profit from trading their own accounts. They supply bids when there may be no other buyers and supply offers when there are no other sellers. In return, they have an edge in buying and selling at more favorable prices. Naked (uncovered) puts: Selling put options to collect premium that contains risk. If the market drops below the short put’s strike price, the holder may exercise it, requiring you to buy stock at the strike price (i.e., above the market). Open interest: The number of options that have not been exercised in a specific contract that has not yet expired. Opportunity cost: The value of any other investment you might have made if your capital wasn’t already in the markets Outlier: An anomalous data point or reading that is not representative of the majority of a data set. Out of the money (OTM): A call option with a strike price above the price of the underlying instrument, or a put option with a strike price below the underlying instrument’s price. Parity: An option trading at its intrinsic value. Premium: The price of an option. Put option: An option that gives the owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. Put ratio backspread: A bearish ratio spread that contains more long puts than short ones. The short strikes are closer to the money and the long strikes are further from the money. For example if a stock trades at $50, you could sell one $45 put and buy two $40 puts in the same expiration month. If the stock drops, the short $45 put might move into the money, but the long lower-strike puts will hedge some (or all) of those losses. If the stock drops well below $40, potential gains are unlimited until it reaches zero. Put spreads: Vertical spreads with puts sharing the same expiration date but different strike prices. A bull put spread contains short, higher-strike puts and long, lower-strike puts. A bear put spread is structured differently: Its long puts have higher strikes than the short puts. Ratio spread: A ratio spread can contain calls or puts and includes a long option and multiple short options of the same type that are further out-of-the-money, usually in a ratio of 1:2 or 1:3 (long to short options). For example, if a stock trades at $60, you could buy one $60 call and sell two same-month $65 calls. Basically, the trade is a bull call spread (long call, short higher-strike call) with the sale of additional calls at the short strike. Overall, these positions are neutral, but they can have a directional bias, depending on the strike prices you select. Because you sell more options than you buy, the short options usually cover the cost of the long one or provide a
continued on p. 40

39

KEY CONCEPTS continued

net credit. However, the spread contains uncovered, or “naked” options, which add upside or downside risk. Relative strength (RS): Measures how much one instrument (stock, future, sector, etc.) has moved compared to another. A common use of RS is to see how strong (or weak) a stock is compared to its sector or the overall market. Relative strength is not the same as the Relative Strength Index (RSI), which is a momentum indicator (oscillator) based on the price of a single instrument. There is more than one way to measure relative strength. One technique is to take all the stocks in an industry group or sector and rank them according to their percentage moves over a certain period (e.g., one month, three months, six months or one year). The stock with the highest relative strength rank is the one that has moved up the most (in percentage terms) over the given time period relative to the group. Relative strength index (RSI): Developed by Welles Wilder, the relative strength index (RSI) is an indicator in the “oscillator” family designed to reflect shorter-term momentum. It ranges from zero to 100, with higher readings supposedly corresponding to overbought levels and low readings reflecting the opposite. The formula is: RSI = 100 – (100/[1+RS]) where RS = relative strength = the average of the up closes over the calculation period (e.g., 10 bars, 14 bars) divided by the average of the down closes over the calculation period. For example, when calculating a 10-day RSI, if six of the days closed higher than the previous day’s close, you would subtract the previous close from the current close for these days, add up the differences, and divide the result by 10 to get the up-close average. (Note that the sum is divided by the total number of days in the look-back period and not the number of up-closing days.) For the four days that closed lower than the previous day’s close, you would subtract the current close from the previous low, add these differences, and divide by 10 to get the down-close average. If the up-close average was .8 and the down close average was .4, the relative strength over this period would be 2. The resulting RSI would be 100 (100/[1+2]) = 100 - 33.3 = 66.67. Schaeffer’s put/call open interest ratio (SOIR): The ratio of open puts to open calls among options set to expire in three months or less. This time period intends to offer a better gauge of speculative options activity than measuring all open contracts. Simple moving average: A simple moving average
(SMA) is the average price of a stock, future, or other market over a certain time period. A five-day SMA is the sum of the five most recent closing prices divided by five, which means each day’s price is equally weighted in the calculation.

Support and resistance: Support is a price level that acts as a “floor,” preventing prices from dropping below that level. Resistance is the opposite: a price level that acts as a “ceiling;” a barrier that prevents prices from rising higher. Support and resistance levels are a natural outgrowth of the interaction of supply and demand in any market. For example, increased demand for a stock will cause its price to rise, creating an uptrend. But when price has risen to a certain level, traders and investors will take profits and short sellers will come into the market, creating “resistance” to further price increases. Price may retreat from and advance to this resistance level many times, sometimes eventually breaking through it and continuing the previous trend, other times reversing completely. Support and resistance should be thought of more as general price levels rather than precise prices. For example, if a stock makes a low of 52.15, rallies slightly, then declines again to 52.15, then rallies again, a subsequent move down to 52 does not violate the “support level” of 52.15. In this case, the fact that the stock retraced once to the exact price level it had established before is more of a coincidence than anything else. Time decay: The tendency of time value to decrease at an accelerated rate as an option approaches expiration. Time spread: Any type of spread that contains short near-term options and long options that expire later. Both options can share a strike price (calendar spread) or have different strikes (diagonal spread). Time value (premium): The amount of an option’s value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as “time decay.” Vertical spread: A position consisting of options with the same expiration date but different strike prices (e.g., a September 40 call option and a September 50 call option). Volatility: The level of price movement in a market. Historical (“statistical”) volatility measures the price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period — e.g., the past 20 days. Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums. The higher the implied volatility, the higher the option premium. Volatility skew: The tendency of implied option volatility to vary by strike price. Although, it might seem logical that all options on the same underlying instrument with the same expiration would have identical (or nearly identical) implied volatilities. For example, deeper in-the-money and out-of-the-money options often have higher volatilities than at-the-money options. This type of skew is often referred to as the “volatility smile” because a chart of these implied volatilities would resemble a line curving upward at both ends. Volatility skews can take other forms than the volatility smile, though.
January 2008 • FUTURES & OPTIONS TRADER

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

40

FUTURES & OPTIONS CALENDAR
Legend
CPI: Consumer Price Index ECI: Employment cost index First delivery day (FDD): The first day on which delivery of a commodity in fulfillment of a futures contract can take place. First notice day (FND): Also known as first intent day, this is the first day a clearinghouse can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillment of a futures contract. The clearinghouse also informs the seller. FOMC: Federal Open Market Committee GDP: Gross domestic product ISM: Institute for supply management LTD: Last trading day; the first day a contract may trade or be closed out before the delivery of the underlying asset may occur. PPI: Producer price index Quadruple witching Friday: A day where equity options, equity futures, index options, and index futures all expire.

JANUARY/FEBRUARY MONTH
21 22 23 24 25 26 27 28
Markets closed – Martin Luther King Day LTD: February crude oil futures (NYMEX)

January 1 Markets closed — New Year’s Day
FDD: January natural gas, gasoline, and crude oil futures (NYMEX)

2

ISM FND: January orange juice futures (ICE); FDD: January aluminum, copper, platinum, palladium, silver, and gold futures (NYMEX); January rice, soybean products, and soybean futures (CBOT) FND: January propane and heating oil futures (NYMEX) Unemployment LTD: January currency options (CME); February cocoa options (ICE)

FND: February crude oil futures (NYMEX) LTD: February T-bond options (CBOT)

3 4 5 6 7 8 9 10 11 12 13 14 15 16

LTD: February natural gas, gasoline, and heating oil options (NYMEX); February aluminum, copper, silver, and gold options (NYMEX FOMC meeting Durable goods LTD: February natural gas and gasoline futures (NYMEX); January aluminum, palladium, copper, platinum, silver, and gold futures (NYMEX) FOMC meeting GDP FND: February natural gas and gasoline futures (NYMEX) ECI LTD: February propane and heating oil futures (NYMEX); January feeder cattle futures and options (CME) FND: February aluminum, copper, platinum, palladium, silver, and gold futures (NYMEX)

29

FDD: January propane futures (NYMEX)

30

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

31

JANUARY 2008 30 31 6 7 1 8 2 9 3 4 5 10 11 12

LTD: January rice, soybean product, and soybean futures (CBOT) PPI Retail sales LTD: January lumber futures (CME) CPI LTD: February crude oil options (NYMEX); February platinum options (NYMEX) FND: January lumber futures (CME) FDD: January lumber futures (CME)

February 1 Unemployment
ISM LTD: February pork belly and live cattle options (CME); March cocoa options (ICE) FND: March T-bond futures (CBOT) FDD: February natural gas, gasoline, and crude oil futures (NYMEX); February aluminum, copper, platinum, palladium, silver, and gold futures (NYMEX)

13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 1 2

FEBRUARY 2008 27 28 29 30 31 3 4 5 6 7 1 8 2 9

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 1

17 18

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

LTD: All January equity options; S&P options (CME); Nasdaq options (CME); Russell options (CME); Dow Jones options (CBOT); February orange juice options (ICE)

2 3 4 5 6

FND: February propane and heating oil futures (NYMEX); February pork belly and live cattle futures (CME) FDD: February pork belly futures (CME) FDD: February propane futures (NYMEX)
41

19 20

FUTURES & OPTIONS TRADER • January 2008

FUTURES TRADE JOURNAL
The assassination of Benazir Bhutto in Pakistan sends markets into turmoil and tests a long position in stock index futures.
TRADE
Date: Thursday, Dec. 27. Entry: Long the March E-Mini Russell 2000 futures (ER2H08) at 799.70 and long the March EMini Nasdaq 100 futures (NQH08) at 2,157 and 2,152.25. Reasons for trade/setup: After the big jump off the Dec. 18 low, the market — not surprisingly — slowed down on Dec. 24 and Dec. 26. These trades were an extension of a long trade from Dec. 26, which was entered and exited at Source: TradeStation 794.30 and 804.40, respectively. The market was weak that day but it closed strongly, setting up an extension of the up move above the implied resistance of the the session and accelerated its slide in the final 45 minutes of previous high on Dec. 11. trading. We got out of half the Nasdaq position at 2,132.25 The goal was to get back in the market on the long side near the close. after it pulled back a bit. The opportunity came (in the EWe ignored the initial stops, believing the market was Mini Russell futures) overnight. overreacting to the assassination but would ultimately turn The E-Mini Nasdaq 100 position was opened in the first back to the upside. The decision looked justified in the early hour of trading on Dec. 27 as the market sold off hours of Dec. 28 as the market rebounded, cutting the overmoderately. all position’s loss in half. The market threw in the towel late in the morning, however, with the Russell leading the way Initial stop: 790.20 (Russell), 3.10 below the Dec. 26 low; down. The second half of the Nasdaq trade was liquidated at 2,136 (Nasdaq), 2.25 below the Dec. 26 low. 2,119. At the end of the day, the position was slightly more underwater than it had been the day before. Initial target: 811.00 (Russell), approximately 1.5 points The new year brought no respite; the market sold off on below the Nov. 7 high; 2,173 (Nasdaq), 1 point below the Dec. Jan. 2 and we sold the E-Mini Russell position on a slight 11 high. bounce at 763.10. The negatives of this trade need no further elaboration. RESULT The damage wasn’t quite as bad as it appears because of some intraday short-side hedging that offset some of the Exit: 763.10 (Russell); 2,132.50 and 2,119 (Nasdaq). long-side damage. Also, we at least waited for some minimal bounces to exit, thus avoiding the additional pain of selling Profit/loss: See Trade Summary table. very near the bottom. But what’s that old saying — “your first lost is your smallTrade executed according to plan? No. est loss”? Outcome: The news of the Bhutto assassination didn’t immediately tank the market, which looked set to open the day session around the entry price. Two downthrusts in the morning, however, eventually pushed the E-Mini Russell futures down more than 1.5 percent by noon (ET). After a brief respite the market continued to sell off the remainder of
Note: Initial targets for trades are typically based on things such as the historical performance of a price pattern or trading system signal. However, individual trades are a function of immediate market behavior; initial price targets are flexible and are most often used as points at which a portion of the trade is liquidated to reduce the position’s open risk. As a result, the initial (pre-trade) reward-risk ratios are conjectural by nature.

TRADE SUMMARY
Date Contract Entry 799.7 2,157 2,152.25 Initial stop 790.2 2,136 2,136 Initial target 811 2,173 2,173 IRR 1.19 0.76 1.28 Exit Date P/L -27.1 (4.6%) -24.5 (1.1%) -33.25 (1.5%) LOP 1.4 1.25 5 LOL -47.5 -32.25 -39.75 Trade length 3 days 5 hours 1 day

12/27/07 ER2H08 NQH08 NQH08

763.10 1/2/08 2,132.5 (1/2 trade) 12/27/07 2,119 (1/2 trade) 12/28/07

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).
42 January 2008 • FUTURES & OPTIONS TRADER

OPTIONS TRADE JOURNAL
FIGURE 1 — JUMPING BEFORE THE SPLIT XTO Energy gained 0.92 percent in the final hour of trading on Dec. 13 before its 5:4 stock split the following morning. Instead of buying calls at the close, we entered this trade early and sold at the close, capturing a profit of $0.25 per contract (9.4 percent).

Instead of exploiting an overnight jump, we catch a brief, strong rally just before a stock split.
TRADE Date: Thursday, Dec. 13. Market: Options on XTO Energy (XTO). Entry: Buy 2 January 2008 65 calls at $2.65 each. around 3:20 p.m., we bought two January 65-strike calls for $2.65 each. The position has a total delta of 109.5, so its directional exposure resembles 109.5 underlying shares. Moreover, the calls don’t expire for 37 days, so daily time decay ($7.32) isn’t really a problem for a trade we expect to hold overnight. Initial stop: Exit if calls drop below $1.35 each. Initial target: Hold overnight and exit at tomorrow’s open. Outcome: Figure 1 shows XTO traded higher after the trade was filled, so it was immediately profitable. Within an hour, XTO Energy rallied another 0.69 percent and the long call’s ask hit $3.00. At that point, the stock had climbed further than expected, and we sold each call for $2.90 each — a gain of $0.25 per contract (9.4 percent). Was exiting early a mistake? Figure 2 shows it’s hard to tell: XTO opened 0.3 percent higher, but plunged 1.52 percent within five minutes. Given the logistical problems of trading on stock-split days, we probably couldn’t have captured a larger gain.
FIGURE 2 — HIGHER OPEN, LOWER CLOSE XTO Energy opened 0.3 percent higher, in-line with historical patterns. But XTO fell 1.8 percent within 30 minutes, rebounded somewhat, then closed 0.28 percent lower on the day.

Reasons for trade/setup: On Nov. 14, XTO Energy (XTO) announced plans to split its stock five-to-four (5:4) on Dec. 14, meaning investors will receive five shares for every four shares held. Because last month’s stock-split trade was profitable, we studied options on XTO to find a shortterm, bullish trade. Historically, S&P 500 stocks gained roughly 2.6 percent, on Source: eSignal average, from stock-split announcement days to the day TRADE SUMMARY before stocks actually split in price. This interim period lasted about 30 Entry date: Dec. 13, 2007 trading days, but ranged from two Underlying security: XTO Energy (XTO) to 117 days in length since January Position: Long calls 2000. Then stock-split candidates Initial capital required: $530 gained 0.49 percent from the prior Initial stop: Exit if calls drop in day’s close to the split day’s open. value by 50 percent. XTO Energy climbed 4.65 perInitial target: Hold overnight. cent from Nov. 14 to Dec. 13, rallyInitial daily time decay: $7.32 ing in-line with this historical patTrade length (in days): 1 tern. But will XTO also jump P/L: $50 (9.4 percent) overnight to open higher on Dec. LOP: $70 14? LOL: $0 Buying in-the-money (ITM) LOP — largest open profit (maximum available calls is one way to profit from an profit during life of trade). LOL — largest open loss (maximum potential loss overnight pop, because they have during life of trade). high deltas, which means they move roughly in sync with the TRADE STATISTICS underlying’s price. However, ITM calls have less leverage than calls at Dec. 13 3:20 p.m. 4 p.m. other strikes and are somewhat conDelta 109.5 120 servative. Therefore, near-the-money Gamma 13.32 13.71 calls might offer a larger percentage Theta -7.32 -6.99 return on investment. Vega 16.46 16.38 Figure 1 shows XTO traded at Probability 36 39 $65.02 at 2 p.m. on Dec. 13 before of profit percent percent climbing 1 percent within an hour. At Breakeven 54.12 54.12 first, we planned to buy at-the-money point (split price) (split price) (ATM) calls at the close, but when XTO Energy fell 0.52 percent to $65.35
FUTURES & OPTIONS TRADER • January 2008

Source: eSignal

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