2007-09 - Futures &amp Options

Strategies, analysis, and news for futures and options traders
September 2007 Volume 1, Issue 6
TRADING OPTIONS with the COT report p. 16 STOCK MARKET sell-off patterns p. 15 FUTURES SYSTEM LAB: Dangling carrot system p. 28 ROLLING LEAP strategy p. 22 T-NOTE FUTURES: Trading characteristics p. 8 INTERVIEW: PAYAM PEDRAM AND JACQUES L. DEVORE of Ascendant Asset Advisors p. 34
CONTENTS
Market history update Triple-witching expirations: More bullish in recent years . . . . . . . . . .27
Does the stock market exhibit a tradable pattern around quarterly expirations?
Futures Trading System Lab Trend pullback with progressive target . . . . . . . . . . . . . . .28
An adaptive exit rule is used to fight slippage and avoid giving back profits in a trend-following system. By Volker Knapp
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Options Trading System Lab Buying options on ADX breakouts . . . .32 Trading Strategies Trading todays T-note futures . . . . . . . . . .8
A look at patterns in the 10-year T-note futures: intraday volatility, closing tendencies, and more. By Thom Hartle By Steve Lentz and Jim Graham
Trader interview Payam Pedram and Jacques L. DeVore of Ascendant Asset Advisors . . . . . . . . . . . .34
These options traders sell calls on stock index futures, a strategy that finally paid off this summer. By David Bukey
Summer swoons, fall boons . . . . . . . . . .15

Is the stock market poised for a fall sell-off? Price history holds interesting clues. By FOT staff
Straddling the COT report . . . . . . . . . . . .16

Timing a long options straddle on the S&P 500 with data from the Commitment of Traders report. By Charlie Santaularia
continued on p. 4
Rolling LEAPS calls . . . . . . . . . . . . . . . . . .22

In bull markets, this strategy has the potential to outperform buy-and-hold with less risk. By Tristan Yates
September 2007 FUTURES & OPTIONS TRADER
CONTENTS
Industry News CFTC seeks greater oversight, more funding . . . . . . . . . . . . . . . . . . . . . . . .38
The Commodity Futures Trading Commission might have OTC products under its jurisdiction soon, and the agency is seeking an extended budget. By Jim Kharouf
Nasdaq enters crowded options arena . . . . . . . . . . . . . . .39

A new exchange run by the Nasdaq will bring the number of U.S. options exchanges to seven.
New Products and Services . . . . . . . . . . . . .41 Futures Snapshot . . . . . . . . . . . . . . . . . . . .42
ICE goes two for two . . . . . . . . . . . . . . . . .39

The IntercontinentalExchange closes the deal to acquire the Winnipeg Commodity Exchange and wins a court battle vs. NYMEX. By Jim Kharouf
Momentum, volatility, and volume statistics for futures.
Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .44

Notable volatility and volume.
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .46 Hedge fund goes down . . . . . . . . . . . . . . .40

Sentinel Management Group, a money-management firm, filed for bankruptcy in mid-August after fraud charges were filed against it. References and definitions.
Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .51 Futures & Options Calendar . . . . . . . . . . . .52 Futures Trade Journal . . . . . . . . . . . . . . .54
Long stock-index futures trade is a bumpy ride.
TT patent challenged at USPTO . . . . . . .40

Software firm Trading Technologies is once again facing objections to its patents. By Jim Kharouf
Options Trade Journal . . . . . . . . . . . . . . .56

Buying puts after stock downgrades.
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CONTRIBUTORS CONTRIBUTORS
A publication of Active Trader
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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
Charlie Santaularia is managing director of Parrot Trading Partners, LLC (CPO/CTA). He holds a bachelor of arts in economics from the University of Kansas and has been actively trading for the past four years. He has a NASD series 3 license and is charge of marketing, market research, and client contact, and actively assists with trading decisions. In addition to writing a monthly newsletter for the firms investors, he has been published in industry magazines, http://www.stockweblog.com and http://www.commoditytrader.com. Thom Hartle (http://www.thomhartle.com) is director of marketing for CQG and a contributing editor to Active Trader magazine. In a career spanning more than 20 years, Hartle has been a commodity account executive for Merrill Lynch, vice president of financial futures for Drexel Burnham Lambert, trader for the Federal Home Loan Bank of Seattle, and editor for nine years of Technical Analysis of Stocks & Commodities magazine. Hartle also writes a daily market blog called hartle & flow (http://www.hartleandflow.com). Tristan Yates writes and consults on leveraged indexed investment strategies. He graduated from the INSEAD MBA program in Singapore and now manages the Index Roll, an investment advisory, research group, and Web resource created to help individual investors build and manage longterm leveraged index portfolios. He can be reached at tristan@indexroll.com. 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.
Volume 1, Issue 6 . Futures & Options Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. 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.
TRADING STRATEGIES
Trading todays T-note futures

FIGURE 1 ANALYSIS PERIOD The review period contained an uptrend, a downtrend, and a wide, choppy trading range.
Volatility in the T-note futures is notably lower than it was a few years ago. Find out what that means for your trading strategies.
BY THOM HARTLE
Source: CQGNet (http://www.cqg.com)
FIGURE 2 DAILY RANGE The slight upward slope of the regression line indicates a small rise in daily range volatility over the review period, but overall, the typical range during this time was smaller than during the original analysis period.
lthough some aspects of markets never change, specific volatility and price patterns evolve over time, and only those traders who can adapt their strategies to the prevailing market conditions are likely to enjoy sustained success. Dissecting T-note futures: Tendencies and characteristics (Active Trader, July 2005) details the behavior of the 10-year T-note futures (TY) contract from March 1, 2004 to Feb. 28, 2005. This updated analysis reviews the 10-year T-note from July 3, 2006 to June 29, 2007 and highlights any changes in this markets trading attributes. The characteristics the analysis covers include the markets typical daily ranges, closeto-close moves, lows for up-closing sessions, and highs for down-closing sessions. These statistics help traders understand: How much the market moves during each trading session. Where the market tends to close within the days range. How much below the previous days close the market can be expected to trade and still close up on the day, which is useful information for traders holding long positions or those looking to go long on an intraday pullback. How much above the previous days close the market can be expected to trade and still close down on the day, which is
FIGURE 3 DAILY RANGE DISTRIBUTION: JULY 2006-JUNE 2007 The most common daily range size (90 occurrences) was 0.375 points (12/32nds) through 0.50 points (16/32nds).
useful information for traders holding short positions or those looking to go short on an intraday pull up. In addition, the Fridays when the employment report is released are analyzed as a group, because this report tends to trigger big moves in the treasury market. The tick size for the 10-year T-note contract is half a 32nd, which is referred to as a plus tick. For example, in the price 108-04+ the 04+ represents four-and-a-half 32nds. In the following charts, prices have been converted from 32nds to decimal format, which would make the 10804+ price 108.140625. For more information on T-note pricing conventions, see Treasury refresher. Figure 1 is a daily bar chart of the review period. After the July-September 2006 uptrend, the market essentially entered a wide trading range for several months, making a new high in December and a multi-month low in January. The spring sell-off brought the market to its lowest level in a year.
FIGURE 4 DAILY RANGE DISTRIBUTION: MARCH 2004-FEBRUARY 2005 In the initial review period, the most common daily range size is 0.50 points (16/32nds) through 0.6125 points (20/32nds).
Daily ranges: How much does the market move in a day?

The first market characteristic to be analyzed is daily range. Figure 2 shows the daily ranges from the July 3, 2006 to June 29, 2007 review period with a regression line plotted through the data. The regression line has a slight upward slope, indicating the daily ranges expanded as the review period progressed. The largest daily range was 1.265625 points (1-8.5/32nds), which occurred on Feb. 22, 2007. The smallest daily range was just 0.125 points (4/32nds), which occurred on Oct. 24, 2006. The average and median daily ranges of 0.4204 points (13.45/32nds) and 0.3750 points (12/32nds) were very similar, which suggests a 12 to 13/32nd range can be considered typical. By comparison, the average daily range from March 1, 2004 to Feb. 28, 2005 was 0.6044 points (19.34/32nds) and the median range was 0.516250 points (16.5/32nds). This is the first indication volatility has declined since the first analysis period a drop of more than 30 percent in the average daily range (-28 percent in the median range). Figure 3 shows the frequency distribution of the daily ranges how often daily ranges of different sizes occurred. Distribution analysis
continued on p. 10
FIGURE 5 CLOSE RELATIVE TO DAILY RANGE: JULY 2006-JUNE 2007 In the recent review period there was a slight tendency to close near the bottom or top of the days range.
FUTURES & OPTIONS TRADER September 2007
TRADING STRATEGIES continued
FIGURE 6 CLOSE RELATIVE TO DAILY RANGE: MARCH 2004-FEBRUARY 2005 During the first review period, the market tended to finish the session higher off the daily low than in the latest review period.
Treasury refresher
Treasury bonds and notes are debt securities issued by the United States Treasury. They are considered debt instruments because by purchasing them you are loaning money to the Treasury department, which then pays you interest (determined by a coupon rate) on a semiannual basis and returns the principle when the bond or note matures on the maturity date. T-bonds and T-notes are called fixed-income securities because of the fixed coupon payment an investor receives while holding the bond or note. T-notes are issued in maturities of two, three, five, and 10 years; T-bonds have maturities greater than 10 years. The minimum bond or note size is $1,000. For example, if you purchased a $1,000 10-year T-note with a 4-percent coupon, you would receive $20 every six months, totaling $40 per year; the $1,000 would be paid back to you on the maturity date 10 years from now. A bond or notes yield is its coupon payment divided by the price in this case, $40/$1,000 = 4 percent. Treasury futures prices indicate a percentage of par price, which for any Treasury bond or note is 100. T-bond prices consist of the handle (e.g., 100) and 32nds of 100. For example, 98-14 is a price that translates to 98-14/32nds or $984.38 for a $1,000 T-bond. T-notes are priced in a similar fashion, except they can include one-half of a 32nd for example, 98-14+ is 98-14.5/32nds, or 984.53 for a $1,000 T-note.
FIGURE 7 LOWS ON UP-CLOSING DAYS: JULY 2006-JUNE 2007 The market dropped more than 0.25 points (8/32nds) below the opening price and still closed up only seven times.
helps identify typical market behavior, as well as how often unusual situations occur. The x-axis, which represents range size, increases in 0.0625-point (2/32nd) increments, and the y-axis shows the number of ranges that occurred in the different size categories. For example, the peak reading (90, third bar from the left) means there were 90 days with ranges greater than 0.375 points (12/32nds) up to and including 0.50 points (16/32nds). Now look at Figure 4, which is the frequency distribution
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chart from the March 2004-February 2005 analysis window. Comparing Figures 3 and 4 highlights the daily volatility contraction that has occurred since the original analysis. In Figure 4, the peak reading (64 occurrences) of the daily range was between 16/32nds and 20/32nds which means the upper end of the current most common daily range category was the lower end of the former most common category. There was a slight decline in this category in July 2006-June 2007: there were only 54 days with ranges between 16/32nds and 20/32nds.
FIGURE 8 DISTRIBUTION OF LOWS ON UP-CLOSING DAYS: JULY 2006-JUNE 2007 On days the 10-year T-note closed higher, the lows tended to be no more than 0.1250 points (4/32nds) below the opening price.
Another key trading tendency is how a market tends to close, which is the subject of the next portion of the analysis.
How does the market close?

Figure 5 is a frequency distribution showing where the 10-year T-note futures tended to close within the days range on a percentage basis i.e., a close at precisely 10 percent would mean the close was 10 percent above the low, a close at the 90-percent level would mean the close was 10 percent below the high, a close at 100 percent would mean the market closed at the high of the day, and so on. Each x-axis category in Figure 5 represents a range of 10 percentage points. For example, the 10% bar represents the number of days (11) the market closed more than 10 percent up to and including 20 percent above the low. The two highest bars indicate the market often closed in the lower 20-30 percent of the daily range (the 20% bar) or the upper 10-20 percent of the days range (the 90% bar). Figure 6, which is the comparable chart for March 2004-February 2005, shows that during this period the 10-year T-note futures tended to close farther away from the low of the day than during the more recent period.
FIGURE 9 DISTRIBUTION OF LOWS ON UP-CLOSING DAYS: MARCH 2004-FEBRUARY 2005 During the first analysis period, the market traded more than a full point below the open and still closed higher.
Up-closing and down-closing days

Another attribute to consider is how the 10-year T-note futures trade on up-closing days vs. down-closing days. Figure 7 plots the up-closing daily bars of the current review period relative to the sessions opening price. The bars are adjusted so that zero is the opening price, which makes it easy to see how much price action occurred above and below this price point. The market rarely traded more than 0.25 points (8/32) below the opening price on days it would eventually close higher good information if, for example, youre trading from the long side intraday and want to know how far you should let the market go against you before exiting. Figure 8 is a frequency distribution chart of the lows from Figure 7. Most of the time the market traded no more than 0.1250 below the open on up-closing days. The biggest postopening drop on an up-closing day was -0.4375 (12/32nds).
Figure 9 is the frequency distribution for lows on up-closing days for the March 2004-February 2005 period. Comparing it to Figure 8 reveals there was a shift toward smaller post-opening down moves on up-closing days during the July 2006-June 2007 period, as well as a lack of extreme downside. Figure 9 shows that during the March 2004-February 2005 period the market was down more than a point and still closed up on the day.
continued on p. 12
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Related reading
Dissecting T-note futures: Tendencies and characteristics Active Trader, July 2005. A detailed understanding of a markets price history and characteristics allows you to craft trade strategies founded on statistical reality rather than casual observation. The following analysis takes the pulse of the T-note futures market.
Note: This article is also contained in the discounted compilation, Thom Hartle Strategy and Analysis Collection, Vol. 2.
FIGURE 10 HIGHS ON DOWN-CLOSING DAYS: JULY 2006-JUNE 2007 There were only two times when the market traded more than 0.50 points (16/32nds) above the open and still closed down for the session.
Short-term T-bond trading Active Trader, October 2002. This strategy takes quick intraday profits using rules determined by the daily trend. Using a combination of indicators, it is possible to trade Tbond futures on a short-term basis when the bond market is in a trend or trading range. This technique uses a multiple-time frame approach: Two indicators applied to daily bars work together to determine the trend; two others, Bollinger Bands and the moving average convergencedivergence (MACD) indicator, identify entry and exit signals on an intraday basis. Treasury bonds and notes Active Trader, June 2005. Trading Basics: A primer on the U.S. Treasury market. The TUT spread: An active spread for active traders Active Trader, October 2005. The spread between 10-year and two-year T-note contracts offers a vehicle for taking advantage of interest rate shifts.
Note: This article is also contained in the discounted compilation, Keith Schap: Futures Strategy collection, Vol. 1.
FIGURE 11 DISTRIBUTION HIGHS ON DOWN-CLOSING DAYS: JULY 2006-JUNE 2007 The market tended to climb more above the opening price on days it closed lower than it fell more below the opening price on days it closed higher.
The hidden factor in treasury futures pricing Active Trader, March 2006. Those looking for insights into the treasury market should analyze the interesting relationships between the cash and futures market, as well as interest rate movements. The 2-year/10-year Treasury spread and the S&P 500 Active Trader, September 2006. Traders often infer stock market behavior from developments in the 2-year/10-year T-note spread, but there might be less to this relationship than many think.
You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.
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Figure 10 shows the daily bars for down-closing days adjusted to the opening price. The 10-year note tended to trade higher above the open on down-closing days than lower below the open on up-closing days. The market traded above the open by more than 0.25 points (8/32nds) and still closed down 13 times. Twice, the market was up more than 16/32nds above the open and still closed down. Figure 11 is a frequency distribution chart of the highs relative to the opening price for each session. Figure 12 is the comparable chart for the March 2004-February 2005 period. As was the case for lows on
continued on p. 14

FIGURE 12 DISTRIBUTION OF HIGHS ON DOWN-CLOSING DAYS: MARCH 2004-FEBRUARY 2005 As in Figure 9, during the earlier review period, the market made more extreme highs on down-closing days.
up-closing days, the market made more extreme highs and still closed down in the 2004-2005 period than in the 2006-2007 period. However, while volatility has dropped overall, in both review periods traders showed a tendency to bid prices higher above the open on down-closing sessions than to push it below the open on up-closing sessions.
T-notes and the employment report

The first Friday of each month the Commerce Department releases the employment report, which can trigger wild moves in the T-note market, just as it can in the stock market. Figure 13 shows the daily ranges for each employment Friday between July 2006 and June 2007. The daily range exceeded a full point only twice during the updated review period. This is quite a change from the 2004-2005 period, during which the 10-year note daily range was more than a point on nine different employment Fridays (Figure 14).
FIGURE 13 DAILY RANGES FOR EMPLOYMENT FRIDAYS: JULY 2006-JUNE 2007 The 10-year T-note daily range exceeded one point (1-00) only twice on employment-number Fridays during the current analysis period.
Lessons learned
Some significant differences emerge when comparing the two analysis periods all a function of the markets reduced volatility. First, the average daily range dropped significantly some 30 percent between 20042005 and 2006-2007. The 10-year note still exhibits a tendency to make lows nearer to the opening price on upclosing days than to make highs nearer to the open on down-closing days but again, the extreme levels for both highs and lows have come down during the latest review period. Most striking is the decline in the typical daily ranges on employment Fridays. The market had a daily range in excess of a full point only twice during the new review period on an employment-report Friday. This type of research is critical for staying abreast of the markets current condition and the kind of strategies that most likely work in it. Price targets and stop-loss levels built upon the statistics published in the 2005 article would be inappropriate for todays T-note market.
For information on the author see p. 6.
14 September 2007 FUTURES & OPTIONS TRADER
FIGURE 14 DAILY RANGES FOR EMPLOYMENT FRIDAYS: MARCH 2004-FEBRUARY 2005 During the more-recent review period, the daily ranges exceeded one point on nine of 12 employment Fridays.
TRADING STRATEGY
Summer swoons, fall boons

Traders and investors often get nervous when the leaves start to turn, but summer sell-offs such as the one that occurred this year have usually not presaged fall meltdowns.
BY FOT STAFF
t was a rough summer for the stock market, but traders fearful of more carnage to come in the often-volatile months of September and October might take some solace from analysis of past years in which equities have slumped from June through August. As of Aug. 30, the S&P was down 4.7 percent from the May 31 close. In the 47 years from 1960 to 2006, the S&P 500 lost ground from the last day of May through the last day of August (close-to-close basis) 18 times. In 12 of those years, the S&P posted a positive return from the last trading day of August to the last trading day of October. The median September-October gain is 0.28 percent in years the S&P posted a June-August gain, but that figure jumps to 2.08 percent in years the index lost ground in June-August. Furthermore, of the six times the S&P failed to move higher in September and October, four (including 2001 and 2002) were years in which the S&P 500 was already down for the year as of June 1. In 2007, by comparison, the S&P was up nearly 8 percent at the beginning of June. Of the nine years when the S&P was positive for the year on June 1 but posted a negative June-August, seven had positive
September-October S&P return if June-Aug. was up if June-Aug. was down Median Average 0.28% -0.61% 2.08% 1.60%
47 years from 1960-2006
September-October returns. The number of examples will likely leave statisticians wanting more data, but these numbers bring a hypothesis to mind: In years the stock market is up significantly at the halfway mark, the absence of a summer decline may only postpone a correction until fall and then make it more severe. A summer sell-off might flush out the market and reduce the potential selling pressure that troubles so many traders and investors in September and October. For more information on this study, and other stock-market sell-off trading patterns, see Playing the breaks in the November issue (on newsstands in October) of Active Trader magazine.
TRADING STRATEGIES
Straddling the COT report

FIGURE 1 S&P 500 VS. LARGE SPECS, ONE YEAR Fund managers were net long in the fall of 2006, but shifted to a net short position in May when the S&P 500 began to hit new highs.
Tracking shifts in large-trader sentiment can signal trade opportunities. This long straddle was triggered by an extreme reading in the S&P 500 futures.
BY CHARLIE SANTAULARIA
Source: www.schaeffersresearch.com
Strategy snapshot
Strategy: Long straddle. Underlying market: E-Mini S&P 500 futures (ES). Market bias: Neutral. Components: One ATM call, one ATM put. Logic: A five-year low in large speculators net positions will lead to a significant underlying move in either direction. Timing: 67 days. Profit target: Exit after 25-percent gain. Stop-loss: Exit after 25-percent loss in first two weeks; or exit 14 days until expiration. Best-case scenario: Underlying market moves sharply in either direction before options expire. Maximum reward theoretically unlimited. Worst-case scenario: Underlying market goes nowhere and both options expire worthless.
raders often view the Commitment of Traders (COT) report as a futures market Rosetta Stone the key to deciphering where different markets are headed. The problem is that the report can confuse as much as it clarifies. Each week, the Commodity Futures Trading Commission (CFTC) publishes the COT report, which lists open interest in more than 90 futures markets from stock indices, interest rates, and foreign currencies to coffee, corn, and milk (for more details, see The Commitment of Traders report). Positions are broken down into categories representing commercial traders (businesses that either use or produce the actual commodities they trade), large speculators (hedge funds, commodity trading advisors, and other money managers), and retail speculators (the small specs, or public). Traders and analysts contend trade signals can be tied to extreme position levels among the different groups. If, for example, large speculators net position size (longs - shorts) climbs to a multi-year high, the market could drop, because those long positions will eventually be unwound. (A
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recent article outlining this type of contrarian approach in the Russell 2000 index Cracking the COT code appeared in the July 2007 issue of Futures & Options Trader.) The following discussion uses COT data from the S&P 500 futures (SP) to find an appropriate options trade. Large-speculator net positions in the S&P hit a three-year low in July. In the past seven years, extreme lows in large speculators positions have led to significant underlying moves in either direction. Entering a long straddle (long call, long same-strike put) is one way to profit from a large move in the underlying.
FIGURE 2 S&P 500 VS. LARGE SPECS, FIVE YEARS Large speculators held more than 45,000 net short positions by July 16 a five-year low.
What can open interest tell us?

This analysis focuses on large speculators, the COT group consisting of hedge-fund managers, mutual-fund managers, brokerage firms, banks, and other professional managers who hold least 600 contracts in the S&P 500 futures. CFTC reportable levels are 600 contracts or more, a benchmark that defines a large speculator (more than 600 contracts) and a small speculator (less than 600 contracts). As a general rule, if a markets COT data shows a net short position (less than zero), that market might fall (or consolidate) as traders anticipate a sell-off. Also, if more traders are net long (greater than zero) the sentiment may be bullish. However, this relationship isnt always accurate, as the following examples demonstrate.
Shifting winds in the S&P 500

Figure 1 compares the S&P 500 futures (red line) with the net position of large speculators during the past 12 months (blue line). Figure 2 shows the same comparison over the past five years. Large speculators held 40,000 long positions in November 2006 and stayed long until the S&P 500 began to hit new highs this past spring. They shifted to a net short position in May the first negative reading in more
continued on p. 18
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TABLE 1 POST-PATTERN STATS After large-speculator positions hit yearly lows, the S&P 500 tended to be more volatile than usual over the next 67 days. Entering a September straddle is one way to capture a possible volatility increase.
TABLE 2 LONG STRADDLE COMPONENTS The E-Mini S&P 500 futures must move 4.8 percent in either direction by Sept. 21 to overcome the straddles cost ($4,062.50).
S&P 500 performance 67 days after yearly lows in net large speculator positions since 2000. Close-to-high Close-to-low Close-to-close move move move Median Benchmark 7.90% 4.76% -6.14% -2.35% 5.75% 1.31%
E-Mini S&P 500 September contract closed at 1,559.75 on July 16. Position Price Commission Cost 1 long September 1,550 call 1 long September 1,550 put $45.25 $35 $25 $25 $2,287.50 $1,775
than 12 months when the S&P 500 futures climbed above 1,520. By July 16, they held more than 45,000 short positions a three-year low. What was the meaning of this sentiment shift? On the surface, it seems bearish, because demand for equities waned among large specs. However, testing showed the S&P 500 tended to move more than usual up or down in the two months after large speculator positions reached yearly lows since 2000. Table 1 shows the S&P 500s median close-to-high, closeto-low, and close-to-close moves in the two months following yearly lows in smart-money positions. It compares
FIGURE 3 RISK PROFILE LONG STRADDLE
Total cost/risk: Breakeven point:
$4,062.50 4.8 percent (up or down)
these moves to all same-length moves during the same period (benchmark). Although open interest hit annual lows only six times in seven years, Table 1 provides some clues about how the S&P 500 behaves in these situations. Over the next two months, the index climbed 7.90 percent to its high and fell 6.14 percent to its low at least 1.5 times further than its benchmarks (4.76 and -2.35 percent, respectively). On a close-to-close basis, the S&P 500 gained 5.75 percent, but it tended to fall just as far to its lows. How can you trade this type of directionless forecast?
The long September 1,550 straddle could profit from a major price swing in the E-Mini S&P 500 futures in the next 67 days. If the market goes nowhere, it will lose $4,062.50.
Source: OptionVue
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TABLE 3 STRADDLE PERFORMANCE The straddle was unwound on Aug. 1 with a $1,312.50 total profit (32.31 percent).
Buying or selling the underlying futures outright isnt ideal here, but you can enter a long at-the-money (ATM) straddle to exploit a possible large rally or decline. This trade can also benefit from an increase in implied volatility (IV), especially if the market plummets.
Building a long straddle
A long straddle consists of an ATM call and a put with the same strike. If the underlying market goes nowhere, the options will expire worthless the strategys biggest risk. Ideally, the market will rally or fall enough that one of the options will more than offset the straddles cost. On July 16 the S&P 500 cash index closed at 1,542.52 and the E-Mini S&P 500 futures closed at 1,559.75. Lets assume you bought a 1,550 September call for $45.25 and a same-strike September put for $35.00. In dollar terms, the straddles total cost was $4,062.50 (($45.25+ $35) * $50 multiplier + $50 commission). Table 2 lists the long straddles details. (Although a 1,550 straddle was not technically ATM on July 16, this strike was chosen instead of the 1,560 ATM strike because the futures market was trading at a 10-point premium to the cash market. By September expiration, however, this premium will erode.) Its important to choose an expiration month that gives the market ample time to move. Using September options gave the market 67 days to make a sufficiently large move in either direction before expiration. Although an August straddle was cheaper, it had a higher negative theta. And time premium bleeds most rapidly in the last month before expiration. For example, the August 1,550 straddle had a daily theta of -$201; the September 1,550 straddle had a daily
continued on p. 20
Date 7/16/07 7/17/07 7/18/07 7/19/07 7/20/07 7/23/07 7/24/07 7/25/07 7/26/07 7/27/07 7/30/07 7/31/07 8/1/07 8/2/07 8/3/07 8/6/07 8/7/07 8/8/07 8/9/07 8/10/07 8/13/07 8/14/07
Sept. 1,550 call $45.25 $44.25 $40.25 $43.50 $38.75 $38.25 $25.25 $26.50 $13.25 $10.75 $10.50 $8.50 $10.50 $10.50 $5.00 $7.00 $9.00 $15.25 $7.50 $8.25 $5.50 $3.25
Sept. E-Mini 1,550 S&P 500 Sept. put contract (ES U7) $35.00 1,559.75 $33.00 1,558.75 $37.50 1,554.75 $34.00 1,559.75 $41.00 1,545.00 $38.50 1,549.00 $53.00 1,522.50 $50.75 1,524.75 $77.50 1,488.00 $95.25 1,458.00 $80.00 1,480.75 $72.00 1,462.00 $96.00 1,470.00 $96.00 1,481.75 $78.25 1,443.00 $111.50 1,467.75 $78.50 1,482.50 $76.25 1,504.00 $88.00 1,458.00 $105.00 1,451.00 $105.50 1,455.00 $118.50 1,434.25
CBOE VIX index 15.59 15.63 16.00 15.23 16.95 16.81 18.55 18.10 20.74 24.17 20.87 23.52 23.67 21.22 25.16 22.94 21.56 21.45 26.48 28.30 26.57 27.68
Gain/ loss NA -$150.00 -$125.00 -$137.50 -$25.00 -$175.00 -$100.00 -$150.00 $525.00 $1,287.50 $512.50 $12.50 $1,312.50 $1,312.50 $150.00 $1,912.50 $362.50 $562.50 $762.50 $1,650.00 $1,537.50 $2,075.00
Percentage gain/loss 0% -3.69% -3.08% -3.38% -0.62% -4.31% -2.46% -3.69% 12.92% 31.69% 12.62% 0.31% 32.31% 32.31% 3.69% 47.08% 8.92% 13.85% 18.77% 40.62% 37.85% 51.08%
19
Related reading
Articles by Charlie and Jes Santaularia
Playing defense: Long puts vs. bear put spreads Futures and Options Trader, June 2007. Protecting a portfolio from a market downturn doesnt have to be complicated. Find out which defensive strategy offers the most bang for your buck. Another look at diagonal spreads Options Trader, March 2007. This position combines bullish and bearish diagonal spreads and is quite flexible if youre willing to adjust its components.
Floyd Upperman: Digging into COT data Active Trader, February 2006. Its not just a matter of hedgers vs. speculators. An engineer turned trader discusses ways to make sense of the futures Commitment of Traders report. Larry Williams looks inside futures Active Trader, January 2006. Larry Williams discusses the twists he puts on the Commitment of Traders report in his latest book. Testing the commitment of traders Active Trader, March 2004. Does knowing how long or short different groups of professional and retail traders are have any value in gauging market direction? This analysis takes a well-known number (Commitment of Traders) and tests it on different markets. All traders big and small: The Commitment of Traders report Active Trader, March 2003. In futures, as in stocks, the institutional money usually dictates price action. The Commitment of Traders report gives you a glimpse of what the big money is doing in the markets you trade.
You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.
Other articles
Cracking the COT code Futures and Options Trader, July 2007. Trading the Russell 2000 with data found in the Commitment of Traders report. Gauging trader commitment Currency Trader, August 2006. Analyzing the euro with Commitment of Traders data sheds light on the strength or weakness of price moves.
FIGURE 4 LARGE SPECS BOTTOM OUT? The large specs positions began to reverse after the S&P futures fell 6.4 percent from July 16 to July 27.
theta of -$146, which is much more reasonable. Figure 3 shows the straddles potential gains and losses on four dates: the July 16 trade entry (upper dotted line), the Sept. 21 expiration (solid line), and two interim days (middle lines). The goal is to take advantage of a major price swing in the S&P 500 before expiration in 67 days. Possible exit criteria: if the trade gains 25 percent, if it loses that much in the first two weeks, or 14 days prior to options expiration. For the position to profit, the EMini S&P 500 futures must move at least 75 points (4.8 percent) the quicker the move, the better. This straddle is a high-vega trade, so you are essentially buying volatility. Profits will likely increase if IV climbs. Therefore, if the underlying sells off, this trade will benefit
20
The Commitments of Traders report

more because volatility will jump. Published weekly by the Commodity Futures Trading Commission (CFTC), the Commitments of Traders (COT) report breaks down the open interest in major futures markets. Clearing members, futures commission merchants, and foreign brokers are required to report daily the futures and options positions of their customers that are above specific reporting levels set by the CFTC. For each futures contract, report data is divided into three reporting categories: commercial, non-commercial, and non-reportable positions. The first two groups are those who hold positions above specific reporting levels. The commercials are often referred to as the large hedgers. Commercial hedgers are typically those who actually deal in the cash market (e.g., grain merchants and oil companies, who either produce or consume the underlying commodity) and can have access to supply and demand information other market players do not. Non-commercial large traders include large speculators (large specs) such as commodity trading advisors (CTAs) and hedge funds. This group consists mostly of institutional and quasi-institutional money managers who do not deal in the underlying cash markets, but speculate in futures on a large-scale basis for their clients. The final COT category is called the non-reportable position category otherwise known as small traders i.e., the general public.
Managing the trade

A long straddle is a passive strategy. After you place it, no adjustments are necessary just wait until the underlying moves. Table 3 lists the daily closing prices of the EMini S&P 500 September contract and the CBOE volatility index (VIX) along with the straddles daily gains and losses. In the first week, the market fell 0.95 percent, and the straddle was basically flat. Remember it doesnt matter whether the market is bullish or bearish, as long as it moves more than 4.8 percent. After a few weeks of volatile trading, the market began to sell off more dramatically. By July 27 it had fallen 6.4 percent to 1,458 and the VIX had jumped 55 percent to 24.17, which increased the straddles profitability. At this point, the trade had gained 32 percent, surpassing its profit target of 25 percent. You could exit at this point or place stops to protect your gains. Figure 4 shows the large specs net positions began to reverse after the S&P futures fell sharply in late July. The straddle was unwound on Aug. 1 when the E-Mini S&P 500 closed at 1,470 and the VIX closed at 23.67. The final profit was 31.07 percent (($-34.75 call loss + $61 put gain) * $50 multiplier + $50 commission = $1,262.50). The market dropped 5.7 percent, and the VIX climbed 51.8 percent during the trades lifetime. Table 3 also shows potential profits if you had held the position for a few more days. The straddle would have benefited from further market weakness and a rising VIX. However, holding the straddle after such a sharp decline is risky; the straddles profits will deteriorate if a sharp bounce-back occurs.
Taking a long view

One way to find tradable ideas in COT reports is to spot longer-term shifts in sentiment and then create strategies based on these changes. But all futures markets are different, which means you cant assume a successful COTbased strategy in one market can be applied to another.
FUTURES & OPTIONS TRADER September 2007 21
TRADING STRATEGIES
Rolling LEAPS calls

Holding LEAPS calls instead of the underlying shares can pay off but only if you know when to roll them forward
BY TRISTAN YATES
ou can make money buying stocks and holding them for long periods, but you risk a large amount of capital when doing so. By contrast, buying calls can provide the same type of returns with less risk. The problem is that time decay works against you. A strategy designed to compensate for this drawback is buying long-term calls on exchange-traded funds (ETFs) that track major market indices, and selling them to buy options that expire even later a technique called rolling. The strategy uses Long-term AnticiPation Securities, or LEAPS, which are options that dont expire for at least a year. These calls behave the same as regular calls, but are designed specifically for investors with longer-term time frames. The goal is to profit from a calls inherent leverage in a
bull market. You can only lose the amount you paid for each call, which limit losses. All options expire eventually, but the rolling process allows you to stay in the trade.
Advantages of longer-term options

Later-expiring options cost more than their shorter-term counterparts, but the additional cost isnt linear i.e., a sixmonth call doesnt cost six times as much as a same-strike call that expires next month. Instead, the cost of adding more time drops as you go further into the future. Longer-term options have lower per-month costs, on average. Table 1 compares the overall and monthly costs of at-the-money (ATM) calls with different expiration dates: one, three, six, 12, and 24 months. A one-month call costs $1.93 and a three-month call costs $3.61. But on a monthly basis, the later-expiring call costs less than the one-month call $1.20 vs. $1.93, respectively. (For simplicity, the examples track a hypothetical underlying stock that is trading at 100; dividends are excluded.) Longer-term calls also give the underlying more time to move. Table 2 shows the cost, value at expiration, and gain or loss for various options, assuming a 10-percent annual gain in the underlying instrument. While each call moves into the money, only the longer-term calls generate profits, because only they have gained enough to offset their initial costs.
TABLE 1 OVERALL VS. MONTHLY OPTION COSTS Although later-expiring options cost more, their per-month costs drop as you go further out.
Strategy snapshot
Strategy: Rolling LEAPS calls. Market bias: Long-term bullish. Components: One long 24-month LEAPS call. Logic: Outperform a simple buy-and-hold approach with the leverage and limited risk of calls. Execution: After 12 months, sell the call and buy a same-strike 24-month LEAPS call. Or roll the call after it moves 20 percent ITM and IV is at (or below) its 12-month average. Best-case scenario: Underlying market rallies. Worst-case Underlying market falls sharply and call scenario: expires worthless. Possible Instead of rolling into same-strike call, adjustments: buy a later-expiring, higher-strike (or ATM) call, which generates cash.
Strike 100 100 100 100 100
Months 1 3 6 12 24
Overall cost $1.93 $3.61 $5.48 $8.48 $13.49
Per-month cost $1.93 $1.20 $0.91 $0.71 $0.56
All tables use the following assumptions, unless otherwise noted:
Market trades at 100, IV = 15%, interest rate = 5%
22
Rolling forward
One way to maintain a position is to sell calls when they have 12 months until expiration and buy same-strike calls that dont expire for at least two years. For example, you could sell a 12-month call for $8.48 and buy a same-strike 24-month call for $13.49 a debit of $5.01 (Table 3). Table 4 compares the Greeks of the 12- and 24-month at-the-money LEAPS, and shows these options share high deltas and low thetas. This means both calls prices will increase by roughly the same amount if the market climbs one (1.00) point, and their prices arent influenced much by the passage of time.
Roll or hold?
If you wait too long to roll a LEAPS call, its delta will drop and time decay will increase, making it difficult to generate additional gains if the underlying doesnt rally sharply. Therefore, you should roll (or simply sell) any call that expires in less than nine months and has a near-the-money strike. For the best results, hold a LEAPS call until it is at least 20 percent in-themoney and implied volatility (IV) is at or below its 12-month average. Then you can sell it, roll it forward into a same-strike call, or roll it forward and up to a higher-strike call, which generates cash. Rolling up always provides cash, but the amount is only significant at lower strike prices. For example, if you
TABLE 4 COSTS AND GREEKS
sell a call that is TABLE 2 PERFORMANCE OF CALLS IN BULL MARKET 10-percent in-theIf the underlying market climbs 10 percent annually, only the money (ITM) and longer-term calls generate profits, because they are the only buy one that is ones that have gained enough to offset the initial cost. five-percent ITM, you will receive Strike Months Cost Value at Gain/loss much less than expiration five percent of 100 1 $1.93 $0.80 -$1.13 the underlyings 100 3 $3.61 $2.41 -$1.20 value, especially 100 6 $5.48 $4.88 -$0.60 in a volatile market. But if you sell 100 12 $8.48 $10.00 $1.52 a call that is 20100 24 $13.49 $21.00 $7.51 percent ITM and buy one that is 10-percent ITM, TABLE 3 ROLL EXAMPLE you could collect To maintain a long-term position, you can sell LEAPS roughly nine percalls and buy same-strike LEAPS calls that expire later, a cent of the undertechnique called rolling. lyings value. You can also Strike Months Cost hold a high-delta, Sell 100 12 $8.48 low-theta deepBuy 100 24 -$13.49 in-the-money difference -$5.01 LEAPS call until expiration. Even if the underlying plummets, increased time value and volatility might help offset the losses. However, never hold at- and out-ofthe-money options until they expire. Always roll or sell these calls. Otherwise, the positions time decay could wipe out any gains in the underlying market, and the call could have trouble increasing in value.
Rolling costs
The rolling process is fairly precontinued on p. 24
Rolling a LEAPS call doesnt significantly change its market exposure. Both calls have high deltas and low thetas, which helps you profit if the market climbs.
Calls that expire in.. 24 months Cost Delta Gamma Theta $13.49 0.72 0.02 -0.01 12 months $8.48 0.66 0.02 -0.02 6 months $5.52 0.61 0.04 -0.02 3 months $3.63 0.58 0.05 -0.02
23

dictable, because any underlying changes in price or implied volatility will be reflected both in the call you sell and the one you buy. Therefore, the cost difference between the short and long calls is minimal. You can use the following formula as a rough guideline: Cost of roll = strike * interest rate - dividend According to this formula, rolling a 100-strike call costs $5, based on a five-percent interest rate and no dividends: 100 * 5% - 0 = $5
TABLE 6 ASSUMPTIONS Buying LEAPS calls and holding them for at least a year could be profitable, given these assumptions. Profits depend upon an underlying market rally and moderate implied volatility.
TABLE 5 COMPARING ROLLING COSTS Rolling costs $5 to $6 when the call is at (or near) the money. It costs more to roll when implied volatility increases.
Strike 100 100 100 100 100
Current price 80 90 100 110 120
IV 16% 18% 20% 22% 24%
24-month call $3.54 $8.90 $16.13 $24.49 $33.50
12-month call $0.99 $4.39 $10.45 $18.30 $27.14
Cost to roll $2.55 $4.51 $5.68 $6.19 $6.36
This formula isnt perfect though. In reality, the rolls cost could be 10 to 25 percent above or below this value. Table 5 lists the prices of 12- and 24-month 100Assumptions for Russell 2000 exchange-traded fund (IWM) strike calls given both mild and extreme changes in underlying price and implied volatility. It also shows Average annual return 12% each scenarios roll cost. Historical volatility 15% For example, if the market trades at 100 with 20Implied volatility 20% percent volatility, it will cost $5.68 to roll into the Market price 100 next year (i.e., sell the ATM 12-month call for $10.45 and buy the same-strike, 24-month call for $16.13). Years to expiration 2 Table 5 shows that rolling costs $5-$6 when the call is Interest rate 5% at (or near) the money. Rolling costs could be close to zero if the call is very deep ITM and the underlyings dividend covers the interest cost. These costs will also be low if the call is so far OTM that any additional time premium has little value. Long-term AnticiPation Securities, or LEAPS, are Estimating performance longer-term options contracts that expire up to two No stock index is perfect, but the Russell 2000 is a good canyears and eight months in the future. They are no difdidate for the rolled LEAPS call strategy. Composed of 2,000 ferent from regular puts and calls, and give the owner small-cap stocks, this index has gained an average 13.09 perthe right to buy or sell 100 shares of stock at any time. cent annually since 1993. It is more volatile than the S&P 500 But instead of expiration months, they have expiration and the Dow Jones Industrial Average about as volatile as years (e.g., January 2008 LEAPS expire on Jan. 19, the Nasdaq Composite. 2008). The following estimates use options on the heavily traded All LEAPS are divided into three cycles that deterRussell 2000 exchange-traded fund (IWM). High liquidity is mine when they are listed. Cycle 1 LEAPS are listed not necessarily a prerequisite, because the strategy only rolls after May equity options expire, cycle 2 are listed after each option once a year, but narrow bid-ask spreads can help the June expiration period, and cycle 3 are listed after lower costs. the July period, three calendar years in advance (i.e., For simplicity, we assumed the Russell 2000 ETF trades at 2010 LEAPS begin listing in 2007, 2011 LEAPS in 100, bought 24-month LEAPS at different strikes, and rolled 2008, etc.) As of Aug. 14, you can buy LEAPS on the them forward each year. Rules: S&P 500 index that expire on Jan. 16, 2010 almost 30 months from now. 1. Buy 24-month LEAPS calls with strikes In theory, LEAPS behave the same as regular of 80, 90, 100, and 110. options. In practice, however, new LEAPS have low thetas and deltas in the first few months. This means 2. After 12 months, sell calls and buy 24-month time decay is reduced, but changes in the underlying calls with the same strike. market dont affect the options price as much, at least initially. Table 6 lists other assumptions used here: Rolling costs are
What are LEAPS?
24
based on an estimated annual return of 12 percent; bid-ask 70 percent of the time. Remember, it could always expire spreads and transaction costs were not included. worthless, which is why rolling is important. Table 7 shows the initial costs, rolling costs, total gains, and the internal rates of return (IRR) for all four LEAPS Risks: Sell-offs and volatility calls in three-, five-, and seven-year time periods. The IRR Historically, markets have tended to climb during longrepresents an estimated rate of growth, given the costs to term periods, but sharp sell-offs such as the 10-percent drop enter the strategy and to roll LEAPS calls forcontinued on p. 26 ward. TABLE 7 ESTIMATED RESULTS The strategys costs and total gains are ultiThe 90-strike calls balanced risk and reward well. After seven years mately determined by the LEAPS calls strike these calls had an IRR of 20.4 percent. price. Lower-strike calls are more expensive at first, but rolling them costs less and they generStrikes ate more profit from the underlying. The effect Three-year period: 80 90 100 110 tends to balance out. Initial cost -$29.12 -$22.03 -$16.13 -$11.46 ATM calls had the highest IRR of 24.7 percent vs. 24.5 percent (or less) for other strikes, assuming IWM rallied 12 percent each year. Higherstrike calls are more sensitive to changes in the underlying and thus include more risk. Table 7 suggests that 90-strike calls (10 percent below the market) balance risk and reward well. After seven years, these calls have an IRR of 20.4 percent, which means they double their capital every 3.5 years, on average. But if the Russell 2000 ETF climbs more than 12 percent annually, higher-strike calls would outperform them. Table 8 shows the average IRRs and standard deviations for each strike price and time period. Rolled LEAPS calls lose leverage as the market rallies. This reduces returns, but it also reduces their volatility. After seven years, the strategys one-standard-deviation range is very narrow (11 to 28 percent), which means performance is predictable. (For a spreadsheet containing the formulas used in this estimate, visit http://www.futuresandoptionstrader.com between Sept. 5 and Oct. 1.) Roll cost Final value IRR Five-year period: Initial cost Roll cost Second roll cost Third roll cost Final value IRR Seven-year period: Initial cost Roll cost Second roll cost Third roll cost Fourth roll cost Fifth roll cost Final value IRR -$29.12 -$4.20 -$3.94 -$3.80 -$3.74 -$3.72 141.1 19.3% -$22.03 -$5.11 -$4.73 -$4.44 -$4.27 -$4.21 131.1 20.4% -$16.13 -$5.92 -$5.65 -$5.23 -$4.91 -$4.74 121.1 21.0% -$11.46 -$6.34 -$6.50 -$6.14 -$5.69 -$5.36 111.1 20.9% -$29.12 -$4.20 -$3.94 -$3.80 $96.23 20.8% -$22.03 -$5.11 -$4.73 -$4.44 $86.23 22.1% -$16.13 -$5.92 -$5.65 -$5.23 $76.23 22.6% -$11.46 -$6.34 -$6.50 -$6.14 $66.23 22.1% -$4.20 $60.49 23.0% -$5.11 $50.49 24.5% -$5.92 $40.49 24.7% -$6.34 $30.49 22.4%
A more practical approach

In reality, few investors buy a stock, hold it, and sell it after a predefined period. Therefore, lets assume you will hold a LEAPS call until it gains 50 percent and then sell it. In a bull market, near-the-money LEAPS calls can rise in value quickly. Lets start again with an index trading at 100 and use the same assumptions from Table 6. If you buy a twoyear LEAPS call with a strike of 90 for $22.03, what are the odds it will gain 50 percent? Table 9 shows the probabilities of gaining 50 percent within different time periods. If the underlying index rallies 12 percent, the LEAPS call climbs this far within 12 months 48 percent of the time. After 24 months, it gains this much
TABLE 8 OVERALL PERFORMANCE The strategys returns are more predictable over longer-term periods.
Strikes Three-year period: IRR, average IRR, 1 std dev Five-year period: IRR, average IRR, 1 std dev Seven-year period: IRR, average IRR, 1 std dev 20% 13% to 26% 21% 13% to 27% 21% 11% to 28% 22% 9% to 31% 23% 7% to 33% 22% 2% to 35% 90 25% -4% to +44% 100 25% -14% to +49% 110 22% -41% to +54%
25

TABLE 9 ODDS OF A 50-PERCENT GAIN If the underlying index rallies 12 percent in a year, a 10-percent ITM LEAPS call will gain 50 percent nearly half the time.
Related reading
Squeezing extra profits from long calls Futures and Options Trader, May 2007. These spreads can boost profit and lower risk if you build them from an already-profitable long call. Selecting calls based on ROI Options Trader October 2006. Traders seem drawn to complex options strategies, but sometimes simply buying calls is the best way to catch an up move. Learn how to weigh the possibilities by comparing various calls return on investment. Carryover losses and deep in-the-money calls Options Trader November 2006. Deep ITM covered calls help extract profits from a long-term underlying position, but you may lose the trades favorable tax status. Large carryover losses from prior years can fix this dilemma. Managing profitable trades Options Trader August 2006. Handling a profitable option trade might seem easy, but it can be difficult to decide whether to cash out or hold on for further gains. Making the options LEAP Options Trader December 2005. Long-Term Equity AnticiPation Securities can have expiration dates more than two years away. Find out the difference between these options and standard options and how you can use them to your advantage.
You can purchase and download past articles at http://www.activetradermag.com/ purchase_articles.htm.
10-percent ITM 2-year call on the Russell 2000 ETF Time frame Within 3 months Within 6 months Within 12 months Within 24 months Probability of 50% gain 8% 24% 48% 70%
TABLE 10 SHORT-TERM RISKS Although this is a long-term strategy, it has short-term risks. ITM LEAPS calls with 70 strikes fell at least 25 percent when IWM plunged 10.12 percent from July 13 to Aug. 14.
Russell 2000 ETF (IWM) fell 10.12% from July 13 to Aug. 14 and closed at $76.13 July 13 price 70-strike call Jan. 2008 70-strike call Jan. 2009 70-strike call Jan. 2010 $17.58 $23.90 $24.30 Aug. 14 price $10.00 $15.00 $18.25 Loss -43% -37% -25%
in the Russell 2000 this summer could hurt this bullish strategy. Table 10 compares the prices for three deep inthe-money LEAPS calls on the Russell 2000 before and after it fell 10.12 percent from July 13 to Aug. 14. Each LEAPS call fell at least 25 percent within a month, which highlights the strategys potential short-term risks. As with any option, IV changes can affect the profitability of a LEAPS call, especially when the strike is near the money. When you buy an option, you cant lose more than you pay for it. This characteristic is a hedge, and the more volatile the underlying security is, the more expensive this hedge becomes. At first glance, the recent sell-off seems to offer a buying opportunity. But the Russell 2000 ETFs average IV climbed from 18.1 percent slightly below its three-year average of 19.2 percent to 27.7 percent during this period. Buying new calls or rolling existing ones isnt a good idea when implied volatility spikes. If IV does surge, you can always wait a week or two before placing any trades.
Entering spreads
Instead of buying LEAPS calls outright, you can also sell a higher-strike call that expires sooner and create a diagonal call spread. While selling a call to create a spread lowers costs, it also reduces your potential profit if the short call expires in-the-money. But this could be a good idea, especially if implied volatility surges as it did in July and August. For example, lets assume you buy a LEAPS call that is 10-percent ITM and sell an ATM call that expires in three to six months. If IV is near its historic highs, you can collect a large premium when selling that short-term call, which helps offset the LEAPS calls cost. But if the market rallies within six months, you may have to buy back that call at a loss. The strategy outlined here can outperform a simple buy-and-hold approach, but if the market pulls back, you could lose ground. However, the strategys risks and rewards are quite predictable if you hold LEAPS for long periods.
26
MARKET HISTORY UPDATE
Triple-witching expirations: More bullish in recent years

Longstanding volatility patterns surrounding quarterly expirations have shifted in the past few years.
he S&P Witch Project (Active Trader, December 2004) analyzed how the S&P 500 index behaved surrounding triplewitching expiration days the two-day periods in March, June, September, and December when stockindex futures, stock index futures options, and equity options expire. (After single-stock futures were launched in November 2002, triple witching days were sometimes called quadruple witching days because these new contracts also expired on the quarterly cycle). The goal was to find out whether the market displayed any tradable patterns around these events. The article compared the S&P 500s behavior during these quarterly expirations to its behavior during serial expiration months (e.g., non-quarterly months January, February, April, May, etc.). The study uncovered a surprising distinction: The S&P 500 was actually more volatile around serial-month expirations than quarterly-cycle expirations. The index climbed more before serial-month expirations and fell more afterwards than it did in March, June, September, and December. The S&Ps behavior surrounding quarterly expirations was tame by comparison. The analysis measured the S&P 500s average daily performance in the 16 days surrounding both types of expirations eight days preceding expiration Friday and seven days following it, plus the expiration day itself. Figure 1 compares the markets serial-month behavior from 1983-2004 to its performance since the original study was published (2004-2007, red and blue lines, respectively). Day -1 represents the final Thursday of each contract and Day 1 is the final Friday the last trading day for stock options, stock-index options, and single-stock futures. Overall, the S&P rose 0.68 percent, on average, prior to expiration Friday from 1983 to 2004. It then dropped 0.39 percent in the next two days before recovering in the subsequent week. Since 2004 the index has moved roughly in-line with this pattern, but the decline began one day earlier. The behavior around triple-witching expirations, however, has changed more notably since 2003. Figure 2 compares the S&Ps 1982-2004 average daily performance around triple-witching Fridays to its 2004-2007 performance. From 1982 to 2004 the market fell 0.29 percent leading up to quarterly expirations, but it recovered by expiration Friday. It
FIGURE 1 SERIAL-MONTH EXPIRATIONS The market rallied before serial-month expirations, slumped afterwards, and then recovered in the subsequent week. This decline began one day earlier over the past three years (blue line).
FIGURE 2 QUARTERLY TRIPLE-WITCHING EXPIRATIONS From 1982-2004 the S&P was less volatile surrounding quarterly expirations than it was around serial expirations, but that pattern changed during the 2004-2007 period.
then rallied 0.22 percent over the next seven days. From 2004-2007 by comparison, the S&Ps typical move was much bigger and more bullish at expiration the index gained an average of 0.52 percent by expiration Friday, and although the average return declined in subsequent days through day 4, it was still much larger than the average gains during the 1982-2004 period.
Related reading
The S&P witch project Active Trader, December 2004. You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm
27
FUTURES TRADING SYSTEM LAB
Trend pullback with progressive target

A different approach is placing the so-called chandelier stop (in the case of a long trade in an uptrend) a certain System concept: This system combines a pullback rule amount below the highest high or close the market has to enter existing trends with a moving target exit made since the position was established. As the market approach that closes positions when the market is still mov- makes new highs, the chandelier stop moves up with it. ing in the trades favor. The exit approach used here is similar to the chandelier Typical trend-following systems have low winning per- stop except that the exit price is usually above the market centages and generate the majority of their profits during (in the case of an uptrend) and is determined by the marinfrequent extended trends. A trailing stop order is often kets current volatility, as measured by the average true used to exit trades: As the market moves in the trades range (ATR). direction, an exit order is moved progressively closer to the The exit rule has two basic elements a reference point current market price to lock in profits on the position. and a reversal amount. The reference point is the level that A common trend-following exit is the channel-based exit, defines the trends short-term turning points, or swing which stops out (or reverses) the position when price highs and swing lows. In this case a swing high is a moves below (in the case of a long trade) the n-bar low or price bar preceded and followed by bars with lower highs, close. while a swing low is a low preceded and followed by highOne disadvantage of this type of exit is that some open er lows. The number of lower highs or higher lows surprofits are lost because the market must reverse to trigger rounding the swing bars can vary. This approach will use the exit. Another drawback is its popularity. When the n-bar two-day swings, which requires two consecutive lower highest high/lowest low levels are crowded with a large highs before and after a swing high bar, and two consecunumber of stops, negative slippage is likely. tive higher lows before and after a swing low bar. The reversal amount is the distance from the FIGURE 1 SAMPLE TRADES swing high or low used The exit level hovers above the market, rising as the swing highs continue to climb throughout the to determine the exit. rally. The exit is constructed by adding (for long trades) the ATR-derived reversal amount to the most recent two-day swing high. For short trades, the reversal amount is subtracted from the most recent two-day swing low. Figure 1 shows the exit typically dangles above the market and, when a trend is in place, continues to move in that direction. When the trend stalls, the exit level follows the market lower and can even reverse direction. The exit has two objectives. The first is to Source: Wealth-Lab exit trades on strength
Market: Futures.
FIGURE 2 SAMPLE TRADES

LEGEND:
The exit rules drawback is that it offers no protection from trend reversals.
Avg. hold time The average holding period for all trades. Avg. hold time (losers) The average holding time for losing trades. Avg. hold time (winners) The average holding time for winning trades. 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
Source: Wealth-Lab
of consecutive profitable periods. Max consec. unprofitable The largest num-
rather than weakness and benefit from positive slippage. The second is to let winners run as much as possible. The obvious weakness of this exit approach is that it doesnt offer any loss protection, as illustrated in Figure 2: The exit misses the boat when a trend gives way to volatile, rangebound conditions. Strategy rules: 1. If yesterdays close was above
STRATEGY SUMMARY
the 20-day moving average of closing prices, enter long with a limit order at yesterdays close minus 1.5 times the 14-day ATR. 2. If yesterdays close was below the 20-day moving average of closing prices, enter short with a limit order at yesterdays close plus 1.5 times the 14-day ATR. 3. Exit long position with a limit order at the recent two-day
continued on p. 30
ber 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.
Profitability Net profit: $5,366,045.77 Net profit: 536.60% Profit factor: 1.37 Payoff ratio: 0.72 Recovery factor: 2.52 Exposure: 14.76% Drawdown Max. DD: -36.56% Longest flat period: 483 days
Trade statistics No. trades: 306 Win/loss: 66.99% Avg. profit/loss: 2.38% Avg. holding time (days): 131.36 Avg. profit (winners): 9.71% Avg. hold time (winners): 93.12 Avg. loss (losers): -12.51% Avg. hold time (losers) : 208.97 Max consec. win/loss: 14/5
Profit factor Gross profit divided by gross loss. Recovery factor Net profit divided by max. drawdown. 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.
29
FUTURES TRADING SYSTEM LAB continued
FIGURE 3 OPTIMIZATION The ATR multiplier for the exit rule was 3.0 because of its location in the stable performance area.
swing high point plus three times the 14-day ATR. 4. Exit short position with a limit order at the recent two-day swing low point minus three times the 14-day ATR. Parameter selection: As a rule, trading system parameters are determined through a portfolio-based optimization on a sample data period. Figure 3 shows the systems profitability from August 1992 to July 1997 using ATR values (for the exit rule) from 1.0 to 4.0. The majority of values were profitable, except for the 1.0-1.5 range. Three ATRs was selected from the area of stable values. (Note: The reversal amount can be customized to the magnitude of trend the trader wishes to trade.) Money management: Risk 1 percent of account equity per position. Starting equity: $1,000,000. Deduct $8 commission and one tick slippage per trade. Test data: The system was tested on the Active Trader Standard Futures Portfolio, which contains the following 20 futures contracts: British 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), euro (EC), gold (GC), Japanese yen (JY), coffee (KC), wheat (W), live cattle (LC), lean hogs (LH), natural gas (NG), sugar #11 (SB), silver (SI), Swiss franc (SF),
Source: Wealth-Lab
FIGURE 4 EQUITY CURVE The equity curve rises, but not without some share pullbacks.
Source: Wealth-Lab
PERIODIC RETURNS Percentage profitable periods Max consec. profitable Max consec. unprofitable
Avg. return Monthly Quarterly Annually
Sharpe ratio
Best return
Worst return
1.85% 5.70% 22.16%
0.24 0.37 0.63
24.02% 46.66% 111.40%
-18.24% -26.46% -9.90%
58.33 58.54 63.64
6 6 5
3 2 2
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FIGURE 5 DRAWDOWNS There were several medium-to-large reversals, but none of them lasted too long.
FIGURE 6 PROFITS BY MARKET Two markets coffee (KC) and cotton (CT) accounted for the majority of the systems gains.
Source: Wealth-Lab
Source: Reports-Lab
and T-Bonds (US). This test used ratio-adjusted data from Pinnacle Data Corp. (http://www.pinnacledata.com). Test period: August 1997 to July 2007. Test results: Testing in the out-of-sample period (August 1997 to July 2007) resulted in a profit of 536 percent a steady 20.3-percent annualized gain. The equity curve (Figure 4) displays a fairly steady increase until 2005, punctuated by a few drawdowns and pauses. The trade statistics reflect something of a blend of trend-following and countertrend characteristics. The system has a high success rate (67 percent), and the average profit is relatively large (2.4 percent). The system had several drawdowns in excess of 20 percent (two were deeper than 30 percent), but most of them were relatively short-lived (Figure 5). The systems high exposure is a concern, though. The average holding time for winning trades was 93 days, while losers were held for a whopping 203 days. Both long and short components were profitable, with the short side responsible for more of the systems gains. Finally, coffee and cotton (Figure 6) accounted for nearly half the systems gains. Bottom line: The systems exit rule is not without its drawbacks as mentioned, it doesnt offer protection from
trend reversals. Holding positions for so long is not for every trader. A protective stop would be needed to cut losers more effectively. One possible way to cut the time in the market would be to use a factor that would shorten the ATR multiplier with each day a trade is unprofitable. Similarly, watching medium and large profits fade away is quite difficult psychologically, so the reversal amount could be tightened after an outsized profit, as well. The dangling carrot system is designed to go for big profits. The exit isnt a perfect solution, but its rules are simple and adapt to current market conditions. Volker Knapp of Wealth-Lab

Futures Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.s testing platform. If you have a system youd like to see tested, please send the trading and money-management rules to editorial@activetradermag.com. 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 systems behavior in real-time trading.
31
OPTIONS TRADING SYSTEM LAB
Buying options on ADX breakouts

FIGURE 1 LONG PUT RISK PROFILE
Market: Options on individual stocks. System could also be applied to indices and exchange-traded funds (ETFs) with liquid options contracts. System concept: When anticipating a move in the underlying, should you enter a vertical credit spread or simply buy an in-the-money (ITM) option? This test is designed to help answer that question. The system uses the Average Directional Movement Index (ADX) to identify new trends and then buys ITM calls and puts to exploit directional moves in several widely held stocks. The August Option Strategy Lab entered credit spreads with the same trade rules and lost 6.8 percent since 2001 (see ADX credit spread system, Futures & Options Trader, August 2007). Can long ITM options perform any better? When you buy an option, you really need a large and quick underlying move to profit. If the underlying moves in the right direction quickly, you can make a lot of money. But if it moves against you, you can lose most, or all, of your capital. Also, when implied volatility (IV) drops, a long option loses value and may do so even if the underlying moves in your direction. Finally, time decay is an option buyers main enemy. All long options lose time value each day, all other things being equal. Figure 1 shows a long Wal-Mart (WMT) July 47.5 put. The system bought the put when WMT closed at $46.62 on May 21 and required a move below $45.93 by expiration on July 20 to be profitable. The overall system will be profitable only if it can consistently pick the correct direction and entry point.
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The system bought a Wal-Mart ITM July put on May 21. To be profitable, WMT must drop 1.5 percent in two months.
Source: OptionVue
FIGURE 2 PERFORMANCE Not only did this system lose money, but it was wiped out by April 2005.
Source: OptionVue
Trade rules: 1. Entry: If the 14-day ADX has remained below 20 for the past 30 days:
Note: This test included minimal commissions, but larger fees and bad fills will likely affect performance. Steve Lentz and Jim Graham of OptionVue
a) Buy calls if the trend strengthens (+DI moves above DI), or b) Buy puts if the trend weakens (-DI moves above +DI). 2. Option selection: Use ITM options in the second available expiration month. ITM is defined as the first available strike price above the market (puts) or below it (calls). 3. If the trade is stopped out and another signal appears when the ADX is below 20, enter another position. Exit: 1. Sell long calls if the underlying stock reaches a five-day low, or 2. Sell long puts if the underlying stock reaches a five-day high, or 3. Sell any long option at intrinsic value at the close of last day of trading.
Test details: The test account had $20,000 initial capital. It bought as many options as possible with $5,000 in capital per position. Daily closing prices were used. Trades were executed at the bid and ask, when available. Otherwise, theoretical prices were used. Commissions were $5 base fee plus $1 per option. Test data: The system was tested using options on Apple Computer (AAPL), Citicorp (C), General Electric (GE), Intel (INTC), Johnson and Johnson (JNJ), Microsoft (MSFT), and Wal-Mart (WMT). Test period: Jan. 2, 2001 to May 29, 2007. Test results: Figure 2 shows that the strategy lost $5,154 (-25.8 percent) in the six-year test period. By contrast, the credit-spread system used the same amount of capital ($5,000) for each trade and lost just $1,360 (-6.8 percent). The win/loss ratio was only 39 percent, which isnt any better than if you had randomly bought options with no rules. More importantly, the system lost all of its $20,000 initial capital by April 2005. If you had continued to trade the strategy with additional funds, it would have recovered somewhat. But it is clear buying options in the direction of a breakout is a volatile strategy that performed worse than entering credit spreads.
STRATEGY SUMMARY
Net loss ($): Percentage return (%): Annualized return (%): No. of trades: Winning/losing trades: Win/loss (%): Avg. trade ($): Largest winning trade ($): Largest losing trade ($): Avg. profit (winners): Avg. loss (losers): Avg. hold time (winners): Avg. hold time (losers): Max consec. win/loss :
5,154.00 -25.8 -4.0 59 23/36 39 -87.36 8,270.00 -2,910.00 2,041.17 -1,447.25 18 8 4/5
LEGEND: Net gain/loss Gain or loss 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 OptionVues BackTrader module (unless otherwise noted). If you have a trading idea or strategy that youd like to see tested, please send the trading and money-management rules to Advisor@OptionVue.com.
33
TRADER INTERVIEW
Payam Pedram and Jacques L. DeVore of Ascendant Asset Advisors

Selling naked options can be risky, but it can also be lucrative if you know how to defend them. These fund managers discuss their tactics.
BY DAVID BUKEY
nlike some traders who suffered major losses during this summers market turmoil, Payam Pedram has benefited from it. Pedram, cofounder of Ascendant Asset Advisors in Beverly Hills, runs a managed futures program with a short bias that trades options on several indices an approach that ultimately paid off this summer after losses in April and May. We sold a lot of calls and the market kept rallying against them, he says. It was crazy the market made new highs every day. These days, Pedram, 24, feels vindicated. After drawdowns as high as 49 percent, each of his programs bounced back in June and July, gaining 12.7 percent so far this year. Jacques L. DeVore, 48, a former managing director at Deutsche Bank, joined Pedrams firm in December 2006. His institutional program is up 38.26 percent year-to-date the fifth-best performing fund among all commodity trading advisors (CTAs) from January to July 2007, according to the Institutional Advisory Services Group. Pedram and DeVores approach to trading options is somewhat unconventional because, unlike many money managers, they dont place the same type of positions each month. Instead, they gauge the markets overall bias and use technical tools to find specific options to sell. If those positions begin losing money, they will defend them aggressively by creating different types of spreads to limit risk and lower margin requirements. Pedram began a career in computer networking after earning a computer-science degree in Iran in 1999. Two
Jacques DeVore (left) and Payam Pedram (right).
years later he moved to Los Angeles and started a consulting firm that provided technical support to local businesses. After working for a brokerage firm, Pedram became fascinated with the trading industrys technology. He began trading stocks, futures, and then options. He co-founded Ascendant Asset Advisors in August 2005, generating a 79.87-percent return in his main programs first five months and 139.66 percent in 2006 (Figure 1). Ascendant currently has around $33 million under management. Pedram and DeVore admit their approach can be risky, but their profit goals are ambitious. They monitor each accounts margin in real-time with software Pedram developed.
34
[With these customized tools] I feel I can take more risk, achieve better returns, and protect the portfolio better, Pedram says. In mid-August Pedram and DeVore discussed their strategy, the markets recent volatility spike, and their programs performance.
JD: Part of it is dictated by timing. If we feel volatility and risk is high on the call side, but we still want to be in this market, well enter a spread sooner rather than later. PP: Normally, we buy fewer calls than we sell when creating a spread (creating a ratio spread). But we buy more puts than we sell (put ratio backspread).
Trading options is almost like triage. A patient arrives, we take his vital signs, and figure out the best way to save his life.
FOT: How would you describe your strategy? PP: We have a short bias on the market. We sell calls and occasionally we might also sell puts. But most returns come from the call side. It was very difficult from March to May, because the market went up every day. We had to constantly adjust our positions and monitor margin requirements. Anyone who wrote calls had this problem. FOT: What underlying market do you focus on? PP: We sell options on all the stock index futures Russell 2000, E-Mini S&P 500 and Nasdaq 100, and the Mini Dow. We also trade interest rates and currencies the 30-year T-bond and 10-year T-note futures, and the euro and Japanese yen. We dont typically focus on one index, but in the past four months we concentrated on the Russell 2000 because we thought the S&P 500s large-cap stocks had more upside potential. So we sold calls on the EMini Russell 2000. As of (Aug. 10), the Russell 2000 was down more than any of the other indices we trade. (It fell 13.6 percent from July 13 to Aug. 6.) For instance, we sold puts with a 730 strike on the E-Mini Russell 2000 recently. (It dropped to 737.70 and closed at 774.50 on Aug. 16.) Lets say we sold 30 puts with a strike price of 730 and bought 100 puts with a strike price of 680. As the market dropped and the VIX (CBOE volatility index) rose, the long 680 puts almost limited the loss on the short 730 puts.
FIGURE 1 PERFORMANCE ASCENDANT ADVISORS VS. S&P 500 INDEX Despite a recent 49-percent drawdown, Ascendants largest options program has outperformed the S&P 500 since its August 2005 inception.
FOT: I understand you typically enter a position by selling calls. If the market goes against you, you buy a higherSource: www.ascendantasset.com strike call to protect it a bear call spread. Is this accurate? PP: We feel much more comfortable selling a naked call FOT: Is this because you held more long contracts? than a naked put. We dont sell naked puts. Instead, we PP: Right. The long 680 puts increased from $0.30 to $1, mainly create put spreads. while the short 730 puts climbed from $3 to $10. And its a The market can move limit down much easier than it can great hedge, because well make money if the market drops move limit up. I may sell a naked call and then create a significantly. But the net gain is limited. spread if we need to reduce margins. Then I might add some type of put position. continued on p. 36
FUTURES & OPTIONS TRADER September 2007 35
TRADER INTERVIEW continued

FIGURE 2 SELLING NAKED CALLS Pedram and Devore sold naked July 870 calls on the E-Mini Russell 2000 futures in June. They expired worthless on July 20.
PP: Both the front month and the upcoming month. FOT: Can I assume you enter multiple trades in multiple months for diversification purposes? PP: Right.
Source: eSignal
FOT: If you sell more calls than you buy above the market, you capture more premium, right? PP: Yes. We sell more naked calls and have less of a spread position (buy fewer higher-strike calls for protection). FOT: Could you elaborate on how you select the underlying markets and specific options you sell? JD: We look at several macro indicators, the overall market bias, and how that is going to affect existing positions. We try to estimate where risk is most acute. Then we try to forecast the options market over the next 30 to 40 days. Were short-term players. PP: We also consider technical indicators momentum,
FOT: How far out-of-the-money do you sell calls and puts? PP: We are very conservative with puts. We might sell puts 10 percent out of the money. But it depends on market performance in the last 30 days and what might happen going forward. If the market has already dropped 15 percent, we might sell puts five percent out of the money. You capture better premium that way. If you create a spread, you limit the maximum loss. A bull put spread with a short strike that is five percent out of the money might be a better trade than selling a naked put 10 percent below the market. A couple of weeks ago, the Russell 2000 futures traded at 860. We sold calls roughly 3 percent above the market and it dropped (Figure 2). We try to get the best premium with the least amount of risk. JD: We tend to be contrarian in nature. In some cases, the short strikes may look closer to the money, but thats because we feel the market has either peaked or stabilized. On the surface, it looks riskier. PP: All of our programs are pretty risky. We try to achieve much higher returns than other CTAs. FOT: Are you trying to sell strikes at a certain low delta and gamma? PP: Not necessarily. We might sell calls with large deltas. With the VIX at multi-year highs, you can collect a lot of
With the VIX so high, time decay appears later in the options cycle. Normally, we would have covered some of our positions a week ago.
the TICK, the TRIN, and different moving averages. Ive designed a custom technical indicator that identifies different market opportunities. After measuring the fundamentals, we try to use technical analysis as much as possible. But technical analysis doesnt always work. FOT: Do you sell only front-month options?
36
premium when selling far out-of-the-money calls. You dont have to look for low deltas. FOT: How has the recent spike in implied volatility affected your strategy? JD: It depends. If you want a short options price to drop so you can cover it, then a high VIX level doesnt help. With
the VIX so high, time decay appears later in the options cycle. Normally, we would have covered some of our positions a week ago. Option prices are so inflated that time decay may occur in the last three days before expiration. You can capture large premiums when you sell options near VIX highs. But wed like to see the VIX a bit lower. FOT: Inflated implied volatility helps when you sell an option, but hurts when you try to buy it back, right? PP: Exactly. If you have money to trade and arent occupied by margin, its great to have the VIX at these levels. After the August options expire, we plan to sell calls and capture good premiums. JD: We dont predict the VIX will drop dramatically. We feel there will still be opportunities for options sellers. FOT: Do you use stop-losses? PP: No. Its almost impossible to use stop losses in an options program, because you would be stopped out almost every time. JD: We manage any potential losses by creating spreads, and we decide how much to hedge 100 percent or 80 percent, for example. In other words, do we buy a further outof-the-money option for every one we sell? [We buy more protective options] on the put side than on the call side. Then we adjust the hedge amount based on market conditions. FOT: Do you have a specific profit target? PP: We try to capture 80 percent of the collected premium. If it doesnt make sense to cover the position and pay commissions, we will let it expire worthless. FOT: What percentage of short options do you cover? JD: Most short options are covered. Sometimes we sell an option for $4 and buy it back at $0.90, because we feel volatility is high. We have been successful because we know where to place the strike prices and how much money to spend on the hedges. If we are wrong about the markets direction and we will be then how do we defend the position effectively? Payams software lets us monitor margin in realtime. That doesnt mean our positions are less risky, but we are more comfortable with that risk. FOT: Are margin requirements typically available only at the end of the day? PP: Yes. Most traders can track the value of all accounts as the markets move, but monitoring margin in real-time is unique. JD: It helps avoid problems. A lot of traders can recover from problems after they occur, but it can be tough. It helps to have more time to react.
PP: Lets say you sell an option 10 percent out of the money with a margin-to-equity ratio of 20 to 30 percent. If you cant track margin in real-time, you still might get into trouble, because the markets are so volatile right now. It doesnt matter how far away you sell options a lot can change in one day. FOT: So you dont have a set strategy that you use each month it depends on current market conditions? JD: Right. But theres a long-term strategic aspect to it focusing on risk. The 30-day time period is tactical. Trading options is almost like triage. A patient arrives, we take his vital signs, and figure out the best way to save his life.
It doesnt matter how far away you sell options. A lot can change in one day.
FOT: Would you discuss a recent trade? PP: In mid-June, the E-Mini Russell 2000 futures were rallying. When the September contract traded near 840, we sold naked July 870 calls. The market then dropped, so we didnt enter a bear call spread. We captured premiums of $3-$5 and they expired worthless. At the time, the market was near a top, according to several technical indicators. For instance, price went above the upper Bollinger Band. Price tends to drop back inside the bands if other indicators confirm a reversal. It was an entry signal for selling calls stochastics and the Relative Strength Index (RSI) turned negative and price rose above the top Bollinger Band. My custom indicator also identified a market top. Last month, we sold September 1.405-strike calls in euro currency futures for 33 ticks. Today (Aug. 13), they traded around 7 to 8 ticks. If the euro corrects (heads higher), we may sell some puts. Right now we have open trades in the E-Mini S&P 500, EMini Russell, Mini Dow, E-Mini Nasdaq 100, and 30-year Tbonds. FOT: Has an options price behavior ever surprised you? PP: When the markets fell on (Aug. 9 and 10), market makers couldnt price options fast enough. They seemed to disappear. We wanted to track the accounts in real-time, but there was no market being made. Unfortunately, that has happened in the E-Mini Russell 2000 and E-Mini S&P 500 end-of-month contracts over the last couple of weeks. Ive never seen that before. JD: Its hard to know why. We were just looking at the screen and couldnt get much pricing.
37
INDUSTRY NEWS
Show me the money
CFTC seeks greater oversight, more funding

BY JIM KHAROUF
IntercontinentalExchange (ICE) chairman and CEO Jeff Sprecher told Congress in July, ICE strongly supports legislative and regulatory changes that will enhance the quality of oversight and available information with respect to the natural gas markets. But Sprecher added the CFTC needs more money and more staff to properly take on greater regulatory responsibility. This has been a major problem for the CFTC, which watched its staff numbers drop in recent years while volume at regulated futures exchanges exploded. In its February budget request to Congress, the CFTC noted that over the past 10 years, trading volume has quintupled while commission staffing levels have fallen significantly over the same time period. The funds requested will allow the commission to hire critically needed staff, maintain the technological infrastructure, and acquire contractor assistance to keep pace with the volume and complexity of the burgeoning and dynamic futures markets. The commission needs these funds simply to keep up with the industry we regulate. The CFTC requested $116 million for the 2008 fiscal year, an increase of $18 million from the current fiscal year. The agency, which has charged more than 40 firms and individuals with energy market manipulation over the past three years, estimates it will spend $44.4 million of its budget to fund its enforcement efforts. More will certainly be needed if the CFTC is required to monitor OTC markets as well. Sharon Brown-Hruska, vice president of NERA Economic Consulting and former acting chair of the CFTC, says the agency is in a good posiMANAGED MONEY tion to secure more funding now that the issue of broader OTC regulation has such strong Top 10 option strategy traders ranked by July 2007 return momentum in Congress. (Managing at least $1 million as of July 31, 2007.) [Its critical Congress gives] them addi2007 tional authority in the OTC markets, BrownJuly YTD $ under Hruska says of increased funding. Theyve Rank Trading advisor return return mgmt. already expanded their jurisdiction and adju1. Parrot Trading Partners 19.98 7.58 8.3M dication, but now with Congress attention, it 2. Ascendant Asset Adv. (Strategic2) 18.90 12.72 28.1M is a good time to finally get a fair allocation of resources to police these markets. 3. CKP Finance Associates (LOMAX) 6.55 17.12 7.6M The White House has once again suggested 4. Oxeye Capital Mgmt. (Crude Oil) 5.28 23.34 3.4M a user fee charge to help fund the CFTC, a proposal that has been vehemently opposed by 5. Quiddity (Earnings Diversification) 3.30 3.86 18.0M the industry for years. While sources say the 6. Ascendant Asset Adv. (JLDeVore) 2.50 38.26 5.9M user fee proposal and a call for increased 7. Innovative Capital Mgmt (Call Prem) 2.49 21.46 2.0M funding for the CFTC are not connected, there may be a renewed push to implement such a 8. Censura Futures Mgmt. 1.98 -9.34 47.4M fee to help fund the agency with an expanded 9. Hyman Beck (Volatility) 1.47 7.15 76.6M role. 10. Financial Comm Inv (Option Selling) 1.08 13.57 25.6M However, many futures brokers who also pay fees to fund the National Futures Source: Barclay Trading Group (http://www.barclaygrp.com) Associations intra-industry policing activities Based on estimates of the composite of all accounts or the fully funded subset method. argue a user fee on top of existing taxes on Does not reflect the performance of any single account. profits from those transactions amounts to PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. double taxation on customers.
he Commodity Futures Trading Commission (CFTC) will hold a hearing in September to examine market oversight of over-the-counter (OTC) products and regulated exchanges, a move that keeps OTC energy regulation on the front burner. A looming question is whether the agency has the budget to expand its responsibilities. The hearing is designed to give more information on the OTC issue to Congress, which could substantially expand the regulatory role of the agency and help resolve some ongoing jurisdictional questions. The evolution of these energy markets in recent years requires our agency to address whether the level of regulatory oversight is proper given the importance of energy prices to all Americans, says CFTC acting chairman Walt Lukken. The push for greater regulation of OTC markets, also called exempt commercial markets or ECMs, is getting serious consideration in Washington, especially in the aftermath of recent hedge-fund implosions in the energy markets. Two bills calling for increased regulatory oversight are being formulated in Congress now one from Senator Dianne Feinstein (D-Cal.), a long-time critic of the OTC energy markets, and the other from Bart Stupak (D-Mich.) in the House of Representatives. Industry executives have pushed for greater CFTC oversight in recent Congressional hearings.
Too many chefs?
Nasdaq enters crowded options arena
lthough the global consolidation trend has shrunk the exchange world over the past few years, the U.S. options market has moved decidedly in the opposite direction. The Nasdaq plans to launch an options market in the fourth quarter of 2007, a move that brings the number of U.S. options exchanges to seven and begs the question, Does the U.S. really need a seventh options exchange? Not surprisingly, Adam Nunes, Nasdaq vice president and head of the new options market believes the answer is, Yes. We have an open, fair model, as opposed to the specialty model, Nunes says. We have price-time-priority as opposed to the allocation model. Nunes says the allocation model entails the customer getting filled first, then the specialist, then the market makers; the broker/dealers and other firms get the leftovers. In the Nasdaq model, its first-come, first-served. Despite the proliferation of exchanges, the U.S. options market is essentially a duopoly, with two exchanges the Chicago Board Options Exchange (CBOE) and the International Securities Exchange (ISE) dominating the landscape.
Since 2004, the CBOE and the ISE accounted for more than 60 percent of all U.S. options volume, leaving NYSE/ARCA, the Philadelphia Stock Exchange, the American Stock Exchange, and the Boston Options Exchange to play catch-up. People said we couldnt compete with the New York Stock Exchange in equities, and we did, says Chris Concannon, executive vice president of transaction services for the Nasdaq. The customer demand for a system like this is great. Nunes says the Nasdaq will initially trade options on the 22 stocks the SEC has designated for penny trading, but will quickly ramp up to trade more issues. Our router is built for pennies, but it can handle others, Nunes says. Well roll out those handful in the first phase, but the first phase might only last a few weeks or so. The Nasdaq is working with the Securities and Exchange Commission to hammer out a fee schedule. We can be aggressive as far as fees are concerned, because there is room for competition, Nunes says. Our technology and our model will differentiate us, much like on the equity side, but the other exchanges wont just hand over their market share.
Here we grow again
ICE goes two for two

BY JIM KHAROUF
he IntercontinentalExchange (ICE) may have lost the battle for the Chicago Board of Trade, but in August it purchased the Winnipeg Commodity Exchange (WCE), after upping its bid to $50 million to match a competing offer from an unnamed bidder. The deal, approved by WCE shareholders and expected to close in the fourth quarter of 2007, gives the ICE another foothold in Canada and broadens the exchanges commodity product mix. The WCE is widely known for its canola oil futures contract, which will be integrated into the ICE Futures trading and clearing platform. The deal provides the ICE with a regulated Canadian futures exchange and clearinghouse that could potentially add other products as well. The ICE signed a deal with the Toronto Stock Exchange (TSX) in March to host a joint-venture exchange focused on the Canadian natural gas markets. The WCE also owns the Canadian Climate Exchange, which is expected to focus on offering Canadian carbon derivatives once the federal government passes its legislation outlining pollution mandates. An ICE spokesperson had no further comment on the purchase. The ICE has been busy over the past year. It lost out to the CME Group in a bid for the Chicago Board of Trade in July,
but it purchased the New York Board of Trade and an OTC market called ChemConnect. The ICE also scored a legal victory over the New York Mercantile Exchange (NYMEX) in early August. An appellate court affirmed a lower court decision that allowed the ICE to use NYMEX prices on several energy contracts, including crude oil and natural gas, as its own settlement price. The NYMEX had claimed copyright and trademark infringement. The U.S. Court of Appeals agreed with the U.S. Copyright Office and a District Court that settlement prices are not copyrightable and all market participants are welcome to use them. This is an important decision for all market participants, ICE chairman and CEO Jeffrey Sprecher said in a statement. ICE has been confident all along in its position that NYMEX has no intellectual property in its settlement prices, and we have been steadfast in our position that we will not allow the threats of a competitor to dictate the direction of our business. Given the repeated affirmation of our position, we consider this matter closed. Jim Newsome, president and CEO of the NYMEX, said the ruling would have no effect on his exchange since the ICE had been using the prices for years. Newsome added the NYMEX is considering its legal options.
39
INDUSTRY NEWS continued
Customer funds not protected, regulators say
Hedge fund goes down

n already shaken market received more bad news in mid-August when money-management firm Sentinel Management Group announced it was halting redemptions in some of its funds because of an excessive number of requests. While exchanges scrambled to protect customer interests and other firms attempted to buy out Sentinels assets, the news got worse: Sentinel was charged with fraud by the Securities and Exchange Commission (SEC) and filed bankruptcy a few days later. According to the SEC, Sentinel misappropriated and commingled client funds, and used those funds to leverage other purchases without customer knowledge.
Deposits from futures brokers were quickly unwound, with Citadel Investments buying more than $300 million about 75 percent of the actual value of the portfolio worth of commercial and longer-term bonds. The futures funds were given top priority so as not to force any futures brokerages into bankruptcy. The Citadel deal was monitored and brokered by the National Futures Association (NFA), which initially barred Sentinel from selling off its assets. Citadels participation allowed firms with deposits at Sentinel to get a quick infusion of cash, although the NFA admits all the brokerages suffered losses. There were 23 futures brokerages with accounts at Sentinel. One Frontier Futures failed to meet margin requirements even with the partial payback and was forced to close its Kansas Round 27 City office. Penson GHCO lost a reported $6.5 million and others, including Velocity Futures, Vision Financial Markets, and Farr Financial, also took big hits. BY JIM KHAROUF It could have been a lot worse, says NFA spokesman Larry Dykeman, who he U.S. Patent and Trademark Office (USPTO) granted a added the NFA is still watching the case Chicago-based law firm its request for a re-examination of Trading Technologies (TT) MD Trader patents in August. closely and considering what legal Intellectual property law firm Brinks, Hoffer, Gilson & Lione, which repreaction, if any, to take. Regardless, more sents an anonymous client, says TTs patents were pre-dated by trading lawsuits are expected. software used by the Tokyo Stock Exchange (TSE). Brinks filed its request The NFA is also facing criticism for not with the USPTO in April. properly auditing Sentinel in the months This marks a significant step forward in establishing that these patents leading up to the crisis. are invalid, said James Katz, a shareholder in Brinks Chicago office, in a Sentinel is a plain-vanilla FCM, says statement. the executive of a futures brokerage. A In public filings with the USPTO, Brinks also cites two other prior art junior auditor should be able to go in sources Amazon.com and Friesen that use similar methods or steps there and do a thorough audit of their to the TT patents for entering orders. books and records in one business day or The USPTO offers a process of re-examination of any patent if new eviless. dence of prior art is submitted. This serves as another venue in which to Additionally, the concept of segregatchallenge a patent outside of the courts. TT is in the midst of litigation in a ed funds, which is designed to separate U.S. District Court with eSpeed and several other firms it claims are infringcustomer funds from a firms generaling on its technology. The eSpeed-TT trial is scheduled to begin on Sept. investment fund, is again being thrown 10 after several delays. into the spotlight. As was the case in the In a statement, TT said Brinks is not offering any new evidence to the illegal accounting scandal that bankruptUSPTO: The alleged prior art cited in the Brinks re-examination request ed futures brokerage Refco in October does not present any new arguments. In early 2005, the court considered 2006, segregated funds were switched this same prior art and found that TT showed a very strong likelihood of into other investment pools without the success on the issue of validity. Statistically, the overwhelming majority of customers knowledge. re-examination requests are granted and TT is confident that the validity of To me, this has blown to hell the idea its patents will be upheld. of segregated funds, says one FCM executive.
TT patent challenged at USPTO
40
NEW PRODUCTS AND SERVICES

OptionVue Systems International has introduced a new Web site, www.DiscoverOptions.com. The DiscoverOptions Education Center provides articles, lessons, Webcasts and other content for all levels of options traders. DiscoverOptions aims to dispel options myths and provide individual traders with a clearer understanding of how options can help minimize risk and generate additional income. Advanced training is also available through the DiscoverOptions Personal Mentoring Program. Taught by option professionals who work with students one-on-one, this program shows students how to trade in variable markets using proven back-tested strategies. The three-to-six month program is scheduled at the students pace and includes personal goal setting, customized one-on-one training, online course instruction, live Inside Wire sessions each week, free use of OptionVues options analysis software and data services, and access to the DiscoverOptions Premium Content Site for a year. To learn more about DiscoverOptions Personal Mentoring Program, or to schedule a personal phone consultation with a mentor, call OptionVue at (800) 733-6110. complimentary for Dow Jones Capital Markets Report subscribers. Subscriptions are available via market data providers such as Bloomberg, CQG, eSignal, FactSet, NewsWare, Reuters, and Thomson. Dow Jones news is delivered through more than 130 market data platforms globally. For a tour of Dow Jones NewsPlus Capital Markets Report, and to inquire about access, visit http://www.djnewswires.com/cmr. GlobalTec has launched an online TV network featuring 12 hours of live market programming every trading day. Wizetrade TV is a subscription-based online TV network that allows viewers stock picks to be analyzed on-air by professional traders turned teachers. The network also serves as a public platform for traders looking to swap trading strategies on-air with fellow traders. Programming is from 7 a.m.-7 p.m. ET. Programming covers the major markets from before the opening bell to after the closing bell, from spot forex and stocks to stock options, commodities, and futures. All daily programs are archived for five days and are available via Video on Demand. Visit http://www.wizetradetv.com for more information.
eSignal has launched QuoteTrader, a free, broker-neutral, multi-asset-class trade-management and charting plat- Note: The New Products and Services section is a forum for industry form. QuoteTrader provides simultaneous access to multi- businesses to announce new products and upgrades. Listings are ple brokerage accounts, such as Interactive Brokers Group, adapted from press releases and are not endorsements or recommenMB Trading, GAIN Capital, FXCM, optionsXpress, Oanda, dations from the Active Trader Magazine Group. E-mail press releasand TransAct. eSignal plans to connect QuoteTrader to es to editorial@futuresandoptionstrader.com. Publication is not guaradditional brokerages in the future. QuoteTrader is compat- anteed. ible with eSignals own data-feed and provides technical analysis and links to Quote.com, one of the leading financial portals with extensive global financial asset coverage, news, and fundamental research. QuoteTrader offers instant access to a set of decision-support tools, including its 3-D Depth of Market, real-time charts, streaming quotes support, and portfolio management windows. Free realtime charts support more than 30 technical studies, indicators, and drawing Contact Bob Dorman tools. Integration of QuoteTrader with Ad sales East Coast Quote.com gives traders and brokers a and Midwest free source for powerful pre-, intra-, bdorman@activetradermag.com and post-trade decision-support from (312) 775-5421 a leading financial portal. For more information, visit http://www.esignal.com. Allison Ellis
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41
FUTURES SNAPSHOT (as of Aug. 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 markets 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).
Market Pit Sym ESym Exch Vol OI 10-day move % Rank 67% 47% 37% 67% 0% 64% 17% 30% 0% 0% 0% 40% 0% 0% 67% 100% 29% 12% 10% 0% 0% 90% 100% 23% 75% 55% 72% 0% 15% 9% 100% 0% 38% 18% 11% 60% 31% 25% 90% 0% 0% 0% 71% 100% 75% 75% 95% 20-day move -0.74% 1.12% 0.95% -0.05% -2.14% 1.75% 0.44% 0.13% -0.44% -6.33% -0.35% 1.95% -0.44% -0.14% -0.74% -13.99% 3.77% 1.42% -2.50% -1.57% -5.59% 13.30% -0.97% 0.92% -3.52% 0.22% -8.82% -0.88% -5.75% 4.11% 0.13% -6.33% -3.26% 10.80% -6.66% -7.55% 0.90% -7.72% -0.08% -2.14% -0.44% -5.59% -8.82% -13.99% -0.01% -0.05% 2.04% % Rank 13% 38% 43% 94% 32% 41% 21% 40% 15% 73% 12% 38% 30% 8% 23% 69% 32% 40% 31% 21% 39% 71% 7% 25% 26% 79% 79% 36% 47% 50% 3% 73% 60% 74% 45% 88% 19% 48% 3% 32% 15% 50% 79% 69% 0% 88% 72% 60-day move -4.53% 2.83% 1.98% 0.04% 0.94% 2.73% -7.45% 1.01% -2.46% 10.59% 1.56% 5.19% 1.54% 2.31% -4.53% -29.04% -13.19% 0.83% -0.35% -7.18% 2.38% 38.72% -9.15% -0.90% 4.52% 0.23% -14.37% -3.05% -9.70% 4.77% -3.66% 10.59% 1.03% 6.55% -1.63% -9.58% -0.98% -5.36% 3.74% 0.94% -2.46% -3.36% -14.31% -29.04% -1.57% -0.04% 1.98% % Rank 84% 100% 100% 36% 7% 100% 92% 92% 77% 45% 49% 92% 47% 76% 81% 98% 88% 7% 27% 91% 16% 89% 43% 26% 14% 91% 100% 87% 90% 26% 14% 47% 2% 26% 19% 91% 24% 65% 32% 7% 77% 44% 100% 100% 51% 96% 97% Volatility ratio/rank .60 / 80% .26 / 22% .33 / 50% 1.61 / 100% .57 / 93% .28 / 60% .51 / 76% .41 / 72% .44 / 81% .27 / 45% .59 / 85% .67 / 88% .50 / 78% .39 / 37% .60 / 80% .82 / 90% .31 / 35% .31 / 93% .81 / 88% .51 / 75% .25 / 22% .28 / 55% .44 / 78% .53 / 52% .29 / 62% .36 / 27% .71 / 72% .56 / 65% .47 / 47% .38 / 48% .58 / 78% .27 / 42% .29 / 75% .43 / 38% .65 / 88% .41 / 83% .53 / 53% .36 / 38% .46 / 100% .57 / 93% .44 / 82% .57 / 78% .70 / 69% .79 / 90% .47 / 75% 2.59 / 73% .30 / 77%
S&P 500 E-Mini ES CME 2.40 M 1.95 M 1.01% 10-yr. T-note TY ZN CBOT 1.59 M 2.73 M 1.03% 5-yr. T-note FV ZF CBOT 765.9 1.57 M 0.89% Eurodollar* ED GE CME 585.0 1.79 M -0.06% Nasdaq 100 E-Mini NQ CME 485.5 433.0 0.41% 30-yr. T-bond US ZB CBOT 443.1 978.6 1.80% Russell 2000 E-Mini ER CME 341.0 627.4 1.02% 2-yr. T-note TU ZT CBOT 327.1 993.6 0.09% Mini Dow YM CBOT 232.4 96.9 0.73% Crude oil CL NYMEX 215.7 322.6 0.49% Eurocurrency EC 6E CME 177.4 218.1 0.18% Japanese yen JY 6J CME 172.7 246.5 1.74% British pound BP 6B CME 91.2 136.2 0% Swiss franc SF 6S CME 79.7 115.7 0.12% S&P 500 index SP CME 55.7 572.3 1.01% Natural gas NG NYMEX 55.5 92.2 -17.72% Corn C ZC CBOT 50.0 243.2 1.39% Canadian dollar CD 6C CME 48.9 133.4 -0.15% Australian dollar AD 6A CME 48.1 107.4 -1.36% S&P MidCap 400 E-Mini ME CME 42.2 91.0 -0.08% Sugar SB NYBOT 41.9 364.1 0.11% Wheat W ZW CBOT 41.3 141.0 8.37% RBOB gasoline RB NYMEX 39.4 57.9 5.25% Gold 100 oz. GC NYMEX 33.9 60.4 -0.65% Heating oil HO NYMEX 33.3 53.9 2.20% Fed Funds FF ZQ CBOT 28.0 116.3 0.12% Silver 5,000 oz. SI NYMEX 21.1 56.9 -8.48% Mexican peso MP 6M CME 19.7 75.6 -0.14% Nikkei 225 index NK CME 15.6 54.1 -2.63% Soybeans S ZS CBOT 13.7 26.7 -1.11% Coffee KC NYBOT 12.8 62.9 -6.34% Crude oil e-miNY QM NYMEX 12.8 5.3 0.49% Soybean oil BO ZL CBOT 10.9 30.8 -1.17% Soybean meal SM ZM CBOT 10.9 21.4 -0.46% Copper HG NYMEX 9.9 31.4 -2.66% Lean hogs LH HE CME 9.6 43.0 -5.18% Gold 100 oz. ZG CBOT 8.6 7.3 -0.68% Cocoa CC NYBOT 7.9 52.4 -4.35% Live cattle LC LE CME 6.5 22.4 3.80% Nasdaq 100 index ND CME 5.5 66.6 0.41% Dow Jones Ind. Avg. DJ ZD CBOT 5.5 36.2 0.73% New Zealand dollar NE 6N CME 4.8 35.5 -2.58% Silver 5,000 oz. ZI CBOT 4.7 5.0 -8.46% Natural gas e-miNY QG NYMEX 3.9 3.6 -17.72% U.S. dollar index DX NYBOT 3.8 34.7 -0.32% LIBOR EM CME 3.4 35.2 -0.06% 10-year interest rate swap NI SR CBOT 2.5 67.7 1.88% *Average volume and open interest based on highest-volume contract (March 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 todays close. 20-day move: The percentage price move from the close 20 days ago to todays close. 60-day move: The percentage price move from the close 60 days ago to todays 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 20-day move, the % Rank field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the % Rank field shows how the most recent 60-day move compares to the past one-hundred-twenty 60-day moves. A reading
of 100 percent means the current reading is larger than all the past readings, while a reading of 0 percent means the current reading is smaller than the previous readings. These figures provide perspective for determining how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the 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.
42
OPTIONS RADAR (as of Aug. 28)

MOST-LIQUID OPTIONS*
Indices Russell 2000 index S&P 500 index S&P 500 volatility index S&P 100 index Nasdaq 100 index Stocks Research in Motion Baidu.com CIT Group Transocean Trident Microsystems Futures Eurodollar 10-year T-notes Crude oil 5-yr. T-note 30-year T-bonds Options Open Symbol Exchange volume interest RUT CBOE 674.0 841.7 SPX CBOE 251.9 2.07 M VIX CBOE 31.8 1.26 M OEX CBOE 31.0 140.5 NDX CBOE 25.5 354.3 10-day move 0.65% 0.41% -4.99% 2.75% -0.11% % rank 25% 0% 0% 100% 0% 20-day move -1.07% -1.57% 11.82% -1.17% -1.70% % rank 26% 38% 33% 33% 32% IV/SV ratio 29.8% / 29.6% 23.3% / 24.6% 121% / 176.6% 23% / 23.1% 23.9% / 25.5% IV/SV ratio 20 days ago 26.8% / 20.6% 21.9% / 16.2% 96.7% / 122% 21.8% / 15.7% 22.4% / 15.1%
RIMM BIDU CIT RIG TRID
7.30 M 3.04 M 2.43 M 2.43 M 2.43 M
248.1 114.2 73.1 324.0 76.2
12.54% 5.19% 7.05% 0.16% 0.42%
78% 50% 60% 0% 33%
8.33% -1.13% -11.46% -7.07% -4.67%
24% 25% 52% 45% 15%
51.9% / 67.6% 54.6% / 67.8% 59.3% / 95.4% 31.6% / 45.6% 45.8% / 60.5%
46.1% / 44% 51.7% / 71% 38% / 45.6% 39.5% / 33.1% 52.5% / 39.7%
ED-GE TY-ZN CL FV-ZF US-ZB
CME CBOT NYMEX CBOT CBOT
1.21 M 96.0 57.4 47.6 35.3
14.63 M 1.28 M 673.4 354.8 533.7
-0.05% 1.75% -0.90% 0.99% 1.78%
25% 79% 13% 58% 57%
-0.05% 1.89% -8.29% 1.09% 1.07%
88% 63% 94% 55% 29%
21.2% / 15.7% 5.6% / 5.4% 26.6% / 29.8% 4.2% / 4.4% 7.7% / 6.9%
12.7% / 4.2% 5.7% / 5.4% 28.9% / 22.6% 4.4% / 3.8% 7.8% / 7.8%
VOLATILITY EXTREMES**
Indices High IV/SV ratio Semiconductor Index Russell 2000 index Dow Jones index Indices Low IV/SV ratio Oil service index S&P 500 volatility index Gold/silver index Morgan Stanley retail index E-mini S&P 500 futures SOX RUT DJX PHLX CBOE CBOE 1.0 674.0 4.3 20.0 841.7 133.7 -2.94% 0.65% 0.10% 50% 25% 0% -4.61% -1.07% -1.29% 55% 26% 37% 27.4% / 26.5% 29.8% / 29.6% 22% / 21.9% 27.5% / 21% 26.8% / 20.6% 20.8% / 15.2%
OSX VIX XAU MVR ES
PHLX CBOE PHLX CBOE CME
1.0 31.8 1.3 1.1 25.0
24.9 1.26 M 54.2 60.4 146.9
0.30% -4.99% -3.72% 2.44% 0.28%
0% 0% 20% 67% 0%
-4.36% 11.82% -10.44% -4.13% -1.62%
47% 33% 83% 56% 32%
31.9% / 46.9% 121% / 176.6% 35.6% / 43.6% 29% / 35.3% 23.3% / 28.2%
32.7% / 27.3% 96.7% / 122% 30.6% / 34.1% 22.7% / 22.7% 21.3% / 17.4%
Stocks High IV/SV ratio Sirius Satellite Radio SIRI Neurochem NRMX MSCI Japan index (iShares ETF) EWJ Linear Technology LLTC Vanda Pharmaceuticals VNDA Stocks Low IV/SV ratio Countrywide Financial Leap Wireless Intl Foster Wheeler WCI Communities Southern Copper Futures High IV/SV ratio Natural gas Japanese yen Eurodollar British pound Wheat
3.3 4.0 609.0 1.9 2.8
563.7 309.7 113.0 152.1 88.5
-3.79% -67.23% -1.22% -2.12% -5.14%
39% 100% 5% 40% 16%
-7.31% -63.03% -4.85% -4.29% -21.06%
71% 64% / 39.2% 100% 122.1% / 80.5% 69% 24.4% / 17.3% 39% 27.3% / 19.7% 74% 101.6% / 76%
53.5% / 41.7% 106.4% / 88.5% 20.7% / 11.4% 28.3% / 26.1% 79.7% / 45.5%
CFC LEAP FWLT WCI PCU
1.27 M 1.0 4.3 1.7 2.4
694.6 20.5 59.6 184.4 94.9
-21.05% 8.83% 8.59% 18.60% 4.20%
45% 75% 25% 67% 67%
-31.45% -24.32% -1.97% -6.12% -12.27%
90% 58% 22% 9% 53%
78% / 159.3% 61.7% / 44.7% 44% / 89.2% 36.8% / 34.7% 46.4% / 93.2% 49.6% / 48.1% 118% / 236.6% 108.2% / 101.5% 47.8% / 94.7% 40.5% / 33.4%
NG JY-6J ED-GE BP-6B KW-KE
NYMEX CME CME CME KCBT
6.6 3.7 1.21 M 1.5 1.6
50.1 -16.99% 67.7 2.64% 14.63 M -0.05% 13.4 0.52% 13.1 1.22%
90% 70% 25% 100% 15%
-6.95% 3.35% -0.05% -1.31% 8.17%
33% 74% 88% 65% 50%
82.6% / 55.8% 13.7% / 9.3% 21.2% / 15.7% 7% / 5.6% 29.6% / 24.9%
73.2% / 49.2% 9.1% / 6.8% 12.7% / 4.2% 6.3% / 4.6% 30.8% / 30.6%
Futures Low IV/SV ratio Sugar SB NYBOT 13.4 Corn C-ZC CBOT 30.5 Cocoa CC NYBOT 1.5 Silver SI NYMEX 5.8 E-Mini S&P 500 futures ES CME 25.0 *Ranked by volume **Ranked by high or low IV/SV values.
468.6 873.3 30.5 46.0 146.9
-0.11% -0.06% -4.48% -7.71% 0.28%
0% 0% 30% 61% 0%
-8.52% 0.49% -8.86% -9.62% -1.62%
87% 12% 50% 79% 32%
22.6% / 32.3% 26.7% / 36.5% 24.7% / 30.3% 28.5% / 34.8% 23.3% / 28.2%
24.7% / 34.3% 28.2% / 34.8% 26.3% / 27.8% 21.7% / 24% 21.3% / 17.4%
LEGEND: Options vol: 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 asset. 10-day move: The underlyings percentage price move from the close 10 days ago to todays close. 20-day move: The underlyings percentage price move from the close 20 days ago to todays 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.
44
KEY CONCEPTS
The option Greeks
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. Average and median: The mean (or average) of a set of values is the sum of the values divided by the number of values in the set. If a set consists of 10 numbers, add them and divide by 10 to get the mean. A statistical weakness of the mean is that it can be distorted by exceptionally large or small values. For example, the mean of 1, 2, 3, 4, 5, 6, 7, and 200 is 28.5 (228/8). Take away 200, and the mean of the remaining seven numbers is 4, which is much more representative of the numbers in this set than 28.5. The median can help gauge how representative a mean really is. The median of a data set is its middle value (when the set has an odd number of elements) or the mean of the middle two elements (when the set has an even number of elements). The median is less susceptible than the mean to distortion from extreme, non-representative values. The median of 1, 2, 3, 4, 5, 6, 7, and 200 is 4.5 ((4+5)/2), which is much more in line with the majority of numbers in the set. Average directional movement index (ADX): Measures trend strength, regardless of direction. The higher the ADX value, the stronger the trend, whether the market is going up or down. The indicator can be applied to any time frame, although it is typically used on daily charts. Although the ADX concept is straightforward, its calculation is rather lengthy. The indicator was designed by Welles Wilder and is described in detail in his book New Concepts in Technical Trading Systems (Trend Research 1978). Calculation: 1. Calculate the positive or negative directional movement (+DM and -DM) for each bar in the desired lookback period. Bars that make higher highs and higher lows than the previous bar have positive directional movement. Bars that make lower highs and lower lows than the previous bar have negative directional movement. If a bar has both a higher high and a lower low than the previous bar, it has positive directional movement if its high is above the previous high more than its low is below the previous low. Reverse this criterion for negative directional movement. An inside bar (a bar that trades within the range of the previous bar) has no directional movement, and nei46
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 options price changes per a onepercent change in volatility. ther does a bar whose high is above the previous high by the same amount its low is below the previous low. 2. If a bar has positive (negative) directional movement, the absolute value of the distance between todays high (low) and yesterdays high (low) is added to the running totals of +DM (-DM) calculated over a given lookback period (i.e., 20 bars, 30 bars, etc.). The absolute value is used so both +DM and -DM are positive values. 3. Calculate the sum of the true ranges for all bars in the lookback period. 4. Calculate the Directional Indicator (+DI and -DI) by dividing the running totals of +DM and -DM by the sum of the true ranges. 5. Calculate the directional index (DX) by taking the absolute value of the difference between the +DI value and the -DI value, dividing that by the sum of the +DI and -DI values, and multiplying by 100. 6. To create the ADX, calculate a moving average of the DX over the same period as the lookback period used throughout the other calculations. Bear call spread: A vertical credit spread that consists of a short call and a higher-strike, further OTM long call in the same expiration month. The spreads 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. Bollinger Bands: Bollinger Bands are a type of trading envelope consisting of lines plotted above and below a moving average, which are designed to capture a markets typical price fluctuations. The indicator is similar in concept to the moving average envelope, with an important difference: While moving average envelopes plot lines a fixed percentage above and below the average (typically three percent above and below a 21-day simple moving average), Bollinger Bands use standard deviation to determine how far above and below the moving average the lines are placed. As a result, while the upper and lower lines of a moving average envelope move in tandem, Bollinger Bands expand during periods of rising market volatility and contract during periods of decreasing market volatility. Bollinger Bands were created by John Bollinger, CFA, CMT, the president and founder of Bollinger Capital Management (see Active Trader, April 2003, p. 60). By default, the upper and lower Bollinger Bands are placed two standard deviations above and below a 20-period simple moving average. Upper band = 20-period simple moving average + 2 standard deviations Middle line = 20-period simple moving average of closing prices Lower band = 20-period simple moving average - 2 standard deviations Bollinger Bands highlight when price has become high or low on a relative basis, which is signaled through the touch (or minor penetration) of the upper or lower line. However, Bollinger stresses that price touching the lower or upper band does not constitute an automatic buy or sell signal. For example, a close (or multiple closes) above the upper band or below the lower band reflects stronger upside or downside momentum that is more likely to be a breakout (or trend) signal, rather than a reversal signal. Accordingly, Bollinger suggests using the bands in conjunction with other trading tools that can supply context and signal confirmation. 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. Butterfly: A non-directional trade consisting of options with three different strike prices at equidistant intervals: Long one each of the highest and lowest strike price options and short two of the middle strike price options. 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. Carrying costs: The costs associated with holding an investment that include interest, dividends, and the opportunity costs of entering the trade. Condor: A non-directional trade with options at four different strike prices at equidistant intervals: Long one each of the highest and lowest strike price options and short two options with strikes in between these extremes. Continuous futures data (sometimes referred to as nearest futures): Unlike stock (or spot currency) prices, which are unbroken price series, futures prices consists distinct contract months that begin and end at specific points in time. To perform longer-term analysis or system testing you need a continuous, unbroken price series, similar to stock prices. However, because of the price differential between different contract months in the same futures market, moving from the prices in one month to the next creates a fractured price series that doesn't accurately reflect the markets movement. Continuous futures data are prices that have been adjusted to compensate for the price gaps between successive contract months. Typically, the data is back adjusted by raising or lowering all previous prices in the series by the difference between the last price in the continuous series and the new data to be added to the series. The result is an unbroken price series that accurately reflects the day-to-day (or week-to-week) price changes in a market, but not the actual price levels. 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.
continued on p. 48 47
KEY CONCEPTS continued

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. 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 its unaffected by underlying price movement. However, delta will change as the underlying moves up or down, so you must buy or sell shares/contracts to adjust delta back to zero. Diagonal spread: A position consisting of options with different expiration dates and different strike prices e.g., a December 50 call and a January 60 call. Double diagonal spread: A double diagonal resembles an iron condor (call credit spread + put credit spread), but the long side of each spread expires in a later month. This position combines two diagonal spreads on either side of the market and tries to exploit the time decay of the short, near-term options. It collects the most profit if the market trades sideways by expiration. To construct a double diagonal, enter two spreads simultaneously: a call spread, which consists of a short out-ofthe-money call and a long, higher-strike call in a further month; and a put spread, which consists of a short OTM put and a long, lower-strike put in a more-distant month. Both spreads short options share the same expiration month, and the long options expire together at least one month later. 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). Internal rate of return (IRR): The discount rate required when the net present value of future cash flows is zero. This percentage value represents an estimated rate of growth that can be used to evaluate different investment schemes. Higher percentages indicate either greater profitability or more favorable timing. Lets assume, for instance, you buy a bond for $1,000 and receive annual payments of $50 each year for five years: Year 0 1 2 3 4 5 Cash flow -$1,000 +$50 +$50 +$50 +$50 +$1,050
In the fifth year, you get the $1,000 back, plus the last $50 annual payment. Formula: Net present value (NPV) = 0 0 = -1,000 + 50/(1+i)1 + 50/(1+i)2 + 50/(1+i)3 + 50/(1+i)4 +50/(1+i)5 where, i= internal rate of return, i=5% In the money (ITM): A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instruments price. 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. Iron condor: A market-neutral position that enters a bear call spread (OTM call + higher-strike call) above the market and a bull put spread (OTM put + lower-strike put) below the market. Both spreads collect premium, and profit when the market trades between the short strikes by expiration. All options share the same expiration month. Limit up (down): The maximum amount that a futures contract is allowed to move up (down) in one trading session. Linear regression (best-fit) line: A way to calculate a straight line that best fits a set of data (such as closing prices over a certain period) that is, a line that most accurately reflects the slope, or trend, of the data. A regression line is calculated using the least squares method, which refers to finding the minimum squared (x*x, or x2) differences between price points and a straight line. For example, if two closing prices are 2 and 3 points away (the distance being calculated vertically) from a straight line, the squared differences between the points and the line are 4 and 9, respectively. The squared differences are used (instead of just the differences) because some differences are negative (for points below the line) and others are positive (for points above the line). Squaring all the differences creates all-positive values and allows you to calculate a formula for the straight line.
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The best-fit line is the line for which the sum of the squared differences between each price and the straight line are minimized. The formula for a straight line (y) is: y = a + b*t where t = time a = the initial value of the line when t is equal to zero (sometimes called the intercept value i.e., the point at which the line intercepts the vertical y-axis) or the point at which a specific line begins; b = the slope of the line, which is the rate at which the line rises or falls (e.g., 0.75 points per day). When fitting a straight line to N data points, the best-fit coefficients a and b can be solved for by: a = [2(2N+1)/N(N-1)] p(t) + [6/(N(N-1)] t*p(t)
t=1 t=1 N N N
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 instruments 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 net credit. However, the spread contains uncovered, or naked options, which add upside or downside risk. 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:
continued on p. 50 49
b = [12/N(N2 1)] t*p(t) - [6/N(N-1)]p(t)

t=1 t=1
where p(t) = the price at point t; N = the number of prices we are using to calculate the coefficients. 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. 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 puts 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.
KEY CONCEPTS continued

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 days 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 days 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. Stochastic oscillator: A technical tool designed to highlight shorter-term momentum and overbought and oversold levels (points at which a price move has, theoretically at least, temporarily exhausted itself and is ripe for a correction or reversal). Calculation: The stochastic oscillator consists of two lines: %K and a moving average of %K called %D. The basic stochastic calculation compares the most recent close to the price range (high of the range - low of the range) over a particular period. For example, a 10-day stochastic calculation (%K) would be the difference between todays close and the lowest low of the last 10 days divided by the difference between the highest high and the lowest low of the last 10 days; the result is multiplied by 100. The formula is: %K = 100*{(Ct-Ln)/(Hn-Ln)} where Ct is todays closing price Hn is the highest price of the most recent n days (the default value is five days) Ln is the lowest price of the most recent n days The second line, %D, is a three-period simple moving average of %K. The resulting indicator fluctuates between 0 and 100. Fast vs. slow: The formula above is sometimes referred to as fast stochastics. Because it is very volatile, an additionally smoothed version of the indicator where the original %D line becomes a new %K line and a three-period average of this line becomes the new %D line is more commonly used (and referred to as slow stochastics, or simply stochastics). Any of the parameters either the number of periods used in the basic calculation or the length of the moving averages used to smooth the %K and %D lines can be
50
adjusted to make the indicator more or less sensitive to price action. Horizontal lines are used to mark overbought and oversold stochastic readings. These levels are discretionary; readings of 80 and 20 or 70 and 30 are common, but different market conditions and indicator lengths will dictate different levels. Straddle: A non-directional option spread that typically consists of an at-the-money call and at-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a standard long straddle would consist of buying a 25 call and a 25 put. Long straddles are designed to profit from an increase in volatility; short straddles are intended to capitalize on declining volatility. The strangle is a related strategy. Strangle: A non-directional option spread that consists of an out-of-the-money call and out-of-the-money put with the same expiration. For example, with the underlying instrument trading at 25, a long strangle could consist of buying a 27.5 call and a 22.5 put. Long strangles are designed to profit from an increase in volatility; short strangles are intended to capitalize on declining volatility. The straddle is a related strategy. Strike (exercise) price: The price at which an underlying instrument is exchanged upon exercise of an option. 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 options value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as time decay. TRIN (Arms Index): The TRIN (short for TRading INdex) is an indicator developed by Richard J. Arms that is designed to highlight bullish and bearish momentum in the market, as well as overbought and oversold points. The TRIN uses the number of advancing stocks vs. the number of declining stocks, and the volume of advancing stocks vs. that of declining stocks. The TRIN is the ratio of advancing issues to declining issues divided by the ratio of advancing (up) volume to declining (down) volume. The formula is: (Advancing issues/declining issues) / (advancing volume/declining volume)
Basically, the TRIN indicates whether trading volume is concentrating in advancing or declining issues. It can be calculated on a daily basis, but it is also commonly calculated on intraday data. The commonly referenced TRIN is based on NYSE stocks, but the same indicator can be calculated for any index or exchange (i.e., Nasdaq stocks). True range (TR): A measure of price movement that accounts for the gaps that occur between price bars. This calculation provides a more accurate reflection of the size of a price move over a given period than the standard range calculation, which is simply the high of a price bar minus the low of a price bar. The true range calculation was developed by Welles Wilder and discussed in his book New Concepts in Technical Trading Systems (Trend Research, 1978). True range can be calculated on any time frame or price bar five-minute, hourly, daily, weekly, etc. The following discussion uses daily price bars for simplicity. True range is the greatest (absolute) distance of the following: 1. Todays high and todays low. 2. Todays high and yesterdays close. 3. Todays low and yesterdays close. Average true range (ATR) is simply a moving average of the true range over a certain time period. For example, the
five-day ATR would be the average of the true range calculations over the last five days. 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.
EVENTS
Event: FIA and OIC New York Equity Options Conference Date: Sept. 19-20 Location: Grand Hyatt New York For more information: Visit http://www.futuresindustry.org and click on Conferences. Event: Paris Trading Show Date: Sept. 21-22 Location: Espace Champerret, Paris, France For more information: Visit http://www.salonat.com Event: FIMA 2007 Date: Nov. 5-7 Location: Olympia Exhibition Centre, London For more information: http://www.fima-europe.com Event: 20th Annual IFTA Conference Date: Nov. 8-11 Location: Sharm el Sheikh, Egypt For more information: Visit http://www.ifta.org/events/next-conference/
Event: The Traders Expo Las Vegas Date: Nov. 15-18 Location: Mandalay Bay Resort and Casino, Las Vegas, Nev. For more information: Visit http://www.tradersexpo.com Event: ETFs 2007 Date: Nov. 27 Location: Cafe Royal, London For more information: http://www.wbr.co.uk/ETF
Event: 23rd Annual Futures & Options Expo Date: Nov. 27-29 Location: Hyatt Regency Chicago, Chicago, Ill. For more information: Visit http://www.futuresindustry.org and click on Conferences.
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FUTURES & OPTIONS CALENDAR SEPTEMBER/OCTOBER MONTH

September
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. futures and options (CME); September Russell futures and options (CME); September Dow Jones futures and options (CBOT); October crude oil Markets closed Labor Day August ISM futures (NYMEX)
1 2 3 4 5 6 7
August employment LTD: September currency options (CME); September U.S. dollar index options (NYBOT); October cocoa options (NYBOT)
21
Quadruple witching Friday LTD: October T-bond options (CBOT); October soybean product options (CBOT); October orange juice options (NYBOT)
22 23 24 25
LTD: October coal, natural gas, gaso line, and heating oil options (NYMEX); October aluminum, copper, silver, and
8 9 10 11 12 13 14
LTD: September cocoa futures (NYBOT) LTD: September oats, rice, wheat, corn, soybean product, and soybean futures (CBOT); October sugar and coffee options (NYBOT); October cotton options (NYBOT); September lumber LTD: September orange juice futures (NYBOT)
gold options (NYMEX)
26
LTD: October natural gas futures (NYMEX); September aluminum, palladium, copper, silver, and gold futures (NYMEX)
27
Q2 GDP (final) LTD: September platinum futures (NYMEX); September feeder cattle futures and options (CME)
28
LTD: October propane, gasoline, and heating oil futures (NYMEX); October sugar futures (NYBOT)
SEPTEMBER 2007 26 27 28 29 30 31 2 3 4 5 6 7 1 8
futures (CME)
15 16 17
LTD: September currency futures (CME); October crude oil options (NYMEX)
29 30 October 1 2 3 4 5
LTD: September milk options (CME) September employment LTD: October currency options (CME); October U.S. dollar index options (NYBOT); November cocoa options (NYBOT); October live cattle options (CME)
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 1 2 3 4 5 6
18
OCTOBER 2007 30 1 7 8 2 9 3 4 5 6 10 11 12 13
FOMC meeting August PPI LTD: September coffee futures (NYBOT); September Goldman Sachs Commodity Index options (CME)
September ISM
14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 1 2 3
19
August CPI LTD: September T-bond futures (CBOT); October platinum options (NYMEX)
The information on this page is subject to change. Futures & Options Trader is not responsible for the accuracy of calendar dates beyond press time.
20
LTD: All September equity futures and options; September S&P futures and options (CME); September Nasdaq
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FUTURES TRADE JOURNAL FOREX DIARY
Intraday volatility knocks position out of the market.
TRADE
Date: Thursday, Aug. 30. Entry: Long September 2007 E-Mini Nasdaq 100 futures (NQU07) at 1,982.00. Reasons for trade/setup: The combination of the down day on Aug. 28 and nearly symmetrical up day on Aug. 29 in the S&P 500 (with closing prices in the botSource: TradeStation tom and top 25 percent of their ranges, respectively) is consistent with a pattern that has favorable odds in testing of upside Outcome: Given the markets volatility in August, we follow-through for the next three days. The Nasdaq is the strongest index on Aug. 30, so a long expected to have to weather some significant gyrations. position is entered on a slight pullback from the intraday Expecting volatility and experiencing it are two different high of 1,987. (The S&P pattern appears toward the right of things, however. Although this pretty much turned out to be a case of buythe chart inset.) ing at the high, at the time it seemed the greater risk was not Initial stop: 1,956.25, which is 16.75 below the regular getting on board on a big up day. The Nasdaq 100 (NDX) session low. Were using a wider stop because of the mar- was up around 1 percent and the other major indices were turning from down to up on the day at the time of the trade. kets high level of intraday volatility. We put in a limit order and actually waited a good 30 minInitial target: 2,001.00, which is a little below the Aug. 8- utes for the market to pull back enough to get filled. After surviving an initial dip, the market made a lower 9 highs. Take partial profits and raise stop. Secondary tarhigh on the day putting the trade briefly back in the get: 2,039.00. money and then drifted down before dropping like a stone when it reached 1,970. The price just missed the stop RESULT point but the selling was energetic enough to convince us the trade was a mistake. We exited on the close of the reguExit: 1,969.75. lar session after a nice bounce up to around 1,970. With multiple economic reports due the next morning, we decidProfit/loss: -12.25 (-0.62 percent). ed to forego any additional volatility. Although the NDX was the only major U.S. index to end the day in the black, Trade executed according to plan? No. poor timing sabotaged the plan the trade should have been entered on the previous close.
TRADE SUMMARY
Date 8/30/07 Contract NQU07 Entry Initial stop Initial target 2,001.00 IRR 0.74 Exit 1,969.75 Date 8/30/07 P/L -12.25 (0.62%) LOP 21.75 LOL 14 Trade length 4 hours
1,982.00 1,956.25
Legend: IRR initial reward/risk ratio (initial target amount/initial stop amount); LOP largest open profit (maximum available profit during lifetime of trade); LOL largest open loss (maximum potential loss during life of trade).
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OPTIONS TRADE JOURNAL FOREX DIARY
FIGURE 1 RISK PROFILE LONG PUT This long put will be profitable if BEBE trades below $14.80 by Sept. 22 expiration.
Lack of discipline leaves money on the table.
TRADE Date: Thursday, Aug. 9. Market: Options on bebe Stores Inc. (BEBE). Entry: Buy 1 September 17.5 put for $2.70. Reasons for trade/setup: Equity research firm Brean Murray downgraded its rating on bebe Source: OptionVue Stores (BEBE) to sell from hold on Aug. 9. Historical testing shows TRADE SUMMARY that on downgrade days, stocks drop an average 0.45 percent (open to close) and slide another 0.33 perEntry date: Aug. 9 cent the next day (see Playing the Underlying security: bebe Stores (BEBE) ratings game, Active Trader, Position: 1 long September 17.5 put September 2007). Initial capital required: $270 BEBE fell 2.6 percent on the news by 1 p.m. ET. Meanwhile, the S&P Initial stop: Exit if put loses half its value. 500 index also plunged 1.4 percent Initial target: Hold until the next days close. that morning. Given these bearish Initial daily time decay: $0.75 conditions, it seemed likely that Trade length (in days): 2 bebe Stores will decline further by tomorrows close. We bought a P/L: $20 (7.4 percent) September 17.5 put on BEBE for LOP: $30 $2.70 $0.10 below its fair value LOL: -$50 when bebe Stores traded at LOP largest open profit (maximum available profit during lifetime of trade); $15.10. LOL largest open loss (maximum potential loss during life of trade). Figure 1 shows the trades potential losses on three dates: trade entry (Aug. 9, dotted line), halfway until expiration (Aug. 31, dashed line), and expira- Initial stop: Exit position if September 17.5 put drops tion (Sept. 22, solid line). The long put is in-the-money and $1.35 (or more) within two days. has a delta of -82.8. Therefore, its directional exposure is Initial target: Hold until tomorrows close. similar to selling short 83 shares. We intend to hold the put until tomorrows close and then sell it. It doesnt expire for 44 days, so time decay wont RESULT be a factor. We will exit early if BEBE jumps sharply and the Outcome: Figure 2 shows the trade didnt unfold as 17.5 put loses half its value.
FIGURE 2 MISSED OPPORTUNITY Although we didnt lose money, we missed BEBEs 5-percent drop on Aug. 10 by exiting early.
expected. We bought the put when bebe Stores traded at $15.10, and it jumped 3.2 percent within 90 minutes. Although BEBE gave back that gain by the close, our confidence was shaken. In addition, this long put went nowhere while the S&P 500 fell 2.96 percent its biggest daily decline since Feb. 27. The timing was right, but we picked the wrong stock. Fortunately, bebe Stores Source: eSignal declined 1.64 percent overnight and the September 17.5 put became profitable. The spike in market volatility, though, led to an early exit. We sold the put for $2.90 when BEBE traded at $14.69 at 10 a.m. a meager $0.20 gain that barely covered commissions. Exiting early was a big mistake, because bebe Stores slipped another 5 percent by the close. If we had followed the original plan, the September 17.5 put could have been sold for at least $3.50.
TRADE STATISTICS
Date: Delta: Gamma: Theta: Vega: Probability of profit: Breakeven point:
Aug. 9 -82.8 7.86 -0.75 1.38 47% 14.80
Aug. 10 -80.44 10.90 -0.64 1.37 50% 14.80
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2007-09 - Futures &amp Options

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2007-09 - Futures &amp Options

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Strategies, analysis, and news for futures and options traders

September 2007 Volume 1, Issue 6

Summer swoons, fall boons . . . . . . . . . .15

Straddling the COT report . . . . . . . . . . . .16

Rolling LEAPS calls . . . . . . . . . . . . . . . . . .22

September 2007 FUTURES & OPTIONS TRADER

Nasdaq enters crowded options arena . . . . . . . . . . . . . . .39

New Products and Services . . . . . . . . . . . . .41 Futures Snapshot . . . . . . . . . . . . . . . . . . . .42

ICE goes two for two . . . . . . . . . . . . . . . . .39

Momentum, volatility, and volume statistics for futures.

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .44

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .46 Hedge fund goes down . . . . . . . . . . . . . . .40

TT patent challenged at USPTO . . . . . . .40

Options Trade Journal . . . . . . . . . . . . . . .56

Looking for an advertiser?

September 2007 FUTURES & OPTIONS TRADER

A publication of Active Trader

For all subscriber services:

September 2007 FUTURES & OPTIONS TRADER

Trading todays T-note futures

Source: CQGNet (http://www.cqg.com)

September 2007 FUTURES & OPTIONS TRADER

Daily ranges: How much does the market move in a day?

FUTURES & OPTIONS TRADER September 2007

TRADING STRATEGIES continued

How does the market close?

Up-closing and down-closing days

TRADING STRATEGIES continued

September 2007 FUTURES & OPTIONS TRADER

TRADING STRATEGIES continued

T-notes and the employment report

Summer swoons, fall boons

47 years from 1960-2006

Straddling the COT report

September 2007 FUTURES & OPTIONS TRADER

What can open interest tell us?

Shifting winds in the S&P 500

FUTURES & OPTIONS TRADER September 2007

TRADING STRATEGIES continued

Total cost/risk: Breakeven point:

$4,062.50 4.8 percent (up or down)

September 2007 FUTURES & OPTIONS TRADER

Building a long straddle

FUTURES & OPTIONS TRADER September 2007

TRADING STRATEGIES continued

September 2007 FUTURES & OPTIONS TRADER

The Commitments of Traders report

Managing the trade

Taking a long view

Rolling LEAPS calls

Advantages of longer-term options

Strike 100 100 100 100 100

Overall cost $1.93 $3.61 $5.48 $8.48 $13.49

Per-month cost $1.93 $1.20 $0.91 $0.71 $0.56

All tables use the following assumptions, unless otherwise noted:

Market trades at 100, IV = 15%, interest rate = 5%

September 2007 FUTURES & OPTIONS TRADER

FUTURES & OPTIONS TRADER September 2007

TRADING STRATEGIES continued

Strike 100 100 100 100 100

Current price 80 90 100 110 120

IV 16% 18% 20% 22% 24%