Strategies, analysis, and news for futures and options traders.

June 2007 • Volume 1, Issue 3

OPENING GAP STRATEGY: KAMA RANGE-TRADER

Rare opportunities, quick SYSTEM:
profits p. 8 Adaptive moving
average technique p. 28
DEFENSIVE
OPTIONS TRADING: CREDIT SPREADS:
Puts vs. put spreads p. 20 Profiting in different
market conditions p. 24
ALL ABOUT OIL:
Short-term price YEHUDA BELSKY:
behavior insights Focusing on call
p. 12 spreads p. 34
 CONTENTS

Futures Trading System Lab

KAMA range trader . . . . . . . . . . . . . . . . . . .28
By Volker Knapp

Options Trading System Lab

Trading iron condors with the ADX . . . .32
By Steve Lentz and Jim Graham

Cover image courtesy of CBOE

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Trader Interview

Yehuda Belsky:
A market marker’s perspective . . . . . . . .34
Trading Strategies This fund manager’s market-making skills
Opening gap short help him manage the risk of trading call
selling strategy . . . . . . . . . . . . . . . . . . . . . . . .8 spreads in the S&P 500 futures.
Exploring ways to take advantage of days the By David Bukey
S&P 500 index gaps lower.
By FOT staff
Options News
Short-term crude oil tendencies . . . . . . .12 CME, ICE sweeten their bids
A breakdown of oil’s daily and intraday for CBOT . . . . . . . . . . . . . . . . . . . . . . . . . . . .39
trading characteristics and patterns. After a counteroffer by the Chicago Mercantile
By FOT Staff Exchange, the IntercontinentalExchange
responded with one of its own.
Playing defense: Long puts
vs. bear put spreads . . . . . . . . . . . . . . . . .20 Dollar index trading goes electronic . . .40
Protecting a portfolio from a market downturn The New York Board of Trade’s U.S. dollar index
doesn’t have to be complicated. Find out futures contract will trade side-by-side with the
which defensive strategy offers the most pit-traded contract beginning June 15.
bang for your buck.
By Charlie Santaularia CBOE suit vs. ISE continues . . . . . . . . . .40
A judge denied a motion by the International
The debit spread option . . . . . . . . . . . . . .24 Securities Exchange to end a lawsuit
The front-month bull call spread gives brought upon it by the Chicago Board
traders not approved for more advanced Options Exchange.
techniques the opportunity to profit from
time decay.
continued on p. 4
By John C. Larsen

2 June 2007 • FUTURES & OPTIONS TRADER

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 CONTENTS

USFE has new name, game . . . . . . . . . . .41

The United States Futures Exchange,
formerly known as Eurex U.S., is again
trying to gain a foothold in the U.S. derivatives
market.
By Jim Kharouf

Futures Snapshot . . . . . . . . . . . . . . . . . . . .42

Momentum, volatility, and volume statistics
for futures.
Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49
Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .43
Notable volatility and volume in the
options market. Futures Trade Journal . . . . . . . . . . . . . . .50
Pattern analysis identifies a buying
Futures & Options Calendar . . . . . . . . . . . .44 opportunity that captures some, but not all,
of the May bounce in crude oil.
New Products and Services . . . . . . . . . . . . .45

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .46 Options Trade Journal . . . . . . . . . . . . . . .51

References and definitions. Ignoring the Greeks leads to tragedy.

Have a question about something you’ve seen

in Futures & Options Trader?
Submit your editorial queries or comments to webmaster@futuresandoptionstrader.com.
Looking for an advertiser?
Click on the company name below for a direct link to the ad

in this month’s issue of Futures & Options Trader.

CBOE HedgeAnswers
Expo Trader Brazil Options Mentoring
Futures & Options Trader bookstore Zecco

4 June 2007 • FUTURES & OPTIONS TRADER

 CONTRIBUTORS
CONTRIBUTORS

 Jim Graham (advisor@optionvue.com) is the product man-

ager for OptionVue Systems and a registered investment advisor
for OptionVue Research.

A publication of Active Trader ®

 Steve Lentz (advisor@optionvue.com) is executive vice pres-
ident of OptionVue Research, a risk-management consulting company. He also
For all subscriber services:
heads education and research programs for OptionVue Systems, including one-
www.futuresandoptionstrader.com
on-one mentoring for intermediate and advanced traders.

Editor-in-chief: Mark Etzkorn  Charlie Santaularia is managing director of Parrot Trading

metzkorn@futuresandoptionstrader.com Partners, LLC (CPO/CTA). He holds a bachelor of arts in eco-
nomics from the University of Kansas and has been actively trad-
Managing editor: Molly Flynn
ing for the past four years. He has a NASD series 3 license and is
mflynn@futuresandoptionstrader.com
charge of marketing, market research, and client contact, and
Senior editor: David Bukey actively assists with trading decisions. In addition to writing a monthly newslet-
dbukey@futuresandoptionstrader.com ter for the firm’s investors, he has been published in industry magazines,
http://www.stockweblog.com, and http://www.commoditytrader.com.
Contributing editors: Keith Schap,
Jeff Ponczak
jponczak@futuresandoptionstrader.com  Thom Hartle (http://www.thomhartle.com) is director of
marketing for CQG and a contributing editor to Active Trader mag-
Editorial assistant and
azine. In a career spanning more than 20 years, Hartle has been a
Webmaster: Kesha Green
kgreen@futuresandoptionstrader.com commodity account executive for Merrill Lynch, vice president of
financial futures for Drexel Burnham Lambert, trader for the
Art director: Laura Coyle Federal Home Loan Bank of Seattle, and editor for nine years of
lcoyle@futuresandoptionstrader.com
Technical Analysis of Stocks & Commodities magazine. Hartle also writes a daily
President: Phil Dorman market blog called hartle & flow (http://www.hartleandflow.com).
pdorman@futuresandoptionstrader.com
 Volker Knapp has been a trader, system developer, and
Publisher,
Ad sales East Coast and Midwest: researcher for more than 20 years. His diverse background
Bob Dorman encompasses positions such as German National Hockey team
bdorman@futuresandoptionstrader.com player, coach of the Malaysian National Hockey team, and pres-
ident of VTAD (the German branch of the International
Ad sales
West Coast and Southwest only:
Federation of Technical Analysts). In 2001 he became a partner in
Allison Ellis Wealth-Lab Inc. (http://www.wealth-lab.com), which he is still running.
aellis@futuresandoptionstrader.com
 Jim Kharouf is a business writer and editor with more than 10 years of
Classified ad sales: Mark Seger
experience covering stocks, futures, and options worldwide. He has written
mseger@futuresandoptionstrader.com
extensively on equities, indices, commodities, currencies, and bonds in the U.S.,
Europe, and Asia. Kharouf has covered international derivatives exchanges,
Volume 1, Issue 3. Futures & Options Trader is pub- money managers, and traders for a variety of publications.
lished 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  John Larsen is the president of Wizetrade for Options trend recognition
form without written permission from the publisher.
software and the chief options strategist for Wizetrade TV. His career as a trad-
The information in Futures & Options Trader magazine
is intended for educational purposes only. It is not er and educator spans more than two decades, and he has traded equities and
meant to recommend, promote or in any way imply the
effectiveness of any trading system, strategy or stock indices, fixed income and derivatives, currencies, futures, commodities
approach. Traders are advised to do their own
research and testing to determine the validity of a trad- and options. Larsen earned Series 3, 7, and 63 licenses and is a former member
ing idea. Trading and investing carry a high level of
risk. Past performance does not guarantee future of the Chicago Board of Trade.
results.

6 June 2007 • FUTURES & OPTIONS TRADER

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 TRADING STRATEGIES

Trading the equity market from the short

Opening gap side requires skill. Keeping trades brief and
short selling strategy small can pay off if you use an
appropriate strategy.

FIGURE 1 — DOWN-GAP SIZE AND NUMBER OF CLOSES ABOVE BY FOT STAFF

OR BELOW THE OPEN
As the size of the opening down gap increases, days that closed below

G
the open began to outnumber days that closed above the open.
iven the stock market’s implacable
upward drift, selling the stock mar-
ket short is a tricky game. If you’re
conservative, disciplined, and adept,
you can augment the more significant returns the
long side of the market provides, but if you’re too
aggressive or too complacent, you can decimate
your trading account.
The following analysis outlines an interesting
idea for an intraday short-selling strategy that
trades relatively infrequently (29 signals in the past
three years) and uses the size of the opening gap to
determine whether to take a trade. The study spans
May 14, 1997 to May 16, 2007 and uses S&P 500
index (SPX) daily and intraday data.
TABLE 1 — INTRADAY PRICE ACTION AFTER OPEN 0.129 PERCENT
OR MORE BELOW PREVIOUS CLOSE Down but not out
If you come into each trading day flat and
When the S&P 500 opened 0.129 percent or more below the previous day’s
you want to take advantage of the day’s
close, the index closed below the open approximately 70 percent of the time.
intraday trend, you need to determine the
No. probabilities the market will move far
patterns O-C Down/up C<O %C<O O-L enough in your direction after the open to
5-14-97 to 5-16-07 87 61 70.11% make a trade worthwhile.
Average 7.51 4.01 1.16% Is there any way to determine from the
Median 7.39 1.79 1.04% size of the opening move when the S&P is
Max. 48.58
most likely to trade lower during the ses-
Min. -21.55
sion?
There are any number of trade setups
5-14-97 to 12-31-03 60 42 70.00%
based on the size and direction of the
Average 8.90 4.59 1.34%
move from yesterday’s close to today’s
Median 9.94 1.97 1.17%
Max. 48.58 open — the “opening gap.” For example,
Min. -21.55 depending on the approach, a large open-
ing gap (given certain prevailing market
1-1-04 to 5-16-07 27 19 70.37% conditions) might indicate the market has
Average 4.41 2.33 0.74% overextended itself on the open and is like-
Median 2.90 0.66 0.72% ly to reverse.
Max. 19.84 13.89 In this case, we’ll analyze opening gaps
Min. -8.06 0.31 to see whether down gaps — when the
S&P 500 index opens below the previous

8 June 2007 • FUTURES & OPTIONS TRADER

day’s close — offer any clues about the current day’s trend. size of the opening gap — that is, how far today’s opening
price is below the previous close. Are downward opening
Eye on the opening gaps of a certain size — either large or small — more likely
Given the stock market’s upward bias, it should come as no to be associated with larger intraday price moves, higher
surprise that — despite the 2000-2002 bear market — only probabilities of certain price moves, or both? (The fact that
1,202 of the 2,516 trading days from May 14, 1997 through electronically traded stock index futures do not have the
May 16, 2007 (47.7 percent) closed lower than they opened. same opening gaps as their corresponding cash indices will
Similarly, of the 847 more recent trading days from Jan 2, be addressed later.)
2004 through May 16, 2007, only 379 (44.7 percent) had clos- Downward opening moves in the S&P ranged from -0.10
ing prices below the opening prices. Also, the S&P 500 to -21.89 points over the 10-year analysis period. Because
opened below the previous close only 621 times (25 percent) the S&P index more than doubled over this time span (mak-
in the May 1997 to May 2007 period. ing point-value comparisons from one period to the next
In other words, most of the time the S&P closed above its misleading), Figure 1 translates these point values into per-
open — 52.1 percent of the time between May 14, 1997 to centages of the previous closing price and charts them in an
May 16, 2007, and 55.1 percent of the time from Jan. 2, 2004 unusual way: The horizontal axis shows the size of the
to May 16, 2007 — and it opened above the previous close opening gaps (as positive numbers). The vertical axis shows
75 percent of the time. the difference between the number of these days that closed
Now consider what happens after a lower open. From higher minus the number of these days that closed lower.
Jan 2, 2004 through May 16, 2007, the S&P closed below its The smaller gap sizes correspond to a greater number of
open 52.5 percent of the time when it opened below the pre- up-closing days before giving way to mixed results and,
vious day’s close. This suggests that a lower open increases eventually, a clear prevalence of lower-closing days as the
the odds of the S&P closing below that open for the day, opening-gap size exceeds 0.129 percent.
although not dramatically. However, given the overwhelm- Table 1 details the intraday price moves that occur when
ing upward skew of the S&P’s day-to-day behavior, a sim- the S&P 500 opens 0.129 percent or more below the previ-
ple pattern with any correlation to downward price move- ous day’s close. The results are shown for the entire study
ment is worth investigating. period as well as for two sub-periods. From left to right, the
columns in the table show:
Comparing opening gap size continued on p. 10
These statistics leave out a key consideration, though: the
 TRADING STRATEGIES continued

• The number of patterns (no. patterns). The numbers show these lower opens offer potential
• The difference between the day’s open and its close intraday shorting opportunities — if you could enter at the
(O - C). day’s opening price. The S&P closed lower 70 percent of the
• The day’s ratio of down movement to up movement time in all three observation periods and, with the excep-
(down/up), which is the difference between the open tion of the most recent January 2004 to May 2007 period, the
and the low divided by the difference between the average and median open-to-low moves were larger than 1
high and the open. This shows how much of the percent.
day’s price action occurred in favor of a short trade The most recent period’s average and median open-to-
on the open, and how much was against it. low moves of 0.74 percent and 0.72 percent — along with a
• The number of times the close was below the open 0.66 median down/up ratio — hint the pattern has weak-
(C < O). ened.
• The percentage of times the close was below the
open (% C < O). Practical trading
• The move from the day’s open to its low, expressed Breaking down the statistics for days that open a certain
as a percentage of the opening price (O - L). amount lower than the previous close in the S&P 500 indi-
cate favorable probabilities for intraday down
moves. There are more things to consider, how-
Related reading ever, including potential slippage that would
“Morning reversal strategy,” Active Trader, May 2003. occur applying the pattern in the S&P futures or
Historical tests reveal the tendency of the major stock indices to the S&P 500 index tracking stock (SPY). The
revert to the previous day’s closing price in the early minutes of the futures, especially, may already have sold off
trading session. before the cash market opens, which means the
entry price might already be too low to capture
“Trading the overnight gap,” Active Trader, March 2001. further downside price action (which raises the
With increasingly reactionary markets comes the higher risk of open- possibility of buying these down moves in cer-
ing gaps. Learn how to spot the early warning signs and how to take
tain circumstances).
advantage of them.
Also, this analysis did not consider the context
“Trading the opening gap,” Active Trader, December 2004. in which this pattern appeared — e.g., the nature
Watching pre-market volume is a good way to determine whether to of the preceding price action, whether a signifi-
trade or fade the opening move. cant piece of news accompanied any of the pat-
tern days that were studied, and so on.
“Trading system lab: gap closer (stocks),” Active Trader, May 2003. Finally, only the simplest application of the
Historical testing of a gap-based system. pattern was considered, and no attempt was
made to filter or otherwise improve the trade sig-
“Trading system lab: gap closer (futures),” Active Trader, May 2003. nals (entries or exits), or explore different ways to
The gap-based system summarized above is tested on a portfolio of take advantage of the information the study sup-
futures markets.
plied. A basic way to trade the pattern might be:
(Note: The five preceding articles are included in the discounted arti-
cle collection “Gap trading techniques: Five-article set.”) 1. Sell the S&P futures short when the
S&P 500 index opens 0.129 percent or
“Filling in the gap picture,” Active Trader, November 2005. more below the previous day’s close.
This article probes what happened after gaps in the S&P 500 tracking 2. Enter a buy stop-loss order x percent
stock (SPY) over a 12-year period. (Note: This article is also part of above the [open/previous
the discounted article collection “Market Pulse: Stock market patterns close/previous high (etc.)].
and tendencies, Vol. 1.”) 3. Exit x percent below today’s open.
4. Exit any open positions at the close.
“Gauging gap opportunities,” Active Trader, January 2007.
“Filling In the Gap Picture” studied price gaps in the S&P 500 tracking
To see the realities of this strategy and its per-
stock (SPY) to see whether the market tends to continue to rally after
formance in the futures market,
up gaps and drop after down gaps. The S&P 500’s tendency to
reverse direction following down gaps within downtrends leads to a see “Intraday gap short” in the August
new question: How does the market react after price gaps get filled? 2007 issue of Active Trader (http://www.active-
tradermag.com) and next month’s issue of
You can purchase and download past articles at Futures & Options Trader. As we shall see, trans-
http://www.activetradermag.com/purchase_articles.htm lating analysis from a cash index to a futures
market changes results significantly. 

10 June 2007 • FUTURES & OPTIONS TRADER

 TRADING STRATEGIES

Short-term
crude oil tendencies
Crude can be a wild market, but understanding the typical price behavior
of both the pit and electronically traded sessions will sharpen your trading strategies and skills.

BY FOT STAFF

T he crude oil market plays a pivotal role in

today’s trading world. No trader in any mar-
ket — stocks, bonds, or forex — starts out the
day without first checking the action in the
crude oil market. With electronic contracts at the New York
Mercantile Exchange (NYMEX) and
IntercontinentalExchange (ICE) augmenting the NYMEX’s
the
Although most people are aware of crude oil’s historic
rise in recent years, few understand its day-to-day behavior.
And considering the typical news story about the energy
markets being driven higher by ongoing global economic
expansion, continued Middle East tensions, and lack of
refining capacity, just to name a few factors, oil has had
quite a ride over the 12 months of this analysis.
longstanding pit-traded crude oil futures, oil is tradable Crude oil futures rallied from around $65.00 in April 2006
nearly 24 hours a day. to above $77.50 in July 2006, dropped to $50.00 in January
2007, and rallied back above $65.00 in
FIGURE 1 — CRUDE OIL ANALYSIS PERIOD late March 2007.
To understand the typical behavior
The study of crude oil price behavior spanned April 2006 through March 2007, a of crude oil, we will analyze daily price
period marked by a major downtrend
action of the pit-traded NYMEX crude
oil futures (CL) for the 12 months (248
trading days) beginning in April 2006
and ending in March 2007. Also, the
study compares the pit-traded session
to the electronic session (traded
through the Chicago Mercantile
Exchange’s Globex network) from
September 2006 through March 2007,
illustrating why it is critical for traders
to pay attention to this market on a 24-
hour basis. The price characteristics we
will analyze include the size of daily
ranges and daily net changes, the low-
est the market tends to drop on days
that close higher, and the highest the
market tends to rally on days that close
lower. Intraday analysis of crude oil
prices (using the Globex contract) will
Source: CQGNet (http://www.cqg.com)
identify the times of day crude offers

12 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — CRUDE OIL DAILY RANGES

The daily ranges during the analysis period are sorted here from
lowest to highest. The size increases accelerate at the far right of
the chart, indicating the market is prone to outliers.

the most volatility.

Figure 1 is a daily chart of the pit-traded crude oil
contract (which trades from 10:00 a.m. to 2:30 p.m.
ET) during the review period.
Let’s look at what the daily ranges can tell us
about how this market behaves.

Daily bar statistics

Figure 2 shows the daily ranges of the pit session,
sorted from the smallest to largest. The smallest
range was $0.50 and the largest was $3.10. The aver-
age was $1.41 and the median was $1.31. The dif- FIGURE 3 — DISTRIBUTION OF DAILY RANGES
ference between the average range and the median
range indicates outliers — in this case, a relatively The majority of daily ranges were between $0.91 and $1.70 (the
1.10 and 1.70 categories).
small number of exceptionally wide-range days —
pulled the average range up.
Next, frequency distribution analysis is applied
to the daily ranges to determine how often ranges
of different sizes occurred. Figure 3 displays the
number of times the daily ranges fell within certain
categories. In Figure 3, the horizontal axis repre-
sents categories of daily ranges of different sizes.
For example, the category labeled $1.10 (the third
column from the left) is the number of daily ranges
that were greater than $0.90 up to and including
$1.10 (i.e., between $0.91 and $1.10). In this case,
there were 42 daily ranges that met those criteria.
Sixty-six percent of ranges fell into the $1.10
FIGURE 4 — DISTRIBUTION OF CLOSE-TO-CLOSE CHANGES
through $1.70 categories, which includes ranges
from $0.91 through $1.70. The most occurrences (47) The majority (61 percent) of the close-to-close changes were
were in the $1.50 category, which contains daily between -$0.99 and +$1.00.
ranges from $1.30 through $1.50. The daily range
for the pit-traded session exceeded $1.90 only 15-
percent of the time.

Close-to-close changes
Figures 2 and 3 give you an idea of what to expect
within a given trading session. Figure 4 looks at
what happens from session to session — that is,
from close to close. This chart shows the distribu-
tion of the pit session’s net closing changes.
Sixty-one percent of the daily net changes were
between a net loss of -$0.99 and a gain of $1.00 (the
continued on p. 14

FUTURES & OPTIONS TRADER • June 2007 13

 TRADING STRATEGIES continued

FIGURE 5 — DAILY PIT SESSION UP-CLOSING DAYS

The daily bars’ opening prices are adjusted to the previous days’
closing prices (the zero line) to highlight how much of the intraday
price movement was above or below the previous close.

-$1.00 to $1.00 categories). The market closed with

a gain greater than $2.00 only five times (2 percent)
and closed with a loss of more than -$2.00 12 times
(5 percent).
The next sections analyze how far crude tends to
decline intraday on days it closes higher and how
much it tends to rally on days it closes lower. They
paint a picture of a volatile market, prone to wide
swings and intraday reversals.

Intraday lows on up-closing days

Knowing how much a market is likely to trade
below its previous closing price but still close high-
er on the day is useful information for a trader with
Crude oil price behavior an upside bias: If the market is initially down on
Insights from analyzing crude oil futures the day, there may be a certain price level that rep-
from April 3, 2006 through March 30, 2007: resents a low-risk entry point for a long trade.
The market closed up 129 of the 248 pit sessions
• The average daily range for the crude oil pit-traded session was in the review period; the market was unchanged
$1.41. Sixty-six percent of the daily ranges were between $0.91 two times.
and $1.70. The daily range exceeded $1.90 only 15-percent of the Figure 5 shows the bars (pit sessions) of all up-
time. closing days adjusted so each bar’s opening price is
• Sixty-one percent of the daily close-to-close changes in the pit- matched to the previous day’s closing price, which
traded contract were between -$0.99 and $1.00. The contract is represented by the zero line.
posted a close-to-close gain larger than $2.00 only five times (2 There are several days when crude oil traded as
percent) and a close-to-close loss larger than -$2.00 12 times (5 much as $1.00 below the previous close but rallied
percent). to end the session in positive territory. However,
• From Sept. 1, 2006 through March 30, 2007, 67 percent of the there are also days when the low for the day was
time the Globex session’s low was between unchanged and a more than $1.00 above the previous day’s close.
$0.69 loss for up-closing sessions. The market traded more than
Figure 6 shows the frequency distribution analy-
-$1.00 down and still recovered to close up for the session only
sis of the data from Figure 5. On up-closing days,
seven times (10 percent).
the market trade in the red intraday before advanc-
• On days the Globex session closed down, the high was between
ing to close higher 82 times (63 percent). Crude oil
$0.01 and $0.60 above the previous close 62 percent of the time
was down $1.00 or more and recovered to close
and was more than $1.00 above the previous close only five times
higher only nine times. On the other hand, the pit-
(7 percent).
• In the Globex session from Sept. 1, 2006 through March 30,
session low was more than $0.50 above the previ-
2007 the 10 a.m. ET hour had the largest hourly range. This was ous day’s close 10 times.
driven by the release of the weekly crude inventories report each
Wednesday. The average hourly range for all 10 a.m. hours was Electronic trading
$0.66 (median $0.64), while the 10 a.m. hours on Wednesdays Comparing the electronically traded crude oil mar-
produced hourly ranges with a low of $0.61 and a high of $1.26. ket’s behavior is revealing. NYMEX products start-
ed trading on Globex June 12, 2006. Crude oil
futures trade on Globex from 6:00 p.m. ET Sunday

14 June 2007 • FUTURES & OPTIONS TRADER

FIGURE 6 — DISTRIBUTION OF LOWS FOR UP-CLOSING
SESSIONS
FIGURE 7 — NYMEX CRUDE OIL: ELECTRONIC (GLOBEX)
During the pit-traded session, crude oil traded at or below the TRADING SESSION
previous day’s close 63 percent of the time on days the
market closed up. The data for the electronically traded crude oil produced
different statistics than the pit-session data.

through 5:15 p.m. Friday, with a 45-minute break each day

FIGURE 9 — GLOBEX SESSION CRUDE DURING MARCH
between 5:15 p.m. and 6:00 p.m.
Figure 7 shows the adjusted daily ranges for up-closing The March 27 Globex session traded more than $5.00
above the previous day’s close and settled with a gain of
sessions in Globex crude from Sept. 1, 2006 through March
just $0.02. This price spike was not part of the pit-session
30, 2007. data for the day.
The statistics change using the nearly 24-hour Globex
trading data. Crude oil closed up 70 of the 145 sessions in
the review period. The market traded below the previous
continued on p. 16

FIGURE 8 — DISTRIBUTION OF LOWS ON GLOBEX

UP-CLOSING SESSIONS
For up-closing Globex trading sessions, the low was between
unchanged and -$0.69 below the previous day’s close 67
percent of the time.

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

FUTURES & OPTIONS TRADER • June 2007 15

 TRADING STRATEGIES continued

FIGURE 10 — PIT SESSION DOWN-CLOSING DAYS FIGURE 11 — DISTRIBUTION OF HIGHS ON

DOWN-CLOSING SESSIONS
Similar to Figure 5, the daily bars are adjusted so the current
opening price is the same as the previous close (the zero Just 57 percent of the time did the market trade above the
line). There are many times when the high is well below the previous day’s close during the pit session on those days the
previous day’s close. market closed down.

day’s close on 86 percent of up-closing days (60 times). trated (67 percent) between unchanged and a loss of -$0.69
A closer inspection of Figure 7 reveals an interesting phe- (the -$0.70 to $0.00 categories). Crude traded more than
nomenon. The high for the day three from the right was -$1.00 down and still recovered to close in positive territory
more than $5.00 above the previous day’s close but the mar- just 10 percent of the time.
ket fell back to close up only $0.02 for the session. Figure 9 is a chart of the Globex-traded crude oil. It
This trading is not apparent in Figure 5 — it occurred underscores the importance of monitoring positions on a
only on the Globex session. This trading session was driven 24-hour basis.
by rumors of escalating confrontations between Iran and
the U.S. during the British soldier hostage crisis in late Intraday highs on down-closing days
March. Figure 10 is the adjusted daily chart of the 12 months of pit-
Figure 8 shows the frequency distribution for Figure 7’s
data. The lows for up-closing Globex sessions are concen-
FIGURE 13 — DISTRIBUTION OF HIGHS ON GLOBEX
DOWN-CLOSING DAYS
FIGURE 12 — GLOBEX SESSION DOWN-CLOSING DAYS
The high was between $0.01 and $0.60 above the previous
The highs for those sessions that closed down on the day day’s close 62 percent of the time when the Globex session
tended to be above the previous day’s Globex-session close. closed down.

16 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 14 — INTRADAY PRICE ACTION

The intraday review period contained uptrends, downtrends, and one

session where the market traded $5.00 above the previous day’s
close.

session trading for down-closing days. Here we

are analyzing the relationship between intraday
highs to the previous day’s close.
The market closed down 119 sessions. Fifty-
seven percent of the time the market traded in
positive territory, reversed, and then closed
down. The market traded more than $1.00 above
the previous close and still closed lower on the
day only five times (4 percent).
Figure 11 is the frequency distribution of the
data from Figure 10. The two highest categories
represent days with highs that were between
$0.11 and $0.30 (the $0.20 and $0.30 categories)
above the previous close that reversed and closed
lower. This happened 26 times (22 percent of
down-closing days).
Figure 12 shows the adjusted bars for down-
closing days using the Globex session price data
from Sept. 1, 2006 through March 30, 2007.
During these six months, the market closed
down 74 times and the high was above the previ-
ous day’s close 68 times (91 percent of the time).
Figure 13 is the frequency distribution of Figure
12.
On down-closing days, high was between
$0.01 up to and including a gain of $0.60 (the
$0.10 to $0.60 categories) 62 percent of the time.
The high exceeded a gain of $1.00 and still closed
down only five times (7 percent).

Intraday analysis
The intraday analysis uses 60-minute bars based
on a 24-hour clock. The NYMEX crude oil con-
tract on Globex trades from 6:00 p.m. ET Sunday
through 5:15 p.m. Fridays, with a 45-minute
break each day between 5:15 p.m. and 6:00 p.m.
Figure 14 charts the 60-minute bars from the
Feb. 1, 2007 through March 30, 2007 review peri-
od.
Figure 15 shows the average and median
ranges for each hour. The Globex session’s hourly
ranges expand noticeably when the pit session is
continued on p. 18
Source: CQGNet (http://www.cqg.com)

June 2007 • FUTURES & OPTIONS TRADER 17

 TRADING STRATEGIES continued

FIGURE 15 — AVERAGE AND MEDIAN HOURLY RANGES

The Globex day session ends at 2:30 ET, which coincides with
the close of the pit session. Globex trading resumes at 6:00 ET.
the hourly ranges decrease for two hours, climb for
the final two hours of the pit session, then steadily
decline again for the rest of the Globex session.
The hour with the largest range is 10 a.m., with an
average range of $0.66 (median $0.64). Why is this
hour, rather than the first hour of the pit session, the
most volatile of the day?
Every Wednesday at 10:30 a.m., the U.S. Energy
Information Administration announces the weekly
crude oil inventories and other key petroleum statis-
tics. This report plays a big role in how traders view
the current demand-supply equation driving the
price of crude oil.
Figure 16 shows the 10 a.m. hours for February
and March 2007. The red histogram bars are the
open. When the pit session is closed, the hourly ranges Wednesdays of each week. These hourly bars
shrink by more than half. ranged from $0.61 to $1.26; recall the average range for all
There is a steady climb to the 10 a.m. hour, at which point hourly bars was $0.66 and the median was $0.64.
This weekly inventory report can drive the hour
range to nearly twice the average hourly range.
FIGURE 16 — IMPACT OF THE WEEKLY CRUDE OIL
INVENTORY REPORTS
24-hour markets need watching
The red bars are the 10 a.m. bars on the days the weekly crude In addition to the summary provided in “Crude oil
oil inventories are released. These hourly bars had more volatility
price behavior patterns” (p. 14), there are a few key
than the typical Wednesday.
points to take from this analysis. First, the review
period was marked by a downtrend — something
many pundits likely did not foresee. The point is,
any market can go down.
Performing this kind of analysis on a regular
basis will help keep you on top of changing market
environments and allow you determine whether
the market is behaving within expectations.
Also, it is helpful to look behind the numbers and
understand what is causing certain market patterns,
such as the spike in the 10 a.m. hour volatility trig-
gered by the release of the weekly inventory report.
Finally, like other markets, the coming of nearly
24-hour electronic trading is a very positive step by
allowing traders to managing positions around the
clock.

18 June 2007 • FUTURES & OPTIONS TRADER

ads0707 5/7/07 1:35 PM Page 75
 TRADING STRATEGIES

Playing defense:
Long puts vs. bear put spreads
Buying puts to protect a stock portfolio can be expensive.
Instead, consider a bear put spread, which cuts costs and adds flexibility.

BY CHARLIE SANTAULARIA

I f you own a house or car, you (hopefully) own insur-

ance to protect these assets. Buying insurance is a
prudent decision, so why do most investors fail to
protect their stock market portfolio, one of their
largest assets?
Long-term investors assume the stock market will climb
over time, so few plan to protect against losses in bear mar-
losses in another. This is helpful, but it won’t completely
protect you against a widespread downturn.
Options can insure your stock portfolio in a variety of
ways. In theory, you could buy puts on all your individual
stocks, but that can be tedious and expensive. Alternately,
puts on stock indices can hedge an entire portfolio in one
shot. The following discussion compares two protective put
kets. The buy-and-hold approach is reasonable over strategies: long puts and bear put spreads (long put + short
decades, but withstanding a 20-percent correction can be same-month, lower-strike put). Both approaches protect
quite painful. against loss without completely limiting potential upside
To avoid losses, you can diversify by buying stocks in dif- gains.
ferent sectors so gains in one area of the market may offset Buying puts can completely hedge a portfolio, but it isn’t
cheap. A bear put spread is less expensive,
but it only protects against moderate losses.
Strategy snapshot These examples use puts on E-Mini S&P
Strategy: Portfolio hedging with long puts and bear put spreads. 500 futures, but you can apply the same
principles to options on other stock index
Market: Options on major indices, stock index futures, or futures or standard indices. Try to use the
exchange-traded funds. underlying sector or index that contains a
Rationale: Protect stock portfolio with index options. Balance risk majority of your holdings.
and reward.
Buying puts outright
Market bias: Long put: Protect against steep decline. The easiest and most popular way to pro-
tect a portfolio is to buy puts on a major
Bear put spread: Protect against defined selloff. stock index such as the S&P 500. This
Components: Long ATM or OTM put. To create spread, sell sounds simple, but a few questions arise:
same-month put below long put. Downside protection What are the costs and risks involved?
increases as the distance between long and short strikes What is the best strike price and expiration
widens. month? If the puts expire worthless, should
you buy more?
Maximum profit: Limited to a long portfolio’s gain minus the options’ cost. To answer these questions, let’s first
A long put costs more than a spread. assume you want to protect a portfolio of
Maximum risk: Long put: Limited to market’s current value minus strike stocks worth less than $100,000 against a
price. Protects completely below the strike. market decline in the next 30 days. To sim-
plify the math, these stocks will be repre-
Bear put spread: Limited to market’s current value minus sented by the E-Mini S&P 500 June futures
long strike price. Additional losses possible if market contract (ESM7), which traded around
drops below the short strike. 1,450 on April 12. Therefore, the portfolio’s
value is $72,500 (1,450 * $50 multiplier).

20 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 1 — PROTECT WITH LONG PUTS

Buying an E-Mini S&P 500 May 1,375 put, which is roughly five percent below the
market, will limit losses to less than $4,000 (purple line).

If you want to fully protect these

stocks until May 18 expiration, you
could buy an at-the-money (ATM)
May 1,450 put. However, on April 12 it
traded at $15 for a total dollar cost of
$760 ($15 * $50 multiplier + $10 com-
mission). To lower the cost, you could
buy an out-of-the-money (OTM) put
instead, which only protects against
larger losses.
Let’s assume you can handle losses
of up to five percent but want protec-
tion if the market drops further. In this
case, you would buy one 1,375 May
put for $4.50 that is roughly 5 percent
OTM and expires in 36 days.
Including commissions, the put costs
$235 ($4.50 * $50 multiplier + $10 com-
mission).
Note: In the futures mar- Source: OptionVue
ket, always make sure you
trade options that are appro- TABLE 1 — LONG PUT VS. BEAR PUT SPREAD
priate to the underlying posi- A bear put spread costs $52.50 less than simply buying the 1,375 long put, because the
tion’s contract month. For premium collected from the short 1,300 put offsets some of this cost.
example, because there is no
May E-Mini S&P 500 futures No. of contracts Long/short Position Price Commission Cost
contract, May options are Protective put:
matched to the next available 1 Long May 1,375 put -$4.50 -$10.00 -$235.00
futures contract — June 2007. Totals: -$4.50 -$10.00 -$235.00
This example assumes Bear put spread:
your portfolio is worth 1 Long May 1,375 put -$4.50 -$10.00 -$235.00
$72,500, so you buy one put. 1 Short May 1,300 put $1.25 -$10.00 $52.50
In reality, you need to calcu- Totals: -$3.25 -$20.00 -$182.50
late how many puts to buy
for protection. To do this,
divide the amount to be hedged ($72,500) by the S&P 500’s month, and car insurance can cost 0.66 percent of a car’s
nominal value: value per month.

$72,500 / $72,500 [1,450* $50 multiplier] = 1 To summarize, the steps for protecting your portfolio with
puts are:
Figure 1 compares the potential gains and losses of a
portfolio that is protected with a long May 1,375 put (pur- 1. Calculate the total portfolio amount and the portion
ple line) to an unprotected portfolio (green line). If the mar- you want to protect. Then, calculate how many puts
ket rallies in the next month, either scenario continues to to buy.
profit; however, you give up the premium paid for the put 2. Select the put’s strike price. If you want to
($235). If the market drops more than five percent, the pro- completely protect your stock, buy ATM puts. If
tected portfolio’s losses are limited to $3,985 (75 point drop you can handle 5 (or 10) percent losses, buy puts 5
* $50 multiplier + $235 put cost). But an unprotected port- (or 10) percent below the market’s current value.
folio could lose much more. Lower-strike puts cost less, but offer incomplete
Essentially, you have used 0.32 percent of the portfolio protection.
($235/$72,500) to hedge a drawdown of more than five per- 3. Determine how long you want to protect the port-
cent in the next 36 days. That premium seems reasonable folio (e.g., 30, 60, 100, or 150 days). Longer-dated
compared to typical insurance costs. For example, home options cost more.
insurance can cost 0.05 percent of a home’s value per continued on p. 22

FUTURES & OPTIONS TRADER • June 2007 21

 TRADING STRATEGIES continued

Buying longer-term puts might be a better idea, because

If the put expires or is exercised, should you buy more time decay doesn’t have an immediate effect on the put’s
protection? It is a good idea to insure a stock portfolio on an value. You will pay more initially, but longer-dated puts
ongoing basis, because a sell-off such as Feb. 27’s 3.94-per- (i.e., nine months out) offer more bang for the buck and
cent drop in the E-Mini S&P 500 futures could form any could benefit from a spike in volatility.
time. Buying front-month puts can be useful, because you
can adjust risk by selecting different strikes each month. Bear put spread: lower cost, less protection
However, this approach is expensive, because short-term Entering a bear put spread is a cheaper way to hedge your
puts include a large amount of time premium, which portfolio. The trade-off is the spread only offers partial
decays quickly. downside protection. To add a bear call spread, sell a same-
month put below the long one,
which offsets some of the protection
FIGURE 2 — BEAR CALL SPREAD – LIMITED PROTECTION costs. If the market continues to rally,
Adding a May bear put spread is $52.50 cheaper than simply buying a long 1,375 your portfolio will gain more
put, but it only limits losses if the market drops less than 10 percent (blue line). because of these lower costs. But if
Additional losses occur below the spread’s 1,300 short put. the market falls, the spread only pro-
tects within a defined range between
its long and short strikes.
For instance, let’s assume you
think the market could fall five to 10
percent within two months. You can
handle a five-percent decline, and
you don’t expect the market to drop
more than 10 percent during this
period. Buy the same May 1,375 put
that is five percent OTM for $4.50
and sell a May 1,300 put that is 10
percent OTM for $1.25. Selling the
1,300 put lowers the entire position’s
cost to $3.25 ($4.50 long put - $1.25
short put), or $182.50 total ($3.25 *
$50 multiplier + $20 commissions).
Table 1 compares the total costs of
both protective strategies and shows
the spread costs $52.50 less. Figure 2
compares the potential gains and
Source: OptionVue losses of a portfolio with a bear put
spread (blue line) to an unpro-
tected portfolio (red line) at May
TABLE 2 — LONG PUT DETAILS (AT MAY EXPIRATION)
18 expiration.
Buying puts outright can protect a portfolio against large losses. The May 1,375 put This strategy limits potential
costs $52.50 more than entering a 1,375/1,300 bear put spread, so it is only preferable gains and losses. If the market
if you expect a downturn of more than 10 percent.
continues to rally, the portfolio’s
gains are reduced by the
Portfolio value Compare
spread’s cost ($182.50). In a bull
S&P 500 Portfoilo Put (with put to bear
market, a protected portfolio
move gain/loss profit protection) call spread
will lag the E-Mini S&P 500
10% $7,250.00 Expires worthless $79,515.00 -$52.50
futures by 0.25 percent
5% $3,625.00 Expires worthless $75,890.00 -$52.50
($182.50/$72,500), but that cost
0% $0.00 Expires worthless $72,265.00 -$52.50
protects the portfolio from a
-5% -$3,625.00 Expires worthless $68,640.00 -$52.50
drop of five to 10 percent in the
-10% -$7,250.00 $3,500.00 $68,515.00 -$105.00
next 36 days. If the market
-15% -$10,875.00 $7,125.00 $68,515.00 $3,322.50
drops up to 10 percent to the
-20% -$14,500.00 $10,750.00 $68,515.00 $6,947.50
1,300 short strike, losses are lim-
ited to $3,932.50 (75 point drop *

22 June 2007 • FUTURES & OPTIONS TRADER

 TABLE 3 — BEAR PUT SPREAD DETAILS (AT MAY EXPIRATION)
Adding a May 1,375/1,300 bear put spread to a portfolio is better than simply buying
puts unless you want to protect against a large selloff.
$50 multiplier + $182.50 spread
cost). Bear Portfolio value Compare
S&P 500 Portfoilo put spread (with spread to put
Which is the better move gain/loss profit protection) protection
hedge? 10% $7,250.00 Expires worthless $79,567.50 $52.50
If you compare Figures 1 and 2, 5% $3,625.00 Expires worthless $75,942.50 $52.50
you will notice the trade-off 0% $0.00 Expires worthless $72,317.50 $52.50
between simply buying a long put -5% -$3,625.00 Expires worthless $68,692.50 $52.50
and adding a bear put spread. The -10% -$7,250.00 $3,552.50 $68,620.00 $105.00
long put costs $52.50 more, because -15% -$10,875.00 $3,750.00 $65,192.50 -$3,322.50
the spread lowers costs by selling a -20% -$14,500.00 $3,750.00 $61,567.50 -$6,947.50
further OTM put. However, the
spread does not protect a portfolio
completely if the market drops below its 1,300 short strike. ware, check out Schaeffer Research’s portfolio protection
You can modify both strike prices according to how much calculator in the Market Tools section (http://www.schaef-
risk you are willing to take and how much you are willing fersresearch.com). Although this Web tool uses the S&P 100
to pay for protection. This bear put spread offers 75 points index (OEX) as the underlying asset, the same principles
of protection from 1,375 to 1,300, but you can protect from a apply. 
steeper decline by selling puts below 1,300. As the distance
between strikes widens, the spread offers more protection, For information on the author see p. 6.
but it costs more.
Dozens of software programs and
Web-based tools can model theoretical Related reading
positions, which is the best way to bal-
Article by Charlie and Jes Santaularia:
ance risk and reward. The process resem-
bles an insurance agent adjusting home- “Another look at diagonal spreads,” Options Trader, March 2007.
insurance premiums based on a home’s This position combines bullish and bearish diagonal spreads and is quite
value, amount of protection, credit histo- flexible if you’re willing to adjust its components.
ry, etc.
Tables 2 and 3 compare both protec- Other articles:
tive strategies’ potential gains and losses
at expiration, based on different percent- “The collar trade,” Options Trader, March 2007.
age moves in the E-Mini S&P 500 futures. Collars offer low-cost protection for new or existing long positions.
Table 2 shows the long put limits losses
to $3,985 if the market drops more than “Using options instead of stops,” Options Trader, January 2007.
five percent. By contrast, Table 3 shows Buying options in a volatile market limits risk and offers more flexibility
the bear put spread is only preferable if than simply placing a stop order.
the market doesn’t decline more than 10
percent. “The simplicity of debit spreads,” Options Trader, February 2006.
Both strategies can be adjusted to pro- Using spreads instead of buying options outright can reduce risk and
vide more or less protection, depending increase opportunity. This discussion of “debit” spreads highlights their
on which strikes you select. When just versatility.
buying a put, pick the strike based on
your risk tolerance. When adding a bear “Controlling risks with spreads,” Options Trader, July 2005.
put spread, the level of protection Tired of fighting time decay and volatility fluctuations? Here’s a look at an
depends upon the short put’s strike. The option spread trade that was a much lower-risk alternative to an outright
spread costs more when the short strike purchase.
is further OTM. In both cases, the more
you pay, the more protected your portfo- “Hedging risk with collar trades,” Options Trader, April 2005.
lio will be. Collar trades can help reduce the risk of a stock or futures position —
The key to hedging a portfolio with and lock in gains without wiping out additional profits.
options successfully is to research each
position before you jump in. You don’t You can purchase and download past articles at
necessarily need software, but it helps. If http://www.activetradermag.com/purchase_articles.htm.
your brokerage firm doesn’t offer soft-

FUTURES & OPTIONS TRADER • June 2007 23

 TRADING STRATEGIES

The debit spread option

If some credit spreads are too high risk or not allowed by your options trading level,
a debit bull call spread is a good alternative.

BY JOHN C. LARSEN

D ebit spreads, such as a bull call spread (buy-

ing one call option and selling a higher-strike
call option against it), are typically used by
traders with an intermediate time horizon —
usually somewhere from 60 days to six months until expi-
ration. The high premium paid for the long side of the
spread, a strike at the money or slightly in the money, is par-
ship offers an initial risk-to-reward ratio of approximately
2-to-1.
If the stock moves slowly higher over time, the long
option appreciates and goes deeper in the money as its
intrinsic value increases, thereby driving its delta higher as
well. The short option will also gain, but at a slower rate
with the passage of time; it could maintain its value or even
tially offset by the credit received from the short side of the decrease in value as time decay, a change in perceived risk,
trade, an out-of-the-money strike. or implied volatility puts a damper on any out-of-the-
This creates a spread between the two strike prices, with money options. This is a lower-risk way to trade higher-
the ultimate price objective for the underlying security priced stocks that have higher volatility and higher-priced
being a move to or above the higher strike (over the next options.
couple weeks or months, but well before the expiration Some traders, however, will avoid this scenario because
date). the options that make the most sense for it are too expen-
The maximum gain for the spread is the difference sive. Naturally, the thinking would be that if these options
between the two strikes minus the net debit (cost) of the are too expensive, they should be sold for some premium
spread. As a rule of thumb, traders should look for spreads (i.e., a credit spread). Perhaps that is a better approach.
that cost around one-third of the difference between the two However, some traders may not have the necessary level of
strike prices. The remaining two-thirds is the maximum options trading authorization from their broker to capitalize
profit potential at expiration if the stock is trading at or on credit spreads. Or, they might be intimidated by what is
above the upper strike. This one-third, two-thirds relation- sometimes described as a higher-risk strategy.
Here is the interesting part: Options traders
can and do capitalize on time decay, even
Strategy Snapshot though they are not implementing higher-risk
Strategy: Bull call spread. strategies such as a front-month bull call
spread. Being long premium (i.e., buying
Market: Options on individual stocks, exchanged-traded funds, options) means the stock must move the trad-
indices, and futures contracts. er’s way for the trade to profit. It would only
Rationale: To benefit from time decay and offset the cost of buying make sense that a debit spread, such as the
an in-the-money call. bull call spread, would also need directional
price movement in the trader’s favor.
Time frame: 20 days until expiration. However, front-month bull call spreads
Components: Long front-month in-the-money call. offer short-term swing traders opportunities
to profit from an up move, a non-directional
Short front-month call with higher strike. (sideways) move, or even a modest decline in
To select short strike, subtract weekly average true the price of the stock.
range (ATR) from current price. Buy call one strike below it.
Options 101
Max. profit: Difference between the two strikes minus the spread’s
All call option premiums are made up of two
cost.
components: intrinsic value and time value.
Max. risk: The spread’s cost. The intrinsic value of the call option is the pos-
itive difference between the strike price of the

24 June 2007 • FUTURES & OPTIONS TRADER

FIGURE 1 — CHOOSING THE PROPER OPTIONS

Subtracting Google’s weekly ATR from its stock price tells us to sell the 440 call and buy the 430 call.

Source: GlobalTec

call and the current underlying stock price. with a higher strike.
For example, with the underlying stock trading at $39, a As expiration draws near, the spread will move toward
$35 call option has $4 of intrinsic value. This call may have, its maximum value. This occurs as time decay erodes both
depending on its expiration date, a total premium of, say, options. The long option will lose less value than the time-
$5.50. The other $1.50 is the time value component. The value-heavy short option, and therefore will produce the
more days until expiration, the more time for the underly- profit. A limit order to exit at a net credit 10 to 20 cents
ing stock to move, and the higher the option’s time value below the maximum value of the spread can result in an
will be. early exit with a tidy gain.

The intrinsic value of the call option is Basically, three things can happen with this trade:

the positive difference between the The stock rallies and both call options move deeper
into the money. As this occurs, both options will con-
strike price of the call and the current tinue to increase in intrinsic value and lose their time
value. This is not because of the passage of time (loss
underlying stock price. of time value is, by definition, a function of the passage
of time), but a result of moving deeper in the money.
As time passes, the option may gain intrinsic value if the Deep in-the-money options inherently contain mini-
trader was correct about the direction of the market. mal time value, especially within the current expira-
However, some of its time value will be slowly eroding and tion month. (While all options in a chain with the same
that erosion will accelerate as expiration approaches. expiration do not contain the same time value, ATM
The rate of decay (theta) is not linear. The closer expira- options contain the greatest amount, and as you go
tion draws near, the faster time value shrinks — typically, deeper in and deeper out it gets smaller.) The limit
the final two to three weeks prior to expiration are the worst order to exit may be filled at this point, negating the
for time decay. At expiration, when there is no more time for need to hold the trade until expiration. If held until
the stock to move, the time value of the expiring option will expiration, with the current stock price above both call
be zero. However, that can be a good thing. strikes, both options would expire in the money.
Assignment on the short side is offset by the long posi-
The front-month bull call spread tion, and a small assignment fee could be incurred
In this strategy, the trader buys a deep-in-the-money call from the broker. The spread at this point can be worth
option and sells a call one strike above it. Ideally, both are only the difference between the two strikes, and the
front-month options with less than 20 days remaining until debit to enter the trade was considerably less than that
expiration. The long call should contain very little time amount. This scenario results in a profit.
value (or at least less than the short option), so it needs to be
deeper in the money. The short call is closer to the money, The stock trades sideways and both call options
so it will contain more time value in its premium and there- remain in the money. Both strikes did not change with
fore have more to lose. The difference between those two respect to their intrinsic value, but they have lost all
amounts of time value is the potential profit for the trade. their time value because of time decay. The long call
Determining which strike prices are best is a simple had less to erode than the short call. This is also a prof-
process. Calculate the average true range (ATR) for the itable scenario, by the same amount as the first sce-
stock on a weekly basis (i.e., the last five trading sessions). nario; it just takes a little longer.
Subtracting this ATR from the current stock price should
produce the short call’s strike price. The strike price one The stock drops in value. The stock price can drop to
strike below the sell strike is the one to buy. The deeper in- the short call’s strike price and the spread would still
the-money call option will have a higher premium, but it realize its maximum profit as long as the stock remains
will also contain less time value than the cheaper short call continued on p. 26

FUTURES & OPTIONS TRADER • June 2007 25

 TRADING STRATEGIES continued

above this level at expiration. The Related reading

short strike was found by subtract-
ing the five-day ATR from the cur- “The hidden cost of credit spreads,” Options Trader, May 2006.
rent stock price; this should provide Credit spreads are a popular way to collect premium, but traders often overpay
plenty of wiggle room for the stock. for the long option part of the spread. However, it’s possible to find debit
spreads with the same characteristics that offer less risk and more potential
The stock can actually dip below
profit.
that strike and the trader will still
see some profit. “The simplicity of debit spreads,” Options Trader, February 2006.
The breakeven for the front-month Using spreads instead of buying options outright can reduce risk and increase
bull call spread is the long strike opportunity. This discussion of “debit” spreads highlights their versatility.
price plus the debit or cost of the
spread. “A lower-risk way to generate trading capital”
Options Trader, November 2005.
Trade example If you trade with limited capital, placing low-cost, low-risk option spreads could
Google (GOOG) is trading at $471.44 per improve your odds of success. Bull put and bear call spreads, strangles, and
share. The ATR on a weekly basis is a lit- butterflies help you take advantage of the market without excessive risk.
tle less than $25 a week. There are 15 cal-
“Controlling risks with spreads,” Options Trader, July 2005.
endar days until the front-month options
Tired of fighting time decay and volatility fluctuations? Here’s a look at an
expire. option spread trade that was a much lower-risk alternative to an outright
Subtracting the $25 ATR from the cur- purchase.
rent stock price of just more than $470 per
share identifies $440 as the strike price for “Reducing risk with vertical spreads,” Options Trader, June 2005.
the front-month short call. The current Vertical spreads can help you sidestep the complications of changes in implied
premium of $35.10 indicates $3.66 of time volatility.
value (440 + 35.10 - 471.44 = 3.66), which
will continue to erode right up until expi- You can purchase and download past articles at
ration. http://www.activetradermag.com/purchase_articles.htm
The next-lowest strike is the 430 call,
“The hidden cost of credit spreads” article can be downloaded free at the
which becomes the long side of the
International Securities Exchange’s Web site:
spread. This option is quoted at $44.10, http://www.iseoptions.com/education/ise_education.asp
$2.66 of which is time value. The differ-
ence between the two time value compo-
nents is $1. Subtracted from the spread, this creates a $9 ference of $10. Their intrinsic value did not increase, as
value for the spread (Figure 1). in the first scenario, but their time value eroded to zero
The $1 difference is the maximum profit on the trade and as expiration drew near. So, no movement in the stock
will be realized at expiration as long as the stock is any- price also resulted in the spread going out to $10 and
where above $440 (the short call’s strike). That represents a producing a $1 per contract gain — again, an 11-per-
rate of return of more than 11 percent. cent return.

Scenario review: The stock drops. A $31 per share decline in the stock
price still puts the stock just above the $440 strike and
The stock rallies into expiration. Both options have still offers the same return as the first two scenarios. A
moved deeper in the money, lost all of their time value, move below $440 is not the end of the world, as the real
and are now worth their intrinsic value only. The 430 breakeven for the spread is its cost — $9 plus the long
call will naturally be worth $10 more than the 440 call, strike of $430. So any stock settlement on expiration
so the spread has unwound to $10. The long option lost Friday above $439 means some profit, just not the max-
only $2.66 to time but the short option lost $3.66. At imum.
expiration, regardless of how high the stock has gone A move below $439 should set off warning bells. It
in price, the spread will only be worth $10, but the may be time to admit defeat and look for an exit.
trader paid $9 and therefore realized the maximum
profit of $1 per contract, or 11 percent. The front-month bull call spread is a way for traders with
a lower level of options trading approval to capitalize on
The stock trades in a range until expiration. After 15 time decay. It can be profitable if the stock goes up, down,
days the stock price is basically unchanged. The two or sideways. 
options are still in the money and will only be worth
their remaining net intrinsic value, which will be a dif- For information on the author see p. 6.

26 June 2007 • FUTURES & OPTIONS TRADER

 FUTURES TRADING SYSTEM LAB

FIGURE 1 — KAMA VS. EMA

The KAMA tends to flatten during range-bound trading periods more than the
EMA (dashed line).

KAMA
range trader

Market: Futures.

System concept: Like last month’s

Futures Trading System Lab (“ADX
Consolidation Breakout 1,” Futures &
Options Trader, May 2007), this system
focuses on trading the least interesting
type of the market activity — the trad-
ing range. It does this by executing
short-term trades with a price pattern
after a combination of indicators has
identified suitable range-bound price
action.
Source: Wealth-Lab Kaufman’s Adaptive Moving
Average (KAMA) is a dynamic indica-
FIGURE 2 — SAMPLE TRADES tor developed by Perry Kaufman and
described in his books New Trading
The system trades both sides of the market when a trading range is identified. Systems and Methods (Wiley, 2005). The
KAMA adapts to market conditions by
adjusting the moving average length
when volatility increases or decreases.
It is based on the premise that a noisi-
er, more volatile market should be
traded with a longer moving average
length (a slower “trend speed”) to
avoid unnecessary penetrations of the
moving average. When volatility is
lower, a shorter moving average length
can be used. This system uses the rec-
ommended initial look-back period of
10 for the KAMA.
Figure 1 highlights one of the distin-
guishing characteristics of the KAMA.
While it effectively tracks trend moves,
it also tends to flatten when price
enters a consolidation. The exponential
moving average (EMA) included for
comparison in the chart is less stable
when the market consolidates.
A second indicator, rate of change
(ROC), is applied to the KAMA to find
its percentage change over the look-
Source: Wealth-Lab

28 June 2007 • FUTURES & OPTIONS TRADER

 PERIODIC RETURNS

Percentage Max Max

Avg. Sharpe Best Worst profitable consec. consec.
return ratio return return periods profitable unprofitable
Monthly 0.60% 0.18 13.09% -9.94% 55.83 7 6
Quarterly 1.81% 0.29 30.14% -11.19% 60.49 7 3
Annually 6.84% 0.74 23.90% -10.35% 76.19 5 2

STRATEGY SUMMARY

Profitability Trade statistics

back period. When the ROC of the
KAMA is low (between -0.50 and Net profit ($): 2,720,860.15 No. trades: 3,178
+0.50), it indicates a pause in the Net profit (%): 272.09 Win/loss (%): 37.35
trend. Profit factor: 1.191 Avg. profit/loss (%): 0.15
When these conditions are in place, Payoff ratio: 2.00 Avg. holding time (days): 3.85
the system attempts to enter long on
Recovery factor: 4.99 Avg. profit (winners) %: 2.45
short-term weakness or enter short on
Exposure (%): 2.23 Avg. hold time (winners): 6.44
short-term strength. (The entry signal
is derived from the “Oops!” method- Drawdown Avg. loss (losers) %: -1.22
ology made famous by Larry Max. DD (%): -22.00 Avg. hold time (losers) : 2.30
Williams.) Trades are closed when Longest flat period: 1,290 days Max consec. win/loss: 10/17
price penetrates the two-day high or
low.
LEGEND:
Strategy rules: If the five-day rate Avg. hold time — The average holding period for all trades.
of change (ROC) of the 10-day KAMA Avg. hold time (losers) — The average holding time for losing trades.
is between -0.5 percent and +0.5 per- Avg. hold time (winners) — The average holding time for winning trades.
cent:
Avg. loss (losers) — The average loss for losing trades.
Avg. profit — The average profit for all trades.
1. Enter long tomorrow with a
stop at yesterday’s high if Avg. profit (winners) — The average profit for winning trades.

yesterday’s opening price Avg. return — The average percentage for the period.
was below the previous day’s Best return — Best return for the period.
low. Exposure — The area of the equity curve exposed to long or short positions, as opposed to
cash.
2. Enter short tomorrow with a Longest flat period — Longest period (in days) between two equity highs.
stop at yesterday’s low if
Max consec. profitable — The largest number of consecutive profitable periods.
yesterday’s opening price
Max consec. unprofitable — The largest number of consecutive unprofitable periods.
was above the previous day’s
high. Max consec. win/loss — The maximum number of consecutive winning and losing trades.
Max. DD (%) — Largest percentage decline in equity.
3. Exit long position with a stop Net profit — Profit at end of test period, less commission.
at the lowest low of the past No. trades — Number of trades generated by the system.
two days.
Payoff ratio — Average profit of winning trades divided by average loss of losing trades.
Percentage profitable periods — The percentage of periods that were profitable.
4. Cover short with a stop at the
highest high of the past two Profit factor — Gross profit divided by gross loss.
days. Recovery factor — Net profit divided by max. drawdown.
Sharpe ratio — Average return divided by standard deviation of returns (annualized).
Figure 2 shows several representative Win/loss (%) — The percentage of trades that were profitable.
trades.
Worst return — Worst return for the period.
continued on p. 30

FUTURES & OPTIONS TRADER • June 2007 29

 FUTURES TRADING SYSTEM LAB continued

Money management: Risk 1 percent of account equity Starting equity: $1,000,000 (nominal). Deduct $8 com-
per position. mission and 0.1 percent slippage per trade.

Test data: The system was tested on

FIGURE 3 — EQUITY CURVE
the Futures & Options Trader Standard
The system’s equity curve had a very smooth, steady ascent in the first 10 Futures Portfolio, which contains the
years of trading. 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),
five-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), and T-
Bonds (US). The test used ratio-adjust-
ed data from Pinnacle Data Corp.
(http://www.pinnacledata.com).

Test period: May 1987 to April 2007.

Test results: The system generated

a net profit of 272.1 percent — an annu-
alized gain of 6.8 percent. Considering
the extended (20-year) test period, the
Source: Wealth-Lab performance suggests the system is sta-

FIGURE 4 — DRAWDOWNS
FIGURE 5 — ANNUAL RETURNS
The maximum drawdown was relatively moderate.
There were only two consecutive losing years in the
20-year test period.

Source: Wealth-Lab Source: Wealth-Lab

30 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 6 — PROFIT BREAKDOWN
ble. Figure 3 shows the long and short components comple-
No single market dominated profits, although five
mented each other, resulting in steady equity growth; the markets contributed most of the system’s gains.
individual long and short maximum drawdowns occurred
at different times (not shown). And at -22 percent, the sys-
tem’s overall maximum drawdown was relatively moderate
(Figure 4).
The equity curve was very stable for the first 10 years of
the test. There were only five losing years, and only two con-
secutive losers (Figure 5).
However, there were some weak points. The number of
trades (3,178) was quite large, which means higher transac-
tion costs could significantly degrade system performance.
Also, although the average trade size (0.15 percent) was not
too small, the low percentage of the winning trades (37.4
percent) weighed on performance and raises questions of
trade efficiency.
Figure 6 shows profits were not overly concentrated in a
single market, although five of the portfolio’s 20 markets did
account for the bulk of gains. Figure 7 shows the individual
equity curve of the top-performer, live cattle (LC).

Bottom line: The system’s weak points (high number of

trades and low winning percentage) were offset by steady
performance and low exposure (only 2.23 percent). Traders Source: Wealth-Lab
should certainly experiment with fine-
tuning the system’s entries and exits; FIGURE 7 — BEST-PERFORMING MARKET
doing so could make the system more
The system likes oscillating markets such as live cattle, which was the highest-
appealing from a psychological stand-
returning market in the portfolio.
point.
Another avenue to explore is using
this system to complement a main-
stream trend-following strategy — that
is, to pick up the slack when the latter
system is experiencing one of its
inevitable extended drawdowns.

— Volker Knapp of Wealth-Lab

For information on the author see p. 6.

Futures Lab strategies are tested on a portfolio
basis (unless otherwise noted) using Wealth-Lab
Inc.’s testing platform. If you have a system you’d
like to see tested, please send the trading and
money-management rules to editorial@activetra-
dermag.com.

Disclaimer: The Futures Lab is intended for edu-

cational 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 guar-
antee future results; historical testing may not
reflect a system’s behavior in real-time trading. Source: Reports-Lab

FUTURES & OPTIONS TRADER • June 2007 31

 OPTIONS TRADING SYSTEM LAB

Trading iron condors

with the ADX
FIGURE 1 — IRON CONDOR — RISK PROFILE within one standard deviation of its entry
This iron condor will be profitable if the S&P 500 trades within its first standard price by expiration.
deviation (shaded area) by Feb. 16 expiration. The OTM short call and put have
strikes that are one standard deviation
above and below the market’s current
price, and the long protective options are
10 points further OTM. All four options
are entered in the first available expira-
tion month with at least 24 days until
expiration.
The entire position is a credit spread,
because you receive more premium for
selling options closer to the money than it
costs to buy further OTM options to pro-
tect them. This trade has defined risk, so
you can only lose a certain amount even if
the markets are volatile. The spread
requires margin, which varies among bro-
kers. Most brokers require only the maxi-
mum possible loss (strike-price difference
- credit received) as margin, but some bro-
Source: OptionVue kers require twice as much capital.
Figure 1 shows the potential profits
Market: Options on the S&P 500 (SPX) and Russell 2000 and losses of an iron condor entered on the S&P 500 index on
(RUT) indices. The strategy could also be applied to other Dec. 26, 2006 and held until Feb. 16, 2007. The figure’s shad-
indices, ETFs, and stocks with liquid options contracts. ed area represents the first standard deviation of the S&P 500
index’s expected moves, which means the S&P 500 should
System concept: Over the past year, several Options trade within this price range 68 percent of the time by the
Labs have tested market-neutral strategies such as iron con- Feb. 16 expiration date.
dors, iron butterflies, calendars, and double diagonal Although this iron condor has a 66-percent chance of
spreads on the S&P 500. Although these strategies have been gains, it has an unfavorable risk-reward ratio. Its maximum
profitable since 2001, the positions were always in the mar- potential loss (and required gross margin) is $806, but its
ket, a potential drawback for trades that attempt to capture maximum potential gain is just $206 if held until Feb. 16 —
time decay in flat markets. a risk/reward ratio of nearly 4:1.
This system tests non-directional iron condors with a dif-
ferent approach. Instead of entering positions in any market, Trade rules:
it uses the Average Directional Movement Index (ADX) to Entry
find flat markets. The ADX is an oscillator that ranges 1. Enter an iron condor on the close if the 14-day
between 0 and 100 and is designed to measure whether a ADX drops below 20.
price is trending without regard to the direction of the trend.
Last month’s Futures Lab used the ADX to find price 2. To create an iron condor:
breakouts. Here, the system only places iron condors on the
S&P 500 and Russell 2000 indices whenever the ADX drops A. Sell an OTM call and put at the first strike price
below 20, a low reading that points to a sideways market. above and below the first standard deviation.
The goal: Stay out of trending markets to reduce the possi- This standard deviation is calculated using the
bility of losses. implied volatility of the second month’s
An iron condor contains two vertical credit spreads: a bear at-the-money (ATM) call, which is the nearest
call spread (short out-of-the-money [OTM] call + long, high- call with the highest time premium.
er-strike call) and a bull put spread (short OTM put + long,
lower-strike put). This position tries to exploit the short B. Buy a call and put 10 points further OTM than
options’ time decay and collect premium if the market stays the short strikes.

32 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — IRON CONDOR PERFORMANCE
Entering iron condors and using the ADX to find flat periods in the S&P 500 and
Russell 2000 was a profitable strategy. It gained 75.2 percent in the five-year
test period.

C. All options are the same month

with at least 24 calendar days
until expiration.

Exit the entire position if price touches

one of either short strike. Otherwise, let
all four options expire worthless.

Test details:
• The test account began with $3,000 in
capital.
• Daily closing prices were used.
• Trades were executed between the bid
and ask, when available. Otherwise, Source: OptionVue
theoretical prices were used.
• Commissions were $5 base fee plus STRATEGY SUMMARY
$1 per option. S&P 500 Russell 2000
Overall only only
Test data: The system was tested using cash-settled Net gain ($): 2,256.00 858.00 1,398.00
S&P 500 (SPX) and Russell 2000 (RUT) index options Percentage return (%): 75.2
at the CBOE. Annualized return (%): 12.4
No. of trades: 37 21 16
Test period: Jan. 18, 2001 to Feb. 16, 2007. Winning/losing trades: 26/11 14/7 12/4
Win/loss (%): 70 67 75
Test results: Figure 2 shows the iron condor’s per- Avg. trade ($): 60.97 40.86 87.38
formance, which gained $2,256 (75.2 percent) over the Largest winning trade ($): 276.00 276.00 236.00
five-year test period. The system had an unfavorable Largest losing trade ($): -338.00 -338.00 -283.00
risk-reward ratio and didn’t consider the effect of Avg. profit (winners): 190.08 196.36 182.75
volatility when placing trades. However, it still gained Avg. profit (losers): -244.18 -270.14 -198.75
ground because 70 percent of all trades were winners. Avg. hold time (winners): 39 39 38
The Strategy Summary table shows overall test Avg. hold time (losers): 27 28 25
results and also breaks down profits by market. The Max consec. win/loss: 6/2 4/2 4/1
Russell 2000 accounted for more than two-thirds of all
profits, while the S&P 500 gained just $858. The ADX
LEGEND:
system only entered iron condors on the S&P roughly
four times per year but its performance was similar to Net gain – Gain at end of test period, less commission
the standard approach (see the January 2007 issue of Percent return – Gain or loss on a percentage basis.
Options Trader). Annualized return – Gain or loss on an annualized percentage basis.
No. trades – Number of trades generated by the system
Bottom line: The system’s average loser (-$244.18) No. of winning trades – Number of winners generated by the system
was larger than its average winner ($190.08). No. of losing trades – Number of losers generated by the system
However, this strategy had a definite trading edge,
Win/loss (%) – The percentage of trades that were profitable
especially in the Russell 2000.
Avg. trade – The average profit for all trades
Finally, this test included minimal commissions, but
larger fees and bad fills will likely affect performance. Largest winning trade – Biggest individual profit generated by the system
Largest losing trade – Biggest individual loss generated by the system
— Steve Lentz and Jim Graham of OptionVue Avg. profit (winners) – The average profit for winning trades
Avg. loss (losers) – The average loss for losing trades
Ratio avg. win/ avg. loss – Average winner divided by average loser
Option System Analysis strategies are tested using
OptionVue’s BackTrader module (unless otherwise noted). Avg. hold time (winners) – The average holding time for winning trades
Avg. hold time (losers) – The average holding time for losing trades
If you have a trading idea or strategy that you’d like to see
tested, please send the trading and money-management Max consec. win/loss – The maximum number of consecutive winning
rules to Advisor@OptionVue.com. and losing trades

FUTURES & OPTIONS TRADER • June 2007 33

 TRADER INTERVIEW

Yehuda Belsky:
A market maker’s perspective
This options trader explains why call spreads
may offer better opportunities than put spreads.

BY DAVID BUKEY

Y ehuda Belsky understands how options

behave. After starting his career as a stock
broker at Prime Charter in 1993, he took a job
as a clerk for Timber Hill Group (now
Interactive Brokers), one of the largest options market-mak-
ing firms. In 1995 Belsky, 35, bought a seat on the American
Stock Exchange (AMEX) and became an independent
caught up in the tech bubble in the late 90s and lost money
when stocks fell sharply in 2000 and 2001.
But he has used different approaches over the past six
years. Belsky left the options pit and became a commodity
trading advisor (CTA) in May 2001. Initially, he used a
directional, momentum-based approach to trading stocks,
but the results were mixed. After a 12-percent drawdown in
options market maker, taking the other side of retail cus- 2003, Belsky revamped his strategy and traded various
tomer trades while trying to hedge his positions quickly options spreads for Tradewise Associates, a commodity
and efficiently. pool that gained 14.94 percent from March 2004 to April
The experience was invaluable, because it taught Belsky 2005.
to offset risk, and it also helped him realize that markets “I vowed to stick to what I know and what makes more
placing directional bets could lead to trouble. sense — profiting from [spreads with] favorable probabili-
“As a market marker, I traded around an option’s fair ties,” he says.
value,” he says. “I didn’t have any directional opinion.” In December 2005, Belsky founded Innovative Capital, a
This mindset was much different from investors who got managed futures program. He began trading iron condors,
a market-neutral position that combines
bear call and bull put spreads and gains
FIGURE 1 — INNOVATIVE CAPITAL’S IRON CONDORS VS. S&P 500
ground if the underlying market doesn’t
Innovative Capital's iron condor strategy was profitable, but it began underper- move sharply in either direction by expi-
forming the S&P 500 several months ago. ration. The fund traded options profitably
on S&P 500 futures (Figure 1).
However, Belsky soon focused on call
credit spreads, because the calls’ implied
volatility skew helped him capture pre-
mium as expiration neared. He sells calls
with higher implied volatility and buys
further out-of-the-money (OTM) calls
with lower implied volatility to protect
them. He then hedges any directional risk
with a debit spread in later-expiring calls.
Innovative Capital recently began trad-
ing a combination of call credit and debit
spreads exclusively and no longer trades
puts, so there is no downside risk.
Although you won’t find this unusual
approach in textbooks, it gained 9.89 per-
cent from January to April 2007 (Figure 2).
Source: Innovative Capital (http://www.innovativecta.com) We spoke with Belsky in late May about
his previous role as an options market

34 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — INNOVATIVE CAPITAL’S CALL SPREAD PROGRAM VS. S&P 500
maker and his program’s approach.
Yehuda Belsky began focusing on call spreads in S&P 500 futures earlier this
FOT: Could you describe your role as an year, an approach that gained 9.89 percent through April. By contrast, the S&P
options market maker in the late 90s? I 500 climbed just 4.55 percent during this period.
assume you were trying to buy at the bid
and sell at the offer while hedging your
directional risk. How did you do that?
YB: At the American Stock Exchange,
market makers assist a specialist who
trades specific products — individual
stocks and their options. Specialists are
obligated to provide a two-sided market
(bid and offer) in any option on their
assigned stocks.
A broker can walk into the pit with an
order of any size on any strike. Also, many
multi-contract positions — vertical
spreads, straddles, and strangles — are
quoted at one price. There are more exotic
combinations, from buying one option and
selling another to buying a pair and selling
a third one. The possibilities are almost Source: Innovative Capital (http://www.innovativecta.com)
limitless.
Market makers stand in the pit and also make a two- n’t time to research the best solution.
sided market. We helped the specialist accommodate larger Hedging delta (directional risk) by buying or selling stock
orders. Sometimes we thought a specialist’s price was too was the first task. A better way to hedge is to trade a similar
high or low, and we traded against him. For instance, if a option. For example, if you buy an out-of-the-money call
specialist quotes a bid at $2.00 and an offer at $2.25 and I felt with X deltas, it is more effective to sell a call two or three
that was too cheap, I could quote $2.25 (bid) and $2.50 (offer). strikes above or below it to create a vertical spread. Both
options share common characteristics — implied volatilities
FOT: Did you focus on specific stocks?
YB: I moved around, but I traded options on Philip Morris
(MO), Lucent Technologies (now Alcatel-Lucent, ALU),
As a market marker, I traded around
America Online (AOL), and the Nasdaq 100 tracking stock
(QQQQ), all of which traded heavily. I worked at the height an option’s fair value — I didn’t have
of the technology bubble when the Qs traded above $200
per share. That was exciting. any directional opinion.
FOT: Let’s talk a bit more about the mechanics of being a and time to expiration.
market maker. For instance, if you bought calls at the bid, The busiest time was when there was “two-way paper.”
would you sell stock to hedge the directional risk and then A broker would hit our bid, and another broker was taking
sell calls above the long strike to neutralize the risk of the an offer, which fit us perfectly. We bought one and sold the
Greeks (delta, gamma, theta, vega, rho)? other to create the best type of hedge — a spread instead of
YB: At any time, a market maker needs to buy or sell a sig- trading the stock. That spread would also offset the delta
nificant amount of contracts, which was an invaluable risk, which is the main reason market markers trade stock.
learning experience. The options aren’t always the same —
deeply in-the-money or out-of-the-money, front month or FOT: When you first started as a market maker, were there
far month. You constantly have to be on your toes and times when an option’s behavior surprised you?
understand the sensitivities of each option. YB: There were two events. First, in 1997, the government
Of course, there is always delta risk. If you bought a call was suing Phillip Morris (to recoup health-care costs related to
it has long delta, and if you sell a call it has short delta. But tobacco use), and the stock was very sensitive to verdicts. An
there are minute differences, especially between expiration adverse ruling would send the stock down a lot.
months. Also, skews appear when the option is in- or out- In April 1997, we got orders to sell Philip Morris calls,
of-the-money. which looked cheap. Brokers were willing to sell to us even
These trades weren’t planned, so hands-on hedging was below our bid, which seemed great. Usually, they try to sell
required. Suddenly a broker could offer a two-year option between the bid and ask, and we often paid a few ticks more
that was far out-of-the-money, and I could trade 25, 50, or than our bid. But no one was buying calls, so we couldn’t
100 contracts. I had to hedge appropriately, and there was- continued on p. 36

FUTURES & OPTIONS TRADER • June 2007 35

 TRADER INTERVIEW continued

offset risk with a spread. We could have sold stock, but the ed trading your own account. Did that experience lead to
stock fell sharply when the jury handed down its verdict. any changes in your strategy?
Many market makers were left with unhedged long calls. YB: I wasn’t trading options spreads then. One popular
Lucent Technologies was another example of a one-way strategy involved finding stocks with momentum — I was
market. After it went public in 1998, Lucent’s stock price [trading directionally]. I succeeded for awhile, but I found
nearly doubled in a short amount of time. Market makers that when you are wrong on direction, you can be very
sold calls they thought were overpriced, but they couldn’t wrong.
create a spread (i.e., buy higher-strike calls) or buy stock as a
hedge at a decent price. Acting as a market marker in a one- FOT: Did you start trading options spreads again when you
sided environment isn’t always fun and games. joined Tradewise Associates as a CTA in 2004?
YB: Actually, I began trading ratio spreads (long one option,
Selling options seems easier than short multiple further-OTM options). These spreads were
attractive because you receive premium while keeping the
position balanced. But they have risk on one side, and I
it is. It might take a long time, grew uncomfortable with the risk of an extreme move.
After founding Innovative Capital in December 2005, I
but you’ll eventually get hurt by traded iron condors on the S&P 500 futures. The strategy
combines a bull put spread below the market and a bear
an extraordinary market move. call spread above the market. In January, I began to focus
on trading call spreads only. There were more opportuni-
ties trading calls above the market than trading puts below
FOT: Did the market downturn that began in 2000 take you it.
by surprise?
YB: No. Technology stocks were shooting higher and high- FOT: Why did you stop trading puts and focus on call
er, but I thought they would eventually run out of steam. spreads?
From a mathematical standpoint, market makers empha- YB: Further out-of-the-money puts have higher implied
size the theory of efficient markets: At any given time, the volatilities, so put credit spreads (short put, long lower strike
market is priced efficiently. If you consider time and volatil- put in same month) offer less premium. You sell a put at one
ity, markets have probabilities of where they can move. But implied volatility and buy a lower-strike (and cheaper) put.
we don’t expect any specific direction. However, the long put has a higher implied volatility than
As stock moved more wildly in the late 90s, our volatili- the one you sell. In other words, the long protective put’s
ty assumptions increased, but we were neither bullish nor cost is closer to the short put’s premium, which is a prob-
bearish. We considered each day’s closing price as an effi- lem.
cient absolute value. Stocks surged and then fell sharply in Also, I don’t want downside risk. Investors have enough
2001, but we just took that in stride. That attitude plays a downside risk in other investments. My fund doesn’t par-
big role in how I trade today. ticipate in a downward market. If the market goes down
When clients ask where the market is going, the best one, five, or 50 percent, it doesn’t matter to us.
answer I can give is “I don’t know, because it’s efficiently But on the call side, implied volatilities drop as you look
priced.” That [neutral] mindset and my skills in offsetting further out-of-the-money and as the front-month expira-
risk help me most when trading now. tion nears. You can enter a call credit spread by selling one
out-of-the-money strike and buying higher-strike call at a
FOT: Why did you decide to become a CTA in 2001? lower volatility.
YB: Exchange seats on the AMEX lost more than 90 percent The goal is to capture the discrepancy between both
of their value that year when all equity products were calls’ implied volatility. But that spread has upside direc-
“dually listed” and traded simultaneously on all four tional risk, so I enter a call debit spread (long call, short high-
national options exchanges (AMEX, the Chicago Board er-strike call) in the next month where the skew hasn’t
Options Exchange, the Philadelphia Stock Exchange, and the appeared yet. Ideally, I can sell a front-month credit spread
International Securities Exchange). for the same amount that the next-month’s debit spread
Also, stocks and options began trading in decimals, and costs.
retail interest fell as technology stocks collapsed. At that Both call spreads move in tandem and are near delta-
point, two-way markets that were easy to hedge became neutral. The position is hedged directionally and provides
one-way markets of professional orders that market makers positive theta (i.e., time decay helps). That’s very similar to an
couldn’t benefit from. ideal market marker position.

FOT: I noticed you had some losses in 2003 after you start- FOT: I thought puts had the largest implied-volatility skew

36 June 2007 • FUTURES & OPTIONS TRADER

 FIGURE 3 — TRADE EXAMPLE

In early May, Belsky sold a 1,540/1,550 credit spread in

June calls and bought a corresponding debit spread in July
calls for protection. The S&P 500 climbed from 1,510 to
1,534 by May 21, but the combined spread hadn’t lost
money.
The value of an option is exactly
what traders are willing to pay for it.
You’re not getting any free lunches.
Overall, the position has positive theta. The front-month
credit spread loses value each day. The later-expiring debit
spread also decays a little bit, but not as much because of
the extra time.
At a certain point — usually when the market moves
above the near-term spread’s strikes — they still move
together, and I haven’t lost any money.
When a front-month spread goes into the money, theta
will work against me, which means I pay a debit on a daily
basis. That’s when I want to get out. I exit when the overall
position’s theta turns from positive to negative; its risk-
reward ratio has shifted.

FOT: Is that a good stop-loss point?

YB: It doesn’t always avoid losses. But the overall spread
is usually trading near its entry price, which means I can
get out near the break-even point.

FOT: How do you select strikes for both spreads? Are the
Source: eSignal back-month’s debit spread’s strikes above the correspon-
ding credit spread’s strikes?
in the S&P 500 because investors are willing to pay more for YB: They often are. But both spreads aren’t always a spe-
downside protection. By contrast, S&P 500 calls have cific distance above the
seemed relatively underpriced. Has that dynamic changed? market, and the distance
YB: No. That’s true. I’m just exploiting volatility in a better between each spread’s
way. Calls are underpriced, but to varying degrees. I’m sell- short and long strike
ing a slightly underpriced call and buying a much more isn’t always the same.
underpriced one.
Let’s assume all September options in the S&P 500 FOT: I read that you
futures trade at 15 percent implied volatility. When expira- focus on statistics to
tion is within 30 days, at-the-money calls might trade at 15 pick strikes. Is that simi-
percent implied volatility, and calls that are three and five lar to saying, “Okay, the
percent out-of-the-money might trade at 12 and 10 percent market trades within
implied volatility. When entering the front-month spread, three standard devia-
the higher-strike calls I buy have already lost more volatili- tions of the current
ty than the lower-strike ones I sell. price, so let’s try to sell
strikes far above the
FOT: And how does the next-month debit spread protect it? market?”
YB: I enter the entire position at no cost. The credit spread YB: No. That works if
pays for the next-month’s debit spread. Then, if the short- you want to sell uncov-
term spread expires worthless, you can sell the debit ered calls and you want
spread, which is pure profit. to feel safe the market
isn’t going to climb to
FOT: The S&P 500 has rallied sharply and is flirting with that point. But that’s not
record highs. Are your call spreads vulnerable? our approach. We focus
YB: The goal is for both spreads to move in tandem until on the combined posi-
the front month expires and I exit the next-month’s debit tion. What are the odds
spread. continued on p. 38

FUTURES & OPTIONS TRADER • June 2007 37

 TRADER INTERVIEW continued

of the front-month spread expiring Related reading

profitably?
Selling options seems easier than it “Trading against the pros,” Options Trader, November 2006.
is. To just establish parameters and say Understanding how market makers manage risk may help you get better fills.
the market is not likely to get there is
“The hidden cost of credit spreads,” Options Trader, May 2006.
dangerous. It’s fine as long as the mar-
Credit spreads are a popular way to collect premium, but traders often overpay
ket doesn’t move to that point. It might for the long option part of the spread. However, it’s possible to find debit spreads
take a long time, but you will eventual- with the same characteristics that offer less risk and more potential profit.
ly get hurt by an extraordinary market
move. The value of an option is exactly You can purchase and download past articles at
what traders are willing to pay for it. http://www.activetradermag.com/purchase_articles.htm.
You are not getting any free lunches. The credit spread article can be downloaded free at the International Securities
Exchange’s Web site: http://www.iseoptions.com/education/ise_education.asp
FOT: What is an ideal market for this
strategy — bullish, bearish, or flat?
YB: The program’s largest profits
occur when the S&P 500 is flat or rising slightly. The front- traded at 1,510, and we sold the June 1,540/50 credit spread
month credit spread should expire worthless, and the next- (short 1,540 calls, long 1,550 calls). We also entered a debit
month debit spread should be worth as much as possible. spread in July calls with higher strikes. By May 21, the S&P
However, a down market doesn’t hurt the strategy. The 500 rose from 1,510 to 1,534, and both spreads rose in value
debit spread won’t be worth as much, but it will always (hurting the June credit spread and helping the July debit spread).
have some value. So the position was still flat (Figure 3).
We weren’t betting on the market running out of steam.
FOT: Can you give an example of a recent trade? If the market rallies past 1,550, that would probably trigger
YB: A few weeks ago, the S&P 500 June futures contract an exit, and the position would likely break even.

38 June 2007 • FUTURES & OPTIONS TRADER

 INDUSTRY NEWS

Disagreements in the ranks

CME, ICE sweeten their bids for CBOT

C hicago Board of Trade (CBOT) Chairman

Charles Carey was confident the CBOT’s “merg-
er” with the Chicago Mercantile Exchange
(CME) was all but wrapped up after the CME raised its bid
in May.
not worried about interference from the DOJ.
Regardless, the opinion of the CBOT board of directors —
members who have been with the exchange for years and
see the merger as a way to keep Chicago as the premier
derivatives marketplace in the world — won’t mean much
However, while the new proposal was endorsed by the to a hedge fund manager in Connecticut who owns several
CBOT’s board of directors, many CBOT shareholders may thousand shares of CBOT stock and is only concerned with
not be so easily persuaded. The new bid increases the which deal will provide the higher price.
CME’s offer to about $9.9 billion — about a billion dollars Plus, some CBOT members who are also shareholders
more than its original bid, but still more than a billion dol- believe the CME is vastly undervaluing the exchange. In
lars less than the bid made by the IntercontinentalExchange April, Eurex paid an almost 50-percent premium to buy the
(ICE) in March. International Securities Exchange. The offer presented by
And, the ICE sweetened the pot in late May when it the CME is nowhere near that much of an upgrade from the
struck a deal with the Chicago Board Options Exchange current CBOT stock price.
(CBOE) that would give CBOT members $500,000 in “The word on the floor is that they are trying to low-ball
exchange for their CBOE trading rights. us again,” says one CBOT member. “People are upset that
CBOT claims its members are eligible to benefit from the not only is the Merc not paying market price, but they are
upcoming CBOE IPO because members have always had paying below market. So they’ve not endeared themselves
trading rights at the CBOE. (The CBOE was originally a to the people who have the most amount of votes.”
spin-off from the CBOT.) The CBOE claims that when the Another longtime member says the Merc has annoyed
CBOT enters a merger deal with the Merc, it no longer exists many CBOT shareholders by taking measured steps in
in its original form and therefore cannot participate in the countering the ICE bid, rather than coming back strong
CBOE IPO. The ICE-CBOE agreement, which will only with an offer of a share ratio around 0.40 CME shares per
occur if the CBOT takes the ICE offer, could end any angst CBOT share.
CBOT members have about trading rights. “The burden is on the Merc to get the votes because it’s a
Still, Carey says he and the board of directors believe political issue now,” he says. “The political issue is going to
there is more security in an all-Chicago deal and the Merc is rise or fall on the ratio and how that translates into the stock
better-equipped than the ICE to handle such an enormous price. The general tone is that the current ratio at 0.35 is just
merger. not enough.”
Also, the CME and the CBOT already use the same clear- The CBOT has a member and shareholder meeting sched-
inghouse. The ICE uses the New York Board of Trade clear- uled for July 9, and a vote will take place on the CME offer.
inghouse, and there is some question regarding the NYBOT For its part, the CME added another carrot to sharehold-
system’s capacity. ers, offering to buy back up to $3.5 billion of stock, or 12
Nonetheless, there is still considerable opposition to the percent of outstanding shares, for $560 per share. CME
deal outside the boardroom. shareholders and current CBOT shareholders who would
For starters, some CBOT members aren’t convinced the become CME shareholders under the deal would be eligible
CME and CBOT have completely resolved issues with the to sell their stock under the tender offer.
Department of Justice (DOJ), which announced it was The buyback offer replaces a $3 billion feature of the orig-
investigating the merger and had some concerns about inal proposal that offered some CBOT shareholders cash
clearing. However, CME and CBOT executives say they are instead of CME stock. 

39 June 2007 • FUTURES & OPTIONS TRADER

 INDUSTRY NEWS continued

Less holler for the dollar

Dollar index trading goes electronic

T he electrification of the New York Board of Trade

(NYBOT) by its new owners, the Intercon-
tinentalExchange (ICE) continues.
The ICE announced it would begin trading certain index
futures contracts — including U.S. dollar index futures
able electronically over the next few months.
NYBOT soft commodity futures — cocoa, coffee, cotton,
orange juice, and sugar — began trading side-by-side in
early February. About 60 percent of the NYBOT’s soft con-
tracts trade electronically.
(DX) — electronically beginning June 15. Russell 1000
futures stock index futures, both full-sized and mini, will
also trade electronically on the ICE platform.
Right vs. right
Electronic trading hours will begin at 8 p.m. ET and end
at 4:15 p.m., allowing these futures to trade side-by-side
CBOE suit vs. ISE continues
with their pit-traded counterparts.
The electronic trading has been in beta mode since March
16, with brokers, software and data vendors, and algorith-
mic traders testing the system.
Tom Farley, president and COO of the NYBOT, says there
has been strong interest in trading the dollar index and the
T he Chicago Board Options Exchange (CBOE)
scored a victory over the International Securities
Exchange (ISE) in May when a state court refused
to dismiss the CBOE’s lawsuit against its rival.
The CBOE filed suit against the ISE in 2006 when the lat-
Russell 1000 futures electronically, and the exchange ter began trading S&P 500 and Dow Jones Industrial
expects to increase the number of financial products avail- Average index options. The CBOE claimed the ISE’s action
violated the exclusive agreement the CBOE
had with the two index providers.
MANAGED MONEY The ISE sought to have the suit dis-
missed, but an Illinois court sided with the
Top 10 option strategy traders ranked by April 2007 return
CBOE.
(Managing at least $1 million as of April 30, 2007.)
“We believe the attempt to trade these
2007
April YTD $ under
products without a license — essentially to
Rank Trading advisor return return mgmt. free ride on CBOE’s enormous investment
1. CKP Finance Associates (LOMAX) 14.21 11.58 7.4M in creating these products — is a disincen-
2. Financial Comm Inv (Option Selling) 7.10 8.72 14.1M
tive to innovation,” said CBOE Chairman
and CEO William J. Brodsky in a statement.
3. Quiddity (Earnings Diversification) 7.00 -1.39 23.2M
“We are prepared to vigorously defend our
4. Welton Investment (Alpha Leveraged) 6.58 1.86 15.0M contractual rights with the owners of these
5. Nantucket Hedge Fund 4.17 10.43 2.0M indices, Standard & Poor’s and Dow
6. Oxeye Capital Mgmt. (Crude Oil) 3.75 3.32 9.5M Jones.”
The CBOE filed the lawsuit in Illinois
7. Trading Concept (TC Chronos K ) 3.65 -4.93 1.0M
state court, but the ISE had it moved to
8. Welton Investment (Alpha) 3.44 1.73 15.0M Illinois federal court. However, the federal
9. Daniel J. Bennett (S&P Options) 3.36 7.96 31.0M court ruled the case should be moved back
10. Raithel Inv. (Target Volatility) 1.96 -3.95 6.3M to state court, because there is no federal
jurisdiction over the claims.
Source: Barclay Trading Group (http://www.barclaygrp.com) “It has been CBOE’s firm view that
Illinois state court is the appropriate forum
Based on estimates of the composite of all accounts or the fully funded subset method.
in which to litigate this dispute, and we are
Does not reflect the performance of any single account.
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. gratified by today’s decision,” Brodsky
says.

40 June 2007 • FUTURES & OPTIONS TRADER

Trying again

USFE has new name, game

BY JIM KHAROUF

W ith new ownership and a different outlook, the

U.S. Futures Exchange (USFE) launched its
first contract in April.
The USFE, which was formerly known as Eurex U.S.,
entered the U.S. market space in 2003 intent on competing
first several weeks with just a few dozen contracts bought
and sold, but Man is serious about building a new exchange
with a new focus.
It invested in upgrades to the Eurex trading platform and
is reconnecting former Eurex U.S. member firms. The next
with the Chicago Board of Trade (CBOT) in U.S. treasury step is to bring on more partner firms. In time, USFE execu-
futures, but flamed out spectacularly. tives expect to be innovators in the derivatives space.
The USFE is now majority owned (70 percent) by Man “We definitely aim to be a changing dynamic market-
Group and began trading binary futures contacts on the place, focused on the needs of customers and innovation,”
outcome of the CBOT/Chicago Mercantile Exchange Nandapurkar says. “So it is new asset classes or new ways
(CME)/IntercontinentalExchange (ICE) merger. A binary to trade within asset classes, new events you couldn’t trade
contract pays a fixed amount if the event happens or zero if until now that are binary in nature. You will see us with a
the trader is incorrect. wide range of products a few years from now, in a wide
“One idea that came up months earlier was on mergers range of asset classes.”
— would a merger take place by a certain date after it was However, the USFE is not alone in this product space. In
announced, especially if something was surrounding the late May, HedgeStreet, which is partly owned by the
merger such as Department of Justice issues or other Chicago Board Options Exchange, launched its own set of
things,” says Satish Nandapurkar, CEO of the USFE, who binary options on several possible mergers and acquisition
held the same title with Eurex U.S. “When we saw ICE’s deals. Among the contracts listed were contracts on tie-ups
announcement, it became a two-way play on CBOT. The between Deutsche Boerse and the International Securities
opportunity was there relatively quickly. Exchange, as well as NYSE-ISE and Nasdaq-Philadelphia
“We thought this would be interesting because this is the Stock Exchange.
type of risk in the marketplace that is very hard to hedge.” The USFE, though, hooked up with research firm
Essentially, traders are “predicting,” through the pur- Morningstar in late May to offer futures contracts on 16 of
chase of the contracts, who they think will ultimately gain Morningstar’s indices. The contracts are expected to begin
control of the CBOT. The contract has traded lightly over its trading in the third quarter of 2007.

Three good tools for targeting customers . . .

— CONTACT —
Bob Dorman Allison Ellis Mark Seger
Ad sales East Coast and Midwest Ad sales West Coast and Southwest Account Executive
bdorman@activetradermag.com aellis@activetradermag.com mseger@activetradermag.com
(312) 775-5421 (626) 497-9195 (312) 377-9435

FUTURES & OPTIONS TRADER • June 2007 41

 FUTURES SNAPSHOT (as of May 30)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute
trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility.
See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and
may not reflect total volume for all contract months.
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures
is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
Pit E- 10-day % 20-day % 60-day % Volatility
Market Sym Sym
Exch Vol OI move Rank move Rank move Rank ratio/rank
S&P 500 E-Mini ES
CME 1.16 M 2.03 M 1.69% 89% 2.76% 40% 9.92% 99% .17 / 5%
10-yr. T-note TY ZN
CBOT 1.15 M 2.49 M -0.99% 64% -1.77% 97% -1.93% 98% .52 / 85%
5-yr. T-note FV ZF
CBOT 504.8 1.56 M -0.91% 75% -1.04% 97% -1.76% 98% .46 / 82%
Eurodollar* ED GE
CME 410.7 1.85 M -0.01% 30% -0.03% 40% -0.02% 46% .09 / 0%
30-yr. T-bond US ZB
CBOT 359.0 835.2 -1.12% 42% -1.97% 94% -3.55% 99% .56 / 85%
Nasdaq 100 E-Mini NQ
CME 300.6 449.3 2.07% 69% 1.95% 16% 10.17% 96% .25 / 15%
Crude oil CL NYMEX 213.4 305.4 0.51% 0% -1.41% 37% 5.69% 44% .29 / 25%
2-yr. T-note TU ZT CBOT 203.1 977.3 -0.76% 95% -0.83% 97% -0.90% 98% .32 / 53%
Russell 2000 E-Mini ER CME 189.5 495.9 3.34% 100% 2.96% 62% 11.37% 99% .48 / 71%
Eurocurrency EC 6E CME 152.3 221.1 -1.25% 100% -1.51% 83% 2.37% 36% .13 / 8%
Mini Dow YM CBOT 130.0 119.5 1.62% 35% 3.63% 49% 11.80% 99% .11 / 2%
Japanese yen JY 6J CME 84.6 256.1 -1.28% 50% -1.86% 67% -3.99% 93% .18 / 10%
Gold 100 oz. GC NYMEX 76.5 199.0 -3.17% 80% -3.57% 56% 2.17% 6% .20 / 3%
British pound BP 6B CME 75.2 133.1 -0.48% 24% -1.19% 58% 2.39% 49% .26 / 27%
Corn C ZC CBOT 70.6 252.0 2.91% 60% 4.03% 70% -7.32% 21% .23 / 28%
Swiss franc SF 6S CME 48.8 83.0 -0.92% 50% -1.17% 59% 0.02% 1% .13 / 2%
Natural gas NG NYMEX 45.6 74.1 0.98% 19% 2.89% 22% 9.47% 54% .27 / 43%
RBOB gasoline RB NYMEX 45.4 54.4 -4.46% 67% -2.04% 0% 19.21% 51% .26 / 82%
Sugar SB NYBOT 43.4 341.4 8.32% 100% 2.52% 56% -12.10% 62% .42 / 95%
Soybeans S ZS CBOT 42.8 138.5 3.88% 40% 9.04% 67% 10.26% 25% .23 / 43%
Canadian dollar CD 6C CME 41.5 145.2 2.24% 85% 3.33% 71% 9.62% 98% .31 / 43%
S&P 500 index SP CME 34.8 612.5 1.69% 89% 2.76% 40% 9.93% 99% .17 / 7%
Australian dollar AD 6A CME 32.1 111.9 -1.18% 71% -0.70% 36% 6.16% 86% .09 / 0%
Heating oil HO NYMEX 29.6 48.9 -0.87% 14% -0.48% 15% 8.64% 42% .20 / 3%
Gold 100 oz. ZG CBOT 28.9 25.1 -3.20% 80% -3.60% 59% 1.08% 1% .19 / 0%
Wheat W ZW CBOT 21.7 105.4 1.71% 44% 4.55% 53% 11.14% 67% .72 / 80%
Soybean oil BO ZL CBOT 21.1 99.1 2.77% 25% 6.50% 64% 20.75% 97% .17 / 7%
S&P MidCap 400 E-Mini ME CME 20.2 90.8 2.17% 100% 2.63% 40% 10.83% 99% .23 / 35%
Silver 5,000 oz. SI NYMEX 19.5 53.7 -0.71% 5% -0.19% 2% 3.69% 10% .24 / 28%
Soybean meal SM ZM CBOT 19.2 50.9 4.13% 33% 9.44% 70% 1.55% 1% .21 / 43%
Mexican peso MP 6M CME 15.1 91.3 0.43% 11% 1.73% 72% 3.43% 94% .22 / 32%
Crude oil e-miNY QM NYMEX 14.5 6.1 0.51% 11% -1.41% 42% 5.69% 45% .30 / 25%
Live cattle LC LE CME 13.6 75.9 -2.60% 57% -3.38% 53% -7.07% 100% .29 / 48%
Cotton CT NYBOT 12.1 119.5 5.51% 78% 4.48% 100% -5.03% 36% .27 / 46%
Coffee KC NYBOT 9.7 70.4 3.77% 43% 6.20% 75% -0.13% 0% .23 / 40%
Nikkei 225 index NK CME 9.4 56.0 1.03% 58% 2.22% 61% 4.67% 56% .25 / 15%
Copper HG NYMEX 8.5 29.4 -6.61% 42% -8.63% 91% 24.29% 35% .14 / 3%
Fed Funds** FF ZQ CBOT 8.2 63.3 -0.01% 0% -0.01% 0% -0.01% 4% .74 / 100%
Cocoa CC NYBOT 5.9 62.3 -1.21% 60% 2.40% 18% 5.56% 3% .24 / 37%
Lean hogs LH HE CME 5.8 22.9 0.97% 100% -1.02% 16% 15.81% 85% .07 / 0%
Mini-sized gold YG CBOT 5.7 5.9 -3.20% 80% -3.60% 59% 1.08% 1% .19 / 0%
Silver 5,000 oz. ZI CBOT 5.2 7.3 -0.72% 10% -1.05% 8% 2.66% 4% .25 / 31%
Dow Jones Ind. Avg. DJ ZD CBOT 5.2 45.9 1.62% 35% 3.63% 49% 11.80% 99% .11 / 2%
Nasdaq 100 index ND CME 4.2 57.3 2.07% 69% 1.95% 16% 10.17% 96% .25 / 15%
Natural gas e-miNY QG NYMEX 3.5 3.1 0.98% 13% 2.89% 24% 9.64% 50% .20 / 20%
New Zealand dollar NE 6N CME 2.4 25.2 -0.88% 55% -1.31% 40% 7.04% 84% .11 / 30%
U.S. dollar index DX NYBOT 2.2 33.3 0.84% 94% 1.13% 69% -1.98% 45% .08 / 0%
*Average volume and open interest based on highest-volume contract (December 2007)
**Average volume and open interest based on highest-volume contract (August 2007)

Legend (10-day moves, 20-day moves, etc.) show the of 100 percent means the current reading is
Vol: 30-day average daily volume, in thou- percentile rank of the most recent move to a larger than all the past readings, while a read-
sands (unless otherwise indicated). certain number of the previous moves of the ing of 0 percent means the current reading is
same size and in the same direction. For smaller than the previous readings. These fig-
OI: Open interest, in thousands (unless other-
example, the “% Rank” for 10-day move ures provide perspective for determining how
wise indicated).
shows how the most recent 10-day move relatively large or small the most recent price
10-day move: The percentage price move compares to the past twenty 10-day moves; move is compared to past price moves.
from the close 10 days ago to today’s close. for the 20-day move, the “% Rank” field shows Volatility ratio/rank: The ratio is the short-
20-day move: The percentage price move how the most recent 20-day move compares term volatility (10-day standard deviation of
from the close 20 days ago to today’s close. to the past sixty 20-day moves; for the 60-day prices) divided by the long-term volatility (100-
60-day move: The percentage price move move, the “% Rank” field shows how the most day standard deviation of prices). The rank is
from the close 60 days ago to today’s close. recent 60-day move compares to the past the percentile rank of the volatility ratio over
The “% Rank” fields for each time window one-hundred-twenty 60-day moves. A reading 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 June 2007 • FUTURES & OPTIONS TRADER
 OPTIONS RADAR (as of May 31)
MOST-LIQUID INSTRUMENTS*
Options Open 10-day % 20-day % IV/SV IV/SV ratio —
Indices Symbol Exchange volume interest move rank move rank ratio 20 days ago
Nasdaq 100 index NDX CBOE 626.6 307.3 1.94% 57% 2.04% 16% 15.6% / 13% 14.4% / 12.1%
S&P 500 index SPX CBOE 159.7 1.21 M 1.09% 47% 2.32% 16% 11.4% / 9.4% 11.3% / 9.6%
E-Mini S&P 500 ES CME 26.7 148.5 1.04% 53% 2.18% 13% 10.3% / 10% 11.2% / 9.8%
S&P 100 index OEX CBOE 24.8 140.6 0.93% 25% 2.33% 18% 10.9% / 9% 11.2% / 9.3%
S&P 500 futures SP CME 17.2 176.8 1.05% 58% 2.19% 13% 10.1% / 9% 11.1% / 9.2%

Stocks
3M Company MMM 8.49 M 212.4 2.27% 15% 4.19% 40% 17.3% / 17% 15.8% / 16.6%
Neurochem NRMX 3.05 M 802.7 1.56% 0% -35.50% 62% 178.2% / 147.5% 161.4% / 110.2%
Elan Corp ADS ELN 1.23 M 241.2 30.77% 100% 39.17% 100% 45.7% / 52.7% 54.3% / 35.2%
MasterCard MA 1.22 M 145.5 9.81% 50% 18.36% 60% 32.1% / 38.3% 27.9% / 20%
American Intl Group AIG 1.22 M 274.5 -0.17% 25% 2.73% 34% 12.6% / 11.8% 14.7% / 12.4%

Futures
Eurodollar ED-GE CME 500.2 10.08 M -0.01% 30% -0.03% 40% 9.1% / 1.1% 11.9% / 3%
10-yr. T-note TY-ZN CBOT 115.1 1.58 M -1.03% 80% -1.79% 97% 3.8% / 3.5% 3.7% / 3.5%
Crude oil CL NYMEX 61.4 730.5 2.67% 22% 0.85% 15% 26.6% / 24.5% 27.3% / 26.8%
5-yr. T-note FV-ZF CBOT 38.1 405.0 -0.93% 100% -1.05% 97% 2.7% / 2.3% 2.7% / 2.4%
Corn C-ZC CBOT 36.2 964.4 3.78% 73% 4.89% 83% 40.7% / 30.3% 39.8% / 41.7%

VOLATILITY EXTREMES**
Indices — High IV/SV ratio
Dow Jones index DJX CBOE 8.7 151.2 1.04% 5% 3.15% 29% 11.2% / 9.1% 10.8% / 10.2%
S&P 500 index SPX CBOE 159.7 1.21 M 1.09% 47% 2.32% 16% 11.4% / 9.4% 11.3% / 9.6%
S&P 100 index OEX CBOE 24.8 140.6 0.93% 25% 2.33% 18% 10.9% / 9% 11.2% / 9.3%
Nasdaq 100 index NDX CBOE 626.6 307.3 1.94% 57% 2.04% 16% 15.6% / 13% 14.4% / 12.1%
S&P 100 index XEO CBOE 5.2 33.8 0.93% 25% 2.33% 18% 10.6% / 8.9% 10.9% / 9.8%

Indices — Low IV/SV ratio

Oil service index OSX PHLX 3.2 53.5 3.40% 32% 5.90% 27% 26.2% / 29.7% 25.8% / 24%
Russell 2000 Index RUT CBOE 12.9 402.0 3.29% 93% 2.26% 44% 16% / 16.5% 16.2% / 11.2%

Stocks — High IV/SV ratio

Kraft Foods KFT 4.2 218.3 3.27% 90% 1.68% 25% 22.5% / 12.7% 18.8% / 22.8%
Bristol-Myers Squibb BMY 4.6 653.6 0.76% 24% 5.61% 65% 27.8% / 16.6% 23.9% / 29.9%
Rambus RMBS 1.3 118.8 -0.94% 0% -4.65% 18% 41.5% / 25.8% 42.4% / 31.5%
Penwest Pharmas PPCO 1.9 66.0 3.01% 35% 7.53% 24% 69.8% / 45.7% 73.1% / 70.9%
MGIC Investment MTG 4.8 116.5 -1.02% 100% 4.30% 28% 31.1% / 20.8% 26.6% / 34.1%

Stocks — Low IV/SV ratio

Alltel AT 1.7 211.1 4.40% 50% 7.87% 83% 10.8% / 18.1% 28.5% / 19.7%
Fremont General FMT 3.3 124.3 87.68% 100% 67.93% 100% 63% / 98.9% 90.4% / 95.2%
Foster Wheeler FWLT 1.2 6.8 10.38% 40% 51.77% 98% 39.5% / 57.6% NA
GameStop GME 1.3 33.0 4.91% 31% 9.41% 57% 31.5% / 44.3% 31.9% / 31.3%
ValueClick VCLK 3.9 21.7 14.68% 22% 6.89% 44% 49.7% / 69.4% NA

Futures — High IV/SV ratio

Eurodollar ED-GE CME 500.2 10.08 M -0.01% 30% -0.03% 40% 9.1% / 1.1% 11.9% / 3%
Japanese yen JY-6J CME 4.8 72.1 -1.00% 30% -1.64% 51% 6.3% / 4.1% 7.4% / 6.7%
Soybeans S-ZS CBOT 16.6 213.7 1.72% 10% 9.81% 75% 24.5% / 16.5% 22.1% / 21%
Coffee KC NYBOT 10.0 134.1 1.78% 13% 6.64% 77% 29.2% / 21.5% 27.3% / 22.6%
Lean hogs LH CME 1.3 20.8 -0.69% 36% -0.66% 12% 18.7% / 13.8% 18.8% / 17.5%

Futures — Low IV/SV ratio

Sugar SB NYBOT 19.6 415.8 7.03% 83% 1.64% 22% 25.8% / 37.5% 26.2% / 26%
Gold 100 oz. GC NYMEX 9.0 120.5 0.79% 100% -1.24% 16% 12.9% / 15.8% 13.9% / 15.1%
Silver 5,000 oz. SI NYMEX 4.5 31.3 4.18% 100% 1.01% 5% 18.8% / 22% 23.4% / 26.1%
Cotton CT NYBOT 9.4 155.0 3.68% 60% 4.90% 100% 22.7% / 26% 21.3% / 24.1%
* Ranked by volume ** Ranked based on high or low IV/SV values.
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 underlying’s percentage price move from the close 10 days ago to today’s close.
20-day move: The underlying’s percentage price move from the close 20 days ago to today’s close. The “% Rank” fields for each time window (10-day moves,
20-day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For exam-
ple, the “% Rank” for 10-day moves shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “% Rank”
field shows how the most recent 20-day move compares to the past sixty 20-day moves.

FUTURES & OPTIONS TRADER • June 2007 43

 FUTURES
GLOBAL & OPTIONS
ECONOMIC CALENDAR
CALENDAR JUNE/JULY
MONTH

June 20 LTD: June T-bond futures (CBOT); July

Legend
crude oil futures (NYMEX); July platinum
1 May unemployment
CPI: Consumer Price Index options (NYMEX)
LTD: July cocoa options (NYBOT); June
ECI: Employment cost index live cattle options (CME) 21 FND: July coffee futures (NYBOT)
First delivery day (FDD): FDD: June T-bond futures (CBOT); June
The first day on which deliv-
22 LTD: July T-bond options (CBOT); July
coal, natural gas, and crude oil futures
ery of a commodity in fulfill- oats, rice, wheat, corn, soybean
(NYMEX); June aluminum, palladium,
ment of a futures contract can products, and soybean options (CBOT)
take place. copper, platinum, silver, and gold futures
FND: July crude oil futures (NYMEX)
(NYMEX)
First notice day (FND): Also 23
known as first intent day, this 2
is the first day a clearing- 24
house can give notice to a
3
25 FND: July cotton futures (NYBOT)
buyer of a futures contract 4 FND: June propane, gasoline, and
that it intends to deliver a heating oil futures (NYMEX); June live 26 LTD: July coal futures (NYMEX); July
commodity in fulfillment of a cattle futures (CME) natural gas, gasoline, and heating oil
futures contract. The clearing- options (NYMEX); July aluminum,
house also informs the seller. 5 copper, silver, and gold options
FOMC: Federal Open Market 6 FDD: June propane futures (NYMEX) (NYMEX)
Committee
GDP: Gross domestic
7 FDD: June live cattle futures (CME) 27 FOMC meeting
LTD: July natural gas futures (NYMEX);
product 8 April trade balance
June aluminum, palladium, copper,
ISM: Institute for supply man- LTD: June currency options (CME); June
agement silver, and gold futures (NYMEX)
U.S. dollar index options (NYBOT); July
FND: July coal futures (NYMEX)
LTD: Last trading day; the sugar and coffee options (NYBOT)
first day a contract may trade FDD: June gasoline and heating oil 28 Q1 GDP (final)
or be closed out before the futures (NYMEX) FOMC meeting
delivery of the underlying LTD: June platinum futures (NYMEX);
asset may occur. 9
June milk options (CME)
PPI: Producer price index 10 FND: July natural gas futures (NYMEX)
Quadruple witching Friday: 11
A day where equity options, 29 LTD: July propane, gasoline, and
equity futures, index options, 12 heating oil futures (NYMEX); July sugar
and index futures all expire. futures (NYBOT); June live cattle futures
13
(CME)
14 May PPI FND: July aluminum, palladium, copper,
JUNE 2007
LTD: All June equity options and futures; platinum, silver, and gold futures
27 28 29 30 31 1 2 June S&P futures and options (CME); (NYMEX); July oats, rice, wheat, corn,
3 4 5 6 7 8 9 June Nasdaq futures and options (CME); soybean products, and soybean futures
10 11 12 13 14 15 16 June Russell futures and options (CME); (CBOT)
17 18 19 20 21 22 23 June Dow Jones futures and options
(CBOT); June lean hog futures and
30
24 25 26 27 28 29 30
options (CME) 31
15 May CPI JULY
JULY 2007
Quadruple witching Friday 1
1 2 3 4 5 6 7 LTD: July crude oil options (NYMEX);
8 9 10 11 12 13 14 July orange juice options (NYBOT); July
2
15 16 17 18 19 20 21 cotton options (NYBOT); July Goldman 3
22 23 24 25 26 27 28 Sachs commodity index options (CME)
4 Markets closed — Independence Day
29 30 31 1 2 3 4 16 5
17 6 June unemployment
18 LTD: June currency futures (CME) LTD: July currency options (CME); July
FND: July cocoa futures (NYBOT) U.S. dollar index options (NYBOT);
The information on this page is
August cocoa options (NYBOT); July
subject to change. Futures &
Options Trader is not responsible
19
pork belly options (CME)
for the accuracy of calendar dates
beyond press time.

44 June 2007 • FUTURES & OPTIONS TRADER

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markets and deliver region-specific financial news supplied businesses to announce new products and upgrades. Listings are
by COMTEX, AFX, and RTT News. Mobile Quote.com adapted from press releases and are not endorsements or recommen-
offers stock, futures, forex, and mutual fund quotes, includ- dations from the Active Trader Magazine Group. E-mail press releas-
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cell phone, PDA, or Smartphone with access to the Internet. anteed.

FUTURES & OPTIONS TRADER • June 2007 45

 KEY CONCEPTS The option “Greeks”
Delta: The ratio of the movement in the option price for
Account equity: Value of account, which includes cash every point move in the underlying. An option with a
and investments. delta of 0.5 would move a half-point for every 1-point
move in the underlying stock; an option with a delta of
American style: An option that can be exercised at any 1.00 would move 1 point for every 1-point move in the
time until expiration. underlying stock.

Assign(ment): When an option seller (or “writer”) is Gamma: The change in delta relative to a change in the
obligated to assume a long position (if he or she sold a put) underlying market. Unlike delta, which is highest for
or short position (if he or she sold a call) in the underlying deep ITM options, gamma is highest for ATM options
stock or futures contract because an option buyer exercised and lowest for deep ITM and OTM options.
the same option.
Theta: The rate at which an option loses value each day
(the rate of time decay). Theta is relatively larger for
At the money (ATM): An option whose strike price is
OTM than ITM options, and increases as the option gets
identical (or very close) to the current underlying stock (or
closer to its expiration date.
futures) price.
Rho: The change in option price relative to the change
Average directional movement index (ADX): in the interest rate.
Measures trend strength, regardless of direction. The high-
er the ADX value, the stronger the trend, whether the mar- Vega: How much an option’s price changes per a one-
ket is going up or down. The indicator can be applied to any percent change in volatility.
time frame, although it is typically used on daily charts.
Although the ADX concept is straightforward, its calcu-
lation is rather lengthy. The indicator was designed by absolute value of the difference between the +DI value
Welles Wilder and is described in detail in his book New and the -DI value, dividing that by the sum of the +DI
Concepts in Technical Trading Systems (Trend Research 1978). and -DI values, and multiplying by 100.

Calculation: 6. To create the ADX, calculate a moving average of the

1. Calculate the positive or negative directional move- DX over the same period as the lookback period used
ment (+DM and -DM) for each bar in the desired look- throughout the other calculations.
back period. Bars that make higher highs and higher
lows than the previous bar have positive directional Bear call spread: A vertical credit spread that consists
movement. Bars that make lower highs and lower lows of a short call and a higher-strike, further OTM long call in
than the previous bar have negative directional move- the same expiration month. The spread’s largest potential
ment. gain is the premium collected, and its maximum loss is lim-
If a bar has both a higher high and a lower low than ited to the point difference between the strikes minus that
the previous bar, it has positive directional premium.
movement if its high is above the previous high more
than its low is below the previous low. Reverse this Bear put spread (call credit spread): A bear debit
criterion for negative directional movement. An inside spread that contains puts with the same expiration date but
bar (a bar that trades within the range of the different strike prices. You buy the higher-strike put, which
previous bar) has no directional movement, and nei- costs more, and sell the cheaper, lower-strike put.
ther does a bar whose high is above the previous high
by the same amount its low is below the previous low. Beta: Measures the volatility of an investment compared
to the overall market. Instruments with a beta of one move
2. If a bar has positive (negative) directional move- in line with the market. A beta value below one means the
ment, the absolute value of the distance between instrument is less affected by market moves and a beta
today’s high (low) and yesterday’s high (low) is added value greater than one means it is more volatile than the
to the running totals of +DM (-DM) calculated over a overall market. A beta of zero implies no market risk.
given lookback period (i.e., 20 bars, 30 bars, etc.). The
absolute value is used so both +DM and -DM are pos- Bull call spread: A bull debit spread that contains calls
itive values. with the same expiration date but different strike prices.
You buy the lower-strike call, which has more value, and
3. Calculate the sum of the true ranges for all bars in sell the less-expensive, higher-strike call.
the lookback period.
Bull put spread (put credit spread): A bull credit
4. Calculate the Directional Indicator (+DI and -DI) by spread that contains puts with the same expiration date, but
dividing the running totals of +DM and -DM by the different strike prices. You sell an OTM put and buy a less-
sum of the true ranges. expensive, lower-strike put.

5. Calculate the directional index (DX) by taking the Butterfly: A non-directional trade consisting of options

46 June 2007 • FUTURES & OPTIONS TRADER

with three different strike prices at equidistant intervals:
Long one each of the highest and lowest strike price options European style: An option that can only be exercised at
and short two of the middle strike price options. expiration, not before.

Calendar spread: A position with one short-term short Exercise: To exchange an option for the underlying
option and one long same-strike option with more time instrument.
until expiration. If the spread uses ATM options, it is mar-
ket-neutral and tries to profit from time decay. However, Expiration: The last day on which an option can be exer-
OTM options can be used to profit from both a directional cised and exchanged for the underlying instrument (usual-
move and time decay. ly the last trading day or one day after).

Call option: An option that gives the owner the right, but Exponential moving average (EMA): The simple
not the obligation, to buy a stock (or futures contract) at a moving average (SMA) is the standard moving average cal-
fixed price. culation that gives every price point in the average equal
emphasis, or weight. For example, a five-day SMA is the
Carrying costs: The costs associated with holding an sum of the most recent five closing prices divided by five.
investment that include interest, dividends, and the oppor- Weighted moving averages give extra emphasis to more
tunity costs of entering the trade. recent price action. Exponential moving average (EMA)
weights prices using the following formula:
Covered call: Shorting an out-of-the-money call option
against a long position in the underlying market. An exam- EMA = SC * Price + (1 - SC) * EMA(yesterday)
ple would be purchasing a stock for $50 and selling a call where
option with a strike price of $55. The goal is for the market SC is a “smoothing constant” between 0 and 1, and
to move sideways or slightly higher and for the call option EMA(yesterday) is the previous day’s EMA value.
to expire worthless, in which case you keep the premium.
You can approximate a particular SMA length for an
Credit spread: A position that collects more premium EMA by using the following formula to calculate the equiv-
from short options than you pay for long options. A credit alent smoothing constant:
spread using calls is bearish, while a credit spread using
puts is bullish. SC = 2/(n + 1)
where
Deep (e.g., deep in-the-money option or deep n = the number of days in a simple moving average of
out-of-the-money option): Call options with strike approximately equivalent length.
prices that are very far above the current price of the under-
lying asset and put options with strike prices that are very For example, a smoothing constant of 0.095 creates an
far below the current price of the underlying asset. exponential moving average equivalent to a 20-day SMA
(2/(20 + 1) = 0.095). The larger n is, the smaller the constant,
Delta-neutral: An options position that has an overall and the smaller the constant, the less impact the most recent
delta of zero, which means it’s unaffected by underlying price action will have on the EMA. In practice, most soft-
price movement. However, delta will change as the under- ware programs allow you to simply choose how many days
lying moves up or down, so you must buy or sell you want in your moving average and select either simple,
shares/contracts to adjust delta back to zero. weighted, or exponential calculations.

Diagonal spread: A position consisting of options with In the money (ITM): A call option with a strike price
different expiration dates and different strike prices — e.g., below the price of the underlying instrument, or a put
a December 50 call and a January 60 call. option with a strike price above the underlying instru-
ment’s price.
Double diagonal spread: A double diagonal resembles
an iron condor (call credit spread + put credit spread), but Intrinsic value: The difference between the strike price
the long side of each spread expires in a later month. This of an in-the-money option and the underlying asset price. A
position combines two diagonal spreads on either side of call option with a strike price of 22 has 2 points of intrinsic
the market and tries to exploit the time decay of the short, value if the underlying market is trading at 24.
near-term options. It collects the most profit if the market
trades sideways by expiration. Iron condor: A market-neutral position that enters a bear
To construct a double diagonal, enter two spreads simul- call spread (OTM call + higher-strike call) above the market
taneously: a call spread, which consists of a short out-of- and a bull put spread (OTM put + lower-strike put) below
the-money call and a long, higher-strike call in a further the market. Both spreads collect premium, and profit when
month; and a put spread, which consists of a short OTM put the market trades between the short strikes by expiration.
and a long, lower-strike put in a more-distant month. Both All options share the same expiration month.
spread’s short options share the same expiration month,
and the long options expire together at least one month Kaufman’s Adaptive Moving Average (KAMA):
later. continued on p. 48

FUTURES & OPTIONS TRADER • June 2007 47

 KEY CONCEPTS continued

This dynamic moving average technique was developed by tum extremes (overbought or oversold points).
Perry J. Kaufman and described in his books Smarter The most common calculation for momentum is simply
Trading (McGraw-Hill, 1995) and New Trading Systems and today’s price (typically the closing price) minus the price n
Methods (Fourth Edition, John Wiley & Sons, 2005). Its days ago:
underlying concept is that a “noisy” market requires a (Ptoday – Pn days ago).
longer-term moving average than one with less noise — i.e., The most basic ROC formula is today’s price divided by
in choppy market conditions, price will repeatedly pene- the price n days ago:
trate a too-short moving average. (Ptoday/Pn days ago).
The KAMA uses an exponential smoothing formula to Alternate calculations for rate of change are 100*(Ptoday
adjust the moving average length (which the author limits /Pn days ago) or (Ptoday – Pn days ago)/Pn days ago.
to two periods at the shortest on 30 periods at the longest): Except for scaling, the resulting momentum and ROC indi-
cators are the same; momentum simply expresses price
KAMAt = KAMAt-1 + sct * (Price - KAMAt-1) change as the difference between two prices, while ROC
expresses price change as a percentage or ratio.
where
KAMAt = the new adaptive moving average value Naked (uncovered) puts: Selling put options to collect
KAMAt-1 = the previous adaptive moving average value premium that contains risk. If the market drops below the
Price = the current price (for period t) short put’s strike price, the holder may exercise it, requiring
sct = the smoothing constant, calculated each period as: you to buy stock at the strike price (i.e., above the market).
sct = [ERt * (fastest - slowest) + slowest]2
Open interest: The number of options that have not
and been exercised in a specific contract that has not yet expired.

fastest = 2/(fastest moving average period +1) Out of the money (OTM): A call option with a strike
slowest = 2/(slowest moving average period + 1) price above the price of the underlying instrument, or a put
option with a strike price below the underlying instru-
ERt = |Pricet - Pricett-n| ment’s price.

t-n Parity: An option trading at its intrinsic value.

∑ |Pricei - Pricei-n|
i=1 Premium: The price of an option.

“Fastest” and “slowest” refer to the shortest and longest Put option: An option that gives the owner the right, but
look-back periods allowed for the average, by default set to not the obligation, to sell a stock (or futures contract) at a
two and 30 periods, respectively. fixed price.

Lock-limit: The maximum amount that a futures contract Put spreads: Vertical spreads with puts sharing the same
is allowed to move (up or down) in one trading session. expiration date but different strike prices. A bull put spread
contains long, higher-strike puts and short, lower-strike
Long-Term Equity AnticiPation Securities puts. A bear put spread is structured differently: Its long
(LEAPS): Options contracts with much more distant expi- puts have higher strikes than the short puts.
ration dates — in some cases as far as two years and eight
months away — than regular options. Ratio spread: A ratio spread can contain calls or puts and
includes a long option and multiple short options of the
Market makers: Provide liquidity by attempting to prof- same type that are further out-of-the-money, usually in a
it from trading their own accounts. They supply bids when ratio of 1:2 or 1:3 (long to short options). For example, if a
there may be no other buyers and supply offers when there stock trades at $60, you could buy one $60 call and sell two
are no other sellers. In return, they have an edge in buying same-month $65 calls. Basically, the trade is a bull call
and selling at more favorable prices. spread (long call, short higher-strike call) with the sale of
additional calls at the short strike.
Momentum (or “price momentum”): A generic term Overall, these positions are neutral, but they can have a
used to describe the rate at which price changes as well the directional bias, depending on the strike prices you select.
name of a specific calculation. Rate of change (ROC) is Because you sell more options than you buy, the short
simply an alternate version of this basic indicator. The options usually cover the cost of the long one or provide a
implications and interpretations of these two studies are net credit. However, the spread contains uncovered, or
identical. “naked” options, which add upside or downside risk.
Momentum/ROC are similar to oscillators, such as the
relative strength index (RSI) and stochastics, in that they are Straddle: A non-directional option spread that typically
generally intended to highlight shorter-term price momen- consists of an at-the-money call and at-the-money put with

48 June 2007 • FUTURES & OPTIONS TRADER

the same expiration. For example, with the underlying Concepts in Technical Trading Systems (Trend Research, 1978).
instrument trading at 25, a standard long straddle would True range can be calculated on any time frame or price
consist of buying a 25 call and a 25 put. Long straddles are bar — five-minute, hourly, daily, weekly, etc. The following
designed to profit from an increase in volatility; short strad- discussion uses daily price bars for simplicity.
dles are intended to capitalize on declining volatility. The True range is the greatest (absolute) distance of the following:
strangle is a related strategy.
1. Today’s high and today’s low.
Strangle: A non-directional option spread that consists of 2. Today’s high and yesterday’s close.
an out-of-the-money call and out-of-the-money put with 3. Today’s low and yesterday’s close.
the same expiration. For example, with the underlying
instrument trading at 25, a long strangle could consist of Average true range (ATR) is simply a moving average of
buying a 27.5 call and a 22.5 put. Long strangles are the true range over a certain time period. For example, the
designed to profit from an increase in volatility; short stran- five-day ATR would be the average of the true range calcu-
gles are intended to capitalize on declining volatility. The lations over the last five days.
straddle is a related strategy.
Vertical spread: A position consisting of options with
Strike (“exercise”) price: The price at which an under- the same expiration date but different strike prices (e.g., a
lying instrument is exchanged upon exercise of an option. September 40 call option and a September 50 call option).

Time decay: The tendency of time value to decrease at an Volatility: The level of price movement in a market.
accelerated rate as an option approaches expiration. Historical (“statistical”) volatility measures the price fluctu-
ations (usually calculated as the standard deviation of clos-
Time spread: Any type of spread that contains short ing prices) over a certain time period — e.g., the past 20
near-term options and long options that expire later. Both days. Implied volatility is the current market estimate of
options can share a strike price (calendar spread) or have future volatility as reflected in the level of option premi-
different strikes (diagonal spread). ums. The higher the implied volatility, the higher the option
premium.
Time value: The amount of an option’s value that is a
function of the time remaining until expiration. As expira- Volatility skew: The tendency of implied option volatil-
tion approaches, time value decreases at an accelerated rate, ity to vary by strike price. Although, it might seem logical
a phenomenon known as “time decay.” that all options on the same underlying instrument with the
same expiration would have identical (or nearly identical)
True range (TR): A measure of price movement that implied volatilities. For example, deeper in-the-money and
accounts for the gaps that occur between price bars. This out-of-the-money options often have higher volatilities than
calculation provides a more accurate reflection of the size of at-the-money options. This type of skew is often referred to
a price move over a given period than the standard range as the “volatility smile” because a chart of these implied
calculation, which is simply the high of a price bar minus volatilities would resemble a line curving upward at both
the low of a price bar. The true range calculation was devel- ends. Volatility skews can take other forms than the volatil-
oped by Welles Wilder and discussed in his book New ity smile, though.

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FUTURES & OPTIONS TRADER • June 2007 49

 FUTURES
FOREX TRADE JOURNAL
DIARY

Exiting too early from a well-placed crude oil trade.

TRADE

Date: Thursday, May 10, 2007.

Entry: Long July mini crude oil

futures (QMN07) at 63.375.

Reasons for trade/setup: July

crude sold off nearly $6 from the April
30 high to the May 9 low, and testing a
price pattern at this juncture (includ-
ing the establishment of a 20-day low
and at least a three-point drop over the
previous four days) showed favorable
odds for an up move — with the
caveat that a notable portion of the
past examples reversed after the mar-
ket had bounced one or two days.
Source: TradeStation
Initial stop: 62.23, which is 0.17
below the May 9 low.

Initial target: 65.00, which is the next round-number position. We decided it was better to take a one-point prof-
price more than a full point away. Take partial profits and it and end the risk of being subjected to one of this market’s
raise stop. famously sharp reversals.
We felt smart for exactly one day, because July oil
dropped below our entry price the day after we exited.
RESULT However, it immediately reversed to the upside and soon
traded above 67 — more than two points above the initial
Exit: 64.40. target price.
The desire to avoid any risk whatsoever resulted in miss-
Profit/loss: +1.025 (1.6 percent). ing out on the best up move in this market in two months.
In retrospect, we were influenced by the pattern exam-
Trade executed according to plan? No. ples we had found that reversed after only a day or two of
gains. However, if we had studied our analysis more close-
Outcome: There was a lot more potential upside to this ly, we would have discovered that positions that were in the
trade, but we bailed out early after a volatile, down-closing money after three days had greater odds of continuing to
day (May 14) in the market shook our confidence in the profit.

TRADE SUMMARY
Date Futures Entry Initial Initial IRR Exit Date P/L LOP LOL Trade
stop target length
5/10/07 QMN07 63.375 62.23 65.00 1.42 64.40 5/15/07 +1.025 (1.6%) 1.30 0.15 3 days

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

50 June 2007 • FUTURES & OPTIONS TRADER

 OPTIONS TRADE JOURNAL

Selling puts on Whole Foods leaves us holding the bag.

FIGURE 1 — RISK PROFILE — SHORT PUTS

Selling May 40 puts has a 98-percent chance of success, because Whole Foods
must drop 12 percent before the trade loses ground.
TRADE

Date: Tuesday, May 8.

Market: Options on Whole Foods

Market (WFMI).

Entry: Sell 10 May 40 puts at $0.33

each.

Reasons for trade/setup:

Whole Foods Market (WFMI) has
been quite volatile after past quar-
terly earnings reports, so it was no
surprise that May options were
trading with inflated implied
volatilities (IV) ahead of WFMI’s
second-quarter earnings release on
May 9. However, testing showed
some of its options may have been
overpriced, which means selling Source: OptionVue
premium before earnings are
released could be profitable.
TRADE SUMMARY
Whole Foods has traded in a fairly wide range in the
two weeks after quarterly earnings were released since
May 1997, but that range has had a bullish bias. The aver- Entry date May 8
age up move was 10.24 percent and the average down Underlying security: Whole Foods Market (WFMI)
move was -6.56 percent. The plan: sell May puts more than
Position: 10 short May 40 puts
7 percent out-of-the-money (OTM) with the expectation
they will expire worthless May 19. Initial capital required: $4,865
continued on p. 52 Initial stop: Exit trade if WFMI drops below $38.89 —
two percent below breakeven ($39.67).

TRADE STATISTICS Initial target: WFMI trades above $40 short strike
until May 19 expiration.
Date May 8 May 15 Initial daily time decay: $47.36

Delta 119.2 803 Trade length (in days): 7

Gamma 37.29 -620.6 P/L: -$950 (19.5 percent)

LOP: $60
Theta 47.36 19.52
LOL: -$1,035
Vega -16.17 -8.47
LOP — largest open profit (maximum available profit during
Probability of profit 98 percent 30 percent lifetime of trade); LOL — largest open loss (maximum poten-
Breakeven points: $37.67 $37.67 tial loss during life of trade).

FUTURES & OPTIONS TRADER • June 2007 51

 OPTIONS TRADE JOURNAL continued

FIGURE 2 — WRONG FORECAST, BAD EXIT

On May 8, WFMI was trad-
ing around $45.26 and May 40 Whole Foods gapped 11.63 percent lower after earnings hit the Street May 9. The short
puts could have been bought back at a small $60 profit when WFMI bounced back two
puts, which were 11.6 percent
days later, but we held the position until it was stopped out, which produced a $950 loss
OTM, cost $0.33. These puts
(19.5 percent).
had IV of 65 percent, while all
puts on Whole Foods had an
IV of 50 percent. Although
WFMI could drop in response
to earnings, we sold May 40
puts for $0.33 each because
the stock was unlikely to fall
enough to hurt the position
by expiration. Also, IV will
likely plummet after the
release, which will help the
trade.
Figure 1 shows the posi-
tion’s potential gains or losses
on three dates: trade entry
(May 8, dotted line), halfway
until expiration (May 14,
dashed line), and expiration
(May 19, solid line). The shad-
ed area represents WFMI’s
possible trading range in the Source: eSignal
seven trading days between
its May 9 earnings release and May 19 expiration. The red position’s vega (16.17) was so low that it didn’t help much.
and blue bars (below) show the first and second standard However, Whole Foods bounced 3.78 percent off its low
deviations, respectively. by May 11, and the short puts could have been bought back
The trade has a 98-percent chance of gains because the at $0.27 each for a $60 unrealized gain. At this point, the
short puts are nearly 12 percent below the market. The short puts still could have expired worthless, so we contin-
short 40 puts will be held until they expire on May 19. ued to hold the trade, which was a mistake. On May 14,
Normally, an exit is triggered if Whole Foods hits the Whole Foods turned lower again and the short puts moved
breakeven point ($39.67), but this method has caused into the money and doubled in price. The stop-loss was hit
unnecessary losses in past trades. Instead, the stop-loss is the next morning, and the puts were bought back at $1.28
loosened to $38.89 — two percent below breakeven, which — a total loss of $950 (19.5 percent).
offers WFMI a chance to recover if it does drop below the What went wrong? According to Mike Tosaw, director of
short strike. education at optionsXpress, the position should have been
delta and gamma neutral to help eliminate directional risk.
Initial stop: Buy back puts if WFMI drops to $38.89 — “I’m not a fan of selling naked options before a big event,
two percent below the breakeven point of $39.67. because if [the market] goes against you, it could really
hurt,” he says.
Initial target: WFMI trades above $40 until May 18 (last Tosaw explains the trade correctly anticipated a drop in
trading day). implied volatility, but its deltas climbed as the short puts
moved near the money, which caused problems.
RESULT For instance, position delta rose from 119 at trade entry to
345 after Whole Foods gapped down on May 10, meaning
Outcome: Figure 2 shows Whole Foods opened 11.63 per- the trade’s directional risk resembled 119 “shares” initially
cent lower May 10 after it released earnings after the previ- but then tripled to 345 “shares” as gamma also moved from
ous day’s close. Although the short 40 puts didn’t initially -37 to -187. When the stop-loss was triggered, position delta
move into the money, the trade was in trouble. As expected, had surged to 803, which is similar to holding 803 shares of
implied volatility fell to 29 percent from 65 percent, but the Whole Foods as it sold off — a bad idea.

52 June 2007 • FUTURES & OPTIONS TRADER

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