Copyright©

1996, David L.
Caplan
Published by Marketplace
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Charts are reprinted
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CA 90265, (310) 456-9699
Volatility Charts: Option Vue
Systems International, 1117
S. Milwaukee Ave. Suite C–
10, Libertyville, IL 60048,
(800) 733-6610
There is risk of loss in all
trading. Any time an option is
sold there is an unlimited risk
of loss, and when an option is
purchased the entire premium
is at risk. In addition, any
time an option is purchased or
sold, transaction costs,
including brokerage and
exchange fees are at risk. No
representation is made
regarding the success of our
recommendations or that any
account is likely to achieve
profits or losses similar to
those shown, or in any
amount. Any account may
experience different results
depending on factors such as
timing of trades and account
size. Trading is risky, and
many traders lose money.
Before trading, one should be
aware that with the potential
for profits, there is also
potential for losses which
may be large. All opinions
expressed are subject to
change without notice.
eISBN 978-1-59280-529-7
Adapted to ePUB in the
United States of America.
 Contents
SECTION I
Trading Plan and
Special
Circumstances
CHAPTER 1
The Option Secret -
Using Option
Volatility to Take
Advantage of
Trading
Opportunities
CHAPTER 2
Step No. 1 —
Formulating Your
Option Trading Plan
CHAPTER 3
Money Management
When Trading
Options
CHAPTER 4
Using Special
Circumstances to
Improve Your Odds
of Success in Trading
CHAPTER 5
Special
Circumstances by
Way of Option
Skewing; What it is,
Why it Exists, and
How to Use it.
Section II
Using Volatility to
Determine
Actual Trading
Strategies
CHAPTER 6
Analyzing Your
Option Trading
Opportunities
CHAPTER 7
How Option
Volatility Determines
Which Option
Strategy to Use
CHAPTER 8
Using The Neutral
Option Trading
Strategy to Trade
Like a “Bookie”
CHAPTER 9
Using “The Free
Trade” to Construct
a Large Position
CHAPTER 10
“The Ratio Option
Spread” How it
Works and Why It's
One of Our Favorite
Trades.
CHAPTER 11
Using “In-The-
Money Options” to
Take Advantage of
Option Price
Disparities
CHAPTER 12
The “Calendar
Spread”
CHAPTER 13
“No-Cost Option
Strategy”
CHAPTER 14
Monitoring Your
Positions and Follow-
up Strategies
SECTION III
The Technical
Material
CHAPTER 15
An Options Overview
CHAPTER 16
Types of Volatility
CHAPTER 17
Technical
Explanation of the
Use of Vega, Delta,
and Theta
CHAPTER 18
Trading Gems and
Tidbits
CHAPTER 19
Special Articles
Section IV
Trading Rules and
Articles
APPENDIX A
APPENDIX B
Charts Of Volatility
Of Future Options
BIBLIOGRAPHY
RECOMMENDED
READING
 INTRODUCTION
This book is dedicated to all
traders who have decided that
there is more to trading than
just following a moving
average, or a television
commentator’s view on the
market. It is for those who are
seeking a “Trading Edge”
over the markets; an
advantage over others in this
most difficult, but also most
rewarding of all professions.
This book is not for the trader
who has decided that it looks
easy to make money in this
“game” and by spending very
little time, he can just buy a
futures contract in his favorite
market and place a “stop
loss” for protection. In fact, if
you are proficient enough to
have successfully done this
on a regular basis over many
years, we would like to have
you trade our own money.
This is a book for individuals
who are willing to spend the
extra time and effort
necessary to learn methods
that can provide a significant
advantage in their trading
careers. It is for the hands-on,
real-time trader who wants to
expand and learn, get an
“edge” over others, and do
the best he can to succeed in
his “bottom-line” goal of
making money in the
markets.
We will borrow philosophies
from other seemingly
unrelated fields such as
martial arts and gambling.
However, our intention is not
to be philosophical or to be
the “Zen of trading.” It is
merely provided to give
examples of how new ways
of looking at things have
worked successfully in other
areas. Part philosophy, part
experience, part statistics, The
Option Secret is different
from any book you have read
in the past in both its
innovative approaches and
simplifying methods.
We must reemphasize several
caveats that we mentioned in
the front of this book. First,
there is risk of loss in all
trading, no matter how
attractive these strategies may
seem. We have tried to
emphasize the best positions
to use and most opportune
times to trade; however, even
in these situations there is no
assurance that trading will be
successful or profitable.
Second, the statement, “Past
performance is not indicative
of future results,” suggests
that although a particular
strategy may have worked in
the past, circumstances
change, and there are no
assurances of similar results
in the future. Finally, as you
will see in this book, there are
significant benefits when
selling options, and therefore
many of our strategies will
involve selling puts and calls.
However, anytime a trader
has a short position in an
option, there is unlimited risk
of loss. Although we present
our methods for taming this,
this potential still exists and
must be taken into account by
the trader with both
psychological and monetary
considerations.

PLAIN ENGLISH
VS.
MATHEMATICAL
FORMULAS
Most books written about
options provide the
appropriate definitions and
descriptions of option
strategies and mathematics
and theoretical formulas.
These scholarly approaches
do little to answer the
questions: “When should I
use (and not use) options?;”
“Why is option volatility
important?;” “How do I use
option volatility figures?;”
“Which option strategies are
the best (and why), and when
do I use them?” Instead of the
formal, definitive,
mathematical approach, we
present the practical, “hands-
on” trading methods that we
use in our own trading.
There are several reasons we
decided to do this. First, there
are already many good books
(which we have listed in our
bibliography) which include
definitions and mathematics;
however, there are few that
delve into the practical end.
Second, even the most
deductive of our readers will
have a difficult time
translating the masses of
descriptive material into their
own option trading plan. It
has taken us years of full time
daily trading and research to
get where we are. We are
presenting the deductions,
conclusions and plans
formulated from many years
of research and trading. We
have learned what works and
what doesn’t, and there is no
reason for our readers to have
to experience the pain of
using inappropriate trades or
strategies when they can be
avoided.
FROM THESE YEARS OF
RESEARCHING AND
USING OPTION
VOLATILITY WE HAVE
CATALOGED WHAT WE
FEEL ARE THE MOST
SIGNIFICANT BENEFITS
OF HIGH AND LOW
OPTION VOLATILITY. WE
HAVE PUT THIS TO USE
IN OUR ACTUAL REAL
TIME TRADING. OUR
THEORIES HAVE ALL
BEEN TESTED UNDER
FIRE TO LET US KNOW
WHICH OPTION
STRATEGIES ACTUALLY
WORK AND WHICH DO
NOT; THE BEST TIMES TO
USE THESE STRATEGIES
(AND HOW NOT TO
ABUSE THEM); AND
WHAT TO LOOK FOR IN
THE FUTURE.
For readers requiring either
the basics of options or in-
depth mathematics and
explanations, we have
included these in Section 3;
(it is also available in the
books we have listed in our
bibliography). However, the
goal of this book is to take the
mysterious subject of option
volatility which has always
been surrounded by formulas,
Greek letters, statistics and
confusion, and make it easily
usable to the advantage of all
traders.
 SECTION I

Trading Plan and

Special Circumstances
 CHAPTER 1
The Option Secret -
Using Option
Volatility to Take
Advantage of
Trading
Opportunities
Our trading philosophy is to
use options to take advantage
of trading opportunities by
using the characteristics of
options to provide us with a
“Trading Edge” over the
markets. Option volatility is
one of the most important
characteristics. We look for
benefits such as purchasing
undervalued options (low
volatility), selling overvalued
options (high option
volatility), combining under
and overvalued options in
spreads, and using the time
decay and limited risk aspects
of options.
No option is considered for
purchase or sale unless the
current volatility is compared
to past levels as well as levels
of other strike prices of the
same option series. We search
for anything that can give us
an “edge” in trading, such as
significantly higher volatility
than normal, significantly
lower volatility than normal,
or a combination of the above
in the same option series
providing a disparity in
option pricing.
We have seen volatility differ
as much as ten times in one
market! For example, in
1992-1993 the volatility in
the S&P 500 options was
often near 10%, while during
significant market moves like
the October crash, the same
market volatility was at over
100% for the put options.
This means the same option
can cost $300 at one time
and, perhaps, $2,500 at
another time when volatility
is soaring, which is obviously
a significant difference.
Volatility can also differ
significantly within a market
during the same time. In
silver, for example, during
big market moves, volatility
for the out-of-the-money
options can be 200% higher
than the at-the-money
options. This occurs often in
the grain markets during
periods of potential crop
problems in the summer
months. Teaching you to
know when to expect and
how to use these
opportunities to your
advantage is our goal in The
Option Secret.
However, you can not trade
options in a vacuum. That is,
you must be cognizant of the
trend of the underlying
market, whether it is bullish,
bearish or neutral, and then
design your option trading
strategy accordingly. We use
technical analysis, mainly
trend line, with some pattern
recognition as our method of
analyzing the direction of the
underlining market.
A question I often hear, is
“Which is more important,
option volatility levels or
market trend?” We prefer
markets where there is high
option volatility (which
usually leads to premium
disparity). That is because in
these markets, positions can
often be designed such as
“Ratio Spreads” that can be
successful under a wide range
of prices and market
conditions. Trending markets
can also provide significant
opportunities for “Free
Trades” and “In-The-Money-
Debit Spreads,” while trading
range markets allow us to
initiate “Neutral Option
Positions.” Therefore, our
conclusion is that we prefer to
take the best opportunities the
markets provide for us, and
combine them with the
benefits of options. Also of
paramount importance, as we
discuss in the next two
chapters, is having a trading
plan and using money
management principles.
Without these two elements,
your odds of success are very
slim.
Our goal in trading has
always been to use options to
take advantage of trading
opportunities. Options were
chosen as our trading vehicle
because, in addition to being
able to take advantage of
trends similar to futures
traders, other characteristics
of options provide us with
opportunities to gain a
“trading edge” over the
markets. These opportunities
include:

1. Using option positions

that have a better
risk/reward than a
futures position to
follow market trends;
2. Purchasing low volatility
(commonly called
“undervalued”) options;
3. Selling high volatility
(“overvalued”) options;
4. Combining
“undervalued” and
“overvalued” options in
option spread strategies;
and
5. Using the “time decay”
and “limited risk”
aspects of options to our
 benefit.

These are some of the ways

we find using options can
improve the odds in trading to
our benefit beyond that of
trading only net futures
positions.
The great thing about trading
is that THERE IS NEVER A
SHORTAGE OF NEW
OPPORTUNITIES! We just
need to patiently wait for the
right time, and new
opportunities will arise to
enter the markets. Instead of
guessing or “predicting” like
others, we prefer to have the
“market tell us” when its
ready to move by its trend,
improved technical pattern,
reaction to news, increased
volatility, etc.
 CHAPTER 2
Step No. 1 —
Formulating Your
Option Trading Plan
In Market Wizards, sixteen of
the most successful traders in
the world described their
trading methodology.
Although the systems,
methods and markets traded
were different for all of them,
they had one thread in
common. They all had a
trading system or plan they
strictly followed. In fact, it
has been correctly stated that
even a bad plan is better than
no plan at all. That is because
without any plan, you are
driven by the trader’s worst
enemies, fear and greed. Fear
makes certain that you are
taken out of a good trade
prematurely; while greed gets
you involved with bad ones.
Most traders I talk to are
reluctant to discuss their
trading plan. They might say,
“Well, I look for a breakout
and then follow it.” However,
this statement leaves many
unanswered questions such
as: “What do you consider a
breakout?;” “Do you require
the breakout to be on a
monthly chart or a five-
minute tick chart?;” “Can a
breakout be valid opposite to
the existing trend?;” “How
many contracts do you
purchase for each
commodity?;” “What money
management principles do
you use?;” “What type of
stop-loss or trailing stop do
you use?;” “Do you have a
provision for adding contracts
or taking profits?” I find that
traders either can not answer
most of these questions or
else pick their answer by “the
seat of their pants.”
Studies have shown that 80%
of traders do not have
complete trading plans while
almost 90% do not have their
trading plans in writing. (It’s
an interesting fact to find that
most floor traders and
professional traders do have
trading plans, and these
traders are usually
successful). Although most
traders look at this as a
painful exercise, there are
easy ways to evaluate your
own trading plan.

WRITE IT DOWN
This is the first and most
important step. A solid,
concrete plan must be written
down. If it is not, we find that
it is easy to modify your plan
to meet your current feelings
during the day. You will find
that any news article, or tip
from a broker or friend can
spur you to take emotional
action without basis.
By writing your plan, you can
determine whether you really
do have a plan or are merely
firing out trades when you
“feel like it.” Once you have
finalized your plan, we
recommend you have at least
two copies, one that is always
on your desk and another
blown up on your wall.
Other important items to look
at are whether your trading
plan has provisions for taking
profits as well as losses and
adding positions when the
market moves in your favor.
(For example, we do this
using our “Free Trade,”
allowing us to add to our
positions when the market
moves in our favor, and have
enough capital ready to add
new positions on pullbacks).

Other items of
importance include:
DOES YOUR
TRADING PLAN
INCLUDE RULES
FOR MONEY
MANAGEMENT?
This includes risking no more
than 10% of your capital on
small accounts for any one
position, and no more than
2% for larger accounts, as
well as rules for hedging and
increasing your positions as
we discussed above.

IS YOUR TRADING
PLAN FLEXIBLE
ENOUGH TO
ALLOW FOR
CHANGES IN
MARKET
CONDITIONS?
In the early eighties there
seemed to be a direct
relationship between markets
such as the metals and foreign
currencies, which now often
move in totally different
directions. Similarly, options
had much higher premium in
1982 through 1987, providing
a high probability of success
for option selling strategies.
However, today’s markets are
fluid, and one must not be
married to any particular
strategy or method. (Chart
2.1)
WHAT LENGTH OF
TRADING IS BEST
FOR YOU?
At one of my seminars, an
attendee told me that he was
most comfortable with long-
term trading of “two to three
weeks.” We are also long-
term traders (with the
exception of “Neutral Option
Positions”), but view this as a
minimum of six months, and
particularly want to be
involved in trends that last for
several years. We have found
the most successful traders
are very long-term traders.
Generally, the only successful
traders that trade on a short-
term basis are floor traders.
This is because they can take
advantage of the quick
movements and disparity in
prices that occur in the
markets with less time lag,
slippage, or commission cost
than off-floor traders.
Without a plan, even the most
talented trader is destined to
failure and burn out. Let’s
first consider one of the most
popular strategies, buying
options. Say that in your
account right now you have
several gold calls, copper
puts, and bond calls. In each
case you have designated a
stop loss of one-half of the
option premium as your
money management and risk
point. You have a profit
objective of turning these
option purchases into “Free
Trades” by selling options
several strike prices further
out-of-the-money on a move
in your favor.
Now let’s assume that gold
and bonds move in your
favor, and you are able to turn
these positions into “Free
Trades,” while copper moves
against you far enough to a
point where you close out
your option position. Two
important parts of the money
management aspect of your
trading plan have been
accomplished here. First, you
have limited your losses in a
market that did not move in
your favor. Second, you have
preserved your capital while
still benefiting from
profitable trades in the
markets that did move in your
favor. That’s great so far, but
what’s next?
The next and equally
important aspect of your
trading plan should be to
build a large position in a
market that moves in your
favor. Therefore, you await a
pullback in bonds and gold to
allow you to add new
positions at favorable prices.
Long-term moves will
continually accelerate and
correct. By using the natural
gyrations of the market to
your benefit (for example, by
purchasing calls on a
pullback in a bull market, and
hedging on rallies), you can
slowly build a large position
while maintaining your risk at
manageable levels, never
more than the risk on your
initial trade. As you complete
more “Free Trades,” you can
even let some options remain
“uncovered” for unlimited
profit potential.
This process can be looked at
as continual cleansing and
building; the cleansing of bad
trades through your stop loss
levels, limiting your capital
expenses; and the building of
positions that move in your
favor by using the benefits of
options - purchasing the most
fairly valued options on
pullbacks and selling the
most overvalued options on
rallies.
Option selling strategies
present a quite different
problem. When purchasing
options, we would be happy
to turn three out of ten trades
into larger positions;
however, in option selling,
we must look closer for eight
out of ten winners, and make
certain that we strictly limit
our losses on the losers.
Talented traders have lost
years of profits in one
unplanned moment, when an
unexpected war occurred or
the stock market crashed.
Unbelievably, events like
these affect other seemingly
unrelated markets. For
example, option volatility in
cattle almost doubled in one
day when the stock market
crashed in 1987. These seem
like two totally unconnected
events, but the realities of the
market react quite differently.
For example, our plan of
using “Neutral Positions” to
sell options (selling an out-of-
the-money put and call), calls
for us to close out or adjust
the position to maintain the
original balance if it exceeds
our expected trading range on
either side of the market, or if
the price of either option that
we sold doubled. If we
assumed bonds were going to
remain in a trading range
between 96 and 100 over the
next 3 months, we could sell
the 94 put and 102 call to take
advantage of this expected
range. We would then keep
this position on as long as
bonds stayed within this
range, or if neither option
doubled in value. We would
also be alert to take profits
when 75% of the premium
was collected, not waiting to
collect the last dollar. Often,
when an option becomes
close to worthless, traders
leave it on wanting to get the
last few ticks. This may work
great 90% of the time;
however, the one or two
times it doesn’t, may wipe
out all of the previous profits.
 CHAPTER 3
Money Management
When Trading
Options
What is it about option
trading that makes it so
fascinating? Besides the
obvious desire to “make
money” and “beat the
market” (part of everyone’s
goal), trading provides a
unique opportunity in today’s
business world: the ability to
set up 40 small businesses
(the number of option
markets), each with limited
risk and unlimited profit
potential! You can set up
these businesses with very
little overhead (phone bill,
chart service). You can be
wrong many times and still
come out ahead (by using the
old maxim of “...cutting
losses and letting profits
run.”) And, you don’t need to
know anything about what
you’re trading! In fact, unless
you are an expert with up-to-
the-minute information, it is
better if you don’t. (You
won’t have any
preconceptions to make you
change your plan).

Our money
management principles
can be summarized in
four easy rules:

1. Follow Trends - let the

market tell you where
it’s going. Don’t guess
or predict.
2. Take Small Losses - get
rid of losers quickly.
3. Let Winners Run - add
to winning positions on
 pullbacks.
4. Trade Only When The
Best Opportunities Arise
- otherwise practice the
three R’s - rest, research
or recreation.

One of the major differences

between winners and losers in
trading is placing an
emphasis on money
management principles. We
rely on our objective of
obtaining a “trading edge”
through the use of options
and don’t predict the
direction of the market.
Instead, we let the market
“tell us” where it’s going - by
its trend, technical pattern, or
variance of action when
fundamental news is released.
Rather than guess on ideas or
views, phases of the moon,
triangular lines or other
methods that work perfectly
about twice a year (just like a
broken clock!), we prefer to
trade only on what the market
has already told us by its
pattern, trend, or action.
“If you take an infinite
number of monkeys with an
infinite amount of time,
sooner or later they will write
all the great works of the
world.”
Unfortunately, this also
applies to market prediction -
the problem is trying to find
the right monkey! Anyway,
why should we predict, when
the markets tell us everything
we need to know?
In addition to using the
characteristics of options to
obtain a “trading edge” and
trading on a long-term basis,
money management is
another crucial (if not the
most important) principle.
Money management means
never risking more than 10%
of your trading account’s
capital on any one position.
(In fact, larger traders use
even lower figures of
between 2% and 5%). These
figures may actually be better
for strict money management
principles; however, for
smaller accounts and more
aggressive traders, a 10%
maximum would still be
within reason on selected
trades.
Does this mean that you can
never build a large position,
since you take so little risk
initially? Absolutely not! You
can still accumulate a large
long-term position, keeping
your risk within these
manageable guidelines.
First, you must determine
your risk level for every
trade. Every trade is entered
with a certain set of
principles. In determining the
amount of potential loss, you
have to decide what would
change your mind from this
reasoning. Then you
determine the options you
want to use by analysis of
various options strategies and
their benefits.
Next, you must calculate
what the loss level would be
if the market “stopped you
out.” This makes it easy to
determine how many
positions you can afford to
initiate. (I have a standard
rule: I will not risk more than
$500 per position, in any
case, and occasionally, when
I feel that there is not a great
“stop-out” point, I limit my
risk to either one-half of the
premium of the option, or to
some other arbitrary
maximum amount, such as
$150, $200, etc.).
All of these principles have
one goal in common - the
preservation of capital in
times when your positions are
wrong. Limiting losses to
10% of your capital gives you
at least nine more entry points
into the markets.
You would have to have a
very bad string of luck to
quickly lose your capital
using this principle. In fact,
this principle gives you more
than the ten times it seems to
challenge the markets.
Assume that in your $10,000
account you are stopped-out
for the maximum 10% loss
each time. The first time you
lose $1,000 your account
would be worth $9,000. The
second time you would lose
$900 and your account would
be worth $8,100, etc., giving
you, in fact, twenty chances
at the market before your
trading capital got down to
$1,000.
For a change, let’s look at the
much more exciting time
when your trading decision is
right and the market begins to
move in your favor. Are
profits limited because you
entered into too small a
position instead of using all
of your capital as margin?
Not at all. Although some
initial profits may be missed,
as a long-term trader, I have
almost never seen a market in
a long-term trend that didn’t
pull back or consolidate
several times, providing
traders with many chances to
enter along the way.
One trader described in
Market Wizards did
extremely well in silver’s
move in 1978-1980, when
silver moved from under
$3.00 to $50.00. He did not
enter the majority of his
position at $3 or $4 or $5, or
even at $7 or $8 or $10. In
fact, most of his position was
entered into at $15.00 when
the trend in silver was
confirmed. Then was he
lucky/intelligent enough to
exit silver at the top near
$50.00? Nope. He got out at
$30.00 after the uptrend had
been broken, and only made
an average of $15.00 or
$7,500 per contract! What he
did was take the easy money
out of the market looking for
only 50% to 60% of the trend,
out of the middle, without
trying to pick tops or
bottoms.
How do you apply this to
your trading? After you enter
into your initial position,
always have a profit objective
and look to hedge your
trades, take some profits or
turn your positions into “Free
Trades” after the market
moves in your favor. When
you have your initial capital
protected and more funds
available for new positions,
you can then look to enter
into new option positions on
the next reaction. This type of
trading continues as long as
the trend continues. It is
entirely conceivable that over
a period of a year this could
become a large position,
never having a risk exceeding
your initial amount.
You must keep your losses
small when the markets don’t
work for you! You are then in
a position to hit the markets
hard when you are correct!
Using options to get a
“trading edge,” being
disciplined to trade only at
times when the best
opportunities are present, and
continually following your
trading plan are the essence
of good trading. By following
these guidelines, your odds of
success will be greatly
increased.
 CHAPTER 4
Using Special
Circumstances to
Improve Your Odds
of Success in Trading
Studies involving money
management in gambling
have found that there are
times the odds can shift up to
90% in the player's favor. We
feel this also occurs in
trading.
The average beginning trader
first looks at the market trend
and technical indicators, then
decides whether he is going
to buy or sell options, or use a
bullish or bearish strategy.
The professional option trader
does just the reverse. He first
considers the option volatility
levels of the various markets
and strike prices. Then he
determines whether there is
significantly low or high
volatility or disparities or
inefficiencies between option
strike prices (Chart 4.1).
Once he looks at these factors
he then determines whether
there is a particular option
strategy that will give him a
“trading advantage” based on
the technical pattern of the
underlying market.
Unfortunately, to most traders
option volatility remains the
“Option Secret.” Traders
know that if the volatility of
an option is extremely high
they would like to somehow
sell that option to take
advantage of the “over-
valued” nature of that option;
and if it has low option
volatility, purchasing the
option should provide an
“edge.” However, new traders
quickly find out that selling
an over-valued option itself is
not an easy road to profits,
especially if a strongly
trending market continues to
move against you, eventually
making that over-valued
option seem cheap; while
purchasing under-valued
options is also not an
assurance of making money if
the underlying market fails to
move (Charts 4.2 and 4.3).
Although option volatility is
often discussed in a technical
sense, specific examples of
how to use it in trading are
lacking. Therefore, the
specific purpose of our book
is to provide you with easy to
use rules and guidelines that
will work in almost all
situations and help you gain a
“trading edge over the
markets” using option
volatility.
What are these special
circumstances and when are
they most likely to occur? In
the next chapter we discuss
special circumstances by way
of “options skewing”
(substantial differences in
price between option strike
prices) which can create
trading opportunities. In
addition, to “options
skewing,” special
circumstances are likely to
arise during severely trending
markets where option
volatility rises to extremely
high levels: before important
government reports (which
often cause option volatility
to rise to unsupportably high
levels); during and before
holiday periods (in which
many traders take vacations
and volatility drops to
extremely low levels,
providing us with substantial
opportunities for “Neutral
Option Positions”); reliable
seasonal volatilities (Chart
4.7); unexpected world and
national events of great
impact (such as the Gulf War
(Chart 4.8), droughts, etc.);
and significantly low
historical volatility that can
precede important long term
changes after historical lows
in volatility are reached.
What is important is that
there is no exact time frame
as to when a change will
occur; however, traders
should look for a technical
indicator such as a break in
the chart pattern before
initiating any position based
on low volatility alone
(Charts 4.9 & 4.10).
These are some of the most
obvious examples that create
“special circumstances” in
our markets and the times we
should be most alert for our
opportunities to trade the
heaviest because they
substantially move the odds
of trading in our favor.
As option traders, we
recognize the importance of
using favorable situations.
These situations include: 1)
Premium disparity, such as in
the summers of 1990-1993 in
soybeans, where the out-of-
the-money options were
trading at twice the volatility
levels of the close-to-the-
money options; 2) Extremely
high volatility in options that
are approaching expiration,
such as in the S&P 500 in
1993; and 3) Low volatility
(premium cost) in option
markets that are about to
make a big move, such as in
gold & silver at the beginning
of 1993, etc.
We have known about the
need to look for the best
trading opportunities before
entering a market, and the
need for patience when
trading. However, we were
surprised to see the extreme
importance of this aspect
emphasized in the classic
book on success in gambling
- “Beat The Dealer” by
Edward Thorpe - which
discusses the importance of
using favorable situations as
follows:
“The winning strategies to be
given in this book depend
largely on the fact, that as the
composition of a deck
changes during play, the
advantage in blackjack will
shift back and forth between
player and casino. The
advantage often ranges
between 10% for one side or
the other and on occasion
even reaches 100%... With
the advance in computer
technology and
mathematical theory, we can
expect dramatic progress in
predicting stock prices.”
In fact, the author of this
book recognized applications
of these theories in trading:
“The similarity between
casinos and a brokerage
house is striking. The
commissions respond to the
house percentage. The board
rooms are the casinos
themselves.”
I was surprised to read this
statement in a book written
30 years ago, since this is the
basis for much of our trading.
(By the way, Edward Thorpe,
author of “Beat The Dealer,”
later went on to become a
successful market trader).
Similar to the revolutionary
discovery made by Edward
Thorpe, we have found that
waiting for and properly
using favorable situations in
option trading can provide a
significant “trading edge”
over the market.
This same theory is also
discussed in a 1992 book on
gaming theories:
“The skilled card counter
(trader) is able to identify this
situation where the deck
(market) is rich in high cards
(opportunities) which favor
the player (trader). When this
happens the skilled blackjack
player (trader) increases his
bet (positions)...Also, the
skilled card counter (trader) is
willing to wait for the deck
(market) to become rich in
high cards (opportunities)
before making a big bet
(position). He doesn’t make
his large bets just because he
needs to get even, or because
he has a hunch.
“Let’s change the subject and
look at the stock market. One
bit of advice that is constantly
given is to diversify. ‘Don’t
put all your eggs in one
basket.’ Diversification will
allow one to do as well as the
public in general. The expert
investor will carefully study
the market and select at most
a varied number of stocks
(markets) and then invest
heavily in them. If there are
no stocks currently meeting
the investors standards, he
just won’t buy any at that
moment...In addition...the
investor is willing to do a lot
of reevaluating. This means
that he is willing to buy and
sell quickly if a profit or loss
materializes.” “Gambling
Theory And Other Topics,”
by Mason Malmuth.
These exact theories on
success in gambling also
relate to the option markets
today. However, it is my
contention that even more
significant advantages exist in
our option markets.
In addition to trend lines and
reliable chart patterns that are
available to all net traders,
option players have other
significant advantages in
being able to take advantage
of disparity in option
premium; high volatility in
options that are approaching
expiration allows traders to
take advantage of the time
decay of option premium and
low volatility (premium cost)
in option markets that are
about to make a big move.
Another significant advantage
that applies particularly to
option sellers who seek to
take advantage of premium
decay, is that traders do not
have the same “limits” that
casinos place on individual
betters. The reason casinos
use limits is that they know
this is one of the most
valuable tools in being able to
profit; i.e., if a bettor can
continually double his bet, the
theory is that if he has enough
money, eventually, he will be
able to win.
Therefore, casinos generally
place limits on the amount of
bets. However, although there
are limits in the markets
applicable to only the largest
traders, these do not affect
99% of traders (or even large
traders who use money
management principles).
In fact, one of the biggest
causes for loss is getting
involved in a good trending
market at the wrong times,
then placing stops that are too
close, and getting stopped out
even while the market moves
in the direction predicted.
To prevent this from
happening, we recommend
the following:

1. Pay close attention to the
“favorable situations”
that are best entry
points;
2. Use pullbacks and
consolidations thereafter
to initiate positions if
these entry points are
missed or to add to
existing positions. By
doing this we can take
advantage of both
favorable prices and
volatility to enter the
market and also use
extended moves in our
favor to sell options,
turning our initial
 positions into “Free
Trades” when volatility
is at its highest levels.

Along the same lines, upon

entering the markets in these
“favorable situations” or
during periods of pullbacks or
consolidation, make sure you
get in by proper use of market
orders or limit orders that are
very close to current prices.
Problems often occur because
of a trader's desire to “get a
bargain” and stubbornness in
attempting to obtain the
bottom tick. Often, the only
orders that are filled in these
situations are in markets that
have turned around anyway,
and are moving in the
opposite direction that we
desire.
In a trending market, traders
that are too protective with
their orders may find
themselves left on the
sidelines, faced with a
difficult situation of how to
enter the market later when
prices are much higher. When
I began trading, I was taught
that once you make your
decision to enter the market,
get in with a market order to
make sure you’re involved.
We are long-term traders,
anyway, and getting involved
in the long-term trend a few
ticks higher than desired is
unimportant. Yet, where it
really hurts is being left in the
dust as the market takes off.
Concentrate more on your
trading plan and money
management principals than
stealing a few ticks here and
there.
Of course, once the market
has begun to move
substantially, it has, in fact,
confirmed its previous action
and now has a stronger
probability of moving in your
direction, providing any of
your trades with a higher
probability of profit.
However, this must also be
balanced with the desire to
get favorable entry points.
When you purchase an option
after a market has made an
extended move and while
option volatility (premium) is
high, you will probably be
overpaying for that option,
and it may be difficult for you
to profit even if the market
continues to move in your
favor.
Jumping in at that point
causes you to lose your
“trading edge.” Therefore,
before you enter new
positions, look for either
pullbacks or periods of
consolidation, which allow
you to enter these markets
during favorable price action
and when volatility may be
declining, so that you can
regain your edge. Also look
at other markets (remember,
there are 40+ of them), where
new “favorable situations”
may be forming.
We have found the proper use
of “special circumstances”
and “favorable situations” to
be one of the most important
items in determining whether
to initiate a trade. This is
because becoming involved
in markets during these times
can dramatically alter the
odds of success; and
therefore, along with money
management principles, it
becomes essential to follow
these principles.
 CHAPTER 5
Special
Circumstances by
Way of Option
Skewing; What it is,
Why it Exists, and
How to Use it.
Option skewing can also
present traders with “special
circumstances.” Option
skewing is the difference in
volatility (premium cost) of
different strike prices of
options. First, the “implied
volatility” is calculated (the
average volatility of the
options closest to the money
of the closest-to-expiration
option, having at least two
weeks prior to expiration).
When options are closer to
expiration than two weeks,
both out-of-the-money
options and markets which
are becoming more volatile
may provide misleading
volatility figures.
We then compare the
volatility of all the other
options with the implied
volatility. The difference
between implied volatility and
the volatility of the out-of-
the-money options is known
as “option skewing.” The
most common option skewing
is where both the out-of-the-
money puts and calls increase
slightly (differing about 10-
20% in value as they move
further out-of-the-money, as
shown in Chart 5.1 of cattle
options and Chart 5.2 of bond
options). Although there are
differences in the volatilities
between the strike prices with
the out-of-the-money options
usually becoming more
“overvalued,” we often find
these slight differences do not
provide the “special
circumstances” that give us
an advantage in our trading.
The knowledgeable option
trader must recognize markets
whose characteristics of
skewing are different than
usual and that severe changes
in option skewing in certain
circumstances will provide
significant opportunities.
We have provided printouts
of the actual computer screen
that we use in determining
whether any “volatility
skewing” exists. The symbols
on the left are the strike price
of the option. For example,
PLQ3 7200 is an August
cattle 72 put; CLZ3 7400 is a
December cattle 74 call; etc.
On the far right is a column
entitled “IMPVOL.” This is
the actual volatility level of
the option strike price. In the
cattle example in this table,
all of the options are ranging
in volatility between
approximately ten and twelve
percent, in sort of a
haphazard manner. This is not
unusual, however, more
normally we will see
volatility increasing slightly
for further out-of-the-money
options about ten to twenty
percent. Neither of these
situations provide us with the
“special circumstances” that
we look for in taking
advantage of “volatility
skewing.” Contrast this with
the volatility levels in Charts
5.3 and 5.4.

Some general rules

that are prevalent in
option skewing
include:
1. Volatile markets exhibit
 greater skewing in out-of-
the-money options.
2. Calls almost always have a
greater increase in the
“skewing effect” than puts.
It is our view this occurs
because of small traders
demand for call options in
bullish markets. Most
traders prefer to be “long a
market” rather than short
based on the psychological
assumption that a market
can move to infinity and an
unlimited amount of money
can be made; while prices
can only drop to zero
thereby “limiting”
potential profits. Not a very
logical argument, but
understanding of this
provides important clues to
the option trader who is
looking for volatility
differences. The precious
metals and grains,
particularly silver and
soybeans, exhibit the most
dramatic effects of option
skewing in bullish
situations (As shown in
Charts 5.3 & 5.4).
3. Option volatility is
normally somewhat higher
in the “front month” of an
option series. This effect is
exaggerated as the market
approaches expiration and
in volatile market
situations.
4. The S&P 500 options
exhibit some of the best
circumstances for option
skewing, however, they do
not follow any of the above
rules. In the S&P 500 we
find :
A. Volatility decreases
on calls as they move
out-of-the-money while
they increase for puts
(Chart 5.5).
B. Volatility for puts
often range 50% to
100% higher than for
calls.
C. Just like volatility
increases in bullish
markets in the grains,
volatility increases in
bearish markets in the
S&P 500 (Chart 5.6),
from volatility lows of
10-11% to over ten
times that level.
D. The furthest out-of-
the-money puts have the
greatest disparity in
values (Chart 5.7).
Also interesting is the fact
that the differences in the
volatility of S&P options
from other markets began to
occur only in the last several
years. Prior to that the S&P
500 behaved similar to the
grains and metals, with
volatility increasing
substantially on rallies.
However, over the last few
years, fund managers have
become aware of the
importance of using proper
hedging techniques to protect
their portfolios, and have
started selling out-of-the-
money calls to hedge their
portfolio (thereby driving
down their volatility) and
purchasing puts for the same
reason, thereby increasing the
demand and volatility of
these options. In fact, many
of them use a variation of
buying puts and selling calls
to pay for these puts (our “No
Loss-Cost Free Hedging”
method) to protect their
portfolio and increase returns.
The extreme effects of
volatility skewing were
evident in 1992 and 1993 in
the grain markets where
volatility for out-of-the-
money soybean calls during
the summer rally were two to
three times higher than the at-
the-money-options; in the
sugar market where the close-
to-expiration options were
trading at twice the volatility
levels of options having nine
months before expiration; in
the oil markets during the
gulf war, where option
volatility soared over ten-fold
in several days, causing the
out-of-the-money options to
trade at levels two to three
times higher than the close-
to-the-money options; and in
the S&P 500 during any
recent plunge when volatility
usually doubled (moving
even higher during the
October declines of the past
several years).
The positions we initiate to
take advantage of this
“volatility skewing” normally
involve the sale of out-of-the-
money “overvalued” options.
In the grain markets in 1992,
we recommended “Ratio
Spreads” to take advantage
of the overvalued, out-of-the-
money calls; in sugar, we
recommended the “Calendar
Spread” of purchasing July
1993 options and selling the
close-to-expiration options,
thereby taking advantage of
the much higher volatility in
the expiring series; and in the
S&P 500, we recommended
“Neutral Option Spreads” to
take advantage of the
increased volatility and
premium levels during short
declines.
In fact, sometimes we find
volatility increasing in a
market with no corresponding
reason. This occurred in the
Eurodollars where option
volatility doubled in the
middle of 1992 (Chart 5.8).
At that time we
recommended using “Neutral
Option Positions,” selling
out-of-the-money options to
take advantage of the
extremely high volatility we
felt was without merit.
Although we did not know
the reason for this increased
volatility, and in fact still do
not, we do know that option
volatility decreased greatly
during the next year (Chart
5.9). (That’s the nice thing
about being informed of these
types of option characteristics
and mathematics. We don’t
always need to know the
facts, just how to use them
when they occur!)
We have discussed some of
the opportunities that can take
advantage of a thorough
knowledge of “option
skewing” in different
circumstances. However, we
would be remiss not to
mention the potential problem
areas. First, since taking
advantage of the skewing
effect always involves selling
options, traders must
continually be aware of the
unlimited loss potential
anytime an option is sold.
Further, although the
probability of profit is
generally high in these types
of trades, the risk/reward is
less favorable because profits
are always limited when
selling options to the amount
of premium received.
Therefore, strong attention to
money management
principles is essential in these
situations. Further, no matter
how high volatility has risen
or how much the market has
moved, it does not mean that
these differences can not
become even greater or
continue for a very long time.
(This is where proper money
management becomes
essential).
Also of importance is that the
strike prices you may want to
use may not be trading
actively, and there may be
extreme differences between
the bid/ask. Therefore,
although the prices on your
screen theoretically tell you
that terrific positions exist, it
will be difficult or impossible
to actually execute them. At
times, we cannot even rely on
the bid/ask obtained by the
floor, both because of the
quick market movements and
floor traders reluctance to do
anything in these situations.
(In fact, these reasons are
exactly why we did not
recommend any positions in
lumber options during the
extreme moves in this market
in early 1993. Although
option volatility increased
almost ten times higher than
normal during the extreme
parts of this move, the
illiquidity of this market
made it both difficult and
dangerous to attempt any
positions). In fact, unless you
are an experienced, full-time,
well-capitalized trader, we
would hesitate recommending
these positions, especially
during volatile market
conditions in the grains (even
though this is when the best
opportunities exist).
Knowing that volatility
skewing exists and how
markets normally react is
important in being able to
recognize disparities which
may lead to option trading
opportunities.
In the next section, we move
into the “meat” of The
Option Secret. The technical
aspects of trading options will
be presented in Section 3.
SECTION II

Using Volatility to
Determine
Actual Trading
Strategies
 CHAPTER 6
Analyzing Your
Option Trading
Opportunities
In The Option Secret, we
have compared trading to
playing poker in many areas.
This analogy was not meant
to be cute, but rather because
they are quite similar in many
ways. Also, it may be the
easiest way to visualize when
and why we should be
trading. (In comparing
statistics to trading, gambling
analysts have stated that
80%-90% of poker players
lose and professional players,
although they may lose
occasionally, year after year
come out ahead).
One of the biggest mistakes
and money losers for
beginning poker players is
playing too many hands.
These players tend to like the
“action” and are not
discerning enough about
when a hand should be played
or dropped.
The expert player, on the
other hand, plays only when
he finds the odds significantly
in his favor. He may adjust
his style according to the
other players in the game
(loose versus tight; expert
versus amateur, etc.).
However, in general, he will
not put his money in the
“pot” unless he feels that
there is a good reason to do
so. He knows that eventually
the cards will turn in his favor
and better hands will come up
to provide him with his best
playing opportunities.
This is exactly the same for
the trader. Beginning traders
are normally excited, wanting
to get involved in the
“action.” Positions are taken
without adequate planning.
The professional option trader
does not get involved without
being able to obtain a
significant opportunity. He
analyzes option volatility
levels, the technical pattern of
the market, the trend of the
market, and the market’s
current reaction to
fundamental news to
determine whether volatility
is high, low or there are
disparities in option premium.
He then decides the best
trading strategy to take
advantage of both the
volatility levels and the
technical pattern and plans
his trade accordingly.

IF THERE IS NO
SIGNIFICANT
ADVANTAGE OR
TRADING
OPPORTUNITY, HE
WILL STAND
ASIDE.
He knows there will be other
days and other markets that
will provide “better playing
hands” for him.
We first analyze the
underlying futures market to
find a directional “bias” for
our options positions. As we
said earlier, you can not trade
options in a vacuum. That
means you must know what is
going on in the underlying
market as well as the option
market.
Again, this is similar to
playing poker. Three aces is
generally considered a very
good hand. However, in a
situation where there are
many other players in the
“pot” betting strongly, it
could be the right move to
throw that hand away. Not
playing borderline hands, and
not trading in inappropriate
situations are probably the
two most important things
new poker players and traders
must learn.
After analyzing the technical
pattern of the market, we then
examine option volatility
levels. We prefer to look at
“comparative” volatility
levels, ranking markets on a
1-10 scale depending upon
their current “implied”
volatility levels, relative to
periods in the past .
Then we combine the
comparative volatility level
with the technical pattern of
the underlying market to
determine whether a “special
circumstance” or “favorable
situation” exits. We can
significantly increase our
probability of profit and/or
risk/reward ratio by
purchasing/selling either an
option or a combination of
options (“Option Spread
Strategy”). This information
is of such critical importance
that its proper use can at
times allow us to be
inaccurate in our market
views and still be successful;
while improper use (such as
buying high priced, out-of-the
money options) can lead to
losses even when the market
moves significantly in your
favor!
The following outlines
virtually all the trades that we
consider for the different
volatility levels. (This
information is directed at the
off-floor trader. Floor traders
have the ability to use these
positions plus other, more
“arbitrage” type positions
because of their speed of
execution and low trading
costs. Floor traders tend to
use many “Delta Neutral”
positions to squeeze out
premium from options on a
short term basis. This
includes not only the
“Neutral Option Position”
and “Ratio Spreads,” which
are our favorite (“Delta
Neutral”) positions, but
positions matching futures
and options in almost any
configuration to provide them
with an advantage including
“boxes,” “conversions” etc.).

The following are the

only positions we use
in our own trading
portfolio 99% of the
time:

1. NEUTRAL OPTION
POSITION - High-
medium option
volatilities/trading
range market (sell out-
of-the-money put and
out-of-the-money call in
the same expiration
month). The “Neutral
Option Position” is best
used in markets that
have extremely high
premium (by selling far
out-of-the-money
options), and trading
 range markets at any
volatility level that have
little likelihood of
significant movement.
2. FREE TRADE - Low
option volatility
trade/trending market
(buy close-to-the-money
call or put, and if the
market moves in the
direction intended, later
sell much further out-of-
the-money call or put at
the same price). The
“Free Trade” is used in
trending markets to
purchase options of low
to medium volatility that
are close to the money
(particularly on
pullbacks or reactions
against the trend), and
further out-of-the-money
options which can have
much higher volatility
levels are sold on rallies
to complete the “Free
 Trade.”
3. RATIO OPTION
SPREAD - Premium
disparity between option
strike prices, high
volatility in out-of-the-
money options/mildly
trending market (buying
close-to-the-money
option and selling two or
more further out-of-the-
money options). The
“Ratio Spread” is used
when disparity in option
premium exists. This
generally occurs in
extremely high volatility
markets such as those
that occur in silver and
soybeans during rallies.
In this case the close-to-
the-money option is
purchased and two or
more further out-of-the-
money options which
can have up to twice as
high option volatility
 levels are sold.
4. CALENDAR OPTION
SPREAD - Premium
disparity between option
months, high volatility
in close-to-expiration
options (sell close-to-
expiration month, buy
deferred month in the
same market). The
“Calendar Option
Spread” is used to take
advantage of disparities
 in volatility between
different contract
months of the same
option. The trend is not
as significant for this
position as long as we
feel the option we sell
will probably not be “in-
the-money” at
expiration.
5. IN-THE-MONEY-
DEBIT SPREAD -
Premium disparity
between strike
prices/trending market
(buy in-the-money, or at-
the-money option and
sell further out-of-the-
money option). The “In-
The-Money-Debit
Spread” is initiated in
volatile markets that are
trending. Again, similar
to the “ratio spread,” the
at-the-money option
which is more fairly
valued is purchased and
 the further out-of-the-
money “overvalued”
option is sold.
6. NO-COST OPTION -
Higher option volatility
in out-of-the-money
options/ take advantage
of strong technical
support and resistance
levels (buy near money
option, sell out of money
put & call). The “No
Cost Option” allows us
 to purchase an option
with the premium we
receive from selling
other option premium to
pay for it.

That is it and that is all there

is. You may want to use other
positions yourself, you may
want to invent complicated
multi-legged positions, but
we have found these to be the
only consistently effective
ones that can be practically
used and provide a significant
advantage.
In the following pages we
describe the situations where
we would use these positions,
how to manage these
positions, and look at
histories of how these
positions have worked in the
past.
It is volatility that decides
whether options are high or
low priced. (Most other books
and analysts commonly refer
to these as “overvalued” and
“undervalued” options). We
believe that this can be a
dangerous misnomer and the
cause of unnecessary losses
for traders. For example,
during the explosion in
lumber prices in 1993, which
carried lumber from 10000 to
over 40000 in several months,
lumber call options could
have been said to have been
“overvalued” (when lumber
reached 20000). These
options were trading at the
highest volatility in their
history, up to ten times above
levels of “normal” markets.
However, what do think
happened to the trader who
sold these grossly
“overvalued” call options? Or
to the trader who sold
“overvalued” puts during the
October S&P drop in 1987
and 1989 and during the
plunge in crude oil during the
Gulf War? (See charts).
Similarly, the purchase of
“undervalued” call options in
gold and silver in 1991-1992
(trading at their lowest
volatility levels in their
history) were also losers, as
those markets failed to move,
and 100% of out-of-the-
money calls expired
worthless.
We prefer to look at
“comparative” volatility
levels, ranking markets on a
1-10 scale depending upon
their current “implied”
volatility levels, relative to
periods in the past (Chart
6.1).
Volatility Comments For
September - New six month
lows for sugar; new six month
highs for crude oil, and
Japanese yen.
We compare option volatility
readings to determine
whether option volatility is
relatively high or low to know
whether we should be
considering option buying or
selling strategies.
(Source: Opportunities In
Options monthly Newsletter).
Then we combine the
comparative volatility level
with the technical pattern of
the underlying market to
determine whether a “special
circumstance” or “favorable
situation” exits. We can
significantly increase our
probability of profit and/or
risk/reward ratio by
purchasing/selling either an
option or a combination of
options (option spread
strategy). As we discuss in
the following Chapters, this
information is of such critical
importance that its proper use
can at times allow us to be
inaccurate in our market
views and still be successful;
while improper use (such as
buying high priced, out-of-the
money options) can lead to
losses even when the market
moves significantly in your
favor!
HOW TO RECOGNIZE
THESE “FAVORABLE
SITUATIONS” AND
PROPERLY USE
VOLATILITY TO YOUR
ADVANTAGE IS THE
GOAL OF THE OPTION
SECRET.
 CHAPTER 7
How Option
Volatility Determines
Which Option
Strategy to Use
When I first started trading, I
noticed that commentators
and brokers would often
recommend a vertical bull
spread if the market was
going up and a bear vertical
spread if the market was
going down. Their reasoning
was that if the market
behaved as they predicted,
this position would make
money.
However, they rarely gave
reasons for using these
strategies, nor was there any
discussion of how this
position would give the trader
an “edge” over a net future or
option position.
In fact, when there is no
particular reason to use these
strategies (such as disparity in
option premium), this
position would actually be
detrimental to the trader
because of both slippage and
commissions in entering and
exiting this position. In
addition, profits would be
limited if the market moved
substantially in the trader’s
favor. Also, unless the broker
analyzed all of the volatilities
of the different strike prices
of every option month, the
trader could easily be
purchasing an “overvalued”
option.
Our requirement when
initiating any option position
is that we are able to get some
type of “edge” by reason of
either low volatility when
purchasing options, high
volatility when selling
options, or disparity in option
premiums when combining
the two.
When a futures or equities
trader decides to take a
position, he need only
determine the direction he is
predicting the market will
move by analyzing
fundamental and technical
data and the price level he
wishes to initiate his position.
However, this is not the case
in options trading (although
this is all that many beginning
option traders use). As we
have discussed, there are
many times where you could
buy an option, have the
market move in the direction
you predicted, and still lose
money (Chart 7.1).
Additionally, there are other
detrimental factors of option
trading including much lower
liquidity, causing slippage in
both entering and exiting the
position.
THEREFORE, TO AVOID
BEING SUBJECT TO THE
DETRIMENTAL ASPECTS
OF TRADING OPTIONS,
AND BE IN A POSITION
TO BENEFIT FROM THE
SIGNIFICANT
ADVANTAGES
AVAILABLE BY USING
THE CHARACTERISTICS
OF OPTION STRATEGIES,
THE OPTION TRADER
MUST WORK MUCH
HARDER AND BE MORE
KNOWLEDGEABLE. HE
MUST NOT ONLY
ANALYZE THE SAME
FACTORS NECESSARY
FOR A NET FUTURES OR
EQUITIES POSITION (I.E.,
DIRECTION AND ENTRY
AND EXIT POINTS), BUT
ALSO MUST BE
KNOWLEDGEABLE
ABOUT USING OPTION
VOLATILITY. THE
TRADER MUST KNOW
WHETHER VOLATILITY
IS RELATIVELY HIGH OR
LOW, THE BEST STRIKE
PRICES, MONTH, AND
STRATEGIES THAT TAKE
ADVANTAGE OF OPTION
PRICING DISPARITIES.

How To Use Option

Volatility
The most overlooked and
under utilized factor by most
option traders is the
significance of volatility. This
includes both the effect of
volatility on the premium cost
of the option and the effect of
future changes in volatility on
an option position or strategy.
It is volatility that decides
whether options are high or
low priced. (Most books and
analysts commonly refer to
these as “overvalued” and
“undervalued” options). This
can be a dangerous misnomer
and the cause of unnecessary
losses for traders. For
example, during the
explosion in lumber prices in
1993, which carried lumber
from 10000 to over 40000 in
several months, lumber call
options could have been said
to have been “overvalued”
(when lumber reached
20000). These options were
trading at the highest
volatility in their history, up
to ten times above levels of
“normal” markets. However,
what do think happened to the
trader who sold these grossly
“overvalued” call options? Or
to the trader who sold
“overvalued” puts during the
October S&P drop in 1987
and 1989 and during the
plunge in crude oil during the
Gulf War? Similarly, the
purchase of “undervalued”
call options in gold and silver
in 1991-1992 (trading at their
lowest volatility levels in
their history) were also losers,
as those markets failed to
move, and 100% of out-of-
the-money calls expired
worthless.
Volatility is a mathematical
computation of the magnitude
of movement in an option.
This is based on the activity
in the underlying market. If
the market is making a rapid
move up or down, volatility
will rise; in a quiet market,
volatility will be low.
For example, if gold is
trading $500 per ounce and
had a volatility of 20%, the
probability is that gold will
hold a range of $400 to $600
(20% on either side of $500)
for a one year period. Based
on this, option sellers can
calculate the premium they
would want to receive for
selling various gold puts and
calls based on the probability
that the strike price would be
reached prior to the
expiration of the option. If the
volatility is high, option
sellers would determine that
it is more likely that the
option price could be reached
and ask a higher premium; if
volatility is low the option
seller would determine that it
is unlikely that the option
would be exercised and
therefore ask less for selling
that option.
There are two types of
volatility - historical and
implied. Historical volatility
is calculated by averaging a
past series of prices of
options. For example, a trader
could use a 90-day price
history, a 30-day price
history, a 10-day price
history, etc... to determine the
options “historical volatility.”
Obviously, each set of
calculations results in a
different figure for volatility
and produces different
theoretical (fair value) for the
options.
Implied volatility is
calculated by using the most
current option prices,
commodity price level, time
to expiration, and interest
rate. This method provides a
more accurate picture of the
current volatility of an option,
compared to the historical
volatility which is a
smoothing of past price
action. I use “implied
volatility” in my option
pricing calculations, and then
compare the current numbers
to past records of implied
volatility to determine
whether volatility is relatively
high or low.
A characteristic of volatility
is that option volatility tends
to drop gradually, then level
off. However, at times,
volatility increases can be
characterized by very sharp
changes in volatility driving
option premium to extremely
high levels. These events
occur rarely, but when they
do they can be very damaging
to those holding short option
positions. An example was
the volatility increase in
many markets at the
beginning of the Gulf War.
Oil volatility doubled, while
other markets such as gold,
bonds, and currencies
increased 20% or more. Even
seemingly unrelated markets
such as cattle increased
dramatically. This also
occurred in October 1987,
when the stock market
crashed.
There are also intraday
fluctuations in volatility and
premium. Since implied
volatility is based on the
closing price of the option,
many times intraday
fluctuations in prices will
create option volatility that is
much higher than the
volatility based on the closing
price. These types of
fluctuations seem to always
be of the higher nature.
Rarely does option volatility
drop any significant degree
during a trading day. Taking
advantage of these intraday
price swings and distortions
in option valuation can
provide a trader with trading
opportunities.
Changes in volatility affect
the premium levels in options
you are going to purchase, as
well as those you have
already purchased or sold. An
example of this is in the crude
oil and the S&P 500 option
market where volatility has
ranged between 20% to over
100%. With high volatility, if
we were to purchase an out-
of-the-money option, you
would need a substantial
price rise before that option
would be profitable at
expiration. Both the expense
of the purchase price of the
option and time value would
be working severely against
you. However, with volatility
at lower levels, this option
would not only cost much
less but would require a
smaller move for the position
to be profitable. This is
because many times as prices
begin to rise, volatility also
increases, thereby increasing
the premium of the option
purchased.
The concepts of option
volatility, along with the time
decay characteristic of
options, are the two most
important and most
overlooked factors in option
trading. These concepts can
be difficult to learn and use,
but the proper use of these
option characteristics can
result in a “trading-edge”
over the markets.

How Option Volatility

Can Alert You In
Advance To
Significant Market
Moves
When option volatility is at
low levels, there is a high
probability that a large move
is about to occur. It seems
that when a contract is very
quiet, traders seemingly “fall
asleep” and don’t expect
anything to happen. Of
course, this is exactly when
everything explodes! On the
other hand, many times when
the market has been very
active (volatile) for a period
of time, since most traders are
already in the market, it is
likely to maintain a trading
range. However,
understanding this concept of
volatility is much easier than
using it in trading.
WHEN VOLATILITY IS
RELATIVELY LOW, YOU
SHOULD LOOK FOR
OPTION BUYING
STRATEGIES AS THE
MARKET IS QUITE
LIKELY TO MAKE A
STRONG MOVE; AND,
WHEN OPTION
PREMIUM IS HIGH,
OPTION SELLING
STRATEGIES SHOULD
BE CONSIDERED TO
TAKE ADVANTAGE OF
THE RELATIVELY
OVERVALUED
PREMIUMS.
The new option trader often
disregards volatility. He
determines only that a market
is moving in a certain
direction, and purchases an
option that best fits his view
of the market and risk
exposure. This trader will
lose when the market moves
against his desired direction
or remains neutral. He will
also often lose, even when the
market moves in his
direction, because of the time
decay of the value of the
option premium.
The knowledgeable option
trader will examine the
volatility of the option
contract and determine
whether it’s in the high, low
or middle of it’s historical
range. He will then evaluate
the different strike price and
months of options, and not
only choose the option or
strategy that provides him
with an “edge.”
For example, call option
purchases provided positions
with an excellent risk/reward
ratio in silver and in the
grains in early 1993. The
options had low volatility
combined with reliable
technical chart pattern which
suggested that there was a
strong probability of a
breakout to the upside.
The opposite picture was
evident in the bond options in
late 1993. A trader who
would have purchased any
out-of-the-money options
would have lost money, since
the market remained in a
trading range. All of the out-
of-the-money options, both
puts and calls, lost value
during this period. Therefore,
it didn’t matter in this market
whether you were bullish or
bearish. All buyers of options
were wrong, all sellers were
right.
Recognizing these principles
is not only important in
determining the best option
strategy to use, but also can
alert you to potential changes
in the direction of the
underlying market.

Using Option Trends

To Your Advantage
One of the first principals I
learned when I started trading
was “The Trend Is Your
Friend.” I have found that to
be one of the most important
aspects of a trading plan.
Attempting to fight the trend,
guessing tops or bottoms,
trading the correction etc., is
probably the biggest cause of
losses in the marketplace.
Most traders have done this at
one time or another - and paid
the price.
Trends are important to
option traders not only in
determining market direction,
but also in determining if
option volatility is likely to
move higher or lower.
Volatility trends similar to
price action. Volatility trends
are just as reliable and long
lasting as price trends, and
like price action, when
volatility hits low levels and
begins to turn up (or high
levels and turns down) it can
continue to trend for several
years.
Volatility trends in options
are also important in
determining the type of
trading strategies that are
most likely to be successful.
At the beginning of 1988,
option volatility in the foreign
currencies was extremely
high, just coming off
historically high levels in
some of the foreign currency
markets at the end of 1987.
Similarly, option volatility
was also near the high end of
historical levels in the
Treasury bond and Eurodollar
option markets. With
volatility continually
declining during 1988, selling
option premium presented
trades with high probabilities
of profit. This is because the
daily shrinkage of time value
of option premium was
accelerated by the decreasing
volatility. In fact, during that
period, there were many
weeks that option premium
for both puts and calls moved
lower. This type of action,
obviously, was very
beneficial for “Neutral
Option Positions.”
Similarly, the 1982 through
1984 period was excellent for
option sellers. The markets
had just come off large
movements in the metals and
grains, and traders’
perceptions were that these
conditions would continue.
Additionally, options on
futures were new, and
disparity in pricing occurred
more often, since traders were
inexperienced in their use and
pricing. On the other hand, in
1993, the low option
volatility in the metals and
grains along with the
technical price beak-outs,
provided excellent option
purchasing opportunities.
 CHAPTER 8
Using The Neutral
Option Trading
Strategy to Trade
Like a “Bookie”
The “Neutral Option
Position” is one of our
favorite strategies because it
is a position that can allow
you to be successful without
having to predict the direction
of the market.
This strategy involves selling
an out-of-the-money put and
call containing only time
value, with the expectation of
collecting the entire amount
of time value premium as the
underlying futures contract
remains within a wide trading
range. This may be best
understood as seeing
ourselves as “bookies.” We
are, in effect, taking “bets”
from participants on both
sides of the market who are
attempting to pick the
direction of the underlying
futures market. Some feel that
the market is going up, while
others are betting that the
market will head lower. The
traders who feel that the
market is going to go up will
purchase calls; while those
negative on the market
purchase puts.
We become “bookies” by
taking their bets on both sides
of the market (“laying off our
bets” by staying evenly
balanced). However, we have
several advantages that are
not available to both the
bettor and the house
(“bookie”), even in Las
Vegas.
For example, if a “bookie”
takes bets on a prize fight and
“balances” his book properly,
half the people betting will
win and half will lose. He
must pay off half these bets.
The bookie derives his profit
by establishing odds for the
two fighters (Assuming that
the fighters are evenly
matched, the “bookie” may
quote 6 to 5 odds “pick ‘em.”
This means you can pick
either fighter and receive a
five dollar profit for each six
dollar bet).
Therefore, if a “bookie” is
able to obtain bets of
$600,000 on each participant
in the fight, for a total bet of
$1,200,000, no matter which
fighter wins he is obligated to
pay off $1,100,000, for a
profit of $100,000. However,
our “Neutral Option
Position” can allow us to do
even better, by allowing us to
“win” on both sides of the
“bet” (Charts 8.1, 8.2 and
8.3).
For example, in August, 1992
with treasury bonds trading
near 105, we took the view
that the market was going to
remain within the 100-110
range and recommended
selling the December 100 put
and the 110 call. The
combined premium available
for the sale of these options
was approximately $1,000.
Two months later as treasury
bonds moved down to 103
and up 107, while remaining
in this wide range, premium
had decreased in half to $500.
Premium could have been
collected on both sides of the
market simply because the
option premium time value
had declined, producing a
return of 25% on
maintenance margin in a two
month period (150%
annually), and best of all,
without having to predict
market direction.
These options were, in effect,
sold to other traders who
were “betting” on their
prediction of market direction
- that the market was going
below 100 (puts) or above
110 (calls). We were making
no predictions other than it
would remain in a very wide
trading range.
Even if the market moved out
of this range, the position
could still have been
successful. This is because
every day both options we
sold lost some of their time
value. This continued loss of
time value on both sides
provides significant
protection. Further,
“adjustment” techniques are
available, allowing us to
“rebalance” this position by
moving options that are
approaching being in-the-
money further away, and
conversely adding more
options on the “other side.”
For example, using the above
situation, if bonds continued
above 108, we could have
repurchased the 110 calls and
sold “safer” 112 or 114 calls,
and at the same time
repurchased the 100 puts,
which probably had declined
substantially in value, and
sold 102 or 104 puts to
collect additional premium.
The benefits of this
position include:

1. Not having to predict

market direction (Chart
8.4 and 8.5).


1. Being able to collect and

win from both sides of
the transaction - both the
buyer of puts and buyer
of calls.
2. Being able to take
advantage of the
“overvalued” time value
of out-of-the-money
options (although the
amount of option
premium changes from
time to time, traders
continued to buy
options, thinking they
can “beat the market”)
(Chart 8.6).


1. We can increase the

amount of positions
based on favorable
market conditions (high
option premium), and
we have 40 different
markets from which to
choose for the sale of
option premium.
2. Finally, we have the
ability to both adjust our
position and increase our
position size. (This is
exactly the reason that
casinos have limits on
the amount you can bet,
because it has been
mathematically proven
that with an unlimited
amount of money, the
odds of beating the
“house” become
significantly greater.
However, we are able to
increase our positions to
 an almost unlimited
level. Since the position
limits established by the
CFTC are so high,
unless we became very
greedy, it will not affect
us at all).

Is this an easy road to profits?

Not really, without significant
safeguards. First, because
profits are limited, and
potential losses unlimited,
this strategy is unattractive to
many traders.
Second, many traders have
been unsuccessful because of
lack of discipline, controls, or
a trading plan for the best
time to initiate and close this
position and how to adjust it
when necessary. (Floor
traders tend to be more
successful using “delta
neutral” strategies, since they
generally are more
experienced, have a trading
plan and strong money
management rules.)
 CHAPTER 9
Using “The Free
Trade” to Construct
a Large Position
The “Free Trade” combines
the best principles of money
management and taking
advantage of “undervalued”
and “overvalued” options.
However, the most exciting
aspect of the “Free Trade” is
that it can allow you to build
a large position in a trending
market without risking your
initial risk.
To initiate the “Free Trade,”
first purchase the best-priced
option. Then, when (and if)
the price and volatility
(premium) rise, sell a further
out-of-the-money option at
the same price. (Of course, if
the market does not move in
your favor, you can not
complete the “Free Trade.”)
Another benefit of the “Free
Trade” is that after it is
completed there is no margin,
capital necessary, or potential
loss (other than brokerage
fees and costs).

The “Free Trade”

accomplishes several
objectives:
First, it keeps your account
intact if the market turns
around. Just as quickly as
markets rise, they can also
fall. The “Free Trade”
positions provide protection
from loss in this situation
(Chart 9.1).
Second, if the market moves
in your favor, you can
continue to add to your
position on the next pull-
back. If the trend remains
intact and the market pulls
back, as it eventually does,
you are then in a position to
purchase another option to
begin building a larger
position. You can then look
to turn the second position
into a “Free Trade” using the
same method without
increasing your initial risk.
By doing this you can take
advantage of the normal
swings of the market to
purchase options when they
are the cheapest, and sell
them when they are the most
expensive, on rallies. Further,
you will be purchasing
“closer to-the-money
options” which are normally
the most fairly valued options
and selling “out-of-the-
money options” which are
usually the most over-priced
options.
Also, the collateral benefits of
the “Free Trade” — being
able to look at other potential
opportunities, (since this
position is secure from loss
and requires less monitoring),
and the emotional security of
having your equity protected,
should not be overlooked.
Another benefit of the “Free
Trade” is that it gives you
time to unemotionally
examine your position,
without the panic other
traders may experience as
their profitable positions
begin to nose-dive. Since you
are protected you can wait for
emotions to subside and the
market to give you a better
indication of its next move.
You can then decide to hold
your position and look for full
profit potential (knowing you
are completely protected from
loss) or you can cash out and
take your existing profits.
The final benefit of “Free
Trade” is that when these
“Free Trade” are completed,
since your capital is
protected, you can turn your
attention elsewhere. You may
find opportunities in other
markets, or even in the
market you have completed
“Free Trade” in, to add more
positions. This can now be
accomplished without
increasing your original risk
— since your first positions
are now risk-free! It is
difficult to closely monitor
more than two or three net
positions, especially in
volatile markets. The “Free
Trade” allows you to
concentrate more fully on
other situations.
WHEN TO
COMPLETE A “FREE
TRADE”
The dilemma with the “Free
Trade” is when to “Free
Trade” and which strike price
to use. In determining this we
must first realize that there is
little science, but mostly
“art” here. What we do is
look for the location of the
heavy resistance on the
futures chart (which must
correspond to a place that the
market can reasonably get to
within a thirty day period),
and then we sell options
outside of that range. For
example, in March, 1993,
when silver was trading
between $3.70 and $4.00, we
recommended purchasing $4
and $4.25 silver call options,
and selling options six strike
prices out-of-the-money at
the same price paid for the
option purchased to turn these
positions into “Free Trade.”
We had determined these
options would be trading at
enough of a premium to turn
these positions into “Free
Trade” if silver reached 420-
450. However, in this silver
rally we obtained an
additional benefit of volatility
increasing 50% or more in
some cases. This allowed
traders to “Free Trade” even
more than six strike prices
away (which or course allows
for more profit potential).
How do we really know that
this is the most opportune
time to initiate the “Free
Trade?” Traders who had
purchased our recommended
silver calls began calling in
early April after silver had
risen 10-15 cents to discuss
turning these positions into
“Free Trade.” We
discouraged clients from
completing "free trades" at
that time, not because we
"knew" that the market was
moving substantially higher;
but we could only complete
"free trades" by selling
options one or two strike
prices out, which we felt was
not enough of a profit
potential for this trade.
However, in May, after silver
had risen another 50 cents,
we were more receptive for
“Free Trading” for several
reasons. First, the volatility
had risen making the out-of-
the-money options we wanted
to sell much more expensive
and "overvalued" than the
options we had previously
purchased. Second, we could
now “Free Trade” by selling
options six strike prices out-
of-the-money allowing a
significant profit potential of
$7.500.
Were we certain that we were
correct in recommending
“Free Trade” then?
Definitely not! However, the
laws of probability and
"stress control" were in our
favor by doing this. First, for
our actions to be entirely
incorrect, silver needed to
take off and move at least one
dollar from these levels
before the expiration of the
option. That is the "worst"
that could have happened by
completing the “Free Trade”
at this time. And, if the
"worst" occurs, we would be
in a position of "only"
making $7,500 per contract!
If instead silver remained
under the level of the option
we sold, in every case we
made the right decision, since
this option will eventually
worthless. We protected our
capital and perhaps added
profits to our trade. Finally, if
silver had a substantial
pullback, we not only
protected our original capital,
but placed ourselves in a
position where we could add
additional positions without
increasing our initial risk,
thereby allowing us to build a
large position.
The “Free Trade” also
allows us to meet our
objective of getting a "trading
edge" over the markets by
using options. You are taking
advantage of the increased
volatility of the out-of-the-
money options, which can be
quite exaggerated on market
rallies.
 CHAPTER 10
“The Ratio Option
Spread” How it
Works and Why It's
One of Our Favorite
Trades.
As the markets begin to heat
up, opportunities to use the
“Ratio Spread” are presented
to us. This option strategy has
numerous benefits over just a
net long or short position.
We all know the benefits of
buying an option or future
contract that moves in our
favor. Not only is it exciting
to “beat the market,” but you
are also making profits in
your account which, bottom
line, should be the most
important factor to traders. In
fact, the only negative factor
to trading, of course, is that if
the market goes against you,
normally you must lose
money.

WHAT IF WE
COULD DESIGN A
POSITION THAT
WOULD NOT ONLY
MAKE MONEY IF
THE MARKET
MOVED AS WE
EXPECTED, BUT
WOULD NOT LOSE
(AND SOMETIMES
MAKE A SMALL
PROFIT), EVEN IF
THE MARKET
MOVED
DRASTICALLY
AGAINST US?
Fortunately, it is not a
position that we have to make
up or design. It is already
well known to professional
traders and is called the
“Ratio Spread.”
A “Ratio Spread” is initiated
by purchasing a close-to-the-
money option and selling two
or more further out-of-the-
money options. For example,
with November soybeans
trading at $6 we may decide
to purchase a November
soybean $7 call and sell two
$10 calls. Let’s assume that
the $7 call is trading at a
premium of 20 cents and the
$10 call at a premium of 12
cents. We would then pay 20
cents for the $7 call ($.20 X
$50 per penny = $1,000); and
receive two times 12 cents or
24 cents for the $10 calls we
sell ($.24 X $50 = $1,200.) In
this case, since we would
receive $200 more than we
paid out, we would be doing
the spread at a credit of 4
cents or $200. Receiving this
credit is very important when
doing the “Ratio Spread,”
and beneficial for the
following reasons:

1. First of all, if the market

goes up as we expect in
this example, we will
receive a profit of $50
for every penny
soybeans moves over $7
 at expiration (up to $10)
for a maximum profit
potential of $15,000.
2. Unlike a normal option
purchase, you have no
cost for your initial
option purchase, since it
was paid for by the sale
of the two $10 calls.
3. In doing this position we
are also taking
advantage of the
disparity in option
 premium between strike
prices. We find in most
markets, particularly in
the grains and metals,
that options that are
closer to the money have
lower volatility
(premium costs) than
further out-of-the-money
options.

These out-of-the-money
options have no actual value,
since they have only what is
known as “time value
premium.” This is a certain
amount that people will pay
for an option because it has a
“chance” of becoming
valuable some time in the
future.
We find that this “time value
premium” increases the
further out-of-the-money an
option is. This is because
there seems to be more
demand by smaller traders to
purchase “cheap” options.
This can greatly increase the
time value of these out-of-
the-money options to a point
where they, at times, are
twice as expensive as the
close-to-the-money options.
By using the “Ratio Spread”
we can take advantage of this
disparity in premium since it
allows us to purchase the
more reasonably priced close-
to-the-money option and sell
the more expensive options
that are further out-of-the-
money.
4. The further out-of-the-
money options that we sell
also will lose their time
value quicker as they
approach expiration. Time
value decreases for both an
option at-the-money and
out-of-the-money option as
it approaches expiration.
This decline in time value
is much more dramatic for
 the out-of-the-money
option.
5. Finally, one of the biggest
benefits of the “Ratio
Spread,” as we mentioned
earlier, is the fact that if the
market does not move as
we expected, as long as we
obtain a credit when the
spread is initiated, we will
not have a loss. In our
soybean example above,
let’s assume that soybeans
are plentiful and the price
of soybeans drops to $4. In
that case, the options we
purchased and sold will all
be worthless at expiration
and at that time the only
difference in our account
from this position will be
the 4 cent premium that we
took in when we initiated
this position. Therefore, our
account will increase by
$200 even though the
market moved against us
 less commissions and
exchange fees)!
In fact, there is only one case
where the “Ratio Spread” can
run into trouble, when the
price of the futures market
exceeds the price of the
options sold. For example, in
our previous discussion of the
soybean “Ratio Spread,” if
November soybeans expire at
$10 we make 300 points X
$50 a point or $15,000.
However, if the price of
soybeans exceeds $10 we
begin to lose $50 of our profit
for each penny that soybeans
exceeds $10. Therefore, at the
price of $13 we would break
even on this position, and
over $13 we would begin to
have a net loss of $50 for
each penny soybeans
exceeded the price of $13 in
this example.
To help control the potential
for large losses in these kind
of conditions, we have a rule
that we follow that requires
us to close out our “Ratio
Spread” if the futures price
exceeds the strike price of our
short option. Therefore, if
November soybeans were to
rise to above $10, we would
recommend closing out the
position at that point.
We normally find that if the
market rises slowly towards
the strike price of the options
we sold that we still have a
profit on the position when
we close it out. Usually, only
in the case of a quick rise is it
necessary to close the
position out at a loss.
The best time to initiate a
“Ratio Spread” is when the
market has made a quick
straight up move. This is
because this type of action
normally will increase the
demand for out-of-the-money
“cheap” options for the
reasons we described above.
This also seems to be the time
when there is the greatest
disparity in premiums
between the close-to-the-
money and the out-of-the-
money options, providing the
best opportunity for “Ratio
Spread.”
We feel that the many
benefits of the “Ratio
Spread” far out-weigh the
single problem area, that of
the market rising too quickly,
too soon. Also, these
problems are easily handled
by our contingency plan and
rules that we described above.
The ability to initiate a spread
that can be profitable over a
wide range of prices and
market conditions, (in the
case of our soybean example
this position is profitable
from $0-$13!), provides us
with a position that allows us
to have both financial and
emotional security in the
markets.

HOW TO EASILY
FIND THE BEST
OPPORTUNITIES
FOR “RATIO
SPREADS,” AND
PICK THE BEST
OPTIONS
There are two areas
that seem to be the
most difficult in
considering this
position:

1. How can a trader
recognize opportunities
for “Ratio Spreads?”
 2. How can you determine
which are the best strike
prices to use?

With over forty futures

markets that trade options and
at least three trading months
in each of these markets, it
would be a tedious task of
several hours per day to
determine which options are
overvalued; even if you had
an on-line computer. Since
the types of “Ratio Spreads”
we like to take advantage of
occur usually no more than a
couple times a year, even the
most dedicated trader could
soon lose interest after
putting in months of hard
work and not finding trades.
Fortunately, the markets
themselves usually tell us
when the best “Ratio Spread”
opportunities occur. Simply
stated: a vertical move up, or
any large break to the upside
is our sign to begin watching
that market for “Ratio
Spread” opportunities. Why
is this? We found that when a
market begins to make a
bullish move such as we had
in the summer of 1992 in the
soybean market, small public
traders have a demand for
“cheap” options to purchase
to be involved in this move.
In a non-trending or slowly
trending market, the out-of-
the-money options usually
have somewhat of a higher
volatility and are slightly
overvalued as compared to
the at-the-money options. For
example, in March, 1993, in
cattle, the in-the-money call
option is trading at a volatility
of 10.1% and the out- of-the-
money call options are
trading at about 10.6%,
providing very little
“opportunity” difference.
However, at the same time,
contrast this with the
September silver market
where the $4 call is trading at
27.6%, and the $6 call at
46.5%, an increase of over
59% over the at-the-money
option! (Charts 5.1 and 5.4).
This disparity in the price of
the out-of-the-money options
increasing on bullish break-
outs to the upside do not
always occur when markets
move lower. Small public
traders that make up the call
option buyers in bullish
markets do not seem as
interested in bear markets to
allow the same discrepancy
on the put side. There are
exceptions, however, such as
the October 1987 stock
market crash, and the oil
market during the Gulf War;
both of these events even
caused the out-of-the money
put options to greatly increase
in volatility and provide
“Ratio Spread” opportunities.
Also, as a general group, the
metals and agricultural
markets tend to provide the
best opportunities for “Ratio
Spreads.” We have found our
best “Ratio Spreads” over
the last years to occur in
silver and soybeans, closely
followed by sugar, gold and
corn. However, in addition to
these markets we have
previously used “Ratio
Spread” in treasury bonds,
S&P 500, Swiss Franc,
Japanese Yen and cotton.
Now that we have some idea
of the best methods to locate
the potential for “Ratio
Spreads,” determining the
contract month and strike
price to use can be confusing.
There are several points to
look at here. First, and most
important in constructing a
“Ratio Spread” we want to
make certain (as much as
possible) that we do not sell
options that are likely to go
“into the money.” For
example, in the silver market
recently, silver moved up
from 370 to 470 in two
months. A “Ratio Spread” of
long the September 450 call
and short two 600 calls,
would produce a credit of 20
cents premium (the net of the
money we receive for selling
the two 600 calls minus
payment for the 450 call we
purchased). This money
would be ours to keep if
September silver expired
under 600. This position
would also produce the best
profits if silver expired in the
range of $4.50 to $6, as again
we would still receive the
$1,000 credit plus 50 cents
for every penny that silver
closed above $4.50 to a
maximum of $7,500 at $6.
However, this position
becomes dangerous if prices
exceed $6. This is because
even though we are at a $1.50
per cent profit ($7,500) at $6,
for every penny the market
moves over $6 at expiration,
we lose one cent ($50) of that
profit.
Therefore, at $7.50, we would
lose back our initial credit
and have a potential
unlimited loss of $50 for
every cent the market
exceeded $7.50. This is
particularly disconcerting —
to have a bullish outlook and
have the market move in our
direction (although stronger
than we expected), and still
lose money.
Contrast this position with the
“Ratio Spread” of buying the
September silver $5.50 call
and selling two $7 calls at a 4
cent ($200) credit. In this
position, if silver closes
below $7 at expiration we
collect $200. Although this
provides more upside
protection than the previous
position, the reward is also a
lot less (80% lower). Also, if
silver closes between the
range of $4.50 to $5.50, there
is no additional profit as there
would be in the previous
position. However, on the
upside, if silver were to begin
a runaway bull market, a
maximum profit of $7,500
can still be made (plus our
initial credit) can be made if
silver closes at $7 at
expiration, and our profit
range on this spread extends
all the way to $8.50.
Therefore, in comparing these
positions from a money
management standpoint, we
come to a simple conclusion.
If our market perception is
that silver is going to stay in
the current range, move
lower, or just slightly higher,
the first, more aggressive
position is the best one.
However, if our belief is that
the market may continue to
move rapidly higher, and we
want to have a conservative
position that will make
profits, whether the market
moves lower, stays in the
same range, or moves
substantially higher (in this
case up to $8.50), the second,
more conservative position is
better.

To summarize, here
are some absolute
rules we use in looking
for THE BEST
"RATIO SPREADS":

1. Look for markets that

are beginning to have
 large bullish moves.
2. Use options having
between three and six
months before
expiration.
3. Always initiate the
“Ratio Spread” at a
credit (for complete
downside protection)
4. Sell options as far as
possible from the current
price of the underlying
market (while still
 obtaining a reasonable
premium).
5. Make certain that there
is a substantial disparity
in the premium between
the options bought and
options sold to provide
you with a real
advantage.

However, the discretionary

part of this trade occurs in
determining which options to
use. As we mentioned above,
some of this will come into
play based on your view of
the underlying market, and
your decision whether to take
a conservative or aggressive
position. Whichever stance is
taken, remember that these
positions are flexible and can
be easily modified at a later
date.
For example, if a market has
a long period of consolidation
or retracement after initiating
the “Ratio Spread,” you may
want to consider taking
profits and repurchasing one
of the short options to allow
for greater profits and less
risk if the market begins to
trend in your favor. (We often
do this when the market
shows some sign of life after
this pullback). On the other
hand, if the market does
begin to trend strongly and
move close to the price of the
options sold, we recommend
considering moving the
options to higher strike
prices.
 CHAPTER 11
Using “In-The-
Money Options” to
Take Advantage of
Option Price
Disparities
The “In-The-Money-Debit-
Spread” (purchasing an in-
the-money option and selling
an out-of-the-money option
of the same expiration month)
is a position that can be used
to take advantage of a
trending market, and also
provide us with significant
benefits over a straight “long
or short” future’s position.
We have always
recommended that option
positions be used when they
can provide us with an
advantage (“trading edge”)
over futures. In conventional
futures trading, after using
your favorite analysis method
(technical, fundamental,
trend-following, etc). to
determine market direction,
you then initiate your trade by
purchasing or selling a
futures contract. If the market
does not move in the
direction predicted, you lose
money on this trade. (In fact,
often money is lost even
when the market moves as
predicted, after first making a
sharp move against you,
thereby “stopping” you out of
your position).
This is where the proper use
of options and option
strategies becomes important
and can provide us with a real
“trading edge.” First, when
buying an option, since risk is
limited to the premium paid
for the option, we can trade
without “stops,” since we no
longer have to worry about
unlimited losses if the market
moves against us. This can
prevent us from losing our
position (and our money)
when the market makes a
sharp, temporary, short-term
move.
In addition to not being
“stopped out” in temporarily
adverse circumstances, this
strategy can be successful
even in some cases when the
market fails to move in our
desired direction, as we will
collect premium because of
the declining value of the out-
of-the-money option that we
have sold.
This type of position can be
successful if the market
moves in the direction that we
predicted (put spread - lower;
call spread - higher), or even
if the market is stable! Only if
the market changes direction
will this position be
unprofitable. It is for this
reason that we recommend
this position be entered only
in the direction of the existing
trend. Since the probability is
that a trend in force tends to
continue, this will add to our
mathematical probability of
success.
This is the advantage of this
position. A market can
move only in three
directions: 1. Higher 2.
Lower 3. Neutral
This position is profitable
both if the market moves in
our desired direction (higher
or lower) and, in many cases,
if the market remains neutral;
thereby creating a successful
position in two out of three
instances. Compare this with
conventional futures trading
where not only is our trade
profitable in only one out of
the three circumstances, but
since we can also be stopped
out at times even when we
are correct on our market
direction, our chances for
success are closer to 25%.
However, our advantages do
not stop here. In addition to
more than doubling our odds
of success on a trade, this
position also allows us to take
advantage of disparity in
option pricing
(overvaluation), and the time
decay of option premium.
And, unlike a futures position
where the risk is always
unlimited, the risk in this
strategy is absolutely limited
to the premium deficit (plus
commission and fees).
In the past, we avoided using
in-the-money options, since
they are both expensive,
providing us with very little
leverage - which is one of the
significant benefits of using
options; and at times they can
be relatively illiquid, causing
slippage (losses arising from
the difference between the
bid and ask) when entering
and exiting the trade.
However, after extensive
research we have determined
that the benefits from using
these in-the-money options
can far outweigh the
disadvantages.
We have found that by
purchasing in-the-money
options and selling one or
more further out-of-the-
money options we can
construct a position that takes
advantage of:

1. The trend of the market;

2. The overvaluation of
out-of-the-money
options;
3. The time decay of out-
 of-the-money options;
4. The tendency of in-the-
money options to hold
their value better than
out-of-money options
under most market
conditions (Chart 11.1).
This position works to help us
take advantage of the
overvaluation of the out-of-
the-money options. Many
times we find that the out-of-
the-money options are
overvalued anywhere from
10% to 50% or more as
compared to the in-the-money
options. This means that the
premium a trader pays for the
out-of-the-money option is
much higher than the in-the-
money option, and it will
decay at a much faster rate
(Chart 11.2).
The best
circumstances for
using this position are:

1. A trending market;
2. Markets where the out-
of-the-money options
are trading at a premium
of at least 20% over the
“In-The-Money
Options.”
Another advantage of this
strategy is that usually we
need less capital to enter a
position, thereby allowing
both more leverage and
diversification of funds.
While a future’s position in
the S&P 500 currently
requires $12,000 initial
margin, a “debit spread”
requires only a $2,500
premium, a reduction of
almost 90%. We recommend
initiating an “In-The-Money-
Debit-Spread” when the out-
of-the-money option we are
selling has a higher implied
volatility rate (is more
overvalued) than the closer-
to-the-money option we are
purchasing. We also should
not expect the market to
move beyond the level of the
out-of-the-money option we
are selling (so our potential
profits will not be limited).
We would not recommend a
bull or bear spread in the
initial stages of a trending
market, because normally at
that time the out-of-the-
money options do not have
enough premium because of
the low volatility. Further, we
do not want our profits
limited at this initial stage
where the market may be in
its “blast off” stage. Net
option purchases and “Free
Trades” are preferred here.
In the second stage of
trending markets, where the
trend has begun to mature, is
the most opportune time to
initiate “In-The-Money Debit
Spreads.” In this case, a more
“normal” trend can be
expected, and significant
benefit can be obtained by
initiating an “In-The-Money
Debit Spread” which both
limits risks and allows us to
take advantage of the more
over priced out-of-the-money
options.
It is in the last stage of
trending markets out-of-the-
money premium really soars,
when the market is less likely
to make an extremely large
move in the direction of the
trend, that ratio spreads
become our preferred vehicle.
The “Ratio Spread” (when
initiated at a credit) provides
the best of all worlds by
providing the following
benefits:

1. Continuing profits if the

market moves in the
direction we expect;
2. Profits (the amount of
the credit received) if the
market moves lower or
remains in a trading
range;
3. The ability to take
significant advantage of
 the higher priced out-of-
the-money over valued
options.

Finally, this position can also

be effectively used as a hedge
for your cash or future
portfolio. For example, if you
own a stock portfolio, put
positions can be constructed
to hedge your downside risk
at a minimum cost. Similar
hedges can also be
constructed to protect bond,
currency, metal, and
agricultural positions.
 CHAPTER 12
The “Calendar
Spread”
The “Calendar Spread”
(selling a nearby month
option and purchasing a
further out option) is a
position that we do not often
recommend. This is because
in the normal situation where
volatility is the same between
two option months, a trader
receives very little benefit or
“edge” in this position. If the
market moves in the direction
the trader predicted, both
options will respond
favorably; and if it moves
opposite, then both options
will lose value.
There is only one situation
when we would consider a
“Calendar Spread” at all.
That is when the option
volatility of a closer-to-
expiration option greatly
exceeds the volatility of a
further out month. In this
case, we have two important
factors working in our favor:
1) the time decay of the
closer-to-expiration option
will continue at a much great
rate because of the fewer days
to expiration; and 2) the
higher volatility allows us to
sell a much more “over-
valued” option than we are
purchasing (Chart 12.1).
What we look for before
entering this trade is a market
where the nearby month is
trading at an extremely higher
volatility level than a further
out month. This happens in
markets like soybeans and
sugar, or the precious metals
where there is a volatile
market causing traders to use
options to hedge or otherwise
protect their positions. In this
case, there may be more of a
demand for the front month
options which then become
more expensive (Chart 12.2).
A good example of this
occurred in March 1992, in
the sugar option market. In
this case, July 92 sugar
options were trading at a
volatility level of almost
double the July 93 options,
prompting us to recommend
“Calendar Spreads” to take
advantage of this disparity.
This is an important example
of how the professional trader
only uses option strategies
when he has determined that
option volatility levels
provide him a “trading edge”
by initiating that position.
 CHAPTER 13
“No-Cost Option
Strategy”
How about a position with a
5-1 risk-reward plus a 75% or
better probability of profit? A
trade that can not only make
money if the trend continues
in our favor, but will not lose
if the market remains flat, or
even, at times, goes
somewhat against us!
This position also removes
the major complaint that most
professional traders have
when purchasing options -
that the time decay in a flat or
slowly moving market causes
loss of premium - making a
losing trade out of the option,
where a future’s position
would have broken even or
been profitable. We are going
to rid ourselves of this
disadvantage, and also be
able to not lose, at times,
even when the market moves
against us.
We have named this position
the “No-Cost Option,”
because we will be selling
option premium to pay for the
option we are purchasing. To
initiate this strategy we first
look for a trending market
that is undergoing a pullback
within the trend. We then
purchase the best-priced in-
the-money option that has at
least 60 days before
expiration, and at the same
time, sell the most overvalued
out-of-the-money put and call
options.

In doing this we are

obtaining several
important advantages
including:


1. Trading in the direction

of the trend. You can
have the worst trading
system in the world, but
if it gets you in the right
direction in a trending
market - you’ll make
money!
2. Entering on a pullback.
This has always been a
good principle of money
 management.
3. Buying the best-priced
in-the-money options.
These options contain
little or no “time value”
and therefore will not
lose premium as out-of-
the-money options do in
flat markets. They will
also increase in value
quickest when the
market moves in your
favor.
 4. Selling the most
overvalued out-of-the-
money options. These
options contain only
time value which will
decay every day,
whether the market
moves up, down, or is
flat.

This position will make

money if the market moves in
the direction we predicted, of
course, but the real benefit is
that it will not lose money if
the market remains (1) flat or
moves just slightly; (2)
higher; or (3) lower
(contrasted to a net option
purchase that will lose in
these three instances). This
position is an aggressive
position that should only be
used in a strongly trending
market close to its support or
resistance levels.
 CHAPTER 14
Monitoring Your
Positions and Follow-
up Strategies
Two equally difficult areas
along with when to initiate
positions are (1) when to exit
them; and (2) follow-up
strategies if the market
changes. The following are
guidelines that we use in
these situations. Of course,
some of them require
judgment calls as to your
view of what market action is
most likely to happen;
however, we like to use the
action that creates the highest
probability of profit when
available.

The follow-up action

we recommend on
our strategies are as
follows:
1. “Neutral Option Position”
- We maintain this position if
the market stays within our
trading range (between the
options we have sold). If the
futures market approaches
either side and the premium
on either side is more than
twice the premium on the
other, then adjustment
techniques are necessary.
This is accomplished by
either selling more options on
the weaker side or moving the
side that the market is
approaching further away.
For example, if we are short
the bond 100 put and 110
calls and the market, which
was initially at 105 begins to
move towards 107-108, we
would sell additional higher
up puts such as the 102 or
104, as well as repurchasing
the 110 calls and sell 112 or
114 calls to make the position
somewhat “safer.” We also
have an absolute rule of never
allowing an option that we
have sold to go into-the-
money. If volatile action
begins to occur, close out the
position and then consider
whether you want to resell
further out-of-the-money
options or just sit on the
sidelines entirely. Sometimes
this is the best course of
action, especially if the
market becomes very volatile
and unpredictable.
In doing “Neutral Option
Positions,” we like to only
use a small portion of our
margin, initially. That allows
us to make several
adjustments to our position
before we run into a problem
with available margin money.
For example, if your account
is $15,000 and you sell one
“Neutral Option Position” for
an approximate margin of
$1,500, you can then later
adjust and add to your
position many times before
you approach your margin
levels. This substantially
increases your probability of
profit.
Also, we like to close out our
“Neutral Option Positions”
when option premium drops
75-80%, or any option is
worth less than $50. Although
it is unlikely that these
options will ever have any
value, an unexpected move
with these cheap options
could cause them to rise
many times in value.
Therefore, we would prefer to
leave some of our potential
profits on the table in
exchange for safety.
2. “Free trade” - After you
have entered into a “Free
Trade” the market may do
three things - move higher,
remain in the same range, or
move lower. If the market
continues to move much
higher, beyond the strike
price of the option you have
sold, your decision is an easy
one. You merely hold on to
your position and eventually
you will receive the entire
difference between the strike
prices of the options you
purchased and sold. Do not
be concerned regarding the
short option you sold,
because if it is exercised
against you, you can exercise
your long option and
therefore your profit will be
the difference between the
two strike prices. For
example, if you purchased the
$4 silver call and later sell a
$5 silver call against it to turn
it into a free trade, if silver
rises above $5, and the $5 call
is exercised against you, you
exercise the $4 call. This will
make you long one contract
of silver at $4 and short one
at $5 which will be canceled
out by the clearinghouse and
show a profit of $5000 on
your statement.
However, most cases are not
so clear. If the market rises in
our favor we are normally
content to receive 80% of the
profit level by closing out our
positions before they are
exercised against us. This is
because the market always
has an opportunity to make a
substantial pullback any time
before expiration thereby
losing our profits. Again, we
feel it is wise to leave a small
percentage of our profits on
the table and not be greedy.
In the case where the market
merely stays in the same
range that it was when we
executed our “Free Trade,”
our choices are a little less
clear and in all cases dictated
by our view of what is
happening and the risk we
would like to take. If the
market stays in the trading
range for several weeks after
we have entered the position,
we then look at the technical
pattern of the market. If it is
our view that the trend is still
intact, then we hold onto our
position. However, if
evidence later arises to show
us that the trend has possibly
changed or for other reasons
we decide to “bank” our
profits, we close out the
position. This is the beauty of
the “Free Trade.” We have
substantial opportunity to
review the market situation
and determine what to do
while we are not in the “heat
of the battle.” This is because
although the option we
purchased may be losing
some of its time value, the
out-of-the-money option we
sold is providing some
protection against this loss.
The out-of-the-money option
is also losing its time value
and providing protection from
loss.
In some cases, we will find
that the out-of-the-money
option we have sold has lost
almost all of its value. In that
case, if you still maintain
your same view on the
market, you may wish to
repurchase this option, and
remove the limited profit
aspect of this trade. At times
you will find that you are
even able to complete another
“Free Trade.”
3. “Ratio spread” - In this
trade we will assume that you
have taken our
recommendation and initiated
the “Ratio Option Spread”
only at a credit. In this case,
we are entirely protected if
the market remains in the
same range or moves lower
because we will receive the
credit obtained on initiating
the spread if the market does
not continue to move in the
direction we have predicted.
Normally if the market
remains in the same range or
moves lower we take no
action and just allow the
options in this position to
expire worthless and collect
our credit. We do not like to
take any action by legging out
of positions as it becomes too
difficult to monitor and
requires exacting analysis to
profit.
If the market moves slowly in
our favor, this is the best
action that we could ask for.
In this case, upon expiration
we will receive not only the
credit that was available
when we initiated the
position, but also the profits
on the out-of-the-money calls
that should still be worthless
if the market has moved only
slowly in our favor, and also
the intrinsic value of the at-
the-money option that we
purchased. This is the best of
all worlds. Similar to the
“Free Trade,” we also take
profits on this position when
it reaches 80% of its potential
value.
As we discussed in our
analysis of the “Ratio Option
Spread,” the only problem is
when the market makes a
quick move and approaches
the strike price of the options
we sold. In this case, similar
to the “Neutral Option
Position,” we always close
out our short options before
they go in-the-money. We do
this by either closing out the
position entirely or
“adjusting” our short options
to higher strike prices. This is
again a judgment call that
must be made by analyzing
the current conditions of the
market.
4. “Calendar Option Spread”
- The best result here is
obtained when the market
remains stable and the close-
to-expiration option we sold
expires worthless. In that case
we look for the market to
begin moving in our favor
after that point, providing us
with an opportunity to turn
our position into a “Free
Trade.” Then we would use
the same guidelines that we
discussed under “Free
Trades” to monitor this
position.
If the market moves in a
direction other than we have
predicted, then we use a
predetermined dollar amount
for our “stop-out” point. For
example, we might decide to
purchase the December corn
250 call and sell the July corn
230 call and use a risk of
$200 as our stop-out point. In
this case, if the market begins
to collapse and we are at a
$200 loss or more we then
close out this position.
The danger point in this
position is if the market
strongly moves in favor of the
direction of the options we
have purchased, thereby
putting the option that we
have sold “in-the-money.”
Although in this case we are
protected by the option we
purchased, we will begin to
lose money the further in-the-
money the close-to-expiration
option goes, because its
“delta” (reaction to the
futures market price) is closer
to the movement of the actual
futures market. Because this
position is partially protected
by the option we have
purchased, we allow this
strategy a little more latitude
before we close it out.
However, we recommend that
if the option you have sold
goes in-the-money by more
than one strike price, close
out this position.
5. “In-The-Money Debit
Spread” - We use several
standards to monitor this
position. First of all, we
always close this position out
if the trend changes and
moves against us. Second, we
use an absolute dollar amount
similar to what we mentioned
in our discussion of the
“Calendar Option Spread”
above as a “stop-out” point.
If this position moves in our
favor we then use similar
standards to those of the
completed “Free Trade.”
That is, if it moves quickly in
our favor and far beyond the
strike price of the option we
have sold, we normally wait
for the maximum profit.
However, if it slowly moves
in our favor, we are again
satisfied with 80% of the
potential profit.
6. “No-cost option position”
- With this position you must
be more careful since it is a
very aggressive position
combining the “In-The-
Money Debit Spread” with
the sale of a naked option. In
this case, if the market begins
to move against you quickly,
there could be larger losses.
We always set an absolute
dollar amount on our loses
similar to the “Money Debit
Spread,” and also close out
this position if the trend of
the market changes, or if the
strike price of the option we
sold on the downside is
exceeded.
If the market moves in our
favor, use the same standards
as the “In-The-Money Debit
Spread” for closing this
position out.
 SECTION III

The Technical
Material
In writing this book we came
across a dilemma as to what
type of material to present.
Some readers want a
technical explanation and
analysis, while others want
just the practical side...the
rules and conclusions. We are
the latter, since we are
traders. We want to get to the
bottom line, i.e. what
methods to use to give us the
best chance of meeting our
goal - making money. This
section is for those desiring
the more in-depth technical
knowledge.
 CHAPTER 15
An Options Overview
An option is the right to buy
(call) or sell (put) an
underlying instrument for a
specific quantity, at a specific
price, in a designated time
frame. This right may also be
sold, in which case a
premium will be paid to the
option seller. The right to
own this instrument is termed
a “call.” The right to sell the
instrument is termed a “put.”
The following table is an easy
guide for beginning traders to
use.

- - - - - - - - - - - - - - -
LONG CALL =
UPWARD MARKET
BIAS
LONG PUT =
DOWNWARD
MARKET BIAS
- - - - - - - - - - - - - - -
SHORT CALL=
DOWNWARD
MARKET BIAS
SHORT PUT =
UPWARD MARKET
BIAS
- - - - - - - - - - - - - - -
Options provide the trader
with vehicles to accurately
implement a specific market
opinion. A trader initiating a
futures position is only
concerned with market
direction, up or down. The
speed of the market
movement, and the extent of
this movement are not
necessarily considered when
the trade is initiated. The
difference between the entry
price and the exit price of the
trade determines the profit or
loss of the trade. These price
levels are very easy to
understand. If someone buys
a March T-bond future at
107-16, they have a bullish
outlook on T-bonds. For
every tick above 107-16, they
are making $31.25; for every
tick below 107-16 the
position is losing $31.25 (not
including transaction costs).
For every tick the market
makes, the trader can easily
calculate the net effect.
In options trading, the “cost”
of the option is more
complex. If a trader purchases
a March T-bond 108 call, the
out-of-pocket cost is the
amount of the premium, for
example, 2-00 ($2,000.00).
We will assume that there are
90 days until expiration and
the futures price is, as in the
previous example, 107-16.
What makes up the cost of
this option? The option has
no “intrinsic” (real) value
because the call’s strike price
is above the current futures
price. (If the contract were to
expire here, the option would
be valueless). There is a
better chance of the 108 call
being in-the-money than the
110 call, but less than the 106
call. The 108 call will always
cost more than the 110 call,
and less than the 106 call.
Even though in this case the
108 call has no intrinsic value
at this point, the current
futures price and the options
strike price are components
of the options premium. An
option that is “at-the-money,”
mathematically has a 50-50
chance of being in-the-money
before expiration.
How does the time
component affect the price of
an option? Given that all
other factors are equal, an
option with a greater
expiration date (more time)
will be worth more than an
option that expires sooner.
The March 108 call will be
worth more than the February
108 call, which has 60 days
until it expires. This option
component, the amount of
time left in the option’s life,
is the “time premium.”
Compare the amount of the
premium you pay for an
insurance policy, with the
calls just mentioned.
Normally, you would pay
more for a three-month policy
than a two-month policy,
because you would be insured
longer. What if an insurance
company would sell a three-
month policy for less than a
two-month policy (given that
all other aspects of the
policies are identical)? No
one would buy the two-month
policy, because the premium
holder would be receiving
one month of free coverage.
Just as no insurance company
is in the business of giving
away coverage, the options
market would not give extra
time for no cost. Given all
other factors are equal, the
longer the life of the option,
the greater period of time it
has to become valuable.
Therefore, it is more valuable
now than an option with a
shorter life.
THE EFFECT OF
TIME ON AN
OPTION
Time is the ally of the short
option trader and the enemy
of the option purchaser. The
short premium trader thinks
like a troubled adolescent
who cannot wait for the time
to pass, and move on to the
next stage of life. Every day
seems like a year. Each day
presents the possibility of a
major tragedy. The
adolescent thinks, “When will
it be over?” "Will the earth
shattering problems ever go
away?" As we all know time
is definitely on their side;
time does pass.
The long premium trader
worries like an old man who
has not yet left his mark on
life, but is still trying to. He
knows his days are numbered,
and he is dependent on others
to assist him. He says to
himself, “If I only had more
time.”
These analogies are meant to
represent the thought
processes and worries from
each perspective. The
advantage the options trader
has over the adolescent and
the old man is that the trader
can measure the effect of time
passage on his position.
We measure a day by the
amount of hours, twenty-four,
as a constant, each and every
day. The unit of measure for
an option time decay is not
constant.
The often used analogy to
describe time decay is that of
the ice cube melting. Take the
ice cube out of the freezer,
and it remains in its original
frozen state. It then starts to
melt, becoming smaller and
smaller. The smaller it gets,
the faster it melts, until
finally, it is no longer an ice
cube.
To more accurately replicate
the time decay of an option,
one would leave the ice cube
in the freezer, but turn the
temperature up, for example
one degree at a time. The rate
of melting depends on what
temperature you start at. The
ice cube will stay frozen
longer if you start with a
colder temperature. The
amount the ice cube melts
every day is the measure we
seek. The amount of the
difference between the
starting temperature and the
temperature in which the ice
cube has completely melted,
can be compared to the
amount of days until
expiration of an option. The
one degree increase in
temperature, represents one
day of time passage.
The Greek letter which
represents time decay is
called “theta.” We will call it
the daily time decay. Just as
the ice cube’s melting
accelerates, an option reaches
a point in time where this
acceleration starts increasing
dramatically. This point
seems to occurs with 21-30
days left until expiration.
In long-term options (over
180 days), the daily time
decay effect is hardly
noticeable. The long-term
option is much more sensitive
to volatility changes than
time erosion. Short-term
options are extremely
sensitive to time decay,
because when expiration
occurs, all time premium will
be gone; the ice cube is
melted.
Time decay can be measured
in dollars per day, or in
“ticks” per day. Dollars/day is
preferred because it is more
accurate. A short premium
position will have a positive
daily time decay, because it
benefits from the passage of
time. A long premium
position has a negative daily
time decay, due to the fact
that the position is adversely
affected from the passage of
time.
To give an example of how
the daily time decay
accelerates with the passage
of time, consider this. A 180-
day at-the-money T-Bond
option may lose $.01 of its
value a day. A 10-day at-the-
money bond option loses
about $30.00 dollars a day
from time decay alone. With
two days left the daily time
decay is about $100.00 for
the at-the-money option. No
matter whether you are long
or short premium, the
awareness of time decay is
essential to the options trader.
Time is not the only effect on
the daily time decay.
Volatility changes also
influence this measure. Since
volatility increases result in
higher premiums, more
premium exists to erode.
Therefore, increases in
volatility lead to a higher
daily time decay number for
an option. Decreases in
volatility cause lower
premiums, resulting in a
lower daily time decay for an
option.
No matter which side of
premium you choose to “bet”
on, you always give
something up. A long
premium player has his risk
limited to the purchase
amount. Volatility increases
help, decreases hurt.
However, if he holds the
position like a melting ice
cube in his hand, it may melt
into nothing, and become
worthless.
The short premium trader, as
unlimited risk, is adversely
affected by volatility
increases. However, time is
his greatest ally as options are
wasting assets. The key to
choosing the right position is
mastering the most
underestimated, under-
utilized tool in options
trading: volatility.
 CHAPTER 16
Types of Volatility
A trader is interested in
having the best probability of
making profitable trades. The
most essential element of
options trading is
understanding that the trader
is not only trading market
movement, but also trading
volatility. This section
examines the powerful tool of
volatility and how to use it
for increasing the odds of a
profitable trade.
Four types of volatility we
will examine are implied
volatility, historical
volatility, forecast volatility
and actual volatility.
Implied volatility is a
component of an option’s
current price. Implied
volatility describes the
market’s current expectation
of the future behavior of the
underlying contract. If
implied volatility increases,
premiums increase. Premiums
decrease when implied
volatility decreases. As
technical analysts use past
market data to make their
prediction of future
directional movement,
options traders use the
historical price behavior as a
component of forecasting
future market action.
This past market behavior
measurement is called
historical volatility.
Historical volatility is
expressed in percentage
terms. This type of volatility
tells the trader the range of
the market over a specific
time frame 68% of the time.
For example, if bonds are at
100, and the historical
volatility is 10%, based on
past prices, one can expect
bonds to be in a range of 90
to 110 68% of the time for a
one-year period. Historical
volatility can be applied to
any period of data.
Frequently, traders will adapt
the sample period to the
number of days left until
expiration. If an option has 30
days of life, a trader would
use 30-day historical
volatility, etc. It is important
to note that historical
volatility fluctuates also. If
you had a perfect driving
record for the past ten years,
and all of sudden had four
accidents in one year, you
would expect to pay more for
your auto insurance for the
next several years. In addition
to this standardized measure
of past market fluctuation,
other factors influence market
volatility.
If you were buying hurricane
insurance in New Orleans,
would you pay more if the
weather forecast was for clear
skies, or if you heard there
was a storm beginning in the
Caribbean headed north?
Obviously, if there is a
chance of disaster, people
will pay more for protection
than if there does not appear
to be a threat. In reality,
people are able to purchase
hurricane insurance anytime
during the year. The
premiums are calculated by
the actuaries at the insurance
companies via statistical
probability analysis of the
chance of a hurricane
affecting the area, and the
cost to the company for the
claims they must make good
on. However, if you did not
have coverage, and a report
of a storm beginning in the
Caribbean hit the news wires,
you could expect that
premiums would increase or
maybe not be available at that
time. Consequently, if the
storm fizzles out, the
premiums would return to
where they were prior to the
announcement.
The options markets react
similarly. The psychological
effect of anticipating future
events which will influence
the price fluctuation of the
underlying market are
reflected in the option
premium as a component of
implied volatility. The
expectation of a weather
forecast in the grain markets,
before the contents of the
report are known, can cause
implied volatility to rise. The
anticipation of the release of
USDA statistics in all
agricultural commodities can
effect premiums, even
without much of a move in
the futures market. This
psychological premium
component is the market’s
interpretation of
uncertainty and risk.
Meetings of the world’s
major economic powers, the
G-7 conferences, can make
currency traders uncertain
about exchange rate policy. A
Federal reserve
announcement, or statement
of economic condition, can
effect the currency and
interest rate markets. A world
conflict, like the Gulf War,
even effected volatility in live
cattle options. In fact, in
October 1987, when the
market dropped precipitously,
the option volatility in the
totally unrelated cattle market
also soared, for no other
reason. Is this psychological
effect on volatility the right
reaction? No one knows until
the reports and world events
are digested in the market.
The professional traders are
estimating what volatility will
be or forecasting volatility.
The volatility of the
underlying future which
traders project, from a given
time until expiration, is called
forecast or future volatility.
Forecast volatility is the
individual trader’s perception
of future price activity, not
the consensus option of the
market.
Remember, to increase the
odds in your favor of having
a profitable trade, you need a
“trading edge” over the
market. One way of “getting
the edge” is by the use of
forecast volatility. When
taking a futures position, the
trader has an opinion that the
market is not currently valued
correctly. If a trader thought
the market was valued fairly,
why make a trade? This
thought process also applies
in options trading. An option
trader may have an opinion
on volatility alone, or in
concert with a directional
play. The edge exists in
accurately interpreting what
the range, not necessarily
direction, of the market will
be from now until expiration.
The current volatility could
be higher or lower than the
trader’s forecast volatility.
The prediction of future
volatility would be based on
the historical range of the
volatility of the underlying
market, the range of implied
volatility, and the trader’s
interpretation of external risk
factors, as discussed above.
The profit or loss made as a
result of a volatility trade
based on the trader’s forecast
volatility will arise from the
future price behavior of the
underlying future from the
time the trade is initiated until
expiration. This market action
is the bottom line of options
trading.
The standardized
measurement of the
fluctuation of a market, from
a given time until expiration
(or the time the position is
offset), is called actual
volatility. Again, this is the
bottom line; not the market
behavior before the trade, not
the number which is plugged
into a formula to represent the
current option price, but the
actual price behavior of the
market which affects your
position. This type of
volatility is the most sought
after knowledge by options
traders. Futures traders
want to know where the
market is going; option
traders are interested in the
how and when, actual
volatility. In order to
determine the impact of
actual volatility, the trader
must compare the current
implied volatility, the trader’s
forecast volatility, and the
resulting actual volatility.
For example, examine the
hypothetical T-bond 108
calls, with 90 days before
expiration in a position which
is market neutral, i.e. without
directional opinion. In order
to achieve market neutrality,
the trader has to “hedge” the
option with the underlying
future, or another option. For
this example, we will use the
underlying future. If the
futures are trading at 108-00,
the hedge ratio, or delta of
the 108 calls would be .50
(the option’s delta is the rate
an option changes for a given
price change in the
underlying). Therefore, in
order to hedge with futures,
the position must be taken
with a minimum two options,
against the future. The call
price is $2500, which would
equate to around a 12%
implied volatility. Our
forecast volatility is 10%,
therefore we would write
(sell) two 108 calls and buy
one future. The reason for the
forecast volatility being lower
the current implied, might be
that the historical average is
around 10%, and the
announcement of Federal
policy is coming out in two
weeks. The market’s
anticipation of the
announcement which may or
may not lead to a policy
change, has caused the
implied volatility to rise from
10% to 12%. Assuming that
we will keep the position
“delta neutral,” thereby
taking away the price
forecasting element, we may
measure the profitability of
the trade by examining the
actual volatility for the
duration of the trade. If the
actual volatility was less than
the implied (12%), we may
assume the trade was a
winner; if actual volatility
was greater than the implied,
the trade was a loser. The
new implied volatility at time
of offset is an important
factor in the computing the
profit/loss of the trade.
Almost always, the implied
volatility will be positively
correlated in its movement
with the actual movement. If
the actual volatility was
higher than the implied was at
time the trade was initiated,
the new implied most likely
will rise, therefore increasing
the loss of our trade. If actual
volatility was lower than the
12%, most likely the new
implied volatility at time of
offset (2 weeks) also fell and
increased the profit. These
effects, changes in implied
volatility, and the differential
between forecast and actual
volatility, are the most
overlooked, under-utilized
factors of options trading by
the non-professional trader.
They are the most important
factors to the experienced,
professional trader.

HISTORICAL VS.
IMPLIED
VOLATILITY
Much debate exists in the
options world between
historical and implied
volatility. Does the past or
current movement gauge
what will happen more
accurately? There is no single
right answer to this question.
The relationship between the
two, however, can give the
trader indications about the
underlying market’s behavior.
All traders look for “signals,”
via pattern recognition,
momentum indicators, cycles,
wave counts, etc. Few traders,
even options traders, look at
the historical/implied
volatility relationship as an
indicator that a trend is about
to begin, or end. In addition,
it appears that when volatility
is at its extremes for a
particular instrument, whether
at the high or low end,
implied volatility is reluctant
to penetrate these bands
before historical volatility.
The method used to observe
this relationship does not
involve complex
mathematical models, but
only charts. The charts
required for this analysis are:
a daily bar chart of the
underlying, an implied
volatility chart, and a
historical volatility chart,
with the relevant time
intervals (compare the
historical volatility of the
amount of days close to the
days left in the options life).
One way to observe this
relationship is to overlay the
two volatilities and compare
this to the action in the
underlying instrument.
By examining these charts,
the trader may draw several
conclusions.
First, when the market is in a
low volatility situation,
historical volatility is often
lower than the implied. The
market makers are not willing
to sell premium, which could
subject them to an
undesirable level of volatility
risk. Traders have decided
either: 1) implied volatility is
over-priced relative to recent
underlying price behavior; 2)
the options traders are
expecting a move in the
market.
As we go on in time, and the
market action begins to pick
up, historical volatility may
rise and equal the current
implied. Once the trend is
established, historical
volatility may exceed
implied. At this point, the
options traders are not willing
to pay for the current market
action, therefore, implied is
undervalued with respect to
recent price activity.
When historical volatility
rises to its highest, implied
volatility may suddenly start
dropping. This can be a
warning signal that implied
volatility can “sense” a loss
of momentum in the market.
A divergence in direction
between implied volatility
and historical volatility has
occurred; implied volatility is
dropping, historical volatility
is rising, though leveling off.
Although the market is still
volatile, premiums begin to
decrease. The underlying
market often thereafter
reverses direction. The
“trend” has ended. As market
prices revert into a
“comfortable” range, implied
volatility and historical
volatility again come
together. The divergence in
direction between historical
and implied can indicate the
end of a trend. Is this
observation absolute? As we
said earlier, no one trick or
tool is the key or short cut to
successful trading.
By definition, historical
volatility is a measure of what
the market did. One could
logically conclude that
historical volatility lags
implied.
However, historical volatility
can lead implied when it
comes to a market breakout.
Remember, prior to the
breakout, the market was
quiet, and implied was higher
than the historical. When the
market actually made its
move, the traders are
somewhat reluctant to believe
it, since the implied volatility
has not been justified by the
market movement. As the
move becomes more evident,
the implied catches up, but
usually doesn’t equal the
peak of the historical.
Another reason for the
apparent “lag” of implied
volatility is the role of the
inexperienced “public” or
speculative non-commercial
players. We assume that since
you are reading this book that
you will not be an
“inexperienced” trader but
will think like a “pro!”
Typically, the public buys
into the trend well after it
begins. Since this type of
trader often buys options,
volatility increases after the
move has begun. The public
trader often is “long” and
“wrong” volatility.
They often do not understand
the “price” they pay. This late
surge of premium buying can
also be accentuated by the
volatility shorts, especially of
out-of-the-money options,
who cannot afford to
maintain their positions due
to increases in margin. The
result is panic liquidation
buying, often by the clearing
firm, to cover a customer
with insufficient funds. Their
motivation is not to buy
undervalued volatility, but for
protection.
When implied volatility is at
the upper limit of its
historical bands, it can drop
sharply. An educated guess to
this phenomenon may be that
after the panic buyers are
through liquidating, the
professional can get a handle
on defining their risk
parameters. Infinite becomes
finite to them. An unknown
becomes a “reasonably
known.” The pros are
comfortable to begin selling
premium. Combine this with
the weak volatility longs, who
entered the market well into
the move, and the result is the
domino effect to the
downside of implied
volatility.
The underlying market is still
very active, so in this case it
takes some days for the
historical volatility to catch
up. Implied volatility has
become the leader, with
historical volatility the lagger.
It appears that the
combination of
supply/demand factors with
the experienced intuitiveness
of professional options
traders, can give a signal that
the trend has reversed or at
the minimum, subsided
through the comparison of
implied volatility with
historical volatility. Keep
these relationships in your
mind, but there is no
substitute for actual
experience and hard work
when it comes to options
trading.
There is no magic formula
that guarantees profitable
results. However, the use of
these observations to help in
your trading decisions,
increases your odds for
success. The first step is to
look for the volatility
relationships and compare
them to the underlying’s
chart. Concentrate on relative
relationships, not absolute
numbers. The minute
volatility differentials are for
the professional arbitrage
traders to take advantage of.
It is not economically
feasible, or time practical to
be caught up in the exact
figures, carried out seven
decimal points. Use the
information in the framework
of the decision making
process as a weapon to
increase the probability of a
successful trade, and to help
keep the losing trades from
becoming disasters.

MEASURING
VOLATILITY AND
ITS EFFECT ON AN
OPTION’S PRICE
In the previous section we
defined and discussed the
different types of volatility.
Knowing something exists,
and knowing how to use it
and gain a significant
advantage from it are two
different propositions. To
grasp the impact of volatility
on an option’s price, we must
quantify it. Since we are
looking at the impact of
current options prices, the
type of volatility change to
measure is the implied
volatility. The change in an
option’s price, with respect to
a 1% change in the implied
volatility is referred to as the
option’s vega. Vega is
typically expressed in “ticks”
(minimum price fluctuations).
If the 108 calls in our
previous example, had a vega
of 16, then for every 1%
change in the implied, the
option would change by 16
ticks ($250.00). If the implied
volatility came in line with
our forecast volatility,
therefore dropped from 12%
to 10%, with this vega, the
options would be worth
approximately $500 or less or
$2,000.00. The following
properties hold true with
vega:


1. The longer the life of an

option, the greater the
vega. Longer-term
options are more
sensitive to implied
volatility changes than
shorter-term options.
The June 108 calls (in
the same year) have a
higher vega than the
March 108 calls.
2. Calls and puts with the
same strike price and life
have the same vega.
March 108 calls have the
same vega as the March
108 puts, regardless of
the underlying price.
3. At-the-money options
have a higher vega than
in-the money or out-of-
the money options. At-
the-money options are
the most sensitive to
 implied volatility
changes in a particular
options series.

Given these properties, we

may define vega as the
measurement of volatility risk
for an option. As you can see
by our previous example,
volatility changes impact an
option’s price tremendously.
Not considering potential
changes in option volatility
when initiating options
trades, especially longer-term
options, is like driving a car
with bad brakes; you do not
know when the brakes will
stop working, but when they
do, you’re going to crash.
In order to implement this
newly acquired knowledge,
the trader should have access
to computer software, or
hand-held calculators which
calculate option sensitivities,
theoretical values, and
volatility for you. Different
software packages, both on-
line and off-line are covered
in another chapter. Due to the
expansive interest in this
information, the packages are
available at costs, often less
than the price of an option. If
a trader is to attain an edge,
he must first begin on an
equal playing field and then
use every device, piece of
information, and knowledge
he can acquire. The trader
must have access to volatility
information in order to trade
it and take advantage of the
opportunities which present
themselves. Understanding
volatility and its effects are
the building block to options
trading. The calculations are
easily done by computer,
calculator, or other similar
devices, freeing up the
trader’s time to make
decisions, not crunching
numbers. This understanding
of vega, and measurement of
volatility, give the trader the
weapons which the
professional uses.

IMPLIED
VOLATILITY
MEASUREMENT
AND
CONFIGURATION
Understanding the effect of
volatility on an options price
is essential. The type of
volatility associated with an
option’s price is always
implied volatility.
Professional traders often ask
each other, “Where’s
volatility trading?” The
response could be: “11.2 at
11.3.” What does this mean?
To the professional, this
means that the at-the-money
strike of the particular
commodity can be purchased
for 11.3% implied volatility,
and sold at 11.2% volatility.
The market makers wish to
buy and sell the options at
these particular implied
volatilities. When an options
trader wants to know the
volatility of a particular
instrument, this is the
volatility he/she is asking for.
We cannot over-emphasize
the fact that volatility is the
most important tool
professional traders use.
Let’s assume that the trader
has access to an option
valuation system. The trader
looks at the screen, for a
particular series of options,
with the same expiration date,
like June 93 S&Ps. The S&P
June futures are trading at
445, therefore the 445 strike
would be considered at-the-
money. The 445 calls and
puts have an implied
volatility of 10%, but the 410
put has an implied volatility
of 15%. Can this be possible?
Different strike prices trade at
different volatilities for a
series of options (same
expiration date). Which
volatility is correct? If we
refer to our conversation
between two professional
traders, we know that the
implied volatility most often
used as a barometer for the
entire series is the at-the-
money volatility. Look at all
the strikes. It appears that all
strikes above 445 are trading
around the same volatility as
the 435; the implied
volatilities of the strikes
below 445 increases.

VOLATILITY
SKEWS - THE
TECHNICAL SIDE
Examining closer, the trader
may observe that for every
strike below 435, the
volatility increases. This
volatility makeup for a
particular market is referred
to in the industry as the skew.
Each commodity, or group of
commodities has their own
particular skew. In many
markets a skew exists,
meaning that the out-of-the-
money calls/puts trade at a
higher volatility than the at-
the-money options. Some
markets have a normal skew,
which if you graphically
plotted the implied volatilities
the picture would be a “V.”
This occurs because the out-
of-the-money options “vega”
is so low, therefore a
percentage point increase in
volatility in these options
equates to a small price
change. Other markets have a
skew to only one side or the
other, meaning the further
you go out-of-the-money in
either the calls of the puts, the
higher the implied volatility
of those strikes is.
In reality, volatility skews
have three basic
configurations. The “normal”
configuration is “U” shaped.
The strikes more distant from
the at-the-money strike trade
at higher volatility; the at-the-
money having the lowest
implied. If one was to plot out
the different volatilities, and
connect the dots, the
formation would be that of a
“U”. The reason that this
phenomenon exists ties in
with the properties of vega.
We know that vega decreases
as the strike moves further
from being at-the-money. The
sensitivity to volatility
changes decrease as the strike
moves away from being at-
the-money. Deep in-the-
money or out-of-the-money
options have small vega. A
volatility change will not
effect the price of the option
that much. Currency options
commonly have this
configuration.
For instance if we notice that
the vega of the June
Deutsche-mark 68 strike is
one tick, the option premium
of the call is three ticks, with
the implied volatility being
13%. These calls are
approximately 600 points out-
of-the-money. The 62 calls,
running at 11.5% implied
volatility, are trading at 175
points, with a vega of 13. For
far out-of-the-money options,
it seems that people, usually
the non-professional trader,
are willing to pay more for a
lottery-type trade. At the
same time the professional
traders, who are usually net
sellers of out-of-the-money
options, demand more of a
premium for taking the
unlimited risk. These options
are less liquid, and less
frequently traded. For this
reason of illiquidity, and a
desire not to engage in large
positions by the
professionals, the implied
volatility of these options are
not a good indication of
implied volatility for the
option series. Since the vega
of these options is one, we
know that a 1% volatility
change equates to a one tick
change in the price of the
option. Contrast this with a
13 tick change for the at-the-
money option. An
inexperienced options trader
does not look at the volatility
cost of an option, but only at
the dollars spent for the
option.
The second type of volatility
skew is configured by
increasing implied volatility
in the strikes below the at-
the-money, and implied
volatility equal to the at-the-
money implied volatility in
the strikes above the money.
This type of configuration,
looks like an obtuse angle
(greater than 90 degrees). In
fact, the shape of this skew is
very similar to the shape of a
profit/loss graph of a long put
position. S&Ps and T-Bonds
are configured in this manner.
This phenomenon occurs in
the institution-dominated
markets. Pension Funds and
portfolios of institutions
operate under directives to
hold underlying securities. In
essence, they are always
“long” the underlying, i.e.
stocks and bonds. The real
risk to these portfolio
managers is a rapid
unforeseen decline in prices.
In order to “hedge” this
position, they must buy puts,
sell calls, or both, thereby
driving up the out-of-the-
money puts, and keeping the
out-of-the-money calls under
pressure (more demand,
hence lower implied
volatility). In addition,
accounting provisions may
prohibit the managers from
buying calls or selling puts at
any time, again forcing them
to hedge in this manner only.
If the portfolio managers
have fear only in one
direction, the downside,
because they are holding the
securities, these managers are
willing to pay more for
protection on the downside.
As we know, the further an
option is from being at-the-
money, the smaller the vega,
therefore a small actual dollar
change in value equates to a
larger implied volatility
change in that option. The
manager’s ability to write
calls as a hedge apparently
outweighs the speculative
effect on the upside. Since
these managers have no fear
of an upside move, they will
sell the out-of-the-money
calls. This fear of unforeseen
and rapid downside
movement also stems from
the theory that markets
almost always decline more
rapidly then they ascend.
The third type of volatility
skew is the configuration in
which the strikes above the
at-the-money options trade at
higher volatility, and the
strikes below the at-the-
money options are priced at
equal or lower volatility. This
type of configuration is
prominent in the grain
markets, the metals markets,
and most soft commodities.
This configuration is a result
of perceived or actual price
floors of these commodities.
If the USDA guarantees
farmers a specific price for
their commodity, this
decreases the probability that
the commodity will trade
below this floor. However, if
an unexpected drought during
the growing season hits,
uncertainty about the yield of
the crop becomes widespread.
These commodity markets are
more volatile when prices
increase. Traders, right or
wrong, are willing to pay
more for the small limited
risk with unlimited reward
that a long out-of-the-money
call offers them in these
commodity markets.
Another way of examining
the phenomenon of volatility
skews is by incorporating
forecast volatility. We know
that the at-the-money
volatility is the recognized
volatility for a particular
commodity. For example, if
July soybeans are trading at
600, the 600 strike trading at
20% implied, and the 675
strike is trading at 26%
implied volatility. The market
may be forecasting that if the
July beans trade up to 675
before expiration, the new at-
the-money implied volatility
would be 26%. We know that
an option’s vega, at its
extrinsic value, decreases
with the passage of time.
Therefore, the net effect of
this forecast is dependent not
only on whether the
underlying price moves to the
strike, but also when.
It is important to note that
although these skews exist,
their shapes are not absolute.
The configuration of a
particular commodity may
change over time. Market
conditions may change
rapidly, which calls for
adaptation. The aspect of the
skews which changes over
time and changing market
conditions is the steepness of
the skew, or the slope. Option
traders who trade on the
exchanges use theoretical
value tables as a guide to
making markets. Many of
these traders will use tables
all at the same volatility, the
current at-the-money implied
volatility, and estimate the
volatility differentials of the
skewed strikes by having a
knowledge of what rate the
implied volatility increases
per strike in the direction of
the skew. For instance, a
trader may have a table of
values for an implied
volatility of 20% in gold
options, with the gold future
trading at $350/ounce. By
trading experience, the
market maker may know that
for each strike above the at-
the-money, the implied
volatility increases by 1%,
therefore, the 360 strike is
trading at 21%, the 370 strike
at 22%, the 380 strike at 23%,
etc. By knowing the option’s
vega, the trader can make
accurate calculations in
estimating each option’s
theoretical value, despite the
fact that his tables only use
one volatility. If a mining
strike in South Africa hits the
news wires, the price may
increase. Additionally,
uncertainty has entered the
market. The “skew” may also
be affected. Instead of the
“normal” 1% per strike, the
new skew may increase to 2%
per strike.
Most often, the steepness of
the skew increases at times of
higher volatility, and
decreases at times of lower
volatility. The new trader
must be careful in observing
the skew for options with less
than 2 weeks remaining in
their life. Since the vegas are
very small, the skew might
seem to be steepening, or
changing form. This effect
occurs when options have
little or no value anyway,
therefore it should not be
construed to be significant.
Generally speaking, to
observe a commodity’s
volatility configuration, look
at an option series with a
minimum of 30 days left until
expiration.

VOLATILITY
MEASUREMENT
AND
FORECASTING
An experienced futures trader
would not take a position in
the market without a reason.
Typically, traders look at
charts of a futures price
history as input into the
decision. Futures traders tend
to follow market trends. Even
fundamental traders use some
technical analysis to
determine entry and exit
points. Traders study where
the market was in order to
forecast direction. These and
other technical tools apply in
volatility forecasting.
The main advantage in
volatility trading over
directional trading alone is
that volatility, both historical
and implied seem to trade
within bands the majority of
the time. On a historical
basis, these bands seem to be
rarely violated. The idea is to
recognize that volatility can
be gauged as being low, high,
or in the middle of its
historical range. Observing
the behavior of volatility,
both historical and implied, is
as important, as the behavior
of the underlying. Each
particular market seems to
have a volatility tendency, or
range which is considered
average or normal. This
average volatility is not an
exact number, but a range in
which professional traders
associate with typical
behavior for a particular
commodity.
This interpretation applies
directly to forecasting
volatility. The trader should
not pick a specific number,
for instance 21.7%, as the
forecast volatility, but a range
relative to where volatility is
currently trading. The options
trader must make a judgment
on the relative value of
volatility. The trader uses all
the vehicles available to make
the best decision possible.
The most important vehicle
for an options trader is the
relative value of volatility.
In order to make a judgment
on the value of volatility, the
trader must know what the
volatility character is for the
commodity he wishes to
trade. These figures are now
readily available for past
historical volatility, and past
implied volatilities for each
commodity, and in many
cases equities. Although in
theory, it may seem
straightforward to extrapolate
the average volatility ranges,
the trader must be aware that
the averages may shift over
time. The guide a trader
should go by when measuring
volatility’s relative value is a
two-step process. Step one
involves the comparison of
the historical tendency range,
on an annual basis with the
present implied and current
historical volatility.
Professional traders compare
the historical volatility of a
sample length equal to the
time until expiration.
The second step consists of
determining the current
volatility trend. One of the
oldest and simplest adages in
trading is “the trend is your
friend.” Not only does this
hold true in directional
trading, but also in the trading
of volatility. The trader’s
awareness of volatility trends
is an essential part of trade
determination. If a futures
market is in an upward price
trend, chances are that the
price is above a medium term
moving average. If the market
is really in a strong trend, it
will stay above the average
for quite some time. If the
market was in a down-trend,
we can expect it to stay below
the medium term moving
average during the duration
of the trend. As each specific
market has characteristics for
making tops and bottoms, so
does volatility. For example,
many technicians describe the
stock market as making
“rounded tops” and “spike
bottoms.” However, as we
noted earlier the stock market
is more fearful of declines
than rises in price, based on
its volatility configuration.
Volatilities of all markets
seem to share the same trend
characteristics.

VOLATILITY
TRENDS
Volatility moves up and
down like any underlying
market. We have indicated
that each market has a normal
or average volatility range in
which markets seem to
respect and “trade within” the
majority of the time.
Although each market has a
particular volatility
configuration, the trend
behavior of volatility is
similar throughout the
markets. A similarity of
behavior in the making of
extremes exist. Volatility
seems to make spike tops and
rounded bottoms. As you can
see when volatility peaks, it
begins decreasing sharply,
back into its channel of
normalcy. When volatility
bottoms, it stays at depressed
levels for extended periods of
time, forming a smooth,
rounding pattern. This pattern
is a function of the
psychological perception of
risk by the major market
players. This phenomenon
occurs in both historical and
implied volatility, although
the psychological aspect is
reflected in implied volatility
as a result of the market
player’s perception of
“actual” volatility.
This aspect of volatility’s
behavior stems from the fear
of being “short premium,” or
naked short volatility, during
the occurrences movement of
the underlying instrument. A
shift in the supply/demand
equilibrium of options pricing
occurs. The players who are
already short premium want
to get out and re-evaluate
their market outlook. The
market makers who have to
sell to these players, demand
a higher price to take on the
risk of the unknown. Thus, a
vacuum effect of rising
volatility occurs, regardless
of the underlying price
movement. After the event or
occurrence has been digested,
players re-evaluate and re-
enter the market. When
professional options traders
once again feel they have a
grasp of the market’s price
behavior, volatility will
decrease dramatically.
Although the stock market
was the focus of attention
during the market crash, the
volatility of other financial
and agricultural markets were
affected. Volatility rose in
treasury bonds from around
13% at-the-money implied
volatility to almost 30%
during that week. As soon as
you bought an option,
someone was bidding a
higher price. It did not matter
if it was a call or put,
premiums increased
irrespective of underlying
price.
The reason for the increase in
volatility was people were
unsure of the financial
stability of the world. Traders
who were expecting frantic
markets to continue had long
volatility positions. When it
became apparent that the
frantic premium buying was
over, long volatility position
holders began trying to sell,
and volatility dropped like a
rocket. Volatility has been
declining in bonds, with the
exception of a brief rise in
1989, (the mini-crash) ever
since.
Besides the knowledge of
trend behavior of volatility,
the trader must realize that
when buying volatility in a
volatile uptrending market,
you must have a plan to take
your profits when they are
there, for they can disappear
in an instant. Long premium
positions are fighting time, as
well as predicting market
options with less than 30 days
of life. Investors who
purchased out-of-the-money
calls in October, 1987 with an
implied volatility of almost
30%, thinking that the bonds
were going to continue their
rapid price ascent, got a re-
education instantly. Even
though the T-bond options
are considered the most
mature futures options,
traders still made mistakes by
forgetting the relative
volatility value and not
properly gauging the risks.
An options trader who buys
premium for the limited risk,
unlimited reward aspects
loses money 90% of the time.
The vast majority of this
money would have been
better spent on lottery tickets!
If the trader is going to use
options, he should understand
the vehicle. Understanding
options starts with and ends
with the understanding of its
most important, most
misunderstood tool, volatility.
 CHAPTER 17
Technical
Explanation of the
Use of Vega, Delta,
and Theta
A trader may see if current
market volatility is high and
implied and the historical
volatilities are at the upper
band of their normal range,
and volatility has been rising.
He then initiates a “Neutral
Option Position.” If the trader
has incorrectly forecasted that
volatility was going to
decline, he can suffer a loss
due to a greater actual
volatility than anticipated.
The effects of these type of
volatility increases on the
position may be quantified by
using the option risk
variables. The risk of implied
volatility fluctuation is
measured by the position’s
vega. “Delta” is the rate of
change of an options price
with respect to a unit change
in the underlying price. The
rate of change of an option’s
delta with respect to unit
price change in the
underlying is called
“gamma.”
If a trader purchases options
during periods of declining or
down-trending volatility, the
market does not punish the
long volatility player quickly,
but lets his position die a
slow death. If the trader was
taking a long volatility
position based on his forecast
volatility as compared to the
current implied and historical
volatilities, he might, for
example initiate a long at-the
money straddle position,
again with 120 days until
expiration. If the trader has
guessed wrong on his forecast
volatility, the position does
not change much day after
day, giving a trader a hope
that volatility will increase
and “bail him out.” Since the
trader over-estimated
volatility, the lack of implied
volatility increases and
market movement causes the
position to erode from time
decay.
Each option has its own
weighting with respect to the
price movement of the
underlying. This weighting is
expressed by the number of
equivalent underlying
(futures), or the amount an
option moves for a minimum
price fluctuation of the
underlying. For example, at-
the-money options move by
half the move in the futures.
The term for this
measurement is called delta.
The at-the-money option has
a delta of 0.5. Futures always
have a delta of 1. In
mathematics, this term is
commonly termed the rate of
change. This measurement is
also called the hedge ratio,
because it represents the ratio
of options needed to equal
one future. This figure does
not take other factors into
account, such as volatility and
time erosion. Additionally,
this number changes with
market movement. The more
in-the-money an option is, the
higher the value; the further
out of a money the smaller
the value of this measure is.
The sum of the absolute
values of this ratio (delta), for
a call and put of the same
month and strike price equals
one. If December gold is
trading at $350, the
December 350 calls and puts
each have a delta of .5, equal
one. If the 360 calls have a
ratio of .35, .65, is the hedge
ratio for the 360 put with the
future at $350. If we examine
the 350 strike, we would find
that no matter what volatility
is trading at, this ratio will
still be .5 for both the calls
and puts. This also means that
there is 50/50 chance of these
options being in-the-money at
expiration, or a 50%
probability.
In-the-money options are
affected by volatility changes.
For example, the Dec 360
put, with Dec gold at $350
has a hedge ratio of .65. An
increase in volatility would
decrease this measurement,
while a decrease in volatility
would increase this figure.
This is because volatility is a
risk measurement tool of the
perceived range by the
marketplace of the
underlying, in this case
December gold futures. A
higher volatility figure
implies a larger range of
movement for the underlying
future. Therefore, in-the-
money options have less
weight with higher volatilities
because the market is
implying that the market is
more likely to move away
from where it currently is. A
volatility decrease would
increase the probability of the
market staying closer to its
current price level until
expiration.
You can predict what an
implied volatility change
would do to out-of-the-money
options. If implied volatility
increases, the hedge ratio of
the in-the-money option
decreases. The opposite is
true for decreases in
volatility. Mathematically,
using the same gold option
example:

- - - - - - - - - - - - - - -
IF DEC 360 PUT
PRICE RATIO = .65
THAN 360 CALL =
APROX. .35
VOLATILITY
INCREASE:
360 PUT HEDGE
RATIO <.65
THAN 360 CALL
HEDGE RATIO >.35
IMPLIED
VOLATILITY
DECREASE:
360 PUT HEDGE
RATIO >.65
THAN 360 CALL
HEDGE RATIO <.35
- - - - - - - - - - - - - - -
The length of time of an
options life acts identical to a
change in volatility; more
time means higher deltas for
out-of-the-monies and lower
deltas for in-the-monies, a
shorter options life means an
increase in in-the-money
delta, and decrease in out-of-
the-money deltas, assuming
all other variables (price and
volatility) remain constant.
The hedge ratio (delta) or
price ratio, changes for each
option with a change in the
underlying price. This
measurement, or rate of
change of the hedge ratio
given a unit change in
underlying price, is
represented in option models
by the Greek letter
“gamma.”
This measure may be
illustrated by using our gold
option example again. We
know that the at-the-money
option will always have an
approximate price ratio of .5.
We assumed that with Dec
gold at $350, the Dec 360 put
had a price ratio of .65, with
the 360 call .35. If our unit
change for this “gamma”
measure is $10 in the
underlying, we can estimate
the measure if the futures
were to move up to $360. If
the Dec gold futures are
trading at $360, the 360 strike
is now the at-the-money
strike.
Therefore, the new price
ratios are .5 and .5 for the
calls and puts respectively.
The change from .65 to .5,
and from .35 to .5, is equal to
.15. This number, .15 is the
gamma for the 360 strike, or
change in price ratio.
This is an important measure
for risk analysis of an options
position. This risk of the
options position is directly
related to price risk in the
underlying. The moment a
trader initiates a position
three possibilities exist as to
the directional market bias
the position has; long the
market, short the market, or
neutral the market. Gamma,
or the change in price ratio,
allows the trader to measure
how market movement
affects the directional bias.
This measure is one of the
tools necessary in making
adjustments to the “core”
position, as the underlying
market moves.
A position that is net long
premium, long options, is
long this measure. Keeping
time and volatility constant,
this type of position, an
outright call or put purchase,
or a straddle or strangle
purchase, is “always the right
way,” with respect to market
moves. The position becomes
“more long” as the futures
move up, and “more short” as
the futures price declines.
For example, with June T-
bonds at 110, a trader
purchases 10 June 110 calls
for 2-00 ($2,000). Since these
are the at-the-money options,
they have a price ratio (delta)
of .5. This means that in
futures equivalent terms, the
position is long 5 June T-
bonds (.5 X 10 = 5). If the
change-in-price ratio measure
is .1 for the 110 calls, how
many futures equivalents will
the position be long if June
Bonds rally to 111? We
simply add the change in
price ratio measure (gamma)
to the existing price ratio, .5
to attain the new hedge ratio
(delta), .6. By multiplying .6
times the number of
contracts, 10, we now have
calculated the current futures
equivalent number to be 6. If
the market moved down to
109, instead of up to 111,
what would be the result?
Instead of adding .1 to .5, we
would subtract .1 from .5,
giving us a new hedge ratio
of .4. 10 X .4 = 4, resulting in
the amount of futures
equivalents the 10 contract
position equals with T-bonds
at 109.
Short premium positions are
short or negative this measure
(gamma). Short outright calls
or puts, straddles and
strangles, are always the
“wrong way,” regarding
market moves, keeping time
and implied volatility
constant. These positions
become more short, market-
direction wise, as the futures
move up, and more “long”
with declining futures prices.
We can examine the effect of
this measure on short
premium positions by taking
the other side of our T-bond
option trade. Instead of being
long ten 100 calls, we are
short ten 110 calls. The
change in price ratio will act
the same; on a move from
110 to 111, the hedge ratio
(delta) will move form .5 to
.6. We are using the same
option, therefore it will have
the same change in price ratio
(gamma) of .1. Since we
initiated the position with a
futures equivalent of short 5,
the increase in price from 110
to 111 has caused the position
to become more short in a
rising market. At a futures
price of 111, the new futures
equivalent measure of the
position, or position delta,
becomes short 6. The position
is adversely affected, with
time and implied volatility
constant. A price decline in
the futures, from 110 to 109,
decreases the futures
equivalents from short 5 to
short 4, given our position.
As the futures move
downward in price, the
futures equivalents decrease,
thereby deriving less benefit
from the price movement.
We earlier defined the limits
of the hedge ratio from -1 to
1, negative ratios are for short
positions, positive for long
positions. This means that the
futures equivalents have a
limit from 0 to the number of
contracts, for the option
cannot be more valuable than
the underlying. The change in
price ratio, (gamma) therefore
must have its own limits.
The at-the-money options are
the most sensitive to change
in price ratio. As the strikes
go further from the at-the-
money strike, this measure
decreases.
Additionally, this measure is
the same for calls and puts
with the same strike and
expiration date. With the
passage of time, options are
more sensitive to this change.
In other words, the risk of
change in price ratio
increases as expiration nears.
This risk is a benefit for long
premium positions, and a
disadvantage for short
premium positions. The
change in price ratio for at-
the-money options is more
sensitive to volatility
changes. Volatility increases,
decrease the change in price
ratio; volatility decreases,
increase this measure. This
effect is based on the
volatility effect respective to
hedge ratio. Higher volatility
results in a narrowing margin
between in-the-money and
out-of-the-money hedge
ratios, therefore the change is
smaller. Lower volatility
causes a widening margin
between in-the-money and
out-of-the-money hedge ratio,
therefore the rate of change is
larger.
The volatility long trader is
betting that the actual market
behavior will be volatile
enough for the position to
prosper from the positive
change in price ratio. The
volatility short player is
betting that the price behavior
of the market will not punish
the position, with a negative
change in price ratio, thereby
allowing time to pass, and the
premium to erode.
In summation, it is important
to note that the change in
price measure only allows for
approximation of hedge ratio
estimate. As the hedge ratio
changes with changes in
futures prices, so does the
change in price ratio
(gamma).

USING VOLATILITY
SPREADS
Options trading allows the
trader to take advantage of
other opportunities of markets
other than directional
movement. A trader may
have an opinion that the
market is going to make a
sharp move, or not move at
all. Options are the “tools” a
trader uses to create a more
customized trading strategy.
Trading strategies can
incorporate “mispriced”
options spreading against
“fair value” options, volatility
spreads, time decay
strategies, and directional
range spreads.
The spreading of mispriced
options against fair value
options relates to the
discrepancy in volatility
between two options with the
same underlying future and
usually the same expiration
date. The crux of this method
is getting a “trading edge” in
a mispriced option
(over/under valued), and
spreading it against a
properly priced option. As
time passes, the hope is that
the trader will realize a profit
as the options volatility
equalizes. In the “real world”
of options, options with the
same expiration date do not
always trade with the same
volatility.
Depending on the current
market conditions and the
extent of the mispricing, a
trader can spread with a ratio
that is “neutral” in both
direction and volatility, or
take an opinion in both or
either. Volatility spreading is
utilized if volatility is
severely under/over valued to
its mean over a specific time
frame.
Time decay strategies would
be considered if the
determination is made that
the underlying market is in a
“stable” trading range and
will remain that way. Most
likely, volatility will stay
constant or decrease. The
essence of these spreads is
that options are wasting
assets, and it is better to have
time work for you than
against you.
Directional range spreads
utilize option strategies which
also allow time to be on the
side of the position. These
spreads have limited
risk/reward properties. Rather
than take a futures position,
or simply buy or sell a put or
call, a directional opinion
could be taken.
SUMMARY OF
TECHNICAL
MATERIAL
In this chapter, we have
explained how implied
volatility is configured
differently in different
commodities. We know that
the at-the-money implied
volatility is the universally
recognized volatility for a
particular series of options.
The magic in discovering that
different strikes of options in
the same series may trade at
different implied volatilities
is the necessary basis for
uncovering and using many
of The Options Secret’s
trading strategies. Being
aware of this phenomenon
permits it to be used in the
trader’s decision making
process.
So far we have looked at the
in-the-money value, or
intrinsic value, the amount of
days until expiration, and the
interest rate as being
components of an option’s
premium. Does that mean that
every time a futures contract
is at a certain price, an option
with the same time to
expiration, and strike price,
given interest rates are
constant, will have the same
value? For example, if a T-
bond futures contract is at
107-16 and there are 90 days
until option expiration,
should the 108 call always be
priced at $2,000.00? All the
fixed components are the
same; the futures price, the
strike price, the time to
expiration and the interest
rate.
We can call these the known
variables. What if the next
time the futures are at 107-16,
the 108 calls with 90 days
until expiration are priced at 2
32/64ths ($2500.00). Is this
an incorrect price? If
someone is willing to buy or
sell this option at this price, it
must be the right price at that
given time. What is the
unknown variable? What is
this secret component of
options pricing? Although the
answers to these questions
may not have as much
importance as determining
the reason for human
existence, they are as
significant in understanding
and trading options.
The unknown component
contained in the price of an
option is similar to the
unknown variable of futures
trading: Where is the market
going and how fast is it going
to get there? Many market
watchers and traders believe
they have the ability to
predict the future movement
of the market. Market
forecasters make future
predictions based on past
information. Everyone knows
where the market has been.
However, no one can predict
the day-to-day movement of
any market in the future. Yet
every trader has an opinion of
where the market is going.
The options trader is not only
concerned with direction, but
the range and rate of market
movement in either direction.
Volatility is the most difficult
and important factor in option
trading. However, in all but
the most advanced books, is it
given its deserved attention.
And even when it is
discussed, little more than
definitions and general
concepts are presented. This
is surprising to us, because
both our research and actual
trading have shown that
volatility is the most
important, while also the
most overlooked and
misunderstood aspect of
option trading!
Options traders, on any level
have to learn from their
trades. There is no substitute
for hands-on experience in all
aspects of trading. An
essential part of gaining
experience is the process of
evaluating a trade; from the
thought process and
reasoning of why the trade
was initiated, to the
explanation of the net result
when the trade is offset. If a
position made or lost money,
the trader has to ask, “Why?”
Many times a trader will
make money for the wrong
reasons, not considering the
volatility effects, and repeat
the same technique over and
over. This typically results in
being categorized with the
majority of non-professionals,
a loser 80% of the time. By
running through the
“volatility thought process”
throughout the duration of a
position, the options trader
will be learning successful
evaluation techniques.
Mastering these techniques
will increase the probability
of success in your trading.
The steps of the volatility
thought process are:

1. Measure both current

 implied (at-the-money or
near the money average)
and the relevant
historical volatilities.
2. Convert these
percentages into
expected ranges for the
underlying instrument.
3. Compare the current
levels of the volatilities
to their normal bands.
4. Be aware of the
volatility trend.
5. Based on the above,
determine a range of
your forecast volatility.
This forecast range
should be kept simple:
higher, lower or equal to
the current volatility.
6. Examine the
approximate expected
range of the underlying
based on your forecast
volatility.
7. Examine the volatility
 skew of the options
series.
8. Based on your
evaluation of volatility
and market trend (the
technical pattern) decide
whether this is an option
position that will provide
a “trading edge” over the
markets.

After going through these

steps, the options trader is
prepared to make a trade
determination. The trader
should review these steps at
regular intervals after the
trade is initiated. There is
nothing wrong with changing
an opinion. The object is not
to be right on any forecast,
but to make money. Options
are flexible vehicles, and
options traders should always
remain flexible. The stubborn
trader, or the trader who is
afraid to admit to being
wrong, cannot be successful,
no matter how much
knowledge he or she has. Use
these steps to make better and
more informed trading
decisions.
 CHAPTER 18
Trading Gems and
Tidbits

1. IT DOESN’T MATTER
WHY THE MARKETS
ARE MOVING OR IF
THEY’VE GONE TOO
FAR — IT COULD BE
REAL, IT COULD BE
“MEMOREX”, BUT
 IT’S PROBABLY
“TULIPMANIA.”

The actual price movement in

any market may have no
relationship to the actual
supply, demand or
fundamental of that
commodity. Look at the chart
of lumber on the next page.
For the past 15 years, the
median price for lumber has
been about 20000. The
market varied at most 5000
from this level during this
period. However, in late
1992, what I call
“tulipmania” began and the
price of lumber increased
about 250% in four months.
This was followed by a drop
of 50% in the next three
months bringing lumber back
to the range that it had always
been in over the last 15 years.
What caused the “tulipmania”
pattern in the lumber chart?
Was it disease, lack of
supply, or strikes? None of
the above! The only reason
was emotion and fear (Chart
18.1).
Although almost every
market is prone to
“tulipmania” the most prone
to these conditions are the
grains, softs, and metals.
However, forms of this
“mania” occur in the
currencies, financials and
S&P 500. The charts on the
following page give examples
of these conditions (Chart
18.2-18.5).
There are various forms of
“tulipmania.” Tulipmania
originated from a situation in
Holland that occurred quite a
long time ago when the price
of tulips was driven up to
astronomical extremes, when
in fact there was an abundant
supply of them. This was
probably the first documented
example of how fear, greed
and emotion can drive a
market without any reason or
logic. These movements as
can be seen in the
accompanying charts, can be
relatively swift, occurring
over a period of days or
drawn out for months.
However, the final result is
the same. The market ends up
back where it should have
been according to the normal
laws of nature, supply and
demand, etc.
Does that mean that we
should disregard these types
of markets, question any
severe movement, stay out of
fast moving markets etc.? Not
at all. In fact, these types of
markets can be some of your
best sources of profit.
Remember the saying “Don’t
look a gift horse in the
mouth.” In the same vein,
don’t question your good
fortune when the market
starts to move in your favor.
However, if the market is
moving against you, and you
“know” there is no good
reason for this, and it is flying
in the face of all
fundamentals; realizing the
above - that it is not
necessary for markets to
always be in tune with the
actual facts - should help you
exit a position although you
are “certain” the market is
wrong. Remember, it is our
view that we let the market
tell us where it wants to go,
not predict or guess. The
bottom line is that in many
cases emotions, not logic,
move the markets.
2. “I KNOW EVERYTHING
ABOUT THE MARKETS
AND TRADING. I’VE
STUDIED FOR YEARS
AND STILL CAN’T
MAKE MONEY. WHY IS
THAT?”
In the following quote from
the book Poker, Sex and
Dying, by Juel Anderson,
replace the word “gambling”
with “trading” in every
instance and this may
enlighten you.
“Gambling is difficult. In
some respects it is the most
difficult of all endeavors. To
succeed takes an enormous
conviction and commitment.
Most individuals don’t
succeed because of the
inability to know themselves
and or the inability to control
their own actions. In
gambling the only asset you
have is yourself. The majority
of individuals simply don’t
have the capacity to be able
to depend solely on nothing
more than themselves. The
reasons are many, but the
main one is the self
developed habits or traits that
undermine the very structure
you are dependent on... In
gambling you set the
guidelines and make the
rules. In effect, you become
God. When you’re God it is
easy to change the rules. You
simply say, ‘Well they don’t
really apply to me.’”
The above statement
accurately describes the
reasons for losses for over
half the traders I know. And
even professional traders,
who among us has not been
singed at one time or another
by the above?
3. TAKE ADVANTAGE OF
THE DISADVANTAGED.
In option trading, when you
can lose money even when
you make a correct market
call by purchasing options
that appreciate too slowly; or
when you can make money
selling options when you’re
wrong and the market moves
against you, because of the
time value decay, you then
bring into the equation a
strong need for skill. The
simple difference between the
winner and loser is the skill
and knowledge you acquired
about trading.
A good example is that of
two pilots about to take off
from the airport. Both have
the same planes, however,
one checks the weather report
and finds that there is a
severe storm and turbulence
ahead. He chooses not to fly.
The second pilot flies into the
eye of the storm which he
may or may not survive.
Similar analogies can be
made for a trader. Trading at
the wrong time, such as
selling options during times
of national turbulence, unrest
or financial calamities is
almost sure to make the
flying ahead very difficult.
Similarly, buying options
during quiet periods, or when
option volatility is extremely
high, will also make it
extremely hard for the trader.
Similar to the pilot who can
choose his time when to fly,
why not choose the time you
want to trade, by selling
options during favorable
times and purchasing options
only when the technical
pattern and volatility levels
are to your benefit.
This flies in the face of what
our mothers always told us:
"Help the underprivileged and
less fortunate than yourself."
Unfortunately, “trading is
hell.” You must be ready,
willing and able to take
advantage of traders that
make poor decisions or are
uninformed. Those traders
who are purchasing high
priced, overvalued, out-of-
the-money options that we
love to sell to them are the
unwitting participants in the
“tulipmania” markets. If you
are a seasoned professional
and have done your
homework, you will find
yourself in the upper 10% of
the elite that consistently
succeed when trading.
4. I HAVE LOST MONEY
IN THE PAST BECAUSE
I HAVE BEEN
UNLUCKY.
As also discussed in detail in
Poker, Sex and Dying, luck is
a short term apparition.
Anyone can make money on
a single trade without
knowledge for a short period
of time. (In fact, the “dart
board portfolio” that is
chosen by the Wall Street
Journal by throwing darts at a
newspaper, beat the pros
many months out of the year).
However, trade often enough
and the money invariably
falls into the hands of the
pros. Trading is similar to any
business which becomes
successful by hard work and
the ability to discover,
understand and use
information to its advantage.
However, it amazes me to see
successful people who have
worked hard for 20 or 30
years mastering their
profession, then spend two
hours learning how to trade
and five minutes making a
trading decision that could
risk a month of their income.
(And, if it is done often
enough, even years of
income). They wouldn’t think
of doing that in their “real”
business, but for some reason,
it is okay in trading. “Poker
(and trading) has no peers in
terms of complexity,
challenge, exhilaration,
frustration and income
potential,” Poker, Sex and
Dying.
5. TRADE LIKE AN
INSURANCE COMPANY.
Why do insurance companies
consistently win? Insurance
companies are consistently
profitable because they use
the laws of mathematics,
probability and “special
circumstances” to their
advantage. They can pick and
choose who they want to
insure and the price they want
to charge for insurance.
Therefore, they “own” the
game by being able to call the
shots and rates that we must
pay to enter into their playing
field. Research shows that
older smokers tend to have
high mortality rates.
Therefore, the insurance
companies charge excessive
premiums for these types of
people; while young healthy
people tend to be the best
risks, so lower rates are
charged as the probability of
paying a premium to this
person’s family is relatively
small. This is not a level
playing field, as the insurance
company makes the rules and
requires the charges to be
paid. Do the same with your
trading.
6. THINGS WILL CHANGE.
Just as Anderson states in
Poker, Sex and Dying, “...
more information ...and a
different type of poker player
will continue to emerge at the
poker table,” you can be
assured that this will equally
apply to trading. “...a new
different bolder type of player
changed the economic face of
this country in the
1980’s...when there is
sufficient money on the table,
you can be assured that a
better informed wolf will
show up at your door.”
“...The Tao of Jeet Kune Do
(The Option Secret) is not
complete...(it is) changing
everyday...The Tao of Jeet
Kune Do (The Option Secret)
has no real ending. It serves,
instead, as a beginning. It has
no style; it has no level,
though it is most easily read
by those who understand their
weapons. To probably every
statement within the book,
there is an exception - no
book could give a total
picture of the combat arts (or
trading). This is simply a
work that describes the
direction of Bruce’s
studies...Hopefully, this book
will be used as a source of
ideas for all ...... that should
then develop further.” The
Tao of Jeet Kune Do, Bruce
Lee.
These ideas are no different
than what we are presenting
in The Option Secret. Options
trading is constantly changing
with new opportunities being
presented by the markets as
the technical pattern and
volatility levels constantly
change. Like a martial artist,
we must move with these
changes and use them to our
advantage; not stand rigid and
try to parry them. Traders
should develop their own
ideas, as invariably, new
situations in the market will
provide opportunities that we
have not previously
envisioned.
7. THE RULE OF 90-10.
“This rule simply states that
at any given time the
behavior of 90% is working
to create an advantage for
10%,” Poker, Sex and Dying.
The 90-10 rule seems to
classify winning and losing
traders. Over the long term, it
seems that 90% of people
lose and 10% win. We have
found that the
unknowledgeable, below
average, average and above
average all still lose. The
consistent winner in that 10%
is the professional trader who
has his trading plan and sits
with it year in and year out.
This is similar to one of my
favorite theories set forth by
another writer in which he
stated he felt that you could
publish a detailed trading
system that was entirely
perfect in the Wall Street
Journal with the assurance
most people would not follow
it, without modifying or
otherwise destroying it. “The
vast majority of poker players
who buy this book will reject
the material out of hand. To
them the value will never
exceed the effort needed to
understand and use it. Others
will use it only to confirm
what they already know and
discard the remnants of what
they don’t agree with. It is
this behavior of the 90% that
creates the advantage for you,
the 10%,” Poker, Sex and
Dying. This is no different
from the information being
set forth in The Option
Secret. Be among the 10%
who use it successfully.
8. KNOW YOURSELF.
“Poker is an explosive game
combining money, ego and
emotions. It is not enough to
know, have information, and
insight regarding your
opponent (the markets), you
must know of yourself,”
Poker, Sex and Dying. Again,
this is most important to
know in trading the markets.
How many times have you
faced a situation where you
“know” exactly where the
market is going, have a
trading plan, but fail to follow
it. Of course, greed, fear and
your other emotions stood in
your way. All your
knowledge, planning and
information quickly became
useless.
9. YOU CAN’T LEARN IN
THE MIDDLE OF A
TRADE.
“The very worst time to learn
anything about yourself or
your opponent (the markets)
is when you are involved in a
hand (a trade). The
information is skewered,
prejudicial. Too often, you
will see only what you want
to see or what you don’t want
to see. If you are involved,
the information you receive
and store will always be
emotionally tainted...If you
want to become immediately
superior in the game of poker
(trading), start trading when
you are not involved in a
hand (a position),” Poker, Sex
and Dying.
While involved in a bad trade
(or immediately thereafter), a
trader can become skeptical
about his abilities and his
trading plan. After several of
these in a row, a trader will
doubt his ability and become
too cautious. There is a
definite need to step back and
review the situation to
determine whether the plan
was at fault or just a plain old
losing trade occurred.
Similarly, after several wins,
the trader can become too
“loose” disregarding his
trading plan thinking that no
matter what he does he will
come out ahead. Again, this
just shows the necessity of
constantly reviewing your
trading plan when you are not
actively engaged in the
markets.
10. ADAPT YOURSELF
AND STYLE TO
DIFFERENT MARKET
SITUATIONS.
With almost 50 options and
futures markets and over
1,000 options on stocks
trading about 200 days per
year, we know for sure that
circumstances will continue
to change. Technical patterns
will range from flat to
vertically up and down, to
slow trending markets. At the
same time, option volatility
will range from extremely
high to low, and disparities
will occur between option
strike prices of the same
group. A successful trader
must be able to “switch
gears” and adapt his trading
to the market. You must let
the market tell you where it is
going, and what the best
strategy is. Again, as we
mentioned in our
introduction, do not stand in
its way or try to fight it.
11. KNOW THE
CHARACTERISTICS OF
THE MARKET YOU’RE
TRADING.
In addition to the normal
trading information that must
be learned by all serious
futures and options traders,
successful option traders must
also be most aware of
statistics and probability in
several different areas.
First, it is necessary to be
aware of every market’s
particular range of volatility,
both over the long and short
term. The examples of the
usefulness of this are almost
endless.
As I complete this book, call
volatility in the S&P 500 has
risen over the last week from
10-12%. This 20% rise has
caused several commentators
to recommend selling these
“overvalued” options.
However, although these
options may seem overvalued
based on the short term rise,
these commentators have
failed to notice both that past
volatility of the S&P 500 has
been many times higher than
current levels (Chart 18.6),
and that often a rise in
volatility such as this is an
accurate predictor of a large
market movement.
In fact, even more potentially
overvalued are the S&P 500
puts which are now trading at
a volatility level above 20%
in some instances (twice as
high as the calls). A likely
candidate for sale (in fact, we
have sold these options
ourselves), however, this is
certainly no “easy road” to
profits. The S&P 500 market
has moved significantly
higher for the last several
years without a substantial
correction, and it is our view
that not only is a correction
overdue, and likely to happen
by the end of the year, but
once a correction begins, we
expect the market to move
down 15% or more. These
overvalued puts will then
look quite cheap.
Without knowing the past
implied volatility levels of the
option markets you are
trading and the tendencies of
those markets, whether they
be seasonal or how they react
to news etc., you will be
placed in the losing 90% of
the traders almost for sure.
Conversely, knowing the
volatility tendencies of option
markets will not only keep
you out of bad trades, but
present and allow you to
anticipate some of the best
ones. For example, it doesn’t
take a computer to determine
the best times to buy and sell
options in the soybean option
market which consistently
increases in volatility in the
second and third quarters of
the year and decreases the
rest of the time.
12. PURCHASE AN
OPTION INSTEAD OF A
FUTURE CONTRACT
WHEN THE COST OF
THE OPTION IS
SIGNIFICANTLY LESS
THAN A FUTURES
MARGIN.
Currently the margin for
purchasing an S&P 500
contract is $12,000. However,
an at-the-money option can
be purchased for less than
one-half that amount (and
further out-of-the-money
options are even cheaper).
This provides the trader with
two important benefits. First,
risk is reduced, since the risk
of loss is unlimited when
purchasing/selling a futures
contract, while the maximum
loss when purchasing an
option is the premium plus
costs. (commission, exchange
fees, etc.).
Secondly, since less margin is
being used on this trade, there
are additional funds available
to diversify into other
opportunities that may arise.
This situation often arises
when option premium is
relatively low, such as seen
currently in the S&P 500,
which is near historical low
option volatility levels.
13. WRITE OPTIONS
AGAINST FUTURES
CONTRACTS FOR
ADDITIONAL INCOME
WHEN OPTION
PREMIUM IS HIGH.
Last summer, we had a
situation in the soybean
market where the weather
scare increased the premium
values significantly. In fact,
the further out-of-the-money
that an option was, the greater
its volatility and relative
premium level. This disparity
in premium value led to great
opportunities.
For example, the volatility for
the furthest out-of-the-money
November soybean call, the
950 call, was almost double
the “normal” premium level.
In this case, far out-of-the-
money soybean options, the
November $8 through $9.50
calls could have been sold for
a premium of $2000 against
futures contracts already
owned, with no additional
margin at all. In fact, the only
risk on these trades would be
the limitation of profit of the
underlying future contract to
the strike price of the option
sold.
Track option volatility and
compare it both on a monthly
(short-term) and yearly (long-
term) basis. By simply
knowing whether option
volatility is either relatively
high or low, a trader can
quickly become aware of
potential option trading
opportunities without having
to study and learn the
complexities of option
trading.
14. THREE RULES OF
 RISK MANAGEMENT.
Three rules of risk
management when you are
selling option premium are:
1. Never risk more than 50%
on short option premium
without initiating a follow-up
position.
2. Never sell naked option
premium against a trend.
3. Never hold a short option
premium once 80% of the
premium has been captured.
15. USE FLEXIBILITY TO
TAKE ADVANTAGE OF
THE OPPORTUNITIES
THAT THE MARKETS
PRESENT YOU.
At the end of 1988 option
volatility (premium) in the
bonds and foreign currencies
rose steadily along with the
prices, climaxing when those
markets made contract highs.
Option volatility then began
to steadily drop in 1989
making option selling very
attractive. However, the
markets eventually
overcompensated to a point
where option volatility was so
low in the foreign currencies
that it was substantially
trailing futures market
volatility, benefiting option
buyers.
In 1993, we experienced low
option volatility in a majority
of the markets at the
beginning of the year, which
was interrupted by extreme
rises in volatility, such as in
the metals and in the grains
by mid-year. The same
occurred in 1992, during the
summer weather scare where
option volatility more than
doubled in soybeans and
corn, and at the start of the
war in the gulf, when crude
oil option volatility rose over
five times its previous range.
Today’s markets emphasize
the need for flexibility.
Although we might like to be
only option buyers or option
sellers, traders of bull
spreads, ratio spreads, neutral
positions, etc., we must be
ready to use flexibility to take
advantage of
OPPORTUNITIES THAT
THE MARKETS
PRESENT US. If option
volatility is low and the
potential for a move in the
underlying markets large, we
must be ready to purchase
options to use both the benefit
of limited risk and unlimited
profit to our advantage. When
option premiums are high, we
must be willing to do more
option selling to take
advantage of the disparity in
the value of the out-of-the-
money options.
To be successful in option
trading, the professional must
be not only knowledgeable
regarding the mechanics of
buying and selling options
and option strategies, but
must be willing to be flexible
by taking the opportunities
that the markets provide us,
not trying to manufacture
trades that do not exist.
 CHAPTER 19
Special Articles
GOING AGAINST
THE CROWD;
CONTRARY
OPINION
REVISITED
For some reason traders have
cherished the idea of buying
markets at the bottom, or
selling them at the top. The
potential thrill of squeezing
out the last tick in market
before it changes trend is an
exciting goal, but
unfortunately usually as
obtainable as finding the
fountain of youth. I would
estimate that for every dollar
that is made in such type of
trading, $1,000 is lost.
Over the last several years I
have had traders contact me
and assure me that certain
markets were going to take
off or nose dive quickly for
every reason from momentum
isolators to faces of the moon.
Of course, nothing goes
straight up (except our deficit
and taxes) and every market
is subject to corrections and
consolidations. However,
without any other supporting
evidence, that is all these
pullbacks can be said to be -
corrections, not changes of
trend.
Yes, you can constantly
predict market turning points,
and eventually, just as a
broken clock is right twice a
day, you will be right.
However, unless you are
extremely well capitalized
and don’t mind the fact that
you probably will be wrong
99+% of the time, this is not
the type of trading we would
recommend. Similarly, a
book titled You Can’t Lose
Trading Commodities, uses a
method of buying more
commodities as they move
lower. However, how many
traders’ stomachs or
pocketbooks would be able to
take 10 years of a downtrend
in gold and silver or the
decline of orange juice of
almost 60% last year; the
decline in pork bellies of over
50% in the last two years; etc.
This doesn’t mean we don’t
try to get an entry point into a
market when it is NEAR its
best levels. However, we let
the market tell us, instead of
guessing and predicting. At a
minimum we look for a break
in the short term downtrend
and then gage how the market
challenges the lows from that
point.
For example, live hogs were
in a downtrend since the
beginning of 1990. After
consolidating in July through
October of 1992 at 3900, the
market then broke out of its
short term down trend and
consolidation and quickly
moved to the 4200 level,
catching our attention. We
then waited for the market to
have its first reaction and
gage its new strength at that
point. After successfully
challenging its
resistance/support at $.40, we
became bullish at the end of
1992, and began
recommending the purchase
of calls. Did we miss the
absolute lows near 3850?
Yes. Why should we think
that this level was any
different than any of the other
levels reached while the
market declined 30 cents in
the last three years?
Going against the trend,
contrary opinion psychology
has strong psychological
appeal. However, we strongly
recommend that in doing so,
you are either privy of facts
that others are not; or that you
otherwise have and are
prepared to lose a lot more
money than the people you
are going against. Look to
take the easy 60%-80% out of
the middle of the trend; leave
the top and bottom ticks to
the broken clocks!
THE TWO MOST
IMPORTANT
ASPECTS TO
CONSIDER IN THE
UNDERLYING
MARKET WHEN
TRADING OPTIONS.
The underlying futures
market is important in two
major aspects to be
considered before any option
trade is initiated. First, you
must be able to relate the
volatility of the futures
market to the option volatility
levels. This is often
overlooked, as most traders
“feel” that option volatility
should change naturally with
the movement in the futures
market.
Although this is true in
theory, in real life, often there
are differences. This can be
caused by emotion, small
traders desire for certain
options, or just market
disparity and mis-pricing.
An example of this was in the
currency markets in 1988 and
1989 which we discussed in
our newsletter at that time,
where option volatility in the
currencies had fallen from
historical highs at the end of
1987 to historical lows, and
was trading at extremely low
levels when compared to the
futures market volatility.
Simply stated, when option
volatility is low compared to
the action in the futures
markets, option purchases
should be considered; when it
is high, option selling
strategies should be used.
The second principle to be
considered is the trend of the
underlying market. “Neutral
Option Positions” are the
least predictive of any type of
option position. Our concern
is determining where the
market is not going to go. We
then initiate positions that are
outside our projected range of
the market. In this way we
don’t have to pick a specific
direction, but only a wide
range of potential price
action. Further, this range can
be easily adjusted if the
market begins to trend
strongly in either direction.
In addition to the benefit of
being profitable over a wide
trading range, and not having
to be predictive of market
direction, the “Neutral
Option Position” also uses
the benefit of the time decay
factor of options, along with
the market’s tendency to
over-value out-of-the-money
options. These are the factors
we will be considering in
constructing our trading
program.
We have found that money
management is probably the
most important, yet
overlooked aspect of a
trader’s plan. Most traders are
concerned only with
improving their system so
that it will be able to either
predict the market or find
favorable entry and exit
points. Money management is
looked at casually as using
some simple rules such as
“don’t risk more than 10% of
your capital” or “how many
contracts per dollar amount
should you use in trading
each commodity.”
These are good reference
points, but only a rudimentary
beginning. Without strong
money management
principles, even the best
trading plan will be fighting
the odds. Conversely, a good
trading plan which
incorporates some principles
of money management will
provide the trader with a
significant advantage, again
the “trading edge” that we
find to be so important.

CHOOSING THE
BEST OPTIONS TO
PURCHASE -
BALANCING
BETWEEN
LEVERAGE AND
AN OPTION THAT
WILL RESPOND
WELL TO THE
MARKET MOVES.
If I had to construct a perfect
trading vehicle it would be
one that had limited risk, cost
little, but still responded well
to market moves. Even
though options have all of
these attributes, unfortunately
they are not found in the
same option.
When purchasing options we
are faced with a continual
battle of purchasing one that
is in or close-to-the-money
which is very expensive, as
compared to a further out-of-
the-money option which is
much cheaper, but will not
respond anywhere near as
well to a market move. We
must also consider whether to
purchase an option of nearby
expiration, or the more
expensive further from
expiration option that will
hold its time value better and
give us more opportunity for
the moves that we expect to
occur.
How do we balance these
priorities? First, our analysis
requires us to disregard
options that are too far out-of-
the-money since it is unlikely
that they will obtain enough
value to overcome their
premium cost (low
probability of profit), and we
disregard options that are in-
the-money, since they
provide us with little or no
benefit over a futures
contract.
One of the reasons we
recommend options is
because they do provide us
with lower cost and better
leverage than are found in
futures. If this is unavailable
and we must put up with low
liquidity and slippage that
occurs from trading these
relatively illiquid options, we
would have difficulty
recommending this type
position. Therefore, this
process of elimination brings
us to the options that are
close to, but not in-the-money
(except when initiating our
“In-The-Money Debit
Spread”). True, it is a
compromise between these
two competing factors, but
over the long run, this
provides us with trades that
have the highest probability
of profit.
We must also balance our
desire to have as long a time
before expiration as possible,
with keeping down our cost
of acquiring the option. For
example, a gold option, one
strike price out-of-the-money
with an expiration in two
weeks, currently costs $200,
while a similar option having
an additional two months
costs 3-1/2 times more, and in
August more than 5 times as
much. Again, these conflicts
are difficult to balance, and
we often find it best to
purchase a little of each if our
account allows us this luxury,
and having about three
months prior to expiration, a
compromise that will again
provide us with a trade that
has the highest probability of
profit along with a favorable
risk-reward.

OPTION
BUYER/OPTION
SELLER - WHO HAS
THE EDGE?
This is a question that has
haunted every serious trader
of options. Do I sell options
and take advantage of the
time value decay and
mathematical probability? Or
do I purchase options to take
advantage of the limited risk
aspect and the potential for
unlimited profits?
Ever since I began trading
options, I have heard
arguments regarding the
benefits and disadvantages of
option buying and option
selling. Option buyers
commonly cite the benefits of
limited risk and the potential
for unlimited profit; while
option sellers point to the
advantages obtained through
using premium disparity and
time decay of option
premium.
Some of this material can be
classified as “self-interest”
depending on who has
prepared it. The brokerage
houses promotional material
usually discusses option
buying, centering on the
benefits of the limited risk
aspect of options and the
potential for unlimited profit.
The potential for unlimited
profits is, of course, of great
interest to the individual
speculator, while the security
blanket of limited risk
provides protection for
BOTH the trader and broker.
(While a future trader or a
trader that is short an
uncovered option has the
potential for unlimited losses,
an option buyer can only lose
the amount of the premium
paid). Further, a brokerage
company has an easier time
developing promotional
material explaining the
benefits of purchasing
options, which is far less
complicated to explain and
monitor than option sales.
On the other side of the
picture, much of the material
regarding option selling is
written by research analysts
and floor traders. Research
analysts, particularly those
who have not had extensive
experience trading, probably
have the easiest time
explaining the benefits of
short option positions.
“Options are a decaying
asset...the time value
decreases every day as the
option approaches
maturity...you can still profit,
at times even if the market
moves against you,” The
Options Advantage, by David
Caplan. Further, the
researcher can
mathematically show how
with proper money
management that it is
impossible to lose money on
short options.
Experienced traders know,
however, that nothing is
impossible in the markets.
Unless a trader has had actual
experience of what can
happen with option pricing
during a drop of 500 points in
the Dow due to the
commencement of
international political
turbulence or war, these
explanations will be
meaningless when the trader
is caught in the vise of rising
volatility and huge price
swings.
Floor traders, as a group, are
the largest sellers of options.
They typically sell options
and then hedge their positions
with futures contracts. This
process is an excellent
venture on the floor, but
unworkable by all floor
traders. This is because the
transaction cost, slippage, and
time delay of entering orders
will cause any advantage to
be lost by those trading off-
floor.
As usual in these types of
arguments, the truth lies
somewhere in between. Both
long and short options have
their benefits and detriments,
depending on the conditions
of the futures market and
option volatility levels.
When futures options were
first introduced in 1982, there
were often valuation
problems because of trader’s
inexperience with options.
Out-of-the-money options,
especially call options were
typically overvalued,
compared to the closer-to-the-
money options, sometimes
exceeding twice the volatility
level. For example, during
silver’s brief rally in 1986,
the out-of-the-money calls
were trading at a volatility
level more than double the at-
the-money options. This
disparity, of course, led to all
types of opportunities for
option sellers including ratio
spreads, neutral positions, etc.
Also, any time a new option
market opened, there seemed
to be extreme disparities in
option premiums especially in
the out-of-the-money options
(probably because of
inexperience in valuing these
options). Secondly, during
this period, bull markets
would cause premiums to sky
rocket. I attributed this to the
demand for “cheap” options
by smaller traders.
A trader bullish on a market
can either buy a call or sell a
put. Both are bullish
strategies, but with entirely
different characteristics,
risk\reward, and probability
of profit. Both sides look
good on the surface, and
contain the qualities that are
touted by the brokers and
exchanges as the reasons for
using options.
However, before any decision
is made by the trader as to
whether option buying or
selling strategies may be
better, he must also assess
current market conditions in
both the futures and options
markets, and the
disadvantages that may be
evident with either under the
current conditions.
Unfortunately these aspects
are quite often overlooked by
many traders, who see only
the benefits of option
strategies. Before any
answers are possible, we must
look at the fundamentals
underlying option buying and
selling.
The “perfect” environment
for sellers of option premium
is a market that has high
option volatility (when option
volatility is high, the “time
value” premium of an option
increases greatly), is just
entering into a consolidation
phase, or at worst, a slow
trend. These are excellent
markets in which to initiate
the “Neutral Option
Position” (selling an out of
the money put and call), as
this strategy will take
advantage of both the time
value decay of the
“overvalued” out-of-the
money options, as well as the
loss of premium by the
lessening option volatility
which often occurs in this
instance.
We have seen this
opportunity in the currency
option markets in the
beginning of 1988; in the
S&P after the October crash
in 1987; in crude oil in
1990/1991 during the Gulf
War; and just about every
summer for the last five years
in grain markets. In all of
these situations the
historically high option
volatility levels caused option
premium to decline quickly
once these markets became
less emotional and entered
normal trending phases.
Another of our favorite times
to initiate the “Neutral
Option Position” is when
markets are consolidating or
slowly trending over the long
term, or have seasonally
shown the tendency to
maintain a trading range.
These trades work great in
flat, choppy and
consolidating markets for
traders like myself that hate
to predict market direction.
(Another real benefit of the
“Neutral Option Position” is
that you only have to predict
where the market ISN’T
going; not where you think it
is going to go).
Option buying, on the other
hand, is attractive to traders
seeking a position that has
potentially unlimited profits,
and risk that is limited only to
the premium paid for the
option, no matter how far the
market moves against you.
The risk/reward on this
position can be exceptional,
usually at least 10 to 1 in the
trades we recommend, and at
times it can be substantially
higher. However, this being
the real world where there are
exceptional benefits, there is
generally some “catch.” The
“catch” here is that the
mathematical probability is
often against the option
buyer.
The reason is when
purchasing an option, precise
timing is needed to properly
enter and exit the trade, or
else potential profits can be
eroded by the “time decay”
that effects all options every
day. A trader becoming
bullish, in August, 1992,
could have purchased a
December bond 104 call, and
three months later with bonds
trading about two points
higher ($2,000 per contract
profit in a futures contract),
would have seen the price of
this option decline about
25%.
Although the allure of
unlimited profits seems
promising, the reality is that
without a proper plan, the
option buyer is facing heavy
odds. Further, the purchase of
an option with extremely high
volatility (premium), an
option that is too far out-of-
the-money or too close to
expiration, further dooms the
potential purchaser of options
to a trade that is likely to lose.
However, as long as we have
significant quick moves in
markets such as the grains in
the summer months during
crop problems; in the S&P
during the “October Effect;”
in crude oil, the metals and
currencies in times of a
national crisis; there will be
option buyers around seeking
to take advantage of these
opportunities that can be
extremely favorable at certain
times.
As you can see from our
analysis, there are benefits to
both option buying and
selling that are useful at
various times. The
professional trader learns the
benefits and disadvantages of
these strategies and the best
time to use them. He will not
hesitate to stay on the
sidelines if no trade is
available that provides a
“trading edge” over the
markets. At the same time he
has to be ready to use option
selling techniques to his
advantage in choppy trading
range markets and markets
that have high option
premium; while being ready
to use option purchases in
markets that have well priced
options to put themselves in a
position to profit, should a
potential quick move occur.
Trade like the professional.
By being knowledgeable,
keeping alert and remaining
flexible, you can keep the
odds in option trading in your
favor by knowing the right
time to buy or sell options.
The professional trader will
not favor one strategy over
another, but allow the
fundamental and technical
pattern of the underlying
market as well as the option
volatility level dictate to him
which strategy is the best to
use for the current markets.

EXAMPLES OF
STRATEGIES THAT
TAKE ADVANTAGE
OF “OVERVALUED”
OPTIONS
Crude oil volatility exploded
at the end of 1990 and in the
beginning of 1991, virtually
quadrupling in three months.
As volatility reached
historically high levels, there
were three strategies that
produced trades that had
excellent probabilities of
profit.
Our favorite is the “Ratio
Spread,” which is a position
constructed by purchasing a
close-to-the-money option
and selling two or more
further out-of-the-money
options. The “Ratio Spread”
works well for several
reasons. First, since we
normally construct the
positions by having the
options sold bring in more
premium than the option
purchased, there would be no
loss if the market changes
direction and moves against
us.
For example, in November,
1990, with January crude oil
trading at 3365 a ratio spread
could be constructed by
purchasing the January crude
oil 37 call and selling two 42
calls at a 30 point ($300)
credit. Since we would be
receiving $300 more than we
paid out, if January crude oil
expires at $37 or less (all the
options that we bought and
sold would be worthless), we
will still keep this $300 credit
which will be our net profit.
This will apply anywhere in
the range from $0 to $37.
However, if crude oil were to
close over $37 we would
make $10 for each point it
closed over $37 to a
maximum of $5000 if crude
closed at $42. If crude goes
over $42 per barrel we will
begin to lose $1 profit for
each $1 that crude goes over
the $42. However, we will
still be profitable up to $47.
Since unlimited risk can
occur in this strategy if the
market continued higher than
$47, for money management
principles, we always close
out the position, if the price
of the commodity exceeds the
price of the options we sold.
For example, if crude were to
exceed $42 at any time, we
would close out this position.
If this occurred soon after
putting the position on, there
would be a loss of
approximately $500, since the
short options we sold would
gain more than the long
option we purchased.
However, if we were able to
hold this position for about
thirty days, the time decay of
the short options would
normally protect us from loss,
even if we had to close out
the position after that.
We find that the “Ratio
Option Spread” is an
excellent option strategy for
markets with high volatility,
i.e. crude oil at the end of
1990. In this case, out-of-the-
money options can be priced
up to 100% higher than the
close to the money options in
volatile markets. In using this
position properly, we can
profit if:
A. The market remains stable;
B. The market moves lower;
and
C. The market moves
reasonably higher.
Only if the market moves
substantially higher, very
quickly, will this position
result in a loss.
Another position that
produces a trade with a
favorable probability of profit
in markets with extremely
high volatility is the “Neutral
Option Position.” This trade
is initiated by selling an out-
of-money put and call of the
same expiration month of the
same future.
Since both of these options
contain only time value, they
will both decay quickly
unless the market makes a
large move. Even in the case
of the market making a large
move in one direction, the
other option will rapidly lose
value, thereby providing
some protection from loss.
This trade is best entered into
thirty days prior to the
options expiration, as this is
the period for the maximum
time decay of the option
premium.
For example, on October 26,
1990, with two weeks until
the expiration of a December
crude oil option, and the
December contract trading at
3300, a 23 put and a 44 call
could have been sold for a
total premium of 70 points or
$700. Since both options
were at least 1000 points out-
of-the-money, unless the
market made an extremely
large, quick move, this
premium would be yours at
the expiration of the options
and would produce an
annualized return of over
250%.
However, since risk is
unlimited if the market does
make a large move, we
always have a rule, similar to
the “Ratio Spread,” of
closing the position out
before either side goes in the
money. In this case, we
recommended closing the
position, if it came within 250
points of being in-the-money.
We often use this position in
the Treasury Bond market to
collect premium, especially in
times of stable interest rates.
This is also an excellent
position to use when a market
becomes volatile (after it
shows some sign of
consolidating), because in
these cases the out-of-the-
money options can double or
more in volatility. This
occurred this summer in both
the out-of-the-money soybean
and corn options providing
excellent option selling
opportunities. (This seems to
happen frequently in the
grains during the critical
growing periods).

ARE THE FACTS

ALONE ENOUGH
FOR SUCCESS?
“Many years ago, my
economics professor
endowed me with the theory
that steady growth and good
performance earnings were
the leading factors in inflating
the value of a corporation
stock. This theory was
substantiated by such giants
as Xerox, IBM and General
Motors where the purchase of
stock escalated into a return
of 100-fold and more.
However, on the basis of
today’s market, that theory
does not prove out, as
evidenced by a number of
stocks that reflect good
earning and steady growth or
stability, yet these same
stocks may rise or fall sharply
daily.
In the past year, the Dow has
fluctuated from 2700 at the
beginning of the year to a
high of 3000 during the
summer; and then back down
to 2400 last month. (In a
single day moves of 25 to 50
points were not unusual
sometimes in both
directions). Economic
analysts attribute this to an
endless variety of reasons;
inflation, interest rates, take-
overs, trade imbalance,
federal deficit, congressional
legislation, elections, threat of
war, shortage of oil, industrial
lay-offs, etc., etc. Market
commentators state that a
strong sneeze on the floor of
the exchange could, at times,
cause a panic.
Our government, with a
deficit of over three trillion
dollars, reversing from the
leading creditor nation to the
leading debtor nation, as well
as the steady increase in trade
imbalance, is a major
contributor to a shaky
economic unrest and a
growing fear of recession
resulting in unpredictable up
and down surges in stock
values. Meanwhile, Japan has
emerged as the world’s leader
in finance, taking over large
areas of our metropolitan
cities and Hawaii, as well as
portions of our industrial
empire.
The media’s daily reports of
the Persian Gulf crisis, along
with the statistics issued by
the government’s reports and
indicators, are sufficient
cause to induce mass hysteria
in the strength of the
economy and ultimately lead
to recession. Also, the
flooding of the market with
over 200,000,000 credit cards
encourages heavy
expenditures on the basis of
buy now, worry about paying
later, leading to further
economic woes.
Auto stocks, such as Ford and
Chrysler are experiencing
rapid declines in value due to
failure to replace obsolete
equipment and plants, high
labor costs and benefits, and
the steady influx of foreign
competition, resulting in
sluggish sales of the domestic
output.
Sears Roebuck, K-Mart and
other leading retailers, some
of whom are now bankrupt,
are victims of poor
management, out-dated
marketing programs, over-
expansion, and the energetic
competition of better run
firms.
Major department stores
enjoyed their heyday for over
50 years with an ancient sales
force and a loyal clientele,
but they failed to update their
marketing programs and
modernize their stores; and
now higher overhead and
advertising rates put a dent in
their cash flow. The most
devastating blow came in the
sixties and seventies when
huge modernized shopping
malls were constructed,
allowing their customers
greater convenience, more
leisure time and additional
savings on costly travel
expenses.
The costly collapse of our
banking system can be
attributed to over- expansion,
involvement in take-over
deals, junk bonds, friendship
loans, high-risk loans to real
estate developers and the
selfish competitive race to
become known as the tops in
their area.
Airline issues, since
deregulation, are
experiencing steady declines
due to strikes, unhealthy fare
wars, higher fuel and labor
costs and a dismal financial
prognosis.
Insurance giants such as
Aetna, Hartford, and
Travelers are not immune
from their own types of
financial difficulties.
Is it logical that Disney, with
its multi-billion dollar
expansion program and a
record of good earnings
performance, in the past year
rose to over 134 and then fell
below 90? Barnett Bank, of
Florida, has a strong
capitalization and a healthy
earnings record, yet, in the
past year, its stock
skyrocketed to over 35 and
then fell to 16. Another issue
that reflects a wide range of
fluctuation (mostly due to
take-over offers and
withdrawal of same) was
UAL, with a high of almost
300 and a low of 89.
Based on facts such as those
above, and on the stock
markets fluctuations during
the past year, I have
concluded that the Dow has
developed into a roller-
coaster market, very
unpredictable regardless of
earnings performance. While
longer-term investors who
can ride out a loss will
probably do well, short-term
the markets are for gamblers
only!”
(Ed. note:) While this article
relates only to the stock
market, our futures’ markets
have not behaved much
differently. As we mention in
our discussion of
“Tulipmania,” many
examples can be seen of
markets acting on emotion
and not rational fact such as
the silver market of 1980,
with silver going to almost
$50, before plunging to $10
four months later; the sugar
market of 1982, with sugar’s
rise to 45 cents in 1980 and
then its plunge to under 3
cents in 1985, both of which
were exaggerations; the stock
market crash of 1987, and
then move to new highs in
1989 & 1990; and the dollar’s
move from post-war highs to
lows from 1985 to 1988. All
of this provides evidence of
our need to be long term
traders using a trading plan,
discipline, and mathematical
probability to give us our
“trading edge over the
markets” during these
turbulent times.
The writer of the above
article was Norman Caplan.
He is a distant relative -
3,000 miles distant. Well,
O.K., he’s my father. But that
had no bearing on my
publishing the article. Being
a trader for the last ten years,
I’ve learned to be disciplined
and unemotional. Only money
will persuade me. And he
refused when I asked him for
a bribe to print this article.

EVALUATING
DIFFERENT
TRADING
METHODS —
WHICH IS BEST
FOR YOU?
FUTURES/OPTIONS/S
OF THE MANY
METHODS OF
TRADING - WHICH
REALLY WORK
THE BEST?
We are going to analyze the
following popular trading
systems/methods in an
attempt to determine which
has the best chance of
success:
1. Trend Following Systems
2. Fundamental Trading
3. Option Trading
a. Purchasing Options Only
b. Selling Options Only
c. Option Strategies
4. Combinations of the Above
We are not examining the
innumerable other technical
methods for several reasons.
First, an in-depth examination
of the multitude of systems
could easily produce a 200+
page book instead of an
article for our book. Second,
our studies have shown that
the methods we have listed
have been the most successful
and popular. That is not to
say that the new “sure-fire”
trading system that you just
received a brochure for - you
know, the one with a 3-year
hypothetical track record, and
$1995 price tag - will not be
successful. It’s just that it’s
too easy now to “curve fit” a
system using old data and a
computer. The second
problem is that a system can
be successful for many years,
but may be unable to adjust to
current changing market
conditions. One of my clients
was a very successful CTA
who only sold options. This
system worked wonderfully
in the higher option volatility
of the mid 1980’s. However,
in 1988 when option
volatility began to decline, a
trend that has continued up to
the present, so did his results.
We will discuss the
importance of flexibility in
adjusting to changing market
conditions later in this article.
We don’t suggest you avoid
all other or new systems, only
that you evaluate them
carefully. If you find one that
you think you might like, ask
for recommendations of
others that have used it
especially in different times
and market conditions; if it is
traded by a CTA, he should
receive most, if not all of his
compensation through
incentive fees (participation
in the profits). If you trade it
yourself, make sure you
follow it completely - not
modify it by taking only the
trades you like, changing
stops, etc. By doing this you
will be making a completely
new system, one whose
performance will have no
correlation to the original
system.
Finally, you must have a plan
that contains strict principles
of money management and
have the discipline to stick to
it. Even a great plan that fails
to provide for money
management and disciplined
trading is likely to fail.
1. TREND FOLLOWING
SYSTEMS
“The Trend Is Your Friend”
is the first item most of us
learned in our trading
education. It is also the most
widely used method of
trading today. Our conclusion
is that long term technical
trend following systems,
when combined with rules
that provide for strict money
management, are still among
the best trading methods.
Trend following systems
work particularly well in the
currencies, which tend to
trend reliably for many years.
However, there are several
problems that trend following
traders commonly run into
that can produce poor results.
These include:

1. Short-term trading
where the average profit
is too small.
2. Stops too close - causing
the loss of a good
position.
 3. Failure of discipline -
causing over trading.
This commonly results
from the boredom in
long-term trend trading
because of relatively few
trades that are initiated.

2. FUNDAMENTAL
TRADING
Fundamental trading is more
difficult to evaluate. This is
because the results depend
strictly on the knowledge,
ability, and talents of the
individual. At least with other
technical or trend following
trading systems some of it
can be mechanized or
computerized and less
interpretation is required after
the system is devised.
We have found that the
results of fundamental traders
vary as widely as the results
of any other business. (Over
90% of businesses fail, while
only a few become IBM or
Disney. This is the same
result that we see among
traders). We have found the
odds favor the knowledgeable
fundamental trader, who also
uses the strict principles of
money management to
manage his account. This
type of trader seems to have a
distinct advantage over others
because of his inherent
knowledge of what moves the
market. In fact, the most
consistently successful are
those knowledgeable,
fundamental traders who also
use option strategies to
complement their positions.
We will discuss this further in
Section 4 below.
3. OPTION TRADING
a. Purchasing Options Only
Many new traders begin by
only initiating option
purchases. This is because of
the limited risk factor and it
being the easiest type of trade
to understand. Many brokers
also seem to like
recommending these trades to
their clients because of their
simplicity. However, as we
described in detail in our
option trading manual, The
Options Advantage, unless
options are purchased only
when the right circumstances
exist, a trader is likely to lose
money even when the market
moves in his favor.
We reserve purchasing
options only for those
markets that we feel will be
in a long term trend, giving us
a substantial chance for large
profits. We then use our
“Free Trade” techniques to
help us build a large position
with the minimum of risk.
b. Selling Options Only
After learning about
overpriced options and the
time decay of out-of-the-
money options, traders often
embark on a program of
selling options to collect the
premium. This was an
excellent trading method
from 1986 through 1988
when option premiums were
high. However, in 1988
option volatility began to
decline which, with some
exceptions, has continued to
date. This has occurred in the
light of futures volatility
which in many markets has
remained almost the same.
Lower option volatility with a
potential for large moves in
the futures makes option
selling inadvisable. Even
though a trader could
experience 75% or more
winners, the potential for
unlimited losses in turbulent
times can quickly out strip all
profits previously earned.
Remember, the only thing
consistent about the market is
change. The 90’s have
continued the trend of the late
80’s, toward larger
institutional types of traders.
Similar to program trading in
the stock market, this can
cause larger moves in
relatively short periods and
more volatility in turbulent
times (e.g., crude oil in 1990-
91). Also, since trading has
become much more
international, we have more
large overnight moves - such
as those in the currencies this
year, where openings of +/-
100 are not unusual.
We believe that option selling
is a viable strategy when used
at appropriate times
depending on the volatility
levels of the futures and
options market. However, this
strategy, more than any,
requires discipline and strict
principles of money
management to prevent large
losses from occurring.
c. Option Strategies
This is the type of trading that
we recommend as it
combines the best attributes
of buying and selling options
either by themselves or in
combination with others
(option spreads). The proper
use of options can
significantly improve
anyone’s chances of success,
by taking advantage of the
many advantages found in
options including limited risk,
leverage, time decay, etc.
4. COMBINATIONS OF
THE ABOVE
Up until recently, many of the
best traders and money
managers did not use options.
This is because they were
successful in what they were
doing and did not want to
institute another variable into
their trading that they were
perhaps unsure of. However,
we are finding more
professional traders are now
instituting option strategies as
they find the use of option
strategies to hedge, add
income, and at the
appropriate time substitute for
a future position, can greatly
increase their returns. Almost
every trader that we have
found who uses options to
supplement his otherwise
successful future system has
improved his results. We
strongly recommend that
every serious trader look at
supplementing his trading by
the use of option strategies at
appropriate times.

MARKET BREAK
OUT ON
DECREASING
VOLATILITY =
STRONG
LIKELIHOOD OF
“FALSE” MOVE.
As part of our ongoing
research we have investigated
whether option volume,
put/call ratio and volatility
have any correlation or
predictive value in
determining market direction.
While there have been some
interesting studies showing
correlations in put/call
volume and movement in
stock prices by Larry
McMillian and others, there is
no correlation between
call/put volume or ratios in
futures options trading. This
is because of the different
uses of options between
traders who use options for
speculation and hedging. For
example, a trader may sell the
March bond 100 call because
he is bearish bonds and
expects to profit; or another
trader may sell March bond
100 calls because he is bullish
and just wants to increase his
income on his underlying
bond portfolio.
However, one indicator that
we have found to be very
accurate is that of option
volatility. We have found
consistently that when option
volatility moves near
historical low levels that the
market is likely to breakout.
(The only variable is the time
frame, and we use technical
analysis to enter the market in
that case). In 1994,
historically low option
volatility preceded the
breakout and large moves in
coffee in April, 1994 when it
broke out and rose 16,000
points (Chart 19.1); cocoa’s
300 point move in May 1994;
bond volatility dropped near
two year lows before bonds
declined about 20 points
(Chart 19.2); the 700 point
decline in live cattle that
commenced after volatility hit
long term lows in April, 1994
etc.(Chart 19.3) We have
found time and time again
that low volatility is an
accurate warning of a large
move about to occur.
However, in the past we have
seen little or no correlation
between high volatility and
market movement, except
that if volatility continues to
be too high the market
generally will continue
trending. However, this
indicator is not effective until
after the fact. Spikes to the
upside in volatility, although
they may produce some of
our best trading opportunities,
alone are not an accurate
predictor of future market
action.
However, there is a pattern of
predictability of determining
a market’s continuing move
after a breakout. Specifically,
if a market breaks out and
option volatility increases, we
expect to see a continuing
move in the direction of the
original breakout. However,
if option volatility began to
decline after the breakout, the
breakout would usually fail
and we could expect the
market break-out to also fail.
For example, you can see
from the chart below, the
Swiss Franc broke out in
October, making new
contract highs and matching
its highest level in over 20
years. However, this action
was short lived as it
immediately plunged 500
points in the next month.
(Chart 19.4)
We will continue to monitor
the connection between
market breakouts and the
predictive factor of increasing
volatility in upcoming issues
of our newsletter and the
Option Volatility Chartbook.
However, similar to this
example, we have found that
the increase or decrease in
volatility is an accurate
advance predictor of the
velocity of a breakout in an
underlying market.

Preparing for Option

Premium Disparities
in The Grain Market
When option volatility is at
historically low levels in the
grains during the seasonal
lows, each winter, option
purchasing strategies are
recommended. We
recommend using low
volatility periods to purchase
July soybean options, and
then turning them into “Ratio
Spreads” when volatility
increases in the next several
months.
The patient option trader
encounters many cases of
“special circumstances” in the
option market throughout the
year. One of the most
reoccurring of these has been
in the soybean option market
over the last five years. Every
year, option volatility has
risen between 100 to 400%
from its winter lows.
At first thought, one would
think this would provide
some exciting opportunities
for option selling strategies.
However, further
investigation shows that in
some options, option
volatility rises to even more
inflated levels. The out-of-
the-money soybean calls
almost always have a greater
increase in volatility and
option premium (this is
normally referred to as
“skewing”). It is our view
that one reason for this is
because of small traders
demand for low priced call
options in bullish markets.
This “skewing” effect is
particularly exaggerated in
the front month of extremely
bullish markets such as
soybeans and silver. Implied
volatility levels of out of the
money call options in the
grains can trade at levels 50%
higher than the in the money
options. This provides the
trader with the ability to
initiate “Ratio Spreads”
(buying at the money options
and selling multiple out of the
money options) that provide a
position that has a large range
of success. Be alert and ready
to take advantage of these
opportunities as they arise in
the coming months.

Opportunities In
Options 25 Rules of
Trading; the trading
principles that should
always be considered
before any trade is
entered.


1. USE “PREMIUM
DECAY” AND
“LIMITED RISK” IN
YOUR FAVOR. These
are the two most
important benefits of
options, and they should
always be considered
before entering any
option trade. Remember,
that “overvalued” high
volatility options decay
 rapidly in trading range
markets and as they
approach expiration;
conversely, use the
limited risk advantage of
purchasing options when
option volatility
(premium) is low and
the technical pattern or
trend of the market
suggests a large move is
likely to occur.
2. BE AWARE OF THE
VOLATILITY OF
THE OPTION THAT
YOU ARE
PURCHASING. You
must know whether
volatility is historically
high or low. For
example, in March/April
1994 when cattle
volatility moved to near
all-time lows, we
recommended
purchasing puts as the
technical pattern
suggested the market
was topping. As cattle
rapidly declined over
500 points, volatility
then moved near all-time
highs increasing by over
250%, providing us with
the reverse opportunity
of selling options to take
advantage of this
historically high option
premium. However,
without access to
historical data on option
 volatility, the trader
would be unaware of
these opportunities.
3. USE EXTREMES IN
OPTION
VOLATILITY TO
YOUR BENEFIT.
Option volatility
presents its best
opportunities when
options are at their
highest or lowest levels.
When option volatility is
 high, both option selling
opportunities and
premium disparity are
often present; while
when option volatility is
at historically low levels,
we often find significant
market breakouts occur.
4. BE ALERT FOR
PREMIUM
DISPARITIES
BETWEEN OPTION
STRIKE PRICES
AND CONTRACT
MONTHS. In addition
to “Neutral Option
Positions,” the option
trades with the highest
mathematical probability
of success are “Ratio
Spreads” and “Calendar
Spreads” that are
initiated when the
options sold have
volatility levels of 25%
to 50% over the options
that are purchased.
5. BE AWARE OF
OPTION
VOLATILITY WHEN
THE MARKET
BREAKS OUT. If
option volatility fails to
rise on a significant
breakout, this is often a
signal that the breakout
is destined to fail.
6. MATCH YOUR
OPTION STRATEGY
TO THE
TECHNICAL
PATTERN OF THE
MARKET. While
option purchasing
(“Free Trades”) are
excellent positions in
markets with low
volatility at initial stages
of trending markets that
may be subject to
extreme moves; they
may be inappropriate in
long-time trending
markets, if option
 premium has risen
substantially. In these
cases “In-The-Money
Debit Spreads” provide
a better risk/reward and
probability of profit.
7. LOOK FOR A
TRADING EDGE IN
ANY POSITION YOU
INITIATE.
Opportunities come by
often enough during the
year to provide us with
 significant advantages
that are our best trading
opportunities. Use
patience and await these
special circumstances.
8. TRADE ON A LONG-
TERM BASIS. The
odds favor longer-term
traders as the markets
are more unpredictable
in the short term.
9. ADJUST YOUR
TRADING PLAN TO
MARKET
CONDITIONS. One
benefit of options is that
you can constantly
change your strategies to
fit the market pattern
and option volatility
levels; there are option
strategies that work
better with flat markets,
choppy markets,
trending markets, or
volatile markets.
10. DON’T FALL IN
LOVE WITH ONE
TRADING
STRATEGY - YOU
MAY MISS MANY
OTHER
OPPORTUNITIES.
The “Ratio Spread” was
the first option trade that
I initiated, and for
awhile the only one I
wanted to consider. The
benefits of using a
“Ratio Spread” when the
out-of-the-money
options that we sell are
trading at much higher
volatility levels than the
options we purchase are
overwhelming.
However, not only are
the opportunities for the
best “Ratio Spreads”
rare, sometimes
occurring only once or
twice a year, but we
would also miss many
other significant
 opportunities for
“Neutral Option
Positions,” “Calendar
Spreads,” “Free
Trades,” etc.
11. USE “NEUTRAL
OPTION
POSITIONS” TO
TRADE FLAT OR
CHOPPY MARKETS.
While most traders
constantly look for the
“home run,” the markets
are not so cooperative.
Studies have shown that
between 65% to 80% of
the time markets are in a
trading range, making
extremely difficult
trading for net futures or
option traders. Use the
natural tendencies of
markets to remain in a
trading range, the time
decay benefits of selling
options and the
mathematical probability
 which is in your favor in
“Neutral Option
Positions” to get a
trading edge in these
markets.
12. USE LIMITED RISK
OPTION
STRATEGIES IN
VOLATILE
MARKETS. There are
many times that volatile
markets such as the
currency and coffee
market in 1994
presented significant
trading opportunities,
but the unlimited risk
involved in taking the
net futures positions was
too great. By using a
limited risk option
strategy (i.e. option
purchases or “Debit
Spreads”) a trader could
hold a position without
risk of unlimited loss in
these situations. Further,
using a stop, which
could be hit on a sudden
reaction right before the
market moves in the
trader’s favor, is no
longer necessary.
Options are also
recommended in volatile
“summer” grain markets
where fast market
conditions and limit
moves often become
commonplace.
13. PURCHASE
OPTIONS FOR BIG
MOVES ONLY. Option
purchasing is
advantageous only when
used for taking
advantage of large long-
term moves. If the
market does not move in
your favor within a
reasonable time of your
option purchase,
consider closing out
your position and
 standing aside. Set
reasonable loss limits on
any option purchase and
don’t let your option
expire worthless.
14. ALWAYS HAVE
PROFIT
OBJECTIVES WHEN
INITIATING ANY
OPTION
STRATEGIES. Take
advantage of declines in
option volatility and
erosion of premium to
take profits on “Neutral
Option Positions” when
they lose 50% to 75% of
their initial value; sell
out-of-the-money
options to turn your
option purchases into
“Free Trades” when the
market moves in your
favor, etc. Using these
principles of profit
objectives, in addition to
your money
 management principle of
keeping losses small,
will increase your
mathematical probability
of success.
15. USE BOTH THE
“ART AND SCIENCE”
OF TRADING
OPTIONS. Trading
options is both an art and
a science. The science is
knowing how an option
works, volatility, and
 time decay
characteristics. The “art”
is gained by experience,
including how to get the
best prices for option
orders in different
markets; how to use
disparity in option
pricing; and which
option strategies work
the best under differing
market conditions.
16. LET THE MARKET
 TELL YOU WHERE
IT’S GOING - DON’T
GUESS. Don’t predict
unless it’s based on
reliable technical
patterns, clues from
option volatility, etc. Let
the market tell you
what’s happening by its
trend and reaction to
news.
17. FEEL
COMFORTABLE
WITH YOUR
TRADING. Trading too
large a position, naked
option selling in volatile
markets, or being long
option premium in
markets that are not
moving, can cause the
trader discomfort. If,
after analyzing the
markets and available
option strategies, you
don’t feel that this type
of strategy is suitable for
 you or the current
market conditions, then
don’t make the trade.
18. BE FLEXIBLE AT
ALL TIMES. Market
conditions are constantly
changing - both the
underlying technical
pattern and volatility
levels of the options.
Today’s best strategy
may be tomorrow’s
worst. As we described
 in number 2, we moved
from option purchasing
to option sales in cattle
in a two-month period as
option volatility moved
from historical lows to
highs during that time
period.

With fifty options and futures

markets and over a
thousand different strike
prices trading two hundred
days per year, we know for
sure that circumstances will
continue to change.
Technical patterns will
range from flat to vertical,
to slow-trending markets.
At the same time, option
volatility will range from
extremely high to low, and
disparities will occur
between option strike
prices of the same group. A
successful trader must be
able to “switch gears” and
adopt his trading to the
 market. You must let the
market “tell you” where it
is going, and what the best
strategy is.
19.KNOW THE
CHARACTERISTICS
OF THE MARKET YOU
ARE TRADING.
Recently, market
commentators have noted
the rise in volatility of the
S&P 500 options and
recommended selling those
options as an “easy road”
to profits. While it is true
that option volatility has
increased almost 20% in
the past several months in
the S&P 500, what these
commentators fail to note is
that if the market was to
make a severe decline, that
option volatility could rise
from its current 14% level
to well over 50% (in fact,
in the 1987 and 1990
declines, option volatility
 was over 100% at times).
Knowing that this could
happen, allows the trader to
put limits on his trade to
prevent a disaster from
occurring.
20. WRITE OUT-OF-THE-
MONEY OPTIONS
AGAINST FUTURES
CONTRACTS FOR
ADDITIONAL INCOME.
This places the
mathematical odds strongly
 in your favor as these
“covered writes” will be
profitable if the market
moves against you, remains
stable, or even continues to
move slowly in your favor
as option volatility decays.
21. ALWAYS USE A
TRADING PLAN AND
MONEY
MANAGEMENT
PRINCIPLES. We have
stressed these items
constantly in our newsletter
over the years. USING A
TRADING PLAN WITH
MONEY
MANAGEMENT
PRINCIPLES TO KEEP
LOSSES SMALL AND
ALLOW PROFITS TO
RUN WILL GREATLY
ENHANCE YOUR
CHANCES OF
SUCCESS IN TRADING.
Remember, the winning
trades always take care of
 themselves, it’s the losers
that we have to watch out
for. Cut them off quickly.
22. LISTEN TO
OPINIONS, BUT ACT
ONLY ON YOUR OWN
ANALYSIS. Don’t follow
the crowd, your friend,
your broker’s or advisor’s
recommendation without
doing your own
independent research.
23. BE VERY SELECTIVE
WITH YOUR TRADE
SELECTION AND
INITIATE TRADES
ONLY WHEN
CIRCUMSTANCES
INDICATE THE BEST
OPPORTUNITIES.
24. TREAT YOUR
TRADING AS A
BUSINESS. Similar to
starting a new business
where most traders lose
 money, work, research,
effort and skill is necessary
to be successful.
25. MAKE LIBERAL USE
OF THE THREE R’S.
The three R’s - REST,
RELAXATION, and
RESEARCH are always
necessary to maintain a
balance. While trading the
markets you are in “battle”
and must be always be
prepared with your
 research. However, without
rest and relaxation you will
be too tired and “battle
weary” to either recognize
the best trading
opportunities or properly
pursue them. Sometimes
your best trade is a week’s
vacation in Bermuda!

"HOW TO
DETERMINE WHAT
THE BEST OPTION
POSITION IS FOR
TRENDING
MARKETS"
Why do we recommend
“Free Trades” in some
trending markets, and
“Synthetic Positions” or “In-
The-Money Debit Spreads” in
others. For example, earlier
this year we were
recommending “In-The-
Money Debit Spreads” in the
corn and soybean markets;
but now we have switched to
option purchases (“Free
Trades”)
There are three factors to
consider when determining
which position is the best: the
aggressiveness of the
position, the technical pattern
of the market, and option
volatility levels. While these
positions all have different
characteristics and
advantages, they all have an
important place in a traders
portfolio at the proper time.
(While we have discussed
these positions in detail in
both of our books “The
Option Advantage” and “The
Option Secret,” the following
should help you determine
which of these positions is the
best for a particular market or
situation.
In the beginning stages of a
market trend, we often
recommend “Free Trades.”
In this case, option premium
is normally low and the
potential for an explosive
market move high; so there is
no reason to limit our profit
by selling an out-of-the-
money option. We also do not
want to take the chance of
using the more aggressive
“Synthetic Option Position”
because the market is
unproven and could cause a
larger loss, if the market then
turns around and heads
against us. Our objective in
the “Free Trade” is to sell a
further out-of-the-money
option to entirely pay the
original premium cost of the
option purchased after the
market moves as we
predicted. (If it doesn’t,
although your risk is limited
to the premium +
commissions & fees we
recommend setting stricter
limits.)
The more aggressive
positions of the “Synthetic
Option Position” is used after
a market’s trend is formed
and the market is resting
above heavy support levels
(bullish markets) or below
resistance levels (bearish
markets). In this case we will
sell options beyond those
support or resistance levels
that are not likely to be
breached, to pay most or all
of the costs of the options that
we have purchased. This
option sale provides
protection for the option
purchases if the market does
not make an explosive move,
but merely stays within the
existing range, making small
moves in either direction; and
also additional profits if the
market moves as we
expected.
In this position, our follow up
procedure is similar to the
“Free Trade” in that our
option purchase is hedged by
the sale of a further out-of-
the-money option if the
market moves in our favor,
and the short option we had
originally sold is repurchased
and profits taken.
The “In The Money Debit
Spread” is initiated by
purchasing an in the money
option and selling a more
overvalued out of the money
option. It is best used in more
mature stages of a trending
market or where premium for
out-of-the-money options has
begun to expand. In this case,
although profits are limited,
we are protecting ourselves
from the potential
consolidation of this more
mature market by receiving
the time decay for the out-of-
the-money option.
The “Ratio Spread,” is one of
our favorite option positions.
It is a position that when
initiated at the proper time
has a large range of
profitability, as well as high
probability of profit. This
position is similar to the
“Debit Spread” described
above, except multiple further
out of the money options are
sold. This position is
recommended after explosive
moves have occurred and the
option premium for far out of
the money options is 50 to
150% higher than the at the
money options. We
recommend only initiating
these position at a credit, and
closing them out if the price
of the underlying market
approaches the strike price of
the options sold.
As you can see, these
strategies have significant
differences among them, both
in the technical pattern of the
market and the
aggressiveness of the
position. However, they all
have an important place in a
traders portfolio at the proper
time.

THE BEST
TECHNICAL
PATTERNS FOR
USING OPTION
STRATEGIES
It is easy to make money
trading options. All you have
to do is buy coffee calls in
May when coffee was at the
8000 level and sell them in
July when coffee reached
25000 and make $60,000 per
option, or almost one hundred
times your initial investment
in less than three months!
Unfortunately, it is not that
easy. No one “rings a bell”
before a giant move is going
to occur and then calls you
again to tell you the move is
over. Of course it was great if
you bought coffee calls in
May, but how about all
during 1990 through March
of 1994 (chart 19.8-9) where
coffee made no move at all. If
you had purchased options at
that time, you would have
lost on all of your purchases.
Since we usually don’t have
someone to “ring a bell” for
us, we have determined
technical patterns that allow
us to enter the markets at
times when the move is more
reliable; that will allow us to
take profits “out of the
middle” instead of attempting
to get the top or bottom tick.
This is also Peter Lynch’s
attitude in buying stocks (he
is one of the most successful
fund managers in history):
“There is no harm in taking a
show me attitude. Once in
awhile you will miss a few
dollars of profit by not getting
in at the bottom of the
successful cases. But in the
unsuccessful cases, you’ll
save yourself a lot of money
and frustration. Missing the
bottom on the way up won’t
cost you anything. It is
missing the top on the way
down that is always
expensive.”
A classic example of this is
the lumber market (chart
19.10) which has twice run
from near contract lows to ten
year highs since 1993.
Without any trading rules, it
would have been very
difficult to successfully trade
this market. Here are the chart
patterns we look for in
initiating option trades:

1. Option purchasing.
Our favorite pattern for
initiating option purchases is
a break out from a long term
consolidation pattern. The
following charts (charts
19.11-12) are examples of
this type of pattern. The
second pattern that we also
find to be excellent in
purchasing options is when a
long term trend is broken
(charts 19.13-14). Neither of
these methods will allow you
to enter the market at its
absolute lows, however, your
entry points would have been
within 5% of the markets
highs or lows. And as Peter
Lynch said in describing a
similar market entry point,
“... eventually I made only
ten times my money, but at
less risk.”
Another one of our favorite
patterns for initiating option
purchases is a pullback after
initial market bottoms or tops.
In this case, the market has
begun to “prove” itself and
risk can be more clearly
defined by using a “stop out”
point below this reaction low
(charts 19.15-18).
In exiting the positions we
recommend two different
ways. First, the same method
that we use in entering
positions can be used for
exiting positions also. For
example, in coffee, after
entering the position on a
break out in May, you use a
trendline to determine your
exit point, and would have
exited the market in
September after it declined to
the 21000 level. Therefore,
using this “breakout” entry
method and trend line exit
combination, you would have
been able to participate in
75% of the total move (chart
19.19).
We also use our “Free Trade”
system of protecting profits.
In this case we pick a
resistance level that we feel
the contract will have
difficulty in piercing.

THE MOST
OVERLOOKED
OPTION BUYING
STRATEGIES
OR DON’T TRADE
ANOTHER FUTURE
UNTIL YOU READ
THIS!

1. THE IN-THE-MONEY
DEBIT SPREAD

The “In-The-Money Debit

Spread” consists of
purchasing an in the money
option and selling an out the
money option of the same
expiration month. It is a
position that requires that we
pay a premium - the cost
difference between the option
we purchase and the option
we sell - in exchange for the
potential for receiving the
difference between the two
strike prices.
For example, currently, the
September S&P is trading at
455. A trader who is bearish
on the S&P 500 could
purchase the September 465
put for 1300 points ($6500)
and sell the 445 put for 500
points ($2500) for a net cost
or debit of $4000. The
potential profit on this
position is the difference
between these two strike
prices 465 minus 445 2000
points ($10,000).
As uninspired as this position
may seem, it actually has
substantial benefits over a
short futures position
including:

1. Lower cost
2. Limitation of risk
3. Ability to take advantage
of premium disparity.

As we described above, the

cost or debit of the September
S&P in-the-money debit
spread is $4000. However,
the exchange minimum
margin for initiating a short
futures position is almost
three times higher at over
$11,000. This allows a trader
to commit less of his capital
to any one trade.
The second, and probably
more important advantage, is
limitation of risk. While a
short futures position burdens
the trader with unlimited risk,
the risk of the “In-The-Money
Debit Spread” is absolutely
limited to the amount paid for
the spread plus commissions
and transaction fees. This can
be more of a substantial
benefit than most traders
realize. Even though many
traders feel that their risk
when trading futures they can
limit by the use of “stops,”
what is not taken into account
is that many times the futures
traders can be “stopped out”
because of the risk of taking a
large loss in a market that has
begun to make a big move
against this position, only to
then later see the market
reverse and move in their
favor. With the “In-The-
Money Debit Spread” the
trader knows that not only is
his risk limited, but actually
he is hedging some of his
losses by the gains on the
option he sold.
These factors can be very
important, especially to a
trader who finds that his
ability to predict market
direction is good; however,
who is emotionally and
financially unable to handle
the normal market “noise” of
corrections even when the
market is trending in his
favor. This psychological
advantage of knowing that
your losses are absolutely
limited can make the
difference between a winning
or losing trade.
The third advantage of this
position is being able to take
advantage of disparity in
option premium. In the debit
spread described above, the
volatility of the 465 put was
10% and the 445 put 13%.
This means that we were
selling an option that was
trading at a volatility of 30%
higher than the option we
were purchasing, providing
another significant benefit for
the trader.
The advantages of this
position seems so
overwhelming that one
wonders why anyone would
trade futures. There are
several disadvantages that
should be considered by all
traders before they initiate
this position. The first is that
since we are initiating a
spread of two positions
instead of one there is an
extra commission for each
trade. Second, orders should
always be placed at a specific
limit price to avoid slippage
that can occur with less liquid
options. Third, profit on a
“Debit Spread” is limited, as
opposed to the unlimited
profit potential of futures
positions. However, we feel
that these disadvantages are a
small price to pay for the
benefits that accrue from this
type of position, that could
make the difference between
a profitable or unprofitable
trade.
2. OPTION STRADDLE
PURCHASE
This strategy is also a greatly
overlooked “non-directional”
option strategy. The “Option
Purchase Straddle” is a
purchase of a put and a call of
the same month and
underlying market. In this
strategy, we recommend as in
all option purchasing
strategies, that at the money
or close to the money options
be used. Similar to the “In-
The-Money Debit Spread,”
risk is absolutely limited to
the premium paid for the
options, plus commissions
and transaction fees.
However, not only is the
potential profit unlimited, but
we can also profit by a move
in either direction. This is
why we call it a “non-
directional” option strategy -
we don’t care which way the
market moves, as long as it
moves.
Since this strategy will only
be unsuccessful if the market
does not make a significant
move in either direction, we
limit the times we
recommend initiating this
position to the following:

1. Before important
reports, meeting and
other releases of
information that could
substantially affect the
market in either
direction;
2. When option volatility
(premium cost) is low;
or
 3. When the market’s
technical pattern
suggests that a large
breakout is imminent.

This strategy was

successfully initiated in July
when a Deutsche Mark
straddle was recommended
just prior to the G-7 meetings.
We expected these meetings
to have a severe impact on
the market, either by action or
disappointment from non
action. Further, the option
volatility in the D-Mark was
near historically low levels in
spite of large daily moves that
were occurring in the
underlying future market.
This strategy was
immediately successful as the
D-Mark jumped almost 200
points the day after the
meetings concluded, allowing
traders who initiated this
position to turn their call
purchases into “Free Trades.”
In fact, since the market
began to turn around right
after this jump, the puts
began to gain significantly in
value, and on a continued
move down, traders will be in
a position to turn the puts into
a “Free Trade” also. This is
the ultimate of all positions,
to have a “Free Trade” in
both directions, and be able to
profit without having to pick
market direction!
This position is also highly
recommended when the
market has moved itself into a
explosive chart pattern. Our
favorite type of chart pattern
for this position is the
“triangle” pattern, where the
market has made lower highs
and higher lows over an
extended period of time. The
market then “coils” itself into
a tighter and tighter trading
range from which a large
breakout always occurs, (as
we discussed in our Gold
Market Comments).
However, the problem is in
guessing which way this
move will happen. The option
straddle removes this
question, allowing the trader
to profit by a large move in
either direction. Further, this
is normally an opportune time
to purchase options as
volatility often moves to very
low levels as the market
“quiets down” and moves into
this trading range. Then, after
the breakout, not only does
the option gain from the price
movement, but volatility can
increase substantially (coffee
option volatility moved from
20% to over 100% on the
breakout) thereby also further
increasing the value of the
options that you purchase.
We have found that these two
positions are not only the
most overlooked option
purchasing opportunities, but
they are two strategies that
can provide the trader with
significant advantages in the
right circumstances - a
substantial “trading edge”
over the markets.

THE MOST
OVERLOOKED
OPTION SELLING
STRATEGIES
We have often discussed the
benefits of the “Neutral
Option Position” (which is
our favorite option strategy
for choppy, flat or non-
trending markets) and the
“Ratio Option Spread,”
which is our favorite option
strategy, when out of the
money option premium is
extremely over priced (which
we often find in severely
trending bull markets, or
when weather scares occur in
the grains during the summer
months). However, two
positions that have great
benefits in many diverse
situations, “Covered Call
Writing” and “Calendar
Spreads” are often over
looked by most traders. These
overlooked strategies can
provide a trader with some
overwhelming advantages
when used in the right
circumstances.
1. COVER CALL
WRITING -
ADDITIONAL
INCOME on every
trade;
This strategy is one of the
best methods of increasing
your returns without any
additional risk, margin or
capital necessary. This
strategy is initiated by selling
an out-of-the-money option
against a long futures
position. For example, a
trader purchases silver futures
contracts at $5 and at the
same time sells $6.50 calls
for $500 each. There is no
additional cost or margin for
this position (except
commissions and fees) since
the calls you sell are
“covered” by the long futures
contract. Thereafter, the
market can react in four
ways:

1. It can move lower;

2. It can remain stable;
3. It can move higher, but
remain below $6.50;
4. It can move above $6.50
(An increase of 30%)

In the first three instances the

net effect of initiating the
covered call would be to add
$500 to our account to either
lower our losses in situation
a, or increase our profits in
situations b and c. However,
even in situation d, which is
the only scenario that writing
a call would be detrimental to
us, the only loss here is that
of limitation of potential
profits above the $6.50 price.
Our initial profits of $7500 in
a futures contract plus the
$500 we received for selling
the option would be ours to
keep; we would just receive
no additional profits if silver
futures really took off and
continued to move
substantially above $6.50.
However, there are several
ways to even lessen the
impact of this situation. First
of all, the likelihood of this
happening (a move over 30%
before the option expires) is
very rare, occurring less than
5% of the time. Secondly, the
consequences of this
occurring are not “account
threatening” as a substantial
profit has already been made
on this trade; third, an astute
trader can decide to close out
the “covered call” at any time
when he sees the market
beginning to make a large
move. In doing this, he is
back in the same situation he
was originally of a long
futures position with the
potential of unlimited profits.
All in all, this is a strategy
that has an extremely high
probability of success with
little risk and no additional
capital necessary. All traders
should initiate this strategy in
almost every case of
purchasing (or selling) a
futures or stock position.
There is also variation of
“covered writing” that can
provide the trader with a
more aggressive position, and
additional profits in a
trending market situation. In
this case, after purchasing the
silver futures contract with
silver at $5, you also
purchase a $5 silver call and
sell two 650 silver calls at
even money. Our existing
position now would be long
one silver futures contract at
$5, long one silver $5 call;
and short two silver 650 calls.
In this situation, our
maximum profit level would
be $15,000 if December
silver expired at the 650
level, instead of the $7500
that we would make alone if
we had only purchased the
silver futures contract without
the aggressive option
strategy. In fact, silver would
have to go all the way from
$5 to $8, a move of over 60%
for us to make as much
money with the silver futures
alone as we had made with
the aggressive option
strategy. In fact, only above
$8 does this strategy become
detrimental to us, as profits
will be limited above this
level.

In summary, with this

aggressive option
strategy, the scenario
is as follows:

1. If silver were to move

 under $5 there would be
no detriment from this
strategy (except for extra
commissions, fees and
premium debit, if any);
2. If silver were to move
above $5, all the way up
to $6.50, our profits
would be double what
we would make with a
futures contract alone;
3. There would be
additional profits for
 traders while silver was
between $6.50 up to $8
above those that would
be made on a silver
futures contract alone;
and
4. Only above $8 would
profits be limited
(however, we would
have now made $15,000
for each position).

2. CALENDAR
OPTION STRATEGY
- TAKE
ADVANTAGE OF
DISPARITIES IN
FUTURES AND
OPTIONS
The “Calendar Option
Spread” is initiated by
purchasing a deferred month
option and selling a closer to
expiration option. The initial
advantage of this position is
taking advantage of the steep
time decay that close to
expiration, out-of-the-money
options undergo. This in itself
is enough to bring a
substantial advantage to a
trader. However, in addition,
there are two other situations
when this trade turns the odds
overwhelmingly in favor of
the option strategist. The first
situation is when option
volatility for the closer to
expiration months is trading
at substantially higher levels
than the deferred contract.
This often happens in volatile
markets as there is an
increased demand for these
“more active” options for
speculation and hedging.
Often, we find that the
deferred month options are
“forgotten” and trading at
volatility levels of 50% or
more lower than the active
front month contract.
Examples of this occurred
earlier this year in the cocoa
and coffee option markets
when they began to breakout;
in the grains during the rally
attempt at the beginning of
the summer where the front
month options were 20-30%
higher in premium; in live
cattle in May and June after
cattle had experienced a
severe decline of 1,000 points
in two months, option
volatility in the August
contract rose up to 24% for
the out of the money options
while the deferred month
December contract was
trading at 15%, almost 40%
lower.
However, one of the best
instances of the benefits of
this strategy occurred in
August in the live hog option
market. In that market, the
spread between February and
October live hogs had moved
from February being 100 over
October in the beginning of
June to February being more
than 150 under October in
July. Our research had shown
that this did not happen often
and many times this disparity
in the futures contracts was
quickly corrected.
Additionally, because of the
volatility in the live hog
market, the February calls
were 20% less expensive than
the October calls. Therefore,
we recommended an
excellent “Calendar Spread”
of purchasing in-the-money
February call options, while
selling out of the money
October options that were
close to expiration and
entering the period of their
most severe time decay.
Additionally, the February
contract corrected in late
August moved back towards
parity with the October
thereby further increasing the
value of the February calls in
relation to the October. This
trade combined the best of all
worlds of the “Calendar
Spread,” allowing:

1. The trader to take

advantage of the
undervaluation of the
deferred month futures
contract;
2. The overpricing of the
 close to expiration
option; and
3. The rapid time decay of
the close to expiration
options.

The Best Technical

Patterns For Using
Option Selling
Strategies
Option Selling
(Neutral Option
Positions)
There are two
circumstance that are
our favorites for
option sales.
a. Trading range markets.
When a market maintains a
trading range for a long
period of time by continually
bouncing off support and
resistance, this provides an
excellent environment for
option selling. For example,
treasury bonds in 1991 and
1992 maintained a range
(Chart 19.20) from 95 to 105.
This presented an excellent
opportunity to sell puts on
declines with the support
under this level and calls on
rallies above the 105 level.
This would allow the trader to
collect all of the premium
while the option “chopped
around” within this wide
trading range. Similarly, the
live cattle market over the last
six months provided an
excellent opportunity for
option sellers as this market
also maintained a range
between 6800 and 7200, and
option volatility (premium)
was very high. (Chart 19.21)

b. Vertical Market Moves

“Ratio Spreads” have always
been one of our favorite
option positions. The “Ratio
Spread” allows us the luxury
of buying fairly valued
options and selling out-of-
the-money overvalued
options to pay for this
purchase. The position also
provides for a wide profit
range, since when the
position is initiated at a credit
the position can be profitable
if the market moves against
us, remains neutral or is even
more profitable when the
market makes a move in our
favor. (It is only in the case of
an extreme move upward that
the position can begin to
move against us. For this
reason, we always
recommend closing out the
“Ratio Spread” when the
strike prices of our options
that we have sold are
exceeded).
We recommended a “Ratio
Spread” be initiated in coffee
this summer at a 300 point
credit to take advantage of the
near vertical move and the
extremely high option
volatility for the out-of-the-
money options. Although the
market became very volatile,
moving up to 1000 points
lower and higher during the
same day, traders who
initiated “Ratio Spreads” had
little concern, since they were
well insulated from these
adverse moves.
“FLEXIBILITY
AND MONEY
MANAGEMENT -
THE TWO MOST
IMPORTANT, BUT
OVERLOOKED
RULES FOR
SUCCESSFUL
TRADING”
With conditions in all
markets constantly changing,
successful trading requires
flexibility; each market has
its own individual
characteristics requiring
specific trading methods to be
designed for it. Also methods
must be different for markets
that are bullish, bearish or
non-trending. If the system
can not take this into account,
it will not be successful in the
long term. Finally, money
management principles must
be built into the trading
system. Without sufficient
money management
standards, even the best
system will not stand up to
scrutiny.
The need to have a flexible
trading system that can not
only adapt to the parameters
of each individual market,
including different methods
for non trending, bullish or
bearish phase is of paramount
importance. Compare a
Eurodollar chart of the past
year with a chart of the coffee
market, and you can see that a
trading system devised for
one of them would have
extreme difficulty with the
other. As you can see from
these charts, while
Eurodollars have had little
volatility moving about 2%
during the year, coffee has
been extremely volatile,
moving almost 300% during
1994.
Secondly, a trading system
that uses the same rules for
bullish and bearish markets
can also be destined to
difficulty. Today’s markets
decline much quicker than
they rise. For example, after a
bullish year like 1993 in the
S&P 500, where the contract
gained 4,000 points, and then
gave back almost the entire
gain during six trading days
in April, 1994. Also in
October 1987, the S&P gave
up almost all of four years
of steady gains in two
trading sessions.
Different rules should be used
for the early, middle or late
stages of a trending market.
For example, low risk entry
points were available in 1993
when gold gave its first
indication of breaking its
steady two year downtrend,
and in September-October
1994, when the market broke
out of its one year
consolidation, allowing
positions to be aggressively
entered; however, could a
trader similarly take
aggressively bullish positions
after ten years of bullish
markets in the S&P 500?
Even though the trend was of
long standing nature, this
market could be subject to
severe declines, causing large
losses to a trader that would
blindly follow the same
methods for this market as the
gold market in its initial bull
stages.
We have a few basic money
management rules that we
follow in initiating positions:

1. Enter markets at the

early stages of
significant trend changes
and on pullbacks; risk
can more often be
controlled by use of
support and resistance
levels;
2. Do not buy on rallies,
especially in the late
stages of a bull market.
If you buy silver when
the market is up 15-cents
during the day, you
begin to fight the laws of
probability. 1993 was a
bullish year for silver,
which moved up over
30% during the year;
however, the average
price rise was
approximately 1/2 a cent
per trading day! If you
buy silver on a day when
it is up 15-cents that
means mathematically it
must decline on the
average 30 days to
maintain its mean price.
Wouldn’t you rather buy
when the market was
down 15-cents to
provide yourself with the
ability to use
mathematics and
probability in your
favor?
 3. The rule is different for
bear markets. For
example, we would not
hesitate to take a bearish
position in S&P 500
which began to decline,
as this market is
vulnerable to a collapse,
and when the decline
starts to occur, many
traders are going to
“jump ship.”

You must have flexibility in

your trading and design your
method or system to the
market and times you are
trading. And even when this
design is complete, you must
continue to use “flexibility” if
conditions change.
SECTION IV

Trading Rules and

Articles
Christopher A. Bobin
Reprinted from
“Agricultural Options
- Trading, Risk
Management, and
Hedging”
by Christopher A.
Bobin
John Wiley & Sons
©1992
605 Third Avenue,
New York, N.Y.
10158-0012
Chapter 3
The Limits,
Boundaries, and
Seasonality of
Implied Volatility in
Agricultural Options
Before discussing how the
knowledge of option prices
and risk can be applied in
trading strategies, it is
necessary to understand how
implied volatility behaves in
agricultural options. Indeed, a
trader’s expectation of
volatility must dictate his or
her strategy, since the flat-
price outlook can be traded
from either a long or short
volatility perspective. Again,
what beginning option traders
often fail to realize is that,
more often than not, it is the
correct volatility perspective
that determines the success or
failure of options trading, not
the correct flat-price outlook.
Intuitively, just as there is
seasonality in the level of
agricultural prices, there is
seasonality in the movement
of agricultural prices. After a
three- or four-month growing
period in the United States,
crop production will either be
abundant or deficient, and
prices must adjust
accordingly during that short
period. Therefore, weather is
the overwhelming
determinant of price
volatility, though volatility
will rise or fall due to other
isolated events. The
Chernobyl nuclear accident in
the Soviet Union in May
1986 is one example of this
type of isolated event. These
phenomena are unpredictable
and common to all options
markets, however; they are
not our concern here.
Agricultural options have
been traded during periods of
both abundant crops and
drought; therefore, options
traders effectively have their
volatility boundaries defined,
as well as a clear picture of
the seasonality of volatility.
From this, a partial solution
to the long volatility/short
volatility quandary alluded to
in Chapter 2 is obtained.

Soybean Implied
Volatility: Historical
Trends
If one disregards the 1988
drought (May-August 1988),
soybean option implied
volatility has averaged about
20 percent from 1985 to
1988. Distinct boundaries are
recognized above and below
this average: 30 Percent as
the upper boundary and 10
percent as the lower
boundary. Drought scares did
occur in 1986 and 1987, but
with large stocks in the hands
of farmers and the
government, large price
adjustments were not
necessary, and thus volatility
had trouble maintaining the
30 percent level.
In the summer of 1988,
however, the severity of the
drought, combined with an
earlier drawdown of stocks,
called for radical price
adjustments. Volatility broke
through the 30 percent level
and reached an average high
of 72 percent in July 1988. In
fact, in some strike prices,
implied volatility went over
100 percent.
This was because exchange
rules allowed nearby futures
contracts to trade without
limits, and these contracts
were subjected to price
moves on the order of fifty
cents to a dollar (that is, more
than three times the normal
limits). In addition, since
futures contracts were often
locked-limit while options
continued to trade, traders
used the options pit to offset
risk or to initiate new trades,
which caused volatility to be
bid up accordingly.

Corn, Wheat, Soy

meal, and Soy oil
Implied Volatility
Because the fundamentals of
other agricultural
commodities were similar to
those of soybeans during the
period in question (1985-
1988), they tended to follow
the same implied volatility
pattern. Again, ignoring the
1988 drought for the moment,
corn option implied volatility
has averaged 20 percent; its
lower boundary is 10 percent,
and its upper boundary has
reached 35 to 40 percent. The
1988 drought caused a
breakout above the upper
boundary to a high of 75
percent. The upper boundary
for wheat option implied
volatility is 30 percent, and
its drought breakout reached
60 percent. Soymeal and
soyoil option implied
volatility are nearly identical
to that of soybeans.

Trading Conclusions
Three important trading
implications can be drawn
from the situation just
described. First, lower
boundaries are similar across
commodities and tend to be
solid; that is, they represent
opportunities to buy
volatility. Specifically, the
area between the average and
the lower boundary (10 to 20
percent) is generally a buying
opportunity, especially when
implied volatility is expected
to increase from a seasonal
standpoint (more on
seasonality later).
Second, upper boundaries are
usually firm and represent
opportunities to sell volatility;
again, especially when a
seasonal decline is expected.
Finally, when implied
volatility breaks out above
upper boundaries and stays
there, traders should give
serious thought to exiting or
to adjusting short volatility
trades - especially those that
have deltas with signs
opposite to that of the price
move; for example, when the
market starts a rapid upward
adjustment and a trader is
short calls.
At that point, the market
should be reanalyzed both
fundamentally and
technically to establish the
significance of the volatility
breakout. As a rule of thumb,
however, if such a breakout
occurs at the beginning of
summer during a short crop
year, the bias will be for
further movement upward. If
the breakout occurs during
any other time of year -
especially in a fundamental
background of abundant
stocks or sluggish demand -
the move should be suspect.

Case in Point: The

1988 Drought
The soybean and corn option
trading environment during
the 1988 drought is an
excellent example of these
points. Tables 3-1 and 3-2
show the lows and highs of
the different option contracts
traded during that period
(April 1988 to August 1988).
Observations
In the case of both soybeans
and corn, the area between
the average and the lower
boundary (10 to 20 percent)
tends to hold; that is, low
volatility does not go much
lower, and it represents an
opportunity to be long
volatility. Note also that the
20 percent historical average
for soybeans and corn held
fairly well before the
May/July leap in implied
volatility.
The highs seem to have no
limit once they break out of
their long-term upper
boundaries. There are
exceptions: The May soybean
and corn options never passed
their historical upper
boundary and represented a
shorting opportunity. This is
because from a seasonal
standpoint the upside in
implied volatility of the May
option was limited, as it
expired in April. For the rest
of the option months, buying
the breakout in implied
volatility would have been
the correct strategy.
One final observation is that
both the deferred soybean and
corn option volatility
(November and December,
respectively) lagged behind
the front options (see Figures
3-8 and 3-9). In addition, the
deferred months’ volatility
was less volatile; that is, its
peaks and valleys were not as
pronounced as the front-end
options. These two facts
combined to make the
deferred soybean and corn
options excellent shorting
opportunities during the
seasonal volatility high in late
July and early August of
1988.

Seasonality in the
Implied Volatility of
Agricultural Options
Table 3-3 shows the
seasonal highs and
lows of implied
volatility among
agricultural
commodities.
It should be noted that the
graphs represent the average
of implied volatility during
each month for each
commodity in question. No
effort was made to construct
indices, because indices
would not add to the
illustration. In fact, they
would distract attention from
the absolute numbers that
effectively define seasonal
boundaries. Again, a
distinction must be made
between price level and price
movement:
It is the latter, not the former,
with which we are concerned
here. Thus, there is nothing
preventing the price of
soybeans from going to 20
dollars, but it would be
surprising to see price
movements greater than those
of the summer of 1988.
The seasonal patterns in
Table 3-3 indicate the general
trading strategies outlined in
Table 3-4.
Of course, each of the
seasonal strategies shown in
the table must be undertaken
in the light of a market
outlook; for example, it may
be logical to sell both puts
and calls in July or only puts,
or only calls, depending on
the fundamentals that govern
at the time. The important
point is that traders use these
approaches as a general
guideline for being net long
or short volatility while
constructing their strategy to
reflect a flat-price bias.
For example, a trader who is
bearish at the beginning of
the summer is most likely
better off buying puts than
selling calls. Or, if the trader
insists on selling calls, it is
more rational to spread the
short volatility risk by
purchasing a higher strike call
simultaneously.
Simply stated, it is one thing
to be wrong on one’s flat-
price outlook, but it is even
worse to lose more money
because one’s volatility
assumptions were also
incorrect - especially when
this might have been avoided
by a better understanding of
seasonal fluctuations. The
reverse - and probably more
humiliating - situation is
when the trader’s flat-price
analysis was correct but the
trader failed to make money
due to volatility
considerations. The two
situations cause many traders
to vow never to touch these
instruments again.
There is one caveat to this
analysis: the increasing
importance of South
American soybean, corn, and
wheat production. Up to
1990, there has been no
discernible influence on the
seasonality of implied
volatility by weather scares
during the South American
planting and growing season,
which is roughly between
December and March. In fact,
from the graphs it is evident
that implied volatility tends to
decline into March. This
situation may not be expected
to continue, as shortfalls in
the United States must be
increasingly recouped in
Brazil and Argentina. Only
future developments will bear
out this observation, but at
the minimum it underscores
the importance of being
apprised of domestic (US)
and world market
fundamentals at all times.

Seasonality of Implied
Volatility and Plant
Water Use
Some analysts associate the
seasonal rise in implied
volatility with the rise in plant
water use from early summer
to mid-summer. For instance,
the peak in the corn plant’s
water usage is about seventy
to ninety days after planting,
while the peak in the soybean
plant’s water usage occurs
about one hundred days after
planting. This puts the peak
water use for both corn and
soybeans in mid-July to mid-
August, or, coincidentally,
right at the seasonal highs of
corn and soybean implied
volatility.
This reasoning is neither
intellectually sound nor
intuitively appealing. First,
water use simply conveys the
idea that corn and soybean
crops use more water at
certain times and less at
others. If that is supposed to
convey the fact that corn and
soybean plants are sensitive
to adverse weather during
specific periods of the
growing cycle. We already
know that from the seasonal
graphs of implied volatility.
This reasoning also fails to
guide our volatility positions
during the remainder of the
year when weather is not a
factor.
Consequently, it is more
logical to focus on those
factors that affect water use -
temperature and rainfall, for
instance - rather than water
use itself. If temperatures are
ideal and rainfall is adequate,
prices will fall. In that case,
one should be long volatility
(puts) with the price trend or
short volatility (calls) with
the price trend (see Table 3-
4).
This underscores the fact that
our knowledge of the
seasonality of implied
volatility does not remove the
burden of making trading
decisions; it only narrows the
choices. The rest is a matter
of conviction regarding the
variables at hand, such as
weather. To recommend only
long volatility positions based
on a rising water use chart or
only short volatility positions
based on a falling water use
chart is dogmatic trading. At
the very least, dogmatic
trading is boring; at the
extreme, it leads to losses.

Differences Between
In-/At-/Out-of-the-
Money Option
Volatility
In general, the seasonal
pattern is the same, but the
level of implied volatility is
different; specifically, out-of-
the-money options are valued
at a volatility five to ten
percent higher than in-or at-
the-money options.
Technically, this means that
the statistical distribution of
prices is something other than
normal; that is, there is a
higher probability that out-of-
the-money options will come
into the money than is
suggested by the normal
probability distribution; thus,
market participants assign a
higher volatility to these
options.
A less elegant but equally
plausible explanation is that
there is a tendency on the part
of option buyers and sellers to
focus on the out-of-the-
money options. Buyers like
the out-of-the-money options
for the leverage they can
command; sellers also like
out-of-the-money options
because it seems a safe bet
that they will be able to keep
the writing income. Sellers,
however, expose themselves
to open-ended risk, so an
added inducement is needed.
Therefore, between buyers’
eagerness to buy and sellers’
reticence to sell, out-of-the-
money option volatility is bid
up, and with it, premiums.
The implications for trading
are straightforward. Traders
should be cautious about
selling out-of-the-money
volatility at lower volatility
boundaries or before seasonal
volatility up-trends are
expected, because these are
the options that buyers will
flock to at the first sign of an
imminent price move.
Conversely, buyers should be
cautious about buying out-of-
the-money volatility at higher
volatility boundaries or
before seasonal volatility
down-trends are expected,
because these are precisely
the options that sellers will
short with a vengeance. The
reader will note that these
conclusions are in line with
the general volatility
strategies outlined in Table 3-
4.

Implied versus
Historical volatility
This controversy was
introduced in Chapter 2:
Should a trader follow
implied volatility, historical
volatility, or both? And which
leads or lags behind the
other? In general, if historical
volatility remains flat,
implied volatility will be
conditioned by historical
volatility. Implied volatility
may be at a premium to the
historical measure - as buyers
and sellers may be expecting
an imminent price move - but
it will not diverge radically
from the historical measure.
As a corollary, once historical
volatility moves up or down,
the implied volatility follows.
Therefore, for trading
purposes, it is best to use
historical volatility as a
constant check against
movements in implied
volatility; that is, if historical
volatility is flat, then any
divergent moves in implied
volatility should be suspect.
For the trader short volatility,
this may provide a
substantive reason to hold on
to a position despite a one-or
two-day adverse move in
implied volatility. The same
is true for the volatility long:
If historical volatility does
not move, there is no reason
to abandon a long volatility
position because of a random
adverse move in implied
volatility (although a trader
may want to continually
reassess the probability that
his or her position will gain
value as time to expiration
approaches).
Finally, historical volatility is
often a valuable indicator by
itself. If a historical volatility
chart is unusually flat, it often
portends a radical move in
futures prices. Traders who
have open positions with
paper profits should consider
liquidating and going to the
bank with profits. Others who
plan to initiate option trades
should enter from the long
side of volatility or use option
spreads.
The Spread between
Call and Put
Volatility
In normal market situations,
the spread between call and
put implied volatility is very
narrow; however, in
abnormal situations (such as
the drought of 1988) the
disparity between put and call
volatility increases. This is
important for three reasons.
First, wide disparities
between call and put
volatility seem to be
indicative of market tops; that
is, the market is moving
wildly in one direction, which
eventually calls for a reaction
in the opposite direction.
Note that in June 1988, call
volatility wildly outpaced put
volatility as the market
reached new heights. In July,
however, put volatility
outpaced call volatility as the
market plummeted;
eventually, call and put
volatilities came back into
line.
Second, from a money
management standpoint,
option strategies during these
periods should be limited to
those of predefined risk such
as spreads (more on this in
the next chapter), because
naked buying or writing
strategies leave a trader open
to costly swings in implied
volatility.
Third, it should be
emphasized that when
implied volatility is
fluctuating wildly above its
upper boundary, anything is
possible. For example, traders
who consider 50 percent or
75 percent volatility as a good
sale should understand that in
extraordinary situations,
implied volatility can easily
double from those levels.
This was exactly the case
during the 1988 drought.
Eventually, volatility will
come back to normal levels
and call/put volatility spreads
will come back into line, but
the pain inflicted in the short
term can be severe.
Russell R. Wasendorf
& Thomas A.
McCafferty
Reprinted from “All
About Options From
The Inside Out"
by Russell R.
Wasendorf & Thomas
A. McCafferty
©1993 Probus
Publishing Company
Chapter 2
Learning The Basic
Option Trading
Strategies (And Uses)
To Solidify
Objectives
“The happiest time in any
man’s life is when he is in
red-hot pursuit of a dollar
with a reasonable prospect of
overtaking it.”
Jack Billing (1818-1885)
American Humorist

Key Concepts

Power of Leveraging
Law of Probability and
 Three Rights
Distribution of Winning
and Losing Trades
Four Ways to Approach
the Market
Twelve Trading
Strategies
Writing Puts and Calls
Hedging with Options

Normally a discussion of
strategies comes at the end of
a book of this nature. We
have chosen a more
prominent position because
we want you to be thinking
about your strategies and
objectives as you study the
remainder of the text. Our
expectation is that if you have
a good idea of what you want
to gain from options trading,
all the information that
follows will be more
meaningful.
In the title of this chapter, we
have included the words
“strategies” and “uses.”
These two concepts blend or
cross over where options are
concerned because options
are so versatile. They come in
all sizes, shapes, and colors.
Some are built for speed;
others for dependability and
smooth sailing. Still others
are very crafty, putting the
odds in your favor. Which
suits you?
There are basically two types
of options traders, namely,
speculators and hedgers. The
specs are risk takers, while
the hedgers wish to transfer
risk to someone else. The
objective of the speculators
“specs” is to generate profits.
Hedgers want to preserve the
status quo. We’ll probe the
role of speculators first, since
this is what most traders are.
Then we’ll tackle the hedging
because it can have a
dramatic impact on the specs.
Some investors who speculate
in one market, such as stocks,
can manage or hedge that risk
in another one, such as the
options market.
All speculators are not
created equal, but all have the
same goal (profits) even
though their strategies vary
widely. Also, the complexion
of the market can strongly
influence or change your
approach. You must be more
flexible than the markets you
trade to win.
As you develop your
strategies, keep two things in
mind - the Power of
Leveraging and the Law of
Probability. Leveraging
allows you to control a large
amount of a commodity, or a
large number of shares of a
stock, with a small amount of
capital. For example, let’s say
corn is trading at $2.10 per
bushel and the $2.10 strike
price call is trading for
$0.055 (5 1/2¢). The contract
has six weeks to expiration.
You would have control of
$10,500.00 worth of corn
with an option that costs
$275.00 plus $50.00 in
commissions and fees for a
total of $325.00. Your
leveraging ratio would be 32
to 1 ($10,500/$325). A
similar situation in the stock
market would be the purchase
of an AT&T $40.00 per share
call at 1 7/8 ($1.875) or
$187.50 (100 shares x
$1.875), plus $40.00
transaction costs. If the stock
is at 41 1/4 or $41.25 per
share at the time, the total
value of 100 shares would be
$4,125.00. Divide this by the
total invested giving you a
ratio of approximately 18:1
($4,125.00/$227.50).
Now, what does leveraging
do for you? It gives you the
opportunity to make a high
return percentage wise on
your investment. Take the
corn example. When corn
gains a dime, the total value
of the contract increases
$500.00. Your $2.10 options
is at-the-money. Therefore,
its intrinsic value would
increase by an equal amount
or a 65% return. Additionally,
there could be some increase
in the time value, depending
on how much left to
expiration.
You would have a similar
situation with the stock
option. It’s for 100 shares.
Therefore, every $1.00 gain
per share increases the value
of the in-the-money option by
at least $100.00 of intrinsic
value. A gain of $4.00 per
share doubles your
investment.
Also, remember we are
talking about relatively short
periods of time. These
options had only six weeks to
expiration. There are few
investment opportunities that
offer that potential of
doubling your money in a
matter of weeks or months.
To make the gains
meaningful from a dollar
standpoint, serious options
investors trade multiple lots
of contracts. This would be
10, 20, 50, or 100 options
(lots) at a time.
Before you call your broker
to make one of these “piece
of cake” trades, you need to
think it through. The sellers
of these options, in the
trading pits and all over the
world, are not dumb. When
you buy a put or a call,
someone has to sell it to you
(underwrites it). That person
expects your option to expire
worthless so he or she can
keep the premium. To put it
more bluntly, the option seller
wants you to lose 100% of
your investment. Writing
(selling or granting) options
entails more risk than buying
options. The seller can be
assigned the opposite side of
the buyer’s option position
any time the buyer decides to
exercise it. It would probably
only be done when it was in-
the-money, which means the
seller would be losing money
as soon as the buyer acted.
The loss could be substantial.
Think what would happen to
a seller in the futures market
who has been assigned a
position that is making daily
limit moves against him. For
hogs on the CBOT, it would
be $600.00 per day per
contract. After a day or two
of limit moves, the daily limit
- or maximum a contract can
trade in a single trading
session - might be extended
to $700.00 or $800.00. Some
markets, like the foreign
currencies, have no daily
limits. It is because of this
possibility that the downside
risk of selling option is
considered unlimited. The
upside or profit is limited to
the amount of the premium,
less transaction costs. Why
would anyone enter an
investment where the profit
potential is limited and the
risk of loss is unlimited? This
will be covered when we
discuss selling options as a
strategy. You’ll also learn
why you may have a better
chance of making money in
the long run selling than
buying options.
Since selling options can be a
profit strategy, it insinuates
that buying option must be
risky. It isn’t a “piece of
cake.” The risk may be
limited to your initial
investment, but all of this can
be lost. This line of thought
brings us to the law of
probability. The strategy you
select will have a greater
probability of succeeding if it
is diversified. This means
trading options on a variety of
commodity markets or stocks.
To be a successful trader, you
must be in the right market, at
the right time, and on the
right side (put or call). You
are investing in what you
expect to happen in the future
- five days, five weeks, or
five months from the moment
you call your broker and
place your order. You have
no way of knowing if you
will be right or wrong until
afterwards.
At the same time, you must
protect your risk capital as
carefully as possible. This
requires sound money
management techniques,
which is the second part of
the Law of Probability. A
sure way of ending a trading
career abruptly is putting all
our risk capital on one or two
trades. A “double or nothing”
approach to the markets will
invariably, in our opinion,
lead to you ending up with
nothing.
Just as you increase the
probability of being in the
right market at the right time
on the right side by trading
several different markets,
you’ll increase your
probability of success by
putting no more than 10% of
your risk capital on any one
trade. This gives you at least
10 opportunities to select one
or more trades to pay for the
ones that lose or just break
even.
You must further consider
what is know as the
“distribution of wining-losing
trades.” For example, your
distribution might look like
this:
Your objective is to let
winners run and cut losers
short. If you do an analysis of
the trading performance of
the most successful CTAs
(professional commodity
trading advisors), you rarely
find a winning percentage
higher than 60 percent.
Keep in mind, the prime
objective is to make money,
not to generate a high
percentage of profitable
trades. You can be a net
winner with a low percentage
of winning trades. By low, we
mean 40 percent, 30 percent
or even 20 percent.
To do this, you must be very
disciplined. You develop, for
example, strict rules for
exiting losing trades (these
are detailed later). For
example, when a trade begins
to make money, you place a
trailing stop behind it (below
a long position or above a
short). Eventually this stop
position is taken out,
offsetting your position. In
other words, the market
decides for you when to close
a position.
As you develop your personal
trading strategy, you need to
keep all this in mind. Trading
several markets takes more
time than just one. As does
updating a system that is
tracking a number of
alternative commodities or
stocks. On the one hand, you
need to be diversified.
Equally important it to avoid
becoming over extended
financially, psychologically,
or personally.

Overview of
Strategies
We’ll begin with a general
discussion of option trading
strategies and then move to
an explanation of specific
ones. There will be no
attempt to provide a
definitive discussion of every
possible strategy. But we will
explain most of the common
ones appropriate for a novice
options investor.
There are four basic ways to
trade and forecast the trend.
Or you can use a system that
mechanically alerts you to
options that are over or under
priced. Thirdly, you can be a
writer or grantor of options
and underwrite the buyers.
Last of all, you can use a
combination of the three
approaches just mentioned.
Now, let’s discuss each of
these approaches.
As a market analyst, you can
use fundamentals or technical
analysis to decide where the
market is headed.
Fundamental analysis is the
study of all the underlying
factors that affect the supply-
demand equation for a stock
or commodity, and thus the
price. Technical analysis
disregards all fundamental
factors. It relies on the study
of price action, rates of
change in price, volume, or
open interest. Prices are often
charted and the patterns
analyzed. Or it could be
computerized, and numerous
studies run with the hope of
discovering recurring
patterns. These two
alternatives will be discussed
in detail in later chapters.
Once you arrive at an opinion
of the direction of the trend of
a market, you must quantify
it. Are you mildly or
aggressively bullish or
bearish? Are you neutral - do
you think the market will
trend sideways?
Your second possibility is to
adopt some type of
mechanical trading system.
The most common of these
are computer programs (see
appendix for listing and
descriptions) that evaluate
options using a theoretical
pricing model. You calculate
the price of a option using the
amount of time to expiration,
market volatility, carry costs,
and current price of the
underlying entity (stock or
futures contract). Then you
compare this theoretical price
with the actual market price.
This tells you if the option is
over or under priced. You
then buy or sell a call or a put
depending on the analysis.
We’ll talk in more detail
about how this all is
calculated in the chapter on
volatility.
The third approach is to be a
writer of options. Here you
have limited profit potential
and substantial risk. Again,
you have some choices, such
as whether you sell covered
or uncovered options.
Underwriting options is an
approach that is rarely
recommended to new traders,
but it can have an appeal to
experienced investors - even
if they are new to options.
Lastly, it is common to create
trading strategies which
utilize a combination of the
four basic methods. You can,
for example, use the premium
you receive for writing an
option to buy one. This is
sometimes called a “free”
trade, since you don’t have to
pay directly for the option
you buy.

Specific Trading
Strategies
Now, let’s talk turkey. We’ll
begin with “Raging Bull
Strategies.” You think the
market is grossly oversold -
poised for a major move
higher.
Let’s use the silver as an
example. It has been trading
below $5.00 an ounce for
almost two years and under
$4.00 for the last 12 months.
Your analysis indicates that it
is about to make a move from
the $3.50 level to over $5.50.
Your best estimate calls for
$6.00 silver within the next
60 days.
The simplest and most
common approach for a new
investor is to buy a call. The
call gives you the right, but
not the obligation, to take a
long position in the
underlying futures. As the
underlying futures gains, so
does the call. You can either
exercise the option and take
your long futures position, or
you can offset your option
positions at a profit as it gains
intrinsic value.
The more difficult question is
which strike price to buy.
Here are your choices for
calls with 60 days to
expiration on 5,000 troy
ounces of silver.
The $3.00 strike price option
has 50 cents intrinsic value
and 5 cents time value. The
$3.25 strike price is a quarter
in-the-market with a nickel
time value. The at-the-market
option has no intrinsic value
and 5 cents time value. The
two out-of-the-money options
only have time value. The
farther out-of-the-money, the
less time value.
Studying these values
indicates the market doesn’t
agree with your analysis.
Sellers of out-of-the-money
options are making them very
attractive. A $4.00 call carries
a $50.00 premium (5,000 oz.
x $0.01).
The at-the-money strike price
is very reasonable, if your
analysis proves to be
anywhere near accurate. At 5
cents per ounce, the call costs
$250.00 plus transaction costs
of, let’s say $50.00, for a total
of $300.00. A $2.00 per
ounce gain in silver would
amount to $10,000.00. The
ratio of profit to loss would
be 33 to 1.
Another way of looking at
this trade would be to
calculate the breakeven. How
much does silver have to gain
just to get your $300.00
back? Each penny gained
adds $50.00 to the intrinsic
value of the at-the-money
option. Therefore, all that is
needed is no more than six
cents and maybe a little less,
if the time value increases as
well.
A put works the same way
but in the opposite direction.
We call it the
“Doomsdayer’s.” You think,
for example, the shares of
ABC Company now at
$50.00, are headed south in a
big way, maybe even as much
as 50%. Checking the paper,
or calling your broker,
provides the following prices:
Again, the market isn’t
bracing for a major slide in
the price of ABC’s stock. It is
only asking $75.00 (100
shares x $0.75) for an option
with a strike price of $10.00
out-of-the-money and
$100.00 for one $5.00 out.
The breakeven for the at-the-
money option would be a
decrease in the per share price
by approximately $1.00 plus
1/8 in time value, or about
$1.50 to include transaction
costs. The reward to risk
ratio, if the shares do drop
$25.00 per share before the
at-the-money option expires,
would be approximately 16 to
1 ($2,500.00/150). See Figure
2.2.
We call these two strategies
the “Raging Bull” and
“Doomsdayer” because that
is the way they are often
presented to investors. For
these strategies to work, you
need a major price move,
which is rare. Additionally,
you really have only one
opportunity to profit and that
is if your analysis is
absolutely correct.
Experience has shown that
the odds of this happening
consistently are remote.
One of the most expensive
errors people new to options
make is getting caught up
with the excitement a broker
may create regarding a trade.
“Silver is headed off the
charts! Get in now! What can
you lose?” The answer is
100% of your investment.
This trading strategy requires
you to hit home runs each
time at bat. If they pay off
big, they are grand slammers!
It is for this reason, in our
opinion, most option traders,
particularly new and/or small
traders, are net losers as
options traders. There are
occasions when you should
swing for the fence, but most
of the time you should try a
strategy with a higher
percentage success rate.
Unfortunately, most stock
and futures options traders
never get beyond this point in
the learning curve.
 George Tzakis
Reprinted from July
Futures The Magazine
of Commodities &
Options 1989 Issue
by George Tzakis
©1989 Oster
Communications Inc.
219 Parkade, Cedar
Falls, Iowa 50613
Buying the calm
Before the release of key
economic reports, interest
rate markets usually trade in a
narrow range. Once the
reports are announced, the
markets may react so
violently that someone not
already positioned has little
chance to participate.
One short-term strategy that
takes advantage of this type
of market involves buying
near- or at-the-money options
about two weeks before
expiration. Examples are
buying a straddle or strangle -
both involve simultaneous
purchase of a call and a put.
The week of the U.S.
quarterly refunding, usually
two weeks before Treasury
bond options expire, major
economic reports are
released. This is an opportune
time for such position.
Imminent expiration means
inexpensive options. The
options are in danger of
losing most or all of their
value. Any options position
has its pluses and minuses,
but the primary drawback of
this particular strategy is lack
of time.
The market must make a big
move quickly. If not, the
position will suffer steady
time decay, which accelerates
as expiration approaches. So
does gamma, the rate of
change of the hedge ratio of
the option (delta) with respect
to price movement of the
underlying instrument.
Gamma is how much delta
will change given a one-point
move in the underlying. The
bigger the gamma, the more
bang for the buck.
Say June T-bond puts have a
delta of 0.30 and gamma of
0.20 with futures at 89-00. If
futures fall a point to 88-00,
the delta of the put would be
0.50 (0.30 + 0.20). Put deltas
increase with favorable
market moves.
But with a high gamma
comes rapid decay of time
value. Close to expiration, an
investor could attain a high
gamma by buying the June
88-90 strangle - long 88 puts
and 90 calls. But, even if the
market moved quickly in
either direction, profits could
be wiped out by decay.
Volatility, which usually
increases in options before an
economic report, would also
affect the position. Wild price
swings not only could put the
straddle in the money but also
pump up the premium.
However, when volatility
falls, premium decay even
faster.
For the long June 88-90
strangle, you can hedge
against such a decrease while
still taking advantage of
favorable movement in prices
by selling a farther out
strangle: September 86 puts
and 94 calls. On May 11, the
day before the Producer Price
Index release, this
combination was available for
a credit of 15/64 ($235).
Hours after the May 12
release, the position could
have been unwound at 43/64
($672) profit.
Selling deferred-month
strangles with out-of-the-
money strikes can hedge the
risk of being long options
near expiration and make the
position cheaper. The
position has high gamma
(from being long expiring
options) and will actually be
profitable on a volatility
decrease.
George Tzakis is an options
analyst for CAPCOM Futures
Inc., futures commission
merchants, and for Weighted
Hedge Management Inc., a
trading advisor.
 Kenneth R. Trester
Reprinted by
permission of Kenneth
R. Trester from “The
Compleat Option
Player”
Published by the
Institute for Options
Research Inc. ©1997,
1992
P.O. Box 6586
Lake Tahoe, NV
89449
(702) 588-3590
The Compleat Option
Player
Chapter 26
The Ten
Commandments of
Option Trading
I DON’T BE
GREEDY
II LOOK BEFORE
YOU LEAP
III FOLLOW YOUR
STRATEGY
IV PULL THE
TRIGGER
V USE
CONTINGENCY
ORDERS
VI BEWARE OF
COMMISSIONS
VII AVOID
EXERCISE
VIII BE PATIENT
IX USE AN
OPTIONS
SPECIALIST
X MANAGE YOUR
MARGIN
I. Don’t be greedy.
The first commandment of
option trading is a simple
one, but it is probably the
most important one. Don’t be
greedy. You may laugh, but
this is probably the root cause
of many an option player’s
failure to succeed in the
options game. When we say,
“Don’t be greedy,” we just
mean, “Do not be unrealistic
when you take a position, or
take profits, or move out of a
position.”
An old option trader with
plenty of experience
frequently states the
following seasoned principle:
“You can buy the world for
an eighth.” What he is
referring to is simply an
eighth of a point. Option
players incur significant
losses and lose significant
opportunities because they do
not give their broker enough
room to execute new trades,
or to execute and take profits
properly. They spend their
time looking for that extra
eighth of a point profit
whenever they conduct an
option transaction, and
unfortunately this prevents
them either from taking
advantage of many profitable
opportunities, or from exiting
a position when the danger
zone has been reached. When
you get too greedy in the
options market, your portfolio
will suffer the consequences;
you may pay a high price for
an eighth of a point.

II. Look before you

leap.
In the options game, as in any
other game, it is critical that
you have some kind of a plan,
and that you carefully map
out a detailed picture of what
will occur in the future to
your strategy. Because of the
nature of options, strategies
can be formulated in great
detail. Right in front of you,
you have the exact amount of
time left in the life of each
option. This can help you
clearly map out what will
happen at every point in the
life of your strategy. By
doing this, you will have no
surprises and you can build a
defense against any
unexpected contingencies.
Without a strategy, you are
playing with dynamite,
especially when you write
naked options.

III. Follow your

strategy.
You have now spent many
hours mapping out several
alternative strategies and you
have selected the strategies
you feel have the highest
profit potential and the lowest
possible risk. Now follow
them. This may be easy to
say, but in the heat of battle,
your emotions may attempt to
take command of your
actions. Many an option
player will fall by the
roadside because he has been
swayed by his emotions,
rather than following the
detailed strategies he mapped
out before he entered this
action filled market.

IV. Pull the trigger.

This recommendation may be
the hardest one to follow. We
have discussed this concept
many times throughout the
text. I have repeated it
numerous times because it is
so important. You have been
trained to build defense
mechanisms into your
strategies: danger points,
break-even points, parameters
where you bail-out of your
positions to avoid a potential
loss. Because of the inherent
dangers in the writing of
naked options, it is critical
that you take action when
these points are reached, that
you pull the trigger and
immediately move out of an
these positions We have
talked about ways of building
this ejection system into your
strategies through the use of
contingency orders and stop-
losses. Whether you use a
stop-loss, or whether you rely
on your own discretion to pull
the trigger, it must be pulled.
The only way you will open
yourself up to financial
disaster in the options market
is to hesitate one time and not
pull the trigger.
When we talk about pulling
the trigger, we also refer to
your ability to take profits
when they develop in your
strategies. The best comment
I can make here is never,
never be afraid to take a
profit. Then don’t have any
regrets because the strategy
would later have become
more profitable. Once you are
out of a strategy, do not
consider what happens to it in
the future.
V. Use contingency
orders.
We’ve talked about the many
types of trading tactics that
can be used in the options
market. For the extremely
experienced option player,
legging-in and legging-out
techniques might be
considered—they provide the
most profit and take
advantage of market moods.
But to the player who does
not have the time or the
inclination to monitor his
positions closely on an hour-
by-hour basis, or to spend
large amounts of time moving
into and out of strategies, or
for the player who does not
have that good intuitive feel
for the market, the
contingency order is the best
type to use.
VI. Beware of
commissions.
I have not, in my examples,
clearly displayed the
commission costs involved in
different types of options
transactions. In the next
chapter, I will identify the
different possible commission
costs involved in each type of
option strategy, and discuss
which ones can best minimize
commission costs over an
extended period of time.
Being aware of commission
costs is one of the Ten
Commandments because
commissions are so important
in your options portfolio.
Options are traded far more
extensively than are stocks,
and therefore, commission
costs per dollar of investment
are much greater. These
commissions costs should be
offset by the many
advantages of the options
market, but they are there,
and they must be watched
closely and controlled
carefully.
The use of options as a
trading vehicle, where you
move in and out of option
positions on a daily basis, can
be extremely dangerous
unless you carefully watch
the buildup of commission
costs. Options have been
highly touted as an excellent
trading vehicle, but if you
look closely at the amount of
commission costs involved in
such transactions, this method
could become far less
attractive. Only those who
have commission advantages,
where they receive heavy
discounts, or where they have
a seat on the Exchange, can
be viable daily option traders.
VII. Avoid exercise.
We spent one full chapter
talking about exercise and
dispelling some myths that
are passed on about the
dangers, uncertainties and the
fears of exercise. Exercise is
nothing to fear, but when you
are exercised, there are
additional costs.
There is a simple prescription
to guard against exercise. To
avoid exercise, never hold a
short position (a writing
position) in an option where
the option has no time value,
or a negligible time value.
This is an easy principle to
follow, and it will save you a
lot of money if you follow
this commandment.

VIII. Be patient.
We have talked about being
patient when you plan to buy
options because you are
starting with a slight
disadvantage, and, therefore,
you must get an excellent
price. Only through a good
price can your overall results
be profitable. Consequently
you may have to wait
extensive periods of time
until the market and the
option price are ideal.
In strategy development, the
same rules apply. Do not be
overly impatient in
attempting to find an
interesting option strategy.
Wait for the ideal strategies to
develop, those which have
high profit potential and low
risk considerations. As you
bide your time and continue
to compare different strategy
alternatives, you can always
have your money invested in
Treasury Bills. They are
acceptable collateral when
you are writing options, and
the time that you wait will be
productive.
Because of the high
commission costs of different
strategies, and the importance
of executions, it is vital that
you select the most powerful
strategies that are available,
but these strategies may not
be present every day of the
week; you may have to wait
for them. The question of
getting the right prices for
that strategy is another story,
and if you cannot, you must
pass and move onto other
strategies. There are over 400
stocks that have options on
the options exchanges, and
there are over 1,500 different
options available. So, there
are plenty of strategies to pick
from. Take your time and
pick the best of the crop.
Make sure you get the prices
you need and the strategy that
satisfies you before you make
a move.

IX. Use an options

specialist
Even though this is the ninth
Commandment, it is probably
one of the most important
ones. Because of the
intricacies of the options
market, and the numerous
strategies available, because
of the complicated and
complex problems involved
in options trading, because of
the need for effective option
implementation and
execution, and because of the
need for day to day
surveillance of all strategies,
your broker is an important
member of your team.
A competent options
specialist (not a stock broker)
who spends all of his time in
the options market and has
years of experience in that
market can be an
indispensable asset to your
portfolio and to your
performance. He will get you
out of a lot of tough spots, get
you into some good
strategies, and obtain good
executions for you.
He will solve many problems
and guide you through many
of the commandments that we
have talked about. Equally
important, he will provide
you with the on-the-job
experience and education that
I cannot cover in this text. So,
when you select your broker,
choose an options specialist
to guide you. It will be one of
the best moves you make
toward winning the options
game.

X. Manage your
margin.
Another subject the option
player must be concerned
with is margin, the good faith
deposit you will put up in
order to initiate and maintain
your naked option writing
strategies and spreads.
The amount of margin
required for an option
position or strategy will have
a significant impact on your
return on investment.
Maintenance margin calls
may force you out of
potentially profitable
strategies and cause havoc to
your portfolio. Therefore,
managing margin
requirements is an important
activity to the option trader.
Your ability to select low
margin strategies and to avoid
margin calls will be a strong
determinant in the profit
picture of your portfolio
Chapter 32
PREPARING FOR
ACTION
The Psychological
Battlefield
As you prepare to enter the
options game, your greatest
obstacle to success probably
will be the psychological
battlefield that you must
survive. To be a winner, most
novice option traders think
that all they need is a little
luck - a few big winners right
off the bat and they’ll be on
Easy Street. It’s just a matter
of being at the right place at
the right time, or so they
think. Of course, they
couldn’t be more wrong.
Proper money management is
just as important as using the
right strategy, probably more
so. Most people fail to realize
that. For example, if they just
buy options (even if they are
theoretically undervalued),
they could have a long losing
streak and, if they’re not
careful, lose their entire
investment capital. Most
people aren’t careful.
Typically, after a few losses
traders become hesitant - they
take profits away so they
can’t hit any home runs, and
they run up their
commissions by over-trading
Their goose was cooked
before they began, because
they were emotionally
unprepared to trade options.
Your foremost opponent
when you trade options is not
the exchange and its
members, nor the other
traders. It’s your emotions,
and if you can’t control them,
you’re going to be licked.
Don’t get down about it
though, most money
managers have the same
problem.

The Game Plan

The best way to keep your
emotions out of your
investment decisions is to
have a well-defined game
plan. Write it down and stick
to it.
1. Decide how much money
you are willing to risk in
options during the next
twelve months, and don’t
blow it all in the first few
months. This is really
important—plan to spread
your option trades over the
entire year. Can you risk that
much money? Is the money
you could lose more
important to you than the
money you could make?
Would a loss affect your life-
style? If you answer “yes,”
you shouldn’t be trading at
all. You also should trade as
if options are chips on a
poker table—if you’re afraid
to lose, you will.
Plan to diversify, both over
time and position. If you
spread your purchases over
one year, for example, and
buy both puts and calls on
several stocks, you won’t be
wiped out if the stock market
is dull for months on end (it
can happen). Also, you’ll
have a better chance of being
around when things pick up
and options pay off. Always
invest the same dollar amount
in each position. If you do,
you’ll eliminate the risk of
having small investments in
the winners and big
investments in the losers.

Chapter 15
THE SECRETS OF
STRATEGY
DESIGN
Three Magic Words
Three words will expose the
secrets of strategy design.
These three magic words are:
STRATEGY, DISCIPLINE,
and DEFENSE.
1. Strategy
The first hidden secret of
strategy design is a simple
prescription—make sure that
you always have a well
defined strategy, a well
defined plan of attack. The
options market has generated
a high powered method of
making money, but with that
high powered potential, we
also have some high powered
risk. The game player
requires a carefully planned
out strategy to control that
risk. With such a strategy, the
limitless risks which are
continually present to the
option writer can be
controlled to a degree. The
game player who enjoys the
glamour and glory in flying
by the seat of his pants will
surely crash land when he
enters the options game.
2. Discipline
The second key word of
strategy design is discipline.
Discipline relates to your
ability to follow your game
plan. You may consider this
secret to be elementary, but
usually it is totally ignored by
the option player. The
greatest enemy of any option
player is his emotions. As
you begin to play with your
own personal money, the
most powerful elements of
your emotions come into
play, attempting to coax you
off of your plan of action.
Once you have lost your
rationality in the options
game, you have lost the
options game.
You must have the discipline
to follow your well-defined
strategy to the letter, not
breaking one rule or
parameter that you have set.
True, this may result in some
inflexibility, but in the long
run, discipline will provide
for a far more consistent
return, and a far safer, more
successful venture into the
extremely volatile options
market. Remember, the
options market attracts the
most brilliant game players in
the world: the COMPLEAT
OPTION PLAYER must be
cool, calculating, and totally
disciplined, able to disregard
past losses with ease, without
disturbing his present
strategies and tactics.

3. Defense
If you have ever watched a
college football team, you
have seen many teams that
will let it all hang out. Hook
or crook, they will put all
their offense on the line,
trying to win big, throwing
numerous passes, trying out
exotic plays, taking every risk
in the book in order to win
the game. Many of these
teams falter in the dust
because of the numerous
errors that occur from such a
wide open offensive stance.
Then we look at the
professorial football team
which plays a much duller
game. They have good
offense, but their defense is
where all the action lies: a
defense that creates openings
for the team, prevents any
damage from occurring, and
that generates a far more
consistent win record than
teams with a wide open
offense.
In the options market,
DEFENSE is the name of the
game. As we grow older and
wiser, we discover that it is
far more practical and there is
a far better return if we
conserve and protect our
capital, and aim for a
consistent return rather than
laying everything on the line
and going for that one super
victory, using all of our
resources in one burst of
energy.
The options market has been
beautifully designed to aid
the investor in building a
powerful defense. The wise
option player uses these
investment tools to create
strategies which provide a
high degree of safety and a
high and consistent return,
not strategies which will live
or die on the price action of
the stock market. The wise
option player paces himself,
follows his strategies
carefully to avoid any type of
costly error, and shows
tremendous maturity in using
his offense. He continually
conserves his resources, using
his offense only when the
time is ripe, patiently waiting
for the best opportunities to
develop, and then striking
hard leaving enough in
reserve to be able to return
another day.
Option strategies have
tremendous potential if you
remember the three key
words to success:
STRATEGY, DISCIPLINE,
and DEFENSE. If you do not
heed these words, there are
numerous risks and
tremendous disappointments
that will face you.

Chapter 18
Advantages of Naked
Option Writing
1. The Potential
Rewards Are
Outstanding.
To the professional option
player, naked option writing
is the Cadillac division of the
options market. The profit
potentials here are greater
than in any other segment of
the options market. The
skilled and disciplined naked
option writer can generate
from a 50% to a 100% return
annually on his investment,
and normally can do this
consistently over a long
period of time. The naked
writer can become a “man for
all seasons,” confronting
numerous opportunities in
bull, bear, and nomad market
conditions.

2. The Odds of
Winning Are Strongly
in The Writer’s Favor
You will discover, if you
decide to participate in this
Grand Prix of the options
market, that when you run a
naked option writing
portfolio, a high percentage
of your positions will be
winners. By following the
rules that we will set out in
Chapter 19, 80% of your
positions are likely to come
out profitable, and only 20%
will be losers. In other words,
the odds are stacked heavily
in your favor. Naked option
writing is probably the only
game in town where the
investor truly has a strong
advantage over the rest of the
market. Consider this
analogy:
The casino operator who
offers roulette, craps, and
blackjack to patrons who visit
his casino is similar to the
option writer. The casino
operator backs the bets of the
gaming customers. He pays
off when the customers are
big winners; he takes in the
profits when they are losers.
The casino operator has a
slight advantage in each
game. In the game of roulette,
for instance, he has
approximately a 5%
advantage over the gaming
customer. The option writer is
in a similar position, but his
advantage is better than 5%.
The academic studies and
research that have been done
so far have indicated that the
option writer (seller) actually
has approximately a 10% to
20% advantage over the
option buyer (if he writes
over-valued options). The
option writer, like the casino
owner, provides the option
buyer with a market in which
to speculate, in which to
gamble. For this service, the
option writer receives better
odds.
The major advantage that
gives him this percentage
edge is TIME. The option
buyer bets that the stock will
go up significantly when he
buys a call. But the option
writer wins under all other
stock price conditions. The
call option writer is a winner
even if the stock moves up
too slowly because as time
passes, the premium that the
option writer receives from
the option buyer for backing
his bet depreciates, moving
into the pocket of the option
writer.

The option writer has

two important factors
in his favor:

1. He does not
require that the
underlying stock
 price moves to
make a profit.
2. He is continually
making a profit as
the option shrinks
in value with
passing time.
The option writer who writes
strictly naked options with no
hedges, no stock and no long
options to cover his naked
positions is attempting to
maximize these two
advantages. For example:
An option buyer purchases an
Upjohn Jan 40 call option at
3, with three months to run.
The stock price is at 37—
there is actually no real value
in that option at the time the
option buyer purchases the
option. The only value the
option holds is time value.
The $300 option price goes to
the option writer.
In order for that option to
take on any real value at all,
the stock price must move
above 40. For the option
buyer to break even at the end
of that three month period,
the stock price must be at 43.
If the Upjohn stock price is
below 40 at the end of the
three month period, the
option will expire worthless.
The writer will have made
$300 less commissions, and
the buyer will have lost $300.
Therefore, the profit
parameters for the option
writer would read - by the
end of January, if the stock
price is below 43, he wins.
Conversely, If the stock price
is above 43, the option buyer
wins. However, the option
writer starts with the
advantage because when the
option was purchased, the
stock was 6 points below the
break-even point for the
buyer. Actually, the option
writer starts with a profit—he
has $300 and 6 points to work
with before the time period
begins.

1. Success Does Not

Depend on
Predicting Stock
 Price Behavior.
The option writer, unlike the
option buyer, is not required
to predict the exact extent of
a stock price move. By the
fact that the option writer
begins the game with the
odds stacked in his favor, he
can afford a wide margin of
error in measuring and
predicting what a stock price
will do in the future.
In fact, there are many
theorists who believe that it is
impossible to predict the
price action of a stock in the
future. They consider the
stock market a random walk
down Wail Street. As you
operate your naked option
writing portfolio, although
you should not ignore the
trend of the market, or the
trend of a stock, you can
partially adopt a random walk
theory. Even if you write an
option, and the stock moves
in the wrong direction, if that
move is slow enough, or is
short enough, you can still
come out ahead.
Remember that in our
scenario regarding the price
action of a specific stock, a
stock can move up
significantly, can move up a
little, can stay where it is, can
move down a little, or can
move down a lot. Thus when
you are writing calls, the only
time that you will lose is if
the stock moves up
significantly during the
period that you back that
contract. If you are writing
puts, the only time that you
will lose is if the stock moves
down significantly.

1. The Theoretical
and Academic
 Arguments
Supporting Naked
Option Writing
Are Excellent.
Before the existence of the
options exchanges, naked
option writing was practiced
by a select few in the old
over-the-counter (OTC)
market, and was a far more
dangerous game than writing
listed options today. The
OTC option writer faced
numerous obstacles which
made it unfeasible for most
investors to enter that game.
Yet, even with these
dangerous pitfalls, studies of
the old OTC market show
encouraging results which
support the more
advantageous position of the
option writer today. The
opinions of the experts
indicate that almost 65% of
all options in the OTC market
were never exercised (expired
without value).
In the old OTC market, when
an option was written, or
sold, the stock price was right
at the strike price. This is not
true today; now you can write
options where the stock price
is a great distance from the
strike price. We refer to these
as out-of-the-money options.
In the old OTC market,
normally the only type of
option that was written was
an out-the-money option, an
option in which the strike
price and the stock price were
identical.
Even in the OTC options
market, and even when
options were at-the-money,
the writer had a slight
advantage in the fact that only
35% of all options were
exercised. These performance
claims are backed by a
considerable body of
research. In the book,
Strategies and Rational
Decisions in the Securities
Options Market, the authors,
Burton G. Malkiel and
Richard E. Quandt, reported
that their research concluded
from 1960-1964 proved that
writing OTC options on a
random basis, without any
judgments or safeguards, was
indeed a profitable game in
all cases.
In contrast, those who bought
during that period, regardless
of what strategy was used,
always ended up with a
negative result. Therefore,
they discovered that the
writing of naked call options
was one of the optimum
strategies available in the
options market, generating
over a 10% annual return.
With such encouraging
results on a random basis,
imagine what the returns
would be if a little skill, a
little knowledge and the
proper timing were added to
this investment mode!
Another study which
indicated the feasibility of
option writing came from the
book Beat the Market, by
Sheen Kassouf and Ed Thorp.
The results of their strategy,
based on the shorting of
warrants on the Stock
Exchange (which is almost
the same process as writing
call options on the Options
Exchange), were presented at
the beginning of this text in
Chapter 1. These results are
impressive, and will be
discussed further in a later
chapter. Kassouf and Thorp
proved, through the use of
track records and through
some sound theoretical and
academic studies, that the
short selling of warrants can
provide a high and consistent
profit when the investor also
uses a hedging strategy.
Though they did not discuss
writing warrants without any
type of hedge, the maximum
flow of profit came from this
technique.
Finally, documentation
verifies that in the first year-
and-a-half of operation of the
CBOE, only 10% of all
options in the new options
markets had any real value
when their lives expired.
 Larry McMillan
Reprinted by
permission of Larry
McMillan from “The
Option Strategist”
Published by the
McMillan Analyst
Corporation
P.O. Box 1323,
Morristown NJ, 07962
(800) 724-1817
Strategy Decisions
Based on Market
Volatility
Most stock and futures
traders are familiar with
approaches to option
strategies that rely upon
overbought or oversold levels
of the underlying instrument.
While it is not always easy to
measure what is overbought
or oversold, approaches
generally use trading volume,
rate of ascent (or descent) of
the price of the instrument, or
more exotic things such as
oscillators. Option strategies
can then be constructed about
one’s outlook for the
underlying. For example, if a
stock is determined to be
oversold, then one would
want to employ bullish
strategies. These might vary
from the aggressive (outright
call purchases) to the
moderate (bull spreads), to
the basically conservative
(naked put sales - the
equivalent of covered call
writing). Of course, the
option trader should not
entirely ignore the pricing
structure of the options. If the
options are priced
unfavorably, he may want to
switch strategies or he may
just buy the underlying
common stock and not use
options at all. A futures trader
would make analogous
decisions. Conversely if a
stock or futures contract were
determined to be overbought
then strategies such as put
purchases (aggressive) or
bear spreads (moderate)
would be in order.
The above approach generally
requires one to predict the
movement of the underlying
instrument and then to
construct an option strategy
about that outlook. While this
is a valid approach, it relies
on being able to predict the
direction of stocks and
futures — not an easy task, in
fact, according to some
academics, it is nearly
impossible, for they adhere to
the outlook that price
movements are virtually
random. As subscribers
know, we prefer to utilize
market neutral strategies in
our recommendations. The
strategist who is doing this
can also alter his strategies
according to market
conditions, just as the stock-
picker attempts to do.
However, the neutral
strategist — rather than trying
to determine if the stock or
future is overbought or
oversold and therefore predict
the direction of the
instrument — uses the option
pricing structure itself to help
him in his strategy decisions.
One way in which the pricing
structure can be of use is to
determine whether the
options are inordinately
expensive or cheap, based on
historical levels. This
“cheapness” or
“expansiveness” is what we
refer to as the implied
volatility. Options on
individual stocks or futures
give us the measure of
volatility on those
instruments, while options on
broad-based indices, such as
OEX, S&P 500, or the Major
Market Index (XMI) give us a
feeling for the overall stock
market. Once the strategist
has determined how the
options are priced he can
often gear his option trading
strategies to take advantage
of these conditions. His
reasoning is similar to that of
the stock or futures picker
mentioned above, but his
implementation is slightly
different. The stock picker
feels that an overbought stock
is due for a fall, the strategist
feels that a stock whose
options are underpriced is due
to become volatile. That is, he
expects the price to undergo
some rather violent changes.
He is not certain whether
these will result in the stock
going higher or lower, but he
wants to make money in
either case. For example, if
the neutral strategist felt that
options were substantially
underpriced, he would look
for (neutral) strategies that
favor option buying. One
example is a straddle
purchase (buying both the put
and call).
Volatility Has
Implications For
Others
In addition to the neutral
strategist, there are other
types of traders or investors
that can use this information
as well. One might be the
stock owner who buys put
options as a form of
insurance. If implied
volatilities are extremely low
- as they are currently - his
cost of insurance is lowered.
Ironically, it may be less
costly just when he needs it
most if the market becomes
volatile on the downside. This
has been the case just before
most large market downside
breaks, as the cost of put
insurance was quite low
preceding each break. Other
option buying strategies are
also favored when implied
volatility is low, for the
obvious reason that options
are cheap. However, it must
be stressed again that low
option prices are not a
predictor of the future price
direction of the underlying
instrument, they only warn of
increased volatility. Thus, one
cannot blithely buy a large
number of call options and
expect to profit, for the
market may drop instead.
There are other groups of
option traders who prefer to
sell options. Some are
covered call writers. Some
sell only naked puts (a
strategy that is the same as
covered call writing, but is
more efficient in its use of
capital) while others sell
naked call and puts. In any
case, when options become
very cheap, it is a signal to
these traders to curtail their
option selling activities as a
price explosion may loom on
the horizon.
Volatility skewing has
exacerbated this effect of put
sellers getting better prices
for their sales and call buyers
can’t seem to get any boost in
prices unless the market
rallies substantially. As more
people hear about traders or
hedge funds making
considerable profits from
selling options they want to
do the same. Thus option
sellers are becoming more
and more aggressive. On the
other hand, option buyers are
very conservative; they will
not bid up for options that
they can buy at ever-
decreasing prices from the
aggressive sellers.
History has indicated that
when market psychology
swings to one side or one
philosophy, then it is time for
the strategist to take the other
side. Thus one should be
concentrating on option
buying strategies until this
period of low volatility ends,
with the proviso that one is
not interested in whether the
market will go up or down -
merely that it will be volatile.
For stock owners, this would
mean buying puts as
insurance. One could buy
index (OEX) puts as
protection for his entire
portfolio of stocks, or he
could merely buy the puts of
the individual stocks that he
owns. If these puts are
purchased slightly out-of-the-
money, then one could still
profit if the market rose
abruptly, and he would be
protected if it fell sharply.
The strategist, on the other
hand, would want to buy both
puts and calls in order to be
able to profit from a large
market move in either
direction. Our
recommendation in the last
issue was to buy the OEX
February 390 straddle. This
has not become a profitable
position yet. At this point one
would probably want to
purchase either the February
or March straddles with a
striking price close to the
current OEX price.
In summary, we are near a
historically low level of
volatility as measured by
index options. Our conclusion
is that a price explosion lies
in the near future. Perhaps it
will not come before the new
year, as the holiday season is
often one of low volatility,
but our feeling is that it is
better to be prepared in
advance, for marked moves
are over quickly these days
and it may therefore be
difficult to get in once the
market begins moving. The
serious option investor will
either be buying some
straddles as an outright profit
play or he will be buying puts
to protect his holdings. The
tables of OEX implied
volatility are included with
this article in this issue, rather
than in their usual place in
“Index Option Commentary.”

VOLATILITY
SKEWING
Volatility skewing is a topic
that is discussed often in
these pages. This week’s
advice will expand on the
concept primarily by looking
at how the skewing affects a
position that is already in
place. First, some definitions:
volatility is a measure of how
quickly a stock or futures
contract changes in price. For
the purposes of option
analysis, volatility is
expressed as a percent.
Implied volatility is the
volatility that is being implied
by the current market price of
an option; alternatively, it is
the volatility number that one
would have to plug into his
mathematical model in order
for the models result to be
equal to the current market
price of the option. In a
perfect world, all options on
the same underlying
instrument would have equal
implied volatilities.
Unfortunately, in the real
world, things are never that
easy. Volatility skewing is the
phenomenon in which the
implied volatilities of options
on the same underlying
future, equity, or index are
not equal. Moreover, these
implied volatilities display a
distinct pattern of either
increasing or decreasing
volatility as one views the
strikes from lowest to highest.
The box on the right shows
two theoretical examples of
skewing. OEX options have
displayed this decreasing
pattern since the crash in
1987. Primarily it is due to
the fact that there is excess
demand for puts (as
protection) and decreased
supply since margin
requirements were increased.
Soybeans and many other
futures options display the
opposite pattern: increasing
implied volatilities as one
scans the strikes from low to
high. It should be noted that
the calls and puts at the same
strike must trade for the same
implied volatility: otherwise
conversion or reversal
arbitrage would move in and
eliminate the difference.
However there is no true
arbitrage between different
striking prices. Hence,
arbitrage cannot eliminate
volatility skewing.
Profit Opportunities
When the strategist finds
volatility skewing he has an
opportunity to profit. He
merely buys options with a
lower implied volatility and
sells options at another strike
with a higher implied
volatility. He would normally
establish strategies in a
neutral manner in order to
attempt to capture the
volatility differential without
having to predict the market’s
movement per se. For OEX,
this might mean establishing
put ratio spreads. For
example, he might buy 1 at-
the-money OEX put and sell
2 out-of-the-money puts. For
soybeans, call ratio spreads
would do the trick.
Backspreads could also be
used to take advantage of
volatility skewing. The table
below shows the basic
strategies that one would use.
For purposes of this example
the ratios in these spreads are
2-to-1. In actuality, one must
use the deltas of the two
options involved in order to
determine the neutral ratio,
which is most likely not 2-to-
1.

How Skewing Biases A

Position
Volatility skewing introduces
a bias into a position - a bias
which informed strategist can
plan for. For example, in the
last issue, we recommended
the purchase of straddles on
both OEX and soybeans. In
either case, we wanted the
markets to move (which they
did). However, the strategist
who owns a straddle on an
instrument that has volatility
skewing definitely prefers
one direction of movement
over the other. We bought the
OEX September 385 straddle
when OEX was near 385. A
straddle buy is not a position
that is designed to take
advantage of volatility
skewing - only the above
strategies are. However, since
skewing exists in OEX
options, we were destined to
do better if OEX rose in price
as opposed to falling. This is
true even though we could
make money if OEX moved
far enough in either direction.
In reality, OEX rose to a price
of more than 395, which
meant that the 385 straddle
represented options that were
then two strikes in-the-money
(on the call side). Refer again
to the table on page 1: when
the straddle was purchased
the options were at-the
money (14% implied
volatility in the example
table). But as OEX moved
higher the calls became in-
the-money and the options
automatically gained implied
volatility from the skewing
effect (to a volatility of 18%
in the table). This is a definite
benefit to the owner of this
OEX straddle. Consequently,
the owner of a straddle on
OEX will do better if OEX
moves higher, even though he
could eventually make money
on the downside if OEX fell
far enough. The seller of an
OEX straddle has the
opposite result: he will do
better (or get hurt less) if
OEX falls in price, since the
options will lose volatility if
that happens.
The soybean straddle buyer
has a bias in the other
direction: he will do better if
prices fall than if they rise.
Again, refer to the chart on
page one. If the straddle is at-
the-money when purchased,
the options have an implied
volatility of 18%. If beans
drop by one strike, the
skewing effect means that the
options will then be trading
with an implied volatility of
20%. As we showed in the
last issue, even a small
increase in implied volatility
means a nice profit for the
straddle holder. This is
essentially what has happened
to the November soybean 550
straddle that we
recommended buying. Of
course, if beans had risen in
price by one strike instead,
then the skewing would mean
that the implied volatility
would drop to 16%. This
would hurt the position, but it
might still be making money
since the actual price of
soybeans had risen.
In general, this propagation of
the skewing as the
underlying’s price changes
will affect any strategy, of
course. For example, the two
neutral ratio strategies in the
above table will perform
better if the underlying moves
toward the strike of the
written options; the two
backspreads will perform
better if the underlying moves
the options deeper into-the-
money.

Summary
Whenever volatility skewing
exists, opportunities arise for
the neutral strategist to
establish a position that has
advantages. These advantages
arise out of the fact that
normal market movements
are different from what the
options are implying. The
strategist should be careful to
project his profits, prior to
expiration, using the same
skewing for it may persist for
some time to come and will
definitely introduce a bias
into the position. We always
do this in the profit graphs
that are shown to you.
However, at expiration, the
skewing must disappear, of
course. Therefore, the
strategist who is planning to
hold the position to expiration
will find that volatility
skewing has presented him
with an opportunity for a
positive expected return.

CALENDAR
SPREAD USING
FUTURES
OPTIONS
In the last issue, we looked at
some of the rewards and
pitfalls of calendar spreads
using index or equity options.
This week, we’ll take a look
at the calendar spread using
futures options.
A calendar spread using
futures options is constructed
in the familiar manner — buy
the May call, sell the March
call with the same striking
price, for example. However,
there is a major difference
between the futures option
calendar spread and the stock
option calendar spread. The
difference is that a calendar
spread using futures options
involves two separate
underlying instruments while
a calendar spread using stock
options does not. When one
buys the May soybean 600
call and sells the March
soybean 600 call, he is
buying a call on the May
soybean futures contract and
selling a call on the March
soybean futures contract.
Thus the futures option
calendar spread involves two
separate, buy related,
underlying futures contracts.
However, if one buys the
IBM May 100 call and sells
the IBM March 100 call, both
calls are on the same
underlying instrument —
IBM. This is a major
difference between the two
strategies although each is
called “calendar spread.”
To the stock option trader
who is used to visualizing
calendar spreads, the futures
option variety may confound
him at first. For example, a
stock option trader may feel
that if he can buy a four-
month call for 5 points and
sell a two-month call for 3
points, that he has a good
calendar spread possibility.
Such an analysis is
meaningless with futures
options. If one can buy the
May soybean 600 call for 5
and sell the March soybean
600 call for 3, is that a good
spread or not? It’s impossible
to tell, unless you know the
relationship between May and
March soybean futures
contracts. Thus in order to
analyze the futures option
calendar spread, one must not
only analyze the options’
relationship but the two
futures contracts’ relationship
as well. Simply stated, when
one establishes a futures
option calendar spread, he is
not only spreading time — as
he does with stock options —
he is also spreading the
relationship between the
underlying futures.
Example: A trader notices
that near-term options in
soybeans are relatively more
expensive than longer-term
options. He thinks a calendar
spread might make sense as
he can sell the overpriced
near-term calls and buy the
relatively cheaper longer-term
calls. This is a good situation
considering the theoretical
value of the options involved.
He establishes the spread at
the following prices:

The May/March 600 call

calendar spread is established
for 7 points debit. March
expiration is two months
away. At the current time, the
May futures are trading at a
four point premium to March
futures. The spreader figures
that if march futures are
approximately unchanged at
expiration of the March
options, he should profit
handsomely because the
March calls are slightly
overpriced at the current time,
plus they will decay at a
faster rate than the May calls
over the next two months.
Suppose that he is correct and
March futures are unchanged
at expiration of the March
futures. This is still no
guarantee of profit, because
one must also determine
where May futures will be
trading. If the spread between
May and March futures
behaves poorly (May declines
with respect to March), then
he might still lose money.
Look at the following table to
see how the futures spread
between March and May
futures affects the
profitability of the calendar
spread. The calendar spread
cost 7 debit when the futures
spread was initially: March 4
points under May.
Thus, the calendar spread
could lose money even with
March futures unchanged —
top two lines of table. It also
could do better than expected
if the futures spread widens
— bottom line of table.
The profitability of the
calendar spread is heavily
linked to the futures spread
price. In the above example it
was possible to lose money
even though the March
futures contract was
unchanged in price from the
time the calendar spread was
initially established. This
would never happen with
stock options. If one
established a calendar spread
in IBM and the stock were
unchanged at the expiration
of the near-term option, the
spread would make money
virtually all of the time.
The futures option calendar
spreader is therefore trading
two spreads at once. The first
one has to do with the relative
pricing differentials (implied
volatilities, for example) of
the two options in question,
as well as the passage of time.
The second one is the
relationship between the two
underlying futures contracts.
As a result, it is difficult to
draw the ordinary profit
picture. Rather one must draw
a series of profit pictures that
show the option spread
results at various value of the
futures spread. The profit
graph on the next page shows
how this approach looks: the
above example spread’s
profits are shown for three
different values of the
March/May futures spread at
March expiration. Several
general conclusions can be
made about the profitability
of the futures option calendar
spread. First, if the futures
spread improves in price, the
calendar spread will generally
make money. This is the top
curve on the graph in which
the March/May spread
widened from its original
value of March trading 4
points under May to where
March is trading 16 points
under May. Second, if the
futures spread behaves
miserably, the calendar
spread will almost certainly
lose money (bottom line of
graph, where the future
spread collapsed from March
4 points under to a
horrendous level of 24 points
over!). Third, if March
futures rally and the futures
spread worsens, one could
lose more than his initial
debit (bottom right-hand
point on graph). This is partly
due to the fact that one is
buying the March options
back also if March futures
rally, and may also be forced
to sell his May options out at
a loss if May futures have
fallen at the same time.
Fourth, as might be expected,
good results are obtained if
March futures rally slightly or
remain unchanged and the
futures spread also remains
relatively unchanged (middle
curve on graph).
This example demonstrates
just how powerful the
influence of the futures
spread is. The calendar spread
profit is predominately a
function of the futures spread
price. Thus, even though the
calendar spread was attractive
from the theoretical
viewpoint of the option’s
prices, its result may not
reflect that theoretical
advantage, due to the
influence of the futures
spread. Another important
point for the calendar
spreader used to dealing with
stock options to remember is
that one can lose more than
his initial debit in a futures
calendar spread if the spread
between the underlying
futures inverts.

A Substitute For The

Intramarket Spread
Recall that an intramarket
spread in futures involves two
different contracts on the
same underlying commodity
— for example, long May
soybeans and short March
soybeans. The futures option
calendar spread can be
thought of as a substitute for
this type of spread, especially
when both options are in-the-
money. If the options are
statistically attractive (that is,
one is selling an option that is
expensive relative to the one
he is buying), then the
calendar spread generally
outperforms the intramarket
spread. This, then, is where
the true theoretical advantage
of the calendar spread comes
in. So, if one is thinking of
establishing an intramarket
spread, he should check out
the calendar spread in the
futures options first. If the
options have a theoretical
pricing advantage, the
calendar spread may
outperform the standard
intramarket spread.
In summary, the futures
option calendar spread is
more complicated when
compared to the simpler stock
or index option calendar
spread. As a result, calendar
spreading with futures
options is a less popular
strategy than its stock option
counterpart. However, this
does not mean that the
strategist should overlook this
strategy. As the strategist
knows, he can often find the
best opportunities in
seemingly complex situations
because there may be pricing
inefficiencies present. For
this strategy, its main
application may be for the
intramarket spreader who also
understands the usage of
options.

HOW THE PROS

USE OPTIONS
The listed options business is
going to celebrate its 20th
anniversary this year in April.
The CBOE began trading on
April 5, 1973. It hardly seems
possible that twenty years
have passed since then.
Unfortunately, many
individual investors and
money managers still are not
really familiar with option
strategies and applications. In
today’s feature article we’re
going to look at some of the
things that professional
option traders consider
important. The gist of this
discussion will be from the
point of view of “I have some
cash available. What option
spread strategy can I use to
make money?” This
viewpoint will be developed
as opposed to one where an
investor merely wants to use
options in conjunction with
an already existing stock or
futures portfolio.
Be Flexible
It is fine for a stock mutual
fund manager to only use one
strategy: buying stocks. In
fact, the charter of the fund
might even limit him to that
particular strategy. However,
there are certainly times when
that is not the best strategy. It
might be more advantageous
to short stocks or to buy
bonds. Futures fund managers
certainly have no qualms
about being either long or
short in any particular futures
market. So in the overall
scheme of things, one can
make his best profits by being
flexible — by adapting to the
current market environment.
The same thing applies even
more strongly to option
strategies. You have probably
heard that option buyers
eventually lose. I’m not
certain that’s true for sensible
option buyers, but there are
certainly times when options
are quite expensive, and that
fact will certainly harm the
performance of an option
buyer. In a like manner, it
isn’t correct to always be a
seller of options either, for if
the options are statistically
cheap, you are probably
going to lose money
eventually. Some investors
who use options only do
covered call writing, because
they understand it to be a
conservative strategy. But
this strategy suffers if
markets decline or options are
too cheap. The point is that
there is no one option strategy
that should be used all of the
time. Rather, the professional
will be flexible and use the
strategy that best fits the
current situation.

USE A MODEL!
The worst thing that one can
do in the option market is to
ignore the relative valuation
of an option that he is going
to buy or sell. Option
modeling programs are cheap
(for example, we sell a stand-
alone one for $100). Every
professional not only uses a
model to assess the
overpriced/underpriced nature
of the option he is
considering, but he also is
aware of at least the delta of
the option — the amount the
option will change in price
for a one point move by the
underlying instrument. A
strategic neutral position has
a zero position delta and
contains at least one
favorable price option in it.
That is, either the long option
in the position is
“underpriced” or the short
option is “overpriced.”
Another way of stating
“underpriced” or
“overpriced” is to evaluate
the implied volatility of the
option and to relate the
option’s value in those terms.
The implied volatility is
merely the volatility that the
current option price is
implying; alternatively stated,
it is the volatility which one
would plug into his model in
order to make the model’s
result equal to the current
market price of the option.
Example: The following
table of option prices shows
how one might typically
describe them. Assume that
the historical volatility of
XYZ is 25%.
Even if you don’t completely
trust the correctness of the
model’s evaluation of the
“theoretical” price, it is still
true that the January 50 call is
expensive with respect to the
April 40 call because of their
relative differences in implied
volatility. Therefore, a spread
in which one buys the April
40 call and sells the January
50 call is a statistically
attractive position.
Let The Option Market
Lead You To
Opportunities
The one thing that any
investor does is to try to
concentrate his efforts in
situations where he best
thinks he can make money.
For many traders, this means
doing some technical or
fundamental analysis on a
particular stock or futures
contract and then buying
options on the underlying
instrument. However, most
professional option traders
will approach this problem
from the other end of the
spectrum. That is, they will
attempt to identify situations
in which the options
themselves present an
opportunity. Then they see
how they might construct a
strategy using those options.
This is one of the
cornerstones of our option
trading philosophy as well.
For example, if one sees that
out-of-the-money calls are
more expensive than at-the-
money calls, a bull spread or
ratio write is the preferred
strategy because one would
be buying the cheaper of the
two options and selling the
more expensive one. He
would then check the
technicals or fundamentals on
this stock or commodity to
see if a bullish stance is
warranted. If it is, he might
select he bull spread; if the
situation looks more neutral,
he might decide upon a call
ratio write instead.
Example: continuing with
the previous example,
suppose that we also look at
the deltas of the options
involved:
Using the delta, one can
determine his exposure to the
market. If he is bullish on
XYZ, he may decide to try to
buy one Apr 40 call for each
Jan 50 call that he sells. The
delta for doing this is 25
“shares” long (0.50 - 0.25
times 100 shares per option).
So if he bought 10 Apr 40
calls and sold 10 Jan 50 calls,
he would have a position that
resembles being long 250
shares of XYZ. However, if
he wants to be neutral, he
would buy 5 calls and sell 10
calls so that his position delta
is zero.

REMOVE MARKET
OPINION IF YOU
CAN
It is much easier to make a
decision about a position if
you can do it unemotionally.
Generally, if one is long and
the market is crashing, it is
just very hard to make an
unemotional decision.
However, if your funds are in
a neutral option strategy, it is
likely that you will be able to
make a more rational
decision. These are
generalities, of course, and as
we all know, an option
position that starts out as a
market neutral one may not
be market neutral after the
passage of time or after the
stock or futures contract
makes a substantial move.
So how do you remove
market opinion? If you are
buying options, you buy both
puts and calls. It is a common
mistake to identify a situation
in which the options are
cheap, and then fail to fully
exploit by buying the calls,
for example, only to later see
the stock take a dive. The
option strategist who
determines that options are
cheap will buy both puts and
calls (that is, he will buy a
straddle) as the preferred
strategy. In a similar manner,
if one calculates that a certain
set of options are expensive,
then he should sell both puts
and calls in order to have a
position that is initially
neutral to the market.
Example: A continuation of
the previous example can
demonstrate this point. Of the
two options shown, the
January 50 call is overpriced
(both with respect to the April
40 call and with respect to the
historical volatility of XYZ
stock). A one-sided, riskier,
position would be merely to
sell the January 50 call
because it is “overpriced.”
This naked call sale has the
distinct disadvantage of being
a loser if the underlying stock
moves higher — even over
the next couple of days. On
the other hand, the more
neutral using the deltas
described in the last example
would not have that problem
since one would expect the
position to experience only a
small change in price over the
near term.
ALWAYS HAVE A
PLAN OF FOLLOW-
UP ACTION AND
ADHERE TO IT
Any trader can be wrong in
his projection of the future.
Perhaps you sold puts and
calls because they were
expensive, but now the
underlying instrument has
made a move and you no
longer have a neutral
position; moreover, you are
losing money. Option buyers
can face similar problems.
Your long options stand at a
loss and may begin to decay
rapidly. When should you get
out? Without a rational, pre-
planned follow-up action, you
might be tempted to change
your philosophy from that of
a neutral option trader to that
of a market speculator who is
attempting to “rescue” a
position. The pros will
generally adjust their position
to make it neutral (or at least
more neutral) once again and
continue to monitor it.

FEEL
COMFORTABLE
WITH WHAT
YOU’RE DOING
The final point of this article
is possibly the most
important. If, after analyzing
the options and deciding on
the optimum strategy, you
don’t feel that that type of
strategy is suitable for you,
then don’t make the trade.
Many novice option traders
might feel that they are
uncomfortable with the sale
of naked options; ironically,
many professionals just don’t
feel comfortable being long
option premium. Whatever
the case, it is important for
your mental well-being as
well as your financial well-
being that you feel relaxed
about the strategies you are
using. If you don’t, you may
find yourself making
irrational decisions such as
taking follow-up action too
soon or abandoning your
game plan when the action
begins to heat up. There is no
guaranteed optimum option
strategy, of course, but the
above points are things the
pros consider important, and
they are the types of
techniques that we attempt to
employ in our
recommendations and follow-
up actions.

Trading Increased
volatility
The feature article this week
will discuss the various ways
that one approaches a
situation in which options
have become expensive on a
particular stock or index. The
strategist is often drawn to
such situations because there
is liquidity and because an
apparent statistical advantage
may exist. We will use a
current example to
demonstrate our points. As
you know, IBM has suffered
several large price declines in
the past few months,
culminating in last week’s
drop on bad earnings. As
might be expected, this latest
drop has ballooned the
premium in IBM options,
particularly in the November
series. The longer-term
options have not increased in
volatility as much.
One way that the average
trader will approach such a
situation is with calendar
spreads. Calendar spreading
is a simple strategy that
appeals to many traders, but it
has severe limitations which
we will explore. First, the
definition: a calendar spread
is constructed by buying an
option at a certain strike and
simultaneously selling the
same type of option at the
same strike, but the option
that is sold expires earlier
than the option that is
bought.Examples: XYZ is
trading at 100. Any of the
following would be calendar
spreads:
Buy XYZ Jan 100 call & sell
XYZ Nov 100 call
Buy XYZ Dec 90 put & sell
XYZ Nov 90 put
Buy XYZ Jan 110 call & sell
XYZ Dec 110 call
In each case, the type of the
options is the same: that is, if
one buys a call, he also sells a
call; if he buys a put, he also
sells a put. Moreover, in each
case, the option that is bought
has more time remaining than
the option that is sold.
In this type of position, one
has essentially created a
spread on time since the
strikes and types of the
options are the same. Hence
the name “time spread” or,
more commonly, “calendar
spread” is applied to this
strategy. The idea behind the
strategy is to be able to
capture the faster rate of
decay of the short-term
option without having a large
exposure to the movement of
the underlying security. The
graph above depicts the profit
curve for a typical calendar
spread when the near-term
option is expiring. A
strategist will always treat a
spread as a single entity and
will remove it when one side
expires. Note that there is a
definite profit area that is
more or less centered about
the striking price of the
options in the spread.
Moreover, if the underlying
stock or index moves too far
away from the strike, a loss
will result. However, that loss
is limited to the initial cost of
the spread since a longer-term
option cannot sell for less
than a shorter-term one with
the same striking price. Thus,
the chance to capture time
decay with a limited risk
exposure makes this an
attractive strategy for many
traders.
However, the strategy has its
drawbacks as well. First,
there is the fact that multiple
commissions on a spread will
eat into the profit potential.
Second, there is usually a
rather large chance that the
stock will move outside of the
profit area. Some traders
attempt to counter this
tendency by establishing
calendar spreads when the
near-term options have only 2
or 3 weeks of life remaining.
This means, unfortunately,
that a larger debit is being
paid and hence the risk is
larger (in dollars) if the stock
moves away from the strike.
Finally, if the calendar spread
is established after implied
volatilities have increased,
there is the problem of a
subsequent decrease in
implied volatility.

DETERMINING IF
THE SPREAD IS
ATTRACTIVE
As you must know by now,
we are not proponents of
merely establishing a strategy
because it “there.” We want
to have an edge. For calendar
spreads, this would mean that
we want to sell an option that
is more “expensive” than the
one we are buying; that is, we
want the implied volatility of
the option we are selling to be
higher than that of the option
we are buying. The graph on
the right shows the
hypothetical advantage of
having sold the more
expensive options. The higher
curve — the one with the
bigger profit potential —
depicts a calendar spread in
which one sells a call that has
a higher implied volatility
(i.e., is more expensive) than
the one that he purchases.
The lower curve depicts the
same spread if both options
initially have the same
implied volatilities. Notice
that the “expensive sale”
graph has a profit area of
about 93 to 109 for XYZ at
expiration, while the other
has a considerably smaller
profit area of 95 to 107.
When can one reasonably
expect to find a situation
where the near-term options
are more expensive than the
longer-term ones? Typically,
during periods of increased
volatility or at least increased
implied volatility. When a
stock or index makes a large
move — particularly a large
downward move — then
near-term options become
expensive as traders rush in to
either buy them as a hedge or
as a speculation. There is
generally less of that
speculation in the longer-term
options and, therefore, the
calendar spread seems to be
an attractive strategy at that
time. Note that the longer-
term options’ implied
volatility will have generally
increased as well, but not by
as much as the short-term
options’ volatility has. This is
the current situation in IBM
where the November options
have an implied volatility of
as much as 32% while the
December or January options
are lower, at 27%. The
historic volatility of IBM is
normally about 20% so all are
expensive by that measure.
Establishing the calendar
spread in times of higher
volatility can lead to
problems later on down the
road, however. If the options
return to their former (lower)
implied volatility, the
calendar spread will not have
as wide an area of
profitability. In fact, if the
implied volatility decreases
too much, there could be
almost no chance to make
money at all at expiration of
the near-term options. The
graph on the next page shows
a hypothetical IBM calendar
spread: long Jan 70 call, short
Nov 70 call. The top curve
shows the profitability at
current volatility; the lower
curve shows what would
happen if the long January 70
calls returned to a 22%
volatility at November
expiration — a substantial
drop in implied volatility.
Note that the area of
profitability is much smaller
(at the higher volatility the
profit area ranges from 66 to
75, but at the lower volatility
it is only from about 68 to 72
1/2), that the maximum profit
potential is substantially less,
and that the overall chance of
losing money is larger.
Thus it is clear that calendar
spreads not only have the risk
that the stock might move
away from the striking price,
but also have the risk that the
long option’s value may
decrease as implied volatility
falls. Are there any cures for
these potential problems?
Let’s say there are tune-ups
that can be made to the
strategy, but they are not a
panacea. It is still possible to
lose money even if these
additional strategies are
implemented. First, let’s
address the problem of stock
movement. This can
generally be countered in a
relatively simple manner. The
following example
demonstrates the technique:
Example: suppose XYZ is
trading at 102 and one wants
to establish a call calendar
spread by buying the Jan 100
call and selling the Nov 100
call. He can counter the risk
of stock movement by buying
a few extra Jan 100 calls and
also buying some puts —
either Nov 100’s or Jan
100’s. The resultant position
might thus be:
Long 13 Jan 100 calls
Short 10 Nov 100 calls
Long 3 Jan 100 puts
Now the position would still
benefit if XYZ were at the
striking price of 100 at
November expiration
(although not by as much as
if the extra options had not
been purchased). However, in
addition the position will
make money if XYZ has a
volatile move in either
direction because of the
presence of the extra long
calls and puts. The profit
graph on the right shows how
this position might look at
November expiration: the
profit area in the center is
smaller than the normal
calendar spread (see graph,
page 1), but there is now a
profit area on both edges of
the graph.
Subscribers who have been
with us for awhile recognize
that we have recommended
this type of calendar spread
before. The number of extra
calls and puts to buy is not
usually determined “by eye”
but is computed in a manner
that makes the position delta
neutral. This is an important
point, for the strategist would
not want the position to be
biased to either the upside or
the downside. Thus, the
problem of stock movement
in a calendar spread strategy
can be countered in this
manner. However, this does
not help one if the other
problem occurs — that is, if
the implied volatility drops
while the position is in place.
In fact, since extra options
were purchased, a decrease in
implied volatility would harm
this type of position even
more than it would a normal
calendar spread. Is there a
way to “have your cake and
eat it too?” Not really, but in
certain cases, one might be
able to sell some out-of-the-
money options to mitigate the
possible effects of a decrease
in implied volatility. For
example, if one had adjusted
his XYZ calendar spread as
shown in the previous
example by buying 3 extra
calls and 3 extra puts, he
might add the following to his
position if he were worried
about a decrease in implied
volatility:
Sell 3 XYZ Nov (or Dec or
Jan) 110 calls
and Sell 3 XYZ Nov (or Dec
or Jan) 90 puts
In the case of IBM, however,
neither of these remedies can
salvage the calendar spread
strategy. If one buys extra
January 70 calls and puts at a
27% volatility and they
subsequently decline to a
22% volatility, he will have
virtually no profit potential
unless IBM stock experiences
a large upward or downward
move. The profit area near
the strike of 70 will be
virtually nonexistent. Selling
out-of-the-money options
won’t help much either,
because that will just cut off
the profits that could be made
if IBM is volatile.
In summary, calendar
spreading strategies in IBM
appear to be a waste of time,
as was shown above.
Moreover, spreading
strategies in November
options (e.g., a ratio spread)
have no “edge” because all of
the November options are
equally expensive. So what
approach should one use to
take advantage of the
expensive IBM options,
assuming he wants a neutral
strategy? Sometimes the
simplest approach is best. For
IBM, that would be the sale
of uncovered options. While
this sale theoretically has
unlimited risk, one needs to
analyze the situation before
rejecting a naked sale out of
hand. First, notice the chart of
IBM below. Every time the
stock has had a break
downward, it has stabilized in
a sideways manner before
trading lower. Second, IBM
has a long history of a
volatility at about 20%. The
current implieds are just too
high and can be expected to
return to a more normal level
quickly. A naked sale could
be removed at that time,
rather than waiting for
expiration. How quickly is
quickly? Well, possibly as
soon as a week or so, because
IBM is having a dividend
meeting next week and, if
they keep the dividend at
$1.21 as they promised they
would, that would do a lot
towards calming the stock’s
volatility down. Finally,
while the naked option sale
clearly has more risk than the
calendar spread strategy, it
also has a much higher
probability of realizing a
profit and that is the
important thing to a strategist.
Profitability: The profit
graph on the left below
depicts the profits or losses
from this position in three
different situations. First, the
straight lines show the profit
or loss at November
expiration. Second, the lowest
curve shows the profit in 14
days if implied volatilities
remain where they are — at
inflated levels. Third, the
middle curved line shows
where profits or losses could
be expected in 14 days if the
implied volatility drops to
22%.
Investment: The sale of
naked stock options requires
20% of the price of the stock,
plus the option premium.
Thus, we will allot $1500 per
naked combination, or a total
of $6000 for this position.
Note that if we have a profit
of $400 in one month, this is
an excellent return of over
6% in one month.
Follow Up: Buy the combo
back at a price of 1 or less
(doing so would generate a
profit of over $400).
Otherwise, cover the calls if
IBM trades over 72, and
cover the puts if IBM trades
under 64. The other major
aspect of follow-up in this
position has to do with
observing the time value of
the options just before IBM
goes ex-dividend in early
November. If the November
options should lose their time
value before the stock goes
ex-dividend, then one could
be assigned on his short
options. While this does not
change the profitability of the
position, it would incur a
much larger investment. The
ex-dividend date has not yet
been set, but it should be
known by next Friday,
October 30th, so check the
HOTLINE for information at
that time.

VOLATILITY
RULES!
Crude oil is up nearly a dollar
per barrel, a fact which drives
bonds down and scares the
stock market. In an unrelated
market, the weather changes
in the Midwest are wreaking
havoc with grain prices — up
when it doesn’t rain for a
couple of days, and then back
down when it does rain. It
seems that expectations of
increasing volatility are
rampant. Volatility is a major
item of concern of any option
trader. Option buyers want it;
options sellers would rather
do without it. Moreover, our
recommendations and articles
often refer to volatility and its
ramifications. So, in this
issue, we’re going to take a
more in-depth look at how the
option trader can measure and
use volatility.
In review, volatility is a
measure of how quickly a
stock or futures price
changes. It is an important
input to any option pricing
model; probably the most
important input. When one
computes volatility by using
past stock prices, the result is
called the historic volatility.
Using the historic volatility
can present some problems to
the option strategist because
current events in the market
may change the price
behavior, rendering the usage
of historic volatility
ineffective. For stocks, these
events might include such
things as takeover rumors or
large revisions in a
company’s earning estimates;
for futures, events such as
weather changes or an OPEC
agreement can cause
volatility changes. When the
current market volatility rises
dramatically due to such
events, all options will appear
to be overpriced according to
any option pricing model that
is using historical volatility.
This fact could lead the
strategist to sell options
heavily. If the true volatility
of the stock has changed, the
strategist may be making a
big mistake if he sells
options. In effect, the option
prices may be based on a
projection of future volatility,
not on the past performance
of prices.
Thus, many traders prefer
another measure of volatility
— one that is able to cope
with current changes in the
marketplace. This volatility
would be the one that is being
implied by the marketplace
itself. That is, one only need
ask the question, “What
volatility would I need to
plug into the Black-Scholes
(or any other) model in order
to arrive at the current price
of the option?” The answer is
called the implied volatility.
Example: with XYZ at 49,
the Jan 50 call is trading at 3-
1/2. Assume that, if one uses
32% as his volatility input to
the Black-Scholes model, the
model gives 3.46 as the value
of the call. This result is very
close to the actual trading
price of the Jan 50 call, and
thus the implied volatility of
the Jan 50 call is 32%.
Each individual option has its
own implied volatility. In a
perfect world, of course, each
option on the same future or
stock would have the same
implied volatility. Then the
strategist could use that
implied volatility as the
volatility of the underlying
stock itself. In the real world,
unfortunately, things rarely
work out so well. In fact, it is
possible that no two options
on the same underlying stock
will have the exact same
implied volatility. The
strategist needs to average
them in some fashion —
perhaps by trading volume —
in order to be able to get a
composite implied volatility
for the underlying instrument.
This “averaged” number is
the one that is used in our
recommendations and
articles.
How can this information
help the strategist? It can alert
him to options that are
theoretically mispriced,
allowing him to establish a
position with favorable
expected returns. There are
two basic ways that the
implied volatility can be used
to establish or adjust
positions. First, if the implied
volatility of the stock is
significantly different from
the historical volatility, an
opportunity may exist.
Second, if the implied
volatilities of individual
options on the same
underlying stock are
significantly different from
each other, then an
opportunity surely exists. It is
the first of these that will
comprise the rest of this
discussion. The second will
be the subject of a
forthcoming feature article.

Historical Volatility
Differs From Implied
Volatility
This differential is often the
basis for our
recommendations on buying
or selling straddles. For
example, in the last issue it
was pointed out that OEX
option premiums were quite
low. That is, the implied
volatility is less than the
historical volatility. The chart
on the right shows how OEX
premiums are at their lowest
point in quite some time. The
historical volatility of the
stock market — and OEX as
well — is generally around
15%. Thus, these options
have implied volatilities
which are less than historic
volatilities. In such a
situation, one would buy
straddles or combinations (a
straddle is a put and a call
with the same strikes, while a
combination is a put and call
with different strikes). A
chart was presented in the last
issue to show when the
implied volatility of the
straddle dropped below 13%,
and subscribers were advised
to buy if that happened. As
one can see from the chart,
the implied volatility has
slipped down below 12% and
the straddles should be
bought. The recommendation
made on the on 5/21/92 was:
The straddle is available at
even lower prices now, as the
market has not moved
substantially away from the
390 level for OEX. There are
now three weeks remaining
until June expiration, so
subscribers who have not yet
purchased the straddle should
buy the July 390 straddle
instead as it is trading with
low implied volatility as well.
As a follow-up action, sell the
straddle if there is an
unrealized loss of 3 points.
Thus, if you paid 11 for the
straddle, you would use a
mental stop of 8 to take
losses. Use of this mental
stop will prevent one from
holding too long if expiration
approaches.
Returning to our
discussion: the trader has two
ways to profit from a long
straddle position. First, the
underlying may move far
enough to make the straddle
profitable (in the OEX
position above, one would
want OEX to climb above
401 or fall below 379 — in
either case, the June 390
straddle would be worth more
than 11 points). Second, even
if the underlying instrument
does not make the required
move, the straddle holder
could profit if the implied
volatility of the options
increased. Suppose that index
option traders perceive
volatility is imminent and bid
straddles up to 15% implied
volatility. The straddle holder
would profit even if OEX
were relatively unchanged in
that case.
So, is this a good position or
not? The answer does not
necessarily lie in whether the
position eventually makes a
profit. It is always possible
that an excellent position
(theoretically) fails to
produce a profit. Rather, the
answer lies in whether the
historical volatility estimate
of 15% can be trusted, or
should one be using the
implied volatility estimate of
12%? Each is a known
quantity — it can be
computed easily. But the real
question that one must ask is,
“Is the future volatility of
OEX going to be 12% or
15%?”
No one knows what the future
volatility of OEX is going to
be for sure, but obviously that
is what is going to be a major
factor in determining if this is
a profitable position or not.
All one can do is try to decide
if the historical volatility is a
better estimate of future
volatility than is implied
volatility. Making that
decision is more of an art
than a science, but there are
clues that may help.
If the historical volatility is
distorted for some reason,
then one should view it with
caution. For example, when
the market crashes or has a
tremendously volatile period
(generally to the downside),
price swings magnify and
historical volatilities increase.
As time passes, these price
swings diminish on a daily
basis. The historical volatility
is generally calculated over a
specific historical period (50
trading days, for example). If
the volatile price behavior is
encompassed in that historical
period, the historical
volatility may be inflated. In
such a case, one should not
buy the options for the
implied volatility is probably
more accurate than the
historical. However, if the
underlying security has not
experienced any particularly
abnormal price movements in
the recent past, then the
historical volatility can be
relied upon. Therefore, a
situation such as the one
presented above would lead
one to option buying because
he feels that the historical
volatility can be trusted. Our
earlier recommendations of
straddle buys on Archer-
Daniels, Syntex, and Atlantic
Richfield were all based on
similar analysis because the
historical volatility was
higher than the then-current
implied volatility of the
options.
Inflated Implied:
Conversely when the implied
volatility is too high in
comparison to the historical
volatility, a related analysis
takes place. However, in this
case, one would be led
toward selling options. Again,
the strategist must attempt to
determine which of the two
volatilities — historical or
implied — is more accurate.
When the implied is inflated,
he needs to be extremely
careful, for he will almost
certainly be establishing a
position that contains naked
options if he decides to sell
premium. In many cases, the
implied increases
dramatically when there are
rumors in the market — for
stocks these might include
takeover rumors, rumors of a
dramatic change in earnings,
or the supposed
announcement of a new
product discovery or
approval. For futures, rumors
might center on government
supply/demand reports, or the
action of a cartel. If the
strategist feels that such
rumors are the reason for
inflated implied volatility,
then he should probably
avoid selling the options,
because other people may
have better information
regarding the fundamentals
than the strategist does. In
these cases, the implied
volatility is probably a better
predictor of future volatility
because, if the rumor proves
to be true, then the stock or
future will be more volatile.
Of course, even rumors based
on facts which eventually
prove to be true can get
overdone. If the strategist
feels that the implied is so
inflated that it has discounted
even the most extreme
rumors then he could feel
safer about selling premium.
Following is a very short-
term recommendation based
upon the fact that implied
volatilities are higher than
historical volatilities. Sugar
recently challenged its old
highs near 10 cents per
pound. However, the July
contract backed off and
closed below the old highs.
The next day there was little
follow-through. Thus,
technically it appears that
there might be stable prices,
but a blow-off top is unlikely.
However, the option
premiums jumped
tremendously, reaching
implied levels of 34% (the
historical volatility is no
higher than 26%).
Consequently, the strategist
should attempt to sell these
options if he believes that
sugar is not going to blow out
to new highs immediately.
Profitability: This is a very
short-term position, since the
options expire in 2 weeks.
Even if sugar does eventually
move, each passing day is
heavily to the advantage of
the option seller. Note that 3
calls are being sold against 5
puts; this produces a more
delta neutral position initially.
However, the position will
not remain delta neutral for
long if July sugar makes
another major move. At
expiration, the position
breaks even at 10.48 on the
upside and at 9.21 on he
downside (note the straight
lines on the profit graph on
the right). Also shown on the
profit graph is how the
position would look in 1
week. The position is rated
“above average risk” because
of the fact that naked options
are involved and losses could
be large if sugar should make
a limit move before follow-up
action could be implemented.
Investment: Exchange
minimum margin is $750 for
sugar futures, and the margin
required to sell a naked
combination is the futures
premium plus the option
premium. In order to allow
for some adverse futures
movement, we are
recommending that one allow
$6000 in maintenance margin
for this position. This will
give room for the futures to
move up to 10.50 without
necessitating a margin call.
Follow-Up Action: The best
thing about a position with
such a short time horizon is
that there is very little time
for a whipsaw to occur (for
example, rising prices
followed by falling prices).
On the upside, place a good-
until-canceled stop order to
the buy 3 July sugar at 10.45.
This will prevent large losses
from occurring if the stop is
elected near 10.45. On the
downside, a similar action is
recommended: place a GTC
order to sell 5 July sugar at
9.24. This would prevent
large downside losses. If
neither stop is elected, the
position will be profitable.
This above recommendation
is an example of taking action
when the implied volatility is
perceived to be too high in
comparison to the historical
volatility. In this sugar
recommendation, there does
not seem to be any
fundamental reason or rumor
that would spark an extreme
rise in the volatility of sugar.
The breakout seems to be
largely technical and, as such,
its effects are known to all
and should be discounted by
the market. The options thus
appear to be overpriced and
should be sold.
In summary, when there is a
large discrepancy between
historical volatility and
implied volatility, the
strategist may have an
opportunity to establish a
theoretically profitable
position. However, he must
decide which of the
volatilities is the better
predictor of future volatility.
If he decides that the
historical volatility is the
better predictor, then he has
the opportunity to do
something: buy options if the
historical is less than the
implied; sell options if the
opposite is true. Some
traders, however, feel that the
market is efficient enough
that the current implied
volatility should almost
always be trusted with respect
to the future volatility. In
other words, the options will
always be the correct
predictor of future volatility.
If this is the case, then one
would not even bother with
attempting to establish
positions based on
discrepancies between the
two volatilities. The
strategist, too, realizes that in
many cases, the options’
implied volatility may be the
better predictor — especially
if that prediction is based on
information not available to
the strategist; however they
will not always be, and when
one feels comfortable with
the historic volatility
estimate, he may be able to
profit.
 David L. Caplan
Reprinted from “The
Options Advantage:
Gaining a Trading
Edge Over The
Markets"
by David L. Caplan
copyright 1992
Probus Publishing
Company
1925 N. Clybourn
Avenue
Chicago Il 60614
Chapter 3
Volatility
Ways To Use Option
Volatility
The most overlooked and
under utilized factor by most
option traders is the
significance of volatility. This
includes both the effect of
volatility on the premium cost
of the option when purchased
and of future changes in
volatility on the position.
Volatility is simply a
mathematical computation of
the magnitude of movement
in an option. This is based on
the activity in the underlying
market. If the market is
making a rapid move up or
down, volatility will rise; in a
quiet market, volatility will
be low.
When volatility is relatively
low, you should look for
option buying strategies as
the market is quite likely to
make a strong move; and,
when option premium is high,
option selling strategies
should be considered to take
advantage of the relatively
over-valued premiums.
Volatility is an important
factor in determining the
price of an option because all
option models depend heavily
on the calculation of volatility
in determining the “fair
market value” of an option.
What we are actually saying
when we calculate volatility
is that the odds are 67% or
better that the market will
hold within the calculated
range over a period of one
year.
For example, if gold is
trading $500 per ounce and
had a volatility of 20%, the
probability is that gold will
hold a range of $400 to $600
(20% on either side of $500)
for a one year period. Based
on this, option sellers can
calculate the premium they
would want to receive for
selling various gold puts and
calls based on the probability
that the strike price would be
reached prior to the
expiration of the option. If the
volatility is high, option
sellers would determine that
it is more likely that the
option price could be reached
and ask a higher premium; if
volatility is low the option
seller would determine that it
is unlikely that the option
would be exercised and
therefore ask less for selling
that option.
There are two types of
volatility - historical and
implied. Historical volatility
is calculated by averaging a
past series of prices of
options. For example, a trader
could use a 90-day price
history, a 30-day price
history, a 10-day price
history, etc... to determine the
options “historical
volatility.” Obviously, each
set of calculations result in a
different figure for volatility
and produce different
theoretical (fair value) for the
options.
Implied volatility is
calculated by using the most
current option prices,
commodity price level, time
to expiration, and interest
rate. This method provides a
more accurate picture of the
current volatility of an option,
compared to the historical
volatility which is a
smoothing of past price
action. I use “implied
volatility” in my option
pricing calculations, and then
compare the current numbers
to past records of implied
volatility to determine
whether volatility is relatively
high or low.
Another overlooked area is
the difference in volatility
between different months and
strike prices of options. When
I calculate volatility, I always
use strike prices that are
nearest to the money, as I feel
that this is the most accurate
representation of the actual
volatility of the option
contract. Many times,
premiums of out-of-the-
money options can be
distorted greatly.
For example, in June 1987,
silver ratio spreads provided a
high probability of profit,
because the volatility for the
out-of-the-money silver calls
were double the volatility of
the at-the-money calls. This
can lead to significant
opportunities. When options
approach expiration, volatility
for all of the strike prices will
tend to equalize. In this
instance I purchased the most
fairly priced call (near-the-
money), and sold the most
overvalued calls (out-of-the-
money). I could expect the
options sold to lose premium
faster as the market moved in
either direction. Even if the
market were to move higher
(unless making a straight up
vertical move) this spread
would have also worked as
the nearer-to-the-money
option would have gained
value faster than the already
overpriced out-of-the-money
options.
Another overlooked
characteristic of volatility is
that option volatility tends to
drop gradually, then level off.
However, at times volatility
increases, can be
characterized by very sharp
changes in volatility driving
option premium to extremely
high levels. These events
occur rarely, but when they
do they can be very damaging
to those holding short option
positions. A recent example
was the volatility increase in
many markets at the
beginning of the Gulf War.
Oil volatility doubled, while
other markets such as gold,
bonds, and currencies
increased 20% or more. Even
seemingly unrelated markets
such as cattle increased
dramatically.
There are also intraday
fluctuations in volatility and
premium. Since implied
volatility is based on the
closing price of the option,
many times intraday
fluctuations in prices will
create option volatility that is
much higher than the
volatility based on the closing
price. These types of
fluctuations seem to always
be of the higher nature.
Rarely does option volatility
drop any significant degree
during a trading day. Taking
advantage of these intraday
price swings and distortions
in option valuation can
provide a trader with
significant trading
opportunities.
Changes in volatility affect
the premium levels in options
you are going to purchase, as
well as those you have
already purchased or sold. A
good example of this is in the
crude oil and the S&P 500
option market where
volatility has ranged between
20% to over 100%. With high
volatility, if we were to
purchase an out-of-the-money
option, you would need a
substantial price rise before
that option would be
profitable at expiration. Both
the expense of the purchase
price of the option and time
value would be working
severely against you.
However, with volatility at
lower levels, this option
would not only cost much
less but would require a
smaller move for the position
to be profitable. This is
because many times as prices
begin to rise volatility also
increases, thereby increasing
the premium of the option
purchased.
The concepts of option
volatility, along with the time
decay characteristic of
options, are the two most
important and most
overlooked factors in option
trading. These concepts can
be difficult to learn and use,
but the proper use of these
option characteristics can
result in a “trading-edge”
over the markets.

How Option Volatility

Can Alert You In
Advance To
Significant Market
Moves
As discussed above, when
option volatility is at low
levels, there is a high
probability that a large move
is about to occur. It seems
that when a contract is very
quiet, traders seemingly “fall
asleep” and don’t expect
anything to happen. Of
course, this is exactly when
everything explodes! On the
other hand, many times when
the market has been very
active (volatile) for a period
of time, since most traders are
already in the market, it is
likely to maintain a trading
range. However,
understanding this concept of
volatility is much easier than
using it in trading.
The beginning option trader
disregards volatility. He
determines only that a market
is moving in a certain
direction, and purchases an
option that best fits his view
of the market and risk
exposure. This trader will
lose 100% of the time when
the market moves against his
desired direction or remains
neutral. He will also often
lose, even when the market
moves in his direction,
because of the time decay of
the value of the option
premium.
The professional option trader
will examine the volatility of
the option contract and
determine whether it’s in the
high, low or middle of it’s
historical range. He will then
examine a computer
evaluation of what the
different strike price and
months of options will do
under various market
conditions, and not only
choose the option that is the
most likely to be profitable,
but also determine whether
this is an appropriate time to
be purchasing options.
For example, call option
purchases provided positions
with an excellent risk/reward
ratio in silver in 1987, and in
the grains in 1988. The
options had low volatility
combined with reliable
technical chart pattern which
suggested that there was a
strong probability of a
breakout to the upside.
The opposite picture was
evident in the S&P 500
options in. A trader who
would have purchased any
out-of-the-money options in
the December S&P 500
would have lost money, since
the market had very high
option volatility premium and
a short time to expiration. All
of the out-of-the-money
options, both puts and calls,
lost value during this period.
Therefore, it didn’t matter in
this market whether you were
bullish or bearish. All buyers
of options were wrong, all
sellers were right.
Changes in volatility can also
occur over short or long
periods of time. Treasury
bonds had decreased in
volatility almost 50% in the
beginning of 1987, reflecting
a change in traders’ views on
the market from volatility to
stability. On the other hand,
Swiss Franc options
decreased 30% in volatility in
one day after a meeting of the
European countries to
reevaluate currency rates at
which no segment changes
were made. Volatility on both
puts and calls had increased
dramatically during the
previous week, and when it
was determined that no
significant changes were
going to occur, in one day,
put and call options lost over
a forth of their value.
Recognizing these principles
are not only important in
determining the best option
strategy to use, but also can
alert you to potential changes
in the direction of the
underlying market.
Consider The
Volatility of The
Underlying Market, as
Well as The Options
Option traders, like all other
investors, are always looking
for a deal. In the option
trading world this would be
the ability to buy a cheap
option that is likely to
appreciate greatly, or sell an
expensive option which is
likely to deteriorate.
Along with the benefits in
option trading, there are
complexities. For example, a
trend-following trader may
decide that Treasury bonds
are in an up-trend; the market
has experienced a 30% re-
tracement of its current rally,
and therefore the most active
bond futures contract is
purchased with a stop below
the last reaction low.
The option trader must not
only similarly analyze the
market, but also decide what
strike price and month of
options to use, whether
options are to be bought or
sold, or whether a
combination of options is to
be used (a strategy). One of
the primary factors option
traders use in deciding
whether to buy or sell
options, or which strategy to
use is the volatility of the
option market, as this will
determine the “premium”
paid or received for the trade.
There are times when looking
at the underlying market
volatility is equally
important. The most dramatic
example of this occurred in
the foreign currencies over
the last few years.
From December of 1988
through May 1989 the Swiss
Franc declined from 7000 to
5500, a decline of 1500
points in 7 months. During
that time option volatility
ranged from 12% in the
beginning of the move to the
9% level in May and June. In
a similar price move, the
Swiss Franc had increased
from August through
December 1988, from 6500 to
8000, a move of 1500 points
in 5 months. However, option
volatility differed
dramatically from the first
half of 1989, at times being
twice as high.
Why did the option volatility
vary so much when the
underlying market movement
was almost the same? In late
1987, the general attitude in
the currencies was very
bullish as the market was in
the throws of a three year bull
move. In a bullish market,
option premium is almost
always higher than bear
markets, since small public
traders prefer to be long on a
market rather than short, thus
creating a demand for call
options.
This great difference in
option volatility means that
you also must change your
option trading strategies.
With volatility at high levels
at the end of 1987, selling
options premium presented
trades with high probabilities
of profit. In fact, premium
was so high at times, that on
days of little activity, option
premium shrunk for both puts
and calls. However, in 1991,
with option premium at levels
50% or more lower, option
buying strategies were
recommended.
In trading options one must
learn to be flexible, using
what the market gives you to
your best advantage. Sticking
to one strategy may not be
appropriate for current
conditions. Changes in
volatility levels require the
use of different option
strategies depending on both
the relative level of volatility
in the option or underlying
market.
Using Trends To Your
Advantage
One of the first principles
learned when I started trading
was “The Trend Is Your
Friend.” I have found that to
be one of the most important
aspects of a trading plan.
Attempting to fight the trend,
guessing tops or bottoms,
trading the correction etc., is
probably the biggest cause of
losses in the marketplace.
Most all traders have done
this at one time or another -
and paid the price.
Trends are important to
option traders not only in
determining market direction,
but also in determining if
option volatility is likely to
move higher or lower.
Volatility trends similar to
price action. Volatility trends
are just as reliable and long
lasting as price trends, and
like price action, when
volatility hits low levels and
begins to turn up (or high
levels and turns down) it can
continue to trend for several
years.
Volatility trends in options
are extremely important in
determining the type of
trading strategies that are
most likely to be successful.
At the beginning of 1988,
option volatility in the foreign
currencies was extremely
high, just coming off
historically high levels in
some of the foreign currency
markets at the end of 1987.
Similarly, option volatility
was also near the high end of
historical levels in the
financial markets, in the
Treasury bond and Eurodollar
option markets. With
volatility continually
declining during 1988, selling
option premium presented
trades with high probabilities
of profit. This is because the
daily shrinkage of time value
of option premium was
accelerated by the decreasing
volatility. In fact, during that
period, there were many days
and weeks that option
premium for both puts and
calls moved lower. This type
of action, obviously, was very
beneficial for neutral option
positions.
Similarly, the 1982 through
1984 period was excellent for
option sellers. The markets
had just come off of large
movements in the metals and
grains, and traders’
perceptions were that these
conditions would continue.
Additionally, options on
futures were new, and
disparity in pricing occurred
more often, since traders were
inexperienced in their use and
pricing.
 Sheldon Natenberg
Reprint from “Option
Volatility and Pricing
Strategies: Advanced
Trading Techniques
for Professionals”
by Sheldon Natenberg
Probus Publishing
Company
1925 N. Clybourn
Avenue
Chicago, IL 60614
Appendix D -
Characteristics of
Volatility Spreads
Appendix E - What’s
the Best Strategy?
The following chart is
designed to help the reader
choose the types of strategies
which are likely to be
profitable given a trader’s
opinion on market direction
and implied volatility. Even
though several strategies may
be appropriate under the same
market condition, each
strategy will have different
risk/reward characteristics.
The reader should refer to the
text for a detailed analysis of
each strategy.
Any appropriate strategy may
also be done synthetically.
For example, instead of
selling the underlying
contract (moderate implied
volatility, bearish market
perspective), a trader can
instead sell a call and buy a
put with the same exercise
price (synthetic short
underlying). Instead of selling
naked puts (high implied
volatility, bullish market
perspective), a trader can
instead buy the underlying
contract and sell a call
(buy/write, equivalent to a
synthetic short put).
The only scenario for which
there is no appropriate
strategy is the one in which a
trader has no opinion on
either implied volatility or
market direction. When there
is no apparent profit
opportunity, a disciplined
trader will choose to sit on
the sidelines.
Chart Abbreviations:
ITM=in-the-money
ATM=at-the-money
OTM=out-of-the-money
In-the-money call butterflies
and time spreads, and out-of-
the-money put butterflies and
time spreads, are those in
which all exercise prices are
lower than the current price
of the underlying.
Out-of-the-money call
butterflies and time spreads,
and in-the-money put
butterflies and time spreads,
are those in which all exercise
prices are higher than the
current price of the
underlying.
 Ronald Frost
Reprinted from
“Options On Futures”
by Ronald Frost
Probus Publishing
Company copyright
1989
1925 N. Clybourn
Avenue
Chicago, Il 60614
Factors Affecting the
Pricing of Options
Changes in Volatility
As we have seen, volatility
plays an important part in the
pricing of an option. To
understand why volatility is
so important, just use your
trading common sense. If you
think prices have a good
chance of moving up or down
dramatically, you’ll be
willing to pay more for an
option. If you’re the seller of
an option, you’ll want to
receive a higher premium for
the risk you’re taking! When
traders talk about volatility,
it’s usually implied volatility
that they’re talking about.
They let the market tell them
how volatile the market is
likely to be. If traders were
using historical volatility in
1987, that is, if they expected
prices to stay in a range
similar to 1986, they would
have received a few shocks.
Implied volatility should be
the basis for many trading
decisions! Normally, traders
want to buy premium when
volatility is low and sell
premium when volatility is
high. In theory, all the call
and puts for a given futures
contract should have the same
implied volatility, because
they are all based on the same
underlying futures. In
practice, however, each call
and put has its own implied
volatility, and each month has
its own volatility.
Prior to 1987, S&P and OEX
options traded in the range of
.10 to .15. In the early part of
1987, volatility started
reaching levels around .20
and then in mid-year around
.24. After October 19,
implied volatilities on equity
products soared above .70.
They then drifted downward
to .40 in November and by
December in the mid-thirties.
The fact is that implied
volatilities on nearly all
futures jumped after October
19, 1987. Look at what
happened to the implied
volatilities of the grains once
the 1987 drought began.
Premiums soared!
As you work through the
exercises in this book, it will
become clear just how
important volatility is in
trading options. It will
become clear how you can be
wrong the market direction
and make money, and how
you can be right the market
and still lose money! You’ll
quickly know why traders
talk about buying 12 percent
volatility and selling 80
percent volatility. Calculate
volatilities during the trading
day. Implied volatility can
jump or decline significantly
during the day.

Here are some facts to

keep in mind about
volatility:

1. Options with lower
volumes will tend to
have larger bid/ask
 spreads because of less
liquidity.
2. Some strikes are not
traded during the day,
and therefore settlement
prices are calculated
based on activity in the
other strikes according
to formulae selected by
the various exchanges
3. It’s often easier to do
large volumes in options
because market makers
 can delta-neutral their
positions more easily.
4. Once futures become
more volatile, exchanges
have the right and often
do raise margins. This
obviously becomes
critical to option sellers.
5. In effect, the time value
and market expectations
are priced according to
the volatility of the
underlying contract.
Here are some implied
volatility ranges for certain
futures. The trader should be
aware that this is a guide and
dramatic events can change
these ranges.
Different Strikes -
Different Volatilities
Implied volatilities differ for
different strikes of the same
option. The trader should be
aware of this in selecting
strategies. Here are different
volatilities for puts and calls
on February 2, 1988, for
March contracts. Too often,
people refer to just one
volatility as if it represented
all the strikes (in theory it
should, but it’s just not true).
At different times of the day,
there can be significant
changes from the closing
volatility.
JYen table here
Gold (Comex) table here
S&P Futures table here
Notice the JYen and gold
implied volatilities are lowest
at-the-money and get higher
at higher and lower strikes,
although the JYen volatilities
are fairly constant. The S&P,
meanwhile, seems to be
diagonal, with the lower
strikes showing the highest
volatility for calls and puts.
What this really means is that
traders believe the probability
distribution (as discussed
earlier) is not lognormal.
They believe the shape of the
distribution is a little different
than what the theorists
believe to be normal.
One explanation of higher
volatilities at lower strikes for
the S&P has to do with the
psychology of the stock
market. Think about it. Do
you think the stock market
could ever crash on the
upside? Say a 500 point rally
in one day? Possible, yes.
Possible, but not too likely in
the near future. Total greed
doesn’t seem to set in on all
the people at the same price
level. Panic at a particular
price level is more likely.
Volatility effect on in-
the-money (ITM), at-
the-money (ATM), or
out-of-the-money
(OTM):

Examples are for calls.

Review of Key Factors

1. The shorter the time, the

faster the time decay.
2. Changes in volatility
have a greater
percentage change on
out-of-the-money
options.
3. The higher the volatility,
the lower the deltas for
 the in-the-money strikes;
the higher the volatility,
the higher the deltas for
out-of-the-money
strikes.
4. At-the-money strikes
have the most time
premium.
5. More distant options are
more responsive to
volatility changes if you
look strictly at vegas.
But in reality the nearby
 options tend to respond
to increased volatility.
Why? Probably because
traders do not expect the
sudden increases to last
more than a few weeks.
6. At-the-money strikes are
more responsive to
changes in volatility.
7. Futures always have a
delta of 100.
8. For calls and puts at the
same strike price, the
 sum of the delta is
approximately 100.
9. Bullish positions have +
signs for deltas, gammas
and vegas. Bearish
positions have - signs.
Exception: a short put is
bullish but looks for
reduced volatility.
10. Time decay helps short
options; if hurts long
options.
Checklist for Choosing
a Strategy

1. Where’s the price today

compared with the
weekly charts?
2. Where’s the price today
compared to a monthly
chart?
3. What’s the seasonal
pattern?
4. Is a cycle top or bottom
near?
5. Is your outlook bullish,
bearish or neutral?
6. What are the technicals
telling you?
7. What are the key
fundamentals?
8. What key reports are
expected soon?
9. What’s the impact of
passing time on your
 proposed position?
10. Do you expect volatility
to rise, fall or stay the
same?
11. What is the delta of the
position that you are
considering?
12. How long do you expect
to hold this position?
13. Which strategy would
make you feel best if the
market went against
 you?
14. How much are you
willing to risk?
 Sheldon Natenberg
Reprinted from “The
Chicago Merchantile
Exchange Options
Trading Seminar
Workbook”
by Sheldon Natenberg
Types of Volatility


1. Future Volatility

This is what every option

trader would like to know, the
extent to which an underlying
contract’s price will fluctuate
over some period in the
future. If the trader knows the
future volatility of a contract,
he can evaluate options on the
contract with increased
confidence. Of course no one
really knows what the future
volatility will be.

1. Historical Volatility

When we speak of the

historical volatility of a
contract, we are referring to
its price fluctuations over
some specific period in the
past. For example, we can
talk about the volatility of
S&P 500 index over the last
90 days. Or we can talk about
volatility of a Deutschemark
futures contract over the last
50 days. The historical
volatility is important because
it helps us make an intelligent
guess about what the future
volatility might be.

1. Forecast Volatility

This is someone’s’
“guesstimate” of what the
future volatility of some
contract will be. Most
services which forecast
volatility do so for periods
covering the life of options on
that contract. Depending on
his confidence in the
forecaster, an option trader
might take a forecast
volatility into consideration
when trying to estimate the
future volatility of a contract.

 1. Implied Volatility

Given the basic inputs

required for option evaluation
(time to expiration, exercise
price, underlying price,
volatility, interest rates) we
can run these inputs through a
theoretical pricing model to
obtain a theoretical value for
an option. If this theoretical
value is different than the
price of the option in the
marketplace, we can replace
our theoretical value with the
market price of the option,
and then run our pricing
model backwards to obtain a
volatility which yields a
theoretical value identical to
the price of the option in the
marketplace. This new
volatility is the volatility
which the marketplace is
implying to the underlying
contract through the pricing
of the option.
Example: Suppose there are
90 days remaining to
expiration with interest rates
at 4.50%. With an underlying
Deutschemark futures
contract trading at 61.48 and
a 62 call trading at 1.39, we
might ask: “What volatility
would we have to feed into
our theoretical pricing model,
along with the other inputs
given above, to obtain a
theoretical value for the 62
call of 1,39:” The answer is
13.5%, and we refer to this
number as the current implied
volatility of the 62 call.
(Because of the complexity of
the calculations, a computer
is necessary for calculating
implied volatilities).
Technically speaking it is
only possible to talk about the
implied volatility of any one
particular option. However,
most services which supply
implied volatility figures do
so for the whole class of
options with the same
underlying. They do this by
calculating the implied
volatility of each individual
option, then weighting them
by various criteria such as
volume, open interest, or (as
is most common) by giving
the at-the-money options the
greatest weight.
Even though the term
“premium” really refers to an
option’s price, traders tend to
refer to the implied volatility
of options in the marketplace
as the premium, or premium
level. If implied volatility is
relatively low, one might say
that premium levels are low.
If implied volatility is
relatively high, one might say
that premium levels are high.
To better understand the
difference between the
various types of volatilities,
consider the following
analogy to weather and
weather forecasting.
Suppose a trader lives in
Chicago and gets up on a July
morning. The trader is
interested in what the weather
will be that day since it will
affect his decision about what
clothes to wear. Do you think
the trader would consider
putting on a parka? That’s
unlikely because he knows
that historically the weather
in Chicago in July is not
sufficiently cold to warrant
wearing a parka.
Now the trader attempts to
add to what he knows about
the historical weather by
turning on the radio or
television to listen to the
weather forecast. The
weatherman is predicting
sunny skies with temperatures
in the 90’s. Based on this, the
trader has decided on a short
sleeve shirt with no sweater
or jacket.
As a final check, the trader
walks over to the window to
see how things look outside.
To his surprise, everyone on
the street is wearing a jacket
or coat and carrying an
umbrella. The people in the
street are implying
completely different weather
than is being forecast by the
weatherman
Finally the trader makes his
decision about what to wear
based on all the available
information: his knowledge
of the historical weather in
Chicago in July, the
weatherman’s forecast, and
the weather implied by the
people passing in the street.
Did the trader wear the right
clothes? He won’t know that
until the end of the day when
the future weather for which
he was planning becomes
historical weather.
 Lawrence G.
McMillan
Reprinted from
“OPTIONS AS A
STRATEGIC
INVESTMENT, 2nd
Edition”
by Lawrence G.
McMillan
copyright by New
York Institute of
Finance
a division of Simon &
Schuster, Inc.
70 Pine Street, New
York, NY 10270
Chapter 26
The Best Strategy?
There is no one best strategy.
Although this statement may
appear to be unfair and
disappointing to some, it is
nevertheless the truth. Its
validity lies in the fact that
there are many types of
investors, and no one strategy
can be best for all of them.
Knowledge and suitability are
the keys to determining
which strategy may be the
best one for an individual.
The previous 25 chapters
have been devoted to
imparting much of the
knowledge required to
understand an individual
strategy. This chapter will
attempt to point out how the
investor might incorporate his
own risk/reward attitude and
financial condition to select
the most feasible strategies
for his own use. The final
section of this chapter
describes which strategies
have the better probabilities
of success.

General Concepts -
Market Attitude and
Equivalent Positions
A wide variety of strategies
has been described. Certain
ones are geared to
capitalizing on one’s
(hopefully correct) outlook
for a particular stock, or for
the market in general. These
tend to be the more
aggressive strategies, such as
outright put or call buying,
and low-debit (high potential)
bull and bear spreads. Other
strategies are much more
conservative, having as their
emphasis the possibility of
making a reasonable, but
limited, return coupled with a
decreased risk exposure.
These would include covered
call writing and in-the-money
(large debit) bull or bear
spreads. Even in these
strategies, however, one has a
general attitude about the
market. He is bullish or
bearish, but not overly so. If
he is proven slightly wrong,
he can still make money.
However, if he is gravely
wrong, relatively large
percentage losses might
occur. The third broad
category of strategies is the
one that is not oriented
toward picking stock market
direction, but is rather a
neutral approach that allows
one to earn time value
premiums. If the net change
in the market is small over a
period of time - and there are
historical indications that it is
- these strategies should
perform well. These
strategies would include ratio
writing, ratio spreading
(especially “delta spreads”),
straddle and combination
writing, neutral calendar
spreading, and butterfly
spreads.
Certain other strategies
overlap into more than one of
the three broad categories.
For example, the bullish or
bearish calendar spread is
initially a neutral position. It
only assumes a bullish or
bearish bias after the near-
term option expires. In fact,
any of the diagonal or
calendar strategies whose
ultimate aim is to generate
profits on the sale of shorter-
term options are similar in
nature. If these near-term
profits are generated, they can
offset, partially or
completely, the cost of long
options. Thus one might
potentially own options at a
reduced cost and could profit
from a definitive move in his
favor at the right time. It was
shown in Chapters 14, 23,
and 24 that diagonalizing a
spread can often be very
attractive.
This brief grouping into three
broad categories does not
cover all the strategies that
have been discussed. For
example, some strategies are
generally so poor that they
are to be avoided by most
investors - reverse calendar
spreads, high-risk naked
option writing (selling
options for fractional prices),
and covered or ratio put
writing. In essence, the
investor will normally do best
with a position that has
limited risk and the potential
of large profits. Even if the
profit potential is a low-
probability event, one or two
successful cases may be able
to overcome a series of
limited losses. Complex
strategies that fit this
description are the diagonal
put and call combinations
described in chapters 23 and
24. The simplest strategy
fitting this description is the
T-bill/option purchase
program.
Finally, many strategies may
be implemented in more that
one way. The method of
implementation may not alter
the profit potential, but the
percentage risk levels can be
substantially different.
Equivalent strategies fit into
this category.
Example: Buying stock and
then protecting the stock
purchase with a put purchase
is an equivalent strategy in
profit potential to buying a
call. That is, both have
limited dollar risk and large
potential dollar profit if the
stock rallies. However, they
are substantially different in
their structure. The purchase
of stock and a put requires
substantially more initial
investment dollars than does
the purchase, but the limited
dollar risk of the strategy
would normally be a
relatively small percentage of
the initial investment. The
call purchase, on the other
hand, involves a much
smaller capital outlay, and
while it also has limited
dollar risk, the loss may
easily represent the entire
initial investment. The
stockholder will receive cash
dividends while the call
holder will not. Moreover, the
stock will not expire as the
call will. This provides the
stock/put holder with an
additional alternative of
choosing to extend his
position for a longer period of
time by buying another put or
possibly by just continuing to
hold the stock after the
original put expires.
Many equivalent positions
have similar characteristics.
The straddle purchase and the
reverse hedge (short stock
and buy calls) have similar
profit and loss potential when
measured in dollars. Their
percentage risks are
substantially different,
however. In fact, as was
shown in Chapter 20, there is
another strategy that is
equivalent to both of these -
buying stock and buying
several puts. That is, buying a
straddle is equivalent to
buying 100 shares of stock
and simultaneously buying
two puts. The “buy stock and
puts” strategy has a larger
initial dollar investment, but
the percentage risk is smaller
and the stockholder will
receive any dividends paid by
the common stock.
In summary, the investor
must know two things well -
the strategy that he is
contemplating using and his
own attitude toward risk and
reward. His own attitude
represents suitability, a topic
that will be discussed more
fully in the following section.
Every strategy has risk. It
would not be proper for an
investor to pursue the best
strategy in the universe (such
a strategy does not exist, of
course) if the risks of that
strategy violated the
investor’s own level of
financial objectives or
accepted investment
methodology). On the other
hand, it is also not sufficient
for the investor to merely feel
that a strategy is suitable for
his investment objective.
Suppose an investor felt that
the T-bill/option strategy was
suitable for him because of
the profit and risk levels.
Even if he understands the
philosophies of option
purchasing, it would be
improper for him to utilize
the strategy unless he also
understands the mechanics of
buying treasury bills and,
more important, the concept
of annualized risk.

What Is Best For Me

Might Not Be Best
For You
It would be impossible to
classify any one strategy as
the best one. The
conservative investor would
certainly not want to be an
outright buyer of options. For
him, covered call writing
might be the best strategy.
Not only would it accomplish
his financial aims - moderate
profit potential with reduced
risk - but it would be much
more appealing to him
psychologically. The
conservative investor
normally understands and
accepts the risks of stock
ownership. It is only a small
step from that understanding
to the covered call writing
strategy. The aggressive
investor would not consider
covered call writing to be the
best strategy, most likely,
because he would consider
the profit potential too small.
He is willing to take larger
risks for the opportunities of
making larger profits.
Outright option purchases
might suit him best, and he
would accept, by his
aggressive nature, that he
could lose nearly all his
money in a relatively short
time period. (Of course, one
would hope that he only uses
15 to 20% of his assets for
speculative option buying).
Many investors fit
somewhere in between the
conservative description and
the aggressive description.
They might want to have the
opportunity to make large
profits, but certainly are not
willing to risk a large
percentage of their available
funds in a short period of
time. Spreads might therefore
appeal to this type of investor
- especially the low-debit
bullish or bearish calendar
spreads. He might also
consider occasional ventures
into other types of strategies -
bullish or bearish spreads,
straddle buys or writes, and
so on- but would generally
not be into a wide range of
these types of positions. The
T-bill/option strategy might
work well for this investor
also.
The wealthy aggressive
investor may be attracted by
strategies that offer the
opportunity of making money
from credit positions, such as
straddle or combination
writing. Although ratio
writing is not a credit
strategy, it might also appeal
to this type of investor
because of the large amounts
of time value premium that
are gathered in. These are
generally strategies for the
wealthier investor because he
needs the “staying power” to
be able to ride out adverse
cycles. If he can do this, he
should be able to operate the
strategy for a sufficient
period of time in order to
profit from the constant
selling of time value
premium.
In essence, the answer to the
question of “which strategy is
best” again revolves around
that familiar word suitability.
The financial needs and
investment objectives of the
individual investor are more
important than the merits of
the strategy itself. It sounds
nice to be able to say that one
would like to participate in
strategies with limited risk
and potentially large profits.
Unfortunately, if the actual
mechanics of the strategy
involve risk that is not
suitable for the investor, he
should not use the strategy -
no matter how attractive it
sounds.
Example: The T-bill/option
strategy seems attractive:
limited risk because only
10% of one’s assets are
subjected to risk annually; the
remaining 90% of one’s
assets earn interest; and if the
option profits materialize,
they could be large. What if
the worst scenario unfolds?
Suppose that poor option
selections are continuously
made and there are three or
four years of losses, coupled
with a declining rate of
interest earned from the
Treasury bills (not to mention
the commission charges for
trading the securities). The
portfolio might have lost 15
to 20% of its assets over
those years. A good test of
suitability is for the investor
to ask himself, in advance:
“How will I react if this worst
case occurs?” If there will be
sleepless nights, pointing of
fingers, threats, and so forth,
the strategy is unsuitable. If,
on the other hand, the
investor feels that he would
be disappointed (because no
one likes to lose money), but
that he can withstand the risk
the strategy may indeed be
suitable.

Mathematical
Ranking
The discussion above
demonstrates that it is not
possible to ultimately define
the best strategy when one
considers the background -
the reader may be interested
in knowing which strategies
have the best mathematical
chances of success, regardless
of the investor’s personal
feelings. Not unexpectedly,
those strategies which take in
large amounts of time value
premium have high
mathematical expectations.
These would include ratio
writing, ratio spreading,
straddle writing, and naked
call writing (but only if the
“rolling for credits” follow-up
strategy is adhered to). The
ratio strategies would have to
be operated according to a
delta neutral ratio in order to
be mathematically optimum.
Unfortunately, these
strategies are not for
everyone. All involve naked
options, and also require that
the investor have a substantial
amount of money (or
collateral) available to make
the strategies work properly.
Moreover, naked option
writing in any form is not
suitable for some investors,
regardless of their protests to
the contrary.
Another group of strategies
that rank high on an expected
profit basis are those that
have limited risk with the
potential of occasionally
attaining large profits. The T-
bill/option strategy is a prime
example of this type of
strategy. The strategies in
which one attempts to reduce
the cost of longer-term
options through the sale of
near-term options would fit in
this broad category also,
although one should limit his
dollar commitment to 15 to
20% of his portfolio.
Calendar spreads such as the
combinations described in
Chapter 23 (calendar
combination, calendar
straddle, and diagonal
butterfly spread) or bullish
call calendar spreads or
bearish put calendar spreads
are all examples of such
strategies. These strategies
may have a rather frequent
probability of losing a small
amount of money coupled
with a low probability of
earning large profits. Still, a
few large profits may be able
to more than overcome the
frequent, but small, losses.
Ranking behind these
strategies would be the ones
that offer limited profits with
a reasonable probability of
attaining that profit. Covered
call writing, large debit bull
or bear spreads (purchased
option well in-the-money and
possibly written option as
well), neutral calendar
spreads, and butterfly spreads
would fit into this category.
Unfortunately, all these
strategies involve relatively
large commission costs. Even
though these are not normally
strategies which require a
large investment, the investor
who wants to reduce the
percentage effect of
commissions must take larger
positions and will therefore
be advancing a sizable
amount of money.
Speculative buying and
spreading strategies rank the
lowest on a mathematical
basis. The T-bill/option
strategy is not a speculative
buying strategy. In-the-
money purchases, including
the in-the-money
combination, generally
outrank out-of-the-money
purchases. This is because
one has the possibility of
making a large percentage
profit but has decreased the
chance of losing all his
investment, since he starts out
in-the-money. In general,
however, the constant
purchase of time value
premiums - which must waste
away by the time the options
expire - will be a burdensome
negative effect. The chances
of large profits and large
losses are relatively equal, on
a mathematical basis, and
thus become subsidiary to the
time premium effect in the
long run. This mathematical
outlook of course precludes
those investors who are able
to predict stock movements
with an above-average degree
of accuracy. Although the
true mathematical approach
holds that it is not possible to
accurately predict the market,
there are undoubtedly some
who can and many who try.

Summary
Mathematical expectations
for a strategy do not make it
suitable even if the expected
returns are good, for the
improbable may occur. Profit
potentials also do not
determine suitability - risk
levels do. In the final
analysis, one must determine
suitability of a strategy by
determining if he will be able
to withstand the inherent risks
if the worst scenario should
occur. For this reason, no one
strategy can be designated as
the best one, because there
are numerous attitudes as to
the degree of risk that is
acceptable.
 Len Yates
Reprinted from
“OptionVue
Newsletter”
by Len Yates
OptionVue Systems
175 E. Hawthorn
Vernon Hills, Il 60061
RECENT
OPPORTUNITIES
It has been a while since I
have written about volatility
based trading. This would be
a good time, as there have
been a number of terrific
opportunities to make money.
If you read our newsletter,
you know how much we
preach volatility awareness.
Years ago, almost no
investors were aware of the
importance of volatility in
their options trading. Today,
things have changed. There is
a great deal more knowledge
and understanding out there.
Books have been published
on the subject (e.g. Option
Volatility and Pricing
Strategies, by Sheldon
Natenberg). Other books
contain significant
discussions about volatility
(e.g. The Option Advantage
by David Caplan, Options —
Trading Strategies That
Work, by William Eng, and
All About Options, by Russell
Wasendorf and Thomas
McCafferty). Seminar
instructors are talking about
volatility, Robert Krause’s
Volatility Handbook is
making a big contribution,
and the widely read
Opportunities in Options
newsletter discusses volatility
as a matter of course.
However, I would say that
this increased knowledge and
understanding is still
concentrated within a limited
circle. The majority of
options traders are still
completely oblivious to
volatility. And it costs them
dearly. Since these traders are
still making ad-hoc decisions
without volatility awareness
(and usually without
computer assistance), those
who ARE aware, and who
DO use computer software,
enjoy a significant advantage
over those who do not. Case
in point — gold.

GOLD
As you know, the price of
gold “slept” for a long time
between 330 and 350. But
recently, it has jumped to life
and burst through 370. At the
time of this writing, it stands
at 380. While momentum
seems to have weakened, you
can’t really say that it has
broken. If you sense that this
could be the beginning of a
real bull market, you might
be tempted to get involved by
purchasing call options.
However, you have no way of
knowing whether current gold
option prices are reasonable
— just by looking at them —
so you start up OptionVue IV
and see what is says. That
turns out to be a wise move,
because you will see that gold
option prices are so inflated
right now that, in a historical
context, they are at levels not
seen in years (although a bit
less than it was a few weeks
ago). Apparently, unusual
demand has produced prices
so high that to buy options
right now would be just
BEGGING to be left holding
the bag!
But options are like a chess
game, and you know that
there are other bullish
strategies besides just simply
buying calls. You ask
OptionVue IV to recommend
something. It suggests two
possibilities — both much
safer than the simple call
purchase.
One is to purchase futures
contracts and sell calls
against them. The other is to
enter into a “spread” —
where you buy one option
and sell another of the same
kind, but at a different strike
price. Either way, you make
money if gold goes higher.
Plus, you get into a position
where you will not be hurt if
the “fever” cools down. In
fact, you would MAKE
money if that happened. If
you believe that this whole
thing is just a “flash in the
pan,” you can use OptionVue
to pick a strategy that is
bearish on both volatility and
price. One example would be
to sell naked calls. If you
need to play it safe, go farther
out-of-the-money.
The current situation in gold
is an excellent example where
the SMART investor, armed
with the proper tools, takes
advantage of market excesses
and imbalances, placing the
odds in his favor, while
others let market situations
fool them into loosing money.

SILVER and
COPPER
Options on these metals have
exploded recently as well.
However, it is interesting that
the price of copper is well
below recent highs, and it has
not even rallied. So you
might consider copper
especially attractive right now
for a delta-neutral volatility
sale. The purest form of
volatility sale is the naked
strangle, which involves
selling both out-of-the-money
calls and out-of-the-money
puts. To delta neutralize the
combination, you can use the
Matrix in OptionVue to
discover how many calls and
how many puts you need to
sell in order to obtain a total
position delta near zero, while
at the same time using an
appropriate amount of capital.

LUMBER
The opportunity in lumber
has long passed. However, I
will discuss it because it was
such a terrific one, and easy
to play. The price of lumber
skyrocketed in January,
reaching a peak of 44. At that
point implied volatility
zoomed to an amazing 60%
or so — up from a “normal”
25%. Operating assumption
in volatility-based trading is
that when implied volatility
goes to excessive levels, you
can enter into a position that
will benefit when things
return to normal. This places
the odds in your favor. I knew
that sooner or later, lumber
option prices would have to
collapse, and the way it
usually works with
commodities, it would
probably be when lumber
prices came back down.
After lumber peaked and
seemed to loose momentum, I
wrote a naked strangle using
the 400 calls and the 330
puts, approximately 130 days
out. My choice of time frame
was determined by the
attractiveness of individual
options volatilities, plus the
fact that farther-out options
have greater vegas (hence
they collapse faster when
volatility comes down).
Lumber was just under 40 at
the time, and the delta of my
position was slightly
negative. I did this because I
felt that the price might come
down a bit more, and this
would put me in a balanced
(delta neutral) position.
If you follow lumber, you
know what happened
afterwards. The price went
down, down, down — in a
clean, almost uninterrupted,
slide — to its current price of
23. Along the way, when the
price dropped below 34, I
took my losses on the 330
puts, and opened up more
naked call positions.
Experience has taught me that
it pays to go with the trend,
even though a tenet of pure
volatility-based trading is to
stay delta neutral. Trying to
stay delta-neutral is such a
struggle sometimes, and you
just end up loosing money. If
you don’t like the risk of
going one-sided, consider
using far out-of-the-money’s
to lessen the risk. It so
happens I took a big chance
by selling at-the-money calls,
and they paid off big.
I entered into a balanced
position at first, because I
wasn’t sure at that time that
the price of lumber was really
going to break. All I knew
was that I wanted to get in on
selling the phenomenal option
premiums. Once the
downtrend became obvious, it
seemed appropriate to switch
over to the one-sided
position.

SOYBEANS
This is the opportunity
dujour. I didn’t really think
soybeans were going to jump
this summer, since there isn’t
a threat of drought, but they
have. Suddenly, the implied
volatility has soared to above
30% — just as high as last
summer. Normal is about
15%. And, if you’ll look at
the figure, you’ll see that
volatility tends to come back
down just as swiftly at it goes
up.
Also notice that statistical
volatility — a measure of
how much the price of the
asset itself is moving — has
NOT increased significantly.
This means that the
expectations expressed in
currently exaggerated options
prices are so far not based on
any REAL price volatility.
And one more thing. If you
will look at the Matrix, you
will notice how severe the
skew is right now. For
example, the out-of-the-
money calls are inflated far
more than at-the-money calls.
I’m taking a bearish position
from the outset on this one. It
might hurt me. However, I’m
putting the position on a little
at a time, and I’m using the
far out-of-the-money’s to take
advantage of the skew. Five
days ago I put on a few naked
calls, and today I added a few
more after the price of
soybeans jumped a bit higher.
You can play it anyway you
like. The important thing is
that you get on the right side
of volatility. Right now
Soybeans are sizzling.
However, sooner or later
they’ll got to cool off. When
they do, you can be
positioned to make a profit!
In this article, the examples
were all cases of high current
volatility. That is because
these were the most exciting
opportunities I have been
aware of recently. The other
side of the VBT (volatility-
based trading) coin is buying
into situations of low current
volatility. I will keep my eyes
open for these kind of
opportunities, and make this
the subject of my next article.
 Financial Futures
Professional
CBOT Marketing
Dept. (312) 341-7955
141 W. Jackson Blvd.
Ste 2280
Chicago, IL 60604
Volatility - The Key
To Option Pricing
Option pricing is often
depicted by the proverbial
“black box.” Several
mathematical models, the
most notable of which may be
attributed to Black-Scholes
and Cox-Ross-Rubinstein,
have been forwarded to
calculate the “fair market”
premium. All of these models
depend heavily on
marketplace volatility.
An option may be compared
to an insurance policy. The
riskier the proposition you
want to insure, the greater
your premium. Likewise, the
more variable or volatile the
instrument for which an
option may be exercised, the
higher the option premium.
Therefore, it behooves option
traders to track volatility
closely.
Volatility is most often
defined as an absolute
concept. A market may be
volatile whether it is strongly
bearish or very choppy.
Formally, we may define
volatility as the annualized
standard deviation of logged
percentage price changes.
Generally, this statistic is
expressed in percentage
terms.

For example:
A volatility of 19% suggests
that one may be
approximately 68% confident
that the price of a commodity
will fall within plus or minus
19% of its current level at the
conclusion of one year. This
may be expressed on a daily
basis as 19% divided by the
square root of 365 days in a
year (approximately 19), or
1% Thus, you may be 68%
confident that the price will
fall within plus or minus 1%
of its current level within a
single day.
An “historical volatility” may
be calculated using a time
series of past observations of
the commodity in question.
Of course, one may reference
longer or shorter time
periods.
Stock analysts often seem to
rely upon an “18-day”
volatility, i.e., they calculate
this standard deviation using
the past 18 days worth of
data. Of course, one may use
10 days, 20 days or 30 days,
as illustrated in Table 1.
The historical method is
perhaps the most direct way
of calculating a volatility.
Most option traders, however,
prefer to reference “implied
volatility.”
An implied volatility is the
volatility which is indicated
or is implicit in the prevailing
option premium. If you can
run the “black box” forward
and calculate a premium as a
function of the market price,
strike price, term to
expiration, short-term interest
rates and volatility, you can
likewise run the black box
“backwards” and find
volatility as a function of the
prevailing option premium
and the other variables.
Implied volatilities provide an
indication of the way in
which traders are looking at
the market. Over the past two
months, implied volatilities
appeared much more stable
than 10, 20 and 30 historical
volatilities, suggesting that
traders may be much less
reactive to fluctuating market
conditions than one might
give them credit for.
 Len Yates
Reprinted from
“OptionVue
Newsletter”
by Len Yates
OptionVue Systems
175 E. Hawthorn
Vernon Hills IL 60061
EXPLOITING
VOLATILITY FOR
MAXIMUM GAINS
When the Voyager spacecraft
gave scientists a closer view
of the planets and moons than
they ever enjoyed before, it
was supposed to answer
questions and confirm
theories. Instead, it opened up
more possibilities and showed
us that our universe is more
wonderful than we imagined.
In the same way, close
examination of the historical
volatility graphs on a number
of popularly traded assets
reveals a variety of new
possibilities in the area of
volatility-based trading. This
shows us that there is not just
one way to take advantage of
volatility, but many.
Almost everyone tends to
think of options trading in
terms of price-based trading
— you buy or sell calls or
puts based on what you think
the price of underlying is
going to do. If you’re good at
calling the turns and the
trends in the market, you can
do very well at price-based
trading.
Volatility-based trading can
also be very profitable. Not
only that, it can be more
reliable and less risky.
Moreover it does not require
good price forecasting skills.
The mechanism for profiting
from volatility fluctuations is
option premiums. Option
premium levels rise and fall
with expectations of how
volatile the underlying asset
is going to be. Essentially you
buy options when their
premium levels imply “too
low” a volatility for their
underlying, and sell options
when their premium levels
imply “too high” a volatility
for their underlying.
Volatility-based trading is
more sophisticated than price-
based trading, requiring more
sophisticated tools, i.e.
computer software. Current
volatilities are not printed in
the newspaper, nor are they
displayed on the screen of
any quotes monitors that we
know of.
The most obvious kind of
volatility-based trading is
based on the observation that
volatilities, unlike prices,
often tend to move within
observable bounds, and after
moving to one extreme or the
other, volatility often returns,
sometimes within short time,
to “normal.”
Historical volatility charts can
make it easy to see what
“normal” volatility is for a
given asset. It can also
uncover assets whose options
are chronically overvalued or
undervalued, reveal special
lead-time/lag-time situations,
and identify many exciting
short-term opportunities.

Key Terms
Option premium levels rise
and fall with expectations of
how volatile the underlying
asset is going to be. A
parameter that is useful for
measuring option premium
levels is implied volatility
(I.V. for short). Option
premiums imply a level of
volatility for their underlying.
The more “inflated” the
option premiums, the greater
the expected volatility level
in the underlying.
Statistical volatility, on the
other hand, is a measure of
how volatile the price
behavior of the asset itself has
been in recent days.
Options do not always behave
according to statistical
volatility. For one thing,
statistical volatility has to do
with the past (up to the
present). Option premiums
inherently reflect perceptions
about the near-term future
volatility of the asset. Hence
the need for these two
separate terms: implied
volatility and statistical
volatility.

The Source of
Information For This
Study
In this article we will be
examining a number of
historical volatility charts
produced by a software
package called OptionVue
IV. OptionVue IV provides,
by virtue of its background
data base, implied and
statistical volatility charts for
every optioned asset in the
U.S. The charts used in this
study cover a six month
period. Ideally we would
have preferred to use a longer
period, but at the time of this
writing only six months of
data had been accumulated.
Still, the methods of
interpretation are the same no
matter how much data you
have. More data will simply
broaden your basis of
observation and make for
sounder decisions.

Some Initial Overall

Observations
In researching for this paper,
I looked at the charts for all
the most popularly traded
assets, and then some. As I
studied some of these charts I
discovered there are more
opportunities to do volatility-
based trading than one might
expect.
The equity indexes and many
individual stocks exhibit very
“playable” volatility swings
with observable “floor”
levels. I also found several
instances of chronic
over/undervaluation, and
obvious advantages to certain
indexes for “selling”
strategies and other indexes
for “buying” strategies. I
found a stock where implied
volatility lags actual volatility
by a week or two, another
stock where the lag time is
several weeks, and several
unusual special situations
where implied volatility took
a dip and came right back in
less than a week.
Commodity option volatilities
seem to “trend.” In many
cases with commodity
options, once volatility goes
to a low level it can stay low
for a long time.
Volatilities for bond and
currency options do not
change very much over time,
and might not be very useful
for volatility based trading.
In the author’s opinion,
volatility-based trading can
be most lucrative in the
equities and equity indexes.
In the following pages we
will look at charts, observe
patterns, and discuss exactly
what option strategies to
employ to take advantage of
them. We will also give some
rules of thumb on when to
close out a profitable position
and when to cut losses.

We will discuss five

different ways to take
advantage of
Volatility:

1. Chronic
Over/Undervaluation.
2. Differences Among the
Indexes.
3. Playing Volatility
Fluctuations.
4. Miscellaneous Special
 Situations.
5. Volatility Skewing.

Chronic
Over/Undervaluation
In this category, the most
notable are the indexes. All
index options seem to be
chronically overvalued. Their
implied volatilities ride
higher than their statistical
volatilities throughout the
period under study.
For example, the chart for the
OEX shows that options
typically trade at an implied
volatility level 4 percentage
points above the actual
volatility level. The
difference this can make in
the price of a typical option is
substantial.
To illustrate, an at-the-money
OEX call option with 50 days
to go is worth 5-3/4 at a 12%
volatility level, but is worth
7-5/8 at a 16% volatility
level. Out-of-the-money
comparisons are even more
dramatic. A 15-points-out-of-
the-money OEX call option
with 50 days to go is worth 1-
1/4 at a 12% volatility level,
and is worth 2-1/2 at a 16%
volatility level.
This means that you can sell
an option at 2-1/2 that is
really worth 1-1/4 according
to the way the underlying
index really behaves. (To find
this price using OptionVue
IV, you would simply step
the price of the option down
until you see the option’s
MIV equal to 12%).
What this says is that you
should “sell premium” and
take advantage of these
overpriced options. Some
good strategies for selling
premium are 1) out-of-the-
money credit spreads, 2)
butterflies, and 3) naked
writing (preferably both
sides, i.e. strangles), and 4) if
we were discussing an asset
where you could buy the
underlying, covered writing.
We can not take the time to
explain the basics of these
strategies here, but will refer
the reader to any number of
good books and brochures put
out by the exchanges.
The credit spread strategy is
perhaps the purest and most
conservative way of “selling
premium.” Butterfly spreads
can be just as good, except
that you often have more
flexibility with credit spreads
to pick the separate strike
levels of your two sides (calls
and puts) and take advantage
of temporary “bargains.” The
sale of naked strangles is not
as feasible as it used to be,
thanks to high margin
requirements, and is more
risky. Covered writing is a
completely different kind of
strategy, with unique
characteristics, and is more
for the investor who already
holds stocks.
Many of the specific
examples in the remainder of
this article make use of credit
spreads. In selecting which
strikes and months to use for
a credit spread, you will want
to do three things: 1) Go as
far out of the money as it
takes to make you
comfortable. The farther out
of the money you go, the
more “room” you give the
underlying to move around
without concerning you with
the need to make any
adjustments (i.e. cut losses),
but the lower your
prospective returns. 2)
Choose a month that you’re
comfortable with. The nearby
months change faster, and
obviously reach their
conclusion sooner. 3) Shop
for the best bargains, based
on theoretical values. This
will be a strong factor in the
decision, possibly influencing
your choice of month and
strike(s).
Many stocks also have
options that are chronically
overvalued. One example is
Federal Express. Let’s see
what could have been
accomplished during the six
months under study using
vertical credit spreads to take
advantage of these
exceptionally high premiums.
As a game plan, we’ll use
options with 1 to 2 months
life remaining, we’ll hold
each hypothetical position all
the way to expiration, and
then immediately put on
another. Using prices dug out
from old newspapers, we
have the following:
On August 4th, our first date
of record in the charts,
Federal Express stock was at
50-1/8. The September 50
calls were 2-5/8, the
September 55 calls were 3/4,
the September 50 puts were
2, and the September 45 puts
were 3/4. Putting on credit
spreads in both the calls and
the puts would have netted a
$312.50 credit. Collateral
requirement for the combined
position would have been
$1,000 ($500 for each
spread).
At expiration the stock was
52. The September 50 calls
have to be “covered” at 2, for
a cost of $200. This leaves a
profit of $112.50, or 12.5%
return on collateral.
This and 3 other subsequent
positions in Federal Express
are summarized below, along
with their results:
Totaling up the results, we
would have had a $606.25
gain on the $1,000 collateral,
or 61%. This ignores the cost
of commissions and other
transaction costs, but doing
spreads like these in
sufficient quantities (5 or
more) will minimize the
relative impact of transaction
costs.
Other stocks with chronically
high implied volatilities as of
1-19-90 include Litton
Industries, Saint Jude
Medical, Alcoa, American
Cyanamid, Aristech
Chemical, and of late, Coca-
Cola.
Covered writers should be
very interested in finding
stocks such as these, because
by consistently writing call
options at slightly higher
premiums than they ought to
be they can achieve much
higher overall returns.
Covered writers might also be
interested in timing their call
sales to coincide with implied
volatility peaks.
If you prefer “higher octane”
option plays than covered
writing then it is probably
best to use index options
instead of stock options for
three reasons: First, based on
the historical volatility charts,
the indexes have a more
consistent, attractive
differential, as discussed
earlier. Second, indexes are
not subject to sudden
surprises such as merger
deals or bankruptcy, which
can ruin a good “premium
writing” strategy in stock
options. Third, the large
selection of available strikes
and nearby months that you
have with index options
provides a great deal more
flexibility to fine tune a
position and make
adjustments to it when
necessary.

Differences Among
the Indexes
The charts reveal another
interesting thing about the
indexes. Among the several
most popular broad-based
indexes, implied volatility
levels are fairly equal. Yet,
actual volatilities differ
considerably. This
discrepancy can be exploited.
The Major Market Index
(XMI) is the most volatile
index, with actual volatility
readings ranging between
12% and 21%. The New
York Stock Exchange
(NYSE) Index is the least
volatile with readings
between 8% and 15%. The
S&P 100 is in the middle
with actual volatility readings
between 10% and 18%.
This means that if you want
to “sell premium,” you should
be doing it with NYSE
options. If you want to
“purchase,” you should use
XMI options. The difference
this can make is remarkable.
For example, with NYSE
options trading at a typical
implied volatility level 6
percentage points above the
actual volatility level, selling
5% out-of-the-money calls
with 50 days remaining life
allows you to collect a 1-1/2
point premium on an option
that is really worth only 5/16,
a 4.8 : 1 advantage.
With XMI options trading at
a typical implied volatility
level just 2 percentage points
above the actual volatility
level, selling 5% out-of-the-
money calls with 50 days
remaining life allows you to
collect a 4-3/8 point premium
on an option that is really
worth 3-1/4, a 1.3 : 1
advantage.
In the middle ground, OEX
options, trading at a typical
implied volatility level 4
percentage points above the
actual volatility level, selling
5% out-of-the-money calls
with 50 days remaining life
allows you to collect a 2-1/2
point premium on an option
that is really worth 1-1/4, a
2.0 : 1 advantage.
Traders with sufficient
collateral might like to work
both sides of this for a really
“pure” volatility play — a
kind of “volatility arbitrage,”
if you will. You would buy
straddles in the XMI and
simultaneously sell straddles
in the NYSE. By making
each straddle delta neutral
with the appropriate ratio
between puts and calls, plus
doing an appropriate ratio
between the two indexes
(inversely proportional to
their relative prices and
betas), you can establish a
position that is immune to
market price changes and
overall volatility changes. As
you approach expiration this
position is bound to pay off.
If there is little movement in
the market your NYSE
straddle will gain more than
the XMI straddle loses; if
there is much movement in
the market your XMI straddle
will gain more than the
NYSE straddle loses.
Sufficient collateral is
required, however, to cover
for the “naked writing” of
NYSE options. (Brokerages
will not be able to recognize
the long XMI options as a
“cover” for the NYSE
options, even though that is
practically what they do).
Playing Volatility
Fluctuations
From the charts you can see
that almost every asset has its
own unique volatility
characteristics — how
subdued it gets during a quiet
period, how active it gets
during a volatile period, and
whether there seems to be
observable volatility cycles.
You can also observe how its
implied volatility behaves
relative to its statistical
volatility. Implied volatility
levels often depend on the
kind of control exerted by the
market makers in each asset’s
options. The market makers
in Exxon stock options, for
example, hold implied
volatility at a relatively
constant 16%-19%, even
while the stock itself exhibits
volatilities ranging from 14%
to 27%.
Unlike ordinary price
fluctuations, volatility
fluctuations are more likely to
exhibit observable “floor”
levels, transition times, and
sometimes even “ceiling”
levels. It stands to reason that
volatility patterns would be
this reliable. Fischer Black,
coauthor of the Black/Scholes
model, observes: “Changes in
volatilities are often
temporary; after a significant
change up or down,
volatilities seem to revert
back toward their previous 1
levels.”
Quite a number of stocks and
indexes exhibit volatility
patterns which can be used
for handsome gains.
For example, from the
historical volatility chart for
the ever-popular S&P 100
(OEX) you can see a very
definite floor level at around
16%, as well as two peaks at
around 23%. If one’s
preference were “selling
premium” in OEX options,
one might time the opening of
such positions to coincide
with levels above, say, 20%.
(I wouldn’t recommend
trying to catch the peaks. For
one thing, you might miss out
if the volatility level falls just
short. For another, it appears
that the time between peaks
can be about 3 months, which
could be a bit long. Notice
that I.V. stays above 20% for
more than a month in one of
the peaks, which is long
enough to exhaust one
position and open another).
One could also play the
volatility upswings. For
example, you could purchase
a straddle when I.V. settles
down to the apparent “floor”
level. This might not be
advisable with the indexes,
however, for two reasons:
First, the perpetually high
options premiums put you at
a theoretical disadvantage.
Second, as you can see from
the charts, implied volatilities
in the indexes can tend to stay
“on the floor” for several
weeks. Without knowing
when the next upswing might
occur, one or two straddle
positions could “rot on your
shelf” before the movement
you need finally arrives. It
might be possible to hold
back and try to catch an
upswing in its early stages.
However, it would certainly
require close attention
because onsets of higher
volatility often come
suddenly.
Among stocks, some
especially promising
fluctuation patterns are those
of Bolar Pharmaceutical,
Philip Morris, Disney,
WalMart Stores, and Dow
Chemical.
Bolar Pharmaceutical is an
especially good example.
From the chart you can see
that its implied volatility
swung several times between
49% and 70%. If we were to
have bought a straddle every
time I.V. was at 49% and sold
it as soon as I.V. reached
70%, the results would have
been impressive. Refer to the
Bolar Pharmaceutical chart
for the indicated buy and sell
points. Using old option
prices dug out from the
newspapers, here is what
reasonably could have been
done:
Another good example is
Philip Morris which seems to
swing back and forth between
levels of 21% and 35%.
Based on actual option prices
at the time, you could have
made the following trade:

Having 4 times the number of

option contracts than what
you started with, the net
profit would be (6.625 x 4) -
10.25, or a 159% gain.
In all honesty, the next
apparent buying time in
Philip Morris — mid
December — would not have
led to a profitable trade. Your
straddle would have
languished as the price of
Philip Morris’ stock went
nowhere for weeks.
Fortunately, with straddles
you seldom experience a total
loss, as that would require the
stock to land precisely on the
strike price at expiration.
In these examples we have
been using straddles. A
straddle is not the only
strategy you could use to take
advantage of a volatility
upswing. Others might be
buying out-of-the-money
vertical (price) spreads and/or
horizontal (time) spreads.
However, it is the author’s
opinion that the most
powerful strategy, for its
return on investment and
limited risk, is the simple
straddle purchase.
When buying a straddle, you
will want to purchase options
with 6 - 8 weeks or more of
remaining life, provided they
are liquid. This is to provide
the needed time frame (based
on the charts, it sometimes
takes as long as 5 weeks for
implied volatility to rise again
after it has come down).
Don’t be discouraged by the
higher price of longer term
options. While they cost
more, longer term options
always exhibit a higher
“vega” — volatility
sensitivity, as well as a lower
“theta” — time decay rate.
This is exactly what you
want. You want high vega
because, when volatility goes
up, you want the options that
will respond the most. You
also want low theta so that
your position loses little to
time decay while you wait.
Your choice of strike depends
on risk preferences and
possible available bargains.
At-the-monies are more
conservative than out-of-the-
monies and have higher
vegas. Out-of-the-monies are
potentially more rewarding,
however, if the underlying
itself makes a volatile move,
because of their higher
leverage.
A good rule of thumb on
when to sell your straddle is
when implied volatility has
swung to the upper extreme
or at least returned to
“normal,” depending on the
pattern and how you want to
play it, or, when the straddle
has achieved your profit
objective. One thing you will
not want to do is continue a
straddle after one side has
become deep in-the-money
and the other side is almost
worthless. There are two
problems with this: 1) This is,
for all practical purposes, not
a straddle any more but a
single-option position, and
you are subject to the same
risk as a single-option
position. 2) Deep in-the-
money options and far out-of-
the-money options exhibit
almost no vega. When your
stock’s options finally do
show an increase in implied
volatility, your options will
not respond. So, if the stock
is still a good straddle-
purchase candidate, sell your
old straddle and buy a new
one.
As for a losing position, this
is a subjective matter, but I
would not use a stop loss. I
would continue to hold onto
the straddle until implied
volatility returned to
“normal.” However, if
implied volatility did not
return to “normal” before the
options had less than 20 days
to go, I would close out (or
adjust) the straddle early
because its vega will have
deteriorated.
As a final example, we will
have a look at Disney. It has
an apparent I.V. floor level of
24%. If you were to have
purchased a Disney straddle
both times Disney’s I.V. fell
to 24%, and then sold when
the I.V. rose to about 30%,
your results would have been
as follows:
30% was selected as the
upside target because, while
volatility went as high as 38%
one time, it only reached 30%
another time. This illustrates
the point that sometimes it
might be safer to set your
volatility target at about
“average,” and not wait for
volatility to swing all the way
to its previous extreme.

Miscellaneous Special
Situations
Sometimes when looking
through the charts you can
come across some unique
situations. We picked out two
to show here:
The first, BellSouth Corp.,
shows an interesting “lag”
tendency. Its implied
volatility seems to lag behind
statistical volatility by
approximately one month.
With statistical volatility very
high at the end of this period,
and still rising, we would
consider buying a straddle to
benefit from the increased
option premiums when
implied volatility eventually
catches up, presuming it will.
(Even if implied volatility
never rises, the increased
volatility now evident in the
stock should help our
straddle).
So, on January 19, 1990, with
the stock at 52-5/8, we may
have bought the Feb 50 calls
@ 3-1/4 and the Feb 55 puts
@ 2-5/8. In the ensuing
weeks this stock went
nowhere, and unfortunately,
by February expiration we
would have had to close our
position. With the stock at
52-5/8 on that day, we would
have sold the Feb 50 calls @
2-5/8 and the Feb 55 puts @
2-3/8, a net loss of 15%.
We’re only being honest with
ourselves when we admit that
these things don’t always
work out.
The second example is Ford.
Even though the volatility of
the market in general has
risen dramatically by the end
of this period, Ford
volatilities haven’t risen at
all. They should. One of
Fischer Black’s observations
about volatility (easily
confirmed) is that “the
volatilities of different stocks
tend to change together in 1
the same direction.” The
implication of this is to buy a
Ford straddle immediately,
expecting that Ford options
will eventually rise in
sympathy with the rest of the
market.
So, on January 19, 1990, with
the stock at 44-3/4, we may
have bought the Feb 45 calls
@ 5/8 and the Feb 45 puts @
1-1/2, for a net cost of 2-1/8.
Implied volatility soared the
following week as Ford stock
dropped to 41-1/2. At this
point we may have sold the
straddle for a net 3-1/2, a gain
of 65%.

Volatility Skewing —
The “out-of-the-
money” Phenomenon.
Ever since the panic of 1987,
index options have exhibited
what is generally called
“volatility skewing”. Out-of-
the-money puts trade at
progressively higher implied
volatility levels the farther
out-of-the-money you go. At
the same time, out-of-the-
money calls trade at
progressively lower implied
volatility levels the farther
out-of-the-money you go. At
times this “skewing” is worse
than at others, but currently a
difference of 6 percentage
points from at-the-money to
far out-of-the-money is
typical.
One hypothesis for this is that
institutional portfolio
managers, buying protection
for their long stock positions
through purchased puts
and/or sold calls, continually
drive the market makers near
their position limits in these
options. Being near their
position limits and not
desirous of taking on any
further short puts and/or long
calls, the market makers shift
their prices accordingly.
Another plausible explanation
is the idea that the market
seldom ever makes an
upward move as dramatic as
many of its downward moves.
Maybe so, but does Wall
Street have that good of a
memory? The position limit
hypothesis is a more solid
reason. As to why October
1987 marked the starting
point for the phenomenon, it
is probably because the panic
sell-off did such terminal
damage to “portfolio
insurance” as a method of
risk control, increasing the
need for index puts and calls.
Whatever the cause, this
volatility skewing is
unnatural and represents a
profit opportunity.
The first strategies that
suggest themselves are put
debit spreads and call credit
spreads, since both of these
would involve selling an
option that is priced “too
high” relative to the option
that you are buying.
Unfortunately, both strategies
are inherently bearish, and
unless you are bearish on the
market you may have to do
some “ratioing” to take the
bearish bias out. Ratioing will
introduce naked options into
the picture, with their high
margin requirements and
more or less undesirable risk.
Consequently we will look at
the following example two
ways, one with and one
without ratioing.
On January 2, 1990 the OEX
was trading at around 336.00.
The just-out-of-the-money
Jan 330 puts were trading at
2-3/8, an implied volatility
level of 19%. At the same
time, the much farther out-of-
the-money Jan 315 puts were
trading at 3/4, an implied
volatility level of 24%. Had
the 315’s been trading at the
same volatility level as the
330’s, they would have been
nearly worthless. Hence there
was an opportunity to buy a
spread between these puts for
1-5/8 which should have cost
2-1/2 or more. (This trade
was not found in hindsight.
The author actually noted this
particular opportunity and
remarked about it to several
people the same day).
In subsequent days, with the
market moving briskly lower,
the value of this spread grew
to its eventual maximum: 15.
However, the fact that the
market moved the right way
was just “luck” as far as
we’re concerned. If the
market had moved higher we
might have lost money. The
point is that with options on
the same asset trading at such
disparate levels relative to
each other, the probabilities
favor the investor in the long
run who takes such positions
(maybe a 60% - 70% success
rate). It’s like spinning
quarters on a table. They
come up tails some of the
time, but because of a slight
weight displacement they
come up heads much more
often.
You can play the spread this
way (1:1), and count on
losing 30-40% of the time, or
you can “ratio” away the
market risk. This involves
selling a greater number of
the far out-of-the-money
options than the near-the-
money options bought. The
optimum ratio is easily
computed if you have
computer software to tell you
the “delta” of each option. On
the day we open this position
the delta of the near-the-
moneys was 42 and the delta
of the out-of-the-monies was
11. This indicates a nearly
perfect 4:1 ratio. You sell 4
out-of-the-monies for each
near-the-money you buy.
What this gives you is a
temporary immunity to price
changes in the underlying;
temporary because with the
passing of time and with new
price levels in the underlying
comes new option deltas.
Hence you will have to keep
an eye on this kind of
investment and make
occasional adjustments to
bring it back to “delta
neutral.”
With the market falling so
rapidly after January 2nd, a
ratio spread between the two
options cited above would
have probably fared worse
than a simple 1:1 spread,
because the falling market
would have forced you to
adjust your position one or
two times — buying in the
315’s at a loss or buying
more of the 330’s at
increasingly higher prices.
However, this occurrence is
probably more the exception
than the rule. Ratioing can be
worth the trouble for those
who have sufficient collateral
to do naked writing, because
it amplifies the advantage of
the mispricing while reducing
your exposure to price
changes in the underlying.
Those who do naked writing,
however, should be fully
advised of the attendant risks.
(The author is not liable for
suggesting that you employ
naked writing).

Part IV. Conclusion

Options trading has been
compared to playing a 3-D
chess game. Indeed there are
three primary dimensions to
options trading: price, time,
and volatility. Everyone is
familiar with thinking of
options in terms of price —
using one strategy or another
to take advantage of an
expected price change in the
underlying. I call this the
“price game.” Success with
the “price game” requires
good skills at predicting price
swings.
There is very little that can be
done with the second
dimension — time — as it
has no fluctuations, only a
steady forward progress.
Certainly we have to deal
with time, and we can pick a
strategy that we believe puts
time on our side, but we
cannot make a “game” of
time.
The only other thing we can
make a “game” of is
volatility. Very few traders
are used to thinking of
profiting from options in this
way. However, volatility
itself ebbs and flows like a
price, and you can take
advantage of these
fluctuations using options.

- - - - - - - - - -
Options Markets, by Cox and
Rubinstein, Prentice-Hall
Inc., p.280, section “Fischer
Black’s Approach to
Estimating Volatility.”

- - - - - - - - - -
The author, Len Yates, is the
founder and president of
OptionVue Systems
International Inc. of Vernon
Hills, Illinois.
Since March 1983,
OptionVue Systems Int’l has
been developing investment
software for professional
money managers, traders, and
serious private investors, with
a focus entirely on options.
Although a small company,
OptionVue Systems Int’l
provides a very personal level
of support and service, and
works from an intimate
knowledge of the business.
Prior to founding OptionVue
Systems Int’l, Len Yates
worked as a software
engineer at Tandem
Computers for 2 years.
Prior to Tandem, Len was a
hardware and software
engineer at IBM Corp. for 6-
1/2 years, where he was
promoted three levels, to staff
engineer, in just 4-1/2 years.
Len has been an active
options trader for many years.
He has studied corporate
finance, and financial models,
since the founding of his
company and has made
important contributions in the
field of options pricing
models — the most notable
being the “Yates adjustment”
to the popular Black/Scholes
model as applied to American
style puts. By accounting for
the possibility of early
exercise, this model has the
advantage of both speed and
accuracy, mutually exclusive
qualities with other models.
Len holds a Bachelor of
Science degree in Electrical
Engineering from Purdue
University, with top 5%
honors.
 Jeffrey Korzenik
Reprinted from
Futures Magazine
Option Strategy
Oster Communications
Inc.
219 Parkade
Cedar Falls, Iowa
50613
Seasonal Option
Volatility Trends In
The Grain Markets
The following article
provides more information on
tendency of volatility to
expand in the grain markets
during the summer months,
that we have discussed in
several places in this month's
newsletter. We also
recommend an excellent book
on this subject --
“Agricultural Options-
Trading, Risk Management,
and Hedging.” You can order
this book from our office for
$49.95 + $5 P&H.

Playing Volatility
Seasonality
by Jeffrey Korzenik
Futures traders know many
agricultural commodities are
more volatile at certain times
of the year. Weather and
other seasonal factors affect
volatility.
Most options players are
aware of the key role of
implied volatility in trading.
Oddly, little has been done on
combining the option trader's
approach to volatility with the
ag trader's awareness of
seasonality.
Analyzing the seasonality of
volatility can help strategy
selection. Certain periods
point to "long volatility"
strategies, others favor "short
volatility" plays. One
commodity clearly showing
seasonal volatility traits is
soybean volatility to move
with the seasons, based on
data from 1970 to 1989.
Readings above zero show
the 20-day historical volatility
tends to be above the year's
average. Negative readings
reflect below average
volatility. The index
measures relative volatility in
each year. Years of extreme
volatility (like 1988) do not
skew the chart unjustly.
The index, scaled from -1 to
+1, measures the significance
of seasonal tendency. The
strong peaks correspond to
North America's summer.
The changes in market
volatility can be translated
into the implied volatility of
the options to some degree.
An options on September
soybean futures with 30 days
to expiration, for example,
typically would show higher
volatility than a May option
with the same time to
expiration.
This adds a twist to option
evaluation. Consider March
1, 1990. Options on May
1990 soybean futures settled
with an implied volatility of
about 13 while the September
1990 options implied 20. This
difference doesn't mean one
was overvalued. It means
from March 1 to option
expiration, prices should be
more volatile for September
options than for May because
of the seasonal pickup into
the summer.
In June, with peak volatility
periods for soybeans just
ahead, option traders can take
advantage of potential
increases in implied
volatilities through "long
volatility" strategies, which
range from simple long
call/long put strategies to
sophisticated ratio spreads.
This could consist of buying
options: Calls for bulls, puts
for bears and straddles or
strangles (involving calls and
puts) for those neutral.
Because you anticipate a rise
in implied volatility, the
option should have
substantial life left.
In soybeans, options on the
September 1990 contract are
preferred because their
implied volatility he is most
likely to increase before
expiration. Any pickup in
implied volatility mitigates
time decay. It "buys" the
trader time to wait for the
underlying price to move.
Traders should expect
volatilities to peak near the
end of July. While levels
reached 70 in 1988, a more
reasonable target would be
30. A trader who went long
volatility below that level
should liquidate when the
target volatility is achieved or
the period associated with
peak levels arrives. Traders
putting on a position after this
peak should favor "short
volatility" strategies. You
could liquidate the long
volatility position and switch
into a short option (a short
put for bulls) or "leg" into a
vertical spread. The latter,
selling short a more
expensive option, can
eliminate the long volatility
exposure of the original.
Jeffrey Korzenik is an
assistant vice president
specializing in agricultural
markets at PaineWebber
Futures.
 George Tzakis
Reprinted from
Futures Magazine
by George Tzakis
Oster Communications
Inc.
219 Parkade, Cedar
Falls, Iowa 50613
Volatility as a
Trading Vehicle
Trading volatility in
agricultural options can be as
rewarding as playing
directional change, especially
moving into a growing season
when the prospects of
drought or lack of one can
make traders edgy.
The two types of volatility
most often used in making
trading decisions are
historical and implied
volatility. Historical volatility
is based on the range of
movement of the underlying
future; implied volatility is
the option market's opinion of
expected price movement,
reflected in the premium of
an option.
The impact of a change in
volatility on an option's
premium is measured by
vega, the rate of change of
volatility with respect to
price. Because put and call
options of the same strike and
expiration have roughly the
same volatility, they also
have equal vega. This change
in premium, or vega, is
affected by three factors:
price change, volatility
change and time.
The soybean market in the
spring of 1988 illustrates
volatility's effect on an option
premium. On May 19,
November soybean futures
traded between $7.81 and
$8.08 per bu. Implied
volatility on this date
averaged 0.26.
Anticipating rising volatility,
you could have bought the $8
straddle (simultaneously
buying and selling both a put
and a call of the same strike
and expiration) in the
November soybean options.
Buying this $8 at-the-money
straddle, shows little market
bias. This strategy anticipates
either a large futures price
move or a volatility increase.
The vega of the straddle at
this point was 4¢ (per
percentage point increase in
volatility): The put has a vega
of 2¢. With 147 days until
option expiration, futures
closed at $7.82 and the
straddle at $1.05. Let's
assume the straddle could be
purchased for $1 ($5,000 per
contract).
Two weeks later November
soybean futures were at
$8.60. The $8 straddle closed
at $1.35 with an implied
volatility of 0.35. When
purchased, the straddle was
slightly bearish the market
because futures were 20¢
under the strike price. After a
90¢ rise in futures, the profit
of 35¢ can be attributed
solely to the volatility
increase. The vega of the
straddle was 4¢, volatility
gained by 0.09, and the
straddle's value increase by
35¢ or a total of $1,750.
Going into late spring this
year, similar opportunities
will arise. Remember to
compare implied to historical
volatility. Simply put, when
deciding to buy or sell
volatility, know if implied
volatility is in line with the
market. Be aware of trends in
volatility as well as prices.
George Tzakis is an analyst
and a broker for CAPCOM
Futures Inc., futures
commission merchants
headquartered in Chicago,
Ill.
 John C. Nelson
Reprinted from
Futures Magazine
by John C. Nelson
©1989 Oster
Communications Inc.
219 Parkade, Cedar
Falls, Iowa 50613
Using Implied
Volatility to Measure
an Option's Value
When most options traders
speak about volatility, they
are referring to a measure of
how much a market has been
moving.
“Dead” markets have low
volatility; “hot” markets high
volatility. This definition is
sometimes referred to as
historical volatility or actual
volatility. This is something
very different, however, from
implied volatility, which is
useful in option trading.
Volatility is expressed as a
number similar to a stock
index. Its value is almost
always between 0 and 1 and
usually falls between 0.10
and 0.50 for most markets.
When a market begins to
“heat up,” its volatility will
increase.
Volatility values, while acting
like an index, are not
comparable from market to
market, however. The fact
that volatility for soybeans
might be twice that of
Treasury bonds does not
provide much information for
making a profitable trade.
Percentage Error
Volatility is often expressed
as a percentage. This is
unfortunate because this
practice has led to some
common misconceptions
concerning the interpretation
of volatility.
The best way to use volatility
information is to treat it as an
index - a number that
measures variability in the
market. When that number
goes up, the market has
become more active; when
that number goes down, the
market has become less
active.
Five factors affect the price of
an option. When values for
these factors are used as
inputs to an option-pricing
formula, a mathematical
model, the result is a
theoretical value (sometimes
called a fair value) for that
option under those particular
conditions.
Of option pricing factors,
market volatility is the only
one that is not known
precisely. The other four
factors are always known.
Market volatility is not
known so precisely because
many different methods can
be used to measure it. Each
method used can give a
different volatility value,
resulting in a different
theoretical option value from
the option-pricing formula.
A one-to-one relationship
exists between different
levels of volatility and
different theoretical option
values when the other four
option-pricing factors are
held constant.
Because of this, you can use
the option-pricing formula "in
reverse" to find a volatility
level that makes a certain
option worth a certain price
(usually the current market
price). This volatility level is
the one that makes the
option's current price a "fair"
price.
Although option-pricing
models were designed to
produce a theoretical value or
price for an option, their
greatest worth is in
calculating implied volatility.
The arithmetic involved in
calculating implied volatility
is tough. Option-pricing
formulas are so complex that
the only way to go about
calculating implied volatility
is by trial and error.

'Guess' computations
An initial "guess" for implied
is made, and the resulting
theoretical value is compared
to the actual option price. If
the theoretical value is too
low, then the volatility
"guess" is too low. On the
other hand, if the theoretical
value is too high, then the
volatility "guess" is too high.
The process is repeated over
and over until the volatility
"guess" results in a theoretical
value equal to the current
market price for the option. It
is not hard to believe that this
process is next to impossible
if you don't use a computer.
Every different price that an
option trades at in the market
has a unique implied
volatility value if the other
four option-pricing factors do
not change. This is how
option positions can change
in value even though the
underlying instrument does
not.
Although calculating implied
volatility is hard, interpreting
it is not, even though a lot of
explanations that exist make
it seem so.
For some options traders,
implied volatility is the only
market factor they trade.
First, two simple definitions:
The intrinsic value of an
option is the value it would
have if exercised
immediately; the extrinsic
value of an option is its
current price less its intrinsic
value.
For example, if November
soybean futures are trading at
$7.60 per buy., a November
750 call has an intrinsic value
of 10¢, regardless of its
market price. If that call is
trading at 52¢, then it has an
extrinsic value of 42¢ (52¢ -
10¢).
The intrinsic value is the
amount an option is in the
money. The extrinsic value of
an option is the amount of its
value that is not in the money.
Extrinsic value is sometimes
called time value because the
time remaining for the option
to make a move is the key to
its worth.
Intrinsic values are
determined by the underlying
market. Extrinsic values are
determined by the option
market. When one changes,
the other may or may not
change.
When a market starts to move
or “heat up,” traders are
more uncertain about what
might happen. When this
happens, options become
more valuable, and option
prices go up. This is because
chances are greater that any
one option might come in the
money.
When option prices change in
this way, it is the extrinsic
value of the option that is
increasing. For any price in
the underlying market, a
certain intrinsic value will be
the same, whether the
underlying market is active or
not.
In addition to a one-to-one
relationship between option
prices and implied volatility
for a given underlying price,
a similar one-to-one
relationship exists between
option prices and extrinsic
values for a given underlying
price.
This leads to the following
definition: Implied volatility
is a measure of the extrinsic
value in an option price. For
example, the November 750
soybean call with an extrinsic
value 44¢ and about seven
months to expiration
translated to an implied
volatility 0.21.
Why is this number
necessary? We already know
the extrinsic value to be 42¢.
What does this 0.21 do for
us?
When expressed as an
implied volatility, the
extrinsic value does not
depend upon intrinsic value
or time. With three months to
expiration, this option might
be trading at 44¢. This is
certainly a lower price than
52¢ and a lower intrinsic
value (34¢) than 42¢.
However, implied volatility
also is higher at 0.26. This
option, now at 44¢ with three
months left, is actually a
"more expensive" option than
when it traded at 52¢ with
seven months left.
When options become more
valuable, implied volatility
for those options goes up
because their extrinsic value
goes up. When fewer option
buyers are in the market,
implied volatility goes down.
It this way, implied volatility
also is a measure of the
supply and demand for
options.

What's high or low?

When implied volatility is
"high," options are
"expensive." When implied
volatility is "low," options are
"cheap." How high is "high"
and how low is "low" is
different from market to
market and should not be
compared among markets.
Before the stock market
crashed in October 1987,
implied volatility for options
on Standard & Poor's 500
Index futures routinely was
between 0.18 and 0.23. Soon
after the crash, it was more
than 0.40 and stayed above
0.30 until well after the start
of 1988. This was "high" for
this market. Anything less
that 0.15 probably would be
considered "low" for this
market by most options
traders.
Sugar and copper markets, on
the other hand, will see
implied volatility near 0.50
on a daily basis. For these
markets, implied values
below 0.30 indicate relatively
"cheap" options and implieds
above 0.70 are on the
"expensive" side.
Options often are compared
to insurance. Insurance is no
different than any other
product that is bought and
sold in that it is subject to the
laws of supply and demand.
When demand is low, the
price goes down; when
demand is high, prices go up.
Implied volatility measures
the price of options on a scale
that does not depend upon
strike price, underlying price
or time.
Just like trading the
underlying market, the goal in
trading options is to buy low
and sell high. In options
trading, buy implied volatility
low and sell it high.
John Nelson is director of the
Options Group for Oster
Communications Inc. in
Chicago.
 Marc Clemons
The Rules of The
Game by Marc
Clemons
Reprinted by
permission of
OptionVue Systems
(708) 816-6610
Successful options trading is
a combination of market
knowledge, technical analysis
and discipline. The
integration of OptionVue IV
with market knowledge will
provide traders with the
analytical tools necessary to
make prudent decisions.
One element of options
trading that is rarely
discussed is “The Rules of
The Game.”
Here are ten rules I
consider essential to
profitable options
trading:

1. When trading, think
about how little you will
lose when you are
wrong, not how much
you will make if you are
right.
2. When you are wrong,
exit your position. It is
better to take a number
of small losses than two
or three big hits which
will bankrupt you. You
will live to trade another
day.
3. Increase your profit
sensitivity. Never let a
profit turn into a loss. If
you make a good trade
and have a profit, don’t
 try to hold on until the
top, take your profit and
be satisfied. If it starts to
move against you,
liquidate your position.
4. Determine your entry
point and stick to it. Do
not chase the market.
Cherries ripen every
day.
5. Liquidity is important.
Make sure the options
you are trading can
 support the size of your
position.

OptionVue IV provides you

with the average volume of
trades in an option for the
last four trading days, when
you use an automatic quote
service. Use this
information to your
advantage. If you manually
enter quotes, look up daily
volume as well as quotes,
and keep a record of it.


1. Utilize risk management

techniques. Select trades
with good risk/reward
characteristics. Do not
risk ten dollars to make
one.
2. Develop strategies based
on what the market is
giving, not what the
crowd is doing. Think
for yourself. Analyze the
 market and understand
the underlying pressures.
The market is a living
entity and it changes
from day-to-day. Just
because something
worked yesterday does
not mean it will work
today.
3. Use stop orders. If your
brokerage does not
accept them, find one
that does. Without stops,
 you subject yourself to
unlimited risk.
4. There is not room in the
options market for ego.
The market will tell you
what it thinks about your
opinion anyway.
5. Greed kills. The market
loves both bulls and
bears, but it eats pigs
alive.

Follow these rules and take

the time to learn as much as
you can about what you are
doing.
You have to accept the fact
that you will make some
wrong decisions.
Make sure you gain as much
knowledge as you can from
these decisions and then turn
them into profits the next
time round.
Copyright Premium Research
Group 1993, all rights
reserved.
 Larry McMillan
Reprinted by
permission of Larry
McMillan from “The
Option Strategist”
Published by the
McMillan Analyst
Corporation
P.O. Box 1323,
Morristown NJ, 07962
(800) 724-1817
Some Random
Thoughts on Option
Trading
The following is an article
from Larry McMillan’s
“Option Strategist
Newsletter” at the end 1993.
(For those of you not familiar
with my view of Larry
McMillan’s Option Strategist
Newsletter - This newsletter
provides some of the best
ideas on option trading
around). The following article
was particularly interesting
and I am in agreement with
his views:
“Some Random Thoughts On
Option Trading” by Larry
McMillan, The Option
Strategist, November 26,
1993.
After giving the matter some
thought, it seemed like it
might be beneficial to list
some of the “rules” that we
follow, either consciously or
subconsciously after all these
years. For the novice, they
may be eye-opening; for the
experienced option trader,
they may serve as a reminder.
These guidelines are not the
path to easy riches, or some
such hype, but following
these guidelines will
generally keep you out of
trouble, increase your
efficiency of capital, and
hopefully improve your
chances of making money
with options. They are not
presented in any particular
order.
Trade in accordance with
your comfort level and
psychological identity. If you
are not comfortable selling
naked options, then don't;
even though such strategies
are nicely profitable for some
traders, they should not be
used if they cause you
sleepless nights. If hedged
positions drive you crazy
because you know you'll have
a losing side as well as a
winning side, then perhaps
you should trade options
more as a speculator -
forming opinions and acting
on them accordingly. The
important thing to realize is
that it is much easier to make
money if you are "in tune"
with your strategies, whatever
they may be. No one strategy
is right for all traders due to
their individual risk and
reward characteristics, and
accompanying psychological
demands.
Always use a model. The
biggest mistake that option
traders make is failing to
check the fair value of the
option before it is bought or
sold. It may seem like a
nuisance - especially if you or
your broker don't have
realtime evaluation capability
- but this is the basis of all
strategic investments. You
need to know whether you're
getting a bargain or paying
too much for the option.
Don't always use options -
the underlying may be better
(if options are overpriced or
markets are too wide). This is
related to the previous rule.
Sometimes it's better to trade
the underlying stock or
futures contract rather than
the options, especially if
you're looking for a quick
trade. Over a short time
period, an overpriced option
may significantly
underperform the movement
by the underlying instrument.
Buying an in-the-money call
is often better than buying
the underlying instrument;
buying an in-the-money put
is usually better than
shorting the underlying. An
in-the-money option has a
high delta, meaning that it
moves nearly point-for-point
with the underlying stock or
futures contract. Furthermore,
the option's price contains
only a small amount of time
value premium - the
“wasting” part of the option
asset. Thus, the profit
potential is very similar to
that of the underlying
instrument. Finally, the risk is
limited by the fact that one
cannot lose more than the
price he paid for the option
(plus commissions), while
one has much larger risk
when owning or shorting the
underlying instrument.
Don't buy out-of-the-money
options unless they're really
cheap. This is really a
corollary of the above rule,
but it's important enough to
state separately. Obviously,
you can't tell if the option is
“cheap” unless you use a
model. If the out-of-the-
money option is expensive,
then revert to the previous
rule and buy the in-the-
money option.
Don't buy more time than
you need. The longer-term
options often appear, to the
naked eye, to be better buys.
For example, suppose XYZ is
50, the Jan 50 call costs 2,
and the Feb 50 call costs 2
3/4. One might feel that the
Feb 50 is the better buy, even
if both have the same implied
volatility (i.e., neither cone is
more expensive than the
other). This could be a
mistake, especially if you're
looking for a short-term trade.
The excess time value
premium that one pays for the
February call, and the
resultant lower delta that it
has, both combine to limit the
profits of the Feb 50 call vis-
a-vis the Jan 50 call. On the
other hand, if you're looking
for the stock or futures
contract to move on
fundamentals - perhaps better
earning or a crop yield - then
you need to buy more time
because you don't know for
sure when the improving
fundamentals will reflect
themselves in the price of the
underlying.
Know what strategies are
equivalent and use the
optimum one at all times.
Equivalent strategies have
same profit potential. For
example, owning a call is
equivalent to owning both a
put and the underlying
instrument. However, the
capital requirements of two
equivalent strategies (and
their concomitant rates of
return) can vary widely. The
purchase of the call will only
cost a fraction of the amount
needed to purchase the put
and the underlying stock for
example. However, the call
purchase has a much larger
probability of losing 100% of
that investment.
Naked put selling is
equivalent to covered call
writing, but is generally a
better strategy. We've
mentioned this often before,
but it bears repeating because
so many option traders don't
follow this rule, or don't
believe it. Both strategies -
naked put selling and covered
call writing - have limited
upside profit potential and
large downside risk.
However, the naked put sale
involves less of an investment
in terms of collateral
required, has a lower
commission cost, and allows
one to earn interest on his
collateral while the position is
in place. For these reasons,
naked put selling is the better
strategy of the two.
The option positions that are
equivalent to long stock (or
long futures) and to short
stock (or short futures) are
perhaps the most important
ones. Buying a call and
selling a put, both with the
same terms (strike price and
expiration date) produces a
position that is equivalent to
being long the underlying
instrument. Similarly, buying
a put and selling a call with
the same terms is equivalent
to being short the underlying
instrument. The next three
rules deal with these
equivalences.
The equivalent option
strategy may be better than
owning the underlying stock
itself. If one buys a call and
sells a (naked) put, his
investment is smaller than
that required to own the
stock, and the "investment"
may be in the form of
interest-earning collateral.
The equivalent option
strategy is better than selling
stock short, and of course is
the only way to completely
short an index. The option
strategy not only has the
advantage mentioned above,
but does not require a plus
tick to establish the short
position. As for the index, it
theoretically might be
possible to short the index by
shorting every stock in the
index, but that would be
almost impossible because of
the uptick requirement.
The equivalent option
strategy is mandatory
knowledge for futures
traders, for it allows one to
extricate himself from a
position that is locked limit
against him. When futures
are locked limit, the options
will generally still be trading.
The prices of the options
provide a price discovery
mechanism, in that one can
see where the futures would
be trading were they not
locked at the limit.
Furthermore, one can take an
equivalent option position
opposite to his (losing)
futures position, and
effectively close out the
position at the current loss
without risking further limit
moves on succeeding days.
Naked combo selling in
indices is usually less trouble
than selling combos in
individual futures or equity
options. Selling both puts and
calls is an attractive strategy
to many option traders, since
the benefits of the wasting
asset are on your side.
Unfortunately, large or
sudden moves by the
underlying instrument can
create some nasty surprises
for the option writer. One
way to counter this is to
concentrate the option selling
in index options. The broader
the index, the less likely it is
to experience a gap opening.
There cannot be a takeover
attempt on an index nor can
an individual earnings report,
for example, cause the index
to move a great distance as it
can for a stock. For the index
to gap, many of the stocks
that comprise the index
would have to gap as well;
that might be possible in a
very narrow-based index, but
is quite unlikely in a broad-
based one. These statements
generally apply to U.S.
indices; indices on foreign
markets (JPN or FSX, for
example) gap virtually every
day since the actual trading in
those markets is occurring
while the U.S. markets are
closed.
Trade all markets. There are
strategic option opportunities
in all markets - equities,
indices, and futures. To
ignore one or two of these
just doesn't make sense. The
same principles of option
evaluation needed to
construct a statistically
attractive strategy apply
equally well to all three
markets. Furthermore, there
are often inter-market hedges
that are extremely reliable,
but in order to take advantage
of them, one has to trade all
of the markets.
Trade in accordance with
your comfort level and
psychological identity. This
is the first and last rule and,
ultimately, the most
important one.
 C&S Marketing
Soybean Market
Seasonal Volatility
Spikes
Deltas, theoretical values,
rhos, time depreciation,
vegas, premiums, disparity,
gammas, strikes, standard
deviations, thetas, volatility,
etc. The options world has
successfully created a stream
of jargon and technical terms
that is sure to drown all but
the extreme professional
traders. Keeping your head
above water and staying
abreast of the terms
definitions and applications
can appear a full time
endeavor.
While it is true that options
are more complicated than
straight futures, a Ph.D. is not
required to trade options
successfully. The basic recipe
for option trading only has
three main ingredients. The
first and most essential
element is an understanding
of buying and selling both
puts and calls. The final two
critical components are a
comprehension of time decay
and volatility.
Time decay is a relatively
straightforward concept. All
options are wasting assets. If
you buy an option, time
decay hurts your position. It
slowly erodes part of the
value of your option. If you
sell an option, time benefits
your trade. It continually
whittles away at the premium
(price) of the option. To
consistently trade options
successfully, you must
account for the impact of
time.
Volatility is the final crucial
ingredient. Volatility is
perhaps the most
misunderstood and misused
concept in option trading.
There are two key types of
volatility, statistical (often
called historical) and implied.
Statistical (often called
historical) and implied.
Statistical volatility is simply
the measure of how volatile
the futures have been. If the
futures market has made wild,
erratic swings, the statistical
volatility will be high. If the
futures have been quiet, the
statistical volatility will be
low.
Implied volatility is the
option markets attempt to
predict how volatile the
market will be in the future. If
the option traders believe the
futures may undergo large
erratic moves, they
compensate by raising the
price of the options to counter
the anticipated price swings.
Conversely, if the option
traders believe the futures
market will be in a quiet,
consolidating trading range,
they will lower the price of
options.
In summary, implied
volatility is a measure of the
nervousness in the options
market. If implied volatility is
increasing, option premiums
(prices) expand. If implied
volatility is decreasing,
option prices decrease.
Volatility is just like price.
You want to buy options
when volatility is low and sell
options when volatility is
high. (Buy low, sell high.)
The summer months hold a
great deal of uncertainty for
the grain markets. Corn and
soybeans are extremely
susceptible to problems such
as drought, flooding. Disease,
and insect infestations. This
volatile period creates and
excellent atmosphere to
examine the effects of
increasing volatility on option
premiums.
To compensate for the
vulnerability of the crops, the
implied volatility seasonally
expands greatly into the
summer months. The option
traders simply become
nervous that the price could
explode. So, they raise the
price of the options to give
themselves some extra
cushion in case a major
problem does occur.
In Figure 1, we have the
Soybeans weekly chart. In
seven years, the futures
sustained a significant
summer rally only three times
(1988, 1993, 1994). Now
compare this chart with the
charts on Page 3. These
charts depict the implied
volatility for the Sept.
Soybean contract from 1988
to 1995. As you can see, the
implied volatility has
expanded every year, even
though only 3 out of the 7
years saw a significant
futures rally.
The implied volatility
expanded in years when the
futures made no sustained
move because implied
volatility is a measure of
nervousness. Even though a
drought did not occur, the
possibility of a drought still
existed. So the option sellers
demanded a higher price to
protect themselves. Hence,
the implied volatility
increased.
If we further examine the
charts on Page 3, we can
determine the average
implied volatility increase has
been around a 29%. The
smallest increase was
approximately 16% in 1990
and the largest increase was
over 50% in 1988. The real
question is, what impact does
this implied volatility
increase have on option
premiums?
In Figure 2, we answer that
question by examining the
price of a Sept. 600 Soybean
call under different volatility
levels. The 600 call is
currently trading at .17 or
$850 (.17 x 5000 bu,
contract). The Sept. average
implied volatility is running
16.60%.

In order to create a realistic

analysis, we must take time
decay into account.
(Remember time decay
continually erodes away at
option premiums.) For all of
our studies, we will use an
evaluation date of July 1.
This date represents the
average date at which the
volatility peaked.
In our first example, we will
hold volatility and price
constant and simply examine
the effect of time decay. The
time decay will erode the
premium by .14 3/4 (.17
initially less .02 3/4). In
column 2, we only increase
implied volatility by 16%.
(The lowest increase.) In
column 3, we examine the
impact of an average
volatility increase of 29%.
Notice that with only an
average volatility increase the
negative affects of time decay
are totally offset. Finally, in
column 4, we examine the
impact of a volatility increase
of 50% (The largest increase
in the past seven years.) In
this situation the 600 call
would have expanded by .23
1/4, despite time decay,
resulting in a profit of
$1162.50 (.23 1/4 x 5000 bu.
contract) to the option
purchaser!
It is important to remember
that we held the futures price
constant at current levels.
Yes, it is possible to make
money on an option purchase
even if the futures do not
move in your direction! The
reason option purchases are
so attractive during the
summer months is because
the seasonal volatility
increase greatly reduces your
exposure. If the price does
explode, you will not only
benefit by price movement.
The volatility increase should
be substantial, raising profits
even further. Armed with a
knowledge of volatility, you
can trade with additional
leverage, and still maintain a
limited risk posture.
In the upcoming months, we
will be featuring additional
trading strategies designed to
exploit summer grain
volatility. We encourage you
to keep in touch and stay
abreast of all your
alternatives for this excellent
seasonal opportunity.
 David L. Caplan
Using Probability of
Profit and Gaming
Theory in Trading
by David L. Caplan
Reprinted by
permission of David L.
Caplan
Several years ago, I began to
research the similarities
between gambling and
trading, particularly in the
areas of money management
and probability of winning
(or profit). I presented the
outlandish concept at one of
my seminars, that traders
should consider principles
long used by successful
gamblers. One of the
participants complained:
“How can you compare
gambling to trading? What
could they possibly have in
common?”
After thinking about it for a
moment, I answered: “You’re
right. By comparing a
professional gambler to a
trader, I was doing the
gambler a disservice!” The
professional gambler always
knows the odds before
making a bet; most traders
don't analyze probability at
all. A professional gambler
plays only when the odds are
in his favor.
One of the first authors to
consider the relationship
between gaming and trading
was Edward Thorpe, who at
one time was a successful
gambler and trader. He states
in his classic book, “Beat the
Dealer”: The similarity
between the casino and
(trading) is striking... The
advantages... for one side or
the other on occasion even
reaches 100%.”
Then, in 1992, while reading
“Market Wizards,” I realized
that many top traders had
previously been successful
gamblers, and poker or bridge
players. What trading rules
did they all have in common?
They learned from their
gambling rules to trade only
when they were certain that
the odds were tilted heavily in
their favor. They traded only
when ‘special’ situations
were present. They were not
in the market every day. They
waited for the times when the
odds (probabilities) favored
them.
In 1994, the Nobel Prize in
economics was awarded to
researchers who used gaming
theories to accurately predict
future economic events. I
realized then that the same
theories of money
management and probabilities
applied to both gambling and
trading. THE ONLY
DIFFERENCE WAS
THAT WHILE ALMOST
ALL TOP GAMBLERS
REALIZED THIS, MOST
TRADERS WERE
UNAWARE OF THESE
PRINCIPLES!
We have reported our
findings of the use of gaming
theory and probability in our
“Trade Like A Bookie”
manual and newsletters.
Professional gamblers know
the odds on every bet they
make; if they’re holding a
pair of aces in draw poker,
they know the odds of having
the best hand before the draw;
and after the draw they
recompute the odds of having
the best hand based on
whether they have improved
or not, and the number of
players in the game. Then
they can make a decision on
whether they should bet, call
or fold based on the amount
of money in the pot and the
odds of having a winning
hand. Virtually every
advanced book on gaming
theories or methods discusses
probability in one way or
another.
One of the most useful
descriptions of probability in
gaming is in the book
“Thursday Night Poker,” by
Peter Steiner: “Propositions
in probability sometimes
seem like...highly esoteric
mathematics, but this need
not be the case. YOU MUST
BE ABLE TO COMPARE
POT ODDS (THE SAME AS
YOUR POTENTIAL
WINNINGS IN A TRADE)
WITH PROBABILITY
ODDS TO KNOW WHEN
OR WHETHER, IT MAKES
SENSE TO CALL A BET
(MAKE A TRADE).”
On the other hand, very few
traders consider probability at
all in their trading plan, and
even fewer know their
probability of profit before
they enter a position (How
many traders would purchase
an overvalued, out of the
money, close to expiration
option, if they knew the
probability of profit was less
than 5%?)
The reason for this is less
mysterious, when you
consider that almost no
futures or options books
mention probability at all; the
few that do give it either
fleeting notice, or a technical
explanation, with no clue on
how to use it in your own
trading. The best explanation
of probability in trading is in
the book “Winning in the
Options Market” by Allan
Lyons, who accurately states:
“Probability is the basis of all
investing.’
However, even this book does
not accomplish what we think
is most important: telling
traders how to use probability
to improve their own trading
and how to find option
strategies with the highest
probabilities of success.
USING
PROBABILITY OF
PROFIT TO YOUR
ADVANTAGE
We use ‘probabilities’ to our
advantage as much as
possible in our option trading.
First, we must identify the
most undervalued and
overvalued options, or
premium disparity. Our
analysts and computer
programs then search for
positions and strategies that
have a probability of profit
that is substantially in our
favor. What does this mean?
Probability of profit is
determined by computer
programs which calculate the
volatility and previous range
of the futures contract and
then determine the likelihood
of the options we are buying
or selling having any real
value at expiration. Normally,
when you buy or sell a
futures contract or stock, your
probability of profit is 50%.
Your probability of profit can
be as low as 10% or less if
you buy an overvalued
option, and of course, this the
reason that we like to sell
these options.
Trades with the highest
probability of profit are
usually Ratio and Calendar
spreads which take advantage
of premium disparity, and
Neutral Option Positions
created by selling the most
overvalued puts and calls.
This is because it is not
necessary to predict market
direction for Neutral
Positions, and (except for
large market moves or where
volatility increases), even if
one side of the Neutral
Position is losing, the other
side will be working in our
favor. Also, time value is
always working in our favor
every day. Sometimes an
option is so overvalued that
even a large move in its favor
will not help it gain value.
For example, during the first
3 weeks in July, the S&P 500
dropped almost 2000 points,
and while all call options lost
value, many out of the money
puts still lost value, because
of their overvalued premium
and time value decay. This is
our best circumstance,
because, then both sides are
working in our favor.
However, probability is not a
certainty, just a likelihood
that this will occur. I look at
this as similar to reliable
technical patterns, such as
“double bottoms,” “head and
shoulders patterns,” etc.,
which are also reliable a high
percentage of the time, but
are not perfect. That is why
we use money management
techniques such as “stop out
points” and adjustments to
our positions by “rolling” the
options up or down, if the
market moves outside our
expectations.
(This article is an
introduction to our latest
research into the practical
uses and theories behind
probability in trading. In
subsequent newsletters, we
will provide detailed
probability analysis for all of
the trading strategies we use;
discuss how money
management and “rolling”
your position can increase
your probability of success;
and look at how to integrate
probability with other trade
analysis factors - as Larry
McMillan correctly states in
his newsletter, The Option
Strategist, probability
analysis is important, but
“...figuring the probability of
profit is only part of what on
we must do in order to
evaluate a position.”)
Since probability is one of the
most important factors of
trade analysis, we make
certain that we know the
probability of profit on every
trade before we initiate it. We
use the ‘BookMaker’
software to quickly determine
this (a sample of
‘BookMaker’ analysis is
shown below).
The ‘BookMaker’ probability
analysis software is $195; the
entire ‘BookMaker’ program
including ‘Bookie’ rankings
and recommended position
adjustments is $495. Both of
these are available through
the Opportunities In Options
publication office at (800)
456-9699 or (805) 278-4350.
There is a money back
guarantee to allow you to test
this software for 30 days
without any cost or
obligation.
 CONCLUSION
When I began trading options
in 1982, I decided that I
would read and study all the
books that I could find on
trading principles so I could
choose which methods would
work best to become part of
my trading plan. What I
didn’t know then was that if
my education had been
strictly limited to this
information, my abilities as a
trader would have been
severely limited. While there
is no substitute for as
complete knowledge as
possible regarding all trading
methods, history of the
markets etc.; I have found
that other seemingly
unrelated areas, such as the
martial arts and the poker
table, provide important ideas
to greatly improve my
trading. In fact, I am certain
that any top option trader
must be part warrior, part
poker player and part
statistician to be consistently
successful.
When I began researching
option trading, I was very
excited because of the
mathematical possibilities of
combining options together,
and what I discovered as
certain characteristics that
seem to provide significant
benefits such as disparity in
volatility between option
strike prices and the decay of
overvalued options. However,
after reading all the material,
I felt almost helpless because
there was no “road map” to
guide my option trading from
that point on. It was trial and
error with my own money! It
was like reading all the books
available on becoming a
martial artist, and then having
to fight in a tournament
match without any real
“hands-on” training.
In fact, I thought back to my
own martial arts training.
While many of the
movements and “katas” were
flowing and beautiful, they
seemed unusable in an actual
bout. Since my natural ability
and speed was not of the
highest level, I thought it
would be impossible for me
to be successful using most of
the standard principles. I
began searching for other
ideas and methods and at that
time stumbled upon the
philosophies of Jeet Kune Do
which was first made popular
by Bruce Lee. If I had to
summarize the philosophy of
Jeet Kune Do in my own
words it would be “the most
effective way of winning.”
“Jeet Kune Do avoids the
superficial, penetrates the
complex, goes to the heart of
the problem and pinpoints the
key factors.” The Tao of Jeet
Kune Do, Bruce Lee.
This is how we structure our
own option trading methods
of using option volatility to
our benefit, and how we have
presented them in this book.
We have discarded the
unnecessary, complex,
unusable principles of options
and volatility and focused
only on the facts and
principles necessary to meet
our bottom line GOAL of
making money.
As you can tell from my
many references to Poker,
Sex and Dying, it is one of
my favorite books. The
closing paragraphs in this
book are particularly
reflective on trading (and
life). (I have added my own
trading references in
parentheses).
“When we are dealing with a
subject as explosive or
difficult as human personality
traits (different markets)
caution becomes necessary.
There are no absolutes. All
individuals (markets) are
unique. Every opponent
(market) is particularly
dangerous. We can, with a
certain degree of accuracy,
predict actions and reactions,
however we can not
definitively define how any
human being (market) will
react 100% of the time. In
many respects, insight,
knowledge and understanding
creates a pandora's box. The
more knowledge we acquire,
and the more understanding
we gain often only serves to
highlight the knowledge and
understanding that we don’t
have. The more we learn
simply teaches us that we are
always on the tip of the
iceberg and ironically, may
never be able to move beyond
that point. Expertise, be it
given, or solicited, is like a
jagged piece of glass in that it
is best handled with care.
“There are many aspects of
the human spirit (trading) that
can not be predicted or
measured. No one is an
expert when it comes to
predicting the higher qualities
of the human experience
(markets). Qualities like,
love, faith, hope and desire
can not be measured or
defined in terms of their limit
or their impact. At best, we
can only hope that we possess
these qualities for ourselves.
If there is one certainty in
life, it is that there will
always be uncertainty.
Acceptance and change are a
part of life. Our ability to deal
with it is directly related to
our success. Success is not a
mystery. It is easily defined.
If we have happiness and joy
we are successful. If we don’t
have happiness and joy then
any imaged success we think
we have is some day destined
to be a bitter pill that is called
an awakening. Ultimately the
game you play won’t matter.
What will matter is you, the
individual. Be brave, be kind,
be bold, find your happiness.
Give it your best at all times.
The results will speak... in
your defense and in your
honor. It is the mark of a
champion, in life and in poker
(trading).”
APPENDIX A
This information is believed
to be reliable, but can not be
guaranteed. Use it at your
own risk. Past performance is
not indicative of future
results. When an option is
sold, there is an unlimited
risk of loss, and when an
option is purchased the
premium plus commission is
at risk. There is substantial
risk of loss in all trading. Any
account may experience
different results because of
factors such as timing of
trades and account size.
Subject to change based on
market conditions.
 APPENDIX B
Charts Of Volatility
Of Future Options
OptionVue Systems
International
1117 S. Milwaukee
Ave. Suite C-10
Libertyville, Il 60048
Chart 1 and 2 are option
volatility charts of the corn
and soybean markets. They
both show the same summer
“volatility spike” that has
occurred every year for the
past 6 years in these markets.
Does this suggest anything to
you by way of option
strategies? Our favorite
strategies during the highest
option volatility periods are
“Ratio Spreads” to take
advance of the overvalued out
of the money options, while
still being able to profit from
the trend of the market. Then
in late summer, “Neutral
Option Positions” are favored
as the markets still have high
premium and are beginning to
enter a trading range. Finally,
in early spring we begin to
purchase option “straddles” to
take advantage of the
seasonal breakouts in price
and option volatility.
Chart 3 is the cocoa option
market that shows option
volatility ranging from 20%
to 48% over the last three
years. Volatility spikes
occurred only during
significant rallies in 1992 and
1994, when the market made
several year highs.
Chart 4 is crude oil options
showing a range from 10
1/2% to 38 1/2% over the last
three years. However, traders
should be aware that these
options have been as high as
100-130% during extremely
volatile times such as the
Gulf War!
Chart 5 is the cotton option
market showing a volatility
range of 15-25%. These
options have been relatively
illiquid and are very difficult
to trade.
Chart 6, 7 and 8 are the
German mark, Japanese yen
and Swiss franc. All of the
foreign currencies are trading
near historical lows in option
volatility. They were at
almost double these levels in
1987. Of further significance
in the foreign currencies is
that the underlying market is
as volatile as ever while
options are very “cheap;”
Therefore, we have
recommended (in early 1995)
that options not be sold
“naked,” but used for hedging
or option purchases only.
Chart 9 and 10 are the gold
and silver markets showing
these markets in a relatively
quiet range with option
volatility near historical lows
in both markets. This will
change quickly once these
markets become more active,
especially if a breakout is to
the upside. We can expect
volatility to rise to almost
double current levels. We will
then also see extreme
“disparity” in option premium
in the out of the money call
options.
Chart 11 is option volatility in
the live cattle market showing
the market making historical
lows in option volatility in
April 1994 and highs two
months later in June of 1994.
This volatility spike is a very
rare occurrence. It created
some of our best option
trading opportunities as we
purchased cattle put options
in April and used “Neutral
Option Positions” in the
summer of 1994 to capture
the high option premium. We
further noted in the beginning
of 1995, after cattle rallied
over 10%, that this rise was
not accompanied by any
increase in option volatility,
which usually means that the
bullish move is likely to fail.
Similar to cattle, the late 1994
rally in copper (chart 12) and
sugar (Chart 13) were also
not accompanied by increases
in option volatility at the end
of 1994. We expect both of
these rally attempts to
dissipate because of this non-
confirmation.
Chart 14 in coffee was an
example of option volatility
moving from historical lows
near 20% in April 1994 to all
time highs near 90% during
the summer rally. The trading
range in the futures with low
volatility led us to
recommend option
purchasing in April;
thereafter, Ratio Spreads were
recommended to take
advantage of the high option
volatility and disparity in
option premium for the out of
the money options during the
summer of 1994.
The derivative problems
caused treasury bond options
(chart 15) to rise to new three
year highs in May - June,
1994. However, other than
that increase, option volatility
drifted between 9 and 11%
throughout 1994.
Option volatility in the S&P
500 (chart 16) moved to near
all time lows in early 1995.
Also, significant disparities
were occurring in option
premium levels with at the
money puts and out of the
money calls trading at very
low levels; while out of the
money puts were trading
volatility levels of 50-100%
higher than corresponding
calls.
 BIBLIOGRAPHY
In addition to our
Opportunities In Options
newsletter, our trading
manual “The New Options
Advantage,” and “The Option
Secret,” the following are my
favorite books, newsletters
and publications on options
and general trading. I would
rate all of these books as
mandatory reading for anyone
who takes his trading
seriously. I have read and re-
read most of these books
several times. I would
particularly like to make
special note of the following
people and their writing:

1. Larry McMillan’s
“Options Strategist”
newsletter continues to
amaze me with the new
ideas and novel ways of
 looking at old trading
strategies that we have
often found to be
invaluable in our
trading.
2. Sheldon Natenburg’s
“Option Volatility and
Pricing Strategies” is an
excellent advanced work
on option volatility.
3. Jim Yates’ articles
comparing gambling to
trading options provide
 great insights into how a
trader’s thought process
should work in the
important area of money
management and trade
filtering.
4. Sid Woolfolk's
agricultural option
newsletter (C&S
Marketing) is similar to
Larry McMillan’s in
providing great analysis
and ideas in the ag and
 livestock markets.
5. “Market Wizards;”
“Supertraders;” “The
New Market Wizards.”
These books track the
success and methods
used by some of the top
traders in the world. I
learned from their
methodology, and found
these books to be
inspirational in my own
trading.
6. “Poker, Sex and Dying,”
a one-of-a-kind book, is
one of the most
influential of all works
that I have read
providing keen insights
on trading and a winning
gambler’s philosophies
that are no different for
that of a successful
trader. DO NOT MISS
THIS ONE!
7. “Gambling Theory and
Other Topics” by Mason
Malmuth discusses how
top gamblers can
“...consistently make
decisions that devastate
their opponents..and
what is necessary to
become successful at
this challenging
occupation.” (Not any
different than the skills
necessary to be a top
trader). Discussion of
the “dynamic concept of
self weighing strategies”
is probably the best
discussion of this
essential area of money
management that I have
ever seen. The author
describes this book as
“...must reading for all
serious gamblers. Many
of these concepts are
necessary to assure
survival and success in
this extremely dangerous
but rewarding
profession.” I must say
that this applies for all
traders, also. Don’t pass
this one up, either.
(Along the same lines,
the first several chapters
of John Fox’s — Play
Poker; Quit Your Job;
Sleep Till Noon show
how playing (trading) at
the right times — When
both you are feeling best
and the cards (markets)
are the best — provide
you with a significant
advantage).
 RECOMMENDED
READING
Basic Option
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Understanding
Popular Pricing
Models
by Sheldon Natenberg
Item # 6091437
Spending time with a trading
legend is usually a dream for
most traders, but this is your
opportunity to get the inside
tactics of one of the most
sought-after educators in
options. With the personal
touch of his presentation,
Natenberg's educational tool
gives all traders, beginner to
advanced, access to the
powerful insights that can
bring ongoing option trading
success. INCLUDES-Instant
Access to Online Video,
Interactive Tests, and Online
Charts. - more info...

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Volatility Indicators:
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Profiting from the
Market's Moves
by Lee Leibfarth and Jean
Folger
Item # 10353118
In this new eBook, Jean
Folger and Lee Leibfarth,
authors of Make Money
Trading, help you to
understand volatility and the
indicators that can help to
harness its power. Volatility
indicators provide predictive
insight into the price
movements of the market and
are powerful technical
analysis tools that can be used
to find profitable trades. This
new eBook format makes
everything you need to know
about volatility indicators—
from a history of the most
popular volatility indicators
to experimental application,
to finding unique
opportunities for short and
long-term traders—just a
click away! It’s a breeze to
get right to the information
you’re looking for and even
tap into answers that go
beyond the book! - more
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Trading Volatility for
Profit: Using VIX as
a Predictive
Indicator to Find
Winning Trades
by Larry McMillan
Item # 9681881
Finally, VIX, the volatility
index, and its formula are
handed to you in an
understandable and useable
way. McMillan reveals his
own tactics to exploit the
effects of volatility on the
market and gives you the
power to use them in your
own trades. He even lays out
the buy and sell signals so
that you can consistently
know when to enter and exit a
trade for the best possible
profitability. - more info...

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Planning Option
Trades for
Beginners: The
Greeks, Volatility,
and How to Pick the
Best Trades
by Peter Lusk
Item # 7584036
If you are just beginning to
trade options, you may have
seen that option prices don’t
behave like stock prices. You
need to understand how
changing stock price,
changing time, and changing
volatility may impact an
option’s price. Only with this
knowledge can you develop
realistic expectations about
how and why option prices
change the way they do, and
learn to trade them profitably.
- more info...

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VIX Options and
Futures: How to
Trade Volatility for
Profit
by Peter Lusk
Item # 7584037
Futures and options on the
VIX have unique
characteristics and price
behavior. As an advanced
trader, you need to know how
they differ and how they can
be traded properly. Peter
Lusk, instructor at The
Options Institute at the
CBOE, will walk you all the
way from the history of these
trading vehicles to case
studies illustrating their
effectiveness. - more info...

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Mastering Debit
Spreads: Conquer
Volatility and Time
in Option Trading
by Peter Lusk
Item # 7584038
Are you worried about time
erosion or declining volatility
in your option trading? Are
you looking for a potentially
high return strategy in a
sideways trading market?
Debit spreads—both bull and
bear—might be just what the
trading doctor ordered. Enter
Peter Lusk, an instructor at
The Options Institute at the
CBOE. A natural educator,
Peter will use trading
exercises, stories, and humor
to teach you how debit
spreads can boost your option
trading success. - more info...

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