that’s exactly true.Similarly, I’ve a very open mind regarding strategies and methodology. Ifsome strategy works, or seems to have worked in analytical studies, and ifI at least generally understand the rationale behind the strategy, I’ll give ita try. As for markets, historically, I’m an absolutely terrible grain trader, butI’m still completely open to ideas on how to trade those markets successfully. I prefer to write options as a means of generating profit because I understand to at least a modest extent the structure and dynamic of futuresoptions, because I’m comfortable with the process, and, of course, becauseI do very well at it. Does this preference imply that I reject other strategies,those not involving options? Not for a moment.Lots of opportunities don’t lend themselves very well to option trading,or can be much better implemented by trading futures contracts. One such,which has persisted throughout most of 2002 and might last for another 6months or more, has to do with interest rates. Early in 2002, the wise menwere busily speculating as to when Mr. Green Beans (my private name forthe Chairman of the Federal Reserve Board, after the old Captain Kangaroocharacter) would get around to raising the overnight Fed Funds rate. It became evident rapidly that conditions in the economy were so iffy that raising this rate was not a pleasing prospect, and Mr. Green Beans (correctly, inmy view, but who cares about my view) has sat on his hands to date. Knowing that the Fed is not going to do something is every bit as valuable as knowing what it’s about to do and when it will be doing it.If overnight rates aren’t going to move higher, then I think we wouldreadily agree with each other that 90-day rates aren’t going to move muchor perhaps at all higher, over the same period. The CME Eurodollar contractis a 90-day rate strip. Due to the earlier prevailing market view that shortterm rates were about to rise, the spreads between the 2003 contracts andthe 2002 contracts had become very wide, more than 100 basis points, upwards of one full per cent, in the June 2003/December 2002 spread. Youdon’t have to be a Fortune 500 firm’s chief economist (heck, you don’t evenneed to know any more economics than a Congresscritter, i.e., virtuallynone), to see that these spreads had to change, had to become narrower, aslong as the Fed continued doing nothing. As time passes, the closer to expiration a Eurodollar contract becomes, the more its price tends to moveright toward the current Fed Funds rate, less a small discount. The only thingthat will alter this price action is a perception on the part of the market participants that the Fed is about to start changing the Fed Funds figure, but itwas exactly the opposite perception that market participants held duringthis period.
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Ah, but, there’s really no good way to take advantage of this situationwith options. Trading the ordinary futures spread is far superior, and muchmore profitable. Over the eight weeks ending August 5, 2002, the June 2003/December 2002 spread narrowed from 1081⁄2 to 38 basis points, a terrificmove. The nicest thing about this trade was that exactly no timing was required. Had you undertaken the trade virtually any day in that period, youwould have profited . . . without a single option in the mix. I managed topocket a few dollars in this little enterprise, and wouldn’t hesitate to try todo so again if the Federal Reserve continues to take no action at the nextmeeting and Eurodollar spreads remain somewhat wide.The point here is not that you and I make a profit, or do not, on a particular type of trade. The point is that if, say, swing trading is your preferredstyle, to state baldly that “I don’t trade options, because . . .” of whateverreasons, is a good sign of a closed mind, and a sure sign that you aren’tearning as much profit as you might, and likely should, make. It’s the samefor me. I trade futures positions only rarely because I’ve more confidenceand better results in trading options. However, if an opportunity in an assettrade or asset spread is present and I (mostly, at least) understand it, andcan get good indications of its likely success through research, I’ll jump onit like a starving man on a deluxe pizza.An open mind enhances our chances for success, but it’s the understanding of an opportunity that puts profit into our trading accounts. Absentour understanding of at least the main part of a market’s mechanism and itssupply/demand considerations, how in the world can we attempt in some reasonably organized fashion to make a profit trading in it? For example, I’vebeen looking at the CME Grade III Milk market for more than a year. If you’venever run across this market, I wouldn’t be at all surprised, for it isn’t a highvolume one, somewhat of a backwater as such things go.This market’s options, rather surprisingly, are considerably more liquidthan are those in a number of much higher-profile futures markets andwould appear to be very much worth trading, but how? The terms of the futures contract are readily obtainable at the CME’s Internet site, but that’snot much help. Why do the options sometimes expire after the named month,nearly a unique situation in markets? Is the market completely dominatedby commercial interests, or is there some participation by the public? Howwide are the bid-ask spreads? Is there just one options market-maker on thefloor, or a half dozen? These and numerous other questions need to be answered before a rational trader can enter this market. That’s my next project after sending this text off to the publisher, and it will probably takesome little time to gather the information necessary to understand this market’s basics well enough to attempt to trade in it.
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Randomness and Options—Markets AreEfficient . . . Aren’t They?Want to get into an argument? Neither do I, but sometimes we’re going tohave no choice when we’re talking with traders and especially with academics. I made a huge mistake in one of these conversations in 1974, rightabout when the grain, oilseed, and sugar markets were going crazy for thesecond year in a row. A bunch of us—brokers and traders, the treasurer ofthe company, several other folks, and, gulp, an economics professor—weresitting around jawing after another huge bull day. I happened to mentionthe notion of efficient markets, and that I thought the current-day marketsweren’t operating very efficiently. From the reaction to this remark, you’dhave thought I’d called someone’s mother a Nazi hooker.Our company’s treasurer, a real stuffy type, started a discourse aboutmarket efficiency being necessary to market continuity. The professor (anabsolutely terrible trader, and not my client, thank you) weighed in with abunch of polysyllabic academic duckspeak, the gist of which was that Ididn’t know what I was talking about. One of my buddies, not too politely,asked the professor why, if he knew what he was talking about, he was sucha rotten trader, and suggested that maybe knowledge of economic theory hadno relation to trading success. One of our floor guys pointed out, pointedly,to the treasurer that these big bull markets weren’t continuous anyway, citing the seven limit-up days followed by eight limit-down days in the cottonmarket the previous year. (The exchanges were just starting to adopt expandable daily limits at that time, but fixed limits were still more or less thenorm except in grain markets.) The discussion heated up considerablyand went downhill pretty quickly after that, with all the people who actuallydealt in the markets lined up opposite all the theorists and executives andexecutive-wannabees. At least no one threw a punch at anyone, and that’sthe best I can say about this little soiree.Now, you’ve seen me argue frequently in this text that the introductionof new information into a market changes the minds of some/most/allmarket participants and induces them to take actions that lead to a changein that market’s price. Presumably, this change will be toward the postnew-information now theoretically correct market price. This process is, inessence, the basis of what is usually called efficient market theory, and soyou might reasonably think that I’m a student or a devotee of this theory. I’mnot, at all, and the reasons why not are both straightforward and potentiallyprofitable to us.Just because some proportion of the traders in a market act on a pieceof information and the market price subsequently moves somewhere doesn’tfor a microsecond imply that the resulting price is the correct one, the pricesuggested by efficient market doctrine. I’d be very willing to accept that the
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new price is less incorrect than the former one, but the notion that the newprice is correct is absolute poppycock. If, after some new information is introduced into the market, the new price of corn is 2.85/bushel, give me oneeven marginally plausible reason why that price is correct, and not 2.821⁄2 or2.851⁄4 or 2.87. Right, you can’t. Don’t fret about it, the efficient market crowdcan’t, either.For that matter, you’ve probably seen many occasions yourself on whicha new, post-new-information-into-the-market price cannot possibly be correct, in any reasonable usage of that word. Local traders frequently searchfor price levels at or near which lots of stop-loss orders are entered, and tryon occasion to run the stops, make them execute all at once, if possible, andthereby profit from the resulting abrupt short-term market movement.They’re pretty talented at doing so, too, which makes placing stop-loss orders in certain markets a rather risky proposition for the trader. Would you,or anyone, claim that, after a big batch of stops has been run and the market has moved an extra 80 points (or whatever amount), that this resultantprice is correct, even though it’s likely enough to snap back to previous levels very quickly? Of course you wouldn’t—we all realize that this is a shortterm market distortion that will right itself rapidly in all likelihood. So,where, during such a period of action in a market, is the correct price?The best we can say is that, over time, a market will tend to move towardits correct price, the price at which it would be if every market participanthad perfect information about the market, and probably roughly equal capital too. Consider the conditions, though. Huh, whazzat? Perfect information? Equal capital? When does this fantasy occur? Wake me when it does,okay?The point of this discussion is that, as far as traders are concerned, thereis rarely if ever a determinable correct price for a market. Ordinarily, themost accurate observation we can make about a market’s correct price at anygiven time is that “it’s around here somewhere.” The size of the price rangeimplied by this “somewhere” increases or decreases along with the market’svery short-term SV. If the market is jumping all over the place, “somewhere”is larger, maybe much larger, and the converse is true if the market is veryquiet. If you’re interested in physics, this concept of “somewhere” bears a certain theoretical kinship to Werner Heisenberg’s famed uncertainty principle,although, continuing the comparison, Heisenberg’s principle is impeccablydressed in an academic tuxedo, whereas “somewhere” is much less formal,lounging around in jeans and a sweatshirt.What does all this have to do with trading? Stated baldly, the notion ofa market’s correct price being “somewhere” is one of the considerations thatimpel me to prefer trading options to trading assets. “Somewhere” represents an extra chunk of randomness, and in most markets, to my observation,there’s quite enough of that to satisfy anyone. The asset trader is almost
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always trading in the neighborhood of “somewhere,” and his capital ismuch more subject to severe short-term fluctuation, as the market wandersaround “somewhere” seeking the correct price, than is the capital of the disciplined option trader.This is, of course, largely a philosophical view and subject therefore to allkinds of objections. Not about capital fluctuation; that’s for all practical purposes inarguable—all you need to do to confirm it is compare the monthlybrokerage statements of a disciplined asset trader with those of a disciplinedoptions trader. There is, however, at least a small set of empirical data to support the notion of relative steadiness of profit resulting from disciplined options trading. The available set of data is too small to be a valid statisticalsample, but it is large enough, I think, to be really rather suggestive.
Real-World Results—Proof of the Pudding?I’ve traded in the markets for decades, and for a considerable number ofyears very indifferently. Beginning in the 1990s, I started studying variousfeatures of risk in a semi-formal way, and began systematically to discardideas and strategies that either embodied too much risk or were unsatisfactory for other reasons. By 1996, I’d come firmly to the conclusion that thetrader can do best for himself by dealing principally in options, due to thewide variety of insurance and risk-reduction features that options offer.A couple of years later (I’m pretty deliberate about these things), itseemed clearly to be the case that event risk in the stock markets was simply too dominating a factor to be overcome, if I were sincerely interested ingenerating steady, as opposed to more erratic event-driven, profit. By mid2000, I had functionally left the stock markets to the bubble boys and theone-way market advocates (and I’m sure they haven’t missed me . . . nor haveI missed them). By March of 2001, I was dealing solely in options on futuresmarkets, using the strategies discussed throughout this text.Traders aren’t, or shouldn’t be, interested in hitting home runs; that’sBarry Bonds’ job. Prudent bankers and competent bookmakers, those whoare best overall at making money with money, have no use for financial homeruns. They make their profit a bit at a time, steadily, daily, weekly . . . inexorably. I’ve exactly no interest in trading contests, or being top dog or achampion trader or whatever. If you enjoy that sort of thing, that’s great, myvery best wishes to you, and I hope you win. I want to generate profit in thesteadiest possible fashion, just somewhat more quickly than bankers andbookies; 6% per month here, 4% there, occasionally 9–10% if such an opportunity presents itself. If some opportunity requires four months to put 18%net ROC in my pocket, that’s fine with me. You can have the whole cheesecake, I’ll just take a forkful every so often.
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Does this attitude, do these strategies and similar ones, succeed? Judgefor yourself. I trade three accounts right now, one mine and the other twosmall partnerships involving friends and business associates. As I mentionedin the Preface, I’m just a retail trader.The Fly-By-Night Trading Partners (I like whimsical names for partnerships) were organized in March 1995, originally with a plan to trade in listedstock options. We weren’t notably successful in this, turning $25,000 originalcapital into $20,420.80 by April 15, 2001, at which point the partners agreedthat we should instead attempt to apply the strategies discussed herein,and to deal almost solely in futures options henceforth. Another partnerjoined us in July 2001, his contribution raising the effective capitalization ofthe partnership from April 15, 2001 to $25,420.80.Account equity improved to $33,539.04 by December 31, 2001 and, as ofthe close of business December 31, 2002 was $56,475.49, just 3.86% belowthe partnership’s best equity level of $58,656.02, attained on November 26,2002. The maximum peak-to-trough interim loss, or drawdown, in the partnership’s equity was a 31.32% loss, from August 13 to August 26, 2002. Thelargest drop under the partnership’s “initial” equity on April 15, 2001 was to$17,357.92 on October 29, 2001, an unpleasant but modest 17.69%. Our average capital from April 15, 2001 to December 31, 2002 was $24,109.07, andthe overall ROC for the partnership from April 15, 2001 to December 31, 2002was therefore 134.25%, or 64.41% on a compounded annualized basis.Consolidated Chaos, another partnership, was established on November15, 2001, with an initial capitalization of $45,000. Two new partners joined, inJanuary 2002 and February 2002 respectively, contributing between themanother $20,000 in capital. At the close of business on December 31, 2002,the partnership equity was $101,310.17, unfortunately 21.64% down from itsbest level of $123,242.14 attained on July 26, 2002. This is entirely my fault.ConChaos, as the partners call it, was entirely too successful in the first halfof 2002, and I subsequently became undisciplined, even a little careless, inselecting trades for about 30 days, costing the partners a bunch of equity forno reason. Well, only temporarily, but another lesson learnedConChaos’ average capital to December 31, 2002 was $62,037.03% andthe overall ROC over 131⁄2 months was 63.31%, or 54.65% on a compoundedannualized basis. The maximum drawdown for the partnership occurred between July 26 and August 26, 2002, a figure of 36.11% due almost completelyto my lack of trading discipline over that period. The largest drop under initial equity occurred right at the start, with account equity falling 9.63% to$41,046.52 on November 30, 2001. Fortunately, the partners don’t seem tooannoyed about our less than optimum results to date, but I do wonder whatto make of the blindfold and the package of cigarettes they sent me, ostensibly as a Christmas present.
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My personal account is somewhat less clear regarding its results, because I use it as a sort of piggybank, withdrawing capital from it occasionally,as convenient. By January 2001, I’d ceased applying any trading strategiesexcept the ones discussed in the text (and their cousins), but still held severalpositions based on inferior strategies, which positions, perversely enough,made a healthy profit during the month. But, bad news rising, some of thesepositions weren’t due to expire until various times in February and March.These remaining positions resulting from inferior strategies were notsound—far too low in positive expectation—and I’ve not employed suchstrategies since. At the start of 2001, my account held a ridiculously largeamount of written option premium, and I was sailing far too close to thewind regarding margin usage as a percentage of equity, waiting around forSister Theta to gobble up these excess premiums. She (mostly) obliged, fortunately for me and even more fortunately given the inferior strategies anddicey margin situation. Here, for what they’re worth, are the results fromJanuary 31, 2001 through December 31, 2002. Frankly, I’d be cautious aboutaccepting this account’s results as being as indicative as those of the twopartnership accounts.The account equity at the close of business December 31, 2000 was$47,335.84. Through January 2001, things went very well, with the equity onJanuary 25 reaching $66,831.22. On that date, after a considerable numberof options had expired and the account’s margin usage was back down toabout 14% of equity, I withdrew $45,000 to apply to a different investment—and, looking back, I should clearly have left that sum right where it was.Dummy! At the close of business January 31, 2001, account equity was$20,748.01. The remaining positions in the account that were based on poorstrategies performed very badly in February and March. The now-depletedaccount saw (gasp, choke) a drawdown of 40.91% from February 1 to March22, 2001, the worst I’ve endured since applying the strategies herein on aconsistent and (presumably, cough . . .) disciplined basis. Once again, I hadto learn the hard way. Inferior strategies, sooner or later, bring with themtheir own punishment for the trader.The equity in the account, with no further additions or withdrawals,reached $34,580.70 on December 31, 2001 and improved to $58,841.11 byDecember 31, 2002, implying ROC of 183.59% over the 23 months, or 72.26%as a compounded annualized figure. The best equity level was $61,338.97, attained on August 13, 2002. The largest drop under the beginning equity waswhen total equity fell to only $13,141.02 on March 22, 2001.Please note that, for the results based on the methodology and strategies I’ve advocated here to be proven statistically valid, similar or better results will need to be produced for the next two, three, perhaps even fouryears. That’s fine with me. In fact, for an objective conclusion about the mer-
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its of the methodology and these strategies, it’s entirely necessary. Candidly,these trading results weren’t nearly as good as they could have been, andlikely should have been.I’m all too aware of the assorted strategic and tactical errors I’ve madeover the past two years. I won’t mention any further the sundry delusionsand, not unlikely, madnesses that I indulged in during this period. They’re depressing in retrospect, and I detest the attitude of “woulda, coulda, shoulda.”A far better attitude for traders is “Excelsior!”—onward and upward! Fortunately, my departures from practicality and discipline have been rare, andideally will become rarer still over time. The acquisition of discipline in anyfield of endeavor is a cumulative process; the more we practice it today,and next week, and next month, the more habitual it becomes for us.Well, no doubt, we’ll soon see how things turn out in future futures(er, so to speak), but I suppose these results are acceptable for a part-time retail trader. The trick, of course, for you and me and any trader, is to keepimproving all the component factors necessary to successful trading: our tactics, our strategies, our methodological approach, our knowledge and understanding of markets, and our trading discipline.
Method Generates Strategy and Strategy TrumpsTacticsIn our chosen endeavor, there is only one overriding consideration: tradingto win is about making a profit. Everything else, absolutely everything else,is just a sideshow. If, theoretically, you might earn X% profit by applyingstrategy Y in a particular situation, but in the real world you only manage toearn half of X%, this isn’t a problem. The trade is or has been profitable, it’sproceeded generally according to plan, and you’ve had the chance to observe your strategy in action. Very possibly, while observing the trade, you’vespotted a way to improve the strategy, and I surely hope you’ve been lookingfor such improvements. If it became desirable or even necessary to defendthe trade, you’ve gained an opportunity to sharpen your defensive tactics,preserve your capital, and practice keeping trading risk under tight rein. Allthese situations, all these outcomes, are in one way or another advantageous.Some more than others, certainly, but none of us wants to pay too much tuition for a course in Markets 203a and 203b, right?Strategy trumps tactics every time. You might be the finest tacticaltrader in the world, but your profitability is still subject to the methods youuse to select your strategies. If your methodology involves reading chickenentrails or tea leaves, and you profit by employing the strategies these imply,then, by all means, do it. Let the rest of the traders laugh while you visit the
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bank regularly, what do you care? Somewhat more likely, I imagine, you’lladopt or develop other less exotic but equally or more successful methods.If your method and your strategic approach(es) to that method work foryou, that’s all that need be said.There is obviously no single methodology and no single set of strategieswithin a methodology for making money with money. There are dozens ofprofitable methodologies, but what is the common ground among these? Justthis: they attempt to minimize risk, to exploit a (presumably) well-defined situation, to establish a discipline for entering and exiting trades, to set oneself up to claim a healthy return on capital over any given period, and at alltimes to keep the expectation in any particular trade in the plus column. Tothese ends, the trading strategies that I’ve described here work very well forme. It wouldn’t be a bit surprising if these strategies would work as successfully or even better for you, and I wouldn’t wonder for a moment thatyou’d be able improve on them, or discover highly advantageous variationson their respective themes.As Ethel Barrymore used to say, “That’s all there is, there isn’t anymore.” I hope you’ve enjoyed this little examination of one profitable broadmethodology and philosophy of trading, and that you’ve run across several(or, better still, a lot of) useful and profitable ideas, strategies, and tacticsin the text. If you decide you’d like to kick around some of these notions, orothers, may I invite you to visit the Internet site forum.ino.com, where I canfrequently be found theorizing about trading and generally lowering property values. Or if, you consider these strategies to be false-to-fact or nonsense, let’s discuss those views too.No matter what else, healthy profits and good trading to you!
APPENDIX A
Studies of HistoricalGross Movement inSelected Markets,1990–2002Those who do not learn from history . . .—George Santayana. . . had better not trade futures and options.—SAJ
find the use of historical gross movement in the evaluation of potentialstraddles and strangles to be invaluable. This appendix presents lineargross movement studies for 30 of the most popular North American futures markets in the accompanying tables. There are any number of ways toapply these data to your trading.Clearly, if we’re looking into these two strategies, the tables will indicatemonths in which the purchase of straddles has historically been advantageous or disadvantageous, and we can also easily see spans of months overwhich writing strangles is likely to have been profitable. Buying DecemberAustralian dollar straddles in July is historically a definite winner if you canmanage to do so—this is a notably thin market. Writing 1-month NG stranglesin the spring and early summer, more than $1.00/MMBTU wide, has been ahuge winner ever since the great bull market of 2000–2001, and looks to beprofitable for the next few years if certain structural problems in that marketcannot be resolved. You can easily spot numerous potential opportunitiesby examining the tables.This sort of analysis, though, as noted in the text, is only one of the factors to consider when straddling or strangling a market. Please don’t skimpon your analysis of the other preconditions! The overall success of applyingthese strategies depends at least as much on current supply/demand conditions and present-day market volatility as on historical tendency. Also, your
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own research well may turn up other useful, and subsequently profitable,preconditions. After all, the more research you do, the more likely you areto find another means of generating an extra advantage in setting up a trade,and I wish you the best results possible.The tables herein are also somewhat useful for evaluating non-seasonaltrades. They do not, however, replace a specific historical analysis of a definite period, for few non-seasonals begin and end conveniently on monthboundaries. I’d suggest using these tables merely as a shortcut to locating interesting non-seasonal ideas, and then refining the trading idea from thatpoint using an historically-based entry/exit analysis.These tables are completely straightforward, but a brief note is in order.They represent, once again, a whole-month analysis. Thus, the computed results for, say, NYMEX crude oil in March, are computed from the May crudeoil contract’s daily data. The March crude contract expires in February, andso cannot be used. The April contract expires in March, and does not affordus the entire month of March for the calculations.The “Average” columns are computed as follows: for a March result, Itook the settlement price on the appropriate futures contract on the lasttrading day in February, and computed the intraday highs and lows, both intotal points of movement and percentage of price change, all through March.Then, I just repeated this calculation over 12 or 13 years and took the arithmetic mean of the March results. Use either analysis you prefer, gross pointsor gross percentage of movement.
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CME/IMM Australian Dollar December 1989 Through May 2002 (0.01 = $10.00)
JanFebMarAprMayJunJulAugSepOctNovDec
Years
AverageUp
Average %Up
AverageDown
Average %Down
AverageRange
Average %Range
131313131312121212121213
1.741.611.291.712.071.381.532.001.221.571.451.24
2.722.471.902.563.192.152.272.961.762.362.201.90
2.041.881.181.311.721.321.181.921.482.262.331.26
2.852.651.822.082.571.921.662.792.373.453.491.83
3.783.492.463.033.792.712.703.922.703.833.782.50
5.575.113.724.645.764.063.925.754.135.815.693.72
CME/IMM British Pound December 1989 Through May 2002 (0.01 = $6.25)
JanFebMarAprMayJunJulAugSepOctNovDec
Years
AverageUp
Average %Up
AverageDown
Average %Down
AverageRange
Average %Range
131313131312121212121213
5.073.902.883.774.653.325.196.474.645.9