only threats to the trade are a wicked upwardmove in the market and the reemergence of aggressive WOOM call buyers.We can’t, or at least I can’t, name all the circumstances that might get thesefolks frothing at the mouth again, but we can describe the features of thedefense we will conduct when either of these does occur.
When and How to DefendFirst, let’s defend a little bit, a little bit early. Consider the coffee ratio-spreaddiscussed previously. The May coffee market was at 124.20 on entry, andthe lower strike in the trade was the 210. At the time, this being my first attempt at this style of ratio-spreading, I had originally thought to buy anothercall, perhaps a 240 strike, if May coffee moved a third of the way from 124to 210, up to 152–153. The market never reached that level, but it turns outthat my putative initial defense would have been a bit dilatory. We shouldtake our first defensive action at between 15 and 20% of the distance between the market price on entry and our lower strike. This would have beensomewhere around the 144 level.This is a policy I’ve held to since, but I can’t say that it’s prevented anydisasters. Instead, I’ve cost myself some capital with each of these 15–20%level defenses, bar one. Once again, we can improve on this tactic, if we thinkthings through (which I was very slow in doing, but at least you won’t have
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to pay this bit of tuition yourself). Just because we’re defending a tradedoesn’t mean at all that we are despairing of its ultimate success, its ultimatevalidity if you will. What is our original market view in a Martian ratiospread? It isn’t bearish, it is a not-extremely-bullish view. What is the initialdelta of our position? It’s unquestionably negative, typically about 25 to60% of one full contract, or –0.25 to –0.60. In theory, we’ll lose some capital(presumably temporarily, a paper loss, or as my broker likes to call it, a“loan”) if and as the market moves up early in the trade, well before thetabegins to eat into the calls’ remaining time premiums.Well, how does this information help us decide when and how to defend? We refuse to turn the trade from a net credit to a net debit in our firstdefense, and we therefore know in advance the absolute maximum that wewill pay for the first defensive call. As the market moves up 15–20% from itsinitial price, we want to examine the change in the total delta of our ratiospread. Almost surely, total delta will have become more negative by thistime, and we’d like to buy a defensive call that will return our total delta toclose to its original level. Problem solved. We examine the table of our market’s call prices and deltas and select the lowest-priced WOOM call whosedelta (which is, again, a positive figure when we buy it, and will thus makeour total delta less negative) will put the trade’s total delta approximatelyback where we prefer.
So Far, So Good . . . UsuallyJust as when we apply a hedge defense to a non-seasonal trade, if we undertake a hedge defense here and the market turns back around on us, we’llsell back the defensive option and accept a presumably modest loss. Todate, I’ve accepted 12 of these modest losses . . . but I can hardly complainbecause, with one exception, all 29 ratio-spreads I’ve undertaken to datehave ended up ultimately profitable. That one exception occurred when themarket added two more whipsaws right around and through my initial defensive price level. Up again, defend again, whipsaw again. The series oflosses finally put the trade into losing territory. Lots of fun, that was . . .su-u-ure it was. There’s nothing to say except “That’s the market for you.”The overall 28-to-1 ratio of actual profitable ratio-spread trades to losers isvery encouraging, though, and the dollar and percentage gains have beenthoroughly enjoyable.Perhaps I chose a poor defensive point in that multi-whipsaw trade dueto chart considerations, or for other reasons. It’s probably correct, even if notalways possible, to avoid applying a defense at or near prices that are, effectively, obvious chart points for technical traders. It took a little while for yourthick-headed author to understand that the change in the total delta of the position was likely the best indicator of when to defend and which option strike
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to buy for the defense. Generally speaking, the ratio-spread defenses that I’veapplied must have been correct in attitude at least, even if unsuccessful intheir immediate result. I view these interim losses, one of them costing 120points in loss per defensive option (way too much!) in the NYMEX unleadedgasoline market, as necessary insurance against a real live disaster. I’ll pay forthis insurance every time, and gladly, but I’ll try in future not to go out of myway to give the floor 50–60 points more than necessary.In actual experience, I’ve only been in one ratio-spread trade that required a second line of defense. I even applied a third, in a 1-to-4 trade. Thishappened in the January 2001 NYMEX natural gas futures market, and thatwas one scary market, my friend. The only truly smart way to have tradedthis puppy was to have liquidated all positions, disconnected the phone,and taken a vacation. When ratio-spreading, we don’t intend to get involvedwith a runaway bull; we have observed on entry that the market volatilityis declining and we consider it will continue to do so. Volatility was declining when I entered the ratio-spread in that market. Events overtookthis trade, though, a shortage of supply and a brutally cold winter in highgas-consuming regions, plus the assorted machinations and fumblings ofenergy trading companies, politicians, and bureaucrats. Even if this tradedid end up putting a good deal of money in my pocket—and it did—to thisday I wish I’d never even seen it. Trading to survive, as was necessary inthat market, is not trading to win.
Suitability—Round Up the SuspectsThe inflation of options’ IVs can theoretically occur in any market, from azukibeans to wheat, and probably in stamps, baseball cards, and Ming porcelain, too, but not all markets offer opportunities for Martian ratio-spreads.In some markets, call premiums can become wildly out of line relative tothat market, but still not reach the quite high levels required for this style ofratio-spreading. Currencies and interest-rate bull markets, for example, typically will feature their call IVs below 20% even in a strong bull market, andwhile the WOOM and WTBOOM options’ premiums will surely have risen,they won’t likely be anywhere near the levels we want to see before employing this strategy.I rarely trade stock-index markets, but I’d guess that in the late 1990sthese markets offered some excellent Martian ratio-spread opportunities.(Once I acquire that historical database of option prices, I’m definitely goingto hunt around for such occurrences). These markets, after all, could hardlyhave been much more bullish than they actually were, and SVs and the call
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options’ IVs probably had some hefty spikes on occasion. Nonetheless,index futures probably are only rarely good candidates.McMillan and other writers have commented on a long-lasting overvaluation in the call option IVs and premiums in certain markets, naming coffee, soybeans, and gold as prime examples. I don’t really believe in a sort oflong-term collective market psyche, but in these markets the evidence is incontrovertible. When the bull threatens to rumble, these markets’ call premiums go absolutely bazoo. Natural gas, too. These are all excellent candidatesfor us, the “A” list so to speak, and these markets, along with silver occasionally, have offered the vast majority of the ratio-spreads I’ve entered inthe past few years.You might be tempted to think that NYMEX crude oil and heating oilwould be markets to watch here also, and I would too. Maybe they are. I’venever yet found a really good possibility in either of these, but who’s to sayI haven’t just missed one when it was present? So, I’ll keep looking, and perhaps a good, disciplined ratio-spread will turn up one day. Right around thetime the bombs start falling on Iraq, as a guess.I wouldn’t doubt for a minute that CBOT corn had some dandy ratiospread possibilities in 1995 when the market topped $5.00. Unfortunately, Iwasn’t looking for them then, and, barring some enormous weather disaster,the Congress has seen to it that giant bull markets in corn and other grainsand oilseeds probably will be rare for several years. An example of lowerthan possibly expected IVs may be seen in the 2002 grain crops, seriouslydamaged by heat and drought, yet whose volatilities haven’t spiked sharplyenough to allow creation of a good Martian-style trade. Curiously, the CBOToats market may become an exception to this situation, because some largefraction of the crop each year comes from Canada, Sweden, and Finland,which nations are (mostly) beyond the depredations of Congress, and thisyear’s Canadian harvest is beset by all sorts of problems. A bad crop nextyear, too, and . . . who knows?The various metals markets are half-yes, half-no. NYMEX/COMEX goldand silver offer us excellent ratio-spreads from time to time. NYMEX/COMEX copper might at some point, but opportunities here have been nonexistent for the last few years. The NYBOT platinum and palladium marketscertainly meet the preconditions for ratio-spreading every so often, buttheir options are completely impossible to trade for the careful and practical trader. I can’t see even trying to ratio-spread these two markets.I haven’t seen any ratio-spread opportunities in the CME meat markets,either, although other opportunities abound for option trading on thesefloors. This brings us to the softs markets, what we used to call “exotics” 30years ago. Aside from NYBOT coffee (one of my favorites), CME lumber,NYBOT cocoa, and frozen concentrated orange juice will very likely present
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good opportunities from time to time and are very much worth keeping aneye on. The options markets in lumber and OJ are thinly traded as a rule,and our contest risk, particularly our slippage, will generally be higher thanwe want to see, but an opportunity is an opportunity, and not to be ignoredout of hand.
We Don’t Need—or Want—The Runaway BullOne important point needs to be clearer than perhaps I’ve made it so far.While many traders consider a rip-snorting bull market as necessary for thesharply rising IVs we want to observe as the initial setup for a good ratiospread, this is not the case. We distinctly do not require a long-lasting runaway bull market such as NYMEX natural gas in late 2000 or COMEX gold inlate 1979. Any circumstance that sends SV higher and also causes WOOM calloption premiums to rise apace is definitely good enough for our purposes.From November 21, 2001 to January 9, 2002, NYMEX/COMEX May silver had a nice bull move, from 408.6 to 470.7 on a closing-price basis. I’m stillnot certain of the cause of the move—believe me, you can get more nonsensepassing for information about gold and silver than about any two othermarkets you care to name, including dot.coms.However, lo and behold, a few days later in January, the volatility situation in May silver met all our preconditions, with futures trading at $4.68.Being a suspicious sort (and not understanding the silver market too well),I waited a couple of days and only took a moderate position in a comparatively short-term ratio-spread. The strikes were 5.25 versus 6.25, 1-to-4, parking 3.6 cents, about $180 per spread, in my pocket on an initial SPANrequirement of $278. Everything I could learn—history, economic conditions,currency markets, too—seemed to be in favor of the trade, with the exception of rumor. For my money, if the cause of the rise in volatilities isn’t fairlyclear, I turn on the caution lights right away, and in any event we simply donot take overly heavy positions in ratio-spreads, no matter how much freetrading capital we may have. Sooner or later, we usually (not always by anymeans) find out what did happen to cause this surge in volatility, but in themeantime we must keep capacity risk at a known and presumably very safedistance.The trade turned out to be thoroughly dull, my favorite kind. Along theway, while the WOOM option premiums were still nicely inflated, I put ona similar trade in the July silver contract, using slightly higher strikes. Thisone wasn’t quite as dull. Silver had another mild little upmove, and lookedas if it might become obnoxious for a day or two. It didn’t, fortunately. A couple of decent profits in hand over 5 months, no extravagant market movement, no defense required, no aggravation? Sounds pretty good to me.
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Now, this wasn’t good trading, or excellent trading, or brilliance in action or any such nonsense. It was simply trading to win. The opportunity waspresent, the preconditions were met, and the trade worked generally according to plan. Had defense been required, excellent resources were available. In the event of a sharp upward move in the May silver, say to $4.95 overtwo weeks, possibly before, I’d have bought one 5.75 or 6.00 May call andactually would have been rooting after that point for the market to continuemoving higher.I’m absolutely certain that constructive refinements to this strategyexist. Even though the Martian ratio-spread strategy has demonstrated itsprofitability over a couple of years, it can be improved. I’m working on it,and I’d welcome your suggestions . . . but in the meantime, earning 30 or 40%net ROC, or more, over three to five months when these opportunities showup is entirely satisfactory.
Practicality and TacticalityYou may be wondering about my assertion that 1-to-4 and 1-to-5 ratios inthis strategy are, or are close to, optimum. From an offensive standpoint, theyaren’t; higher ratios are probably warranted. We probably can make higherprofits with higher ratios, but we can also undergo endless pain on occasion,unless our trading pockets are quite deep. These ratios work best, and reasonably so in my view, because of defensive considerations. At the criticalfirst defensive point, it has invariably been the case in my experience thatwe’ll only need to purchase one defensive call in order to restore the tradeto good order and cool out the trading risk inherent in a hot market. Thisapparent fact makes our trading lives much easier, because it isn’t (or atleast, hasn’t been to date) any sort of problem to locate a defensive callwhose premium is in compliance with one of our main principles of defense.Once more, we simply must not spend more to defend than we intendedto make in the trade when we entered it . . . at the first defensive point.Suppose a ratio-spread turns up that has a huge differential between thetwo calls’ striking prices, and the options’ IV is well down from its highs. If,therefore, we reasonably consider that a 1-to-6 ratio is a good choice, thenwe should again defend a little bit, a little bit earlier, to accommodate ourdefensive philosophy and keep capacity risk on a firm, tight leash.There’s one last important tactical point that arises when using thisratio-spreading strategy, and it seems to some extent to be out of the trader’scontrol. Which do we want: to send two separate orders to the exchangefloor and wait/hope for both of them to be filled, or to put the whole tradeon one ticket so that we have zero risk of only entering half the trade? Prettyeasy question, right? Who needs or wants any extra risk, and nobody I know
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wants to end the day with only half their intended trade. So, we’ll enter ourorder for establishing a ratio-spread on one ticket, correct? Well, maybe.In the practical world, maybe we can place this unbalanced spread orderon one ticket and maybe we can’t, and the causes of this uncertainty aren’tentirely clear. In the developing electronic markets, from the no-volumecurrency-cross contracts to the enormously popular CME e-mini S&P 500contract, we can’t. This circumstance isn’t terribly important to optiontraders at this time, because options volume in every e-contract on everyNorth American exchange ranges from non-liquid to non-existent. Presumably, this situation will be remedied as the exchanges’ order-matchingsoftware improves, and as the exchanges come around to the notion of hiring market-makers to provide liquidity for options on popular and liquide-contracts.More to our purpose here, the fact of the matter is that our ability toenter ratio-spread orders on one ticket mostly depends on our brokerage.Some houses, including most discount houses of which I’m aware, simplywon’t accept the order as one item and insist on two tickets. Some houseswill accept the order, but their exchange and clearing arrangements mayresult in the order being broken into two parts in order to be executed. Ilearned about this highly disadvantageous situation completely by accident.I trade with REFCO, Inc., and I’m perfectly happy with their service andthe executions I receive (although their back office could use a lot of work. . . sorry, folks, but that’s this trader’s considered view). However, it turnsout that, in some of the NYBOT markets, coffee and orange juice to nametwo, REFCO does not use its own employees as filling brokers for option orders (at least), preferring to use the services of local firms that perform thisfunction. There’s nothing wrong with this arrangement, but it does lead toodd results. Some of its agency firms will accept one-ticket ratio-spread orders and some won’t. How’s a trader to know which situation prevails on agiven day? Right. The trader doesn’t know; he has to guess. What fun.On some exchanges, executing unbalanced spreads on one ticket is notan issue. The floor traders on the Chicago Board of Trade are absolutely excellent executors of such orders. The floor traders on NYMEX are also extremely good. Nonetheless, in other markets, our net result is that we mayhave to enter ratio- and other unbalanced spread trades as two separate orders. We traders can handle this, of course, even if we may be muttering various unflattering comments under our breath.In unbalanced spread trades that cannot, for whatever reason, be executed as one order, we will place the larger order first. If we’re entering a1-to-5 ratio-spread, we must unfailingly write the five WTBOOM optionsfirst, and only when filled on these enter our order to buy the WOOM option(s). To attempt to enter the two positions in the other sequence, buying
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the 1-lot and only then writing the 4- or 5-lot, is a very poor tactic and can onoccasion be ridiculously costly.Listen to the voice of experience here, because I did this . . . exactlyonce and never again. It was a very calm market, too, that day, or at least itwas calm until two minutes after I’d bought the WOOM calls. The markettook a nice swan dive off some convenient cliff, and I had to write the upperstrike calls for 45 points less, apiece, than intended. This is more slippagethan any trader can tolerate, and this is the reason we must always executethe larger side first if we’re required by situation to use two tickets to execute our spread. Always.How frequently do good Martian ratio-spreading opportunities arise?Just as anything else in trading, it varies. We can go for months, even yearsI suppose, and not see a one. Then, five will turn up over 60 days. When we’retrading to win, we have to look around regularly for these opportunities andnot become annoyed or impatient if we’re in a period where they’re scarce.These opportunities will show up sooner or later, and all we have to do is stayprepared to jump on them when they do, and subsequently claim our veryhandsome profit.Martian ratio-spreads can turn up at any time, but they do turn up almostinevitably at the end of the speculators’ favorite type of market, the runaway parabolic bull. That’s useful to know, and we’ll tuck that little fact awayfor Chapter 12. You see, there’s another excellent strategic approach towardcarving out a set of tasty porterhouse steaks from such a bull market, andmaking the bulls pay the dinner check in the bargain.What do you say to a little metaphorical side trip to sunny Spain?
CHAPTER 12
Every Once ina WhileThe Picador
Will you have some [roast beef] rare, or the slice off the end?—Robert A. Heinlein (“If This Goes On—”)
don’t know the first thing about bullfighting. As far as I can tell from films,the object of the exercise is for a bunch of guys to chase a bull around aring until he gets worn out, then stab him with a bunch of colored spearsuntil he keels over. The guy who waves the cape around is the matador andthe guys with the spears are called picadores, so they tell me. Well, to eachhis own. If I have to stab a dying bull, I’ll do it in the markets, and I’ll do it sitting down and not under a hot Spanish sun in the afternoon, thank you verymuch.Big bear markets are persistent. Big bull markets are crazy, basically.Bear markets can and do become overdone, but big bull markets almostwithout exception become screamingly overdone at some point. I suspectthis is due to a combination of human nature and the side effects of the admixture of emotions such markets produce, but that’s just idle speculation.We’re not concerned about why this situation occurs, but we do want toknow how to profit from the end of, pardon my plagiarism, this irrational exuberance. Let’s have a look at a very effective approach to fattening our trading accounts when the bull starts to bite the dust.Bull markets result from fear. In physical commodities, this is the fearthe users of a commodity have that they won’t be able to acquire said commodity at acceptable prices (or, occasionally, at all) in the future, and they’dbetter buy the goods today. In interest rate markets, this is generally thefear that other asset values will decline and therefore existing fixed income
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instruments will become relatively more valuable, especially if interest ratesare declining or about to decline. In currency markets, it’s the fear that theeconomy of some nation is about to undergo substantial adversity or thatthe sundry governmental policies of that nation are about to become morebone-headed than usual. Such currency panics produce the well-known“flight to quality” and can, interestingly, have the effect of superchargingother nations’ currency and interest rate markets, occasionally turning anordinary bull market into a super-bull.For our purposes, the existence of fear in a market is excellent (assuming, of course, that we ourselves aren’t in that market right this minute). Fearis an emotion, and when considerable numbers of market participants become emotional, markets become distorted. The good news is that such distortions only infrequently last for long periods, and the even better news isthat, just as in riding the bear, the market itself is going to give us a stronghint as to when to make a dollar. So, if this is true—and it is—when do westart pitching spears at the bull?
El Toro Grande—Runaway Parabolic MarketsIn physical futures markets every so often, supply, demand, and market sentiment among the participants become so unbalanced that prices becomebid to amazing levels. Usually, the bull move in such markets begins whenthe market participants realize the possibility of a supply shortage in future.Developments unfold and supply problems do begin to emerge, promptingusers to begin to anticipate future needs in advance of their normal schedule, and also attracting speculative interest into this market. At some point,in addition to whatever degree of supply shortage actually exists, some number of market participants also begin trading on a perceived worse shortagein future, and that’s when prices go wild. The daily price bar chart movesupward in a manner resembling the right-hand side of a parabola, margin requirements go to the moon, and people who have been caught short in thismarket begin thinking that the window ledge on the 35th floor looks mightyattractive.As all this develops, you and I should be sharpening up our coloredspears, because we’re about to be handed a whole lot of money. These runaway parabolic markets all end, typically in a few weeks or months, and theyalmost invariably give a very clear signal to the watchful trader as to whento help himself to other traders’ capital. We’ll just sit around and watch,laughing with the bulls and commiserating with the bears (assuming theyhaven’t availed themselves of a trip to the 35th floor yet).
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By and by, and we simply don’t care how long it takes, the bull marketis going to top out. We are distinctly not going to attempt to time this action,or to anticipate it; it’ll happen when it happens. The market will top out,begin heading lower, sometimes very sharply, and then, a little later, a coupleof weeks or a month or two, the market will make a run at the old highs. Ifit makes new highs (rarely), we’ll continue to watch and wait. If this secondary run-up fails, though, that’s it—that’s the end of the party, and it’s timefor us to become picadores and start to carve up the dying bull.When exactly do we swing into action? We wait, specifically, for the thirdday down after the top of the secondary run-up. That’s all, nothing fancy, andanyone can play. Furthermore, we discard the notion of statistical risk, andwe park our pricing model in a desk drawer for a while, at least regarding thismarket. There’s nothing at all normal or lognormal about price distributionunder these conditions, and it will probably be quite some time before thistool will be useful again in this specific market.
Carving Up the Bull—The Knife to SelectI maintain, and have for years, that a successful trader is generally a professional coward, and this sentiment is at its truest during and just after parabolic markets. Statistical risk calculations are meaningless in such markets,and we will opt for an absolute and measurable dollar risk here. As far asI’m concerned, the single most cowardly way to slice up this kind of ailingbull is to apply a debit put spread, also called a bearish put spread. This isa structurally simple tactic that involves buying a put option, in this casehaving a strike moderately below the market, and selling exactly one otherput, with a further OOM strike, that expires in the same month. All right, nowhow do we select an advantageous pair of puts for this spread?The first thing we’ll do is to stop looking at the nearby contract in ourbull market. It’s fun to watch, to be sure, but is definitely not the best placeto make our profit. Once again, we must allow the other market participantssome amount of time to fatten our wallets, and to this end we’ll want to lookat the put options in a regular month 2 to 4 months away, or even further outif the premiums are encouraging. The further-out futures contract will usually be lower in price than the nearby month most of the time under theseassumed bull market conditions, but if it isn’t, if instead it’s a little higher,that’s fine with us.The put option we’ll buy will have a striking price typically 3–10% underthe current market price of the month we’re watching. Which put we writewill depend on our level of confidence in this strategy. I’m quite confident ofits profitability, and I tend to write a put whose striking price is 3 or 4 strikes,even 5 strikes below the put I’ve bought. If you’re less confident, then writing
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the put only 2 strikes below is a good compromise, because your capitalcommitment to the trade will be lower.Our trade begins at a debit, which I don’t much like (as you know verywell by now), but its historical success is nothing short of astounding. Ihaven’t ever found a (former) parabolic bull market that met our not-veryrestrictive entry condition, where this strategy took more than 30-40 elapseddays to become profitable. This isn’t too surprising, though, when you thinkabout things for a moment, because we have strong tactical advantages whenwe’re picadores.First, our dollar risk is absolutely limited to the amount of the debit weincur on entry, plus our contest risk, of course. Second, there is effectivelyno margin requirement in our trade, and this fact itself represents anotheredge for us. Those traders who are still long in this bull market are at leastbeginning, at this point, to have major margin problems. The exchange hasunquestionably raised margin requirements during the huge bull run, probably several times, and the volatility of the market is almost certainly up inthe clouds, which will cause the SPAN procedure to produce an even highermargin figure for the bulls. This happy condition will continue to nudge somenumber of the remaining bulls in the market toward the exit, which, in turn,helps us along by the amount of induced selling thus created. What a shame,eh? Contrarily, our debit put spread isn’t subject to any margin aggravationwhatever.
Enhancement—It Gets Better from HereSome strategies are just “there.” We enter a statistically favorable trade, defend it perhaps 10–15% of the time, and simply cash out on the remainingoccasions, end of story. The Picador strategy is not one of these. We usuallyhave excellent chances to enhance our profit during the trade. Logically, thismust be so.Consider. We’re in a trade that profits when the market moves lower.When the trade begins to become profitable, clearly our market view hasbeen confirmed, at least so far. If a market is moving downward, it isn’t moving upward, and if it isn’t moving upward, we might begin to think aboutapplying a non-seasonal approach to this market and writing short-datedWOOM or WTBOOM calls. The IVs of the calls are surely still high enoughfor this to be a nicely profitable endeavor, and this style of enhancement isperfectly viable. I prefer a more cautious approach . . . but I don’t supposethat’s any sort of surprise to you, is it?Why not put on a ratio-spread instead? All the preconditions are almostcertainly in line, and our chances of success must be very high. Now, we’re
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not going to enter this ratio-spread recklessly—in a technical sense, this market is still probably a bull. If we can observe a couple of conditions, though,we’re just giving money away by not attempting to enhance our picadoreanprofit.The time to look at adding a ratio-spread to our position is just whenour original debit spread becomes profitable. Additionally, we’d like to learnwhether or not the initial severe supply problem in this market may bestarting to correct itself, either through declining demand due to high pricesor through the potential of increased supply over time due to an influx ofphysical goods. The place to look for a ratio-spread is above the now-fadedtop of the bull move, in options 3 to 6 months out, possibly even in the samemonth in which we own our debit put spread.We neither need nor