3-05-21
98.7389.8566.2567.20
99.9591.3567.4574.95
84.5082.7556.8058.90
90-07-2391-07-2292-07-2293-07-22
87.1583.0561.3572.90
+11.58+6.80+4.90–5.70
+221.22+227.86+232.60+226.74
94-05-23*95-05-2296-05-2197-05-21*
136.65165.10123.30225.05
274.00169.50125.30277.00
114.00120.00101.50156.00
94-07-2295-07-2496-07-2297-07-22
219.40146.70104.05169.10
–82.75+18.40+19.25+55.95
+218.58+236.82+255.91+247.75
98-05-2199-05-2100-05-2201-05-21
131.85 135.25 105.00120.25 128.00 91.35105.80 122.00 82.4067.80 68.60 53.25
98-07-2299-07-2200-07-2401-07-23
114.8098.1086.3053.95
+17.05+22.15+19.50+13.85
+264.64+286.63+278.47+292.16
High
Low
Average on 28 sells: +10.434 cents; stop w/loss of: 8.00 centsGross Movement (cents/lb)Avg Up 14.336 Max Up 137.350
Avg Dn 25.421
Max Dn 96.920
Notes: September Coffee (NYBOT), KCU; sell on 05-21, buy on 07-22
*Refer to text discussion.
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historically or due to present-day conditions, might occur. Fortunately forour sanity and our capital, we can observe many historical time frames inwhich we might unsuspectingly commit seppuku in a particular market. Also,in the vast majority of cases, we can quite easily dodge current-year potentially suicidal non-seasonals.We can make the process of dodging present-day risks easier for ourselves by being very, very scrupulous about a market complying with ourpreconditions before entering a trade. We’ll refuse outright to even considerwriting call options using this strategy when a market’s volatility is high andrising, or during runaway bull markets (again, more on this topic in Chapter 12, The Picador). Make a note: the barest visible possibility of catastrophe trumps both seasonality and non-seasonality every time.We really have only one more topic to examine regarding non-seasonalsand other option-writing strategies, and trading strategy in general. Whathappens when our trade starts going wrong, as once in a while it will? Thissubject is more important to profitable trading as I understand it than anyother, and it requires its own chapter.
CHAPTER 7
Apocalypse NeverThe Uses of Defense
The best defense is a good offense.—Adage. . . and vice versa.—SAJ
rading is an enterprise of offense. When we enter a trade, we are taking positive action, taking the initiative if you like, to lighten anothertrader’s wallet. Naturally enough, the other trader is up to the sametricks, and whenever our trade begins to go wrong and we can feel the othertrader’s grubby little fingers starting to reach into our pocket, we have threechoices. We can sit quietly and look for (hope for, more likely) the trade toresume working in our favor. We can exit the trade and accept our loss orour diminished profit. Or, on many occasions, and particularly when we’rein an option position or in a position involving a combination of futures andoptions, we can defend the trade.Hope may spring eternal in the human breast, but Alexander Pope wouldhave gone bust if he had attempted to apply his famous words to his trading.Write it down: the trader who hopes to win, won’t. Dante Aligheri phrasedthis principle even more elegantly. Traders really ought to post his words,slightly modified, on their desk or above their trading screen: “Abandon allhoping, ye who enter here.” Hoping is purely poisonous to profitability, representing as it does the triumph of emotion over discipline, and it can playno constructive part in a successful trading methodology.This circumstance removes one of our choices when a trade begins towork against us. Presumably, prior to entering any trade, we have fixed in ourmind some loss point or dollar amount past which we don’t want any further
T
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part of the trade. As the trade moves against us and approaches this losspoint, we may decide to wait until this point is reached and just accept theloss if and when the market gets there. Nothing wrong with this policy atall, it’s perfectly disciplined in that we’re keeping to our previously designedplan. Of course, we will frequently take this loss when the market persistsin moving in the undesirable direction, but we have in fact allowed for sucha loss in our trading plan, and in any case we cannot profit in every trade.For most traders of my acquaintance, this tactic—the simple exiting ofa losing or threatened position—represents their total concept of protectingtheir capital. They’re very serious about it, too. They’ll agonize over exactlywhere to place a stop or over what type of order to use and so forth, sometimes for hours. (Hard to believe? It’s absolutely true, and I can name thedate, the trader, and the market. His agonizing over the placement of a stoploss order for about 21⁄ 2 hours was in retrospect hilarious, because the trademoved in his favor handsomely later in the day.) While this fretting is goodin that it represents a devotion to disciplined trading, it’s not so good in thatit distracts the trader from other possibilities. Under many conditions, wecan take positive action to protect our capital as opposed to passively accepting a loss. We can give ourselves the opportunity to eliminate or reducethe threatened loss, to buy ourselves some extra time, or to convert the potential loss into a profit with the passage of time.There are five general types of defense in option or options-with-assetstrading. In no particular order, they are hedging, rolling, flipping, spreading,and moving the goalposts. Each is situational in nature. Any one of these defensive tactics may or may not be applicable at any given time, depending onwhat we’re trading, current market conditions and prices, and the strategywe employed in the original trade.
The Hedge—Trading Potential Profitfor Lower RiskA hedge is the purchase or sale of some instrument, usually not an asset, inorder to protect against an adverse price move in a market in which we’reinvolved. A perfect hedge is a hedge that removes all the risk of adverseprice movement. Wheat growers sell futures contracts and write call optionsas hedges against downward price movements in their market, and breadmakers buy these same futures or write put options to lock in their cost ofthe raw material used in production. These are the two traditional hedges,and they can be perfect hedges against price risk in numerous cases. Whilewe traders cannot usually apply perfect hedges in our trading, we can definitely reduce our risk in many instances by using similar tactics.
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In the general case for traders, a risk-reduction hedge consists of establishing a second position that is in some fashion opposite to our current position in a market. Ordinarily, we use options as our instrument of hedgedefense. If we own 10 July wheat futures and are concerned about a possibleprice decline, we might hedge the trade and provide some protection againstsuch a drop by writing 10 July call options against our position. This is acommon hedge, usually called a covered write. We might write only 5 callsand establish a partial hedge. We might write 15 or 20 calls, typically somewhat OOM, and hedge with a ratio-write. On a different tack, we might buysome number of wheat put options to aid in minimizing the risk we’d incurif the wheat market moves lower. This is an insurance hedge and, as withall insurance, requires us to pay dollars out of pocket. Hedging tactics thatinvolve option writing, contrarily, provide comparatively less risk reductionbut put dollars into our pocket. All these are reasonable hedges, providedonly that current market conditions and the expectation of the resulting position indicate their use at a particular time.When we trade pure assets, as opposed to trading assets in combinationwith options or options by themselves, the hedge is maximally useful if weapply it at the very start of the trade. If the (unhedged) asset price moves inour favor after entering a trade, we could write some appropriate options andput part or all of the trade’s open profit back into our pocket at that time.This can be an inferior tactic in asset trades, though, because we might create the undesirable situation of having to stay in both parts of the trade untilthe options expire or at least until their time value has declined to a pittance,regardless of subsequent market developments. Hedging an asset trade afterentering the position reduces our risk by some amount by definition, but simultaneously costs us a good deal of flexibility should the underlying assetprice move unfavorably after we apply the hedge.If the (unhedged) asset price has moved against our position, applyinga hedge after entry is even less desirable. Why? For the same reason. To gainthe full advantage that a hedge offers, namely, protecting against adversityand pocketing and keeping the premium on the options we write as hedges,we must remain in at least one part of our trade until the options expire orbecome worth only pennies. If we buy 10 July wheat contracts at $3.02/bushel, taking a 14-cent risk and intending to hold them for, say, 50 days oruntil wheat reaches $3.30, and wheat thereafter declines 10 cents, applyinga hedge at this point becomes downright dangerous. Suppose that, after this10-cent drop, we write the July 300 call options for 6 cents apiece, and theyexpire in 40 days. We’ve cut down our open loss in the position from 100cents to 40 (excluding contest risk here, for simplicity), and that’s fine asfar as it goes. It doesn’t go very far, however.If wheat moves lower still, our hedge actually creates a new problem forus. If we leave our original 14-cent stop-loss order in place and do get stopped
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out of our long position, we are now short unhedged, or naked, calls in a market that we thought was bullish only a few days or weeks ago. Oof! If we’renot stopped out, we will constantly be in doubt whether to liquidate the entire trade and accept our loss or to sell back the futures and try to recoupsome of the loss by waiting until the calls expire. Either decision might becorrect, but in both cases we’re trying only to reduce loss, not to make aprofit—because we have almost no potential profit remaining to us. Themaximum profit now available to us has shrunk to just four lousy cents percontract minus all the contest risk (when wheat moves above 3.04), and,speaking candidly, this situation is just awful. It’s also no way to succeed intrading.If we look at this trade from the perspective of expectation, what do wesee? We entered a pure asset trade when we bought wheat futures. This tradewas dubious to start, because the initial expectation of such a trade is negative, as we saw very clearly in Chapter 3. We watched the price of our assetdecline and only then took action to protect our capital. Now we find ourselves sitting on a 40-cent-plus-costs open loss with a maximum possible40-cent-minus-costs profit if wheat rises, and the market must move in ourfavor for us just to break even. There’s nothing to say about this situationexcept “ugh.”It gets worse. The belated hedge presents us with some prospect of having to take yet more action in future, to make yet another decision, or to havea decision made for us courtesy of our stop-loss order. This situation is undesirable, too, especially since our first two trading decisions have been incorrect, as demonstrated by the market’s movement. Why should our thirdaction now and perforce be correct?There are two valuable principles to observe in this example. First, usinga hedge to defend a losing asset trade is simply a bad idea. Let’s cross thattactic off our list right now. Second, if we intend to trade assets and we wantto hedge the trade by design, the right time to establish the hedge is when weenter the trade. Writing moderately OOM calls in a 1-to-1 ratio against theasset(s) we own eliminates our contest risk, protects against some decline inthe asset price, and still makes us a nice profit when the asset’s price movesin our direction. For these advantages, we pay the price of forgoing a hugeprofit if the asset price moves sharply in our favor, and we acquire the risk ofpossibly having to stay in the trade longer than we’d like.
Hedging Options with Options—More Reward,Less RiskIf we enter an option trade instead of an asset trade, whether by buying options or writing them, hedging becomes more useful. We can again apply ahedge when we enter an option trade if we wish, and we have remarkable
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flexibility in how we may employ this tactic. If we believe that May silverwill rise and its price is now at $4.30/oz., we might consider buying May silver 4.25-strike calls, or perhaps the 4.50 calls. We can, of course, just buythese options and hope the market moves in our favor, but we are not statistical favorites to profit if we do, other things being, again, equal. If wehedge the trade when we enter it, possibly by writing the same number of4.50- or 4.75-strike calls, we create an option spread, in this case what is usually called a bullish call spread. This tactic has its advantages. As we preferto do, we’ve eliminated the contest risk in the trade by writing the options,but we’re still dependent on the market moving in our desired direction, inthis case higher, if we want to claim a profit.The truly pleasant thing about applying a hedge to an option trade isthat, unlike in an asset trade, we can still do so usefully after the market hasmoved somewhat higher or lower. Suppose it’s July 24 and we’ve just boughta March Chicago wheat 3.40-strike call, with March wheat (ticker symbolWH) now trading at $3.37/bushel. We paid 23 cents for this option, and itwill expire next February 21. Suppose now the case that WH moves up to$3.60 by October 1. Our call will have moved up rather nicely, to roughly 351⁄4cents, and we’re sitting on about 115⁄8 cents profit net of costs.We can take our profit right now if we wish, or we can sit still and enhance the profit if the market will oblige by continuing higher. We have athird choice, though. We can retain chances for enhancing our profit and simultaneously reduce our capital risk, in the case of WH moving back lower,by writing a different strike December or March wheat call against our nowprofitable position. December wheat is probably trading around $3.56 whenMarch is at 3.60, and the December 3.50 call is probably trading for 18–19cents. If we write this call and net 18 cents for doing so, we will have established a position that will be profitable from approximately $3.40/bushelto infinity between now and the expiration of the December options on November 22. In short, we’ve insured against the wheat market giving up thebulk of its gains, and we’ll make a few more cents if wheat proceeds higheror stays right here until Thanksgiving Day. If we were more bullish but stillwanted to exercise some caution and protect part of our gain, we might alternately write the December 3.70 call at this point.If WH instead moves lower, let’s say down to $3.20 by October 1, the3.40-strike call we bought is now only worth perhaps 131⁄ 2 cents. We can accept the loss, or we can sit and hope that wheat turns back around and moveshigher, or, again, we can take action. The December 3.40-strike calls are nowtrading at 8 cents. We could write one of these calls and reduce our currentloss without adding any trading risk, but we will curtail our profit potentialunless we are very lucky with timing and market movement. We could writetwo or even more of the December 3.50-strike calls, now trading at 51⁄4 cents,and eliminate our loss entirely (for the time being), if we decide that Decem-
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ber wheat will not move well above $3.50 before its options expire. This latter tactic embodies some risk, definitely, because various events might propel the price of wheat way over $3.50.The point here is entirely that, when trading options rather than assets,we have more useful tactics available to lay off some or all of our risk, or toreduce or erase our open loss in a position, and risk reduction is the goaltoward which we always must work. Unlike establishing a hedge against alosing position in an asset, the fact that we initially chose an option positionremoves one major disadvantage. We no longer have to worry about the possibility of choosing between a continuing adverse move in prices or morphing our position into a new one that is the effective opposite of our originalmarket view. All we can possibly lose from here is the remaining value ofthe initial option purchase less the amount we pocket by applying the hedge.The trade may even return to profitability at some point, but we certainlywon’t be counting on such a result.
Hedging an Option Write—It’s a Process,Not a Single ActionThe hedge can be a useful defense when purchasing assets or options, butit really comes into its own in tandem with several option-writing strategies, particularly the non-seasonal and the ratio-spread (see Chapter 11). Ifwe’ve entered a non-seasonal trade, we have a couple of different ways todefend the trade via hedging.For a detailed example of a defense, let’s suppose the date is January22, May unleaded gasoline (ticker symbol HUK) is 63.60 cents, each contractrepresenting 42,000 gallons of RFG II unleaded gasoline, and the May optionsexpire on April 25. We’ve looked at price histories and discovered that theprice of HUK has had a very reliable upward seasonal tendency from thisdate through the expiration of its options. We also observe that the maximuminterim decline ever recorded for HUK between now and April 25 is just14.64%. This year, with HUK trading at 63.60, that degree of decline wouldrepresent 931 points, or 9.31 cents.We’ve done our homework regarding the expectation of the trade andhave satisfied ourselves that it is satisfactorily positive at this time. We’vealso seen in our look at the behavior of this market during this period that, because of a generally warm winter throughout the United States, demand formotor gasoline has stayed atypically high so far this year. The longer-termweather forecasts, for whatever they’re worth, indicate that there is littleprobability of a reversion to severe winter conditions and temperatures, and,sure enough, we can’t see anything at all immediately wintry on the horizon.The HUK 48-strike puts, which are 24.53% OOM, or 67.55% further awaythan the price that would be represented by the largest observed percentage
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TRADING OPTIONS TO WIN
downmove in history in this period, are quoted in today’s market at 70 bid/90 offered. We elect to write five of these at 75 points, our order is filled,and we find ourselves with $1,500 net in pocket, about 357 pointsThe term of the trade is right at 12 weeks, a little longer than we’d like,but we’ve been impressed by the historical reliability of the seasonal tendency and the current supply/demand situation in this market. We’ve decided that these factors justify accepting a little more time risk present inthe slightly extended term of the trade. Our trade will be profitable whenHUK stays above approximately 47.35, contest risk included—anywhereabove it. That’s nice enough, and to defeat our trade the market will, again,have to move about 68% further downward than it has ever done beforeduring this time frame. This market’s history complies handily with one ofthe vital conditions for a non-seasonal that we examined earlier, and this isa very encouraging factor.For the first month, things go well. The weather stays temperate, andAmericans are out cruising around burning up gasoline at very un-seasonalrates. A not-completely-unexpected scandal materializes involving the nowfederalized cretins who imitate inspection personnel at airports, and pollsshow that the citizens have become even less enamored of air travel thanformerly, and are increasing their auto miles driven. HUK rises 4.82 cents to68.42 and we note with some satisfaction that our short 48-strike puts arenow trading at just 21 points.That’s great, but now things start to go wrong. Over the next four weeks,the Russians decide to buck the OPEC cartel and export as much crude asthey want. The President persuades the Congress to relax certain rules involving refineries, and a late-season Siberian Express weather pattern develops and threatens to put Detroit and points east into the deep freeze. Allof these developments clearly either increase supply or potential supply, ordecrease demand. HUK sells way off, all the way down to 58.40 cents, andwe ruefully note the price of our short puts at 105 points. We’re looking atabout a $710 open loss. We still like the possible profit we may earn, but wedon’t want to deal with the possibility of a further immediate decline and asharply rising open loss. It’s time to defend the trade.
Starting the DefenseWe have two ways to defend this trade using a hedge. We can either sellsome number of futures or buy some number of puts having a strike higherthan 48.00, perhaps the 53.00 strike. As far as I’m concerned, the first principle of defense is always to use options for defense when feasible. Thereis a very good reason for this principle when we defend both non-seasonaltrades and WOOM option writes in general. If the market should whipsaw,in this example turning back higher, our cost of defense will be much, much
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lower. Here, if we defend by selling one single futures contract against ourfive short 48 puts and the market moves back up 300 points, 3.00 cents, we’rein deep, er, weeds. We will have an additional open loss of $1,260, less whatever amount the short 48 put options decline during the whipsaw. Sheesh,we’re now utterly dependent on the market to move lower—against the putative seasonal tendency—merely to regain even minimal profitability. This,putting it mildly, is rotten. We are back to hoping that things will work out,that the market will move in the desirable direction . . . and with a monthremaining in the trade as originally conceived. Very bad business.If we adopt the other style of hedge defense, buying a different strike putoption, the result of a whipsaw is vastly less unpleasant. Here, by purchasing our hypothetical 53-strike put, probably for about 180–200–220 points,if the market whipsaws the same 3.00 cents, we will sell back the defensiveput we purchased, incurring a loss of perhaps 50–70–90 points, and our tradewill still be well profitable under our original market view. Let’s say we buya 53.00-strike put for our defense and pay 210 points for it.This comparison of futures versus options in defense leads to a secondprinciple of hedge defense, one which may be intuitively obvious but is stillwell worth stating. Unless we come to believe that all the market factors thatprompted us to enter a trade have become invalid, then we will absolutelynot spend more to defend than the amount of the initial credit we realizedfrom the option sale . . . at the first line of defense. If the initial defensivehedging move we’re considering violates this condition, then we’ll select adifferent strike put to buy, or accept the loss in the trade, or apply a different defense, about which we’ll have more to say in short order.All right, we’ve hedged our original trade by purchasing a put. Whatnext? We’ll likely have more potential risk to confront, with a month left inthe life of the options we wrote. If the market turns back higher, we’ll sellback the defensive put and accept our smallish loss, as we previously decided. If the market becomes range-bound, whopping and flopping for a couple of weeks in a 3- or 4-cent range, we’ll just sit still. We’ll also reexamine,throughout, the seasonal tendency for the remainder of the original trade tosee if any other profitable action might be indicated, including even sellingback the defensive put without an upmove in the market. In either of thesecases, we still retain a clear positive expectation for the trade, and we’vepushed our loss point down to about 46.65 in the bargain. Not bad.“Now dadgummit, hold on there, hotshot,” you may be saying to yourself (or out loud) if you’re not too familiar with options trading, “Whaddayamean the loss point has moved? If HUK falls further than 75 points below48.00, we’ll still be looking at a loss.” Uh, no, we won’t. If the market falls to,say, 46.75 by expiration day, our short 48 puts will be worth 125 points, andprobably be trading at 140 or so, and we’ll be losing 65 points each, or 325points loss plus all our trading costs. The 53-strike put we bought, though,
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will be worth at least 625 points (53.00 – 46.75), showing us a gain of 415points (625 – 210) less costs, so at worst we’d be profiting by about 60 pointsnet, at 46.75. Therefore, 46.65 is a perfectly honest estimated loss point (orbreak even point, same thing), and it has indeed moved down from its original level of 47.35.
More Defense? Yes, If NecessaryHowever, the real question is what to do if HUK keeps falling from here.We’ll defend again. We won’t particularly like it, but we will . . . as long aswe can find a reasonable defense. We must be careful on establishing a second line of defense, though; we’ll need to be rather more precise in how wego about it. First, we will absolutely not undertake a second line of defenseuntil the notional upward seasonal tendency of the HUK market has beenformally violated. Violation will occur in our example if HUK moves lowerthan our entry point minus the historical maximum interim percentage decline, in this case 63.60 – 9.31, or 54.29.Let’s say the gasoline market tanks another 4.30 cents to 54.10 in 10days’ time, thus rendering the seasonal tendency invalid for this year andtempting us to reach for the Maalox. Such a move happens in considerablyless than 1 in 10 times for all disciplined non-seasonal trades in my experience. We see that our short 48-strike puts are now trading at 160 points andthe defensive 53-strike put is now 340 points, so our open loss is 295 pointsplus costs, call it $1,380.00, and there are still 20 days until expiration.We check the weekly supply figures published by the American Petroleum Institute (API) and the Energy Information Administration (EIA) andfind that supply has increased somewhat more than is typical at this time ofyear, and the weekly refining utilization figure has moved smartly higher,up to 94.5% of capacity. Refiners are cranking out gasoline more or less asfast as they can, evidently. The weather nationwide has moderated and demand is still considerably higher than usual at this time of year, but thesefactors evidently haven’t helped the price of gasoline much.We’ll look around for a second put to purchase. For the first defense,we selected an option about 51⁄ 2 cents OOM, with 30 days left in the trade.Now, though, time is beginning to press firmly on the option premiums(thank you, Sister Theta!), but we haven’t the luxury of as much space inwhich to defend. The 50-, 51-, and 52-strike puts settled at 186, 224, and 275points, respectively. Because we still must be cautious about a whipsawmove, by policy we will prefer to spend the least amount for the second defense that we can manage.Thus, it appears that the 50-strike is our candidate now that HUK hasfallen below 54.29. We’ll likely be paying something on the order of 190–215
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points for it, let’s say 210 points again, just to have a number (please understand that there will be few bargains on the NYMEX option floor after sucha substantial move). Purchasing this put leaves our capital position at a smalldebit, which is undesirable. We’ve spent 210 + 210 = 420 points plus all trading costs, less 375 points originally sold, putting us in debit in our capital account for this trade. This debit is not a problem, however. We don’t intendto hold both defensive puts through to expiration, at least not yet, and theproceeds from their resale ultimately will put our capital account back intothe plus column.If the market persists in working lower over the next two weeks, thingsmay get interesting, and that’s the last thing we want. Still, we must deal withthis adverse movement if it occurs, and our choice of methods for doing sowill have become limited. Suppose the market declines to 51.30 over thesetwo weeks, what will we do? In this situation, nothing at all. Theta is busilymunching on the time premium of the short 48-strike puts and their pricewill almost surely have declined considerably, given they now have only 6days to live. Our defensive 53-strike put in now in-the-money, and we canexpect its price to have risen a bit over the 2-week period given the market’sfurther downward action. Our second defensive put, the 50-strike, probablyshows a loss. We’re almost certainly better off now with 6 days remainingthan we were at the 20-day mark, even though the market has kept movinglower over these two weeks.If, however, the market has fallen further than this, to, say, 