and the 62.50 puts for 55.This move was opportune, because the option premiums were such that Ididn’t even need to write two put-call pairs for each repurchased call. Writing three of these for each two calls repurchased replaced almost all thecost of repurchase very adequately.Certainly, I’d changed a 12.50-cent wide strangle into a 10-cent wideone, but counterbalancing this modest negative was the fact that the original trade was of 25 days’ duration, while the defense, theoretically, was to be
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in place for just 10 days. I was still short the 55.00 puts, and a severe market downturn would have been both costly and difficult to defend, but—andhere’s something to remember—when the coffee bulls have the bit in theirteeth, even modestly, short-term downside risk is anything but severe.July coffee traded up as high at 69.70 over the next 10 days, finished at67.65 on May 11 (oops! all I had to do in retrospect was sit still, rats!), andall the remaining options expired worthless. For each two original put-callpairs written, the scorecard looked like this: wrote 2 KCM 55.00–67.50 putcall pairs for 110 points gross each, total 220; repurchased 2 KCM 67.50 callsfor 420 points total; wrote 3 KCM 62.50 puts for 165 points total; and 3 KCM72.50 calls for 240 points total. Receipts before commissions, +205 points, or$768.75, less 12 commissions @ $15.00, or $180.00, for a net result of about+$580.00, allowing for exchange and other fees.Not a poor defense at all, as thing turned out. We expect that defendinga trade will cost us something, either hard dollars or potential profit forgone, but here the cost was tiny. The original pair of written strangles, hadthey expired without defense being required, would have shown a profit of220 points, $825.00, less four commissions and fees, or about $760.00. We’llhave to rate this defense as pretty successful. And, we’ll take as the moralof the trade that writing coffee strangles only 12.50 cents wide, no matterhow the trade may look statistically (it looked very good prior to entry, by theway), is a good deal more risky than it may seem.
Defense in General—Other ConsiderationsIn my experience, the longer we try to defend a trade, the less likely we areto achieve a desirable outcome. We prefer to defend, particularly in the caseof straight option writes, for no longer than a month, two months at the outside if very specific market conditions are present. Longer-term defenses,whether using a hedge, a flip, or any other tactic, tend rather solidly to endup being too expensive. These are expensive not only in terms of absolutedollar cost, but also in terms of aggravation, more trading decisions required,and a possible resultant loss of opportunity in other trades because some ofour capital is tied up. This increased expense is why condition 2 exists in thechapter on non-seasonals (Chapter 6), and the disadvantages of long-termdefense are broadly present in any option-writing strategy.How do we tell when the time is right to defend a trade? This decisioninvolves some degree of personal taste, clearly, but there are several principles that are universal, as far as I’m concerned. First, if the market movessharply against our trade immediately or almost immediately, say within thefirst week, and the trade is a standard-term WOOM option write, we have just
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two reasonable choices. We can exit the trade and accept the loss or we canaccept more risk and move the goalposts. The practical questions we mustask here are, one, how far can we manage to move the goalposts and, two,has some important supply/demand factor undergone a sudden change?If the answer to the second question is yes, we exit the trade right now.Our original information about supply/demand conditions in this market, orour reading of them, was evidently in error, and we almost certainly haveno practical way to determine how far the changed market condition willmove the market. Nor is it correct to execute an early flip or roll defense inthis situation, for again we are in the position of not knowing, and any defensive decision we might make has a nasty component of guesswork embedded within.If, however, the answer to the second question is or appears to be no,then we’ve some work to do in order to determine whether to fold the tradeor defend it. Using the previous June coffee trade as an example, we can seethat one key facet of applying the move-the-goalposts defense was the relative ratios of the width of the straddle to the time remaining in the trade,before the defense and after its implementation.One other broad point about defense needs to be mentioned. You’veprobably noticed that all the example or putative trades we’ve looked at haveinvolved positions of at least five option contracts. There is a very goodreason for this, but be prepared to accept another chunk of heresy regarding traditional trading theory. Unless you are willing to use only roll and flipdefenses, you will do better overall when writing options to set a minimumposition size of three contracts, and five contracts is better still.“Huh! What are you saying, that I should trade a position larger than Iwant? Nobody recommends that I should take too big a position for my account size, that’s just insane.” You’re right, of course, about one thing. Itcan’t be correct to enter positions that are too large for your account size,but I’m advocating no such thing. In the first place, the SPAN margin requirement is usually pretty low when we write WOOM options. Even witha smallish account, we should be able to handle two or three 3-lot positionscomfortably. In the second place, we by design commit three times the SPANrequirement to the trade, therefore, if we don’t have sufficient free capital inour account to support a new 3- or 5-lot position, we don’t enter the trade.It’s called discipline, my friend. Why fret about missing a trade? Another goodopportunity will come along shortly, no matter what.The reason we’d like to set a minimum position size of at least three options is that, if we don’t, if we only trade one or two lots at a time, our defensive choices become limited. A disciplined hedge defense that adheres tothe preconditions is literally impossible, for we will spend too much capital, by definition, for the first defense. A spread defense, which is rarely ourbest effort, is also difficult here, though less risky in absolute terms. Moving
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the goalposts will involve writing more than one or two options in almostevery case, and if we don’t want to trade more than one or two lots in amarket at a given time, we can’t use this tactic either. The roll and the flipare the only two defenses remaining to us. There’s nothing wrong with rollingor flipping; they’re excellent defensive tactics, but why are we voluntarilysurrendering our ability to use other equally fine tactics? Where’s the advantage in that?
Defense—It’s IndispensableWe’ve only scratched the surface of the subject of defense here. Just as thereare an enormous number of strategies we might employ in trading, thereare a whole flock of different defenses, and combinations of defenses, thatwe might usefully apply during a trade in any particular strategy. We canlearn about and apply these and other defensive tactics, or we can passivelyaccept a loss when a trade goes against us. If we choose the latter road, wewill end up surrendering an enormous amount of capital and practical advantage over time, and to absolutely no purpose. The alternatives are there,and we must learn to use them, for our own sake.Part of success in trading is the acquisition of a disciplined method forthe selection of trades to enter, but the market will prove our selectionswrong in some number of cases, no matter what. Another, and correlate,part of our success is the application of organized methods to protect ourcapital when adverse market movements occur, when we have undertakena—temporarily—losing trade. If we simplistically and morbidly accept acapital loss whenever a trade begins to go awry, we should probably takeup beet farming or politics (nothing against beet farmers, certainly). Our ultimate success in trading if we do not develop defensive skills will be highlyproblematic, and we’ll be at a completely voluntary disadvantage to othertraders who do apply defensive tactics to protect their capital.
CHAPTER 8
Don’t JustStand There,Do SomethingThe Straddle
The markets will fluctuate.—John Pierpont Morgan
’m not much of one for buying options. Being correct about the directionof a market is difficult enough, and having additionally to be correctwithin a known and limited period of time, and by more than a namedamount, is usually a little more than I can manage to do successfully. Besides, I want a demonstrable historical or statistical edge on my side beforeentering a trade, and ordinarily there’s a strong statistical edge on the othertrader’s side when we buy options. There have been several studies compiled that analyzed the percentage of options that ultimately expire worthless in particular markets. One of the sharpest options experts I know, JayShartsis, the director of options trading at R. F. Lafferty & Co. in New York,pegs this figure at 82–83%. David Caplan cites an 80% figure. The options department at the Chicago Mercantile Exchange indicates that, historicallyover the past four years, this number has ranged from 61% to 68%. Contrarily, Larry McMillan indicates that his studies show that 60–65% of all optionsare worth half a point or more at expiration, definitely not worthless.Which view is correct? Both Shartsis and McMillan are principally concerned with securities options, but, when dealing in futures options, I’mpretty comfortable with the CME’s figure, and take as a rule of thumb thattwo out of three options will expire worthless. That’s one heck of a disadvantage for option buyers, especially those who persist in buying WOOMs.Nevertheless, if we rationally approach the subject of purchasing options, we come to realize very quickly that there must exist some number ofprofitable strategies, else sooner or later no trader would buy them at all.
I
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Far from that happening, though, options trading is and has been for yearsundergoing a stunning growth worldwide, so clearly lots of traders are buying lots of options, and some fraction of these traders are definitely profiting by doing so. How do we go about joining the ranks of the profitable?
Simplifying the GameOne positive step we can take is to simplify the game. Why does any tradertrade in a market? He expects, sometimes rightly, sometimes wrongly, thatthe market’s price will move in his favor over some period of time. This expectation is completely reasonable. Why would we trade anything if we didnot anticipate some sort of profit from the movement of its price? I certainly wouldn’t, and I somehow don’t think you would either. Of course, ifthe market moves in the undesirable direction, our trader is going to losecapital. Now, card-carrying capitalists that we are, we must ask “OK, how canwe turn a profit from this information?”Our initial simplification process consists of removing the concept ofdirection from consideration when purchasing options. I’m confident you’dagree that the more variables we are able to eliminate from our trading considerations, the better off we apt to be. The straightforward way to profitfrom the simple gross price movement of a market without fretting aboutits direction is to buy a straddle, a call and a put having the same strikingprice and expiration date.The naïve view of a straddle is that it will become profitable when theunderlying market moves one direction or the other by more than the totalpremium we paid for the straddle. The price points (one higher, one lower)at which this occurs are sometimes called points of absolute profitability,but the view itself is incorrect. The underlying market doesn’t have to moveanywhere nearly that far before we begin to profit. For a quick and entirelytypical example of this phenomenon, let’s take a look at the CME/IMM Japanese Yen. On November 8, 2001, I bought a few March 2002 yen straddles witha strike of 84.00 when the March yen contract was trading at 83.90. We’lllook at the rationale behind this purchase shortly, but right now we want tosee how long it took and how far the futures contract moved before thetrade became profitable. It did so more quickly than usual, a lucky outcome,but the amount of price movement March yen underwent was in no wayextraordinary.The straddles cost 368 pips apiece, $4,600 plus two commissions, and,courtesy of the bid-ask spread, they settled at 360 pips the day I bought them,contest risk having been present as always. March yen (ticker JYH) edgeddown 108 pips to 82.82 over the next five trading days . . . by which time the
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straddle was at 376 pips, a touch better than breakeven after allowing forcommissions paid on the exit side of the trade. In the next two days, forwhat reason I can’t recall, JYH moved down another 90 pips, to 81.93, andthe straddle was now well profitable. I made a note during the day sessionthat the straddle was quoted at 390 bid/415 offered when JYH was tradingat 82.53, so I suppose it’s fair to say that the straddle had moved legitimately into the plus column approximately when JYH was trading at thatpoint.March yen had moved just 137 pips, 1.63%, in a little less than seventrading days and the straddle had already become profitable? Exactly.Granted, this almost-immediate move doesn’t and certainly won’t alwaysoccur (it was a bit of good luck), but that’s not the point. The point here isdistinctly that a market in which we buy straddles does not have to movemore than a decent fraction of our purchase price for our straddle to becomeprofitable.Now, sometimes this apparently too-quick profitability occurs becauseof markedly rising IVs in our market’s options. Not this time; yen’s 6-monthIVs were 9.2%, and were just 0.4% off the low point in their recent historicalrange. The yen option IVs did rise later on in this trade, but when the straddle became profitable, IVs were still sitting at a lowly 9.7%. March yen subsequently went on an extended cruise downriver, and the trade ended upvery nicely in the profit column. That’s all very well, and hurrah for the hometeam, but the question to answer is “How do we select straddles having ahigh theoretical probability of success?” Our procedure for making this decision turns out to be a direct and fairly easy one. We’ll decide which markets’ straddles may present an opportunity, then we’ll see if the history andthe current volatility of one or another of these markets look as if they’ll cooperate in putting dollars into our pocket.
Which Straddles to Look At, and Why—SettingUp Our AdvantageIn any market we examine, we’ll have a wide choice of straddles to considerfor purchase. There are lots and lots of different option strikes out there. Wecan save a whole bunch of time, and no little aggravation, by adhering to acouple of principles regarding our selection. First, while I dislike using theword “always” in connection with trading, as far as I’m concerned, we willalways buy the at-the-money straddle, the ATM, and no exceptions. This isone of very few tactical points in trading about which I’m (nearly) a fanatic.Furthermore, this is one of the very few times in option trading in which weshould attempt to be as precise as possible. The term ATM in ordinary usagemeans “the striking price closest to the current market price.” Well, “closest”
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just isn’t good enough. I want the market price to be right smack on top ofthe striking price, certainly no more than a very, very tiny amount away fromit, before I’ll even bid for the straddle.Why insist on this precision? Because to do otherwise, to buy a straddle at a near-the-money strike but some distance away from the market,say a September soybean 4.60-strike straddle when the market is trading at4.69 in March, wastes some amount of the putative historical or statisticaledge we have. I want every blasted bit of every edge I can get, and I wantit all the time. “Wait a minute,” you may be thinking, “why not buy the 4.70strike straddle? That’s plenty close enough, isn’t it?” That’s a fair question,and it would definitely be close enough, but the fact is that, for most of itslife, the September soybean contract doesn’t have any 4.70-strike options.They don’t exist. This strike only comes into existence a couple of monthsbefore the expiration of the futures contract. The Chicago Board of Trademay change this situation at some point, but that’s the way things standtoday.“All right, so you can’t buy the 4.70 straddle. Why does buying the 4.60strike surrender some part of our advantage here?” Another reasonable question. When we buy straddles, we absolutely don’t care about the directionthe market moves, just so it does move some decent amount within our selected time frame. In our example, if we buy the near-the-money 4.60-strikestraddle with the market trading at 4.69, we do care about direction. We definitely prefer that the market go higher, because we will start to profit rightquickly in that event, probably after a move of only 10 cents or thereabouts,which might occur on any given trading day. If the market instead moveslower, it must move approximately 17.5 cents lower before we’re even backto the same relative position in which we began the trade. Worse still, someof the life of the options, ergo some amount of the time premium, will havebeen burned up while the market moves down these putative 17-odd cents.This is downright ugly. Not only are our tactics here provably inferior,but we’re also deluding ourselves (a definite no-no, right?) that we’ve undertaken a market-neutral, don’t-care-about-direction trade when, in fact, we’rebulls. If we have a bullish view on beans, fine, then let’s use an appropriatestrategy. Buying this 4.60 straddle isn’t it, my friend, not in this case, not atthis market’s current price. If we want to buy soybean straddles, we’ll justwait around for the market to move very close to either 4.60 or 4.80, then reexamine the potential of the trade.
Other Selection ConditionsOur pre-selection process has other conditions, just as important as thefirst one. When we write options, we love the decay of the option premiumover time, and Sister Theta is our very good friend. When we buy them, she
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presents a mortal danger to our trading capital. Sadly, we can’t kill her rightoff, but we can keep her usefully at bay for awhile. In options of a longerterm, time decay operates slowly, sometimes very slowly, and the slower thebetter, as far as straddle buying is concerned. We will therefore consideronly straddles having an absolute minimum of 3 months remaining until expiration, and a term of 4–12 months is much to be preferred, assuming thatsatisfactory opportunities over this longer term can be located. Simpleenough, so far.The process of selecting the term of our straddle isn’t entirely straightforward, however, because an additional factor comes into play: the liquidity of the options. Except in the most liquid options markets such asEurodollars and (typically) crude oil, natural gas, corn, gold, S&P 500 Index,30-year bonds and 10-year notes many times, and a few others on occasion,the liquidity of longer-term options tends to be pretty low. This unlucky factimmediately implies that the bid-ask spread will be wider than we’d like, and,further, that the market for the long-dated striking price that we’re interestedin is likely to be completely made by the local traders (or trader, singular)on the exchange floor. There’s nothing wrong with this situation, it’s a condition of contest, and let’s have no yowling about “thieves” and “pit sharks,”please. The local traders have an immediate advantage, not a doubt in theuniverse of it, but hey, they’ve paid hard cash for this advantage in the purchase or lease of their exchange seat.The way to compensate for less-than-liquid markets and the locals’ advantage therein is to maintain our trading discipline. In direction-neutralstraddle trading, just as in any other strategy, call your broker and get thecurrent bid-ask spread on the straddle from the floor. Then, make a bid somewhere just a tad under the midpoint of the quoted range. Probably, the orderwon’t be filled straightaway . . . and that’s actually a very good result for us.Surprised? Don’t be. When there are only one or two traders making a market in a thinly-traded option strike, we don’t want our order filled quickly.If it is filled fairly quickly (or worse, almost immediately) on our first bid, Iguarantee you like the sun rises in the East that we’ve either been dead luckyor we’ve paid too much. If some other off-floor trader like you and me happens to offer our longish-dated straddle at our price right now, that’s great,but it’s infrequent. If, however, the floor (the local trader) takes the otherside of our straddle on our first bid, bet your life we’ve paid up for our trade.We do have a small advantage regarding liquidity when we buy straddles,even longer-dated ones. We’re always and only interested in the ATM strike,whichever month’s straddle we’re bidding for. The ATM puts and calls tendto be the most liquid strikes most of the time, but double nothing is still nothing. If the straddle doesn’t trade, it doesn’t trade. If a couple or three hourspass without the order being filled, and if the underlying market is still
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smack on or right next door to the strike whose straddle we’re bidding for,let’s call the broker and get a fresh quote. Why?Perhaps the volatility of the market has changed somewhat. Perhapsthe local who is making the market in our month and strike had to leave thefloor for some reason. Perhaps the principal market maker was off the floorthe whole time and another market maker, less active than the main man,had set his bid-ask spread too wide for us, whereas the principal marketmaker, on his return, will quote a narrower one. We’ve no way to know whichof these situations may be the case today, and we’ve absolutely no reason toguess. Find out where the market is quoted right now.If the original quote for our straddle was 650 bid/800 offered, and it’squoted identically when we get the later requote (never mind in which market, that’s a pretty wide spread in any market), we’ll almost certainly befilled by a local, if at all. If we had originally bid 710 for it, we might decideto change our bid, perhaps to 740. Our potential change of mind will dependon how long we’ve had the order in, where the underlying market is now, andhow much we want the trade. A good straddle is like a good steak, though—there’s a better one out there somewhere, so let’s avoid being overeagerand willfully overpay the floor just to get into the trade.Generalizing this principle, let’s make a firm policy that, when enteringan option position, whether buying or writing, and irrespective of any particular market, we’ll trade at our price without exception. If we don’t getfilled on our order, we don’t get filled, and ho hum. Tomorrow is another day,and we might have another try then if market conditions still meet our specifications. We certainly will reserve to ourselves the decision to bid a littlemore when buying or offer at a somewhat lower price when writing, butthere will be no dearth of potentially profitable trades turning up tomorrow,or next week, or whenever. We never, ever, have to enter a trade, okay? Sure,we’ll miss out on some fine trades under this policy, but who cares, becausethere’s another profitable trade coming along in due course. Speakingbroadly, this is the same policy that the local traders employ. Locals musteither profit or leave the floor, and they most certainly don’t have to takethe other side of our trade unless it’s to their liking, so it’s entirely logical toconclude that this policy works to their advantage. Why not to our advantage, too?
A Practical ConsiderationChanging an order is perfectly legitimate and a common action, but we mustonce again be courteous about doing this—if we want to get and keep gettingour orders filled. If we should change our orders around frequently duringthe day, and especially by small amounts, 5 or 10 points in this example,
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at some point the good nature of our brokerage’s floor men is going to snap.They’re working every bit as hard as we are, or harder, and they’re doing avery demanding job both physically and mentally, the more so when weenter a multi-part order such as a straddle.Change an order three times in an hour by 10 points each time (in thisexample), and your brokerage’s floor man will start saying to himself, “Aw,geez, not this clown again,” and you can forget about his exerting any efforton your behalf in future to fill that order. It will be filled at his convenienceonly, and your further trading in his market will become substantially moredifficult. Likely enough, he’ll mention your account to his colleagues, andyou might start to experience difficulty trading in other markets on thatexchange floor. This reaction isn’t a conspiracy or anything like it. This ishuman nature in action, and markets are made up of people, true? (Sidenote: I am thoroughly indebted to Bob McKenna of Lafferty & Co. for takingme aside like a Dutch uncle and explaining this practical lesson to me, veryforcefully, some years ago. And he was absolutely right to do so. Thanks,Bob!).
Historical Movement—When Does the MarketLike to Boogie?As you probably knew well enough before you picked up this book, and aswe saw in some detail in Chapter 6, many futures markets tend to move upward or downward during specific times of the year. That’s just fine with us,and you and I certainly should be prepared to exploit the opportunities thesetendencies present. When we buy straddles, however, we are by definitionnot interested in direction, but rather only in the amount of movement themarket is likely to see. This attitude is advantageous to us because suchmovement, historically, is easily calculated. We can, if we like, employ goodold SV as a possible measure of the likelihood of X amount of movement,but I prefer a simpler tool. Let’s just examine the gross movement of a couple of markets during each month for the last few years. Tables 8.1 and 8.2present such examinations of the NYBOT frozen concentrated orange juice(OJ) contract.To produce these tables, I’ve used the closest futures contract that spansa whole month, no partial months allowed. The reason for constructing thestudy in this fashion is that orange juice futures expire in the middle of themonth. Sticking to whole months allows us to avoid any skewing of the databy omitting any price shenanigans that may have occurred during the last fewdays of a contract’s life. The orange juice market’s futures contracts openevery two months, in January, March, May, and so on. Therefore, for theMarch 2000 futures, the studies have used the price data from January 1,
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TABLE 8.1
NYBOT F.C. Orange Juice—January 1990 through July 2002AverageUp
Average %Up
AverageDown
Average %Down
AverageRange
Average %Range
Jan years 13Feb years 13Mar years 13
9.858.527.63
8.857.477.72
8.209.641.82
7.929.391.78
18.0518.169.44
16.7816.869.50
Apr years 13May years 13Jun years 13
6.958.857.55
7.089.188.01
4.433.546.95
4.483.125.65
11.3812.3814.49
11.5612.3113.66
Jul years 12Aug years 12Sep years 12
4.746.414.65
4.506.824.62
6.537.667.17
6.187.166.43
11.2714.0811.82
10.6813.9811.05
Oct years 12Nov years 13Dec years 13
9.977.1410.12
9.447.3310.56
10.894.258.72
9.513.807.79
20.8611.3918.83
18.9511.1318.35
TABLE 8.2
NYBOT F.C. Orange Juice—January 1998 through July 2002AverageUp
Average %Up
AverageDown
Average %Down
AverageRange
Average %Range
Jan years 5Feb years 5Mar years 5
5.596.144.59
6.597.185.18
6.068.231.38
6.708.781.70
11.6514.375.97
13.3015.966.88
Apr years 5May years 5Jun years 5
3.597.426.62
4.288.608.05
5.511.441.68
6.131.541.65
9.108.868.30
10.4110.139.71
Jul years 4Aug years 4Sep years 4
2.619.233.90
3.1210.734.41
6.996.067.19
7.817.226.88
9.6015.2911.09
10.9317.9511.29
Oct years 4Nov years 5Dec years 5
7.497.9910.17
7.8110.0813.63
9.190.984.62
9.200.974.18
16.678.9714.79
17.0111.0517.81
2000 through February 29, 2000, and the same construction applies for allthe other contracts in the studies.From the longer-term study in Table 8.1, it’s very easy to see over whichmonths the OJ futures historically have had their largest gross movement.Obviously, we want to own November straddles going into the fall, theAugust–September–October period showing a high gross movement. Similarly, we’d like to own March straddles into the December–Janu