reports when a market is in a state of highuncertainty, and like hurricanes any time. Smaller bull moves can have thiseffect also, in usually proportional degree. We’re not concerned about howa market’s call options came to be so overpriced, but we can usually createa profitable trade indeed when such overvaluation has occurred.We can easily tell when the premiums of a market’s WOOM calls aregetting to be relatively well overpriced by simply watching their IVs andcomparing these against their recent historical range and to the underlyingmarket’s SV. The principal timing indicator here is to watch for the underlying market’s SV to begin declining while the IVs remain lofty or possiblyeven move higher for a week or 10 days. Alternately, if both measures arehigh relative to their recent ranges and SV begins falling faster than the option IVs, this, too, is a good wake-up call. There will be a reason for thesechanging volatilities, there’s always at least one cause here. Supply/demandconsiderations may be beginning to migrate in favor of supply, or perhaps apending weather event has dissipated or appears as if it will.
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Spreading with an Attitude—The Ratio-SpreadA ratio-spread is a trade in which we purchase a call option and write somenumber of higher-strike call options against it. In a traditional ratio-spread,we buy an ATM or slightly OOM option, and we write two higher-strike OOMoptions of the same expiration against it, with the written options typicallyhaving too high an IV relative to the option we purchase. Or, we might buyfive calls and write seven other calls against them. Traditionally, we try to takeadvantage of an apparent skew in today’s option premiums, as compared tothe computed fair values in our selected model.Ratio-spreading is a time-honored strategy and works very well undereither of two conditions. If the skew in the option premiums is pronounced,we might well profit just from the correction of this skew over the passageof time. If the underlying market moves moderately higher during the life ofthe options, the trade will almost certainly end up profitably. The traditionalratio-spreader obviously prefers to see both these conditions eventuate.From our unashamedly pragmatic standpoint, though, this strategy is a bitof a problem to execute.Option pricing skews in near-the-money options vanish very quickly asa rule. There are lots of institutions and traders who look for these opportunities on a more or less continuous basis, and who have the computingpower to locate them efficiently and speedily. You might have the time andcomputing power available (I don’t), but the chances are very good that investment banks and funds have just a trifle more of both of these than you do.That’s fine, not a problem at all. We don’t need to play the game accordingto their rules. Additionally, this type of ratio-spread begins at a debit. Whiletraditional ratio-spreaders are delighted when they can generate a creditfrom a (typical) 1-to-2 ratio-spread, they don’t mind a bit entering the tradewith a debit.As is very clear by now, I do mind. I flat won’t do that, except when buying straddles and in one strategy described in Chapter 12. Therefore, thisstrategy is off the table for me . . . or, at least this version of the strategy is.Here, we must gracefully part company with most of the folks who theorizeand write about ratio-spreads, for we can do far, far better with our time andcapital.
This Is Not Your Father’s Ratio-Spread—My Favorite Martian?When the volatility of a market, having risen sharply in previous days, weeks,or months, begins to decline, we can look around for ways to implement ourversion of the ratio-spread. When the force or event(s) driving the volatilityincrease begins to subside, our mission becomes simple. If the rise in volatil-
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ity was based on drought (coffee, October-November 1999), and it begins torain in critical geographical areas, we’re in. If the rise was based on the condition of some nation’s economy, and this economy stops going in the tank(USD/MXN, the dollar versus the Mexican peso, early 1995), we’re in. If therise was based on political developments, and the feared politico-economicsituation improves substantially (crude oil, January 1991), we’re in. So, whatdoes our version of the ratio-spread look like?When I first showed my new methodology (new to me, anyway; someone undoubtedly has thought of this before) in ratio-spreading to a coupleof other traders, one of them—gotcha, Don!—shook his head at me, rolledhis eyes, and said “Man, that’s really from Mars. You’re gonna get killed withthat.” All right, if I’m a Martian then I’m a Martian, but obviously, he wassomewhat incorrect in his evaluation. To paraphrase Mr. Twain, rumors ofmy death have been greatly exaggerated. Herewith, then, the Martian ratiospread strategy. This is the single most consistently profitable strategy I’veever run across.The usual ratio-spread trader is concerned with mispriced options ATMor moderately OOM, and he would prefer the market to be slightly bullishin its orientation. We Martians are also concerned with mispriced options,but only with WOOM- and WTBOOM-strike calls, and the farther OOM fromthe current market price the better. Occasionally we can locate absolutelyexcellent opportunities to exploit overpriced calls and the underlying IV situation by using these strikes.The delightfully useful fact of the matter is, that, when call premiumsget bid to very high levels, they tend to stay there for a while and the IVsof these options tend to decline fairly slowly over time. Some markets havetaken a year and more before the premiums of its WOOM and WTBOOMcalls have returned to historically typical levels. We might apply a nonseasonal trade in these situations, assuming our preconditions were fullymet, but if we do take the simple non-seasonal trade when call option volatilities are way high, we might end up accepting more risk than we should.Let’s not do that.In its basic form, the Martian ratio-spread involves buying a WOOM call,typically with 3 to 6 months to live, and writing some number, generallyfrom three to seven WTBOOM calls against them, with both (sets of) callshaving the same expiration. We look for opportunities to use this strategywhenever and whyever call premiums have become wildly inflated. This situation might occur without a sharp bull move in the underlying market, butusually there will have been considerable upward price movement. We establish a spread position instead of a straight option writing position as insurance against a further sharp move in a known high-volatility market. Inshort, we hedge a little bit at the start of the trade, before we might need to.Whatever market developments originally caused option buyers to bid theWOOM calls to the sky may recur, which would seriously threaten our
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capital in a non-seasonal trade or in any other straight option writing strategy. We gain a secondary advantage, too. In this type of trade, where webegin with a hedged position, defending the trade will be substantially easier if a defense should come to be required.
Everyone Needs an Epiphany—December 1999Throughout the last half of 1999, I’d had some success in writing OOM putsagainst the NYBOT coffee market, on a generally non-seasonal basis. Cashedevery trade, and wasn’t complaining a bit. The ROC of these trades was acceptable, even a little better than acceptable. I’d traded coffee before, fordecades in fact, with indifferent success. When options on the coffee market became available after the CFTC re-legitimized them in 1984, life becamea little easier and trading more profitable, but it was perfectly clear to methat, while profitable, the strategies I was employing were just adequate, nobetter.While looking for information on the corn market one day in August1999, I happened upon an Internet site, forum.ino.com. The participantson this site include a number of industry pros, cash and futures brokers,successful traders, unsuccessful traders, enthusiasts, novices, and a fewgen-u-wine clowns . . . in general, a fascinating mix of people. Brazil’s coffeegrowing states were at the time enduring a fairly severe soil moisturedeficit, possibly a precursor to a seriously damaging drought. In the nextcouple of months, the moisture situation worsened, which was very pleasant. I was busily writing OOM puts and banking solid profits each month.Coffee kept moving higher as the rains stayed away, even though themarket was enormously erratic and supplies in storage edged up a little bit.Day after day, the folks who posted on this forum kept becoming more andmore bullish. From October 7th to the 13th, March 2000 coffee rose a remarkable 33.40 cents, from 87.95 to 121.35, with 22.05 cents of the move occurring on just the 13th. Now, I was loving this state of affairs, of course,having written a comparative flock of the December 1999 and January 2000puts with strikes of 77.50 and 80.00 and 82.50. I noticed a curious thing aboutthe messages on this trading forum; something like 9 in 10 of them hadsomething to do with either NYBOT coffee or COMEX gold (which had justhad a goldbug bull party, and was looking like it might have another at thetime). At this point, the bullish posters on the forum were only raving aboutcoffee going to $2.50.Here’s another of my tiresome little trading maxims: the public are always wrong, sooner or later. When Bernard Baruch started getting stock tipsfrom shoeshine boys and cab drivers in 1929, so the story goes, he started
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selling. Baron Rothschild is supposed to have said, “When the blood is running in the streets, I buy.” Doubtless some similar good stories will emergefrom the recent tech/dot.com fiasco in the stock markets. Even if these stories are apocryphal, they reveal several valuable truths about markets, asfar as I’m concerned.All right. This forum represents a reasonable sample of retail traders’opinion, the “public” if you like, so now all I had to do was solve the problems of how and when to fade them. An outright short position in coffeewas out of the question, far too risky and far too much margin required. Inany case, a crop-wrecking drought was a distinct possibility, according tothe cash coffee brokers whose ear I was bending. Rather than try to guessthe market, I wrote a few more WOOM puts non-seasonally and startedstudying.Meanwhile, March coffee was just berserk. Down to 93.90 by October21, back up to new highs at 126.10 on November 12 and at 132.75 the nextday. Now, the bulls were screaming about $3.00 coffee. Then, for a changeof pace—change of pacemaker, more likely—the coffee market tanked outto 110.85 over the next 11 days (it rained a little bit in Minas Gerais and SaoPaulo, key coffee states). Two days later, it had turned around and made another new high for the move at 134.60, followed by touching 149.00 on December 2 and closing at 144.05 on the December 3. So help me, now I sawnot one, but five different posters on the forum ranting about FOUR dollarcoffee. If New York “C” coffee has ever reached that price, ever, I can’t findit in my historical files. There just had to be a trade in here someplace.I got lucky. I got very sick for a couple of weeks (talk about silver linings!), and the coffee market was off my mind. By the time I felt like tradingagain, it was Christmas week, not usually an auspicious time to embark ontrades in wild markets because too many market participants are absent,and such a market can become even more distorted. However, I was watching the option premiums on and off, and something had struck me. Ordinarily, as we’ll see in Chapter 12, there’s a very clear signal that I look for at theend of raging bull markets. A little light bulb came on (only a 10-watter, butwe all have to start someplace). I didn’t need that signal, if I took a differentperspective.
Staring Off the 10-Meter Platform—Trade or Fade?Merry Christmas, ho, ho, ho. My family was thoroughly annoyed with methat year because I couldn’t get these ideas out of my head. Call option pricesin coffee were just insane, their IVs were out of sight, but these goofball market opinions about $3.00 and $4.00 coffee prices meant there actually werepeople willing to pay these outrageous premiums for call options with strikes$1.50 and more OOM. These strikes, have no doubt of it, were the textbook
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definition of WTBOOM. Finally, without having gotten in hand all the datathat I wanted, on December 27, with May coffee trading at 124.20, I triedwhat I’d been thinking about. Bought a May coffee 210 call for 300 points, 3cents (think about that!) and wrote eight May 300 calls for 120 points, netcredit of about 597 points, with the options due to expire on April 14.Now, even before you say anything, I’m going to tell you that you’re absolutely right: this trade as executed was, putting it bluntly, stupid and fartoo risky. The ratio in this trade was too high, absolutely. As I’ve figured outsince, 1-to-4 or 1-to-5 or 2-to-9 are statistically much more favorable ratios. . . but I didn’t know that then.However, I did do a couple of things correctly. I had checked the weatherforecasts, especially what Brazilian ones I could locate, and January wasuniversally predicted to be at least decently moist in the coffee states. TheSPAN margin in the trade as entered was, if I recall correctly, $868, which Iquadrupled, not trebled, on the grounds that I was flying blind, as it were,having had exactly zero experience with this strategy. I’d determined (via amarginally informed guess) a first defensive point in case the market startedgoing cuckoo again. And, I’d checked the certified stocks in warehouses,and their changes over the past 6 weeks (up each week, which auguredsomewhat in favor of the trade). Further, the Central American coffee crop,most of which is deliverable against the New York contract (most Braziliancoffee is not), was apparently in fine shape, not a problem anywhere on thehorizon.The trade succeeded, not due to any cleverness on my part, of course.The CentAm crop was a fine one, and stocks in certified warehouses rosevirtually every week for months. Brazil received some rainfall shortly aftermy entering the trade, then quite a bit more later on, and the IVs of the Maycoffee calls fell off a cliff within three weeks of entering the trade. I addedto the position as coffee relaxed, using lower strike calls and a more conservative ratio (I finally figured that part out), and in April and May cashedout a tasty profit. Well, whoopee. Just a dumb trade that lucked out? I don’tthink so, because opportunities to use this strategy, absent my initial stupidity about reasonable ratios but otherwise on more or less exactly the samebasis, appear several times a year.
The Journey to Mars—No Passport RequiredOther markets have offered excellent Martian ratio-spreading opportunitiessince then, and not necessarily the most natively volatile ones, either. I’mratio-spreading October and November natural gas as I write this, very prof-
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itably and with practically zero statistical risk. In December of last year andJanuary of this year, COMEX silver offered good opportunities in ratiospreads in the May and July options (and I almost never trade silver, either,because I don’t understand the dynamics of that market).As a follow-up to December 1999, the coffee market’s call option premiums stayed high enough to employ successive Martian ratio-spreads forabout another year (always excluding the summer months, just don’t try thisor any call writing strategy in coffee in the summer, period.) COMEX goldoffered a fine ratio-spread trade in the June 2000 contract, but hasn’t since.November or January soybeans may be offering a good trade right thisminute, but not quite good enough for me to try this year . . . yet. If theweather stays dry in the Canadian prairies, there might develop an excellentopportunity to ratio-spread wheat or even the widely ignored CBOT oatsmarket later this year. NYBOT cocoa has had a dandy run-up this year, andif it should continue to the point where the bulls get out of hand, I’ll cheerfully lighten a few wallets with a good ratio-spread. When the WTBOOM option buyers come out of the woodwork waving fistfuls of cash, wait for them,wait for them, and then pick their pockets.Your question now, reasonably enough, is what marks the opportunityto apply a profitable ratio-spread. The envelope, please . . .1. We must have a market in which the premiums, hence the IVs, of the
WTBOOM calls are, for lack of a better term, outrageous. We then waita little for the SV of the market to begin to decline, which we take assuggesting that whatever situation created the rise in volatility in thefirst place is beginning to subside or has subsided.2. We want to buy WOOM-strike calls as far as possible away from the current market and write WTBOOM calls as far as possible above the strikeof the WOOMs, and the ratio of the WOOM-to-WTBOOM premiums forthe strikes we select should be between 2-1 and 3-1.3. The ratio of the number of WOOMs to WTBOOMs will be larger orsmaller according to the relative strength of a market’s options’ IVs. Ifthe market situation that prompted the explosion in option premiumshas definitely passed, we will consider using ratios of 1-to-5 or 1-to-6. Ifthe IVs are still well toward the high side of their 6-month range, then1-to-4 or 1-to-3 is more prudent. The trade MUST begin at a healthy netcredit.4. The ratio between the number of written and purchased calls should beadjusted upward the further OOM the two strikes are from the currentmarket price, and downward the closer they are, with 1-to-4 and 1-to-5being typical.
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5. Patience is a necessity. The terms of the best ratio-spreads I’ve seen
(and traded) have been from 31⁄2 to 6 months, but there’s no particularreason to think that similar 2-month and 8-month ratio-spreads mightnot be equally successful, provided the other preconditions are inorder.6. SPAN margin requirement on ratio-spreads as described is very low asa rule, in absolute dollar terms. We must avoid taking too heavy a position, even if we mentally allot 3 or 4 times the SPAN figure for our margin cushion.7. The notional ROC of a desirable ratio-spread should approximate 8%,net of costs per month, over the term of the trade, using treble or (better) quadruple SPAN initial margin. This ROC can easily be much higher,and will vary widely by market and current market IVs.8. We must select a first defensive point before entering the trade. Thispoint should be about 15–20% between the current market price and thelower strike of our pair of options. As always, we must not spend moreon the first defense than we intended to make in the trade originally.We must not change a ratio-spread from a credit to a debit on the firstdefense.9. If there is a doubt about whether or not to defend the trade at any givenpoint, defend it, period, by buying an appropriate strike call or calls. Wecan always sell the defensive calls back later if the market turns backlower, and accept a modest loss while keeping the trade both intact andprofitable, and while keeping our margin requirement and risk (capacity risk, mainly, here) manageable.Just as the first step in a recipe for rabbit stew is to catch a rabbit, thefirst step in Martian ratio-spreading is to find a market that is suitable. Thistask is straightforward—all we have to do is consult a table of the IVs ofvarious markets. Several times a year, we’ll see one or another market’s option IVs being bid well past the top of their current 6-month range. When wedo, we start watching for the trigger condition of declining SV along with(ideally) market prices starting to move away from the apparent recentpeak.In physical futures markets, we also want to look for increasing supply,or at least the potential of increased supply clearly on the horizon. As ithappens, I’ve never found a worthwhile ratio-spread in financial and currency markets, but that’s not to say that such an opportunity won’t occur—merely that it seems unlikely according to these preconditions. In thesemarkets, for proper entry conditions (especially including outlandish callpremiums) to exist, some government(s) somewhere would have to be in a
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state of panic, and the indicator of this would likely be a set of screamingheadlines about the utter destruction of a country’s economy. The problemhere is obvious: absent World War III, no developed nation is likely to collapse in your and my lifetime because its trading partners can’t afford to letit go under.This fact implies directly that any Martian ratio-spreads we would undertake in a currency or interest rate market would be in a so-called developing nation . . . but these nations’ bonds and currencies don’t have viablefutures markets, do they? Oops, we’d be forced to trust to the tender mercies of the interbank foreign exchange market and, gulp, customized options.Waiter, check please! Not on your life. I wouldn’t try this strategy in the interbank forex market with your capital, let alone mine.Side note: Barbara Rockefeller, a trader/analyst/author of strong opinions and thorough experience in all forms of currency dealing, once eviscerated the idea of retail trading in the interbank forex market very eloquently.I was looking for a way to take advantage of the collapse in South AfricanRand in 2000, but the CME/IMM S. A. Rand futures market is, frankly,necrotic. I had asked her about possibilities in the interbank market. Herreply? “Look, some futures brokers might be scumballs, but at least they’reheavily regulated scumballs. You don’t really want to deal with un-regulatedscumballs, do you?”She has her reasons for disdaining retail interbank forex trading, andperfectly good ones they are. For a long time, forex trading was, for all practical purposes, completely unregulated, the Wild West of the world of trading. Abuses were rampant; fraud was everywhere the trader turned. In 2001,the CFTC started taking American forex trading firms in hand and forciblycleaning them up and, in several cases, making them guests of the taxpayerfor extended periods. There aren’t as many crocodiles as there used to be,at least domestically, but those that still exist would take a bite out of yourleg just as soon as they would one out of your wallet. Who needs this kindof risk? Right. Not us.Oddly, corrupt practice is not my principal reason for avoiding this market, because I have a more immediate one. The retail forex market doesn’teven come close to meeting a condition we very much desire. It is very asymmetric. Larger accounts can execute certain orders that are disallowed forsmaller ones. Options we might buy in a straddle have no secondary marketwhatever, zero resale liquidity; if we want to take profits in a straddle, wemust exercise our options and liquidate the positions that result. Ugh!Writing options? Forget it. Can’t be done, with most (all?) retail forex firms.They simply won’t accept the order. What is this nonsense? We have zero, orhighly limited, defensive possibilities, is that right? Right again. Two words:stay away.
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Setting Up the Advantage—Selecting StrikesA ratio-spread involves selecting two different call option strikes in thesame month of expiration. Selecting the lower strike first is pretty much anart form, and it’s more than a little dicey. In the best of all possible ratiospreads, we’d love to see the market move up to or somewhat above thelower strike with just a week or two left until expiration. When this occurs(rarely), we will pocket a profit on both sides of the spread, which is alwaysa lot of fun. We do want to leave some small chance for this result to happen, while at the same time leaving only the most miniscule statistical possibility that the market will go as far as the upper strike until we’ve defended/adjusted our position satisfactorily. Clearly, the wider the price differentialbetween the two strikes of our trade, the more relatively likely this doubleprofit will be, although it won’t (or at least shouldn’t) ever be a statisticallylikely outcome when we enter the trade. The rule here is safety first, then adash of opportunism when and as available.The better way to select our strikes is to choose the upper strike first.Set it at the maximum distance away from the current market price, consistent with our goals for ROC. One good way to locate a promising upper strikeis to set up a dummy account in the PC-SPAN program. Then, begin theselection process by examining the highest WTBOOM strike in the optionsprice table for a particular month that has a net premium of $150–200 (ormore, of course, as in the coffee example), typically expiring in 4 or 5months. Next, scan back down the table until reaching a strike having a netpremium of 2 to 3 times the net premium of the upper strike option. We definitely must include commission cost when evaluating these strikes, for thecalls that we’ll write in this strategy will not ordinarily have super-high dollar premiums, and the Martian ratio-spread is fairly highly commission intensive compared to other strategies.Having gotten this far, let’s next check the SPAN initial requirement fora 1-to-4 trade using these two strikes, and multiply that number by 3. If theresultant notional return on capital meets precondition 7, this might be agood opportunity. There are still the other preconditions to check, and inany case the chance that our order(s) will be filled at tonight’s closing pricesis virtually nil. If the notional ROC isn’t satisfactory, move the lower striking price up one notch and check the figures again. If it still isn’t satisfactory, let’s run another analysis based on writing one more call, making theratio 1-to-5, or adjust the ratio to 2-to-9. Sometimes, we can ratchet theratio up to 1-to-6, but the option IVs must have fallen off rather sharply fromtheir recent highs before we consider this ratio, as noted in precondition 3.Move the parameters around, check the spreads a month further out, useyour imagination in order to find an optimum combination. Typically, I’ll
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have to run through a dozen or fifteen combinations of strikes and ratios andmonths in the market I’m examining before either finding a disciplined pairof strikes or deciding this strategy isn’t suitable for this market at this time.Conditions 3 and 4, concerning option IVs, are a bit redundant. Martianratio-spreads aren’t about picking tops, though, and we must insist on seeing at least the start of a decline in the market’s volatility, preferably accompanied by some sort of modest downmove in the price, before using thisstrategy. The behavior of this market’s options’ IVs won’t follow a hard-andfast pattern. Sometimes IVs fall out of bed immediately when SV begins todecline, sometimes they stick around at lofty levels for awhile, sometimesthey move down in tandem with IV as the market declines. When the IVs aretoward the high end of their 6-month range, we’ll probably be able to establish a good ratio-spread having a lower ratio; when they’re not (they’re stillrelatively high, regardless), we’ll likely have to employ a higher ratio or elsepass on the trade.No matter what ratio and which strikes we ultimately select, if the tradecannot be established at a very clear net credit and with ROC in line with orbetter than required by our precondition, forget about it. When we’re tradingto win, the other trader’s dollars start off in our pocket, not ours in his, savein two distinct strategies discussed elsewhere in the text.Precondition 5 is unavoidable. If you don’t favor trades with a term ofthree to six months, don’t use this strategy. As mentioned, I’ve never seena 2-month term in a worthwhile Martian trade. Not to say such a trade can’toccur, but there are better ways to spend your time than looking for shorterterm Martian ratio-spreads, except in the markets having the very highestnative volatility. Condition 6 is more vital in this strategy than in others. Ifthe market moves so that we must defend the trade, our defensive tactic initially will be a hedge, and these get downright expensive when defendingwritten calls in markets when option IVs (hence premiums) are at or moving toward nosebleed levels. SPAN requirement will also probably increasesubstantially under such conditions, to boot. Don’t skimp on the margincushion here, okay? If anything, you should probably increase it.In the runaway parabolic bull market in NYMEX natural gas in late 2000,the margin requirement moved from $4,800 per contract up to $21,500(!) overabout two months. Now, those figures are for one single futures contract, anda 1-to-4 Martian ratio-spread was a heck of a lot cheaper . . . but even so, itsmargin requirement rose some 450% in the same period, even after I’d appliedone hedge defense. After a second hedge defense, the margin situation wasagain well under control, but the trade was now at a net debit, and stayedthere for fully 32 days—very unpleasant. If ever there is a strategy in whichwe must not take too heavy a position, it is this one; a severe adverse move,even though we may and likely will profit in the end, will force us to put up
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more and more capital, sometimes a small fortune. Been there, done that, andyou really don’t want to duplicate the experience.
Defending Mars Against Invasion—Have YourWallet ReadyWe enter this type of ratio-spread knowing that the underlying market hasrecently been very volatile and attempting to take advantage of relativelyoverpriced WTBOOM calls. This situation of entry implies that, due to nothing more than normal price fluctuation in such an excitable market, it maybecome necessary to defend the trade more frequently than when we useother strategies. This has been the case for the Martian ratio-spreads I’vetraded. Defense, usually lasting a very few days, has been necessary (or, atleast, I’ve undertaken a defense, not at all the same thing!) 13 times in 29ratio-spreads I’ve traded since December 1999.From the structure of the trade, long one WOOM call, short four or fivecalls many strikes further out, we have a lot of tactical room in which toplot our defense, so we have the clear advantage of flexibility. By being prudent about when we enter the trade, presumably at some little time after themarket’s SV has peaked, the