ary–February
154
TRADING OPTIONS TO WIN
period. The shorter-term study (Table 8.2) confirms this, generally. And, Ibelieve that we can fairly say that owning July straddles over the April–May–June period is probably quite unsatisfactory. However, as you correctlysuppose (you know my methods by now, Watson), there’s more to it thanthis. We can extend our advantage by looking at two more factors, one ofwhich is specific to the year in which we are trading.
Selecting Volatility—Avoiding the DreadedPremium SagAs we saw in Chapter 3, the volatilities of a market change over time. Thisapplies to both the market’s SV and its options’ IV. The present level of a market’s volatility is of considerable concern to straddle buyers. If it happens tobe up in the clouds when we purchase the straddle, we are accepting the riskof a decline in volatility. IV is the important one here, because we are dealingin options, and IV is a representation of the level of options’ time premiums.There’s no need for us to accept this extra risk and doing so would be justplain careless, in addition to likely being costly. Prior to buying the straddle,we must examine the relative IVs of the market we’re considering.If the IVs of the options on the market we want to straddle are to thehigh end of their historical range (and I always use the previous 6-monthrange of the IVs of the options for this analysis), then we’ll look at anothermarket. There’s no point and little profit to be made in buying straddles in amarket with lofty IVs, unless we’ve some outstanding reason to expect a continuing high volatility in that market. When we buy straddles that have IVsat skyscraper levels, we might ultimately profit if IV stays up or moves higher.If, though, especially early in the term of our trade, these high IVs (and hencethe option premiums) develop a case of Cooper’s droop, we are largely helpless. We’ll become dependent on a sizeable move in the underlying marketto return our trade to profitability. Now, such a move might indeed occur,but I intensely dislike “might” as a parameter of trading. “Is likely to” is much,much more friendly to our trading capital.We’d strongly prefer, in fact I make it a condition of entry, to buy straddles in markets whose options’ IV is specifically in the lowest quintile, thelowest 20% of their 6-month range. This policy eliminates the great bulk ofthe so-called sag risk from declining volatility and gives us the additionalpossibility of being aided by a rise in IV during the term of the trade, a veryprofitable double advantage when such a rise occurs. We could easily bemore conservative still, and only consider buying straddles when IVs are inthe bottom 10% of the recent range. This policy is fine, and very disciplined,but will unfortunately and smartly reduce the number of good straddle op-
Don’t Just Stand There, Do Something
155
portunities we see, perhaps by as much as two-thirds. It’s your call here. Thefurther the IVs from the bottom of their range, the more likely we shouldpurchase an extra month or two of time when we enter the trade.Naturally, there is utterly no guarantee that we’ll see a favorable rise inour options’ IVs. The IVs of a market’s options can stay in the dumps formonths and months, but, luckily for us, this is relatively rare. Volatility iscyclical in fairly regular degree, and over a 4- to 12-month period we realistically can expect some considerable change in it, within the particular market’s recent historical range. If we insist on only considering markets whoseoptions’ IVs are well toward the low end of their recent 6-month range, moreoften than not over our chosen term of trading we will encounter a helpfulrise in IV and a resultant boost to the value of our straddle.Again, all this discussion of IVs assumes that we can either compute orobtain them. If for whatever reason you cannot do either, I strongly recommend avoiding the purchase of straddles. Historical studies are extremelyuseful (we’ve one more valuable use for them, too), but being able to observea low relative IV in a market’s options is probably the handiest immediatetrigger for our decision to buy the straddle. Comparing the importance of IVin straddle buying to its importance in non-seasonal option writing as described earlier (I’ve no mathematical basis for this view, merely experience),I’d rate the importance of the existence of a proper IV when we buy straddles at 50–60% compared to 10–15% in a non-seasonal trade.
Ignoring a Higher IV—Where’s the SuicideSeasonal When We Want It?Using basic seasonal tendencies in our selection of straddles is clearly toour advantage, and a necessity when we’re trading to win. The good newsis that we can try to ratchet our advantage from seasonal analysis up anothernotch—and we should certainly, at least, try. By agreement previously, wewill avoid writing an option in some market, using the non-seasonal strategy or any other, which option is subject to enormous external event risk ifsome extreme event occurs. Wouldn’t it be just plain common sense for usto look for opportunities to buy options in that same market over the sameperiod, catering to the possibility of occurrence of such an event, in effectbuying into what for option writers would be a suicide seasonal? Oh, yes.Yes, indeed.We can easily find such opportunities, but, sadly, we face another twoedged sword when we attempt to trade them. Let’s be candid here; everytrader who applies seasonal considerations to his trading is perfectly wellaware of the periods of the year when a particular market is apt to have a
156
TRADING OPTIONS TO WIN
higher than normal probability of seeing an outrageous event. The immediate result of this awareness is that the premiums of the options that expireafter this period of putative volatility will, almost without exception, be verywell bid. In other words, the IVs of the options we would like to purchasefor our straddle may be too high, relative to their recent 6-month range, andbe unsuitable for us to use, by rule. What to do?If we do decide to bend our precondition about the options we purchasein a straddle having to have IVs in the lowest quintile of their recent range, wecan compensate for the disadvantage we incur through this decision. We’llsimply move the expiration of the straddle further away; in short, we’ll buymore time. This tactic compensates us in two ways. First, our per-unit costof time drops, and this always works in our favor to one extent or anotherwhen we purchase options. Second, we push Sister Theta further away fromour wallets, invariably an excellent idea. The negative side of this tactic isthat the straddle might be awfully expensive in dollar terms.If, for example, we would be interested in taking on the supreme suicideseasonal, summertime coffee, when coffee options’ IVs are moderate (notlow—we should be so fortunate!), the considerations might be along thefollowing lines. Say it’s February 14, and we prefer to buy straddles with aterm of 4–8 months, as a rule. Well, the September coffee options will expireon the second Friday in August, about 6 months from now, so we might ordinarily be tempted to buy a September straddle. Bad idea. Prime freezeseason in Brazilian coffee is late June through late July. If we purchasethe September straddle, then, to give ourselves the best chance of seeing afreeze or freeze scare, we might have to sit until the options only have twoor three weeks of life left. Real bad idea. Sister Theta will be on the rampage by then, and will be gobbling time premium like that Japanese fellowwho can eat 41 hot dogs in 15 minutes.The way to snap our fingers right in Sister Theta’s face is instead to buythe December straddle, if possible waiting until the IVs of coffee’s optionsdecline somewhat, a likely enough occurrence in late winter. Sure, if no radical event turns up by late July, we will probably end up with a loss in thetrade. However, coffee is coffee, the utterly untamed market, and like asnot there will be a period during our trade where the coffee bulls’ noses willbe scenting the air and pushing up the option IVs. Additionally, as noted before, absent the appearance of a freeze or frost threat, coffee prices can takea hefty dive in the summertime (which is why we buy the straddle, not justthe call option). If none of our three desired eventualities occur, then, whenwe go to sell back our losing straddle, our percentage loss in the trade will bemuch smaller if we’ve purchased the December straddle than if we boughtthe September. Once again, coffee is coffee—and in late July there will stillbe upwards of three months before the December options expire, with lotsof premium left in them.
Don’t Just Stand There, Do Something
157
“So, what is the cost difference between buying the September and theDecember straddle?” I hear you asking. Well, this year the respective costs ofATM straddles on February 14 happened to be 16.36 cents for the Septemberand 21.07 for the December, or $1,766.25. Is buying the December straddle agood trade from a risk standpoint if no weather event occurs? Should we gofor the gusto and try to catch either a freeze or glorious price-destroyingsummer weather? I personally wouldn’t, it’s not my style of trade—but thatdoesn’t necessarily make buying the December straddle a poor idea. Historyindicates that this straddle should have been profitable at some point 12 or13 years out of the past 17, but how profitable? And, what would our accruedloss have been over those years when the weather did not oblige us in thetrade? Without a history of coffee option prices, answering these questionsfairly is guesswork. Therefore, as a guess, buying the December straddle hasbeen fairly profitable, oddly, mostly from large down moves. Contrarily, buying the September straddle has been breakeven, perhaps a little better, evengranting the trader (generously) very good exit prices in the huge bull years.Oddly enough, this sort of trade, buying perhaps-high-IV straddles inanticipation of a potential outrageous event, is likely to be more successfulin stock markets than in futures markets. The way for a careful trader toprofit from this type of trade in stocks is to study governmental informationreleases, especially those from the FDA. Suppose the FDA indicates that adecision on a new drug is to be made on May 15. Supposing also that todayis November 18 or December 12 or January 3, I very much like buying ATMstraddles in the shares of the company that makes the drug, selecting a Juneor July expiration for the trade. Caveat emptor! If you do decide to try sucha trade, enter the trade immediately, ASAP, after the FDA (or whichever) announcement. Don’t wait around, because options on the affected company’sshares will start to become expensive right quick—you and I are hardly theonly folks looking for this sort of trade.
Performance Above All—How Has the StraddleBehaved Before?A careful selection process for buying straddles, as with almost every othertrading strategy we might employ, must include an examination of the history of the straddle over its entire term in some number of years. Just asfor the non-seasonal strategy, if the market we’re straddling has not movedaround satisfactorily during our intended trading term, historically, for whatever reason and no matter how otherwise attractive it may appear, let’s giveit a miss. Let’s find something else to trade, because any statistical advantage we may believe we have to this point is too possibly only a mirage. Wemay or may not understand all the factors involved in this market’s poor
158
TRADING OPTIONS TO WIN
historical performance in this portion of the year, but, frankly my dear, Idon’t give a damn . . . and neither should you.A study of only the historical price movement of the underlying marketover the life of our intended straddle is a slightly inferior tool, but it doesseem to be sufficient to the task. As mentioned, I haven’t yet acquired anhistorical options price database, which would be very nearly the definitivetool for backtesting a straddle-buying strategy, and yet I’ve been quite profitable in buying straddles according to the preconditions described previously. Simple good luck? Possibly, and I wouldn’t discount it. I’d love tohave the remaining piece of the analytical puzzle for this strategy, but I canhardly complain, for these entry conditions seem to work both well andconsistently.
A Selection Analysis—November 2002Orange JuiceWhile looking over the markets as I do a couple of times a week, in late Aprilof 2002 I happened to notice that the IVs on the November orange juice(ticker symbol JOX, or OJX sometimes) ATM options were at the dead bottom of their 6-month range. Nothing necessarily indicative about this—OJcan be a very slow market in the spring—but I took a further look. Was ittime to buy straddles on JOX? You decide—Table 8.3 provides the relevantdata for JOX and its options on the first day of May, 2002 (which by the wayis the date I’m writing this).How say you, ladies and gentlemen of the jury? Do we have the advantage we desire in this market? Shall we lighten the other traders’ wallets?This trade looks to be historically very advantageous to us. Never a year inthe last 12 with less than a 12-cent move one direction or the other in theprice of JOX from now until its options expire. The straddle costs us, allegedly, only 710 points, 7.10 cents (but we should always add a minimumof 40–75 points to compensate for general mopery and dopery on straddlesin the thin OJ options, trust me on this). The IVs are kissing the bottom oftheir 6-month range, and that’s favorable, too. We even get a hefty chunk ofhurricane season into the term of the trade. Hurricanes, though they rarelyharm the Florida OJ crop significantly, can get the bulls’ juices flowing, andthere have been numerous dandy hurricane-scare rallies over the years.Grab it! These conditions are nearly perfect for this approach to straddle buying. The term of the trade is sufficiently long, about 51⁄2 months, andvirtually everything is on our side. The 90-strike options are tradable, butthey are thin markets even though 90 is the ATM strike, which implies thatwe’ll have to pay to play, maybe as much as 30–60 points over the midpoint
159
Don’t Just Stand There, Do Something
TABLE 8.3
Snapshot of Orange Juice, May 1, 2002
JOX2—November Orange Juice (NYBOT)05-01-2002 close = 89.60option expiration = 10-18-2002
6-month range of 6-month IVs13.2–35.4%tonight’s 6-month IV13.4% (bottom decile)
Premiums
StrikingPrice
Calls
Puts
70.0075.00
19.6014.60
0.000.15
80.0085.00
9.905.90
0.551.35
90.0095.00
3.352.10
3.757.10
100.00105.00
1.200.85
11.2515.70
110.00115.00
0.600.40
20.4025.40
Historicals—JOX, 1990 –2001, between May 1 and October 18EntryDate
Interim
Close PriceMay 01
High
Low
Close PriceOct. 18*
MaximumPeriod Move
05-01-199005-01-199105-01-1992
180.25116.80112.70
188.40166.30121.00
107.75113.4596.10
108.65165.10101.10
72.5049.8016.60
05-03-199305-02-199405-01-1995
95.25110.25107.15
134.00111.00119.80
93.2585.0097.00
114.75105.20117.45
38.7525.2512.65
05-01-199605-01-199705-01-1998
125.5081.00111.20
127.4090.00131.95
103.0065.0094.50
111.6568.70121.50
22.5016.0020.75
05-03-199905-01-200005-01-2001
84.6583.5082.80
99.9087.9096.60
73.3069.2577.70
86.6571.1586.95
15.2514.2513.80
Mean Interim UpmoveMaximum Upmove
15.26749.500
Mean Interim DownmoveMaximum Downmove
17.97972.500
*Or next business day.
of the bid-ask spread. On a steady or higher opening tomorrow, I’ll be bidding for the November 90 straddle, without a doubt.What’s our expectation in this trade? What kind of risk to reward ratiocan we putatively establish, assuming we can purchase the straddle for 760points, 50 more than tonight’s settlement price? Historically, we can reasonably expect to make 4 to 6 cents, less all contest risk, call it $650–$750 net,
160
TRADING OPTIONS TO WIN
a perfectly acceptable ROC on our initial cost of $1,170, commissions included. The ROC with this level of profit over the whole term of the trade is59.8% or 10.9% monthly, but practically never will we stay in this trade untilthe October 18 option expiration. It’s probable that we’ll exit sometime inAugust or September, and the simple monthly ROC if we exit on September1 is 14.9%. The compounded monthly return (which many traders prefer touse, your humble servant included) is 12.4%. Either figure should be highlyacceptable to any but the most, uh, optimistic traders.What’s our probability of success? As in one of the examples in Chapter 6, the undesirable outcome has never occurred throughout the term ofour historical study (and only once going all the way back to 1980), so we’lluse an arbitrary 0.10 failure rate, implying 0.90 probability of success. Ourpositive dollar expectation is, therefore, roughly $700 times 0.90, or $630 perstraddle. Interestingly, we could theoretically risk every penny of our initialcapital and still be net profitable in the long term. If we enter this trade in10 consecutive years, 0.10, the estimated probability of failure, times $1,170is just $117, and our total theoretical expectation would therefore be $630– $117, or +$513 per straddle per year. Risking our entire initial capital whenpurchasing options is spectacularly bad policy, though, so let’s do somethingjust a little more practical.It may sound odd (or absolutely heretical), but here we do want to riska relatively high percentage of our initial capital, in the interest of not lettingSister Theta force us out of the trade if the market goes dead in the water fora couple of months initially. Wiggle risk operates within the framework oftime, too. Suppose OJ continues to be a very dull market for the next coupleof months. Sister Theta will have lightened our wallets to some extent, butthere will still be quite a bit of time remaining until expiration. If we decideto accept only some traditionalist minimal risk level, perhaps 10–15% of ourcapital, we’ll get bounced out of this trade far too frequently . . . and we’llhave only ourselves to blame. When buying straddles in which our historicalexpectation of profit is very high, as in this case, I use a figure of 35% of capital as the loss point. Is 30% a better figure? Is 40%? Any figure we choose isa rough approximation and pretty arbitrary. As far as I’m concerned, if thefigure we set is sufficient to avoid self-induced wiggle risk, it’s good enough,and 35% works very well. There’s one more factor in deciding about our losspoint, though.
When the Straddle Isn’t Working—Liquidateor Defend?Once we’re in a straddle trade, our position doesn’t require any immediatemanagement. Essentially, we’re waiting around for the underlying marketto move somewhere, or for option IVs to increase, preferably both. About the
Don’t Just Stand There, Do Something
161
only thing we need to do is to set a loss point, but the process by which weset this point is noticeably different than when trading pure assets, or whenwriting options. When we enter these kinds of trades, if the trade goes wrong(in the case of asset trading) or if it moves considerably against us quickly(the first week, say, in the case of an option write), we’ll exit the trade atour previously decided loss point. This is mostly a one-dimensional decisionprocess and our only usual concern is dollar loss.When buying straddles, setting a dollar or percentage loss point isn’t sufficient. Deciding on a loss point in this strategy is at least a two-dimensionalproblem and therefore trickier. Our concern is not entirely the gross amountof loss, as previously discussed, but also at what point in the trade we reachthis level of loss. The great thing about buying straddles is that it’s almostimpossible to lose a lot of capital quickly, assuming only that we were disciplined in our original selection methods and trade only according to thecriteria above (or other criteria that you may discover and find useful). Ifour straddle’s underlying market goes dead in the water for roughly the firstthird of the straddle’s life, we will surely be looking at an open loss, andwe’ll be facing our usual question: stay in the trade or accept the loss?The first thing to do at such a pass is to re-examine the current conditions in our straddle’s market. Has the market simply reached equilibrium?Equilibrium occurs at various times in any market, and is obviously a rottendevelopment for straddle buyers when it does. Can we obtain an indicationof market equilibrium? Maybe, and I’ll warn you right now that the methodI use is suspect. It’s usually helpful, but can be laughably wrong at times.Assume our straddle is at or very near our pre-decided loss point with twothirds of the trade’s life still to go. If the trading volume in our chosen market has been pretty steady and the open interest, the number of contractsoutstanding, has also been steady or declined moderately, the market is likelyat or near equilibrium. In such a case, we probably should exit our trade,because we have exactly no way of knowing how long this unfortunatelybalanced market may persist, and each week it does persist will remove dollars from our pocket.In contrast, if trading volume or open interest, or better still both, are rising (keep in mind, we’re only at the one-third mark of the straddle’s life) overthis period, we should hold our straddle a while longer. Why? Traders expectmarkets to move, correct? If new traders are entering the market now, whichis the case if open interest is rising, they doubtless have this expectation, presumably for some good reason, and we should wait around a bit to give thema chance to put dollars into (or in this case, back into) our pocket.
Elapsed Time Changes Our Decision ProcessThis decision process, stay or exit, changes once the trade reaches the only10-weeks-left mark. Now, ten weeks is usually adequate time for a market
162
TRADING OPTIONS TO WIN
to move far enough to make our straddle profitable, but the knife’s edge begins to approach our throat past this point, and the knife is being wieldedby Sister Theta, who is completely merciless. The theta figure for our straddle at this point is typically somewhere between 0.7 and 1.5%, meaning thatwe can expect to lose about 1% per trading day of the time premium remaining. Worse, theta will begin rising slowly any time now, and the decayof time premium will accelerate. The only counters for the damage theta willwreak on our capital from this point onward are significant market movement, or a rise in the options’ IVs, or both.If the options’ IVs are still well to the bottom of their 6-month range atthis point in the trade, we should consider it unlikely that we will get any assistance here. If the past month’s gross movement is atypically low whencompared to our original historical study, we’ve got still more trouble.We’re definitely in the trickbag if both these conditions are true at this point.If both these conditions obtain, we exit, and right now—no crossing our fingers and rubbing our lucky rabbit’s foot and staying around. If just one ofthese undesirable conditions is present, and we can see no potential marketmoving event (a government report or possible weather scare, for instance)on the immediate horizon, we’ll exit the trade and accept the loss rightaway, unless one other set of conditions happens to apply.If the options’ IV has indeed risen somewhat over the first part of ourtrade, if the market has moved perhaps a third of the way toward a point ofabsolute profitability point even though its overall gross movement has beenunder par so far, we might employ a defense. In the JOX 90 straddle we’relooking at, suppose we had bought the straddle on May 5 for 750 pointswith JOX trading at 89.60 and the IV of the November options at 14%. Suppose we had originally decided to accept 260 points of risk, but now it’s July15th and the orange juice market has been really slow. Suppose the marketclosed at 87.50 tonight, the options’ IV has moved up all the way (cough) to15%, and our straddle is now worth just 620 points.Our original trading plan isn’t threatened yet. Theta is hovering somewhere around 1.1% and 30 days from now will likely be sneaking up on1.8–2%, implying a further loss to us, if the FCOJ market stays dead, ofsomething like 130 points in time premium over the next 30 days. Finally,suppose that a major independent crop report on Florida OJ is due to be released in 10 days, and the Brazilian crop is a pretty good one according tothe information we can obtain.If the overall IV of the OJ options is now sufficient for the September80-strike puts to be worth 90–100 points or more, we have a legitimate opportunity to either restore profitability to or reduce the loss in our positionvia a mildly risky defense. Let’s say also that we’ve noticed a smallish risein trading volume and the open interest has been crawling higher over thepast week. These are normal enough during the run-up to an anticipated (and
Don’t Just Stand There, Do Something
163
presumably respected) market report, so we should probably not drawmuch inference here, but at least some factors of the trade are working a little bit in our favor.It’s possible, though unlikely, that the upcoming report will cause a sharpmove in OJ. If the market reacts negatively, we may find ourselves back inthe profit column very quickly. If the report is neutral or moderately bullish,our straddle is going to lose a chunk of value equally quickly. Of course, ifit’s very bullish and OJ runs up 6 or 7 cents or more right away, we might endup profitable on the call side of the trade. Okay, so where’s our risk over thenext 11 days? In the neutral or moderately bullish case, right? Can we takeout some insurance against this outcome? You bet we can.Given all these conditions (and I’ve omitted some, but I figure you’renot really interested in reading a futures market version of War and Peace),we can take worthwhile action. Let’s look at writing exactly two SeptemberOJ 80-strike puts for each straddle we own, netting perhaps 160 points, 1.6cents, for the pair. “What!?!” (Oh yes, I hear you screaming.) “What’s thisnonsense? 160 points in OJ is 240 lousy dollars, what the blazes is this supposed to defend against? What happens if the report is way bearish and JOXfalls 10 cents? And, hey, didn’t you say earlier that you don’t trade in frontof a report? This is bull!”Calm down already. I don’t initiate trades in front of a report, ever, butthat’s not what we’re doing here. We’re attempting to defend against an immediate and quite possible loss of capital. The more radically the marketreacts to the report, the better off we are in both the immediate and the intermediate term, even if the reaction is to the downside. How does that grabyou? Consider all the cases.If our feared result, a neutral or mildly bullish market reaction, occurs,we can liquidate our straddle, temporarily accepting a loss. The time premium of the September puts we wrote for defense, which expire in midAugust, will most certainly decline in short order, and we’ll have the choiceof sitting with them until expiration if we wish, minimizing our loss and ending up close to breakeven. In this case, the likelihood of being able to watchthese puts expire quietly is quite high. There tends to be a comparative newsand event void after the market digests a major report, and the only real seasonal factor in play in OJ until mid-August is the off-chance of a hurricanescare, which would be very pleasant for our adjusted position.If the market reacts very positively, the puts we wrote are toast, andwe’ll just keep the premium, thank you. The IVs of OJ options are enormously likely to increase for at least a little while after such a report, andthat fact combined with a sizeable upside move in JOX should put our position into the black straightaway.If the market reacts a little bit negatively, we’re still better off than wewere. Our straddle will be closer to profitability, maybe even actually
164
TRADING OPTIONS TO WIN
profitable, and our apparent new downside risk point will be about 76.60,which gives us a lot of room to construct a defense should the market dropdown to the 79–80 cent level.Things become slightly interesting if the market drops 10 cents. Suchan occurrence is distinctly not probable, both historically and because OJis cheap in terms of its relative economic value and has been an indifferentto-bearish market for a few years, but, as always, anything not provably impossible is possible. Even in this case, though, we can easily keep our riskwell under control.There are several constructive actions available to us, should we seesuch a sharp drop. We could liquidate our November 90 call for perhaps70–90 points. We could repurchase our excess short September 80 put, converting our trade to a bearish put spread, for around 330–350 (the market isnow 77.50 by our hypothesis, and 80–100 points time premium in the nowfront-month September option is about right). We could even turn aroundand write a September 75-strike put or a pair of September 7