the first four trading days of the succeeding month? Idon’t know, do you? There are hundreds of such shorties available, but I staywell away from them unless and until I come to understand the reason forand mechanics of such price movements. Which, by the way, occurs rarely.Condition 3 is partly obvious. If a market is trending the wrong way forour proposed trade, then proceeding with the trade is clearly akin to playing
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on the railroad tracks, but there’s more to it than that. This condition alsobrings back our old nemesis, information risk. For an example, we can examine a seasonal in the NYBOT “C” May coffee contract. There is a longstanding, pronounced, and quite reliable seasonal in May coffee from earlyto mid-March into April, and it is downward.In this period in 2002, May coffee went more or less straight up. Whathappened? The daily/weekly explanations from the pundits were so muchblah-blah, fund buying, technical rally, rata-rata. What seems to have occurred, as things turned out, was a change in an important supply condition.The Central American coffee harvest (which includes Colombia, oddly)was some 15–20% lower than the previous year, due largely, so it was said,to high levels of crop abandonment in the face of historically very low prices.A huge Brazilian crop, perhaps 50 million 60-kilo bags, or more, was on thehorizon. Ah, but, most Brazilian coffee is not deliverable against NYBOT’s“C” contract, and the “C” certified stocks in storage were shrinking ratherrapidly at the time. Call it a window of opportunity for those who were bullish on coffee. With no immediate threat from the putative enormous Brazilian crop, and temporarily declining supplies even with a known overallsurplus hanging over the market, May “C” coffee became very well bid during a time when ordinarily its price would have been falling.What’s the point of the example? Simply this: some traders latched onto the possibility of a temporary mini-reduction of supply very early and tooka bullish stance, whether with futures or options, and reaped a fine profit forthemselves. Other traders, your humble servant included, traded accordingto the historical tendency. Those who did so and who dealt in futures werebeaten up badly. Those of us who had applied the non-seasonal strategy bywriting calls with striking prices well above the market went through someamount of aggravation. At one point we had the, er, privilege of sitting withan untidy paper loss, but Father Time and his option-dealing sidekick, SisterTheta, showed up just like the U.S. Cavalry in an old Western film. We gaveourselves an extra chance to be successful by using the non-seasonal strategy, and it came in very handy, too.Nonetheless, my capital in this trade became threatened purely becauseI, and probably also the majority of seasonal/non-seasonal traders, eitherdidn’t acquire the pertinent supply information, didn’t realize its significance,or ignored its implications. In the plainest possible English, we stupidly acquired an extra portion of information risk. I plead “guilty as charged, yourHonor,” and am delighted to have emerged from the trade with a profit. However, this was definitely not a competently executed trade, and it illustrateswith crystal clarity that, even in the most statistically favorable non-seasonaltrades (and this one is and has been hugely favorable), we must constantly bealert to the implications of new information on the market.
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Extra Advantages, and a Little Common SenseConditions 5 and 6 are ideal when we can find them, but are not essential forprofitability in a non-seasonal trade. Lower figures are certainly acceptable,especially when the principal conditions are all in place. Too, there’s thepossibility that one aberrant year has skewed the maximum and average upmove or downmove figures. Even so, we want these ratios as high as we canfind them. Conditions 5 and 6 also presuppose the existence of a legitimateregular seasonal tendency, which is fine if it happens to exist, but is by nomeans necessary for our success in using the non-seasonal strategy.Let me clarify a bit. Every time a market has a seasonal tendency oversome period during the year, there exists by definition a corresponding andlikely worthwhile potential non-seasonal trade within that same time frame.However, the existence of a seasonal tendency is not a precondition for theexistence of a non-seasonal trade. All that is required for a non-seasonaltrade is that the market, whichever one we’re examining, regularly does notbehave in some fashion. If a market, say from June 1 through July 28, dropssharply in some years, usually stays in a restricted range in most years, andrises only modestly in the remaining years, there is no visible seasonal tendency. Nonetheless, this market is a candidate for writing WOOM calls ona non-seasonal basis during this period, because of what it does not do, orrather, has not done historically. There are therefore many more legitimateopportunities for non-seasonal trades than for seasonal trades, and this factrepresents a terrific opportunity for us.Condition 8 is merely applied common sense. If a specific market hasnever behaved in a specific fashion over a named period of the year, whyshould we even think of challenging history? Just as with our capital usage,it can never be anything but advantageous to us to be conservative in choosing the parameters for our trades. Assume there’s a possible non-seasonaltrade with a potential 6% ROC over a month’s time and a striking price 40%beyond the largest contrary move in history. Assume also that there’s another trade available in the same market having a potential 15% ROC and anoption strike only 20% beyond the maximum contrary move. I’ll take theformer trade every single time, other things being equal. Pardon my proselytizing, but so should you. Be the bookie, not the player. Maximize the occurrence of the profitable outcome, give yourself an extra measure of safety, andlet the optimists take all the risk to their capital.Condition 8 is framed in terms of “usually,” not “always,” for a good reason. Consider again the presence of a really aberrant year in the history ofa market over a particular time period during the year. Suppose that a particular non-seasonal trade would meet our preconditions if it weren’t forthe presence of that one year’s price movement. If we can learn that the aber-
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rant move was due to conditions that simply cannot occur this year, we maysafely discard that year from consideration. If the resulting analysis excluding the aberrant year indicates that a non-seasonal trade is warranted,we’ve no reason not to undertake the trade.
The Non-Seasonal Advantage—FrequentOpportunity and Wide VarietyThe non-seasonal strategy is advantageous for another reason. Unlike numerous other strategies we might employ over the same 3- to 10-week termas the non-seasonal, this one offers us opportunity in almost every activelytraded market at some time or times during the year. This happy circumstance enhances our ability to diversify our trading, allowing us to reducemodel failure risk, the overall risk to our capital that exists when we onlytrade in one, two, or three markets.Agricultural markets have had for centuries more or less obviously defined seasonal tendencies, but even currency and interest-rate markets havesome well-established non-seasonals that, objectively, we might not otherwise expect. After all, since governmental action is a—sometimes the—major determinant factor in which way and how far the value of currenciesand the level of interest rates move, why should a currency or interest-ratemarket behave in a very consistent fashion at specific times of the year? Forexample, there’s a notable tendency for the longer interest rate markets, the30-year bond and the 10-year note, not to rise very much from about the firstweek in April through the middle of May. Swiss franc and British pound donot tend to fall very far against the dollar during certain times of the year; thefranc from mid-August through the end of September, the pound during theautumn. There are surely reasons for such tendencies, although many timeswe haven’t any idea what they are. We’d like to know about them, but evenif we don’t, and if the non-seasonal is historically reliable and we can garnera profit by trading it, we should absolutely keep these markets on our list ofpossibilities.Am I advocating some sort of cult of willful ignorance here? Hardly. I’mjust being practical. Can you explain down to the last detail the working ofyour car’s engine? I certainly can’t, but this doesn’t prevent either of us fromdriving, now does it? It’s really the same in trading. We must acquire a useful and reasonable base of knowledge about a particular market’s workingsin order to begin attempting to trade in it successfully, no matter what strategies we may employ. It must also be correct to acquire more and more information over time, but we quite literally cannot afford to defer all tradinguntil our knowledge is complete, for it never will be.
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Acceptable Results—The Risk andthe RewardThere are a few other topics we want to examine concerning non-seasonals,and option writing in general. It’s all very well to talk about ROC in the abstract, but I’m not abstract and neither are you. We’d like to know what sortof return on our capital we can reasonably expect to see in a typical carefullyselected non-seasonal trade, and what levels of percentage and dollar riskwe should consider tolerating.The fact of the matter is that there aren’t hard and fast answers tothese questions, for a couple of reasons. We know perfectly well that themarkets are going to move around to some degree during the trade. By definition, then, the SPAN margin requirement (plus our comfortable margincushion, which is absolutely essential) is going to float around also. If thetrade is what I call a “flier” and works in our favor right from the startinggate, the average margin and cushion we’ll have to employ will be well lessthan indicated by our pre-trade analysis, and the ROC will be correspondinglyhigher. If the market behaves contrarily, we will certainly employ morecapital than originally anticipated and our ROC will fall, sometimes a lot,if the adverse market move becomes extended. Short of keeping detaileddaily records of margin and cushion levels and crunching quite a few numbers at the end of the trade, we cannot obtain a precise ROC for a particular trade.Now, I’m not lazy (well, not too lazy), but this amount of record keepingis more trouble than it’s worth, as far as I’m concerned. I’ll compute the capital usage and cushion figures once a week or so, more often if the trade evenseems as if it may work against me, and live with the approximate ROC result very happily. This is probably a sensible way to go about it, but if thisis too Bohemian for you, then by all means track your capital-usage-per-tradeon a daily basis. I’ll wager you’ll change your mind about doing this within60 days. Or less.As for the general question of typical or average ROC over a series ofdisciplined non-seasonal trades, this will be a function of the markets inwhich we actually do make a trade. ROC will tend to be higher in marketsthat normally have higher volatility on an absolute basis: coffee, natural gas,possibly gold or cocoa, lumber, crude oil and its products not infrequently,soybeans when they’re active. Equally, we’ll anticipate a rather lower ROCwhen trading non-seasonals in currencies, bonds and notes, and usuallythe metal markets. Except when the goldbugs have one of their occasionalthe-world-is-about-to-die-and-we’ll-all-be-poor-forever-unless-we-buy-goldright-now orgies . . . in which case, if we simply wait until their own fervorand their trading losses tire them out, we will see our ROC dancing atstratospheric levels.
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In any market, 5% net potential ROC per month is the least I’ll accept,and 7–9% for carefully selected and disciplined non-seasonals is a perfectlynormal prospect. If the non-seasonal trade should happen to begin rightwhen the market’s options’ IVs are to the high end of their 6-month rangeand option premiums are correspondingly high, such a trade can easily return 13–15%, even more, per month. This is sort of the best-of-all-worldscase, though. I’ll tell you this right now: if you undertake non-seasonal trading and consistently take out 12, 15, 18% net ROC per month for a while,first, I’m delighted for you and, second, you are selecting striking pricesthat are too close to the market price when you enter the trade. Back it offsome, be more conservative in your selection of the option strikes to write infuture. You’re tempting fate, my friend . . . and that’s just never a good idea.So much for our goals for profit. What about risk, much the more important consideration in the long run? The Duchess of Windsor once famouslyremarked that one can never be too rich or too thin. In trading, one can almost never be too cautious, and, speaking for myself only, I try to be a professional coward. To this end, I must match an approximate potential dollarrisk and its likelihood of occurrence against the theoretical positive dollar return. In short, I have to keep the old eyeball on, what else, expectation.At the end of our example HUQ trade, Table 6.2 shows that we have anicely positive expectation on option expiration day. Fine, and we certainlywouldn’t even undertake the trade if the expectation weren’t positive, butthis approximate figure is only valid at the very end of the trade. During thelife of the option, suppose HUQ rises, say, 6.00 cents in the first 10 days of thetrade and our short options rise in price from, say, 80 points to 190. Shouldwe exit the trade? What is a reasonable level of interim dollar risk to assume?
Wiggle Risk Redux—Timidity and RecklessnessAre Equally DeadlyThe answers to these questions vary with our personal temperament andour trading capital. Some traders are terribly risk-averse and wouldn’t dreamof ever risking more dollars than they could possibly make in a trade. Bluntlyput, if you are one such trader, change your attitude or don’t use this strategy. There is no third alternative. No matter how carefully we select a nonseasonal option write, no matter how disciplined we remain, in some numberof these trades event risk will turn up, the trader’s ultimate nemesis. Extremeevents will work in our favor more or less half the time, but we’re not concerned when they do. We’ll bank the profit and smile at the world.However, when even a minor event risk intervenes and works againstour position, a straight risk-no-more-dollars-than-we-can-make policy is 100%guaranteed to cost us dollars in the medium run and in the long run. Thispolicy is essentially a wiggle risk generator, and I can’t see any reason to
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introduce a higher, and completely avoidable, component of risk into ourtrading.In our HUQ example, our odds of success, of ending up profitable, areroughly 93-to-7 in our favor at the end of the trade if our pricing model isreasonably reliable. We stand to make about $300 net per option whenwe’re successful. Suppose we would accept a dollar risk, during the trade,of up to four times our potential profit, or $1,200. Outrageous, you say?Complete lunacy? Not so. Assuming only that our model is merely in thesame neighborhood as reality, in seven cases we’d lose $1,200, an $8,400total. In 93 cases, we’d make $300, a $27,900 total. Over a nominal seriesof 100 identical trades, even accepting what some would consider an outrageous risk amount of four times our potential profit, we’d end up withsomething like $19,500 dollars in pocket, all contest risk paid, at the endof this series of trades.Admittedly, this figure is too rosy. A sharp price spike will likely occurmore frequently than 3 times in 100, but will it be sufficient to cause us toexit the trade, given our generous dollar-risk level? Please note that such aspike will have to be really quite sharp in order to drive the price of theHUQ call option we wrote up to 358 points. That’s right; we lose the $1,200if and only if the premium of the option we wrote for 73 points net shouldsubsequently move up to 358 points. If the gasoline market’s volatilitymoves right up along with the price of HUQ, this would probably occur inour example if HUQ rose 8 or 9 cents, 800 or 900 points, within a week ortwo days of our entering the trade. If this wild little move occurs later in this5-week trade, Sister Theta will likely gobble up enough time premium toprevent the option from reaching this price, bar the historically non-existentcase in which HUQ actually moves above the strike of the WOOM call we’vewritten.Let’s say, being actively pessimistic, that a wicked spike as describedoccurs 10 times in 100, and that we exit immediately when such a spike occurs, losing $1,200 each time. Adding these occurrences to our original presumptive 7 statistically expectable losses, we will lose 17 times $1,200, or$20,400, and profit in 83 cases times $300, or $24,900, yielding $4,500through all 100 trials. We’re still very solidly in the profit column, correct?Clearly, whether or not we like the notion of risking four times the potential profit in a trade, we must match the dollar risk per position to ourtrading capital. If our account equity is, say, $15,000, this level of risk is toohigh, representing as it does fully 8% of capital. In such an account, it wouldbe more practical to set the interim dollar risk level at three times potentialprofit (and it is probably correct also to refrain from employing the non-seasonal strategy in markets having volatility above 35%, too. Don’t fret, youwon’t lack for other opportunities).
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Exiting a Non-Seasonal Early—When theReal World Meets the Trading WorldAs an ordinary thing, when we write options in the non-seasonal strategy,we’d like to sit on them until expiration and avoid the trading costs of exitingthe trade via repurchasing the option. That’s fine when we can convenientlydo so, and I support this policy completely, with exactly one exception.There’s such a thing as making money too quickly.Suppose we undertake a longer-dated non-seasonal trade having 14weeks until option expiration, and we write some number of WOOM optionswe select, with full discipline, for 140 points each. Suppose also that themarket tendency operates perfectly and vigorously right from the get-go.The premium of the options we’ve written falls all the way down to 9 pointsor even 5 or 2, within 6 weeks. Repurchase these options now if you can possibly do so. (Side note: a lot of times, WOOM options will show a settlementprice of 2 or 3 points, but when you try to repurchase them there, you’ll findthe market quoted at something like 2 bid/14 offered. Nonetheless, try to repurchase them for just a few points if expiration is a more than a monthaway.)Why do this? Because the risk/reward picture of the trade has changed,and this change is radical. In the case just described, we’d be sitting in ourtrade and waiting six, seven, eight weeks to collect 6 whole points. If ourtrade is in, for example, heating oil, 6 points is a big, bad, bold $25.20 per lot.“Well, what can happen?” you’re asking. “Geez, if I wrote November heatingoil puts (ticker: HOX) in July to take advantage of strong demand going intothe fall, and they were 10 cents OOM then, and heating oil has moved sharplyhigher, say 9 more cents, why am I worried? They’re 19 cents out of themoney, 1900 points! Hey, I’m better off risk-wise than I was when I got intothe trade. Thanks, but I’ll just sit and wait for expiration.”Good luck. You are now in roughly the same tactical position as the folksat LTCM were, attempting to “pick up nickels in front of a bulldozer,” asNicholas Dunbar quotes one of LTCM’s principals in his book InventingMoney (Wiley, 2000), (wonderful book by the way, great reading). If somebody starts up the bulldozer, if the one-off event, the impossible-to-predictcatastrophe occurs, you’ll rue this decision very rapidly. Why did I chooseheating oil in July–October for this example? Easy. I was in that exact trade,in that exact circumstance, and thought exactly as you do . . . in 2001. I hadwritten the November 62.00 puts for 140 points in July, straight non-seasonaltrade, actually anticipating a typical seasonal rise in heating oil. Here’s a snapshot of what happened when those jerks played kamikaze with the WorldTrade Center (my apologies: my editor doesn’t want me to use a muchstronger and far more appropriate term for those alleged humans).
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The markets closed for the next few days, very honorably so in light ofsuch a fantastic atrocity. Upon reopening, the energy markets went up, presumably on war fears, for precisely one day, with HOX closing at 82.00 (!)on Monday, September 17. The short HOX puts settled at 6 points on September 14 and at 5 points on the 17th. And then the energy markets just collapsed. One week, just five trading days later, HOX settled at 62.52, havingmade an intraday low of 61.50. I’d blundered into one of the sharpest movesin the history of the heating oil market—event risk at its most virulent.I had protected the position somewhat by selling futures (which I hatedoing) in the overnight NYMEX ACCESS session on Sunday the 23rd. I’d soldone future at 67.00 for every four 62.00-strike put options I’d written, and another at 63.30 (dumb and dumber, sigh) on Monday the 24th. The whole messwas not an outright disaster, but I still had brilliantly transformed a profit intoa loss by simply not accepting the lovely profit available, which represented90 or 95% of the absolute maximum profit that I could ever have made. And,no rest for the wicked, if I wanted to try to let the trade return to profitability, I was now faced with trying to keep up a defensive position for a monthor so, while heating oil prices would probably be gyrating furiously.Ultimately, with HOX trading at 64.90 or so some trading days later andmargin requirement going through the roof, I exited the whole position,losing about $1,380 on each 4-lot of options written, and pocketing a smallprofit, $300 on average on each short futures. There’s a term for trading inthis fashion: rank stupidity. Trading genius at work . . . ri-i-i-ight.Usually, I add very well. Occasionally, somebody should grab me by thecollar and yank my stupid butt off to remedial math class. By not wantingto spend perhaps 10 or 12 points plus a commission, call it $65.00 per lot, Igave away about $480 profit per option and oh so cleverly (choke, wheeze. . .), turned it into a $300+ loss to boot. Moron! One of the great sins in trading is sitting still while the market takes your profit away. Learn the lesson,save yourself time, aggravation, and capital. If a non-seasonal trade worksferociously in your favor early in the trade, and the options you wrote havetraded down to pennies, buy them back now. If you can make 85–90% of theoriginal intended profit over just 40–50–60% of the life of the trade, then exitgracefully, pay the extra commission, and go and make another profit somewhere else. It doesn’t pay to stay in such a trade, for the only things that canhappen while you wait are bad.
Staying Alive—Skipping the Suicide SeasonalThere’s one final consideration concerning our selection of markets fornon-seasonal trades. We must avoid what I call the “suicide seasonal.” Thereare several markets that have enormously reliable seasonals, but, when the
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seasonal does go wrong, it goes wildly and bizarrely wrong, and the risk becomes far too large to manage. Perhaps the classic such market is coffee,for the period of roughly May 22 through July 22, and for most of the Southern Hemisphere winter in general. Its 28-year seasonal tendency is shownin Table 6.3.Hey, look at all those nice pluses in column seven. This seasonal worksthree years out of four or better, and the associated non-seasonal has evena higher rate of success. The cumulative and average yearly results are impressive, too. Oh, really? Now, focus on the asterisked years. Ow! That’sright, in a straight seasonal trade, if we simply sold coffee, in three of theseyears, we might have had to contend with somewhere between 50 cents and150 cents of risk, between $18,500 and $56,000 of adversity per contract.That’s way too much. Gigantically too much. Unthinkably too much.Uh, uh—I know what you’re thinking. “Well, with a non-seasonal approach, I’ll just write the call options 100 or 150 cents away from the currentmarket price, and I won’t have to be threatened by huge moves as occurredin 1979 or 1994 or 1997.” Don’t even think about it. These enormous run-upsin the price of coffee occurred when freezing weather, which coffee treescan’t tolerate, visited the prime coffee-growing states in Brazil. Mark itdown in big, black letters: when a freeze hits Brazil’s coffee states, there iseffectively no upper limit on prices in the short term. Bill Gates can weatherthis type of extreme move, but you and I cannot, and there’s absolutely noreason to risk having to do so. Non-seasonal traders, and option writers ingeneral, want no part of writing coffee calls from late May through the endof July—not if they want to stay solvent. As the baseball players say, it onlytakes one, and you don’t want to even get close to this one. You’d rathergargle with nitric acid.Few other non-seasonal trades embody as much risk. Some historicallyvery risky ones are soybeans in May–July when prices are high, and cornfrom mid-June to early August under the same condition. When the goldbugs are having one of their scare parties, non-seasonal trades in gold canbe very dangerous (although we’ll have another look at these in connectionwith the Picador strategy in Chapter 12). No sane trader wants any part ofnon-seasonal trades in the NYMEX energy markets (possibly excepting natural gas) when there’s a war or the immediate threat of war in the MiddleEast, and sure as sunrise there will be a few of these in the next decades.The non-seasonal strategy is about normalcy, about things occurringmore or less as they usually do. This implies directly that, the higher the likelihood in a given time frame of some wild event occurring—be it involvingweather, war, or something else—the less desirable a non-seasonal trade isin the markets such an event would affect.We can’t predict the one-off event, of course, but we can and must avoidnon-seasonal trades during periods of the year when such events, either
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TABLE 6.3
Seasonal Sell Study, September Coffee “C”, 1974–2001
EntryDate MOC
EntryPrice
74-05-2175-05-2176-05-2177-05-23
Interim
ExitDate MOC
ExitPrice
GrossResult
Cumulative NetResult
75.88 77.80 67.8055.00 65.00 52.65138.35 158.40 120.35305.25 307.65 208.33
74-07-2275-07-2276-07-2277-07-22
69.5065.00126.35208.33
+6.38–10.00+12.00+96.92
+6.22–1.94–10.10+86.66
78-05-2279-05-21*80-05-2181-05-21
153.11157.50206.87118.17
179.52 113.02221.54 151.10210.40 159.84118.75 83.75
78-07-2479-07-2380-07-2281-07-22
113.63208.29165.69116.63
+39.48–50.79+41.18+1.54
+78.50+70.34+111.36+112.74
82-05-2183-05-2384-05-2185-05-21
120.12127.75155.03146.03
134.30131.75155.87150.20
117.00124.15139.10134.10
82-07-2283-07-2284-07-2385-07-22
124.75128.76143.68135.48
–4.63–1.01+11.35+10.55
+104.58+103.41+114.60+124.99
86-05-2187-05-2188-05-2389-05-22
218.21123.49133.85128.59
219.75 157.00125.00 99.50143.15 130.35130.00 84.75
86-07-2287-07-2288-07-2289-07-24
187.36104.65137.7284.83
+30.85+18.84–3.87+43.76
+155.68+174.36+166.20+209.80
90-05-2191-05-2192-05-219