<s> TradingOptionsto Win
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TradingOptionsto WinProfitable Strategies andTactics for Any Trader
S. A. JOHNSTON
John Wiley & Sons, Inc.
Copyright © 2003 by S. A. Johnston. All rights reserved.Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.Designations used by companies to distinguish their products are often claimed astrademarks. In all instances where John Wiley & Sons, Inc. is aware of a claim, theproduct names appear in initial capital or all capital letters. Readers, however, shouldcontact the appropriate companies for more complete information regarding trademarksand registration.No part of this publication may be reproduced, stored in a retrieval system, ortransmitted in any form or by any means, electronic, mechanical, photocopying,recording, scanning, or otherwise, except as permitted under Section 107 or 108 ofthe 1976 United States Copyright Act, without either the prior written permission ofthe Publisher, or authorization through payment of the appropriate per-copy fee tothe Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923,978-750-8400, fax 978-750-4470, or on the web at www.copyright.com. Requests to thePublisher for permission should be addressed to the Permissions Department, JohnWiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008,e-mail: permcoordinator@wiley.com.Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties withrespect to the accuracy or completeness of the contents of this book and specificallydisclaim any implied warranties of merchantability or fitness for a particular purpose. Nowarranty may be created or extended by sales representatives or written sales materials.The advice and strategies contained herein may not be suitable for your situation. Youshould consult with a professional where appropriate. Neither the publisher nor authorshall be liable for any loss of profit or any other commercial damages, including but notlimited to special, incidental, consequential, or other damages.For general information on our other products and services, or technical support, pleasecontact our Customer Care Department within the United States at 800-762-2974, outsidethe United States at 317-572-3993 or fax 317-572-4002.Wiley also publishes its books in a variety of electronic formats. Some content thatappears in print may not be available in electronic books.For more information about Wiley products, visit our web site at www.Wiley.com.Library of Congress Cataloging-in-Publication Data:Johnston, S. A.Trading options to win : profitable strategies and tactics for any trader /S. A. Johnston.p. cm.ISBN 0-471-22685-8 (alk. paper)1. Stock options. I. Title.HG6042 .J64 2003332.64′5—dc212002153117Printed in the United States of America10
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Contents
Preface
vii
CHAPTER 1
Making Money with Money
1
CHAPTER 2
On the Trail of a Method: Risk, Leverage,and Markets
22
CHAPTER 3
Profitability 101: Expectation and Options
45
CHAPTER 4
Just the Facts, Ma’am: AvoidingMoonshine, Morons, and Myths
71
No Hammer, No House: The Tools ofthe Trader
89
Thomas More’s Revenge: A Strategy for AllSeasons
100
CHAPTER 7
Apocalypse Never: The Uses of Defense
122
CHAPTER 8
Don’t Just Stand There, Do Something:The Straddle
146
CHAPTER 5
CHAPTER 6
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Contents
Don’t Just Do Something, Stand There:The Strangle
168
CHAPTER 10 Hi-Yo, Yogi! Riding the Bear
188
CHAPTER 11 The King of Strategies: The MartianRatio-Spread
207
CHAPTER 12 Every Once in a While: The Picador
226
CHAPTER 13 Pay Me after Lunch: The Endplay
238
CHAPTER 14 Filling in the Cracks: Ideas,Understanding, and Winning
252
APPENDIX A Studies of Historical Gross Movement inSelected Markets, 1990–2002
263
APPENDIX B Distribution of Contract Highs and Lows inSelected Markets, 1980–2002280
Index
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Preface
here are thousands of books about trading. Some books approach trading as an exercise in mathematics and focus on effective ways to turnthe mathematics of the marketplace into a profit-generation machine.Some approach trading as an exercise in psychology and tactics, attemptingto generate profit from a correct understanding and appreciation of what theother traders in the market are doing. Some are catalogues of strategies.Some apply economic, statistical, or logical principles to trading in the marketplace. Some are practical guides to the minutiae of markets.This book either fits into none of those categories or is a mixture of allof them with several other topics included. I’m not sure which. What it is, atbottom, is my understanding of the whats, hows, and whys of earning a trading profit, acquired over 30 years of trading in all sorts of markets (all sorts—remind me to tell you sometime about the great caviar-for-condoms caper).I didn’t become a steadily profitable trader until I came to understand someof the assumptions and conditions that underlie markets and to figure outcertain practical and usually effective ways to combat the assorted risksthat markets present; in short, to learn to deal effectively with the nature ofthe beast.This book is informal, because I’m an informal guy. There’s almost nothing I like better than talking with other traders about trading, and so the textis written in a generally conversational style. We will crunch a few numberson occasion, to clarify various topics and as an aid in looking at practicalexamples of trading, but there are no formal mathematical demonstrations atall in this book for two very good reasons.First, a number of fine analysts and remarkable scholars have publishedextensive compilations of the mathematics involved in quantitative analysis, numerical methods, and risk and price modeling, and there’s no pointwhatever in even attempting to replicate their efforts. A motto of mine is,“Always go to the best source available,” which is usually the original author.Who wants to read a rewrite of someone else’s work, anyway, particularlya very good original work? Can you even imagine Hamlet as rewritten by,say, Danielle Steele? Ghastly thought.
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Preface
Second, a whole lot of people (possibly including you) find formalmathematics either mind-numbingly boring, or impenetrable, or both.Cards on the table, I want you to turn the next page, not fall asleep or usethe book to stoke up your barbecue. To this end, I figure that, in addition toproviding what I believe to be useful and in the best cases profitable information, the text had darned well better be entertaining too.This book is for traders, particularly retail traders. That’s easy to say buttricky to accomplish, because the level of experience varies greatly amongany group of traders. This is not a primer. I’m assuming first of all that youtrade in some market, and that your principal interest is to look at ways toimprove the profitability of your trading. In addition, I’m assuming that youare moderately familiar with what a futures market is and with its basicworkings, and that you are at least comfortable with the idea of options,even if you believe you’ve never traded an option in your life. You have dealtin options, of course; you very likely deal in them implicitly every single dayof your life . . . but we’ll get into that subject a little later. Don’t believe it?Care to bet against it? Read on, and save your money.If you know the difference between a put and a call, and know what apremium, a striking price, and an expiration date are, you’ll have no difficulty with the text. If you’re a sophisticated and experienced trader in futures and options markets, you’ll doubtless find some of the text to beelementary, even possibly annoyingly so. Sorry about that, but this resulthappens to be a condition of contest when writing for a wide (I sincerelyhope!) audience about the subject of trading. Frankly, I think that anytrader, no matter how sophisticated, will find a number of worthwhile ideasinside . . . but there’s only one way to find out, isn’t there?Few books are the product of any single person’s thoughts and efforts,and most certainly this one is not. It literally would not even have been written without the encouragement of Alex McCallum of INO, and without hisintroduction to my generous (and patient!) editors, Pamela van Giessen andLara Murphy, at John Wiley & Sons. I also owe a considerable debt to JayShartsis and Bob McKenna at R. F. Lafferty & Co., for the enormous amountof practical advice they’ve offered, and explained, over the years. Manytraders, including especially David H. Murray, Elaine Long Knuth, JanetdiGregorio, John Anderson, and Mark Kelly were kind enough to read myoriginal drafts, offer a variety of valuable suggestions, and point out andcorrect several instances where I had driven neatly off a literary cliff. DanReinhart, a marvelous statistician (among his other considerable talents),was gracious enough to check over the analyses in the text and correct several that I had fluffed. Thank you, Danimal.
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Even though my principal business is the design of computer systems,I’m an absolute idiot when the subject is graphics, and I’m fortunate to havea very talented friend to bail me out of my fumblethumbedness. The tablesand figures in the text were produced by the ultimate sweetheart, Lee Fleming, one of the masterminds behind InfoPulse LLC (www.infopulsellc.com),of Norwalk, Connecticut.My long-time futures broker, Ken Margherio at REFCO, Inc., has contributed mightily to this little effort by applying his 30-plus years of experience to helping refine some of the strategies discussed in the later chapters.Mark Kinoff, a local trader at the Chicago Board of Trade, offered severalcreative ideas about useful tactics in interest rate markets. The noted currency analyst and author, Barbara Rockefeller, was extremely generous,both in offering constructive criticism and in introducing me to a bunch offolks who could, and did, clarify a number of points. I also want to thank EdRittershausen for taking his time to make several excellent and practicalsuggestions.In theory at least, we learn from our mistakes. I know for a certainty I’velearned much more from my errors in trading than from my successes. Booksabout trading or investing that focus on the author’s successes, usually withat least an implied “Hey, look how wonderful this method (or this author)is!”, exasperate me no end. Look, I already know how to win; what I wantto know is how not to lose. Consistent with this view, the examples of actualor hypothetical trades throughout the text are generally negative examples—demonstrating what to do if a trade goes awry, how to deal with unanticipated risk, and even, occasionally, how to turn a loss back into a profit.After all, if a trade goes well, it goes well, we bank the profit, and there’s little more to be said about it, right? There just isn’t much value in yammering on about a wonderful trade I made last year or last month, and I want toprovide as much value to you as I can manage.I’m just a trader, a part-time trader at that. I realize that there are numerous ways to profit in trading. Unfortunately, there are a much larger number of ways to lose. Many of these losing methods are superficially appealingand seem to offer an advantage to traders, but turn out ultimately to be onlyexpensive illusions. Larry McMillan, the inestimable author of, among hisother works, Options as a Strategic Investment (New York Institute of Finance 1993), states on page 467 of the third edition, “There are certain investors who will enter positions only when the historical percentages areon their side.”He is exactly right, as usual, and his statement applies with equal validity to traders as well as investors. I’m one of those traders and, by George,I will have an advantage. Whether the advantage is historical, statistical, or
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Preface
one based on demonstrable fact, I will have some sort of advantage in handbefore I enter a trade. Trading without some sort of definable advantage isgambling. Gambling is about amusement or ego. Trading is about making aprofit.This book is about attempting to recognize and gain advantages in ourtrading in a methodical fashion, but our flight through this world will not benon-stop. We must visit several interim topics, the practical and logical underpinnings of markets, before reaching our ultimate destination. May I suggest you get a cup or a glass of your favorite beverage and settle into acomfortable chair as we examine together a number of ways to view and understand and profit from the mechanism of the marketplace. Our destination? The ability to put and keep an advantage on our side when we trade,that is, when we engage in making money with money.
OFFICIAL WARNING: The author is about to commit heresy. Do not readfurther unless you are willing to consider revising at least some of yourbeliefs about markets, particularly about the desirability of trading incertain of them. The author disclaims any and all responsibility for theresults of shattering any and all long-held illusions, particularly thoseabout stock markets.
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CHAPTER 1
Making Moneywith Money
If we win here, we will win everywhere.—Ernest Hemingway, (For Whom the Bell Tolls)
trade in the markets. I expect to win. I expect to profit handsomely bytrading, over both the short term and the long term. And you can andshould, also.That said, I don’t have any surefire “system” to offer, nor any originalmathematical or analytical techniques to employ, nor any special knowledge of a market or markets. I concentrate on method, that is, an approachto the development of trading strategies that put the likelihood of profit onmy side of the table. With your permission, I propose to illustrate severalmeans by which you can do so, too.Since time is money—and time absolutely is money when trading themarkets—let’s get right down to cases. Let’s play a game, a wagering game.All games have rules, and here are the rules for this one:
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1. I select all the wagers to be made between us.2. You will pay me, in cash, an indeterminate amount of money that I will
name before I will accept your wager.3. Wagers are not settled immediately, but after some amount of time, andthe net value of both our wagers fluctuates day to day.4. Either you or I may transfer our wager to a third party of our choice atany time prior to settlement.5. I can purchase insurance against a bad outcome of my wager at any time,while you may or may not be able to insure your wager satisfactorily.1
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6. You know at the start that if you see your wager through to the end, you
will win only one time in four or five, but that winning wager may beenormously profitable, and that the other times you will likely lose yourwhole wager.7. Other rules may apply from time to time, or there may be changes inthe rules, according to circumstances over which neither you nor Ihave any control.Do you really want to play such a game? Right, I didn’t think so, and yourdecision to refuse this game is entirely accurate. Those who do play such agame lose, just as you almost surely would. Not all the time, certainly, butthey lose, and steadily. Why would anyone kick his own shins by playing agame such as this? I really don’t know. Misplaced hope, or greed? Possibly.Lack of information or failing to analyze the game properly? Perhaps. Outright stupidity is definitely in the running, too, as is compulsive gambling.Believe it or not though, large numbers of people play a game highly similar to this every business day of the year. They spend a great deal of timeand capital buying options that are exceptionally unlikely to return a profitto them, an activity that is functionally identical to the hypothetical game Ijust described. For the most part, I trade against these folks, which impliesdirectly that I win some very large percentage of the time.There is only one legitimate reason why someone might play our hypothetical game or any of its real-world analogs. He may be required to play bylaw, much as you and I must purchase car insurance in order to drive legally.We could be cynical here, and note that the game I’ve described is more thana little bit like my taking the part of an insurance company. The only rulethat doesn’t really fit is the rule about your possibly making exceptionalprofits from time to time. Making a profit is impossible when dealing withinsurance companies, except, of course, if you can manage to defraud themsuccessfully.The point of this example is not that there is some terrifically profitable game waiting to be played, but rather to find a starting place. What isit, really, that we’re doing when we trade? In the sense of the example, andas far as some mathematicians are concerned, we’re playing a game. Manyother people would answer, very reasonably, that we’re trying to makemoney. Both answers, though, miss the mark to some degree, and this erroris not only not unimportant, it is vital. What traders do is attempt to makemoney with money, within a societally defined game-like context.Does this strike you as a bit odd? It should. Money is primarily a tool foruse within the context of society. Suppose you have a huge stack of $100bills right in front of you. Suppose also that you’re in a house outside WestBroken Glass, Montana, the pantry is bare, your car won’t start, and thephones are out. A flood has just washed out the bridge on the road to town,
Making Money with Money
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your nearest neighbor is miles away, and, worse yet, there’s nothing goodon cable. How useful is that stack of bills now? Hardly useful at all (well,you could light them to keep warm for a little while). Other tools do notshare this limitation of usefulness only within a specific context. A canopener works just as well at the North Pole as it does at the Equator, or inyour kitchen.Equally, no one would attempt to make a screwdriver with a screwdriver, a radial arm saw with a radial arm saw, or even a computer with acomputer, although this last concept does have some interesting possibilitiesfor futurists and cyberneticists. Money is unique among tools for these reasons. Therefore, if we intend to make money with money by trading, wewould be well advised to take a reasonably hard look at other ways tomake money with money and at what each of these may involve, and, evenmore importantly, to see what we can learn from them. And so we will,right now.To my observation, there are just four generic ways to make money withmoney: gambling, bookmaking, banking, and trading or investing. Each has,naturally enough, advantages and disadvantages for their respective practitioners. With a view toward learning more about developing a successfulmethodology for making money with money, let’s take a look at the characteristics of each activity in turn.
Gambling—Skill, Luck, or Something Else?Gambling is an enterprise in which the entrepreneur, usually called the“player,” attempts to profit by winning games consisting either of foretelling the outcome of a specific event or of beating an opponent at a contest. These games can be broadly separated into two groups: low-skill andhigh-skill. By “skill” here, I distinctly mean the ability of the player to alterthe outcome of the game in his favor through the use of advantageousstrategies. In the typical low-skill game, casino games for instance—craps,roulette, keno, what have you—there are no such strategies; the player may,through accurate play, only reduce the size of his expected loss over time.Indeed, in quite a number of casino games, various types of coin-operatedmachines for instance, the player may not even have the option of minimizing his loss through correct play, but must willy-nilly accept the pre-setnegative outcome of the game.Gambling in high-skill games, sometimes called proposition betting, involves the player accepting a partially predictable prospect of success orfailure and will almost always contain a considerable mix of skill and nonskill factors relevant to the outcome. Examples of this form of gambling arecommonplace. You might bet a friend that you will beat him at golf, tennis,
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TRADING OPTIONS TO WIN
cards, or any of thousands of different activities each involving some degree, sometimes a staggering degree, of skill. You might, alternatively, bethim that your favorite sports team will beat his favorite team in the upcoming game. “Wait a minute, where’s the skill in that?” you may be asking.Have no doubt here; skill is and must be involved in this latter bet if theplayer intends to prosper over time.In playing a golf or tennis match, the player’s skill is applied; his strokesimmediately affect the outcome. In a sports wager, the player’s skill is implied. The player himself does not affect the outcome of the game directly,short of perhaps introducing strychnine into the other team’s pre-game meal,but the player’s outcome, win or loss, is a function of his skill in rating therelative talents of the teams involved. In addition, to succeed, he must accurately evaluate other conditions that will or may affect the outcome before the game takes place.If you are a purist, you may object to the characterization of a gambler as “making money with money” by contesting a golf or tennis match,or by playing a card game, or by wagering on a hockey match. Such an objection is specious. The only important question is, “What is at risk?” Thebanker, the bookmaker, the gambler, and the trader all put their capitaldirectly at risk. The physicist, the baker, the assembly-line worker, theteacher, the salesman, and the policeman put their time, talent, and effortright square on the line—but not their capital. To be such a purist here isequivalent to asserting that the only true way of making money withmoney is to play some form or another of flipping coins, wherein the onlyintermediary device used is actual currency or specie. That’s much tooformalistic a view.
The Starting LineTo make money with money, whether by gambling or through any other enterprise, first involves a selection process of profit possibilities. For thegambler, the selection process amounts to “Which game(s) shall I play?” Inlow-skill games, this selection is basically emotional, that is, the gamblerlikes the game. It’s entertainment for him and he enjoys it, notwithstandingthat some large percentage of the time he is going to lose. Likely enough,he’s aware of this high probability of loss . . . and simply doesn’t care. Inhigh-skill games, though, the selection process is much more empirical, aswell as much more important to the player’s outcome. The high-skill gambler wants, in short, to maximize his confidence level methodically, eitherby selecting opponents he “should” beat or by choosing wagers that appear,empirically or intuitively, to be to his advantage. He will ultimately end upmeasuring his success or failure with the yardstick of careful selection ofhis profit possibilities, of opponents, or propositions. This success or failure
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will be modified only by the intrusion of non-skill factors, of somethingvery much like Shakespeare’s “outrageous fortune.”If the result for the gambler in low-skill games is more or less preordained, the result for the gambler in high-skill games is nothing if not highlyvariable. Part of the reason for such variability is that, in a disproportionatenumber of games the gambler might play, he will not know his profit expectation beforehand. He may perceive he has an advantage in a given proposition or in playing against a given opponent, and, based on experience, hemay very well be correct. The notion of perceived advantage in propositions, however, is in most cases a subjective view. There’s nothing wrongwith subjectivity per se, but it has a notable tendency to work against consistency of success in any enterprise, the more so if subjective measuresare employed when objective measures are available. When actual advantage can be calculated, the gambler who relies on perceived advantage issubjecting his profit expectation to unnecessary fluctuations. Even beyondskill of whatever type, the winning gambler must have or have access to theability to calculate his advantage when such a calculation is available.
Risky BusinessThere are other factors contributing to his uncertain profit expectation. Players in high-skill games, as do we all, have the well-known bad day occasionally, whether self-induced or due to external circumstance. Perhaps yourecall a famous scene in the film The Hustler. After a long night of shootingpool, Minnesota Fats steps away from the table, washes his face, re-combshis hair, re-knots his tie, generally refreshing himself and renewing his concentration on the match, while Fast Eddie Felson uses the time to make wisecracks and guzzle bourbon. Subsequently, of course, Fast Eddie gets cleanedout. This is a nearly perfect parable of the self-induced loss.External circumstance can cause loss in any way imaginable. The golfball hits a rock as it lands and kicks off into a bunker instead of going ontothe green. An outfielder slips on a patch of loose turf while chasing a flyball and the winning run scores. The pool player hits a perfect shot but anauto accident outside causes a car to come through the wall and wreck thetable before the object ball drops into the pocket. The gambler will certainly try to and may well succeed at eliminating self-induced losses, buthe is almost completely helpless against the occurrence of adverse external circumstances.These external circumstances collectively are called event risk, andevent risk is relatively large for the gambler in high-skill games. If you’re notimmediately persuaded of this, consider that a high-skill game, any one youlike, is played over time and usually involves thousands, even millions ofsub-events during the course of the game. What’s a sub-event? It’s any event
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TRADING OPTIONS TO WIN
that occurs within the context of the game. It might be the move of a rook,a pitched ball, a rainstorm occurring (or not occurring) on the 14th hole, theturn of a card, literally anything that happens over the course of a game.The likelihood of any one particular sub-event occurring in such an improbable fashion as to alter the outcome of a game is tiny, yet the likelihoodof some sub-event doing so during the course of a game is larger, sometimes much larger. Why? Because this likelihood increases multiplicativelyover the number of sub-events to be considered. When the sub-events in agiven game are numbered in the millions, the probability that some of themwill materially alter the game’s outcome is no longer insignificant and mayeven end up being the largest determinant factor in the outcome. Worsestill, from the gambler’s standpoint, he has no way of knowing either whenor how often the feared improbable sub-event(s) will occur, and there is almost nothing he can do about it in any case. Therefore, in his attempt tomake a profit, the high-skill gambler must accept a rather high level of eventrisk, and this level increases along with the complexity of the game.It would be very useful to be able to quantify the amount of event riskfor the high-skill gambler, but such a quantification is impossible in thegeneral case. What is the probability before the fact that, say, an opponentwill play an unexpected and effective move during a game of chess and thatthe gambler will be unable to counter it? What odds that a fly or some otherinsect decides to inspect the gambling golfer’s inner ear in the middle of hisbackswing on an important shot? Before the game starts, how likely is it thatthe quarterback of the team on which the gambler bets, who hasn’t thrownan interception all season, will throw five interceptions in today’s game? Perhaps someone knows how to compute the probability of occurrence ofevents such as these with some degree of accuracy. I’m not that person, probably you aren’t, and I somehow don’t think the gambler is, either. The netresult, and a very undesirable one it is too, is that the gambler must not onlydeal with event risk, but also has no objective measure of how large or smallit may be at any particular point during the game.The gambler faces other kinds of risk. Suppose that he wins his proposition bet and the opponent, for whatever reason, doesn’t pay him? Or, suppose that he’s wagered on a football game and won, but his bookmaker hasbeen arrested before the gambler can collect? Without resorting to unlawful means such as rearranging someone’s anatomy, the gambler is entirelydependent on the good will of the other party for his profit, and he has noworthwhile way to offset the risk of the other person not playing fair. Thisis a different and specific risk, called counterparty risk, wherein one partyto a transaction does not perform as previously agreed. Every method of making money with money involves counterparty risk to some extent. If you consider the point for a moment, you’ll realize that this statement must be true
Making Money with Money
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de facto. If we are engaged in making money with money, where does ourprofit originate? It comes from other people, some of whom, for various reasons, may occasionally fail to perform as agreed. The good news is that othermethods of making money with money have certain built-in advantages inavoiding and offsetting counterparty risk which gambling does not.Gambling in low-skill games as a way of making money with money isstatistically a hopeless proposition, but even so we can learn something veryuseful from those who attempt to profit in this futile enterprise, that is, whatnot to do. Specifically, we can’t take the short end of the bet and expect toprofit over time. That sounds pretty obvious, doesn’t it? I agree, but a littlelater on we’re going to see that some people, even some sophisticated andinformed people, fail to adhere to this seemingly obvious notion.Gambling in high-skill games may indeed prove to be profitable, provided the player himself has sufficient skill, but his making a steady profitis subject to still other obstacles. Can the gambler find a continuous sourceof games to play, propositions to wager on, and opponents to contest? It’snot exactly as if he can dig up profit possibilities in the telephone directory,after all. Further, with regard to opponents, won’t the successful gamblerneed to continually locate new opponents? He definitely will, because sooneror later everyone gets tired of losing at the same game. If you’re even thinking, “Heck, the gambler can go to Las Vegas or Atlantic City and find all theproposition bets he wants, and probably a lot of opponents besides,” thensit right down and have another think. If he does so, he’s going to find himself competing directly against another way of making money with money—bookmaking. And, if he does so, he’s going to lose.
Bookmaking