0 puts, if thepremiums of these and the other pertinent market factors are high enoughto point toward this tactic. We might do nothing and wait a bit for a bounce,hardly a remote possibility after such a drop. And, certainly, we might electto liquidate the whole position and accept the loss.The point of the defense is that, in four cases of five we will improve ourposition to a greater or lesser extent, and in the fifth case we will still retaingood opportunities to reduce our loss or return to profitability. In this fifthcase, what we actually will do will depend, again, on taking another lookaround the market, and particularly the historical tendency of OJ betweennow, approximately July 26 by hypothesis here, and the expiration of theSeptember options in mid-August.
The Battle of Midway—The Straddle Is Profitable;Now What?When the straddle we’ve bought has become profitable, and the 10-weeksleft point at which theta will start becoming nasty is still some time away,we have a decision to make, and it’s the usual one: fold ’em or hold ’em.Claim the profit, or try for more? I would dearly love to write down threeeasy rules for us to follow in order to make this decision, but I don’t happento know them. There are clearly some principles worth adhering to, though.First, perform two more historical studies. The first runs from now(whenever “now” is in our trade) to the date our straddle expires. The second runs from now through whatever date is 9 weeks from expiration. Ifboth studies indicate that the market is historically apt to continue in ournow-profitable direction, and if we aren’t already profitable to an above-
Don’t Just Stand There, Do Something
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average extent (as suggested by our original historical study of the strangle), let’s sit for a bit. If short-term supply/demand factors appear to be favorable also, that’s a bonus, but not necessary to our decision.Our mission in this case is to retain or enhance profit in hand. Takingany action (and sitting still is an action) that is less than 3-to-1 in our favorfrom this point is just plain wrong. Clearly, the probability of success fromhere (that is, increased profit) is not well-defined for every action we mighttake, but this isn’t an undesirable situation. If we can’t approximate our continuing advantage for any given action, we simply won’t take that action. Ifnone of the possible set of actions offers us, even apparently, the degree ofadvantage we want, we’ll just take our profit, and find another good trade.Reasonable?Or, maybe, not so fast. Just because our trade began as a straddle in noway implies that it must remain so for all its life. Suppose that our historical studies from this date are moderately favorable toward our trade, towardthe direction the market is now moving, but nothing to rave about. Perhapscurrent supply/demand considerations are also somewhat in our favor, too.We do have an option here (er, so to speak). We can consider converting thestraddle to an option spread, biased in the market’s current direction.The mechanics of this conversion are a snap. Let’s say that the marketwe’re straddling has moved higher since we entered the trade. If we elect toconvert the trade, we sell back the put option we originally bought, at a lossto be sure, but this sale still shifts capital back into our pocket. We’ll complete the conversion by writing an OOM call that expires when or before ouroriginal long call does. If, in our example trade, JOX had moved to 102.00 byJuly 15, the strangle would have been trading at 1280–1350, perhaps higher,and the September orange juice (JOU) 105 call would have been priced atsomething like 240–270 points. Not a rich reward for writing the JOU 105call, I grant you, but if we have reason to consider that orange juice is evena reasonable favorite to move higher between now and the expiration of theSeptember options, this might be worth our examination.Selling back our JOX 90 put probably nets $50 to $60 at this point, nothing really, and writing the JOU 105 call for 230 points net would add about another $200 to our side of the ledger, totaling perhaps $400 per original straddleafter all our trading costs. This amount may be numerically small in the worldof trading, but dismissing these dollars out of hand would be plain silly. Theyhappen to represent about 34% of our original per-straddle capital.No matter which way we decide, to attempt an enhancement or simply toaccept the profit, on occasion we’ll be wrong. When we accept our tradinggain, sometimes the market will keep on moving, and we’ll be tempted tokick ourselves for throwing away a chance at an exceptional profit. Resist thetemptation! If a trading decision is sound, if it represents the best or nearlythe best we can do at a given time and with a given set of information about
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TRADING OPTIONS TO WIN
the market we’re trading, let it go. Traders wander into the “woulda, shoulda,coulda” game far too often, and where’s the benefit? Second-guess yourselffor the next X months or years? What an incredibly unprofitable idea.If we elect to try to enhance the profitability of the trade by convertingthe straddle to a directional spread (bullish, in our example), and the marketbegins to move against our newly adjusted position, the same reasoningshould apply, with one important exception. If the market begins to movein such a fashion that our existing profit is at risk of vanishing, we exit, period, stop, end, no discussion, and as fast as we can. Sell back the long sideand repurchase the shorter-term September options we’ve written, or, if historical studies and current market conditions warrant, try to hold the shortside of the spread until expiration. Once we’ve latched onto another trader’scapital, we do not want to give it (all) back for any reason, at least as far as weare able to control the situation.
Take the Cash and Leave the Sound of Distant DrumsSometimes, our metaphorical “Battle of Midway” can’t or shouldn’t befought. In our continuing example, I finally did manage to buy several JOX90 straddles on May 16, at 790 points, with the OJ market right near 90 cents.Oh, I overpaid a little, not a doubt of it, and regretted it, too. Gave myselfthe rare privilege of spending about 65 days just watching the orange juicemarket do nothing. JOX dithered within a 5-cent total range from mid-Mayto mid-July, and this, my friend, defines “dead in the water” perfectly. Thestraddle fumbled its way down to 650, then 630 and I spent my time tryingto ignore this morticians’ market and finding some profitable trades. Then,out of the blue, a report surfaced that, due to the low level of spring and earlysummer rainfall in Florida, the juice content in the Florida crop this yearwould be 12–15% lower than last year. JOX popped up to 101.20 in about 10days and I couldn’t get out of the trade fast enough, throwing back thestraddles for between 1120 and 1160 points during this period.Too quick to exit, you say, sold them out too cheaply? Maybe, and so faryou’d be right, because JOX has moved right on higher, to 106.40 tonight, andlooks as if it might keep on rising. That’s fine with me, and good luck to theOJ bulls. I was losing capital, the market gave it back and tacked on a profitnot much less than that originally anticipated. Now I should be complaining? Not a chance; I’m delighted. If JOX moves on up to 120.00 or into thatneighborhood, I’ll just shake my head ruefully and mark the experience downfor next year: be a little greedier . . . but not much. Meantime, if the volatility of the options dips back down somewhat, there’s no reason not to try thisstrategy again in the March options later in the year, is there? Perhaps a goodtime to try it might be in the low gross-volatility month of September, conditions warranting.
Don’t Just Stand There, Do Something
167
Well, we’ll see about that shortly. Right now, let’s have a look at waysof earning a trading profit when buying a straddle in one or another marketis not a favorable proposition. If straddle buying is distinctly unfavorable ata given time, is there an opposed strategy, a sort of anti-complementary oneif you will, that is? Such strategies do exist, and we’ll examine one of themin the next chapter.
CHAPTER 9
Don’t JustDo Something,Stand ThereThe Strangle
Then Joshua spake . . . and he said in the sight of Israel, “Sun, standthou still” . . . And the sun stood still, . . .—Joshua 10:12-13A potentially GREAT strangle trader!—SAJ
hink about buying straddles for a moment. In theory, we could buy anATM straddle, say of 4 to 6 months’ duration, in every futures marketthat has reasonably liquid options, perhaps 25 markets in all. If weheld all these straddles until the respective markets’ options expired, and ifbeing profitable in this broad selection were an even-money proposition,we would expect over time to lose just our contest risk, true? What reallywould happen? Would that be the extent of our loss?Not even close. Such a strategy would be deadly to our capital. Most ofthe time in such a trade, we’d be heavy losers. We might profit, occasionally,maybe. If there were a serious summer drought, we might see the all thegrain markets rise substantially. Maybe there would be an oil shock, too, ora banking or currency crisis might set the IMM currency futures on fire. Theproblem with this sort of strategy is that we are wagering that not one, butseveral different events will occur that move prices around sharply. For us toturn a profit by buying a sizeable number of markets’ ATM straddles, at leastsix or seven markets, perhaps more, would need to undergo substantialmoves, and all in the same period of time.What is far more likely to happen is that the majority of all our marketswould move around somewhat, a few would see a significant market-movingevent, and we’d lose on all the rest. We’d very likely end up thinking seri-
T
168
Don’t Just Do Something, Stand There
169
ously about putting our remaining capital into CDs at the bank. The negativesin this strategy are astonishing. First, we have exit problems. If we hold allthe straddles until expiration, one of each pair of options will by definitionexpire worthless, for clearly no market can be simultaneously above andbelow the striking price of our straddle. No problem, you say, we don’t usually intend to hold straddles all the way to expiration in the first place. Trueenough, but if we sell off, say, all the straddles showing a loss after 90 dayshave passed, we impose on ourselves yet another trading condition, onethat’s more than a little arbitrary. If instead we exit on a case-by-case basis,we will create numerous extra trading decisions. Write it down: more tradingdecisions equal lower profit. Our exit problems vanish only if we can formulate a workable and general exit rule that applies to most or all the futuresmarkets having tradably liquid options. Good luck trying to find that!Second, if this buy every-straddle strategy were profitable, the previouschapter must have been very much in error in discussing the highly restrictiveconditions necessary to profiting when buying straddles. It isn’t. Third, as youundoubtedly expect, there’s empirical evidence, too. Consider Table 9.1.The table lists 22 markets, each of which have a December contract,and therefore markets such as soybeans, orange juice, and lumber aren’tpresent. The table tracks the value of ATM December straddles, and omitsmarkets like IMM British Pound futures where one side of the straddle isn’ttrading yet, as of June 28. The CBOT 30-Year Bond future was omitted because the December contract settled at 102-22 on June 28 and the ATMstrike of the options, 103-00, isn’t open for trading yet. The popular S&P 500Index market was omitted because one straddle in this market usuallycosts $30,000 or more, rather beyond most retail traders’ pocketbooks fora single straddle. The e-mini S&P 500 market was omitted for the lack of liquidity in its options.In this study, the buy-every-straddle strategy proceeded as it usuallydoes . . . it lost badly. The one positive note about the strategy over the period June 28 to November 15, 2002 is that the trader actually had a chanceto cash out a profit in the middle of the trade. This is atypical. I keep a similar study four times a year, and this buy-every-straddle strategy has succeeded exactly once since December 1997 at expiration, and has shown apaper profit during any implementation of this strategy just five times, ineach case only for a brief period.A trader might be able to turn a profit using this strategy if he set an arbitrary profit exit point and an arbitrary loss exit point for each market, butyou and I can easily agree, I think, that determining such points is an enormously difficult task. The task may actually be impossible in the general case,over a series of such trades, because both market conditions and optionvolatilities change over time, which would require the trader to developnew entry and exit points for each cycle of the trade.
170
320–0
330–0
Wheat – Chicago
Wheat – KC
329–4
323–4
105–29
36–2
37–4
4–18
4.57
2.10
20.29
364–2
340–0
108–035
69.56
45–6
38–6
4–22
4.51
2.34
18.85
+475
+ 63
+63
–75
+144
–40
–295
Final settlement prices of straddle used
(e) December option expired before named date
Approximate Net Result, to date
Less Slippage (est. @ $40 entry/$20 exit per mkt)–1320———––1682
–330
106–0
10–Year Notes
67.76
18.89
169.8
.431
+150
+170
+80
0
+688
–55
–280
–550
–250
–170
– 63
+ 88
–165
Less Exit Commission (22 contracts @ $15.00)
67.00
Swiss Franc
19.25
5.108
33–0
.981
5.92
8.75
4.74
11.27
23.7
6.03
4.00
6.30
32–4
8.30
10.08
+330
+320
–660
19.00
Soybean Oil
166.2
.490
173–6
3.582
68.85
40.47
87.05
72.61
326.1
100.70
26.91
48.74
244–6
72.75
51.90
284
2.50
$Chg
+628
165.0
Soybean Meal
4.883
30–0
.964
5.72
8.75
4.19
11.40
26.5
6.64
33–6
7.95
10.52
1789
July 19Straddle
Result to date
5.000
Silver NYM/COMEX
159–4
3.876
66.72
37.02
84.43
70.68
315.9
49.53
243–4
78.05
251
64.53
Price
Less Entry Commission (22 straddles @ $30.00)
3.900
160–0
Natural Gas
66.00
Oats
38.00
320.0
Live Cattle
98.00
Euro Currency
Gold NYM/COMEX
Lean Hogs
50.00
26.00
Cotton #2
Crude Oil
70.00
98.47
240–0
Corn
84.00
26.03
78.00
Heating Oil #2
6.30
51.95
50.00
Coffee
H–G Copper
Japanese Yen
4.25
1639
1650
2.18
Cocoa
65.69
66.00
Canadian Dollar
Straddle
June 28
Price
Strike
Straddle
396–6
361–0
110–045
67.30
21.09
177.6
4.521
186–4
3.757
70.62
37.37
85.53
75.22
315.4
97.85
27.55
45.64
282–6
68.25
50.35
1883
63.87
Price
68–0
44–1
5–45
3.24
2.48
21.10
.614
35–2
.810
6.27
5.97
3.80
11.39
23.5
4.43
4.18
6.69
43–7
11.05
6.44
313
2.90
Straddle
August 16
–1320———––3850
–330
–660
–1540
+1588
+331
+1422
–1663
+228
+185
+620
+263
–1540
+220
–1110
–488
–4
–300
–2338
– 70
+ 25
+506
+775
–1530
+620
+720
$Chg
448–4
392–6
118–6
75–2
7–57
2.87
1.55
17.10
.545
37–6
.763
7.12
6.62
3.47
13.10
19.50
3.94
5.03
6.98
37–4
9.05
12.35
376
3.19
Straddle$Chg
–1320———–+2414
–330
–660
+4724
+3625
+1888
+3609
–2125
–330
–215
+275
+388
–2010
+560
–850
–900
+714
–700
–2950
+780
+170
+188
+275
+686
+1250
+1010
September 13
113–210
66.45
20.26
179.8
457.5
195–4
4.110
72.42
38.02
82.54
80.24
318.1
96.80
29.76
43.17
276–2
69.70
61.60
2016
62.83
Price
479–4
413–0
112–220
66.22
20.27
170.7
4.360
192–4
4.460
70.70
41.12
79.92
80.87
313.3
96.94
29.60
44.45
254–2
69.25
62.60
1910
63.42
Price
149–5
93–1
6–55
1.98
1.46
8.60
.654
33–2
.745
5.42
5.55
4.39
11.50
13.30
2.62
3.85
5.64
18–0
8.85
12.92
276
2.70
Straddle
October 18
–1320———––2978
–330
–660
–668
+6688
+2781
+2578
–3238
–384
–1065
+820
+163
–2190
–120
–1280
+250
+42
–1320
–4600
–400
–500
–788
+225
+900
+250
+520
$Chg
432–4
389–6
113–235
68.89
22.36
164.4
4.575
190–4
3.984
72.97
45.75
83.17
68.85
320.9
100.73
25.51
48.39(e)
242–0
71.85
67.85(e)
102–5
69–7
7–48
2.09
3.37
2.90
.475
30–5
.273
7.07
8.10
1.67
4.05
4.5
2.83
0.50
1.62
5–4
620
1786
301
2.99
Straddle
–330
–660
–18907
+3319
+1169
+3469
–1850
–162
–1635
–75
+31
–6910
+560
–260
–3150
–3087
–2200
–4338
–3750
–2510
–1413
–438
+2753
+500
+810
$Chg
–1320————–21217
November 15
1901(e)
63.03
Price
Interiim Results—Straddle “All” Markets Strategy, 06/28/2002. All contracts are December 2002—$Chg rounded to nearest $
Market
TABLE 9.1
Don’t Just Do Something, Stand There
171
The difficulties here are compounded by the fact that, even though theseare notionally 5- to 6-month straddles, the trader dares not own them forthat length of time. As the table demonstrates quite clearly, Sister Thetabegins wreaking her havoc on the options’ time premiums after midSeptember, and the trader must surrender a good deal of the remaining lifeof the options or face very dire consequences.You can confirm these results for any implementation of this strategyany day you wish. Visit your local library and look up old issues of Investor’sBusiness Daily, or consult the various exchanges’ records, and you’ll persuade yourself very quickly that this is a stunningly rotten way to employyour capital. Knowing this, however, is highly useful to us because it helpsus find another profitable strategy. If buying a broad selection of straddlesisn’t profitable (and it isn’t, at all), what about writing them?Writing put-call pairs ATM, otherwise called “short straddling,” is lessevil but still unacceptable from the standpoint of both ROC and excessivetrading risk. If the 1995 summer grain markets or the 2000–2001 energymarkets or the summer-autumn 1998 currency markets should recur, we’dhave considerable difficulty in meeting our profit goals over the whole setof straddles we’ve written. Still worse, constructing a defense when one ofour short straddles begins moving sharply will require our adopting an accurate market view instead of letting normal market fluctuations work forus, as we’d much rather do. Nevertheless, most of the time, writing a givenoption is statistically more favorable to us than buying that option. As longas we can control our trading risk, we should be able to find at least oneprofitable strategy when we write a put and call together, as opposed tobuying them.
Half a Loaf, and Frequently the Whole Thing—Strangling a MarketThe approach we want to take in selling put-call pairs is to move away fromATM striking prices. In the best possible case, we’d like to apply the nonseasonal strategy twice in the same trade, to apply it in both directions in asingle market. Outrageous? Fantasyland? Hardly. All we need to do is takeour usual look at current volatilities and historical tendencies, because opportunities for such trades turn up every so often. When the historical grossprice movement of a market is moving lower from month to month at sometime during the year, and its options’ IVs are not falling (or not rapidly), profitable examples of these trades will likely appear. Just as the tables in Appendix A are useful for helping us decide when to buy a particular straddle,they’re also helpful in this strategy for selecting time frames within whichto strangle a market.
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TRADING OPTIONS TO WIN
A strangle, as described earlier, is the paired sale of an OOM put and anOOM call having the same expiration, and it’s a highly advantageous strategywhen we can meet certain not-very-restrictive conditions. The distancebetween the striking price of the call and that of the put is the width of thestrangle. Oh, I know what you may be thinking right now, “Aw, what isthis? You talk about writing WOOM options for a non-seasonal trade, andabout being careful because good disciplined ones are a little hard to find.Now, I’m supposed to find what is basically a double non-seasonal? Why notthrow in a four-leaf clover and an honest politician, too? And a unicorn,while you’re at it. Sheesh!”You surprise me. After all this time, now, out of the blue, you considerthat I’m advocating some sort of Ponce DeLeon Memorial Trade, somethingwonderful if you can find it, but that doesn’t actually exist? No chance. Suchopportunities occur reasonably often. I’ve never tried to count them up, butI’d be willing to wager quite a tidy sum that we can locate about half as manygood, disciplined strangle trades as we can non-seasonals over a year’s time.Just read on and you’ll see why this is so.Writing a put-call pair with the put having its striking price below themarket and the call having its strike above, a strangle, is approximately thelogical inverse of buying a straddle. When we buy a straddle, we want a market to move somewhere over a longish period of time, don’t care where, justmove, drat you! When we write a strangle, we want a market to move eithernowhere or only a little bit over a severely limited period of time. Why shoulda promising strangle trade be difficult to find? Haven’t we agreed long sincethat, in many trades in our personal experience, a market has done nothingfor quite a while—frequently irritatingly so? I believe we have. Why not thentake advantage of this non-movement, provided we can determine that suchnon-movement is likely over a particular period? I can’t think of a singlereason.Talk is cheap. How do we locate advantageous possibilities for astrangle?
Necessities for Strangling—Rope, Gloves,. . . uh, Volatility, Width, and Short DatesIf you’re thinking that the preconditions for entering a strangle trade constitute an admixture of the preconditions for the non-seasonal strategy andthe reverse of the preconditions for buying a straddle, you’re exactly right.We’d love to find situations where, historically, we can select OOM strikingprices of options to write, a put and a call, where both meet our criteria inthe non-seasonal strategy. These situations come around from time to time,but they aren’t at all essential for success in writing strangles. Why? Be-
Don’t Just Do Something, Stand There
173
cause we don’t need the same amount of potential ROC in either option wewrite—we’re writing two options here, not one, and we can (and should) select strikes even further away from the current market than we wouldchoose for a non-seasonal trade.We have a structural advantage when we write strangles. Specifically,one side of the strangles we’ll select will expire worthless some giganticmajority of the time, well more than 95% of all cases (about two standarddeviations), and even more frequently if we remain very disciplined in ourselections. If the market threatens the other option we’ve written, we haveavailable the identical defenses that we would apply to a non-seasonal option write. The only difference, really, between these two strategies is thefrequency with which we may be required to employ a defenseIn theory, we should have to employ a defense against the threatenedside of a strangle about twice as often as we would when using the nonseasonal strategy. This frequency of defense is reasonable given the natureof the trade, for we’re dealing with two simultaneous and opposed short option positions. However, when strangling a market, we have the relative luxury of selecting striking prices usually a bit further away from the currentmarket price than in the non-seasonal strategy. This extra distance OOMreduces the likelihood that we’ll have to defend one side of the trade. Also,as previously noted, we have two revenue sources, not one, and so thesefurther-away strikes are perfectly convenient to use. We’ll normally be ableto start off with a larger potential profit in a strangle trade than we will in anydisciplined straight option write. This flexibility also partially compensatesus for the increased likelihood that we may have to defend one side of thetrade.The conditions we’d prefer to observe before writing a strangle are asfollows:1. Any market we propose to strangle should have a relatively high but de-
clining SV, and we’ll avoid markets whose SV is to the low end of the 6month range. We’d prefer the IVs of the options to be highish, too, butthis is not a necessary condition.2. Volatility aside, we’ll avoid strangling a market during months in whichits historical gross movement,