the soybeanstrangles, could be held all the way to expiration without adjustment, expiring worthless, so our gains in those trades were precisely equal to the initialcredits received. The corn strangle of 2002 ran into trouble, however, whencorn prices rose above the strike price of the initial calls. So the initial strangle was closed for a small gain and a new, balanced strangle was opened thesame day. The new strangle expired worthless in just 11 days. These tablesinclude a conservative commissions estimate of $25 per contract.From Tables 3.1 and 3.2, you can see that trading the seasonal cornand soybean cycle could have been very proﬁtable the last two years.While not guaranteed to be proﬁtable every year (and certainly a longerperiod study would be helpful), from this you can begin to see why tradingthe annual cycles in corn and soybeans is one of my favorite strategies.
OTHER COMMODITIESWhile not as regular as the grains, orange juice has a seasonal pattern aswell, with IV often reaching its highest levels in late December. (See Figure3.11.) Perhaps more important would be the observation that orange
FIGURE 3.11 Seasonal Volatility of Orange Juice
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VOLATILITY
juice’s IV ﬂuctuates a lot. After falling to a low extreme, it’s not very longbefore IV goes back up, and after reaching a high extreme, you can usuallycount on IV coming back down before long. For the V-trader, this is a desirable trait.Another good asset for V-trading, with frequent IV ﬂuctuations and agood base IV level of about 30%, is crude oil. (See Figure 3.12.)Also worth mentioning is natural gas, which often peaks in the winterbut can also shoot up at other times during the year. Buying IV every timeit falls to the apparent ﬂoor level of 40% looks like a decent ploy. However,be careful about selling high IV in this asset, as it sometimes spikes to extremely high levels. I once knew a trader who was ruined when, after hehad taken naked short options positions in natural gas, volatility pushedrelentlessly higher and he was forced to liquidate at the worst price levels.(See Figure 3.13.)
VOLATILITY SKEW—WHAT IS IT AND HOW CAN I USE IT?Traders say that volatilities are skewed when the options of a given assettrade at increasing or decreasing levels of implied volatility as you movethrough the strikes.I’ll illustrate using a situation that existed in the gold market at the time
FIGURE 3.12 Seasonal Volatility of Crude Oil
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FIGURE 3.13 Seasonal Volatility of Natural Gas
of this writing. (The most signiﬁcant skew situations seem to happen in thecommodities. However, skews also happen in securities and index options,and the principles discussed here apply in those markets just as well.)The gold situation described here was an outstanding opportunity. Itshows what can be done using the dimension of volatility—a dimensiononly options can provide.The price of gold had jumped 9 percent in a few days, fueled by Japanese investors worried about their country’s economic woes. Checking thegold option volatilities, I noticed that there was a large skew at the time,with out-of-the-money calls trading at much higher IVs than at-the-moneycalls. Figure 3.14 shows the price and IV of each option. You can clearlysee how the IVs go higher the farther out-of-the-money you go in the calls.When the skew is this pronounced, it represents an opportunity toconstruct a position with favorable odds of success. Figure 3.14 portraysan example of a fairly aggressive position that takes advantage of thisskew. The position involves selling 10 far out-of-the-money calls (with anIV of 30.3%) and buying one at-the-money call (with an IV of 18.8%) tohedge. The position costs $3,500 to put on. Note that only one of the shortcalls is covered; the remaining nine are naked. If gold moves higher, morecollateral may be required.The single long option almost overcomes the negative delta of the 10
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FIGURE 3.14 Skew in the Gold Market
short options, giving us a nearly zero net delta. This is important because itgives us breathing room in case gold moves further to the upside. The onething that could ruin this position is gold moving much higher, and it is important that we be able to respond to such a move by controlling our risk.There is room for gold to move up some without requiring any action, butbeyond a certain point we might need to trim our short option position oradd more long options.Figure 3.15 shows the theoretical performance of this amazing position. It is proﬁtable across a wide range of underlying prices. If gold goesnowhere or down, we make $1,600. We make even more if gold moves upmodestly. Losses will occur only if gold goes above 370 by expiration.The software has estimated that the chance of gold going above 370would be only 1% (referring to the 99% probability of proﬁt [P.P.] in thelower left corner). Still, I would not be that optimistic. The program’s projection is based on recent volatility readings, but years of experience incommodities tells me there might be a 5% chance of gold going above 370,and mentally I’m going to be prepared for the possibility of gold doing that.It’s better to be conservative.Opportunities to sell expensive out-of-the-money call options comealong fairly often in the commodities markets. In fact, a similar opportu-
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Long 1 Jun 300 Call, Short 10 Jun 360 Calls
3
May 11, 2002O.0%
$
9000
Profit/Loss by Change in GC Jun Futures Price
60003000
= Orig. Reqmt.
0–3000
Profit/Loss
–6000–9000–12000241.00
257.00
273.00
289.00
305.00
321.00
337.00
353.00
369.00
FIGURE 3.15 Proﬁting from the Skew in the Gold Market
nity also existed in silver at the time of this writing. While some skew always seems to be present in the precious metals options, the skew is often more pronounced just after a minor shock wave moves through. Atsuch a time, speculative fever ﬂares up and tends to inﬂate all of the calloption prices, especially the cheaper, far out-of-the-monies. For example,with the recent jump in the price of gold, advisers are popping up andcalling for further action to the upside. I don’t know about you, but I’drather fade them.Other commodities, such as coffee and orange juice, exhibit tremendous skewing in their call options each year as the potential frostseason approaches. I would caution against being too aggressive inshorting naked calls in those markets, however. Once every few years aserious frost does hit, and the commodity may jump a high percentageovernight. However, small, conservative positions in these commoditiescan be rewarding.The gold market might feel more comfortable for positions like this,because one would think that worldwide supplies should keep a better lidon price. And gold usually provides more opportunities for this kind oftrade. It seems like several events per year come along affecting the precious metals markets.
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SOME WORDS OF WARNING ABOUT NAKED WRITINGI have seen traders who regularly use naked writing post regular gains formonths and even years on end, and then suddenly and spectacularly blowout. It happens at times when the market goes to an extreme that no onehas ever seen before. (Of course, it probably has happened before; there isnothing new under the sun. People just don’t remember it.)This doesn’t have to happen to you. If you use naked writing, have aprearranged plan on how you will hedge or reduce your position at certain stages.In the gold example above, why do you suppose the out-of-the-moneycalls jump so dramatically every time there is an event that moves theprice of gold just 10%? For starters, it is because other traders, somewhatpanicked, are getting out of the very kind of position you are consideringgetting into. They are covering their short calls, driving the prices up.You were smart, of course, to have waited for the opportunity to sell atbetter prices. But what happens if gold surges higher still? Are you goingto be the one who panics to cover his naked calls at even higher prices? Orare you going to ﬁnd a way to reduce your exposure in stages and allowyourself to stay with the position?If you decide to stay with your position, plan ahead at each stage whatyou’ll do if the market moves even further against you. Smart naked writers guard against allowing that one “unthinkable” event to blow them outof the water.
THE RELATIONSHIP BETWEEN VOLATILITY AND PRICESince volatility is measured using percentage price variations, higherpriced assets don’t exhibit higher volatilities just because of their higherprice. Therefore, one would think that volatility and price would bear nocorrelation. However, it so happens that with most assets, volatility andprice do exhibit some degree of correlation. In stocks, the correlation is anegative one; volatility increases as stock prices decline, and volatility declines as stock prices increase.The reason volatility increases as stocks decline is presumably because falling stock prices mean deteriorating business conditions,which translates into higher risk and greater uncertainty. This leads togreater daily price ﬂuctuations (on a percentage basis) and, thus,greater volatility.On the other hand, as stock prices climb, this implies improvingbusiness conditions and greater stability. In that climate, stocks exhibit
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smaller daily price ﬂuctuations (on a percentage basis)—in other words,lower volatility.Would logic dictate that the converse be true? Does a period of lowvolatility presage a drop in stock prices? While it would be false logic toassume the converse is true, it turns out from historical observation thatthis is often the case. Does extremely high volatility mark the bottom of abear market? Again, very often it does.In Figure 3.16, the solid line represents statistical volatility (how muchthe price of the Nasdaq-100 shares (QQQ) has bounced around recently).The dashed line represents implied volatility (how much underlyingvolatility is implied by current option price levels). Also superimposed is aprice chart. Notice how often volatility peaks corresponded with marketbottoms, and volatility bottoms corresponded with market tops.So what does this mean to the options trader? How can we proﬁt fromthis information?For one thing, volatility can be used as a conﬁrming indicator. Whenvolatility is high, for example, you know that the bottom is probably near.When volatility is low, one should be on guard for a potential breakdown.Also, the low volatility at market tops should make us lean toward buyingoptions at those times, and the high volatility at market bottoms shouldmake us want to sell options then.When volatility is low, we can watch for signs of a breakdown and go
FIGURE 3.16 The Relationship between Volatility and Market Price
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short by buying puts. One of the most reliable signals of a breakdown iswhen the market begins to fall off the right shoulder of a head-and-shoulders formation. If a sell-off actually develops, the originally cheap optionswill expand from the double barreled effect of falling prices and increasing volatility.To get more of a bang from a possible volatility increase, one couldbuy farther out options, as farther out options expand more when volatility increases. The downside is that the farther out options cost moremoney and respond more slowly to falling prices. However, they are alower risk position compared with the “fast lane” nearby options. It is important for the trader to take appropriate risks according to his own goalsand temperament.Once prices are falling and the options are expensive, if a trader stillwanted to buy puts in anticipation of a further price drop, he could switchto buying nearby options that are deep in-the-money to avoid paying extrafor the inﬂated time premiums. Even when IVs are running high, the deepin-the-money nearbys typically hold very little time premium.When volatility is high and the options are expensive, but the traderfeels that prices are showing signs of bottoming, conditions would suggestgoing long by selling naked puts. If a rally materializes, the options willquickly lose value from both rising prices and falling volatility.However, selling naked puts in a down-trending market that you believe is about to reverse is rather like standing on the road in front of oncoming trafﬁc and shouting “Stop!” It might work, but it’s kind of scary. Toreduce risk (and stress!) to acceptable levels, one could simply take asmall position, but that won’t make as much money when you’re right.Luckily, with options there are several other strategies you could use thatallow you to limit the risk to an acceptable level.One approach would be to use a credit spread in puts. While a creditspread does not respond to declining volatility as well, it does makemoney in a rising market and limits your risk. Or a vertical debit spread incalls might make sense. Much of the high volatility is neutralized becauseyou’re selling an expensive option at the same time that you’re buying anexpensive option.If you own, or would like to own, some shares of individual stocks at reduced prices, an approach to consider is the covered combo. With a coveredcombo, you buy (or already have) shares of the stock. You then sell both callsand naked out-of-the-money puts (1 contract of each for every 100 shares youown). Selling all these expensive options really places the odds in your favor.However, note that the short calls place a cap on your stock price appreciation. We’ll discuss covered combos in more detail in a later chapter.In practice, I have found that buying puts at the start of a breakdown is far more rewarding than selling options (naked or covered) at a
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suspected bottom. Long puts expand in value dramatically during a market sell-off. At a suspected bottom, sometimes I feel more comfortablejust buying a few of my favorite stocks. If I feel strongly about my timing, I might even load up with extra shares on margin for a short time.Despite what they say about the risks of buying stock on margin, thatcan be a less risky approach than some of the options strategies at thatjuncture.
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CHAPTER 4
The OptionTrader’s Arsenal
O
ptions are enormously ﬂexible in the ways you can use them, notonly to speculate, but also to hedge or even simulate a portfolio.Through combinational strategies, you can construct a positionthat closely ﬁts your goals, price predictions, time frame, and the currentvolatility environment. With options, it is possible to construct a positionwith almost any kind of performance curve.It is important for the trader not to fall in love with any particularstrategy. The trader must be ﬂexible and take advantage of the opportunities that the market brings. This means using different strategies in different situations.There are more than 20 different option strategies. Of these, around18 are of interest to the individual trader, including all the single and dualoption strategies, plus one triple option strategy. We’ll limit our discussionto these. Other strategies, including some involving four options, are usedprimarily by market makers and are not practical for the individual trader.
BUYING NEARBY OPTIONS—THE SWING TRADER’S PERFECT TOOLYears ago, the conventional wisdom was to sell options, placing timedecay on your side. In recent years, pundits have made a case for buying options. Lawrence McMillan, the icon of options, in the April 27,2000, issue of The Options Strategist, wrote about how often stocks69
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make second and third standard deviation moves—more often than theyshould, based on the assumption that stocks follow a lognormal probability distribution. This favors option buying. And it’s interesting to notethat McMillan’s only managed fund, at the time of this writing, is chartered to do straddle buying.Nassim Taleb, in the September 2000 issue of Stocks & Commodities,wrote how his fund invests constantly in both puts and calls, tolerating thedrain of time decay while waiting for the big strike. Nassim loves the nonlinear performance curve of an option. And the only way to put this qualityof an option in your favor is to be long the option.An option is a beautiful thing. Buy one. When you’re correct about thedirection of the market, gains are unlimited. When wrong, losses are limited. No other instrument gives you a better chance of hitting a home run.Sure, time decay works against your position while the underlyinggoes nowhere, or takes an excursion in the wrong direction ﬁrst, but this isan acceptable cost if the option is reasonably priced; that is, when impliedvolatility is at normal or below normal levels. There is nothing wrong withbuying a reasonably priced option.Prior to expiration, an option’s proﬁt/loss proﬁle is a gentle curve,bending the most in the middle, and ﬂattening in either direction—kind of like a bent steel bar. On one end the curve straightens out intoa 45-degree angle. This is when the option is deep in the money. In theother direction the curve ﬂattens out into a zero-degree angle. This iswhen the option is far out-of-the-money. See Figure 4.1 for the familiarproﬁle of a call option purchase.An at-the-money option is at its maximum inﬂection point. From there,as the underlying moves in the desired direction, your position makesmoney faster and faster. For example, the ﬁrst point that the underlyingmoves in your direction, the option gains perhaps 0.5 point. The next pointthe underlying moves in your direction, the option gains perhaps 0.55point. And so on until, when the option is deep in the money, it movespoint for point with the underlying.On the other hand, if the underlying moves against you, your positionloses money slower and slower as the curve ﬂattens out. This is the beautyof the nonlinear performance curve of an option.
Which Option to Buy?The question of which option to buy is a good one, because options withdifferent strike prices and duration will respond in widely varying degreesto price movements of the underlying and other conditions.An out-of-the-money option has higher leverage. So if the underlyingmakes a swift, sizable, and immediate move in your favor, an out-of-the-
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FIGURE 4.1 Call Option Purchase
money option does the best job of multiplying your money. However, ifthis move does not quickly materialize, the out-of-the-money option’s performance will probably disappoint you.At-the-money and in-the-money options move better with the underlying because their delta is greater. The delta of an at-the-money optionis typically around 50—meaning that a one-point move in the underlyingtranslates into a half-point move for the option. In-the-money optionshave deltas approaching 100—moving almost point-for-point with theirunderlying.While in-the-money options best track their underlying, they are moreexpensive, lowering your leverage. They can also be less liquid, increasingyour transaction costs. On the positive side, in-the-money options have alower time premium component, so their time decay is slower. So youmight be more comfortable using an in-the-money option when you wantto allow several days or even weeks for the underlying to move.Often the best balance of leverage, cost, and liquidity can be found inusing just-in-the-money options. That happens to be my personal favoritefor positions I plan on holding for one to ﬁve days.As for duration, a good rule of thumb is to buy an option with at leasttwice the remaining life as the maximum length of time you plan on holding the position, although this requirement can be relaxed for deep in-themoney options where time decay is not a signiﬁcant factor.Sometimes an option does not respond predictably to a price change
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in the underlying. What trader has not experienced the frustration of seeing his stock move several points and his option move very little?While this can happen because the trader has bought an option that istoo far out-of-the-money, it is more likely due to a drop in implied volatility—something that can happen at any time but very often happens when astock is advancing.Usually, when a stock advances it exhibits less and less volatility (asmeasured by percentage daily price swings). Professional options tradersknow this, and they gradually lower the volatilities they use in their options pricing models as the price of the stock goes up. This works againstcall prices as the stock goes up, with the result that your call options gainless than you expected, sometimes.In contrast, as stock prices fall, implied volatilities increase and thishelps put buyers. This cause-effect relationship between stock prices andimplied volatilities is called constant elasticity of volatility (or CEV forshort). To draw an analogy with distance running, CEV is like having thewind at your back if you’re a put buyer, but like having the wind in yourface if you’re a call buyer.
What Is a Bullish Trader to Do?To counter the CEV effect, you can lean toward using more in-the-moneyoptions. Deeper in-the-money options have a lower time premium, so avolatility reduction hurts less. Another thing to consider is simply buyingthe stock. Remember, the stock has zero time premium, and great liquidity! Of course, this gives you less leverage, even if buying the stock on margin, but it’s worth considering.Finally, in addition to buying just-in-the-money calls, you can alsosell out-of-the-money calls, entering into a vertical debit spread. Thislowers your cost, and volatility risk is effectively canceled out with theaddition of the short leg. However, a spread behaves differently from asimple purchase. Reaping the full beneﬁt from a spread requires havingthe anticipated exit date coincide with the expiration date of the options.For example, if the nearby expiration is 14 days away and your expectedholding time is also 14 days, a spread using the nearbys might be perfect.But if the nearby expiration is 21 days away and your expected holdingtime is 5 days, the spread might not ﬁt so well; the simple call purchasemight be better.A good options analysis program will usually show that a simple option purchase makes more money than a spread or any other option strategy, albeit with greater variance, when projecting a holding period of 1 to10 days, even when the model includes the CEV effect. Beyond 10 days,the software begins to favor spreads.
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Finally, good discipline dictates that the trader set objectives andstops. These should be decided and written down the moment the position is opened. If the underlying moves in the desired direction, theseshould be reevaluated and adjusted upward at intervals. I have no adviceon how to set objectives and stops, nor when to adjust them—only thatyou should set them and obey them. Traders must settle on a system thatworks for them.
DEBIT SPREADS—THE CALM APPROACHMost traders are ﬁrst attracted to options for high-leverage directionaltrading. Directional trading is where the trader believes he knows whichway a stock, index, or future is going and opens an option position to takeadvantage of the expected move. More often than not, the new optionstrader starts out simply buying calls or puts. However, buying calls andputs is high-octane trading.Traders, especially beginning options traders, should consider thebeneﬁts of spreads. A spread is constructed by buying an option and selling another option of the same type (call or put) on the same underlying.Usually the two options are of the same expiration month. Such a spread issaid to be a vertical spread because the options differ only by strike, andin a matrix of options you typically picture the strikes running vertically.When the option bought is more expensive than the option sold, thespread is said to be a debit spread because its opening results in a netdebit to your trading account. When the option sold is more expensivethan the option bought, the spread is a credit spread. We’ll say more aboutcredit spreads later. For now, let’s just talk about debit spreads.
How Does a Debit Spread Work, and Why Use It?When you buy a debit spread, you are essentially buying the difference, orspread, between the two options prices. You are expecting that, with theright market move, the price difference, or spread, will widen, resulting ina proﬁt. A trader who buys a debit spread in calls expects the underlyingto go up in price. As the underlying goes up, both legs (options) of hisspread will increase in price, but the higher-priced leg will increase faster,thus widening the spread.Conversely, a trader buys a debit spread in puts when he expects theunderlying to go down in price. As the underlying goes down, both legs ofthe spread will increase in price, but the higher-priced leg will increasefaster, thus widening the spread.
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THE OPTION TRADER’S ARSENAL
One reason a spread is attractive relative to a simple purchase is thesize of position you can afford to own. For example, say the following twocall options are available (with the same expiration month):Strike110115
Price3.301.50
With $3,000 you could afford to buy only 9 of the 110s. However, withthe same money you could afford to enter 15 units of a debit spread between these two options, as the spread (difference) is currently 1.80.As with buying an option, you can only lose the amount paid for aspread and no more. However, unlike buying an option, where the valueof your position could theoretically increase without limit, the value of aspread can increase only to the difference in the strikes. For instance,continuing with the same example, the difference between the strikes is5. If we buy a spread now for 1.8, the value of the spread could go eitherto 0 (losing the 1.8 paid because both options ended out-of-the-money), to5 (a proﬁt of 3.2 because both options ended in-the-money), or to anyprice in between (with the 110 option in-the-money and the 115 optionout-of-the-money).Figure 4.2 shows the performance of a vertical debit spread using calls(often called a bull call spread), compared to a simple call purchase withthe same amount of capital. The shaded area represents our expectationthat the price of IBM stock, currently 108, will increase to somewhere between 110 and 115. The dashed lines represent the theoretical performance of each strategy as of today. Clearly, the simple call purchase willoutperform the spread if IBM goes up today.The solid lines represent the theoretical performance of each strategyat expiration, 44 days from now. You can see that within the price range weexpect, the spread outperforms the simple call purchase. The downside isthe same for both trades (i.e., you could lose the amount paid). However, ifyou are wrong and the price increases substantially, your proﬁt with thespread is capped, while your proﬁt with the simple call purchase increaseswithout limit.
Psychological FactorsA spread behaves very differently than a simple purchase, so traders mustdecide whether spreads are appropriate for their psyche. The price of aspread changes very gradually as the price of the underlying moves. Thusit is more sedate, requiring less attention. Again, a spread has minimum
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FIGURE 4.2 Bull Call Spread
and maximum outcomes. Thus, much like a casino bet, you either win orlose. The angst of picking an exit point, so critical with simple option buying, is abated.Simple option buying requires great discipline. A simple call or put position is like raw energy. It responds dramatically to every move in the underlying. Therefore the trader must bring his own discipline intoplay—using objectives, stops, and perhaps trailing stops.In contrast, spreads allow the trader more time to make an exit decision. Spreads may even be held all the way to expiration without concern for rapid time decay. In fact, if the underlying has made the moveyou expected, your spread, now in-the-money, makes money with thepassage of time.In times of exceptional volatility, when options are more expensive,the option buyer is at a disadvantage. However, the spread trader gets toneutralize this effect by selling an overpriced option at the same time he isbuying an overpriced option.One caveat with spreads is that if the underlying quickly makes themove you expected, you may be disappointed to see that your spread hasnot gained much, and that achieving its full potential requires holding thespread to the ﬁnal day of its life. Not only could this be too boring for yourtrading psyche, but it also risks giving the underlying time to slip back.
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Also note that since spread trading involves trading more option contracts with the same capital, it incurs greater commission charges.Bottom line: For directional trading, the trader needs to use a strategythat best matches his or her trading psyche. A lot depends on how