—since I can see no way to test selective option writingBORN AGAIN 133
based on comparing implied volatilities with absolute or refer-ence levels. Now it is true that long-term average implied volatil-ities can be calculated for all commodities and that comparisonof a current implied volatility with its long-term average is a wayof segregating hypothetical straddles into overvalued and under-valued categories.
But there are any number of problems associated with such asegregation. First, how do you handle commodities which exhibitstrong seasonal patterns in the implied volatilities of theiroptions? Second, how do you deal with commodities like stockindex futures, which show a long-term secular increase inimplied volatility? Furthermore, broad-stroke empirical evidencedoes not suggest that absolute volatility is likely to be a good dis-criminator. In the straddle tests carried out on 1996 data, wheat(unusually high implied volatility) is a big loser for the optionwriter, while cocoa and sugar (low implied volatilities) are bigwinners.
At one point during the research for this book, I did begin totest the 1996 data base for an absolute valuation strategy, first,by finding the average implied volatility by commodity during1996 then by comparing daily implied volatilities with these aver-ages. Naturally, half of the hypothetical straddles were defined ashaving above-average implied volatilities, while the other halfwere defined as having below-average implied volatilities.Hypothesizing straddle-writing on just the the "overvalued"options yielded very favorable option writing results, so favorable,in fact, that I knew something had to be wrong —and it most cer-tainly was. I was committing the cardinal sin of hypothesis test-ing, which is to use information in a test that could not possiblyhave been available at the time the supposed test took place. Anaverage implied volatility can only be computed after the fact,that is after the calendar year is over, and cannot, therefore, beused to segregate hypothetical straddles into overvalueds andundervalueds.
It seems imprudent now to have embarked on such a funda-mentally unsound test, but it did not seem that way at the time.I mention this unfortunate detour as a reminder that it is rathereasy to unintentionally concoct falsely optimized results. On134 OPTION REALITY
common-sense as well as on practical grounds, therefore, I havechosen to reject for testing any strategy that is based on long-term valuation comparisons.
It did also occur to me to test the strategy of selectively writ-ing options depending on whether the underlying futures marketappeared to be in an uptrend, a downtrend, or stuck in a tradingrange. Everyone would love to write options in trading marketsand buy options in trending markets, but this information is alsonot available until it is too late to capitalize upon it. While I don'tdiscount the possibility that favorable times exist for writingoptions or buying options--on a purely technical basis—I don'tsee how such a hypothesis can be tested on a sound statisticalbasis. Therefore, again, on common-sense and practical grounds,I have rejected for testing any hypotheses based on forecastingfutures market direction.
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If the results of the hypothetical tests on the option andfutures data from 1996 are representative — and there is no rea-son to suppose otherwise —it seems that a payout ratio of 0.88 isapproaching the limit of the edge an option writer can expect toachieve by purely technical means. However, it will not neces-sarily be routine for even a well-disciplined trader to attain thislevel of edge, for an option writer, like a futures trader who isworking a "system," is exposed to the same temptations to delaythe taking of unpleasant decisions, any one of which can seri-ously affect overall expectation. In the case of straddle writing,the temptation is to delay covering the losing side, to give it "onemore day,” which, of course, easily becomes "one more week.”Nevertheless, the numbers do suggest that with discipline andvigilance, a dedicated option writer can approach businesswith the confidence that his or her expectation is significantlypositive.
If an option writer hopes to bring the payout ratio down muchbelow 0.88, then it will almost certainly be through nontechnicalmeans, and that implies trade selectivity based on fundamentaljudgments. These, by definition, are not amenable to statisticalBORN AGAIN 135
testing. Based on personal observation and trading experience, Ibelieve that a dedicated option writer can, by judicious tradeselectivity and shrewd timing, improve an already favorable edgeof 0.88 by several points. Iam not suggesting that in order to bea successful option writer, it is necessary to exercise fundamentaljudgment, only that the possibility exists for sharpening the edgeand that the opportunity should not be dismissed.
An option writer who is cognizant of the fundamentals thataffect option premiums —as opposed to the fundamentals thataffect futures prices—should not be afraid to disagree with themarket and from time to time take option positions based on asubjective estimate of uncertainty. However, a subjective dis-agreement with the uncertainty registered in the marketplace hasto be more than a wild guess. It may be little more than a hunch,but a hunch which is still fundamentally based. I intend lookingat some specific circumstances in which an option trader is likelyto want to override his purely technical indicators. First, let'sconsider the components of uncertainty that contribute to anoption’s total value.
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The price that the market places on a commodity option is afunction of the uncertainty level surrounding the price outlookfor its underlying commodity future. Most of this uncertainty isalready reflected in the long-term and short-term volatilitiesobservable in the price history of the commodity future. Asalready discussed in great detail, current market volatility, modi-fied by historical norms, is the key to the fair pricing of a com-modity option—wunder most circumstances. Historical averagevalues of volatility —by individual commodity —are especially rel-evant when current volatility in a commodity future is unusuallyhigh or unusually low.
Coffee, for example, is consistently the most volatile com-modity of all, with a long-term average implied volatility for itsoptions around the 40 percent level. In contrast, the impliedvolatility of a currency option is usually below 10 percent. Themarket is well aware of what is "normal" volatility for each com-136 OPTION REALITY
modity and will reflect this normal value to some extent in theoptions, regardless of current market volatility in the futures.However, the option market cannot ignore what is happening inthe futures market and will find a compromise pricing structurewhich takes into consideration both what is normal and what iscurrent.
From a purely technical standpoint, then, an option writercan always obtain an objective fix on the current price of anoption by determining where its implied volatility lies in relationto both its average level and the level implied by the current fluc-tuations in its future. Nothing new here, yet. These compar-isons — currentimplied volatility versus historical average impliedvolatility, and current implied volatility versus current marketvolatility—can suggest potential overvaluation or undervaluation.For instance, an option that appears to be overvalued on bothcomparisons would clearly be a candidate for writing and cer-tainly a candidate worthy of further investigation.
Whenever an option appears to be overvalued on both long-term and short-term volatility comparisons, there will usually bean identifiable fundamental reason: a source of uncertainty thatis known to exist but is not being reflected in recent variability ofthe futures price. When unreflected uncertainty (let's call it theU factor) is a dominant component in an option premium struc-ture, it is a prime opportunity for the fundamentally motivatedoption trader to exercise fundamental judgment.
The essential feature of a U-factor in operation is an upcom-ing resolution of uncertainty at a very specific and preciselyknown point in future time. This uncertainty component of anoption premium typically reaches a peak just prior to the releaseof fundamental information from a government report or justprior to a decision by some quasi-political body wielding signifi-cant economic clout. Guesses as to the impact of the fundamen-tal information to be released will be wildly divergent, but thisdivergence of opinion need not be reflected in a high volatility ofthe price of the commodity future in question. In fact, upcomingresolution of a major uncertainty may lead to subdued futurestrading just prior to the event. The opposite is true of options,which will usually command premiums way in excess of thoseBORN AGAIN 137
indicated on a purely technical basis. Apparent overvaluation insuch cases is therefore not overvaluation at all. Worth remem-bering: Prior to the release of important fundamental informationaffecting a commodity, futures volatility typically falls while optionimplied volatilities typically rise. After the release of fundamentalinformation, futures prices often sustain large moves, whereasoption premiums almost always shrink substantially.
Although the above statement is most certainly true, it isreally no more than a self-evident, if not so obvious, truth, andno strategy can be devised to exploit in any systematic way thatwhich is already known. It is true that when uncertainty is aboutto be resolved, more opportunity exists for a cool head to prevailin turbulent conditions, but remember that it is only by register-ing superior fundamental judgment in specific circumstances thata trader can hope to add to his or her trading edge.
An option trader may choose to play the U-factor before therelease of fundamental information (second-guessing its con-tents or its probable impact) or after the release of fundamentalinformation (by analyzing and reacting to the market's reaction).To get a feel for how fundamental judgment may be exercised, itwill be useful to review how particular options have reacted inthe past, in the days leading up to and in the days following thereleasc of significant news.
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A regular resolver of uncertainty is the Federal Open MarketCommittee (FOMC) meeting of the Federal Reserve Board,which meets every other month to decide whether to raise inter-est rates, lower interest rates, or leave interest rates unchanged.Achange in the prime rate can have a major impact on the wholeeconomy and can affect currencies, the stock market, the yieldcurve, and all interest-rate-sensitive commodity futures. The rea-son that the uncertainty surrounding a FOMC meeting cannotbe quantified is that the economic conditions prevailing at thetime of the meeting change from month to month, as does thelikelihood of a policy change and the impact of any such change.138 OPTION REALITY
If inflation is low, the unemployment rate steady, and wagepressures subdued, there is a strong probability that the Fed willdo nothing. Under this scenario, the U-factor going into themeeting will be low. If, however, there is fundamental evidencethat the economy may be overheating, there will be a good num-ber of players who believe that the Fed will tighten. Under thissecond scenario, the U-factor will be much more important.Regardless of the outcome of a FOMC meeting, and regardlessof the impact of any FOMC decision on futures prices, optionpremiums on interest-sensitive financial instruments will almostalways drop as soon as the Fed's decision is announced. The at-the-money strike price may change, and change in a big way, butthe at-the-money option premium will decline, simply becauseuncertainty has been removed.
How much option premium should the Fed command?Nobody knows, of course, but it is a question on which a funda-mentally motivated option trader who trades volatility might havean opinion. Where would such an opinion come from? Fromobservations of past market reactions, perhaps. From intuition,too, or from a correct assessment of the political climate. Thereare many, many reasons why a trader might disagree withthe implied volatility of an option. One thing is fairly certain:The days surrounding the release of major information areoften prime opportunities for a trader to exercise fundamentaljudgment.
Option writers are interested in trading "volatility." Theywould like to sell volatility when it is too high and avoid sellingvolatility (oreven buy it) when they feel it is too low. A trader whocan identify a market which is vastly overvalued might feel thatthere must be a way to capitalize on an assessment of overvalua-tion—a way to lock in a profit as it were. Unfortunately, evenunder conditions of large positive expectation, a negative resultfrom an option trade is always possible. There are ways ofimproving the odds that a trade will turn out to be profitable, butno way of guaranteeing that it will be profitable, for there isalways something the market can do to confound the best-laidstrategy of the most astute option writer---on any one trade,that is.Born AGAIN 139
Of course, the option writer is not going to be unduly con-cerned over the outcome of one trade, any more than a book-maker is going to worry about paying off a single punter, or aninsurance company is going to be jeopardized by any one claim.All these activities depend on spreading the risk and letting thepower of high volume ensure a predictable overall return. For dif-ferent ways in which a trader can buy and sell volatility using avariety of inter-option spreading techniques, I refer the reader toSheldon Natenberg's Option Volatility and Pricing. This book,written by a floor trader with expert knowledge, covers a greatdeal of interesting territory I have tread but lightly upon.
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There may not seem much connection between the interest-rate policy of the FOMC and the release of grain data bythe United States Department of Agriculture. In terms of theU-factor, however, the potential impact on option premiums ismuch the same—Jjust substitute corn and soybeans for curren-cies and bonds.
As a specific case in point, consider the action in the cornmarkets (futures and options) following the release of the impor-tant "Stocks in All Positions" report after the close of trading onJanuary 15, 1996. At the close of trading that day, the closest-to-the-money March corn options were registering an impliedvolatility of 23.61, a relatively high number for that time of year.(Compare years 1993 through 1997 on page 238 of the referencesection.) January is usually a low volatility month for corn, sim-ply because not much can affect the supply/demand balance atthat time: It is the middle of the marketing season, the old crophas been harvested and is known in size, and the new crop is stillto be planted.
The relatively high volatility in corn futures in January 1996was understandable, however, in light of the low carryover stocksthat were almost certainly going to be a fact-of-life later thatsummer, and the stocks report scheduled for release in mid-January was being anticipated with more than usual interest. Thequestion for options traders was whether an implied volatility of140 OPTION REALITY
23.61 was ascribing too much or too little option premium to theU-factor about to be resolved with the release of the stocks fig-ure. Here's the Wall Street Journal (January 16, 1996, p. C16)reporting after the news was out and the market had had anopportunity to react:
According to the Agricultural Department's report, released yesterdaymorning after a three-day delay caused by last weekend's east coastsnowstorms, corn stockpiles at December 1, totalled only 6.101 bil-lion bushels down from 8.081 billion a year ago, signalling that highprices have yet to curb consumption levels.
More important, ending stocks —the amount of corn expected tobe available by August 31, when this summer's crop is harvested—were trimmed to 507 million bushels, the lowest level in 20 years.That's down 110 million bushels.
While these kinds of bullish data might have been expected tosend prices soaring to fresh highs, traders said speculators hadalready factored in that kind of report in their recent buying.
The market had in fact dropped substantially that day—from$3.65 to $3.54 a bushel for March corn futures, a typically per-verse response to allegedly bullish news, and the largest pricemove in corn in 2 months. Yet, despite this relatively large movein the futures price—usually accompanied by an increase inoption implied volatility —the implied volatility of the new at-the-money option dropped from 23.61 to 18.72, an extremely largemove for one day's trading. For option premiums, the effect ofremoving the uncertainty in the fundamentals (the release of thestocks figure) had overwhelmed any tendency toward an increasein volatility resulting from the price move in the futures. This isthe normal reaction of option implied volatility to new supplyinformation when the futures market turns lower.
If, after the report, corn futures had turned higher instead oflower, it is less clear what would have happened to the impliedvolatility of corn options. Most probably, option premiums wouldalso have shrunk, but to a lesser degree. And, if the upside movehad been extremely large, it is possible that option premiumswould have increased. The important point here is that the reac-tion of option implied volatility to price action in crop futures isBORN AGAIN 141
substantially asymmetrical, and the trader must be aware of whatare viewed as "normal" changes in implied volatility in such situ-ations, for it is the abnormal response — the occasion when themarket does not respond according to its historical norm— thatthe option trader seeking an additional edge should be searchingfor.
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Sometimes, fundamental judgment is appropriate in circum-stances that are completely without precedent. In April 1996, theimplied volatility of options on cattle futures shot up rather sud-denly from under 15 percent to almost 30 percent, in a decliningfutures market. The volatility of cattle futures does have a ten-dency to increase in a falling market —in contrast to grains, say—but a large component of the increase in option implied volatilityat that time was a large U-factor associated with "mad cow"disease.
How much option premium is a mad cow worth? Rather a lotit seems, or seemed at the time. Consider what was goingthrough traders' minds when the mad cow rumors were flying:fear of the unknown, of course. Traders were reluctant to holdlong futures positions in American cattle contracts, even thoughthe problem seemed to be confined to Europe, specificallyBritain. Although the mad cow story was not new, it receivedbroad media coverage, which created a climate of great uncer-tainty, not necessarily supported by the facts at hand but withlarge potential implications. What if the public's appetite for beefwere to vanish rather suddenly? What if cattle ranchers were topanic, rush their cattle to market and liquidate breeding stock?In the cattle futures market, prices fell precipitously, but it wasnot clear how the situation would be resolved. There was even abullish case to be made: What if a preemptive slaughtering of cat-tle were to lead to a shortage of healthy deliverable animals lateron, after the scare had passed—as scares almost always havedone?
One commodity was in great supply--confusion. And a con-fusion that led to a doubling of the option implied volatility on142 OPTION REALITY
the nearby cattle contract. All this is retrospective, of course, butlooking back, was there any opportunity for an option trader tograb a fundamental edge in such a confused situation? Possibly.Cattle futures traders would have noticed that the volatility ofthe nearest future was much greater than the volatility of themore distant contracts. Experienced traders knew that the con-fusion would not last and that the bullish and bearish argumentswould probably cancel each other out over the longer term.
The market, therefore, was clever enough not to permit theimplied volatilities of options on deferred contracts to rise to thesame extent as the implied volatility of the nearby. Nevertheless,the former were dragged substantially higher, with the impliedvolatility of the August at-the-money option increasing at thepeak of the scare by almost the same amount as the June at-the-money —at that time, the lead contract. (On April 9, 1996, theimplied volatilities of the June and August options were 15.18and 15.22, respectively; by April 26, June implied volatility hadincreased to 28.31, and August to 26.80.)
Should the implied volatility of August have risen almost asmuch as the implied volatility for June? Probably not—at leastthat seems to be what I'm implying. While I could be legitimatelyaccused of taking unreasonable advantage of hindsight, I offerthis cattle story as an example of "opportunity in confusion" ofthe kind that an option fundamentalist might want to try andexploit.
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Another market where the U-factor is always present to somedegree is crude oil. Here, the trick is to guess when politicalintervention is likely to occur. Supply is in the hands of a cartelwhich makes periodic attempts to prop up falling prices by reduc-ing production. The implied volatilities of crude oil options willexpand or contract according to the consensus of opinion aboutwhen "intervention" will occur and how successful it is likely tobe if it takes place. The cartel members usually get together incrisis situations, which to them is a declining price for crude oil.There is no record of them ever getting together to expandBorRN AGAIN 143
supplies in a rising oil market. The net effect of cartel interfer-ence is to make crude oil rather more volatile on the downsidethan on the upside. Given the general venality of the regimes thatmake up OPEC, and the propensity of individual members tocheat on their self-imposed production quotas, past attempts atpropping up oil prices have only been marginally successful.
Consider the market action in crude oil futures during Marchand April of 1998, a typical bear market positively crying out forOPEC support (Figure 8-6). All during March of 1998, as crudeoil was dropping in price, the implied volatility of the May crudeoil option was increasing —from an already above average 32.01percent on March 2 to 37.94 percent on March 16. Technically,both on a long-term and short-term comparison basis, the Maycrude oil option was overvalued. But the market was anticipatingOPEC interference and incorporating a high U-factor into theoption premium structure.
On Tuesday, March 17, implied volatility jumped to a newhigh of 42.32 percent. The reason was quickly forthcoming; afterthe close of trading that day, the oil producing countriesannounced that a special meeting would be held in very shortorder. This news produced a typical sharp rally in crude oilfutures on March 18, accompanied by a further increase inoption implied volatility to 46.60 percent. The New York Times(March 19, 1998, p. D7) commented on the rally, as follows:
Crude oil prices rebounded 8.6 percent yesterday as the market wasencouraged by news that there might soon be a special meeting of thebig oil producing countries to discuss reductions in output.
Reductions of 1.5 to 2 million barrels per day are reportedly beingconsidered. Such cuts, some analysts have said could increase theprice of crude oil by $4 to $5 per barrel.
Did the increase in option implied volatility after theannouncement of an upcoming meeting make sense? Yes, it did.Although it was true that the market had been half expectingsome such announcement, its confirmation did not reduceuncertainty, for no one yet knew the extent of the measures thatwould be proposed. Three days later the hard news came out.Crude oil futures soared by $2 a barrel, and option implied144 OPTION REALITY
May crude oil futures Atthe-money Days ImpliedLow
Date High Close straddle premium jeft VolatilityMar 2 1599 1565 1566 144 33 32.01Mar 3 1590 1552 1561 146 32 33.07Mar 4 1580 1844 1565 141 31 32.36Mar 5 1588 1563 1567 135 30 31.46Mar 6 1574 1526 1530 133 29 32.28Mar 9 1529 1441 1472 126 28 32.35Mar 10 1488 1460 1463 128 27 33.68Mar 11 1486 1455 1456 132 26 35.56Mar 12 1478 1438 1457 137 25 37.61Mar 13 1472 1440 1443 133 24 37.63Mar 16 1442 1360 1385 126 23 37.94Mar 17 1374 1315 1350 134 22 42.32Mar 18 1475 1356 1461 156 21 46.60Mar 19 1490 1441 1460 145 20 44.42Mar 20 1484 1430 1461 155 19 48.68Mar 23 1750 1575 1651 149 18 42.54Mar 24 1597 1573 1592 132 17 40.22Mar 25 1651 1570 1648 127 16 38.53Mar 26 1770 1648 1683 137 15 42.04Mar 27 1704 1668 1676 139 14 44.33Mar 30 1690 1607 1621 123 13 42.09Mar 31 1626 1556 1561 12Apr 1 1578 1631 1554 WApr 2 1580 1548 1574 10Apr 3 1608 1575 1599 9Apr 6 1595 1534 1845 8Apr 7 1548 1517 1522 7Apr 8 1568 1516 1555 6Apr 9 1580 1552 1556 5Apr 13 1568 1528 1532 3Apr 14 1535 1510 1512 2Apr 15 1560 1502 1846 1Apr 16 1600 1547 1590 May option expires
FIGURE 8-6. Price action on May 1998 crude oil futures, and the May 1998 at-the-money crude oil straddle, during March and April of 1998. Premiums on options wereunusually high, reflecting uncertainty about what OPEC might try to do to stem amajor price decline.
volatility dropped, though not by very much. Again, from theNew York Times (March 24, 1998, p. D10):
The price of crude oil rose 13 percent yesterday in world petroleummarkets, the biggest one day surge since the Persian Gulf War morethan seven years ago; in reaction to weekend promises by producingnations to reduce their exports.Born AGAIN 145
By yesterday, seven other major producers had joined SaudiArabia, Venezuela, and Mexico, the three that led the drive to reduceexports, which they announced on Sunday.
In the days following the agreement, the implied volatility ofthe May crude oil option fell slightly, but by Friday March 27, itwas back near its highest level at 44.33 percent. Here we have asituation where the news is out, and the U-factor has beenresolved, yet option premiums have not declined appreciably: inother words, the atypical response, and a potential overvaluationsituation.
The corn, cattle, and crude oil examples described above arenot offered as obvious cases of option overvaluation, but rather aspointers towards potential overvaluation. As stressed earlier, theoutcome of any one option trade—be it a buy or a sell, a put ora call, a straddle or a strangle--will depend very much on fortu-itous timing. For example, in the crude oil scenario above—animplied straddle-writing situation due to possible overvalua-tion — crude oil futures made a subsequent large move before theexpiry of the May option; a move which would have demanded acovering response {rom a disciplined option writer (Figure 8-6).That outcome does not mean that writing a straddle on March 27would have been a bad idea; it just would not have worked out inthis particular case due to unlucky timing. Had the straddle beenwritten on any of the subsequent five trading days, it would, ifheld to expiry, have been rather profitable.
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No discussion of volatility would be complete without somereference to the "mother of all futures contracts"— the S&P500Index. Not only has this contract the largest daily trading range,in dollar terms, it has become, along with its options, one of themost liquid to trade. The S&P options market is one of the fewwhere it can truly be said that commission charges are not goingto have a serious impact upon the profitability of option trading.Of course, the S&P futures and options complex has benefittedenormously from the huge bull market in stocks over the last fif-146 OPTION REALITY
teen years. The options, in particular, have gained great popular-ity with the general increase in the volatility of stock prices.
I can't pretend to be able to read much into the day-to-daychanges in the implied volatility of S&P options, or to have cor-rectly identified many cases of potential overvaluation or under-valuation; the S&P futures contract is still a relative newcomeron the trading scene. In addition, because of the secular bullmarket that has been in place since the inception of the contract,there is some question as to whether past history is going to berepresentative of the future.
Certainly, the same U-factors that affect interest rate and cur-rency futures are going to impact upon the stock market.However, there may be a U-factor particular to stocks, stockindexes, and futures. With the broad-based public participationthat is unique to stock trading, there is some reason to supposethat price action there may be fundamentally different from priceaction in conventional commodities. (More of this, shortly, whenI discuss my own uncorroborated theories on what makes thestock market tick.)
During its fifteen-year bull run, the stock market has experi-enced two very large one-day price declines, neither of which wasfollowed by any further downside action. The first of these dropsoccurred in October of 1987, and the second almost exactly tenyears later in October of 1997. In percentage terms, the 1987plunge was almost four times as large as the 1997 plunge; itcame so suddenly and was of such a magnitude that it probablywiped out a generation