eterminable in many cases, but when it is determinable—as, for instance, when there is a known supply shortage that will not and cannot beeased for some time—opportunity awaits. In such a case, we can select ordesign a trade that will be profitable unless this market resumes its zippycountertrend move within a known period of time.We are also able to design similar trades when a market is about to entera period of the year in which it tends firmly to move in one or the other direction. This is a very valuable strategy for our purposes, because such seasonal tendencies occur much more frequently than do countertrend movesin trending markets. Seasonally based strategies have been used ever sincethere have been markets, and with good reason. The Earth revolves aroundthe sun after all, supplies of agricultural products increase when they’re harvested, obviously, and harvests occur within a broadly predictable periodfor any given crop.When I was a futures broker in the 1970s, there was a surprisingly accurate and therefore popular set of seasonal trades, so popular in fact thatsome brokerages marked these trades’ entry and exit dates on the tradingcalendars they gave to their clients. These were called collectively “The VoiceFrom The Tomb” and were the creation of a remarkable person whosename I’ve never known. Whoever he was, with only pencil and paper, mindyou, he kept track of decades of grain prices and figured out a set of optimized entry and exit dates for trades in a considerable number of futurescontracts. He directed that his calculations not be published until well afterhis death, thus the colorful name for these trading ideas.As you rightly suppose, the advent of the personal computer has giventhis type of analytical capability to anyone who wants it. There are nowbooks and Internet sites and newsletters, electronic or otherwise, devotedto the analysis and discussion of seasonal trades. With a database of historical prices, a computer, and a spreadsheet program, anyone can perform asmany seasonal entry/exit analyses as desired in a very few minutes, and fora ten-thousandth or less of what such capability would have cost only 30
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years ago. If you’re of a mind to perform this sort of analysis yourself, let mestrongly encourage you, because studying these seasonal entry/exit analysesis an absolutely wonderful method of learning about market tendenciesover time, and a good way to turn a trading profit, too.
The Non-Seasonal—Being Not Wrong Is EasierThan Being RightWe can easily use a seasonal-following strategy when we want to, but sucha strategy is hardly flawless or without its own considerable risk. Seasonaltrades, let’s face it, don’t always behave this year as they did in previousyears, for a large variety of reasons. Actually, we can build the proverbialbetter mousetrap if we examine what markets don’t do at specific times ofthe year, looking in effect for a seasonal non-tendency, or, as I like to callit, a “non-seasonal” tendency. If a seasonal tendency is valid over the years,traders will trade it, and probably profitably too, but the amount of profitability and the interim risk will vary widely from year to year (or else everyone would trade it every year, right?). All right, that’s perfectly clear, butlet’s ask a different question. Pick a market, any market, during some portion of the year. What are the largest moves upward and downward for thatmarket within that period, over some reasonable number of years?For an example of the non-seasonal strategy, take a look at Table 6.1,will you? These are the historical market prices for the NYMEX August unleaded gasoline (ticker symbol HUQ) contract from June 17 through July 26over 12 years. The first column is the putative entry date, and the second isthe market-on-close (MOC) price on that date, which we’ll name as our theoretical entry point. The third and fourth columns are the interim highs andlows reached by the market during the named period. The sixth column isthe MOC price on the end date of the period or the next business day following, which is the fifth column. The seventh column is each year’s resultif one had held the trade from the start date through the end date, ignoringall trading costs and not setting any stop-loss point. The last column is thecumulative result achieved over the years by undertaking this trade on thestart date and holding it through to the end date unless the stop-loss point(shown below the table, at right) has been hit. This last column’s figures dotake our estimated contest risk into account.August unleaded gasoline closed at 79.40 on Monday, June 17, 2002(which by a huge coincidence is the date I’m writing this). From Table 6.1,it would seem to be the case that this market’s price tendency is moderatelydownward in the period we’re examining. Whether trading this very modestseasonal tendency is a good idea is not of immediate concern to us. But,
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TABLE 6.1
Seasonal Buy Study, August Unleaded Gasoline, 1990–2001Interim
EntryDate MOC
EntryPrice
High
Low
ExitDate MOC
ExitPrice
GrossResult
Cumulative NetResult
90-06-1891-06-1792-06-1793-06-17
56.1261.4566.0555.31
65.5566.7066.2556.10
54.1059.8057.2049.90
90-07-2691-07-2692-07-2793-07-26
65.2665.8061.8952.06
+9.14+4.35–4.16–3.25
+9.000+13.210+9.270+5.330
94-06-1795-06-1996-06-1797-06-17
55.3257.5660.4157.84
57.3058.7065.5665.50
51.7551.5056.7054.65
94-07-2695-07-2696-07-2697-07-28
57.1652.8960.1664.84
+1.84–4.67–0.25+7.00
+7.030+3.090+2.700+9.560
98-06-1799-06-1700-06-1901-06-18
47.45 49.7053.56 62.6098.27 104.0084.09 86.00
41.1051.4086.0069.70
98-07-2799-07-2600-07-2601-07-26
42.8261.7589.2576.36
–4.63+8.19–9.02–7.73
+5.620+13.670+9.730+5.790
Average on 12 buys: +0.482 cents; stop w/loss of: 3.80 centsInterim MovementAvg Up 4.211 Max Up 9.430
Avg Dn 5.803
Max Dn 14.390
Notes: August unleaded gasoline (NYMEX), HUQ; buy on 06-17, sell on 07-26.
what about the non-seasonal tendency, that HUQ doesn’t rise strongly during this period?HUQ historically has never risen 17% in price over this period, and themaximum gross price rise has been 9.43 cents, 943 points. We want to askourselves, “Is there some reason that HUQ might move upward more thanthis in this period this year?” What are the current market factors thatmight propel the price of gasoline well higher?Well, the Middle East situation is as muddled as ever. OPEC is meetingnext week, and the “wise men” are saying, to a man, that OPEC members willnot raise their production quotas this summer. With West Texas Intermediate(the American benchmark grade) crude oil above $25.00 and the OPEC “basket” of several crudes almost to $24.00, OPEC appears to be perfectly satisfied with oil’s price level, and its members likely won’t lower the productionquotas either. The homicide bombings in Israel are at an all-time high, but thisfact doesn’t seem to be affecting energy prices so far. This situation rates toget worse, though, principally because no one seems to have any idea how tostop it, and the Palestinians sound as if they’ve no intention of desisting.After a spring season of refinery problems due in part to 2001’s heroicproduction runs, refiners seem to have hit a steady stride, and the big Citgo
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refinery in Illinois is back on line (very important for supplying the customblend of gasoline required in the upper Midwest). The EPA, notably and foronce, hasn’t issued new onerous regulations concerning summer gasoline.Supplies of motor gasoline are a touch higher than last year, although thisfigure is down from a 7% year-on-year increase six months ago. Demand isabout nine million barrels per week in America, fairly typical for the Memorial Day–Fourth of July period over the past few years. Norwegian oil workers have just opted not to strike, removing one potential disruptive factor,and Norway and Russia (who aren’t OPEC members) have stated that theywon’t honor the OPEC production cutbacks in the next quarter, beginningJuly 1. The price of gasoline, after a spring run-up, has been whopping andflopping in the 75–80 cent range for a couple of weeks.In terms of supply and demand, there doesn’t seem to be a strong bullor bear case to be made in gasoline right now. This situation can change in aheartbeat, without doubt, if one of the players in the Middle East does something sufficiently stupid, but, as the guy who jumped off the Empire StateBuilding said as he passed the fiftieth floor, “So far, so good.”
Who Needs a Trend to Profit? Not UsNow, how do we propose to profit from all this wonderful information aboutthis apparently neutral market? It looks like there’s little to choose betweenbuying the market and selling it, but who says we must do either? Why notprofit by writing an option whose striking price is most unlikely to bereached within a very limited time? Given that the HUQ options expire infive-plus weeks, on July 26, let’s just crunch a few numbers.HUQ’s price tonight is 79.40. Seventeen per cent, just a trifle more thanthe maximum percentage upmove from June 17 to July 26 in our study, of79.40 is 13.50, which added to 79.40 gives 92.90. We can reasonably assertthat HUQ is historically unlikely to reach the 93.00 cent level. Is this analysis good enough? Should we therefore write the 93.00 HUQ calls? We coulddo so and have a fine expectation of earning a profit, but first we want to consider some other implications from our historical price study.When did HUQ have its largest upmove in the period we’re examining?In 1999. What was happening in the energy markets in 1999? After years ofbickering, back-stabbing, and cheating, and after the price of crude oil hadcollapsed in 1998, OPEC finally started getting its act together. It became, forthe first time in a long while, a reasonably effective cartel. Crude and itsproducts were wildly oversold throughout 1998, for one reason because various of the OPEC players were fighting for market share to the detriment ofprices. The major non-OPEC producer, Russia, was trying desperately to restore its financial credibility after its horrendous currency devaluation andbond default in 1998. Russia simply hadn’t the capital to invest in upgrading
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its oil industry’s infrastructure and increasing production of its staggeringlyhuge oil and natural gas reserves.The other 16+% rise in HUQ during our sample period, in 1990, was ofcourse due in large part to some market participants’ anticipation of Iraq’sreckless action on August 1, 1990, leading ultimately to the Gulf War. In theory, this sort of thing can recur at any time, but Iraq’s military posture offersno hint at the moment that they are preparing for a general mobilization,and certainly not in the next five weeks.It seems that neither of these sets of factors will affect the energy markets this summer. HUQ, particularly, is nearer its yearly highs than its lowsand isn’t oversold at all; some analysts even consider gasoline to be overbought at this time, and, if actually so, this factor would likely work to ouradvantage in writing call options. Gasoline supply is ample, considerablyimproved over the past three years. Capital, in limited but still significantamounts, is flowing back into the Russian oil industry, and the President isclearly making overtures to the Russians, presumably with a view towardestablishing long-term supply agreements. Even OPEC has finally seemed torealize that crude oil at $30.00/barrel when the world economy is relativelyslow is not to their longer-term advantage.The practical implication of this supply change from 1999 for us tradersis to allow us to be slightly bolder than we might otherwise be. Another wayto say this is that the lack of evident threats to supply such as those that impelled large upward price moves in 1990 and 1999 lowers our potential eventrisk somewhat. We ordinarily prefer to select a striking price well past theextent of the largest historical price movement. In this HUQ example, sucha strike would be calculated as 13.50 (17% times tonight’s closing price) times1.15, or 15.53, plus tonight’s price of 79.40, or 94.93. Achieving this pricewould require a 15% greater upmove than has ever occurred during the period. The 95.00-strike HUQ call would, by this process, be our candidate forwriting tomorrow morning. Historically, and absent some off-the-wall event,we should bank a profit by writing this option some enormous percentageof the time, perhaps as often as 99 cases out of 100.We might gain an additional perspective to aid in our selection of thestrike of the call to write. Have another look at Table 6.1. Check the coupleof years when HUQ prices were high at the start of our sample period. Interesting, no? If we accept this very limited set of data as indicative, upmovesin our named period are quite small when prices are high at the start of theperiod. This is understandable. The dynamics of any market change alongwith its price. Cocoa prices don’t behave the same when the market is at$1700/tonne as when it’s $750/tonne. An $8.00/bushel soybean market behaves nothing like a $4.50/bushel market. And so with gasoline, too, no matter how much some academic types may yap about the price inelasticity ofdemand that is peculiar to gasoline.
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With these additional supply/demand and market history considerations,writing the 95.00-strike call becomes a little conservative, but still a very goodselection. The overall set of factors, though, leads me to prefer writing HUQcalls with a strike of 91.00, 92.00, or 93.00, likely the 92.00. It settled at 81points tonight, and, given a steady opening tomorrow, we can probably writeit for 72–76 points net of contest risk. The SPAN initial margin requirementtonight for writing one HUQ 92.00 call is $1,355. Because I’m trading a number of other markets right now, fourteen to be precise, I consider that theportfolio is sufficiently diversified to allot only 2.5 times the SPAN requirement, or $3,387.50, for each call that I’ll write. If I can manage to write thecall for 74 points net, that will represent 74 times $4.20/point, or $310.80 grossin pocket, suggesting a notional ROC of 9.17% over 40 days, or 6.88% permonth, a perfectly acceptable figure.Am I at risk in this trade? Sure. This isn’t a pure arbitrage, and there isalways some statistical risk and, in energy markets, event risk is never absent. Are the odds of success substantially on my side? Oh, yes. If our modelis to be believed at all, this trade will be profitable about 93% of the time, alittle bit under two standard deviations in the lognormal distribution ofprices (see Table 6.2). The only thing that beats the trade is a rise of 34% inthe price of HUQ in 40 days’ time.Now, there are traders who do have such an apocalyptic view of the energy markets, and have staked and will continue to stake their capital on theoccurrence of extreme short-term upward price movements. Who are theseoptimists (or are they really pessimists, an interesting philosophical question)? That’s easy enough; these are the folks who have purchased HUQ92.00-strike calls recently, and who will buy them from me when I write theseoptions tomorrow. I love these guys. Everyone should have such a positiveview of life and the markets—such a view makes it so much easier to put asmile back on your face after you’ve helped someone else pick your ownpocket.
So, How Often Do We Win?Before we make any decision about whether to help ourselves to a chunkof the optimists’ capital, we’ve a little bit more work to do. We naturally wantto learn what our pricing model has to say about the probability of successif we write WOOM August unleaded calls at this time. Table 6.2 is our usualincremental analysis of the expectation for writing the HUQ 92.00-strikecall options, expiring on July 26.The SV of HUQ is a measurable number, but it reflects the recent past.The deltas and the IVs of its call options, as ever, represent the current sentiment of all the market participants regarding the future price of HUQ. Evidently, sentiment is relatively modest at this moment, because the IV of the
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TABLE 6.2
Expectation of Writing HUQ 92.00 Calls on 6/17/2002
StrikePrice
OptionPrice
Delta× 100
ProbabilityBelow*
Probability ofRange
Profit atRange Midpoint
Expectationin Range
92.0093.0094.0095.00
0.810.710.610.53
13.8712.4411.019.86
0.91960.93100.94180.9502
0.91960.01140.01080.0083
+310.80+84.00–336.00–756.00
+285.81+0.96–3.63–6.27
96.0097.0098.0099.00
0.460.430.340.29
8.698.056.795.87
0.95830.96260.97060.9760
0.00810.00430.00790.0055
–1176.00–1596.00–2016.00–2436.00
–9.52–6.86–15.93–13.40
100.00101.00102.00103.00
0.250.220.190.16
5.154.774.193.67
0.98010.98220.98520.9877
0.00410.00210.00300.0025
–2856.00–3276.00–3696.00–4116.00
–16.71–6.88–11.09–10.29
104.00105.00106.00107.00
0.140.130.130.11
3.243.012.952.60
0.98970.99080.99110.9926
0.00200.00100.00030.0015
–4536.00–4956.00–5376.00–5796.00
–9.07–4.95–1.61–8.69
108.00109.00110.00111.00
0.100.090.090.08
2.352.182.051.86
0.99360.99430.99480.9955
0.00100.00070.00050.0007
–6216.00–6636.00–7056.00–7476.00
–6.22–4.63–3.53–5.23
112.00113.00114.00
0.070.060.05
1.731.551.31
0.99590.99650.9973
0.00040.00060.0007
–7896.00–8716.00–8736.00
–3.16–4.99–6.12
Overall expectation:
$127.97
Notes: HUQ = 79.40; Q options expire 07/26/2002.
*Probability of being below the striking price on the same line.**The option is assumed to expire worthless if HUQ is exactly 92.00 cents.
HUQ options has ranged from 33.2% to 55.1% over the past six months andtonight’s IVs are down toward the low end of this range, at 38.0%.Oddly, even given the lowish call IVs (we prefer to write options withrelatively higher ones, per their recent 6-month range of volatility) and considering the theoretical possibility of severe supply disruption due to warsor related occurrences, we should have a high degree of confidence in thistrade. The non-seasonal tendency of this market at this time is solidly onour side, as indicated by Table 6.1, and we’ve also enlisted in our cause ourfavorite ally, time. When a trader buys a short-dated WOOM option, he notonly must be correct in his view about the direction of the market, he must
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be correct P.D.Q., and he has taken much the short end of the odds, in thiscase roughly 93-to-7 against. Do you want to trade along with the optionbuyer in such a situation? Very likely not, I’d wager. Each day that passeswithout some amount of market movement in his favor is another nail in hiscoffin, and we who have sold him this option find our trading capital increasing merely by courtesy of the passage of time. A very painless process,I assure you.When we write short-dated options, we have a useful measure for approximating our potential rate of dollar gain. This measure is theta, the rateof decay per day of the time premium remaining in an option. Other considerations being equal or roughly so, theta increases steadily for near-themoney options toward the end of an option’s life. Theta’s rate of dailyincrease actually accelerates going into these last few weeks, if the marketremains fairly close to the option’s striking price. When the option moves orstays WOOM as it nears expiration, theta becomes more or less irrelevant—there’s little time premium left to decay. For those of us who write options,especially short-dated WOOM options, theta is easily the best friend wehave other than the price of the underlying asset moving smartly away fromthe striking price of the option we’re writing.All the numbers generated by our pricing model are approximations, aswe’ve seen, and we must keep in mind three other things. First, the probability of the success of our trade will change daily, as the market moves upand down. Second, and this point cannot be overemphasized, any computations using the lognormal model to measure expectation and/or success/failure apply only to the whole term of the trade, only if we sit until the expiration of the options. Third, the numbers in Table 6.1 do not consider theamount of loss we can incur if HUQ moves outrageously higher. This is,again, why we must perform the incremental analysis of expectation asshown in Table 6.2. To skip this step would be at minimum careless andself-deceiving, and we would be plainly stupid for putting our capital at riskby simply ignoring potentially useful information . . . creating in effect a sortof voluntary knowledge risk.The first and second points are related. The typical lognormal modeltreats a trade as something to be examined in one big chunk; it says nothing at all about what may happen during the term of the trade. If we wantedto analyze a trade thoroughly, we would perform an analysis similar to ourpreceding incremental analysis for each day remaining in the trade and compute what amounts to a cumulative sum of each day’s expectation. Doingsuch an analysis is quite possible (such an analysis is the heart of the CoxRoss-Rubenstein and Whaley quadratic models, for instance), but the analysis is somewhat involved and is, in my view, better suited and more usefulto institutional traders. We can—and we will—put and keep profitability onour side without such an extensive analysis.
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Conditions of Entry—The Criteria for aNon-Seasonal TradeThe practical preconditions involved in applying the non-seasonal strategyare as follows:1. The underlying market we’re examining must have an historically valid
non-seasonal tendency over an upcoming period. A non-seasonal isfully valid if it was not violated at minimum 9 years in the past 10, 18 inthe past 20, and so forth, with the more recent years’ results being moreindicative.2. The non-seasonal must persist for an absolute minimum of 2 weeks, 3to 10 weeks is more desirable, longer occasionally, and 4 to 7 weeks isthe typical case.3. Immediate supply/demand factors that might operate against the success of the non-seasonal must be moderate or remote, as far as we cantell, and the market we’re examining must not be in the midst of a strongtrend toward the striking price of the option we write.4. The maximum counterseasonal move during the period under consideration must be known (that is, we have to do our homework) in orderto select an advantageous striking price to write.5. In the best case, the average interim price move for the regular seasonalasset trade in our favor (away from the strike we write) over the wholeperiod should be at least 1.5 times the average interim price move toward the strike we write.6. In the best case, the maximum interim move in the direction of the seasonal should be at least 1.75 times the maximum contrary move.7. The theoretical ROC of the trade at the start, net of all costs, should benot less than 7% per month, compounded, of double the initial SPANmargin requirement of the trade. Using a standard of 5% of treble theinitial SPAN requirement is better still, from the essential standpoint ofcaution.8. The distance from tonight’s closing price to the striking price of theWOOM option we’re considering writing should usually be at least 10%larger than the maximum historical contrary move over the term of thetrade, although present day supply/demand considerations may, as inthe HUQ example, suggest modifying this condition.9. The non-seasonal tendency should persist until the option’s expirationin the best case, and without exception to at least within 1 week of theoption’s expiration, unless we, by design, intend to exit the trade at somepoint during the option’s life.
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Why These Criteria? What’s Our Advantagein Adhering to Them?Now, that’s quite a list of conditions, and rarely will all of them fall into linefor us. That’s all right. They don’t have to be all aligned for us to earn ahealthy profit and still be sensibly cautious in the process. Some conditionsare much more important than others. Conditions 1, 3, 4, 7, and 9 are vital ornearly so, but the various markets meet these five conditions frequentlyenough. Let’s look a little more closely at these conditions.Fooling with less than 90% successful non-seasonals means that, morethan 1 time in 10 historically, the non-seasonal trade will either aggravate usor be an outright loser. I prefer better odds than that, thanks. If we don’t doour homework regarding condition 4, thus remaining unaware of how faran adverse move might persist, we’re juggling chainsaws in the dark, and Istrongly suspect that this cannot be profitable unless we’ve arranged double or triple indemnity on our medical insurance. Concerning condition 7, ifthe ROC isn’t fairly handsome, why should we bother entering the trade inthe first place? These are all straightforward enough, but condition 9 wantsa little more comment.If we should trade what I call “shorties,” in which the non-seasonal tendency evaporates more than a week before option expiration, we foist uponourselves an extra market decision. Should we wait for expiration and cashout the whole trade, or simply take our profit now (at the end date of themeasured non-seasonal tendency) and thereby incur extra trading cost andaccept a diminished profit? The principal factor that prompted our use ofthis strategy is now gone. Why stick around and make an extra decision,one that has a distinct component of guesswork in it? Match the term of thetrade to the option’s expiration before entering the trade, and save yourselfthe implied risk of this extra trading decision.Condition 2 is a restatement of a point made earlier. We must allow themarket participants some amount of time to put dollars into our pockets.The notion of a 6- or 9-day seasonal, although some traders favor these andseek them out, is dubious at best from a supply/demand standpoint and oursuccess in such a trade might well depend on an external event. This is acceptable if we know what the external event is, but do we? Why is there ashort-term tendency for the S&P 500 Index to rise over the last two tradingdays of a month and