loss. No one wasparticularly upset—an honest effort had been made to identify a profitabletrade. But the executive vice president jokingly said that I must have made amistake, accidentally calculating that there was a “90 percent chance of rain”instead of a “90 percent chance of a rising market.” From that time on, thesystem became known as the “probability of rain” indicator.
For those readers who are intending to program this type of system on their computer or are going to hire someone to do it, I shouldpoint out that you can reduce the number of calculations greatly whenyou are constructing the trees. For example, if you are looking for alocal maximum over the next 10 days and you calculate a node of atree only three days out that exceeds the current moving averagevalue, then you don’t need to calculate any more nodes on thatbranch of the tree. They are irrelevant, since the current value wasalready exceeded. All you need to do is count all the possible outcomes that would have emanated from that node as outcomes thatexceed the current value. You don’t actually need to evaluate the outcomes, you just need to count how many there would be; and that isa simple matter (for example, if we are three days out, then there areseven days to go, and if there are nine possible values each day, thenthere would be 63 outcomes that would be considered to haveexceeded the current value). However, with today’s very fast comput-
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ers, you may not want to get so esoteric—the computer can blast itsway with brute force through the entire array of calculations.The advantage of knowing the probability—in advance—of a signal occurring is very useful. It allows you to get into a position muchcloser to the actual local maximum or minimum, if you are using thattype of system. Also, it can assign a probability that two moving averages will cross over each other in the next few days (in order to calculate this type of system, you need to apply the technique to bothmoving averages and then see how many of the possible outcomesresult in a crossover).
SUMMARYThis chapter has demonstrated that options can be used in variousways to predict markets. Unusually heavy stock-option trading isoften a tipoff that the underlying stock is about to experience a significant move. Also, option premium levels can be an important indicator in several situations. In some cases, it is a warning of a largemove by the underlying stock. In others, it may indicate the end of adowntrend when options are expensive. Similar conclusions can bedrawn from index-option premiums; when they are extremely expensive, the market may be reaching a bottom, and when they are verycheap, a market explosion may occur (often to the downside).Finally, the put–call ratio is a valuable indicator for the broad marketas well as for certain futures contracts.We also presented you with a method for predicting whether amoving average is making a local maximum or minimum. This isextremely useful in conjunction with the put–call ratios, since that ishow we identify buy and sell points.
5
Trading Systemsand Strategies
In this chapter, we describe a number of trading strategies that haveprofitable track records. These include day-trading systems, intermediate-term market-timing systems, intermarket spreads, and a numberof seasonable strategies. It is not necessary to trade options to employmost of these strategies, although, as with any trading decision, it maybehoove the trader to use options in many circumstances.We have already discussed one very profitable set of strategies—those having to do with trading at the time of option expiration,especially during the week of expiration and the week after. Severalstrategies for expiration trading were presented in Chapter 3. Theseincluded a hedged strategy for expiration Friday itself, a way to determine if there was a possibility of expiration-related buying in the daysprior to expiration Friday, and finally a strategy for trading the weekafter expiration (the postexpiration effect).
INCORPORATING FUTURESFAIR VALUE INTO YOUR TRADINGIn Chapter 3, the concept of fair value for Standard & Poor's (S&P)futures was presented. This is an important concept—especially forday-trading of S&P futures, S&P 100 Index (OEX) options, or otherindex options—and the reader should review it if he is not familiarwith “fair value of futures.” When the S&P futures are overvalued,OEX calls will also be overly expensive, and OEX puts will be cheap.Therefore, that is not normally an appropriate time to buy either thefutures or the calls, for you will almost immediately suffer the aftereffect of overpaying when the futures return to fair value. But if you351
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happen to be buying puts, it is a most opportune time to do so. Similarly, if the S&P futures are undervalued, then OEX calls will becheap, and puts will be expensive. In that situation, if you are bearish, you would be hurt by selling the futures or buying the puts; but ifyou are bullish, the calls are a good buy.Thus, if you have a broad market-trading system that has given asignal, it doesn’t always pay to rush right in and take a position. Youshould first look at the relationship of the S&P futures to fair value. Ifthey are expensive and you are looking to buy the market, you maywant to wait until the futures return toward fair value before makingyour purchase.This statement makes the tacit assumption that the futures will,in fact, return to fair value rather quickly. Normally, they do, especially in this day of efficient arbitrage. However, they don’t alwaysspring back to fair value if there is an extenuating influence on themarket, particularly on the downside. Recall the description of howfutures traded at huge discounts to fair value during the crash of1987. While that is an extreme example, more common ones mightinvolve some piece of bad news that affects the entire market—anunexpected government unemployment figure, for example. Thismight cause the futures to trade at discounts for more than a briefperiod of time.A trader should use judgment in deciding when to trade eventhough futures are not “fairly priced.” Typically, if the market is relatively stable and is not reacting to some sort of extreme news, thenyou can be choosy, refusing to buy when the futures are overpricedor to sell when the futures are underpriced. However, in a fast-moving market where news is a factor and, perhaps, T-bond futures aremoving fast in the same direction as well, discretion may dictate thatyou trade without consideration of fair value. For example, whenthese fast market conditions exist and you are already long, if themarket drops down through your mental stop price, you probablyshould be more willing to sell at the market rather than wait for thefutures to return to fair value.So, in the discussion of trading strategies in this chapter, youshould realize that you may sometimes be able to improve your overall profitability by paying attention to premium levels at which theS&P futures are trading before actually entering your order.
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DAY-TRADING VEHICLESIn many of the systems to be presented in this chapter, we are goingto be trading “the market,” often over a fairly short-term time horizon. The question inevitably arises as to what trading vehicle to use—futures or options. In some of these systems, there will be specificcomments on when to use options (in intermarket spreads, for example). However, in others, the choice is the trader’s.In general, I prefer to use the S&P 500 futures to day-trade,but I prefer the OEX options for a trade with a longer time horizon (3 to 15 days, for example). There are a couple of reasonsbehind my choice, and I will attempt to explain them.The S&P 500 futures are the “truest” trading vehicle that thereis, as long as you are aware of the fair value. There is no impliedvolatility that can collapse your value as it can with an OEX option. Ithas been my experience over the course of the 22 years that theS&P 500 futures have been trading that they more accurately mirrorthe movement of the underlying cash index than OEX options do, bya wide margin.Here is an actual story from a trading day in 1995, December 1, to beexact. The market gapped open, higher, on a good economic report. Thistriggered a sell signal from the TICKI System (to be discussed shortly). TheS&P 500 futures were trading at 608.50, and the OEX was almost exactlyat 581. The following prices sum up the position that I, or any trader, wasfacing at the time:S&P 500 Cash Index: 607.60S&P 500 Futures: 608.50Futures Premium: 0.90Fair Value: 1.25OEX: 580.98OEX Dec 580 put: 45⁄8Implied Volatility of the put: 12.5%CBOE Volatility Index: 11.5%The controlling factor in all of this was the premium on the S&Pfutures. It was then at 0.90, which was below fair value. This means that
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OEX puts were going to be on the expensive side, since OEX market makers are quite diligent about watching the S&P futures premium.You can often get a quick idea of how expensive an OEX at-the-moneyoption is, by comparing its implied volatility with the Chicago BoardOptions Exchange (CBOE) Volatility Index (symbol: $VIX at that time, butcurrently $VXO), which can be quoted on any quote machine. You can seethat this particular Dec 570 put was “overpriced” in that its implied volatility of 12.5 percent was a full point over the VIX level of 11.5 percent. Inthe case of this option, that one point of implied volatility was worth 0.45 tothe price of the option. That is, if the implied volatility fell to 11.5 percentand OEX were at 580.98, the option would sell for about 41⁄8. That’s ahuge amount of the price of this option.As it turned out, I shorted the futures and the market did top out, butonly lazily; and it slid slightly lower, so that by 3:45 P.M. Eastern time, 15minutes before the close, the following prices existed (the net change of eachprice from the earlier prices in this example is included in parentheses):S&P 500 Cash Index: 606.20 (–1.40)\S&P 500 Futures: 607.40 (–1.10)Futures Premium: 1.20 (+0.30)Fair Value: 1.25OEX: 579.60 (–1.38)OEX Dec 580 put: 43⁄4 (+1⁄8)Implied Volatility of the put: 11.5 percent (–1.0%)CBOE Volatility Index: 11.2% (–0.3%)The futures had dropped 1.10, and I was able to cover and make $550,less commissions. But look at the OEX Dec 580 put—it only advanced aneighth of a point! Moreover, if you went to sell it, you’d probably have totake an eighth less to hit the bid. What happened here?Well, let’s analyze it. The implied volatility of the put dropped back tobe much more in line with the Volatility Index (11.5 percent versus 11.2percent). As was pointed out, that drop in volatility cost the option 45 cents.Moreover, the delta of the put option was only about 0.43 to begin with,meaning that if OEX fell by a point, the option was only going to increasein value by 43 cents. As it turned out, OEX fell by about the same distanceas SPX, but the loss of implied volatility in the option essentially wiped outall the profit potential. Thus, the futures were the much better buy; theyclosely mirrored the 1.40-point drop in the SPX, except for the amount lostwhen they returned to fair value (30 cents).
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This is a fairly typical occurrence. The OEX options are overpriced because of the discount premium on the futures contract. Ifyou get only a small market move, the futures are going to be thebetter choice as a trading vehicle. Of course, if the market move islarger, then you probably won’t notice much difference. Also, thisexample indicated that implied volatility fell; that doesn’t always happen, either, although it often does when the ensuing market move isa small one.Thus, for day-trading purposes, I prefer the S&P 500 futuresbecause they more closely mirror the performance of the SPX itself.However, for longer-term speculative positions that I might be carrying for a couple of days or even a couple of weeks, I will often use theOEX in-the-money options because of their limited risk nature andthe smaller capital outlay required. However, if implied volatility weretoo high, I would be leery of buying OEX options, even in thoselonger-term situations.
THE TICKI DAY-TRADING SYSTEMI devised the TICKI system a number of years ago for day-tradingS&P 500 futures. It is based on the following basic concept: if anartificial buy or sell program (see Chapter 3 for definitions) is executed in a stable market, the market has a tendency to return to itsprevious price once the artificial buying or selling is over with. Overthe years, this has been a correct observation much of the time. Ofcourse, there is the aberrant case where wave after wave of programs hit the market; but those are the exception, not the rule.So, in order to create a system to take advantage of this concept,we need a way to identify when a program trade is taking place, andwe also need a way to identify when it is over. I have found a verysimple way to determine both of these things. It is called the TICKI,and it is something that you can quote on any quote machine, including at-home systems such as Signal or Bonneville.TICKI is the net plus or minus ticks of the stocks in the 30 DowJones Industrials. For example, if at the current time, 20 Dow stocksare trading on plus ticks (or zero-plus tick) and 10 are trading onminus ticks (or zero-minus ticks), then the value of TICKI would be
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10 (20 minus 10). A brief example will define the terms plus tick,zero-plus tick, minus tick, and zero-minus tick.Example: Suppose that XYZ stock trades at the following prices over ashort time period during a trading day. Each trade is identified as the appropriate type of tick.Price5050.05505050.0550.1050.10
Type of TickPlus tickMinus tickZero-minus tick (same price as last trade,which was a minus tick)Plus tickPlus tickZero plus tick (same price as last trade,which was a plus tick)
TICKI shows where the 30 Dow Jones Industrials’ last ticks are atany point. Since there are 30 stocks in TICKI, the highest that it canget is +30, and the lowest it can become is –30. If TICKI gets to+22 or higher, buy programs are being executed in the marketplace; if TICKI drops to –22 or lower, sell programs are being executed. Note that for TICKI to be +22, 26 stocks have to be on plusticks and 4 on minus ticks. Thus, nearly all of the 30 Dow JonesIndustrial stocks have to be on plus ticks for TICKI to get to +22. Thedownside is similar: 26 of the 30 stocks would have to be trading onminus ticks in order for TICKI to be –22.Since nearly all program trades that are large enough to movethe market noticeably involve the 30 Dow Jones Industrials, TICKIis a good way to identify program trading. There is a similar measure called the TICK—the net of plus and minus ticks on all NewYork Stock Exchange (NYSE)-listed issues. TICK is too broadbased to quickly and accurately detect when a buy or sell programis hitting the market. Thus, TICKI is our choice for making thatidentification.Having quantified the first half of what we need to know — whena program is being executed—we now need to address the other
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half—how to identify when the program is over. No matter howlarge a buy program is, it has an end. During the program, TICKImay rise to +22 and stay at or above that level for some time. Whenthe program ends, TICKI will begin to fall, reflecting the fact thatsome of the stocks are beginning to trade on minus ticks. WhenTICKI drops back to +12 after having been at +22 or higher, thebuy program is over; conversely, when TICKI rises to –12 afterhaving been at –22 or lower, the sell program is done.Obviously, some buy or sell programs may be executed in a morediscrete manner, but a lot of them are executed just by pushing a computer key and letting a flood of orders race into the marketplace. Thistype of program trading causes the TICKI behavior just described.Moreover, it is this type of program trading that draws out traderswith opposite opinions. A trader who sees a stock that he owns jumpup in price may often sell his stock into the program, thereby obtaining a better price than he would have in a stable market.Having established the criteria for determining when the programs begin and end, we can now lay out a trading system that isgeared toward making money when the market reverses directionafter a program is finished:• When TICKI rises to +22 and then falls back to +12, sell theS&P futures. Hold the position until one of the followingoccurs:a. The trading day ends.b. TICKI trades back up to +22.c. The S&Ps exceed the highest price reached duringthe buy program by 0.20.• When TICKI falls to –22 and then rises back to –12, buy theS&P futures. Hold the position until one of the followingoccurs:a. The trading day ends.b. TICKI trades back down to –22.c. The S&Ps fall 0.20 below the lowest price reachedduring the sell program.
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• Don’t enter into any trades after 3:30 P.M. Eastern time, forprograms near the close of trading may not have enough timeto reverse direction.• If you take two consecutive losses on one trading day, ceasetrading the system for the remainder of that day.Note that this system often has a built-in advantage: since you areselling right on the heels of a buy program, the futures may beinflated (trading above fair value), which is an additional benefit. Conversely, when you buy immediately after a sell program, you may findthat you purchase the futures below fair value.Some comments on the system are in order, for I don’t believe intotally ironclad adherence to rules. It’s a day-trading system, so wegenerally don’t hold any positions overnight; positions are closed outat the end of the trading day if they haven’t been stopped out bythen. However, some well-known traders have modified their stanceon day trades: if you are holding a profit at the close and the marketaccelerated in your direction, then close out the trade the next morning. Of course, since S&Ps trade all night on Globex, you can literallyclose out your position at any time.You should note that when you close out your position will affectyour margin requirement. Most brokerage firms require less margin fora day trade than they do for a position held overnight. For S&Pfutures, a “day” begins at 4:45 P.M., when the Globex market opensand continues through 4:15 P.M. the next day, when trading ceases onthe Chicago Mercantile Exchange (Merc). Thus if you don’t close outyour position by 4:15, you will be required to margin the position asan overnight position.Back to the system. Note that if you are stopped out by rule (b),you will be reentering another trade as soon as that program ends.Thus, rule (b) is sort of a temporary stop—it momentarily takes youout of the market since there is another program being executed, butyou will reenter your trade shortly.Finally, the stop loss defined as rule (c) may take a little explaining. This is a rule that I have instituted after years of observingthe market’s behavior in line with program trading. Generally, if
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prices exceed the highest point reached during a buy program,then there isn’t much hope of the program’s effect being reversed,so you should close out your position. Similar thinking applies tothe downside.
Example: Suppose the following prices are observed during a buy program:S&P Price
TICKI
Comments
550.00550.50551.00550.75550.50
+22+26+26+20+12
Buy program is taking placeBuy program is acceleratingProgram still going onProgram winding downSell signal
In this example, the S&Ps reached a peak price of 551.00 during theheight of the buy program. Then, typically, they backed off a little bit beforethe system issued a sell signal. That sell signal came with the S&Ps at550.50. You would set your stop at 551.20, just above the highest pricereached during the program.
Since traders are allowed to think when trading, the setting ofthe stop in rule (c) is one of those places where thinking may come inhandy. I typically adjust my stop based on the level of premium in thefutures. If the premium is large—in excess of fair value—then I usethe tightest stop because I fear that another buy program may belurking just around the corner. However, if the premium on thefutures is at or especially if it’s below fair value, then I may give theposition a little more room than just 0.20 over the high pricereached during the program.I generally trade only with mental stops, which forces me tothink every time I reach a stop. I do this because I want a chance toevaluate the premium on the futures before I buy or sell them. I donot try to outguess the market; any system depends on adherence toa stop-loss point. It’s just that I’ve found, through experience, that
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there is something to be gained from observing the level of thefutures’ premium before I make a trade.Once the position is in place, if unrealized profits begin to buildup, I recommend using a trailing stop to lock in some of those profits. Generally, you should use a trailing stop of 1.70 or 1.80 S&Ppoints. So, if you sell the futures and they subsequently drop by 1.80,begin to use a trailing stop of 1.80 from any subsequent low price forthe rest of the day. In this manner, if you get a large move in yourfavor and it is later reversed, you will take some profits out of theposition.I would call someone a real-time trader if he is trading this system, since he should be able to watch the market and make thesereal-time decisions. However, if you would rather use a fixed leveland not risk getting too emotional over the choice forced on you bya mental stop, then use the fixed 20 cents as specified in rule (c).Here is the chronology of some actual trading that took place during a typical week in the summer of 1995. It will help to explain how the system actually works.
Date
Time
Aug 24
12:20 P.M.12:27 P.M.4:15 P.M.
Sep S&PFutures
Premium
TICKI
Action
560.101.80559.701.20559.10 (never stopped)
+22+12
On alert for a sellSELLBuy @ close (+0.60)
At the time of this example, fair value premium of the September S&Pfutures was about 1.10 points. Just after noon on this day (a Thursday,although that’s not really important), a buy program entered the market. Thisprogram ballooned the premium to 1.80—well above the 1.10 fair value—and got TICKI up to +22, which put us on alert for a sell signal. A few minutes later, at 12:27 P.M., the buy program had abated, and TICKI was backdown slightly to +12. That gave us our sell signal, and we sold the S&Pfutures at 559.70. Notice that the premium had shrunk back to 1.20 by thattime, only slightly above fair value. As it turned out, this was a rathermediocre signal, as the market drifted quietly lower in the afternoon, and thetrade resulted in a 60-cent profit when it was closed out at the end of the day.
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That was the only trade of the day. However, over the next few daysthe system was active; and when it is active, that is generally when the bestprofits occur. The trading history for the next four days is:
Date
Time
Sep S&PFutures
Aug 25
9:40 A.M.9:45 A.M.3:18 P.M.
560.60560.40561.60
Premium
TICKI
Action
2.001.20
+22+12
On alert for sellSELLStopped (–1.20)
The highest point that the futures had reached during the buy programof the early morning was 561.40. So when the futures eventually exceededthat point in the last hour of trading, the trade was stopped for a loss.
Date
Time
Aug 28
9:35 A.M.9:40 A.M.4:15 P.M.
Sep S&PFutures
Premium
TICKI
Action
563.001.65563.101.20559.40 (never stopped)
+22+12
On alert for sellSELLBuy @ close (+3.70)
Early buy programs produced a nice sell signal point early in the day,and the market traded down all day, resulting in a very good profit.
Date
Time
Aug 29
9:40 A.M.9:44 A.M.12:07 P.M.12:13 P.M.12:24 P.M.12:30 P.M.4:15 P.M.
Sep S&PFutures
Premium
TICKI
Action
559.501.30559.000.90556.500.40557.201.20556.400.50557.001.15560.55 (never stopped)
+22+12–22–12–22–12
On alert for sellSELLOn alert for buyBUY two (profit +1.80)Stopped: rule (b) (–0.80)BUYSell @ close (+3.55)
The action was interesting on this day, as the system generated profitsin both directions. Initially, another early buy program resulted in a sell signal, which was closed out when sell programs came into the market justafter noon. These sell programs resulted in a buy signal, and we bought two
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futures: one to close out the short sale, and one to go long on the buy signal. This buy signal was aborted, however, at 12:24 P.M. when another sellprogram hit the market; we were stopped out of our long position becauseTICKI fell back down to –22 at that time. Finally, the second buy signal wasgenerated at 12:30 P.M., and the market spent the rest of the day rallying,resulting in a very profitable trading day.
Date
Time
Aug 30
9:42 A.M.9:51 A.M.4:15 P.M.
Sep S&PFutures
Premium
TICKI
Action
561.501.75562.001.30561.15 (never stopped)
+22+12
On alert for sellSELLBuy @ close (+0.85)
Again, the market traded higher early, and those buy programs generated a sell signal. This was a moderate profit by the day’s end.
When the market is in a trading range, the system is particularlyeffective. I’m sure everyone remembers days when a bit of news thatwas released before the market opened caused a gap opening, whichwas then reversed as the market spent most of the day trading in theother direction. This system is excellent at getting you into a profitabletrade on days like that. Such news items are often the release of government figures such as unemployment, the consumer price index, orsome similar item that affects both the bond and the stock markets.The preceding examples occurred during such a period. You can seethe number of signals that occured right after the opening of tradingon five successive trading days: August 25 through August 30.When the market is moving steadily in one direction during atrading day, the system is least effective. That’s why we recommendceasing trading on any particular day in which you are forced to takelosses on two consecutive trades. Note that to take two consecutivelosses, there have to either be three programs in the same directionor two programs followed by prices moving against you. The following examples demonstrate this fact.Two consecutive losses could be created by three successive sell programs;for example:
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1. Sell program #1: you buy the S&Ps when it’s done.2. Sell program #2: you stop yourself (presumably at a loss) whenTICKI goes to –22 during program #2; when program #2 ends,you again buy the S&Ps.3. Sell program #3: you stop yourself when TICKI goes to –22.Two consecutive losses could also be created in this way:1.1a.2.2a.
Sell program #1: you buy the S&Ps when it’s done.The S&Ps trade lower anyway, and you are stopped out.Sell program #2: you buy the S&Ps when it’s done, again.Again, the S&Ps trade to new lows, stopping you out.
There are a couple of other scenarios— combinations of the onesin the preceding example—that could cause two consecutive lossesalso. In all cases, however, there are two or three programs in thesame direction consecutively that caused the losses. It is my experience that on days like that there are more programs to come, and itis best to stand aside rather than get run over. Fortunately, such daysare rare, and the damage is limited by retreating to the sidelines aftertwo consecutive losses are taken.
The Intraday Market-Reversal CorollaryThe market has made some very impressive intraday reversals overthe years, on both the upside and the downside. Every day traderwould like to be a participant during these times.On Monday, October 5, 1992, the market was in a tenuous state. The market had dropped 75 points on the previous Thursday and Friday, includingdown 54 on Friday. To make matters worse, there had been selling overseas