are growing to replenish supply, and natural disasters, such as draught, threaten production. This is referredto as seasonal volatility and provides the scale trader some excellentprofit opportunities, as you will learn.There are also historical and implied volatility. I like to compare one against the other to see how the current situation reflectsthe long term. Historical volatility uses a long series of price datapoints in its formula—let’s say the closing prices for the last 200,100, and 30 trading days. Has volatility increased, decreased, orremained constant? Are there any discernible trends? Take thesecharts and juxtapose them against implied volatility charts, whichuse only current data. How do they vary? Historical volatility chartstend to smooth out the data and give you an insight into your worstcase scenario.What volatility does not tell the trader is which way prices arelikely to go. Millions of dollars have been expended over the yearsto create computer models that predict price trends. To my knowledge, none has been remotely successful over any sustainable timespan. It is still a random walk down State Street as far as futures areconcerned.There are two other conclusions most serious students of thefutures market agree upon that reinforce the random price theory.First, prices defy artificial manipulation over the long term; eventually supply and demand come into balance. In other words,attempts to corner markets have failed, as have attempts by governments to artificially support or maintain prices over long periodsof time. Eventually tides, time, and supply-demand conquer all.The second conclusion is that prices, in terms of dollars,should generally be skewed toward the positive side of the meanto be realistic, using lognormal distribution because of price inflation and other upward pressures. This is particularly true for real,
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consumable commodities, those that should be scale trading candidates. As you will see, taking advantage of these axioms is one ofthe strengths of scale trading, as is capitalizing on volatility to capture oscillating profits.All this discussion leads us to the concept of fair value. Howdo the professional options traders decide what the fair value of anoption is? The most common answer is by using the Black-Scholesformula or a variation of it. Basically, the Black-Scholes model takesfour known variables and solves for the fifth. The variables are1. The time to expiration of the option2. The price of the underlying entity (a futures contract forus)3. The exercise or strike price of the option being evaluated4. The carrying cost (interest rates, dividends for stocks) ofthe underlying entity5. The volatility of the price of the underlying entityIt is obvious that, for options-on-futures, four of the variablesare immediately available—time to expiration, price of the futurescontract, strike price, and carrying cost. The last one is negligiblefor futures because the amount traders are allowed to leverage ona futures contract is so high and no dividends are paid. That leavesvolatility as the wild card. It is a problem because it is constantlychanging and you can use implied or historical volatility. In mostcases when calculating fair value, use implied volatility because itreflects the current market situation.Running the formula produces a price, which is called fairmarket value. All things being equal, that is what an option shouldcost. You then compare it with the current market price and see ifthe option is over- or underpriced. Seems simple, until you factorin supply-demand for that particular option and realize the fairmarket price you calculated is static while the market is dynamic.As a scale trader, knowing fair market value helps you evaluate options, as you seek to buy those that are undervalued. Buyingthe cheapest insurance you can get is important as long as the coverage matches your needs. Since we are dealing with fungible contracts, there is no problem.Also, there is no need to worry about being able to calculatethe Black-Scholes model. There are many inexpensive software
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packages available that will do that for you. Many of these packages will even rank the options being appraised for you. SeeAppendix 2 for some sources.After comparing fair value to current market value and selecting potential option trading candidates, the speculator often calculates a breakeven price. How far will the underlying entity have toincrease or decrease for the trader to get his or her money back?What are the odds of that happening between the buy date and theexpiration date?Breakeven for buyers is determined by adding the premiumand the transaction cost to arrive at a total investment. For callbuyers, this figure is added to the strike price. Once the underlying entity reaches that price, the owner of the call is at breakeven(see Figure 2-3). For put buyers, it is just the opposite. The totalinvestment is subtracted from the strike price. Once the underlying entity trades at that price, the owner of the put is at breakeven.For speculators, the breakeven point is a good place to totallyreevaluate the trade. How has volatility changed? What is thetrend of the underlying futures contract? How strong is momentum? Is the trade going as planned or is it weakening? The tradercan bail out at this point and recoup the total investment.Combination trades, using calls and puts together, are a little morecomplicated, but basically they involve netting out what is paidout and what is collected.Now we are getting into some basic strategies. What is goingon in the minds of the various option players? How do tradersexpect to make money trading options, and how does each help thescale trader?The simplest players to understand are the rank amateursmentioned earlier. They are the dentists of Peoria and the florists ofSt. Louis, who can’t get away often enough to gamble. A brokergets hold of them, delivers a good story about why heating oil isabout to skyrocket in price, raises their greed level, and sells themsome calls. Buying a call is a bullish strategy. It has theoreticallyinfinite upside potential and predetermined downside. The underlying entity can increase in price to any level (theoretically), but allthat can be lost is the premium along with the transaction costs. Ofcourse, what can be lost amounts to only 100 percent on the investment. Some brokers, sad to say, do not call this fact to the attention
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FIGURE
2-3
Breakeven Analysis
Buying an at-the-money call in the Futures MarketAssumptions:Traders outlook is bullish for gold.COMEX $400.00 call priced at $12.00 per ounce.Commissions and fees amount to $25.00Premium ($12.00 x 100 oz.)Commissions and FeesTotal Investment
$$
1,200.0025.001,225.00
Breakeven — gold must increase $12.25 per ounce.Profit
$1,225Breakeven$1,225
Loss 55
$340
$360
$380
$400
$420
Per Ounce PriceNote: Analysis does not take time value into consideration, since it isvirtually impossible to calculate with any exactitude.Maximum Gain, Loss, and Breakeven Chart:Basic Call*
Basic Put*
Long
Short
Long
Short
Maximum Gain
Infinite
Premium
SP - Premium
Premium
Maximum Loss
Premium
Infinite
Premium
SP - Premium
*SP = strike price
of their clients. They talk about limited risk involved in optionstrading, but this is misleading, to my way of thinking.These amateurs rarely buy puts, which is a bearish strategy.Again, the risk is predetermined, but the maximum profit potentialis limited to the difference between the strike price and zero. The
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only futures contract that was estimated to have traded below zerowas the onion contract. It once traded so low that the value of thebags the onions were packaged in exceeded the bids. Michiganfarmers were so outraged that they got their congressman, GeraldFord, to get the contract defrocked.Amateurs rarely sell options, which are considered by theindustry regulators to be very high risk. If one sells a call, forexample, the underlying entity (the futures contract) can gain aninfinite amount of value by the time the grantor of the option isexercised upon and required to deliver a long futures position.Selling a put has a similar risk. The futures contract can dropthrough the strike price of the put sold all the way to zero, and thegrantor would be on the line to deliver a short position priced atthe strike price. In other words, the grantor of the put would beobliged to make up the difference between the strike price andzero in cash.Reality check: The pros who do the selling are often the traderswho make the most profits. Remember, a large percentage ofoptions expire worthless. In addition, the pros stay on top of theirmarkets and cover naked positions the minute their positionsappear to be in harm’s way. Responding rapidly and unemotionally is a hallmark of a professional trader.The pure amateurs add liquidity to the market. Since it is primarily on the long side, it does not provide much value to scaletraders who buy puts to protect long futures positions. But there isanother group of amateurs that is more helpful—the semiprofessional traders. These are the serious options players who workhard at understanding exactly how money can be made tradingoptions. They are not professional in the sense of being licensed totrade as a broker or commodity trading advisor, but they are everybit as serious. Some derive their entire livelihood from their trading. These traders add liquidity to the market but do it with a muchwider variety of strategies; they improve the liquidity of both theput and call sides of the market, often at the same time.They buy puts but, more important, they sell them and alsouse a variety of strategies that combine calls and puts simultaneously. I want to briefly outline a few of the most prominent of thesestrategies so you will recognize them in the market and understandthe motivation of these key players.
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One characteristic of the serious options players is that theyjust do not see much value in time. When you study the optionprice quotes in the paper or on a computerized trading platform,you will see that the in-the-money and near in-the-moneyoptions on the nearby contract are the ones most in demand; theyare priced the highest and have the most trading volume. Optionsthat have six or nine months left on them are not priced two orthree times higher. As matter of fact, they are lower; the demandis not there. Trading volume, again, is not high for the distantoptions. The majority of the trading action centers around optionswith less than a few weeks to expiration, whose strike prices arenear the current market value of the underlying entity. Does thattell you where the scale trader should be looking for bargainpriced insurance?The pros trade the nearby options and the amateurs the distantbecause the pros need the liquidity and volatility the nearbys provide. To trade the nearby options, you must be in constant contactwith the market, spending a good part of the trading day monitoring positions. Amateurs cannot devote that much time to the market. Therefore, they buy positions with two, three, or six months ormore to expiration and sit on these positions.Another characteristic of the pros is that they often use strategies that have some risk management built into them. This is donethrough the use of combinations of puts and calls bought or soldsimultaneously. There are five basic ways to spread commodities:Spread
Example
IntercommodityIntracommodityInterexchangeInterdeliveryIntermarket
Long corn/short wheatShort July corn/long September cornLong CBOT wheat/short KC wheatLong July/short DecemberShort CBOT corn/long CBOT corn
One of the nice things about spreading futures and optionson-futures is that for the most active spreads, there are brokers whospecialize in them. This means your broker can call an order to thefloor and just state the spread desired. For example: “SpreadAugust/December hogs calls 2.” The fill will come back buyingAugust hogs and selling December calls with a two-tick spread. It
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is so fast in the most actively traded spreads that it is possible today trade them. The first contract mentioned is the long and thesecond is the short.The following list names a few of the most common spreadsand describes how they are used:Volatility Spread–—Buy a put and a call at the same strikeprice at-, near-, or in-the-money. The expectation is thatnews will hit the market and drive prices up or down, butthe direction is unknown. The news causes increasedbuying and selling, moving the market one way or theother. You close the losing position and ride the winner. Ifthe news does not materialize, you lose.• Time Spreads—Sell a put or a call near to expiration andbuy a put or a call in a more distant month at the samestrike price. The intent is to sell time. The more distantoption loses value at a slower rate and covers the shortposition. When the short expires, you offset the long. Thetrader profits if the underlying commodity stays relativelystable, but loses if the futures price moves against theoption position (i.e., higher for puts and lower for calls).• Bull and Bear Spreads—Bulls are long the nearby delivermonth and short the distant. The expectation is that theunderlying commodity’s price will rise, driving the nearbyhigher faster than the more distant, yet the nearby positionis protected from a catastrophic move in the oppositedirection. When the nearby gains against the distantoption, both options are offset and the net gain is theprofit. Bear spreads are run in just the opposite manner.• Straddles and Strangles—Long straddles involve thepurchase of a put and a call for the same commodity at thesame strike price and expiration date. Like the volatilityspread, the objective is to take advantage of a major movewithout knowing the direction. With the short straddle,you sell instead of buy, anticipating little or no pricemovement, so you can collect the premiums. Yet you havesome protection from the unexpected by being on bothsides of the market. The strangle strategy is similar to thestraddle, but the options are out-of-the-money and at•
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different strike prices. This is most commonly played onthe short side. Its advantage over the straddle in veryvolatile markets is that the options are out-of-the-money,which provides a cushion.• Synthetics—This is an option position that creates the sameeffect as trading the underlying futures. A scale tradercould use synthetics in place of futures positions, but thedoubling up on commissions might make it inappropriate,not to mention keeping the delta in line. We’ll get to deltasin a second. A long synthetic position is contrived by thepurchase of a call and the sale of a put with a commonstrike price and expiration date. If price goes up, the callgains value, and the premium for selling the put enhancesthe return. If price goes down, the premium paid for thecall is lost, and the put is exercised against. The syntheticsshort is the opposite (i.e., buy the put and sell the call).There are a lot of other option strategies, such as butterflies,condors, call ratios, etc., but this should be enough to provide a feelfor where the liquidity is coming from. Now let’s turn our attentionto a couple of measurements you need to be aware of when opening option positions.The first one that should be covered is the delta, which wasjust alluded to. The delta measures the difference between the pricemovement of options compared with the price movement of theunderlying futures contracts. It is calculated by dividing the pricedifference of the option by the price difference of the respectivefutures contract over the same period of time. For example, theprice of an option increases 20 cents when the price of the futurescontract climbs 40 cents. Dividing 20 by 40 yields 50 percent. Sincethe prices of both the option and the futures contract are constantlyin flux, so is the delta.It stands to reason that an option that is in-the-money wouldhave a delta of 1 or 100 percent because it could be exercised for theunderlying entity. At-the-money options have deltas in the 50 or50 percent range, depending on the volatility of the underlyingfutures. Out-of-the-money options or deep-out options have deltasranging from 50 to zero. The percent sign is usually dropped fromthe number. Deltas do not exceed 100, since the option cannot bemore valuable than the underlying entity.
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Speculators use deltas when evaluating which option to buyor sell. For example, a trader believes soybeans are headed $2.00higher and wants to buy a call. The delta of one is 50 and anotheris 60. This means the value of the first option will increase $1.00and the second $1.20 per bushel. If the latter option costs a dimemore, it is a better buy. Or, if the trader is long two call options andis ready to offset one, then the one with the lower delta, equatingto lower profit potential, is the one to dump.Now the hedger has a special use for deltas. The term hedger, inthe general sense, includes scale traders who use options. To be 100percent hedged, using options to cover futures contracts, the hedgermust buy enough options to cover all his or her risk. Therefore, if theoption to be used had a delta of 50, the hedger would need to buytwo options to cover each futures position. This provides dollar-fordollar coverage. The tricky part, since the deltas constantly changebecause the prices of the options and the underlying entities are influx, is adjusting them to stay 100 percent covered.A useful exercise to further your understanding of deltas is toplot the price of a volatile futures contract (lean hogs for example),the price of the corresponding option, and the delta on a dailybasis for a month or so using closing prices. Draw three lines on asingle sheet of graph paper, and you will quickly begin to get a feelfor the relationship and when you would have to adjust your positions to stay 100 percent hedged. As you do this, you will noticethe rate at which the delta increases and decreases as volatilityfluctuates. The rate of change of the delta is called the gamma andis calculated in delta points. For example, if an option has agamma of 10, for each point increase in the price of the futurescontract, the option’s delta gains 10 points. That means that if anoption has a delta of 25 and the underlying futures contract gainsa point, the delta would increase to 35. If you know the gamma, itwill alert you to which options are most volatile. A high gammameans a big opportunity for speculators—and big risk. Not whatthe scale trader is seeking.As discussed earlier, the relationship between the price of anoption and the volatility of the underlying futures contract is a keyissue. The term to describe this is the vega. You may also comeacross the term rho. It measures the sensitivity of an option to interest rates. This is usually relatively unimportant for options-onfutures but comes into play when pricing options-on-securities, so
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you may stumble across it. Don’t panic about all this soundingGreek to you; a good option-pricing software package will calculate all these measurements for you, which is something I wouldstrongly recommend.Should you, as a scale trader, try to stay 100 percent hedged?I will discuss the pros and cons of this in Chapter 4, which coversstrategies.One of the most important requirements of an option speculator is liquidity. As with any type of trading, you must be able toenter and exit expeditiously. For almost any option, even deep-outof-the-money, you can almost always find someone willing to sellit to you. Finding a buyer, however, can be much more difficult. Itis common for amateur option traders to get into, or be talked into,positions they cannot get out of.Another problem with thinly traded options is the use ofstops. When you begin to trade futures, you are almost alwaystaught to use protective stop loss orders. These are orders placedbelow long positions (or above shorts) to offset your position incase the market moves against you. They are necessary because ofthe volatility of the futures market and the amount of leverageallowed. Traders often carry over this safety precaution when theybegin trading options. The problem with using stops in optionsmarkets is that some of the options are so thinly traded that floorbrokers or locals will spot the stops. They then drive the marketdown to them and immediately offset them for a risk-free profit atthe current market price.When speculating in options, stops are still very important, butthey must be mental stops. If you cannot constantly monitor themarket, you need the services of a good broker. The scale trader, onthe other hand, will often buy thinly traded options. But since theobjective of ownership is protection and not speculation, it is not aproblem. Additionally, when the scale trader is ready to offset theseout-of-the-money options, they are now in-the-money and the market is thick. More on this later.When it comes to the types of orders you can use to buy andsell options, you do not have as much flexibility as you do with themuch more liquid futures markets. Most conditional types oforders (price and time limits, market if touched, stops, etc.) are notaccepted or not effective. Option traders are usually restricted to
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market or limit orders; the latter are the ones to use on most occasions. You will often hear brokers tell you that your order is notheld, meaning that they cannot guarantee a fill. Just keep in mindthat most of the liquidity in most options markets occurs duringthe last few weeks before expiration, particularly the last week.Scale traders will be buying options with months left to expirationthat are out-of-the-money. In other words, the markets will be veryilliquid, but this will not be a handicap.Chapter 3 takes a look at how traditional scale trading works.As it is taught traditionally, it is very inflexible. The scale trader isexpected to begin opening positions at specific prices and to holdthem as long as need be for them to become profitable. As you willcome to learn, I have a problem with this philosophy.
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Traditional Scale Trading
The theme of most books and articles describing traditional scaletrading has been “you cannot lose trading commodities.” This istrue if—and this is a giant if—you have an unlimited amount ofcapital you can tie up indefinitely. Think about that for a second.To the traditionalist, the scale trader is expected to begin buying a commodity, or more accurately futures contracts on thatcommodity, once that commodity reaches the lower one-third orone-quarter of its 10-year trading range. (I’ll discuss in detail inChapter 7 when to use the one-third or one-quarter as the startingpoint.) The scale trader buys on a scale down and sells on a scaleup. For example, a scale may call for buying a futures contract ona specific commodity, say corn, every time the commodity’s futuresprice drops 5 cents. As the commodity descends to make a low, thescale trader adds to his or her inventory of futures contracts. Oncea bottom is in place and the commodity begins to move higher, thescale trader sells every time the current market price is 10 centsabove the most recently purchased futures contract.The scale trader buys in an orderly fashion on the way downand sells in an orderly fashion on the way up. The objective is totake a modest profit, in the range of $300 to $500, per contract.Discipline replaces fear and greed.The logic behind the program is also sound, to my way ofthinking. Properly selected commodities are always in demand bycompanies that use them to produce the products that they sell.The price is a matter of availability. If supply is too high, prices fall.47
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At some price point, the commodities become too cheap. Demandbuilds, while producers of that commodity have been cutting backdue to the previous period of low prices. The commodity works itsway out of the cellar. The natural law of supply and demand wins.Sounds like a perfect system, doesn’t it? It even suited my previous experiences in the futures market, because it relies on usinga combination of fundamental and technical analysis. The fundamentals provide the long-term analysis, while technical signals areused for timing the entry point.Since I had some experience with both types of analysis, I feltright at home with scale trading when I became a commodity broker. Like a lot of brokers, I never set out to be one. I got into thefutures industry by working for two firms that specialized in commodity price forecasting, but they were diametrically opposed inphilosophy. Thus, I had a wonderful opportunity to master theirtotally opposing approaches to analyzing commodity prices andacquired the background needed to understand scale trading. Asuccessful scale trader needs to have a good feel for both and knowhow to distinguish between real, physical commodities and futurescontracts.Note that I usually use the term commodities from now on,rather than the more popular futures or futures contract. I do this toget you thinking about real, honest-to-goodness commodities youcan feel, smell, eat, and make things out of. I recommend you scaletrade only those types of commodities. The term commodities is theold terminology for futures, referring to grains, oil, coffee, sugar,gold, silver, copper, livestock, and the like. As mentioned earlier,the term futures came into vogue when futures contracts on financial instruments (e.g., interest rates, bonds, the S&P, currencies,stock indexes) came into existence.One of the companies I worked for was Doane AgriculturalServices, Inc. (DAS). It had three divisions—farm management,market research, and publishing. My work involved publishing,specifically the company’s weekly newsletter, The Doane’sAgricultural Report. The editorial objective of the newsletter was toassist farmers in the management of their operations. This included all forms of help, from information on the latest seed varietiesto reports on the annual Nebraska tractor tests, a consumer reporton tractor performance.
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The weekly newsletter was the flagship of the publicationdivision. It dealt only with the cash side of the farm commoditymarkets, and its price forecasters used only fundamental analysis.They had no use for futures; they thought it was gambling and thattechnical analysis was witchcraft. In the five years I was there, Inever once saw a chart of futures prices. Every scrap of fundamental information on the world’s grain and livestock markets wasstudied and evaluated.DAS even did primary research, through its market researchdivision, into farmers’ planting intentions each year. This figureprovides a major insight into the size of the coming year’s crop,which impacts prices throughout the growing season. Additionally, DAS had a superb Washington (D. C.) Bureau headed byJim Weismeyer (now with Sparks). Reliable intelligence fromWashington alerts farmers and traders to what is coming from theDepartment of Agricultural (USDA) in the way of farm programs.Will acreage be taken out of use and farmers paid to leave landidle? This impacts supply and tells the scale trader the market willeventually be going higher, which is good news. By the time USDArecommends such drastic action, the scale trader is well into a grainscale. USDA also provides reports from agricultural attachés in keycrop-producing countries. Again, these areas can have a majorimpact on commodity prices because they can help the analyst pegsupply and demand numbers on a worldwide basis.The other firm I worked for was Oster Communications, Inc.It had two primary products—Professional Farmers of Americaand Futures magazine (originally Commodities magazine). Professional Farmers of America’s primary product was the newsletter entitled Pro Farmer. It had the same basic purpose as Doane’sAgricultural Letter—predicting farm prices and income—but itsphilosophy was drastically different. Pro Farmer preached thatfutures prices are the harbinger of cash prices and the only accurateway to project prices is by studying and analyzing the futures market. The primary analytic tool was technical analysis.One of Pro Farmer’s preeminent missions was to teach everyfarmer in the country how to use technical analysis to determinewhen to hedge crop production. The most advantageous timemost often occurs during the summer, when commodity pricesoften soar due to weather scares. Technical analysis can be used by
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farmers as a time tool. It provides a way of selecting the mostadvantageous time to sell on the futures market. Too many farmers, in the newsletter’s opinion, were strictly cash marketers andsold their production out of the fields at harvest when prices aretraditionally at lows. As a scale trader, you will learn to play theseasonal game to your advantage.In other words, I spent five years saturated in fundamentalanalysis of the cash markets followed by five years of technicalanalysis of the futures markets with the same objective—to projectthe prices of the major commodities months into the future. Whichapproach was the most effective in forecasting prices 3, 6, or 12months into the future?This question became even more important to me when Ijoined a commodity brokerage firm. My clients expected me toknow, or at least have a firm opinion on, the direction futuresprices were headed. By that point, I knew that both technical andfundamental analysis had strengths and weaknesses. Fundamentalanalysis was an excellent tool to view the long-term situation. Itattempts to quantify the supply-demand equation, so producersand users of commodities can anticipate periods of overabundanceor scarcity.One of the problems with fundamental analysis for the average futures trader, or the typical broker, is