as indicated in Appendix A, is high.3. Shorter-term strangle writes are more favorable for us than longer-termones on a net-return-per-unit of time basis, and we’ll avoid most stranglesof a term longer than eight weeks, preferring instead 2- to 6-week terms.4. If our historical analysis over the term of the strangle shows that wecan actually generate a double, or bi-directional, non-seasonal trade,we’ll accept it gladly, but we will not see these frequently and this condition is not a requirement.
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5. Our potential ROC when we write a strangle should be on the order of
7–11% per month, net of costs, using our regular comfortable cushionof 3 or 2.5 times initial margin requirement in the trade.6. Supply/demand conditions in the market we’re examining must be benign, as far as we can tell, and we’ll simply not even look at markets thatmay encounter high seasonal event risk over the term of a proposedstrangle.
Why These Criteria Work in Our FavorAs always, these preconditions want some elaboration. If a market’s SV iswell to the lower end of its 6-month historical range, it’s likely that the premiums of its options are a little stingier than we’d like to see. In order togenerate our targeted 7–11% per month theoretical ROC in a low-SV marketin such a case, we’ll probably have to write options whose striking pricesare closer to the current market than we’d like. This requirement will prettymuch guarantee our having to defend one side of the strangle at some point.Defense is fine, and very useful to us when we conduct it carefully, but let’snot seek trades that are more likely than usual to require a defense. Defensealmost always costs either time or money, sometimes both, even thoughwe may expect to make these dollars back, and more, over the term of thedefense.If we observe a market whose SV is relatively low, but whose options’IVs are relatively middling to high, and the IV is rising, let’s just omit thismarket from consideration for writing strangles right now. We might learnsomething useful without risking a dime of our capital. Surely, there’s somesort of risk present when the volatilities of a market and its options are inthis rather odd relation, and, once again, we’ve no reason to guess at thecause or take a poorly defined risk by writing strangles here. This marketmight turn out to have been a profitable candidate for a straddle, but we’llhave to observe subsequent market movement, and the presumable causesfor it, before we know. I’m not a good guesser. If you are, you might attemptthis. Let me know how you make out.By the definition of a strangle, we prefer to employ this strategy in markets whose SV has been declining moderately over the past few days or couple of weeks. Certainly, it can’t be to our advantage to attempt the usual sortof short strangle, with both the put and the call decently OOM, when a market is or is threatening to become more volatile, can it? Monitoring the recentvolatility of a market is easy to do, and will contribute solidly to our bottomline as our observations allow us to shun markets having this rising volatility. True, we might get lucky, and the formerly rising SV might decline fromhere, but we’re trading to win, not to get lucky. Let’s wait for SV to begin declining before we act.
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We always allocate enough margin capital for a comfortable cushionagainst adversity, and strangling presents no exception to this policy. Anargument can be made that we should allot even more margin cushionthan usual when strangling, on the grounds that we’re more likely to have todefend the trade, ultimately. This view is plausible, because the margin requirement of the trade will undoubtedly have increased by the time we decide to defend, but this argument is generally self-negating. When we doapply a defense, the defense itself usually lowers our margin requirement.One hand washes the other, as it were.Condition 6 applies with more force to strangling than it does to straightone-way option writing. In an ordinary option write, we’ll select the termand direction of the trade deliberately, as best we can, to avoid known seasonal and other potential event risk. We can make this selection effectivelyin most markets in a one-way option write, and we don’t mind at all if eventrisk works in our favor during the trade. When strangling, though, all eventrisk is evil, plain and simple, and its occurrence will be costly for us.For example, most of the time, I don’t want to strangle the CBOT 5-yearnotes through a meeting of the Federal Open Market Committee. The FOMCmay tinker with the Fed Funds rate unexpectedly, or may not tinker with itwhen the market expects it, or may tinker in the opposite direction from thatthe market expects, threatening our strangle potentially three different ways.Do such developments surprise the interest rate markets frequently? No, theydon’t, because the interest rate futures markets are dominated by pros whousually have a good knowledge of and feel for what the Fed is likely to do.Nonetheless, who needs this kind of potential aggravation? No one I know.
Selecting Strangles—Possibilities, PossibilitiesThe preceding preconditions are valuable guideposts to choosing a marketfor our strangle, but they indicate practically nothing about how we shouldgo about choosing the striking prices of the put and call we’ll write. We havetwo of our favorite tools available for this task, historical tendency and SV,but we need a quick look at a feature of SV that I skipped over in Chapter 3.Volatility is almost always quoted as an annual figure, and this convention can cause confusion from time to time. If we say that a market’s 60-daySV is 20%, it really isn’t that over the past 60 days. When we looked at SV inChapter 3, you’ll recall that the final step in the calculation was to annualize the result of the figure we had obtained to that point. Annualizing is reasonable, and it’s traditional practice. The SV we obtain, 20% in our example,is the model’s way of saying that, over a year’s time, the market will end upwithin ±20% of tonight’s price about 68.3%, or one standard deviation, of thetime.
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Well, that’s fine if we’re trading for a whole year, but not very helpfulwhen we’re strangling a market for three or four weeks. We want the nonannualized figure here, and to this end we’ll simply leave off the last step ofthe calculation. The resulting short-term SV will be our first good indicatorof the strikes of the options to write. Let’s see if this notion helps us in practice, if perhaps our old friend the NYMEX natural gas market is a good candidate to strangle just now.
Under the LensNYMEX August 2002 natural gas (ticker symbol NGQ) settled at 3.245 onJune 28, 2002. The August options will expire on July 26, in just 19 tradingdays. Prices have recently been a little soft in this market due to the welladvanced levels of gas in storage in both the United States and Canada atthis time of year. Summer heat waves have been known to spike NGQ’s priceon occasion, but will likely have less effect this year (should one occur) because of the large amount of gas already on hand.We check the market’s SV and find that the non-annualized 19-day SVis 2.762%, rising a little over the past week, and the IV of the NGQ optionsis, interestingly, right in line with the SV. This alignment doesn’t occur all thatoften in the NG market. The price of NGQ is 3.245, and 2.762% of this is0.0896, or 8.96 cents. This figure is very disturbing for strangle writers whohave some familiarity with the natural gas market. It’s too low for the realworld. The figure is indicating that there is about a 0.683 probability of NGQending up between 3.335 and 3.155 at option expiration. A theoretical 18cent target range in natural gas in 19 trading days is likely? Hmmm, that’s alittle hard to believe. Pick up Barron’s any weekend and check the weeklymarket movements; you’ll immediately find out why we should cast a waryeye at this figure. The price range of natural gas for any one week, for just fivetrading days, is enormously likely to be larger than 18 cents. However, ifthat’s what the model says, then that’s what it says, and we’ve no businesssecond-guessing it before acquiring more information.Upon looking up the price history of natural gas, as shown in Table 9.2,we see that there is actually a pretty strong downward tendency in this market during July, and now we should start being quite skeptical about strangling natural gas at this time. We may well end up just trading this marketusing the non-seasonal strategy and writing WOOM calls, but let’s keep examining the potential of a strangle a little longer.The maximum interim decline in NGQ was 25.63% over this period inJuly 1996 (not in 2000, check the figures!), and this is a very hard number todeal with if we intend to write puts on this market today. On tonight’s close,a 25.63% drop would indicate an historical potential for this market to movedown to 2.413, and this sizeable move in 1996 began when prices were fully
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TABLE 9.2
Seasonal Sell Study, Natural Gas, 1991–2001Interim
EntryDate MOC
EntryPrice
High
Low
ExitDate MOC
ExitPrice
GrossResult
CumulativeNet Result
91-06-2892-06-2993-06-28
1.2081.5082.197
1.2801.9602.215
1.1451.4961.960
91-07-2392-07-2493-07-23
1.1951.9392.121
+0.013–0.431+0.076
+0.010–0.403–0.340
94-06-2895-06-2896-06-28
2.2001.5322.911
2.2401.6052.980
1.7651.3352.165
94-07-2295-07-2496-07-25
1.7891.3852.249
+0.411+0.147+0.662
+0.058+0.192+0.841
97-06-3098-06-2999-06-28
2.1392.3892.324
2.2252.5202.580
2.0511.9252.100
97-07-2898-07-2799-07-26
2.1831.9652.542
–0.044+0.424–0.218
+0.784+1.195+0.964
00-06-2801-06-28
4.3973.280
4.5753.816
3.6102.910
00-07-2601-07-26
3.7633.128
+0.634+0.152
+1.585+1.724
Average on 11 attempts: +0.157 dollars; stop w/loss of: 0.40 dollarsGross Movement (dollars/MMBTU)Avg Up 0.201 Max Up 0.536 Avg Dn 0.326
Max Dn 0.787
Notes: August natural gas (NYMEX), NGQ; sell on 06-28, “buy” as expires.
10% lower than this year. Not good. If we want anything approaching a double non-seasonal for our strangle, we’ll have to write August puts with astriking price no higher than 2.35. One small problem with writing the NGQ2.35 puts: they’re worth a hot $10.00 apiece tonight, before any contest risk.We will be dollars out of pocket, after commissions, by writing these options? The devil we will. Strike three for this idea . . . we don’t even need tolook at the rest of the analysis of writing a strangle in this market right now.Writing the NGQ WOOM calls, cautiously, on a non-seasonal basis doeslook rather tasty though, wouldn’t you say?
Can’t Find if We Don’t LookThe natural gas market isn’t suitable for a strangle at this time. Are others?Summer is not usually the best time of year for strangling, because manymarkets have strong seasonal trends or high degrees of weather uncertainty.The grain and oilseed markets are nervous right now, for large parts of theNorth American grain belts are extremely short on moisture, and severalcrops are in or approaching critical development stages. Uncertainty inthese markets is high, far too high for any but the greediest trader to attempta strangle. The CME’s meat markets are, as a rule, very difficult to strangle
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unless we’re willing to accept a longer term than we prefer, perhaps 8 to 12weeks. The other energy markets on NYMEX historically show strong seasonal tendencies from mid-summer through about Labor Day, makingstrangle writing unsuitably risky here. The gross movement tables in Appendix A are not encouraging for currencies, either—historically, we’d muchrather buy straddles about a month from now than write strangles today.This year, too, the marked weakness of the dollar for most of this year arguesforcefully against any sort of currency strangle at this time. Maybe a littlelater in the year.That leaves us with metals, interest rate markets, and the soft markets.The FOMC is meeting on August 13, and ordinarily that event would eliminate the major CBOT interest rate markets and the CME Eurodollar contractfrom consideration. The September options in these markets don’t expireuntil after this date, and will likely retain highish premiums until the Fed offers its newest wisdom. I really don’t think the Federal Reserve will take anyaction at the meeting; the whole of the financial side of the administration appears to be paralyzed by the dive in the stock markets. Even if I’m right in thisview, though, that doesn’t help with finding a strangle, because the interestrate markets will tend to trade in the other direction from the S&P and DJIAindexes for a while. We might strangle the August options that expire 3+weeks from tonight, but interest rate markets are trending smoothly higherright now. Let’s not initiate a strangle in a trending market, ever, all right?As for the soft commodities, it’s high winter in Brazil, so forget aboutcoffee. Cocoa is in the midst of a solid bull move, and strangling that market can’t be correct just now. Cotton is subject to the same weather considerations as corn and soybeans, and I want exactly no part of that mess atthis time. Orange juice is dead in the water and its volatility is way too lowfor us to strangle at this point. Metals and lumber don’t seem at all promising to strangle at the moment; their respective historical price movementsfrom this date can be quite large.Well, rats. This happens occasionally: no market looks attractive tostrangle here. The only the thing to do is have another look at the prospects,a little ways down the road. We never have to enter a trade, right? You betthat’s right. The markets will still be there in two weeks or a month.
Defending Strangles—Just a Variation on theNon-Seasonal TechniqueMethods of defending a strangle are essentially identical to those we use indefending a non-seasonal option write. We won’t be writing low-width strangles ever, except occasionally in connection with the Endplay strategy we’llexamine in Chapter 13. In the typical wide strangles written according to the
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179
preconditions set forth previously, if the market should move so as tothreaten one of our written options, then the other option will now beWOOM, trading for just a pittance, and we can essentially ignore it regarding defensive considerations. When defense is necessary for a strangle,don’t get fancy; defend the option whose striking price is being threatenedjust as you would if it were the only option you’d written in the trade.There is an interesting and effective, but fairly aggressive, alternativestrangle defense, sometimes called the “permanent strangle,” which we’lllook at in just a moment.
A Variation on Creating a Strangle—The Step-InSome strategies allow us to enhance our potential gain during the trade without accepting noticeably more risk, or, in the worst case, no more than wehad when we entered the trade. The non-seasonal is one of these. Supposewe’ve entered a 7-week non-seasonal option write in a market that historically rises somewhat over the seven weeks, but has never fallen more than 7%during that time, historically. We’ve written the puts whose strike is 12% or sobelow the current market price, notionally attempting to make 9.7% on capital over the 7 weeks, using 2.5 times initial SPAN requirement as our capitalcommitment. The trade proceeds beautifully, with the market rising 4.5% in3 weeks’ time, and we’re perfectly happy with developments. Can we do better from here?Sometimes we can. We should analyze the historical actions of this market over the time period remaining in the trade. Suppose that there aren’tany obvious supply/demand risks in the trade’s remaining four weeks thisyear, hardly a rare condition. Suppose it’s also the case that this market ishistorically neutral or slightly negative from now until the expiration of theputs we’ve written. And, just to have a number, let’s say that the maximumhistorical rise of this market has been 5% during these four weeks. Supposealso that the IVs (hence, as always, the premiums) of the call options thatexpire along with our short puts are still interesting, still worthwhile towrite from the perspective of ROC. Why shouldn’t we help ourselves to another piece of the pie?Why not indeed . . . and this is easily done. We’ll take a look at the premium of a call option whose strike is somewhat OOM from the now-currentmarket price. If the premium of this option is worth our consideration andhistorical price movement and current events are on our side, let’s stepright in and write a few of these calls, in the process converting our originalnon-seasonal trade into a strangle. Naturally, there are a few things we wantto observe before we take this step, or, step-in.
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When we step into a so-far profitable trade and adjust the position, forany reason, our first goal is to minimize the chance of shooting ourselves inthe foot and creating a problem (or, much worse, a loss) where there wasnone before. When we step into a strangle, as here, we will be just a bit paranoid about the strike of the option we elect to write. Opportunities to stepin occur not infrequently in the currency markets. Let’s have a look at a realworld example of such an opportunity in Japanese yen, summer 2002.
Stepping Out with the Step-InI’d written several August Japanese yen 81.50 puts (ticker: JYQ), expiringAugust 9, in order to attempt to profit from the weakness of the U.S. dollarthat was quite evident through most of early and mid-2002. The trade hadproceeded in good order, without September yen futures (ticker: JYU), theunderlying asset, ever approaching 81.50. By mid-session on July 22, with141⁄2 trading days until August expiration and JYU having moved favorably to86.35, I stepped in and wrote a few JYQ 89.00-strike calls. Taken by itself, thiswas a disciplined non-seasonal action, as we see in Table 9.3, my usual nonseasonal study, from July 22 through option expiration on August 9.If we can enhance our original notional ROC by 30–50% or more, underdisciplined if not absolutely ideal conditions, we should strongly considerattempting some form of the step-in. The original notional ROC in writing theJYQ puts had been about 6.35% per month, and the trade was on track toward that goal. When the market moved smartly in my favor, and with onlythese 14-odd trading days remaining, SPAN requirement had dropped to$350 apiece for the puts. The capital commitment for the short puts, withcushion, had shrunk to $1,050 total per option, well down from the marginand cushion at the start.The JYQ 89.00 calls were trading for 18 pips at that point, and now appeared to be a good time for a step-in. In no year had yen futures moved up250 pips from here at this time of year (think—vacations!), even when yenruled over the dollar in the mid-1990s. With no contrary information in hand,I elected to write these calls. The initial SPAN requirement moved up to $878per strangle, and the capital commitment per option popped back up to$2,634 each, cushion included. However, the notional ROC increased wellmore than did the capital commitment. Net of costs, I was now trying toprofit by $260 for each put plus $210 per call, or $470 net of costs, in the remaining 141⁄2 trading days. This was a very decent notional enhancement, to470/2634, or 17.8%. Pardon my opinionating, but that figure ought to be tastyenough for any trader, over less than a 3-week period. The ROC, in theory,was enhanced by more than 100%—probably I should have written the JYQ90 calls instead of the 89s, in the interest of risk control.
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TABLE 9.3
Seasonal Buy Study, Japanese Yen, 1990–2001Interim
EntryDate MOC
EntryPrice
High
Low
ExitDate MOC
ExitPrice
GrossResult
CumulativeNet Result
90-07-2391-07-2292-07-22
67.5272.4978.78
68.6373.7879.15
66.2771.7577.93
90-08-0991-08-0992-08-10
66.7773.0678.14
–0.75+0.57–0.64
–0.800–0.280–0.970
93-07-2294-07-2295-07-24
94.16101.51115.01
96.0892.83102.7298.50115.72 109.42
93-08-0995.3294-08-0998.9995-08-09 109.71
+1.16–2.52–5.30
+0.140–1.310–2.760
96-07-2297-07-2298-07-22
93.7387.4171.33
94.6588.1x71.89
92.6284.0668.52
96-08-0997-08-1198-08-10
92.8386.5868.75
–0.90–0.83–2.58
–3.710–5.160–6.610
99-07-2200-07-2401-07-23
86.3992.9080.82
88.5093.4182.72
85.1591.8980.14
99-08-0900-08-0901-08-09
87.2593.3782.39
+0.86+0.47+1.57
–5.800–5.380–3.860
Average on 12 buys: –0.322 cent; stop w/loss of: 1.40 centGross Movement (cents/100 yen)Avg Up 1.108 Max Up 2.110 Avg Dn 1.914
Max Dn 5.590
Notes: September Japanese yen (CME/IMM), JYU; buy on 07-22, sell on 08-09.
Obviously, the profit isn’t in pocket yet (I’m writing this in the eveningof July 25, and JYU closed the day session at 86.32), but we can hardly dislike this situation, can we? There are statistically very fine chances of cashing both sides of the strangle, and even if defense becomes necessary, thedefensive prospects are excellent, because all the written options are nowshort-dated and becoming shorter-dated every day.Please understand that, assuming both sets of written options expireworthless on August 9, the real-world ROC in the completed trade isn’t17+%. Once again, to calculate our ROC figure accurately, we would have tocalculate the SPAN requirement and our cushion for each day of the trade,find the average capital-in-use-per-day, divide the ultimate net profit by thisnumber, and then convert it to a per-month figure. Save your effort, don’tbother with this. This trade will have performed very well, and the total dollar profit figure will be quite enough detail.Now, if yen would turn around and go straight south from tonight’s price,requiring me to defend the original written puts, as the study in Table 9.3suggests is possible, note that, even so, I’m much better off for havingstepped into the strangle. Effectively, I’m taking two new risks by stepping
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in at this point. I’m risking a capital loss if yen zooms higher and I’m unable,for some curious reason, to take defensive action. There’s also a risk of having to stay in the trade for another month if and when defense of the callsbecomes necessary. Against this, the reward is a richly enhanced profit inthe statistical majority of cases where yen stays below about 89.14 over thenext 14 trading days, and a tidily improved result if the market would whipsaw back lower and I had not stepped in.How does this trade turn out? How well does the step-in do? I’ll put theresult at the end of the chapter (I don’t know yet, after all). Maybe this tradeis a turkey just asking to be basted, and maybe I’ve stuck my head in the ovento watch, but I have much the long end of the odds, historically and statistically. We’ll see.
Another Variation—The Permanent Strangle,the Counterpuncher’s DelightTake a very simple case. Pick a market with reasonably liquid options in allor most months and with a present volatility toward the middle of its 6-monthrange. Exclude from consideration coffee, soybeans, natural gas, all the usualnative high-volatility suspects. Choose a market that is currently historicallyneutral, or only moderately bullish or bearish for the next couple or threemonths (whatever part of the year it happens to be when you do this). Finda decently disciplined strangle trade available in that market, according toour preconditions. The wider the strikes you can find, the better, but thistime I want you to look at a trade of six to ten weeks’ duration. Don’t be a fanatic about selecting the strikes of the puts and calls to write, just be reasonable about it, based on historical studies and current supply/demandconsiderations, as best you can discover.Here comes another piece of trading heresy. Ready? I don’t care if youselected optimum strikes or mediocre ones, you should earn a profit. Aslong as the width of the trade is sufficient that the market hasn’t ever (oronly in very odd years) had an historical range that would threaten bothstrikes during the upcoming 6–10 week period, you should profit . . . eitherimmediately or ultimately. You just won’t necessarily collect all your profitin the original term of the trade.What we’re attempting to create here is nothing more or less than amoney machine, and, bar some radical development in our chosen market,we should succeed at doing so practically every time, given only patienceon our part. I call this variation the “permanent strangle,” for we propose tocarry on with this trade for as long as the market allows us to earn a profitor allow us to keep extending or regenerating the trade.
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There are only two cases to examine over any cycle of this trade. Eitherthe market stays in our selected range, and the options expire worthless, orwe are required to defend one or the other position. In the first case, we say“Thanks very much,” have a festive dinner with friends, and go and look tore-implement a similar trade in this or another market. In the second case,we defend. We accept profits on one side of the trade as it expires andreposition the strangle in the next month further out, or perhaps 2 monthsfurther out, if defense becomes necessary. This is a good place for the fission defense, for the aggressive trader. We will intend to reduce the size ofeach side of the position over time. We also will intend, as always, to writemore option premium each time we defend, should defense be required. Tothis end, we must be prepared also to increase the size of the trade modestly if the market behaves perversely (well, from our standpoint) and wemust engage in multiple defenses over several months.Markets with reasonably liquid serial-month options are very useful tous in the event we must defend one side of the trade, so please keep thiscondition of contest in mind before establishing a permanent strangle trade,if the selected market doesn’t happen to have 12 regular months.
Gentlemen, Start Your StrangleIn a step-by-step fashion, using statistically approximate option strikes andprices, here’s what a permanent strangle trade might look like.1. On December 9, we write a 60-day strangle in NYBOT March cocoa. The
market price is 1720, and we write three strangles of 1400-strike putsand 2050-strike calls, collecting $310 gross, $280 net premium per strangle, total $840. Initial SPAN requirement is $746 per strangle, which wetreble as usual, allotting $6,714 ($746 × 3 × 3 strangles) for the trade.This represents a notional 12.5% ROC overall, about 6.07% per month,compounded. The trade will end, if nothing too radical occurs in cocoa,on the first Friday in February. Unluckily for us (look, we don’