/short position has been held, and then doles out the assignment notices. If the trader who owns the option we sold simply abandonsthe position, we won’t know about it, usually, until tomorrow morning. Inshort, we will not know if we have a position in the market, and this ismajor-league bad news. The overnight session, whether on ACCESS, on
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CME’s GLOBEX2, or even conceivably on CBOT/Eurex’ A/C/E session, mightkick us in the head with a sharp move in our market, when we don’t evenknow for certain whether we’re still involved in the market.In the event we find ourselves in this nasty situation, we must try to findout from our broker’s back-office people whether we have been assigned aposition. This is not necessarily easy to do. The back-office people, on optionexpiration day in any market, have an extended workday matching up exercises and assignments, and quite naturally want to get home as quickly aspossible afterwards. When the last assignment notice is posted, they’re outthe door immediately, so our finding out about our particular position is amatter of timing and, to some extent, of luck. If we’re unable to talk to them,all we can do is guess whether we have a position. Get out your lucky silverdollar and flip it . . . and hope you call it correctly.Fortunately, this situation will occur only once or twice a year when weemploy the endplay strategy. In my experience in a half-dozen or so of thesecases, it seems to be about a 2-to-1 favorite that the very slightly ITM optionwill in fact be exercised, but this data sample is far too tiny to generalizeinto a firm rule, so be very careful. If one of your short options is right smackon top of its striking price near the close on its last trading day, I’d stronglyconsider buying it back with a market-on-close order or something similar,no matter how much I loathe market orders when trading options. Doing thiswill probably cost several points in contest risk, but the extremely undesirable case of not knowing if you have a position, a little later on if the marketmoves adversely, can cost a heck of a lot more.
More Fun and Games—Digitalis, Anyone?In one NYMEX market, we must also contend with what I call the phantomheart-attack margin call. Every month, the natural gas contract expires on thenext business day after its associated options expire. Here, we’re not concerned with exercise and assignment. Suppose we’ve written five 3.00 naturalgas calls, and the market has obligingly stayed down around 2.90. The options expire, we pocket the profit, and everyone’s happy except the guy whobought the options, right?Not quite. When we receive our daily trading and equity statementovernight via e-mail or fax, we find our margin requirement has increased byupwards of $30,000—I am not kidding here—and we may find ourselves receiving a margin call from our broker. What?! We don’t have more positionsnow than we did yesterday; we have fewer, in fact exactly none in thismonth’s contract! This can’t be right, can it? Sadly, it can be and is. What happens is that the brokerage takes an extra day to clear expired optionspositions off their books, so, even though we don’t have any natural gas
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position, we are still charged margin requirement as if we did have. And, itgets worse. The next trading session is the last trading day for this month’snatural gas, true? Last-day margin requirement in a delivery-settled marketlike natural gas does exactly one thing: it goes straight up, and hugely, because the brokerage wants to make certain the trader can handle anydelivery/redelivery situations that materialize.Don’t worry, I hear you. You’re absolutely right, too. We don’t have a position, why the devil are we being charged any margin when we’re entirelyout of the market? This is crazy, but that’s the way it is. The good news hereis that I know of no experienced broker in the world who will give you anytrouble about this phantom margin call, and if you know of one who does,don’t trade with him or his firm. Just ignore it. This goofy margin situationclears up by itself, always and every time, the very next business day.Pardon the lengthy discussion of these topics, but knowledge of theseunusual conditions concerning option expiration is, frankly, essential if youintend to use the endplay strategy in your trading. I’d have done you no service at all by omitting it. For that matter, I’d have done myself no favor byomitting it and having you swear at me the first time you ran afoul of any ofthese tawdry little details.
Filling Out the Deposit Slip—Preconditions for theEndplaySo much for negativity. The preconditions for a good endplay trade are remarkably straightforward and easily met, and here they are:1. Option expiration must be no more than two day sessions away when
we write the options, whether using the one-sided approach or thestrangle, and the less time remaining, the better for us.2. The IVs of the nearby options in this market must be high. If the markethas natively very high absolute volatility (natural gas, coffee, etc.), westill prefer that the present IV be in the upper half of its 6-month range.If the market has only middling-highish native volatility (cocoa, soybeans, crude oil, etc.), we insist that the IVs be near the top end of their6-month range.3. In the strangle approach to endplays, ROC net of costs should be atleast 3% of double the initial SPAN margin requirement. In the onesided approach, net ROC should be at least 2% of double initial SPANrequirement.4. If the market can be strongly affected by overnight weather developments, and one or more such developments are even possible in the next
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2–3 days, do not use the endplay strategy at this time in this market.This strategy is completely dependent on our being very confident thatthere exists a short-term news/event vacuum in our selected market.5. If there is any supply/demand news pending in a market in the next 2–3days, or better still 4–5 days, do not use the endplay strategy. The endplay strategy works best when the trade is entered a day or two after ascheduled supply/demand report or other significant information hasreached the market, and the news/event vacuum is now present.6. Don’t be greedy. Attempting to make 8–10% or more, while possible,gives away the structural advantage of the trade. Select the strike(s) ofthe endplay as far away from the current market as possible, consistentwith the goals for ROC.Condition 1 is part of the definition of the strategy. Don’t adapt it by extending the trade to three or four days, because more time until expirationmeans more possibility of external events intruding on the trade. Condition2 is likewise vital, particularly for the strangle approach. If option IVs arelow, strangle-style endplays will need to be defended much more often thanwe’d like, which defeats the purpose of the trade. Sure, we’ll defend if necessary, but, once again, we do not want to seek out trades that we are morelikely to have to defend. Lower IVs are acceptable in the one-sided approach,as long as you’ve a reasonable measure of confidence that your view of themarket’s direction over a day or two isn’t considerably off the mark. Usenon-seasonal reasoning here: you don’t need to be right to make a profit,merely not significantly wrong.Conditions 3 is included because a considerable number of traders consider a 2–3% return on a trade to be not worth their while. Two or three percent over a year? I agree completely. But, 2 or 3 per cent over 1 or 2 days?How greedy are these traders, anyway? If we were able to find enough tradesyielding 2% over 2 days, consecutively throughout a year’s time, we’d bestaring at a 1,161% total ROC at the end of the year. Maybe I’m missing something here, but that’s certainly enough for me. Condition 6 applies here, too.As in other option writing strategies, keep the strikes of the written optionsas far from the current market price as feasible, the more so given the modest ROC requirement.Condition 4 is somewhat amorphous, but still easily implemented.For example, the natural gas market is notoriously affected by certainweather conditions—an extended nationwide heat wave in the summer,prolonged cold as we saw in the winter of 2000–2001, or the advent of a hurricane near the production areas in the Gulf of Mexico. If any of these exist,or might come to exist within 48 hours, don’t enter an endplay trade. If theydon’t, then go ahead. Condition 5 is really the key to this strategy. In anendplay, the occurrence of new news is either outright evil, in the straddle
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approach, or halfway risky, in the one-sided approach. The less likely thatnew information will appear in the marketplace over the 1–2-day term ofthe trade, the more likely the trade is to succeed.Markets that have regularly scheduled weekly or monthly releases ofsupply/demand data are considerably more likely than other markets to begood candidates for endplays. This is why the NYMEX energy markets tendto offer more opportunities to apply this strategy. For crude oil, heating oil,and gasoline, the major weekly reports and their times of release are wellknown and, even more importantly, well trusted by the market participants.By mid-morning every Wednesday, the market has digested the weekly APIand DOE supply/demand figures, and if the current month options expireon that Thursday or Friday, we have the potential for a good endplay trade.The natural gas figures, now also from DOE/EIA, are released Thursdaymorning, and, if the front-month options expire on Friday or Monday, wemay be able to spot a good opportunity. Keep in mind that it is entirely toour advantage to seek out Friday expirations in all these markets, in orderto avoid even possibly being snagged by the NYMEX contracts’ odd conditions at option expiration.
C-Y-A in the Old Endplay—DefenseDefense in an endplay trade comes in two flavors, one less undesirable thanthe other. (All defense is undesirable, from a profit and ROC standpoint, but,just as mother told you to, so also eat your broccoli because it’s good for you,and defense is good for your capital, ultimately.) The first is immediate—howwe’ll try to defend if we’d want to keep our trade expiring as planned, in justa day or two. Usually, in an endplay, the striking price(s) of the options we’vewritten are much closer to the market than in other option-writing strategies.This factor makes a hedge defense using options very difficult. Moving thegoalposts is also not feasible, for the option(s) that are further OOM than theone(s) we’ve written are only worth pennies at this point.A time-spread defense can be very useful in this case. The usual condition for this defense must be in force: the option(s) we buy to create a timespread must have significantly lower IV than the current IV of the optionswe originally wrote. Fortunately, this is not an uncommon situation at all,but we must watch one other parameter of this defense closely. Assumewe’re in an endplay in September natural gas (ticker: NGU), and one of ourwritten options is the September 2.80 put. Assume also that the price of September NG is 2.82, and the price of October NG is 2.86. To defend properlywith a time spread, we should purchase, 1-for-1 (or perhaps 3- or 4-for-5, depending on comparative IVs), the October 2.85 put, not the 2.80 put. Thiswill be expensive, and this purchase will certainly violate our policy of not
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spending more on a first defense than the trade is worth. Nevertheless, ifthe two options’ IVs are correctly aligned for our purposes, this will be anexcellent defense as a rule, unless the market reverses sharply. This reversalmust occur almost immediately in order to be costly to us, though, and thisnecessary immediacy, and its usual non-occurrence due to the presumablenews and event vacuum, should work to our advantage.We have one other choice if we want to try to keep to the original expiration date of the trade. In this example, we’re clearly concerned about themarket falling well below 2.80. If we have 3 or more lots in the trade, we canusually do well for ourselves by defending with futures, again, an action thatis against our normal policy. Just as with the spread defense, we will distinctlyimprove our position unless the market reverses sharply. Typically, something between a 1-to-3 and a 1-to-5 futures-to-options ratio in defense is whatwe’ll want, but, unfortunately, each case in the real world is unique.Of course, even notwithstanding the very short time frame of an endplay trade, sitting for even an hour or two in a trade that appears to be working against us can be an eternity. We may, and reasonably, consider that therisk of an adverse market movement is too high in either of these defenses.We may readily decide that an extended defense is the best choice, and wehave our familiar tactical tools available, the roll and the flip, or some combination of the two. If we elect to roll or to flip, we’ll select the appropriateoptions for the next cycle of the trade according to the conditions describedin Chapter 7.I mentioned the fission defense earlier. This defense is a combinationof rolling and flipping, and, when executing this defense, we also reduce thesize of our position. Suppose we’ve written five options in an endplay, andthe market is threatening our position. We can repurchase the written options and write either three or four strangles, as wide as we can manage,in the next month further out. As always, we must make certain that wewrite more premium than we repurchase. Here’s a practical, if not entirelywonderful, example of the fission defense in a real-world endplay trade.
Gentlemen, Start Your EndplayOur market: NYMEX natural gas. The contract: initially June 2002 (ticker:NGM). The date: Thursday, May 23, 2002. Option expiration date: Tuesday,May 28, 2002, after Memorial Day. Sometimes, we have to contend with 3-dayweekends, whether we like it or not.NGM was trading at 3.462 late in the day session on Thursday the 23rd,and, in accordance with the endplay strategy, I wrote seven strangles, selecting the June 3.30 puts and 3.65 calls that were to expire the following
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Tuesday. Given the Memorial Day holiday, there were about two tradingdays remaining in the life of the June options, depending on how you chooseto count the overnight ACCESS session on NYMEX on Monday night June27. I received a gross total of 4.0 cents, $400 for each pair, about $370 net.NGM had reacted rather negatively after the weekly storage statistics thatthe EIA published on Thursday morning, but it seemed to have steadied uparound the 3.46 level, with the day session starting to run out.The market weaseled a little lower toward the close of the session, finally settling at 3.438. Friday’s shortened trading session was predictablydull. Hey, why not take a 4-day weekend, eh? Lots of floor traders do exactly this on holiday weekends and the trading volume tends to shrink noticeably on the Friday before the weekend. Volume or no volume, the marketkept sneaking lower, setting 9 cents down to 3.347. I had established a smalldefense by selling a couple of NGM futures very late in the session on Fridayat 3.33. Boy, am I slick or what? Now, I’m holding two losing positions. Ifound myself using some very choice descriptive terms to myself in the mirror. The ACCESS session on Monday night was equally dull, but the marketkept edging lower, down to 3.29 at one point before I decided I had to getsome sleep. Monitoring trades overnight is definitely not my favorite hobby,but sometimes it’s necessary, unfortunately.The profitability range of the trade, as entered, was between about 3.266and 3.684, all costs paid. Obviously, I wanted the market in the best case tofinish between 3.30 and 3.65 on Tuesday. Let’s let the short options expireworthless, as always . . . if possible. Forget about that. The market, as ever,did no such thing. Tuesday morning, expiration day, saw the market openat 3.27 (mutter, grumble), and at one point early in the day it traded down to3.255. I wasn’t in terrible shape in the trade. It was still slightly profitable at3.255, but I was sitting on a whole pile of risk, and I hate that.Rather than hope/gamble that NGM would bounce back up over 3.30, Iapplied a fission defense to the 5 naked 3.30-strike puts, repurchasing themfor 3.8 cents each as the market diddled around 3.275–3.280 with a coupleof hours left in the day session. The other 2 short 3.30 puts were covered bythe 2 short NGM futures. No brilliance involved, I guarantee you. This movewas merely risk reduction, in combination with trying to retain some of theprofit potential of the position.Now, please note that I could easily have decided to accept the loss of,basically, commissions on the 5-lot I repurchased. Total loss on these wouldhave been 5 × (4.0 – 3.8 ) × 100, or +$100, less 15 commissions @ $15, –$225,for a net of –$125 minus a few dollars in floor fees. Accepting this loss, probably, was the intelligent thing to do. What, me intelligent? Only occasionally,I’m sorry to say. If the market would remain below 3.30, the remaining twolots in the trade, given the two futures sold, would have had the following
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result. I’d have been +$400 × 2 on these two short option strangles, less 4commissions, –$60, plus 3 cents each on the two futures, or (3.0 × 2) × 100= $600, less 4 more commissions on the futures, another –$60, for a net of+$840 on these last two. Net for the whole trade? Roughly, +$710 with allcosts paid.
Extended Defense—Another Month in the MuckDid I do this? Don’t be silly. I elected to extend the defense. Why? I haven’tany idea, and I must have realized the general stupidity of my actions, too,because there isn’t a single line in my trading notebook about it.After finding out where several strikes of the July options were quotedby the floor, and crunching a few numbers for a statistical analysis, a good(cough . . .) defensive possibility emerged. I wrote the July NG (ticker: NGN)2.85 puts and July 4.00 calls, but only four pairs apiece, not five, for 7.3 centsthe pair. This is the idea behind a fission defense: turning one positioninto two opposed and smaller ones. Could this defense be wrong (aside, ofcourse, from my sappy notion of not accepting a profit in hand and gettingon to other opportunities)? Absolutely, because natural gas might easily popback up 10 cents or more in any given hour. Given the market’s behaviorover the three previous days, this development didn’t appear likely, but whoknows about any given 1-hour period in the natural gas market, eh?The result that did occur represented $2,920 gross premium for the fourpairs sold, less 5 times 3.8 cents, or $1,900 gross premium repurchased, less13 commissions, $195 (4 pairs equals 8 lots sold, plus 5 lots repurchased).This works out to $825, net of all costs, plus the proceeds of the originaltrade. NGM ended at 3.285 at the market close, the two remaining short 3.30puts were exercised by their owner, thus assigning two long NGM positionsto me, which offset against the two NGM shorts I held. OK, we’re flat, no position left in June natural gas, and sitting with a position in July. Good position, or bad? A worthwhile defense or not?Let’s run the numbers. Original credit: 7 times 4.0 cents, $2,800, less 14commissions. First defense: sold 2 NGM futures at 3.33, with 2 more commissions. Repurchased 5 NGM 3.30 puts at 3.8 cents, or –$1,900, and 5 morecommissions. Wrote 4 NGN 4.00 calls and 4 NGN 2.85 puts, gross credit$2,920, with 8 commissions. The two remaining short 3.30 puts were assigned, giving me a long position of 2 NGM futures, which offset neatlyagainst the two NGM short futures at 3.33. Gross profit on futures and the assigned puts, $600, less 2 more commissions.Bottom line: + $2800 – $1900 + $600, minus 31 commissions at $15.00, or$465, equaling about $1,035 net in pocket on Wednesday, May 29. Formerposition: short 7 NGM 3.30 puts, short 7 NGM 3.65 calls, short 2 NGM futures.
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Former differential between the put strike and the call strike, the width,3.65 – 3.30 = 35 cents. New position: 4 July NG strangles, width 4.00 – 2.85 =115 cents. New position expires in 28 days.Disadvantages in applying the defense: refusal to take a good profit inhand (very bad, don’t do it!), having to sit for another month and tie up someamount of capital, and possibly be required by market movement to applyanother defense to one or the other side of the remaining trade. Advantagesto the defense: now only dealing with four lots as opposed to five (or seven,depending on how you count), margin requirement significantly lower (4very wide strangles versus 7 narrow ones plus 2 short futures), hard dollarsin hand, and more profit yet to be earned, potentially.While the natural gas market can become ridiculously erratic at times,supply and demand didn’t look particularly conspiratorial at this point,there having been an historically high level of gas in storage, and demandhaving been staying moderate. Weekly injections into storage continued tobe quite decent, even relatively high on a nationwide temperature-adjustedbasis. The remaining July position was probably more risky to the downsidethan the upside, whether considering a possible summer heat wave or not.This risk profile was acceptable, because excellent defensive possibilitiesexisted if NG moved sharply lower, had the trade required a second month’sdefense. With profit in hand and a lower gross risk due to the now-smallerposition, though having to stay in the market for another month, I was aboutas happy as the proverbial clam, except, of course, for having been just plaindumb in applying the defense in the first place. All defenses should workout so well.“Aw, that was a lucky outcome,” you might be scoffing, “I’m glad youmade a profit, but that was a fluke and you’re just picking out a good case toshow off.” Lucky, you say, that NGM moved lower after I’d sold futures, andthe short futures position became profitable? Not a chance in the world.You’re forgetting about time and its effect on the return earned on capital.In terms of ROC, I strongly preferred that NGM had moved a little higher.I’d cheerfully have forgone half or so of the initial potential profit in thetrade, roughly $1,300, had NGM moved 6 cents higher after I’d sold the futures. Had it done so, I almost surely wouldn’t have considered applying adefense and sitting for another month. Remember the extremely limitedtime span over which this trade occurred, just 5 total days and only about2 actual trading days, and the yet more limited time during which I wasshort the futures? Which would you prefer: about $1,100 profit in hand in 5days’ time, or $2,400 or so in 5 weeks? Yep, I thought so. Me, too.Had NGM run up 6 or 7 cents, I’d have exited the short futures position,taken that loss, and would have had the remaining profit in the original position in my pocket by Wednesday, May 29, with all the margin capital freedup and available. Trade as you like, of course, and my best wishes for your
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profitability, but I will always accept half a loaf, especially when I can obtain that half a loaf in 95% or more of all cases, and in just a day or two. Except, of course, when the old brain isn’t operating. Sigh.What do you say, my friend? Is there any part of this result you don’tlike (barring, naturally, my error in not accepting the immediate profit)? Doyou want even better news? Believe it or not, this wasn’t a superior resultat all. In terms of ROC, endplays ordinarily do significantly better, becausewe usually collect all our profit in a very few days. How did the defensiveJuly position turn out? Both sides expired worthless, thanks, but it wouldn’thave mattered if they had not. One side was going to expire worthless—itwould have taken an almost unimaginable market movement to threatenboth 2.85 and 4.00 in 20 trading days, given the supply/demand conditionsthen obtaining in the market. And, by the way, yes, I would indeed have defended the threatened side of the remaining July trade, had such a threatdeveloped.The endplay strategy is, just as any other, not about outsmarting themarket, but about trying to locate and enter a high-expectation, high-ROCtrade when the terms of doing so are in our favor. The existence of a newsand event vacuum is absolutely essential to the success of the trade, andthe premiums of the options must remain high or highish right down to thelast little part of their lives. News vacuums tend to occur after previouslyscheduled supply/demand reports, but the release date of these reports mayor may not be near a given market’s option expiration. When they are, wemay have an opportunity for a good solid endplay.Nor can we afford to forgo checking a market’s options’ IV. In the pastcouple of months (July, August 2002) in natural gas, the IVs (hence, as always, the premiums) of the options haven’t been nearly suitable for trying anendplay trade. The gold market seems to be warming up, though, and perhaps an opportunity will occur here before the end of the year. IVs are risingright now in the grain markets, but who knows whether option pricing will besuitable to an endplay for the September options. We watch, we wait, maybewe pounce. The next opportunity will come along in its own good time.
CHAPTER 14
Filling in theCracksIdeas, Understanding,and Winning
There is no substitute for victory.—General of the Army Douglas MacArthur
n the best of all worlds, what we’d like to do is examine a large numberof strategies that we might employ and rank them for effectiveness, relative ease of use, relative risk-to-reward, and frequency of applicability.I wanted to include detailed discussions of three more strategies we haven’texamined yet, but deadlines loom. (Trust me, if you intend to be an author,do not irritate your editor!) We’ll have to settle for a short glance at theseideas.The permanent strangle has a one-directional relative called the fadeaway, which is easy to implement, easy to defend, profitable, and applicable quite frequently. In fact, any given option write can be converted into afadeaway trade most of the time, if desired. We compute 80% of the distance from the market’s initial price to the strike of the option we’ve written,and if the market, at any time before the last week or so of the trade, touchesthat point, we apply a roll-out defense. Just one condition on the defense thistime: we must roll further away from the market, no rolling into an equidistant strike in the next month (or two months) further out. We may need torepeat this defense once, twice, or more. Sooner or later, the position expires and we bank our profit. This strategy is similar to what is usuallycalled “rolling for credits,” differing in that this approach always deals withOOM or WOOM options, is much less capital-intensive, and is unlikely everto turn into a Martingale, even accidentally. This seems a better strategy forwriting puts than writing calls, because we won’t even have the possibilityof having to contend with a runaway bull market.
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Another useful but sometimes tricky strategy I call, aptly enough, “thebookie.” It consists of combining the purchase of a straddle and the sale oftwo or three OOM-WOOM strangles of a nearer expiration than that of thestraddle. We might buy a December Swiss franc straddle (ATM, of course)when option IVs are in the middle of their 6-month range, and then write 2October strangles, 350 or 400 pips wide, which options also offset againstthe December futures. The idea behind the trade is to exploit the differentialin volatility or time decay per unit of time remaining in the written optionsversus the long side of the trade. Ultimately, we’d want to let our hypothetical written October options expire or replace them with November optionsat a convenient point, and later on repeat the process, rolling the strangles(or, more likely, one side of the strangle) into December options. We preferto enter this kind of trade when the next couple of months are historicallyneutral, as regards the gross movement of the underlying market. Defenseusually consists of rolling all or all minus one of the threatened written options out-and-away from the market, or selling off the unsuccessful half ofour straddle purchase at a convenient point, typically right when we roll theoptions.Coattailing a squeeze is a situational option-buying strategy. If there appears to exist the possibility of a short squeeze developing in some monthin a physical futures market, we’ll buy near-the-money calls in the next regular month. We don’t buy calls in the month that may be about to be squeezedfor two reasons. First, the options in the potential squeeze month probablywill have expired by the time the squeeze materializes, if in fact it does. Second, ATM and near-the-money options in the squeeze month, even if available, are likely to be both expensive and subject to being heavily chewed onby Sister Theta. By moving out to the next regular month, we avoid this potential problem. If the squeeze doesn’t materialize, we’ll sell back the calls,trying to limit our loss to perhaps 15–20% of capital. If it does, we attempt tostay in the trade until we’ve made 30–40% or more net ROC. We also reservethe right, if the market does run higher, to write a higher-strike call, convertthe trade to a bullish call spread, and recapture all or most of our premiumexpense, reducing risk considerably and potentially enhancing the trade inthe bargain.
An Open Mind Plus Understanding Plus DisciplineEquals a Full WalletWhen we’re trading to win, few abstract things are more valuable to us thankeeping an open mind. You might want to make the case that doing this is
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valuable in any endeavor, but it’s really an essential in trading. This appliesequally to markets and to methods. I mentioned earlier that I’d trade in anymarket in which I thought I understood how to profit, and