t need toconsider a lucky result; in that case, we pocket the profit and there’s nomore to be said), the cocoa market starts edging upward. On January 4,March cocoa hits 1930.2. The March 2050 calls we’ve written are now trading at 25, or $250, withjust under 5 weeks left in their life. We repurchase the three calls andwrite a second strangle—possibly with just two lots of puts and calls,but perhaps three—this time writing the 1650 puts and the 2250 ormaybe the 2300 calls. If we can stay in the March contract and write,net, as much or more premium as we’ve repurchased, that’s great. If not,we’ll move on and write this strangle in the April options, which offset
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against the May contract. Cocoa being bullish right now, we’ll assumethat May cocoa futures are trading at $20/tonne under the March futures.In writing the April options, we might decide to move both the put andcall strikes down a notch to compensate for this differential. Note thatwe are still short the March 1450 puts. Here, we’ll assume the 1650/2250strangle in April can be written for 41, or $410 gross, $380 net per lot,or $1,140 for three, versus our total repurchase cost of $265 per Marchcall, or $795. Net to us, $345 on the defense, at least for now. Margin?Up somewhat, perhaps $1,000 total (I’m being pessimistic), since theoriginal March puts are still on the books.3. Well, drat. Cocoa turns right around, and by January 27, March cocoa
is back to 1760, and May cocoa is, by rough assumption, trading at 1740.We have no intention of letting any of our written strikes be threatened,so we’re going to adjust the position again, and our broker just lovesthis, naturally. We’ll repurchase all the April 1650 puts, now trading at 35.We’ll then, not surprisingly, write another strangle, $600 or $650 wide,in the May options, likely the 1450/2050. Our short March puts expireon the first Friday in February and are now WOOM and almost certainly toast. If we couldn’t before, then by this time, we may be able toreplace the premium we’ve repurchased by just writing two strangleshere. If we must write three, so be it—when defending, we always writeat least as much premium as we repurchase. Assume we write 3 May1450/2050 strangles for 46, yielding $1,380 gross and $1,290 net, versusour total repurchase cost of $1,140, $170 net to us, whether temporarily or not we don’t know.4. Sigh, no rest for the weary. Three-plus weeks later, on February 20,
May cocoa (the March puts have expired and their premium is now inour pocket) runs up to 1980, a new high. Where are we now? The March1450 puts are gone, the second-phase April 1650s were repurchased, andwe’re short 3 May 1450 puts. On the call side, the original short March2050s were repurchased, and we’re short 3 April 2250s and 3 May 2050s.We’ll repurchase the May 2050s and write a pair of strangles to replacethe premium, almost certainly in the June options.5. We need to do this for two reasons. Our position is now unbalanced,
and the next written strangle will correct this. While being unbalancedisn’t evil in itself, when we’re strangling a market, we much prefer thatour short put and short call positions are always equal or very close. Observe, though, that if we have defended in a disciplined fashion, andhave each time written at least as much premium as we’ve repurchased,we have profit in hand and a fine potential for more, at every point during the trade. Our margin requirement will have increased from its level
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at the start, but our cushion has not come anywhere near to beingused up.6. We continue along these lines, replacing threatened options with thesame or, preferably, a lower number of strangles. We also prefer to keepthe term of the newly written strangles as short as we can. If we canavoid moving another month further out in any cycle (while always writing more premium than we repurchase), we’ll jump at the opportunity.Once again, in our theoretical permanent strangle, I’ve taken completelynegative assumptions about the behavior of the market in which we’re involved. The movement of the market has caused us to adjust our positionfrom three lots originally probably up to five, maybe six, at this point in theexample, and we likely have only one profit (possibly two) in pocket, withanother to be cashed out in about 2 weeks. All right, that’s why I make negative assumptions; that’s why I double-whipsawed this trade in our example here. The usual behavior of markets is much less inimical to us, and it’smore useful for learning purposes to watch what happens when the marketbehaves negatively, because we learn how we can compensate for or avoidsuch adversity. When the market trades in a less unfriendly fashion, as itwill do many times, we’ll cash out completely in one or another early cycleof the trade, and have another look at that special gift our spouse has beenhinting about.When we attempt a permanent strangle, some large percentage of thetime we will be much more richly rewarded than in our example, and morequickly, too. This trade ends when the market stays in our movable range andthe most recently written strangles expire. The single key factor in this strategy is to keep the width of each successive strangle as wide as possible,generally as wide as or wider than the original strangle. If the trade has notended by the time our market heads into an historically high-volatility period of the year, we will have to consider folding the trade. If, however, aperiod of rising volatility coincides with a seasonal tendency, we may justas easily convert the trade to a non-seasonal, wait a bit longer, and thencash it.There is exactly no requirement that we use a fission defense in thisstrategy, replacing threatened options with new strangles. At any point thata fission defense appears undesirable, we can use roll or flip defenses at ourpleasure for whichever short position is threatened. There will be numerous occasions when we’ll prefer these defenses to the fission defense. If ourhistorical studies indicate that, six weeks down the road, this market beginsa strong upward seasonal, then we’ll probably apply a flip defense if someof our short calls become threatened. If in the interim the market’s movement comes to menace any of our short puts, we’ll almost surely use a roll
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defense, move the striking prices out a month or two, and wait for the upward seasonal to commence.Match the defense in each cycle of a permanent strangle to the currentmarket situation, but keep looking ahead. These are futures markets afterall. If we’re strangling cocoa, and there are rumors of a coup d’etat in IvoryCoast or Ghana, seasonal tendency or not, I know I’m not going to write awhole lot of calls (read: absolutely zero) as part of a defense in that marketuntil the dust settles. If we’re strangling soybean oil, and it looks as if theCanadian canola crop is going to be enormous, and maybe the U.S. soybeancrop also, writing puts as a defense simply isn’t on the table.There are a considerable number of other variations on the generalstrategy of strangling. Sometimes it will be desirable to strangle a market inan unbalanced fashion, writing more puts than calls, or the other way around.A creative but complex variation of the strategy is what I call the “universal”strangle, essentially the logical inverse of the inferior “buy-every-straddle”strategy, wherein we attempt wide-ish strangles on 10 or more different markets at once, typically for a term of 30 days or so. Here, we anticipate thatnormal market fluctuations will allow us to cash half or more of the positionsin the first cycle. We’ll defend the rest and intend to pick off the remainingpositions one at a time via some flavor of the permanent strangle procedure,or through some other variation suitable to the specific market at the timedefense becomes desirable.Sheldon Natenberg, author of the outstandingly useful book OptionPricing and Volatility, calls strangling one of the most dangerous strategiesthat a trader can employ. It certainly can be, not a doubt of it. If the traderis nonchalant about selecting disciplined striking prices, less than scrupulously careful about watching for supply/demand surprises that may lieahead, or decides that any of the preconditions for a disciplined strangleare not worth his time and attention, he’s asking for a whole lot of trouble.Effectively, by doing any of these, the trader is courting external event risk,even in some sense daring it to show its face. This can never be part of trading to win. Don’t do it.Because the strangles we intend to write have, speaking broadly, shorterlife spans than trades we might undertake when using a number of otherstrategies, we might be able to give ourselves yet another advantage here.Without violating any of our preconditions, we might decide to bias our selections toward a nearer expiration date and tend to be more reluctant aboutaccepting strangle trades having a longer term. While I haven’t any figuresin hand to quantify this potential advantage, I do have the distinct impressionfrom experience that the shorter-dated strangles I’ve traded over the yearshave succeeded, and usually without extended defense, more frequently thanthe longer-dated ones. It would be very nice to have collected a hefty, de-
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tailed history of all these trades, in order to see if my impression is accurate. For right now, though, I’ll have to recommend that you simply considerthis observation for what it may be worth.Although profitable and disciplined strangles don’t turn up as often asdo our opportunities in the non-seasonal strategy, we should always be onthe alert for them. Their property of almost always allowing us to cash someprofit during each month, or each cycle of the trade if we must defend, is anextremely attractive feature. Option traders should not fail to appreciatethe enhanced level of profitability that strangles offer. True, to employ thisstrategy and its variations effectively, we must hone our defensive skills, andI’m well aware that a lot of traders don’t like to employ possibly complexdefenses. Not a problem. If you are one such trader, there are strategies thatare more suited to your temperament, and, just by very good luck, we’ll examine one of these when you turn the page.L’Envoi: September yen traded between 83.37 and 86.52 over the remaining 14 trading days to August 9. Both sides of the 81.50–89.00 strangleexpired worthless.
CHAPTER 10
Hi-Yo, Yogi!Riding the Bear
How low can you go?—Ernest Evans (Chubby Checker, “Limbo Rock”)
ne of the nicer things about physical futures markets is that every sooften they present an opportunity to traders that no other market canoffer. If it turns out that a company is a fraud or it will not or cannotadapt to changes in the marketplace, the price of its shares will sooner orlater go to pennies or to zero. In these cases, and in numerous others besides,dubious companies’ bonds will also trade for a tiny fraction of face value.Government bonds? Hah! Far too often, default is the magic word regardingthese. Not infrequently, the issuing government will accompany its defaultwith a comforting message to debtholders, like “Bleep you, and the llama(or samovar, or camel, or elephant) you rode in on.” Currencies? Don’t getme started—any number of supposedly civilized countries literally cancelledtheir respective currencies in the last century and replaced them withwonderful new currencies, oh so trustworthy, we promise, this time willbe different.Bull. Pure, unadulterated, USDA-inspected, Grade A bull, with whippedcream and a cherry on top. If it’s paper, it’s only worth what the promisebehind it is worth, and, if this promise is dubious or becomes so, then it’stoilet paper.In contrast, someone will always bid for corn, or cocoa, or coffee, orcrude oil at some price, and this price won’t be pennies either. In thesemarkets, there is a price below which, even discounting incompetent governmental (pardon the redundancy) meddling and subsidy and other vote-
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buying distortions, selling will drop off markedly or even essentially cease.This fact offers us a chance to fatten up our trading accounts on occasion.Given a specific set of circumstances within a bear market, we’ll jump righton and ride the bear . . . and not in the manner you might at first think.
Minimum Value—When Suppliers Won’t PlayIn physical futures markets, large numbers of participants, simply by biddingfor or offering these markets’ goods, engage in price discovery. For our purposes, their efforts here can be very helpful under certain circumstances.When there is too much of a physical commodity, we’ll sooner or later seethe famous bear market, and we’ve an excellent opportunity when such abear market meets a few conditions. What will be the low price in Decembercorn this year? I haven’t a clue and have no intention of trying to guess it,for there’s no need. Whether coffee or cocoa, cotton or crude, if a physicalfutures market is in considerable oversupply, the market itself will verykindly tell us when to make a dollar.In any physical market, the economic notion of minimum value applies. There is a hard, objective price for the product, below which producers will sharply curtail production or stop producing altogether. No point inengaging in commercial activity if you can’t turn a profit, is there? Clearly,this effective minimum value varies from producer to producer, and bymarket and year. Can we determine what this price area level is at a specifictime, either actually or approximately?We can get close to figuring this price point, but we need a little help.First and foremost, we want to observe a particular type of event that hintsto us that minimum value is close at hand. I call this a trigger event. In late1999, citizens of the Ivory Coast made the newswires worldwide, first bythreatening to and subsequently by actually dumping great piles of low-gradecocoa in the streets and burning them. Evidently a number of growers wereso frustrated/annoyed/furious at persistently low world cocoa prices thatthey ultimately decided such action was the only way to express their angerand/or plead for higher government subsidies.Bingo. This is a dandy trigger event, nearly a perfect one. I couldn’t puta hard number to it at the time, but minimum value was lurking somewherein the current price neighborhood. When producers spontaneously begindestroying their own production, how in the world can the market price notbe close to minimum value? Opportunities like this are certainly not everyday occurrences, but they come along sufficiently often that we ignore themonly to our detriment.
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Turning Facts into Dollars—How to Do It andWhy It WorksEarning a profit in such situations is a remarkably likely result and involvesapplying an easy, straightforward strategy. We’ll write short-dated puts immediately under the market and, for the most part, sit still. If the front-monthcocoa futures are at a price of 780, we’ll write the short-dated 750 puts; ifthe market is 820, we’ll write the 800s, or just possibly the 750s if the potential ROC of the trade is satisfactory. If we’re alert and a little bit nimble,we can occasionally manage to execute this trade profitably for severalsuccessive months.“Aw, come on, Stu! First you say that when I write options, I should write’em way out of the money, now you want me to snuggle the strike I writeright up to the current market price. You can’t have it both ways!” Oh yesI can, and I do. In usual option-writing strategies, we much prefer to writeshort- and shorter-dated options as far away from the market as is convenient and consistent with a positive expectation and a solid ROC. Here,we’re not dealing with the usual case, though—we not only have Sister Thetaon our team, we also have her little brother, human economic rationality, hitting right behind her in the lineup, and it gets better still. Batting behindhuman nature comes our long-time friend historical tendency—and heknows how to hit this pitcher, believe me. This lineup is trading’s equivalentof the famed Yankees’ “Murderer’s Row” of old.Theta’s on our side because, in the bear market situation just describedfor cocoa, we’ll elect to write short-dated puts, typically with four to eightweeks until expiration. Human nature is under contract to us this time because people won’t produce, or won’t deliver goods to market, if they earnnothing or nearly nothing in return. History is way in our favor because ofa very interesting fact about bear markets in physical futures, one which admits of precisely no historical exception.We have even one more thing going for us here. What is a market, ultimately? I claim—and I’m 100% willing to stake my capital on this definition,and economics professors who disagree be damned—that it is an anticipatory discounting mechanism of price. Yesterday’s news is worth nothing,and today’s little or nothing, save in extreme cases such as Hussein invading Kuwait on August 1, 1990. The market participants have discounted toa considerable extent whatever supply/demand information has beenavailable, and ordinary news will have little effect on their or our future decisions. Under everyday circumstances, market participants in any marketare engaged in two activities: making a profit and price discovery. Shall weassume, again under everyday circumstances, that the market participantscollectively have somehow elaborately failed in their efforts at price discovery? You may, and feel free to do so. I won’t.
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When a market’s price declines to a point at which producers becomereluctant or refuse outright to produce or deliver goods to market, the market participants will pick up on this development almost immediately viatheir continuing price discovery efforts. En route to this point, those whohave been following such a market will have sold as much as they care to sell.We sometimes hear analysts, traders, and even pundits describing a marketas “sold out.” Unlike the ordinary usage of this phrase, which means there’snothing left to be bought, in a trading context the phrase is used to indicatethat market participants have sold all they want and are unwilling to sellmore at current price levels. If there’s little new selling to be expected in thenear term, the market price will have a difficult time indeed in moving muchlower.History bears this out in very clear fashion. Bear markets can persist foryears (for example, coffee from December 1999 to the present date, mid2002). However, an enormously interesting thing happens, or rather does nothappen, when a long-term bear market matures, as it were, and gets closeto the point of being sold out. It may continue to work lower by dribs anddrabs, making a new low every so often, but it never—and I mean not onceI can find by looking through 25+ years of data in 20-odd physical futuresmarkets—makes a sharp, spiky new low at this point. We’ll have a detailedlook at a recent example of this non-phenomenon throughout this chapter.
Entry Conditions—How Mature Is the Bear?By writing puts when a long-term bear market is close to sold out, we areagain anticipating what a market will not do in the near future. The questionis now, “How can we recognize an advantageous entry point?” The preconditions for entry appear to be as follows:1. The bear market, that is, the initial 20% decline from the top of the last
upward move, must have begun not less than 4 months ago, and thelonger ago, the better for us.2. The total decline to date, measured from the top of the last upwardmove, should be not less than 40% of the price at that most recent top.3. If the market we’re examining does not have 12 regular months, then itsserial month options must have sufficient liquidity to be tradable.4. If the market we’re examining is agricultural, we do not initiate the tradejust before harvest season of the crop when a large harvest is forecast.5. The 30-day SV of the market we’re examining should have been declining, at minimum over the past 2 weeks, and preferably longer.
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6. The market must not have undergone any 4% or larger daily decline over
the past 2 weeks, and preferably longer.7. There must occur an observable trigger event—some action taken byproducers, governments, or both.Now we see why opportunities to ride the bear are scarce. At any giventime, some considerable percentage of all markets are moving upward orare doing not much of anything, and are thus excluded from consideration.Then, not all that many bear markets decline 40% or more from their lasthigh. The not-right-before-harvest condition excludes some number of potential ursine excursions, NYBOT “C” coffee having been a perfect examplein mid-2002. Finally, we do not intend, ever, to apply this strategy in any financial, currency, or index market. The whole reasoning behind the strategy is inapplicable to such markets, because there is no practical definitionof the minimum value of paper promises, unless we allow zero.If you happen to be a technically oriented trader and you have a satisfactory method of determining that a particular market is likely to be “puttingin a bottom,” as they say, feel free to substitute your favorite condition orset of conditions for condition 5. A market’s SV doesn’t always move lowertoward the end of a huge, long-lasting bear market, just most of the time.Condition 6 is vital. If a market is still spiking around every few days, it’ssimply too early to try riding the bear. Wait for it.If we have not observed a trigger event, something along the lines previously described for cocoa in 1999, I don’t know what we’re doing, but wearen’t applying the ride-the-bear strategy as I understand it. If you have legitimate cause to believe that a bottom is about to be made in one of theseextended bear markets, go right ahead and write some puts, and I certainlyhope your decision is correct. The occurrence of a trigger event is my security blanket, though, and I pretty well insist on having it.Condition 3 concerning regular/serial months of options wants a littlemore discussion. Some markets, the NYMEX energy contracts for instance,have a regularly traded futures contract for all 12 months of the year and anexpiry of options associated with each month. For markets that do not have12 regular months, the months in which there is no futures contract arecalled serial months. Some markets, NYBOT cotton and orange juice for example, in theory do have options available in their serial months, but goodluck trying to trade them; these months’ option volumes range from imperceptible to nil. We’ll avoid these markets in this strategy. Some markets’ option volumes are negligible in every month, CME pork bellies and NYBOTplatinum to name two, and we’ve no use for these markets here, either. Youmay very reasonably be asking why we care about liquidity in the serialmonths of a market. There are two reasons: profit potential and defensivecapability.
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The Best of Both Worlds—Profit Each Month,or Walk Out on the BillWhat we really would like to do when we ride the bear is to stay right on hisback, to turn a profit for several months in succession while a market putsin an extended bottom. Suppose we’d be required by the lack of liquidity orthe complete non-existence of the next month’s options to move our second, third, nth option write to the options 2 or 3 months away for each successive write. We’d almost surely earn a larger premium on the successivewrites, but the premium, equally surely, would be net lower on a per-monthbasis and we’d have to contend with yet another condition.When a bear market in physical goods exists, supplies are by definitiontoo ample for the existing market demand. The price of each successive regular month futures contract will reflect this excess in the cost of interest,and of storing and insuring the goods for another 60 or 90 days or so, thewell-known carrying charge. These successive months’ prices will behigher than the nearby regular month contract, and this price structure mayforce us to make a decision whether to change the striking price of the nextputs we write.Serial month options are offset against the next regular month’s futures.January and February options in cocoa, for example, are matched off againstthe March futures, just as are the March options. Liquid serial month optionsgive us a sizeable opportunity advantage. If we would want to continue thetrade while the underlying market keeps scraping along its bottom, theiravailability will have removed one variable from our decision-makingprocess, namely, the striking price of the next options we’ll write. If we beginriding the bear by writing the January puts in cocoa or coffee, say, thenwhen or just before the January options expire, our decision process is verysimple—do it again or call it a day. We usually won’t have to examine whichstrike to write; the same strike we originally wrote will ordinarily be the onewe’ll want for the next write. Naturally, wanting and getting are not the samething at all, and we may be required by market conditions to write a different strike, but whichever strike best meets our entry criteria will be allright with us.Liquid serial month options also, beneficially, make defending our position easier should a defense become desirable. A hedge defense isn’t possible when riding the bear because we have deliberately written a strike veryclose to the market price. A spread defense, creating a calendar time spreadby purchasing puts in a further out month with the same striking price asthe ones we wrote, presents more complications than it’s worth, and usuallyrestricts our future range of profitability far too tightly.The usual defense in this strategy is a roll-out; buy back what we originally sold and then write some number of puts in the next month, or possibly
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two months, out. When we can and when the option premiums justify it, we’llprefer to roll out-and-down to a lower strike while the bear market piddlesalong near its bottoms. Our ability to do so will depend on the amount of lifeleft in the puts we originally wrote and the comparative premiums of the twooptions at the time we decide to examine defensive possibilities.
On the Bear’s Back—A Real-World TradeFor a practical example of riding the bear, we can look at a trade conductedover several months in the 1999–2000 cocoa market. Your favorite authormanaged the trade fairly well from November through August (I’d give myself about 65 or 70 marks out of 100, no more). At the time, I was just fooling with developing the ride-the-bear strategy, and if I had known then whatI know now . . . well, never mind.On November 12, 1998, NYBOT March 2000 cocoa, a 10 metric ton(tonne) contract, closed at 1648. The contract began a steady and protracteddecline on continuing good supply news until the market reached 984 onMay 28, 1999. In the next month, it bounced back to 1226 on June 21, thenresumed its price erosion. The market broke 1000 again on August 18, andgave up another $150/tonne through early November.At the time, I was involved in a non-seasonal trade, writing NYBOTcocoa calls, which, as we see above, was certainly a profitable idea over thepreceding period. Then, reading over the newswires on November 12, I sawthe story about Ivorians threatening to burn cocoa stocks. I hadn’t analyzedthe ride-the-bear strategy thoroughly at that point, but was willing to experiment a little bit, so I wrote a few February 2000 800-strike puts for $35/tonne, thus stepping into a strangle along the lines discussed in the previouschapter. As things turned out, I was too early, but only slightly. The marketwasn’t quite sold out.February 2000 cocoa options on NYBOT offset against the March 2000futures (ticker: CCH), and expire on the first Friday in January. March futuresclosed at 838 on November 12, and there were 53 days remaining until expiration of the February options. The trade was uneventful until December 22,when CCH took a dive down to 808. The short puts were now at $18. What todo? Repurchase the puts, roll ’em out, or sit still? I didn’t have any empiricalexperience with this type of trade, but I had had six weeks to learn a littleabout market behavior toward the end of extended bear markets. I decidedthat, if CCH would trade below 800 the next day, I’d simply exit the trade.It didn’t. CCH opened sharply higher (for reasons I still haven’t learned)on the last trading day before Christmas. It settled at 849 and the pressurewas off the trade temporarily. Good news! I also had some time to think.Bad news! You can think yourself into more dumb trades, I swear, and I took
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this opportunity to do exactly that. I wrote several March 800 put optionsfor $26/tonne, due to expire on February 4, 2000. I didn’t write the reasoningin my trading notebook, so I can’t really tell you why. At least nothing tooevil happened subsequently.The February puts expired tamely on January 7, and CCH wanderedaround in the low 800s for the rest of the month. On February 1, it poppedbelow 800, with just three days until expiration of the March options. At leastthis situation I knew how to handle. CCH opened at 779, bounced up to 793,and I couldn’t buy those short March puts back fast enough. I paid $25/tonnefor them, losing commissions on the trade, and rolled the short March 800put position into the May 750 puts for $18/tonne, thus breaking at least oneof our trading conditions. However, I didn’t have our handy list of preconditions at the time, I was learning by doing . . . and making a pretty fair hashof it, too. You’ll notice that the April options got lost in the shuffle? Theysure did. I forgot to write any of the April options. Just plain forgot.Six days later, the market offered me a chance to rectify my error of notwriting more premium than I repurchased, and, good news, cocoa’s volatility had risen. I was able to write about 40% more May 750 puts at $23/tonne,with May cocoa (ticker: CCK) at 810, and the May options due to expire onthe first Friday in April. Nothing much happened in the trade until the lastday of February. CCK zipped down to 756 at one point, and I was faced withthe same dilemma as in December, except this time there were 5 weeks untilexpiration, not 16 days.
Stage Two—Not Pretty So FarWell, if sitting still was the right action once, it might well be the right actionagain. Besides, I’d had a lot of time to research this type of trade by now,and the research strongly indicated that the behavior of extended bear markets toward the bottom of the move is remarkably—remarkably!—consistent. Not to say that CCK had to turn around and go higher right here, rightthis