<s> Also by William R. Gallacher
Winner Take AllTHEOPTIONSEDGE
WINNING THE VOLATILITY GAMEWITH OPTIONS ON FUTURES
WiiiiaM R. GALLACHER
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Gallacher, William R.
The options edge : winning the volatility game with options on
futures / William R. Gallacher.p. cm.
ISBN 0-07-038296-4
1. Commodity options. I. Title.HG6046.G278 1998332.63'28—de21 98-11804
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ISBN 0-07-038296-4
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—William of OckhamCONTENTS
Preface
OPTION BASICS
1 ROADS LESS TRAVELED2 FAST FORWARD
OPTION THEORY3 OCKHAM’S EQUATION
4 THE WORD OF GOD5 THE EMPEROR OF CHINA'S NOSE
OPTION REALITY6 PHANTOM OF THE OPTION7 THE PROMISED LAND
8 BORN AGAIN9 THE ARMCHAIR BOOKMAKER
REFERENCE
10 VOLATILITY PROFILES
Index
15
17
61
8587101
115153
173
175
269PREFACE
The Options Edge will most likely appeal to readers with somepractical experience in the trading of options. It has been writ-ten, however, to be accessible to inexperienced traders who havea strong desire to understand the workings of the options market.Compared with other technical books on the subject, TheOptions Edge is rather sparing in the use of algebra and complexstatistical formulae. However, the book does delve deeply intothe principles of statistical inference. It also analyzes a great dealof data, but data structured in a way that anyone with an affinityfor numbers should find easily digestible. The author takes itfor granted that anyone interested in options is interested innumbers.
Whereas much of what I have to say applies to options in gen-eral, including stock options, the findings of The Options Edgederive from, and are specifically relevant to, options on com-modity futures. Before writing this book, I had to spend muchtime and effort constructing a data base from which to draw con-clusions. This data base is included in full at the end of the bookand may prove useful to other researchers who wish to check out,statistically, for themselves, questions they may have about dif-ferent option trading strategies.
I would like to thank my fellow trader, Stephen Clerk, for hisreview of my manuscript in development, and Jurgens Bauer forhis hands-on lesson at the option pit of the New York CottonExchange.
Bill GallacherSEPTEMBER, 1998PARTONE
OPTIONBASICSCHAPTERONE
ROADS LESSTRAVELED
Aves who read the book I wrote on commodity futures trad-ing can testify that I came down rather emphatically in favorof fundamental as opposed to technical trading. It is somewhatcontradictory, I suppose, that 4 years after writing the futuresbook I should come out with The Options Edge, a study of optiontrading that is almost purely technical in nature. I have adefense, however, for there is a certain ideological consistency.At the time I wrote the first book, I had never come across aconvincing demonstration that trading commodities in a purelytechnical way could generate returns commensurate with therisks involved. Faced with a dearth of information, I decided toresearch the topic for myself, and that research formed thenucleus of Winner Take All (New York: McGraw-Hill, 1993).When I began to explore the subject of options, I found a similarsituation; a lot of intellectual theorizing and fancy terminologybut few hard data from which to draw any general or meaningfulconclusions. As with commodity futures, I found myself com-pelled to research the subject of options from square one.Certainly, much had been written on how to buy or writeoptions and on how to structure combinations of derivatives andfutures depending on one's objectives, but no studies had beendirected at determining the writer's or the buyer's expectation ina general sense. There was little in the way of empirical evidenceto suggest who wins and who loses or whether option tradingresults follow any patterns— whether there are any pointers to2 OPTION BASICS
success, if you will. What's more, I could not relate all the com-plex formulae I saw in books to the option data that werereported in the financial press or to the option prices thatappeared on quotation monitors in brokerage offices or on theInternet.
The concept of fair value was discussed theoretically butnever checked out using actual market data. Authors talkedabout different measures of market volatility as predictors offuture volatility without taking the trouble to compare these pre-dictors in action. I didn't want theoretical conjectures. I wantedto know what would work and what wouldn't work and to under-stand if option theory correlated with option reality. The OptionsEdge is the distillation of the results of a major empirical investi-gation into option pricing carried out over a 2-year period from1996 to 1998—an investigation that evolved into a much largerproject than I could ever have imagined, and an investigationthat took on special relevance with the emergence of an extraor-dinarily volatile stock market in the latter half of 1997.
There are powerful reasons that observational research in thefield of option pricing--empirical research as statisticians wouldsay—has been so limited. .First, it is difficult to collect historicaldata. And second, it is difficult to structure a data bank that maybe tested for statistically valid conclusions. Yet, the much-neglected empirical approach to option pricing promises to yieldthe kind of pragmatic insight that no amount of theorizing is everlikely to uncover.
When I began this book, some very basic questions I hadabout options remained unanswered. I avoid casinos and neverplace bets on horses because the basic questions about casinogambling and horse betting have already been answered for me:The punter cannot win—certainly not in the long run. I had nosuch information about the potential profitability of tradingoptions.
*
In October of 1997, in the days following the record one-daydecline in the stock market, a friend of mine was seduced intoRoaps Less TRAVELED 3
writing options on the S&P500 stock index futures contract;option premiums were huge because of the enormous daily priceswings in the futures. Unfortunately, these apparently hugeoption premiums were inadequate to balance the price volatility,and my friend got burned several times. He was no neophyte totrading and knew how difficult it was to make money as anoption buyer. He was chagrined and somewhat puzzled at his lackof success as a writer. He asked me if I thought it was possible tomake money as an option writer on a purely technical basis. I wasin the middle of writing this book and gave him the best answerI could at the time: I don't know, but I'm also pretty sure thatnobody else knows either. I did tell him, however, that I expectedto have an answer in 6 months. Well, the 6 months are up andit's time to deliver.
While the focus of The Options Edge is most definitely empir-ical, I devote approximately half of the book to theoretical optionpricing. I considered this necessary for the simple reason thatalmost all the existing books on options are exclusively theoreti-cal in nature and that my readers would naturally want to corre-late what I was writing with what had already been writtenelsewhere. Option theorizing is a terrain I share with many oth-ers in the field. Induction from empirical observation is a muchless-traveled road.
Many, many theoretical works have been written on the topicof option pricing. Mathematicians-especially mathematiciansanxious to display an encyclopedic knowledge of the Greekalphabet —are drawn to the subject as flies are drawn to a lightbulb. The typical theoretical work on options covers a great dealof territory — mostly the same territory covered by all the othersto be sure, with stock options getting most of the attention. Eventhe most celebrated of these books are not always accurate.Therefore, at the risk of offending certain sensibilities, I havedirected the reader's attention to egregious instances of mislead-ing information in the literature, especially where this informa-tion has been widely disseminated and even accepted as gospel.
Virtually all theoretical works on options are needlessly com-plex and of limited practical use in the real world of options val-uation and options trading. Much of this complexity stems from4 OPTION BASICS
the option trading community's uncritical allegiance to the mil-lion dollar formula—a wierd and unwieldy equation that hasdominated the literature on options for the last 25 years. Thereis much less to this equation than meets the eye, and I have quitea lot to say about it in Chapter 4.
For all that, The Options Edge is concerned more with prag-matic issues than with theoretical arguments. I would rathersearch for something of practical value than come up withanother set of abstruse mathematical equations of limited applic-ability in the real world. There is but one Greek letter (unavoid-able) in this entire manuscript.
*
L approached the subject of options with certain preconceivednotions that I expected, naturally, would be confirmed ratherthan refuted. For example, I expected to find a significantwriter's edge in the overall market. In other words, I expected tobe able to verify that the writer of an option enjoys a positiveexpectation and that the buyer of an option labors under the bur-den of a negative expectation, even though the outcome of anyone option transaction is bound to be wildly unpredictable. I alsoexpected to find that tracking market volatility would prove to bethe key to identifying specific cases of option overvaluation orundervaluation and, conversely, that comparing option priceswith their long-term historical norms would not be an effectivekey to valuation.
As a strong believer in the hypothesis that markets arebecoming progressively more unstable due to information over-load, I had a hunch that short-term volatility is on the rise whilelong-term volatility isn't, and that exploiting such a trend mightprove possible. In a wider sense, I suspected — hoped, perhaps —that I could demonstrate it was possible to trade options, prof-itably, on a purely technical basis. Some of my preconceivednotions were confirmed. A surprising number were refuted.Since human nature prefers confirmation over refutation, theprocess of hypothesis testing required that I continually reviewwhether I was adhering to or straying from the scientific method.Roabs Less TRAVELED 5
Not all scientific research is useful or even honest; many pub-lished results suffer from "confirmation bias," a malaise whichcan contaminate the best-intentioned authorship. No one wouldaccuse the Beardstown Ladies—a group of mid-western granniegurus of the stock market--of deliberately spreading false news.Yet, the record shows that over a twelve-year period they becamemedia darlings and published several books on the strength of analleged trading acumen that later turned out to be little morethan creative bookkeeping.
To my mind, two principles guide good research. The first isthe principle of common sense. The formulation of a hypothesishas to be considered suspect if it is based purely on observationand cannot be reconciled with common sense. If you look longenough and look hard enough, you can always uncover correla-tions —seemingly beyond the bounds of probability — where purechance is still the preferred explanation.
In a recently published book called The Education of aSpeculator by Victor Niederhoffer (New York: Wiley, 1997), theerstwhile confidant of and advisor to the celebrated market guruGeorge Soros makes the following observation:
In a typical trading day, 3,100 issues are traded on the New YorkStock Exchange and about 725, or 25 per cent show no change forthe day. About 10 days a year, the percentage of unchanged issuesfalls to a low of 15 per cent or less. From 1928 to the present, thesehaye been highly bearish events. On the other hand, when the per-centage of unchanged stocks is 30 per cent or more, the market isbullish over the next twelve months (p. 119).
Let's grant that Victor Niederhoffer is correct in his observa-tion that 25 percent of the issues are unchanged on the typicaltrading day, and let's further grant that there is an apparent cor-relation between the number of unchanged issues and the futuredirection of the stock market. Was Neiderhoffer prudent todeduce that this seeming correlation truly had predictive power,even while the premise on which it is based violates all principlesof common sense? The scientist would say no, the dreamer, yes.I's hard to imagine how someone who has been around themarkets — and around George Soros—could postulate ten major6 OPTION BASICS
bullish and ten major bearish events occurring in one year, letalone suggest that these events could be tipped off by countingthe number of unchanged issues on the New York StockExchange. I did notice that Neiderhoffer must have received atleast one bad signal in 1997. The day after the record one-daypoint decline in the stock market in October, the financial pressreported that he had been completely wiped out —selling puts onstock index futures!
*
Confirmation-bias syndrome can afflict amateurs and profes-sionals alike, and it is usually —if the product of naivety —at leastunintentional. There is another side to bad research that is morepernicious, and perhaps more pervasive, because it is alwayswell-hidden. This is the violation of the principle of full disclo-sure.
If one of my hypotheses or pet notions turns out to be incor-rect, or statistically meaningless, which is really the same thing,I could easily just fail to mention it and pretend that the studynever took place. No one would be any the wiser. But this wouldbe intellectually dishonest, and a severe disservice to otherresearchers. Failure to report on an unwanted result is just as badscience as “fudging the numbers" to back up a desired result.
The danger of committing such an error was brought home tome one evening while I was watching Larry King Live. Larry'sguest was the editor of the major tabloid newspaper which hadjust broken the story that Frank Gifford, the television commen-tator, had been secretly photographed in the company of awoman of dubious repute in a motel room, The truth was thatGifford had been entrapped by the tabloid; he had been set upfor the express purpose of tarnishing his squeaky-clean image.The tabloid editor was sanctimoniously defending his newspa-per's tactics: "Well, he did it, didn't he? Nobody made him do it."Someone called in: “My question to the editor is this. If FrankGifford had rebuffed the prostitute's overtures, would the paperhave published that?”CHAPTERTWo
FAST FORWARD
ow’s this for a dream investment? You can't lose more thanH°.: initial stake, but you can multiply this stake many timesover. And should you change your mind at any time, you canalways find a third party willing to buy you out at a fair price.
These are the tantalizing prospects offered to buyers of com-modity futures options. They are also the prospects offered in alottery, where the great majority of players are prepared to sacri-fice their entire investment for an outside shot at coming up abig winner. The buyer of a lottery ticket enters the game with asubstantial negative expectation, since there is a large "housetake" to be subsidized before winnings are distributed. The sizeof this take is usually specified in advance, making the calcula-tion of the negative expectation of a lottery ticket-holder fairlystraightforward.
A widely held perception of option trading is that option buy-ers face a similar negative expectation, though until now no com-prehensive studies have either supported or contradicted thisperception. A primary objective of this book is to investigate thelong-run expectations of options traders, both buyers and writers.A further objective is to investigate how traders may modify theirbasic expectations by employing selective strategies under differ-ent market conditions.
An option buyer must purchase an option from an optionwriter, the universal term used to describe a seller of an option,whether it be a put or a call. Option trading is a zero-sumgame; the prospects faced by option writers are, by definition,exactly the reverse of those faced by option buyers. Neglecting8 OPTION Basics
transaction costs, option traders' net expectations have to bal-ance out at zero.
*
An option writer is making an investment where he may losemuch more than he can possibly gain. If he wins at all, it will beat an agonizingly slow pace; if he loses, he may lose in a very bigway, and the loss may be incurred suddenly, What would induceanyone to enter into a deal with such apparently unattractiveterms? The answer is one word—premium.
In exchange for offering the buyer the possibility of unlimitedprofits along with limited loss liability, the writer wants to be paida fee up front, and paid rather well. If he asks a hefty price andfinds buyers willing to pay the premium, the option writer mayneutralize the transaction odds or even turn them in his favor. Itis generally thought that the option writer receives an option pre-mium which not only equalizes the odds on the bet, but addi-tionally compensates him for the open-ended nature of theobligation he has assumed.
It might be helpful to review the function of an option on acommodity futures contract and to understand why options aretraded in the first place. People who have yet to trade a com-modity futures contract— some of my audience, perhaps — areunlikely ever to have come across a commodity option. Most peo-ple, however, will already be familiar with the concept of anoption in other fields of economic activity. For example, theoption is a common device in the film industry, where a filmcompany offers the author of a novel a sum of money inexchange for the exclusive rights to develop the novel into ascreenplay.
Such rights are typically granted by an author to a producerfor a limited time period only and for a flat fee. The option has anexpiry date, and, if the producer optioning the material fails to actupon the rights he has purchased, the option agreement expires.If that should happen, the author is then entitled to keep theproceeds received up front and is also free to option or sell theFasT FORWARD 9
material elsewhere. The buyer of a screenplay option is essen-tially buying time in which to test the product. If the screenplaydevelopment turns out to be positive, the producer wants to becertain of having secured the production rights. If the screenplaydevelopment proves negative, the option fee is simply written offas a cost of doing business.
The essence of all option contracts is the right without theobligation. There are, however, significant differences betweenan option on a piece of property like a novel and an option on acommodity futures contract. In the case of a novel, the bigunknown is its marketability in another medium, and this ques-tion will not be answered without a considerable investment oftime and money. In the case of a futures contract, the price ofthe contract is known at all times during the life of the option;the big unknown is the value the contract will have on the datethe option expires. If, at option expiry, the price of the futurescontract that has been optioned has moved favorably for thebuyer—up er down as the case may be—the option buyer willexercise the option. However, if the price of the futures contracthas not moved favorably, or not favorably enough to give theoption residual value, the buyer will let the option expire and for-feit the premium paid to the writer.
When a buyer purchases an option on a futures contract, heor she pays a premium to the writer in exchange for the right tobuy or sell that futures contract at a fixed price—called the strikeprice—at any time during the life of the option. Options to buyare known as calls; options to sell are known as puts. The buyerof a call option hopes that the underlying futures contract movesor remains above the strike price of the option at option expiry,thereby giving the option real value. The buyer of a put optionhopes that the price of the underlying futures contract fallsbelow the strike price, allowing the commodity to be delivered tothe writer at a higher price than its current value. Needless tosay, the hopes of all option buyers are diametrically opposed tothose of their writers.
*10 OPTION Basics
Although a commodity futures contract is symmetrical in thesense that both the long and the short have the same exposure inthe market and are therefore subject to the same margin require-ments, there is a distinct asymmetry in the terms of the optionscontract. The buyer has limited risk exposure—albeit the entireinvestment — and need only deposit the option premium with hisor her broker. No matter what happens, the worst outcome forthe buyer is for the option to expire worthless, in which case thebuyer loses the premium— but no more. The option writer, how-ever, is faced with the same level of risk as a futures trader andhas full contract liability and must post margin, just as in tradingan outright futures contract.
Because of the skewed terms of the option contract — limitedrisk with unlimited potential for the buyer—options are attrac-tive to futures traders who don't like using stop-loss orders to pro-tect their positions. An option is a seductive instrument in manyways. For the buyer, an option position as opposed to a futuresposition has built-in stop-loss protection. Set against this advan-tage is the disadvantage of premium erosion, the inevitable decayof the time value component of the premium as the option expirydate approaches. Not everyone can bear watching an option pre-mium erode to zero; for some traders, this experience is little bet-ter than a variation on the infamous Chinese water torture. So,for the buyer, the option contract has its negative as well as itspositive aspects.
For the most part, option buyers and option writers approachthe market with substantively different objectives. An optionbuyer is most likely concerned with making one specific bet. Anoption writer, however, is usually striving to cover many marketssimultaneously. Since option-writing profits accrue slowly, andsince option writers can suffer large losses when they are wrong,continuous and diversified writing can mitigate the pain for writ-ers when they are very wrong on any one trade. Though contin-uously exposed to the risk of a large loss, an option writer canemploy a number of defensive strategies. A troublesome option,for example, can be laid off by passing the risk on to someoneelse, albeit after the writer has sustained a substantial loss.FasT FORWARD il
Option writing, in fact, is remarkably akin to bookmaking,casino management, or insurance broking, where "the house"accepts the inevitable hazard of having to make occasional largepayouts because the house is taking in sufficient funds to coverthese payouts and still generate a tidy profit. Statistics on thelong-run profitability of option writing on commodity futures donot exist; it as a fundamental question that I probe at length inthe second half of the book. Conventional beliefs notwithstand-ing, the hypothesis that option writers as a group are able tofunction as successfully as a casino, say, has simply never beenput to the test.
*
The price of an option that is freely traded on a commodityexchange fluctuates in response to price changes in the underlyingcommodity futures contract. The same anonymity exists betweenan option buyer and an option writer as exists between the buyerand the seller of a commodity futures contract. Like a futuresposition, an option position may be closed out at any timethrough simple transference to a third party, via an offsettingtransaction made in the options trading pit on the floor of thefutures exchange. There are fixed strike prices at which optionson futures may be contracted, and each option has a fixed expirydate, preceding the expiry date of the underlying future by up tofive weeks. Some actively traded commodities, such as gold, cur-rencies, and the S&P500 stock market index have options expir-ing every month.
The life of an option is always less than the life of its associ-ated futures contract, with 6 months being about the maximumterm. Since an option is traded right up to its moment of expiry,the term to expiry of an option continuously diminishes with thepassage of time. It is possible to buy or sell an option with a termto expiry as short as 1 minute.
An option is defined by its strike price and by its date ofexpiry. For example, the buyer of an August 360 gold call is buy-ing the right to purchase a contract of August gold at $360 per12 OPTION BaSsIcs
ounce at any time up to and including the moment the optionexpires (expiry of August gold options is on the second Friday ofJuly). Each listed option is traded independently of all others; forexample, an August 360 gold call, and a September 370 gold callare separate and independent options contracts.
The price at which an option trades in the free market willdepend upon the strike price of the option, the prevailing price ofthe futures contract to which the option is attached, the antici-pated price variability in that futures contract, and the timeremaining until expiry of the option. In the very short term, anyincrease in the price of a futures contract will result in highercall option values and lower put option values for options on thatfuture. Likewise, any decrease in the price of a futures contractwill result in higher put option values and lower call option val-ues. Price variability in a futures contract will be the main deter-minant of the values that the market will place on its associatedoptions. For this reason, and because there are so many optionson each futures contract, price charts are not normally kept foroptions.
A call option is said to be in-the-money when its underlyingfuture is trading at a price higher than the strike price of theoption. An option which is in-the-money has real value even ifexercised immediately; in practice, this is rarely done unless theoption is so deep in the money that the buyer is willing to sacri-fice a small residual option premium in favor of cash. When a calloption has no immediate exercise value, it is said to be out-of-the-money, its market value deriving entirely from its potential, thatis, the potential for the future to rise above the strike price dur-ing the remaining life of the option. Reverse arguments hold forput options. A put option is in-the-money when the futures priceis under the strike price. An option with a strike price exactlyequal to the futures price is said to be at-the-money and is theoption in which trading is likely to be most active. Options areavailable at strike prices so far out of the money, and with suchshort times to expiry, that only a massive economic dislocation ora mammoth natural disaster could give them any terminal value.These options can be purchased for as little as $25, and veryoccasionally, like a lottery ticket, one of them will pay off.Fast FORWARD 13
*
Option statistics are published daily in the pages of the finan-cial press. Figure 2-1 lists option prices prevailing on June 30,1993 for gold futures. Working down the columns of Figure 2-1,note how the values of call options decrease as one moves fromin-the-money strikes to out-of-the-money strikes and how thevalues of put options vary in the reverse direction. Workingacross Figure 2-1 from left to right, note how the values ofoptions increase as the amount of time to expiry increases. OnJune 30, for example, the August 380 calls with less than 2 weeksuntil expiry closed at $3.90; the September 380s with 6 weeksuntil expiry closed at $10.20, while the October 380s with 11weeks to expiry closed at $12.80.
Note particularly the row entry starting with the strike priceof 380. Since the August future has closed at 379.1, the August380 option is trading very close to the money. Put and calloptions trading close to the money will command very similarprices. Indeed, when a future trades exactly at a strike price, theputs and calls at that strike must trade at exactly equal prices.Precisely why this equality has to prevail will be illustrated in thenext chapter.
Option values also increase with increasing market volatility.As of June 30, 1993, the gold market was the most volatile it had
Strike CALLS PUTS
Price Aug Sep Oct Aug Sep Oct350 29.40 31.70 33.20 0.20 0.90 2.50360 19.50 23.00 24.30 0.30 2.20 3.30370 10.00 15.50 17.50 1.00 4.60 6.40380 3.90 10.20 12.80 4.70 8.80 11.60390 1.50 6.50 8.30 12.30 15.00 16.60400 0.60 4.20 6.10 21.10 22.70 24.10410 0.30 280 4.20 30.90 31.00 33.50
FIGURE 2-1. Price quotationsfor gold options as they typically appear in the finan-cial press. Quoted prices are in dollars per ounce and taken as of the close of trading onWednesday, June 30, 1993. (August gold futures closed at 379.10 that same day.)14 OPTION BASICS
been in a year, the futures having risen $60.00 in less than 3months. At that time, the 5-week at-the-money option was trad-ing at $10.00. In early 1993, with gold in the doldrums, a simi-lar 5-week option was trading at less than half this amount.
Option values are ultimately determined by the free interplayof supply and demand in the marketplace. A number of advisoryservices claim to be able to identify overvalued and undervaluedoption prices. If an option were obviously undervalued, it wouldobviously be worth buying, and buyers would quickly force theprice up into some kind of equilibrium with other options havingsimilar risk-reward characteristics. Similarly, if an option wereobviously overvalued, it would clearly attract a lot of option writ-ers on purely technical grounds. In practice, things are never thatclear.
*
An option on a commodity future is a remarkably soph