June 2008 • Volume 2, No.

OIL: A bubble trade or pullback play? p. 8

DELTA-NEUTRAL trading p. 14

INTERVIEW: Michael Clarke of Clarke Capital p. 22

TRADING THE INTRADAY TREND in the E-Minis p. 39

GOLD volatility system p. 20

ANATOMY of a short strangle p. 40

 CONTENTS
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Trading Strategies
Oil: Tops and pullbacks . . . . . . . . . . . . . . . .8
Bubble or buying opportunity? A look at oil’s
historic run and analysis of top and pullback
patterns that model the market’s current
condition.
By FOT Staff
Shifting into neutral . . . . . . . . . . . . . . . . . .14
You don’t necessarily have to forecast market
direction to make money trading options.
Delta-neutral trading is a non-directional
approach that can profit if you buy options
before volatility picks up or sell them before
it declines.
By Randy Frederick
Options Trading System Lab
Short golden butterflies . . . . . . . . . . . . . . .20
By Steve Lentz and Jim Graham
2 June 2008 • FUTURES & OPTIONS TRADER
Trader Interview
Michael Clarke: Trend follower . . . . . . . .22
After leaving the options pits at the end of the
1980s, a self-taught computer whiz developed
a unique trend-following approach. This year,
his managed-futures programs are thriving
amid skyrocketing commodity prices.
By David Bukey
Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .26
Momentum, volatility, and volume
statistics for futures.
Option Radar . . . . . . . . . . . . . . . . . . . . . . . . . .27
Notable volatility and volume
in the options market.
News
Oil supply forecasts look gloomy . . . . .28
The latest estimates, if accurate, won’t
give the market much breathing room.
Meat futures go their own way . . . . . . . .28
Despite recent upturns, cattle and hog
futures have avoided the über-trends that
have emerged in other commodity markets.
By Chris Peters continued on p. 4
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 CONTENTS

Futures & Options Watch

COT analysis . . . . . . . . . . . . . . . . . . . . . . . .30
A look at the relationship between
commercials and large speculators in
45 futures markets.
Options watch:
Energy-related ETFs . . . . . . . . . . . . . . . . . .30
Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36
New Products and Services . . . . . . . . . . . . .38
Futures Trade Journal . . . . . . . . . . . . . . .39
Quiet market conditions before Memorial
Day lay groundwork for scalp trades in
the mini stock index futures.

Futures & Options Calendar . . . . . . . . . . . .31

Options Trade Journal . . . . . . . . . . . . . . .40
Selling volatility before a quarterly
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .32 earnings report.
References and definitions.

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in Futures & Options Trader?
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 CONTRIBUTORS
CONTRIBUTORS

Randy Frederick is director of derivatives at the Schwab

A publication of Active Trader ®
For all subscriber services:
www.futuresandoptionstrader.com
Editor-in-chief: Mark Etzkorn
metzkorn@futuresandoptionstrader.com
Managing editor: Molly Flynn Goad
mgoad@futuresandoptionstrader.com
Senior editor: David Bukey
dbukey@futuresandoptionstrader.com
Contributing editors:
Jeff Ponczak
jponczak@futuresandoptionstrader.com,
Keith Schap
Center for Financial Research. He is one of the chief architects of
Schwab’s option trading platforms and analytics tools. While he
focuses primarily on public relations, client education, and prod-
uct development, he is frequently consulted on business develop-
ment, operations, and risk procedures for Schwab's derivatives business.
Frederick, a respected industry veteran with more than 20 years of experi-
ence, writes monthly columns for Schwab’s client newsletters and is the
author of the book The Trader’s Guide to Equity Spreads (McGraw-Hill, 2007).
He has been published in trade magazines such as Active Trader, SFO and
Futures. He is a frequent guest on CNBC and Bloomberg TV, and his com-
ments appear regularly in the financial news media including The Wall Street
Journal, Barron’s, the Financial Times, Bloomberg, Dow Jones, Reuters, USA
Today, and TheStreet.com.

Associate editor: Chris Peters

cpeters@futuresandoptionstrader.com

Editorial assistant and
Jim Graham (advisor@optionvue.com) is the product man-

Webmaster: Kesha Green
kgreen@futuresandoptionstrader.com ager for OptionVue Systems and a registered investment advisor
for OptionVue Research.
Art director: Laura Coyle
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President: Phil Dorman

pdorman@futuresandoptionstrader.com

Steve Lentz (advisor@optionvue.com) is executive vice president of
Publisher, OptionVue Research, a risk-management consulting company. He also heads
Ad sales East Coast and Midwest:
Bob Dorman education and research programs for OptionVue Systems, including one-on-
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one mentoring for intermediate and advanced traders.
Ad sales
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Thom Hartle (http://www.thomhartle.com) is director
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of marketing for CQG and a contributing editor to Active Trader
Classified ad sales: Mark Seger magazine. In a career spanning more than 20 years, Hartle has
seger@futuresandoptionstrader.com
been a commodity account executive for Merrill Lynch, vice pres-
ident of financial futures for Drexel Burnham Lambert, trader for
Volume 2, Issue 6. Futures & Options Trader is pub-
lished monthly by TechInfo, Inc., 161 N. Clark Street,
Suite 4915, Chicago, IL 60601. Copyright © 2008
the Federal Home Loan Bank of Seattle, and editor for nine years of Technical
TechInfo, Inc. All rights reserved. Information in this
publication may not be stored or reproduced in any Analysis of Stocks & Commodities magazine. Hartle writes a daily market blog
form without written permission from the publisher.
called hartle & flow (http://www.hartleandflow.com).
The information in Futures & Options Trader magazine
is intended for educational purposes only. It is not
meant to recommend, promote or in any way imply the
effectiveness of any trading system, strategy or
approach. Traders are advised to do their own
research and testing to determine the validity of a trad-
ing idea. Trading and investing carry a high level of
risk. Past performance does not guarantee future
results.

6 June 2008 • FUTURES & OPTIONS TRADER

 TRADING STRATEGIES

Oil: Tops and pullbacks

Price analysis suggests a correction is certainly likely after May’s all-time high,
but pullback patterns point to the possibility of additional long-term gains.

BY FOT STAFF

FIGURE 1 — ON THE RUN

Crude oil rallied 35 percent from April 1 to May 22 before pulling back slightly
into early June.

C rude oil is the John

Dillinger of markets:
Public Enemy No. 1, on
the front page of every
newspaper (well, maybe the business
section). Consumers are feeling the
pinch of energy prices as never before,
and although politicians are itching to
shoot the market down, oil’s unique
dynamics might make it an elusive tar-
get.
Lost amid all the uproar is any rela-
tively dispassionate discussion of
where the market is right now, how it
got here, and what its past behavior
suggests about its future.
Crude oil’s (CL) rally over the past
year has certainly been amazing.
Figure 1 shows the market pulling Source: TradeStation
back from the all-time high above $135
— a 35-percent gain since the beginning of April. Figure 2 But just because a market might be overheated doesn’t
reveals this burst to be simply the latest (but certainly most mean it can’t remain hot. Unlike other commodities, oil’s
spectacular) leg of the rally that launched off the January current “bubble” could potentially pop, but only to give
2007 bottom. Price has more than doubled since then. way to an even larger balloon.
Around the time cries of dismay were coming from con-
sumers flinching at gas and heating oil prices, some market Fundamentals and sentiment
watchers began using the word “bubble” in connection The most fundamental of this market’s fundamentals is that
with the oil market. The market’s overheated, they say — petroleum is not a renewable commodity and the world’s
rampant speculation and even price-fixing have driven reserves are finite — you can’t grow a new and larger crop
prices beyond sustainable levels. next year. There are still untapped sources, but they will
There’s definitely some truth to this. The proliferation of become increasingly expensive to extract. Yes, there’s lots of
commodity trading advisors and hedge funds in the past oil left, but this is still a one-way street.
five to 10 years has resulted in a lot more money chasing the At the same time, global demand is increasing (although
same number of markets. And if you’re a money manager, not to the unmanageable extent some people claim it is —
allocating money between crude oil and, say, oat futures see “$125 crude — and beyond,” Active Trader, July 2008)
(even though they’ve rallied approximately 70 percent since largely because of booming emerging-market economies.
the beginning of 2007) is something of a no brainer. For those of you who haven’t been paying attention, that

8 June 2008 • FUTURES & OPTIONS TRADER

means China and India. (See “Peak FIGURE 2 — THE BIG MOVE
oil” on p. 10 for a discussion regard-
Crude has doubled since the beginning of 2007.
ing the basic supply-and-demand
question in the oil market.)
Sentiment is a difficult-to-quantify
aspect of the oil market. For traders,
the volatile spike in crude that accom-
panied the lead up and launch of the
first Gulf War in 1990-91 was certainly
more earth-shaking than the current
move. It was even more immediate
and dramatic — price doubled over
the course of just a couple of months
(Figure 3) — and its intraday swings
dictated moves in the stock market for
weeks. But the move was short-lived:
The whole thing was basically over in
six months.
But the current oil market has
become part of popular culture — and
a hot political issue. Depending on
continued on p. 10 Source: TradeStation

FUTURES & OPTIONS TRADER • June 2008 9

 TRADING STRATEGIES continued

Peak oil
The term “peak oil,” sometimes referred to as “Hubbert’s peak,” is the theory devel-
oped by geophysicist M. King Hubbert in 1956 that U.S. petroleum production in the
your perspective, politicians are either
lower 48 U.S. states would peak in 1970. The theory was based on the undeniable
responding to public discomfort with
truth that in any given region, there is a finite amount of oil to be found. Hubbert’s
skyrocketing fuel costs and concerns
models have since been applied to other oil-producing regions and total global oil
about economic stability or simply
estimates, was well other natural resources, including metals, coal, natural gas, and
fissionable resources such as uranium. exploiting public discomfort with sky-
Hubbert’s equation results in a production curve that resembles a bell curve rocketing fuel costs. Either way, there
(Figure A). The top of this curve represents the peak of oil production — the point at is: 1) a high probability of outside
which half of the oil has been depleted and demand begins to seriously outpace sup- pressure bearing on the market that
ply. On a global scale this would, in theory, lead to a massive energy crisis. could cause prices to decline in the
Problems with the calculation of peak oil arise from the fact they are based on near-term; 2) a low probability this
assumptions about ultimate recoverable volume. As technology improves, we find will have any impact on the oil mar-
better ways to calculate current reserves, locate new ones, and preserve the life of ket’s long-term dynamics.
those we have. Among the ideas being bandied
“As far as reliability goes, let’s just say you’re always trying to hit a moving target,” about in U.S. political and regulatory
says Howard Simons, president of Rosewood Trading Inc., strategist for Bianco circles is a margin rate increase for
Research, and contributing editor to Active Trader and Currency Trader magazines. energy contracts: increase the cost of
However, these factors don’t change the ultimately finite nature of petroleum ener- entry, and fewer speculators will be
gy supplies. able to fan the market’s flames. The
“It’s sort of like life,” Simons says. “Eat healthy, exercise, do everything else right challenge of this tactic would be to
and you’re going to die, anyway.” find the magic number that would
According to the Association for the Study of Peak Oil and Gas (www.peakoil.net), cool the market off but not completely
discovery of new oil peaked in the 1960s, and the world began using more oil than derail it.
was found in new fields in 1981. Pessimistic predictions on worldwide oil availabili-
With this background information
ty place the production peak as soon as 2010, while others say it’s already been hit.
in place, let’s look at some price pat-
A 2004 report by the Department of Energy’s (DOE) Energy Information
terns designed to reflect the condition
Administration (EIA) said the production peak is likely to occur in the middle of the
of the crude oil market in early June.
21st century, based on mid-range supply estimates.
Although peak oil may not be immediately relevant to shorter-term energy traders
— other than to understand the oil market’s long-term upward bias — it is still used
Weekly price pattern
by oil companies, reservoir managers, and oil-producing countries for strategic pur- analysis: Longer-term top
poses. and pullback patterns
“It’s pretty useless unless you have a 50-year swap on the books,” Simons says. Figure 4 compares crude’s average
“It is taken seriously in strategic terms, even though we can ignore it in tactical one- to eight-day close-to-close
terms.” changes from April 1983 through the
end of May 2008 to the median one- to
FIGURE A — HUBBERT’S PEAK eight-day performance of four price
patterns that were in effect on the
weekly time frame as of June 2 (pit-
contract prices were used):

Pattern 1: 12-week high (week

ending May 23) followed by an
inside week that closes lower
(week ending May 30). There
were 13 previous instances of
this pattern.
Pattern 2: 12-week high that closes
in the upper 25 percent of the
week’s range followed by a
week that closes in the bottom
Source: Energy and Power (1971, Scientific American)
25 percent of the week’s range.
continued on p. 12

10 June 2008 • FUTURES & OPTIONS TRADER

ads 0608 4/9/08 4:12 PM Page 39
 TRADING STRATEGIES continued

FIGURE 3 — GULF WAR SPIKE

Crude oil essentially doubled in the space of a little more

than two months in the lead up to the Gulf War — a far
more dramatic move than today’s extended rally. There were 25 instances of this pattern.
Pattern 3: 26-week high and 26-week high close
followed by a down-closing week. There were 70
previous instances of this pattern.

These are hardly the only ways the market’s condition

as of early June could have been modeled, but the patterns
do incorporate some of crude’s most salient characteristics
at this juncture: a notable high (a three- or six-month
extreme) followed by an immediate interruption or rever-
sal the following week. Table 1 shows the weekly closing
returns and percentage of gains or losses for the three pat-
terns.
Each pattern implies some degree of bearishness after
the tops they identify. Pattern 1 had the most negative
implications — the median return was still slightly nega-
tive after eight weeks. However, this pattern was the least
common. Pattern 2 was slightly more bullish at the end of
Source: TradeStation the eight-week analysis window, but
still underperformed crude’s average
FIGURE 4 — POST-HIGH BEHAVIOR gain. Pattern 3, which was the simplest
Three price-top patterns produced different results, but all followed the same pattern and produced the most previ-
general trajectory through week 4. ous examples, was the most bullish,
but only outperformed the market at
three points (which could be consid-
ered anomalies): week 1, week 5, and
week 8.
The most interesting aspect of
Figure 4 is the collective slide to the
low point at week 4, after which all the
patterns rebounded. There are a cou-
ple of ways to process this informa-
tion. The first is to disregard it and
assume the May high was a major
turning point that will not be mean-
ingfully exceeded, and that crude
TABLE 1 — WEEKLY PATTERN COMPARISON oil is in the process of embarking on
a down move larger than any it has
Patterns 1 and 2 were especially weak in weeks 1-4, with mostly negative median
returns and higher probabilities of declines than gains. experienced since at least 2006.
The second would be to put this
Week 1 2 3 4 5 6 7 8 collective pattern in the context of
April ‘83-May ‘08 10% 20% 31% 41% 51% 60% 70% 79% the market’s more recent historical
Pattern 1 -9% 6% -3% -44% -23% -2% -25% -10% performance and assume a typical
correction is more likely than a
46% 54% 46% 38% 46% 46% 46% 46%
complete reversal, in which case a
Pattern 2 -38% -11% -8% -22% 11% 25% 25% 67%
pullback bottom might be expected
44% 48% 44% 44% 52% 56% 56% 52% toward the end of June (week 4 in
Pattern 3 16% 14% 2% -18% 66% 42% 56% 121% this case would be the week ending
54% 54% 50% 49% 57% 61% 61% 61% June 27; see Figure 5).
A third interpretation would be

12 June 2008 • FUTURES & OPTIONS TRADER

 FIGURE 5 — WEEKLY OIL
that the extreme sentiment level is like- A four-week pullback from the May high would project at least an intermediate
ly to be reflected in political strong- low toward the end of June.
arming that will result in at least a tem-
porary — but still larger than normal
— pullback. It is a safe bet that behind
the scenes more pressure is being
applied to oil-producing countries to
increase supplies than at any time
since the 1970s (although the early
indications are that they are balking at
the idea). And again, increasing mar-
gin rates by more than a token amount
could result in an extremely sharp
downdraft.
Figure 4 paints an interesting pic-
ture of the possible trajectory of a pull-
back and rebound, but because it deals
in average and median prices, it can be
somewhat misleading regarding the
likely magnitude of any individual
correction, especially with crude trad-
Source: TradeStation
ing at such high levels.
For example, of seven previous pull-
backs from 12-week highs (four of which were FIGURE 6 — PULLBACK PATTERN
also all-time highs) that have occurred since A six-week (or longer-term) low combined with an intraweek reversal
January 2007 in crude oil, the average duration was followed by bullish behavior.
(to the lowest low of the correction) was a little
less than three weeks (the median duration was
two weeks). One pullback (week ending March
30, 2007 to week ending May 11, 2007) lasted
six, another lasted five; there were two pull-
backs each lasting two weeks and one week,
and one that lasted three weeks. The average
high-to-low decline was $9.53 ($9.84 median).
The maximum decline was $13.24, from the
high of the first week of January 2008 to the low
of the second week of February. As of June 3 oil
had already pulled back approximately $10
from the May 22 all-time high.
Finally, let’s look at a weekly pullback pattern
that has formed in oil. Figure 6 shows the
results of a setup with the following rules: the strong weekly close indicates a return of upside
momentum.
1.This week’s low must be the lowest low of the past There were 37 previous examples (the most recent occur-
six weeks. ring on Jan. 25, 2008) and the price action following them
2.This week’s close must occur in the upper 20 percent was far more bullish than the market’s inherent upward
of the week’s range. drift. Also, after marginal performance in the first couple of
weeks, when the odds of a higher weekly close were
Falling to a six-week (or longer) low has typified many of approximately 50 percent, from week 4 onward more than
the market’s moderate to larger correction/consolidations; 70 percent of cases posted gains.

FUTURES & OPTIONS TRADER • June 2008 13

 TRADING STRATEGIES
Shifting into neutral
You don’t always have to forecast market direction correctly to make money trading options.
This non-directional approach will gain ground if you buy options before volatility picks up
or sell them before it declines.
BY RANDY FREDERICK
P rofessional options traders don’t always need
to forecast a market’s direction to make money.
Instead, they sometimes use a direction-neu-
tral technique that exploits likely changes in a
market’s volatility, without regard to the underlying’s price.
The key to this approach is to understand the relationship
between the underlying’s historical, or statistical, volatility
and the implied volatility (IV) of its options. For more
details about this relationship, see “Volatility explained.”
For instance, if you think a stock’s actual volatility will be
greater than the IV of its options, you could buy options and
then trade their underlying shares to offset any directional
risk. But if you believe a stock’s actual volatility will lag the
IV of its options, you could sell options and then hedge any
directional risk in a similar fashion.
The trick is to determine if volatility is poised to rise or
Strategy snapshot
Strategy: Gamma scalping.
Components: Long calls + short underlying stock
or
Long puts + long underlying stock
Logic: Create a delta-neutral position by buying
options and offsetting their deltas by trading
an appropriate number of shares. To keep the
trade direction neutral, buy stock when
position delta climbs and sell stock when
position delta falls.
Criteria: Use options with out-of-the-money (OTM)
strikes that expire within one or two months.
Best-case The profits from buying low and selling
scenario: high exceed any time decay from the long
options.
Worst-case Time decay from the long options
scenario: exceed any gains from buying low and selling
high. Transaction costs add to losses.
14
fall. Options with low implied volatility are relatively
cheap; if you think IV is too low, you can enter a position
that will benefit from an increase in volatility.
For example, you might consider buying calls and hedg-
ing them by selling short the underlying stock. Or you
could buy puts and hedge them by buying the underlying
stock. These methods demonstrate how to take advantage
of IV changes while avoiding risk in either direction.
Enter the Greeks
After measuring the likelihood of any IV changes in a stock,
the next step is to evaluate the option “Greeks” — delta,
gamma, and theta. Delta measures the sensitivity of an
option to price changes in the underlying. Delta can also
represent the number of underlying shares you need to own
before the position behaves like an option.
For example, 40 shares of stock behave virtually the
same as a long call with a delta of 0.40. If a stock climbs
by $1, that call should gain $0.40 in value, or $40 over-
all (100 shares * $0.40).
An option’s gamma estimates delta’s rate of change
relative to a one-point (1.00) change in the underly-
ing’s price. But delta is only accurate at a certain price
and time. After the underlying rallies by $1, and a call
with 0.40 delta moves $0.40, then its delta will
increase.
If the underlying climbs by $1, its delta will move
closer to 1.00 as that call moves into the money (ITM).
At that point, its delta will increase, perhaps to 0.55.
This 0.15 change in delta — from 0.40 to 0.55 — repre-
sents this option’s gamma. Because an option’s delta
can never exceed 1.00, gamma falls as the option
moves further into- or out-of-the-money (OTM) as
expiration approaches.
An option’s theta estimates the rate of change in
price for each passing day. Long options have negative
theta values, while short options have positive theta
values. Because this erosion in time value is not linear,
theta increases as expiration approaches.
The role of gamma
One way to view a long option position is as a long
June 2008 • FUTURES & OPTIONS TRADER

gamma position. Therefore, if you buy
options (i.e., gamma), increasing
volatility will typically work in your
favor. By contrast, a long gamma posi-
tion tends to lose money as volatility
falls, assuming all other factors remain
unchanged. Additionally, gamma
tends to be lower for stocks with rela-
tively high IVs and higher for stocks
with relatively low IVs.
Again, you can build a delta-neutral
position by first buying either calls or
puts. Because calls have positive delta
values, you can then sell stock short to
bring its delta back down to zero.
Similarly, puts have negative deltas, so
you should buy stock to bring its delta
back up to zero.
The number of shares you trade
should correspond to the option’s
delta, a technique that differs from
simply holding 100 shares of stock for
each option you trade. With this
“delta-neutral” approach, the delta
values of the underlying and its
options cancel each other out.
It doesn’t matter whether you buy
puts or calls because an option’s delta
always rises along with the underly-
ing’s price; call deltas increase from
0.00 to 1.00, and put deltas advance
from -1.00 to 0.00. While calls have
positive delta and puts have negative
delta, both calls and puts always have
positive gamma, which offers a trad-
ing opportunity.
Volatility explained
Implied volatility
Volatility is one of the standard variables of an option’s price. The others (for stock
options) are the underlying price, the strike (exercise) price, the time (days) until
expiration, the prevailing interest rate, and dividends.
Implied volatility can be thought of as a reflection of the volatility in the market at
a given time (though it is sometimes referred to as the “market’s current estimate of
future volatility”), rather than the actual historical volatility calculated over a certain
past period.
With all other factors static, higher volatility will result in higher option prices. As
a result, many traders look for high relative volatility when selling options and low
relative volatility when buying options. It is possible to determine the implied volatil-
ity by working backward from the option price, inserting all the other variables from
the price of the option in an option pricing model and “solving” for implied volatility.
Historical volatility
Historical volatility is the measure of a stock’s price movement based on historical
prices. It measures how active a stock price typically is over a certain period of time.
Usually, historical volatility is measured by taking the daily (close-to-close) percent-
age price changes in a stock and calculating the average over a given time period.
This average is then expressed as an annualized percentage. Historical volatility is
often referred to as actual volatility or realized volatility.
Short-term or more active traders tend to use shorter time periods for measuring
historical volatility, the most common being five-day, 10-day, 20-day, and 30-day.
Intermediate-term and long-term investors tend to use longer time periods, most
commonly 60-day, 90-day, 180-day, and 360-day.

Delta neutral,
but gamma positive
It helps to think of an underlying
stock as an option with a delta of 1.00
and gamma and theta values of zero.
This “gamma-scalping” strategy’s
goal is to remain delta neutral, but
gamma positive. To do this, you need
to sell shares in the underlying stock
after it rallies and buy more shares
when the stock declines. This process
lets you buy low and sell high when-
ever the stock’s price changes. Success
isn’t guaranteed, however, because
transaction costs and other factors will
reduce the technique’s profitability.
One of those factors is theta: Long
continued on p. 16

FUTURES & OPTIONS TRADER • June 2008 15

 TRADING STRATEGIES continued

TABLE 1 — GAMMA SCALPING

This delta-neutral strategy gained $8,070 from 18 stock trades, while the April 520 calls lost just $4,780 in value. Overall, the technique
earned $3,290 (excluding commissions).
Sell short 290 shares of WXYZ at 475. Buy April 10 520 calls at $12 each.
Days Net Stock Net Net Option Net
to Stock Stock stock $ stock Position Option Option option $ option Option Position Option Option Net
expiration price change position change $ delta price change position change $ delta delta gamma IV delta
Open 50 475 -290 -290 137,750 137,750 -2.90 12.00 10 10 -12,000 -12,000 0.29 2.90 0.005 3.93 0.00
49 480 -30 -320 14,400 153,600 -3.20 13.34 0 10 0 -13,340 0.32 3.20 0.005 39.3 0.00
48 475 30 -290 -14,250 137,750 -2.90 14.75 0 10 0 -14,750 0.29 2.90 0.005 39.3 0.00
47 470 30 -260 -14,100 122,200 -2.60 9.93 0 10 0 -9,930 0.26 2.60 0.004 39.3 0.00
46 455 70 -190 -31,850 86,450 -1.90 6.12 0 10 0 -6,120 0.19 1.90 0.004 39.3 0.00
45 475 -90 -280 42,750 133,000 -2.80 10.53 0 10 0 -10,530 0.28 2.80 0.004 39.3 0.00
44 485 -50 -330 24,250 160,050 -3.30 13.31 0 10 0 -13,310 0.33 3.30 0.005 39.3 0.00
43 460 130 -200 -59,800 92,000 -2.00 6.50 0 10 0 -6,500 0.20 2.00 0.004 39.3 0.00
42 474 -60 -260 28,440 123,240 -2.60 9.52 0 10 0 -9,520 0.26 2.60 0.005 39.3 0.00
41 465 50 -210 -23,250 97,650 -2.10 7.13 0 10 0 -7,130 0.21 2.10 0.004 39.3 0.00
40 472 -40 -250 18,880 118,000 -2.50 8.52 0 10 0 -8,520 0.25 2.50 0.005 39.3 0.00
39 484 -60 -310 29,040 150,040 -3.10 11.61 0 10 0 -11,610 0.31 3.10 0.005 39.3 0.00
38 462 120 -190 -55,440 87,780 -1.90 5.87 0 10 0 -5,870 0.19 1.90 0.004 39.3 0.00
37 475 -60 -250 28,500 118,750 -2.50 8.52 0 10 0 -8,520 0.25 2.50 0.005 39.3 0.00
36 495 -120 -370 59,400 183,150 -3.70 14.43 0 10 0 -14,430 0.37 3.70 0.006 39.3 0.00
35 490 40 -330 -19,600 161,700 -3.30 12.36 0 10 0 -12,360 0.33 3.30 0.006 39.3 0.00
34 480 60 -270 -28,800 129,600 -2.70 9.03 0 10 0 -9,030 0.27 2.70 0.005 39.3 0.00
33 475 30 -240 -14,250 114,000 -2.40 7.48 0 10 0 -7,480 0.24 2.40 0.005 39.3 0.00
Close 32 475 240 0 -114,000 0.00 0.00 7.22 -10 0 7,220 0.00 0 0.00 0.005 39.3 0.00

Totals 0 8,070 0 -4,780

The net return on the stock exceeded the net loss on the options.

options lose value due to time decay, which will always
lower any profits achieved when trading the underlying
stock. If the total amount of profitable stock trades (i.e.,
gamma scalps) exceeds the option’s cost and time decay, the
method will make money. In short, if the stock is more
volatile than the volatility implied by the gamma, the strat-
egy will be profitable.
However, if the market remains flat and is less volatile
than gamma implies, the position will lose money faster
from time decay than it will gain from any profitable stock
trades. Profits will also be affected by the frequency in
which you adjust the underlying position. In these exam-
ples, adjustments are made on a daily basis.
Trade example: Long calls with short stock
Let’s assume the hypothetical stock WXYZ traded at 475 on
Feb. 28, and you buy 10 April 520 calls at $12.00 each. Each
call has a delta of 0.29 and a gamma of 0.005. The 520 strike
was chosen to keep transaction costs and time erosion
down. If we selected a lower strike, the trade’s cost would
be larger (requiring more margin) and the call’s cost would
be much higher. Because theta is typically highest for at-the-
money (ATM) options, using out-of-the-money (OTM)
options for this strategy also lowers your losses due to time
decay.
April options were selected to allow enough time for
many stock price fluctuations, without paying too much.
The more volatile the stock, the more opportunities you
have to buy low and sell high. By contrast, options that
expire sooner may result in lower profits, while later-expir-
ing options might lead to bigger profits in a longer period
of time, which would boost any expenses.
To hedge this position, you sell short 290 shares of WXYZ
at 475 per share. At this point, the position is delta-neutral,
because the 10 long calls have a positive delta of 2.90, while
the short stock has a negative delta of -2.90. However, the 10
long calls still have a positive gamma of 0.05. Table 1 lists
this position’s details.
If WXYZ jumps about 1 percent to 480 in one day, the
April 520 call’s delta should increase from 0.29 to 0.32 by
roughly the gamma’s value of 0.025 (0.005 gamma * 5
points). Because you own calls, you now must sell short 30
more shares of WXYZ at 480 to remain delta neutral. If you
sell 30 shares the following day, the 10 long calls will have

16 June 2008 • FUTURES & OPTIONS TRADER

TABLE 2 — REVERSE GAMMA SCALPING
Instead of buying options, this “reverse” gamma-scalping method sold calls and then bought the underlying stock to keep its position
delta at zero. Although the 14 stock trades lost $590, the short calls dropped $1,300 due to time decay. Overall, the position gained
$710 (excluding commissions).
Buy 53 shares of RRRR at 99. Sell 10 April 100 calls at $8.36 each.
Days Net Stock Net Net Option Net
to Stock Stock stock $ stock Position Option Option option $ option Option Position Option Option Net
expiration price change position change $ delta price change position change $ delta delta gamma IV delta
Open 47 99 530 530 -52,470 -52,470 5.30 8.36 -10 -10 8,360 8,360 0.53 -5.30 0.018 62.29 0.00
46 100 10 540 -1,000 -54,000 5.40 8.80 0 -10 0 8,800 0.54 -5.40 0.018 62.29 0.00
45 104 70 610 -7,280 -63,440 6.10 11.02 0 -10 0 11,020 0.61 -6.10 0.017 62.29 0.00
44 102 -30 580 3,060 -59,160 5.80 9.73 0 -10 0 9,730 0.58 -5.80 0.017 62.29 0.00
43 100 -40 540 4,000 -54,000 5.40 8.51 0 -10 0 8,510 0.54 -5.40 0.019 62.29 0.00
42 98 -40 500 3,920 -49,000 5.00 7.36 0 -10 0 7,360 0.50 -5.00 0.019 62.29 0.00
41 98 0 500 0 -49,000 5.00 7.27 0 -10 0 7,270 0.50 -5.00 0.019 62.29 0.00
40 97 -20 480 1,940 -46,560 4.80 6.70 0 -10 0 6,700 0.48 -4.80 0.020 62.29 0.00
39 94 -60 420 5,640 -39,480 4.20 5.24 0 -10 0 5,240 0.42 -4.20 0.020 62.29 0.00
38 92 -40 380 3,680 -34,960 3.80 4.35 0 -10 0 4,350 0.38 -3.80 0.020 62.29 0.00
37 95 60 440 -5,700 -41,800 4.40 5.48 0 -10 0 5,480 0.44 -4.40 0.020 62.29 0.00
36 98 60 500 -5,880 -49,000 5.00 6.77 0 -10 0 6,770 0.50 -5.00 0.020 62.29 0.00
35 99 20 520 -1,980 -51,480 5.20 7.17 0 -10 0 7,170 0.52 -5.20 0.020 62.29 0.00
Close 34 99 -520 0 51,480 0 0.00 7.06 10 0 -7,060 0 0.52 0.00 0.021 62.29 0.00

Totals 0 -590 0 1,300

The net return on the options exceeded the net loss on the stock.

a delta of 3.20, while the 320 short

shares of WXYZ will have a delta of
-3.20. Therefore, the total position
stays delta neutral.
Now if WXYZ falls back to its pre-
vious price of 475, the April 520 call’s
delta will likely drop back to 0.29
again, and you will buy back 30 shares
of WXYZ at 475 to remain delta neu-
tral.
In this first gamma scalp, you sold
short 30 shares of WXYZ at 480 and
then bought them back at 475 — a 1-
percent profit of 5 points (5 points * 30
shares = $150). The trade was prof-
itable because it was long gamma.
In Table 1, we bought or sold
WXYZ shares of different amounts
every day to keep the combined posi-
tion delta neutral. If you can repeat
this process several times before the
options expire, the profits from the
gamma scalps might exceed the time
decay of the long calls you hold.
However, you must also take the
potentially significant transaction
continued on p. 18

FUTURES & OPTIONS TRADER • June 2008 17

 TRADING STRATEGIES continued

costs into account.

Related reading According to Table 1, for example,
this strategy gained $8,070 from 18
Randy Frederick articles
stock trades, while the April 520 calls
“The simplicity of debit spreads,” Options Trader, February 2006. lost just $4,780 in value. Overall, the
Using spreads instead of buying options outright can reduce risk and increase strategy earned $3,290.
opportunity. This discussion of "debit" spreads highlights their versatility. The technique of buying low and
selling high works the same way if the
“Protective options,” Active Trader, May 2004. stock drops first and then rises. In this
One of the most basic ways to use options is to protect an investment against case, you would repurchase shares
an adverse move. Learn how options do the job and how they compare to stop after the underlying falls and sell
orders in terms of controlling risk. them after it increases. The order
doesn’t matter as long as you sell high
Other articles and buy low.

“Fighting the options battle with the Greeks” Long puts and long stock
Futures & Options Trader, February 2008. You can also create a delta-neutral
Paying attention to options Greeks is vital for options traders. Tracking an position by buying puts and then buy-
option’s delta, gamma, theta, and vega might save your neck in today’s volatile ing stock as a hedge. Suppose the
market. hypothetical stock JJJ traded at 62 on
Feb. 28 and you decide to buy 10 April
“Valuing options with ‘gamma rent’” 60 puts on JJJ at 0.65 each with a delta
Active Trader, August 2007.
of -0.31 and a gamma of 0.094. To
Deciding whether an option is cheap enough to buy or expensive enough to sell
hedge the puts, you can buy 310
can be tough. This simple formula uses implied volatility to find out what the
shares. Again, the entire position is
markets think.
delta-neutral, because the long put’s
-3.10 delta is offset by the delta of the
“Know your Theta,” Options Trader, January 2007.
This third installment of the option “Greeks” series discusses theta, or time 310 underlying shares (3.10).
decay, which erodes an option’s value each day. However, the trade includes a posi-
tive gamma value of 0.94 from the 10
“Get on the fast track with gamma,” Options Trader, November 2006. long puts.
Gamma digs deeper into explaining how underlying price moves affect an If JJJ drops by about 2 percent to
option’s price. 60.76 in one day, the 60 put’s delta
should decrease from -0.31 to -0.43 by
“Delta for the rest of us,” Options Trader, October 2006. the gamma’s amount of 0.116 (0.094
A detailed look at the best-known “Greek” explains how underlying process gamma * 1.24 points). Because you are
moves affect an option’s value. long puts, you will now have to buy
120 more shares of JJJ at 60.76 to
“Implied volatility: An overlooked tool for stock and futures traders,” remain delta neutral. If you buy 120
Active Trader, April 2006. more shares, you will have a delta of
Implied volatility isn’t just for option players — it can provide useful market 4.30 from those 430 underlying shares
estimates and forward-looking support and resistance levels for all traders. and a delta of -4.30 from your long
puts. Again, the positive and negative
“Getting a grip on implied volatility,” Options Trader, February 2006. deltas cancel each other out.
Implied volatility is a crucial, but often misunderstood, concept. We explain what Now if JJJ rises from 60.76 back to
it means and how you can use it to improve a trade’s chance of success.
its previous price of 62, the April 60
put’s delta will likely increase to -0.31
“The option Greeks,” Options Trader, May 2005.
again. Therefore, you should sell 120
Knowing what these calculations represent and how they affect an option’s price
shares of JJJ at 62 to remain delta neu-
will give you a better handle on how options behave — as well as a deeper
tral.
understanding of risk.
After JJJ first fell to 60.76, you
You can purchase and download past articles at bought 120 shares and sold them once
http://store.activetradermag.com. the stock rebounded to 62 — a 2-per-
cent profit of 1.24 points (1.24 points *
120 shares = $148). This round-trip

18 June 2008 • FUTURES & OPTIONS TRADER

trade made money because the total position was long
gamma.
Assuming implied volatility holds steady, you can repeat
this process several times before the options expire.
However, any profits from the stock trades must exceed the
long puts’ time decay during the trade’s duration. Keep in
mind that decreases in implied volatility will cause the
options to lose value faster, reducing your overall prof-
itability.
Adding a spread
The gamma-scalping technique also works with other
options strategies such as vertical spreads. For example,
take stock WXYZ from Table 1. Instead of simply buying 10
April 520 calls, you could also sell 10 April 540 calls to cre-
ate a bull call spread (long call, short same-month, higher-
strike call). Selling 10 April 540 calls reduces the spread’s
total delta by 2.10 to 0.80. Therefore, you would need to sell
only 80 shares of WYXZ to create a delta-neutral position.
As the stock moves up and down, you will buy and sell
fewer shares, resulting in smaller potential profits. But the
spread will require less cash, and it will lose less value due
to time decay.
Because the 520 calls are closer to the money, its theta is
only slightly higher than the short 540
calls’ theta, and the short options’
time-value erosion works in your
favor. Since spreads and other multi-
leg option strategies incur multiple
commission charges, it is also impor-
tant to consider these additional
expenses when using this type of
strategy.
tion is delta-neutral, because the 10 short calls have a nega-
tive delta of -5.30, while the long stock has a positive delta
of 5.30. However, the 10 short calls still have a positive
gamma of 0.018. Table 2 lists this position’s details.
If RRRR jumps about 1 percent to 100 in one day, the
April 100 call’s delta should increase from 0.53 to 0.54 by
roughly the gamma’s value of 0.018 (0.018 gamma * 1
point). Because you are short calls, you now must buy 10
more shares of RRRR at 100 to remain delta neutral. If you
buy 10 shares the following day, the 10 short calls will have
a delta of 5.40, while the 540 long shares of RRRR will have
a delta of 5.40. Therefore, the total position stays delta neu-
tral.
Increases in IV will have a similar impact on this strategy,
by causing your option position to retain value, thereby
reducing any profitability. Table 2 depicts this strategy with
a stable implied volatility.
Gamma scalping is most often used by professional
traders, and because transaction costs can be very high, it is
important to consider transaction costs, margin fees, and
other expenses before applying this technique to real-world
trading.

For information on the author see p. 6.

Taking the other side

If you believe implied volatility is too
high, you can reverse the strategy by
selling calls and buying stock or sell-
ing puts and selling stock short. This
strategy is reversed because you will
sell stock after it drops in price and
buy more after it climbs. While this
will lead to losses on your stock
trades, the reverse technique may still
be profitable if the market is less
volatile than expected. The goal here
is for your short options’ time decay
to exceed any stock losses.
Let’s assume the hypothetical stock
RRRR traded at 99 on Feb. 28, and you
sell 10 April 100 calls at $8.36 each.
Each call has a delta of 0.53 and a
gamma of 0.018. To hedge this posi-
tion, you buy 530 shares of RRRR at
99 per share. At this point, the posi-

FUTURES & OPTIONS TRADER • June 2008 19

 OPTIONS TRADING SYSTEM LAB

Short golden butterflies

FIGURE 1 — RISK PROFILE – SHORT CALL BUTTERFLY
Market: Options on gold futures (GC).
The short call butterfly will profit if April gold futures close either below $912.20
or above $967.80 by May 27 expiration.
System concept: This system places
a short at-the-money (ATM) call butter-
fly spread on gold futures when its
options seem undervalued. A short but-
terfly collects premium from its short
options and tries to exploit time decay,
and it will profit if the underlying’s
price moves significantly (either up or
down). The position’s maximum poten-
tial profit equals the credit received,
which you keep only if price moves
beyond one of its two short strikes.
The system tested this strategy on
gold futures, because its options have
been chronically overvalued since gold
first broke above its 200-day high in
September 2005. Options are consid-
ered undervalued when their implied
volatility (IV) remains below the actual
statistical volatility (SV) of the underly-
ing for long periods of time. The
approach requires options to be under- Source: OptionVue
valued before entry, meaning the
current IV has to be lower than the FIGURE 2 — SHORT CALL BUTTERFLY PERFORMANCE
current SV.
The spread gained $6,070 (60.7 percent) since February 2003, although its equity
A short butterfly is often called a
was flat for the first two years.
poor man’s long straddle (long
ATM call, long same-strike ATM
put), because its required margin
— and risk — is significantly less.
This short butterfly is created by
buying 10 ATM calls and selling
five calls at strikes one-half of one
standard deviation both above and
below the current price. All calls
are in the second expiration month
available with 36 days of life
remaining.
Figure 1 shows the potential
gains and losses of a 905/940/975
short call butterfly entered on Feb.
27, 2008. With April gold futures
trading at $939.50, the breakeven
points at expiration for this trade Source: OptionVue
were $912.20 and $967.80. The

20 June 2008 • FUTURES & OPTIONS TRADER

 STRATEGY SUMMARY

Net gain: $6,070.00

Percentage return: 60.7%
Annualized return: 11.9%
No. of trades: 37
maximum potential profit occurs above $975 or below $905. Winning/losing trades: 22/15
The capital required to place this trade was $832, including Win/loss: 59%
commissions.
Avg. trade: $164.05
If the price of April gold futures does not move in the
next 30 days, this trade could lose a great deal in the last Largest winning trade: $5,730.00
week before expiration. Therefore, the trade will be closed Largest losing trade: -$4,890.00
if the underlying remains between the two short strikes Avg. profit (winners): 1,427.27
(905 and 975) in the week before expiration.
Avg. profit (losers): -1,688.67
Trade rules: Avg. hold time (winners): 16
Entry Avg. hold time (losers): 29
If the ATM call’s IV is lower than the 20-day SV, then: Max consec. win/loss : 6/3
1. Buy 10 ATM calls. If the underlying’s price is
halfway between strikes, buy 5 calls at each
strike on either side of the current price.
2. Sell 5 calls with a strike price that is one-half of LEGEND:
one standard deviation out-of the-money (OTM). Net gain or loss – Gain or loss at end of test period.
Sell another 5 calls that are in-the-money (ITM)
Percentage return – Gain or loss on a percentage basis.
by the same amount.
Annualized return – Gain or loss on a annualized percent-
3. All options are in the second expiration month
age basis.
available with 36 days until expiration.
No. of trades – Number of trades generated by the system.
Exit Winning/losing trades – Number of winners and losers
Be prepared to exit the position beginning in the generated by the system.
seventh day before option expiration: Win/loss – The percentage of trades that were profitable.
1. Close the position if the underlying trades Avg. trade – The average profit for all trades.
between the two short strikes, or Largest winning trade – Biggest individual profit generated
2. Hold the trade and let the options expire if the by the system.
underlying trades above or below the two short Largest losing trade – Biggest individual loss generated by
strikes. the system.
Avg. profit (winners) – The average profit for winning trades.
Starting capital: $10,000.
Avg. loss (losers) – The average loss for losing trades.
Execution: When possible, option trades were executed at Avg. hold time (winners) – The average holding period for
the average of the bid and ask prices at the daily close; oth- winning trades (in days).
erwise, theoretical prices were used. ATM options are Avg. hold time (losers) – The average holding period for los-
defined here as the calls with the largest time value. ing trades (in days).
Standard deviation was calculated using the implied Max consec. win/loss – The maximum number of consecu-
volatility of the ATM call. Commissions were $1 per con- tive winning and losing trades.
tract. Note: Larger fees and bad fills will negatively affect
performance. Option System Analysis strategies are tested using OptionVue’s
BackTrader module (unless otherwise noted).
Test data: The system was tested on options on gold If you have a trading idea or strategy that you’d like to see tested,
futures (GC) traded at the CME. please send the trading and money-management rules to
Advisor@OptionVue.com.
Test period: Feb. 19, 2003 to March 20, 2008.
(-$1,688.67 vs. $1,427.27, respectively). Although the system
Test results: Figure 2 shows the short call butterfly made money overall because of its slightly higher percent-
gained $6,070 (60.7 percent) over the five-year test period — age of winning trades, there was no definitive trading edge.
an annualized return of 11.9 percent. The short call butter-
fly’s average losing trade is larger than its average winner — Steve Lentz and Jim Graham of OptionVue

FUTURES & OPTIONS TRADER • June 2008 21

 TRADER INTERVIEW
Michael Clarke:
Trend follower
After following the trend for nearly 20 years,
this professional commodities trader has raked
in profits in 2008.
BY DAVID BUKEY
F or many veteran traders, the
Crash of ‘87 brings back
painful memories. For fund
manager Michael Clarke, it was cer-
tainly a defining moment, but not in
the way you might expect.
Twenty years ago, Clarke was trad-
ing options at the Chicago Board
Options Exchange (CBOE), and he
made a killing by shorting stock just
before the S&P 500 fell 20.5 percent on
Oct. 19, 1987.
As a proprietary trader, Clarke sur-
Buying options is much more difficult. You have
to be very judicious and cast a very wide net.
At any given time, I may have had positions
in 250 different instruments.
vived both the 1987 crash and the
“mini” crash two years later when the
S&P 500 fell 6.4 percent on Oct. 13,
1989. However, his bosses and col-
leagues were crushed, and Clarke was
soon out of a job.
“Both events soured the public on
options, and there was a marked
decrease in volume,” he says.
“Options become too illiquid if the
22
public isn’t involved.”
A self-taught computer program-
mer, Clarke switched gears in 1989
and began to develop his own trend-
trading systems after reading Bruce
Babcock’s book, The Dow Jones Irwin
Guide to Trading Systems (Irwin
Professional Publications, 1989). As his
research grew more sophisticated, he
built custom software to test systems
on multiple markets and blended sev-
eral systems into a comprehensive
model.
Clarke, 60, performed this research
for more than a year before he started
trading his systems with real money.
In 1993, he became a Commodity
Trading Advisor (CTA) after realizing
his own performance rivaled other
CTAs. In the past 15 years, Clarke’s
basic approach has remained fairly
simple: find trending markets, enter in
the trend’s direction, and control risk
by placing different types of stop
orders.
Clarke now offers 11 variations of
this technique, with each program
consisting of up to 69 individual mod-
els with their own trade signals.
Clarke’s strength lies in blending
dozens of models that track different
time frames, allowing him to enter and
exit small positions as a trend’s
strength changes.
“Ideally, several models will scale
into a position over a period of
weeks,” he says of this approach,
which is designed to produce a
smoother overall equity curve.
After a rough patch in 2005 and
2006, Clarke’s programs are back on
track. In 2007, each of his funds gained
anywhere from 3.6 to 44 percent, with
the biggest programs, Alpha and
Millennium, climbing 37.1 and 14.8
percent, respectively. Clarke’s funds
have continued to shine in 2008:
Millennium climbed 62 percent
through April, the second-largest per-
centage gain of 364 managed-futures
programs followed by the Institutional
Advisory Services Group (Figure 1).
His firm now manages roughly $190
million.
While Clarke is tight-lipped about
the specifics of his strategy, he has a
great deal to say about the key ele-
ments of system design and risk con-
trol.
June 2008 • FUTURES & OPTIONS TRADER

FOT: What kind of a trader were you
when you were trading options at the
CBOE in the 1980s?
MC: I began buying option premium
as opposed to selling premium, which
is what most options market makers
do. They sell options to profit from the
deterioration in option value due to
time decay.
Buying options is much more diffi-
cult. You have to be very judicious and
cast a very wide net. At any given
time, I may have had positions in 250
different instruments. You need a valu-
ation method to know when an option
is really cheap. And you lose money
most of the time. For instance, you
might lose 10 months of the year, but if
you do it right, big underlying moves
can occur that are very advantageous
to options buyers.
FOT: How did you find those cheap
options?
MC: The key is to buy options that you
think are undervalued. I looked at the
combination of implied and historical
volatilities over the [previous] several
years. Is volatility at a low point? And
does a stock tend to explode in volatil-
ity occasionally?
If an option is cheap, and its stock
has been volatile in the past, I would
buy that option and hedge it by trad-
ing stock. Sometimes volatility in the
entire market exploded, which made
my entire portfolio climb.
FOT: Many traders sell options to
exploit time decay in the final month
before they expire. What drew you to
the other side of the trade?
MC: I just didn’t like when markets
would blow up in my face. Selling
options can be profitable for months
and then, suddenly, volatility would
spike and wipe you out. If you did it
right, the odds seemed better on the
other side — buying option premium.
FOT: Were you a proprietary trader
FUTURES & OPTIONS TRADER • June 2008
FIGURE 1 — MILLENNIUM PROGRAM VS. S&P 500, 2002 TO 2008
Like most of Michael Clarke’s trend-following programs, Millennium has hit new
equity highs this year after a flat period in 2005 and 2006.
Source: www.iasg.com
during the October 1987 crash? counterintuitive, but if you test it with
MC: Yes. I was short a bunch of stock proper exits, it has merit.
and long the calls. My short position But a breakout system is a pretty
made tons of money. Most of the continued on p. 24
traders at my firm, French-American
Securities, were options sellers, so the
firm lost a lot of money. At that time,
there were so many premium sellers
that I thought they were going to
bankrupt the clearing firms, but that
didn’t happen.
After hiring dozens of traders and
[leasing] exchange seats, prop-trading
firms got burnt in 1987 and 1989. My
firm grew to about 100 traders before
cutting back to about five after they
got hurt. They decided to close down,
and I had to look for a job in 1989.
I couldn’t find a trading job, so I
began using my computer back-
ground to develop trading models. By
that point, I had made $1 to $2 mil-
lion, which I used to trade. I original-
ly bought a program called System
Writer Plus, which was a forerunner
to TradeStation. But it wasn’t good
enough, so I built my own testing
platform.
The first system I tested was a
breakout strategy from Bruce
Babcock’s book The Dow Jones Irwin
Guide to Trading Systems. It was similar
to a Donchian system that goes long
after a new 100-day high. That is
23
 TRADER INTERVIEW continued

simple approach — too FIGURE 2 — UPTREND IN CRUDE OIL must trade all the markets
simple. There are many One of Michael Clarke’s trend-following programs recently extremely well — going
ways to improve a basic sold crude oil futures at $123 after riding its uptrend for six back 50 years or more.
breakout approach. I added months. Even robust models don’t
multiple components that work well all the time. That
complemented each other. doesn’t mean it’s not a
My systems are dynamic, good model, but you need
so they depend on what the to blend it with other mod-
markets are doing right els that will cover it when it
now and what they’ve hits an inevitable three- to
done in the past two years. four-year flat spot. If you’re
a CTA trading only one
FOT: Why did you switch model, you have a prob-
from a discretionary lem.
to a mechanical trading Our models are very
approach? selective. They are often
MC: It takes all the emo- out of the market entirely.
tions out of trading. I don’t Our small programs aren’t
like to get worked up. trading at all right now.
When I was an options
arbitrageur, I had a phone FOT: I realize that you
in each ear and it really trade about a dozen trend-
wore me out. I’m not good following programs at
at trading by the seat of my Source: eSignal once. Are there one or two
pants. I’ll sell and bottoms overriding principles your
and buy tops just like the first trade doesn’t work out, then systems share?
everybody else. you’ve only taken a small position, MC: The overall philosophy is if a
When I first started out, I could which limits losses. position is working, you don’t want to
apply the system and then use that Over the years, I’ve found certain exit too quickly. Instead, give it some
extra time for further research. If I’ve time periods move out of favor occa- latitude. I might consider a tight stop
tested a system with more than 50 sionally. For example, intermediate only when the position stops going up
years of data, I know it’s robust. signals might not work because the or gives back profits.
market is just too noisy. But the ultra- Our smallest programs — Global
FOT: You’ve mentioned that your pro- long secular models ignore that noise, Basic and Global Magnum — have
grams are complex and include because they have much wider stops tight stops, so they must find an entry
dozens of models. But can I assume and much slower trailing stops. point that doesn’t have a lot of noise.
their trade rules are still based on clas- When you blend those models, if At same time, they must find a market
sic trend-following approaches such as one time period is out of favor, the that’s moving, which is a difficult
moving average crossovers or channel other one is working, which tends to dilemma.
breakouts — going long at new highs smooth the equity curve. Our Jupiter The Worldwide and Orion pro-
and short at new lows? program has 69 models — it’s always grams are blends of intermediate and
MC: Absolutely. doing something. long-term models, designed to be fair-
ly conservative, but to catch occasional
FOT: I understand each model gener- FOT: What are the dangers of back- big pops. Although we hope to earn 12
ates its own trade signals, but how testing strategies? to 13 percent a year, occasionally we
does the overall strategy manage MC: It’s easy to fool yourself, over- might earn 40 percent.
them? optimize, or add so many rules that Bigger programs like Millennium
MC: With a multi-model approach, work great in the past, but not in the and Jupiter are blends of intermediate,
we’re trying to scale into a position future. long, and ultra-long models, which
that’s started to trend. One model can hold a trade for more than a year.
might trigger a long position, and FOT: How do you avoid these pitfalls? Some of the models are looking for big
another one might trigger an addition- MC: When we develop a model, it secular moves.
al position later in the same market. If

24 June 2008 • FUTURES & OPTIONS TRADER

FOT: Do you use profit targets with any
system?
MC: No. But most of the models will
sell a very profitable long position if it
jumps far above the market, which is
what happened recently in heating oil
futures (HO).
FOT: Are there any futures markets
that you avoid?
MC: No. We don’t tailor any model to
any market or group of markets. All
programs don’t trade every market,
however. Only the long-term Jupiter
and FX Plus programs trade stock
index futures because these markets
are very noisy. In testing, I’ve found
stock index futures require larger
stops, which lends itself to only long-
term models.
FOT: Is that because if you exclude a
market that begins to trend, you will
miss out?
MC: Yes. That’s a problem with our
smaller programs. Our smallest pro-
gram uses only five models, and it
could easily miss a trend since it’s so
selective.
FOT: In general, have your systems
evolved over the years?
MC: Yes. We added a so-called fuzzy-
logic trend filter in 1996. All models
have individual entry and exit points,
but now when a model wants to trade,
it asks permission from this filter.
Let’s say there is a long signal in
gold futures. The filter measures the
trend’s strength with a proprietary
indicator using values from +1 to -1.
After identifying the trend’s strength,
we can track this value from yesterday
to up to 800 days ago, which creates a
certain pattern.
At that point, we can apply this pat-
tern to all futures markets to see if it
matches any historical patterns. It
doesn’t have to be an exact match, but
it matches the pattern in a fuzzy way.
FOT: Do any of your systems use a
stop-and-reverse approach — exiting
FUTURES & OPTIONS TRADER • June 2008
longs and switching immediately to the in the markets, but I’ve thought this
short side and vice versa? since 2005.
MC: No. They have stops and trailing
stops, but there are no reversals. Going FOT: Do you mind describing a recent
long or short is an independent deci- trade from one of your systems?
sion for each model. All the models are MC: I don’t follow individual trades
flat most of the time. that closely, but in early May we sold
June crude oil futures (CLM08) at $123
FOT: Have you ever considered trad- per barrel after riding the uptrend for
ing against the trend? about six months. One of our models
MC: The fuzzy logic trend filter uses bought close to an intermediate low in
some countertrend ideas. We look at the fall of 2007 (Figure 2).
trends from zero to 800 days in length,
so if a long signal triggers, the filter FOT: Do you have any advice for indi-
may discover that the short-term zero- vidual traders who use trend-following
to 40-day trend has been straight systems?
down, while the secular 200- to 500- MC: It’s so easy to fool yourself that a
day trend is very bullish. Therefore, system works. You have to find a gen-
this particular set-up may be a buy sig- eralized system that trades a lot of dif-
nal, but it’s taking the opposite side of ferent markets with the same rules —
a shorter-term trend. don’t bend the rules to any particular
market.

FOT: So the filter may use a coun-
tertrend approach to enter at a better
price, perhaps?
MC: Yes. And we often use limit
orders to get in or out of the markets.
FOT: How do you control risk in your
programs?
MC: We have hard stops in any posi-
tions we take. The smaller programs
have tighter stops, and if market
volatility is exceeding those stops, the
program won’t even place the order.
There is also at least one trailing stop
in every model.
Finally, we use a volatility stop,
which I call a “shock to the system”
stop. In other words, if the market
makes a surprise move it will exit the
position. We use the closest stop for
each model, which could be a trailing
stop, hard stop, or volatility stop.
FOT: Given the increased volatility in
the commodity markets in the past
nine months or so, have your pro-
grams been stopped out more often
because of volatility these days?
MC: That’s hard to say because I don’t
monitor where an exit signal comes
from. I agree there is a lot of volatility
25
 FUTURES SNAPSHOT (as of May 27)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute
trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility.
See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and
may not reflect total volume for all contract months.
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures
is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
E- Pit 10-day move/ 20-day move/ 60-day move/ Volatility
Market symbol symbol Exchange Volume OI rank rank rank ratio/rank
E-Mini S&P 500 CME 1.74 M 2.05 M -1.42% / 80% -0.47% / 5% 3.96% / 70% .57 / 100%
10-yr. T-note ZN TY CBOT 976.4 2.00 M -0.03% / 0% -0.75% / 15% -2.40% / 93% .33 / 58%
5-yr. T-note ZF FV CBOT 620.3 1.73 M 0.00% / 0% -0.06% / 5% -2.57% / 97% .31 / 72%
Eurodollar* GE ED CME 364.8 1.35 M -0.01% / 14% 0.14% / 20% 0.15% / 4% .14 / 70%
E-Mini Nasdaq 100 NQ CME 327.6 347.1 -0.65% / 50% 2.78% / 16% 14.75% / 100% .32 / 95%
Crude oil CL NYMEX 308.0 292.2 2.42% / 12% 11.43% / 55% 25.77% / 75% .26 / 20%
30-yr. T-bond ZB US CBOT 300.2 894.3 -0.06% / 8% -0.72% / 21% -2.52% / 84% .39 / 25%
2-yr. T-note ZT TU CBOT 262.6 1.11 M 0.68% / 100% -0.04% / 5% -1.14% / 96% .22 / 52%
Eurocurrency 6E EC CME 220.4 192.9 1.13% / 57% 0.48% / 3% 3.31% / 24% .29 / 52%
E-Mini Russell 2000 ER CME 193.0 678.9 -0.42% / 50% 1.99% / 29% 7.28% / 100% .32 / 68%
Mini Dow YM CBOT 144.5 99.9 -2.13% / 80% -2.13% / 38% 2.46% / 38% .73 / 100%
Gold 100 oz. GC NYMEX 119.5 229.0 4.40% / 44% 3.55% / 22% -7.75% / 100% .58 / 95%
Japanese yen 6J JY CME 114.7 166.8 -0.47% / 23% -0.21% / 3% -0.30% / 100% .23 / 38%
Corn ZC C CBOT 99.7 344.0 -2.70% / 78% -0.33% / 0% 9.52% / 0% .14 / 18%
British pound 6B BP CME 88.0 137.7 1.11% / 67% -0.49% / 16% -0.66% / 20% .86 / 100%
Natural gas NG NYMEX 81.7 87.1 3.32% / 33% 8.85% / 41% 26.27% / 58% .27 / 55%
Swiss franc 6S SF CME 63.5 61.8 1.05% / 20% 0.12% / 3% 0.93% / 3% .32 / 70%
Soybeans ZS S CBOT 55.4 131.6 0.39% / 0% 5.00% / 63% -11.46% / 100% .28 / 13%
Canadian dollar 6C CD CME 45.1 97.1 1.07% / 53% 1.78% / 74% -1.19% / 32% .54 / 80%
Sugar SB ICE 44.9 341.6 -13.56% / 95% -16.50% / 83% -31.12% / 96% .39 / 77%
Australian dollar 6A AD CME 42.5 98.9 1.51% / 71% 2.35% / 50% 2.70% / 16% .39 / 67%
RBOB gasoline RB NYMEX 34.8 58.9 5.72% / 41% 15.10% / 89% 26.61% / 74% .28 / 23%
Heating oil HO NYMEX 32.8 50.9 2.71% / 7% 17.02% / 86% 33.74% / 89% .30 / 28%
S&P 500 index SP CME 32.7 529.8 -1.42% / 80% -0.47% / 5% 3.96% / 70% .57 / 100%
Silver 5,000 oz. SI NYMEX 27.0 57.8 3.79% / 62% 5.59% / 20% -13.45% / 100% .50 / 80%
Soybean oil ZL BO CBOT 26.2 76.8 1.50% / 0% 7.71% / 58% -8.73% / 100% .24 / 20%
Crude oil e-miNY QM NYMEX 25.2 10.2 3.72% / 18% 8.51% / 41% 26.52% / 75% .25 / 18%
Wheat ZW W CBOT 23.6 115.7 -5.76% / 53% -8.11% / 17% -29.26% / 89% .12 / 5%
Soybean meal ZM SM CBOT 21.5 45.6 -1.03% / 31% 1.12% / 27% -10.83% / 97% .58 / 87%
E-Mini S&P MidCap 400 ME CME 20.6 89.8 -0.60% / 100% 2.83% / 10% 9.58% / 93% .29 / 33%
Mexican peso 6M MP CME 20.5 122.4 0.97% / 67% 1.72% / 61% 2.92% / 74% .20 / 18%
Fed Funds** ZQ FF CBOT 16.7 92.3 0.00% / 0% 0.07% / 0% 0.69% / 21% .01 / 10%
Gold 100 oz. ZG CBOT 15.1 9.3 2.58% / 13% 1.36% / 11% -6.84% / 100% .60 / 98%
Live cattle LE LC CME 15.0 72.6 2.55% / 70% 3.15% / 29% 2.52% / 71% .48 / 50%
Coffee KC ICE 11.4 67.5 -4.73% / 83% -1.86% / 17% -20.86% / 100% .22 / 25%
Cotton CT ICE 11.3 105.3 -7.74% / 100% -7.48% / 75% -19.07% / 100% .33 / 64%
Nikkei 225 index NK CME 11.2 84.8 0.72% / 0% -0.39% / 5% 4.96% / 64% .32 / 85%
Cocoa CC ICE 7.1 57.5 -5.85% / 93% -7.47% / 26% -6.73% / 80% .14 / 3%
U.S. dollar index DX ICE 6.6 35.1 -0.96% / 33% -0.52% / 3% 1.80% / 183% .33 / 65%
Mini-sized gold YG CBOT 6.4 4.6 2.58% / 13% 1.36% / 11% -6.84% / 100% .60 / 98%
Copper HG NYMEX 5.2 15.1 -1.30% / 29% -4.71% / 85% -5.47% / 20% .16 / 30%
Lean hogs HE LH CME 5.0 14.1 -0.10% / 0% 1.58% / 3% 28.36% / 85% .08 / 0%
Natural gas e-miNY QG NYMEX 3.7 1.8 3.32% / 33% 8.85% / 41% 26.27% / 57% .27 / 53%
Nasdaq 100 ND CME 3.6 34.9 -0.65% / 50% 2.78% / 18% 14.75% / 100% .32 / 93%
Dow Jones Ind. Avg. ZD DJ CBOT 2.7 28.0 -2.42% / 100% -2.53% / 52% 2.01% / 31% .66 / 100%
Silver 5,000 oz. ZI CBOT 1.4 2.0 1.48% / 33% 2.67% / 5% -11.72% / 100% .47 / 80%
Russell 2000 index RL CME 1.3 38.2 -0.42% / 50% 1.99% / 31% 7.28% / 100% .31 / 62%
*Average volume and open interest based on highest-volume contract (December 2008). **Average volume and open interest based on highest-volume contract (August 2008).
Legend day moves, 20-day moves, etc.) show the per- cent means the current reading is larger than
Volume: 30-day average daily volume, in centile rank of the most recent move to a cer- all the past readings, while a reading of 0 per-
thousands (unless otherwise indicated). tain number of the previous moves of the cent means the current reading is smaller than
same size and in the same direction. For the previous readings. These figures provide
OI: Open interest, in thousands (unless other-
example, the rank for 10-day move shows perspective for determining how relatively
wise indicated).
how the most recent 10-day move compares large or small the most recent price move is
10-day move: The percentage price move to the past twenty 10-day moves; for the 20- compared to past price moves.
from the close 10 days ago to today’s close. day move, the rank field shows how the most Volatility ratio/rank: The ratio is the short-
20-day move: The percentage price move recent 20-day move compares to the past term volatility (10-day standard deviation of
from the close 20 days ago to today’s close. sixty 20-day moves; for the 60-day move, the prices) divided by the long-term volatility (100-
60-day move: The percentage price move rank field shows how the most recent 60-day day standard deviation of prices). The rank is
from the close 60 days ago to today’s close. move compares to the past one-hundred- the percentile rank of the volatility ratio over
The “rank” fields for each time window (10- twenty 60-day moves. A reading of 100 per- the past 60 days.

This information is for educational purposes only. Futures & Options Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Futures & Options
Trader assumes no responsibility for the use of this information. Futures & Options Trader does not recommend buying or selling any market, nor does it solicit orders to buy
or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.

26 June 2008 • FUTURES & OPTIONS TRADER

 OPTIONS RADAR (as of May 27)
MOST-LIQUID OPTIONS*
Indices Symbol Exchange Options Open 10-day move / 20-day move / IV / IV / SV ratio —
volume interest rank rank SV ratio 20 days ago
S&P 500 index SPX CBOE 207.9 1.42 M -1.30% / 100% -0.79% / 14% 18.6% / 15.2% 18.4% / 17.2%
S&P 500 volatility index VIX CBOE 83.9 946.8 10.40% / 100% 0.00% / 0% 164.4% / 93.5% 94.6% / 76.5%
Russell 2000 index RUT CBOE 66.0 841.1 0.16% / 0% 1.24% / 18% 22.9% / 18.6% 22.1% / 23.1%
Nasdaq 100 index NDX CBOE 31.8 200.6 -0.08% / 50% 3.75% / 23% 22% / 20.6% 22.3% / 22.9%
S&P 100 index OEX CBOE 26.2 93.8 -1.84% / 100% -1.69% / 29% 17.7% / 14.3% 17.6% / 17.2%

Stocks
Yahoo! YHOO 360.8 3.15 M 6.89% / 71% 2.16% / 33% 38.9% / 51.9% 58.3% / 26.1%
Apple Inc. AAPL 241.1 914.5 -0.92% / 40% 8.24% / 12% 41.8% / 38.2% 38.9% / 45.5%
Citigroup C 174.8 2.21 M -8.38% / 23% -19.21% / 66% 43.8% / 45.2% 39.4% / 56.8%
Microsoft MSFT 148.1 2.05 M -5.17% / 82% -1.90% / 52% 27.8% / 28.8% 27.3% / 31.2%
Cisco Systems CSCO 102.8 1.22 M -0.97% / 50% 0.95% / 0% 28.2% / 31.6% 32% / 32.3%

Futures
Eurodollar ED-GE CME 533.6 7.74 M 0.08% / 43% 0.09% / 9% 31.9% / 24.7% 33.4% / 36.7%
10-yr T-notes TY-ZN CBOT 98.4 690.5 -1.51% / 77% -0.74% / 15% 5.8% / 7.2% 7.9% / 7.7%
30-yr T-bonds US-ZB CBOT 55.6 432.4 -0.06% / 8% -0.72% / 21% 10.8% / 9.6% 10.3% / 10.9%
Crude oil CL NYMEX 39.0 240.8 2.42% / 12% 11.43% / 55% 37% / 38.5% 36.1% / 34.1%
5-yr T-notes FV-ZF CBOT 31.7 338.3 0.00% / 0% -0.06% / 5% 6.1% / 5% 5.9% / 5.7%

VOLATILITY EXTREMES**
Indices - High IV/SV ratio
S&P 500 volatility index VIX CBOE 83.9 946.8 10.40% / 100% 0.00% / 0% 164.4% / 93.5% 94.6% / 76.5%
Mini Dow YM CBOT 1.4 6.6 -2.13% / 80% -2.13% / 38% 17.7% / 10.4% 16.8% / 13.9%
Eurodollar index XDE PHLX 3.1 58.8 0.95% / 33% 0.26% / 5% 9.5% / 7.1% 10.1% / 9.1%
S&P 500 futures SP CME 9.5 64.5 -1.42% / 80% -0.47% / 5% 20.1% / 15.2% 18% / 16.4%
S&P 100 index OEX CBOE 26.2 93.8 -1.84% / 100% -1.69% / 29% 17.7% / 14.3% 17.6% / 17.2%

Indices - Low IV/SV ratio

Gold/Silver Index XAU PHLX 3.2 38.6 2.36% / 8% 5.40% / 23% 37.2% / 37.8% 40.7% / 39.4%

Stocks - High IV/SV ratio

Elan Corp. ELN 25.5 408.7 -11.09% / 100% -7.75% / 22% 87.2% / 44% 58.1% / 62.7%
Hershey Co. HSY 2.5 36.4 7.34% / 55% 9.85% / 95% 38% / 21% 29.2% / 23.6%
Countrywide Financial CFC 29.5 688.7 -4.18% / 7% -21.27% / 75% 105.1% / 66.3% 65.4% / 76.8%
Sirius Satellite Radio SIRI 21.6 674.6 -9.41% / 100% -3.35% / 15% 59% / 39% 68.4% / 47.7%
GlaxoSmithKline GSK 2.0 46.8 -0.54% / 0% -2.07% / 24% 24.3% / 16.4% 24.4% / 21.4%

Stocks - Low IV/SV ratio

Pacific Ethanol PEIX 3.1 16.4 26.77% / 0% 10.75% / 33% 83.7% / 155.4% 94.2% / 80.6%
Provident Energy Trust PVX 1.8 38.5 -1.04% / 0% 4.27% / 57% 16.3% / 28.9% 27.2% / 23.1%
Electronic Data System EDS 2.6 38.4 0.91% / 0% 28.50% / 78% 17% / 28.3% 29.9% / 37.1%
Solarfun Power Holdings SOLF 28.3 110.6 50.67% / 58% 62.53% / 89% 96.2% / 150.3% 78.7% / 82.2%
Cheniere Energy LNG 7.4 173.5 7.60% / 67% -49.72% / 67% 154.4% / 241.2% 109.8% / 203.6%

Futures - High IV/SV ratio

Mini Dow YM CBOT 1.4 6.6 -2.13% / 80% -2.13% / 38% 17.7% / 10.4% 16.8% / 13.9%
Japanese yen JY-6J CME 2.8 34.8 0.41% / 50% -0.47% / 7% 14.2% / 9% 12.5% / 10.4%
S&P 500 futures SP CME 9.5 64.5 -1.42% / 80% -0.47% / 5% 20.1% / 15.2% 18% / 16.4%
Live cattle LC CME 3.6 89.1 2.55% / 70% 3.15% / 29% 17.9% / 13.8% 18.5% / 14.7%
Eurocurrency EC-6E CME 7.4 60.3 1.51% / 50% 1.00% / 10% 9.2% / 7.1% 10.2% / 9.4%

Futures - Low IV/SV ratio

Sugar SB NYBOT 20.4 633.4 -13.56% / 95% -16.50% / 83% 36.6% / 70.1% 37.8% / 44.1%
Heating oil HO NYMEX 1.3 3.4 2.71% / 7% 17.02% / 86% 33.4% / 45.3% 31.9% / 33.8%
Cotton CT NYBOT 6.3 213.1 -7.74% / 100% -7.48% / 75% 26.3% / 31.8% 33.2% / 36.1%
Coffee KC NYBOT 6.6 141.1 -4.73% / 83% -1.86% / 17% 36.2% / 43.7% 33.7% / 38.1%
Soybean meal SM-ZM CBOT 5.8 60.1 -1.03% / 31% 1.12% / 27% 36.3% / 38.5% 44.2% / 40.7%
* Ranked by volume ** Ranked based on high or low IV/SV values.

LEGEND:
Options volume: 20-day average daily options volume (in thousands unless otherwise indicated).
Open interest: 20-day average daily options open interest (in thousands unless otherwise indicated).
IV/SV ratio: Overall average implied volatility of all options divided by statistical volatility of underlying instrument.
10-day move: The underlying’s percentage price move from the close 10 days ago to today’s close.
20-day move: The underlying’s percentage price move from the close 20 days ago to today’s close. The “rank” fields for each time window (10-day moves, 20-
day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For example,
the “rank” for 10-day moves shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “rank” field shows
how the most recent 20-day move compares to the past sixty 20-day moves.

FUTURES & OPTIONS TRADER • June 2008 27

 INDUSTRY NEWS

Paint it black

Oil supply forecasts look gloomy

FIGURE 1 — WEEKLY CRUDE OIL
Oil skyrocketed to an all-time high just above $135/barrel

C
rude oil (CL) prices have climbed 39 percent so far
in May.
in 2008, hitting $135/barrel on May 22. This most
recent oil spike has prompted the International
Energy Agency (IEA), a Paris-based organization that rep-
resents 26 developed countries outside of the Organization
of Petroleum Exporting Countries (OPEC), to change how
they forecast the balance between supply and demand.
In past years, the IEA has focused on predicting changes
in global oil demand. In November 2008, however, the
agency is planning to release a comprehensive survey of the
400 largest oil fields worldwide to get a more accurate read-
ing of global oil supplies. The IEA’s initial estimates reveal
that demand for oil may outpace production sooner than
originally thought, according to The Wall Street Journal.
Global demand is expected to climb from roughly 87 mil-
lion barrels today to 116 million barrels per day by 2030,
and supplies may have trouble keeping up. According to
the report, oil supplies may rise above 100 million barrels Source: TradeStation
per day, but that would include contributions from alterna-
tive fuels such as ethanol. years, further investment is needed. OPEC countries will
In its 2007 World Energy Outlook, the IEA argues that likely increase their share of total global oil production from
although oil supplies may satisfy demand over the next 22 42 percent today to 52 percent in 2030.

Choppy trading, as usual

Meat futures go their own way

BY CHRIS PETERS
FIGURE 1 — LIVE CATTLE

W
hile many commodity
Compared to some wild moves in early 2006, live cattle futures prices in 2008
markets have shot have been rather tame.
through the roof recently,
for the most part meat futures are per-
forming right in line with their histor-
ical price behavior norms. In other
words, they’re as volatile as usual, but
have failed to embark on the sus-
tained up moves that have emerged
recently in the grains, energy, and
some of the softs.
Prices for August 2008 live cattle
(LCQ08), or cattle ready for slaughter,
have risen 4.7 percent in 2008 to
100.925 cents per pound as of May 29,
but had actually fallen for the first Source: eSignal
three months of the year by almost 5

28 June 2008 • FUTURES & OPTIONS TRADER

 MANAGED MONEY
percent. August feeder cattle (FCQ8),
or the calves that still need to be fat- Top 10 option strategy traders ranked by April 2008 return.
tened up for slaughter, followed a sim- (Managing at least $1 million as of April 30, 2008.)
ilar path the first part of the year, drop- April YTD $ under
ping 7 percent by April 4 to 103.250. Rank Trading advisor return return mgmt.
Over the next two months, feeder cat- 1. CKP Finance Associates (LOMAX) 22.04 5.56 4.9M
tle also moved into the black for the 2. Aksel Capital Mgmt (Growth & Income) 18.12 65.22 8.2M
year, reaching 115.800 on May 29, a 4.3- 3. Paramount Mgmt Group 17.76 64.35 8.0M
percent gain. 4. Kawaller Fund 15.20 1.38 1.2M
Volatile moves such as these are typ- 5. Welton Investment (Alpha Leveraged) 11.51 9.82 4.0M
ical for the traditionally choppy meat 6. ACE Investment Strategists (DPC) 9.18 10.01 5.0M
futures. The continuous live cattle 7. ACE Investment Strategists (ASIPC) 7.32 4.95 9.1M
chart in Figure 1 shows a dramatic 8. Golden West 6.65 12.16 1.0M
drop in the first few months of 2006, 9. Singleton Fund 6.25 14.58 29.7M
which then led into an almost 40-per- 10. ACE Investment Strategists (SIPC) 5.85 -0.07 99.8M
cent rally over the next 12 months. Source: Barclay Hedge (http://www.barclayhedge.com)
Based on estimates of the composite of all accounts or the fully funded subset method.
Hog futures are also considered fair-
Does not reflect the performance of any single account.
ly turbulent — and known for making
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
limit-up and limit-down moves
(sometimes in the same day). July
lean hogs (LHN08) gained almost FIGURE 2 — LEAN HOGS
12 percent through January, from Lean hog futures fell late last year as open interest peaked.
73.050 at the end of 2007 to 81.700
on Feb. 4. The price then fell 16
percent over the next two months
to 68.650, and by May 29 had split
the difference, closing at 76.250, a
4.4-percent gain for the year so far.
July pork bellies (PBN08) start-
ed the year at 86.300, gained 5.5
percent by the end of February to
91.050, and then fell to 75.750 on
May 29, a 16.8-percent drop from
the February peak and a 12.2-per-
cent decline on the year so far. Source: eSignal
Again, these types of moves are
typical. From May 2004 to July 2005 pork belly futures lost corn used to feed them. Historically, this ratio has been
52 percent. Figure 2 shows that while the past 10 months around 20. If it rises above 20 it’s good for the hog farmer;
appear fairly turbulent, they aren’t out of line with the if it moves below 20 it means the cost of corn is cutting into
moves that occurred at the beginning of both 2006 and 2007. the farmer’s profits. With the rising cost of corn, this ratio
The reasons these markets may not be reacting the way was about 10.2 in December 2007. In April, it fell below 8.
many other commodities have relates to the nature of the Another factor causing other commodity prices to rise
products themselves. For one thing, it’s a little harder for across the board is the cost of fuel, which increases the cost
weather to alter the output of a cattle farm than it is for it to of transporting goods. Although hog and cattle byproducts
affect a wheat harvest. need to be hauled somewhere once processed, most are con-
Weather does, however, affect the feed for livestock. Poor sumed in the U.S.; relatively little is imported or exported.
conditions can alter the ability of a pasture to support cat- Despite the absence of a major trend move, volume in the
tle, and the cost of the grains used to feed pigs and cows can meats is robust. The daily open interest (OI) in live cattle hit
determine how many a farmer can afford to raise. a record high of 153,721 contracts on Feb. 23, 2007 and has
One indicator of this is the hog-corn ratio, which com- consistently breached 120,000 since. Lean hog OI hit an
pares the price you can get for selling hogs to the cost of the intraday record of 106,717 on Feb. 11, 2008.

FUTURES & OPTIONS TRADER • June 2008 29

 FUTURES & OPTIONS WATCH
FIGURE 1 — COT REPORT EXTREMES
COT analysis The largest positive readings represent markets in which net commer-
cial positions (longs - shorts) exceeded net fund holdings on May 20.
The Commitments of Traders (COT) report published By contrast, the largest negative values represent markets in which
weekly by the Commodity Futures Trading Commission net fund holdings surpassed net commercial positions.
(CFTC) breaks down the open positions in futures mar-
kets into three categories of traders: commercial, non-
commercial, and non-reportable.
The commercials, or hedgers, are typically businesses
that actually deal in the cash market (e.g., grain mer-
chants and oil companies, that either produce or con-
sume the underlying commodity).
Non-commercial traders are large speculators (“large
specs”) such as commodity trading advisors (CTAs) and
hedge funds — professional money managers who do
not deal in the underlying cash markets but speculate in
futures on a large-scale basis. Many of these traders are
trend followers. The non-reportable category represents For a list of contract names, see “Futures Snapshot.” Source: http://www.upperman.com
small traders — i.e., the general public.
Figure 1 shows the relationship between commercials and large specu- Legend: Figure 1 shows the difference between net commercial
and net fund positions (longs - shorts) for all 45 futures markets, in
lators on May 20. Positive values mean that net commercial positions descending order. It is calculated by subtracting the current net-
(longs - shorts) are larger than net speculator holdings, based on their five- fund position from the net-commercial position and then comparing
year historical relationship. Negative values mean large speculators have this value to its five-year range. The basic formula is:
bigger positions than the commercials. a1 = (net commercials’ 5-year high - net commercials’ current)
b1 = (net commercials’ 5-year high - net commercials’ 5-year low)
In gasoline and corn futures (RB and C), the difference between com-
c1 = ((b1 - a1)/ b1 ) * 100
mercials and funds is near a five-year low, while this relationship is near a
five-year high in the Nikkei 225 and British pound futures (NK and BP, a2 = (net funds’ 5-year high - net funds’ current)
b2 = (net funds’ 5-year high - net funds’ 5-year low)
respectively). While these types of historical extremes aren’t stand-alone
c2 = ((b2 - a2)/ b2 ) * 100
trade signals, they sometimes precede major price reversals.

x = (c1 - c2)
– Compiled by Floyd Upperman

Options Watch: Energy-related ETFs Compiled by Tristan Yates

The following table summarizes the expiration months available for energy-related ETFs. It also shows each index’s average bid-ask spread for
at-the-money (ATM) June options. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of potential
slippage in each option market.
Option contracts traded

2008 2009 2010

Bid-ask spreads
Bid-ask
spread as %
Sept.
June

Dec.
July

Jan.

Jan.
Oct.

Closing of underlying
Stock Symbol Exchange price Call Put price
Oil Service HOLDERS Trust OIH NA X X X X X 209.83 0.24 0.23 0.11%
United States Oil Fund, LP USO NA X X X X 102.32 0.18 0.13 0.15%
Select Sector SPDR-Energy XLE NA X X X X X X 85.19 0.13 0.17 0.17%
United States Natural Gas Fund, LP UNG NA X X X X 54.16 0.15 0.23 0.35%
iShares Trust - DJ US Energy Sector Index Fund IYE NA X X X X 147.33 0.63 0.63 0.42%
PowerShares DB Oil Fund DBO NA X X X X 46.98 0.23 0.19 0.44%
PowerShares DB Energy Fund DBE NA X X X X 49.06 0.21 0.23 0.45%
SPDR Oil & Gas Exploration & Production ETF XOP NA X X X X 62.93 0.46 0.39 0.68%
PowerShares WilderHill Clean Energy Portfolio PBW NA X X X X 21.95 0.19 0.23 0.94%
Claymore/MAC Global Solar Energy TAN NA X X X X 26.46 0.24 0.33 1.06%
Market Vectors Coal KOL NA X X X X 52.43 0.74 0.48 1.16%
First Trust ISE-Revere Natural Gas Index Fund FCG NA X X X X 28.8 0.34 0.34 1.17%
PowerShares Dynamic Oil Services Portfolio PXJ NA X X X X 31.8 0.38 0.44 1.28%
iShares S&P Global Energy Sector IXC NA X X 153.34 3.38 2.74 1.99%
Vanguard Energy VIPERs VDE NA X X X X 124.1 3.03 3 2.43%
SPDR Oil & Gas Equipment & Services ETF XES NA X X X X 47.57 2.68 2.61 5.56%

As of May 29
Legend:
Call: Four-day average difference between bid and ask prices for the front-month ATM call.
Put: Four-day average difference between bid and ask prices for the front-month ATM put.
Bid-ask spread as % of underlying price: Average difference between bid and ask prices for front-month, ATM call, and put divided by the underlying's closing price.

30 June 2008 • FUTURES & OPTIONS TRADER

 FUTURES & OPTIONS CALENDAR
Legend
CPI: Consumer price index
ECI: Employment cost index
FDD (first delivery day):
The first day on which deliv-
ery of a commodity in fulfill-
ment of a futures contract
can take place.
FND (first notice day): Also
known as first intent day, this
is the first day a clearing-
house can give notice to a
buyer of a futures contract
that it intends to deliver a
commodity in fulfillment of a
futures contract. The clear-
inghouse also informs the
seller.
FOMC: Federal Open
Market Committee
GDP: Gross domestic
product
ISM: Institute for supply
management
LTD (last trading day): The
first day a contract may
trade or be closed out before
the delivery of the underlying
asset may occur.
PPI: Producer price index
Quadruple witching Friday:
A day where equity options,
equity futures, index options,
and index futures all expire.
JUNE 2008
1 2 3 4 5 6
8 9 10 11 12 13 14
15 16 17 18 19 20 21
22 23 24 25 26 27 28
29 30 1 2 3 4
JULY 2008
29 30 1 2 3 4
6 7 8 9 10 11 12
13 14 15 16 17 18 19
20 21 22 23 24 25 26
27 28 29 30 31 1 2
The information on this page is
subject to change. Futures &
Options Trader is not responsible
for the accuracy of calendar dates
beyond press time.
FUTURES & OPTIONS TRADER • June 2008
June
1 FDD: June crude oil, gasoline, and
natural gas futures (NYMEX)
2 May ISM manufacturing index
FDD: June gold, silver, platinum,
copper, palladium, and aluminum
futures (CME); June T-bond futures
(CME)
3 FND: June heating oil and propane
futures (NYMEX)
4 gold, silver, copper, and aluminum
5 FDD: June propane futures (NYMEX)
6 May unemployment
LTD: June live cattle options (CME);
July cocoa options (ICE); June
currency options (CME)
7 FDD: June heating oil futures
(NYMEX)
8
9 FND: June live cattle futures (CME)
10
11
12 FDD: June live cattle futures (CME)
13 May CPI
LTD: June lean hog futures (CME);
June lean hog options (CME); July
coffee, sugar, and cotton options
(ICE)
14
July
15
7 16 FND: June currency futures (CME)
LTD: June currency futures (CME)
17 May PPI
FND: July cocoa futures (ICE)
LTD: July crude oil options (NYMEX)
5 soybean, soybean product, wheat,
18 FDD: June currency futures (CME)
LTD: July platinum options (CME)
19 LTD: June T-bond and index futures
5
(CME); June index futures options
(CME)
20 FND: July coffee futures (ICE)
LTD: July crude oil futures (NYMEX)
LTD: July corn, soybean, soybean
product, wheat, rice, and oat options
(CBOT); July orange juice options
(ICE); June equity options
21
JUNE/JULY
MONTH
22
23
24 FOMC meeting
June consumer confidence
FND: July crude oil futures (NYMEX);
July cotton futures (ICE)
25 FOMC meeting
May durable goods
LTD: July heating oil, gasoline, and
natural gas options (NYMEX); July
options (CME)
26 Q1 GDP (final)
LTD: July gasoline and natural gas
futures (NYMEX)
LTD: June gold, silver, platinum,
copper, palladium, and aluminum
futures (CME)
27 FND: July gasoline and natural gas
futures (NYMEX)
28
29
30 FND: July gold, silver, platinum,
copper, palladium, and aluminum
futures (CME); July soybean, soy
bean product, corn, wheat, rice, and
oat futures (CBOT)
LTD: July heating oil and propane
futures (NYMEX); June live cattle
futures (CME); July sugar futures
(ICE); July lumber options (CME)
1 FDD: July crude oil, gasoline, and
natural gas futures (NYMEX); July
gold, silver, platinum, copper,
palladium, and aluminum futures
(CME); July coffee, sugar, cocoa, and
cotton futures (ICE); July corn,
rice, and oat futures (CBOT)
FND: July sugar and orange juice
futures (ICE)
2 FND: July heating oil and propane
futures (NYMEX)
3 LTD: August cocoa options (ICE)
4
5
6
7 FDD: July propane futures (NYMEX)
FND: July pork belly futures (CME)
31
 KEY CONCEPTS
American style: An option that can be exercised at any
time until expiration.
Arbitrage: The simultaneous purchase and sale of similar
or identical instruments (often in different geographical
locations) to take advantage of short-term price discrepan-
cies.
For example, gold trades in several major financial cen-
ters around the world — New York, London, Paris, Hong
Kong, and Tokyo. If gold were trading in New York for $780
per ounce and $782 per ounce in London, you could, in
effect, buy gold in New York and immediately sell an equal
amount in the London market and profit $2 per ounce.
Why would the metal be $2 higher in London? Short-
term supply and demand fluctuations: Perhaps a European
jeweler or metal fabricator placed a large order in the
London market. This short-term demand may cause the
price to rise in London relative to New York or other finan-
cial centers.
Assign(ment): When an option seller (or “writer”) is
obligated to assume a long position (if he or she sold a put)
or short position (if he or she sold a call) in the underlying
stock or futures contract because an option buyer exercised
the same option.
At the money (ATM): An option whose strike price is
identical (or very close) to the current underlying stock (or
futures) price.
Bear call spread: A vertical credit spread that consists
of a short call and a higher-strike, further OTM long call in
the same expiration month. The spread’s largest potential
gain is the premium collected, and its maximum loss is lim-
ited to the point difference between the strikes minus that
premium.
Bear flag: Flags are short-term consolidation patterns.
They are sometimes referred to as “continuation patterns”
because they are often pauses in price trends and imply the
continuation of those trends. Flags are essentially short-tem
trading ranges that last approximately three to 15 bars
(roughly one to three weeks on a daily chart), although
some people argue flags should consist of no more than 10
price bars.
A bear flag pattern represents a time when the market is
taking a “breather” — pausing before resuming a down-
trending move.
Bear put spread: A bear debit spread that contains puts
32
The option “Greeks”
Delta: The ratio of the movement in the option price for
every point move in the underlying. An option with a
delta of 0.5 would move a half-point for every 1-point
move in the underlying stock; an option with a delta of
1.00 would move 1 point for every 1-point move in the
underlying stock.
Gamma: The change in delta relative to a change in the
underlying market. Unlike delta, which is highest for
deep ITM options, gamma is highest for ATM options
and lowest for deep ITM and OTM options.
Rho: The change in option price relative to the change
in the interest rate.
Theta: The rate at which an option loses value each day
(the rate of time decay). Theta is relatively larger for
OTM than ITM options, and increases as the option gets
closer to its expiration date.
Vega: How much an option’s price changes per a one-
percent change in volatility.
with the same expiration date but different strike prices.
You buy the higher-strike put, which costs more, and sell
the cheaper, lower-strike put.
Beta: Measures the volatility of an investment compared
to the overall market. Instruments with a beta of one move
in line with the market. A beta value below one means the
instrument is less affected by market moves and a beta
value greater than one means it is more volatile than the
overall market. A beta of zero implies no market risk.
Box spread: A hedged position in which the profit is
determined in advance. A box contains one long call and
one short put that share the same strike. Also, the spread
contains one short call and one long put that share a higher
strike price. All four options expire at the same time.
Bull call spread: A bull debit spread that contains calls
with the same expiration date but different strike prices.
You buy the lower-strike call, which has more value, and
sell the less-expensive, higher-strike call.
Bull put spread (put credit spread): A bull credit
spread that contains puts with the same expiration date, but
different strike prices. You sell an OTM put and buy a less-
expensive, lower-strike put.
Calendar spread: A position with one short-term short
June 2008 • FUTURES & OPTIONS TRADER
option and one long same-strike option with more time
until expiration. If the spread uses ATM options, it is mar-
ket-neutral and tries to profit from time decay. However,
OTM options can be used to profit from both a directional
move and time decay.
Call option: An option that gives the owner the right, but
not the obligation, to buy a stock (or futures contract) at a
fixed price.
Carrying costs: The costs associated with holding an
investment that include interest, dividends, and the oppor-
tunity costs of entering the trade.
Collar: An options spread with three components — an
underlying long position, a short call, and a long put that
expires in the same month. It is a conservative, flexible strat-
egy that profits if the underlying trades within a certain
range by expiration. The strategy’s goal is to improve a long
position’s odds of success by adding low-cost downside
protection without limiting potential upside profits exces-
sively.
The Commitments of Traders report: Published
weekly by the Commodity Futures Trading Commission
(CFTC), the Commitments of Traders (COT) report breaks
down the open interest in major futures markets. Clearing
members, futures commission merchants, and foreign bro-
kers are required to report daily the futures and options
positions of their customers that are above specific report-
ing levels set by the CFTC.
For each futures contract, report data is divided into three
“reporting” categories: commercial, non-commercial, and
non-reportable positions. The first two groups are those
who hold positions above specific reporting levels.
The “commercials” are often referred to as the large
hedgers. Commercial hedgers are typically those who actu-
ally deal in the cash market (e.g., grain merchants and oil
companies, who either produce or consume the underlying
commodity) and can have access to supply and demand
information other market players do not.
Non-commercial large traders include large speculators
(“large specs”) such as commodity trading advisors (CTAs)
and hedge funds. This group consists mostly of institution-
al and quasi-institutional money managers who do not deal
in the underlying cash markets, but speculate in futures on
a large-scale basis for their clients.
The final COT category is called the non-reportable posi-
tion category — otherwise known as small traders — i.e.,
the general public.
FUTURES & OPTIONS TRADER • June 2008
Covered call: Shorting an out-of-the-money call option
against a long position in the underlying market. An exam-
ple would be purchasing a stock for $50 and selling a call
option with a strike price of $55. The goal is for the market
to move sideways or slightly higher and for the call option
to expire worthless, in which case you keep the premium.
Credit spread: A position that collects more premium
from short options than you pay for long options. A credit
spread using calls is bearish, while a credit spread using
puts is bullish.
Debit: A cost you must pay to enter any position if the
components you buy are more expensive than the ones you
sell. For instance, you must pay a debit to buy any option,
and a spread (long one option, short another) requires a
debit if the premium you collect from the short option does-
n’t offset the long option’s cost.
Debit spread: An options spread that costs money to
enter, because the long side is more expensive that the short
side. These spreads can be verticals, calendars, or diagonals.
Deep (e.g., deep in-the-money option or deep
out-of-the-money option): Call options with strike
prices that are very far above the current price of the under-
lying asset and put options with strike prices that are very
far below the current price of the underlying asset.
Delivery period (delivery dates): The specific time
period during which a delivery can occur for a futures con-
tract. These dates vary from market to market and are deter-
mined by the exchange. They typically fall during the
month designated by a specific contract - e.g. the delivery
period for March T-notes will be a specific period in March.
Delta-neutral: An options position that has an overall
delta of zero, which means it’s unaffected by underlying
price movement. However, delta will change as the under-
lying moves up or down, so you must buy or sell
shares/contracts to adjust delta back to zero.
Diagonal spread: A position consisting of options with
different expiration dates and different strike prices — e.g.,
a December 50 call and a January 60 call.
Donchian breakout (channel breakout, breakout
system, n-bar breakout): Named after the man who
popularized the approach, Richard Donchian, this
continued on p. 34
33
 KEY CONCEPTS continued
approach refers to buying a price move above an n-bar (n-
day, n-week, or n-minute, etc.) high and selling on a move
below a n-bar low. Donchian’s original “system” was called
the “four-week rule” and consisted of buying and selling
moves above and below the four-week high and low,
respectively.
Pure breakout systems are often designed in stop-and-
reverse (SAR) fashion: when a buy signal occurs, any exist-
ing short position is liquidated and a new long position is
simultaneously established; when a sell signal occurs, the
long position is liquidated and a new short position is
established. Thus, the system is always in the market.
One basic variation is whether a trade is triggered by a
simple penetration of the n-bar high or low or by a close
above an n-bar high or below an n-bar low.
European style: An option that can only be exercised at
expiration, not before.
Exercise: To exchange an option for the underlying
instrument.
Expiration: The last day on which an option can be exer-
cised and exchanged for the underlying instrument (usual-
ly the last trading day or one day after).
Float: The number of tradable shares in a public company.
Intermonth (futures) spread: A trade consisting of
long and short positions in different contract months in the
same market — e.g., July and November soybeans or
September and December crude oil. Also referred to as a
futures “calendar spread.”
In the money (ITM): A call option with a strike price
below the price of the underlying instrument, or a put
option with a strike price above the underlying instru-
ment’s price.
Intrinsic value: The difference between the strike price
of an in-the-money option and the underlying asset price. A
call option with a strike price of 22 has 2 points of intrinsic
value if the underlying market is trading at 24.
Leverage: An amount of “buying power” that increases
exposure to underlying market moves. For example, if you
buy 100 shares of stock, that investment will gain or lose
$100 for each $1 (one-point) move in the stock.
But if you invest half as much and borrow the other half
from your broker as margin, then you control those 100
34
shares with half as much capital (i.e., 2-to-1 buying power).
At that point, if the stock moves $1, you will gain or lose
$100 even though you only invested $50 — a double-edged
sword.
Limit up (down): The maximum amount that a futures
contract is allowed to move up (down) in one trading ses-
sion.
Lock-limit: The maximum amount that a futures contract
is allowed to move (up or down) in one trading session.
Long call condor: A market-neutral position structured
with calls only. It combines a bear call spread (short call,
long higher-strike further OTM call) above the market and
a bull call spread (long call, short higher-strike call). Unlike
an iron condor, which contains two credit spreads, a call
condor includes two types of spreads: debit and credit.
Long-Term Equity AnticiPation Securities
(LEAPS): Options contracts with much more distant expi-
ration dates — in some cases as far as two years and eight
months away — than regular options.
Market makers: Provide liquidity by attempting to prof-
it from trading their own accounts. They supply bids when
there may be no other buyers and supply offers when there
are no other sellers. In return, they have an edge in buying
and selling at more favorable prices.
Naked option: A position that involves selling an unpro-
tected call or put that has a large or unlimited amount of
risk. If you sell a call, for example, you are obligated to sell
the underlying instrument at the call’s strike price, which
might be below the market’s value, triggering a loss. If you
sell a put, for example, you are obligated to buy the under-
lying instrument at the put’s strike price, which may be well
above the market, also causing a loss.
Given its risk, selling naked options is only for advanced
options traders, and newer traders aren’t usually allowed
by their brokers to trade such strategies.
Naked (uncovered) puts: Selling put options to collect
premium that contains risk. If the market drops below the
short put’s strike price, the holder may exercise it, requiring
you to buy stock at the strike price (i.e., above the market).
Near the money: An option whose strike price is close
to the underlying market’s price.
June 2008 • FUTURES & OPTIONS TRADER
Open interest: The number of options that have not
been exercised in a specific contract that has not yet expired.
Opportunity cost: The value of any other investment
you might have made if your capital wasn’t already in the
market.
Outlier: An anomalous data point or reading that is not
representative of the majority of a data set.
Out of the money (OTM): A call option with a strike
price above the price of the underlying instrument, or a put
option with a strike price below the underlying instru-
ment’s price.
Parity: An option trading at its intrinsic value.
Physical delivery: The process of exchanging a physical
commodity (and making and taking payment) as a result of
the execution of a futures contract. Although 98 percent of
all futures contracts are not delivered, there are market par-
ticipants who do take delivery of physically settled con-
tracts such as wheat, crude oil, and T-notes. Commodities
generally are delivered to a designated warehouse; t-note
delivery is taken by a book-entry transfer of ownership,
although no certificates change hands.
Premium: The price of an option.
Put option: An option that gives the owner the right, but
not the obligation, to sell a stock (or futures contract) at a
fixed price.
Put ratio backspread: A bearish ratio spread that con-
tains more long puts than short ones. The short strikes are
closer to the money and the long strikes are further from the
money.
For example, if a stock trades at $50, you could sell one
$45 put and buy two $40 puts in the same expiration month.
If the stock drops, the short $45 put might move into the
money, but the long lower-strike puts will hedge some (or
all) of those losses. If the stock drops well below $40, poten-
tial gains are unlimited until it reaches zero.
Put spreads: Vertical spreads with puts sharing the same
expiration date but different strike prices. A bull put spread
contains short, higher-strike puts and long, lower-strike
puts. A bear put spread is structured differently: Its long
puts have higher strikes than the short puts.
FUTURES & OPTIONS TRADER • June 2008
Ratio spread: A ratio spread can contain calls or puts and
includes a long option and multiple short options of the
same type that are further out-of-the-money, usually in a
ratio of 1:2 or 1:3 (long to short options). For example, if a
stock trades at $60, you could buy one $60 call and sell two
same-month $65 calls. Basically, the trade is a bull call
spread (long call, short higher-strike call) with the sale of
additional calls at the short strike.
Overall, these positions are neutral, but they can have a
directional bias, depending on the strike prices you select.
Because you sell more options than you buy, the short
options usually cover the cost of the long one or provide a
net credit. However, the spread contains uncovered, or
“naked” options, which add upside or downside risk.
Simple moving average: A simple moving average
(SMA) is the average price of a stock, future, or other mar-
ket over a certain time period. A five-day SMA is the sum of
the five most recent closing prices divided by five, which
means each day’s price is equally weighted in the calcula-
tion.
Strike (“exercise”) price: The price at which an under-
lying instrument is exchanged upon exercise of an option.
Support and resistance: Support is a price level that
acts as a “floor,” preventing prices from dropping below
that level. Resistance is the opposite: a price level that acts
as a “ceiling;” a barrier that prevents prices from rising
higher.
Support and resistance levels are a natural outgrowth of
the interaction of supply and demand in any market. For
example, increased demand for a stock will cause its price
to rise, creating an uptrend. But when price has risen to a
certain level, traders and investors will take profits and
short sellers will come into the market, creating “resistance”
to further price increases. Price may retreat from and
advance to this resistance level many times, sometimes
eventually breaking through it and continuing the previous
trend, other times reversing completely.
Support and resistance should be thought of more as gen-
eral price levels rather than precise prices. For example, if a
stock makes a low of 52.15, rallies slightly, then declines
again to 52.15, then rallies again, a subsequent move down
to 52 does not violate the “support level” of 52.15. In this
case, the fact that the stock retraced once to the exact price
level it had established before is more of a coincidence than
anything else.
continued on p. 36
35
 KEY CONCEPTS continued
Time decay: The tendency of time value to decrease at an
accelerated rate as an option approaches expiration.
Time spread: Any type of spread that contains short
near-term options and long options that expire later. Both
options can share a strike price (calendar spread) or have
different strikes (diagonal spread).
Time value (premium): The amount of an option’s
value that is a function of the time remaining until expira-
tion. As expiration approaches, time value decreases at an
accelerated rate, a phenomenon known as “time decay.”
Vertical spread: A position consisting of options with
the same expiration date but different strike prices (e.g., a
September 40 call option and a September 50 call option).
Volatility: The level of price movement in a market.
Historical (“statistical”) volatility measures the price fluctu-
EVENTS
Event: Electronic Trading: Securities Industry
Structure and Trends
Date: June 11-12
Location: London
For more information: http://www.fmwonline.com
Event: The Options Initiative Two-day Seminars
Dates: July 17, Nov. 20
Location: CBOE Options Institute, Chicago
For more information: http://www.cboe.com
Event: Traders Expo Los Angeles
Date: June 18-21
Location: Ontario Convention Center
For more information: http://www.tradersexpo.com
Event: Real Trading with Dan Sheridan
Date: July 24, Sept. 24
Location: CBOE Options Institute, Chicago
For more information: http://www.cboe.com
36
ations (usually calculated as the standard deviation of clos-
ing prices) over a certain time period — e.g., the past 20
days. Implied volatility is the current market estimate of
future volatility as reflected in the level of option premi-
ums. The higher the implied volatility, the higher the option
premium.
Volatility skew (“smile”): The tendency of implied
option volatility to vary by strike price. Although, it might
seem logical that all options on the same underlying instru-
ment with the same expiration would have identical (or
nearly identical) implied volatilities. For example, deeper
in-the-money and out-of-the-money options often have
higher volatilities than at-the-money options. This type of
skew is often referred to as the “volatility smile” because a
chart of these implied volatilities would resemble a line
curving upward at both ends. Volatility skews can take
other forms than the volatility smile, though.
Event: TradeStation’s Two Day Futures Symposium
Date: June 26-28
Location: Wyndham Drake, Oak Brook, Ill.
For more information: Call (800) 808-3241
Event: The Options Intensive Two-day Seminars
Dates: Aug. 14, Oct. 23, Dec. 4
Location: CBOE Options Institute, Chicago
For more information: http://www.cboe.com
Event: Forex Trading Expo
Date: Sept. 12-13
Location: Mandalay Bay Resort & Casino, Las Vegas
For more information: http://www.tradersexpo.com
Event: Traders Expo Las Vegas
Date: Nov. 19-22
Location: Mandalay Bay Resort & Casino, Las Vegas
For more information: http://www.tradersexpo.com
June 2008 • FUTURES & OPTIONS TRADER
 NEW PRODUCTS AND SERVICES

Vhayu and StreamBase have joined forces to deliver
an integrated platform for real-time and historical market
data storage and analysis. The platform provides financial
institutions with easy-to-use, high performance complex
event processing (CEP) software integrated with a high-
speed tick database. Customers using StreamBase and
Vhayu can build real-time applications that load or query
large volumes of historical tick data. StreamBase’s high per-
formance CEP platform and Vhayu’s Velocity enterprise
class market data analysis and storage solution allow cus-
tomers to back-test their real-time analytics by drawing on
large quantities of historical data. The partnership includes
the development of the new “StreamBase Chronicle for
Vhayu” integration layer, optimized for high performance
loading and querying. Global availability of the adapter and
joint sales and marketing activities are expected in Q3 2008.

NeuroDimension, Inc. (http://www.nd.com) has
unleashed Trader68, a broker application that handles fully
automated order routing to Interactive Brokers accounts
from third-party trading systems on Collective2
(http://www.collective2.com) as well as signals from
NeuroDimension’s TradingSolutions Real-Time product
(http://www.tradingsolutions.com). Trader68 features
support for stocks, ETFs, futures, and forex markets as well
as advanced asset allocation, complete trading history, and
“safeguards.” Safeguards allow advanced control over
automated trades and market activity to help prevent
potential losses in today’s volatile markets. Trader68 is free
and can be downloaded from the Trader68 Web site
(http://www.trader68.com).

Erik Long, creator of Fractal Finance, has a new product
called QT Quick Fire, designed for short-term intraday trad-
ing. The trading model exploits local and spatial price dis-
covery by trading a predicted price against actual price. The
effect is similar to an arbitrage between two instruments.
The program borrows from the modern science of chaos
theory, complexity theory, fractals, and bi-variate statistics.
Quantrade is putting the final touches on two major
upgrades to the module. QT Quick Fire version 2.0 contains
a dynamic predictor. In addition to the dynamic predictor,
QT Quick Fire 3.0 contains an error containment engine. To
learn more, visit http://quantrade.us/qtquickfire.htm. A
limited number of modules are available.

Eurex, the international derivatives exchange, is
launching derivatives on the MSCI Russia Index denomi-
nated in U.S. dollars on June 23. This step extends the exist-
ing products on Russian underlyings introduced in April
2007. This is the first time Eurex will offer derivatives based
on MSCI indices. The MSCI Russia Index comprises the
largest Russian companies by market capitalization meet-
38
ing certain minimum liquidity and free float screens, for
companies incorporated in Russia with a listing in Russia,
London, or New York. The weighting of the components is
not capped. It contains 32 companies, and it is reviewed
four times a year. Settlement of the index futures and index
options will be made in cash, with one index point worth
$25. The futures expire in March, June, September, and
December. Index options have expirations up to 24 months.
Eurex will also list a new option on Russian stock OJSC
Rosneft. The new contract comprises 100 shares, has a max-
imum maturity of 12 months, and delivery will be physical.
With this, the number of equity options on Russian under-
lyings available at Eurex will increase to five. Additionally,
Eurex offers trading in 19 Russian equity futures.

ICE Futures U.S. has introduced floor-based mini
options, including serial options, on the mini Russell 1000
and mini Russell 2000 index futures contracts. The mini
Russell 1000 and mini Russell 2000 index options are avail-
able in open-outcry trading on the ICE Futures U.S. trading
floor in New York. Serial option contract months for both of
the mini index contracts have also been introduced. The
contract months for serial options are January, February,
April, May, July, August, October, and November. Detailed
information about trading the Russell contracts on ICE is
available at http://www.theice.com/russell.

A new investment vehicle called Fixed Return Options
(FROs) are available to investors at online discount broker
TradeKing (http://www.tradeking.com). These binary
options are a simpler way for investors to begin trading
options without the confusing language and calculations
typically associated with the options market. The FROs’
unique “all-or-nothing” structure provides a straightfor-
ward approach to options with a maximum risk of $100 per
FRO contract. There are two kinds of fixed return options:
finish high and finish low options, each with a per-contract
fixed return amount of $100. The maximum potential profit
for long FROs is $100 per contract less the initial cost, while
the maximum profit for short FROs is the premium received
by the seller. The maximum potential loss for long FROs is
the initial cost, while the maximum loss for short FROs is
$100 per contract less the premium received. FROs are
European style, cash-settled, and are automatically exer-
cised if in-the-money at expiration. They are initially listed
on the American Stock Exchange and are available on 20
widely held equities and exchange traded funds (ETFs).
Note: The New Products and Services section is a forum for industry
businesses to announce new products and upgrades. Listings are adapt-
ed from press releases and are not endorsements or recommendations
from the Active Trader Magazine Group. E-mail press releases to
editorial@futuresandoptionstrader.com. Publication is not guaranteed.
June 2008 • FUTURES & OPTIONS TRADER
 FUTURES TRADE JOURNAL

Going with the flow in the

stock index futures market.
TRADE

Date: Friday, May 23.

Entry: Short June E-Mini Nasdaq 100 futures

(NQM08) at 1,965 and 1,955; long at 1,948.75.

Reasons for trade/setup: Wrapping up what

looks to be a down week, the market is wobbly;
traders are unlikely to reverse the trend dramatically
on the typically low-volatility day preceding the
three-day Memorial Day weekend. We’ll look to take
a shot or two in the direction of the intraday trend
with the goal of capturing a modest profit. We cannot
actively trade or watch positions in real-time.
The market has historically been bullish the week Source: TradeStation
after Memorial Day. In the event traders might want
to establish long positions toward the end of the day to position 1,945.75 a couple of hours after we entered.
themselves for this move, we’ll keep standing stop orders in the As it was, we lowered the initial stop to 1,958.75 and got
market to avoid getting caught in a late-day reversal. stopped out by a move to 1,959.00. Within 15 minutes or so, how-
ever, we decided we’d been stopped out prematurely and the
Initial stop: 1,971.75. market was poised to resume the intraday downtrend.
The rest of the day’s trading was fairly positive. We re-entered
Initial target: None. The goal is to lower the stop to below the the market (short) at 1,955.00 and, this time, put in an order to
breakeven point if the trade becomes profitable and hold the buy at 1,944.25. The next down move began to stall when it fell
position into the close. below 1,947, so we got out at 1,946.75.
Finally, acting on the failure of this last downswing to push
RESULT below the previous intraday low, we went long at 1,948.75: The
final portion of the day was approaching and the market was
Exit: 1,958.75 (first short); 1,946.75 (second short); 1,955 (long). poised to both liquidate intraday positions and establish new
longs for the coming week. However, we didn’t have extreme
Profit/loss: +6.25; 8.25; 6.25. confidence in the market’s bullish conviction, so we set a modest
profit target and resolved to go home flat. We raised the stop to
Trade executed according to plan? Yes. 1,949 as soon as possible, and the market took out the trade with-
in 20 minutes.
Outcome: First, the negatives: The trade highlights the prob- Between all three trades we captured just a little bit more (20.75
lem of attempting to trade on a very short-term basis while main- points) than we would have had we exited at the low of the day
taining (as so many people do) another job — because you can’t after the initial down move — and just a little less than the day
“baby sit” positions all day, you must leave standing stop orders session’s range of 22.00 points. Nothing wrong with that.

in the market to prevent them from getting steamrolled by huge
reversals. Note: Initial targets for trades are typically based on things such as the
However, this means it might be an equally responsible idea to historical performance of a price pattern or trading system signal.
have resting exit orders. We were operating under the assump- However, individual trades are a function of immediate market behavior;
tion this would be a relatively low-volatility day (which it was), initial price targets are flexible and are most often used as points at which
so perhaps we should have had a standing exit order to take a portion of the trade is liquidated to reduce the position’s open risk. As a
advantage of the type downdrafts that took the market down to result, the initial (pre-trade) reward-risk ratios are conjectural by nature.

TRADE SUMMARY
Date Contract Entry Initial Initial IRR Exit Date P/L LOP LOL
stop target
5/23/08 NQM08 1,965.00 1,971.75 — 1,958.75 5/23/08 6.25 (0.32%) 19.75 -2.75
1,955.00 — 1,944.25 1,946.75 8.25 (0.42%) 9.00 -0.50
1,948.75 1,942.25 1,955.00 0.96 1,955.00 6.25 (0.32%) 18.50 -1.00
Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit
during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

FUTURES & OPTIONS TRADER • June 2008 39

 OPTIONS TRADE JOURNAL

A non-directional trade pays off when AutoZone gets stuck in neutral.

FIGURE 1 — SHORT STRADDLE ON AUTOZONE

TRADE Selling a straddle is a good choice if you want to sell volatility and remain delta neutral.

Date: Friday, May 16.

Market: Options on
AutoZone, Inc. (AZO).

Entry: Short 20 June $125

straddles for a $12.50 credit.

Reasons for trade/setup:

AutoZone Inc. planned to
report earnings on Tuesday,
May 20, just three days after
May options expire. On May
16, the implied volatility (IV)
of its June options was higher
than its 52-week average IV
(39 vs. 32 percent, respective-
ly). Implied volatility tends to
Source: OptionVue
rise just before an earnings
report, causing premiums to
increase in value. However, IV tends to crash after earnings
reports are released. Greeks
In the past, AZO’s implied volatility has climbed before Delta — A short straddle is delta neutral and has no
earnings and dropped afterward, so we want to enter a directional bias. The position will earn the biggest profit if
position that will profit from a possible IV decline after the underlying goes nowhere.
AutoZone releases its third-quarter earnings report.
We sold 20 at-the-money (ATM) June 125 straddles for a Gamma — Although the position starts out delta neutral,
combined credit of $12.50 when AZO traded at 127 on May it is also short gamma. If AutoZone moves away from the
125 strike, the gammas and deltas will increase and the
16. We planned to exit after its report on May 20.
trade position will start to lose money as the directional
The goal is to enter a non-directional trade and sell
bias will work against us.
volatility. The trade will earn its maximum profit of $12.50
if AutoZone closes at the 125 short strike at expiration. If Implied volatility/vega — The position’s two short
AZO moves away from the short 125 strike at expiration, options should benefit from a drop in IV, allowing us to
the profit drops as one side of the short straddle moves out- buy them back at a lower price. The goal is to sell a strad-
of-the-money (OTM) and the other becomes in-the-money dle that is relatively expensive and have a short vega
(ITM). However, the trade will be profitable if the cost to position, which will profit if IV falls toward its average level
of roughly 31 to 33 percent.
cover the straddle’s ITM side is less than $12.50 at expira-
tion. For the purpose of this trade, though, we will only

40 June 2008 • FUTURES & OPTIONS TRADER

 FIGURE 2 — STRADDLING THE MARKET

This short straddle made money as implied volatility deflated after

AutoZone’s third-quarter earnings report on May 20.
hold the straddle until earnings are released.
We chose an ITM strike of 125 because stocks
often drop further than they climb following
earnings reports, which is why this straddle
has a slightly bearish bias.
Figure 1 shows the short straddle’s potential
profit and loss on different dates: trade entry
(May 16, dotted line), halfway until expiration
(June 3, dashed line), and expiration (June 21,
solid line). The short straddle will make money
as long as AZO doesn’t gain or lose more than
12.5 points by expiration.

Initial stop: Hold the position four days and

exit after earnings are released on May 20.
Source: eSignal
Initial target: Exit the position after implied
volatility drops from 39 percent to under 33 percent. could not have worked out better. Despite the short strad-
dle’s significant risks, the position lets you sell volatility
while remaining delta neutral.

RESULT
TRADE SUMMARY
Outcome: AutoZone reported positive third-quarter
earnings before the open on May 20 and the stock Entry date: Friday, May 16, 2008
jumped to $129 at the open and before falling to close Underlying security: AutoZone (AZO)
at $127 (see Figure 2). Implied volatility fell to 30 per-
cent. It was an ideal move for a short straddle — AZO Position: Short straddle
went nowhere and IV fell sharply. • 20 short June 125 calls
We bought back the 20 short June $125 straddles for
• 20 short June 125 puts
$10.40, a profit of $2.10, or $4,200 overall. The trade
Initial capital required: $25,000

TRADE STATISTICS Initial stop: Hold four days

Initial target: Exit after IV drops from 39% to 31%
May 16 May 20 Initial daily time decay: 168.9
Delta: -202.1 -648 Trade length (in days): 4
Gamma: 54.85 -134.9
P/L: $4,200 (16.8%)
Theta: 168.9 282.5
LOP: $4,200
Vega: -311.4 -575.3
LOL: -$400
Probability of profit: 64% 65%
LOP — largest open profit (maximum available profit during life of trade).
Breakeven point: 112.50/137.50 112.50/137.50
LOL — largest open loss (maximum potential loss during life of trade).

FUTURES & OPTIONS TRADER • June 2008 41

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