FOT200801

January 2008
Volume 2, No. 1
CRUDE OIL
pullback pattern p. 8
BREAKOUT ANTICIPATION SYSTEM
p. 22
SHORT INTEREST:
Trading investor sentiment p. 18
THE TIME DECAY
vs. delta trading edge p. 12
FUNDAMENTALS
and grain futures p. 26
CONTENTS
Futures Trading System Lab . . . . . . . .22

Bollinger Band breakout-anticipation
system
By Volker Knapp
Options Trading System Lab . . . . . . . .24

Covered calls on the Diamonds
By Steve Lentz and Jim Graham
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Trading Basics
Trading Strategies Rain, soil, and sun:
Oil driller strategy . . . . . . . . . . . . . . . . . . . . .8 Grain futures fundamentals . . . . . . . . . . .26
It doesn’t trigger often, but this signal has Grains are the oldest futures markets, but
the potential to identify favorable buying that doesn’t make them the simplest.
opportunities in the oil market. There’s a great deal of information to digest
By FOT staff before dipping your toes into the grain futures
pool.
The theta-vega relationship . . . . . . . . . . .12 By FOT staff
Focusing on these option “Greeks” can
continued on p. 4
help you avoid missteps when trading
calendar spreads.
By Darren Chu
Short interest and relative strength . . . .18

This contrarian approach combines relative
strength and short interest to identify stocks
that are poised for a “short-squeeze” rally.
By Bernie Schaeffer and Beth Gaston Moon
2 January 2008 • FUTURES & OPTIONS TRADER

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CONTENTS
News
NYMEX hopes it’s easy being Green . . .30
The New York Mercantile Exchange will
enter the emissions trading market with
the launch of the Green Exchange.
By Jim Kharouf
Senate moves CFTC reauthorization Futures Snapshot . . . . . . . . . . . . . . . . . . . .34

forward . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 Momentum, volatility, and volume
The Commodity Futures Trading statistics for futures.
Commission moves one step closer to
reauthorization and picks up some Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .35
additional power along the way. Notable volatility and volume in the
By Jim Kharouf options market.
OneChicago offers remedy Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

to credit squeeze . . . . . . . . . . . . . . . . . . . . .31
Single-stock futures on the Nasdaq 100 Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .38
and Russell 2000 ETFs are now available References and definitions.
at OneChicago.
By Jim Kharouf Futures & Options Calendar . . . . . . . . . . . .41
Options Watch: Financial Futures Trade Journal . . . . . . . . . . . . . . .42

sector ETF components . . . . . . . . . . . . .32 Managing a trade during a market shock.
Tracking bid-ask spreads on financial sector
stock options. Options Trade Journal . . . . . . . . . . . . . . .43
Another stock-split trade profits modestly
New Products and Services . . . . . . . . .33 with long ATM calls.
Have a question about something you’ve seen

in Futures & Options Trader?
Submit your editorial queries or comments to webmaster@futuresandoptionstrader.com.
Looking for an advertiser?

Click on the company name below for a direct link to the ad
in this month’s issue of Futures & Options Trader.
eSignal OptionVue
ISE RS of Houston
New York Expo TradeStation
OptionsMentoring Zecco

CONTRIBUTORS
CONTRIBUTORS
Bernie Schaeffer is chairman and CEO of Schaeffer’s

Investment Research, Inc. and author of The Option Advisor:
Wealth-Building Techniques Using Equity and Index Options. Schaeffer
A publication of Active Trader ®
has edited the Option Advisor newsletter since its inception in
For all subscriber services: 1981. He focuses on equity and index options, investor sentiment, and market
www.futuresandoptionstrader.com timing. He can be reached at http://www.SchaeffersResearch.com.
Editor-in-chief: Mark Etzkorn

Darren Chu is a corporate relations manager for the Montreal Exchange,
metzkorn@futuresandoptionstrader.com
servicing institutional and retail traders/brokers and the buy-side. Chu’s prior
Managing editor: Molly Flynn role at the Montreal Exchange involved educating retail investors, financial
mflynn@futuresandoptionstrader.com
industry professionals, students, and business groups on exchange-traded deriv-
Senior editor: David Bukey atives. Previously, Chu worked at CMC Markets, where he developed and taught
dbukey@futuresandoptionstrader.com
courses on CFD and forex trading. While at CMC Markets, Chu also served as a
Contributing editors: market analyst, providing market commentary to clients from the perspective of
Jeff Ponczak an active trader in the oil and gold markets. Chu is currently a member of the
jponczak@futuresandoptionstrader.com,
Keith Schap Canadian Securities Institute’s Derivatives Board.
Editorial assistant and

Webmaster: Kesha Green Volker Knapp has been a trader, system developer, and
kgreen@futuresandoptionstrader.com researcher for more than 20 years. His diverse background
encompasses positions such as German National Hockey team
Art director: Laura Coyle
lcoyle@futuresandoptionstrader.com player, coach of the Malaysian National Hockey team, and presi-
dent of VTAD (the German branch of the International Federation
President: Phil Dorman
pdorman@futuresandoptionstrader.com of Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc.
(http://www.wealth-lab.com), which he is still running.
Publisher,
Ad sales East Coast and Midwest:
Bob Dorman Jim Graham (advisor@optionvue.com) is the product man-
bdorman@futuresandoptionstrader.com
ager for OptionVue Systems and a registered investment advisor
Ad sales for OptionVue Research.
West Coast and Southwest only:
Allison Ellis
aellis@futuresandoptionstrader.com Steve Lentz (advisor@optionvue.com) is executive vice president of
OptionVue Research, a risk-management consulting company. He also heads
Classified ad sales: Mark Seger
mseger@futuresandoptionstrader.com education and research programs for OptionVue Systems, including one-on-one
mentoring for intermediate and advanced traders.
Volume 2, Issue 1. Futures & Options Trader is pub-
lished monthly by TechInfo, Inc., 161 N. Clark Street,
Suite 4915, Chicago, IL 60601. Copyright © 2007 Jim Kharouf is a business writer and editor with more than 10 years of
TechInfo, Inc. All rights reserved. Information in this
publication may not be stored or reproduced in any
form without written permission from the publisher.
experience covering stocks, futures, and options worldwide. He has written
The information in Futures & Options Trader magazine extensively on equities, indices, commodities, currencies, and bonds in the U.S.,
is intended for educational purposes only. It is not
meant to recommend, promote or in any way imply the Europe, and Asia. Kharouf has covered international derivatives exchanges,
effectiveness of any trading system, strategy or
approach. Traders are advised to do their own money managers, and traders for a variety of publications.
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.

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TRADING STRATEGIES
Oil driller strategy

A weekly bar pattern offers a good — if rare — entry point for traders
willing to hold a position for several weeks.
BY FOT STAFF
T rading oil can sometimes feel like trying to

grab a meteor by the tail — and 2007 was the
market’s biggest year in more than a decade.
Crude has essentially been in a nine-year bull market
(Figure 1), and many believe the market can only go up in
tern has not occurred very often in the past 24 years, but
when it has, the upside follow-through has often been sig-
nificant.
Definition of simplicity
the long run, given oil is a finite resource and unending tur- The pattern consists of a weekly bar in which the opening
moil in the Middle East always threatens (at least in the and closing prices are relatively near each other and are also
minds of traders) global supplies. in the upper 25 percent of the week’s range. In a nutshell,
Even if it seems like crude oil never pulls back, there are during such a week crude sells off at some point after trad-
signals when the market has finished up a downside move ing opens, and then rallies to climb near or above where it
and is ready to move higher. The following weekly bar pat- started the week, and in the upper end of the week’s trad-
ing.
FIGURE 1 — ONE-WAY STREET The implication is easy to grasp:
Crude oil has been in a powerful uptrend for nearly nine years, and topped Whatever catalysts or sentiment pushed
$100 for the first time in early January. the market lower earlier in the week have
either dissipated or been offset by the end
of the week.
If this pattern formed on a daily, hourly,
or 10-minute bar, this implication might
seem to be progressively inconsequential.
During any 10-minute period, for exam-
ple, the market might be pushed down
and recover for any number of reasons, or
just randomly. It is the longer-term week-
ly time frame that offers the possibility the
implication has significance.
To find out if this concept has any merit,
let’s consider the following pattern rules:
1. Both the open and close

prices must be in the
upper 25 percent of the
Source: TradeStation week’s range.

2. The difference between the FIGURE 2 — WEEKLY BUY BARS
open and close prices
Four of the weekly buy patterns occurred in 2007.
must be 0.064 percent or less
of the previous week’s
closing price.
As formulas the pattern rules are:
1. (CLOSE-LOW)/(HIGH-LOW)
>= 0.75 and
(OPEN-LOW)/(HIGH-LOW) >=
0.75 and
2. ABS(OPEN-CLOSE) <=
0.0064*PREVCLOSE
where
All prices are the most recent

week’s prices, except
PREVCLOSE, which is the previ- Source: TradeStation
ous week’s close
ABS = absolute value
FIGURE 3 — BULLISH WEEKLY CRUDE PATTERN
Figure 2 shows four recent exam- The pattern outperformed the typical market gain by a wide margin in the bullish
1998-2007 period, but its advantage was muted between 1983 and 1997. The
ples of the pattern.
pattern is definitely a bull-market phenomenon.
However, this pattern has a notable

weakness — its infrequency. There
were only six instances of the pattern
between April 1983 and the end of
1997 (with the first example in this
period coming in 1990) and 16 from
1998 to October 2007. In addition to
this being a small sample from which
to extrapolate, there is also the practi-
cal matter of how infrequently the
signal would trigger in the future — a
common problem with patterns
based on longer-term data.
Nonetheless, the results are fairly
consistent. Let’s look at the 1998-2007
period, since most of the signals
occurred then — not surprising, since
continued on p. 10
FUTURES & OPTIONS TRADER • January 2008 9

TRADING STRATEGIES continued
this was the more dynamic period for

crude, which increased nearly ten-
fold.
Understanding Table 1 Figure 3 compares the median per-
formance in the 10 weeks after the
Table 1 summarizes the price behavior for patterns to the average performance
one- to 10-week periods, showing the average,
for all one- to 10-week periods in the
median, maximum, and minimum price changes
analysis window. The gains after the
from:
pattern far outstrip crude oil’s typical
1. The pattern’s closing price to the gains — by two, three, or nearly four
closing price of the next day (week 1,
times.
2, etc.).
Table 1 shows the details of the
2. The pattern’s closing price to the 1998-2007 patterns. One of the most
next week’s highest high (largest up salient statistics is the probability of
move, or “LUM”).
gains from week to week — always
3. The pattern’s closing price to the next above 50 percent, and usually signifi-
week’s lowest low (largest down cantly higher. The results from the six
move, or “LDM”). 1983-1997 patterns were not as bullish
(the market itself was less bullish dur-
Also included are the standard deviations (StD) for the close-to-close changes
and the percentage of times the close-to-close change was positive (“% > 0”). ing this period, but the patterns also
Figure A shows the close-to-close moves, LUMs, and LDMs from the initial outperformed the market during this
bar to the two subsequent bars. period). See “Understanding Table 1”
for more information about the fig-
ures in Table 1.
TABLE 1 — 1998-2007 PATTERN DETAILS
The probability of higher closes for the first 10 weeks after the pattern was always at least 50 percent, and usually much higher.
+1 LUM LDM +2 LUM LDM +3 LUM LDM +4 LUM LDM +5 LUM LDM
Avg 0.98 1.61 -1.30 0.74 2.67 -1.93 1.46 3.61 -2.26 3.19 4.45 -2.28 3.16 5.05 -2.80
Med 0.73 1.39 -0.82 0.67 1.70 -1.19 0.48 2.22 -1.37 1.57 2.80 -1.52 1.86 3.28 -2.27
Max 4.34 4.86 0.00 7.16 8.33 0.00 12.07 12.21 -0.26 16.14 16.21 -0.26 16.53 18.31 -0.26
Min -1.40 0.00 -3.33 -5.13 0.52 -5.19 -5.56 0.99 -7.64 -2.57 0.99 -7.64 -4.68 1.20 -14.12
StD 1.47 1.27 1.24 3.24 2.31 1.61 4.40 3.32 1.92 4.86 4.36 1.92 5.32 4.79 3.29
%<0 68.75% 62.50% 50.00% 75.00% 75.00%
+6 LUM LDM +7 LUM LDM +8 LUM LDM +9 LUM LDM +10 LUM LDM
Avg 4.13 5.68 -2.17 4.63 6.21 -2.31 4.62 7.50 -2.34 5.19 8.25 -2.57 5.50 8.84 -3.18
Med 3.06 3.86 -2.82 3.74 5.26 -2.82 4.07 5.50 -2.82 5.79 7.75 -2.82 4.93 7.75 -2.82
Max 15.31 18.31 -0.26 19.65 20.17 -0.26 18.57 20.17 -0.26 23.48 23.62 -0.26 27.55 27.62 -0.81
Min -2.86 1.36 -4.03 -4.21 1.36 -4.83 -4.48 1.36 -5.17 -5.45 1.36 -6.66 -8.77 1.36 -10.16
StD 4.71 4.77 1.40 5.99 5.01 1.57 5.63 5.73 1.61 6.81 6.23 1.96 8.22 6.96 2.33
%<0 85.71% 85.71% 71.43% 78.57% 71.43%

Again, some traders may be thrown by the pattern’s
infrequency, but trade opportunities are trade opportuni- Related reading
ties. Furthermore, if these patterns coincide with more fre- “Futures Insight: Crude oil”
quent signals, there is more reason to pay attention to their Active Trader, July 2004.
bullish implications. A broad analysis of the crude oil market helps highlight its
seasonal patterns and its tendency to make runs.
Not a bear pattern “Short-term crude oil tendencies”

In the past 20 years crude oil has made only a couple of sig- Futures & Options Trader, June 2005.
nificant, extended bear moves — 1997 to 1999 and late 2000 Crude can be a wild market, but understanding the typical
to late 2001 (and only two patterns formed during these price behavior of both the pit and electronically traded
four years). Nonetheless, downtrending market conditions sessions will improve your trading strategies and sharpen
your skills.
would likely negatively affect this pattern — that is, signal
a long trade when the market is likely to continue lower — “Using spreads to find back-month crude oil trades”
or erase it altogether, as the 1997-1999 and 2000-2001 peri- Futures & Options Trader, October 2007.
ods suggest. While many traders have come to believe the A practical approach to analyzing spread relationships can
crude oil market is destined to remain in an uptrend, such be used to locate outright trade opportunities in crude oil.
broad assumptions have a way of unraveling when you
least expect. Markets change, and strategies must change You can purchase and download past articles at
with them. http://www.activetradermag.com/purchase_articles.htm.
TRADING STRATEGIES
The theta-vega
relationship
Profiting from a drop in implied volatility with calendar spreads isn’t as easy as you might think.
The trick is to keep your eye on theta and vega.
BY DARREN CHU
M
TABLE 1 — VEGA AND THETA
ost traders understand options decay in
A long options position is long vega and short theta, which
value over time, but many fail to realize
means its value increases if IV climbs while time works
how the relationship between time decay
against it. This relationship is reversed for short options.
and implied volatility (IV) can influence
an option’s price. The option “Greeks” measure different Options position Vega Theta
ways an option’s price can change: Theta tracks its time Long + -
decay and vega gauges its sensitivity to IV changes. Short - +
Although many traders can define these terms, few can
profit from how they interact. Always remember to adjust theta’s value to match a
Retail traders often enter calendar spreads if the near- trade’s holding period. If, for example, you expect to hold
month option’s IV seems inflated and they expect it to drop. an at-the-money (ATM) option for 14 calendar days, you
However, these spreads can backfire if the longer-term could multiply its annualized theta by 14/365 to calculate
option’s IV is also higher than usual. The trick is to measure theta for this period. However, time decay accelerates for
a position’s total vega and theta to see how it might react to ATM options, particularly in the month before they expire.
changes in implied volatility and the passage of time. Therefore, predicting time decay with this method only pro-
The following examples use calendar spreads (short vides an estimate.
option, long same-strike option that expires later) to illus- Time decay is more linear for out-of-the-money (OTM)
trate how individual options and more complex strategies and in-the-money (ITM) options, and it actually decelerates
may be impacted by changes in theta, vega, and implied in the final days before expiration. The reason is that OTM
volatility. and ITM options have less time value, which decays rapid-
ly toward expiration. Because time decay of OTM and ITM
Defining theta options slows as expiration approaches, options sellers tend
Theta estimates the rate at which an option loses value as to exit earlier than if they had sold ATM options.
time passes, assuming
all other option-pricing
TABLE 2 — CALENDAR CALL SPREAD ON MERRILL LYNCH
factors remain constant.
Traders often refer to This Merrill Lynch calendar spread costs $4.60 and has a positive vega, which means it will
theta as an annualized or benefit from an increase in IV.
daily value. For instance, Per-share numbers
if an option’s annualized
Components Long/short Vega Theta Cost Dollar cost
theta value is -3.5, its
value should drop by 1 April 55 MER call Long 0.134 -0.0284 -$7.20 -$720.00
$3.50 in 365 calendar 1 December 55 MER call Short -0.059 0.0606 $2.60 $260.00
days (if nothing else Totals: 0.075 0.0322 -$4.60 -$460.00
changes).

FIGURE 1 — MERRILL LYNCH
Merrill’s implied volatility (blue line) remained below 40 percent for much of 2007 before
it jumped to historically high levels in November. Selling this seemingly high IV is tempt-
ing, but traders have bid up MER’s IV for a reason.
Both long calls and puts
have negative thetas because
they lose value as time passes.
Short options, on the other
hand, have positive thetas and
benefit from time decay. To cal-
culate the combined theta of a
strategy with multiple options,
just add each option’s theta
value.
Calculating a position’s total
theta can help ensure it benefits
from the passage of time. You
can also determine its total
delta or vega with the same
approach.
Defining vega
Most options traders know that
an option’s value is boosted, or Source: OptionVue
at least supported, by higher
implied volatility. The option Greek
vega measures an option’s sensitivity
to IV changes and represents the the-
oretical amount the option’s value
will change if IV climbs or falls one
percentage point.
Suppose a front-month option on
Research in Motion (RIMM) was near
the money with an IV of 75 percent
and a vega of 0.120. If IV climbed to
76 percent, you could expect the
option’s value to increase by roughly
$0.12, assuming all other option-pric-
ing factors remain constant.
Conversely, if IV fell to 74 percent, the
option’s premium should drop by
$0.12. ATM vegas tend to be roughly
equal for calls and puts (regardless of
time to expiration) and differ more as
options become deeper OTM or ITM.
Relationship between
vega and theta
To better appreciate volatility, think of
it as time. Long options benefit from
an increasingly volatile underlying,
because they are more likely to move
into the money and be profitable at
expiration. With more time to expira-
continued on p. 14

TABLE 3 — VOLATILITY DROPS, SPREAD LOSES VALUE

This Barrick Gold calendar spread seems poised to profit from an IV drop. However, the spread lost $0.07 even though
both options’ IV fell, because its total vega was positive.
Barrick Gold (ABX) closed at $32.39 on Aug. 16:

Components Long-short Bid-ask IV Vega comments
1 Sept. 34 call Short $1.10-$1.17 42.46% October 34 vega is higher than September 34 vega,
as the October call has more time to expiration.
1 Oct. 34 call Long $1.46-$1.62 39.06%
Spread cost: $0.52
Barrick Gold (ABX) climbed to $34.48 by Aug. 23:

Components Long-short Bid-ask IV Vega comments
1 Sept. 34 call Short $1.44-$1.55 31.88% Call vegas benefit from the calls being closer to ATM,
but suffer from time to expiration falling; October 34
vega remains higher than September 34 vega, as the
October call has more time to expiration.
1 Oct. 34 call Long $1.99-$2.10 31.38%
Spread cost: $0.45
Gain/loss: -$0.07
tion, an option has more extrinsic time value, and therefore ing factors fall.
more vega. Table 1 shows a long options position is long vega and
Short options, however, lose value as both time and short theta, while a short options position is short vega and
volatility diminish. Options sellers want to avoid assign- long theta. ATM options typically have the largest time
ment, and this process becomes less likely as these two pric- value; theta is highest at these strikes, because they have the
greatest potential for time decay. Vega is also highest in
ATM strikes, which makes sense if you think of volatility as
synthetic time. Using the same reasoning, the more volatile
Calendar spreads the underlying asset, the greater theta’s value.
Meanwhile, deep ITM options trade close to their intrin-
A calendar, or time, spread contains one long call (put) sic values and contain little time value, resulting in low
option and another short call (put) on the same underlying thetas and vegas. Deep OTM options lack intrinsic value
instrument with the same strike price, but with a shorter and have very little time value. Therefore, theta and vega on
term to expiration. The spread reaches its maximum gain
these options are also low.
when the underlying closes at the strike when the shorter-
term option expires. Calendar spreads work with any strike
price as long as both options share the same strike. Position vega
If, for example, a stock traded at $101, you could sell a Calculating the Greeks for multi-legged positions is impor-
front-month call with a 100 strike and buy a four-month, tant, because their net totals (position Greeks) reveal how
same-strike call to protect it. If the stock falls to $100 by the these trades may react to specific changes in the underly-
first expiration, you will keep the short call’s premium. At ing’s price, time to expiration, volatility, and so on. To cal-
that point, the long call will still have some time value, and culate a position’s overall vega or theta, simply add each
you could either sell it or hold it (if you believe the underly- option’s values together.
ing will rebound sufficiently by the second expiration).
Let’s assume you were either neutral or somewhat bear-
At-the-money (ATM) calendar spreads are most prof-
itable in flat markets and exploit the short option’s time ish on Merrill Lynch (MER) when it closed at $53.54 on Nov.
decay. However, out-of-the-money (OTM) calendars are 23. Therefore, you decided to enter a call calendar spread by
ideal if you expect the market to climb (or drop) to the selling a December 55 call for $2.60 and buying an April
shared strike price at the front-month expiration. 2008 55 call for $7.20 (Table 2). This trade will offer the
largest profit if MER trades below the 55 strike until the first

expiration on Dec. 15 and then trades higher by the second could be “expensive.”
expiration on April 19, 2008. Figure 1 shows a daily chart of Merrill Lynch and com-
Traders often buy calendar spreads to take advantage of pares SV and IV levels since October 2006 (brown and blue
short-term options’ greater rate of time decay. This position lines, respectively). In November MER’s implied volatility
is also called a horizontal, or time, spread and contains all spiked to historically high levels as the December and April
calls or puts at the same strike, but different expiration 55 calls’ IVs were 54.5 percent and 53 percent, respectively.
months. For more details about calendar spreads, see By contrast, Merrill’s IV and SV were below 40 percent dur-
“Calendar spreads.” ing most of 2007.
The first step in measuring position vega is to identify If you believe the long December/April calendar’s vega
each option’s vega. The short December call’s vega is 0.059, risk is too high, you could sell the same calendar spread
while the long April call’s vega is 0.134. Simply add these instead by buying the December call and selling its April
values and then multiply by the number of shares each call 2008 counterpart. But selling the April call is very risky
represents (100): because it will sit uncovered after the long December call
expires.
Short December 55 call’s vega = 0.059 * 100 shares * New options traders often assume calendar spreads are a
-1 contract = -5.9 sure thing. Their logic is as follows: If you sell a near-month
Long April call’s vega = 0.134 * 100 shares * call to capture its high IV and buy a longer-term call with a
1 contract = 13.4 lower IV, you should make money. But IVs trade at certain
continued on p. 16
Net vega = 13.4 + -5.9 = 7.5
Remember that longer-dated options

have higher vegas than short-term
options, so calendar spreads always
have positive vegas, which means they
will benefit from an increase in implied
volatility.
When each of these two calls’ IV
climbs by one percentage point, the cal-
endar’s dollar value should appreciate
by $7.50, assuming all other variables
remain constant. In reality, however,
implied volatility rarely changes uni-
formly across different contracts. For
instance, the December 55 call’s IV may
fall by 1 percentage point, while the
April 55 call’s IV may drop by 0.5 per-
centage points. For simplicity, however,
let’s assume options’ implied volatili-
ties change by the same amount.
The elusive volatility trade

Before buying options or entering a
position with positive vega, you
should compare the underlying’s over-
all current IV to its statistical volatility
(SV). In addition, you should compare
current IV levels to past values. If cur-
rent implied volatility is below these
levels, an option IV might be “cheap,”
and if current IV is higher, an option

Related reading
“Directional calendars on the S&P 500”
Futures & Options Trader, May 2007. levels for a reason. Before you decide
This system compares two strategies with similar profiles: a horizontal calen- to buy “low” volatility and sell “high”
dar spread and a butterfly spread. Both positions try to collect premium from volatility, you must understand the
short options and protect them with long options, but they protect against large fundamental and technical factors
losses differently. behind these numbers. Remember, the
markets are efficient, especially with
“Calendar spreads surrounding earnings news” liquid options classes.
Options Trader, March 2007.
More versatile than you might think, these calendar spreads profit from
Position theta
changes in volatility rather than the time decay.
You can calculate a position’s total
theta in the same way you calculate its
“Swing with the market: Vega and rho”
Options Trader, February 2007.
vega: Identify each option’s value and
Vega and rho are lesser-known “Greeks,” but they measure the effect of two add them together.
critical option-pricing components: implied volatility and interest rates. For example, on Nov. 24 Merrill
Lynch’s December 55 call had a theta
“Know your theta” of 0.0606, and its April 2008 55 call
Options Trader, January 2007. had a theta of 0.0284. This means the
Time eats away at every options position, so it pays to know time decay affects spread benefited from time decay,
option prices. because the December call was decay-
ing from time passing at more than
“Calendar spreads after earnings releases” twice the rate of the April call. The
Options Trader, September 2006. position’s theta was:
The system placed an at-the-money (ATM) horizontal debit (calendar) spread
on stocks after quarterly earnings were announced. Short December 55 call’s theta =
-0.0606 * 100 shares *
“Calendar spreads on the S&P 500” -1 contract = 6.06
Options Trader, August 2006. Long April call’s theta =
This system tested an at-the-money (ATM) horizontal (calendar) debit spread -0.0284 * 100 shares *
strategy on the cash-settled options of the S&P 500. 1 contract = -2.84
“Death, taxes, and time decay”

Net theta = 6.06 + -2.84 = 3.22
Options Trader, March 2006.
Markets that go nowhere can be frustrating, but call calendar and diagonal
The MER December/April 55 call
spreads can generate respectable profits in these situations by taking
calendar’s net theta was positive, and
advantage of time decay.
the spread was gaining $3.22 per day
“Calendar spreads: Taking time out of the market” (as of Nov. 24).
Options Trader, February 2005. Remember theta increases notably
Trading time spreads offers a way to take advantage of time decay and in the final 30 days before an ATM
volatility changes while limiting risk. option expires. Therefore, calendar-
spread traders typically sell the short
Many of these articles are included in “Options Trading System Labs, leg in the front month. Once the short
Volume 2,” a collection of 12 articles that show historical performance of dif- call expires, the spread becomes an
ferent options positions. These strategies are rarely back-tested, but Futures & outright long call position, which
Options Trader showcases back-tested option-trading systems in each issue. remains long vega, but becomes short
This collection contains all the monthly Options Trading System Lab articles theta (see Table 1).
from 2006, exploring event-based strategies, sentiment plays, and non-direc-
tional techniques. Don’t ignore vega
These articles are designed to show good and bad trade ideas. As a result, and implied volatility
back-testing results in some articles may indicate a system or trade idea is The next example in Barrick Gold
likely to be unprofitable. Corp. (ABX) highlights the relation-
You can purchase and download past articles at ship between vega and implied
http://www.activetradermag.com/purchase_articles.htm. volatility by describing how a poorly
constructed calendar spread can suf-

fer from a drop in implied volatility. (Although ABX and its spread to boost its odds of success? The trade would have
options trade on U.S.-based exchanges, the following exam- worked better if only the September call’s IV had climbed
ple uses underlying prices from the Toronto Stock Exchange — not the October call’s. However, the back-month con-
and option prices from the Montreal Exchange.) tract’s IV also rose, which suggested it was more vulnerable
Barrick Gold dropped 5.4 percent on Aug. 16 to close at to a similar-size IV decline in both contracts.
$32.39, and its implied volatility rose on the pullback. The Traders typically buy calendar spreads when they expect
September 34 call’s IV was 42.46 percent, while the same- IV to stay relatively low and stable until the short-term leg
strike October call’s IV was only 39.06 percent. When stocks expires. Ideally, the short option will expire worthless, and
fall, their near-term options’ IVs are often pushed higher the underlying will move in the right direction afterwards.
than IVs of longer-dated options of the same strike. Markets In addition, traders rarely construct calendar spreads
expect implied volatility to gradually subside after it spikes, with options in two back-to-back months, as in the Barrick
eventually reverting to its mean. Gold example. Instead, it’s better to enter a calendar spread
Without paying attention to either call’s vega, let’s with at least three months between its short and long legs.
assume you decide to buy the September /October 34 cal- For example, you could buy an option that expires in more
endar spread. The logic: You expect the September 34 call’s than three months and sell the front-month contract.
IV to decline further than the October call’s IV. Table 3 There are no set rules, however — the number of months
shows the spread costs $0.52 if you sell the September 34 between the calendar’s short and long legs depends on
call for $1.10 (bid) and buy the October 34 call at $1.62 (ask). your IV forecasts and the underlying’s direction as well as
As with all long calendar positions, this spread is long vega your tolerance for risk.
and long theta.
ABX gained 6.4 percent by Aug. 23 and closed at $34.48, For information on the author see p. 6.
above the spread’s strike. Table 3
shows the short September 34 call’s
bid-ask climbed to $1.44-$1.55, reflect-
ing about $1 in intrinsic value; its IV
fell to 31.88 percent, a drop of more
than 10 percentage points. The
October 34 call’s bid-ask rose to $1.99-
$2.10 as its IV declined to 31.38 per-
cent, a decline of nearly 8 percentage
points.
As expected, the September call’s IV
fell further than the October call’s,
which would seem to benefit the cal-
endar spread (if you ignore vega). If,
however, you sold the spread on Aug.
23, you would have collected only
$0.44 ($1.99 - $1.55), a loss of 8.5 per-
cent [(0.44 - 0.52)/0.52] in one week.
What went wrong?

Calendar spreads are always net long
vega, so you should never buy one if
you expect both options’ IVs to drop.
In a calendar spread, the short
option’s vega is always lower than the
long call’s vega. (Remember that later-
expiring options have higher vegas.)
Even though the short call’s IV fell
further than the long call’s IV, the long
call had a higher vega, which indicates
it was more sensitive to IV changes.
How could you have revised this

TRADING STRATEGIES
Short interest
and relative strength
Short sellers aren’t always right about a stock’s future direction. This technique
identifies opportunities to buy calls on stocks that are popular with the short-selling crowd.
BY BERNIE SCHAEFFER AND BETH GASTON MOON
S hort interest is the num-

ber of shares investors
have sold short on any
given stock or exchange
traded fund (ETF). When a stock is
sold short, shares are borrowed, sold,
and then bought back (covered) to
be a bullish signal. The reason: Short
sellers lose money when the underly-
ing price rises, and the more price
climbs, the more likely they will cut
losses and buy their positions back —
a “short-covering” rally. This analysis
suggests one way to find potentially
If a stock’s short interest climbs sub-
stantially and price advances, short
sellers might get “squeezed” and be
forced to exit, boosting price further
and perpetuating the cycle.
Historical patterns
close the trade. Despite these added bullish stocks by combining short Short interest can also help you find a
steps, selling short is simply the oppo- interest and relative strength. bullish options trade. For an aggres-
site of buying stock, because price sive options trade to truly succeed, it
must decline for the trade to become Short interest as fuel has to subscribe to the “FAR” concept
profitable. Generally, a high volume of short by moving fast, aggressively, and in
At first glance, a large amount of interest indicates investors have a neg- the right direction. Stocks that are
short interest seems negative, because ative outlook for a stock (although heavily shorted tend to be more
traders are betting on the stock to fall. heavy short interest can also be created volatile after two-day gains of at least
From a contrarian viewpoint, however, from arbitrage situations such as eight percent, which can help options
this pessimism isn’t necessarily a bear- mergers and the release of convertible buyers. Also, high-short-interest stock
ish sign, especially if the stock has out- bonds). But contrarians believe this prices tend to advance after these ral-
performed on a technical basis. pessimism could be bullish if the stock lies as short sellers throw in the towel.
Historically, stocks that recently out- is in an uptrend. Table 1 breaks down short interest
performed the broader market despite Assuming other bullish factors exist, on NYSE and Nasdaq stocks into four
a large amount of short interest were stocks with high short-interest values categories — less than 5 percent, 5 to
more likely to trade higher within two are prone to rally, because short sellers 10 percent, 10 to 20 percent, and more
weeks. In these cases, short interest can act as potential buyers on the sidelines. than 20 percent of a stock’s float, or the
number of tradable shares, sold short.
Strategy snapshot The table shows how stocks performed
from 2005 to 2007 following two types
Strategy: Contrarian short-interest trade. of up moves: Five-percent gains in one
day (columns 1 to 3), and 8-percent
Market: Options on individual stocks.
gains in two days (columns 4 to 6).
Components: Long near-the-money, front-month calls. Table 1 also lists the number of signals
in each category and the percentage of
Logic: Stocks with high relative strength and large short-interest stocks that gained 10 percent within 10
values are more likely to jump in the next 10 days. days, respectively.
Criteria: Has outperformed S&P 500 by 20 percent in the past 60 Table 1’s statistics support the theo-
days, short interest of at least 1 million shares, and a short- ry that stocks with large short-interest
interest ratio of 7. values will hit this target most often.
After two-day jumps of eight percent
Historical High-short-interest stocks were 62 percent more likely (or more), mid-cap and large-cap
tendency: to gain 10 percent in 10 days. stocks were 50 percent more likely to

TABLE 1 — SHORT-INTEREST STATISTICS
High-short-interest stocks were 62 percent more likely to gain 10 percent within two weeks than their low-short-interest
counterparts (column 6, 12.87 percent vs. 7.96 percent, respectively).
Moved 5% in 1 day Moved 8% in 2 days

SI % range Signals Reached 10% in 10 days SI % range Signals Reached 10% in 10 days
> 5% 5,403 8.05% > 5% 2,814 7.96%
5% - 10% 3,752 8.66% 5% - 10% 2,041 9.11%
10% - 20% 2,701 9.14% 10% - 20% 1,466 9.14%
> 20% 1,765 12.18% > 20% 1,010 12.87%
Grand total 13,621 8.97% Grand total 7,331 9.19%
Source: http://www.schaeffersresearch.com
gain at least 10 percent within two ment, the short-interest ratio is particularly if an earnings report is
weeks if they had more than 10-per- the number of days needed to imminent.
cent short interest (not shown). close all shorted shares at the
This was an even more dramatic sig- stock’s average daily volume, Narrowing the list to one
nal when stocks had at least 20 percent assuming each trade represents stock
of their float sold short, regardless of short sellers covering their posi- One of the better selections from a fun-
their size (small-, mid-, and large-cap tions. The ratio effectively reveals damental, technical, and sentiment
stocks). For example, high-short-inter- the extent of short-covering perspective is BioMarin Pharma-
est stocks were 62 percent more likely potential. Contrarians view large ceuticals (BMRN). BMRN is a biophar-
to gain 10 percent within two weeks ratio values as bullish. maceutical company with two
than their low-short-interest counter- “orphan drugs” under its umbrella,
parts (see Table 1’s column 6, 12.87 Minimum stock price: $10. meaning BioMarin has exclusive mar-
percent vs. 7.96 percent, respectively). keting rights to these medications for
Several Web sites and software pro- continued on p. 20
The relative-strength, grams let you scan for stocks that meet
short-interest filter these criteria. These thresholds are
One way to find these potentially bull- merely suggestions and can be altered.
ish stocks is to scan the universe of Twenty-six stocks met all of these
stocks for a combination of high rela- specifications. The top relative-
tive strength and short interest. On strength stock was American Oriental
Oct. 31 the following criteria were Bioengineering (AOB), which outper-
used as a filter: formed the S&P 500 by 61 percent in
the last 60 days. However, Open Text
Relative-strength look-back period: (OTEX) had the largest short-interest
60 trading days ratio of 22.1.
Stocks must outperform the S&P The remaining stocks had solid
500 index for roughly 3 months. momentum, strong price action, and
short-covering potential. However,
Minimum relative strength: 1.2 there are additional factors you can
Stocks must outperform the S&P use to select candidates. One way is to
500 index by at least 20 percent focus on recent price action — just
during this period. because a stock outperformed the S&P
500 in the past three months doesn’t
Minimum short interest: 1,000,000 necessarily mean it gained ground in
Stocks must have at least 1 mil- the last several weeks.
lion open shorted shares. Other sentiment factors are relevant,
including analysts’ ratings (to deter-
Minimum average daily volume: mine the potential for upgrades or
500,000 downgrades on the underlying stock)
and options activity. Additionally, fun-
Minimum short-interest ratio: 7.0 damental variables such as earnings
Arguably the most important ele- momentum are important to check,

FIGURE 1 — BIOMARIN PHARMACEUTICALS (BMRN), MONTHLY seven years. Its fundamentals appear
BioMarin (BMRN) jumped 358 percent from Feb. 1, 2005 to Oct. 31, 2007, and strong — although biopharmaceutical
traded above its 10- and 20-month SMAs for most of this three-year period. companies are always at risk of
volatile price swings.
Figure 1’s monthly chart shows
BMRN jumped 358 percent from Feb.
1, 2005 to Oct. 31, 2007, and traded
above its 10- and 20-month simple
moving averages (SMA) for most of
this three-year period. In the last three
months, BioMarin gained 53.5 percent
and reached a new seven-year high of
$28.50.
On a short-term basis, Figure 2’s
daily chart shows BMRN has traded
above its 10-day and 20-day SMAs
since early August. Although
BioMarin pulled back below these
moving averages in mid-October, it
crossed above them just before reach-
ing a new yearly high on Oct. 27.
There were roughly 16.7 million
BMRN shares sold short in October.
Source: Thompson/ILX This represents 17.4 percent of
BioMarin’s float and a short-interest
ratio of 9.4. In other words, it would
FIGURE 2 — BIOMARIN PHARMACEUTICALS (BMRN), DAILY take 9.4 trading days — at the stock’s
Although BioMarin pulled back below its 10- and 20-day SMAs in mid-October, average daily volume — to buy back
it crossed above them just before reaching a new yearly high on Oct. 27. all of these short positions (assuming
only short sellers were trading to
close their positions on those days). In
the past two months, the number of
short BMRN shares has dropped
nearly 15 percent, which suggests
short sellers were already exiting, a
process that helps boost its price.
Options hold clues

about sentiment
Options sentiment boded well for
BioMarin from a contrarian perspec-
tive. For example, the Schaeffer’s
put/call open interest ratio (SOIR)
was 1.38 on Oct. 31, which means
there were 138 open puts for every
100 open calls — a bearish preference
from the options crowd. This SOIR
reading was higher than 88 percent of
daily values in the last year, meaning
the indicator neared an annual
Source: Thompson/ILX
extreme.

The majority of open calls were
Related reading by Bernie Schaeffer
in-the-money (ITM, below the stock’s
current price), reducing the threat of “Three types of debit spreads: Bullish, bearish, and neutral”
options-related resistance. Alter- Futures and Options Trader, July 2007.
nately, put open interest offered a Paying to enter an option spread may not be popular, but it can help control
layer of structural support, as most of risk. Learn how to match your market forecast with the right spread.
BMRN’s open short-term puts were
out-of-the-money (OTM, below the “Option pair trading expands profit horizon”
stock’s current price). Options Trader, February 2007.
Buying a call in one stock and a put in another is a simple strategy that can
Buying calls on BioMarin benefit from overlooked relationships between the stocks.
At the end of October, BioMarin trad-
ed in a strong uptrend that could “Getting sentimental about options”
accelerate amid short-covering activi- Active Trader, March 2002.
ty. How can you take advantage of a Successful option trading depends on a number of variables, but one many
possible short-term rally such as a 10- traders overlook is sentiment analysis. Find out what different sentiment tools
percent underlying gain in two represent and how they can round out your trading.
weeks?
One way is to simply buy BRMN
stock, but the leverage inherent in Other articles:
options can produce even bigger and
better gains. Because a call costs less “Short selling basics”
than buying stock, you can earn a Active Trader, December 2007.
large return on margin even if the From a regulation standpoint, selling short is easier now that it was a year ago,
underlying climbs only modestly. The — but there are still things to consider before shorting a stock.
more aggressive the call (in terms of
its time value and ITM or OTM sta- “Indicator insight: Relative strength”
tus), the higher its leverage ratio will Active Trader, June 2002.
be. (Leverage is simply defined as An overview of the ways in which relative strength can be measured and
option return divided by stock interpreted.
return.)
For example, a near-the-money, “Short-term trading with relative strength”
front-month option might earn 150 Active Trader, August 2001.
percent or more if BioMarin moved 10 How do you find the best trading opportunities from day to day? Compare a
percent (up or down). However, stock’s performance to the rest of the market. Relative strength analysis can
short-term OTM options offer the alert you to stocks with great momentum potential.
biggest bang for your buck. These
options are cheap, but can offer large “Relative strength bands”
profits if the underlying stock moves Active Trader, March 2001.
quickly and aggressively in the right This system uses a mix of relative strength (not RSI) analysis and Bollinger
direction. Bands to identify markets that are about to break out of congestion areas.
If you’re more conservative, consid-
er buying an ITM option or one with “A walk on the short side”
more time until expiration. Active Trader, July 2000.
Remember, a sharp upward move in There are benefits and risks to short selling, but working both sides of the
the underlying stock will benefit all market is a key trading survival skill.
long option positions. The difference You can purchase and download past articles at
in profit depends upon the long http://www.activetradermag.com/purchase_articles.htm.
option’s leverage.
For information on the author see p. 6.

FUTURES TRADING SYSTEM LAB
Bollinger Band
breakout-anticipation system
FIGURE 1 — SAMPLE TRADES Market: Futures.
Entries occur when a Bollinger Band “squeeze” occurs. The top panel shows
the Bollinger BandWidth indicator, with the red dots marking the lowest low of System concept: Bollinger Bands
the past 100 days. consist of a moving average (20 days by
default) and two lines, one two stan-
dard deviations above the average and
the other two standard deviations
below it. The bands expand as volatility
increases and contract as it decreases.
The formula for the Bollinger
“BandWidth” indicator, which repre-
sents the distance between the upper
and lower bands as a percentage of the
indicator’s moving average, is:
BandWidth = (upper
band - lower band )/SMA
where,
SMA is the length of the simple
moving average used to create the
Bollinger Bands.
Source: Wealth-Lab Pro 5.0 A low BandWidth reading reflects a

temporary balance of buyers and sell-
ers. When the bands tighten significant-
ly, sharp volatility expansions — and
FIGURE 2 — EQUITY CURVE trends — are possible.
The system produced most of its profits in the second half of the test period. The following system attempts to
capitalize on this idea.
Strategy rules:
If the Band Width is the lowest it’s been
in 100 days and the absolute distance
between the upper and lower Bollinger
Bands is less than 2.5 times the 10-day
average true range (ATR):
1. Go long tomorrow with a stop
loss order at today’s high plus
one tick, or go short tomorrow
with a stop-loss order at today’s
low minus one tick, whichever
comes first.
2. After 10 bars in a position, exit
tomorrow at market.
3. Alternately, exit on a penetration
of the five-day low (for a long
position) or the five-day high
(for a long position).
Standard Bollinger Band parameters

Source: Wealth-Lab Pro 5.0 are used: 20-day simple moving aver-
age and bands set two standard devia-

PERIODIC RETURNS
Percentage Max Max

Avg. Sharpe Best Worst profitable consec. consec.
return ratio return return periods profitable unprofitable
Monthly 1.07% 0.44 33.38% -9.36% 51.67 7 5
Quarterly 3.11% 0.46 26.79% -11.71% 56.10 8 5
Annually 12.09% 0.42 41.28% -13.36% 54.55 4 2
tions above and below the average.

Figure 1 shows some sample trades. STRATEGY SUMMARY
Profitability Trade statistics

Money management: Risk 2 percent
Net profit: $2,103,341.26 No. trades: 453
of account equity per trade.
Net profit: 210.33% Win/loss: 43.27%
Starting equity: $1,000,000. Deduct Profit factor: 1.35 Avg. profit/loss: 0.34%
$8 commission and one tick slippage per Payoff ratio: 1.86 Avg. hold time (days): 7.36
trade. Recovery factor: 2.55 Avg. win: 2.67%
Exposure: 3.42% Avg. hold time (winners): 10.29
Test data: The system was tested on Avg. loss: -1.44%
the Futures & Options Trader Standard Drawdown Avg. hold time (losers): 5.13
Futures Portfolio, which contains the fol- Max. DD: -29.80% Max consec. win/loss: 5/8
lowing 20 futures contracts: British
Longest flat period: 534 bars Total commission: $7,248
pound (BP), soybean oil (BO), corn (C),
crude oil (CL), cotton #2 (CT), E-Mini
Nasdaq 100 (NQ), E-Mini S&P 500 (ES), 5-year T-note (FV),
LEGEND:
euro (EC), gold (GC), Japanese yen (JY), coffee (KC), wheat
(W), live cattle (LC), lean hogs (LH), natural gas (NG), sugar Avg. hold time — The average holding period for all trades.
#11 (SB), silver (SI), Swiss franc (SF), and T-Bonds (US). Data Avg. hold time (losers) — The average holding time for losing trades.
source: ratio-adjusted data from Pinnacle Data Corp. Avg. hold time (winners) — The average holding time for winning
trades.
(http://www.pinnacledata.com).
Avg. loss (losers) — The average loss for losing trades.
Test period: December 1997 to November 2007. Avg. profit/loss — The average profit/loss for all trades.
Avg. profit (winners) — The average profit for winning trades.
Test results: On the whole, the system’s performance could Avg. return — The average percentage for the period.
be described as decent. The system returned 210.3 percent on Best return — Best return for the period.
453 trades over the 10-year test period (12-percent annualized Exposure — The area of the equity curve exposed to long or short
return). A payoff ratio close of 1.86 compensated for the low positions, as opposed to cash.
number of winning trades (43 percent). Longest flat period — Longest period (in days) between two equity
highs.
The equity curve was unspectacular in the first five years of
Max consec. profitable — The largest number of consecutive profitable
the test period, but picked up its pace noticeably in the second periods.
half (Figure 2). Both the long and short sides of the system con- Max consec. unprofitable — The largest number of consecutive unprof-
tributed to its profitability. (In fact, although the short side had itable periods.
fewer trading opportunities, it was a vast benefit to the overall Max consec. win/loss — The maximum number of consecutive winning
returns.) and losing trades.
For more details on this system — including its performance Max. DD — Largest percentage decline in equity.
on intraday stock data — see the March 2008 issue of Active Net profit — Profit at end of test period, less commission.
Trader magazine (http://www.activetradermag.com). No. trades — Number of trades generated by the system.
— Volker Knapp of Wealth-Lab Payoff ratio — Average profit of winning trades divided by average loss
of losing trades.
For information on the author see p. 6. Percentage profitable periods — The percentage of periods that were
profitable.
Futures Lab strategies are tested on a portfolio basis (unless otherwise noted)
Profit factor — Gross profit divided by gross loss.
using Wealth-Lab Inc.’s testing platform.
Recovery factor — Net profit divided by maximum drawdown.
Disclaimer: The Futures Lab is intended for educational purposes only to pro-
Sharpe ratio — Average return divided by standard deviation of returns
vide a perspective on different market concepts. It is not meant to recommend (annualized).
or promote any trading system or approach. Traders are advised to do their
Win/loss — The percentage of trades that were profitable.
own research and testing to determine the validity of a trading idea. Past per-
Worst return — Worst return for the period.
formance does not guarantee future results; historical testing may not reflect
a system’s behavior in real-time trading.

OPTIONS TRADING SYSTEM LAB
Covered calls
on the Diamonds
Market: Dow Jones tracking stock, or FIGURE 1 — COVERED CALL — RISK PROFILE
Diamonds, (DIA) and its options. The managed covered-call strategy entered this position on Nov. 8. Its upside
These strategies could also be applied gains were limited, while its downside risk was much larger (although the posi-
to options on other indices, ETFs, and tion posted gains for all DIA prices shown here).
stocks.
System concept: New options

traders often trade covered calls (long
underlying, short call) on stocks they
own. A covered call is relatively easy
to understand, collects income imme-
diately, and seems as safe as buying
stock. However, capturing gains can
be tough, because it’s hard to know
which calls to sell and how to manage
the position.
A covered call contains a long
underlying position (e.g., 100 shares of
stock) and a short call — one call per
100 shares (or one futures contract).
The short call is “covered” by the
underlying, because if the price of the
underlying climbs above the call’s
strike, you already own the shares of
stock needed to meet your obligations Source: OptionVue
if you are assigned.
To enter a covered call, you can
either sell a call against stock you FIGURE 2 — COVERED CALLS — SEASONAL, MANAGED,
already own or place both trades AND BUY-AND-HOLD
simultaneously. Covered-call traders
often sell calls repeatedly on a stock All three strategies gained from 32.5 percent to 38.9 percent during the test
they already own by buying them period. The two covered call methods (green and pink lines) had less volatile
returns, but the buy-and-hold strategy (blue line) earned roughly 6 percent more.
back (or letting them expire worthless)
and then selling calls in later-expiring
months, a process called “rolling.”
This test compares two different
ways of rolling the position’s short call
vs. a simple buy-and-hold strategy on
the Diamonds over the past five years.
The first “seasonal” approach simply
rolls the short call on the second
Friday of every month. The second
managed approach checks closing
prices each day and rolls if the short
call’s time premium falls by two-thirds
of its value. (Note: The system doesn’t
sell the original 100 shares of DIA —
only calls are sold and bought back
during the test period.)
Figure 1 shows the potential gains
and losses of a covered call — long

STRATEGY SUMMARY
DIA at 132.56, short December 132 call —
Buy and hold Seasonal Managed
that was opened on Nov. 8. It illustrates
the covered call strategy’s downside risk Net gain: $3,867 $3,233 $3,058
and limited profit potential. (Note: The Percentage return: 38.9% 32.7% 32.5%
trade will be profitable at all prices shown Annualized return: 7.1% 6.0% 6%
by Dec. 21 expiration, because the system No. of trades: 1 66 134
bought 100 shares of DIA in June 2002 Winning/losing trades: 1/0 34/32 67/67
when it traded at a multi-year low.) Win/loss: 100% 52% 50%
Avg. trade: N/A $48.98 $22.82
Trade rules:
Largest winning trade: N/A $4,110 $4,045
Seasonal:
1. Buy 100 shares of DIA on June 14, Largest losing trade: N/A -$617 -$389
2002 and sell the call with the most Avg. profit (winners): $3,867 $258.94 $171.43
time premium in the second Avg. loss (losers): N/A -$174.09 -$125.79
expiration month. Avg. hold time (winners): 1,995 88 44
2. Buy back the short call on the Avg. hold time (losers): N/A 30 16
second Friday of each month. Sell Max. consec. win/loss: 1/0 4/6 4/6
another call with the most time
premium in the second expiration
month. generate, it also has one major shortcoming: It has nearly
the same downside risk as owning stock, but limits poten-
Managed: tial upside profits.
1. Buy 100 shares of DIA on June 14, 2002 and sell the Note: This test included minimal commissions, but larg-
call with the most time premium in the second er fees and bad fills will likely affect performance.
expiration month.
2. Buy back the short call if its time premium falls to — Steve Lentz and Jim Graham of OptionVue
one-third of its original value. Sell the call with
highest time premium in the first month with at least
14 days until expiration. LEGEND:
Net gain – Gain at end of test period, less commission.
Test details: Percentage return – Gain or loss on a percentage basis.
• All three test accounts began with $10,000 in capital.
Annualized return – Gain or loss on an annualized percentage
• Dividends were not included. basis.
• No margin was used when buying stock.
No. of trades – Number of trades generated by the system.
• Daily closing prices were used. Trades were executed
Winning/losing trades – Number of winners/losers generated
at the bid and ask, when possible. Otherwise,
by the system.
theoretical prices were used.
Win/loss (%) – The percentage of trades that were profitable.
• Commissions were $6 per option, $8 per 100 shares of
Avg. trade – The average profit for all trades.
stock.
Largest winning trade – Biggest individual profit generated
by the system.
Test data: Dow Jones tracking stock, or Diamonds, and
its options. Largest losing trade – Biggest individual loss generated by
the system.
Test period: June 14, 2002 to Nov. 30, 2007. Avg. profit (winners) – The average profit for winning trades.
Avg. loss (losers) – The average loss for losing trades.
Test results: Figure 2 compares the performance of all Avg. hold time (winners) – The average holding time for winning
three strategies over the five-year test period. The managed trades.
approach gained $3,058 (32.5 percent), slightly less than the Avg. hold time (losers) – The average holding time for losing
seasonal method. Because the managed approach requires trades.
more effort, traders may prefer the seasonal method. Max consec. win/loss – The maximum number of consecutive
winning and losing trades.
Bottom line: In contrast to options’ reputation as risky
investments, a covered call reduces directional risk some- Option System Analysis strategies are tested using OptionVue’s
what. Selling calls against existing underlying shares low- BackTrader module (unless otherwise noted).
ers the overall variance of returns, thus minimizing risk in If you have a trading idea or strategy that you’d like to see tested,
the traditional sense. please send the trading and money-management rules to
But while traders are drawn to the income covered calls Advisor@OptionVue.com.

TRADING BASICS
Rain, soil, and sun:

Grain futures fundamentals
Several fundamental factors determine the prices of agricultural futures,
but their relationships aren’t as simple as you might think.
BY FOT STAFF
I
mation.
n the legendary movie “Trading Places,” Louis
Winthorpe III (Dan Akroyd) and Billy Ray Valentine
(Eddie Murphy) make their fortune by stealing a
crop report from the Duke brothers (who stole it
from the government) and cashing in on that inside infor-
Winthorpe and Valentine knew ahead of time the weath-

discovered a drug that will help reduce cancer, a wise
investment move would be to buy large quantities of
Company X’s stock in anticipation of the price being signif-
icantly higher once the news became public.
However, without some (likely illegal) insider informa-
tion, it would be difficult if not impossible to take advan-
tage of this situation.
er would likely lead to a successful orange crop harvest, On the other hand, diligent agricultural futures traders
keeping the supply of frozen concentrated orange juice high who know where to look and what to search for might be
and demand low. In addition, the protagonists fed a false able to gain an informational edge. Accurately predicting a
crop report — which indicated the harvest would not go so product’s supply base (or at least having an educated
guess) is the first step in successfully trading agricultural
futures.
Accurately predicting a product’s
Talking ‘bout the weather
supply base (or at least having To oversimplify the concept, certain crops will have more
bountiful harvests when temperature and precipitation
an educated guess) is the first step amounts are at a certain level than when those conditions
are abnormal (Figure 1). More bountiful harvests lead to
in successfully trading agricultural greater supply, which leads to lower prices.
Diminished harvests produce less of the crop, which
futures. gives the farmer a reason to sell the product at a higher
price.
well — to the Duke brothers, who thus bid up the market in Of course, nothing is perfect — x precipitation and y tem-
anticipation of higher prices. The truth emerged when the perature may result in corn that sells around z price one
official report was released, and the Duke Brothers went year, but the same weather conditions may produce a dif-
bankrupt at the expense of Winthorpe and Valentine. ferent price the next year because of different macroeco-
While the movie focused on frozen concentrated orange nomic conditions, advances in crop production, etc.
juice, the concept is the same for grains — corn, wheat, rice, Nonetheless, watching and studying pre-harvest weather
oats, and soybeans futures traded at the Chicago Board of conditions can provide a better idea of what prices might do
Trade. The weather leading up to the harvest of these crops in a few months. The important thing is to study the right
is a big determinant in where prices will wind up. information.
The prices of agricultural futures are ultimately deter- Agriculture professors, CTAs, and other professional
mined by the same economic forces that set the price of groups (such as ones hired by large agribusinesses) gener-
stocks, rare pieces of art, real estate, or the 32-ounce foun- ally consider three things when evaluating what the
tain drink at your local convenience store — supply and upcoming crop harvest will produce: precipitation, temper-
demand. ature, and soil condition.
Speculation would be much easier if traders were able to “We focus on crop moisture average, weekly average
accurately predict one side of the supply-demand equation. temperatures, and weekly average precipitation,” says
However, this is obviously easier said than done. Oscar Vergara, agricultural risk-modeling consultant at AIR
If Company X is six months away from announcing it has Worldwide, a risk-management firm that analyzes crop

FIGURE 1 — BIG AND BOUNTIFUL
Because of ideal weather conditions and advancements in harvesting, Wisconsin, South Dakota, Michigan,
corn (top), wheat (middle), and soybean (bottom) futures traded at the Missouri, Kansas, Ohio, and Kentucky
Chicago Board of Trade all set or challenged record highs in 2007. also produce significant amounts, and
a few other states are minor producers.
Two other heavily traded agricultur-
al commodities, wheat and soybeans,
have similar production patterns —
i.e., total production is spread across
several states.
So, how much emphasis can you put
on a particular unusual weather pat-
tern in one of the high-production
areas? It’s easy to understand that tem-
peratures 20 degrees above normal for
two straight weeks in Illinois are bad
for the corn crop, but what weather is
normal in the other corn-growing
areas? How much emphasis should
you put on Illinois’ weather woes?
This is where many traders fall into
a trap.
“It’s important not to hone in on a
headline about a drought affecting
continued on p. 28
Source: eSignal
insurance and reinsurance programs. of the country, the effects of weather

AIR has finished first or second each of would be easier to understand. A pro-
the last four years at the FACTSim longed drought would lead to a less-
Futures and Options Trading than-stellar crop, which would lead to
Competition. higher prices.
“We use 15-, 30-, and 45-day mod- Unfortunately, the situation is much
els,” Vergara says. “We don’t go much more complex. Take corn, for example.
longer because the weather fluxes too Corn is the most commonly grown
much.” crop in the U.S. More than 50 percent
of U.S. corn production comes from
Location, location, location Iowa, Illinois, Nebraska, and
If a crop were grown in only one part Minnesota. However, Indiana,

TRADING BASICS continued
FIGURE 2 — BETTER THAN A NEWSPAPER

The Weekly Weather and Crop Bulletin released every week by the United
States Department of Agriculture provides detailed reports on the weather the dead vegetation around it. At this
across the U.S. and how it might affect certain crops. point, it can be determined how tall
the plants are compared to past year,
the condition of the plant, the size of
the kernels/pods, etc.
Harvesting. This is the final stage,

when yield is determined and the
overall quality of the crop can be accu-
rately assessed.
The entire process takes several

months, and the listing of corn futures at
the CBOT reflects this — there are con-
tracts expiring in March, May, July,
September, and December. Soybeans
have a similar schedule — they also
have January and August contracts, and
their final contract of the year is
November, not December.
Getting help
This is a lot of information to consider
before trading. However, there is a pair
of user-friendly, information-heavy Web
sites traders can consult. The first is the
United States Department of Agriculture
site (http://www.usda.gov), which,
among other things, provides detailed
reports on every commodity tradable on
Source: http://www.usda.gov a U.S. futures market, as well as detailed
weather reports (Figure 2).
somebody,” says AIR senior manager Jack Seaquist. The second is the National Agricultural Statistics Service
“Examine it and see how it’s affecting the entire country.” site (http://www.nass.usda.gov). The NASS is a division of
It’s also important to remember there are myriad seeds the USDA and offers more in-depth info than the USDA
for each crop, each are planted at various times of the sea- site.
son, and each responds to precipitation/temperature in a “The maps we’re using are the same ones you can find on
different way. the USDA site, although ours are a little more detailed,”
Vergara says.
A marathon, not a sprint You can find the seeding, planting, flowering, and har-
Measuring the quality, or lack thereof, of a crop is not a lin- vesting stages of each crop on these sites. This information
ear exercise. There are four things to consider: changes from year to year.
Vergara says the AIR team took second in the latest com-
Seed. What is the quality of the seed? Was there a prob- petition because its trading system included strategies that
lem with the storage facility that damaged some seeds weren’t weather related — what was happening in China
and left others useless? and India, the price of the U.S. dollar vs. the euro, etc.
However, Vergara says he has since learned that while
Planting. Was the soil in ideal shape for planting? Was macroeconomic factors are important, from June to August,
it too hard or too soft? Were there any major delays in weather is the key element.
the process? Also consider that if 2008 produces the exact same weath-
er conditions as 2003 or 1998, the yield will be greater
Tasseling/flowering. After the plant emerges from the because farmers have better technology, better machinery,
ground, it needs to be manicured to remove some of better seeds, and better farm management.

Las Vegas - February 29th, 2008
Don’t Miss the “Under The Big Top”

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Steve Lentz presents the Circus Calendar Spread Strategy which tests out at over 40% annualized returns.
Steve also analyzes other high probability options strategies such as seasonal-ratio butterfly spreads, yield grabs,
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Special guest Len Yates discusses his earning announcement plays strategy, which has provided over
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Steve Lentz
Mentor and Director of Education
Steve Lentz is a well-established options educator and
trader who has lectured all over the United States, Asia and
Australia on behalf of the CBOE’s Options Institute, the
Options Industry Council and the ASX. Steve is constantly
developing new strategies and ways to use options as part
of a comprehensive and profitable trading approach.
For more information or to register for this event, please contact your
OptionVue representative at 1-800-733-6610.
Click here for your FREE subscription

to Futures & Options Trader.
INDUSTRY NEWS
Climate competition
NYMEX hopes it’s easy being Green

BY JIM KHAROUF
“ We’re truly trying to build a global

T he New York Mercantile Exchange (NYMEX)
announced plans to launch a new emissions
exchange in the first quarter, bringing another
entry into an increasingly crowded field.
The new market, called the Green Exchange, partners
exchange and tackle a global
environmental issue. We won’t be judged
NYMEX with Evolution Markets, Morgan Stanley, Credit
Suisse, JPMorgan, Merrill Lynch, Tudor Investment Corp., on the success of this exchange merely
ICAP, and Constellation Energy. NYMEX Chairman
Richard Schaeffer says the partnership structure was by the number of contracts we trade,
designed to build liquidity quickly, and more equity part-
ners from European institutions are expected to sign on as but by the lasting legacy for the
well.
“When you have the people actually doing the trading
and they’ve made commitments to actually put volume on
environment — how big business can
a regulated exchange, it surely gives that exchange a much
better jumpstart at building and growing,” Schaeffer says.
contribute to a sustainable planet.”
The Green Exchange will offer a slate of U.S. and inter- – Andrew Ertel, Evolution Markets
national emissions and renewable energy credit (REC) con-
tracts starting in the first quarter of 2008 with trading on the add other products over time.”
CME’s Globex platform and clearing on NYMEX’s Among the contracts announced, the Green Exchange
ClearPort. will offer global carbon contracts such as EU allowances
Paul Ezekiel, head of environmental trading at Credit (EUAs) under the current European Union Emissions
Suisse, says the emissions market is coming at the right Trading Scheme, certified emission reduction credits
time with the right mix of market participants. (CERs) under the UN Clean Development Mechanism, and
“The exchange-traded futures contracts continue to build voluntary emission reductions called VERs. The exchange
liquidity and depth,” Ezekiel says. “We’re seeing CER also plans to offer U.S.-based emissions trading on sulfur
futures trading now but it’s still [in the] early stages in this dioxide (SO2) and nitrogen oxide (NOx). Options are being
market. And as the market is expected to grow, there is developed as well.
enormous opportunity to create another exchange that can Evolution Markets President and CEO Andrew Ertel says
the market is designed to create a global market
that helps lower global greenhouse gas emis-
MANAGED MONEY sions.
Top 10 option strategy traders ranked by November 2007 return. “We’re truly trying to build a global exchange
(Managing at least $1 million as of Nov. 30, 2007.) and tackle a global environmental issue,” Ertel
says. “We won’t be judged on the success of this
2007
October YTD $ under exchange merely by the number of contracts we
Rank Trading advisor return return mgmt. trade, but by the lasting legacy for the environ-
1. Oxeye Capital Mgmt. (FTSE 100) 18.60 23.44 17.0M ment — how big business can contribute to a
sustainable planet.”
2. Parrot Trading Partners 13.98 44.40 14.1M
The new exchange will bring a lower and
3. Solaris Market Neutral Fund LP 13.13 39.60 1.8M
more competitive fee structure to the sector and
4. Optrize Traders House (Option) 11.49 6.37 4.1M
allow for cross-margining on the NYMEX clear-
5. CKP Finance Associates (LOMAX) 11.41 12.90 6.1M ing platform. Also, firms who are not part of the
6. Ascendant Asset Adv. (Strategic2) 10.00 60.38 42.5M founding partner group will have a chance to
7. ACE Investment Strategists (DPC) 9.07 -24.41 4.3M earn equity in the exchange through participa-
8. Aksel Capital Mgmt (Growth & Income) 8.05 -16.11 4.4M tion.
9. Censura Futures Mgmt. 7.71 11.51 56.0M The new exchange brings more competition to
10. Ascendant Asset Adv. (JLDeVore) 6.00 86.36 7.8M the exchange-traded emissions space currently
Source: Barclay Hedge (http://www.barclayhedge.com) dominated by the Climate Exchange, which runs
Based on estimates of the composite of all accounts or the fully funded subset method. the European Climate Exchange (ECX) and the
Does not reflect the performance of any single account. Chicago Climate Exchange (CCX). ECX is
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. responsible for about 80 percent of the exchange-

traded volume in carbon emissions contracts and CCX is strength at the NYMEX and the Green Exchange.”
the largest U.S. voluntary emissions market. ECX CEO Patrick Birley says the competition will help
That space is becoming increasingly crowded as NYSE the overall market, which is estimated between $60 and $70
Euronext breaks into the emissions market in the first quar- billion in 2007 and expected to grow to $100 billion in 2008,
ter and Eurex pushes European Energy Exchange emissions according to the World Bank.
contracts on its trading platform. That doesn’t faze the “ECX volumes have continued to rise to over one billion
NYMEX. tonnes of CO2 allowances traded this year despite a num-
“We watched what other people did and we don’t think ber of other exchanges making plans to get involved in the
they’ve gotten it right yet,” Schaeffer says. emissions space,” Birley says. “We have good relationships
The Green Exchange brings in a new level of competition, with our members who recognize our long-term commit-
made up in large part of over-the-counter players such as ment to the business and support our continued central
Evolution, ICAP, and others. position. We expect that new exchange entrants into the
“They’ve looked at the OTC market as their partners, not emissions space will have a positive overall impact on trad-
their competitors,” Ertel says. “I think a lot of the other ing activity in line with the predicted growth in this new
exchanges see it differently and that has really been a asset class.”
Now with greater authority
Senate moves CFTC reauthorization forward

BY JIM KHAROUF
T he U.S. Senate passed the farm bill in December, a

move that will give the Commodity Futures
Trading Commission (CFTC) greater oversight of
over-the-counter (OTC) and forex markets.
The bill, which reauthorizes CFTC until fiscal year 2013,
loophole,” which kept the CFTC and other regulators from
fully monitoring the OTC market.
Senators say the new powers will help prevent price dis-
tortions and manipulation of energy markets and provide
more transparency to OTC energy markets such as the
provides a number of new powers for the regulator includ- Intercontinental Exchange (ICE).
ing increased authority to oversee forex trading and to The CFTC Reauthorization Act of 2007 also closes the so-
monitor so-called Exempt Commercial Markets (ECMs), called Zelener loophole, allowing for better oversight of
which are essentially OTC markets. forex markets. The CFTC was dealt a blow in 2004 when a
The CFTC has gone without authorization since 2005. Circuit Court judge ruled in favor of Michael Zelener, pres-
The measure will now go to the House floor, although no ident of British Royal Group. The CFTC charged that
date for a vote has been set. Zelener was defrauding forex customers, but the judge
Much of the focus of reauthorization has been on certain ruled that the types of trades Zelener was providing cus-
ECMs. The provisions in the latest bill mean the CFTC will tomers did not fall under CFTC jurisdiction.
have greater oversight of the OTC energy markets, which It also clarified the agency’s anti-fraud authority to pur-
have been a hot political topic in Washington after the sue fraud cases involving principal-to-principal transac-
recent hedge fund blow up by Amaranth and charges of tions. The measure also increases civil penalties for viola-
price manipulation of natural gas. It also closes the “Enron tions of the Commodity Exchange Act.
Still trying to catch on
OneChicago offers remedy to credit squeeze

BY JIM KHAROUF
S ingle-stock futures exchange OneChicago

launched single-stock futures (SSFs) on two ETFs
in December and is aggressively trying to take
advantage of the current credit squeeze.
OneChicago now offers SSFs on the Nasdaq 100 (QQQQ)
launched in October. The exchange also offers an SSF on the
Dow Jones (DIA) ETF.
David Downey, who took over as CEO in January 2007,
says these ETF products are attractive to traders looking for
better capital efficiencies with equity positions.
and Russell 2000 (IWM) ETFs. The contracts complement “Customers can trade this very highly correlated product
OneChicago’s SSF on the S&P 500 (SPY) ETF, which was continued on p. 32

INDUSTRY NEWS continued
OneChicago continued from p. 31

that is a security future and is eligible for portfolio margin- stock positions by using exchange for physicals on
ing and subject to the offsets,” Downey says. “I really OneChicago. That allows firms to hold the same equity
believe that the customer volume will follow.” position in SSFs and enables firms to carry the position as a
OneChicago volumes for the first 11 months of 2007 rose futures position and an “off balance sheet” item, Downey
13 percent from last year to 7.72 million contracts, but SSFs says.
still continue to struggle to find traction among mainstream “You have longs and shorts out there with bloated bal-
investors. Downey has spent much of his time trying to ance sheets carrying these positions,” Downey says. “We’re
break though major barriers that have prevented SSFs from just trying to find them to bring them in. Everyone under-
succeeding in the U.S. stands this is going to solve their balance sheet problem.
The biggest obstacle for OneChicago is to get prime bro- That’s where we’re seeing some volume growth.”
kers to offer SSFs. Those large firms have resisted offering Downey added that it’s an educational process, but one
the product because it would cut into their extremely prof- that is coming at the right time.
itable stock-lending business. “We’re forcing them to rethink single stock futures, not as
“We’re up against the profit centers for these firms,” a trading vehicle to hedge or speculate, but as a method to
Downey admits, although he believes the current credit participate at preferential financing rates that are much bet-
squeeze in the wake of the sub-prime lending meltdown is ter than they are getting from their broker,” Downey says.
providing the exchange the opening it needs. “The credit Whether OneChicago can succeed is still a question mark
squeeze is pushing everyone to reevaluate their trading. All for the exchange, which is backed by the Chicago Board
they have to do is rethink what they are doing.” Options Exchange, the CME Group and Interactive Brokers
Securities trading firms looking to free up capital on their Group.
books in this tight credit market can lower the risk on their Not only is OneChicago competing with prime brokers
Options Watch: Financial Sector ETF Components (as of Dec. 20)

Compiled by Tristan Yates
The following table summarizes the expiration months available for options on the financial sector exchange-traded fund (XLF) and its top 15 components. It
also shows each index's average bid-ask spread for at-the-money (ATM) January 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
March
June
April
Aug.
Feb.
Jan.
July
Jan.
Jan.
May
Bid-ask spreads
Bid-ask
spread as %
Closing of underlying
Index Sym Exchange price Call Put price
Financial Sector SPDR XLF NA X X X X X 29.02 0.09 0.15 0.41%
Top 15 XLF components:
Citigroup C NA X X X X X X 29.89 0.03 0.02 0.08%
Goldman Sachs Group GS NA X X X X X X 202.67 0.33 0.20 0.13%
Prudential PRU NA X X X X X X 91.89 0.18 0.18 0.19%
Bank of America BAC NA X X X X X X 41.41 0.06 0.10 0.20%
Bank of New York Mellon BK NA X X X X X X 48.91 0.14 0.09 0.23%
American International Group AIG NA X X X X X X 56.74 0.16 0.10 0.23%
American Express AXP NA X X X X X X 51.03 0.15 0.09 0.23%
Met Life Ins MET NA X X X X X X 60.61 0.16 0.13 0.24%
US Bancorp USB NA X X X X X X 31.60 0.06 0.09 0.24%
J.P. Morgan Chase JPM NA X X X X X X 43.33 0.10 0.11 0.25%
Wells Fargo WFC NA X X X X X X 30.37 0.09 0.09 0.29%
Wachovia WB NA X X X X X X X 38.66 0.13 0.11 0.31%
Morgan Stanley MS NA X X X X X X 51.37 0.23 0.14 0.35%
Merrill Lynch MER NA X X X X X X 54.50 0.20 0.20 0.37%
Fannie Mae FNM NA X X X X X X 35.65 0.16 0.16 0.46%
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 clos-
ing price.

but it now finds itself battling with other non-U.S. remain competitive with others.
exchanges such as Eurex, which plans to offer SSFs on the For retail traders, the problem with SSFs goes beyond
S&P 500 in U.S. dollars. firms not wanting to undercut their own profitable stock-
The advantage Eurex currently has over OneChicago is loan businesses. Downey says few securities firms have
that Eurex and other futures markets offer portfolio mar- the necessary technology to offer portfolio margining on
gining on SSFs. OneChicago is saddled with strategy-based SSFs. He says OneChicago is attempting to solve that issue
margining. by working with SunGard, which has new products that
Downey says he is trying to convince U.S. regulators to allow for management of positions from multiple asset
change that margining policy to allow U.S. exchanges to classes.
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interdependencies on financial markets and react to even small

FUTURES SNAPSHOT (as of Dec. 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 % 20-day % 60-day % Volatility
Market sym sym Exch Vol OI move rank move rank move rank ratio/rank
E-Mini S&P 500 ES CME 1.69 M 1.83 M -0.03% 0% 1.31% 21% -4.17% 70% .43 / 46%
10-yr. T-note ZN TY CBOT 1.20 M 2.16 M -0.21% 33% -0.94% 47% 2.71% 20% .28 / 58%
5-yr. T-note ZF FV CBOT 696.0 1.66 M -0.16% 27% -0.16% 17% 2.66% 43% .24 / 55%
Eurodollar* GE ED CME 400.6 1.49 M -0.01% 0% 0.55% 85% 0.64% 87% .13 / 10%
E-Mini Nasdaq 100 NQ CME 386.5 352.2 1.13% 33% 1.72% 11% -0.19% 0% .41 / 85%
30-yr. T-bond ZB US CBOT 382.5 898.2 -0.93% 31% -1.86% 44% 2.62% 20% .37 / 67%
2-yr. T-note ZT TU CBOT 300.4 861.7 -0.05% 27% 0.00% 0% 1.08% 30% .16 / 15%
Crude oil CL NYMEX 262.7 304.0 2.36% 40% 6.62% 40% 20.70% 78% .25 / 50%
E-Mini Russell 2000 ER CME 230.3 569.6 1.04% 50% 1.14% 30% -6.54% 77% .65 / 97%
Mini Dow YM CBOT 156.3 80.0 -0.92% 67% 1.14% 15% -4.59% 98% .37 / 24%
Eurocurrency 6E EC CME 137.9 170.0 -0.58% 0% -1.50% 36% 2.67% 46% .24 / 57%
Gold 100 oz. GC NYMEX 106.1 233.7 1.59% 80% 3.94% 32% 12.97% 59% .21 / 32%
Japanese yen 6J JY CME 99.1 142.1 -1.58% 53% -2.72% 67% 1.69% 16% .28 / 38%
Corn ZC C CBOT 79.6 314.3 4.94% 45% 17.41% 98% 30.41% 100% .22 / 25%
Soybeans ZS S CBOT 74.4 210.9 5.30% 70% 10.56% 89% 28.49% 96% .24 / 57%
British pound 6B BP CME 60.2 89.8 -2.37% 67% -4.24% 90% -2.40% 89% .64 / 73%
S&P 500 index SP CME 57.6 500.1 -0.03% 0% 1.31% 21% -4.17% 73% .43 / 46%
Natural gas NG NYMEX 51.4 80.8 -2.81% 37% -3.82% 5% -3.06% 2% .10 / 0%
Sugar SB ICE 45.2 434.5 6.50% 50% 13.09% 98% 8.08% 65% .67 / 85%
Canadian dollar 6C CD CME 41.4 85.6 3.35% 100% 0.46% 3% 1.03% 6% .37 / 83%
Australian dollar 6A AD CME 41.3 55.9 -0.42% 28% -1.76% 32% -1.94% 62% .24 / 27%
Swiss franc 6S SF CME 38.6 64.0 -0.57% 6% -2.23% 60% 2.53% 48% .20 / 7%
Heating oil HO NYMEX 33.1 55.2 1.40% 8% 4.14% 36% 23.96% 83% .13 / 3%
Wheat ZW W CBOT 30.9 105.0 -2.70% 100% 6.52% 27% -0.80% 33% .22 / 47%
RBOB gasoline RB NYMEX 30.5 48.9 3.46% 20% 9.69% 60% 25.89% 98% .32 / 43%
E-Mini S&P MidCap 400 ME CME 28.9 94.9 -0.18% 0% 1.75% 41% -4.00% 66% .48 / 57%
Soybean oil ZL BO CBOT 23.5 41.3 4.39% 87% 5.66% 55% 28.16% 96% .25 / 45%
Gold 100 oz. ZG CBOT 23.1 12.5 1.60% 81% 3.96% 31% 13.03% 57% .21 / 34%
Silver 5,000 oz. SI NYMEX 21.4 58.0 -0.05% 0% 3.37% 27% 10.17% 54% .30 / 38%
Soybean meal ZM SM CBOT 21.3 34.1 4.16% 18% 14.96% 98% 27.77% 90% .18 / 50%
Mexican peso 6M MP CME 17.4 74.4 -0.33% 50% 0.08% 5% 0.14% 0% .11 / 10%
Fed Funds ZQ FF CBOT 16.8 132.6 0.01% 7% 0.03% 2% 0.50% 48% .04 / 33%
Crude oil e-miNY QM NYMEX 16.5 6.7 2.36% 40% 6.62% 40% 20.70% 78% .25 / 48%
Cotton CT ICE 15.1 111.3 5.69% 87% 5.25% 65% 4.10% 16% .26 / 53%
Nikkei 225 index NK CME 12.6 65.4 -3.62% 71% -0.71% 3% -9.74% 86% .34 / 42%
Coffee KC ICE 9.5 81.9 -1.27% 100% 4.94% 12% 2.45% 15% .11 / 3%
Lean hogs HE LH CME 9.2 58.4 -4.01% 67% 8.02% 63% 1.85% 75% .10 / 8%
Cocoa CC ICE 7.3 76.4 -1.05% 0% 6.60% 64% 1.77% 3% .26 / 33%
Live cattle LE LC CME 7.2 31.0 2.83% 100% 1.24% 72% 0.47% 1% .81 / 100%
Nasdaq 100 ND CME 5.7 43.6 1.13% 33% 1.72% 11% -0.19% 0% .41 / 83%
Copper HG NYMEX 5.5 13.4 3.85% 89% 4.19% 19% -15.60% 92% .45 / 68%
U.S. dollar index DX ICE 4.4 27.9 0.58% 11% 1.99% 47% -2.37% 40% .21 / 43%
Dow Jones Ind. Avg. ZD DJ CBOT 4.0 32.7 -0.92% 67% 1.14% 15% -4.59% 98% .38 / 27%
Mini-sized gold YG CBOT 4.0 3.9 1.60% 67% 3.96% 31% 13.03% 62% .21 / 33%
Silver 5,000 oz. ZI CBOT 3.9 4.0 -0.05% 7% 3.37% 26% 10.25% 55% .30 / 39%
10-year interest rate swap SR NI CBOT 3.4 48.2 -0.92% 42% -1.68% 54% 1.95% 10% .36 / 67%
Russell 2000 index RL CME 3.0 33.4 1.04% 50% 1.14% 30% -6.54% 79% .64 / 97%
*Average volume and open interest based on highest-volume contract (December 2008).
Legend (10-day moves, 20-day moves, etc.) show the percent means the current reading is larger
Vol: 30-day average daily volume, in thou- percentile rank of the most recent move to a than all the past readings, while a reading of 0
sands (unless otherwise indicated). certain number of the previous moves of the percent means the current reading is smaller
same size and in the same direction. For than the previous readings. These figures pro-
OI: Open interest, in thousands (unless other-
example, the “% rank” for 10-day move shows vide perspective for determining how relative-
wise indicated).
how the most recent 10-day move compares ly 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 Volatility ratio/rank: The ratio is the short-
20-day move: The percentage price move most recent 20-day move compares to the term volatility (10-day standard deviation of
from the close 20 days ago to today’s close. past sixty 20-day moves; for the 60-day move, prices) divided by the long-term volatility (100-
60-day move: The percentage price move the “% rank” field shows how the most recent day standard deviation of prices). The rank is
from the close 60 days ago to today’s close. 60-day move compares to the past one-hun- the percentile rank of the volatility ratio over
The “% rank” fields for each time window dred-twenty 60-day moves. A reading of 100 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.

OPTIONS RADAR (as of Dec. 27)
MOST-LIQUID OPTIONS*
Options Open 10-day % 20-day % IV/SV IV/SV ratio —
Indices Symbol Exchange volume interest move rank move rank ratio 20 days ago
S&P 500 index SPX CBOE 632.4 2.20 M -0.69% 22% 0.49% 7% 18.7% / 19.6% 23.6% / 20.8%
Mini Nasdaq 100 index MNX CBOE 117.5 871.4 0.22% 0% 0.51% 5% 20.3% / 24.9% 26.9% / 28.8%
Nasdaq 100 index NDX CBOE 92.3 302.2 0.23% 0% 0.51% 5% 20.6% / 23.6% 27.4% / 27%
S&P 500 volatility index VIX CBOE 76.2 751.0 -9.84% 53% -15.97% 37% 154.3% / 107.2% 87.7% / 154.8%
Russell 2000 index RUT CBOE 65.3 726.6 0.23% 25% 0.45% 7% 24.9% / 27.4% 29.4% / 26.2%
Stocks
Microsoft MSFT 431.3 3.06 M 4.35% 43% 6.74% 52% 25.3% / 30.2% 29.2% / 31.6%
Citigroup C 372.4 2.81 M -6.07% 29% -8.45% 22% 40.8% / 51.3% 49.6% / 65.6%
Yahoo! YHOO 324.8 1.94 M -3.38% 38% -9.50% 47% 43.2% / 36.2% 46% / 64.6%
Apple Inc. AAPL 252.4 1.22 M 4.04% 18% 10.18% 12% 51.7% / 44.3% 42.7% / 59.7%
Cisco Systems CSCO 251.1 1.61 M -3.51% 13% -0.93% 5% 32.8% / 32.6% 35.5% / 39.6%
Futures
Eurodollar ED-GE CME 188.0 5.96 M -0.01% 0% 0.55% 85% 24.3% / 14.7% 22.4% / 12.7%
10-year T-notes TY-ZN CBOT 63.4 326.2 -0.21% 33% -0.94% 50% 7% / 8.1% 6.8% / 5.2%
Crude oil CL NYMEX 49.1 446.3 2.36% 40% 6.62% 36% 30.3% / 36.3% 31.6% / 35.4%
Sugar SB ICE 30.2 637.0 6.50% 50% 13.09% 98% 26% / 23.7% 20.5% / 16.4%
Corn C-ZC CBOT 21.5 398.9 4.94% 45% 17.41% 98% 27.2% / 21.9% 24.9% / 21.1%
VOLATILITY EXTREMES**
Indices — High IV/SV ratio
Euro index XDE PHLX 6.4 63.0 -0.56% 0% -1.44% 36% 8.9% / 6.1% 9.7% / 5.4%
S&P 500 volatility index VIX CBOE 76.2 751.0 -9.84% 53% -15.97% 37% 154.3% / 107.2% 87.7% / 154.8%
Airline index XAL AMEX 2.0 14.0 -4.72% 7% -12.22% 65% 56.6% / 43.7% 50.8% / 60.6%
British pound index XDB PHLX 3.1 23.8 -2.50% 93% -4.15% 95% 8.8% / 7.4% 8% / 7.1%
Morgan Stanley Retail index MVR CBOE 16.3 63.8 -5.53% 67% -5.71% 56% 34.6% / 31% 32.6% / 35.5%
Indices — Low IV/SV ratio

E-mini S&P 500 futures ES CME 17.9 113.3 -0.03% 0% 1.31% 21% 18.1% / 22.7% 23.5% / 23.6%
Mini Nasdaq 100 index MNX CBOE 117.5 871.4 0.22% 0% 0.51% 5% 20.3% / 24.9% 26.9% / 28.8%
Nasdaq 100 index NDX CBOE 92.3 302.2 0.23% 0% 0.51% 5% 20.6% / 23.6% 27.4% / 27%
S&P 100 index XEO CBOE 13.0 123.2 -0.69% 38% 0.54% 4% 17.7% / 19.7% 22.2% / 20.8%
Broker/Dealer index XBD AMEX 3.7 16.0 -1.32% 33% -2.92% 25% 37.4% / 41.4% 38.7% / 52.8%
Stocks — High IV/SV ratio

Advantage Energy Income AAV 1.9 27.5 -11.83% 95% -15.20% 58% 40.2% / 23.8% 36.2% / 36.3%
King Pharmaceuticals KG 2.8 34.5 -0.10% 0% 2.30% 47% 65.6% / 39% 45.7% / 42.7%
UT Starcom UTSI 6.7 122.1 2.96% 67% -3.81% 12% 101% / 60.7% 93.3% / 86%
Crystallex Intl. KRY 1.6 112.3 -5.63% 5% -14.51% 37% 120% / 78.3% 141.4% / 76.5%
Altera ALTR 4.9 119.5 0.57% 17% 0.83% 38% 31.6% / 20.8% 33.7% / 29.8%
Stocks — Low IV/SV ratio

Fed Home Loan Bank FRE 35.5 246.3 10.78% 44% 14.55% 64% 60.2% / 111.9% 75.8% / 102.6%
First Marblehead FMD 8.4 61.5 7.82% 100% -44.38% 74% 96.9% / 174.8% 77.8% / 65.8%
Grant Prideco GRP 4.7 29.2 14.24% 89% 17.31% 76% 24.7% / 43.4% 42.7% / 48.3%
Fed National Mortgage FNM 53.3 404.3 23.32% 70% 22.63% 80% 63.5% / 109.3% 85.3% / 122.5%
Force Protection Inc. FRPT 8.8 85.0 -2.61% 0% -66.85% 98% 146.5% / 244.7% 92% / 100.9%
Futures — High IV/SV ratio

Soybeans S-ZS CBOT 13.6 104.5 5.30% 70% 10.56% 91% 27.9% / 16.6% 23.7% / 17.7%
Soybean oil BO-ZL CBOT 3.6 47.1 4.39% 86% 5.66% 55% 21.1% / 12.7% 21.9% / 16.2%
Eurodollar ED-GE CME 188.0 5.96 M -0.01% 0% 0.55% 85% 24.3% / 14.7% 22.4% / 12.7%
Soybean meal SM-ZM CBOT 2.7 24.6 4.16% 12% 14.96% 98% 32.8% / 22.3% 26.6% / 19.1%
Canadian dollar CD CME 1.9 13.5 3.35% 100% 0.46% 3% 11.6% / 8.4% 14.1% / 11.3%
Futures — Low IV/SV ratio

Heating oil HO NYMEX 2.1 6.5 1.40% 17% 4.14% 36% 27.5% / 35.9% 29.1% / 30.3%
E-mini S&P 500 futures ES CME 17.9 113.3 -0.03% 0% 1.31% 21% 18.1% / 22.7% 23.5% / 23.6%
30-year T-bonds US-ZB CBOT 7.9 103.4 -0.93% 31% -1.86% 44% 10.7% / 13.2% 9.7% / 6.6%
Crude oil CL NYMEX 49.1 446.3 2.36% 40% 6.62% 36% 30.3% / 36.3% 31.6% / 35.4%
10-year T-notes TY-ZN CBOT 63.4 326.2 -0.21% 33% -0.94% 50% 7% / 8.1% 6.8% / 5.2%
LEGEND:
* Ranked by volume ** Ranked based on high or low IV/SV values.
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 exam-
ple, 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.

EVENTS
Event: MTA Mid-Winter Retreat Location: Las Vegas

Date: Jan. 24-26 For more information: Call (800) 733-6610
Location: Don CeSar Beach Resort at St. Pete Beach
(outside Tampa, Fla.) Event: 24th Annual Risk Management Conference
For more information: Call (646) 652-3300 Date: March 9-11
Location: Hyatt Regency Coconut Point Resort and Spa,
Event: The World Money Show Bonita Springs, Fla.
Date: Feb. 6-9 For more information: http://www.cboe.com/rmc
Location: Gaylord Palms Resort and Convention Center,
Kissimmee, Fla. Event: Day Trading Seminar: Presented by Joe Ross
For more information: and Rogerio Kirchbaum
http://www.worldmoneyshow.com Date: March 23-24
Location: Sao Paulo, Brazil
Event: Traders Expo New York For more information: E-mail
Date: Feb. 16-19 info@tradingeducators.com.br
Location: Marriott Marquis Hotel, New York
For more information: http://www.tradersexpo.com Event: Traders Expo Los Angeles
Date: June 23-26
Event: Options Seminar hosted by Steve Lentz Location: Ontario Convention Center
Date: Feb. 28 For more information: http://www.tradersexpo.com
KEY CONCEPTS The option “Greeks”
American style: An option that can be exercised at any Delta: The ratio of the movement in the option price for
time until expiration. every point move in the underlying. An option with a
delta of 0.5 would move a half-point for every 1-point
Assign(ment): When an option seller (or “writer”) is move in the underlying stock; an option with a delta of
obligated to assume a long position (if he or she sold a put) 1.00 would move 1 point for every 1-point move in the
or short position (if he or she sold a call) in the underlying underlying stock.
stock or futures contract because an option buyer exercised
the same option. Gamma: The change in delta relative to a change in the
underlying market. Unlike delta, which is highest for
At the money (ATM): An option whose strike price is deep ITM options, gamma is highest for ATM options
identical (or very close) to the current underlying stock (or and lowest for deep ITM and OTM options.
futures) price.
Rho: The change in option price relative to the change
Bear call spread: A vertical credit spread that consists in the interest rate.
of a short call and a higher-strike, further OTM long call in
the same expiration month. The spread’s largest potential Theta: The rate at which an option loses value each day
gain is the premium collected, and its maximum loss is lim- (the rate of time decay). Theta is relatively larger for
ited to the point difference between the strikes minus that OTM than ITM options, and increases as the option gets
premium. closer to its expiration date.
Bear put spread: A bear debit spread that contains puts Vega: How much an option’s price changes per a one-
with the same expiration date but different strike prices. percent change in volatility.
You buy the higher-strike put, which costs more, and sell
the cheaper, lower-strike put.
Carrying costs: The costs associated with holding an
Beta: Measures the volatility of an investment compared investment that include interest, dividends, and the oppor-
to the overall market. Instruments with a beta of one move tunity costs of entering the trade.
in line with the market. A beta value below one means the
instrument is less affected by market moves and a beta Correlation: The correlation coefficient can tell us the
value greater than one means it is more volatile than the type and strength of the relationship between two data
overall market. A beta of zero implies no market risk. series. The correlation coefficient ranges from +1, which
indicates perfect, positive correlation between two data sets
Bull call ladder: A variation of the bull call debit spread (i.e., they move in the same direction, in tandem) and -1,
that profits if the underlying market doesn’t rally too far. To which indicates the sets are directly inverted; zero indicates
enter a bull call ladder, buy an ATM or ITM long call and no discernible relationship between the two data sets.
sell two calls at different, higher strike prices. The goal is to
profit from a moderately bullish outlook without too much Covered call: Shorting an out-of-the-money call option
upside risk. Ideally, the market will rally and close between against a long position in the underlying market. An exam-
the two short strikes at expiration. But if the market jumps ple would be purchasing a stock for $50 and selling a call
far above the highest short strike, potential losses could be option with a strike price of $55. The goal is for the market
unlimited. to move sideways or slightly higher and for the call option
to expire worthless, in which case you keep the premium.
Bull call spread: A bull debit spread that contains calls
with the same expiration date but different strike prices. Credit spread: A position that collects more premium
You buy the lower-strike call, which has more value, and from short options than you pay for long options. A credit
sell the less-expensive, higher-strike call. spread using calls is bearish, while a credit spread using
puts is bullish.
Bull put spread (put credit spread): A bull credit
spread that contains puts with the same expiration date, but Debit: A cost you must pay to enter any position if the
different strike prices. You sell an OTM put and buy a less- components you buy are more expensive than the ones you
expensive, lower-strike put. sell. For instance, you must pay a debit to buy any option,
and a spread (long one option, short another) requires a
Calendar spread: A position with one short-term short debit if the premium you collect from the short option does-
option and one long same-strike option with more time n’t offset the long option’s cost.
until expiration. If the spread uses ATM options, it is mar-
ket-neutral and tries to profit from time decay. However, Deep (e.g., deep in-the-money option or deep
OTM options can be used to profit from both a directional out-of-the-money option): Call options with strike
move and time decay. prices that are very far above the current price of the under-
lying asset and put options with strike prices that are very
Call option: An option that gives the owner the right, but far below the current price of the underlying asset.
not the obligation, to buy a stock (or futures contract) at a
fixed price. 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 Market makers: Provide liquidity by attempting to prof-
shares/contracts to adjust delta back to zero. it from trading their own accounts. They supply bids when
there may be no other buyers and supply offers when there
Diagonal spread: A position consisting of options with are no other sellers. In return, they have an edge in buying
different expiration dates and different strike prices — e.g., and selling at more favorable prices.
a December 50 call and a January 60 call.
Naked (uncovered) puts: Selling put options to collect
European style: An option that can only be exercised at premium that contains risk. If the market drops below the
expiration, not before. short put’s strike price, the holder may exercise it, requiring
you to buy stock at the strike price (i.e., above the market).
Exercise: To exchange an option for the underlying
instrument. Open interest: The number of options that have not
been exercised in a specific contract that has not yet expired.
Expiration: The last day on which an option can be exer-
cised and exchanged for the underlying instrument (usual- Opportunity cost: The value of any other investment
ly the last trading day or one day after). you might have made if your capital wasn’t already in the
markets
Float: The number of tradable shares in a public company.
Outlier: An anomalous data point or reading that is not
Intermonth (futures) spread: A trade consisting of representative of the majority of a data set.
long and short positions in different contract months in the
same market — e.g., July and November soybeans or Out of the money (OTM): A call option with a strike
September and December crude oil. Also referred to as a price above the price of the underlying instrument, or a put
futures “calendar spread.” option with a strike price below the underlying instru-
ment’s price.
In the money (ITM): A call option with a strike price
below the price of the underlying instrument, or a put Parity: An option trading at its intrinsic value.
option with a strike price above the underlying instru-
ment’s price. Premium: The price of an option.
Intrinsic value: The difference between the strike price Put option: An option that gives the owner the right, but
of an in-the-money option and the underlying asset price. A not the obligation, to sell a stock (or futures contract) at a
call option with a strike price of 22 has 2 points of intrinsic fixed price.
value if the underlying market is trading at 24.
Put ratio backspread: A bearish ratio spread that con-
Leverage: An amount of “buying power” that increases tains more long puts than short ones. The short strikes are
exposure to underlying market moves. For example, if you closer to the money and the long strikes are further from the
buy 100 shares of stock, that investment will gain or lose money.
$100 for each $1 (one-point) move in the stock. For example if a stock trades at $50, you could sell one
But if you invest half as much and borrow the other half $45 put and buy two $40 puts in the same expiration month.
from your broker as margin, then you control those 100 If the stock drops, the short $45 put might move into the
shares with half as much capital (i.e., 2-to1 buying power). money, but the long lower-strike puts will hedge some (or
At that point, if the stock moves $1, you will gain or lose all) of those losses. If the stock drops well below $40, poten-
$100 even though you only invested $50 — a double-edged tial gains are unlimited until it reaches zero.
sword.
Put spreads: Vertical spreads with puts sharing the same
Limit up (down): The maximum amount that a futures expiration date but different strike prices. A bull put spread
contract is allowed to move up (down) in one trading ses- contains short, higher-strike puts and long, lower-strike
sion. puts. A bear put spread is structured differently: Its long
puts have higher strikes than the short puts.
Lock-limit: The maximum amount that a futures contract
is allowed to move (up or down) in one trading session. Ratio spread: A ratio spread can contain calls or puts and
includes a long option and multiple short options of the
Long call condor: A market-neutral position structured same type that are further out-of-the-money, usually in a
with calls only. It combines a bear call spread (short call, ratio of 1:2 or 1:3 (long to short options). For example, if a
long higher-strike further OTM call) above the market and stock trades at $60, you could buy one $60 call and sell two
a bull call spread (long call, short higher-strike call). Unlike same-month $65 calls. Basically, the trade is a bull call
an iron condor, which contains two credit spreads, a call spread (long call, short higher-strike call) with the sale of
condor includes two types of spreads: debit and credit. additional calls at the short strike.
Overall, these positions are neutral, but they can have a
Long-Term Equity AnticiPation Securities directional bias, depending on the strike prices you select.
(LEAPS): Options contracts with much more distant expi- Because you sell more options than you buy, the short
ration dates — in some cases as far as two years and eight options usually cover the cost of the long one or provide a
months away — than regular options. continued on p. 40

KEY CONCEPTS continued
net credit. However, the spread contains uncovered, or Support and resistance: Support is a price level that
“naked” options, which add upside or downside risk. acts as a “floor,” preventing prices from dropping below
that level. Resistance is the opposite: a price level that acts
Relative strength (RS): Measures how much one as a “ceiling;” a barrier that prevents prices from rising
instrument (stock, future, sector, etc.) has moved compared higher.
to another. A common use of RS is to see how strong (or Support and resistance levels are a natural outgrowth of
weak) a stock is compared to its sector or the overall mar- the interaction of supply and demand in any market. For
ket. Relative strength is not the same as the Relative example, increased demand for a stock will cause its price
Strength Index (RSI), which is a momentum indicator (oscil- to rise, creating an uptrend. But when price has risen to a
lator) based on the price of a single instrument. certain level, traders and investors will take profits and
There is more than one way to measure relative strength. short sellers will come into the market, creating “resistance”
One technique is to take all the stocks in an industry group to further price increases. Price may retreat from and
or sector and rank them according to their percentage advance to this resistance level many times, sometimes
moves over a certain period (e.g., one month, three months, eventually breaking through it and continuing the previous
six months or one year). The stock with the highest relative trend, other times reversing completely.
strength rank is the one that has moved up the most (in per- Support and resistance should be thought of more as gen-
centage terms) over the given time period relative to the eral price levels rather than precise prices. For example, if a
group. stock makes a low of 52.15, rallies slightly, then declines
again to 52.15, then rallies again, a subsequent move down
Relative strength index (RSI): Developed by Welles to 52 does not violate the “support level” of 52.15. In this
Wilder, the relative strength index (RSI) is an indicator in case, the fact that the stock retraced once to the exact price
the “oscillator” family designed to reflect shorter-term level it had established before is more of a coincidence than
momentum. It ranges from zero to 100, with higher read- anything else.
ings supposedly corresponding to overbought levels and
low readings reflecting the opposite. The formula is: Time decay: The tendency of time value to decrease at an
RSI = 100 – (100/[1+RS]) accelerated rate as an option approaches expiration.
where
RS = relative strength = the average of the up closes over Time spread: Any type of spread that contains short
the calculation period (e.g., 10 bars, 14 bars) divided by the near-term options and long options that expire later. Both
average of the down closes over the calculation period. options can share a strike price (calendar spread) or have
different strikes (diagonal spread).
For example, when calculating a 10-day RSI, if six of the
days closed higher than the previous day’s close, you Time value (premium): The amount of an option’s
would subtract the previous close from the current close for value that is a function of the time remaining until expira-
these days, add up the differences, and divide the result by tion. As expiration approaches, time value decreases at an
10 to get the up-close average. (Note that the sum is divid- accelerated rate, a phenomenon known as “time decay.”
ed by the total number of days in the look-back period and
not the number of up-closing days.) Vertical spread: A position consisting of options with
For the four days that closed lower than the previous the same expiration date but different strike prices (e.g., a
day’s close, you would subtract the current close from the September 40 call option and a September 50 call option).
previous low, add these differences, and divide by 10 to get
the down-close average. If the up-close average was .8 and Volatility: The level of price movement in a market.
the down close average was .4, the relative strength over Historical (“statistical”) volatility measures the price fluctu-
this period would be 2. The resulting RSI would be 100 - ations (usually calculated as the standard deviation of clos-
(100/[1+2]) = 100 - 33.3 = 66.67. ing prices) over a certain time period — e.g., the past 20
days. Implied volatility is the current market estimate of
Schaeffer’s put/call open interest ratio (SOIR): future volatility as reflected in the level of option premi-
The ratio of open puts to open calls among options set to ums. The higher the implied volatility, the higher the option
expire in three months or less. This time period intends to premium.
offer a better gauge of speculative options activity than
measuring all open contracts. Volatility skew: The tendency of implied option volatil-
ity to vary by strike price. Although, it might seem logical
Simple moving average: A simple moving average that all options on the same underlying instrument with the
(SMA) is the average price of a stock, future, or other market same expiration would have identical (or nearly identical)
over a certain time period. A five-day SMA is the sum of the implied volatilities. For example, deeper in-the-money and
five most recent closing prices divided by five, which means out-of-the-money options often have higher volatilities than
each day’s price is equally weighted in the calculation. at-the-money options. This type of skew is often referred to
as the “volatility smile” because a chart of these implied
Strike (“exercise”) price: The price at which an under- volatilities would resemble a line curving upward at both
lying instrument is exchanged upon exercise of an option. ends. Volatility skews can take other forms than the volatil-
ity smile, though.

FUTURES & OPTIONS CALENDAR JANUARY/FEBRUARY
MONTH
January 21 Markets closed – Martin Luther
Legend 1 Markets closed — New Year’s Day King Day
CPI: Consumer Price Index FDD: January natural gas, gasoline, 22 LTD: February crude oil futures
ECI: Employment cost index and crude oil futures (NYMEX) (NYMEX)
First delivery day (FDD): 2 ISM 23
The first day on which deliv- FND: January orange juice futures 24 FND: February crude oil futures
ery of a commodity in fulfill- (ICE); (NYMEX)
ment of a futures contract can FDD: January aluminum,
take place. copper, platinum, palladium, silver, and 25 LTD: February T-bond options (CBOT)
First notice day (FND): Also gold futures (NYMEX); January rice, 26
known as first intent day, this soybean products, and soybean
is the first day a clearing- 27
futures (CBOT)
house can give notice to a 28 LTD: February natural gas, gasoline,
buyer of a futures contract 3 FND: January propane and heating oil
and heating oil options (NYMEX);
that it intends to deliver a futures (NYMEX)
February aluminum, copper, silver, and
commodity in fulfillment of a
futures contract. The clearing-
4 Unemployment gold options (NYMEX
LTD: January currency options (CME);
house also informs the seller. 29 FOMC meeting
February cocoa options (ICE)
FOMC: Federal Open Market Durable goods
Committee 5 LTD: February natural gas and
GDP: Gross domestic 6 gasoline futures (NYMEX); January
product aluminum, palladium, copper, platinum,
7 FDD: January propane futures silver, and gold futures (NYMEX)
ISM: Institute for supply man-
(NYMEX)
agement 30 FOMC meeting
LTD: Last trading day; the 8 GDP
first day a contract may trade 9 FDD: January heating oil futures FND: February natural gas and
or be closed out before the
(NYMEX); January orange juice futures gasoline futures (NYMEX)
delivery of the underlying
(ICE) 31 ECI
asset may occur.
PPI: Producer price index 10 LTD: January orange juice futures LTD: February propane and heating
Quadruple witching Friday:
(ICE) oil futures (NYMEX); January feeder
A day where equity options, 11 LTD: February coffee and sugar cattle futures and options (CME)
equity futures, index options, options (ICE) FND: February aluminum, copper,
and index futures all expire. platinum, palladium, silver, and gold
12 futures (NYMEX)
13 February
JANUARY 2008 14 LTD: January rice, soybean product, 1 Unemployment
30 31 1 2 3 4 5 and soybean futures (CBOT) ISM
6 7 8 9 10 11 12 15 PPI LTD: February pork belly and live
13 14 15 16 17 18 19 Retail sales cattle options (CME); March cocoa
20 21 22 23 24 25 26 LTD: January lumber futures (CME) options (ICE)
FND: March T-bond futures (CBOT)
27 28 29 30 31 1 2 16 CPI
FDD: February natural gas, gasoline,
LTD: February crude oil options
and crude oil futures (NYMEX);
(NYMEX); February platinum options
February aluminum, copper, platinum,
FEBRUARY 2008 (NYMEX)
palladium, silver, and gold futures
27 28 29 30 31 1 2 FND: January lumber futures (CME)
(NYMEX)
3 4 5 6 7 8 9 FDD: January lumber futures (CME)
17 2
10 11 12 13 14 15 16
17 18 19 20 21 22 23 18 LTD: All January equity options; S&P
3
24 25 26 27 28 29 1 options (CME); Nasdaq options (CME); 4 FND: February propane and heating
Russell options (CME); Dow Jones oil futures (NYMEX); February pork
options (CBOT); February orange juice belly and live cattle futures (CME)
options (ICE) 5 FDD: February pork belly futures
The information on this page is
subject to change. Futures &
Options Trader is not responsible
19 (CME)
for the accuracy of calendar dates
beyond press time.
20 6 FDD: February propane futures
(NYMEX)
FUTURES TRADE JOURNAL
The assassination of Benazir Bhutto in

Pakistan sends markets into turmoil and
tests a long position in stock index futures.
TRADE
Date: Thursday, Dec. 27.
Entry: Long the March E-Mini Russell 2000

futures (ER2H08) at 799.70 and long the March E-
Mini Nasdaq 100 futures (NQH08) at 2,157 and
2,152.25.
Reasons for trade/setup: After the big jump

off the Dec. 18 low, the market — not surprisingly
— slowed down on Dec. 24 and Dec. 26.
These trades were an extension of a long trade
from Dec. 26, which was entered and exited at
Source: TradeStation
794.30 and 804.40, respectively. The market was
weak that day but it closed strongly, setting up an
extension of the up move above the implied resistance of the the session and accelerated its slide in the final 45 minutes of
previous high on Dec. 11. trading. We got out of half the Nasdaq position at 2,132.25
The goal was to get back in the market on the long side near the close.
after it pulled back a bit. The opportunity came (in the E- We ignored the initial stops, believing the market was
Mini Russell futures) overnight. overreacting to the assassination but would ultimately turn
The E-Mini Nasdaq 100 position was opened in the first back to the upside. The decision looked justified in the early
hour of trading on Dec. 27 as the market sold off hours of Dec. 28 as the market rebounded, cutting the over-
moderately. all position’s loss in half. The market threw in the towel late
in the morning, however, with the Russell leading the way
Initial stop: 790.20 (Russell), 3.10 below the Dec. 26 low; down. The second half of the Nasdaq trade was liquidated at
2,136 (Nasdaq), 2.25 below the Dec. 26 low. 2,119. At the end of the day, the position was slightly more
underwater than it had been the day before.
Initial target: 811.00 (Russell), approximately 1.5 points The new year brought no respite; the market sold off on
below the Nov. 7 high; 2,173 (Nasdaq), 1 point below the Dec. Jan. 2 and we sold the E-Mini Russell position on a slight
11 high. bounce at 763.10.
The negatives of this trade need no further elaboration.
RESULT The damage wasn’t quite as bad as it appears because of
some intraday short-side hedging that offset some of the
Exit: 763.10 (Russell); 2,132.50 and 2,119 (Nasdaq). long-side damage. Also, we at least waited for some minimal
bounces to exit, thus avoiding the additional pain of selling
Profit/loss: See Trade Summary table. very near the bottom.
But what’s that old saying — “your first lost is your small-
Trade executed according to plan? No. est loss”?
Outcome: The news of the Bhutto assassination didn’t Note: Initial targets for trades are typically based on things such as the
immediately tank the market, which looked set to open the historical performance of a price pattern or trading system signal.
However, individual trades are a function of immediate market behav-
day session around the entry price. Two downthrusts in the
ior; initial price targets are flexible and are most often used as points at
morning, however, eventually pushed the E-Mini Russell which a portion of the trade is liquidated to reduce the position’s open
futures down more than 1.5 percent by noon (ET). After a risk. As a result, the initial (pre-trade) reward-risk ratios are conjec-
brief respite the market continued to sell off the remainder of tural by nature.
TRADE SUMMARY
Date Contract Entry Initial Initial IRR Exit Date P/L LOP LOL Trade
stop target length
12/27/07 ER2H08 799.7 790.2 811 1.19 763.10 1/2/08 -27.1 (4.6%) 1.4 -47.5 3 days
NQH08 2,157 2,136 2,173 0.76 2,132.5 (1/2 trade) 12/27/07 -24.5 (1.1%) 1.25 -32.25 5 hours
NQH08 2,152.25 2,136 2,173 1.28 2,119 (1/2 trade) 12/28/07 -33.25 (1.5%) 5 -39.75 1 day
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).
OPTIONS TRADE JOURNAL
FIGURE 1 — JUMPING BEFORE THE SPLIT Instead of exploiting an overnight jump, we catch
XTO Energy gained 0.92 percent in the final
hour of trading on Dec. 13 before its 5:4 a brief, strong rally just before a stock split.
stock split the following morning. Instead of
buying calls at the close, we entered this TRADE around 3:20 p.m., we bought two
trade early and sold at the close, capturing a January 65-strike calls for $2.65 each.
profit of $0.25 per contract (9.4 percent). Date: Thursday, Dec. 13. The position has a total delta of
109.5, so its directional exposure
Market: Options on XTO Energy resembles 109.5 underlying shares.
(XTO). Moreover, the calls don’t expire for 37
days, so daily time decay ($7.32) isn’t
Entry: Buy 2 January 2008 65 really a problem for a trade we expect
calls at $2.65 each. to hold overnight.
Reasons for trade/setup: On Initial stop: Exit if calls drop below

Nov. 14, XTO Energy (XTO) $1.35 each.
announced plans to split its stock
five-to-four (5:4) on Dec. 14, mean- Initial target: Hold overnight and
ing investors will receive five exit at tomorrow’s open.
shares for every four shares held.
Because last month’s stock-split Outcome: Figure 1 shows XTO trad-
trade was profitable, we studied ed higher after the trade was filled, so
options on XTO to find a short- it was immediately profitable. Within
term, bullish trade. an hour, XTO Energy rallied another
Historically, S&P 500 stocks 0.69 percent and the long call’s ask hit
gained roughly 2.6 percent, on $3.00. At that point, the stock had
Source: eSignal average, from stock-split climbed further than expected, and we
announcement days to the day sold each call for $2.90 each — a gain
TRADE SUMMARY before stocks actually split in price. of $0.25 per contract (9.4 percent).
Entry date: Dec. 13, 2007 This interim period lasted about 30 Was exiting early a mistake? Figure
Underlying security: XTO Energy (XTO) trading days, but ranged from two 2 shows it’s hard to tell: XTO opened
Position: Long calls to 117 days in length since January 0.3 percent higher, but plunged 1.52
Initial capital required: $530 2000. Then stock-split candidates percent within five minutes. Given the
gained 0.49 percent from the prior logistical problems of trading on
Initial stop: Exit if calls drop in
value by 50 percent. day’s close to the split day’s open. stock-split days, we probably couldn’t
Initial target: Hold overnight. XTO Energy climbed 4.65 per- have captured a larger gain.
Initial daily time decay: $7.32 cent from Nov. 14 to Dec. 13, rally-
Trade length (in days): 1 ing in-line with this historical pat- FIGURE 2 — HIGHER OPEN,
P/L: $50 (9.4 percent) tern. But will XTO also jump LOWER CLOSE
LOP: $70 overnight to open higher on Dec.
XTO Energy opened 0.3 percent high-
LOL: $0
14?
er, in-line with historical patterns. But
LOP — largest open profit (maximum available Buying in-the-money (ITM)
XTO fell 1.8 percent within 30 min-
profit during life of trade). calls is one way to profit from an utes, rebounded somewhat, then
LOL — largest open loss (maximum potential loss overnight pop, because they have closed 0.28 percent lower on the day.
during life of trade). high deltas, which means they
move roughly in sync with the
TRADE STATISTICS underlying’s price. However, ITM
calls have less leverage than calls at
Dec. 13 3:20 p.m. 4 p.m.
other strikes and are somewhat con-
Delta 109.5 120
servative. Therefore, near-the-money
Gamma 13.32 13.71
calls might offer a larger percentage
Theta -7.32 -6.99
return on investment.
Vega 16.46 16.38
Figure 1 shows XTO traded at
Probability 36 39 $65.02 at 2 p.m. on Dec. 13 before
of profit percent percent
climbing 1 percent within an hour. At
Breakeven 54.12 54.12 first, we planned to buy at-the-money
point (split price) (split price)
(ATM) calls at the close, but when
XTO Energy fell 0.52 percent to $65.35 Source: eSignal

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January 2008

Futures Trading System Lab . . . . . . . .22

Options Trading System Lab . . . . . . . .24

Short interest and relative strength . . . .18

2 January 2008 • FUTURES & OPTIONS TRADER

FX OPTIONS FX OPTIONS FX OPTIONS

Learn to trade your views

What are FX Options?

Currency Convention Symbol

Senate moves CFTC reauthorization Futures Snapshot . . . . . . . . . . . . . . . . . . . .34

OneChicago offers remedy Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36

Options Watch: Financial Futures Trade Journal . . . . . . . . . . . . . . .42

Have a question about something you’ve seen

Looking for an advertiser?

in this month’s issue of Futures & Options Trader.

4 January 2008 • FUTURES & OPTIONS TRADER

Bernie Schaeffer is chairman and CEO of Schaeffer’s

Editor-in-chief: Mark Etzkorn

Editorial assistant and

6 January 2008 • FUTURES & OPTIONS TRADER

STOCKS . OPTIONS . FUTURES . FOREX

Oil driller strategy

T rading oil can sometimes feel like trying to

1. Both the open and close

8 January 2008 • FUTURES & OPTIONS TRADER

As formulas the pattern rules are:

All prices are the most recent

However, this pattern has a notable

FUTURES & OPTIONS TRADER • January 2008 9

this was the more dynamic period for

TABLE 1 — 1998-2007 PATTERN DETAILS

10 January 2008 • FUTURES & OPTIONS TRADER

Not a bear pattern “Short-term crude oil tendencies”

12 January 2008 • FUTURES & OPTIONS TRADER

FUTURES & OPTIONS TRADER • January 2008 13

TABLE 3 — VOLATILITY DROPS, SPREAD LOSES VALUE

Barrick Gold (ABX) closed at $32.39 on Aug. 16:

Barrick Gold (ABX) climbed to $34.48 by Aug. 23:

14 January 2008 • FUTURES & OPTIONS TRADER

Remember that longer-dated options

The elusive volatility trade

FUTURES & OPTIONS TRADER • January 2008 15

“Death, taxes, and time decay”

16 January 2008 • FUTURES & OPTIONS TRADER

What went wrong?

FUTURES & OPTIONS TRADER • January 2008 17

BY BERNIE SCHAEFFER AND BETH GASTON MOON

S hort interest is the num-

18 January 2008 • FUTURES & OPTIONS TRADER

Moved 5% in 1 day Moved 8% in 2 days

FUTURES & OPTIONS TRADER • January 2008 19

Options hold clues

20 January 2008 • FUTURES & OPTIONS TRADER

For information on the author see p. 6.

FUTURES & OPTIONS TRADER • January 2008 21

Source: Wealth-Lab Pro 5.0 A low BandWidth reading reflects a

Standard Bollinger Band parameters

22 January 2008 • FUTURES & OPTIONS TRADER

Percentage Max Max

tions above and below the average.

Profitability Trade statistics

FUTURES & OPTIONS TRADER • January 2008 23

System concept: New options