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Strategies, analysis, and news for futures and options traders

September 2007 • Volume 1, Issue 6

ROLLING LEAP strategy p. 22

T-NOTE FUTURES:

Trading characteristics p. 8

TRADING OPTIONS with the COT report p. 16

STOCK MARKET sell-off patterns p. 15

FUTURES SYSTEM LAB:

“Dangling carrot” system p. 28

INTERVIEW:

PAYAM PEDRAM AND JACQUES L. DEVORE of Ascendant Asset Advisors p. 34

CONTENTS Market history update Triple-witching expirations: More bullish in recent years . . . .
CONTENTS
Market history update
Triple-witching expirations:
More bullish in
recent years
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Does the stock market exhibit a tradable
pattern around quarterly expirations?
Futures Trading System Lab
Trend pullback
with progressive target
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An adaptive exit rule is used to fight
slippage and avoid giving back profits
in a trend-following system.
By Volker Knapp
Contributors
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Options Trading System Lab
Buying options on ADX breakouts
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Trading Strategies
By Steve Lentz and Jim Graham
Trading
today’s
T-note futures
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A look at patterns in the 10-year T-note
futures: intraday volatility, closing tendencies,
and more.
By Thom Hartle
Trader interview
Payam Pedram and Jacques L. DeVore of
Ascendant Asset Advisors
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Summer swoons, fall boons
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Is the stock market poised for a fall sell-off?
Price history holds interesting clues.
By FOT staff
These options traders sell calls on stock
index futures, a strategy that finally paid
off this summer.
By David Bukey
continued on p. 4
Straddling the COT report
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Timing a long options straddle on
the S&P 500 with data from the
Commitment of Traders report.
By Charlie Santaularia
Rolling LEAPS calls
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In bull markets, this strategy has the
potential to outperform buy-and-hold
with less risk.
By Tristan Yates
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September 2007 • FUTURES & OPTIONS TRADER
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .
CONTENTS Industry News CFTC seeks greater oversight, more funding . . . . . .

CONTENTS

Industry News CFTC seeks greater oversight, more funding

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.38

The Commodity Futures Trading Commission might have OTC products under its jurisdiction soon, and the agency is seeking an extended budget. By Jim Kharouf

Nasdaq enters crowded options arena

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A new exchange run by the Nasdaq will bring the number of U.S. options exchanges to seven.

ICE

goes two for two

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The IntercontinentalExchange closes the deal to acquire the Winnipeg Commodity Exchange and wins a court battle vs. NYMEX. By Jim Kharouf

Hedge fund goes down

Sentinel Management Group, a money-management firm, filed for bankruptcy in mid-August after fraud charges were filed against it.

TT patent challenged at USPTO

Software firm Trading Technologies is once again facing objections to its patents. By Jim Kharouf

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New Products and Services Futures Snapshot . . . . . . . . .

New Products and Services

Futures Snapshot

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Momentum, volatility, and volume statistics for futures.

Option

Radar

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Notable volatility and volume.

Key Concepts

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References and definitions.

Events

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Futures & Options

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Calendar

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Futures Trade Journal

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Long stock-index futures trade is a bumpy ride.

Options Trade Journal

.56

Buying puts after stock downgrades.

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Have a question about something you’ve seen

in Futures & Options Trader?

Submit your editorial queries or comments to webmaster@futuresandoptionstrader.com.

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September 2007 • FUTURES & OPTIONS TRADER

CONTRIBUTORS CONTRIBUTORS A publication of Active Trader ® For all subscriber services:

CONTRIBUTORS CONTRIBUTORS

CONTRIBUTORS CONTRIBUTORS A publication of Active Trader ® For all subscriber services:

A publication of Active Trader ®

For all subscriber services:

www.futuresandoptionstrader.com

Editor-in-chief: Mark Etzkorn metzkorn@futuresandoptionstrader.com

Managing editor: Molly Flynn mflynn@futuresandoptionstrader.com

Senior editor: David Bukey dbukey@futuresandoptionstrader.com

Contributing editors:

Jeff Ponczak jponczak@futuresandoptionstrader.com, Keith Schap

Editorial assistant and Webmaster: Kesha Green kgreen@futuresandoptionstrader.com

Art director: Laura Coyle lcoyle@futuresandoptionstrader.com

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Volume 1, Issue 6 . Futures & Options Trader is pub- lished monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright © 2007 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher.

The information in Futures & Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trad- ing idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.

Charlie Santaularia is managing director of Parrot Charlie Santaularia Trading Partners, LLC (CPO/CTA). He holds a bachelor of arts in economics from the Trading Partners, LLC (CPO/CTA). He holds a bachelor of arts in economics from the University of Kansas and has been active- ly trading for the past four years. He has a NASD series 3 license and is charge of marketing, market research, and client contact, and actively assists with trading decisions. In addition to writing a monthly newsletter for the firm’s investors, he has been published in indus- try magazines, http://www.stockweblog.com and http://www.commodity- trader.com.

and http://www.commodity- trader.com . Thom Hartle ( http://www.thomhartle.com ) is director of

Thom Hartle (http://www.thomhartle.com) is director of marketing for CQG and a contributing editor to Active Trader magazine. In a career spanning more than 20 years, Hartle has been a commodity account executive for Merrill Lynch, vice president of financial futures for Drexel Burnham Lambert, trader for the Federal Home Loan Bank of Seattle, and editor for nine years of Technical Analysis of Stocks & Commodities magazine. Hartle also writes a daily market blog called hartle & flow (http://www.hartleand- flow.com).

Tristan Yates writes and consults on leveraged indexed investment strategies. He graduated from the INSEAD MBA program in Singapore and now manages the Index Roll, an investment advisory, research group, and Web resource created to help individual investors build and manage long- term leveraged index portfolios. He can be reached at tristan@indexroll.com.

Volker Knapp has been a trader, system developer, and researcher for more than 20 years. His diverse background encompasses positions such as German National Hockey team player, coach of the Malaysian National Hockey team, and pres- Volker Knapp has been a trader, system developer, and ident of VTAD (the German branch of ident of VTAD (the German branch of the International Federation of Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc. (http://www.wealth-lab.com), which he is still running.

Jim Graham (advisor@optionvue.com) is the product man- ager for OptionVue Systems and a registered investment advisor for OptionVue Research.

and a registered investment advisor for OptionVue Research. Steve Lentz ( advisor@optionvue.com ) is executive vice

Steve Lentz (advisor@optionvue.com) is executive vice president of OptionVue Research, a risk-management consulting company. He also heads education and research programs for OptionVue Systems, includ- ing one-on-one mentoring for intermediate and advanced traders.

TRADING STRATEGIES Trading today’s T-note futures Volatility in the T-note futures is notably lower than

TRADING STRATEGIES

Trading today’s T-note futures

Volatility in the T-note futures is notably lower than it was a few years ago. Find out what that means for your trading strategies.

FIGURE 1 — ANALYSIS PERIOD The review period contained an uptrend, a downtrend, and a
FIGURE 1 — ANALYSIS PERIOD
The review period contained an uptrend, a downtrend, and a wide, choppy trading range.
Source: CQGNet (http://www.cqg.com)
FIGURE 2 — DAILY RANGE The slight upward slope of the regression line indicates a
FIGURE 2 — DAILY RANGE
The slight upward slope of the regression line indicates a small rise in
daily range volatility over the review period, but overall, the typical
range during this time was smaller than during the original analysis
period.

BY THOM HARTLE

A lthough some aspects of markets never change, specific vo- latility and price pat-

terns evolve over time, and only those traders who can adapt their strategies to the prevailing market conditions are likely to enjoy sus- tained success. Dissecting T-note futures:

Tendencies and characteristics” (Active Trader, July 2005) details the behavior of the 10-year T-note futures (TY) contract from March 1, 2004 to Feb. 28, 2005. This updated analysis reviews the 10-year T-note from July 3, 2006 to June 29, 2007 and highlights any changes in this market’s trading attributes. The characteristics the analysis covers include the market’s typical daily ranges, close- to-close moves, lows for up-closing sessions, and highs for down-closing sessions. These sta- tistics help traders understand:

How much the market moves during each trading session. Where the market tends to close within the day’s range. How much below the previous day’s close the market can be expected to trade and still close up on the day, which is use- ful information for traders holding long positions or those looking to go long on an intraday pullback. How much above the previous day’s close the market can be expected to trade and still close down on the day, which is

useful information for traders holding short positions or those looking to go short on an intraday “pull up.”

In addition, the Fridays when the employ- ment report is released are analyzed as a group, because this report tends to trigger big moves in the treasury market. The tick size for the 10-year T-note contract is half a 32nd, which is referred to as a “plus” tick. For example, in the price 108-04+ the “04+” rep- resents four-and-a-half 32nds. In the following charts, prices have been converted from 32nds to decimal format, which would make the 108- 04+ price 108.140625. For more information on T-note pricing conventions, see “Treasury refresher.” Figure 1 is a daily bar chart of the review period. After the July-September 2006 uptrend, the market essentially entered a wide trading range for several months, making a new high in December and a multi-month low in January. The spring sell-off brought the market to its lowest level in a year.

Daily ranges: How much does the market move in a day?

The first market characteristic to be analyzed is daily range. Figure 2 shows the daily ranges from the July 3, 2006 to June 29, 2007 review period with a regression line plotted through the data. The regression line has a slight upward slope, indicating the daily ranges expanded as the review period progressed. The largest daily range was 1.265625 points (1-8.5/32nds), which occurred on Feb. 22, 2007. The smallest daily range was just 0.125 points (4/32nds), which occurred on Oct. 24, 2006. The average and median daily ranges of 0.4204 points (13.45/32nds) and 0.3750 points (12/32nds) were very similar, which suggests a 12 to 13/32nd range can be considered “typi- cal.” By comparison, the average daily range from March 1, 2004 to Feb. 28, 2005 was 0.6044 points (19.34/32nds) and the median range was 0.516250 points (16.5/32nds). This is the first indication volatility has declined since the first analysis period — a drop of more than 30 per- cent in the average daily range (-28 percent in the median range). Figure 3 shows the frequency distribution of the daily ranges — how often daily ranges of different sizes occurred. Distribution analysis

continued on p. 10

FIGURE 3 — DAILY RANGE DISTRIBUTION: JULY 2006-JUNE 2007 The most common daily range size
FIGURE 3 — DAILY RANGE DISTRIBUTION: JULY 2006-JUNE 2007
The most common daily range size (90 occurrences) was 0.375 points
(12/32nds) through 0.50 points (16/32nds).
FIGURE 4 — DAILY RANGE DISTRIBUTION: MARCH 2004-FEBRUARY 2005 In the initial review period, the
FIGURE 4 — DAILY RANGE DISTRIBUTION:
MARCH 2004-FEBRUARY 2005
In the initial review period, the most common daily range size is 0.50
points (16/32nds) through 0.6125 points (20/32nds).
FIGURE 5 — CLOSE RELATIVE TO DAILY RANGE: JULY 2006-JUNE 2007 In the recent review
FIGURE 5 — CLOSE RELATIVE TO DAILY RANGE:
JULY 2006-JUNE 2007
In the recent review period there was a slight tendency to close near
the bottom or top of the day’s range.
TRADING STRATEGIES continued FIGURE 6 — CLOSE RELATIVE TO DAILY RANGE: MARCH 2004-FEBRUARY 2005 During
TRADING STRATEGIES continued
FIGURE 6 — CLOSE RELATIVE TO DAILY RANGE:
MARCH 2004-FEBRUARY 2005
During the first review period, the market tended to finish the session
higher off the daily low than in the latest review period.
FIGURE 7 — LOWS ON UP-CLOSING DAYS:
JULY 2006-JUNE 2007
The market dropped more than 0.25 points (8/32nds) below the
opening price and still closed up only seven times.

Treasury refresher

Treasury bonds and notes are debt securities issued by the United States Treasury. They are considered debt instruments because by purchasing them you are loaning money to the Treasury department, which then pays you interest (determined by a “coupon rate”) on a semiannual basis and returns the princi- ple when the bond or note matures on the maturity date. T-bonds and T-notes are called “fixed-income” securities because of the fixed coupon payment an investor receives while holding the bond or note. T-notes are issued in maturities of two, three, five, and 10 years; T-bonds have matu- rities greater than 10 years. The minimum bond or note size is $1,000. For example, if you purchased a $1,000 10-year T-note with a 4-percent coupon, you would receive $20 every six months, totaling $40 per year; the $1,000 would be paid back to you on the maturity date 10 years from now. A bond or note’s yield is its coupon payment divided by the price — in this case, $40/$1,000 = 4 per- cent. Treasury futures prices indicate a percent- age of “par” price, which for any Treasury bond or note is 100. T-bond prices consist of the “handle” (e.g., 100) and 32nds of 100. For example, 98-14 is a price that translates to 98-14/32nds or $984.38 for a $1,000 T-bond. T-notes are priced in a similar fashion, except they can include one-half of a 32 nd — for example, 98-14+ is 98-14.5/32nds, or 984.53 for a $1,000 T-note.

helps identify typical market behavior, as well as how often unusual situations occur. The x-axis, which represents range size, increases in 0.0625-point (2/32nd) increments, and the y-axis shows the number of ranges that occurred in the different size cate- gories. For example, the peak reading (90, third bar from the left) means there were 90 days with ranges greater than 0.375 points (12/32nds) up to and including 0.50 points

(16/32nds).

Now look at Figure 4, which is the frequency distribution

chart from the March 2004-February 2005 analysis window. Comparing Figures 3 and 4 highlights the daily volatility contraction that has occurred since the original analysis. In Figure 4, the peak reading (64 occurrences) of the daily range was between 16/32nds and 20/32nds — which means the upper end of the current most common daily range category was the lower end of the former most com- mon category. There was a slight decline in this category in July 2006-June 2007: there were only 54 days with ranges between 16/32nds and 20/32nds.

FIGURE 8 — DISTRIBUTION OF LOWS ON UP-CLOSING DAYS: JULY 2006-JUNE 2007 On days the
FIGURE 8 — DISTRIBUTION OF LOWS ON UP-CLOSING DAYS:
JULY 2006-JUNE 2007
On days the 10-year T-note closed higher, the lows tended to be no
more than 0.1250 points (4/32nds) below the opening price.
FIGURE 9 — DISTRIBUTION OF LOWS ON UP-CLOSING DAYS: MARCH 2004-FEBRUARY 2005 During the first
FIGURE 9 — DISTRIBUTION OF LOWS ON UP-CLOSING DAYS:
MARCH 2004-FEBRUARY 2005
During the first analysis period, the market traded more than a full point
below the open and still closed higher.

Figure 9 is the frequency distribution for lows on up-clos- ing days for the March 2004-February 2005 period. Comparing it to Figure 8 reveals there was a shift toward smaller post-opening down moves on up-closing days dur- ing the July 2006-June 2007 period, as well as a lack of extreme downside. Figure 9 shows that during the March 2004-February 2005 period the market was down more than a point and still closed up on the day.

continued on p. 12

Another key trading tendency is how a mar- ket tends to close, which is the subject of the next portion of the analysis.

How does the market close?

Figure 5 is a frequency distribution showing where the 10-year T-note futures tended to close within the day’s range on a percentage basis — i.e., a close at precisely 10 percent would mean the close was 10 percent above the low, a close at the 90-percent level would mean the close was 10 percent below the high, a close at 100 percent would mean the market closed at the high of the day, and so on. Each x-axis category in Figure 5 represents a range of 10 percentage points. For example, the “10%” bar represents the number of days (11) the market closed more than 10 percent up to and including 20 percent above the low. The two highest bars indicate the market often closed in the lower 20-30 percent of the daily range (the 20% bar) or the upper 10-20 percent of the day’s range (the 90% bar). Figure 6, which is the comparable chart for March 2004-February 2005, shows that during this period the 10-year T-note futures tended to close farther away from the low of the day than during the more recent period.

Up-closing and down-closing days

Another attribute to consider is how the 10-year T-note futures trade on up-closing days vs. down-closing days. Figure 7 plots the up-clos- ing daily bars of the current review period rela- tive to the session’s opening price. The bars are adjusted so that zero is the opening price, which makes it easy to see how much price action occurred above and below this price point. The market rarely traded more than 0.25 points (8/32) below the opening price on days it would eventually close higher — good information if, for example, you’re trading from the long side intraday and want to know how far you should let the market go against you before exiting. Figure 8 is a frequency distribution chart of the lows from Figure 7. Most of the time the market traded no more than 0.1250 below the open on up-closing days. The biggest post- opening drop on an up-closing day was -0.4375 (12/32nds).

TRADING STRATEGIES continued Related reading “Dissecting T-note futures: Tendencies and characteristics” Active

TRADING STRATEGIES continued

Related reading

“Dissecting T-note futures: Tendencies and characteristics” Active Trader, July 2005. A detailed understanding of a market’s price his- tory and characteristics allows you to craft trade strategies founded on statistical reality rather than casual observation. The following analysis takes the pulse of the T-note futures market.

Note: This article is also contained in the discounted compilation, “Thom Hartle Strategy and Analysis Collection, Vol. 2.”

“Short-term T-bond trading” Active Trader, October 2002. This strategy takes quick intraday profits using rules determined by the daily trend. Using a com- bination of indicators, it is possible to trade T- bond futures on a short-term basis when the bond market is in a trend or trading range. This technique uses a multiple-time frame approach:

Two indicators applied to daily bars work together to determine the trend; two others, Bollinger Bands and the moving average convergence- divergence (MACD) indicator, identify entry and exit signals on an intraday basis.

“Treasury bonds and notes” Active Trader, June 2005. Trading Basics: A primer on the U.S. Treasury market.

“The TUT spread: An active spread for active traders” Active Trader, October 2005. The spread between 10-year and two-year T-note contracts offers a vehicle for taking advantage of interest rate shifts.

Note: This article is also contained in the discounted compilation, “Keith Schap: Futures Strategy collection, Vol. 1.”

“The hidden factor in treasury futures pricing” Active Trader, March 2006. Those looking for insights into the treasury mar- ket should analyze the interesting relationships between the cash and futures market, as well as interest rate movements.

“The 2-year/10-year Treasury spread and the S&P 500” Active Trader, September 2006. Traders often infer stock market behavior from developments in the 2-year/10-year T-note spread, but there might be less to this relationship than many think.

You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.

FIGURE 10 — HIGHS ON DOWN-CLOSING DAYS: JULY 2006-JUNE 2007 There were only two times
FIGURE 10 — HIGHS ON DOWN-CLOSING DAYS:
JULY 2006-JUNE 2007
There were only two times when the market traded more than 0.50
points (16/32nds) above the open and still closed down for the session.
FIGURE 11 — DISTRIBUTION HIGHS ON DOWN-CLOSING DAYS: JULY 2006-JUNE 2007 The market tended to
FIGURE 11 — DISTRIBUTION HIGHS ON DOWN-CLOSING DAYS:
JULY 2006-JUNE 2007
The market tended to climb more above the opening price on days it
closed lower than it fell more below the opening price on days it closed
higher.

Figure 10 shows the daily bars for down-closing days adjusted to the opening price. The 10-year note tended to trade higher above the open on down-closing days than lower below the open on up-closing days. The market traded above the open by more than 0.25 points (8/32nds) and still closed down 13 times. Twice, the market was up more than 16/32nds above the open and still closed down. Figure 11 is a frequency distribution chart of the highs relative to the opening price for each session. Figure 12 is the comparable chart for the March 2004-February 2005 period. As was the case for lows on

continued on p. 14

TRADING STRATEGIES continued up-closing days, the market made more extreme highs and still closed down

TRADING STRATEGIES continued

up-closing days, the market made more extreme highs and still closed down in the 2004-2005 period than in the 2006-2007 period. However, while volatility has dropped over- all, in both review periods traders showed a tendency to bid prices higher above the open on down-closing sessions than to push it below the open on up-closing sessions.

T-notes and the employment report

The first Friday of each month the Commerce Department releases the employment report, which can trigger wild moves in the T-note market, just as it can in the stock market. Figure 13 shows the daily ranges for each employment Friday between July 2006 and June 2007. The daily range exceeded a full point only twice during the updated review period. This is quite a change from the 2004-2005 peri- od, during which the 10-year note daily range was more than a point on nine different employment Fridays (Figure 14).

Lessons learned

Some significant differences emerge when comparing the two analysis periods — all a function of the market’s reduced volatility. First, the average daily range dropped signifi- cantly — some 30 percent — between 2004- 2005 and 2006-2007. The 10-year note still exhibits a tendency to make lows nearer to the opening price on up- closing days than to make highs nearer to the open on down-closing days — but again, the extreme levels for both highs and lows have come down during the latest review period. Most striking is the decline in the typical daily ranges on employment Fridays. The mar- ket had a daily range in excess of a full point only twice during the new review period on an employment-report Friday. This type of research is critical for staying abreast of the market’s current condition and the kind of strategies that most likely work in it. Price targets and stop-loss levels built upon the statistics published in the 2005 article would be inappropriate for today’s T-note market.

For information on the author see p. 6.

FIGURE 12 — DISTRIBUTION OF HIGHS ON DOWN-CLOSING DAYS: MARCH 2004-FEBRUARY 2005 As in Figure
FIGURE 12 — DISTRIBUTION OF HIGHS ON DOWN-CLOSING DAYS:
MARCH 2004-FEBRUARY 2005
As in Figure 9, during the earlier review period, the market made more
extreme highs on down-closing days.
FIGURE 13 — DAILY RANGES FOR EMPLOYMENT FRIDAYS: JULY 2006-JUNE 2007 The 10-year T-note daily
FIGURE 13 — DAILY RANGES FOR EMPLOYMENT FRIDAYS:
JULY 2006-JUNE 2007
The 10-year T-note daily range exceeded one point (1-00) only twice
on employment-number Fridays during the current analysis period.
FIGURE 14 — DAILY RANGES FOR EMPLOYMENT FRIDAYS: MARCH 2004-FEBRUARY 2005 During the more-recent review
FIGURE 14 — DAILY RANGES FOR EMPLOYMENT FRIDAYS:
MARCH 2004-FEBRUARY 2005
During the more-recent review period, the daily ranges exceeded one
point on nine of 12 employment Fridays.
TRADING STRATEGY Summer swoons, fall boons Traders and investors often get nervous when the leaves

TRADING STRATEGY

Summer swoons, fall boons

Traders and investors often get nervous when the leaves start to turn, but summer sell-offs — such as the one that occurred this year — have usually not presaged fall meltdowns.

BY FOT STAFF

I t was a rough summer for the stock market, but traders fearful of more carnage to come in the often-volatile months of September and October might take some

solace from analysis of past years in which equities have slumped from June through August. As of Aug. 30, the S&P was down 4.7 percent from the May 31 close. In the 47 years from 1960 to 2006, the S&P 500 lost ground from the last day of May through the last day of August (close-to-close basis) 18 times. In 12 of those years, the S&P posted a positive return from the last trading day of August to the last trading day of October. The medi- an September-October gain is 0.28 percent in years the S&P posted a June-August gain, but that figure jumps to 2.08 percent in years the index lost ground in June-August. Furthermore, of the six times the S&P failed to move higher in September and October, four (including 2001 and 2002) were years in which the S&P 500 was already down for the year as of June 1. In 2007, by comparison, the S&P was up nearly 8 percent at the beginning of June. Of the nine years when the S&P was positive for the year on June 1 but posted a negative June-August, seven had positive

 

September-October S&P return…

 

if June-Aug. was up

if June-Aug. was down

Median

0.28%

2.08%

Average

-0.61%

1.60%

47 years from 1960-2006

 

September-October returns. The number of examples will likely leave statisticians wanting more data, but these numbers bring a hypothesis to mind: In years the stock market is up significantly at the halfway mark, the absence of a summer decline may only postpone a correction until fall — and then make it more severe. A summer sell-off might flush out the market and reduce the potential selling pressure that troubles so many traders and investors in September and October. For more information on this study, and other stock-mar- ket sell-off trading patterns, see “Playing the breaks” in the November issue (on newsstands in October) of Active Trader magazine.

patterns, see “Playing the breaks” in the November issue (on newsstands in October) of Active Trader
TRADING STRATEGIES Straddling the COT report FIGURE 1 — S&P 500 VS. LARGE SPECS, ONE

TRADING STRATEGIES

Straddling the COT report

FIGURE 1 — S&P 500 VS. LARGE SPECS, ONE YEAR Fund managers were net long
FIGURE 1 — S&P 500 VS. LARGE SPECS, ONE YEAR
Fund managers were net long in the fall of 2006, but shifted to a net short position
in May when the S&P 500 began to hit new highs.
Source: www.schaeffersresearch.com

Strategy snapshot

Strategy: Long straddle.

Underlying market: E-Mini S&P 500 futures (ES).

Market bias: Neutral.

Components: One ATM call, one ATM put.

Logic: A five-year low in large speculators’ net positions will lead to a significant underlying move in either direction.

Timing: 67 days.

Profit target: Exit after 25-percent gain.

Stop-loss: Exit after 25-percent loss in first two weeks; or exit 14 days until expiration.

Best-case scenario: Underlying market moves sharply in either direction before options expire. Maximum reward theoretically unlimited.

Worst-case scenario: Underlying market goes nowhere and both options expire worthless.

Tracking shifts in large-trader sentiment can signal trade opportunities. This long straddle was triggered by an extreme reading in the S&P 500 futures.

BY CHARLIE SANTAULARIA

T raders often view the Commitment of Traders (COT) report as a futures market Rosetta Stone —

the key to deciphering where different markets are headed. The problem is that the report can confuse as much as

it clarifies.

Each week, the Commodity Futures Trading Commission (CFTC) publish- es the COT report, which lists open interest in more than 90 futures mar- kets — from stock indices, interest rates, and foreign currencies to coffee, corn, and milk (for more details, see “The Commitment of Traders report”). Positions are broken down into categories representing commer- cial traders (businesses that either use or produce the actual commodities they trade), large speculators (hedge funds, commodity trading advisors, and other money managers), and retail speculators (the “small specs,” or public). Traders and analysts contend trade signals can be tied to extreme position levels among the different groups. If,

for example, large speculators’ net position size (longs - shorts) climbs to

a multi-year high, the market could

drop, because those long positions will eventually be unwound. (A

recent article outlining this type of contrarian approach in the Russell 2000 index — “Cracking the COT code” — appeared in the July 2007 issue of Futures & Options Trader.) The following discussion uses COT data from the S&P 500 futures (SP) to find an appropriate options trade. Large-speculator net positions in the S&P hit a three-year low in July. In the past seven years, extreme lows in large speculators’ positions have led to significant underlying moves in either direction. Entering a long straddle (long call, long same-strike put) is one way to profit from a large move in the underlying.

What can open interest tell us?

This analysis focuses on large specu- lators, the COT group consisting of hedge-fund managers, mutual-fund managers, brokerage firms, banks, and other professional managers who hold least 600 contracts in the S&P 500 futures. CFTC reportable lev- els are 600 contracts or more, a bench- mark that defines a large speculator (more than 600 contracts) and a small speculator (less than 600 contracts). As a general rule, if a market’s COT data shows a net short position (less than zero), that market might fall (or consolidate) as traders anticipate a sell-off. Also, if more traders are net long (greater than zero) the sentiment may be bullish. However, this rela- tionship isn’t always accurate, as the following examples demonstrate.

Shifting winds in the S&P

500

Figure 1 compares the S&P 500 futures (red line) with the net position of large speculators during the past 12 months (blue line). Figure 2 shows the same comparison over the past five years. Large speculators held 40,000 long positions in November 2006 and stayed long until the S&P 500 began to hit new highs this past spring. They shifted to a net short position in May — the first negative reading in more

continued on p. 18

FIGURE 2 — S&P 500 VS. LARGE SPECS, FIVE YEARS Large speculators held more than
FIGURE 2 — S&P 500 VS. LARGE SPECS, FIVE YEARS
Large speculators held more than 45,000 net short positions by July 16 –
a five-year low.
Source: www.schaeffersresearch.com
by July 16 – a five-year low. Source: www.schaeffersresearch.com FUTURES & OPTIONS TRADER • September 2007
TRADING STRATEGIES continued
TRADING STRATEGIES continued

TABLE 1 — POST-PATTERN STATS

After large-speculator positions hit yearly lows, the S&P 500 tended to be more volatile than usual over the next 67 days. Entering a September straddle is one way to capture a possible volatility increase.

S&P 500 performance 67 days after yearly lows in net large speculator positions since 2000.

Close-to-high

Close-to-low

Close-to-close

 

move

move

move

Median

7.90%

-6.14%

5.75%

Benchmark

4.76%

-2.35%

1.31%

than 12 months — when the S&P 500 futures climbed above 1,520. By July 16, they held more than 45,000 short positions — a three-year low. What was the meaning of this sentiment shift? On the surface, it seems bearish, because demand for equities waned among large specs. However, testing showed the S&P 500 tended to move more than usual — up or down — in the two months after large speculator positions reached yearly lows since 2000. Table 1 shows the S&P 500’s median close-to-high, close- to-low, and close-to-close moves in the two months follow- ing yearly lows in smart-money positions. It compares

TABLE 2 — LONG STRADDLE COMPONENTS

The E-Mini S&P 500 futures must move 4.8 percent in either direction by Sept. 21 to overcome the straddle’s cost ($4,062.50).

 

E-Mini S&P 500 September contract closed at 1,559.75 on July 16.

Position

Price

Commission

Cost

1

long September

1,550 call

$45.25

$25

$2,287.50

1

long September

1,550 put

$35

$25

$1,775

 

Total cost/risk:

$4,062.50

 

Breakeven point:

4.8 percent (up or down)

these moves to all same-length moves during the same peri- od (“benchmark”). Although open interest hit annual lows only six times in seven years, Table 1 provides some clues about how the S&P 500 behaves in these situations. Over the next two months, the index climbed 7.90 percent to its high and fell 6.14 percent to its low — at least 1.5 times fur- ther than its benchmarks (4.76 and -2.35 percent, respec- tively). On a close-to-close basis, the S&P 500 gained 5.75 percent, but it tended to fall just as far to its lows. How can you trade this type of “directionless” forecast?

FIGURE 3 — RISK PROFILE — LONG STRADDLE The long September 1,550 straddle could profit
FIGURE 3 — RISK PROFILE — LONG STRADDLE
The long September 1,550 straddle could profit from a major price swing in the E-Mini S&P 500 futures in the next 67 days. If
the market goes nowhere, it will lose $4,062.50.
Source: OptionVue

TABLE 3 — STRADDLE PERFORMANCE

The straddle was unwound on Aug. 1 with a $1,312.50 total profit (32.31 percent).

 

Sept.

Sept.

E-Mini S&P 500 Sept. contract (ES U7)

CBOE

1,550

1,550

VIX

Gain/

Percentage

Date

call

put

index

loss

gain/loss

7/16/07

$45.25

$35.00

1,559.75

15.59

NA

0%

7/17/07

$44.25

$33.00

1,558.75

15.63

-$150.00

-3.69%

7/18/07

$40.25

$37.50

1,554.75

16.00

-$125.00

-3.08%

7/19/07

$43.50

$34.00

1,559.75

15.23

-$137.50

-3.38%

7/20/07

$38.75

$41.00

1,545.00

16.95

-$25.00

-0.62%

7/23/07

$38.25

$38.50

1,549.00

16.81

-$175.00

-4.31%

7/24/07

$25.25

$53.00

1,522.50

18.55

-$100.00

-2.46%

7/25/07

$26.50

$50.75

1,524.75

18.10

-$150.00

-3.69%

7/26/07

$13.25

$77.50

1,488.00

20.74

$525.00

12.92%

7/27/07

$10.75

$95.25

1,458.00

24.17

$1,287.50

31.69%

7/30/07

$10.50

$80.00

1,480.75

20.87

$512.50

12.62%

7/31/07

$8.50

$72.00

1,462.00

23.52

$12.50

0.31%

8/1/07

$10.50

$96.00

1,470.00

23.67

$1,312.50

32.31%

8/2/07

$10.50

$96.00

1,481.75

21.22

$1,312.50

32.31%

8/3/07

$5.00

$78.25

1,443.00

25.16

$150.00

3.69%

8/6/07

$7.00

$111.50

1,467.75

22.94

$1,912.50

47.08%

8/7/07

$9.00

$78.50

1,482.50

21.56

$362.50

8.92%

8/8/07

$15.25

$76.25

1,504.00

21.45

$562.50

13.85%

8/9/07

$7.50

$88.00

1,458.00

26.48

$762.50

18.77%

8/10/07

$8.25

$105.00

1,451.00

28.30

$1,650.00

40.62%

8/13/07

$5.50

$105.50

1,455.00

26.57

$1,537.50

37.85%

8/14/07

$3.25

$118.50

1,434.25

27.68

$2,075.00

51.08%

$3.25 $118.50 1,434.25 27.68 $2,075.00 51.08% Buying or selling the under- lying futures outright isn’t

Buying or selling the under-

lying futures outright isn’t ideal here, but you can enter

a long at-the-money (ATM)

straddle to exploit a possible large rally or decline. This trade can also benefit from an increase in implied volatility (IV), especially if the market plummets.

Building a long straddle

A long straddle consists of an

ATM call and a put with the same strike. If the underlying market goes nowhere, the options will expire worthless — the strategy’s biggest risk. Ideally, the market will rally

or fall enough that one of the

options will more than offset

the straddle’s cost. On July 16 the S&P 500

cash index closed at 1,542.52 and the E-Mini S&P 500 futures closed at 1,559.75. Let’s assume you bought a 1,550 September call for $45.25 and a same-strike September put for $35.00. In dollar terms, the straddle’s total cost was $4,062.50 (($45.25+ $35) * $50 multi- plier + $50 commission). Table 2 lists

the long straddle’s details. (Although

a 1,550 straddle was not technically

ATM on July 16, this strike was chosen instead of the 1,560 ATM strike because the futures market was trad- ing at a 10-point premium to the cash market. By September expiration, however, this premium will erode.) It’s important to choose an expira- tion month that gives the market ample time to move. Using September options gave the market 67 days to make a sufficiently large move in either direction before expiration. Although an August straddle was cheaper, it had a higher negative theta. And time premium bleeds most rapidly in the last month before expi- ration. For example, the August 1,550 straddle had a daily theta of -$201; the September 1,550 straddle had a daily

continued on p. 20

TRADING STRATEGIES continued Related reading Articles by Charlie and Jes Santaularia “Playing defense: Long puts

TRADING STRATEGIES continued

Related reading

Articles by Charlie and Jes Santaularia

“Playing defense: Long puts vs. bear put spreads” Futures and Options Trader, June 2007. Protecting a portfolio from a market downturn doesn’t have to be complicated. Find out which defensive strategy offers the most bang for your buck.

“Another look at diagonal spreads” Options Trader, March 2007. This position combines bullish and bearish diagonal spreads and is quite flexible if you’re willing to adjust its components.

Other articles

“Cracking the COT code” Futures and Options Trader, July 2007. Trading the Russell 2000 with data found in the Commitment of Traders report.

“Gauging trader commitment” Currency Trader, August 2006. Analyzing the euro with Commitment of Traders data sheds light on the strength or weakness of price moves.

“Floyd Upperman: Digging into COT data” Active Trader, February 2006. It’s not just a matter of hedgers vs. speculators. An engineer turned trader discusses ways to make sense of the futures Commitment of Traders report.

“Larry Williams looks inside futures” Active Trader, January 2006. Larry Williams discusses the twists he puts on the Commitment of Traders report in his latest book.

“Testing the commitment of traders” Active Trader, March 2004. Does knowing how long or short different groups of professional and retail traders are have any value in gauging market direction? This analysis takes a well-known number (Commitment of Traders) and tests it on different markets.

“All traders big and small:

The Commitment of Traders report” Active Trader, March 2003. In futures, as in stocks, the “institutional” money usually dictates price action. The Commitment of Traders report gives you a glimpse of what the big money is doing in the markets you trade.

You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm.

FIGURE 4 — LARGE SPECS BOTTOM OUT? The large specs’ positions began to reverse after
FIGURE 4 — LARGE SPECS BOTTOM OUT?
The large specs’ positions began to reverse after the S&P futures fell 6.4 percent
from July 16 to July 27.
Source: www.schaeffersresearch.com

theta of -$146, which is much more reasonable. Figure 3 shows the straddle’s potential gains and losses on four dates: the July 16 trade entry (upper dotted line), the Sept. 21 expiration (solid line), and two interim days (middle lines). The goal is to take advantage of a major price swing in the S&P 500 before expiration in 67 days. Possible exit criteria: if the trade gains 25 percent, if it loses that much in the first two weeks, or 14 days prior to options expiration. For the position to profit, the E- Mini S&P 500 futures must move at least 75 points (4.8 percent) — the quicker the move, the better. This straddle is a high-vega trade, so you are essentially buying volatility. Profits will likely increase if IV climbs. Therefore, if the under- lying sells off, this trade will benefit

The Commitments of Traders report

Published weekly by the Commodity Futures Trading Commission (CFTC), the Commitments of Traders (COT) report breaks down the open interest in major futures markets. Clearing members, futures commission merchants, and foreign brokers are required to report daily the futures and options positions of their customers that are above specific reporting levels set by the CFTC. For each futures contract, report data is divided into three “report- ing” categories: commercial, non-commercial, and non-reportable positions. The first two groups are those who hold positions above specific reporting levels. The “commercials” are often referred to as the large hedgers. Commercial hedgers are typically those who actually deal in the cash market (e.g., grain merchants and oil companies, who either produce or consume the underlying commodity) and can have access to supply and demand information other market players do not. Non-commercial large traders include large speculators (“large specs”) such as commodity trading advisors (CTAs) and hedge funds. This group consists mostly of institutional and quasi-institu- tional money managers who do not deal in the underlying cash mar- kets, but speculate in futures on a large-scale basis for their clients. The final COT category is called the non-reportable position cat- egory — otherwise known as small traders — i.e., the general pub- lic.

more because volatility will jump.

Managing the trade

A long straddle is a passive strategy. After you

place it, no adjustments are necessary — just wait until the underlying moves. Table 3 lists the daily closing prices of the E- Mini S&P 500 September contract and the CBOE volatility index (VIX) along with the straddle’s daily gains and losses. In the first

week, the market fell 0.95 percent, and the straddle was basically flat. Remember it doesn’t matter whether the market is bullish or bearish,

as long as it moves more than 4.8 percent. After

a few weeks of volatile trading, the market

began to sell off more dramatically. By July 27 it had fallen 6.4 percent to 1,458 and the VIX had jumped 55 percent to 24.17, which increased the straddle’s profitability. At this point, the trade had gained 32 percent, surpassing its profit tar- get of 25 percent. You could exit at this point or place stops to protect your gains. Figure 4 shows the large specs’ net positions began to reverse after the S&P futures fell sharply in late July. The straddle was unwound on Aug. 1 when the E-Mini S&P 500 closed at 1,470 and the VIX closed at 23.67. The final profit was 31.07 percent (($-34.75 call loss + $61 put gain) * $50 multiplier + $50 com- mission = $1,262.50). The market dropped 5.7 percent, and the VIX climbed 51.8 percent during the trade’s lifetime. Table 3 also shows potential profits

if you had held the position for a few

more days. The straddle would have benefited from further market weak- ness and a rising VIX. However, hold- ing the straddle after such a sharp decline is risky; the straddle’s profits will deteriorate if a sharp bounce-back occurs.

profits will deteriorate if a sharp bounce-back occurs. Taking a long view One way to find

Taking a long view

One way to find tradable ideas in COT reports is to spot longer-term shifts in sentiment and then create strategies based on these changes. But all futures markets are different, which means you can’t assume a successful COT- based strategy in one market can be applied to another.

For information on the author see p. 6.

TRADING STRATEGIES Rolling LEAPS calls Holding LEAPS calls instead of the underlying shares can pay

TRADING STRATEGIES

Rolling LEAPS calls

Holding LEAPS calls instead of the underlying shares can pay off – but only if you know when to roll them forward

BY TRISTAN YATES

Y ou can make money buying stocks and holding them for long periods, but you risk a large amount of capital when doing so. By contrast, buying calls can provide the same type of

returns with less risk. The problem is that time decay works against you. A strategy designed to compensate for this drawback is buying long-term calls on exchange-traded funds (ETFs) that track major market indices, and selling them to buy options that expire even later — a technique called “rolling.” The strategy uses Long-term AnticiPation Securities, or LEAPS, which are options that don’t expire for at least a year. These calls behave the same as regular calls, but are designed specifically for investors with longer-term time frames. The goal is to profit from a call’s inherent leverage in a

Strategy snapshot

Strategy: Rolling LEAPS calls.

Market bias: Long-term bullish.

Components: One long 24-month LEAPS call.

Logic: Outperform a simple buy-and-hold approach with the leverage and limited risk of calls.

Execution: After 12 months, sell the call and buy a same-strike 24-month LEAPS call. Or roll the call after it moves 20 percent ITM and IV is at (or below) its 12-month average.

Best-case scenario: Underlying market rallies.

Worst-case Underlying market falls sharply and call scenario: expires worthless.

Possible Instead of rolling into same-strike call, adjustments: buy a later-expiring, higher-strike (or ATM) call, which generates cash.

bull market. You can only lose the amount you paid for each call, which limit losses. All options expire eventually, but the rolling process allows you to stay in the trade.

Advantages of longer-term options

Later-expiring options cost more than their shorter-term counterparts, but the additional cost isn’t linear — i.e., a six- month call doesn’t cost six times as much as a same-strike call that expires next month. Instead, the cost of adding more time drops as you go further into the future. Longer-term options have lower per-month costs, on average. Table 1 compares the overall and monthly costs of at-the-money (ATM) calls with different expiration dates:

one, three, six, 12, and 24 months. A one-month call costs $1.93 and a three-month call costs $3.61. But on a monthly basis, the later-expiring call costs less than the one-month call — $1.20 vs. $1.93, respectively. (For simplicity, the examples track a hypothetical underlying stock that is trad- ing at 100; dividends are excluded.) Longer-term calls also give the underlying more time to move. Table 2 shows the cost, value at expiration, and gain or loss for various options, assuming a 10-percent annual gain in the underlying instrument. While each call moves into the money, only the longer-term calls generate profits, because only they have gained enough to offset their initial costs.

TABLE 1 — OVERALL VS. MONTHLY OPTION COSTS

Although later-expiring options cost more, their per-month costs drop as you go further out.

Strike

Months

Overall cost

Per-month cost

100

1

$1.93

$1.93

100

3

$3.61

$1.20

100

6

$5.48

$0.91

100

12

$8.48

$0.71

100

24

$13.49

$0.56

All tables use the following assumptions, unless otherwise noted:

Market trades at 100, IV = 15%, interest rate = 5%

Rolling forward

One way to maintain a position is to sell calls when they have 12 months until expiration and buy same-strike calls that don’t expire for at least two years. For example, you could sell a 12-month call for $8.48 and buy a same-strike 24-month call for $13.49 — a debit of $5.01 (Table 3). Table 4 compares the “Greeks” of the 12- and 24-month at-the-money LEAPS, and shows these options share high deltas and low thetas. This means both calls’ prices will increase by roughly the same amount if the mar- ket climbs one (1.00) point, and their prices aren’t influenced much by the passage of time.

sell a call that is 10-percent in-the- money (ITM) and buy one that is five-percent ITM, you will receive much less than five percent of the underlying’s value, especially in a volatile mar-

ket. But if you sell

a call that is 20-

percent ITM and buy one that is 10-percent ITM, you could collect roughly nine per- cent of the under- lying’s value. You can also

hold a high-delta, low-theta deep- in-the-money LEAPS call until expiration. Even

if the underlying

plummets, increased time value and volatility might help offset the losses. However, never hold at- and out-of- the-money options until they expire. Always roll or sell these calls. Otherwise, the position’s time decay could wipe out any gains in the under-

lying market, and the call could have trouble increasing in value.

TABLE 2 — PERFORMANCE OF CALLS IN BULL MARKET

If the underlying market climbs 10 percent annually, only the longer-term calls generate profits, because they are the only ones that have gained enough to offset the initial cost.

Strike

Months

Cost

Value at

Gain/loss

 

expiration

100

1

$1.93

$0.80

-$1.13

100

3

$3.61

$2.41

-$1.20

100

6

$5.48

$4.88

-$0.60

100

12

$8.48

$10.00

$1.52

100

24

$13.49

$21.00

$7.51

TABLE 3 — ROLL EXAMPLE

To maintain a long-term position, you can sell LEAPS calls and buy same-strike LEAPS calls that expire later, a technique called “rolling.”

 

Strike

Months

Cost

Sell

100

12

$8.48

Buy

100

24

-$13.49

 

difference

-$5.01

is

fairly

pre-

continued on p. 24

difference -$5.01 is fairly pre- continued on p. 24 Roll or hold? If you wait too

Roll or hold?

If you wait too long to roll a LEAPS call, its delta will drop and time decay will increase, making it difficult to generate additional gains if the under- lying doesn’t rally sharply. Therefore, you should roll (or simply sell) any call that expires in less than nine months and has a near-the-money strike. For the best results, hold a LEAPS call until it is at least 20 percent in-the- money and implied volatility (IV) is at or below its 12-month average. Then you can sell it, roll it forward into a same-strike call, or roll it forward and up to a higher-strike call, which gener- ates cash. Rolling up always provides cash, but the amount is only significant at lower strike prices. For example, if you

Rolling costs

The

rolling

process

TABLE 4 — COSTS AND GREEKS

Rolling a LEAPS call doesn’t significantly change its market exposure. Both calls have high deltas and low thetas, which helps you profit if the market climbs.

 

Calls that expire in…

 
 

24 months

12 months

6 months

3 months

Cost

$13.49

$8.48

$5.52

$3.63

Delta

0.72

0.66

0.61

0.58

Gamma

0.02

0.02

0.04

0.05

Theta

-0.01

-0.02

-0.02

-0.02

TRADING STRATEGIES continued
TRADING STRATEGIES continued

TABLE 5 — COMPARING ROLLING COSTS

Rolling costs $5 to $6 when the call is at (or near) the money. It costs more to roll when implied volatility increases.

 

Current

24-month

12-month

Cost

Strike

price

IV

call

call

to roll

100

80

16%

$3.54

$0.99

$2.55

100

90

18%

$8.90

$4.39

$4.51

100

100

20%

$16.13

$10.45

$5.68

100

110

22%

$24.49

$18.30

$6.19

100

120

24%

$33.50

$27.14

$6.36

dictable, because any underlying changes in price or implied volatility will be reflected both in the call you sell and the one you buy. Therefore, the cost dif- ference between the short and long calls is minimal. You can use the following formula as a rough guide- line:

Cost of roll = strike * interest rate - dividend

According to this formula, rolling a 100-strike call costs $5, based on a five-percent interest rate and no dividends:

100 * 5% - 0 = $5

TABLE 6 — ASSUMPTIONS

Buying LEAPS calls and holding them for at least a year could be profitable, given these assumptions. Profits depend upon an underly- ing market rally and moderate implied volatility.

Assumptions for Russell 2000 exchange-traded fund (IWM)

Average annual return

12%

Historical volatility

15%

Implied volatility

20%

Market price

100

Years to expiration

2

Interest rate

5%

What are LEAPS?

Long-term AnticiPation Securities, or LEAPS, are longer-term options contracts that expire up to two years and eight months in the future. They are no dif- ferent from regular puts and calls, and give the owner the right to buy or sell 100 shares of stock at any time. But instead of expiration months, they have expiration years (e.g., January 2008 LEAPS expire on Jan. 19,

2008).

All LEAPS are divided into three cycles that deter- mine when they are listed. Cycle 1 LEAPS are listed after May equity options expire, cycle 2 are listed after the June expiration period, and cycle 3 are listed after the July period, three calendar years in advance (i.e., 2010 LEAPS begin listing in 2007, 2011 LEAPS in 2008, etc.) As of Aug. 14, you can buy LEAPS on the S&P 500 index that expire on Jan. 16, 2010 almost 30 months from now. In theory, LEAPS behave the same as regular options. In practice, however, new LEAPS have low thetas and deltas in the first few months. This means time decay is reduced, but changes in the underlying market don’t affect the option’s price as much, at least initially.

This formula isn’t perfect though. In reality, the roll’s cost could be 10 to 25 percent above or below this value. Table 5 lists the prices of 12- and 24-month 100- strike calls given both mild and extreme changes in underlying price and implied volatility. It also shows each scenario’s roll cost. For example, if the market trades at 100 with 20- percent volatility, it will cost $5.68 to roll into the next year (i.e., sell the ATM 12-month call for $10.45 and buy the same-strike, 24-month call for $16.13). Table 5 shows that rolling costs $5-$6 when the call is at (or near) the money.

Rolling costs could be close to zero if the call is very deep ITM and the underlying’s dividend covers the interest cost. These costs will also be low if the call is so far OTM that any additional time premium has little value.

Estimating performance

No stock index is perfect, but the Russell 2000 is a good can- didate for the rolled LEAPS call strategy. Composed of 2,000 small-cap stocks, this index has gained an average 13.09 per- cent annually since 1993. It is more volatile than the S&P 500 and the Dow Jones Industrial Average — about as volatile as the Nasdaq Composite. The following estimates use options on the heavily traded Russell 2000 exchange-traded fund (IWM). High liquidity is not necessarily a prerequisite, because the strategy only rolls each option once a year, but narrow bid-ask spreads can help lower costs. For simplicity, we assumed the Russell 2000 ETF trades at 100, bought 24-month LEAPS at different strikes, and rolled them forward each year. Rules:

1. Buy 24-month LEAPS calls with strikes of 80, 90, 100, and 110.

2. After 12 months, sell calls and buy 24-month calls with the same strike.

Table 6 lists other assumptions used here: Rolling costs are

based on an estimated annual return of 12 percent; bid-ask

spreads and transaction costs were not included. Table 7 shows the initial costs, rolling costs, total gains, and the internal rates of return (IRR) for all four LEAPS calls in three-, five-, and seven-year time periods. The IRR represents an estimated rate of growth, given the costs to enter the strategy and to roll LEAPS calls for- ward.

The strategy’s costs and total gains are ulti- mately determined by the LEAPS call’s strike price. Lower-strike calls are more expensive at first, but rolling them costs less and they gener- ate more profit from the underlying. The effect tends to balance out. ATM calls had the highest IRR of 24.7 percent vs. 24.5 percent (or less) for other strikes, assum- ing IWM rallied 12 percent each year. Higher- strike calls are more sensitive to changes in the underlying and thus include more risk. Table 7 suggests that 90-strike calls (10 per- cent below the market) balance risk and reward well. After seven years, these calls have an IRR of 20.4 percent, which means they double their capital every 3.5 years, on average. But if the Russell 2000 ETF climbs more than 12 percent annually, higher-strike calls would outperform them. Table 8 shows the average IRRs and standard deviations for each strike price and time period. Rolled LEAPS calls lose leverage as the market rallies. This reduces returns, but it also reduces their volatility. After seven years, the strategy’s one-standard-deviation range is very narrow (11 to 28 percent), which means performance is predictable. (For a spreadsheet containing the formulas used in this estimate, visit http://www.futuresandoptionstrader.com between Sept. 5 and Oct. 1.)

70 percent of the time. Remember, it could always expire worthless, which is why rolling is important.

Risks: Sell-offs and volatility

Historically, markets have tended to climb during long- term periods, but sharp sell-offs such as the 10-percent drop

continued on p. 26

TABLE 7 — ESTIMATED RESULTS

The 90-strike calls balanced risk and reward well. After seven years these calls had an IRR of 20.4 percent.

 

Strikes

Three-year period:

80

90

100

110

Initial cost

-$29.12

-$22.03

-$16.13

-$11.46

Roll cost

-$4.20

-$5.11

-$5.92

-$6.34

Final value

$60.49

$50.49

$40.49

$30.49

IRR

23.0%

24.5%

24.7%

22.4%

Five-year period:

Initial cost

-$29.12

-$22.03

-$16.13

-$11.46

Roll cost

-$4.20

-$5.11

-$5.92

-$6.34

Second roll cost

-$3.94

-$4.73

-$5.65

-$6.50

Third roll cost

-$3.80

-$4.44

-$5.23

-$6.14

Final value

$96.23

$86.23

$76.23

$66.23

IRR

20.8%

22.1%

22.6%

22.1%

Seven-year period:

Initial cost

-$29.12

-$22.03

-$16.13

-$11.46

Roll cost

-$4.20

-$5.11

-$5.92

-$6.34

Second roll cost

-$3.94

-$4.73

-$5.65

-$6.50

Third roll cost

-$3.80

-$4.44

-$5.23

-$6.14

Fourth roll cost

-$3.74

-$4.27

-$4.91

-$5.69

Fifth roll cost

-$3.72

-$4.21

-$4.74

-$5.36

Final value

141.1

131.1

121.1

111.1

IRR

19.3%

20.4%

21.0%

20.9%

TABLE 8 — OVERALL PERFORMANCE

The strategy’s returns are more predictable over longer-term periods.

 

Strikes

Three-year period:

90

100

110

IRR, average

25%

25%

22%

IRR, 1 std dev

-4% to +44%

-14% to +49%

-41% to +54%

Five-year period:

IRR, average

22%

23%

22%

IRR, 1 std dev

9% to 31%

7% to 33%

2% to 35%

Seven-year period:

IRR, average

20%

21%

21%

IRR, 1 std dev

13% to 26%

13% to 27%

11% to 28%

A more practical approach

In reality, few investors buy a stock, hold it, and sell it after a predefined period. Therefore, let’s assume you will hold a LEAPS call until it gains 50 percent and then sell it. In a bull market, near-the-money LEAPS calls can rise in value quickly. Let’s start again with an index trading at 100 and use the same assumptions from Table 6. If you buy a two- year LEAPS call with a strike of 90 for $22.03, what are the odds it will gain 50 percent? Table 9 shows the probabilities of gaining 50 percent within different time periods. If the underlying index rallies 12 percent, the LEAPS call climbs this far within 12 months 48 percent of the time. After 24 months, it gains this much

TRADING STRATEGIES continued Related reading “Squeezing extra profits from long calls” Futures and Options Trader

TRADING STRATEGIES continued

Related reading

“Squeezing extra profits from long calls” Futures and Options Trader, May 2007. These spreads can boost profit and lower risk if you build them from an already-profitable long call.

“Selecting calls based on ROI” Options Trader October 2006. Traders seem drawn to complex options strategies, but sometimes simply buying calls is the best way to catch an up move. Learn how to weigh the possibilities by compar- ing various calls’ return on invest- ment.

“Carryover losses and deep in-the-money calls” Options Trader November 2006. Deep ITM covered calls help extract profits from a long-term underlying position, but you may lose the trade’s favorable tax sta- tus. Large carryover losses from prior years can fix this dilemma.

“Managing profitable trades” Options Trader August 2006. Handling a profitable option trade might seem easy, but it can be diffi- cult to decide whether to cash out or hold on for further gains.

“Making the options LEAP” Options Trader December 2005. Long-Term Equity AnticiPation Securities can have expiration dates more than two years away. Find out the difference between these options and standard options and how you can use them to your advantage.

You can purchase and download past articles at http://www.activetradermag.com/ purchase_articles.htm.

TABLE 9 — ODDS OF A 50-PERCENT GAIN

If the underlying index rallies 12 percent in a year, a 10-percent ITM LEAPS call will gain 50 percent nearly half the time.

10-percent ITM 2-year call on the Russell 2000 ETF

Time frame

Probability of 50% gain

Within 3 months

8%

Within 6 months

24%

Within 12 months

48%

Within 24 months

70%

TABLE 10 — SHORT-TERM RISKS

Although this is a long-term strategy, it has short-term risks. ITM LEAPS calls with 70 strikes fell at least 25 percent when IWM plunged 10.12 percent from July 13 to Aug. 14.

Russell 2000 ETF (IWM) fell 10.12% from July 13 to Aug. 14 and closed at $76.13

 

July 13 price

Aug. 14 price

Loss

70-strike call — Jan. 2008

$17.58

$10.00

-43%

70-strike call — Jan. 2009

$23.90

$15.00

-37%

70-strike call — Jan. 2010

$24.30

$18.25

-25%

in the Russell 2000 this summer could hurt this bullish strategy. Table 10 compares the prices for three deep in- the-money LEAPS calls on the Russell 2000 before and after it fell 10.12 per- cent from July 13 to Aug. 14. Each LEAPS call fell at least 25 percent within a month, which highlights the strategy’s potential short-term risks. As with any option, IV changes can affect the profitability of a LEAPS call, especially when the strike is near the money. When you buy an option, you can’t lose more than you pay for it. This characteristic is a hedge, and the more volatile the underlying security is, the more expensive this hedge becomes. At first glance, the recent sell-off seems to offer a buying opportunity. But the Russell 2000 ETF’s average IV climbed from 18.1 percent — slightly below its three-year average of 19.2 percent — to 27.7 percent during this period. Buying new calls or rolling existing ones isn’t a good idea when implied volatility spikes. If IV does surge, you can always wait a week or two before placing any trades.

Entering spreads

Instead of buying LEAPS calls out- right, you can also sell a higher-strike call that expires sooner and create a diagonal call spread. While selling a call to create a spread lowers costs, it also reduces your potential profit if the short call expires in-the-money. But this could be a good idea, especially if implied volatility surges as it did in July and August. For example, let’s assume you buy a LEAPS call that is 10-percent ITM and sell an ATM call that expires in three to six months. If IV is near its historic highs, you can collect a large premium when selling that short-term call, which helps offset the LEAPS call’s cost. But if the market rallies within six months, you may have to buy back that call at a loss. The strategy outlined here can out- perform a simple buy-and-hold approach, but if the market pulls back, you could lose ground. However, the strategy’s risks and rewards are quite predictable if you hold LEAPS for long periods.

For information on the author see p. 6.

MARKET HISTORY UPDATE Triple-witching expirations: More bullish in recent years Longstanding volatility patterns

MARKET HISTORY UPDATE

Triple-witching expirations:

More bullish in recent years

Longstanding volatility patterns surrounding quarterly expirations have shifted in the past few years.

“T he S&P Witch Project” (Active Trader,

December 2004) analyzed how the S&P

500 index behaved surrounding “triple-

witching” expiration days — the two-day periods in March, June, September, and December when stock- index futures, stock index futures options, and equity options expire. (After single-stock futures were launched in November 2002, triple witching days were sometimes called “quadruple witching” days because these new contracts also expired on the quarterly cycle). The goal was to find out whether the market displayed any tradable patterns around these events. The article compared the S&P 500’s behavior during these quarterly expirations to its behavior during “serial” expiration months (e.g., non-quarterly months — January, February, April, May, etc.). The study uncovered a surprising distinction: The S&P 500 was actually more volatile around serial-month expi- rations than quarterly-cycle expirations. The index climbed more before serial-month expirations and fell more afterwards than it did in March, June, September, and December. The S&P’s behavior surrounding quarter- ly expirations was tame by comparison. The analysis measured the S&P 500’s average daily performance in the 16 days surrounding both types of expirations — eight days preceding expiration Friday and seven days following it, plus the expiration day itself. Figure 1 compares the market’s serial-month behavior from 1983-2004 to its performance since the original study was published (2004-2007, red and blue lines, respectively). Day -1 represents the final Thursday of each contract and Day 1 is the final Friday — the last trading day for stock options, stock-index options, and sin- gle-stock futures. Overall, the S&P rose 0.68 percent, on average, prior to expiration Friday from 1983 to 2004. It then dropped 0.39 percent in the next two days before recovering in the subse- quent week. Since 2004 the index has moved roughly in-line with this pattern, but the decline began one day earlier. The behavior around triple-witching expirations, howev- er, has changed more notably since 2003. Figure 2 compares the S&P’s 1982-2004 average daily performance around triple-witching Fridays to its 2004-2007 performance. From 1982 to 2004 the market fell 0.29 percent leading up to quar- terly expirations, but it recovered by expiration Friday. It

FIGURE 1 — SERIAL-MONTH EXPIRATIONS The market rallied before serial-month expirations, slumped after- wards, and
FIGURE 1 — SERIAL-MONTH EXPIRATIONS
The market rallied before serial-month expirations, slumped after-
wards, and then recovered in the subsequent week. This decline
began one day earlier over the past three years (blue line).
FIGURE 2 — QUARTERLY “TRIPLE-WITCHING” EXPIRATIONS From 1982-2004 the S&P was less volatile surrounding
FIGURE 2 — QUARTERLY “TRIPLE-WITCHING” EXPIRATIONS
From 1982-2004 the S&P was less volatile surrounding quarterly
expirations than it was around serial expirations, but that pattern
changed during the 2004-2007 period.

then rallied 0.22 percent over the next seven days. From 2004-2007 by comparison, the S&P’s typical move was much bigger and more bullish at expiration — the index gained an average of 0.52 percent by expiration Friday, and although the average return declined in subse- quent days through day 4, it was still much larger than the average gains during the 1982-2004 period.

Related reading

“The S&P witch project” Active Trader, December 2004.

You can purchase and download past articles at http://www.activetradermag.com/purchase_articles.htm

FUTURES TRADING SYSTEM LAB Trend pullback with progressive target Market: Futures. System concept: This system

FUTURES TRADING SYSTEM LAB

Trend pullback with progressive target

Market: Futures.

System concept: This system combines a pullback rule to enter existing trends with a “moving target” exit approach that closes positions when the market is still mov- ing in the trade’s favor. Typical trend-following systems have low winning per- centages and generate the majority of their profits during infrequent extended trends. A trailing stop order is often used to exit trades: As the market moves in the trade’s direction, an exit order is moved progressively closer to the current market price to lock in profits on the position. A common trend-following exit is the channel-based exit, which stops out (or reverses) the position when price moves below (in the case of a long trade) the n-bar low or close. One disadvantage of this type of exit is that some open profits are lost because the market must reverse to trigger the exit. Another drawback is its popularity. When the n-bar highest high/lowest low levels are crowded with a large number of stops, negative slippage is likely.

A different approach is placing the so-called “chandelier” stop (in the case of a long trade in an uptrend) a certain amount below the highest high or close the market has made since the position was established. As the market makes new highs, the chandelier stop moves up with it. The exit approach used here is similar to the chandelier stop except that the exit price is usually above the market (in the case of an uptrend) and is determined by the mar- ket’s current volatility, as measured by the average true

range (ATR). The exit rule has two basic elements — a reference point and a reversal amount. The reference point is the level that defines the trend’s short-term turning points, or “swing highs” and “swing lows.” In this case a swing high is a price bar preceded and followed by bars with lower highs, while a swing low is a low preceded and followed by high- er lows. The number of lower highs or higher lows sur- rounding the swing bars can vary. This approach will use two-day swings, which requires two consecutive lower highs before and after a swing high bar, and two consecu- tive higher lows before and after a swing low bar. The reversal amount

is the distance from the swing high or low used to determine the exit. The exit is constructed by adding (for long trades) the ATR-derived reversal amount to the most recent two-day swing high. For short trades, the reversal amount is subtracted from the most recent two-day swing low. Figure 1 shows the exit typically dangles above the market and, when a trend is in place, continues to move in that direction. When the trend stalls, the exit level follows the market lower and can even reverse direction. The exit has two objectives. The first is to exit trades on strength

FIGURE 1 — SAMPLE TRADES The exit level hovers above the market, rising as the
FIGURE 1 — SAMPLE TRADES
The exit level hovers above the market, rising as the swing highs continue to climb throughout the
rally.
Source: Wealth-Lab
FIGURE 2 — SAMPLE TRADES The exit rule’s drawback is that it offers no protection
FIGURE 2 — SAMPLE TRADES
The exit rule’s drawback is that it offers no protection from trend reversals.
Source: Wealth-Lab

rather than weakness and benefit from positive slippage. The second is to let winners run as much as possible. The obvious weakness of this exit approach is that it doesn’t offer any loss protection, as illustrated in Figure 2: The exit misses the boat when a trend gives way to volatile, range- bound conditions.

Strategy rules:

1. If yesterday’s close was above

the 20-day moving average of closing prices, enter long with

a limit order at yesterday’s close

minus 1.5 times the 14-day ATR.

2. If yesterday’s close was below the 20-day moving average of closing prices, enter short with

a limit order at yesterday’s close plus 1.5 times the 14-day ATR.

3. Exit long position with a limit order at the recent two-day

continued on p. 30

STRATEGY SUMMARY

Profitability

Trade statistics

Net profit:

$5,366,045.77

No. trades:

306

Net profit:

536.60%

Win/loss:

66.99%

Profit factor:

1.37

Avg. profit/loss:

2.38%

Payoff ratio:

0.72

Avg. holding time (days):

131.36

Recovery factor:

2.52

Avg. profit (winners):

9.71%

Exposure:

14.76%

Avg. hold time (winners):

93.12

Drawdown

Avg. loss (losers):

-12.51%

Max. DD:

-36.56%

Avg. hold time (losers) :

208.97

Longest flat period:

483 days

Max consec. win/loss:

14/5

LEGEND:

Avg. hold time — The average holding period for all trades.
Avg. hold time — The average holding period for all trades.

Avg. hold time — The average holding period for all trades.

Avg. hold time — The average holding period for all trades.
Avg. hold time — The average holding period for all trades.

Avg. hold time (losers) — The average hold- ing time for losing trades.

Avg. hold time (losers) — The average hold- ing time for losing trades.
Avg. hold time (losers) — The average hold- ing time for losing trades.

Avg. hold time (winners) — The average hold- ing time for winning trades.

Avg. hold time (winners) — The average hold- ing time for winning trades.
Avg. hold time (winners) — The average hold- ing time for winning trades.

Avg. loss (losers) — The average loss for los- ing trades.

Avg. loss (losers) — The average loss for los- ing trades.
Avg. loss (losers) — The average loss for los- ing trades.

Avg. profit/loss — The average profit/loss for all trades.

Avg. profit/loss — The average profit/loss for all trades.
Avg. profit/loss — The average profit/loss for all trades.

Avg. profit (winners) — The average profit for winning trades.

Avg. profit (winners) — The average profit for winning trades.
Avg. profit (winners) — The average profit for winning trades.

Avg. return — The average percentage for the period.

Best return — Best return for the period.
Best return — Best return for the period.

Best return — Best return for the period.

Best return — Best return for the period.
Best return — Best return for the period.

Exposure — The area of the equity curve exposed to long or short positions, as opposed to cash.

Exposure — The area of the equity curve exposed to long or short positions, as opposed
Exposure — The area of the equity curve exposed to long or short positions, as opposed

Longest flat period — Longest period (in days) between two equity highs.

Longest flat period — Longest period (in days) between two equity highs.
Longest flat period — Longest period (in days) between two equity highs.

Max consec. profitable — The largest number of consecutive profitable periods.

Max consec. profitable — The largest number of consecutive profitable periods.
Max consec. profitable — The largest number of consecutive profitable periods.

Max consec. unprofitable — The largest num- ber of consecutive unprofitable periods.

Max consec. unprofitable — The largest num- ber of consecutive unprofitable periods.
Max consec. unprofitable — The largest num- ber of consecutive unprofitable periods.

Max consec. win/loss — The maximum num-

ber of consecutive winning and losing trades.

ber of consecutive winning and losing trades.
ber of consecutive winning and losing trades.

Max. DD (%) — Largest percentage decline in equity.

Max. DD (%) — Largest percentage decline in equity.
Max. DD (%) — Largest percentage decline in equity.

Net profit — Profit at end of test period, less commission.

Net profit — Profit at end of test period, less commission.
Net profit — Profit at end of test period, less commission.

No. trades — Number of trades generated by the system.

No. trades — Number of trades generated by the system.
No. trades — Number of trades generated by the system.

Payoff ratio — Average profit of winning trades divided by average loss of losing trades.

Payoff ratio — Average profit of winning trades divided by average loss of losing trades.
Payoff ratio — Average profit of winning trades divided by average loss of losing trades.

Percentage profitable periods — The percent- age of periods that were profitable.

Percentage profitable periods — The percent- age of periods that were profitable.
Percentage profitable periods — The percent- age of periods that were profitable.

Profit factor — Gross profit divided by gross loss.

Profit factor — Gross profit divided by gross loss.
Profit factor — Gross profit divided by gross loss.

Recovery factor — Net profit divided by max. drawdown.

Recovery factor — Net profit divided by max. drawdown.
Recovery factor — Net profit divided by max. drawdown.

Sharpe ratio — Average return divided by standard deviation of returns (annualized).

Sharpe ratio — Average return divided by standard deviation of returns (annualized).
Sharpe ratio — Average return divided by standard deviation of returns (annualized).

Win/loss (%) — The percentage of trades that were profitable.

Win/loss (%) — The percentage of trades that were profitable.
Win/loss (%) — The percentage of trades that were profitable.

Worst return — Worst return for the period.

FUTURES TRADING SYSTEM LAB continued FIGURE 3 — OPTIMIZATION The ATR multiplier for the exit

FUTURES TRADING SYSTEM LAB continued

FIGURE 3 — OPTIMIZATION The ATR multiplier for the exit rule was 3.0 because of
FIGURE 3 — OPTIMIZATION
The ATR multiplier for the exit rule was 3.0 because of its location in the stable
performance area.
Source: Wealth-Lab
FIGURE 4 — EQUITY CURVE The equity curve rises, but not without some share pullbacks.
FIGURE 4 — EQUITY CURVE
The equity curve rises, but not without some share pullbacks.
Source: Wealth-Lab

swing high point plus three times the 14-day ATR. 4. Exit short position with a limit order at the recent two-day swing low point minus three times the 14-day ATR.

Parameter selection: As a rule, trading system parameters are deter- mined through a portfolio-based opti- mization on a sample data period. Figure 3 shows the system’s profitabil- ity from August 1992 to July 1997 using ATR values (for the exit rule) from 1.0 to 4.0. The majority of values were profitable, except for the 1.0-1.5 range. Three ATRs was selected from the area of stable values. (Note: The “reversal amount” can be customized to the magnitude of trend the trader wishes to trade.)

Money management: Risk 1 per- cent of account equity per position.

Starting equity: $1,000,000. Deduct $8 commission and one tick slippage per trade.

Test data: The system was tested on the Active Trader Standard Futures Portfolio, which contains the follow- ing 20 futures contracts: British 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), euro (EC), gold (GC), Japanese yen (JY), coffee (KC), wheat (W), live cattle (LC), lean hogs (LH), natural gas (NG), sugar #11 (SB), silver (SI), Swiss franc (SF),

PERIODIC RETURNS

         

Percentage

Max

Max

Avg.

Sharpe

Best

Worst

profitable

consec.

consec.

return

ratio

return

return

periods

profitable

unprofitable

Monthly

1.85%

0.24

24.02%

-18.24%

58.33

6

3

Quarterly

5.70%

0.37

46.66%

-26.46%

58.54

6

2

Annually

22.16%

0.63

111.40%

-9.90%

63.64

5

2

FIGURE 5 — DRAWDOWNS There were several medium-to-large reversals, but none of them lasted too
FIGURE 5 — DRAWDOWNS
There were several medium-to-large reversals, but none of
them lasted too long.
Source: Wealth-Lab
FIGURE 6 — PROFITS BY MARKET Two markets — coffee (KC) and cotton (CT) —
FIGURE 6 — PROFITS BY MARKET
Two markets — coffee (KC) and cotton
(CT) — accounted for the majority of
the system’s gains.
Source: Reports-Lab

and T-Bonds (US). This test used ratio-adjusted data from Pinnacle Data Corp. (http://www.pinnacledata.com).

Test period: August 1997 to July 2007.

Test results: Testing in the out-of-sample period (August 1997 to July 2007) resulted in a profit of 536 percent — a steady 20.3-percent annualized gain. The equity curve (Figure 4) displays a fairly steady increase until 2005, punc- tuated by a few drawdowns and pauses. The trade statistics reflect something of a blend of trend-following and coun- tertrend characteristics. The system has a high success rate (67 percent), and the average profit is relatively large (2.4 percent). The system had several drawdowns in excess of 20 per- cent (two were deeper than 30 percent), but most of them were relatively short-lived (Figure 5). The system’s high exposure is a concern, though. The average holding time for winning trades was 93 days, while losers were held for a whopping 203 days. Both long and short components were profitable, with the short side responsible for more of the system’s gains. Finally, coffee and cotton (Figure 6) accounted for nearly half the system’s gains.

Bottom line: The system’s exit rule is not without its drawbacks — as mentioned, it doesn’t offer protection from

trend reversals. Holding positions for so long is not for every trader. A protective stop would be needed to cut los- ers more effectively. One possible way to cut the time in the market would be to use a factor that would shorten the ATR multiplier with each day a trade is unprofitable. Similarly, watching medi- um and large profits fade away is quite difficult psycholog- ically, so the reversal amount could be tightened after an outsized profit, as well. The “dangling carrot system” is designed to go for big profits. The exit isn’t a perfect solution, but its rules are sim- ple and adapt to current market conditions.

— Volker Knapp of Wealth-Lab

For information on the author see p. 6.

Futures Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see teste