Strategies, analysis, and news for futures and options traders.

CORN FUTURES SPREAD:

Hot market, alternative
trade strategy p. 8

SYSTEMATICALLY CAPTURING
outsized profits p. 30

IRON BUTTERFLY
option system p. 34

SHORT-TERM
oscillator trading p. 16
Talking markets with
COVERED CALLS TOM DEMARK p. 36
from the ground up p. 20
 CONTENTS

Diagonal ratio spread . . . . . . . . . . . . . . . .24

Traders need nerves of steel to trade
natural gas futures, a frequently volatile
market. However, this options spread takes
advantage of seasonal tendencies and
reduces risk.
By S.A. Johnston

Futures System Lab . . . . . . . . . . . . . . . . .30

Extraordinary opportunities
money management
Testing a technique for making the most of big
trade opportunities.
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Options Strategy Lab . . . . . . . . . . . . . . . .34
Employment report iron butterfly
Letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Playing the monthly jobs report with an option
spread.

Trading Strategies
Corn: The new crude oil? . . . . . . . . . . . . . .8
Find out how an intermonth spread trade
can take advantage of the booming corn
futures market.
By Keith Schap

Short-term oscillator opportunities . . . .16

How to use oscillators in trending conditions.
By Thom Hartle Trader Interview . . . . . . . . . . . . . . . . . . . . .36
Tom DeMark
Rolling profitable covered calls . . . . . . .20 Market legend Tom Demark explains why the
You placed a covered call, the stock rallied, tools he created with a calculator and printed
and the position profited. Before letting charts more than 30 years ago are still valid
the stock get called away, consider rolling the today.
short call into the next month and collecting By Mark Etzkorn
additional premium.
By Marc Allaire
Industry News . . . . . . . . . . . . . . . . . . . . . . .40
CME-CBOT deal gets put on ICE
The InterContinental Exchange stunned
the futures world with an unsolicited bid
for the Chicago Board of Trade, which
had previously agreed to a deal with
the Chicago Mercantile Exchange.
By Jim Kharouf

continued on p. 4

2 April 2007 • FUTURES & OPTIONS TRADER

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CONTENTS

Milk and livestock around the clock . . .42

The Chicago Mercantile Exchange is
moving its agricultural contracts to its
electronic platform after pit-trading hours,
allowing the commodities to trade virtually
24 hours per day.
By Jim Kharouf

Futures Snapshot . . . . . . . . . . . . . . . . . . . .44

Momentum, volatility, and volume statistics for
futures. Futures and Options Trading Calendar . .48

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .45 New Products and Services . . . . . . . . . . . . .49

Notable volatility and volume.

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .50

Futures Basics . . . . . . . . . . . . . . . . . . . . . . .46 References and definitions.
Futures contract and rollover
Find out the basics of how futures
work — the process of tracking and Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .52
trading different contract months.
By FOT Staff
Options Trade Journal . . . . . . . . . . . . . . .54
Getting choked by a short strangle.

Have a question about something you’ve seen

in Futures & Options Trader?
Submit your editorial queries or comments to [email protected].
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.

CyberTrader Options Mentoring

Zecco Expo Trader Brazil
Options for Profits Futures & Options Trader bookstore
Options University Generic Trading

4 April 2007 • FUTURES & OPTIONS TRADER

 CONTRIBUTORS
CONTRIBUTORS

 S. A. Johnston is a systems analyst and designer, specializing in systems for

inventory control and optimization. He has traded stocks, futures, and options
since 1973, and has written about futures and futures options since 1998. In 2003,
John Wiley & Sons published his book Trading Options To Win: Profitable Strategies
A publication of Active Trader ® and Tactics for Any Trader. In 2005, he established Time & Timing (www.timeand-
timing.com), a comprehensive Web-based application offering detailed seasonal
For all subscriber services: and historical data and analysis on the futures markets.
www.futuresandoptionstrader.com
 Thom Hartle (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
Editor-in-chief: Mark Etzkorn
account executive for Merrill Lynch, vice president of financial
[email protected]
futures for Drexel Burnham Lambert, trader for the Federal Home
Loan Bank of Seattle, and editor for nine years of Technical Analysis
Managing editor: Molly Flynn
of Stocks & Commodities magazine.
[email protected]

 Keith Schap is a freelance writer specializing in risk manage-

Senior editor: David Bukey
ment and trading strategies. He is the author of numerous articles
[email protected]
and several books on these subjects including The Complete Guide to
Spread Trading (McGraw-Hill, 2005). He is a former senior editor at
Contributing editors: Keith Schap,
Futures magazine and senior technical marketing writer at the
Jeff Ponczak
Chicago Board of Trade.
[email protected]

 Marc Allaire is a consultant to the Chicago Board Options

Editorial assistant and
Exchange, the Montreal Exchange, and other options industry
Webmaster: Kesha Green
[email protected]
firms. He also teaches finance at the University of Indianapolis and
investments and derivatives at the Ningbo Institute of Technology
Art director: Laura Coyle in China. A former senior staff instructor at the Chicago Board
[email protected] Options Exchange’s Options Institute, Allaire was a featured con-
tributor to the CBOE’s book Options: Fundamental Concepts and Trading Strategies,
President: Phil Dorman co-authored Understanding LEAPS, and is a regular contributor to professional
[email protected] publications on options, LEAPS, and trading strategies. His latest publication is
The Options Strategist. He can be reached at [email protected].
Publisher,
Ad sales East Coast and Midwest:  Volker Knapp has been a trader, system developer, and
Bob Dorman researcher for more than 20 years. His diverse background encom-
[email protected] passes positions such as German National Hockey team player,
coach of the Malaysian National Hockey team, and president of
Ad sales VTAD (the German branch of the International Federation of
West Coast and Southwest only: Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc.
Allison Ellis (www.wealth-lab.com), which he is still running.
[email protected]
 Jim Graham ([email protected]) is the product manag-
Classified ad sales: Mark Seger er for OptionVue Systems and a registered investment advisor for
[email protected] OptionVue Research.

 Steve Lentz ([email protected]) is executive vice presi-

Volume 1, Issue 1. Futures & Options Trader is pub- dent of OptionVue Research, a risk-management consulting com-
lished monthly by TechInfo, Inc., 150 S. Wacker Drive,
Suite 880, Chicago, IL 60606. Copyright © 2007 pany. He also heads education and research programs for OptionVue Systems,
TechInfo, Inc. All rights reserved. Information in this
publication may not be stored or reproduced in any
including one-on-one mentoring for intermediate and advanced traders.
form without written permission from the publisher.

The information in Futures & Options Trader magazine  Jim Kharouf is a business writer and editor with more than 10 years of expe-
is intended for educational purposes only. It is not rience covering stocks, futures, and options worldwide. He has written extensive-
meant to recommend, promote or in any way imply the
effectiveness of any trading system, strategy or ly on equities, indices, commodities, currencies, and bonds in the U.S., Europe,
approach. Traders are advised to do their own
research and testing to determine the validity of a trad-
and Asia. Kharouf has covered international derivatives exchanges, money man-
ing idea. Trading and investing carry a high level of agers, and traders for a variety of publications.
risk. Past performance does not guarantee future
results.

6 April 2007 • FUTURES & OPTIONS TRADER

 LETTERS

Getting collared Dear Diary:

Remember what I said last month

T
here is one critical flaw in the
article, “The collar trade” in about the diagonal spread?
the March 2007 issue of

I
Options Trader magazine. While you n the article “Diagonal spread posts last-minute gain” (Options Trade
take into account the dividends, you Diary, Options Trader, February 2007) I believe the profit was $50, not the
fail to take into account the cost of $350 stated. The outcome referenced the IBM January 95 puts expiring
carry on the long stock and this turns ($0.45 profit) and the repurchase of the February 90 put at a loss of $0.10
your collar trade into a risk-free trade, (originally purchased at $0.30 + $0.10 loss = $0.40) for a $0.45-$0.40= $0.05,
which is nonsense. Unless you leg into and therefore the spread gained $50.00 overall per the 10 contracts. If there
a collar you cannot set it up as a risk- was an actual $350 profit, my assumption is the January puts were sold at
free position. I’m specifically refer- $0.75.
ring to the example given in the article:
— Carl Kastner
You could buy 100 shares of the
S&P 500 tracking stock (SPY) at The explanation of what happened in the trade was confusing. First, the January 95
$145.30 on Feb. 23 and sell a puts sold for $0.45 expired worthless. The February 90 puts, originally purchased
February 2008 150 call for 5.80 for $0.30, were sold for $0.20 — a loss of $0.10. The article should have read “sold”
($580). [I]f you bought a February instead of “repurchased.”
2008 145 put for $4.20 on Feb.
23, the combined position can’t
lose ground because you sold the potential loss and gain should be iden-
150 call for more premium than it tical, and unless you leg into a bull call
cost to buy the protective 145 put. spread you cannot enter it for a credit,
[I]f SPY closes at $150, the trade so if you come up with a risk-free col-
will gain $630 ($470 underlying lar you must be missing something —
profit + $580 call premium - $420 the cost of carry.
put premium). However, if SPY The numbers may not be exactly
drops below the long put’s 145 correct in my calculation, as I’m mak-
strike price, the position will still ing an assumption of the number of
gain $130. The collar’s final prof- days to expiration, but I think you get
its will be higher, because you will my point.
also collect $2.22 per share
($222) in S&P 500 dividends dur- — A. Fain
ing the trade.
You are correct — the collar trade exam-
Given that you count the dividends as ples don’t include carrying costs. The goal
$2.22 per share, it means that, for was simply to illustrate the potential out-
whatever reason, you use about 255 come of buying stock and placing a collar
days to expiration: The current divi- on it. The scenario assumed you would buy
dend is 0.7927, which is about $3.1708 the stock outright and not on margin.
per year, so 2.22/3.1708*356 = 249.24. Therefore, you wouldn’t necessary face a
Using 249 days to expiration, the cost loss on this trade.
of carry on a $145 stock at 5.25% is Admittedly, traders should consider all
$5.19 (145*0.525*249/365). Adding the opportunity costs when placing a trade.
numbers gives us a maximum poten- Instead of entering this trade, you could
tial loss of $1.67 (1.30 position gain + buy T-bills at 5.25 percent for a year and
2.22 dividends - 5.19 cost of carry). earn approximately $742. However, decid-
Similarly, on the upside, your maxi- ing to place the collar doesn’t mean you
mum potential gain is $1.11, not $6.3. face a loss.
Here’s another way of looking at it:
A collar is a synthetic equivalent of a David Bukey, Senior Editor
bull call spread, hence the maximum Options Trader magazine

FUTURES & OPTIONS TRADER • April 2007 7

 TRADING STRATEGIES

Corn: The new crude oil?

Corn — it’s not just for dinner any more. This commodity’s expanding economic importance could
make this an exciting year for the July-December futures spread trade.

BY KEITH SCHAP

C orn is the new crude. A New York Times edito-

rial, “The Price of Corn” (Feb. 6, 2007) settles
the case. After several years as commodity
darling of the media, black gold is being
upstaged by the organic gold of the American heartland.
As a result of concerns about over-dependence on high-
priced oil, ethanol has become a major factor in the energy
clearly. This could lead to interesting spread trading oppor-
tunities.

Old crop-new crop corn spread mechanics

To set up and track these spreads, you subtract the price of
the nearby July leg from the price of the more-distant
December leg. On Sept. 13, 2006, July corn futures (CN07)
equation. Because ethanol is derived from corn in the U.S., were trading around 268.50 cents per bushel and December
it has also become an important factor on the demand side corn futures (CZ07) were trading around 285.00. The spread
of the corn equation: For the first time in a long time, there on that day was 16.50 cents per bushel (285.00-268.50). By
may not be enough corn to go around; rationing may be Jan. 16, 2007, the situation had changed. July corn was trad-
required. And more so than in individual corn futures con- ing at 421.50 and December corn was trading at 387.75,
tract prices, it is in intermonth price relationships, such as which made the spread that day -33.75 (387.75-421.50).
the July-December spread (the “old crop-new crop” Grain traders often refer to the type of wide, positive
spread), where you see the market’s rationing impulse most spread seen on Sept. 13 as a “carry spread,” and the narrow,
negative spread on Jan. 16 as an “invert-
FIGURE 1 — THE 1990 JULY-DECEMBER CORN SPREAD ed spread.” What matters to spread
A typical pattern developed in 16 of 20 years from 1987 through 2006: a nar- traders, however, is not whether the
rowing in the spread at some point during the first four months of the year, fol- spread is wide or narrow, but whether it
lowed by a widening move. Here, the spread was trading at -0.5 on March 13, is likely to widen or to narrow in the
1990, narrowed 19 cents to -19.50 by May 7, then widened 16.75 cents to -2.75 future. The spread “narrows” when it
cents by June 27. goes from:

•positive to less positive

(e.g., from 17.75 to 11.00);
•positive to negative
(e.g., from 6.25 to -9.75);
•negative to more negative
(e.g., from -58.50 to -153.00).

The spread “widens” when it goes from:

•positive to more positive

(e.g., from 15.50 to 21.25);
•negative to positive
(e.g., from -16.50 to 4.50);
•negative to less negative
(e.g., from -51.25 to -4.25);

The widening or narrowing of the

spread matters because the old crop-

8 April 2007 • FUTURES & OPTIONS TRADER

 A word on order entry
While it is a good idea to analyze these spreads as
new crop spread expresses the storage impulse of the mar-
shown in Table 4, you can trade them directly — i.e., you
ket. Basically, when corn supplies are plentiful relative to
can buy or sell the spread as a single trade without hav-
demand (or when the market expects them to become plen-
ing to make two separate trades, or leg into the trade.
tiful), market users bid up the December price relative to
However, it is crucial to make sure your broker knows
the July price to encourage grain to be moved into storage.
you mean to, for instance, buy July and sell December
This widens the spread.
when you say you want to “sell the July-December corn
Conversely, when corn is in short supply relative to
spread at 60 or better.” The same caution holds for elec-
demand, or the market expects this condition, the market
tronic order entry. Make sure of what will happen when
bids up the July futures price relative to the December price
you enter a buy or sell spread. Lack of agreement on ter-
to draw corn out of storage. This narrows the spread.
minology can cause ugly results.
You want to buy the spread when you anticipate it will
widen and sell it when you anticipate it
will narrow. You buy and sell the FIGURE 2 — THE 1995 JULY-DECEMBER CORN SPREAD
spread in terms of what you do with
the more-distant contract month — in The 1995 spread narrowed 5.25 cents to 5.50 cents from Jan. 31 to March 30.
this case, the December leg of the It subsequently widened to 12.25 cents by June 7. Unlike the example in Figure
1, this spread remained in positive territory.
spread. To buy the spread you simulta-
neously buy December corn futures
and sell July corn futures. To sell the
spread, you sell December corn futures
and buy July corn futures.
Several factors offer guidance in
planning old crop-new crop spread
trades. A review of spread history is a
good place to begin.

July-December corn spread

history
During the 20 years from 1987 through
2006, a “normal” spread pattern
emerged — a path the market followed
in 16 of these years. Basically, at some
point during the first four months of a
normal year, the spread began a nar-
rowing sequence. In 11 of these 16
years, this move ended in March, April,
or May. From that point, the spread
began a widening move that peaked sometime in June in all the 20-year analysis period. It lists the early peak and the
but one of the 16 years. date on which it occurred, the subsequent trough and its
Figures 1 and 2 illustrate two of the normal years in date, and the final peak and its date. It also defines the
which the pattern is especially clear. In Figure 1, on March amount of narrowing (negative values) from peak to trough
13, 1990 the spread was trading at -0.5 (a negative half cent and the amount of widening (positive values) from trough
per bushel). It narrowed 19 cents to -19.50 cents by May 7 to later peak.
and widened 16.75 cents to -2.75 cents by June 27. There is considerable variation in both the timing and the
Figure 2 shows the 1995 spread narrowed 5.25 cents magnitude of the spread changes. The narrowings range
(10.75 cents to 5.50 cents) from Jan. 31 to March 30, 1995. It from 38 cents per bushel in 1994 to a mere 1.25 cents in 2001.
subsequently widened 6.75 cents per bushel (to 12.25 cents) The widenings range from 37.50 cents in 1994 to 1.25 cents
by June 7. in 2001. A one-cent spread change in your favor translates
Notice the 1990 spread in Figure 1 remained inverted (in into a $50 gain. Clearly, even had you captured the com-
negative territory) during the entire period while the 1995 plete peak-to-trough and trough-to-peak moves in 2001, the
spread in Figure 2 remained in positive territory the whole trades wouldn’t have been worth the effort. Still, in 13 of the
time. This makes no difference. Widening and narrowing 16 normal years, you could have made over $500 if you had
are widening and narrowing, regardless of the level at captured the maximum potential of the two moves, and in
which they occur. eight of these years, the cumulative maximum gain would
Table 1 summarizes all the normal spread years during continued on p. 10

FUTURES & OPTIONS TRADER • April 2007 9

 TRADING STRATEGIES continued

TABLE 1 — NORMAL JULY-DECEMBER SPREAD YEARS

Although there is a great deal of variation in the spread changes,13 of the 16 normal years had a
maximum potential return of more than $500; eight had a maximum potential gain of more than deviation (SD) levels
$1,000. Four of the five years with the highest profits had inverted markets.
were -6.25 (not shown)
Peak Trough Peak and -156.25 cents (red
Year Peak date Trough date Narrowing Peak date Widening line). For purposes of
1987 14.25 4/8/87 -0.25 5/28/87 -14.50 14.25 6/15/87 14.50 trade planning, howev-
1988 er, these levels, though
1989 -6.50 4/3/89 -26.25 6/1/89 -19.75 -11.75 6/14/89 14.50 statistically valid, seem
1990 -0.50 3/13/90 -19.50 5/7/90 -19.00 -2.75 6/26/90 16.75 useless.
1991 5.25 2/25/91 -6.00 4/26/91 -11.25 5.00 6/11/91 11.00 Figure 4 tracks the
1992 -1.00 1/9/92 -11.50 3/25/92 -10.50 10.50 6/29/92 22.00 same spread with statis-
1993 13.50 3/2/93 8.00 4/28/93 -5.50 15.75 6/29/93 7.75 tical ranges based a 30-
1994 -6.25 9/10/93 -44.25 1/13/94 -38.00 -6.75 6/29/94 37.50 day moving average
1995 10.75 1/31/95 5.50 3/30/95 -5.25 12.25 6/7/95 6.75 and 30-day rolling SD
1996 levels. (The ranges
1997 -1.50 1/7/97 -22.25 4/1/97 -20.75 -9.75 6/30/97 12.50 shown on Figures 1 and
1998 13.00 4/9/98 6.00 6/5/98 -7.00 14.25 6/30/98 8.25 2 are the same kind of
1999 17.75 2/26/99 9.25 6/25/99 -8.50 15.00 6/30/99 5.75 calculations.) In all three
2000 17.50 2/29/00 15.50 5/5/00 -2.00 21.25 6/29/00 5.75 cases, you can see the
2001 19.25 1/16/01 18.00 3/21/01 -1.25 19.25 5/3/01 1.25 spread bouncing back
2002 and forth between the
2003 plus and minus two-SD
2004 1.00 12/24/03 -12.00 3/17/04 -13.00 9.75 6/23/04 22.75 levels. These spreads
2005 17.75 2/11/05 11.00 2/25/05 -6.75 20.25 6/10/05 9.25 seem to lose momentum
2006 21.75 3/20/06 20.00 4/13/06 -1.75 26.25 6/1/06 6.25 any time they widen or
2007 narrow even slightly
beyond these bound-
aries.
have been more than $1,000. When the spread enters the analysis period at a narrow
One more observation about Table 1: Four of the five level, don’t assume it must widen. Nor should you assume
highest-earning years had inverted markets. This is no acci- a wide spread must narrow. The 1990 spread was a narrow
dent. In a carry market, the full cost of carry governs the -7.75 cents per bushel on Sept. 1, 1989. By Dec. 19, it had
spread. If full carry is 6.50 cents per bushel per month, and widened to -0.25 cents. The 1996 spread was even narrower
the July-December spread covers five months, full carry is (-36.75 cents) on Sept. 1, 1995. Based only on a mechanical
32.50 cents over that period. This defines the full potential view of mean reversion, you might have expected to see this
of the spread in a carry market. The widest spread in Table spread widen considerably. However, by Jan. 3, 1996, this
1 is 26.25 cents (from June 1, 2006), which represents 80.77 spread had narrowed to -77 cents. In contrast, the 1995
percent of full carry. spread spent the entire tracking period in positive territory
No such economic barrier limits inverted spreads. For and widened from 6 cents on Sept. 1, 1994 to 11 cents on
example, the -44.25 spread of April 1, 1994 tells you July Nov. 30.
corn was selling at a 44.25-cent premium to December corn.
In an inverted market, the July-December spread can nar- Crop news can be important
row far more than this. Although the concept of mean reversion is useful, it is not
As veteran grain trader J.L. MacKinzie has observed, “An enough to predict spread behavior. You must also study
inversion can be more fun to trade, if you have the stomach supply-demand fundamentals. The U.S. Department of
for it.” Agriculture (USDA) issues helpful monthly supply-
demand reports at www.ers.usda.gov/db/feedgrains/.
A statistical factor This information can provide useful clues about whether a
Spreads tend to be mean reverting — that is, they tend to narrow spread will narrow more or widen in the next few
make temporary moves to extremes and then return to weeks or months.
more normal levels — but the question is, to which mean do Table 2 abbreviates the monthly USDA reports by omit-
they revert? ting acres planted and harvested as well as the specific sup-
Figure 3 tracks the 1996 July-December spread from Sept. ply and demand categories, except for the column headed
1, 1995 to July 20, 1996. The mean level for this period was FSI, which stands for food, seed, and industrial use (which
-81.25 cents (blue line). The plus and minus two standard includes demand from ethanol producers). Also, the table

10 April 2007 • FUTURES & OPTIONS TRADER

 FIGURE 3 — THE 1996 JULY-DECEMBER CORN SPREAD
The plus and minus two standard deviation (SD) levels were not very useful in
this case.

includes only data from the May report

for each year from 1990 through 2005.
This report contains the first data for
the current crop year (the 1990 data
refers to the 1990-91 crop year, etc.).
Starting with the January 2006
report, Table 2 shows monthly data
until September, after which the num-
bers are estimates. These numbers
denote millions of bushels — e.g., the
9,432 total supply reported on May 10,
1990, indicates 9.432 billion bushels.
While the growth in both total sup-
ply and total use is interesting (as is the
huge growth in FSI in recent years
resulting from increased ethanol pro-
duction), two pieces of data are key
when predicting what the old crop-
new crop spreads might do: “ending FIGURE 4 — THE 1996 JULY-DECEMBER CORN SPREAD
stocks” and ending stocks as a percent- Like 2007,1996 was a year in which ending stocks dipped below the 500 million
age of total use (ES/TU), which are in bushel threshold.
the final two columns.
Ending stocks of 500 million bushels
or lower are effectively zero, and num-
bers even close to this level set off
alarms among traders. Ending stocks
as a percentage of use below 10 percent
also sets off alarms. When stocks dwin-
dle to these levels, it is time to reduce
demand, and livestock producers
begin to slaughter steers, hogs, and
poultry in large numbers — feed use
being by far the largest demand cate-
gory. Although the 2006 ending stocks
numbers of Table 2 grew steadily
smaller, decreasing from 2.4 billion
bushels in January to 1.035 billion
bushels at the end of 2006, they
remained well above the 500 million
flashpoint.
However, each report includes an
estimate for the next crop year, which is
important because the 2007 spread reflects concerns about total usage.
the 2008 supply-demand situation more than it does the These are the numbers driving corn futures over the $4
2007 situation. per bushel level and the numbers to think about when plan-
Table 3 shows the month-by-month estimates. At the ning 2007 July-December spread trades.
start of the 2006-07 crop year, the May 12, 2006 report shows
the estimates called for a total supply of 12,496 for the 2007- A backward glance to look ahead
08 crop year, total use of 12,115 (which includes the biggest One way to explore what could happen to the July-
FSI number on either table), and a paltry 381 million December corn spread during 2007 is to look for other years
bushels of ending stocks. By Sept. 11, 2006, the total supply when ending stocks dipped below 500 million bushels.
estimate was down slightly, to 12.39 billion bushels, the Table 2 shows one such year — 1996.
total use was unchanged, and the ending stocks were down Figure 4 tracks the 1996 July-December spread from the
to 275 million bushels, which amounts to 2.27 percent of the continued on p. 12

FUTURES & OPTIONS TRADER • April 2007 11

 TRADING STRATEGIES continued

TABLE 2 — CORN SUPPLY-DEMAND REPORTS AND ESTIMATES

The two pieces of data that are key when predicting what the old crop-new cent narrowing from the Feb. 8 level. By
crop spreads might do are shown in the final two columns: ending stocks and April 15, it had narrowed to -110.75 cents,
ending stocks as a percentage of total use (ES/TU). Ending stocks around 500 which was 13 cents below the minus-two
million bushels or lower are essentially zero and set off alarms among traders, SD mark and 52 cents narrower than the
as do ES/TU levels below 10 percent. Feb. 8 level.
Crop Issue Total Total Ending ES/TU The temptation to unwind at either of
year date supply FSI use stocks (%) these points would have been strong.
1990/91 5/10/90 9,432 1,315 8,130 1,330 16.36 Having sold the spread on Feb. 8, an April
1991/92 5/9/91 9,677 1,360 7,920 1,360 17.17 4 unwinding would have earned $1,200
1992/93 5/11/92 9,706 1,485 7,870 1,146 14.56 (24 cents*$50). Unwinding on April 15
1993/94 5/11/93 10,618 1,550 8,395 2,187 26.05 would have resulted in a $2,600 gain (52
1994/95 5/10/94 9,557 1,750 7,650 827 10.81 cents*$50). These might seem to be rea-
1995/96 5/11/95 10,198 1,800 9,375 1,588 16.94 sonable gains, but veteran traders stress
1996/97 5/10/96 9,702 1,690 8,580 367 4.28 the importance of staying with a good
trade as long as it is working for you. The
1997/98 5/12/97 10,759 1,760 8,820 909 10.31
adage, “You can never go broke taking a
1998/99 5/12/98 10,909 1,875 9,050 1,209 13.36
profit” fails to recognize the need to let
1999/00 5/12/99 11,229 1,925 9,285 1,799 19.38
good trades more than make up for less-
2000/01 5/12/00 11,534 1,975 9,480 1,759 18.55
successful ones.
2001/02 5/10/01 11.583 2,040 9,745 1,951 20.02
Although there might not be a sure-fire
2002/03 5/10/02 11,571 2,160 9,795 1,621 16.55 way to know when a trade has reached
2003/04 5/12/03 11,129 2,375 9,610 1,009 10.50 full potential in an inverted market, care-
2004/05 5/12/04 11,246 2,680 10,355 856 8.27 ful attention to the concerns of the market
2005/06 5/12/05 13,210 2,870 10,560 2,215 20.98 can help. April is the beginning of the
2005/06 1/12/06 13,236 2,960 10,735 2,419 22.53 planting season, and during much of
2005/06 2/9/06 13,236 2,985 10,810 2,426 22.44 April 1996, the concern was whether farm-
2005/06 3/10/06 13,236 2,985 10,835 2,401 22.16 ers would be able to plant on time or if
2005/06 4/10/06 13,236 2,985 10,885 2,351 21.60 wet fields would keep them from getting
2006/07 5/12/06 12,736 3,545 10,935 2,301 21.04 the job done. If farmers couldn’t plant the
2006/07 6/9/06 12,736 3,545 11,645 1,141 9.80 crop, corn would be in short supply in
2006/07 7/12/06 12,812 3,545 11,645 1,091 9.37 1997. This concern drove the July-
2006/07 8/11/06 13,047 3,540 11,735 1,077 10.43 December spread narrower — all the way
2006/07 9/11/06 12,850 3,540 11,815 1,232 8.76 to -153 cents on April 26. At this point, the
2006/07 10/11/06 12,850 3,540 11,815 1,035 8.76 spread was 94.50 cents narrower than it
2006/07 11/11/06 12,850 3,540 11,815 1,035 8.76 had been on Feb. 8. Having sold the
2006/07 12/11/06 12,850 3,540 11,815 1,035 8.76 spread on Feb. 8 and unwound at the
2006/07 1/11/07 12,850 3,540 11,815 1,035 8.76 April 26 level, the gain would have been
$4,725.00.
Table 4 summarizes the details of this
beginning in September 1995, when it was a strongly invert- trade. In this case, the July leg made the money. But even
ed -36.75 cents per bushel. The inversion narrowed to -77.00 after netting out the 27.50-cent loss from the December leg,
cents on Jan. 3. Given the direction of this spread change, the “spread net” is a robust 94.50 cents, which translates
you might have focused on opportunities to sell the spread. into a $4,725 gain for a one-lot spread.
Say your sell signal is a spread wider than plus two SDs To see how much the spread narrows or widens during
— that is, slightly above the red line in Figure 4. This signal the term of a trade, subtract the earlier level from the later.
was triggered on Feb. 8, 1996. With July corn at 360.00 cents A negative result indicates a narrowing spread, while a pos-
per bushel and December corn at 301.50, the spread was itive value indicates a widening spread.
-58.50 cents — 1.75 cents wider than the -60.25 cents plus- Patiently following weather reports and reports of plant-
two SD level. ing progress can pay big rewards. By the end of the first
Your buy signal might be a penetration of the minus-two week in May 1996, market watchers had seen the weather
SD level, but be careful — you cannot treat this too mechan- clear and farmers begin planting. This allayed fears about a
ically. As Figure 4 shows, it can be easy to unwind your supply shortage, and the spread widened back to -115.25
trade too soon. cents on May 6.
The spread narrowed past the minus-two SD level at the During June, the crop in the ground often becomes the
end of March and had reached -82.75 cents on April 4, a 24- farmers’ bank. That is, they will sell part of this crop for-

12 April 2007 • FUTURES & OPTIONS TRADER

 TABLE 3 — ESTIMATES FOR THE FOLLOWING CROP YEAR
The May 12, 2006 report estimated a total supply of 12,496 for the 2007-2008
ward to pay bills and meet expenses. crop year, total use of 12,115, and a very low 381 million bushels of ending
Heavy selling is likely to drive down stocks.
the July futures price and widen the
spread. Indeed, from May 21, when the Crop Issue Total Total Ending ES/TS
spread had narrowed to -159.25 cents year date supply FSI use stocks (%)
and the July futures price was 501.25 to 2006/07 1/12/06 13,139 3,404 11,648 1,491 12.80
June 5, the July price dropped 66.25 2006/07 2/9/06 13,114 3,404 11,648 1,466 12.59
cents per bushel to 435.00 cents while 2006/07 3/10/06 13,064 3,404 11,648 1,416 12.16
the December price moved only 1.25 2006/07 4/10/06 13,014 3,404 11,648 1,366 11.73
cents — from 342.00 to 340.75. This 2007/08 5/12/06 12,496 3,794 12,115 381 3.14
widened the spread 64.75 cents — from 2007/08 6/9/06 12,446 3,794 12,115 331 2.73
-159.25 to -94.50 cents. 2007/08 7/12/06 12,432 3,794 12,115 317 2.61
This -94.50-cents spread level is 2007/08 8/11/06 12,587 3,794 12,115 472 3.89
slightly wider than the plus-two SD 2007/08 9/11/06 12,390 3,794 12,115 275 2.27
level, which marks another opportunity 2007/08 10/11/06 12,390 3,794 12,115 275 2.27
to sell the spread, assuming none of the 2007/08 11/11/06 12,390 3,794 12,115 275 2.27
fundamental information alters predic- 2007/08 12/11/06 12,390 3,794 12,115 275 2.27
tions of a corn supply shortage in 1997. 2007/08 1/11/07 12,390 3,794 12,115 275 2.27
The decision concerning where to
unwind this trade requires thought.
TABLE 4 — PATIENCE REWARDED: SELLING AN INVERTED SPREAD
Although Figure 4 shows the spread
narrowing to -187 cents on July 8, it is Despite a 27.50-cent loss on the December leg, the trade’s overall profit
probably wise to avoid carrying a trade (“spread net”) is 94.50 cents ($4,725 per spread).
into the July delivery month. The
-155.00-cents-per-bushel June 28 price is Action C N96 Action C Z96 Spread
probably the optimal time to unwind. 2/8/96 Buy 360.00 Sell 301.50 -58.50
The spread had narrowed 60.50 cents, 4/26/96 Sell 482.00 Buy 329.00 -153.00
and a one-lot trade catching this June 5 1 bushel result 122.00 -27.50
through June 28 move would have Spread net 94.50 -94.50
earned $3,037.50. Spread $ net 4,725.00

That was then, this is now

That was 1996, a time when the market expressed extreme about supply adequacy. By Jan. 12, report day, the spread
concern about a potential scarcity of corn by inverting the had narrowed seven cents to -20 cents.
July-December spread to an extreme extent. Early spread What happened to the spread during the next few days
action, along with the USDA supply-demand reports, sug- suggests the market found no joy in these numbers, at least
gests the 2007 July-December corn spread could develop with regard to supply adequacy. The July-December spread
along similar lines. narrowed to -36.75 cents on Jan. 17, which was half a cent
Figure 5 tracks the 2007 spread from the beginning of narrower than the minus-two SD level and 23.75 cents nar-
September 2006 to Jan. 24, 2007. This spread inverted Oct. rower than the Jan. 9 level. Given the clear Jan. 9 sell signal,
12 amid growing clamor about how much corn the ethanol you could have sold this spread at -13 cents and unwound
manufacturers would need and how scarce supplies were it on Jan. 17 at -36.75. This 23.75 cents per bushel narrowing
likely to be, especially in 2008. By Nov. 20, 2006, the July- would have resulted in a $1,187.50 gain.
December spread had narrowed to -38 cents.
Based on talk of a supply shortage and the large number Larger factors to consider
of new ethanol plants due in 2007, it should have seemed Current projections suggest U.S. ethanol production capac-
likely the 2007 spread would narrow even farther. Granted ity will reach 11.72 billion gallons by early 2008. This would
the spread widened from Nov. 20 to Dec. 18 and again from more than double the production of the 2005-2006 corn crop
Jan. 2 to Jan. 9, 2007. year and almost double estimates for the 2006-2007 crop
Consider what happened in early January. On Jan. 9, with year. To satisfy this and other demands for corn, U.S. farm-
July corn trading at 311.00 cents and December corn at ers will need to produce 3.7 billion bushels as opposed to
358.00, the July-December corn spread had widened to -13 the 2006 harvest of 2.15 billion bushels, which will require
cents, two cents wider than plus-two SDs. This was three as much as 10 million additional acres planted in corn and
days before the USDA January crop report, and expecta- an ideal growing season.
tions were not positive about what the report would say continued on p. 14

FUTURES & OPTIONS TRADER • April 2007 13

 TRADING STRATEGIES continued

FIGURE 5 — THE 2007 JULY-DECEMBER CORN SPREAD

This spread inverted Oct. 12 amid speculation about how much corn the
As 2007 unfolds, several factors could
ethanol manufacturers would need and how scarce supplies were likely to be,
bring about the kind of narrowing July- especially in 2008. By Nov. 20, 2006, the July-December spread had narrowed
December corn spread that occurred in to -38 cents.
1996, or cause it to perform differently.
Extremely wet conditions at planting
time could result in fewer acres planted.
Even if the acres do get planted, a rela-
tively late planting can reduce the yield
potential of the crop. Unfavorable
weather during crucial crop develop-
ment stages can also have a negative
effect on yields. Also, if foreign wheat
producers experience poor crops, as
Australian growers did in 2006, live-
stock feeders who depended on those
crops for feed could enter the bidding
for scarce U.S. corn supplies. Finally, the
drive to plant millions more acres of
corn means some marginal land will
come into production. This may lower
overall crop yield. Any combination of
these factors can lead to precipitous
spread narrowing.
However, the flip side of these factors
could widen the spread or keep it from narrowing as much flocks in record numbers, feed demand could fall off
as it otherwise might. If farmers manage to plant 10 million enough to ease the situation and keep the spreads from nar-
additional acres of corn in a timely fashion and if the weath- rowing quite so much.
er is close to ideal at planting and each crop development These are the basic factors to watch in planning and man-
stage, the market may sense a bumper crop in the making, aging old crop-new crop corn spread trades. All things con-
and the spread may not narrow as much as first anticipat- sidered, this could be an exciting year for these positions. 
ed.
Also, if U.S. livestock feeders liquidate their herds and For information on the author see p. 6.

Related reading: Recent Keith Schap articles

“FOMC option opportunities” “Put ratio spreads: Selling volatility to buy an option”
Options Trader, December 2006. Options Trader, June 2006.
Using options to trade interest-rate announcements. Ratio spreads seem to be relatively simple strategies, but
trading them successfully requires a detailed understanding
“The butterfly in the iron mask” of how implied volatility (vega) and time decay (theta) affect
Options Trader, November 2006. these options.
Butterflies and iron butterflies: These option-strategy twins
are even more alike than most traders think. Learn about the “Death, taxes, and time decay”
subtle differences between them, and when you should Options Trader, March 2006.
choose one over the other. Markets that go nowhere can be frustrating, but call calendar
and diagonal spreads can generate respectable profits by
“Close encounters of the condor kind” taking advantage of time decay.
Options Trader, September 2006.
Don’t alienate yourself from a potentially rewarding strategy “The out-of-the-money advantage”
just because it looks like something from outer space. Options Trader, January 2006.
Using far out-of-the-money options gives you the opportunity
“A closer look at put backspreads” to protect against a big drop in the stock market without put-
Options Trader, July 2006. ting a lot of money on the line.
A backspread can be a theoretically attractive options
position, but it sometimes faces long odds in real trading. You can purchase and download past articles at
www.activetradermag.com/purchase_articles.htm.

14 April 2007 • FUTURES & OPTIONS TRADER

 TRADING STRATEGIES

Short-term
Oscillator opportunities
Exploring the relationship between an exponential moving average and an oscillator
leads to new ways of defining trend changes and capturing price swings.

BY THOM HARTLE

A lthough it sometimes seems as if trends con-

sist of smooth, orderly up or down moves
(especially if your trade is a loser), prices usu-
ally zigzag up and down even during strong
trends. If the longer-term trend is up, price will rise from a
shorter-term oversold state to an overbought state and back
again, repeating this cycle until the market tops, then
time relationship between these swing peaks and troughs.
Life would certainly be easy if a market would simply bot-
tom, rise for five days and peak, fall for three days and bot-
tom, and then rise for five days again, repeating this pattern
indefinitely.
The reality is the number of price bars between swing
peaks and troughs throughout a trend is much more ran-
moves into a downtrend. dom. Nonetheless, some straightforward analysis makes it
The difficulty is that while these price swings are easily possible to identify trade opportunities using the concept
identifiable on historical charts, there is rarely a regular that markets zigzag around their longer-term trends.
To spot such opportunities relative to the
trend, we must first select a method to define
FIGURE 1 — RISING MARKET
the trend. The moving average is probably the
The RSI shifts in the direction of the trend, depending on the strength most popular trend-defining tool, but it is not
of that trend — i.e., readings will be skewed higher in uptrends and the only one. Oscillators, which are calculations
lower in downtrends. that highlight shorter-term price swings, are
usually thought of as tools for identifying over-
bought/oversold conditions or divergences,
not as trend indicators.
However, one of the most popular oscilla-
tors, the relative strength index, can be used
with a simple moving average to trade with the
trend and to warn of trend reversals.

Uptrends and downtrends

In technical analysis, as in most other areas of
life, you always give up something to gain
something else; for every advantage an indica-
tor or approach possesses, it also has a draw-
back.
For example, the longer a moving average’s
lookback period (the number of price bars used
to calculate the average), the less likely it will
result in false signals (when price repeatedly
moves above and below the average), but the
more it will lag changes in market direction.
Although there are several types of moving
Source: CQGNet
averages (simple, exponential, weighted, etc.),

16 April 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — FALLING MARKET
During the downtrend, the RSI peaked each time below 75 and
dropped well below 25 on downswings because of the influence of the
downtrend.

they all have one purpose: identifying the trend

by smoothing price action and removing mar-
ket “noise.”
This allows traders to create simple defini-
tions for trend direction, such as the one we
will use here: If the moving average is rising,
the trend is up; if the moving average is falling,
the trend is down. Using the direction of the
moving average to define the trend, we can
then move on to the next step of qualifying the
nature of intratrend price swings.

Adding the oscillator

Most oscillators, in one way or another, meas-
ure the difference between prices over a short
time period (e.g., three to 20 days). This
removes any longer-term trend influence and
produces a horizontal picture of price zigzag-
ging above and below the trend, which is rep-
resented by the oscillator’s median line (the
midpoint or “zero line”).
“The trend-following RSI” (Active Trader, Source: CQGNet
January 2003, p. 44) illustrated how crosses
above and below the RSI median line are nearly equivalent Each time the market closes below its six-day EMA (at
to price crossovers of a moving average with twice the bars A, C, and E) the RSI moves below 50, which is the indi-
length of the RSI lookback period. cator’s median line. In other words, RSI readings below 50
indicate the market has closed below its six-day exponential
moving average.
In technical analysis, as in most other After bars A and C, the market traded sideways for one
and two days, respectively, before resuming its uptrend.
areas of life, you always give up Following bar E’s close below the EMA, the market
reversed the next day and challenged the uptrend’s most
something to gain something else; recent high.
After bar B’s higher close, the market rallied for three
for every advantage an indicator more days. Following bar D, price rallied five more days,
and it rallied two more days after bar F.
or approach possesses, it also has A couple of other points are worth noting. First, during
the market’s first pullback after crossing above the 30-day
simple moving average in August, the RSI dropped to just
a drawback. below 40 and then rallied to around 75; the same thing hap-
pened in the latter part of September. Although this is a
For example, Figure 1 shows the E-Mini Nasdaq 100 very short-term RSI, the fact that the RSI turned back up
futures (NQ) with a rising 30-day simple moving average from such a high “oversold” level was a sign of strength.
(indicating the trend is up), a six-day exponential moving This example reflects how the RSI values shift in the direc-
average (EMA) and a three-day RSI. (The look-back period tion of the trend, depending on the strength of that trend —
is a function of the desired number of trade signals and the i.e., readings will be skewed higher in uptrends and lower
typical volatility of a given market. For example, a 14-day in downtrends. In this case, the low RSI values around 40
RSI would produce far fewer signals than a three-day RSI.) continued on p. 18

FUTURES & OPTIONS TRADER • April 2007 17

 TRADING STRATEGIES continued

FIGURE 3 — TREND CHANGE

The RSI reflected a subtle shift in the market’s momentum from up to
down well before the market crossed below the 30-day moving aver-
age. At point E the RSI fell below 25, closing below the RSI support
level established by points A and C.
confirm the strength of the uptrend.
Finally, when using such a short-term RSI
look-back period, disregard any thoughts that
divergence between the RSI and price peaks
indicates a potential reversal.
A simple guideline can be derived from this
information: If the 30-day moving average is
rising and the three-day RSI drops below 50,
go long on the next up close; place your stop
two ticks below the low of the entry bar. This
is a good example of how a short-term RSI can
be used to identify swing trade opportunities
in the upward zigzags of a rising trend.
Why not just buy on the first up close fol-
lowing a close below the six-day EMA, which
we’ve already defined as equivalent to the
three-day RSI? Because of the subtle but valu-
able information provided by the level from
which the RSI turns back up: During a rising
market the RSI will bottom around 40. (More
about this in a moment.)

The RSI as trend indicator

Source: CQGNet Figure 2 shows a down-trending crude oil (CL)
chart with a three-day RSI and a 30-day SMA.
FIGURE 4 — MARKET BOTTOM (To provide a clearer view of the price action,
In this case the RSI demonstrates an upward shift against the down- the six-day EMA is not included.)
trend. At point E the RSI turned back up from just below 50, which is At bar A the 30-day moving average is
a sign of strength. falling and the RSI makes its first move above
50. The next day (bar B) the RSI declined as the
market closed lower, but then turned up again
the next day (bar C). The market then dropped
to a new low. At bar E, the RSI closed above 50.
Price turned down again at bar F and price
proceeded to drop to another new low in the
downtrend. Bars G and H repeated the pattern
of bars E and F.
During this downtrend, the RSI peaked each
time below 75 and dropped well below 25 on
downswings because of the influence of the
downtrend, which pushed the RSI readings
lower — the opposite of the situation in the
Figure 1 uptrend.
This trend-influenced shift in RSI readings
can be used to confirm the trend and warn of a
trend change. For example, in Figure 3 the T-
bond futures (US) are in an uptrend (indicated
by the rising 30-day SMA), and at points A and
C the RSI turns back up from lows just above
35. However, points B and D on the RSI form
resistance at a much lower level than the peak
Source: CQGNet RSI readings at the top of the uptrend just

18 April 2007 • FUTURES & OPTIONS TRADER

 Trading approach highlights
Using the RSI to catch swing points
1. Define the trend: If the n-day (default: 30-day) simple
Related reading
moving average (SMA) is rising, the trend is up; if the “Indicator Insight:
SMA is falling, the trend is down. Relative strength index (RSI),”
Active Trader, August 2001.
2. Use a short-term RSI to find swing entry points:
If the 30-day moving average is rising and the three-day “Indicator Insight:
RSI drops below 50, go long on the next up close. Weighted and exponential
Reverse for short trades. moving averages,”
Active Trader, July 2002.
Using the RSI as a trend indicator
1. Support lines drawn along RSI troughs during an uptrend “The trend-following RSI,”
should be just below 50. During a downtrend, resistance Active Trader, January 2003.
lines connecting RSI peaks should be just above 50.
Violation of these levels warns the trend is changing. You can purchase and download
past articles at
2. Consider RSI readings above 75 as signs the market is www.activetradermag.com/
strong or turning strong — i.e., confirmation of an
purchase_articles.htm.
uptrend, not as entry points. The opposite is true of RSI
readings of 25 or lower and downtrends.

prior to point A. At point E the RSI guideline: Support lines drawn along
falls below 25, closing below the RSI RSI troughs during an uptrend
support level established by points A should be just below 50. During a
and C — a downward shift in the downtrend, resistance lines connect-
trend that pushed the RSI readings ing RSI peaks should be just above
lower. The market made one more 50. Violation of these trendlines
attempt to rally and, at point F, the warns the trend is changing.
RSI edged just above the resistance Also, consider RSI readings above
level before turning back down 75 not as entry points, but as signs
again. This RSI pattern reflected a the market is strong or turning strong
subtle shift in the market’s momen- — i.e., confirmation of an uptrend.
tum from up to down well before the The opposite is true of RSI readings
market crossed below the 30-day of 25 or lower confirming a down-
moving average. trend.
Figure 4 shows a bottom in the
heating oil market (HO). This is Further experimentation
example of an upward shift in RSI The RSI was used here to find trade
readings against the downtrend. In opportunities in the direction of the
this case, the 30-day SMA is trending trend, as well as to indicate the trend
down. The RSI forms an initial resist- was shifting direction.
ance level at points A and B near 35, This is not the only tool that could
indicating a weak market. But the function in this role — other oscilla-
indicator soon breaks out above this tors could be used as well. The key is
resistance and makes a higher peak to review market action and deter-
at point C. Next, the RSI climbs mine practical criteria based on the
above 75 (point D) — this higher typical behavior of the oscillator
reading being an early sign the trend within the context of a trend. Once
was turning up. Then at point E the that behavior is quantified, you can
RSI turns back up from just below 50, develop entry strategies and risk-
which is a sign of strength: Strong management points for trades.
markets will flash low RSI readings
between 40 and 50 and then turn up. For information on the author see p. 6.
This behavior leads to a second

FUTURES & OPTIONS TRADER • April 2007 19

 TRADING STRATEGIES

Rolling profitable
covered calls
Taking profits on a winning covered call is tempting, but extending the trade another month
could generate additional profits.
BY MARC ALLAIRE

O ptions traders typically view covered calls as

conservative, boring investments fit only for
widows and orphans. The strategy, which
involves buying stock and selling calls
against these shares, seems dull partly because it’s so
straightforward. You collect income from the short calls in
exchange for giving up potential upside gains on the stock.
Hold or roll?
Let’s assume you hold a profitable covered call on Monday,
Feb. 12 and options expire in four days. The position con-
tains 100 shares of stock and a short call, and the underly-
ing has moved above the option’s strike price, so the trade
has gained ground. Too many traders may be tempted to
leave the trade alone: A covered call’s maximum profit
After entering the trade, most traders simply wait for the occurs when the stock is assigned, and the underlying stock
short calls to expire worthless or have the underlying stock is sold at the strike price. So why not let the call’s owner
called away by the calls’ owner. take the position and move on to another trade?
Despite their stodgy reputation, covered calls remain Specifically, let’s assume you hold 100 shares of
popular. A recent survey of Charles Schwab options traders Chesapeake Energy (CHK) and one short February 27.5 call
showed 65 percent had used covered calls within the last 12 on Feb. 12. At this point, CHK traded at $29.17 and the
months (see “Options aren’t just for trading anymore,” February 27.5 calls, which were in-the-money (ITM), traded
Options Trader, February 2007). And these trades have more at $1.70 (bid)-$1.75 (ask), and will be assigned unless CHK
nuances than most traders realize. Instead of waiting for the drops below the 27.5 strike before Friday. If assigned, you
short calls to expire, you can enhance a covered call’s poten- will be forced to sell the stock at $27.50, which limits gains.
tial profit by buying back the call and selling its same (or The March 27.50 calls traded at $2.10-$2.15. You could
higher-strike) counterpart in a further month, a technique have rolled the February short call by buying it back at
called “rolling.” $1.75 and selling the March call for $2.10 — a credit of $0.35.
This first installment of a two-part series examines the Is rolling the calls worthwhile?
benefits and drawbacks of rolling a profitable covered call First, consider what happens if you do nothing. You will
position as expiration nears. Next month’s study explores sell the stock at $27.50 (excluding commissions) and look
how to salvage a flat or underwater covered call with unre- for a new trade. Because transaction costs reduce the roll’s
alized losses. potential gains, let’s assume you pay $0.05 per spread to
repurchase the February calls and sell the
March calls. (Commissions could be lower
Strategy snapshot or significantly higher, depending on the
number of contracts traded.)
Strategy: Rolling a profitable covered call.
Table 1 shows that if you roll the covered
Logic: Repurchasing a short call before it expires and selling a call, you will collect an additional $0.30
same- or higher-strike call in a further month to collect premium, which extends the obligation to
additional premium or allow the underlying stock to rally sell CHK until the March 17 expiration
further. (another 28 days). The $0.30 gain repre-
sents a 1.09-percent return or 14.2 percent
Criteria: Covered call (long stock + short call) has unrealized gains.
annualized ([$0.30/$27.50] * [365/28
Later-expiring calls offer more premium that it costs to
days]). There isn’t one correct answer here.
repurchase the near-term calls (i.e., the spread). Or the
However, you must feel comfortable hold-
underlying stock could continue rallying.
ing Chesapeake Energy for another month.
Timing: Expiration week of near-term short calls. Also, compare this return to other possible
trades available after CHK is sold. Despite
Maximum profit: Call strike - stock cost + total call premiums received.
the possibilities, many traders would con-
Maximum loss: Stock cost - total call premiums received. sider a 14-percent annualized gain worth-
while.

20 April 2007 • FUTURES & OPTIONS TRADER

 Covered write vs. buy write
Two roads lead to a covered call (long stock, short call): a “covered write” and
That sinking feeling a “buy-write.” A covered write involves selling calls against a stock you
These examples don’t include the already own. You may have bought the shares last week, last month, or last
stock’s original cost or the short call’s year, but you decide to sell calls against that stock now. Traders usually see
premium because these numbers are the stock trading near their target price and think “If Caterpillar (CAT) climbs
irrelevant here. The goal is to measure to $70 from $67.67 on Feb. 12, I want to sell it.”
whether the roll’s potential return is A buy-write is an alternate strategy that purchases the stock and sells calls
large enough to justify holding simultaneously. Most brokers let you execute this as one trade. Traders who
Chesapeake Energy another four place buy writes are motivated by yield; they want to generate a certain return
weeks. The past — sometimes before the calls expire.
referred to as sunk costs — should not The examples shown here apply to either strategy. For simplicity, the term
matter. “covered call” is used.
Of course, buying back the
February 27.5 call will generate a tax-
able event. If you initially sold it for
TABLE 1 — ROLLING A COVERED CALL
more than $1.75, you must report a
short-term capital gain. But remem- If you feel comfortable holding the stock another month, you could roll the
ber, leaving the covered call covered call: Buy back the February 27.5 call for $1.75 and sell the March 27.5
untouched also produces a taxable call for $2.10, capturing another $0.30 in premium (1.09 percent).
event when the underlying stock is
Long/short Credit/debit
sold at a profit.
Chesapeake Energy (CHK)
Enter dividends at $29.17 on Feb. 12 Long -$2,917.00
Let’s assume you also placed a cov- February 27.5 calls Buy to close -$1.75
ered call on DuPont (DD), which March 27.5 calls Short $2.10
includes an unrealized gain on Feb. Spread: $0.35
12. The stock traded at $51 and the Commission: $0.05
short ITM February 50 calls traded at
$0.95-$1.05. If the March same-strike
Net spread: $0.30
calls trade at $1.55-1.65, is rolling this
Return: 1.09%
covered call worth it?
Buying back the February 50 call at Annualized return: 14.20%
$1.05 and selling the March 50 call for
$1.55 adds $0.45 in premium (includ-
TABLE 2 — ROLL TO CAPTURE DIVIDENDS
ing commissions of $0.05 per spread),
extends the position by 28 days, and Rolling this Dupont covered call to March will bring in $0.45 in premium and
generates an annualized return of 11.7 $0.37 of dividends for an overall gain of $0.82 (1.64 percent). But if you don’t
percent ([$0.45/$50] * [365/28]). repurchase the ITM February 50 call, it will be exercised and you will lose the
However, DD goes ex-dividend dividend.
tomorrow (Feb. 13) and the quarterly Long/short Credit/debit
payout is $0.37 per share. How does DuPont (DD) at $51 on Feb. 12 Long -$5,100.00
this change the equation? If you do
February 50 calls Buy to close -$1.05
not repurchase the February 50 call on
Feb. 12, they will likely be assigned, March 50 calls Short $1.55
which means the stock will be sold Spread: $0.50
and you won’t receive the dividend. Commission: $0.05
The call holder will probably exercise
it today to capture the dividend Net spread: $0.45
before you can. Dividends: $0.37
Not only would you miss the divi- Total spread: $0.82
dend, but you must sell DuPont six
days early. Calls exercised on Feb. 12
will settle on Feb. 15, and calls exer- Return: 1.64%
cised on expiration Friday (Feb. 16) Annualized return: 17.60%
continued on p. 22

FUTURES & OPTIONS TRADER • April 2007 21

 TRADING STRATEGIES continued

TABLE 3 — COVERED CALL ON CISCO will settle on Feb. 21.

Rolling the February Dupont calls
Rolling the Feb. covered call on Cisco to March generates more premium ($0.40).
to March has two consequences: The
Long/short Credit/debit covered call will be extended 34 days
Cisco (CSCO) at $27.57 on Feb. 12 Long -$2,757.00 not 28, because the original position
February 27.50 calls Buy to close -$0.35 will be closed early if you do nothing.
March 27.50 calls Short $0.80 Also, the roll offers a $0.82 return
Spread: $0.45 ($0.45 roll spread + $0.37 dividend).
This is a 17.6-percent annualized gain
Commissions: $0.05
([$0.82/$50] * [365/34]), which is
much higher than the original profit
Net spread: $0.40 that ignored the stock’s yield (see
Return: 1.45% Table 2).
Annualized return: 18.96% The rates of return calculated for
the Chesapeake Energy and Dupont
examples assume the stock will still
TABLE 4 — ROLL NOW OR WAIT?
trade above the options’ exercise price
These theoretical prices show the spread between February and March 27.5
at March 16 expiration. Then, the calls
calls will remain unchanged even if CSCO rallies to $28 by Wed., Feb. 14.
would be assigned, the stock sold, and
However, sharper underlying moves will affect potential profits, so waiting to roll
a covered call involves a trade-off: Lower stock prices could enhance the the incremental return earned. Next
spread, while higher stock prices will reduce it. month, you can reevaluate the posi-
tion to see if you should repeat the
Monday, Wednesday, Expiration process.
Feb. 12 Feb. 14 Friday, Feb. 16
Cisco (CSCO) $27.57 $28.00 $28.04 Squeezing all the juice
February 27.5 call $0.29 $0.54 $0.54 Even if you decide to roll a covered
March 27.5 call $0.79 $1.04 $1.04 call from February to March, you still
need to find the best time to execute
the trade. You could roll a position on
Spread: $0.50 $0.50 $0.50
Feb. 12, but you might boost potential
Commission and slippage: $0.10 $0.10 $0.10 profits if you wait a few days. Let’s
Net spread: $0.40 $0.40 $0.40 assume you held a covered call on
Cisco (CSCO) on Feb. 12. The stock
traded at $27.57, the February 27.5
TABLE 5 — ROLLING UP AND OUT
calls traded at $0.30-$0.35, and the
If you are bullish on Federal Express, rolling a short February 110 call to a
March same-strike calls traded at
March 115 call is a good idea, even though the roll won’t generate additional
$0.80-$0.85.
premium. Buying back the February call and selling a March higher-strike call
gives FDX room to rally. The issue is whether to roll now
and collect $0.40 ($0.80 March premi-
Long/short Credit/debit um - February $0.35 cost - $0.05 com-
Federal Express (FDX) at $113.14 on Feb. 12 Long -$11,314.00 mission) or wait and hope the spread
February 110 calls Buy to close -$3.50 improves. Table 3 shows that the roll
April 115 calls Short $3.50 represents an 18.96-percent annual-
Spread: $0.00 ized return ([$0.40/27.50] * [365/28]).
However, the reason for waiting is
straightforward: The February calls
If FDX hits $115 by April 21:
are ITM by only $0.07 and their value
Additional underlying gain: $5.00
should decay substantially as expira-
Return: 4.50% tion nears, assuming Cisco remains
Annualized return: 26.30% unchanged. Although the March calls
will also fall in value, the February
If FDX stays at $113.14 by April 21: calls will drop further, widening the
Additional underlying gain: $3.14 spread and increasing potential gains.
Return: 2.80% The best-case scenario is CSCO
closes at $27.49 on expiration Friday
Annualized return: 16.40%
(Feb. 16), the February 27.50 calls

22 April 2007 • FUTURES & OPTIONS TRADER

 Related reading
Marc Allaire articles:
expire worthless, and you sell the same- “Straddles vs. strangles, round two,” Options Trader, January 2007.
strike March calls. If implied volatility (IV) Neither strategy always outperforms the other. However, having a clear
does not change, the March calls would have price forecast makes it easier to select the best position.
a theoretical value of $0.72, and you could
“Selecting calls based on ROI,” Options Trader, October 2006.
sell them for $0.675 (including commis-
Traders seem drawn to complex options strategies, but sometimes sim-
sions).
ply buying calls is the best way to catch an up move. Learn how to
Waiting to roll these options poses risks:
weigh the possibilities by comparing various calls’ return on investment.
Cisco could drift below $27.50 and the
March calls will lose value. Or it could rally
further and the spread will narrow. Let’s try Other articles:
to quantify the risk of waiting.
“Writing covered calls and puts,” Options Trader, June 2006.
Table 4 shows theoretical prices for
Selling options against a position in the underlying instrument brings risk
February and March 27.5 calls on several
as well as opportunity. Learn how to build covered call and put positions
days during February expiration week. The
and increase the odds of their success.
table indicates how far Cisco can rise before
the roll’s spread of $0.40 is affected. Here, the “Naked puts: The option-selling alternative”
spread’s theoretical value remains $0.50 Options Trader, September 2005.
even if Cisco climbs to $28 by Feb. 14. Although trading “naked” is rarely recommended, selling puts can be a
However, you will probably collect $0.40 way to generate income if you pick the appropriate underlying market.
after selling at the bid and paying commis-
“The synthetic covered call,” Active Trader, November 2004.
sions.
Covering a short call option with options rather than stock has certain
If Cisco climbs to $28 by Wednesday, then
advantages — especially for shorter-term traders.
the roll’s spread remains unchanged; if the
stock is below this level, the spread should “A new look at naked puts,” Active Trader, August 2002.
widen; but if CSCO trades higher, the spread Shorting puts can be a limited-risk strategy that behaves the same way
will narrow. You have to weigh the possibil- as selling a covered call — with potentially lower costs.
ity of collecting more premium against the
“Covered writes: Where trading and investing meet”
risk of the stock “getting away,” which will
Active Trader, June 2002.
reduce the spread amount.
Covered writes are a way to generate income on existing investments
and boost overall returns.
Rolling up and further out in a
bull market “How to write a covered call,” Active Trader, August 2001.
If you hold a covered call that will expire The covered call is a good introduction to the simple uses of options.
soon on a bullish stock, you can roll the posi- Here are the steps for selling options against stock you own.
tion “up and out” by selling a higher-strike
“Taking cover with options,” Active Trader, May 2000.
call in later-expiring months. When the orig-
Using covered calls can add flexibility to your trading plan.
inal covered call’s expiration nears, use this
tactic if you feel comfortable holding the
You can purchase and download past articles at
position an additional two months.
www.activetradermag.com/purchase_articles.htm.
For instance, let’s assume you own 100
shares of Federal Express (FDX) and a short
February 110 call. On Feb. 12, the stock traded at $113.14 But to earn this amount, FDX will have to hit or exceed
and the 110 call traded at $3.30-$3.50. If your two-month $115.
outlook on FDX is quite bullish and you expect the stock to A more conservative estimate assumes Federal Express
climb above $115, holding a covered call that forces you to will continue to trade at $113.14 within nine weeks. At this
sell the stock at $110 isn’t a good idea. On the other hand, point, the April 115 call expires worthless and the stock is
simply buying the call back at $3.50 isn’t attractive, and sell- sold at $113.14, which represents an additional $3.14 gain
ing a March 110 call offered a mediocre return. (2.8 percent or 16.4 percent annualized).
Instead, you could buy back the February 110 call and sell
the April 115 calls at the same price ($3.50, see Table 5). A win-win scenario
While you will not collect additional premium, the new Sometimes letting a covered call expire may be the optimal
covered call will not expire for another nine weeks and it strategy. You may have written calls to sell stock at a certain
raises FDX’s potential selling price to $115. If you sell the price. But you might want to consider rolling the position
underlying stock at $115 at April 21 expiration, you will into another month to generate more premium.
earn an additional $5 (4.5 percent) in this nine-week period
— an annualized gain of 26.3 percent ([5/110] * [365/63]). For information on the author see p. 6.

FUTURES & OPTIONS TRADER • April 2007 23

 TRADING STRATEGIES

Diagonal ratio spread

This trade is poised to exploit imminent seasonal price moves

in October and April natural gas options.

BY S. A. JOHNSTON

S easonal tendencies appear when a market’s

price consistently behaves the same during a
certain time of year. These tendencies also
appear frequently in spread trading, when
you buy one month’s contract and sell another month’s
contract against it.
Trading futures spreads is often less risky than simply
(“Futures and options spreads,” explains some differ-
ences between these positions and describes the diagonal
ratio spread in detail.)

Seasonal spread patterns

Occasionally, the following market conditions align in a
specific time period:
trading the underlying market, but not always. Even if a
spread’s seasonal price movement has been historically 1. The prices of two markets have behaved in a very
consistent, there is no guarantee it won’t move against you consistent fashion for years, even decades.
this year. 2. The volatility of these two markets has also
An options spread can exploit a seasonal spread tenden- behaved consistently.
cy while sharply reducing the potential effect of any nega- 3. At the start of the period, there is an observable
tive swings. The following example describes a diagonal skew in the implied volatilities (IV) of the
ratio spread in natural gas options that profits from a markets’ options.
spread between the October and April futures contracts. 4. Both markets are generally unaffected by
event-driven price shocks.

Strategy snapshot This scenario may seem unlikely, but

Strategy: Seasonal diagonal ratio spread in natural gas. it occurs in at least one pair of futures
markets almost every year. In natural
Market bias: Bullish outlook for the April 2008-October 2007 spread. Non- gas futures, the October contract has
directional with regard to the underlying market. tended to underperform the succeed-
Premise: To exploit the April 2008-October 2007 options’ IV skew, time ing April contract from mid-April to
decay, and the futures spread’s favorable price history while late July.
avoiding sharp drawdowns. Table 1 shows the April-October
futures spread’s price history from
Criteria Seasonal price history: Buying April-October futures spread has April 15 to July 22, but these dates
for entry: been profitable from April to July since 1999. Select strike aren’t etched in stone. The table shows
prices based on historical price range — sell strike 60 percent a futures spread trade has historically
above market, buy strike 30 percent above market. The short earned an average $0.31 annually, or
strike should have notably higher IV than the long strike. $3,140 per spread, including estimated
Action: Sell two October 2007 calls and buy one April 2008 call. Exit trading costs of $400.
around July 23 before hurricane season hits its stride. In theory, you could have entered a
futures spread by selling the October
Maximum See Table 4 for historical results and Figure A for potential contract and buying the subsequent
gain: profitability. April contract. However, in four of the
Maximum Large losses possible if natural gas futures surge above 14.90 years, you would have suffered a hefty
loss: by October expiration. Smaller $320 loss possible if natural gas drawdown at some point.
sells off sharply. In 2003, for example, the spread had
an enormous contrary move early in

24 April 2007 • FUTURES & OPTIONS TRADER

TABLE 1 — APRIL-OCTOBER NATURAL GAS SPREAD, 1993-2006
In the past 14 years, the April-Oct. futures spread has gained an average $3,140 from mid-April to the third week of July.
Entry Entry price Interim Interim Exit Exit Net
date (April - Oct.) high low date price result*
4/14/93 -0.222 0.007 -0.270 7/22/93 0.005 0.227
4/14/94 -0.065 0.074 -0.085 7/22/94 0.074 0.139
4/13/95 0.028 0.205 -0.026 7/21/95 0.205 0.177
4/12/96 -0.275 -0.120 -0.511 7/22/96 -0.120 0.155
4/14/97 0.017 0.025 -0.176 7/22/97 0.020 0.003
4/14/98 -0.215 0.316 -0.278 7/22/98 0.316 0.531
4/14/99 0.008 0.116 -0.097 7/22/99 0.006 -0.002
4/14/00 -0.281 -0.239 -0.770 7/21/00 -0.325 -0.044
4/12/01 -0.780 0.305 -0.813 7/20/01 0.305 1.085
4/12/02 0.114 0.701 -0.03 7/22/02 0.632 0.518
4/14/03 -0.700 -0.148 -1.164 7/22/03 -0.148 0.552
4/14/04 -0.502 0.055 -0.787 7/22/04 -0.158 0.344
4/14/05 -0.315 0.575 -0.315 7/22/05 0.250 0.565
4/13/06 1.185 2.135 0.520 7/21/06 1.895 0.710

Average: 0.354
Average total $ move: $3,540
Estimated commissions and slippage: $400.00
Net average gain: $3,140.00
*All prices are in dollars per million British thermal units (MMBTU), 0.01 = $100.00.
Source: www.timeandtiming.com

the trade. Nobody wants to sit through such a move, so drawdowns, enter a diagonal ratio spread. In mid-April, if
trading the spread outright was probably not the best idea, the October 2007 natural gas contract (NGV7) trades above
unless you had deep pockets. Admittedly, 2003 was a skew — or at a small discount to — the April 2008 contract
year. The natural gas market was rattled by cold weather in (NGJ8), buy one April 2008 call and sell two higher-strike
February, so the market stampeded, but the scare vanished, October calls against it. However, if the April contract is
and price dropped. Fortunately, this situation does not exist trading at a large premium to October, wait until next year
in 2007, so 2003’s price history simply doesn’t apply here. to enter the trade.
To exploit the spread’s seasonal tendency and avoid
Put the wind at your back
TABLE 2 — NATURAL GAS STATISTICAL VOLATILITY, 1999-2006 The natural gas market has a great
deal of event risk. Harsh winters, hot
Market volatility falls and typically reaches its spring low in April. Then volatility summers, and Gulf hurricanes cause
tends to rise from its spring low into July, which should benefit this diagonal
wild price movement in natural gas.
ratio spread.
The trade’s time period is well-select-
Near trade entry Spring low July high ed, because harsh winter weather
Date SV* Date SV* Date SV* rarely appears from April to July.
4/5/99 43.137 4/29 26.148 7/27 37.848 Similarly, this period seldom produces
4/3/00 30.621 5/2 27.241 7/13 71.207 great heat waves. Instead, these tend
to occur from late July through mid-
4/3/01 42.175 5/11 37.282 7/30 63.014
September, especially in the
4/3/02 66.700 6/12 40.422 7/10 50.898
Northeast.
4/3/03 102.622 4/23 29.462 7/10 51.305 What about hurricanes? The natural
4/5/04 32.202 4/23 27.141 7/6 34.685 gas market’s historical price and
4/4/05 29.454 4/22 24.532 7/12 40.105 volatility risk from an early large Gulf
4/3/06 45.483 4/7 36.369 7/31 75.609 hurricane is tiny, and no second-rate
* 30-day annualized statistical volatility storm will affect it much.
Hurricane season begins officially
Source: www.timeandtiming.com
continued on p. 26

FUTURES & OPTIONS TRADER • April 2007 25

 TRADING STRATEGIES continued

Futures and options spreads

A standard futures spread involves buy-
ing one contract and selling a second FIGURE A — DIAGONAL RATIO SPREAD – POSSIBLE GAINS AND LOSSES
one against it. For example, if you sell This trade should gain ground if natural gas doesn’t drop or rally too sharply by
the October 2007 natural gas contract the July 23 exit.
and buy the April 2008 contract, the
trade will profit if:

1. Both contracts rise but October

rises less than April;
2. Both contracts fall but October
falls further than April;
3. October falls while April rises.

You buy or sell futures spreads in

terms of what you do with the longer-
term contract. If you sell October and
buy April, you are buying the spread
and hoping April outperforms October,
which occurs if any of the three above
conditions are true. By contrast, if you
buy October and sell April, you are sell-
ing the spread and hoping April lags
October — the opposite of conditions Source: OptionVue
above.
buys one (a ratio spread). This diagonal ratio spread is bull-
Options spreads ish: You want natural gas to rally toward the short option’s
However, options spreads are entirely different animals. strike price before it expires.
They can profit from many different scenarios and have less The diagonal ratio spread’s potential profits and losses
obvious reward-risk characteristics, because there are are not as clear as a vertical spread’s possible outcome.
more variables involved in option pricing. Two of the most First, the spread contains calls in two contract months,
basic option spreads are the vertical call spread (or “bull which almost always have different volatilities. The differ-
spread”) and its opposite, the vertical put spread (“bear ence in volatilities is what makes this trade desirable in the
spread”). A vertical call spread consists of simultaneously first place. Rather than predicting the market’s direction,
buying a call option with a lower strike price and selling this trade could profit because of the IV difference between
another call option with a higher strike price. short and long calls (i.e., buying cheap and selling expen-
For example, if June natural gas is trading at 7.45, you sive options). This spread trades on volatility and price, not
could construct a vertical call spread by buying a June 7.45 just price.
call for $0.56 ($5,600) and selling a 7.60 call for $0.49 On March 9, two October natural gas 12.75 calls could
($4,900). The goal of this trade is to profit from an up move have been sold for $0.212 each ($4,240) and the April 08
in the underlying market while limiting risk with the sale of 9.75 call bought for $0.456 ($4,560) — a total debit of
the short call option (although this short option will limit your $0.032 ($320). If you include slippage and commissions, an
profit potential as well). entry debit of about $600 is a good estimate. This trade will
In general, the trade’s maximum profit occurs when nat- be unprofitable in two circumstances: If natural gas simply
ural gas futures reach or exceed the higher strike price crashes and the October contract gains radically on the
(7.60) at expiration. Above that price, additional gains in the April contract. Also, it will lose if natural gas spikes more
long 7.45 call are offset by losses in the short 7.60, unless than 80 percent by the July 23 exit date, which has never
IV changes. The strategy’s risk is limited to the difference occurred from April to July in the past.
between long and short calls’ cost ($0.07, or $700 plus trad- Figure A shows this spread’s potential gains and losses
ing costs). based on October natural gas prices on the proposed July
23 exit date. If the market rallies to the short 12.75 strike,
Diagonal ratio spread the spread will gain nearly $15,600. Possible gains drop if
The options spread described here is more complicated: It the market rallies further, and it will lose ground if natural
not only buys and sells calls in different strikes and expira- gas climbs above 14.90 by July 23. The spread could lose
tion months (a diagonal spread), but it sells two calls and $320 if natural gas falls sharply.

26 April 2007 • FUTURES & OPTIONS TRADER

on June 1. However, large, damaging Gulf hurricanes have historical event-risk cushion to the spread, which is the best
rarely formed from June 1 to July 15. The only ones on way to trade this volatile market.
record are Hurricane Audrey on June 27, 1957 and an Hold the trade until late July, with one exception: Exit the
unnamed storm in 1934. spread if natural gas drops 20 percent within six weeks of
Natural gas futures’ volatility also shows a clear pattern. entry. This stop-loss threshold is based on historical price
Table 2 shows the natural gas futures’ statistical volatility moves from mid-April to July (1999-2005).
(SV) each year at three points: the beginning of April, its On March 9, you could have sold two October 2007 nat-
spring low, and its July high. As winter subsides, market ural gas 12.75 calls for $0.212 each ($4,240) and bought one
volatility falls and typically reaches its spring low in April, April 2008 9.75 call for $0.456 ($4,560) — a total debit of
although there have been modest variations. Also, volatili- $0.032 ($320, see Table 3). The multiplier for natural gas
ty rises consistently from its spring low into July, which options is 10,000 because the minimum tick ($0.001) is $10
benefits this trade. per contract.
Even more helpful to the trade, though, is the differential The initial SPAN margin requirement is $1,361 plus com-
between the composite IV of October natural gas calls and missions and slippage. This amount will change by April,
the composite IV for next April’s calls. The higher-strike but is still representative. When dealing in any market,
October calls are overpriced relative to the lower-strike though, as the late Harry Roth said, “minimum margin is a
April calls. On March 9, this differential was 13.6 percent. It sign of minimum intelligence.” Therefore, let’s triple this
seems almost as if traders are viewing April calls as the requirement and allocate $4,583 (3 * $1,361 + $400 commis-
equivalent of a head cold and October calls as the equiva- sions and slippage).
lent of chicken soup.
TABLE 3 — HYPOTHETICAL RATIO SPREAD DETAILS
Building a diagonal ratio
On March 9, you could enter this spread at a debit of $320 (excluding commissions).
spread
Now, how can we turn all this infor- Description Long/short Credit/debit
mation into profits? Create a diagonal 2 Oct. 2007 12.75 calls Short $0.424
ratio spread that exploits three fac- 1 April 2008 9.75 call Long -$0.456
tors: the IV skew between October
and April calls, seasonal history, and Debit: $0.320
time decay.
In early April, wait for October nat-
ural gas to rally for a couple of days, Initial SPAN margin: $1,361.00
then buy one April 2008 (NGJ8) call Estimated commissions and slippage: $400.00
and sell two October 2007 (NGV7) Recommended margin: $4,583.00
calls against it. *All option prices are in dollars per MMBTU, 0.01 = $100.00.
The strike prices are determined as Source: www.timeandtiming.com
follows: Multiply the October 07 nat-
ural gas futures’ price by 1.6 and sell
the nearest 25-cent strike. For example, if October natural
gas is trading at 7.95, sell the October 12.75 strike call (7.95 The case for a seasonal
* 1.6 = 12.72). Next, divide the October strike by 1.3 and buy natural gas options spread
the nearest 25-cent April 2008 strike call (12.75/1.3 = This trade will likely profit for several reasons. First, Table
9.8076). 1 shows April futures tend to gain strongly on October
These factors are based on price history. The October con- futures during this period. Assuming other factors remain
tract has never risen 60 percent from April to late July. The unchanged, a diagonal ratio spread will benefit from this
maximum rise in this period occurred in 2000, when move.
October natural gas rose 46.65 percent from April 15 to June One feature of this spread is the six-month difference in
27 in response to a rare early heat wave that pushed gas expiration dates. This spread behaves in part as a standard
prices higher. Therefore, multiply the current price by 1.6. calendar, or horizontal, option spread (short option + long
The other figure, 1.3, is derived from the maximum premi- same-strike option in later-expiring month). The best way
um of October natural gas over April, which has never to profit from a calendar spread is if the underlying mar-
approached 30 percent in this period (the maximum premi- ket’s SV and option IV increases during the trade. Table 2
um was 22.73 percent on June 21, 2003). shows volatility tends to bottom out around mid-April and
Choosing the option strikes this way adds a generous continued on p. 28

FUTURES & OPTIONS TRADER • April 2007 27

 TRADING STRATEGIES continued

TABLE 4 — DIAGONAL RATIO SPREAD PERFORMANCE, 1999-2005

This table lists the diagonal ratio spread’s gains and losses at four possible exit points. Exiting around July 23 wasn’t the
most profitable approach, but it was a cautious way to capture gains.

Entry Entry Exit A Exit B Exit C Exit D

Year*** date** price* date price* date price* date price* date price* Drawdown
1999 5/5 0.086 5/21 0.139 9/16 0.266 7/26 0.171 9/28 0.309 None
2000 5/17 0.047 9/22 0.816 9/26 0.920 7/24 0.179 9/27 0.922 0.187 on 6/27/00
2001 4/10 -0.215 6/26 0.083 7/18 0.061 7/24 0.054 9/26 0.022 None
2002 4/16 0.121 7/8 0.345 8/5 0.235 7/24 0.306 9/26 0.348 0.046 on 4/22/02
2003 4/17 -0.128 7/22 0.096 8/4 0.114 7/24 0.096 9/26 0.076 0.135 on 6/9/03
2004 4/12 0.039 8/3 0.326 8/12 0.269 7/26 0.221 9/27 0.240 None
2005 4/22 0.127 5/24 0.141 8/12 0.269 7/25 0.239 9/27 0.641 0.872 on 8/30/05

Total gain: 1.946 2.134 1.266 2.558

Total $ gain:**** $19,460 $21,340 $12,660 $25,580

* All prices are in dollars per MMBTU, 0.01 = $100.00.

** In 1999 and 2000, the option strikes suggested by the formula on p. 27 did not start trading until the entry date shown. No prior
price data for these options is available, and theoretical prices were not used.
*** In a couple of years, the option strike for April as suggested by the formula didn't begin trading until June or July. In these cases,
the strike was adjusted upward proportionately by $0.25 or $0.50 to use prices for options which had traded.
**** Doesn’t include commissions and slippage.

Source: www.timeandtiming.com

increase toward July, so this tendency should help the which is not suggested). As this ratio of time remaining
spread. increases, the relative time decay of October 2007 options to
However, this trade is also a ratio spread, which means April 2008 options accelerates. This is a huge and accumu-
you buy one call and write two against it. In general, a ris- lating advantage. Additionally, the short October 12.75
ing market favors an out-of-the-money ratio call spread (see call’s rate of time decay intensifies when option IV is high,
Figure A). The natural gas market may rise or fall, but this which often occurs in natural gas options.
spread has profited since 1999.
The difference between composite IVs of the October and Measuring historical gains and losses
April calls is 13.6 percent. However, the difference between In theory, the trade looks promising. In practice, however,
the two specific calls (October 12.75 and April 9.75) is 21.26 you need to examine its real-world risk and reward. Table 4
percent — much wider. You’re doing exactly what the text- shows the diagonal ratio spread’s performance from 1999 to
books say to do: Buying the lower-IV option and writing 2005 and lists its gains or losses at four possible exit points:
the higher-IV one.
The trade is largely immune to adverse weather, because A. When October call’s price drops below $0.01;
you will exit the spread before most of the summer heat and B. When October call’s price drops to the minimum
before most past Gulf hurricanes. A couple of hurricane tick ($0.001);
scares in the Gulf would actually benefit the trade for this C. Suggested July 23 exit date or next business day;
reason: Some traders will begin buying calls when a scare D. Hold until October option expiration.
comes along, the IVs of the options will increase as they do
so, and, once again, rising option IVs help the calendar fea- We did not enter the trade in 2006, because trade condi-
ture of the spread. tions were not met; April 2007 natural gas traded at a large
Finally, this spread benefits from time decay. At trade premium to the October 2006 contract. Also, prior to 1999,
entry, for example, April 2008 options have about twice the the natural gas market did not exhibit the required volatili-
time left as October 2007 options. Within three months, this ty characteristics. In each year, the option strikes shown
ratio increases to more than 3:1 and then climbs to greater were selected using the calculations on p. 27. (The entry
than 4:1 a month later (if you continue to hold the trade, date was simply the end of April’s first three-day rally,

28 April 2007 • FUTURES & OPTIONS TRADER

 Related reading
S.A. Johnston articles:
“Seasonal straddles,” Options Trader, December 2006.
except for years in which historical A look at seasonal volatility uncovers several attractive long-straddle candi-
prices weren’t available. In those dates in the futures markets.
years, we used the first day the
selected strikes actually traded. See “Non-seasonal options trading,” Options Trader, May 2006.
Table 4’s footnotes for exceptions.) A strategy based on the idea that how a market doesn’t tend to behave
The trade’s interim and final at certain times of the year can be just as important as how it does.
results speak for themselves. The
spread was quite profitable at all Ratio spread articles:
four exit points and experienced
“Trading seasonal volatility in natural gas,” Options Trader, October 2005.
small drawdowns (with the excep-
Energy prices have risen considerably in 2004-2005 and resulted in increased
tion of Hurricane Katrina in 2005).
interest in oil and gas markets. Here, we will enter short strangles using
Although it may seem unlikely, the
options on natural gas futures to take advantage of its seasonal volatility.
trade suffered no drawdowns
(excluding slippage and commis-
“Ratio call spreads: Leverage profits and reduce risk”
sions) in 1999, 2001, and 2004.
Options Trader, June 2006.
Ratio call spreads can enhance an underlying position’s potential gains at no
The ideal exit: July 23
extra cost, or in many cases, for a net credit.
Although the three other exit points
were more profitable, Table 4 shows
“Put ratio spreads: Selling volatility to buy an option”
that exiting around July 23 (exit C)
Options Trader, June 2006.
represented a sound and cautious
Put ratio spreads profit from slightly bearish moves, but the trick is to under-
way of capturing profit. Indeed, if
stand how implied volatility affects these positions. We explore several trade
you exited around July 23 or when
scenarios and discover the best time to place these spreads.
the October call dropped below
$0.01 (i.e., exits A or C), you would
“Selling premium with a twist,” Options Trader, August 2006.
have enhanced profit in 2001 and
Ratio spreads offer more potential profit than other premium selling strategies
still stayed well away from the bulk
such as naked puts or simple credit spreads. And these trades are more flexi-
of hurricane season.
ble than they initially seem.
Table 4 shows why holding the
trade until October expiration is a
“Trader Interview: Trevor Taylor,” Options Trader, June 2006.
bad idea. In 2005, Hurricane Katrina
A professional trader discusses how he places ratio spreads on various stock
wrecked a great deal of Gulf natural
indices.
gas production at the end of
August. Shortly afterward,
Diagonal spread articles:
Hurricane Rita did more damage,
and natural gas prices went berserk “Diagonal put spreads: Beyond the basic credit spread”
surrounding these two events. The Active Trader, March 2005.
diagonal trade was profitable at Discover how to profit from volatility surges and time decay with a put spread
October expiration simply because that encompasses different expiration months.
the October options were so close to
expiration — pure luck. Few traders “Another look at double diagonal spreads,” Options Trader, March 2007.
would have even thought about sit- This position combines bullish and bearish diagonal spreads and is quite flexi-
ting through that enormous draw- ble if you’re willing to adjust its components.
down.
Cautious traders didn’t care, “Two spreads are better than one,” Options Trader, April 2006.
though. They exited the spread long Calendar spreads profit from short option time decay, but only if the underly-
before Katrina hit. That’s the entire ing trades near the strike price. An alternative strategy is to enter a double
point — select a time period in calendar, or “diagonal,” spread, which can boost the odds of success while
which weather-driven event risk is minimizing exposure.
at a minimum, regardless of the
market.  You can purchase and download past articles at
www.activetradermag.com/purchase_articles.htm.
For information on the author see p. 6.

FUTURES & OPTIONS TRADER • April 2007 29

 FUTURES LAB

Extraordinary opportunities
money management
Market: Futures. (upper) and red (lower); the seven-day SMA is blue. First,
using a fixed percentage means the approach will not take
System concept: This month’s Futures Trading System into account the differences between markets and the dif-
Lab highlights a money-management idea introduced by ferences in volatility from one period to the next in the same
Tushar S. Chande in his book by Beyond Technical Analysis market. For example, the seven-day average might move
(1997, John Wiley & Sons, Inc.). outside three-percent bands quite often in a volatile market,
The method is based on the premise that once in a while but rarely in a quiet market.
positive “outliers” — such as prolonged trends or violent These problems could perhaps be addressed by assigning
moves — occur in favor of an open position, and that by different percentages to different markets and updating
identifying when these events are most likely to occur, you these numbers regularly in each market. However, this
can increase your trade size to capture outsized profits. would be a very labor-intensive process.
In his book, Chande suggested a simple rule to identify Another approach would be to create dynamic upper
an extraordinary opportunity. First, calculate a three-per- and lower bands using average true range (ATR):
cent trading band above and below a 50-day simple moving
average (SMA) — that is, add and subtract 3 percent from 1. Upper ATR band calculation: 50-day SMA of the
each day’s 50-day SMA value. An extraordinary opportuni- daily highs plus the 50-day ATR amount.
ty for a bullish move occurs when the seven-day SMA of 2. Lower ATR band calculation: 50-day SMA of the
closing prices crosses over the upper band; the opposite is daily lows minus the 50-day ATR amount.
true for extraordinary bearish opportunities.
However, percentage bands such as these have limita- In Figure 1, these bands are silver.
tions. Figure 1 shows these percentage bands in green The light-green areas on the chart highlight “extraordi-
nary opportunity” zones based on the
dynamic ATR bands — that is, when
FIGURE 1 — SAMPLE TRADES the seven-day SMA crosses above the
The silver lines represent the 50-day SMA of the daily highs (lows) plus upper band or below the lower band.
(minus) the 50-day ATR. Notice the extraordinary opportunity
signals from the ATR bands — which
would be used to increase the position
size of a trading system — preceded
the signals that would have come from
the percentage bands.
In the following tests, a simple
volatility breakout system will be used
to determine the usefulness of the
extraordinary opportunities money-
management rules. Long and short
trades are initiated when price moves
at least 1.5 times the n-day ATR above
or below the most recent closing price
(an entry popularized by Larry
Williams). Exits occur when price hits a
trailing stop placed at the lowest low
for long trades or the highest high for
short trades of the past n days.

Trade rules:
1. Buy tomorrow at the close plus 1.5
times the 10-day ATR if the seven-
day SMA of closing prices is above
the upper ATR band (50-day SMA
Source: Wealth-Lab
plus the 50-day ATR).

30 April 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — EQUITY CURVE

After six years of consecutive gains, the performance essentially went flat.

2. Go short tomor-
row at the close
minus 1.5 times the
10-day ATR if the
seven-day simple
moving average of
closing prices is
below the lower ATR
band (50-day SMA
minus the 50-day
ATR).
3. Exit long position
tomorrow at the low-
est low of the past 10
days.
4. Exit short position
tomorrow at the
highest high of the
past 10 days.

Money
management:
Test 1: Risk 0.5 per-
cent of account equi- Source: Wealth-Lab
ty per position.
Test 2: Risk 1.5 per- FIGURE 3 — EQUITY CURVE AFTER APPLYING MONEY MANAGEMENT
cent of account equi-
The system performed much better with the extraordinary opportunities money-management rules —
ty (triple the original profits were larger and more uniform.
trade size) if extraor-
dinary market condi-
tion exists.

Starting equity:
$1,000,000 (nominal).
Deduct $8 commission
and 0.1 percent slip-
page per trade.

Test data: The sys-

tem was tested on the
Active Trader standard
futures portfolio,
which contains the fol-
lowing 20 futures con-
tracts: British pound
(BP), soybean oil (BO),
corn (C), crude oil (CL),
Source: Wealth-Lab
cotton (CT), E-Mini
Nasdaq (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), Test period: March 1992 to February 2007.
lean hogs (LH), natural gas (NG), sugar (SB), silver (SI),
Swiss franc (SF), 30-year T-Bond (US). Data source: Ratio- Base system results: The volatility breakout system’s
adjusted data from Pinnacle Data Corp. (www.pinnacleda- basic results were mediocre. Figure 2 shows the equity
ta.com). continued on p. 32

FUTURES & OPTIONS TRADER • April 2007 31

 FUTURES LAB continued

curve. The system generated a conservative annualized

OUTLIER ANALYSIS gain of 5 percent, which translated to a net total profit of
108.97 percent. Also, after six years of consecutive gains, the
Long + Long Short performance essentially went flat. The system had a typi-
Short positions positions cally low trend-following winning percentage of 38.7 per-
Positive outliers 25 12 13 cent. On the plus side, the average trade was 0.35 percent,
Negative outliers 5 2 3 which leaves room for the system to survive greater slip-
page.
The great benefit of this system is
NET PROFIT BY SIGNAL that it produced a large sample of
trades (more than 1,600) — enough to
$ Value Percent be able to make valid comparisons of
Original With Original With these trades with and without the
system MM system MM money-management technique.
Regular signals 782,358.69 1,412,115.00 71.79 50.82 To analyze extraordinary opportu-
nities, we also conducted a test of
Extraordinary opportunities 307,356.31 1,366,731.00 28.21 49.18
“outlier trades,” which were defined
as trades that exceeded
STRATEGY SUMMARY the average trade by plus
or minus three standard
Profitability Original With MM Trade statistics deviations. The analysis
Net profit ($): 1,089,714.97 2,778,846.24 No. trades: 1,614 1,619 detected 25 positive out-
liers (see “Outlier analy-
Net profit (%): 108.97% 277.88% Win/loss (%): 38.66% 38.73%
sis,” above, left).
Profit factor: 1.16 1.18 Avg. profit/loss (%): 0.35% 0.38% Results of the test
Payoff ratio: 1.90 1.92 Avg. holding time (days): 17.12 17.14 could be divided into a
Recovery factor: 2.60 2.60 Avg. profit (winners) %: 5.52% 5.57% pair of approximately
seven-year periods, judg-
Exposure (%): 3.21% 4.62% Avg. hold time (winners): 27.65 27.65
ing by their efficiency. In
Drawdown Avg. loss (losers) %: -2.91 -2.90 the first section (1992-
Max. DD (%): -18.26 -27.47 Avg. hold time (losers) : 10.49 10.50 1999), there was a run-up
Longest flat period: 2,415 1,902 Max consec. win/loss: 5/19 5/19 in the portfolio equity
during the trend phase of
Improvements highlighted in blue
the market. Both long
and short components
FIGURE 4 — DRAWDOWN DURATION CHART of the strategy complemented
The money management rules notably shortened the maximum drawdown duration. each other, resulting in
a steeper equity curve
(Figure 2).

Results with money

management: The system
performed much better with
the extraordinary opportuni-
ties money-management rules
(Figure 3). The standard devi-
ation of annualized gains dur-
ing the six consecutive win-
ning years was lower than the
original system’s, as profits
were bigger and more uni-
form. The equity curve chart
shows the annualized gain
notably declined in recent
years.
In the second half of the test
period the basic system did

32 April 2007 • FUTURES & OPTIONS TRADER

nothing but waste time in drawdown which started in July LEGEND:
2000 until present (Figure 4, left). However after applying Avg. hold time — The average holding period for all trades.
the money-management rules, the longest drawdown was Avg. hold time (losers) — The average holding time for los-
around 1.5 years shorter, ending in 2002 (Figure 4, right). ing trades.
Breakdown of the profits by trade signal (Figure 5) shows Avg. hold time (winners) — The average holding time for
winning trades.
that the 16 percent of trades that occurred during extraordi-
Avg. loss (losers) — The average loss for losing trades.
nary opportunity conditions accounted for only 28 percent
Avg. profit — The average profit for all trades.
of the original system’s net profit (left half of Figure 5),
Avg. profit (winners) — The average profit for winning
while accounting for 49 percent after applying the money- trades.
management rules (Figure 5, right). Avg. return — The average percentage for the period.
The money-management technique also improved the Best return — Best return for the period.
system’s risk-reward profile: The ratio of the annualized Exposure — The area of the equity curve exposed to long
rate of return to maximum drawdown (the so-called “gain- or short positions, as opposed to cash.
to-pain” ratio) improved from to 0.28 to 0.34. To further Longest flat period — Longest period (in days) between two
explore this idea, a final test (not shown) that allocated 1.5 equity highs.
percent to every trade resulted in this ratio dropping to 0.31: Max consec. profitable — The largest number of consecu-
tive profitable periods.
Absolute profits soared, but the drawdown was an intoler-
Max consec. unprofitable — The largest number of consec-
able -47.2 percent. utive unprofitable periods.
Max consec. win/loss — The maximum number of consecu-
Bottom line: The tests suggest the extraordinary oppor- tive winning and losing trades.
tunities money-management technique can identify condi- Max. DD (%) — Largest percentage decline in equity.
tions that are likely to produce larger-than-average gains in Net profit — Profit at end of test period, less commission.
trending markets, and the ATR adaptation described here No. trades — Number of trades generated by the system.
has the added benefit of adapting to market volatility. Payoff ratio — Average profit of winning trades divided by
average loss of losing trades.
— Volker Knapp of Wealth-Lab Percentage profitable periods — The percentage of periods
that were profitable.
Profit factor — Gross profit divided by gross loss.
FIGURE 5 — PROFIT BREAKDOWN Recovery factor — Net profit divided by max. drawdown.
After applying the money management rules, the 16 per- Sharpe ratio — Average return divided by standard devia-
tion of returns (annualized).
cent of trades that occurred during extraordinary opportu-
Win/loss (%) — The percentage of trades that were prof-
nity conditions accounted for 49 percent or profits vs. only itable.
28 percent in the original system.
Worst return — Worst return for the period.

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 tested, please send the trading and money-management rules to
[email protected].

Disclaimer: The Futures Lab is intended for educational purposes only to

provide a perspective on different market concepts. It is not meant to rec-
ommend or promote any trading system or approach. Traders are advised
to do their own research and testing to determine the validity of a trading
idea. Past performance does not guarantee future results; historical test-
Source: Wealth-Lab ing may not reflect a system’s behavior in real-time trading.

PERIODIC RETURNS: ORIGINAL VS. MODIFIED SYSTEM

Percent Max Max
Avg. Sharpe Best Worst profitable consec. consec.
return ratio return return periods profitable unprofitable
Orig. Mod. Orig. Mod. Orig. Mod. Orig. Mod. Orig. Mod. Orig. Mod. Orig. Mod.
Monthly 0.46% 0.90% 0.15 0.16 11.66% 34.91% -10.45% -23.65% 50.00 53.89 6 6 5 4
Quarterly 1.32% 2.46% 0.28 0.33 12.94% 22.92% -8.38% -14.54% 54.10 62.30 4 7 4 4
Annually 5.12% 9.58% 0.53 0.66 23.76% 34.10% -8.42% -10.83% 62.50 62.50 6 6 2 2
Improvements highlighted in blue

FUTURES & OPTIONS TRADER • April 2007 33

 OPTIONS LAB

Employment report iron butterfly

Strategy: Short iron butterfly. The butterfly’s long options also limit the trade’s risk,
unlike the short strangle, which faces unlimited losses if the
Market: Options on 10-year T-note futures (TY). 10-year T-note futures drop or rally sharply.
Figure 1 shows the potential gains and losses of a short
System concept: As volatility has dropped in the past iron butterfly entered on Nov. 3, 2006: short one January 108
two years in the treasury market, option-selling strategies call at 26/64, short one 108 put at 56/64, long one 110 call at
have become less successful. Nonetheless, one strategy — 3/64, and long one 106 put at 8/64 — a total credit of
entering short strangles after the monthly employment $1,085.37 (including commissions). The vertical line shows
report — has been profitable since 2001 (see “Jobs report the 10-year T-note futures’ close (107’34), and the two col-
short strangle,” Options Trader, March 2007). ored bars (below) represent the futures’ first (purple) and
This trade — short out-of-the-money (OTM) puts and second (green) standard deviations, based on the volatility
calls — gained 138 percent during this period. The recent and time projections.
lower-volatility environment led to a higher percentage of
winning trades (89 percent), but the average trade ($58.21) Trade rules:
was quite small because of the relatively low premiums.
And as potential profits fell, the trade’s risk, defined as 1. Enter a short iron butterfly in the second expiration
potential gain vs. loss, climbed. month at the close on the Friday of the monthly jobs
This test attempts to capture similar gains with less risk report release. Create the spread using the following
by entering a short iron butterfly — short at-the-money steps:
(ATM) calls and puts plus long OTM calls and puts. The
strategy trades four separate options that expire in the same 1. Sell an ATM call and an ATM put with the same
month. Selling ATM options offers larger premiums even as strike price.
option implied volatility (IV) declines, and the long options 2. Buy an OTM call one strike above the first
limit the trade’s maximum losses. standard deviation.
The system enters the position at the close on the day of 3. Buy an OTM put one strike below the first
the employment report to take advantage of potentially standard deviation.
inflated IV and the quiet market that can initially follow
this number. The strategy’s potential gain is limited to the ATM options have the highest time premium. The first stan-
short premium collected minus the long OTM options’ cost. dard deviation was calculated using the ATM call’s implied
volatility.

FIGURE 1 — SHORT IRON BUTTERFLY

2. Exit each position at the
This strategy has a risk-reward ratio of approximately 1:1 ($927 loss vs. $1,085 close on the day before the
gain), which is better than a short strangle’s ratio when IV is low. next employment report is
released.

Starting equity: $5,000. Deduct

$5 commission per trade plus $1
per contract.

Test data: The system was test-

ed on options on the 10-year T-
note futures (TY). Daily closing
prices were used, and the trades
were executed at the last quoted
price, when available. Otherwise,
theoretical prices were used.

Test period: January 2001 to

December 2006.

Test results: The main goal

Source: OptionVue was to compare the short iron but-
terfly’s performance to the short

34 APRIL 2007 • FUTURES & OPTIONS TRADER

strangle’s, and the butterfly failed miserably. First, it had a This test included minimal commissions; larger fees and
lower probability of profit (59 percent vs. 70 percent). More slippage will likely negatively impact performance.
importantly, the short iron butterfly lost ground since
January 2001, while the short strangle gained 138 percent — Steve Lentz and Jim Graham of OptionVue
(23.1 percent annualized) in this period.
The butterfly was profitable in 42
of the 71 months tested, but its aver- FIGURE 2 — IRON BUTTERFLY PERFORMANCE
age winner was substantially less
This spread lost 3.8 percent since January 2001, while the short strangle (not shown)
than its average loser ($334.44 vs. gained 138 percent in the same period.
-$490.89, respectively). Figure 2
tracks the butterfly’s six-year per-
formance and shows the strategy
lost $189.25 overall — a 3.8-percent
drop (-0.6 percent annualized). Each
trade required roughly $1,000 to
enter and lost $2.67 on average.

Bottom line: It is always difficult

to find one strategy that will per-
form well in all markets. The iron
butterfly lacked a trading edge fol-
lowing monthly jobs reports.
However, one promising pattern
emerged: The approach was prof-
itable when IV declined, and it lost
substantially when IV remained
unchanged. But you couldn’t take Source: OptionVue
advantage of this tendency without
an indicator that forecasts the direction of volatility correct- LEGEND:
ly and consistently.
Net loss — Loss at end of test period, less commission.
No. of trades — Number of trades generated by the system.
STRATEGY SUMMARY — OVERALL
No. of winning trades — Number of winners generated by the sys-
Net loss ($): -189.25 tem.
No. of trades: 71 No. of losing trades — Number of losers generated by the system.
No. of winning trades: 42 Win/loss (%) — The percentage of trades that were profitable.
No. of losing trades: 29
Avg. trade — The average profit for all trades.
Win/loss (%): 59
Largest winning trade — Biggest individual profit generated by the
Avg. trade ($): -2.67
system.
Largest winning trade ($): 1,077.00
Largest losing trade — Biggest individual loss generated by the
Largest losing trade ($): -1,282.38
system.
Avg. profit, winners ($): 334.44
Avg. profit (winners) — The average profit for winning trades.
Avg. loss, losers ($): -490.89
Ratio avg. win/avg. loss: 0.68 Avg. loss (losers) — The average loss for losing trades.

Avg. hold time, winners (days): 29 Ratio avg. win/avg. loss — Average winner divided by average
loser.
Avg. hold time, losers (days): 29
Max. consec. win/loss: 6/6 Avg. hold time (winners) — The average holding time for winning
trades.

Option System Analysis strategies are tested using OptionVue’s Avg. hold time (losers) — The average holding time for losing
BackTrader module (unless otherwise noted). trades.

If you have a trading idea or strategy that you’d like to see tested, Max consec. win/loss — The maximum number of consecutive win-
please send the trading and money-management rules to ning and losing trades.
[email protected].

FUTURES & OPTIONS TRADER • APRIL 2007 35

 TRADER INTERVIEW

Tom DeMark
It might seem like a different trading world
than it was in 1970, but for Tom DeMark,
the game remains the same — price exhaustion.

BY MARK ETZKORN

T here are still about two hours left in the trad-

ing day and Tom DeMark is recounting the lat-
est success of the basketball program at his
high school alma mater, St. Catherine’s high
school in Racine, Wis., which won its 11th state champi-
onship in March to go along with 19 conference champi-
onships since 1933.
Most of the people I know in business end up trading the
markets when they retire, anyway, so I have a head start on
them.
“But,” he adds, “I’ve really been doing this for the equiv-
alent of around 90 years because it’s been seven hours a
week, 20 hours a day.”
He laughs again. “I have no life — maybe that should be
DeMark played on a St. Catherine’s team that took sec- the headline for the interview.”
ond in state his junior year in 1964, and he’s obviously
proud of his alma mater’s continued success, despite its FOT: How many hours do you put in these days?
small size — enrollment is only around 350. TD: On the average day I might get up at 3 a.m. and go
However brief, the discussion is a rare break for DeMark, until 9 at night. I follow the Far East markets, then the
who maintains an obsessive focus on the markets, even European markets, then the U.S. market, and then get ready
after 36 years and success that he admits exceeded his ear- to do it all again the next day.
liest expectations. Even before he published the three pop-
ular books (which he says he wrote because he was tired of FOT: Why do you need to watch the markets all the time?
other people passing off his work as their own) that made TD: I’ve been working on the Cursor Commentary service
him more of a household name among retail traders, for a couple of years, and since it has worldwide market
DeMark had a successful career as an institutional trading application, I’ve been monitoring and researching foreign
advisor and analyst, with clients ranging from IBM and markets. My full-time job of consulting (for SAC) requires
Union Carbide to Paul Tudor Jones and, currently, Steve that I prepare for and follow the U.S. markets.
Cohen of SAC Capital.
DeMark has also become increasingly well known FOT: Are there indicators or systems you’ve developed
because several software platforms and analysis networks, that have fallen by the wayside — things you don’t use any
including Bloomberg, CQG, and Thompson Financial have longer because they don’t work or you’ve developed some-
incorporated the indicators he’s developed over the years. thing better?
(Reuters is a future possibility.) His latest project is TD: Not really. The original TD Sequential, TD Combo, and
Bloomberg’s “Cursor Commentary” service, an interpreta- a several other indicators — TD lines, TD relative and
tion and expert commentary feature users will be able to absolute retracements, and TD trend factor — are the cor-
access by passing their cursors over his indicators. nerstone indicators that have been around more than 30
DeMark has not slackened his pace, perhaps because — years.
like many people who excel in their fields — he appears to Also, they were all developed pre-computer — I created
love what he’s doing; it’s not just a job or a means to an end. them manually, using a calculator and examining charts
I reminded DeMark that, at a presentation nearly a dozen with a magnifying glass.
years earlier, he had mentioned he might not be doing this
that much longer. FOT: Are these tools still valid today, as far as you’re con-
So, after 36 years, does he think he’ll ever retire? cerned?
“No,” he says, laughing. “I retired when I first went to TD: Oh, yeah. Sequential and Combo — the two key indi-
work in this business after finishing law school and gradu- cators — have never really been changed from their origi-
ate business school. This is a vocation/avocation for me. nal designs. There have been a few adaptations —

36 April 2007 • FUTURES & OPTIONS TRADER

FOT: — you have variations of these tools you don’t nec- FOT: But there must have been dead ends in your initial
essarily make public, right? research and analysis, or things that took a long time to
TD: Yes, and it mostly has to do with how aggressively the develop. Sequential, for example, doesn’t seem like some-
different versions of the indicators are applied. Everything thing that could have emerged fully formed, right out of the
is there, in terms of the indicators that are available on the box.
analysis platforms, but it would require some manipulation TD: The indicators often evolved piecemeal and their com-
to get the ideal settings. That’s exclusively for SAC. ponents required research and testing to develop. Much of
But the original Sequential and Combo signals are still the work, despite that trial-and-error approach, was in ret-
viable, which might be surprising, considering they were rospect a result of inspiration more than anything else.
created in the mid-70s and first applied to currency futures,
the Ginnie Mae and municipal bond contracts at the FOT: Are you still creating new tools?
Chicago Board of Trade, and T-bills at the Merc. This was TD: I’ve done things that aren’t for public consumption,
even before the S&P futures were launched in 1982, and including a number of proprietary indicators for SAC.
before the first charting service, ComTrend, that offered
one-minute charts. When one-minute charts became avail- FOT: What’s the unifying principle in your work?
able, it surprised everyone that Sequential and Combo were TD: I think 95 percent of it is price exhaustion, which is the
applicable to that lowest common denominator. antithesis of what almost everyone else does in the industry.
The overwhelming majority of CTAs (commodity trading
FOT: Was that a goal of your work? advisors) are trend followers, for example.
TD: Yes, universal application over all time periods — one-
minute charts, daily charts, weekly charts, monthly charts.
That’s different from the work of many other people, who Ninety-nine percent of the people
seem to optimize or customize things for different markets
or time periods. in trading are not creative and they’re
FOT: Do you really think all markets are created equal,
though, in terms of using your indicators? I mean, would
not willing to rely upon themselves
you feel comfortable applying Sequential to intraday rice
future prices, or cheddar cheese?
to make decisions.
TD: Yes, in fact, the indicators often work better on thinly
traded markets and more-distant futures expiration FOT: Did you ever explore trend-following techniques?
months. TD: I initially worked for a large fund (NNIS) that grew
rapidly from a couple hundred million dollars in 1970 to
FOT: Did computers reveal additional things about your many billions of dollars. Out of necessity we had to buy
tools that you hadn’t been aware of before? weakness and sell strength, so I never thought of the mar-
TD: Definitely. There have been some things, like TDST, ket in any other context. After a bottom was made, it was
which are the resistance and support levels that are formed impossible to accumulate any size, and when a market
from Sequential and Combo price setups. Those levels did- topped, it was impossible to sell after the peak. So my goal
n’t become evident until charts were available on computer was always to anticipate tops and bottoms.
screens and the interaction of price activity and the indica-
tor became apparent. FOT: How precisely are you trying to pick tops and bot-
And the nice thing is that now you see and learn things toms? That’s one of the unattainable “holy grails” of trading,
on one-minute charts instead of having to look at a daily isn’t it? Don’t such approaches run the risk of being too
chart on a piece of paper — you can see prices as they early, just as trend-following techniques are often too late?
unfold and these numbers (from the indicators) appearing TD: Most of the time markets are in trading ranges and
and disappearing, so you can draw conclusions from that. price exhaustion techniques are easily applied. The times
It’s an educational opportunity. when markets are trending can prove to be vexing, but a
market often provides clues to trending by recording steep
FOT: But what about things that just stopped working? moves where price bars fail to overlap.
TD: Well, nothing really comes to mind. Obviously, I’ve cre-
ated these indicators and I’m not going to abandon them — FOT: Do you think about things any differently than when
they’re like children. And most of the things I’ve developed you started — that is, about the principles of price action or
have been programmed and are on different trading plat- the ways markets work?
forms now. continued on p. 38

FUTURES & OPTIONS TRADER • April 2007 37

 TRADER INTERVIEW continued

TD: Obviously, there are a lot of things

that have changed but, of course, the
more things change the more they stay
“Turtle” trader publishes book the same. I still approach the markets
from the perspective of buying weak-
ness and selling strength.

I
n his new book, Way of the Turtle (2007, McGraw-Hill), Curtis Faith
recounts his experiences with the now-legendary “Turtles” — an experi- By the way, I don’t call myself a tech-
mental group assembled by traders Richard Dennis and Bill Eckhardt in nician — I’m a market timer. I’ve
the 80s to settle an argument whether trading skills were inherent or could always believed fundamentals drive
be taught to anyone. Many of the traders in the program went on to start suc- the market. I studied for it, but I never
cessful trading operations of their own. got my CFA (financial analyst certifica-
Only 19 when he was selected to be part of the experiment, Faith was the tion) because I never considered myself
youngest Turtle, and he also turned out to be one of the most successful, a true fundamentalist. And conversely,
racking up profits in excess of $30 million in four or so years of trading. I was one of the first members of the
In his book Faith, now 43, dissects the Turtle trading approach, some of his Market Technician’s Association out-
experiences in the program, as well as broader trading concepts and philo- side of New York City, but I never got
sophical ideas he believes are important to successful trading and life in gen- the CMT (certified market technician)
eral. designation because I don’t consider
In this preview of a full-length interview that will appear in the June issue myself a technician. I’m some sort of
of Active Trader magazine (available in May), Faith talks about his decision hybrid of the two. I have mathematical
to write a book about his life as a Turtle after all these years, and some of the justification for my indicators, which
things he discovered about himself and the basis of good trading. has made institutions more amenable
to using my work.
Why did you write the book, and why now? Fundamentals drive the longer-term
I don’t think I could have written a good book at the time, or shortly after the movement of the markets, but shorter-
Turtle experience, mainly because I don’t think I had a very mature under- term you have to time your entries,
standing of the reasons for my success. I wasn’t old enough to really under- and you do it with psychology and
stand how I was different from other people. market-timing tools — ideally, with
As a young trader in my early 20s I didn’t understand the extent to which price-exhaustion tools.
the way I thought about things was different from the way most people do.
Over the years, I’ve come to appreciate that the things that are easy for me FOT: What are the flaws in the tools
aren’t for a lot of people. And through the process of trying to teach people you see most people use?
over the years, I’ve seen what consistently stands in their way of success. TD: The things that are in the public
Invariably, it comes down to just a few things — essentially, psychological domain? By and large, they’re all
barriers people put in place themselves. They don’t have the ability to place trend-following techniques, and they
enough confidence in their own thinking — especially when it comes to sim- all pretty much have the same basis.
ple ideas. People have this need to create complexity, and they believe trad- Take oscillators, for identifying over-
ing must be more complicated than it really is. When you try to teach them bought and oversold readings, for
something that’s relatively simple and say, “Yes, you can make a lot of money example. An oscillator works well in a
with this,” they don’t believe it. trading-range market, but not when it
evolves into a trending market. One of
Do you think your youth was one of the things that made you different the things I’ve done with some of my
in the Turtle experiment — that you had fewer biases or preconcep- overbought-oversold indicators is to
tions? make time as a factor: If there’s a peri-
I was asked that question before, and my answer was essentially, yes. But od of time when the market remains
looking back, I don’t think that was the major factor. overbought or oversold, the indicator
becomes severely overbought or over-
See the June 2007 issue of Active Trader magazine sold; duration becomes a factor and, as
(www.activetradermag.com) for the in-depth interview with Curtis Faith a result, the amount of time the market
and a review of his new book. is overbought or oversold tells you
[whether it’s a justifiable signal]. Then
you have to wait for the market to
relieve that extreme condition by mov-
ing the oscillator back to neutral and

38 April 2007 • FUTURES & OPTIONS TRADER

 Related reading
Click here for more information about some of the indicators in this article.
Tom DeMark’s books:
• The New Science of Technical Analysis (John Wiley & Sons, 1994)
recording a mild over- • New Market Timing Techniques (John Wiley & Sons, 1997)
bought or oversold read- • DeMark on Day Trading Options (McGraw-Hill, 1999)
ing.
Also, everybody talks The following list include an article cowritten by Tom DeMark, plus an in-depth interview and
about moving averages, analysis of a trading system based on one of his trading techniques.
and they have their ideal
average or series of mov- “Absolute price projections,” by Tom DeMark and Rocke DeMark (July 2004).
ing averages. But if a mar- TD Absolute Retracement, the market-timing approach outlined in this article, is a mechanical
ket is trending, any mov- technique for calculating price retracements and extensions that avoids the subjectivity and
ambiguity of conventional technical approaches.
ing average will work.
And if a market is moving
“Active Trader Interview — Tom DeMark: Objectively speaking”
sideways, any oscillator by Mark Etzkorn (November 2001).
will work. It’s those times
when the market is mov- “DeMarking trend exhaustion zones,” by Lindsay Glass (July 2002).
ing from one to the other This article shows how to use different DeMark indicators — TD Sequential and TD Combo
that you have to deal — to identify trend-exhaustion zones.
with. I’ve also addressed
this with the severe over- “Trading System Lab: DeMark variation,” by Thomas Stridsman (September 2001).
bought-oversold readings This system is based on a pattern called “TD Carrie,” described by Tom DeMark in his book
based upon duration — New Market Timing Techniques.
specifically, if the market
Tom DeMark Four-Article Set: The four articles listed above, in a single PDF file and sold at
remains overbought or
a discount through the Active Trader store.
oversold continuously for
an extended period of You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm.
consecutive price bars, it
typically indicates a trend
is in force and it would
behoove you to respect this trend. TD: Ninety-nine percent of the people
in the business are followers. They’re
FOT: Have any people you worked not creative and they’re not willing to
with influenced you? rely upon themselves to make deci-
TD: There are several people who sions, so they rely upon other people.
have been influential, not in the sense When the decision is right they take
that they directed me one way or the credit for it, and when it’s wrong they
other in my ideas, but by being models point fingers at other people.
in terms of their dedication to — or And out of that one percent who do
really, obsession with — the markets. make their own decisions and create
Larry Williams, I think was an inspi- their own tools, 99 percent of them are
ration to just about everybody in the going to be wrong, so you’ve got
70s. Larry also has something I don’t about one-tenth of one percent that are
have, which is the ability to pursue going to be right.
other interests — politics, exploring — The market is [full of lemmings]:
besides trading. everyone feeding off one another, fol-
Joe Granville was a model for a lot lowing the media, and following a
of people. He is very bright, and he trend.
called the market exceptionally well in But floor traders — the specialists,
the late 70s and early 80s. Both of these when they were still influential in the
people have great work ethics. market — always operated against the
But there are plenty of charlatans in trend. 
the business — people who take credit
for other people’s work. For more of our conversation with Tom
DeMark and specific details about his indi-
FOT: On that topic, what’s the worst cators, see the July 2006 issue of Active
part of the business for you? Trader magazine, available in June.

FUTURES & OPTIONS TRADER • April 2007 39

 INDUSTRY NEWS

Out of nowhere

CME-CBOT deal gets put on ICE

BY JIM KHAROUF

W hen it comes to competing with Chicago

exchanges, you better be ready to fight it out.
In that case, the gloves are clearly off after the
InterContinental Exchange (ICE) turned the annual futures
exercise rights that allow CBOT shareholders to trade
options on the Chicago Board Options Exchange.
The CME is offering 0.3006 CME shares per CBOT share
and will take over the exchange, changing the name of the
industry conference upside down on March 15 with a $9.9 combined company to CME Group. The CME touts the
billion bid for the Chicago Board of Trade (CBOT). The offer numerous synergies and cost savings it will bring to the
blindsided the Chicago Mercantile Exchange (CME), which combined entity by dovetailing the CBOT’s Treasury
agreed to an $8.5 billion offer last October. futures complex with its own Eurodollars, and CBOT grains
All was going smoothly for the CME-CBOT deal until contracts with the CME’s livestock complex.
ICE came along just two weeks before CBOT and CME Contract clearing would continue at the CME
shareholders were scheduled to vote on it. What has Clearinghouse, which now handles CBOT trades via the
emerged since then is a tit-for-tat public debate by CME and CME-CBOT Clearing Link. Both trading floors would be
ICE executives over which deal is better. joined under one roof at the CBOT building.
Here’s what CBOT’s board is now pondering: ICE is Combined, the CBOT and the CME would control about
offering 1.42 shares of ICE stock for each CBOT share, and 85 percent of the U.S. futures market, a factor that is being
has access to another $3 billion in cash. ICE will also allow seriously investigated by the DOJ. The CME and CBOT
CBOT shareholders to control 51 percent of the exchange, shareholder vote dates have been postponed until the
will keep the CBOT name, and will provide the CBOT with CBOT can further examine the ICE bid.
its own clearinghouse. The ICE purchased the New York The CME has since gone on the offensive, belittling the
Board of Trade and its respective clearinghouse in January. ICE offer as “inferior” and exchanging barbs with ICE exec-
The ICE also insists its deal stands a much better chance utives over the quality of the offer. CME executives met
of receiving Department of Justice (DOJ) approval (the with CBOT shareholders on March 22, reiterating its invest-
rumor is the DOJ is concerned with the clearing monopoly ment of more than $1 billion into its Globex platform and
an all-Chicago deal would create) than the CME-CBOT deal clearing, and questioned whether the ICE had the trading
and puts the CBOT in a better position to hang onto the and clearing ability to handle the CBOT’s volume.
The CME said its average daily volume in the
MANAGED MONEY fourth quarter of 2006 was 5.3 million contracts,
while the CBOT averaged 3.2 million contracts
Top 10 option strategy traders ranked by February 2007 return
and the ICE and NYBOT combined to average
(Managing at least $1 million as of Feb. 28, 2007.)
604,000 contracts.
2007 “They have very small scale and infrastructure
February YTD $ under to handle the combined business of ICE, NYBOT,
Rank Trading advisor return return mgmt. and CBOT,” CME CEO Craig Donohue says.
1. Ascendant Asset Adv. (Strategic1) 10.24 9.38 2.9M Donohue argued the CME delivered on two
2. Ascendant Asset Adv. (Strategic2) 8.93 17.19 16.6M major exchange initiatives — the CME-CBOT
3. Argus Capital Mgmt (S&P Option) 7.83 13.48 9.9M Clearing Link in 2003 and an agreement with the
4. Innovative Capital Mgmt (Call Prem) 4.73 10.79 1.5M New York Mercantile Exchange last year to host
the listing of energies and metals on Globex.
5. CKP Finance Associates (LOMAX) 4.06 -7.88 6.7M
“Each was flawless,” Donohue says. “Each
6. Oxeye Capital Mgmt. (Crude Oil) 2.80 -0.59 8.5M
involved two of the largest exchanges in the
7. Censura Futures Mgmt. 2.70 3.41 45.7M world and each has produced significant value
8. Steinitz Voss Cap'l Mgmt (Index Prem) 2.03 4.61 3.0M for the customers and shareholders at each of
9. Nantucket Hedge Fund 1.70 5.11 2.0M those exchanges. ICE has not integrated any-
10. Eickelberg & Associates (Option) 0.71 3.87 2.0M thing on that scale.”
Source: Barclay Trading Group (www.barclaygrp.com) However, ICE CEO Jeffrey Sprecher attacked
such rhetoric and says the ICE has a more cost-
Based on estimates of the composite of all accounts or the fully funded subset method.
efficient technology plan and staff than the CME.
Does not reflect the performance of any single account.
“It’s not necessary in this day and age to spend
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
$1 billion to create a state of the art trading plat-

40 April 2007 • FUTURES & OPTIONS TRADER

form, and we’ve proven it’s not necessary to keep hundreds “It’s not necessary in this day and age
of developers on the payroll,” Sprecher says.
He adds the CME is misrepresenting the facts about to spend $1 billion to create a state
clearing capacity as well.
“It comes down to the number of transactions, not vol-
ume that needs to be cleared and settled,” Sprecher told
of the art trading platform, and we’ve
Wall Street analysts March 26. “ICE estimates it must scale
up the ICE clearinghouse by 13 to 15 times. Over the last
proven it’s not necessary to keep
two years, we’ve scaled up by 100 times.”
As such, Sprecher plans to massively increase the ICE’s
hundreds of developers on the payroll.”
clearing capacity to 10 million trades per day by the end of
the year, five times the CBOT peak of 2 million. Currently — ICE CEO Jeffrey Sprecher
the ICE’s clearing house can handle 1.2 million transactions
a day, more than enough for an estimated 800,000 daily est rate and agriculture contracts within a few months.
trades on CBOT.
The ICE also estimates about $1.3 billion of clearing and Who’s better?
settlement savings through net margining and other cost The ICE and CME bids have been scrutinized by CBOT
offsets, which is close to the CME’s estimate of $1.8 billion shareholders, as well as end users anxious to see how each
in savings from the CME-CBOT Clearing Link. deal will affect them.
Beyond that, the ICE plans to launch an upgrade to its The ICE deal brings another level of competition to the
trading platform in the second quarter. U.S. futures industry and offers a compelling question
“It will significantly outperform all other major deriva- about how the exchange landscape will evolve in coming
tives platforms by the end of this year and our round-trip years. The U.S. exchange space is undergoing a consolida-
times will be in the single digits of milliseconds,” Sprecher tion phase, led by the likes of the New York Stock Exchange
says. (NYSE), which purchased Archipelago and its options
He adds the ICE could handle trading the CBOT’s inter- continued on p. 42
 INDUSTRY NEWS continued

“The most important aspect of this merger is who will make it cheaper for the
customer by continuing to make the bid-offer spread tighter.”
— Chuck McElveen, owner of Chicago-based proprietary trading firm Kingstree Trading
exchange in 2005 and closed the deal on Euronext earlier a fast system that can handle big volumes.”
this year. Other end users would like one CME-CBOT platform
If the ICE wins, the NYSE could jump into the U.S. that features multiple pools of liquidity.
futures space by purchasing the ICE-CBOT exchange. A “The most important aspect of this merger is who will
CME-CBOT deal would neatly roll up the U.S. financial, make it cheaper for the customer by continuing to make the
grains, and livestock futures markets onto one platform bid-offer spread tighter,” says Chuck McElveen, owner of
with one clearinghouse and give the CME Group a solid Kingstree Trading, a proprietary trading firm based in
base on which to compete globally with the NYSE and other Chicago. “Market makers compete with each other for cus-
large exchanges. tomer orders. The more they compete, the tighter and more
Craig Pirrong, professor of finance and the energy mar- liquid the market becomes. It is this competition, not the
kets director for the Global Energy Management Institute at competition between exchanges, that creates the biggest
the University of Houston, says the CME offer looks like a savings for the customer.”
better fit because customers would be able to access prod- After pushing a shareholder vote on the CME deal back
ucts that often trade together as spreads and hedges on one from April 4 to the annual meeting on May 1, the CBOT
platform. then announced it would not vote then, either, and did not
“There is also the issue of scaling up the ICE system and announce a new date.
whether it will be able to handle the volumes that come Where the deal goes from here is still anybody’s guess,
with CBOT,” Pirrong says. “Globex has already shown it is but the fight is already into the middle rounds.

Open all night

Milk and livestock around the clock

BY JIM KHAROUF

S tarting this summer, you won’t be able to get up

early enough to find a time when livestock and
dairy contracts are not trading at the Chicago
Mercantile Exchange (CME).
The CME plans to offer all its commodity contracts on its
because the CME’s agriculture complex will now be open to
more hedgers and speculators worldwide.
Whether CME agriculture products have the same global
appeal as other futures sectors is debatable. However,
hedge funds have pushed heavily into other commodity
Globex electronic platform nearly around the clock begin- sectors, especially energies, metals, softs, and grains in
ning June 4. The move includes lean hogs, frozen pork bel- recent years.
lies, live cattle, feeder cattle, cash-settled butter, class III “For me, it presents more opportunity than risk,” says
milk, dry whey, and fertilizer, which will be offered on Brian Rice, principal of Rice Dairy, a dairy futures broker in
Globex all day except for a one-hour period between 4 p.m. Chicago. “We want to see this market grow.”
and 5 p.m. CT. The timing may work out well, too, as live cattle futures
The CME’s agriculture complex has been running side- open interest continues to rise. That contract set a record for
by-side with the trading floor, but closes after pit hours con- daily open interest in late March of more than 285,000 con-
clude. Pushing the product group onto Globex virtually all tracts. The Chicago Board of Trade also adjusted their agri-
day is expected to open those contracts up to more cus- cultural complex, announcing in late March they would
tomers. As of late March, the typical electronic daily volume add electronically traded smaller-sized versions of their full
for the total complex was between 5 and 10 percent of total contracts.
volume. Mini corn, soybeans, and wheat contracts will be added,
The move helps the ags mirror the CME’s financial prod- and all will represent 1,000 bushels — one-fifth of the regu-
ucts that trade side-by-side, then offered on Globex for the lar contract. The new products are expected to launch in the
remainder of the day. Brokers are supportive of the move mid-second quarter of 2007.

42 April 2007 • FUTURES & OPTIONS TRADER

 FUTURES SNAPSHOT (as of March 30)
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).
Pit E- 10-day % 20-day % 60-day % Volatility
Market Sym Sym Exch Vol OI move Rank move Rank move Rank ratio/rank
S&P 500 E-Mini ES CME 1.48 M 1.64 M 2.31% 70% 3.28% 100% 0.26% 1% .47 / 64%
10-yr. T-note TY ZN CBOT 1.37 M 2.08 M -0.19% 88% -0.22% 19% 0.75% 31% .30 / 32%
5-yr. T-note FV ZF CBOT 602.4 1.35 M -0.73% 83% -0.75% 24% 0.17% 19% .23 / 5%
Eurodollar* ED GE CME 566.6 1.64 M -0.03% 0% 0.07% 67% 0.05% 54% .33 / 52%
30-yr. T-bond US ZB CBOT 466.4 776.2 -1.05% 91% -1.75% 67% -0.20% 17% .42 / 67%
Nasdaq 100 E-Mini NQ CME 359.2 326.3 1.52% 33% 3.74% 100% -1.19% 12% .52 / 64%
2-yr. T-note TU ZT CBOT 228.7 805.3 -0.01% 0% -0.05% 10% 0.10% 39% .19 / 5%
Crude oil CL NYMEX 227.5 314.5 10.56% 100% 6.86% 57% 18.49% 100% .75 / 100%
Russell 2000 E-Mini ER CME 209.4 379.3 3.01% 60% 4.42% 81% 1.52% 10% .46 / 63%
Eurocurrency EC 6E CME 154.3 172.7 0.28% 25% 1.48% 69% 1.39% 26% .14 / 10%
Mini Dow YM CBOT 146.2 87.1 1.88% 83% 2.74% 100% -0.72% 19% .42 / 64%
Japanese yen JY 6J CME 114.6 211.7 -1.05% 83% -0.08% 0% 1.32% 97% .22 / 3%
Corn C ZC CBOT 85.1 291.2 -6.26% 100% -8.91% 100% 1.08% 3% .44 /100%
Gold 100 oz. GC NYMEX 76.2 180.4 2.31% 80% 3.87% 38% 6.83% 70% .22 / 8%
British pound BP 6B CME 76.0 116.4 1.31% 22% 1.21% 85% 0.81% 27% .30 / 51%
S&P 500 index SP CME 62.7 543.4 2.30% 70% 3.28% 100% 0.26% 1% .47 / 64%
Swiss franc SF 6S CME 49.6 67.0 -0.74% 100% 0.67% 10% 0.84% 35% .16 / 7%
Soybeans S ZS CBOT 45.0 141.4 1.04% 20% 3.00% 28% 13.75% 34% .15 / 18%
Sugar SB NYBOT 43.0 250.6 -3.70% 53% -11.94% 100% -14.16% 67% .21 / 15%
Gold 100 oz. ZG CBOT 41.1 33.0 2.32% 80% 3.80% 35% 6.21% 63% .22 / 7%
Natural gas NG NYMEX 39.6 90.1 11.64% 100% 6.72% 18% 25.45% 77% .50 / 100%
Canadian dollar CD 6C CME 37.0 117.8 1.92% 80% 2.22% 100% 1.63% 100% .41 / 86%
RBOB gasoline RB NYMEX 35.7 45.5 7.91% 63% 8.21% 13% 38.40% 100% .28 / 20%
Australian dollar AD 6A CME 34.9 104.0 1.61% 18% 3.24% 100% 2.09% 51% .31 / 31%
Heating oil HO NYMEX 30.0 59.1 11.14% 89% 6.15% 51% 21.63% 100% .86 / 100%
S&P MidCap 400 E-Mini ME CME 25.3 72.1 2.86% 60% 4.00% 63% 5.04% 26% .35 / 53%
Silver 5,000 oz. SI NYMEX 21.6 57.0 1.78% 10% 3.78% 20% 4.79% 24% .16 / 3%
Fed Funds** FF ZQ CBOT 20.9 116.4 0% 0% -0.01% 0% -0.01% 6% .45 / 57%
Wheat W ZW CBOT 20.7 113.3 -4.91% 93% -4.66% 56% -8.06% 68% .47 / 88%
Crude oil e-miNY QM NYMEX 18.5 8.5 10.56% 100% 6.86% 57% 18.49% 100% .75 / 100%
Soybean oil BO ZL CBOT 17.4 93.1 5.56% 80% 9.40% 98% 13.37% 67% .54 / 98%
Soybean meal SM ZM CBOT 17.0 49.4 -2.84% 38% -1.76% 15% 12.78% 23% .24 / 55%
Mexican peso MP 6M CME 16.8 55.1 1.46% 100% 1.23% 100% -1.96% 74% .33 / 36%
Live cattle LC LE CME 15.9 89.0 0.51% 17% -0.05% 0% 4.83% 32% .15 / 0%
Nikkei 225 index NK CME 15.7 49.5 3.23% 67% 2.40% 47% -0.29% 8% .26 / 20%
Lean hogs LH HE CME 12.8 60.0 -0.85% 6% -3.77% 46% 7.31% 77% .14 / 0%
Coffee KC NYBOT 10.0 69.2 -1.00% 21% -5.12% 61% -11.61% 77% .30 / 82%
Cotton CT NYBOT 9.8 104.6 -0.63% 45% -0.59% 20% -2.40% 16% .16 / 20%
Nasdaq 100 index ND CME 7.8 45.1 1.52% 33% 3.74% 100% -1.19% 12% .52 / 65%
Cocoa CC NYBOT 7.7 69.3 9.11% 87% 8.26% 67% 15.97% 82% .38 / 78%
Dow Jones Ind. Avg. DJ ZD CBOT 6.9 47.1 1.88% 83% 2.74% 100% -0.72% 19% .41 / 65%
Mini-sized gold YG CBOT 6.1 5.6 2.32% 80% 3.80% 35% 6.21% 63% .22 / 7%
Silver 5,000 oz. ZI CBOT 4.9 6.9 1.78% 10% 4.62% 23% 7.15% 45% .16 / 2%
Copper HG NYMEX 4.9 15.3 4.57% 44% 16.82% 97% 20.91% 100% .17 / 22%
Natural gas e-miNY QG NYMEX 3.7 4.0 11.64% 100% 6.06% 18% 25.43% 77% .49 / 98%
U.S. dollar index DX NYBOT 3.2 25.0 -0.34% 28% -1.17% 66% -1.70% 55% .18 / 25%
Mini Russell 1000 RM NYBOT 3.1 64.4 2.36% 70% 3.38% 100% 0.75% 4% .47 / 65%
*Average volume and open interest based on highest-volume contract (December 2007)
**Average volume and open interest based on highest-volume contract (June 2007)
Legend (10-day moves, 20-day moves, etc.) show the of 100 percent means the current reading is
Vol: 30-day average daily volume, in thou- percentile rank of the most recent move to a larger than all the past readings, while a read-
sands (unless otherwise indicated). certain number of the previous moves of the ing of 0 percent means the current reading is
same size and in the same direction. For smaller than the previous readings. These fig-
OI: Open interest, in thousands (unless other-
example, the “% Rank” for 10-day move ures provide perspective for determining how
wise indicated).
shows how the most recent 10-day move relatively large or small the most recent price
10-day move: The percentage price move compares to the past twenty 10-day moves; move is compared to past price moves.
from the close 10 days ago to today’s close. for the 20-day move, the “% Rank” field shows Volatility ratio/rank: The ratio is the short-
20-day move: The percentage price move how the most recent 20-day move compares term volatility (10-day standard deviation of
from the close 20 days ago to today’s close. to the past sixty 20-day moves; for the 60-day prices) divided by the long-term volatility (100-
60-day move: The percentage price move move, the “% Rank” field shows how the most day standard deviation of prices). The rank is
from the close 60 days ago to today’s close. recent 60-day move compares to the past the percentile rank of the volatility ratio over
The “% Rank” fields for each time window one-hundred-twenty 60-day moves. A reading the past 60 days.

This information is for educational purposes only. Active Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Active Trader
assumes no responsibility for the use of this information. Active 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.
44 April 2007 • FUTURES & OPTIONS TRADER
 OPTIONS RADAR (as of March 30)
MOST-LIQUID INSTRUMENTS*
Options Open 10-day % 20-day % IV/SV IV/SV ratio —
Indices Symbol Exchange volume interest move rank move rank ratio 20 days ago
Russell 2000 Index RUT CBOE 623.3 393.6 2.82% 50% 3.26% 61% 19.5% / 15.5% 25% / 15.3%
S&P 500 index SPX CBOE 199.3 1.69 M 2.44% 78% 2.43% 89% 13.3% / 13% 17.9% / 12.1%
S&P 100 index OEX CBOE 25.4 131.8 2.52% 78% 2.30% 100% 12.6% / 12.8% 17.8% / 11.9%
S&P 500 E-Mini ES CME 21.5 133.1 2.31% 70% 3.28% 100% 12.9% / 14.4% 20.7% / 13.2%
S&P 500 futures SP CME 17.3 168.0 2.30% 70% 3.28% 100% 13% / 12.8% 19.8% / 11.7%

Stocks
Lowe's LOW 3.03 M 128.1 1.81% 50% -1.41% 5% 27.3% / 29.4% 26.9% / 27.5%
Citigroup C 1.83 M 580.8 3.65% 78% 2.74% 53% 20.6% / 21.7% 24.8% / 22.8%
Washington Mutual WM 1.82 M 233.2 1.25% 67% -5.17% 67% 32.6% / 27.7% 30.4% / 22.6%
Kaufman & Broad Home KBH 1.22 M 98.7 -5.97% 32% -13.55% 78% 40.7% / 43.9% 39.3% / 36.8%
Intuit INTU 1.21 M 37.9 -4.77% 47% -6.04% 46% 27% / 25.5% 28.6% / 36.1%

Futures
Eurodollar ED-GE CME 584.2 10.18 M -0.03% 0% 0.07% 67% 11% / 4.5% 12.9% / 4.1%
10-yr. T-note TY-ZN CBOT 78.8 1.13 M -0.19% 88% -0.22% 19% 4.5% / 4.2% 4.6% / 4.2%
Crude oil CL NYMEX 57.5 781.1 10.56% 100% 6.86% 57% 33.5% / 33.2% 33.1% / 37.7%
Corn C-ZC CBOT 45.9 881.1 -6.26% 100% -8.91% 100% 33.5% / 30.1% 35.3% / 26.9%
30-yr. T-bond US-ZB CBOT 31.1 482.5 -1.05% 91% -1.75% 67% 6.4% / 5.8% 6.8% / 6.2%

VOLATILITY EXTREMES**
Indices — High IV/SV ratio
Mini Dow YM CBOT 1.2 5.4 1.88% 83% 2.74% 100% 18.1% / 12.7% 19.3% / 12%
Russell 2000 Index RUT CBOE 623.3 393.6 2.82% 50% 3.26% 61% 19.5% / 15.5% 25% / 15.3%
Nasdaq 100 Index NDX CBOE 16.6 136.2 1.73% 40% 2.68% 79% 17.4% / 15% 23.1% / 17.4%
Oil service index OSX PHLX 1.7 31.3 5.84% 71% 10.00% 95% 25.7% / 22.2% 30.3% / 26%
Housing index HGX PHLX 1.2 56.9 -2.63% 32% -7.73% 62% 29% / 25.4% 28.7% / 22.9%

Indices — Low IV/SV ratio

S&P 500 volatility index VIX CBOE 16.8 649.6 -12.81% 55% -21.33% 96% 90.9% / 146.3% 229.8% / 142%
S&P 500 E-Mini ES CME 21.5 133.1 2.31% 70% 3.28% 100% 12.9% / 14.4% 20.7% / 13.2%
Banking index BKX PHLX 1.2 35.2 1.67% 63% -0.44% 13% 16.4% / 17.7% 20.1% / 13.5%
S&P 100 index XEO CBOE 12.5 98.3 2.52% 78% 2.30% 100% 12.4% / 12.8% 17.5% / 11.9%
Dow Jones index DJX CBOE 8.9 251.4 2.01% 78% 1.98% 87% 11.9% / 12.2% 18% / 12.2%

Stocks — High IV/SV ratio

Sirius Satellite Radio SIRI 1.1 240.2 -1.23% 16% -9.86% 66% 47.4% / 27.3% 45.5% / 34.4%
Elan Corp ADS ELN 3.4 298.8 1.45% 0% 4.98% 60% 56.7% / 33.3% 52% / 44.3%
Intel INTC 5.7 1.06 M -0.10% 0% -0.47% 12% 28.3% / 17.5% 27.8% / 22.6%
Rambus RMBS 3.4 219.5 5.88% 55% 8.31% 32% 55.4% / 34.5% 68.4% / 58.1%
Research in Motion RIMM 9.6 172.2 1.49% 50% 0.38% 10% 39.9% / 26.5% 45% / 40.3%

Stocks — Low IV/SV ratio

AtheroGenics AGIX 21.6 599.8 -64.11% 70% -72.69% 90% 95.2% / 182.5% 273% / 56.3%
Accredited Home Lender LEND 34.5 163.0 -14.95% 12% -57.28% 90% 144.7% / 236.5% 125.3% / 73.1%
Fremont General FMT 610.7 101.5 -22.13% 10% -20.44% 67% 111.5% / 171.6% 117.1% / 82.2%
CV Therapeutics CVTX 5.7 158.1 -15.38% 35% -36.63% 91% 70% / 103.9% 127.4% / 42.1%
Walgreen Co WAG 1.3 101.0 -0.80% 11% 3.92% 58% 20.1% / 26.7% 22.1% / 21.9%

Futures — High IV/SV ratio

Eurodollar ED-GE CME 584.2 10.18 M -0.03% 0% 0.07% 67% 11% / 4.5% 12.9% / 4.1%
Mini Dow YM CBOT 1.2 5.4 1.88% 83% 2.74% 100% 18.1% / 12.7% 19.3% / 12%
Soybeans S-ZS CBOT 14.0 233.0 1.04% 20% 3.00% 28% 25.1% / 18.1% 23.5% / 21.7%
Wheat KW-KE KCBT 3.6 29.6 -6.17% 100% -9.44% 91% 27.1% / 19.9% 25.7% / 25.3%
British pound BP-6B CME 1.7 8.9 1.31% 22% 1.21% 85% 6.7% / 5.2% 6.9% / 4.9%

Futures — Low IV/SV ratio

S&P 500 E-Mini ES CME 21.5 133.1 2.31% 70% 3.28% 100% 12.9% / 14.4% 20.7% / 13.2%
Orange juice OJ NYBOT 1.6 37.4 -5.35% 93% -9.23% 97% 20.8% / 22.2% 19.7% / 26.2%
Silver 5,000 oz. SI NYMEX 3.7 31.1 1.78% 10% 3.78% 20% 22.7% / 22.8% 30.7% / 34.8%
* Ranked by volume ** Ranked based on high or low IV/SV values.
LEGEND:
Options vol: 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 asset.
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.

FUTURES & OPTIONS TRADER • April 2007 45

 FUTURES BASICS

Futures
contract and rollover
Before you start thinking about strategies for the futures markets,
make sure you have a handle on the basics.

BY FOT STAFF

F irst, let’s clear up one misconception: From a

strategic perspective, there’s really no differ-
ence between stock and futures. Generally, the
same approach used to exploit trading oppor-
tunities in stocks can be applied to futures, and vice versa.
Whether it’s Boeing stock, Nasdaq 100 futures, or gold
futures, the market can go up, down, or sideways, so in that
sell your futures contract before the end of the exchange-
designated delivery period for the June crude oil contract.
This, of course, is precisely what you want to do — sell
your futures at a higher price if crude rallies. If the June
crude oil rallies to 63.60 and you sell your position by the
appropriate time, you will make a profit of 2.20 — which,
because each point in the mini crude oil futures is worth
respect you pay your money and take your chances. $500, represents $1,010 per contract.
However, futures do have characteristics that make trad- Similarly, if you had gone short December crude oil
ing them slightly different from trading stocks: In addition futures and had failed to cover (buy back) your position in
to low margin requirements, futures are contracts, which, time, you would be obligated to sell crude o il (“make deliv-
like option contracts, have a limited life span. ery“) at 63.60 in June. If you bought back your contracts at
63.60, you would have lost $1,010 per contract.
Futures are contracts: Futures exchanges dictate the conditions by which phys-
Can I have that in writing? ical commodities are exchanged as the result of a futures
When you buy a stock, you’re purchasing a little bit of own- trade. These rules are part of the “contract specifications” of
ership in a company. However, when you trade futures, each futures contract, which you can find on any exchange
you are not trading an actual commodity or financial Web site.
instrument — e.g., crude oil, gold, soybeans, T-notes, or the Although it’s worthwhile to understand this aspect of the
S&P 500 index — you’re simply entering into a contract to futures market, in reality, individual speculators are simply
interested in profiting from the price moves in a given mar-
ket — not taking or making delivery of a commodity. Also
Futures exchanges dictate many futures contracts (including most financial futures,
such as stock index futures and treasury futures) are
the conditions by which physical referred to as “cash-settled” because there is no underlying
physical commodity to exchange.
commodities are exchanged as Front months and back months
the result of a futures trade. Like any other type of contract (including options) futures
have finite life spans. Unlike stocks, which represent essen-
tially the same asset month after month and year after year,
buy or sell these instruments at a predetermined point in the futures are traded in a series of contract months, each of
future (typically, in the specific “delivery month,” or con- which is a unique asset.
tract month, you traded). For example, Google (GOOG) was Google last year and
For example, if you go long June 2007 mini crude oil presumably still will be next year. By contrast, the crude oil
futures (QMM07) at 61.40, you haven’t purchased crude oil available for delivery next month is not the same crude oil
— you’ve entered into a contract to buy crude oil at that that will be available for delivery eight months from now;
price in June. You will be obligated to honor this contract last season’s corn crop is not the same as this season’s. For
and “take delivery“ of the physical crude oil — unless you the same commodity, each contract month is a specific asset

46 April 2007 • FUTURES & OPTIONS TRADER

 Related reading
with different factors influencing its
“Apprentice Trader,” Active Trader, May 2007.
price.
A quick look at the issues surrounding the different kinds of price data
Many of the most popular financial
futures traders can use for back-testing systems and strategies.
futures contracts trade in contract
months of March, June, September and
“Flavors of futures: Using the right price data”
December, which is often referred to as
Active Trader, January 2004.
the “quarterly” expiration cycle.
Futures price data comes in more than one format. Depending on your
(Many of the markets have added
analysis and trading needs, one type of data may be more appropriate than
additional “serial” months into their
others.
rotations, but volume will be heaviest
in the four primary contract months.)
“Rolling over,” Active Trader, May 2003.
At any given time, volume is typi-
One thing that makes trading futures different from trading stocks is the fact
cally concentrated in a single contract
that futures are contracts with limited life spans. If you’re going to hold a
month — usually the “front month,”
long-term futures position, or you have a short-term trade that straddles the
which is the next contract month set to
expiration of one contract and another, you need to understand the process
expire. More distant months are
called rollover.
referred to as “back months.”
Note: The final two articles above are also part of the following collection,
Futures contract realities:
which contains other introductory articles for new futures traders.
Rollover
If you are holding a futures position
Futures Basics Collection
when one contract month ends and the
For those new to the futures game, this collection of nine past Active Trader
next begins, you will have to exit your
articles will provide a solid foundation for understanding how the futures
position in the expiring contract and
market works, the unique characteristics of futures contracts, and an intro-
re-establish it in the next contract
duction to some basic futures data and analysis tools.
month — a process called rollover.
The good news for short-term
You can purchase and download past articles at
traders is that rollovers should rarely
www.activetradermag.com/purchase_articles.htm.
be an issue — relatively few trade
opportunities are missed by avoiding
rollover. As a result, rollovers should-
n’t impact a trading system, other than
adding another commission charge and potential slippage. Futures markets generally roll over at specific times: The
Nonetheless, short-term traders must determine whether current front month becomes the new (furthest out) back
these additional costs will render a particular system or month, and the next month in the trading cycle becomes the
trade ineffective. For example, if you’re putting on a swing new front month.
trade that might last two days and generate a modest prof- Note: If you are trading a deliverable market, you’ll want
it (or loss), increasing your commissions and slippage to roll over before “first notice day,” which is the first day
might mean the difference between being profitable or on which a notice of intent to deliver may occur. Exchange
unprofitable. Web sites will provide the dates for first notice day in their
For longer-term traders, rollovers should not significant- contracts, as well as “delivery day” (the day the check is
ly impact the system one way or the other. Presumably, if delivered for the exchange of goods), and “last trading day”
you’re holding a position for many months, you’re doing so (the final trading day). You also can check with your broker
because it’s profitable, in which case your gains make the for these dates.
additional costs insignificant. Related reading has references to other articles address-
As far as the mechanics of switching from the outgoing ing rollover as well as the different formats futures price
front month contract month to the emerging front month, data comes in — the individual contract month data dis-
it’s important to “roll over” a position when there’s enough cussed here and “continuous futures” which link together
liquidity to avoid unnecessary slippage. This varies from individual contract month data in a way that allows you to
market to market, but in general, during the last two weeks analyze a market over long time periods, as well as back-
of an expiring contract’s life, volume is adequate both in the test trading strategies. 
outgoing and upcoming contracts to get out of one and into
another without giving up too much (depending, of course, This article was adapted from material in past issues of Active
on how liquid the market is in the first place). Trader magazine (www.activetradermag.com).

FUTURES & OPTIONS TRADER • April 2007 47

 EXPIRATION
GLOBAL CALENDAR
ECONOMIC CALENDAR APRIL/MAY
MONTH

APRIL 22
Legend 1 FDD: April coal, natural gas, and crude 23
oil futures (NYMEX)
CPI: Consumer Price Index 24 Consumer confidence for April
ECI: Employment cost index FND: May cotton futures (NYBOT)
FOMC: Federal Open Market 2 ISM for March
25 LTD: May natural gas, gasoline, and
Committee LTD: May cocoa options (NYBOT)
heating oil options (NYMEX); May coal
GDP: Gross domestic FDD: April aluminum, copper, palladium,
futures (NYMEX); May aluminum,
product platinum, silver, and gold futures
copper, silver, and gold options
ISM: Institute for Supply (NYMEX)
(NYMEX)
Management 3 FND: April propane, gasoline, and FND: May coal futures (NYMEX)
LTD: Last trading day; the heating oil futures (NYMEX)
26 LTD: May natural gas futures (NYMEX);
first day a contract may trade
or be closed out before the
4 April aluminum, copper, palladium,
platinum, silver, and gold futures
delivery of the underlying 5 LTD: April currency options (CME); April
asset may occur. (NYMEX); April feeder cattle futures and
U.S. dollar index options (NYBOT); April
options (CME)
PPI: Producer Price Index live cattle options (CME)
Quadruple witching Friday: FDD: April propane futures (NYMEX) 27 GDP (advanced) for Q1
A day where equity options, ECI for March
6 Markets closed — Good Friday
equity futures, index options, LTD: May T-bond options (CBOT)
Unemployment for March
and index futures all expire. FND: May natural gas futures (NYMEX)
7
28
8
APRIL 2007 29
1 2 3 4 5 6 7 9 FND: April live cattle futures (CME)
30 Personal income for March
8 9 10 11 12 13 14 10 FDD: April gasoline and heating oil LTD: May propane, gasoline, and
15 16 17 18 19 20 21 futures (NYMEX) heating oil futures (NYMEX); May sugar
22 23 24 25 26 27 28 11 Federal budget for March futures (NYBOT); April live cattle futures
(CME); May lumber options (CME)
29 30 1 2 3 4 5 12 FDD: April live cattle futures (CME)
FND: May aluminum, copper, palladium,
13 PPI for March platinum, silver, and gold futures
LTD: May sugar and coffee options (NYMEX); May oats, rice, wheat, corn,
May 2007
(NYBOT); May cotton options (NYBOT) soybean products, and soybean futures
29 30 1 2 3 4 5
6 7 8 9 10 11 12
14 (CBOT)

13 14 15 16 17 18 19 15
MAY
20 21 22 23 24 25 26 16 Retail sales for March
27 28 29 30 31 1 2 LTD: April lean hog futures and options 1 ISM for April
(CME) FND: May sugar futures (NYBOT); May
orange juice futures (NYBOT)
The information on this page is 17 CPI for March
FDD: May coal, natural gas, and crude
subject to change. Futures & LTD: May crude oil options (NYMEX);
Options Trader is not responsible oil futures (NYMEX); May aluminum,
for the accuracy of calendar dates April Goldman Sachs Commodity Index
beyond press time.
palladium, copper, platinum, silver, and
options (CME)
gold futures (NYMEX); May oats, rice,
FND: May cocoa futures (NYBOT)
wheat, corn, soybean products, and soy-
18 LTD: May platinum options (NYMEX) bean futures (CBOT); May cocoa, sugar,
19 and coffee futures (NYBOT); May cotton
futures (NYBOT)
20 LTD: All April equity options; April S&P
options (CME); April Nasdaq options 2 FND: May propane, gasoline, and
(CME); April Dow Jones options (CBOT); heating oil futures (NYMEX)
May crude oil futures (NYMEX); May 3 Productivity and costs (prelim) for Q1
oats, rice, wheat, corn, soybean LTD: April milk options (CME)
products, and soybean options (CBOT);
4 Unemployment for April
May orange juice options (NYBOT)
LTD: June cocoa options (NYBOT); May
FND: May coffee futures (NYBOT)
pork belly options (CME)
21 FDD: May propane futures (NYMEX)

48 April 2007 • FUTURES & OPTIONS TRADER

 NEW PRODUCTS AND SERVICES

 CyberTrader Pro’s latest release comes with version 7.0 includes a diverse selection of new market cate-
enhanced options trading functionality, more sophisticated gories and features designed to improve traders’
charting and research capabilities, “live help” via instant VantagePoint user experience. For the first time since its
messaging, and a virtual tour. The modified CyberTrader inception in 1991, VantagePoint now forecasts individual
Pro platform’s improved options capabilities include inte- stocks. Version 7.0 makes predictions on approximately 100
grated dividend yields automatically provided in real-time stocks, representing major companies in the following sec-
to options pricing models and watch lists, and the ability to tors: basic materials, conglomerates, consumer goods,
place orders on options in penny increments. The financial, healthcare, industrial goods, services, technology,
CyberTrader Pro enhanced charting package enables users and utilities. Along with the additional market forecasting
to launch a visual, floating menu and dock it anywhere on capability, VantagePoint 7.0 also has added new features.
their trading platform. Additional enhancements include Information about specific contracts, including the data
auto save, custom layouts, and printing upgrades that provider symbol, data file start and end dates, and actual
allow users to configure and print charts in landscape or values for specific days can now be displayed. Several new
portrait format, as well as scale images and add headers leading technical indicators have been added, which can be
and footers. Users can also customize the account balance used as confirmation filters to assist in trading decisions.
display with CyberTrader Pro’s updated Balance Bar. For Different settings can now be applied to charts and reports
more information about CyberTrader, Inc. or the individually rather than only universally. For more infor-
CyberTrader Pro platform, visit www.cybertrader.com or mation, visit www.tradertech.com.
call 1-888-76-CYBER.
Note: The New Products and Services section is a forum for industry
 InstantBull has launched a new feature that displays businesses to announce new products and upgrades. Listings are
a matrix summary of all the latest posts from the Web’s adapted from press releases and are not endorsements or recommen-
most popular stock message boards. From one site users dations from the Active Trader Magazine Group. E-mail press releas-
can now access posts from Yahoo Finance, Silicon Investor, es to [email protected]. Publication is not guaranteed.
Investors Hub, RagingBull,
ClearStation, InvestorVillage, and

HIT YOUR MARK!

MarketWatch. The upgrade also
includes a new button for all-in-one
message board access sorted by
time of posting, pagination buttons, Advertise in Active Trader, Currency Trader and
one-click access to “most active
Futures & Options Trader magazines
boards” on both the aggregated
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FUTURES & OPTIONS TRADER • April 2007 49

 KEY CONCEPTS
The option “Greeks”
Account equity: Value of account, which includes cash Delta: The ratio of the movement in the option price for
and investments. every point move in the underlying. An option with a
delta of .5 would move a half-point for every 1-point
American style: An option that can be exercised at any move in the underlying stock; an option with a delta of
time until expiration. 1.00 would move 1 point for every 1-point move in the
underlying stock.
Assign(ment): When an option seller (or “writer”) is
obligated to assume a long position (if he or she sold a put) Gamma: The change in delta relative to a change in the
or short position (if he or she sold a call) in the underlying underlying market. Unlike delta, which is highest for
deep ITM options, gamma is highest for ATM options
stock or futures contract because an option buyer exercised
and lowest for deep ITM and OTM options.
the same option.
Theta: The rate at which an option loses value each day
At the money (ATM): An option whose strike price is (the rate of time decay). Theta is relatively larger for
identical (or very close) to the current underlying stock (or OTM than ITM options, and increases as the option gets
futures) price. closer to its expiration date.

Bear call spread: A vertical credit spread that consists Rho: The change in option price relative to the change
of a short call and a higher-strike, further OTM long call in in the interest rate.
the same expiration month. The spread’s largest potential
gain is the premium collected, and its maximum loss is lim- Vega: How much an option’s price changes per a one-
percent change in volatility.
ited to the point difference between the strikes minus that
premium.

Bear put spread (call credit spread): A bear debit

spread that contains puts with the same expiration date but Call option: An option that gives the owner the right, but
different strike prices. You buy the higher-strike put, which not the obligation, to buy a stock (or futures contract) at a
costs more, and sell the cheaper, lower-strike put. fixed price.

Beta: Measures the volatility of an investment compared Carrying costs: The costs associated with holding an
to the overall market. Instruments with a beta of 1 move in investment that include interest, dividends, and the oppor-
line with the market. A beta value below 1 means the instru- tunity costs of entering the trade.
ment is less affected by market moves and a beta value
greater than 1 means it is more volatile than the overall mar- Covered call: Shorting an out-of-the-money call option
ket. A beta of zero implies no market risk. against a long position in the underlying market. An exam-
ple would be purchasing a stock for $50 and selling a call
Bull call spread: A bull debit spread that contains calls option with a strike price of $55. The goal is for the market
with the same expiration date but different strike prices. to move sideways or slightly higher and for the call option
You buy the lower-strike call, which has more value, and to expire worthless, in which case you keep the premium.
sell the less-expensive, higher-strike call.
Credit spread: A position that collects more premium
Bull put spread (put credit spread): A bull credit from short options than you pay for long options. A credit
spread that contains puts with the same expiration date, but spread using calls is bearish, while a credit spread using
different strike prices. You sell an OTM put and buy a less- puts is bullish.
expensive, lower-strike put.
Deep (e.g., deep in-the-money option or deep
Butterfly: A non-directional trade consisting of options out-of-the-money option): Call options with strike
with three different strike prices at equidistant intervals: prices that are very far above the current price of the under-
Long one each of the highest and lowest strike price options lying asset and put options with strike prices that are very
and short two of the middle strike price options. far below the current price of the underlying asset.

Calendar spread: A position with one short-term short Delta-neutral: An options position that has an overall
option and one long same-strike option with more time delta of zero, which means it's unaffected by underlying
until expiration. If the spread uses ATM options, it is mar- price movement. However, delta will change as the under-
ket-neutral and tries to profit from time decay. However, lying moves up or down, so you must buy or sell
OTM options can be used to profit from both a directional shares/contracts to adjust delta back to zero.
move and time decay.

50 April 2007 • FUTURES & OPTIONS TRADER

Diagonal spread: A position consisting of options with Iron condor: A market-neutral position that enters a bear
different expiration dates and different strike prices — e.g., call spread (OTM call + higher-strike call) above the market
a December 50 call and a January 60 call. and a bull put spread (OTM put + lower-strike put) below
the market. Both spreads collect premium, and profit when
Exponential moving average (EMA): The simple the market trades between the short strikes by expiration.
moving average (SMA) is the standard moving average cal- All options share the same expiration month.
culation that gives every price point in the average equal
emphasis, or weight. For example, a five-day SMA is the Lock-limit: The maximum amount that a futures contract
sum of the most recent five closing prices divided by five. is allowed to move (up or down) in one trading session.
Weighted moving averages give extra emphasis to more
recent price action. Exponential moving average (EMA) Long-Term Equity AnticiPation Securities
weights prices using the following formula: (LEAPS): Options contracts with much more distant expi-
ration dates — in some cases as far as two years and eight
EMA = SC * Price + (1 - SC) * EMA(yesterday) months away — than regular options.
where
SC is a “smoothing constant” between 0 and 1, and Market makers provide liquidity by attempting to prof-
EMA(yesterday) is the previous day’s EMA value. it from trading their own accounts. They supply bids when
there may be no other buyers and supply offers when there
You can approximate a particular SMA length for an are no other sellers. In return, they have an edge in buying
EMA by using the following formula to calculate the equiv- and selling at more favorable prices.
alent smoothing constant:
Naked (uncovered) puts: Selling put options to collect
SC = 2/(n + 1) premium that contains risk. If the market drops below the
where short put’s strike price, the holder may exercise it, requiring
n = the number of days in a simple moving average of you to buy stock at the strike price (i.e., above the market).
approximately equivalent length.
Open interest: The number of options that have not
For example, a smoothing constant of 0.095 creates an been exercised in a specific contract that has not yet expired.
exponential moving average equivalent to a 20-day SMA
(2/(20 + 1) = 0.095). The larger n is, the smaller the constant, Out of the money (OTM): A call option with a strike
and the smaller the constant, the less impact the most recent price above the price of the underlying instrument, or a put
price action will have on the EMA. In practice, most soft- option with a strike price below the underlying instru-
ware programs allow you to simply choose how many days ment’s price.
you want in your moving average and select either simple,
weighted, or exponential calculations. Parity: An option trading at its intrinsic value.

European style: An option that can only be exercised at Premium: The price of an option.
expiration, not before.
Put option: An option that gives the owner the right, but
Exercise: To exchange an option for the underlying not the obligation, to sell a stock (or futures contract) at a
instrument. fixed price.

Expiration: The last day on which an option can be exer- Put spreads: Vertical spreads with puts sharing the same
cised and exchanged for the underlying instrument (usual- expiration date but different strike prices. A bull put spread
ly the last trading day or one day after). contains long, higher-strike puts and short, lower-strike
puts. A bear put spread is structured differently: Its long
In the money (ITM): A call option with a strike price puts have higher strikes than the short puts.
below the price of the underlying instrument, or a put
option with a strike price above the underlying instru- Relative strength index (RSI): Developed by Welles
ment’s price. Wilder, the relative strength index (RSI) is an indicator in
the “oscillator” family designed to reflect shorter-term
Intrinsic value: The difference between the strike price momentum. It ranges from zero to 100, with higher read-
of an in-the-money option and the underlying asset price. A ings supposedly corresponding to overbought levels and
call option with a strike price of 22 has 2 points of intrinsic low readings reflecting the opposite. The formula is:
value if the underlying market is trading at 24.
continued on p. 52

FUTURES & OPTIONS TRADER • April 2007 51

 KEY CONCEPTS continued

Strike (“exercise”) price: The price at which an under-

RSI = 100 – (100/[1+RS]) lying instrument is exchanged upon exercise of an option.
RS = relative strength = the average of the up closes over
the calculation period (e.g., 10 bars, 14 bars) divided by the Time decay: The tendency of time value to decrease at an
average of the down closes over the calculation period. accelerated rate as an option approaches expiration.

For example, when calculating a 10-day RSI, if six of the Time spread: Any type of spread that contains short
days closed higher than the previous day’s close, you near-term options and long options that expire later. Both
would subtract the previous close from the current close for options can share a strike price (calendar spread) or have
these days, add up the differences, and divide the result by different strikes (diagonal spread).
10 to get the up-close average. (Note that the sum is divid-
ed by the total number of days in the look-back period and Time value: The amount of an option’s value that is a
not the number of up-closing days.) function of the time remaining until expiration. As expira-
For the four days that closed lower than the previous tion approaches, time value decreases at an accelerated rate,
day’s close, you would subtract the current close from the a phenomenon known as "time decay."
previous low, add these differences, and divide by 10 to get
the down-close average. If the up-close average was .8 and Vertical spread: A position consisting of options with
the down close average was .4, the relative strength over the same expiration date but different strike prices (e.g., a
this period would be 2. The resulting RSI would be 100 - September 40 call option and a September 50 call option).
(100/[1+2]) = 100 - 33.3 = 66.67.
Volatility: The level of price movement in a market.
Historical (“statistical”) volatility measures the price fluctu-
Straddle: A non-directional option spread that typically ations (usually calculated as the standard deviation of clos-
consists of an at-the-money call and at-the-money put with ing prices) over a certain time period — e.g., the past 20
the same expiration. For example, with the underlying days. Implied volatility is the current market estimate of
instrument trading at 25, a standard long straddle would future volatility as reflected in the level of option premi-
consist of buying a 25 call and a 25 put. Long straddles are ums. The higher the implied volatility, the higher the option
designed to profit from an increase in volatility; short strad- premium.
dles are intended to capitalize on declining volatility. The
strangle is a related strategy. Volatility skew: The tendency of implied option volatil-
ity to vary by strike price. Although, it might seem logical
Strangle: A non-directional option spread that consists of that all options on the same underlying instrument with the
an out-of-the-money call and out-of-the-money put with same expiration would have identical (or nearly identical)
the same expiration. For example, with the underlying implied volatilities. For example, deeper in-the-money and
instrument trading at 25, a long strangle could consist of out-of-the-money options often have higher volatilities than
buying a 27.5 call and a 22.5 put. Long strangles are at-the-money options. This type of skew is often referred to
designed to profit from an increase in volatility; short stran- as the “volatility smile” because a chart of these implied
gles are intended to capitalize on declining volatility. The volatilities would resemble a line curving upward at both
straddle is a related strategy. ends. Volatility skews can take other forms than the volatil-
ity smile, though.

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Date: June 20-23
Location: Marriott Hotel & Marina, San Diego, Calif.
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52 April 2007 • FUTURES & OPTIONS TRADER

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 OPTIONS
FOREX TRADE JOURNAL
DIARY

More flexible exit rules might have turned this losing trade around.

FIGURE 1 — RISK PROFILE - SHORT STRANGLE

TRADE
This short strangle will profit if SPY doesn’t drop more than 9 percent or jump more
Date: Monday, March 5. than 2.6 percent by March 17 expiration.

Market: Options on the S&P 500

tracking stock (SPY).

Entry: Sell 10 March 141 calls at

$0.40 each.
Sell 10 March 125 puts at
$0.15 each.

Reasons for trade/setup:

The S&P 500 dropped 4.41 percent
from Feb. 26 to March 2 — its
largest weekly decline in more
than four years. These steep
declines have been extremely rare
the past 15 years: The S&P has
fallen more than 4.4 percent in a
week only 12 other times since
November 1991.
Initial historical testing showed Source: OptionVue
the S&P 500’s average maximum
(close-to-low) loss over the following two weeks was 10.42 TRADE SUMMARY
percent, while the index’s average maximum gain was just
0.74 percent during this period. Entry date March 5
We entered a short strangle in March options on the S&P
Underlying security: S&P 500 tracking stock (SPY)
500 tracking stock (SPY) when it closed at 137.35 on March
5: The 141-strike calls were sold for $0.40 each and 125- Position:
strike puts were sold for $0.15 each — a total credit of $0.55. 10 short March 141 calls
continued on p. 56 10 short March 125 puts
Capital required: $24,650
Initial stop: Either short strike — 141 or 125.
TRADE STATISTICS
Initial target: SPY trades flat or slightly lower.
Initial daily time decay: 99.45
Date March 5 March 8
Delta -185.2 -761.8 Trade length (in days): 3

Gamma -85.58 869.8 P/L: -$700 (2.8 percent)

Theta 92.00 98.69 LOP: $0
Vega -99.45 -99.90 LOL: -$700
Probability of profit 80 percent 53 percent LOP — largest open profit (maximum available profit during
Breakeven 133.70 130.13 lifetime of trade); LOL — largest open loss (maximum poten-
points and 136.00 and 139.10 tial loss during life of trade).

54 April 2007 • FUTURES & OPTIONS TRADER

 OPTIONS TRADE JOURNAL continued

This position is basically non-directional and can profit range after these moves. However, we continued to hold
from declining volatility. Assuming SPY’s price and volatil- the position, because the short strangle’s profit zone was
ity remain unchanged, the position will gain $99.45 each fairly wide, and it would still profit as long as SPY doesn’t
day from time decay. rally more than 2.6 percent.
However, the location of its short strikes skews this trade Unfortunately, SPY moved against this trade immediate-
to the downside. The short 125 put is more than three times ly by rallying and threatening the short call’s 141 strike.
out-of-the-money (OTM) than the short 141 call, which Figure 2 shows SPY opened 1.04 percent higher the next
means SPY can drop 9 percent by March 17 expiration with- day (March 6) and climbed another 0.76 percent by the
out hurting the position. By contrast, the short strangle
will lose money if SPY rallies more than 2.6 percent
FIGURE 2 — STOPPED OUT AT A LOSS
within two weeks.
Figure 1 shows the short strangle’s potential gains The S&P 500 tracking stock (SPY) threatened the short 141
and losses on three dates: trade entry (March 5, dotted call immediately. It rallied 2.7 percent within three days and trig-
gered a $700 loss on March 8. However, the trade would have
line), halfway to expiration (March 11, dashed line),
been profitable if we held it another week.
and expiration (March 17, solid line). The shaded area
represents SPY’s likely trading range, which is based
on initial historical testing. The trade’s profit zone cov-
ers most of this area, although it is skewed slightly
higher.
The short strangle has an 80-percent chance of suc-
cess, but the strategy has two drawbacks: It faces
unlimited losses if SPY moves strongly in either direc-
tion, and its initial margin requirement is $24,650,
which means the best-case return on investment is just
2.2 percent ($550 short premium / $24,650 initial mar-
gin).
To control risk, we plan to exit both legs of the stran-
gle if the market hits either short strike before options
expire in two weeks. These stop-loss points will trigger
a loss, but Figure 1 shows this spread can lose ground
fast if SPY moves beyond either strike. Therefore, it is
essential to unwind this position quickly if the market
moves against us.
Source: eSignal
Initial stop: Buy back short 141 call and short 125
put if SPY reaches either strike by March 16 (last trading close. The market rallied again on March 7 and came with-
day). in 0.38 percent of the short 141 strike before falling 0.67 per-
cent to close lower on the day.
Initial target: The S&P 500 tracking stock moves side- SPY opened 0.55 percent higher again on March 8 and
ways or slightly lower. triggered an exit when it reached the short call’s 141 strike
at 10:30 a.m. We repurchased the 141 calls for $1.15 each
and the 125 puts for $0.10 each — a $700 loss (2.8 percent).
Although SPY briefly traded above 141 from March 8 to
RESULT 12, it fell 1.94 percent on March 13 and closed at roughly the
same level by March 17 expiration. The spread would have
Outcome: After entering the trade, we realized the analy- been profitable if the trade’s stop-loss wasn’t as tight.
sis of the S&P 500’s response to large weekly drops was Specifically, it never would have been stopped out if we
wrong. Another look at the index’s historical moves had widened the stop-losses to the spread’s breakeven
showed it was less bearish and traded within a tighter points at expiration (141.55 and 124.45). 

56 April 2007 • FUTURES & OPTIONS TRADER

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