Strategies, analysis, and news for futures and options traders

December 2007 • Volume 1, Issue 9

WHERE’S
the bottom? p. 12
SMOOTH TRADING
with the double
exponential moving
average p. 8
OPTIONS MONEY
MANAGEMENT:
The 1% rule p. 20
VIX OPTIONS p. 16
MACD CREDIT SPREAD
system p. 24
 CONTENTS

VIX options . . . . . . . . . . . . . . . . . . . . . . . . . .16

This primer explains the basic concepts
behind VIX options.
By Marc Allaire

Options and risk management . . . . . . . .20

Limiting trade risk to a small percentage
of account equity is a good idea, but figuring
out how to do it with options positions can be
more complicated than you think. This
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 practical approach helps you limit risk
regardless of which markets you trade —
Letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 stocks, futures, or options.
By Rick Swope and AJ Monte

Trading Strategies Options Trading System Lab

The DEMA smoothing technique . . . . . . . .8 Trading credit spreads
The tradeoff between lag and smoothing with the MACD . . . . . . . . . . . . . . . . . . . . . . . .24
is one of the perennial challenges of moving By Steve Lentz and Jim Graham
averages. This combination of exponential
continued on p. 4
moving average calculations takes on that
challenge.
By FOT Staff

Trading the plunge . . . . . . . . . . . . . . . . . . .12

As December unfolds, the market is still
jittery after the August and November selloffs.
Historically, such moves have more often
than not turned out to be buy-
ing opportunities.
Is this time any different?
By FOT Staff

2 December 2007 • FUTURES & OPTIONS TRADER

 CONTENTS

Trading Basics
Options exercise and assignment . . . . .26
Learn how to exercise a long option
and avoid getting assigned on a short one.
By FOT Staff

News
CFTC wants to beef up . . . . . . . . . . . . . . .30 Futures Snapshot . . . . . . . . . . . . . . . . . . . .34
In the wake of the Amaranth hedge fund Momentum, volatility, and volume statistics
debacle, the Commodity Futures Trading for futures.
Commission has asked Congress to give it
more power in dealing with over-the-counter Option Radar . . . . . . . . . . . . . . . . . . . . . . . . .35
transactions. Meanwhile, talk of a CFTC-SEC Notable volatility and volume in the
merger crops up again. options market.
By Jeff Ponczak and Jim Kharouf
Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36
Nasdaq options pricing
sparks debate . . . . . . . . . . . . . . . . . . . . . . . .32 Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .38
A controversial pricing plan by the Nasdaq, which References and definitions.
will soon launch the U.S.’s newest options
exchange, is drawing heat from other exchanges. Futures & Options Calendar . . . . . . . . . . . .42
By Jim Kharouf

Options Watch Futures Trade Journal . . . . . . . . . . . . . . .43

High-volume stocks . . . . . . . . . . . . . . . . . .32 A well-reasoned risk that paid off, or a lucky
Tracking option bid-ask spreads on break?
high-volume stock options.
Options Trade Journal . . . . . . . . . . . . . . .44
New Products and Services . . . . . . . . .33 A stock-split trade leads to red tape and profits.

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.

eSignal OptionsMentoring
ISE OptionVue
Leverage and Liquidity Partners Trader’s Library
New York Expo Zecco

4 December 2007 • FUTURES & OPTIONS TRADER

 CONTRIBUTORS
CONTRIBUTORS

Marc Allaire is a consultant to the Chicago Board Options

Exchange, the Montreal Exchange, and other options industry
A publication of Active Trader ® firms. He also teaches finance at the University of Indianapolis
and investments and derivatives at the Ningbo Institute of
For all subscriber services: Technology in China. A former senior staff instructor at the
www.futuresandoptionstrader.com
Chicago Board Options Exchange’s Options Institute, Allaire was a featured con-
tributor to the CBOE’s book Options: Fundamental Concepts and Trading Strategies,
Editor-in-chief: Mark Etzkorn
[email protected]
co-authored Understanding LEAPS, and is a regular contributor to professional
publications on options, LEAPS, and trading strategies. His latest publication is
Managing editor: Molly Flynn The Options Strategist. He can be reached at [email protected].
[email protected]

Senior editor: David Bukey
AJ Monte is part of The Market Guys, Inc. team, which is the
[email protected] exclusive education provider for E*Trade’s five million accounts
worldwide. He has more than 25 years experience in the financial
Contributing editors:
Jeff Ponczak industry. Monte is the cohost of Wealth & Wisdom, a weekly finan-
[email protected], cial show on WXEL PBS television in south Florida. He is also a
Keith Schap
chartered market technician and member of the Market Technicians Association.
Editorial assistant and
Webmaster: Kesha Green
Rick Swope is also part of The Market Guys, Inc. team. His
[email protected]
business background has allowed him to create and develop pre-
Art director: Laura Coyle mier consultant teams across America. Swope is the cohost of The
[email protected] Market Guys’ podcast, which is available on Apple iTunes. He is

President: Phil Dorman

also the cohost of Wealth & Wisdom, a weekly financial show on
[email protected] WXEL PBS television in south Florida.

Publisher,
Ad sales East Coast and Midwest:
Jim Graham ([email protected]) is the product man-
Bob Dorman ager for OptionVue Systems and a registered investment advisor
[email protected]
for OptionVue Research.

Ad sales
West Coast and Southwest only:
Steve Lentz ([email protected]) is executive vice pres-
Allison Ellis ident of OptionVue Research, a risk-management consulting company. He also
[email protected]
heads education and research programs for OptionVue Systems, including one-
Classified ad sales: Mark Seger on-one mentoring for intermediate and advanced traders.
[email protected]

Jim Kharouf is a business writer and editor with more than 10 years of
Volume 1, Issue 9. Futures & Options Trader is pub-
lished monthly by TechInfo, Inc., 161 N. Clark Street, experience covering stocks, futures, and options worldwide. He has written
Suite 4915, Chicago, IL 60601. Copyright © 2007
TechInfo, Inc. All rights reserved. Information in this extensively on equities, indices, commodities, currencies, and bonds in the U.S.,
publication may not be stored or reproduced in any
form without written permission from the publisher. Europe, and Asia. Kharouf has covered international derivatives exchanges,
The information in Futures & Options Trader magazine money managers, and traders for a variety of publications.
is intended for educational purposes only. It is not
meant to recommend, promote or in any way imply the
effectiveness of any trading system, strategy or
approach. Traders are advised to do their own
research and testing to determine the validity of a trad-
ing idea. Trading and investing carry a high level of
risk. Past performance does not guarantee future
results.

6 December 2007 • FUTURES & OPTIONS TRADER

 LETTERS

I n the last two issues of Futures & Options Trader there

have been articles by Steve Lentz and Jim Graham
looking at two options strategies. These have both
involved picking strike prices “n” standard deviations
away from the underlying price, where the standard devia-
site, http://www.DiscoverOptions.com. Given these variables, the
calculator shows the underlying price one, two, and three stan-
dard deviations both above and below the market.
You need to register to access this tool, but it is free. I also like
Larry McMillan’s Option Strategist newsletter and Web site
tion was calculated by “using the implied volatility (IV) of (http://www.optionstrategist.com), but (if I recall correctly) his
the at-the-money (ATM) option.” probability calculator only shows the probability of hitting a cer-
How does one use the IV of an option to get a standard tain target price and does not display one, two, and three standard
deviation? I can’t seem to find an answer to this question. deviations of the lognormal distribution.

— Brandon Wilhite

Jim Graham responds: Correction

When creating a lognormal distribution for an asset, you need to
“Adjusting your collar” (Futures & Options Trader,
input a number of variables: the underlying price, the number of November 2007, p. 20) contained an error. Figure 3’s
days ahead you are projecting to, dividend yield, interest rates, risk-profile graph showed the entire position’s risk and
and future volatility. It is this last variable we are talking about. reward at the second expiration (April 2008), including
What the volatility will be in the future is unknown, so we use the the long 160 put on Apple Inc. that would have expired
current implied volatility (IV) of the ATM call option (in the back in January.
appropriate expiration month) for this variable. As a result, the position’s total risk equals its debit of
Most brokerage sites now offer IV as an available calculated $16,213 — not $213 as Figure 3 and Table 2 stated. We
field to be displayed with the option chain (we actually use the fixed the article and reposted it on our Web site. If you’d
mid-point IV — between the IV calculated using the bid and ask like to read the corrected version, you can follow the
prices). original link and download the PDF file again.
There is a free probability calculator on our educational Web Futures & Options Trader regrets the error.
 TRADING STRATEGIES

The DEMA
smoothing technique
Combining two exponential moving average (EMA) calculations helps create a trend indicator
with less lag. Inserting it into a trading system shows how it compares to a standard EMA.
BY FOT STAFF

FIGURE 1 — MOVING AVERAGE COMPARISON

M oving averages are the The simple moving average lagged the market turns the most. The DEMA had
the least lag between market turns.
most popular tool for
smoothing price action
and identifying the
trend. The two most commonly used
averages are the simple moving average
(SMA) and the exponential moving
average (EMA), which is a specific type
of weighted moving average that
emphasizes the most recent price data
with the goal of creating a more respon-
sive indicator.
Here, we look at a lesser-known way
to smooth price data — the double
exponential moving average (DEMA),
which uses two calculations involving
the EMA to reduce lag (the tendency for
moving averages to trail price action).
Figure 1 shows a daily chart of the
EuroFX futures (EC) with three moving Source: CQG Integrated Client
averages, each of which has a 13-bar
look-back period or smoothing technique. Let’s review each For example, the smoothing constant to calculate a “13-
of the calculations. period” EMA is 2/(13+1) = 0.14. The larger n is, the smaller
First, there’s the 13-bar SMA (blue line), which is the sum the smoothing constant, and the smaller the smoothing con-
of the 13 most-recent closing prices divided by 13. stant, the less impact the most recent price action will have
Next is the 13-period EMA (red line), which uses a on the EMA.
“smoothing constant” (SC) to give more weight to the most Because each bar’s weighted closing price is added to the
recent closing price. This weighted closing price is then previous EMA value, one unique feature of the EMA is that
added to yesterday’s EMA value, which is also weighted (1 the average changes direction as soon as price closes above
minus the smoothing constant): or below it: If price closes above the EMA, the EMA will
climb; if price closes below it, the EMA will drop. As a
EMAToday = SC * CloseToday + (1-SC) * EMAYesterday result, there is no lag when the closing price initially cross-
es the EMA.
The smoothing constant (which ranges between 0 and 1) The third average in Figure 1 is the double exponential
equates to an SMA look-period according to the following moving average (DEMA), which was introduced by Patrick
formula: G. Mulloy in 1994.

SC = 2/(n+1) Reducing lag with the DEMA

The DEMA calculates the difference between two compo-
where n is the number of periods in an equivalent SMA’s nents: a doubling of the basic EMA value and a “double
look-back period. smoothing” of the EMA value — that is, an EMA smoothed
by a second EMA:

8 December 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — STANDARD EMA VS. DOUBLE SMOOTHED EMA
Double smoothing creates a smoother average but also trails price more than
the single EMA.

DEMA = 2 * EMA – double-smoothed

EMA

For example, on Nov. 16, the 13-bar

EMA value was 1.4574 and the double-
smoothed EMA value was 1.4465, which
makes the 13-bar DEMA value:

DEMA = 2 * 1.4574 – 1.4465 = 2.9148 –

1.4465 = 1.4683

One attribute of all moving averages is

the tradeoff between smoothing and lag:
The longer the average, the more it will
smooth the data, but the more it will lag
the data as well. The same is true for dou-
ble-smoothing. Source: CQG Integrated Client
Figure 2 compares a single- and double-
smoothed EMA (the latter being the second component of The two systems use the moving average convergence-
the DEMA calculation). Both averages smooth the price divergence (MACD) indicator, which in this case uses the
data, but the double-smoothed EMA smoothes it more — difference between 26- and 13-period EMAs, plus a nine-
and lags the price action more, as well. The 13-bar EMA period EMA of the primary MACD line, which is called the
turns up five days after the low bar in continued on p. 10
August, while the 13-bar double-
smoothed EMA turns up eight days
after that.
To counter this increased lag of the
double-smoothed EMA, the DEMA
calculation doubles the EMA in the
calculation and subtracts the double-
smoothed EMA from it.
In Figure 1, notice in the aftermath
of the August bottom how the SMA
was still declining even while prices
were closing above it; it did not turn
up to follow the uptrend until 10 bars
after the August low. The EMA turned
up five bars after the low bar and the
DEMA turned up only four bars after
it.
It is apparent how much more
closely the DEMA tracks price com-
pared to the SMA and EMA. This
reduction in lag is a result of the dif-
ference between the two components.

Comparing trading systems

To illustrate the difference between
the DEMA and the standard EMA,
two simple systems were created and
applied to EuroFX continuous con-
tract data. The test period spanned
January 2004 to Nov. 19, 2007.

FUTURES & OPTIONS TRADER • December 2007 9

 TRADING STRATEGIES continued

FIGURE 3 — TRADE SIGNAL COMPARISON closing price on the day a signal

The DEMA system (red) has shorter trade lengths and tends to enter the market sooner
is triggered.
than the standard system (blue). The difference between the
two systems is one uses the
standard EMA calculation for
the MACD while the other uses
the DEMA calculation. Both use
the default MACD moving aver-
age lengths of 26, 13, and 9.
Figure 3 shows some trade
signals from August to
November. On the chart, trades
generated by the DEMA version
of the system have red arrows at
the entry bars and red Xs at the
exit bars. Blue arrows mark the
standard MACD trade entries
and blue Xs mark the exits.
In Figure 4, the two panes
below the price display the sys-
tems’ realized profits and losses
(green histograms and red his-
tograms, respectively) as well as
Source: CQG Integrated Client open profits (green line). The
bottom pane shows the stan-
FIGURE 4 — LONGER-TERM VIEW dard MACD version of the sys-
The green histogram represents closed profits and the red histogram represents closed tem and the middle pane con-
losses. The standard system had larger drawdowns than the DEMA system. tains the DEMA version of the
system.
Figure 3 illustrates the aggres-
sive nature of the DEMA
smoothing. First, there is the
much earlier entry signal after
the August bottom. On the other
hand, the DEMA system exited
the first trade well before the
market had stopped rallying.
The standard system stayed in
the trend longer, but exited after
it had peaked. The DEMA sys-
tem then re-entered the market
earlier than the standard sys-
tem.
Figure 4 is a longer-term view
showing the two systems’ per-
formance from April 2004 to
Nov. 19, 2007. This chart shows
the standard system had deeper
Source: CQG Integrated Client and longer drawdowns com-
pared than the DEMA system.
“signal line.” Table 1 contains the perform-
The system trades only on the long side. A buy signal ance details for the two systems. The DEMA system had a
occurs when the MACD line first closes above the signal larger net profit ($18,437 vs. $13,037) and, more important-
line (i.e., subsequent buy signals are ignored until an exit ly, a smaller maximum drawdown (-$13,612 vs. -$18,325).
signal is triggered). An exit occurs when the MACD line Also, the DEMA system had 50 percent winning trades vs.
first closes below the signal line. Trades are executed at the 41.18 percent for the standard system.

10 December 2007 • FUTURES & OPTIONS TRADER

 TABLE 1 — DEMA MACD VS. STANDARD MACD
The DEMA version of the system had a larger net profit and smaller maximum drawdown than the standard version.
Test period: 1/1/04-11/19/07 DEMA Standard DEMA Standard
Total net profit $18,437 $13,037 Max consecutive wins 4 4
Closed net profit $18,437 $13,037 Current consecutive wins 2 3
Total trade count 60 36 Maximum consecutive losses 5 6
Open position 1 1 Profit to max drawdown 1.35 0.71
Percent long 100% 100% Profit loss ratio 1.38 1.36
Average duration 9 16 Percent winners 50.00% 47.22%
Average profit 307 362 Average loss -$1,637 -$1,926
Average win $2,251 $2,920 Maximum loss -$4,925 -$3,662
Maximum win $4,925 $9,800 Maximum drawdown duration 504 days 628 days
Maximum closed drawdown -8,862 -13,925 Maximum drawdown amount -$13,612 -$18,325

On the other hand, the standard sys- ages, such as simple, exponential, and
Related reading tem’s largest win was $9,800 vs. $4,925 weighted. The DEMA calculation uses
for the DEMA system. Other details in a unique calculation that includes both
“Weighted and exponential the table — including the number of double exponential smoothing and a
moving averages” trades — reflect the more aggressive differencing calculation.
Currency Trader, January 2005. nature of the DEMA compared to the Double smoothing can introduce lag
Weighted and exponential moving standard EMA smoothing. while calculating differences can
averages are designed to be more reduce lag. The DEMA technique can
responsive to price changes than The battle against lag be used as a substitute for other mov-
the simple moving average. But There are a number of ways to smooth ing averages when working with
there are advantages and disad- data including various moving aver- studies.

vantages to this sensitivity. This
article includes a historical test
comparison of simple, weighted,
and exponential moving averages.

“Trading System Lab:

Anti-Trend EMA”
Active Trader, November 2006.
The Anti-Trend EMA system
inverts a short-term moving aver-
age crossover system to buy
stocks on a down-scaled basis.
Note: This article is also part of the
“Trading System Labs, Vol. 2:
Countertrend Trading”
discounted article collection.

“Trading System Lab:

The weighted moving
average system”
Active Trader, November 2004.
Analysis of a trading system
designed to catch longer trends
using 30- and 60-day WMAs.

You can purchase and download

past articles at
http://www.activetradermag.com/
purchase_articles.htm.

FUTURES & OPTIONS TRADER • December 2007 11

 TRADING STRATEGIES

Trading the plunge

As the year draws to a close, traders are still debating whether the stock market will rebound
from the October-November sell-off or if it’s just the beginning of a larger decline and recession.
This price-forecast model shows some interesting results.

BY FOT STAFF

B ear market. Recession. Deep recession.

These are just a few of the cheerful words that have been
thrown around recently as the S&P 500 index dropped
2. The highest high of 10 to 31 days ago is
higher than the highest high of 32 to 51
days ago.
approximately 10 percent for the second time in three
months. The seemingly endless reverberations of the hous- 3. Yesterday’s low is below the preceding
ing collapse and uncertainty over a Fed that seems to have 20 lows.
painted itself into a corner turned many days into wild
roller-coaster rides as stocks kept trying, day after day, to 4. Today’s low is above yesterday’s low.
mount a comeback — only to collapse in late trading. Just
when the market seemed to be out of the woods for a day The second rule is particularly important because it
or two, sellers came rushing back in. requires the high from which the 8-percent sell-off is meas-
From the Oct. 11 high of 1,576.09 to the Nov.
26 low of 1,406.10, the S&P 500 index dropped FIGURE 1 — JULY-AUGUST SELL-OFF
10.8 percent in a 31-day period (Figure 1).
The S&P 500 fell more than 10 percent from the July high to the
August low — only to rally strongly to the index’s all-time high on
The pattern Oct. 11.
The price model was designed to reflect the
S&P 500’s condition as of the end of trading on
Nov. 27. The previous day the index had com-
pleted a 10.78-percent drop from the Oct. 11
high and made a new 20-day low. On Nov. 27 it
made a higher low (and a higher close,
although that was not included in the defini-
tion).
Ten percent corrections are relatively rare,
and even rarer when additional criteria (such as
requiring the low of the move to be a 20-day
low followed by a higher low) are added to
them; to get a more statistically reliable number
of examples, the size of the sell-off was
decreased to 8 percent (still quite large). The
pattern rules were:

1. The decline from the highest high of 10

to 31 days ago to yesterday’s low is Source: TradeStation
greater than or equal to 8 percent.

12 December 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — OCTOBER-NOVEMBER SELL-OFF
Despite the recent correction in July-August, the S&P took another
tumble from the October high, falling 10.78 percent to the Nov. 26
low.

ured to be above the high of the preceding 20

days. This is designed to avoid patterns that
formed on the heels of a previous big sell-off
or extended downtrend. As a formula, the
rules are:

1. (MAX(H10:H31)-H1)/
MAX(H10:H31)>=0.08

2. MAX(H10:H31)>MAX(H32:H52)

3. L1<MIN(L2:L22)

4. L0>L1
Source: TradeStation
where

H = daily high
L = daily low
MAX – maximum
MIN = minimum
Subscripts0, 1, 2, etc., refer to
today, one day ago, two days
ago, etc.

There were 42 previous sell-offs

that met these criteria since October
1982, the first one occurring in
February 1984 and the most recent
forming in August 2007 (Figure 2).
Figure 3 compares the median
returns after these patterns (one to 10
days and 15, 20, 40, and 60 days) to the
median returns for same-length
moves over the entire 25-year analysis
period. Each day represents the per-
centage gain from the close of the last
day of the pattern to the close that day.
The percentage of gains (“%>0”) for
each day, which represents how often
the close on a given day was higher
than the close of the pattern’s last day,
are also shown.
The results are interesting. After an
initial downturn the first two days,
continued on p. 14

FUTURES & OPTIONS TRADER • December 2007 13

 TRADING STRATEGIES continued

FIGURE 3 — 8%-PULLBACK PATTERN PERFORMANCE

the post-pattern gains jumped above Although the market has a strong tendency to outperform after big sell-offs, this
the S&P’s median gains from days 3 to price-pattern model shows the S&P to trade a shade weaker than its historical
6 (peaking at day 4). From there the median performance.
post-pattern returns essentially fol-
lowed the S&P’s typical performance,
and slightly underperformed it after
20, 40, and 60 days.
Most analysis shows outsized
returns after big sell-offs — i.e., the
market usually tends to outdo its typ-
ical performance after taking a hard
fall. This model shows the market was
slightly weaker than its historical ten-
dencies after the kind of correction
that occurred in October and
November.
Figure 4 shows the actual S&P clos-
ing price (blue) through Dec. 3, fol-
lowed by the pattern model’s project-
ed prices (the prices after 15, 20, 40,
and 60 days are simply connected by
lines that do not represent interim price action). It is impor- be the most robust and provide the most examples,
tant to note that, even if the market does slightly underper- however.
form in the next few months, the model has the S&P 500 With the holiday season kicking into high gear, many
making a new all-time high sometime between Dec. 27 and traders are no doubt leaning toward an optimistic view.
Jan. 25. However, November is typically one of the strongest
months of the year for the stock market, and that obviously
Unquantifiable factors was not the case this year.

As of Dec. 3, the S&P was inline with the
model’s estimates (and the S&P’s overall his- FIGURE 4 — POST-PATTERN PRICE PROJECTION
torical median returns). However, as this rep-
resents only the fourth day into the post-pat- Will the market outperform or underperform the model’s forecast?
tern projection, it is still too early to determine
whether the market is likely to do better or
worse than the forecast. Which is always the
rub with this kind of trading model: What
inputs do you use to gauge whether the mar-
ket — in this one instance — is likely to under-
perform or outperform a model which, after
all, is a middle-of-the-road depiction of the
market’s possible course?
Also, this is certainly not the only pattern
definition that could define the October-
November downturn. It is possible some
aspect of the price action (which other traders
may notice) is absent from the model used
here. In fact, this is not the only model that was
analyzed for this article; this one happened to

14 December 2007 • FUTURES & OPTIONS TRADER

 TRADING STRATEGIES

VIX options
Despite appearances, VIX options behave differently from other options.

BY MARC ALLAIRE

FIGURE 1 — VXO AND VIX, 1993-2007

The VIX has dropped below 10 just a few times since 1993, and it spiked sharply much
more often.

I n February 2006 the

Chicago Board Options
Exchange (CBOE) listed
options on its S&P 500
volatility index (VIX). The VIX
tracks the implied volatility
(IV) of selected S&P 500
options and measures the mar-
ket’s volatility forecast over the
next 30 days.
VIX options represent a fair-
ly abstract concept — options
on an index that tracks the
implied volatility of S&P 500
index (SPX) options. Despite
their complexity, though, VIX
options have become popular
instruments among retail
traders. In October 2006, VIX
option average daily volume
was only 27,574, a figure that
jumped to 119,630 a year later. Source: CBOE
However, the VIX doesn’t
behave like a standard stock index or futures contract, and February 1994 to November 2006.
its options are also somewhat counterintuitive. But what about those frequent spikes? Table 2 lists all 40+
VIX readings and shows the index rose above that level 17
Historical VIX patterns times since 1993, seven of which were only intraday moves.
Figure 1 shows a weekly VIX chart since May 19, 1993 and Table 2 also suggests the VIX’s highest close and its intraday
combines two symbols: The original volatility index (VXO), high may have occurred on two different days.
which was revised in September 2003 to become the current
VIX. The original volatility index, which the CBOE still cal- S&P 500 vs. VIX
culates, tracks the IV of eight at-the-money (ATM) options The S&P 500 index and the VIX are mostly negatively
on the S&P 100 (OEX), while the current one measures the correlated, which means when stocks climb, volatility tends
IV of various options on the S&P 500. For a detailed discus- to fall and vice versa. Figure 2’s daily chart juxtaposes the
sion of the VIX and this change, see “The volatility index” S&P 500 and the VIX from January 2006 to mid-March 2007.
(p. 17). The S&P 500 rose about 12 percent from early August
The VIX dropped below 10 just a few times, and it spiked through December, while the VIX declined from 15 to
sharply (albeit briefly) much more often. Let’s quantify around 11. Similarly, when the S&P fell 3 percent in May
these moves more precisely. Table 1 lists all the days in 2006, the VIX spiked from about 12 to nearly 20.
which the VIX fell below 10, either intraday or on a closing This phenomenon is easily explained by the concept of
basis. Single-digit VIX readings were quite rare, as the options as insurance. When the market rallies every day, the
volatility index stayed above 10 for more than 12 years from demand for options (e.g., insurance) dries up; and when

16 December 2007 • FUTURES & OPTIONS TRADER

 TABLE 1 — LOW-VOLATILITY DAYS
Over the past 15 years the VIX has dropped below 10 on just 25
buyers disappear, prices and IVs fall. If a market’s days. It remained above this level from Feb. 4, 1994 to Nov. 20,
decline seems dire, buying some insurance against 2006.
further declines appears prudent. Days VIX Intraday Closing
Dates below 10 basis basis
Interpreting the VIX Dec. 20-29, 1993 8 1 7
There are two ways to interpret the VIX: as a Jan. 27-Feb. 4, 1994 7 5 2
barometer that predicts where the S&P 500 could Nov. 20-22, 2006 3 1 2
be headed or as a thermometer that shows how Dec. 14-15, 2006 2 1 1
“hot” the S&P is. Traders who view the VIX as a Jan. 24-25, 2007 2 1 1
barometer see VIX extremes as possible market
Feb. 2, 14, & 16, 2007 3 3 0
turning points (see “Related reading”). This discus-
sion, however, is limited to interpreting the VIX as
a thermometer. futures’ theoretical price from the S&P 500 cash index, you
Because the VIX measures the temperature of S&P 500 should include carrying costs such as the risk-free interest
options, it is most useful to SPX options traders. According rate and the index’s dividend yield. Also the futures price
to Figure 2, the S&P 500 dropped 4 percent in the first half doesn’t stray too far from its theoretical value, because if it
of 2006, pushing the VIX up from 15 to the low 20s. At this did, traders could profit from arbitrage techniques such as
point, let’s assume you thought, “I’ve seen this before. The buying the S&P’s component stocks and selling the corre-
market has overreacted and will bounce back.” If you are sponding futures contract.
bullish, you could use the most basic bullish option strate- It’s a completely different situation with the VIX futures.
gy: buying calls on the S&P 500. Because no tradable underlying exists, VIX futures have no
What’s wrong with this scenario? Your explicit market theoretical value, and arbitrage isn’t possible. In other
forecast is bullish, but your implicit IV forecast is bearish, continued on p. 18
assuming you believe the historical inverse relationship
between the S&P 500 and VIX will continue. If the market
does rise, call values will climb, but they will also be hurt by
a drop in implied volatility. The volatility index (VIX)
Buying calls may be profitable, but another strategy may
offer a better return on investment (ROI). The solution: The Volatility Index (VIX) measures the implied volatility
Enter a position that will benefit from both a rallying mar- of S&P 500 index options traded on the Chicago Board
ket and lower volatility. At the very least, make sure a bull- Option Exchange (CBOE). The VIX is designed to reflect
ish trade won’t be hurt by an IV drop. the market expectation of near-term (in this case, 30-
Strategies that fit these criteria include selling puts, bull day) volatility and is a commonly referenced gauge of the
call spreads (long call, short higher-strike call in same stock market’s “fear level.”
month), and bull put spreads (short put, long lower-strike The original VIX, launched in 1990, was derived from
put in same month). For these spreads, the short option’s eight near-term at-the-money S&P 100 (OEX) options
time premium should equal or exceed the long option’s (calls and puts) using the Black-Scholes options pricing
time premium. model.
The VIX underwent a major transformation in late
Look to the future(s) 2003. The current index is derived from both at-the-
An underlying security’s price is one of the variables need- money and out-of-the-money S&P 500 (SPX) calls and
ed to calculate an option’s price. (Other pricing variables puts to make the index better represent the full range of
include time until expiration, volatility, interest rates, and volatility. At the same time the CBOE applied the new
dividends.) If you trade options on stocks, indices, or calculation method to the CBOE NDX Volatility Index
futures, that variable is the current price or value. Stocks (VXN), which reflects the volatility of the Nasdaq 100
and indices can be bought or sold at their current prices, index.
even if buying or selling the 500 stocks in the S&P 500 index The exchange still publishes the original VIX calcula-
is impractical for most retail traders. tion, which can be found under the ticker symbol VXO.
But what about the VIX? It cannot be traded because it is Figure 1 shows both indices: the VXO from May 19, 1993
just a number, not a true underlying security. Therefore, it to Sept 19, 2003 and the new VIX over the next four
can be neither bought nor sold. VIX futures (VX), on the years.
other hand, can easily be traded. So the true underlying of For more information about the VIX and its calculation,
VIX options is the VIX futures, which makes a big differ- visit http://www.cboe.com/vix.
ence.
Consider the S&P 500 futures (SP). To calculate the

FUTURES & OPTIONS TRADER • December 2007 17

 TRADING STRATEGIES continued

TABLE 2 — HIGH-VOLATILITY DAYS

The VIX exceeded 40 more than a dozen times since 1993 and
stayed above this level for 105 days overall.
Days VIX Highest Intraday
Dates above 40 close high
Oct. 27-28, 1997 2 39.96 55.48 Where is the money?
Nov. 13, 1997 1 36.98 40.40 VIX options use VIX futures instead of the cash VIX
Aug. 27-Sept. 14, 1998 13 48.33 53.43 as the underlying. VIX options are based on the
Sept. 17-21, 1998 3 42.33 46.82 futures’ expected, or forward, VIX value at expira-
Sept. 30-Oct. 15, 1998 12 48.56 60.63 tion, which differs from current VIX values because
April 14, 2000 1 39.33 41.53 options in later-expiring months often have differ-
March 22, 2001 1 39.70 41.99
ent IVs.
When VIX futures trade significantly above or
April 3-4, 2001 2 39.33 40.77
below the cash level, the terms in-, at-, and out-of-
Sept. 17-25, 2001 7 49.04 57.31
the-money take on a slightly different meaning.
July 11-26, 2002 12 50.48 56.74 Assume, for example, that VIX is 16.00, but the
Aug. 1-15, 2002 10 49.31 49.83 futures, which expire in three months, trade at
Sept. 3-9, 2002 5 43.86 44.87 18.00. This suggests the market expects higher
Sept. 12-Oct. 25, 2002 32 49.48 50.48 volatility, because the futures price is driven by
Jan. 27, 2003 1 39.77 40.89 expectations, not arbitrage opportunities.
Feb. 10, 2003 1 37.70 40.48 If you buy a 16-strike VIX call, you may think it
Feb. 13, 2003 1 38.48 40.68 is ATM, but, in reality, that call is priced as if it is 2
March 12, 2003 1 38.99 41.16 points in-the-money. And if you buy a 16-strike
put, it will be priced as if it is 2 points out-of-the-
money, not ATM as it appears. In this scenario, the
words, no buy programs kick in if VIX futures seem over- call appears expensive and the put seems cheap.
priced and no sell programs are triggered by seemingly Although VIX put buyers may be duped by this discrep-
underpriced futures. The cash and futures VIX prices can ancy, they still have an inherent advantage, because VIX
diverge significantly from one another, and the gap can options settle to the VIX cash index, not VIX futures. The
remain for extended periods of time. VIX cash index represents the market’s volatility expecta-
tions within 30 days, so as VIX
options near expiration, the
FIGURE 2 — S&P 500 AND VIX actual VIX becomes more
The S&P 500 and VIX are negatively correlated, which means one tends to fall as the accurate as an underlying
other rises and vice versa. Notice how the VIX climbed to 20 as the S&P 500 fell in May security. As expiration
2006 but slipped below 10 as the S&P rallied in November. approaches, both VIX options
and the VIX index are based
on the S&P 500 options in the
same month.
Suppose you buy a 17-strike
VIX put when the cash VIX is
16 and the VIX futures trade at
18. When you enter the trade,
the put is priced one point
OTM, but it will expire one
point ITM if the VIX remains
unchanged.

Strategy implications
You should also remember the
VIX index behaves differently
from stocks and other indices.
For example, a stock can jump
Source: eSignal
from $100 to $400 and never

18 December 2007 • FUTURES & OPTIONS TRADER

 Related reading
Marc Allaire articles
“Putting put-call parity to work”
Futures and Options Trader, August 2007.
Theories don’t pay the bills. This analysis focuses on the
practical side of the put-call parity equation.

trade at $400 again (think Google, at least so far). But if “Rolling profitable covered calls”
VIX jumps from 10 to 40, the odds are fairly good that it Futures and Options Trader, April 2007.
will drop below 40 again. Table 2 shows the VIX has Taking profits on a winning covered call is tempting, but extend-
never stayed above 40 for more than 32 days. This his- ing the trade another month could generate additional profits.
This first installment of a two-part series examines the benefits
torical pattern has implications for strategies such as
and drawbacks of rolling a profitable covered call position as
selling naked calls.
expiration nears.
When you sell an uncovered call, you collect premium
in exchange for the obligation to sell stock to the call’s “Repairing a losing covered call”
holder at the strike price, which translates to theoretical- Futures and Options Trader, May 2007.
ly unlimited risk. Although you can debate whether this This sequel to the first article on covered calls shows how
upside risk is really unlimited, you can easily get wiped several repair strategies can help minimize a covered call’s
out if the market rallies and get caught on the wrong losses — and can occasionally even turn a loser into a winner.
side of a short naked call.
For VIX, the risk of selling naked calls is running out “Straddles vs. strangles, round two”
of money before the market proves you right. In other Options Trader, January 2007.
Neither strategy always outperforms the other. However, having
words, naked call sellers need to hold a great deal of
a clear price forecast makes it easier to select the best position.
capital so that if they get caught by one of the VIX’s
unexpected spikes, they will have enough staying “Selecting calls based on ROI”
power to outlast margin calls. Options Trader, October 2006.
Selling naked puts could be a portfolio-hedging strat- Traders seem drawn to complex options strategies, but some-
egy. A market correction could hurt you, but if you sell times simply buying calls is the best way to catch an up move.
VIX puts as a hedge, the premium you collect will help Learn how to weigh the possibilities by comparing various calls’
offset those losses. However, this strategy is risky if the return on investment.
market either goes nowhere or rallies consistently. In
these situations, the VIX will probably drop. Other articles
“Getting a grip on implied volatility”
Six degrees of separation
Options Trader, February 2006.
If the VIX index acts as a thermometer and shows how
Implied volatility is a crucial, but often misunderstood, concept.
“hot” SPX options are, how can you gauge the tempera- We explain what it means and how you can use it to improve a
ture of VIX options themselves? The answer is the trade’s chance of success.
implied volatility of VIX options. A note of caution here:
You might generate some bizarre results if you calculate “VIX-based system”
VIX options’ implied volatility with option-pricing soft- Active Trader, January 2006.
ware designed for stock or index options. This test uses a system described by Larry Connors in the
One of the assumptions behind these models is that TradingMarkets.com blog on Sept. 16. The system tries to find
an underlying’s returns are normally distributed, which oversold situations in the S&P by identifying VIX spikes.
means there is an equal possibility of a positive or nega-
“Forecasting the VIX”
tive return, and that most returns will be relatively small
Active Trader, June 2005.
with few very high or low returns. But the VIX is a
A novel approach to analyzing the VIX results in a volatility
mean-reverting index, so this assumption is inaccurate. forecasting technique and countertrend volatility trading
In other words, the VIX has a long-term tendency to method.
move back toward its mean, which is about 16 percent.
Expect unusual IV values when the VIX trades at “The volatility market connection”
extreme lows or highs. If VIX is above 40, then it is more Active Trader, March 2004.
likely to drop than climb — the odds of it going in either Is everything you know about volatility wrong? Find out what
direction are no longer even. An accurate implied history says about the volatility-market relationship — and what
volatility estimate would have to take into account this the VIX is saying about the stock market's 2004 prospects.
mean-reverting phenomenon.

You can purchase and download past articles at
For information on the author see p. 6. http://www.activetradermag.com/purchase_articles.htm.

FUTURES & OPTIONS TRADER • December 2007 19

 TRADING STRATEGIES

Options and risk management

A simple adjustment allows you to apply traditional risk-control techniques to options trades.

BY RICK SWOPE AND A.J. MONTE

O ne of the biggest challenges traders face is

keeping their emotions out of trade deci-
sions. Professional traders often rely on col-
leagues to help them control risk, but most
traders are on their own. No one is reminding you to exit
trades or reduce risk before the close each day, so you are
more likely to hold losing positions overnight.
ficult because of wider bid-ask spreads, time decay, and
complex, multi-leg positions that take time to unwind. The
following example illustrates how to limit a trade’s risk to
one percent of account value using standard money man-
agement techniques, such as position sizing (e.g., determin-
ing how many shares of stock to trade by calculating per-
share risk). This approach is translated to option positions
Managing risk is fairly straightforward for stock and by using each option’s delta to determine how many con-
futures traders, who can simply set stop-loss orders and exit tracts to trade.
trades without too much slippage. If you trade highly liquid
stocks, for instance, you can often exit trades within pennies The one-percent rule
of your stop price. The one-percent rule for managing risk limits your loss on
For options traders, however, controlling risk is more dif- a trade to one percent of total account value. This rule is
especially helpful when you
apply it to an entire portfolio.
FIGURE 1 — SUPPORT AND THE ONE-PERCENT RULE If, for example, you are hold-
Hansen Natural Corp. bounced off support on Oct. 22 and traded around $64 on Oct. ing five positions and are
25. If you placed a stop-loss order below support at $61, you would risk $3 per share. stopped out of all of them,
your entire portfolio won’t
lose more than five percent.
It’s not always possible to
limit risk to one percent
because markets sometimes
open much higher or lower
than their previous closing
price. Such large opening gaps
typically appear after surpris-
ing (good or bad) news hits the
Street; they can hurt a trade
before you get a chance to exit.
Despite this caveat, the one-
percent rule allows you to set a
predetermined exit point for
each position. Consider an
example of how to use this rule
when trading stocks and
Source: eSignal
futures. To calculate the risk

20 December 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — TRIGGERING THE STOP-LOSS
amount based on a $100,000
account: Hansen Natural failed to break above resistance around $68.50 and fell 10.9 percent to
the $61 stop-loss by Nov. 5.
Risk amount = 1 percent
of account value = 0.01 *
$100,000 = $1,000

Notice you do not know any-

thing about the actual trade at
this point. This is an important
point, because many new
traders mistakenly believe they
should exit after a position
moves against them by one per-
cent. However, the one-percent
rule is only applied to account
equity and is just a first step.
The second step is to identify
the risk per share. Figure 1
shows Hansen Natural Corp.
(HANS) fell in late October Source: eSignal
before rising from the $62 sup-
port level that began to form
earlier that month. 1:50 p.m. ET on Nov. 5. Ideally, you LEVERAGE and LIQUIDITY PARTNERS
Suppose you bought HANS at $64 should have exited this trade when • Brings you a Basic Options Training Seminar
on Oct. 25. Because there is support Hansen Natural failed to break above for only $1950.00!
around $62, you might place a sell stop resistance — a bearish sign. But even if • Broaden your Financial Horizons!
at $61, just below that level. The risk you held HANS when it tanked in Learn to trade Options!!
per share would be: early November, your loss would have • Classes offered by an acclaimed professor
of graduate-level finance at two Chicago
been capped at $1,000. universities, who is also a veteran floor trader.
Risk per share = entry price
Here is an opportunity for anyone with only
($64) - stop price Applying the rule to options modest means, regardless of past experience,
($61) = $3 per share You can use this same risk-manage- to acquire the knowledge and tools necessary to:
ment approach with options by using 1. Enhance yield on existing investments.
The final step is determining posi- delta to adjust the per-share risk. OR
tion size to calculate how many shares Instead of buying HANS at $64 on 2. Generate substantial supplemental income.
OR
to trade by dividing the risk amount Oct. 25, you could have bought one
3. Make a consistent living
by the risk per share: June 2008 55 call option. The call cost
Each goal depends on your chosen degree of
$16.20, included about $9 of intrinsic
focus and commitment. All of the fundamentals of
Position size = risk amount value, and expired in eight months. Equity and Index options will be covered along with
($1,000)/risk per share ($3) = Table 1 shows the trade’s details. To proven Strategies. Even more experienced traders
333 shares apply the one-percent rule to this can benefit from this course.
trade, multiply the call’s 0.70 delta by Commencing in January 2008, the class will be held at
the Marriott Courtyard Chicago Downtown/River North
This means you could trade up to the $3 risk per share amount. (It is 30 East Hubbard Street, Chicago; four three hour
333 shares of Hansen Natural, assum- more precise to account for delta’s segments are scheduled for the evenings of the 15th,
ing you had a $100,000 account and change [gamma] as HANS price falls, 17th, 22nd, 24th. 6pm to 9pm; Parking available.
risked $3 per share. but the “static” delta value of 0.70 pro- Payment method: Personal checks/cashier checks
and money orders. Personal checks will be accepted
Figure 2 shows HANS rallied vides an adequate estimate.) If HANS through January 8, thereafter cashier checks and
toward a resistance level around dropped from $64 to $61, the call’s bid money orders only.
$68.50 on Oct. 31 and failed to break should decline from $15.70 to $13.60, Mail to: 21 E. Chestnut, Suite 3F • Chicago, IL 60611
above it. Price then fell 10.9 percent to because a $3 per-share drop should Please email questions to:
$61 and triggered the sell-stop order at continued on p. 22 [email protected]

FUTURES & OPTIONS TRADER • December 2007 21

 TRADING STRATEGIES continued

roughly equal a $2.10 decrease (0.70 delta * $3) in the call’s Notice the November call’s risk and position size make it
bid. Based on an exit price of $13.60, the call’s risk is $2.60, nearly identical to an outright stock position because its
and you could buy up to 385 shares or four calls and still bid-ask spread is tighter than the June call’s by $0.10 and its
limit your total loss to $1,000. delta is larger.
Alternately, you could have bought a (front-month) Instead of simply buying a call, you could enter a diago-
November 2007 55 call option for $10.90 (Table 2). This nal call spread by buying one June 55 call for $16.20 and
option had a delta of 0.85. To apply the one-percent rule, selling one out-of-the-money (OTM) November 70 call for
first calculate the exit price of $7.95 ($10.50 bid - [0.85 delta $2.25. Selling the OTM front-month call lowers the overall
* $3 risk]). Based on this exit price, the option’s risk is $2.95, cost to $13.95 (and also reduces the risk), although it caps
and you could buy up to 339 shares, or just three calls. the maximum gain (at the first expiration).

TABLE 1 — LIMITING RISK ON OPTIONS

You could buy up to four June 2008 55 calls on HANS for $16.20 each and still limit risk to 1 percent of total assets.

Component Long/short Bid-ask Delta Per-share credit/debit Dollar cost

1 June 2008 55 call Long $15.70-$16.20 0.70 -$16.20 -$1,620.00

Exit price: $13.60 = $15.70 - (0.70 delta * $3 risk amount)

Risk per share: $2.60 = $16.20 - $13.60
Position size: 385 shares = $1,000 risk amount / $2.60 risk per share

TABLE 2 — LIMITING RISK ON SHORTER-TERM OPTIONS

Buying up to three November 2007 55 calls for $10.90 each limited risk to 1 percent of total assets.

Component Long/short Bid-ask Delta Per-share credit/debit Dollar cost

1 November 2007 55 call Long $10.50-$10.90 0.85 $10.90 -$1,090

Exit price: $7.95 = $10.50 – (0.85 delta * $3 risk amount)

Risk per share: $2.95 = $10.90 - $7.95
Position size: 339 shares = $1,000 risk amount / $2.95 risk per share

TABLE 3 — DIAGONAL CALL SPREAD

You could buy up to four June/November call diagonal spreads for $13.95 each without risking more 1 percent of total assets.

Components Long/short Bid-ask Delta Per-share credit/debit Dollar cost

1 June 2008 55 call Long $15.70-$16.20 0.70 -$16.20 -$1,620.00
1 November 2007 70 call Short $2.25-$2.50 0.10 $2.25 $225.00

Net debit at entry: $13.95

Exit price of June 2008 55 call: $13.60 = $15.70 - (0.70 delta * $3 risk amount)
Exit price of November 2007 70 call: $2.20 = $2.50 - (0.10 delta * $3 risk amount)
Net credit at exit: $11.40 = $13.60 - $2.20
Risk per share: $2.55 = $13.95 - $11.40
Position size: 392 shares (4 options contracts) = $1,000 risk amount / $2.55 risk per share

22 December 2007 • FUTURES & OPTIONS TRADER

 Related reading
Table 3 shows how to apply the Risk control and money management articles:
one-percent rule to this diagonal
“Principles of risk control and money management”
spread. If HANS broke below support Active Trader, January 2003.
at $62 and you unwound the spread at While some traders argue various aspects of trading are more art than sci-
$61, the spread’s exit price would be ence, that’s not the case with basic risk control and money management con-
$11.40. Based on this price, the cepts. Learn three rules of position sizing, capital allocation, and stop place-
spread’s risk per share is $2.55 ($13.95 ment that illustrate the principles of objective trading.
cost - $11.40 exit). Accordingly, you
can trade up to 392 “shares” ($1,000 / “Putting stops to the test,” Active Trader, March 2002.
$2.55) or four contracts per leg. Placing stops effectively requires understanding how your strategy, trade size
and account equity interact. Here’s an approach that allows you to systemati-
cally find the best stop for your trading system.
The elephant in the room
You can modify the one-percent rule “No such thing as bad luck,” Active Trader, January 2002.
several ways, including accounting Ideally, you should risk the same percentage of your capital on every trade.
for gamma if the stop level is signifi- But determining that figure isn’t as straightforward as it sounds. Here’s how to
cantly different from the entry price. If find the right amount to risk for your strategy and how you can increase your
your stock’s stop level is several dol- odds of success.
lars and your option has a high
gamma, then focusing on a fixed delta “Finding the right amount,” Active Trader, December 2001.
Luck plays a role in even the best trader’s career. But limiting the role of luck
may not be the best way to estimate
— especially bad luck — means controlling as many risk factors as possible.
premium at the stop-loss. Although Sizing your trades appropriately is one way to do it.
there are countless ways to manage
risk, the point is to have a system and “Reining in risk,” Active Trader, July 2000.
stick to it. A look at fundamental money-management concepts, tools, and ideas on how
When managing risk, we must con- to implement them.
stantly battle our skewed perception
of the risks we face. In his book Options articles:
Against the Gods: The Remarkable Story
of Risk, Peter Bernstein relates this “Long-term diagonal call spreads”
Futures and Options Trader, November 2007.
story:
This detailed look at diagonal spreads shows how to trade them with a long-
term perspective.
One winter night during one of the
many German air raids on Moscow “Delta for the rest of us,” Options Trader, October 2006.
in World War II, a distinguished A few simple concepts shed light on delta and how option prices change.
Soviet professor of statistics showed
up in his local air-raid shelter. He “Selecting calls based on ROI,” Options Trader, October 2006.
had never appeared there before. Traders seem drawn to complex options strategies, but sometimes simply buy-
“There are seven million people in ing calls is the best way to catch an up move. Learn how to weigh the possibil-
ities by comparing various calls’ return on investment.
Moscow,” he used to say. “Why
should I expect them to hit me?” “Speculating with stock options,” Options Trader, April 2006.
His friends were astonished to see Many option traders scoff at the notion of buying calls instead of simply going
him and asked what had happened long the underlying market, but in the right circumstances, options can offer
to change his mind. “Look,” he distinct advantages.
explained, “there are seven million
people in Moscow and one ele- Several of these articles are included in the “Risk Control and Money
phant. Last night they got the ele- Management” collection of 22 articles that offer a variety of strategies for limit-
phant.” ing risk, maximizing profit, and managing trades — regardless of your particu-
lar trading approach. Topics range from nuts-and-bolts discussions about the
number of shares or contracts to trade and stop placement to more advanced
Ultimately, if you manage risk at concepts such as diversification between multiple trading systems, MAE-MFE
some level, you will accept small loss- analysis, Optimal f, and Monte Carlo simulations.
es and move on to the next trade
instead of letting those losses threaten This collection is 30 percent off the regular price.
your livelihood.
You can purchase and download past articles at
http://www.activetradermag.com/purchase_articles.htm.
For information on the authors see p. 6.

FUTURES & OPTIONS TRADER • December 2007 23

 OPTIONS TRADING SYSTEM LAB

Trading credit spreads

with the MACD
Market: Options on the S&P 500 FIGURE 1 — RISK PROFILE — BEAR CALL SPREAD
futures (SP). This system could also be This bear call spread included a short June 1,580 OTM call and a long June
applied to other stock-index futures, 1,630 call. To be profitable, the June S&P 500 futures contract must close
indices, and exchange-traded funds below 1,580.85 at expiration on June 15.
(ETFs) with liquid options contracts.

System concept: Vertical credit

spreads are popular because they limit
risk and allow you to make money
even if your directional forecast is
imprecise. Past Options Labs have
entered credit spreads based on a vari-
ety of technical indicators, including
moving averages, stochastics, and the
Average Directional Movement Index
(ADX).
This system compares new 20-day
highs and lows with Moving Average
Convergence Divergence (MACD)
readings to identify bullish or bearish
signals. A bullish divergence signal
occurs when price drops as the MACD
rises, while a bearish divergence signal
appears when price climbs as the
MACD declines. Standard parameters
Source: OptionVue
(12-26-9) were used.
After a signal triggers, the system
enters a credit spread by first sell- FIGURE 2 — PERFORMANCE
ing an option one standard devia- This system was consistently profitable, but each losing trade meant a substantial
tion out-of-the-money (OTM). Then loss of capital.
the system buys a farther OTM
option of the same type. The mar-
ket would need to reverse direction
by more than a full standard devia-
tion before the trade is stopped out
— a relatively unlikely event.
Figure 1 shows possible gains
and losses of a June 1,580/1,630 call
credit spread entered on May 23,
2007. The trade would be profitable
as long as the S&P 500 futures trade
below 1,580.85 by the June 15 expi-
ration date. The spread has a 76-
percent chance of capturing the
maximum potential gain of $213,
but it also has a very poor risk-
reward ratio: If the S&P 500 jumps
dramatically, the trade could lose
Source: OptionVue
up to $12,287 if it isn’t stopped out.

24 December 2007 • FUTURES & OPTIONS TRADER

 STRATEGY SUMMARY

Net gain: $5,100.00

Trade rules:
Percentage return: 34.0%
Annualized return: 5.6%
1. Enter an OTM bull put spread on the first up close
No. of trades: 22
after price drops to a new 20-day low and the MACD
Winning/losing trades: 19/3
fails to fall to a new 20-day low.
Win/loss: 86%
Avg. trade: $231.82
2. Enter an OTM bear call spread on the first down close
Largest winning trade: $2,038.00
after price climbs to a new 20-day high and the
Largest losing trade: -$4,011.50
MACD fails to rise to a new 20-day high.
Avg. profit (winners): $666.29
Avg. loss (losers): -$2,519.83
3. Construct each credit spread with options in the first
Avg. hold time (winners): 37
expiration month that don’t expire for at least 21
Avg. hold time (losers): 20
days by:
Max consec. win/loss : 10/1
a. Selling an OTM option that lies one strike beyond
the first standard deviation. This is determined bear call spreads had a very small potential reward relative
with a probability calculator and the implied to the risk.
volatility of the at-the-money (ATM) call as an Instead of trading both types of spreads, you might want
input. to focus on bull put spreads because they can deliver larger
gains. Another idea is to exit a spread after a set percentage
b. Buying a same-type option with a strike that is 50 loss rather than waiting for the market to hit the short
points farther OTM. (Although this system strike.
followed strict rules, you don’t have to use the Note: This test included minimal commissions, but larg-
same point spread each time; just ensure the net er fees and bad fills will likely reduce performance.
credit is sufficient.)
— Steve Lentz and Jim Graham of OptionVue
4. Exit the spread if the S&P 500 futures touches the
short option’s strike. Otherwise, let the credit spread LEGEND:
expire worthless. Net gain/loss – Gain or loss at end of test period, less
commission.
Test details: Percentage return – Gain or loss on a percentage basis.
Annualized return – Gain or loss on an annualized percentage
• The test account began with $15,000 in capital. basis.
• One-lot spreads were traded each time. No. of trades – Number of trades generated by the system.
• Daily closing prices were used. Trades were executed Winning/losing trades – Number of winners/losers generated
between the bid and ask, when possible. Otherwise, by the system.
theoretical prices were used. Win/loss (%) – The percentage of trades that were profitable.
• Multiple signals: Bullish signals were ignored if a bull Avg. trade – The average profit for all trades.
put spread was already open. Bearish signals were Largest winning trade – Biggest individual profit generated
ignored if a bear call spread was already open. by the system.
• Commissions were $6 per option. Largest losing trade – Biggest individual loss generated by
the system.
Test data: The system was tested using options on the Avg. profit (winners) – The average profit for winning trades.
S&P 500 futures (SP) at the CME. Avg. loss (losers) – The average loss for losing trades.
Avg. hold time (winners) – The average holding time for winning
Test period: May 21, 2001 to June 15, 2007. trades.
Avg. hold time (losers) – The average holding time for losing
Test results: Figure 2 shows the strategy gained $5,100 trades.
(34 percent) in the six-year test period. This trading sys- Max consec. win/loss – The maximum number of consecutive
tem’s win-loss ratio was 86 percent, so it had a definite edge winning and losing trades.
in that department.
However, the average losing trade ($2,519.83) was nearly Option System Analysis strategies are tested using OptionVue’s
four times as large as the average winner ($666.29) — a poor BackTrader module (unless otherwise noted).
risk-reward ratio that would concern any trader. The sys- If you have a trading idea or strategy that you’d like to see tested,
tem tended to enter bear call spreads that often collected far please send the trading and money-management rules to
less premium than its put spreads. In short, each of those [email protected].

FUTURES & OPTIONS TRADER • December 2007 25

 TRADING BASICS

Options
exercise and assignment
If you are new to options, you need to learn the rules behind exercise and assignment.
This guide explains how to avoid mistakes on expiration day.

BY FOT STAFF

W henever you hold an option just before it

expires, you face a dilemma: Should you
close it or exercise it?
Options holders can exercise and options sellers are sub-
ject to their actions. If you buy an option, you can exercise
Table 1 shows the mechanics of exercise and assignment.
If you buy a call, you can exercise it and purchase the
underlying at the strike price; but if you sell it, you may be
forced to sell the underlying at the strike, which could be
expensive if the strike is well below market value.
that right and convert it into an underlying position. But if The first step is to determine whether an option is in-the-
you sell an option, you can be assigned, which means you money (ITM), which represents the difference between its
are obligated to either buy or sell the underlying if a call or strike and the underlying’s current price. A call is ITM if its
put holder exercises before expiration. strike is below the market.
Most traders prefer to close trades by selling long options For example, Adobe Systems (ADBE) closed at $42.13 on
or buying back short ones. Indeed, only 10 percent of all Nov. 16 — the day before November options expired. The
options are exercised and converted into underlying posi- November 40 calls were ITM, because you could exercise
tions, according to the Chicago Board Options Exchange them to buy ADBE at $40, sell shares at $42.13, and capture
$2.13 in value. By contrast, the November 42.50
calls were out-of-the-money (OTM) and expired
TABLE 1 — EXERCISE AND ASSIGNMENT
worthless. You would have lost money if you
Buying an option gives you the right to buy or sell the underlying exercised them to buy ADBE at $42.50 and then
instrument for a specific period, while selling one may force you to sold shares at $42.13.
take the opposite position in the underlying instrument. On the other hand, if you sold November 40
Calls Puts calls short and held them until Nov. 16, they
would be assigned, forcing you to sell Adobe at
Exercise Buy underlying at strike Sell underlying at strike
$40 and buy it back at $42.13 — a loss of $2.13
Assignment Sell underlying at strike Buy underlying at strike per share.
Table 1 shows that puts reverse the exercise
and assignment process. When ADBE closed at
(CBOE). But although traders rarely exercise options, you $42.13 on Nov. 16, the November 40 puts were OTM and
still need to understand how the exercise and assignment expired worthless; exercising those puts to sell Adobe at $40
process works, because it has opportunities and risks that — below the market price of $42.13 — doesn’t make sense.
could make or break your trade. However, the November $42.50 puts were ITM, so you
could have exercised them to sell ADBE at $42.50, buy
Exercising your rights shares back at $42.13, and capture $0.37. Put sellers lost the
A call option offers the right to buy the underlying instru- same amount when November $42.50 puts were assigned,
ment at the strike price before it expires. By contrast, a put because they had to buy Adobe at the $42.50 strike, or $0.37
option includes the right to sell the underlying at the strike above its Nov. 16 price.
price before it expires. The same concepts apply to index options, but they are

26 December 2007 • FUTURES & OPTIONS TRADER

 TABLE 2 — CASH-SETTLED INDEX OPTIONS
cash-settled, so you receive a payment when
exercising a long option, and you owe money if Index options are settled in cash, so you collect money when you
you are assigned on a short option position (see exercise one but you pay it when assigned.
Table 2).
Cash-settled index options (calls or puts)
Stock options have American-style exercise,
which means they can be exercised or assigned Exercise Receive cash
anytime before expiration. However, index Assignment Pay cash
options can also have European-style exercise,
whereby options are only exercised or assigned
on expiration day. Many option sellers prefer European- and its December 5 call, expiring Dec. 15, cost $1.15. If you
style options because there’s no risk of assignment — i.e., exercise E*Trade’s 5 call, you will buy ETFC at the $5 strike
option holders can’t exercise their options until expiration price and capture $0.33. But you lose the call’s time value of
day. $0.82 ($1.15 - $0.33 intrinsic value), so selling the call for
$1.15 is more profitable.
Intrinsic vs. time value Options probably won’t be assigned before expiration
An option’s premium has two main parts: Intrinsic value, unless they are ITM and their time value is close to zero. But
which represents the amount it is ITM, and time value, holders of American-style options can exercise them at any
which is often used to describe a combination of its other time, so options sellers are always at risk of assignment,
pricing variables (i.e., time to expiration, implied volatility, especially put sellers.
interest rates, and dividends). Traders will exercise an option early if this step adds
If an option still has time value, traders typically don’t value or saves money. For example, DuPont (DD) closed at
exercise it because that value will disappear. For instance, $44.69 on Nov. 23, and its December 50 put’s bid was $5.30.
E*Trade Financial Corp (ETFC) closed at $5.33 on Nov. 23, continued on p. 28
 TRADING BASICS continued

TABLE 3 — AUTOMATIC EXERCISE AMOUNTS

Related reading
Any stock option that is slightly ITM at expiration Friday’s
close is automatically exercised by the OCC, which can be a
Articles:
hassle if you want it to expire worthless. Remember to tell “Short selling basics”
your broker if you don’t want to exercise an option. Active Trader, December 2007.
Short selling allows you to profit when the market is going
In-the-money amount down, but traders who use margin need to be especially
aware of the potential drawbacks.
Stocks $0.05 or more
Cash-settled index options $0.01 or more “Options margin explained”
Options Trader, September 2005.
Options margin requirements vary widely across the
This ITM put traded near its intrinsic value, so if you held a industry and can affect a trade's profitability. Find out how
short 50 put, it might have been assigned even though it to limit the capital needed to place a trade.
wouldn’t expire for three weeks. If the put’s owner also
The options margin article is included in the Options
held shares of DuPont, they could exercise that put, sell DD Basics collection, Volume 1, a discounted, nine-article set
at 50, and pay just one commission instead of two (sell put, of past Options Trader and Active Trader articles that
sell underlying). encompasses options terminology, fundamental trading
Another reason to exercise early is to capture a dividend. concepts and simple strategies, as well as practical con-
If an ITM call contains no time value the day before a stock siderations such as margin. This is a collection designed
pays dividends, call holders will sell it before it opens lower for those new to options trading, whether in stock or
the next day by the dividend’s amount. futures.

Exercise and assignment costs You can purchase and download past articles at
Exercising an option requires additional capital, which is http://www.activetradermag.com/purchase_articles.htm.
why some traders avoid it. Suppose a stock trades at $50,
and you buy a 55 call that expires in two months for $0.50. Book:
If the stock climbs to $56 and the 55 call moves ITM, you McMillan on Options by Lawrence G. McMillan
need an additional $5,000 to exercise it and buy 100 shares. (John Wiley & Sons, 2004).
Moreover, exercising a put to sell 100 shares can be a has-
sle if you don’t already own them, because your broker Webcast:
must find shares to borrow first. “The ins and outs of exercise and assignment”
Capital requirements are even more troublesome for http://www.cboe.com/LearnCenter/webcast/archive.aspx
options sellers if they get assigned. For example, you might
have enough cash to sell a call (or put), but not enough to
sell (or buy) stock if it’s assigned. If this happens, your bro- 4:30 p.m. ET. Although your short puts seem poised to
ker will charge commissions and margin interest. expire worthless, a trader who held those puts could exer-
cise them at 4:45 p.m. to sell shares at $100. Instead of just
Expiration day and automatic exercise keeping the short put’s premium, you would be assigned
Holding an options position on the Friday before expiration and forced to buy shares at $100 on Monday morning,
can be risky, even if you bought options that are set to which could be painful if the stock tanked at the open.
expire worthless. There are two rules you need to know: Finally, don’t simply assume near-the-money long
Traders can exercise options up to 90 minutes after the close options will expire worthless. If you bought November 105
on expiration Friday, and the Options Clearing Corporation puts on International Business Machines (IBM), and they
will automatically exercise any stock options that are ITM were priced at $0.20 at 3:45 p.m. on expiration Friday, you
by as little as $0.05 (see Table 3). might decide it’s not worthwhile to buy them back (after
Most brokers let you exercise options up to an hour after commissions).
the close on expiration Friday (5 p.m. ET). Ignoring this However, IBM closed at $104.79 on Nov. 16, so those 105
detail can lead to trouble, because any news that happens puts were ITM by $0.21, and the OCC would have exercised
between the close and this deadline can affect your position. them and sold 100 shares at $105 automatically. Luckily,
Suppose you sold 100-strike puts on a stock that closed at avoiding automatic exercise is easy — just tell your broker
$110, and the company released disappointing earnings at to let them expire worthless.

28 December 2007 • FUTURES & OPTIONS TRADER

 INDUSTRY NEWS

A longer whip, a larger purse

CFTC wants to beef up

BY JEFF PONCZAK AND JIM KHAROUF

T he Commodity Futures
Trading Commission (CFTC)
has long been the ignored
stepchild of U.S. regulators. The
Securities and Exchange Commission
Congress to increase its clout in han-
dling energy trades, whether they
occur at a regulated exchange or not.
A congressional study on the
Amaranth collapse found that over-
kets,” CFTC Chairman Walt Lukken
told Congress.
Lukken also wants the CFTC to
have the authority to disrupt cash or
physical settlement of futures con-
(SEC) has a bigger budget, a bigger the-counter trades made on the tracts in emergency situations, and
staff, and greater authority from IntercontinentalExchange (ICE) — wants to ensure that non-regulated
Congress. which expedited Amaranth’s demise exchanges have a self-regulation plan
Because the SEC has always had — had a significant impact on prices at in place.
jurisdiction over stocks and options the regulated New York Mercantile The CFTC boss believes the changes
and the CFTC has overseen futures Exchange (NYMEX). will give his group greater oversight
(although it is trying to expand its Amaranth switched its trading from while not being overly restrictive to
sphere of influence to include forex), the NYMEX to the ICE when it electronic exchanges to the point of
the inequity was understandable. reached volume limits on the NYMEX. driving them overseas.
Until relatively recently, the U.S.’s The ICE had no volume restrictions, Over-the-counter transactions are
financial world has been dominated but the CFTC wants that to change. exempt from CFTC regulation because
by companies and individuals who “Changes to the Commodities of a rule known as the “Enron
owned stock, and futures were some- Exchange Act (the bill that actually reau- Loophole.” The loophole exists
thing left to farmers and traders who thorizes the CFTC) are necessary in because lobbying on the part of Enron
had doctorates in applied mathemat- order for the commission to detect and — before it collapsed — convinced
ics. prevent manipulation in these mar- lawmakers these markets needed to be
However, the advent of financial
futures — and particularly interest-
rate futures and stock-index futures MANAGED MONEY
— changed that. Futures became
more mainstream, and long-time Top 10 option strategy traders ranked by October 2007 return.
stock traders ditched the moribund (Managing at least $1 million as of Oct. 31, 2007.)
stock market to participate in 2007
futures. September YTD $ under
Also, over the past few years, Rank Trading advisor return return mgmt.
increased interest in energy futures 1. Parrot Trading Partners 14.75 26.69 12.4M
— particularly crude oil and natural 2. Ascendant Asset Adv. (Strategic2) 10.86 45.80 36.3M
gas — has brought those markets to
3. Singleton Fund 9.62 52.35 17.0M
the forefront, and institutional use of
futures has never been greater. 4. Aksel Capital Mgmt (Growth & Income) 8.46 -22.36 3.9M
However, the SEC still gets the 5. Ascendant Asset Adv. (JLDeVore) 7.17 75.81 7.3M
bulk of the attention from Congress, 6. Solaris Market Neutral Fund LP 6.76 23.71 1.7M
and the CFTC is often left to make
7. ACE Investment Strat. (SIPC INST) 5.58 -10.70 29.5M
due with inadequate resources.
How much of the 2006 collapse of 8. Welton Investment (Alpha Leveraged) 5.23 1.96 4.0M
the Amaranth Advisors hedge fund, 9. LJM Partners (Neutral S&P Option) 4.02 7.48 119.9M
which lost $6 billion, could have 10. BC Capital Management 3.96 -0.04 9.8M
been avoided if the CFTC had more
Source: Barclay Hedge (http://www.barclayhedge.com)
authority in that area is unclear.
Based on estimates of the composite of all accounts or the fully funded subset method.
Nonetheless, the CFTC wants to Does not reflect the performance of any single account.
make sure it doesn’t happen again. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
In late October the CFTC asked

30 December 2007 • FUTURES & OPTIONS TRADER

exempt from regulation. potential consolidation of the CFTC hand, Penson calls for a division that
The U.S. Senate and the U.S. House and SEC just for consolidation’s sake. would focus on capital formation that
already have bills submitted that “While all ideas should be thought- includes regulation of public compa-
would close the loophole. fully considered, in my view, policy- nies using rules-based principles. The
The NYMEX and the ICE are both in makers should first focus on how we other division would focus on market
favor of market reforms and increased regulate rather than who is regulat- participation, conduct, and market
CFTC power. The NYMEX says it’s ing,” Lukken said at the Futures integrity, using principles-based rules.
important that regulated products Industry Association (FIA) Expo in Variations of this structure,
aren’t in direct competition with simi- Chicago in November. “No matter the Hehmeyer points out, are already in
lar or identical products on unregulat- Washington zip code, our agencies use in Australia and the Netherlands.
ed markets, while the ICE says it has have differing public missions and While the issue has more traction
always believed some sort of regulato- approaches to regulation. Although than it has in years, most expect it to be
ry certainty for over-the-counter mar- not as eye-grabbing as discussions of a discussed for at least a couple of more
kets was a good thing. merger, reconciling these differences in years before any significant changes
how we regulate should be the first are brought by Congress. In the end,
SEC-CFTC merger focus of our attention.” traders could benefit from this regula-
talk heats up Lukken and others have said that tory change by being able to trade
As the CFTC attempts to solidify its principles-based regulation for both stocks, futures, and options from a sin-
future, momentum is building among agencies at some level is the right way gle account; portfolio margining of
market participants for a major over- to go. Whether the SEC and Congress positions; and a faster rollout of new
haul of the entire U.S. securities and are able to make that switch from set contracts from exchanges.

futures regulatory structure. rules to more flexible rule making and
This topic has been bandied about oversight is a big issue and is fraught
for years, with many calling for a with several challenges. Changing the
merger of the SEC and the CFTC. SEC culture of rather slow and distant
Frustration for exchanges, firms, and interaction with exchanges may be
customers has grown because they are even harder, says Bill Brodsky, chair-
often faced with overlapping and man and CEO of the Chicago Board
sometimes conflicting regulation, as Options Exchange.
well as the practical problem of sepa- “I’m for principles-based regula-
rating securities and futures accounts. tion,” Brodsky says. “But principles-
This comes at a time when trading is based regulation doesn’t solve the
getting more international and more issues between the two agencies. I’m
traders are trading across multiple not advocating a merger of the two
asset classes. The short answer has agencies. There should be a fresh look
always been to merge the SEC and the at the whole thing, which goes way
CFTC. beyond the merger.”
But in the wake of the U.S. Treasury John Damgard, president of the FIA,
Department’s summer study on agrees.
streamlining the U.S. regulatory struc- “There are Congressional turf issues
ture and its request for comments on and attitudinal problems at the vari-
the topic in November, firms, ous committees — banking and agri-
exchanges, and regulators appear to be culture — [that oversee the SEC and
taking a different approach. Now CFTC, respectively],” he says.
many are calling for the SEC to adopt Chris Hehmeyer, CEO of securities
the CFTC’s method of oversight, called and futures broker Penson GHCO,
“principles-based regulation,” which calls for a merger of the CFTC and SEC
allows for more flexible, case-by-case under a proposed “Twin Peaks” struc-
rule interpretation. ture, bringing the two under one roof
Lukken cautioned Congress about but separating their duties. On one

FUTURES & OPTIONS TRADER • December 2007 31

 INDUSTRY NEWS continued

Some afraid of the dark

Nasdaq options pricing sparks debate

BY JIM KHAROUF

T he issue of Nasdaq’s options pricing sparked

debate among long-time options exchange leaders
at the November Futures Industry Association
Expo in Chicago.
The Nasdaq, which planned to launch its exchange in
The Nasdaq refers to this as “Price Improving Orders”
and considers it a different approach to the Price
Improvement Period (PIP) offered at the Boston Options
Exchange and the Price Improvement Mechanism at the
International Securities Exchange (ISE), both of which also
December pending regulatory approval, will introduce a improve orders using penny-pricing auctions.
price-time order book and allow customers to enter option “I think you can separate a PIP type of liquidity from a
prices in penny increments, even though trades will be display order,” says Adam Nunes, Nasdaq vice president of
filled in nickel and dime increments. transaction services. “And on those [display orders], we’ve
For example, customers theoretically will be able to enter seen them in equities. What they have done is provide a tool
a bid at $1.02 for an offer of $1.05. That order will be dis- for institutions to get size done without showing their
played at $1.00 even though the bid is $1.02. If the offer falls hand.”
to $1.00, the trade is executed and the seller gets a two-cent That sparked a strong rebuke from David Krell, CEO of
price improvement. the ISE who will retire and assume the role of ISE chairman

Options Watch: High-volume stocks (as of Nov. 27)

Compiled by Tristan Yates
The following table summarizes the expiration months available for 15 stocks with the largest options volume. It also shows each index's average bid-ask spread for at-
the-money (ATM) December options. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of potential slippage in each
option market.
Option contracts traded
2007 2008 2009 2010
March

June
April
Dec.

Feb.
Jan.

July

Jan.

Jan.
May

Bid-ask spreads

Bid-ask
spread as %
Closing of underlying
Index Sym Exchange price Call Put price
Google GOOG NA X X X X X X 673.57 0.35 0.63 0.07%
Goldman Sachs Group GS NA X X X X X X 213.33 0.33 0.28 0.14%
Bank of America BAC NA X X X X X X 42.94 0.09 0.08 0.19%
Baidu.com BIDU NA X X X X X X 341.34 0.63 0.75 0.20%
McDonald's MCD NA X X X X X X 57.46 0.14 0.11 0.22%
Freeport-McMoRan C&G FCX NA X X X X X X 89.28 0.23 0.21 0.25%
Lehman Bros Holdings LEH NA X X X X X X 59.90 0.18 0.15 0.27%
Merrill Lynch MER NA X X X X X X 53.07 0.14 0.16 0.28%
America Movil AMX NA X X X X X X 56.27 0.09 0.24 0.29%
EMC Corp EMC NA X X X X X X 18.19 0.06 0.06 0.34%
American Intl Group AIG NA X X X X X X 54.49 0.20 0.20 0.37%
Comp Vale do Rio Doce RIO NA X X X X X X 31.20 0.13 0.11 0.38%
Crocs CROX NA X X X X X X 36.87 0.20 0.18 0.51%
Washington Mutual WM NA X X X X X X 17.20 0.11 0.09 0.58%
Countrywide Financial CFC NA X X X X X X 8.97 0.06 0.08 0.77%
Legend:
Call: Four-day average difference between bid and ask prices for the front-month ATM call.
Put: Four-day average difference between bid and ask prices for the front-month ATM put.
Bid-ask spread as % of underlying price: Average difference between bid and ask prices for front-month, ATM call and put divided by the underlying's closing price.

32 December 2007 • FUTURES & OPTIONS TRADER

at year-end. Krell believes that placing an order for $1.02 displays such as Nasdaq’s, since such penny displays will
but displaying the price as $1.00 is misleading to market not be available to all customers.
participants and takes away price transparency from the “Hidden liquidity opens up opportunities for gaming,
market. internalizing, and being exposed to things they didn’t see,”
“We think that’s absolutely the wrong way to go,” Krell says Mike Bickford, AMEX vice president, who adds that
says. “We have been trying for the past 30 years as an indus- Nasdaq’s proposed market model will increase quote traffic.
try to have the most liquid markets, the best displayed size, Sandy Frucher, CEO of the Philadelphia Stock Exchange,
and greatest transparency. They are moving to make the which was recently purchased by the Nasdaq, says dark
markets more opaque, [and] we think that’s the wrong pools are a concern for the industry and called on the
direction.” Securities and Exchange Commission (SEC) to step in.
Some exchange leaders are concerned the Nasdaq’s “The fact is markets have evolved and technology is a big
moves are creating an environment for liquidity “dark part of that evolution,” Frucher says. “Dark pools are a train
pools” to emerge in options. The debate over dark pools is wreck waiting to happen and we need guidance from the
ongoing. Some market participants believe such pools in SEC. I don’t think laissez faire is the way to go.”
the options market will never reach the same level as those The SEC is still analyzing the Nasdaq’s market model
found in the equities market because option orders still and some sources say the regulator has some reservations
have to be executed on an options exchange and cleared by about the Price Improving Orders model. That could delay
the Options Clearing Corporation. the launch of the new exchange, the seventh U.S. equity
Critics say dark pools are being created through pricing options exchange.

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FUTURES & OPTIONS TRADER • December 2007 33

 FUTURES SNAPSHOT (as of Nov. 28)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute
trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility.
See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and
may not reflect total volume for all contract months.
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures
is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
E- Pit 10-day % 20-day % 60-day % Volatility
Market sym sym Exch Vol OI move rank move rank move rank ratio/rank
E-Mini S&P 500 ES CME 2.10 M 2.02 M -0.86% 17% -4.26% 56% -1.28% 13% .41 / 54%
10-yr. T-note ZN TY CBOT 1.37 M 2.35 M 1.71% 65% 2.65% 79% 3.78% 68% .29 / 58%
5-yr. T-note ZF FV CBOT 718.4 1.72 M 1.01% 45% 1.91% 80% 2.90% 68% .27 / 53%
E-Mini Nasdaq 100 NQ CME 504.1 435.8 1.39% 29% -5.51% 29% 3.49% 22% .26 / 29%
Corn ZC C CBOT 435.5 408.2 3.36% 69% 4.59% 35% 15.03% 68% .18 / 3%
Eurodollar* GE ED CME 394.6 1.37 M -0.09% 53% -0.17% 38% 0.78% 100% .12 / 0%
30-yr. T-bond ZB US CBOT 383.3 947.1 1.90% 68% 2.75% 66% 4.61% 66% .37 / 65%
Crude oil CL NYMEX 296.9 344.1 -0.60% 75% 0.27% 0% 20.70% 78% .27 / 48%
2-yr. T-note ZT TU CBOT 281.7 1.01 M 0.17% 20% 0.97% 73% 1.19% 43% .25 / 53%
E-Mini Russell 2000 ER CME 269.7 614.1 -2.27% 11% -5.75% 52% -3.69% 38% .43 / 54%
Mini Dow YM CBOT 216.6 105.3 -0.17% 0% -3.73% 53% -1.11% 30% .43 / 49%
Eurocurrency 6E EC CME 171.9 211.0 1.77% 60% 2.90% 52% 8.92% 100% .24 / 37%
Japanese yen 6J JY CME 137.6 186.6 0.46% 6% 4.08% 68% 5.43% 65% .37 / 68%
Gold 100 oz. GC NYMEX 128.0 273.4 0.16% 0% 1.59% 3% 16.80% 76% .28 / 37%
British pound 6B BP CME 83.0 128.4 0.66% 18% 0.73% 35% 3.17% 92% .42 / 41%
Soybeans ZS S CBOT 58.9 164.0 3.83% 32% 10.54% 68% 22.88% 86% .12 / 7%
Australian dollar 6A AD CME 56.2 83.1 -0.02% 0% -2.95% 47% 9.12% 91% .25 / 10%
Natural gas NG NYMEX 55.7 68.3 -5.82% 82% -6.67% 27% 32.99% 80% .20 / 13%
Canadian dollar 6C CD CME 55.1 125.1 -2.07% 27% -3.21% 90% 7.06% 52% .21 / 20%
Swiss franc 6S SF CME 49.9 77.8 1.42% 10% 4.32% 75% 8.75% 96% .31 / 41%
Sugar SB ICE 46.0 435.9 -0.20% 6% -1.29% 10% 4.85% 46% .27 / 50%
S&P 500 index SP CME 44.0 569.2 -0.86% 17% -4.26% 56% -1.28% 15% .41 / 53%
Wheat ZW W CBOT 43.7 135.8 14.84% 100% 5.53% 20% 6.44% 3% .36 / 87%
E-Mini S&P MidCap 400 ME CME 33.2 101.8 -1.68% 17% -4.62% 52% -2.05% 32% .41 / 60%
Silver 5,000 oz. SI NYMEX 32.8 68.2 -1.88% 29% 0.05% 0% 15.16% 72% .19 / 0%
Heating oil HO NYMEX 31.1 56.9 2.87% 30% 6.15% 29% 23.77% 83% .24 / 13%
RBOB gasoline RB NYMEX 30.7 49.8 -1.77% 60% 0.82% 5% 14.30% 56% .34 / 65%
Gold 100 oz. ZG CBOT 30.5 16.2 0.16% 0% 1.57% 3% 16.83% 76% .27 / 31%
Soybean oil ZL BO CBOT 29.0 87.4 4.30% 20% 10.68% 71% 24.04% 89% .23 / 15%
Soybean meal ZM SM CBOT 26.3 75.4 2.53% 38% 6.37% 56% 17.87% 56% .09 / 3%
Fed Funds ZQ FF CBOT 24.7 129.7 0.17% 53% 0.22% 36% 0.70% 93% .22 / 52%
Mexican peso 6M MP CME 19.7 92.4 -0.44% 8% -1.69% 90% 0.72% 8% .20 / 12%
Crude oil e-miNY QM NYMEX 18.7 9.0 -0.60% 50% 0.27% 0% 20.70% 78% .29 / 50%
Coffee KC ICE 12.5 64.5 5.91% 100% 5.39% 22% 11.31% 77% .27 / 32%
Nikkei 225 index NK CME 12.3 70.2 0.65% 50% -6.67% 58% -6.13% 52% .32 / 50%
Lean hogs HE LH CME 11.9 72.9 1.53% 38% 1.81% 50% -18.19% 65% .18 / 32%
Live cattle LE LC CME 11.7 62.0 -0.60% 67% -0.76% 35% -2.69% 36% .33 / 62%
Copper HG NYMEX 11.1 40.5 -3.25% 0% -13.66% 73% -9.53% 91% .34 / 32%
Mini-sized gold YG CBOT 7.1 6.0 0.16% 0% 1.57% 3% 16.83% 76% .27 / 30%
Cocoa CC ICE 6.3 41.1 3.03% 25% -0.46% 15% 7.86% 65% .27 / 48%
Silver 5,000 oz. ZI CBOT 6.1 5.2 -1.81% 14% 0.11% 2% 15.13% 72% .18 / 0%
Nasdaq 100 ND CME 5.9 53.6 1.39% 29% -5.51% 29% 3.49% 22% .27 / 28%
Dow Jones Ind. Avg. ZD DJ CBOT 4.2 34.2 -0.17% 0% -3.73% 53% -1.11% 30% .46 / 53%
Natural gas e-miNY QG NYMEX 3.9 3.1 -5.82% 82% -6.67% 47% 32.99% 81% .21 / 13%
U.S. dollar index DX ICE 3.4 36.4 -1.05% 35% -2.12% 40% -7.11% 97% .20 / 23%
New Zealand dollar 6N NE CME 2.6 26.0 2.81% 50% 1.59% 26% 10.87% 100% .24 / 23%
LIBOR EM CME 2.4 31.2 -0.44% 100% -0.42% 79% 0.68% 92% .15 / 22%
*Average volume and open interest based on highest-volume contract (December 2008).
Legend (10-day moves, 20-day moves, etc.) show the percent means the current reading is larger
Vol: 30-day average daily volume, in thou- percentile rank of the most recent move to a than all the past readings, while a reading of 0
sands (unless otherwise indicated). certain number of the previous moves of the percent means the current reading is smaller
same size and in the same direction. For than the previous readings. These figures pro-
OI: Open interest, in thousands (unless other-
example, the “% rank” for 10-day move shows vide perspective for determining how relative-
wise indicated).
how the most recent 10-day move compares ly large or small the most recent price move is
10-day move: The percentage price move to the past twenty 10-day moves; for the 20- compared to past price moves.
from the close 10 days ago to today’s close. day move, the “% rank” field shows how the Volatility ratio/rank: The ratio is the short-
20-day move: The percentage price move most recent 20-day move compares to the term volatility (10-day standard deviation of
from the close 20 days ago to today’s close. past sixty 20-day moves; for the 60-day move, prices) divided by the long-term volatility (100-
60-day move: The percentage price move the “% rank” field shows how the most recent day standard deviation of prices). The rank is
from the close 60 days ago to today’s close. 60-day move compares to the past one-hun- the percentile rank of the volatility ratio over
The “% rank” fields for each time window dred-twenty 60-day moves. A reading of 100 the past 60 days.

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

34 December 2007 • FUTURES & OPTIONS TRADER

 OPTIONS RADAR (as of Nov. 28)
MOST-LIQUID OPTIONS*
Options Open 10-day % 20-day % IV/SV IV/SV ratio —
Indices Symbol Exchange volume interest move rank move rank ratio 20 days ago
S&P 500 index SPX CBOE 264.4 1.75 M -0.81% 18% -4.05% 56% 23.6% / 20.8% 19.7% / 15.6%
S&P 500 volatility index VIX CBOE 152.5 1.46 M 0.04% 0% 14.43% 29% 86.7% / 154.8% 96.2% / 128.1%
Russell 2000 index RUT CBOE 79.8 773.3 -2.42% 16% -5.65% 54% 29.4% / 26.2% 26.8% / 21.5%
S&P 100 index OEX CBOE 44.2 121.2 0.17% 33% -5.17% 71% 22.8% / 20.5% 19.1% / 14.9%
Nasdaq 100 index NDX CBOE 43.7 278.2 1.42% 29% -5.08% 29% 27.5% / 27% 25% / 20.4%

Stocks
Apple Inc AAPL 317.9 1.27 M 6.04% 33% -3.63% 18% 42.5% / 59.7% 35.5% / 40.1%
Citigroup C 309.5 2.67 M -10.06% 30% -23.32% 75% 49.4% / 65.6% 37.2% / 37.5%
Microsoft MSFT 165.2 3.12 M -2.21% 17% -5.26% 86% 29.3% / 31.6% 25.2% / 24%
Research in Motion RIMM 145.5 420.9 7.82% 44% 0.12% 0% 67.1% / 89.3% 59.3% / 67.9%
Cisco Systems CSCO 141.4 1.58 M -6.93% 36% -13.98% 96% 36.2% / 39.6% 35.4% / 29.1%

Futures
Eurodollar ED-GE CME 422.7 10.80 M -0.06% 13% -0.12% 29% 23.3% / 12.7% 17.2% / 14.8%
10-year T-notes TY-ZN CBOT 72.7 654.4 1.75% 75% 2.85% 90% 6.8% / 5.2% 5.3% / 5.3%
Crude oil CL NYMEX 48.6 297.0 -3.69% 100% -4.14% 100% 31.5% / 37% 32.4% / 32.4%
5-year T-notes FV-ZF CBOT 40.8 274.0 1.03% 55% 2.05% 90% NA 4% / 3.8%
Corn C-ZC CBOT 36.8 687.1 1.10% 29% 3.14% 22% 24.6% / 21.1% 29.7% / 26.9%

VOLATILITY EXTREMES**
Indices — High IV/SV ratio
Euro index XDE PHLX 4.2 42.5 1.61% 55% 2.78% 49% 9.8% / 5.4% 8.1% / 6.2%
S&P 500 futures SP CME 9.7 78.6 -0.51% 6% -5.42% 64% 23.5% / 20% 19.1% / 16.1%
S&P 500 index SPX CBOE 264.4 1.75 M -0.81% 18% -4.05% 56% 23.6% / 20.8% 19.7% / 15.6%
Russell 2000 index RUT CBOE 79.8 773.3 -2.42% 16% -5.65% 54% 29.4% / 26.2% 26.8% / 21.5%
Dow Jones index DJX CBOE 25.3 291.9 -0.14% 6% -3.65% 59% 21.3% / 19% 18.1% / 14.9%

Indices — Low IV/SV ratio

S&P 500 volatility index VIX CBOE 152.5 1.46 M 0.04% 0% 14.43% 29% 86.7% / 154.8% 96.2% / 128.1%
Banking index BKX PHLX 6.5 104.1 -4.13% 45% -7.36% 62% 36.9% / 46.2% 31.2% / 25.2%
Gold/silver index XAU PHLX 8.3 98.5 -1.30% 0% -3.72% 50% 41.8% / 47% 42.5% / 35.9%
Mini-Nasdaq 100 Index MNX CBOE 32.0 799.6 1.42% 29% -5.08% 29% 27.3% / 28.8% 24.5% / 21%
Oil service index OSX PHLX 2.0 28.3 0.50% 0% -1.25% 17% 36.8% / 38.1% 36.4% / 32.4%

Stocks — High IV/SV ratio

Savient Pharmas SVNT 3.2 54.4 14.01% 100% 1.20% 3% 175% / 55.7% 136.2% / 48.9%
Neurocrine Biosciences NBIX 4.1 127.9 7.30% 78% 17.65% 100% 125.5% / 56.9% 88% / 43.9%
Medarex MEDX 38.3 1.31 M -0.89% 0% 3.36% 33% 113.9% / 59.4% 75.4% / 48.1%
Rite Aid RAD 1.7 313.5 -7.81% 85% -8.29% 26% 63% / 35.9% 45.8% / 36.4%
Tivo Inc TIVO 1.7 56.1 -13.46% 81% -13.71% 74% 75.9% / 46.8% 70.6% / 62%

Stocks — Low IV/SV ratio

Crocs CROX 52.9 244.0 1.85% 0% -44.97% 91% 59.9% / 108.6% 75.8% / 56.5%
Diana Shipping DSX 10.7 78.7 -4.66% 7% -19.24% 57% 68.7% / 120.3% 84.7% / 83.2%
Suntech Power Holdings STP 14.4 125.7 24.51% 76% 25.98% 62% 72.3% / 116.5% 66.8% / 71.5%
PMI Group PMI 8.2 101.9 -23.94% 47% -31.26% 21% 117.2% / 184.1% 91% / 126.6%
Lehman Bros Holdings LEH 48.6 693.5 2.14% 27% 5.69% 22% 49.1% / 76.1% 44% / 50.9%

Futures — High IV/SV ratio

Eurodollar ED-GE CME 422.7 10.80 M -0.06% 13% -0.12% 29% 23.3% / 12.7% 17.2% / 14.8%
Eurocurrency EC-6E CME 5.2 47.63 1.77% 60% 2.90% 52% 8.6% / 5% 8.4% / 6.6%
British pound BP-6B CME 1.1 10.06 0.66% 18% 0.73% 35% 8.9% / 5.7% 7.6% / 5.3%
Japanese yen JY-6J CME 5.3 47.28 0.46% 6% 4.08% 68% 12.8% / 8.2% 10.1% / 6.8%
30-year T-bonds US-ZB CBOT 27.5 326.01 1.90% 79% 3.66% 87% 9.7% / 6.6% 7.7% / 7.4%

Futures — Low IV/SV ratio

Gold 100 oz. GC NYMEX 10.2 86.3 -1.77% 29% 0.63% 0% 22.7% / 27.5% 19.4% / 20.3%
Silver 5,000 oz. SI NYMEX 6.3 51.6 -4.85% 43% -0.71% 20% 34.7% / 29.2% 28.7% / 31%
Crude oil CL NYMEX 48.6 297.0 -3.69% 100% -4.14% 100% 31.5% / 21.4% 32.4% / 32.4%
Australian dollar AD-6A CME 1.2 3.8 -0.02% 0% -2.95% 47% 10.6% / 59.7% 14% / 11.8%
Heating oil HO NYMEX 1.5 3.8 0.02% 0% 1.76% 5% 29.4% / 65.6% 28.7% / 28.1%
* Ranked by volume ** Ranked based on high or low IV/SV values.
LEGEND:
Options volume: 20-day average daily options volume (in thousands unless otherwise indicated).
Open interest: 20-day average daily options open interest (in thousands unless otherwise indicated).
IV/SV ratio: Overall average implied volatility of all options divided by statistical volatility of underlying instrument.
10-day move: The underlying’s percentage price move from the close 10 days ago to today’s close.
20-day move: The underlying’s percentage price move from the close 20 days ago to today’s close. The “% rank” fields for each time window (10-day moves,
20-day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For 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 • December 2007 35

 EVENTS

Event: Opportunity Finance Network Date: Feb. 16-19

2007 Annual Conference Location: Marriott Marquis Hotel, New York
Date: Dec. 11-14 For more information: http://www.tradersexpo.com
Location: Miami, Fla.
For more information: Event: 24th Annual Risk Management Conference
http://www.opportunityfinance.net Date: March 9-11
Location: Hyatt Regency Coconut Point Resort and Spa,
Event: MTA Mid-Winter Retreat Bonita Springs, Fla.
Date: Jan. 24-26 For more information: http://www.cboe.com/rmc
Location: Don CeSar Beach Resort at St. Pete Beach
(outside Tampa, Fla.) Event: Day Trading Seminar: Presented by Joe Ross
For more information: Call (646) 652-3300 and Rogerio Kirchbaum
Date: March 23-24
Event: The World Money Show Location: Sao Paulo, Brazil
Date: Feb. 6-9 For more information: E-mail
Location: Gaylord Palms Resort and Convention Center, [email protected]
Kissimmee, Fla.
For more information: Event: Traders Expo Los Angeles
http://www.worldmoneyshow.com Date: June 23-26
Location: Ontario Convention Center
Event: Traders Expo New York For more information: http://www.tradersexpo.com

36 December 2007 • FUTURES & OPTIONS TRADER

 KEY CONCEPTS The option “Greeks”
American style: An option that can be exercised at any Delta: The ratio of the movement in the option price for
time until expiration. every point move in the underlying. An option with a
delta of 0.5 would move a half-point for every 1-point
Arbitrage: The simultaneous purchase and sale of similar move in the underlying stock; an option with a delta of
or identical instruments (often in different geographical 1.00 would move 1 point for every 1-point move in the
locations) to take advantage of short-term price discrepan- underlying stock.
cies.
For example, gold trades in several major financial cen- Gamma: The change in delta relative to a change in the
ters around the world — New York, London, Paris, Hong underlying market. Unlike delta, which is highest for
Kong, and Tokyo. If gold were trading in New York for $780 deep ITM options, gamma is highest for ATM options
per ounce and $782 per ounce in London, you could, in and lowest for deep ITM and OTM options.
effect, buy gold in New York and immediately sell an equal
amount in the London market and profit $2 per ounce. Rho: The change in option price relative to the change
Why would the metal be $2 higher in London? Short- in the interest rate.
term supply and demand fluctuations: Perhaps a European
jeweler or metal fabricator placed a large order in the Theta: The rate at which an option loses value each day
London market. This short-term demand may cause the (the rate of time decay). Theta is relatively larger for
price to rise in London relative to New York or other finan- OTM than ITM options, and increases as the option gets
cial centers. closer to its expiration date.

Assign(ment): When an option seller (or “writer”) is Vega: How much an option’s price changes per a one-
obligated to assume a long position (if he or she sold a put) percent change in volatility.
or short position (if he or she sold a call) in the underlying
stock or futures contract because an option buyer exercised
the same option. absolute value is used so both +DM and -DM are pos-
itive values.
At the money (ATM): An option whose strike price is
identical (or very close) to the current underlying stock (or 3. Calculate the sum of the true ranges for all bars in
futures) price. the lookback period.

Average directional movement index (ADX): 4. Calculate the Directional Indicator (+DI and -DI) by
Measures trend strength, regardless of direction. The high- dividing the running totals of +DM and -DM by the
er the ADX value, the stronger the trend, whether the mar- sum of the true ranges.
ket is going up or down. The indicator can be applied to any
time frame, although it is typically used on daily charts. 5. Calculate the directional index (DX) by taking the
Although the ADX concept is straightforward, its calcu- absolute value of the difference between the +DI value
lation is rather lengthy. The indicator was designed by and the -DI value, dividing that by the sum of the +DI
Welles Wilder and is described in detail in his book New and -DI values, and multiplying by 100.
Concepts in Technical Trading Systems (Trend Research 1978).
6. To create the ADX, calculate a moving average of the
Calculation: DX over the same period as the lookback period used
1. Calculate the positive or negative directional move- throughout the other calculations.
ment (+DM and -DM) for each bar in the desired look-
back period. Bars that make higher highs and higher Bear call spread: A vertical credit spread that consists
lows than the previous bar have positive directional of a short call and a higher-strike, further OTM long call in
movement. Bars that make lower highs and lower lows the same expiration month. The spread’s largest potential
than the previous bar have negative directional move- gain is the premium collected, and its maximum loss is lim-
ment. ited to the point difference between the strikes minus that
If a bar has both a higher high and a lower low than premium.
the previous bar, it has positive directional
movement if its high is above the previous high more Bear put spread: A bear debit spread that contains puts
than its low is below the previous low. Reverse this with the same expiration date but different strike prices.
criterion for negative directional movement. An inside You buy the higher-strike put, which costs more, and sell
bar (a bar that trades within the range of the the cheaper, lower-strike put.
previous bar) has no directional movement, and nei-
ther does a bar whose high is above the previous high Beta: Measures the volatility of an investment compared
by the same amount its low is below the previous low. to the overall market. Instruments with a beta of one move
in line with the market. A beta value below one means the
2. If a bar has positive (negative) directional move- instrument is less affected by market moves and a beta
ment, the absolute value of the distance between value greater than one means it is more volatile than the
today’s high (low) and yesterday’s high (low) is added overall market. A beta of zero implies no market risk.
to the running totals of +DM (-DM) calculated over a
given lookback period (i.e., 20 bars, 30 bars, etc.). The Bull call ladder: A variation of the bull call debit spread

38 December 2007 • FUTURES & OPTIONS TRADER

that profits if the underlying market doesn’t rally too far. To far below the current price of the underlying asset.
enter a bull call ladder, buy an ATM or ITM long call and
sell two calls at different, higher strike prices. The goal is to Delta-neutral: An options position that has an overall
profit from a moderately bullish outlook without too much delta of zero, which means it’s unaffected by underlying
upside risk. Ideally, the market will rally and close between price movement. However, delta will change as the under-
the two short strikes at expiration. But if the market jumps lying moves up or down, so you must buy or sell
far above the highest short strike, potential losses could be shares/contracts to adjust delta back to zero.
unlimited.
Diagonal spread: A position consisting of options with
Bull call spread: A bull debit spread that contains calls different expiration dates and different strike prices — e.g.,
with the same expiration date but different strike prices. a December 50 call and a January 60 call.
You buy the lower-strike call, which has more value, and
sell the less-expensive, higher-strike call. Double diagonal spread: A double diagonal resembles
an iron condor (call credit spread + put credit spread), but
Bull put spread (put credit spread): A bull credit the long side of each spread expires in a later month. This
spread that contains puts with the same expiration date, but position combines two diagonal spreads on either side of
different strike prices. You sell an OTM put and buy a less- the market and tries to exploit the time decay of the short,
expensive, lower-strike put. near-term options. It collects the most profit if the market
trades sideways by expiration.
Calendar spread: A position with one short-term short To construct a double diagonal, enter two spreads simul-
option and one long same-strike option with more time taneously: a call spread, which consists of a short out-of-
until expiration. If the spread uses ATM options, it is mar- the-money call and a long, higher-strike call in a further
ket-neutral and tries to profit from time decay. However, month; and a put spread, which consists of a short OTM put
OTM options can be used to profit from both a directional and a long, lower-strike put in a more-distant month. Both
move and time decay. spread’s short options share the same expiration month,
and the long options expire together at least one month
Call option: An option that gives the owner the right, but later.
not the obligation, to buy a stock (or futures contract) at a
fixed price. European style: An option that can only be exercised at
expiration, not before.
Carrying costs: The costs associated with holding an
investment that include interest, dividends, and the oppor- Exercise: To exchange an option for the underlying
tunity costs of entering the trade. instrument.

Correlation: The correlation coefficient can tell us the Expiration: The last day on which an option can be exer-
type and strength of the relationship between two data cised and exchanged for the underlying instrument (usual-
series. The correlation coefficient ranges from +1, which ly the last trading day or one day after).
indicates perfect, positive correlation between two data sets
(i.e., they move in the same direction, in tandem) and -1, Intermonth (futures) spread: A trade consisting of
which indicates the sets are directly inverted; zero indicates long and short positions in different contract months in the
no discernible relationship between the two data sets. same market — e.g., July and November soybeans or
September and December crude oil. Also referred to as a
Covered call: Shorting an out-of-the-money call option futures “calendar spread.”
against a long position in the underlying market. An exam-
ple would be purchasing a stock for $50 and selling a call In the money (ITM): A call option with a strike price
option with a strike price of $55. The goal is for the market below the price of the underlying instrument, or a put
to move sideways or slightly higher and for the call option option with a strike price above the underlying instru-
to expire worthless, in which case you keep the premium. ment’s price.

Credit spread: A position that collects more premium Intrinsic value: The difference between the strike price
from short options than you pay for long options. A credit of an in-the-money option and the underlying asset price. A
spread using calls is bearish, while a credit spread using call option with a strike price of 22 has 2 points of intrinsic
puts is bullish. value if the underlying market is trading at 24.

Debit: A cost you must pay to enter any position if the Leverage: An amount of “buying power” that increases
components you buy are more expensive than the ones you exposure to underlying market moves. For example, if you
sell. For instance, you must pay a debit to buy any option, buy 100 shares of stock, that investment will gain or lose
and a spread (long one option, short another) requires a $100 for each $1 (one-point) move in the stock.
debit if the premium you collect from the short option does- But if you invest half as much and borrow the other half
n’t offset the long option’s cost. from your broker as margin, then you control those 100
shares with half as much capital (i.e., 2-to1 buying power).
Deep (e.g., deep in-the-money option or deep At that point, if the stock moves $1, you will gain or lose
out-of-the-money option): Call options with strike $100 even though you only invested $50 — a double-edged
prices that are very far above the current price of the under- sword.
lying asset and put options with strike prices that are very continued on p. 40

FUTURES & OPTIONS TRADER • December 2007 39

 KEY CONCEPTS continued

supposed support and resistance levels derived from the

Limit up (down): The maximum amount that a futures high, low, and closing prices of the previous price bar. The
contract is allowed to move up (down) in one trading ses- pivot point value is added to and subtracted from the pre-
sion. vious bars’ reference points to determine support and
resistance levels for future trading.
Lock-limit: The maximum amount that a futures contract The pivot point (PP) formula is:
is allowed to move (up or down) in one trading session.
1. PP = (H + L + C)/3
Long call condor: A market-neutral position structured 2. First resistance level (R1) = (PP*2) - L
with calls only. It combines a bear call spread (short call, 3. Second resistance level (R2) = PP + (H - L)
long higher-strike further OTM call) above the market and 4. First support level (S1) = (PP*2) - H
a bull call spread (long call, short higher-strike call). Unlike 5. Second support level (S2) = PP - (H + L)
an iron condor, which contains two credit spreads, a call
condor includes two types of spreads: debit and credit. A typical pivot point application is to cover any short
positions and go long at either of the two support levels, or
Long-Term Equity AnticiPation Securities sell any long positions and go short at the projected resist-
(LEAPS): Options contracts with much more distant expi- ance levels. Pivot points are often attributed to a tradition
ration dates — in some cases as far as two years and eight passed down among floor traders. Like any tool, pivot
months away — than regular options. points should be tested to verify their potential before trad-
ing.
Market makers: Provide liquidity by attempting to prof-
it from trading their own accounts. They supply bids when Premium: The price of an option.
there may be no other buyers and supply offers when there
are no other sellers. In return, they have an edge in buying Put option: An option that gives the owner the right, but
and selling at more favorable prices. not the obligation, to sell a stock (or futures contract) at a
fixed price.
Moving average convergence-divergence (MACD):
Although it is often grouped with oscillators, the MACD is Put ratio backspread: A bearish ratio spread that con-
more of an intermediate-term trend indicator (although it tains more long puts than short ones. The short strikes are
can reflect overbought and oversold conditions). closer to the money and the long strikes are further from the
The default MACD line (which can also be plotted as a money.
histogram, as is the case in the accompanying article) is cre- For example if a stock trades at $50, you could sell one
ated by subtracting a 26-period exponential moving aver- $45 put and buy two $40 puts in the same expiration month.
age (EMA) of closing prices from a 12-period EMA of clos- If the stock drops, the short $45 put might move into the
ing prices; a nine-period EMA is then applied to the MACD money, but the long lower-strike puts will hedge some (or
line to create a “signal line.” all) of those losses. If the stock drops well below $40, poten-
MACD = EMA(C,12)-EMA(C,26) tial gains are unlimited until it reaches zero.
Signal line = EMA(MACD,9)
Put spreads: Vertical spreads with puts sharing the same
Naked (uncovered) puts: Selling put options to collect expiration date but different strike prices. A bull put spread
premium that contains risk. If the market drops below the contains short, higher-strike puts and long, lower-strike
short put’s strike price, the holder may exercise it, requiring puts. A bear put spread is structured differently: Its long
you to buy stock at the strike price (i.e., above the market). puts have higher strikes than the short puts.

Open interest: The number of options that have not Ratio spread: A ratio spread can contain calls or puts and
been exercised in a specific contract that has not yet expired. includes a long option and multiple short options of the
same type that are further out-of-the-money, usually in a
Opportunity cost: The value of any other investment ratio of 1:2 or 1:3 (long to short options). For example, if a
you might have made if your capital wasn’t already in the stock trades at $60, you could buy one $60 call and sell two
markets same-month $65 calls. Basically, the trade is a bull call
spread (long call, short higher-strike call) with the sale of
Outlier: An anomalous data point or reading that is not additional calls at the short strike.
representative of the majority of a data set. Overall, these positions are neutral, but they can have a
directional bias, depending on the strike prices you select.
Out of the money (OTM): A call option with a strike Because you sell more options than you buy, the short
price above the price of the underlying instrument, or a put options usually cover the cost of the long one or provide a
option with a strike price below the underlying instru- net credit. However, the spread contains uncovered, or
ment’s price. “naked” options, which add upside or downside risk.

Parity: An option trading at its intrinsic value. Straddle: A non-directional option spread that typically
consists of an at-the-money call and at-the-money put with
Pivot points: Calculations some traders use to determine the same expiration. For example, with the underlying

40 December 2007 • FUTURES & OPTIONS TRADER

instrument trading at 25, a standard long straddle would accelerated rate as an option approaches expiration.
consist of buying a 25 call and a 25 put. Long straddles are
designed to profit from an increase in volatility; short strad- Time spread: Any type of spread that contains short
dles are intended to capitalize on declining volatility. The near-term options and long options that expire later. Both
strangle is a related strategy. options can share a strike price (calendar spread) or have
different strikes (diagonal spread).
Strangle: A non-directional option spread that consists of
an out-of-the-money call and out-of-the-money put with Time value (premium): The amount of an option’s
the same expiration. For example, with the underlying value that is a function of the time remaining until expira-
instrument trading at 25, a long strangle could consist of tion. As expiration approaches, time value decreases at an
buying a 27.5 call and a 22.5 put. Long strangles are accelerated rate, a phenomenon known as “time decay.”
designed to profit from an increase in volatility; short stran-
gles are intended to capitalize on declining volatility. The Vertical spread: A position consisting of options with
straddle is a related strategy. the same expiration date but different strike prices (e.g., a
September 40 call option and a September 50 call option).
Stochastic oscillator: A technical tool designed to
highlight shorter-term momentum and “overbought” and VIX: measures the implied volatility of S&P 500 index
“oversold” levels (points at which a price move has, theo- options traded on the Chicago Board Option Exchange
retically at least, temporarily exhausted itself and is ripe for (CBOE). The index reflects the market expectation of near-
a correction or reversal). term (i.e., 30-day) volatility. The VIX has been around since
Calculation: The stochastic oscillator consists of two 1990, but underwent a major transformation in late 2003. It
lines: %K and a moving average of %K called %D. The basic is a commonly referenced gauge of the stock market’s “fear
stochastic calculation compares the most recent close to the level.”
price range (high of the range - low of the range) over a par- When the CBOE overhauled the VIX in September 2003,
ticular period. it changed it from a volatility measurement based on the
For example, a 10-day stochastic calculation (%K) would S&P 100 (OEX) to one based on the S&P 500 (SPX).
be the difference between today’s close and the lowest low The old VIX formula used the Black-Scholes pricing
of the last 10 days divided by the difference between the model that looked at eight near-term at-the-money OEX
highest high and the lowest low of the last 10 days; the options (calls and puts). The new VIX is derived from near-
result is multiplied by 100. The formula is: term at-the-money SPX options as well as out-of-the-money
%K = 100*{(Ct-Ln)/(Hn-Ln)} puts and calls (so the index reflects the full range of volatil-
where ity).
Ct is today’s closing price The new calculation derives the VIX from the prices of
Hn is the highest price of the most recent n days (the options themselves rather than from a formula. The CBOE
default value is five days) also applied the new calculation method to the CBOE NDX
Ln is the lowest price of the most recent n days Volatility Index (VXN), which reflects the volatility of the
The second line, %D, is a three-period simple moving Nasdaq 100 index. The exchange still publishes the original
average of %K. The resulting indicator fluctuates between 0 VIX calculation, which can be found under the ticker sym-
and 100. bol VXO. For more information about the VIX and its cal-
culation, visit www.cboe.com/vix.
Fast vs. slow: The formula above is sometimes referred to
as “fast” stochastics. Because it is very volatile, an addition- Volatility: The level of price movement in a market.
ally smoothed version of the indicator –– where the original Historical (“statistical”) volatility measures the price fluctu-
%D line becomes a new %K line and a three-period average ations (usually calculated as the standard deviation of clos-
of this line becomes the new %D line –– is more commonly ing prices) over a certain time period — e.g., the past 20
used (and referred to as “slow” stochastics, or simply “sto- days. Implied volatility is the current market estimate of
chastics”). future volatility as reflected in the level of option premi-
Any of the parameters –– either the number of periods ums. The higher the implied volatility, the higher the option
used in the basic calculation or the length of the moving premium.
averages used to smooth the %K and %D lines –– can be
adjusted to make the indicator more or less sensitive to Volatility skew: The tendency of implied option volatil-
price action. ity to vary by strike price. Although, it might seem logical
Horizontal lines are used to mark overbought and over- that all options on the same underlying instrument with the
sold stochastic readings. These levels are discretionary; same expiration would have identical (or nearly identical)
readings of 80 and 20 or 70 and 30 are common, but differ- implied volatilities. For example, deeper in-the-money and
ent market conditions and indicator lengths will dictate dif- out-of-the-money options often have higher volatilities than
ferent levels. at-the-money options. This type of skew is often referred to
as the “volatility smile” because a chart of these implied
Strike (“exercise”) price: The price at which an under- volatilities would resemble a line curving upward at both
lying instrument is exchanged upon exercise of an option. ends. Volatility skews can take other forms than the volatil-
ity smile, though.
Time decay: The tendency of time value to decrease at an

FUTURES & OPTIONS TRADER • December 2007 41

 FUTURES & OPTIONS CALENDAR DECEMBER/JANUARY
MONTH
December 20 GDP
Legend LTD: All December equity options and
1 FDD: December coal, natural gas, and
futures; S&P options and futures (CME);
CPI: Consumer Price Index crude oil futures (NYMEX)
Nasdaq options and futures (CME);
ECI: Employment cost index 2 Russell options and futures (CME); Dow
First delivery day (FDD): 3 ISM report on business Jones options and futures (CBOT)
The first day on which deliv- FDD: December T-bond futures (CBOT); 21 Quadruple witching Friday
ery of a commodity in fulfill- December aluminum, copper, platinum, LTD: January T-bond options (CBOT);
ment of a futures contract can palladium, silver, and gold futures January soybean and soybean products
take place. (NYMEX); December oats, wheat, corn, options (CBOT); January orange juice
First notice day (FND): Also and soybean products futures (CBOT); options (ICE)
known as first intent day, this December coffee, cocoa, and cotton
is the first day a clearing- futures (ICE)
22
house can give notice to a
4 FND: December propane, gasoline, and
23
buyer of a futures contract
that it intends to deliver a
heating oil futures (NYMEX) 24
commodity in fulfillment of a 5 25 Markets closed — Christmas Day
futures contract. The clearing-
house also informs the seller.
6 LTD: December cotton futures (ICE) 26 LTD: January natural gas, gasoline, and
FDD: December propane futures heating oil options (NYMEX); January
FOMC: Federal Open Market (NYMEX) coal futures (NYMEX); January
Committee aluminum, copper, silver, and gold
GDP: Gross domestic
7 Unemployment
options (NYMEX)
LTD: December currency options (CME);
product
December U.S. dollar index options 27 Durable goods
ISM: Institute for supply man-
(ICE); January cocoa options (ICE) LTD: January natural gas futures
agement
(NYMEX); December aluminum,
LTD: Last trading day; the
8 FDD: December gasoline and heating oil
palladium, copper, platinum, silver, and
first day a contract may trade futures (NYMEX)
gold futures (NYMEX)
or be closed out before the 9 FND: December coal futures (NYMEX)
delivery of the underlying
asset may occur.
10 FND: December live cattle futures 28 FND: January natural gas futures
(CME) (NYMEX)
PPI: Producer price index
Quadruple witching Friday:
11 FOMC meeting 29
A day where equity options, 12 30
equity futures, index options, 13 PPI
and index futures all expire. 31 LTD: January propane, gasoline, and
Retail sales heating oil futures (NYMEX); December
LTD: January crude oil options live cattle futures (CME)
DECEMBER 2007 (NYMEX); December cocoa futures FND: January aluminum, copper,
(ICE) platinum, palladium, silver, and gold
26 27 28 29 30 31 1
FDD: December live cattle futures futures (NYMEX); January soybean
2 3 4 5 6 7 8 (CME) products futures (CBOT)
9 10 11 12 13 14 15
14 CPI January
16 17 18 19 20 21 22 LTD: December oats, rice, wheat, corn,
23 24 25 26 27 28 29 and soybean product futures (CBOT);
1 Markets closed — New Year’s Day
FDD: January natural gas, gasoline, and
30 31 1 2 3 4 5 December lean hog futures (CME);
crude oil futures (NYMEX)
January sugar and coffee options (ICE)
15 2 ISM report on business
FND: January orange juice futures (ICE)
JANUARY 2008 16 FDD: January aluminum, copper,
30 31 1 2 3 4 5 17 LTD: December currency futures (CME); platinum, palladium, silver, and gold
6 7 8 9 10 11 12 December U.S. dollar index futures futures (NYMEX); January rice, soybean
(ICE); December Goldman Sachs products, and soybean futures (CBOT)
13 14 15 16 17 18 19
commodity index futures and options 3 LTD: December milk futures and options
20 21 22 23 24 25 26
(CME) (CME)
27 28 29 30 31 1 2
18 LTD: December coffee futures (ICE) FND: January propane and heating oil
futures (NYMEX)
19 LTD: December T-bond futures (CBOT);
The information on this page is January crude oil futures (NYMEX); 4 Unemployment
subject to change. Futures &
Options Trader is not responsible January platinum options (NYMEX) LTD: January currency options (CME);
for the accuracy of calendar dates January U.S. dollar index options (ICE);
beyond press time. February cocoa options (ICE)

42 December 2007 • FUTURES & OPTIONS TRADER

 FUTURES TRADE JOURNAL

Using a mental stop works — this time

— but are we being rewarded for doing
the wrong thing?

TRADE

Date: Friday, Nov. 23, 2007.

Entry: Long the December 2007 E-Mini

Russell 2000 futures at 757.00.

Reasons for trade/setup: The Russell 200

index lost a whopping 14 percent from Oct. 11
through Nov. 20. After getting battered in a
long position during the first part of that sell-
off, we remained out of the market for more
than two weeks.
Source: TradeStation
There is plenty of analysis showing the ten-
dency for stocks to rebound after such large
down moves (“Navigating market shocks,” Active Trader, sharply lower low and lower close. The mood was very, very
November 2006 and “Stock market pullbacks: Know the bearish. We pulled the stop because the market was swing-
odds” Active Trader, August 2007) and, despite (actually, ing up and down so sharply, we were afraid of getting
because of) all the negative news regarding the economy, it knocked out of the market only to watch it go back in our
seems a good time to get back in the market. favor. The contract closed 0.50 points below the stop level
On Nov. 23, the market failed to make a lower low for the and we carried the trade into the next day (Nov. 26).
second straight day. Also, it was apparent the market was The market then extended the slide, falling as far as 730.00.
going to reverse the previous day’s price action (high open We were just about to get out when price turned back up,
and low close). Testing indicated favorable odds for an up closing the day above 743.00
move. Ignoring the stop to this extent could be viewed as a fairly
significant breach of the trade plan, but the market’s volatil-
Initial stop: 733.60, which is 3.10 below the Nov. 20 low. ity made it difficult for any reasonably close stop-loss level
This is a wide stop, but the market is, and will likely contin- not to get triggered. We decided the storm had to be weath-
ue to be, very volatile. This is intended to be a longer-term ered a little more. A dangerous rationalization or an adjust-
trade, so we don’t want to get shaken out of the market ment to changing conditions? Even now it’s still difficult to
unnecessarily. tell.
The next day, Nov. 28, turned out to be a big up day that
Initial target: 788.90, which is the approximate midpoint put the trade back in the black. Having let the position
of the Nov. 14 bar and 1.10 below a round-number target extend beyond the initial stop point made us exit the trade
price (790). sooner than planned. Holding the position until the close
would have tripled the percentage gain, but to be fair, we
added on to what was an overall long position in the stock
RESULT market using Nasdaq 100 futures (NQ) just prior to exiting
this trade.

Exit: 761.30.
Note: Initial targets for trades are typically based on things such as
Profit/loss: +4.30 (0.6 percent).
the historical performance of a price pattern or trading system sig-
nal. However, individual trades are a function of immediate market
Trade executed according to plan? No. behavior; initial price targets are flexible and are most often used as
points at which a portion of the trade is liquidated to reduce the
Outcome: The day after entry was explosive — the market position’s open risk. As a result, the initial (pre-trade) reward-risk
rallied to a higher high before collapsing and making a ratios are conjectural by nature.

TRADE SUMMARY
Date Contract Entry Initial Initial IRR Exit Date P/L LOP LOL Trade
stop target length
11/23/07 ER207 757.00 733.60 788.90 1.36 761.30 11/28/07 +4.3 (+0.6%) 15.80 27 3 days

Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit
during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

FUTURES & OPTIONS TRADER • December 2007 43

 OPTIONS TRADE JOURNAL

Buying in-the-money calls before Dominion Resources’ stock split

captures a bullish overnight move.

TRADE
When a company splits its stock, management gives
investors additional shares and cuts the stock’s price. As a
Date: Monday, Nov. 19. result, a shareholder’s dollar investment doesn’t change.
However, investors tend to view a stock split as bullish,
Market: Options on Dominion Resources (D). because they receive more shares.
Companies sometimes announce stock splits up to six
Entry: Buy 1 December 85 put for $6.50. months in advance, but Dominion Resources planned to
split its stock within three weeks. Historical testing in the
Reasons for trade/setup: Dominion Resources (D) past seven years shows S&P 500 stocks have tended to
announced a two-for-one (2:1) stock split before Oct. 29’s climb after stock splits are announced until the shares actu-
open, and its stock rallied 1.67 percent by the close. D then ally split.
gained as much as 3.79 percent in the next two weeks as the Stock-split candidates gained roughly 3.4 percent, on
S&P 500 plunged 5.66 percent during the same period average, from split announcements to the day before the
(Figure 1). split, the so-called payable date. Stocks then fell an average
0.28 percent on the
payable date before
FIGURE 1 — BEFORE THE SPLIT
rebounding 0.49 per-
Dominion Resources gained 2.70 percent from its stock-split announcement on Oct. 29 cent overnight on the
to Nov. 19 — the day before the split. Historical testing suggests D may jump overnight. split day, also known
as the ex-date.
Although this pat-
tern suggested Dom-
inion Resources would
continue to advance
until its stock split on
Nov. 20, we hesitated
to enter a bullish trade
because of the sharp
decline in U.S. stocks.
However, Dominion’s
behavior followed his-
torical patterns fairly
closely — it even
Source: eSignal
declined 0.30 percent

44 December 2007 • FUTURES & OPTIONS TRADER

 FIGURE 2 — AFTER THE SPLIT

Dominion Resources spiked 3.25 percent shortly after the

open, but we didn’t sell the ITM call until 20 minutes later.
The trade gained $0.70 (10.76 percent) overnight.

on its Nov. 19 payable date.

When D traded at $91.03 just before the Nov. 19
close, we bought a December 85 call for $6.50.
Buying an in-the-money (ITM) call is a simple
directional trade, because it has a fairly large Source: eSignal
delta (89.10) and a small time value ($0.47).
Ideally, Dominion will climb at least 0.50 per- TRADE SUMMARY
cent when it splits two-for-one at tomorrow’s
open. Entry date: Nov. 19, 2007
Underlying security: Dominion Resources (D)
Initial stop: None. Position: Long call
Initial capital required: $650
Initial target: Hold trade overnight and
Initial stop: None
exit at tomorrow’s open.
Initial target: Exit at next day’s open
Initial daily time decay: $3.16
Outcome: Figure 2 shows Dominion
Resources surged 3.25 percent at Nov. 20’s Trade length (in days): 1
open to reach an all-time, split-adjusted high P/L: $70 (10.76 percent)
of $46.99. The December 85 call was immedi- LOP: N/A
ately profitable, but several logistical prob- LOL: N/A
lems kept us from exiting quickly.
LOP — largest open profit (maximum available profit during life of trade).
First, we assumed our broker would LOL — largest open loss (maximum potential loss during life of trade).
exchange one December 85 call for two 42.5-
strike calls, but this process wasn’t automatic.
Instead of selling at least one call at the open, we
TRADE STATISTICS
waited 20 minutes until we received the second
42.5 call. By that point Dominion had declined Date Nov. 19 Nov. 20
1.89 percent, which hurt the position. Delta 89.10 99.70
Moreover, the new 42.5 call was illiquid, with Gamma 2.83 0.66
an opening bid-ask spread of $0.60 ($3.40 bid- Theta -3.16 0
$4.00 asked). After D fell to $46.10, we exited at Vega 6.34 0
$3.60 ($7.20 total) — an overall profit of $0.70 Probability of profit 48 percent 52 percent
(10.76 percent). In hindsight, we should have Breakeven point $45.75 (split price) $45.75 (split price)
sold first and asked questions later.

FUTURES & OPTIONS TRADER • December 2007 45

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