October 2008 • Volume 2, No. 10
T-BOND
seasonals
p. 9
SHORT-TERM
calendar
spreads
p. 15
FUTURES
SYSTEM LAB:
Bottom-catcher
p. 26
THE MARKET’S
stress test
p. 36
FUTURES BASICS:
Commodity
sectors
p. 32
RATIO SPREADS
vs. BACK SPREADS
p. 20
FUTURES:
System trading with
Contributors . . . .
5
Market Movers . . . .6
A roundup of price action in the different futures sectors.
Trading Strategies
Seasonal T-bond patterns . . . .
9
Analysis reveals long-term and short-term tendencies in T-bond futures that show surprising consistency over time. By Jay KaeppelSystem filtering with %C . . . .
10
The %C indicator is designed to showwhen the market shifts from a trading range to a trending environment. See what happens when it’s combined with a volatility breakout system.
By Jack F. Cahn, CMT
Short-term calendar spreads . . . .
15
Exploring the nuances of calendar spreads leads to short-term trading opportunities. By Jonathan MaherBackspreads and ratio spreads . . . .
20
These spreads aren’t for every trader, but their unique structure can capture large profits from big, sudden moves in the underlying market. By Frederic RuffyFutures Trading System Lab
“Nerves of steel” pullback system . . . .
26
Examining a stock-index futures pullback system reveals the potential pitfalls behind some of the attractive performance statistics.By FOT Staff
Options Trading System Lab
Trading credit spreads with the CCI . . . . .
30
Historical analysis of an option systemtriggered by the Commodity Channel Index. By Steve Lentz and Jim Graham
Trading Basics
Futures sectors . . . .
32
A look at the sub-groups that make up the futures market.By FOT Staff
Trader Interview
Bill Greenwalt . . . .
34
A professional option trader explains how to manage risk in today’s difficult markets. By David BukeyCONTENTS
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2008
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News
Financial panic tanks markets . . . .
36
Financial turmoil in late September and early October rocks markets around the world and promises to usher in a new financial era, for better or worse.Other stories:
ICE Futures takes over Russell
stock index futures trading . . . .
38
New markets: Merc launches steel andEuro-denominated S&P futures . . . .
39
Futures Snapshot . . . .40
Momentum, volatility, and volume statistics for futures.
Option Radar . . . .
41
Notable volatility and volumein the options market. Futures & Options Watch
COT extremes . . . .
42
A look at the relationship between commercials and large speculators in 45 futures markets.Options Watch:
Financial Sector ETF components . . . .
42
Futures & Options Calendar . . . .43
Key Concepts . . . .44
References and definitions.
Events . . . .
50
Options Trade Journal . . . .52
Buying puts on Bank of America before the financial storm hits.
New Products and Services . . . .
53
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.
CBOE eSignal GCFF OptionsMentoring PFGBEST.com RS of Houston The Wizard TradeStation
CONTENTS
CONTRIBUTORS
Editor-in-chief: Mark Etzkorn
Managing editor: Molly Flynn Goad
Senior editor: David Bukey
Contributing editor: Keith Schap
Associate editor: Chris Peters
Editorial assistant and Webmaster: Kesha Green
Art director: Laura Coyle
President: Phil Dorman
Publisher,
Ad sales East Coast and Midwest: Bob Dorman
Ad sales
West Coast and Southwest only: Allison Chee
Classified ad sales: Mark Seger
Volume 2, Issue 10. Futures & Options Trader is pub-lished monthly by TechInfo, Inc., 161 N. Clark Street, Suite 4915, Chicago, IL 60601. Copyright © 2008 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Futures & Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote, or in any way imply the effectiveness of any trading system, strategy, or approach. Traders are advised to do their own research and testing to determine the validity of a trad-ing idea. Tradtrad-ing and investtrad-ing carry a high level of risk. Past performance does not guarantee future results.
For all subscriber services: www.futuresandoptionstrader.com
A publication of Active Trader®
CONTRIBUTORS
Jonathan F. Maherhas a Ph.D. in engineering and an MBA from the top-ranked program for technology management. He worked in the high-tech industry for more than 20 years, holding many high-level managerial positions in development and market-ing. Maher first started trading options in 1984 while working on his Ph.D. In 2004, he founded DocMaher Trading LLC, an invest-ment education company that works with traders one-on-one. He has taught hundreds of people about options strategies. Maher’s specialty is con-servative income strategies that capitalize on time and volatility. These include iron condors, calendars, and hybrid strategies such as the “W” trade. Income strategies are intended to be higher probability trades that can profit over a wide range of stock movement. You can also find his writings as an “All Star Commentator” on the TradeKing’s blog.
Jay Kaeppel is a trading strategist with Optionetics, Inc. and writes a weekly column, “Kaeppel’s Corner” for
http://www.optionetics.com. An independent trader, Kaeppel has been active in the financial markets for more than two decades. He was the head trader at a CTA for 8 years and a trading system and trading soft-ware developer for 15 years. As an author, Kaeppel has published three books on trading, The Four Biggest Mistakes in Option Trading, The Four Biggest Mistakes in Futures Trading, and The Option Trader’s Guide to Probability, Volatility and Timing. His latest book, Seasonal Stock Market Trends: The Definitive Guide to Seasonal Stock Market Trading, will be released by Wiley in January 2009. Kaeppel has also been a noted speaker at a variety of live and online investment seminars.
Jack F. Cahn, CMThas been involved in the financial mar-kets since 1974. Over the years, he has worked as a technical market analyst for Stix & Co, Merrill Lynch, Sherson Loeb Rhodes, and R. Rowland and Co. He was director of the Markets Technicians Association from 1990 to 1995 and is a member of the Australian Technical Analysts Association and the International Federation of Technical Analysts. Cahn has developed trading systems as president of Creative Breakthrough, Inc. (http://www.traderassist.com) since 1989.
Frederic Ruffy is the senior options strategist at
http://whatstrading.com, a site dedicated to helping traders make sense of the complex and fragmented nature of listed options trad-ing. In addition to writing market commentary and trading-related books and articles, Ruffy has also worked as an instructor, educat-ing investors on advanced topics such as volatility, the benefits of sector rotation, and trading around earnings. Ruffy is an active trader with more than 15 years experience in the industry. His market observations and analysis of the options market are featured regularly in the financial press including Barron’s, Reuters, The Wall Street Journal, Bloomberg, and Futures Magazine.
Steve Lentz ([email protected]) is a well-established options educator and trader and has spoken all over the U.S., Asia, and Australia on behalf of the CBOE’s Options Institute, the Options Industry Council, and the Australian Stock Exchange. As a mentor for DsicoverOptions.com, he teaches select students how to use complex options strategies and develop a consistent trading plan. Lentz is constantly developing new strategies on the use of options as part of a compre-hensive profitable trading approach. He regularly speaks at special events, trade shows, and trading group organizations.
Jim Graham([email protected]) is the product manag-er for OptionVue Systems and a registmanag-ered investment advisor for OptionVue Research.
Metals
As might be expected, gold and silver benefited from the financial market’s jitters in September. After falling below $740 on Sept. 11, December gold (GCZ08) exploded nearly $200 to $926.40 by Sept. 18. The market was trad-ing around $842.00 on Oct. 3.
Industrial metals did not enjoy the same bounce. December cop-per futures (HGZ08) made a new
low for the year when they fell to 3.000 on Sept. 18, and have subsequently fallen as low as 2.6030.
MARKET MOVERS
Source for all: TradeStation
Financial panic pressures
already-weak commodities
Late summer and early fall have been mostly red ink for commodity futures, with some food and fiber markets bearing the brunt of the most recent decline, along with some grain futures. Meats and metals were among the stronger sectors. For the most part, energy contracts were in the middle of
the pack, stabilizing a bit after their big July-September shakeout.
Until Sept. 29, that is. The financial market calamity that unfolded when the U.S. congress bailed on the $700 billion bailout plan sent many com-modity futures — especially crude oil — into a tailspin as money
man-agers and investors closed out posi-tions across asset classes.
For detailed performance statistics of top-volume futures contracts, see the Futures Snapshot on p. 40.
Energy
Crude oil consolidated between $105 and $110 after bouncing back from its mid-September dive below the $100 mark — only to plunge more than 10 per-cent on Sept. 29. As of Oct. 3, November futures (CLX09) had turned down again and were trading around $94.00.
Grains
After a brief consolidation, grain futures renewed their sell-off in late September and early October, push-ing to new lows for the year. November rough rice (RRX09) futures, however, rallied more than 20 percent from their August low to the Sept. 24 high before pulling back with the rest of the complex.
Currencies
For in-depth analysis of the FX mar-ket, go to http://www.currencytra-dermag.comfor a free subscription to Currency Trader magazine.
Softs and fibers
While coffee, cocoa, and sugar all moved sideways to moderately lower in choppy trading, cotton (CT) and orange juice (OJ) took big hits in late summer, extending their runs of new yearly lows. December cotton (CTZ08) fell some 30 percent from its spring high to lows below 60.00 in September.
Meats
Livestock futures have been relatively robust, if characteristically volatile. After trading as low as 83.600 in early September, February 2009 pork belly futures (PBG09) traded above 100.000 by Sept. 26 before dropping again to below 95 as of Oct. 3.
Treasuries
Treasuries were definitely not the ben-eficiary of the stock market’s woes — at least initially. The December 10-year T-note futures (TYZ08) fell from 119-00 to around 114-119-00 between Sept. 17 and 25. They shot back up on Sept. 29 on a flight-to-quality move, however, climbing as high as 118-00.
Stock indices
E-Mini Nasdaq 100 index futures (NQZ08) took the biggest hit on Sept. 29, plunging as much as 10 percent (to 1,494) before rallying slightly into the close. The Nasdaq 100 index (NDX) fell to its lowest level since August 2006. The market challenged this low with another sharp drop on Oct. 2.
MARKET MOVERS
continuedPutting the Sept. 29 drop in context
TABLE 1 — BIGGEST S&P 500 ONE-DAY DECLINES, 1978-2008
TABLE 2 — BIGGEST DOW ONE-DAY DECLINES, 1928-1978
Any way you slice it, Sept. 29 was a pretty big day, although perhaps not quite the earth-shattering event the news media made it out to be.
But we must cut the commentators some slack, as the U.S. market’s decline that day was bigger than any other in more than 20 years — since the immediate aftermath of the Oct. 19, 1987 crash, in fact.
Table 1 shows the biggest one-day drops in the S&P 500 index (SPX) from September 1978 through September 2008. The first two sections of the table show the 10 largest declines measured from the previous close to the current close and the previous close to the current low, respectively. The bottom section shows the days with the biggest
intra-day ranges, regardless if the intra-day was up or down. (The day’s range is expressed as a percentage of the day’s mid-point, for consistency.)
Sept. 29 trailed only Oct. 19 and Oct. 26, 1987 in terms of the close-to-close and close-to-low declines, but it was only the fifth largest day in terms of range.
Table 2 extends the analysis by looking at the Dow Industrial Average’s (DJIA) biggest one-day declines from October 1928 through September 1978. Sept. 29, 2008 would have been the ninth-biggest close-to-close decline if it had occurred during this period, and it wouldn’t have even cracked the top-10 largest close-to-low moves or intraday ranges.
As % Close Close
of to to
Date Close Range midpoint low close Close to close 10/19/1987 224.83 57.86 22.80% -20.47% -20.47% 10/26/1987 227.66 20.47 8.62% -8.45% -8.28% 9/29/2008 1117.85 96.53 8.32% -8.32% -7.88% 10/27/1997 876.97 64.91 7.14% -6.87% -6.84% 8/31/1998 957.55 76.05 7.64% -6.80% -6.79% 1/8/1988 243.39 18.13 7.19% -6.94% -6.77% 10/13/1989 333.64 22.72 6.60% -6.35% -6.12% 4/14/2000 1356.02 101.11 7.27% -7.02% -5.87% 10/16/1987 282.69 17.39 5.99% -5.56% -5.16% 9/17/2001 1038.77 55.08 5.17% -5.04% -4.92% Close to low 10/19/1987 224.83 57.86 22.80% -20.47% -20.47% 10/26/1987 227.66 20.47 8.62% -8.45% -8.28% 9/29/2008 1117.85 96.53 8.32% -8.32% -7.88% 4/14/2000 1356.02 101.11 7.27% -7.02% -5.87% 1/8/1988 243.39 18.13 7.19% -6.94% -6.77% 10/27/1997 876.97 64.91 7.14% -6.87% -6.84% 8/31/1998 957.55 76.05 7.64% -6.80% -6.79% 10/13/1989 333.64 22.72 6.60% -6.35% -6.12% 11/30/1987 230.3 14.56 6.25% -6.06% -4.17% 10/22/1987 248.25 15.38 6.14% -5.95% -3.92%
Daily range as % of the day’s midpoint
10/19/1987 224.83 57.86 22.80% -20.47% -20.47% 10/20/1987 236.83 29.15 12.62% -3.72% +5.34% 10/26/1987 227.66 20.47 8.62% -8.45% -8.28% 7/24/2002 843.43 68.64 8.47% -2.76% +5.73% 9/29/2008 1117.85 96.53 8.32% -8.32% -7.88% 10/21/1987 258.37 20.46 8.22% +0.83% +9.10% 8/31/1998 957.55 76.05 7.64% -6.80% -6.79% 10/28/1997 921.86 67.82 7.63% -2.47% +5.12% 4/4/2000 1494.72 110.04 7.48% -5.95% -0.75% 4/14/2000 1356.02 101.11 7.27% -7.02% -5.87% As % Close Close of to to
Date Close Range midpoint low close Close to close 10/28/1929 260.6 38.4 13.91% -14.74% -13.48% 10/29/1929 230.1 40.1 17.26% -18.53% -11.70% 10/5/1931 86.5 6.6 7.43% -11.76% -10.73% 11/6/1929 232.1 23.8 9.90% -11.37% -9.93% 12/4/1933 89.9 9.5 10.04% -9.10% -9.10% 8/12/1932 63.1 6.6 10.03% -9.29% -8.42% 1/4/1932 71.6 3.2 4.41% -8.99% -8.09% 7/21/1933 88.7 14.2 15.50% -12.25% -7.89% 9/29/2008 1117.85 96.53 8.32% -8.32% -7.88% 6/16/1930 230.1 13.3 5.65% -8.33% -7.85% Close to low 10/29/1929 230.1 40.1 17.26% -18.53% -11.70% 10/28/1929 260.6 38.4 13.91% -14.74% -13.48% 7/21/1933 88.7 14.2 15.50% -12.25% -7.89% 10/5/1931 86.5 6.6 7.43% -11.76% -10.73% 11/6/1929 232.1 23.8 9.90% -11.37% -9.93% 10/24/1929 299.5 40.5 13.84% -10.98% -2.09% 5/21/1940 114.1 9.9 8.57% -9.64% -6.78% 8/12/1932 63.1 6.6 10.03% -9.29% -8.42% 12/4/1933 89.9 9.5 10.04% -9.10% -9.10% 1/4/1932 71.6 3.2 4.41% -8.99% -8.09%
Daily range as % of day’s midpoint
10/29/1929 230.1 40.1 17.26% -18.53% -11.70% 7/21/1933 88.7 14.2 15.50% -12.25% -7.89% 10/28/1929 260.6 38.4 13.91% -14.74% -13.48% 10/24/1929 299.5 40.5 13.84% -10.98% -2.09% 10/6/1931 99.3 13 13.83% +1.16% +14.80% 10/30/1929 258.5 30 12.20% +0.35% +12.34% 12/18/1931 80.7 8.5 11.06% -1.63% +9.35% 7/20/1933 96.3 10.9 10.87% -8.49% -7.05% 11/7/1929 238.2 24.3 10.57% -6.16% +2.63% 8/3/1932 58.2 5.8 10.39% -0.56% +9.40%
Seasonal T-bond patterns
“
S
easonals” are trends that tend to repeat at regular intervals or at certain times of the month or year. The following analysis looks at seasonal trends that appear to influence T-bond futures, focusing on two areas:1. The most bullish months of the year. 2. The most bearish months of the year. Additional research, noted at the end of this article, indicates there are also certain bullish and bearish trading days each month.
The analysis suggests each of these categories holds unique opportunities for alert traders and investors.
Most bullish months of the year
Research conducted on more than 30 years of T-bond prices indicates the market has a tendency to perform better during certain months of the
year. At first this seems to make little intuitive sense. The idea of seasonal trends in markets such as grains (soybeans, corn, wheat) or softs (cocoa, sugar, coffee) is logical because these “hard” commodities have fixed growing and produc-tion cycles: they must be planted, grown, and harvested, and as a result they are subject to the vagaries of weather.
A T-bond, by comparison, is simply a piece of paper con-ferring certain rights to its owner, so it would seem unlike-ly that T-bonds would be influenced by any seasonal fac-tors. Nevertheless, the data strongly suggest that not all months are created equal when it comes to T-bond price trends.
The most bullish months for T-bond futures are May, June, August, November, and December. First, this infor-mation does not mean T-bond prices will always rise during these favorable months or that these months will show gains during any given calendar year. The implication is simply that bonds have demonstrated a tendency to per-form better during these months than during the rest of the year.
Figure 1 illustrates this by showing the equity growth of being long one T-bond futures contract during May, June, August, November, and December, buying at the close of the previous month and selling at the close on the last day of the favorable month every year since November 1977 (blue line). It also displays what would have happened if you had skipped these favorable months and instead held a long T-bond futures position only during the remaining seven months of the year (red line).
The results are compelling. Between November 1977 and July 2008, a one-contract long position held only during the five seasonally bullish months each year gained almost $112,000 (each one-point move in the T-bond futures is worth $1,000), and was profitable in 22 of the past 31 years. By contrast, a one-contract long position in T-bond futures held during the remaining seven months of the year would have registered a loss in excess of -$75,000.
Most bearish months of the year
Figure 1 shows the seven months other than May, June, August, November, and December produced a net loss in T-bond prices over the past 30 years. Closer examination reveals the damage was done primarily during one seg-ment of the calendar year — January through April.
One way to take advantage of this information would be to hold a short T-bond futures position during this period.
There are no guarantees a short position held during this period will generate a profit during any given year. In fact, the batting average is about 65 percent, as holding a short position in T-bonds during these unfavorable months would have resulted in an annual profit during 20 of the past 31 years. Nonetheless, the long-term trend is what we are focusing on here, and that trend clearly runs to the plus side.
For more in-depth analysis of seasonal tendencies in the T-bonds, including a comprehensive seasonal trading model that combines long-term and short-long-term patterns, see the December issue of Active Trader magazine (http://www.activetradermag.com). For information on the author, see p. 5.
Certain months appear to be more bullish or bearish than others.
TRADING STRATEGIES
Being long during May, June, August, November, and December was profitable (blue line), while going long the other seven months of the year produced a net loss (red line).
FIGURE 1 — THE BEST VS. THE REST, 1977-2008
System filtering with %C
T
raders often try to forecast the market’s direc-tion while ignoring how the market is behav-ing. The key question isn’t where the market is headed, but how it gets there. Anyone can make a directional forecast that becomes accurate, but that doesn’t mean they will make money. Identifying a market’s condition — flat, trending, or volatile — is what increases your trading edge.Identifying a market’s condition can tell you which trad-ing systems will likely be the most profitable, independent of market direction. A good example of this distinction is the difference between the bear markets of 1973 and 1987. Stocks fell 20 percent in both cases, but market conditions were very different in both years. In 1973, the S&P 500 bounced around, staged several strong, fast counter rallies, and took 10 months to drop 20 percent. In 1987, the S&P fell that far on Oct. 19 alone.
Traders who fail to realize why market conditions are rel-evant search in vain for the one robust strategy that trades well across all markets in any time frame over the past five
to eight years. They hunt for the ultimate oscillator that gives great overbought or oversold readings, but they find those signals only work in non-volatile conditions. Or they follow the trend and then suffer losses when the market returns to a trading range.
Instead, you need to know how to identify the current market’s condition and anticipate when it will change. The percent contraction (%C) indicator helps determine the market’s condition and can be used to boost trading system performance.
Different market conditions
The key to finding better trade opportunities is to identify a market as being in one of four main conditions:
1. A strong trend that travels in one direction, either up or down, with little or no retracement along the way. 2. A ranging trend that moves up or down over the
same time period as the first condition, but with increased volatility and deep retracements. These
countertrend moves take the market into overbought or oversold territory as the market remains within a trading channel.
3. A broad trading range that includes the volatility and retracements of the second condition, but lacks direction or trend.
4. A dull trading range that is the opposite of a strong trend. The market lacks volatility and is also directionless. The percent
contraction indicator The %C indicator is designed to identify a market’s condition and when it might shift from one con-dition to another. Like the Average Directional Movement Index
(ADX), the indicator measures trend strength, but it has less lag and contains more information about the market’s condition. Also,
Applying a trend-strength indicator to a volatility breakout system
helps pinpoint the most promising trades.
TRADING STRATEGIES
On Aug. 8, the %C indicator was above its moving average and closed at 59.57, sug-gesting the E-Mini Russell 2000 could break out of its trading range. As expected, the market rallied the next morning.
FIGURE 1 — AN IDEAL TRADE
Source: TradeStation
the %C indicator shows when the market’s condition has reached an extreme and is ready to change.
The %C indicator uses true range
to measure trend strength, as fol-lows:
1. Add each bar’s true range in the 14-bar look-back period. 2. Divide this running total by
the largest one-day true range value of that look-back period.
3. Calculate the logarithmof the raw value from step 2. 4. Divide the result by the
logarithm of the look-back period (14, in this case). 5. Multiply by 100.
The following example uses 15-minute bars on the E-Mini Russell 2000 futures. On Sept. 12 at noon, the run-ning total of the E-Mini Russell 2000 futures’ 14-bar true range was 47.3, and the largest one-bar true-range of the past 14 bars was 5. The %C reading would be: 1. 47.3/5 = 9.46. 2. log(9.46) = 0.9758. 3. log(14) = 1.1461 4. 0.9758/1.1461 = .8514 5. 0.8514*100 = 85.14
Therefore, the %C indicator’s value is 85.14. Logarithms are used in this calculation to make sure the extreme levels range from one to 99.
The indicator’s extremes can vary from market to market but normally cycle in a 40-point range — e.g., 20 to 60, 25 to 65, or 30 to 70. “Indicator code” shows the TradeStation code for the %C indicator.
In general, the %C indicator meas-ures stress levels in a market. A dull trading range develops when market tensions are high, as the lack of direc-tion frustrates both bullish and bearish traders. In this scenario, the %C indi-cator trends higher from its low extreme to its high extreme.
As the indicator’s value rises, the market is increasingly less likely to trend until an extreme is reached. As the indicator’s value declines, the mar-ket is less likely to be range-bound until an extreme is reached. Extreme readings represent turning points.
When the indicator climbs above 55, the market will likely shift from trad-ing sideways (conditions 3 or 4) to breaking out in one direction
(condi-The trade system went short on May 28 but the trade was unprofitable because the market lacked direction as %C moved higher from an extreme low.
FIGURE 2 — TRADING RANGE
Source: TradeStation continued on p. 12
Indicator code
%C indicator: Inputs:lng(numericsimple); Value1=TrueHigh; Value2=TrueLow; Value3=Value1-value2; Value4=Summation(value3,lng); Value5=Highest(Value1,lng); Value6=Lowest(value2,lng);If value5-value6>0 then Value7=value5-value6; Value8=(value4/value7);
if Value8 <> 0 then Value9 = Log (value8); Value10=value9/log(lng);
Value11=Value10*100; @PercentC=Value11;
tions 1 or 2). The strongest trends follow the most extreme indicator readings. However, the longer it stays above this upper threshold, the more likely a weaker trend will devel-op.
As the market starts to trend, the %C indicator’s value will drop as the tension between bullish and bearish traders dissipates. A trend is confirmed when the indicator falls from a high extreme (such as 55) to below its seven-bar moving average. Finally, when the %C indicator drops below 25, the trend is potentially overextended.
You can use the %C indicator either as a filter in an exist-ing tradexist-ing strategy or as a portfolio management tool. As a filter, it can help identify trending markets, avoid losing trades, and boost system performance. At the portfolio level, it can tell you which trading system to favor and when to increase a trade’s size.
Trade examples
Figure 1 shows a 15-minute chart of the E-Mini Russell 2000 futures (ER2) from Aug. 8 to 11. The %C indicator and its seven-bar moving average are plotted below it (red and dashed lines, respectively). Notice Aug. 8 was a dull trad-ing-range day (condition 4). As the indicator’s value rises,
the market remains in a range until the indicator hits an extreme. When it climbs above 55, the trading range is con-sidered overdone and ripe for change. On Aug. 8, the indi-cator was above its moving average and closed at 59.57, which suggests the E-Mini Russell 2000 could break out.
Again, the longer the indicator remains above 55, the more likely the ensuing trend will be weaker. The opposite is also true; the less time %C remains above its upper threshold, the faster and stronger the subsequent price move will be. This is exactly what happened on Aug. 11 as the indicator dropped below 55 and below its moving aver-age. These moves confirm that the breakout is underway. Notice the indicator declined as the market rallied, and the up trend lost steam after the %C indicator fell below 30 and bottomed out around 1 p.m.
The market is in a trading range when %C is ascending and between 15 and 65 while also above its moving aver-age. Figure 2 shows the E-Mini Russell 2000 futures on May 28, which is a good example of a trading range when it pays to buy low and sell high (condition 3). In this example, the breakout short trade failed because the market lacked direc-tion as %C moved higher from an extreme low.
TRADING STRATEGIES
continuedFiltered strategy #1:
[LegacyColorValue = true]; Inputs: fac(.9),facs(.9); Inputs: LChopEx(65),CDLF(14); Inputs: SChopEx(65),CDSF(14); If EntriesshortToday(Date)<1 and PercentC(CDSF)>SChopEx Then BeginSell Short ( "DayTrader-SE" ) next bar at OpenD(0) - ((HighD(1) - LowD(1)) * fac) stop ; end;
If EntriesLongToday(date)<1
and PercentC(CDLF)>LChopEx Then Begin
Buy ( "DayTrader-LE" ) next bar at
OpenD(0) + ((HighD(1) - LowD(1)) * facs) stop ; End;
Filtered strategy #2:
Inputs: fac(0.9),facs(.9); Inputs: TrendExup(36),LChopEx(65),CDLF(14); Inputs: TrendExdw(36),SChopEx(65),CDSF(14); If EntriesshortToday(Date)<2and (PercentC(CDSF)<TrendExdw and PercentC(CDSF)>15 ) or (PercentC(CDSF)>SChopEx )
Then Begin
Sell Short ( "TON%CPlus-SE" ) next bar at OpenD(0) - ((HighD(1) - LowD(1)) * fac) stop ; end;
If EntriesLongToday(date)<2
and ( PercentC(CDLF)<TrendExup and PercentC(CDLF)>15 )
or (PercentC(CDLF)>LChopEx ) Then Begin
Buy ( "TON%CPlus-LE" ) next bar at
OpenD(0) + ((HighD(1) - LowD(1)) * facs) stop ; End;
Filtered strategy #3:
Inputs: fac(0.9),facs(.9); Inputs: TrendExup(36),LChopEx(65),CDLF(16); Inputs: TrendExdw(36),SChopEx(65),CDSF(14); If EntriesshortToday(Date)<2and (PercentC(CDSF)<TrendExdw and PercentC(CDSF)>15 and PercentC(CDSF)<XAverage(PercentC(CDSF), 6))
or (PercentC(CDSF)>SChopEx ) Then Begin
If (time>0930 and time <1000 or time>1200 and time <1530) then Sell Short ( "TON%CPlusA-SE" ) next bar at
OpenD(0) - ((HighD(1) - LowD(1)) * fac) stop ; end;
If EntriesLongToday(date)<2
and ( PercentC(CDLF)<TrendExup and PercentC(CDLF)>15 )
or (PercentC(CDLF)>LChopEx ) Then Begin
If (time>0930 and time <1000 or time>1200 and time <1530) then Buy ( "TON%CPlusA-LE" ) next bar at
OpenD(0) + ((HighD(1) - LowD(1)) * facs) stop ; End;
Filtering a volatility breakout system
To demonstrate how the %C indicator can increase a trading system’s edge, let’s apply it to a volatility breakout system that measures yesterday’s high-low range, adds and sub-tracts a percentage of it from today’s open, and then buys or sells the market when it reaches either threshold. The origi-nal system exited at tomorrow’s open. (Figures 1 and 2 show trades generated by a less-strict version of the system tested here.)
1. Go long on a stop if the market climbs to today’s open + 90 percent of yesterday’s high-low range. 2. Sell short on a stop if the market drops to today’s
open - 90 percent of yesterday’s high-low range. 3. Exit at a $250 stop-loss for short and long trades, or
exit with a trailing stopthat uses a 1-percent retracement after a profit target of $450 is reached. The system was tested on one E-Mini Russell 2000 con-tract using 15-minute bars from Sept. 9, 2003 to Sept. 9, 2008, with $15 commission deducted per trade. Only one trade in each direction was allowed each day.
Test results
Table 1 shows the system basically broke even with a profit factor (gross profit/gross loss) of 1.00 in 564 trades. However, the system’s performance can be improved if you add the %C indicator as a filter. For example, if you only
take trades when %C is above 65, you increase the likeli-hood that the market’s tension has come to a boil and a sus-tained move is imminent.
Table 2 shows the filtered system’s results. The number of trades was reduced by nearly 400, and the net profit rose to $5,170.00 from just $322.00. Also, the profit factor climbed to 1.19 from 1, the percentage of winners increased to 43 per-cent from 38 perper-cent, and the average trade jumped to $32.31.
Waiting for the end of a trend
Despite these improvements, the system could still perform better. Another idea is to use the %C indicator to also take trades near the end of an existing trend when price moves are often strongest. The late technician Joe Granville com-pared this phenomenon to water draining out of a bathtub. At first, the water level seems to barely move, but as the water rushes out, it becomes a rapid whirlpool.
To capture the end of strong trends, the system will be modified to only enter trades when the %C indicator drops below 36 while remaining above 15. At this point, liquidity is added to the market as new traders try to profit from an existing trend (condition 1).
Table 3 shows the system’s net profit climbed to $19,631.50 from $5,170, the profit factor rose to 1.37, and the
continued on p. 14 The unfiltered volatility breakout system basically broke
even with a profit factor of 1.00.
TABLE 1 — PERFORMANCE RESULTS — NO FILTER
Total net profit $322.00
Gross profit $99,737.00
Gross loss $99,415.00
Profit factor 1.00
Total number of trades 564
Percent profitable 37.94%
Avg. profit 0.57
Avg. winner $466.06
Avg. loser $284.04
Ratio avg. win / avg. loss 1.64
Largest winning trade 2295.5
Largest losing trade -1074.5
Max. consec. winning trades 5
Max. consecutive losing trades 8
Avg. bars in total trades 7.79
Avg. bars in winning trades 9.62
Avg. bars in losing trades 6.68
Return on initial capital 0.32%
Account size required $10,561.50
Percent of time in market 10.49%
Annual rate of return 0.06%
Max. drawdown (intraday peak to valley) -$10,744.25
Net profit as percentage of drawdown 3%
The breakout system was improved by adding the %C fil-ter. By only taking trades when %C was above 65, the profit factor climbed to 1.19 from 1, net profit jumped to $5,170.00 from just $322, and the number of trades was reduced by nearly 400.
TABLE 2 — FILTERED RESULTS
Total net profit $5,170.00
Gross profit $31,789.50
Gross loss $26,619.50
Profit factor 1.19
Total number of trades 160
Percent profitable 43.13%
Avg. profit $32.31
Avg. winner $460.72
Avg. loser $292.52
Ratio avg. win / avg. loss 1.57
Largest winning trade $1,015.50
Largest losing trade $1,074.50
Max. consec. winning trades 6
Max. consecutive losing trades 9
Avg. bars in total trades 7.54
Avg. bars in winning trades 8.62
Avg. bars in losing trades 6.73
Return on initial capital 5.17%
Account size required $3,190.50
Percent of time in market 4.71%
Annual rate of return 1.01%
Max. drawdown (intraday peak to valley) -$3,386.00
Net profit as percentage of drawdown 152.69%
Source: TradeStation
average profit increased to $55.61. Short trades generated $13,713 in profits, while long trades contributed just $5,918.50 (not shown), despite the sustained bull market from March 2003 to October 2007.
The stock market tends to rally slower than it falls, which is one reason to use a slightly longer look-back period on %C for long trades than for short ones. The test results in Tables 1 to 3 use the same 14-bar look-back period for all trades, but the final test uses a 16-bar look-back period for long trades and a 14-bar look-back period for short trades. In addition, the profit target is increased to $1,000, the stop-loss is raised to $550, and trades are only taken during two time periods — after the 9:30 a.m. open but before 10 a.m., and from 12 p.m. to 3:30 p.m.
Table 4 shows the revised system’s net profit jumped to $47,601, the profit factor edged up to 1.48, and the average profit increased to $147.83.
The statistics in Tables 1 to 4 show there are several ways to filter an existing strategy’s trade signals to improve its overall edge. Other ideas include taking trend-following signals only when the %C indicator is falling, enter count-er-trend signals only when %C is rising, or tracking the indicator on daily or weekly intervals to identify the under-lying market condition for an intraday strategy.
For information on the authorsee p. 5.
TRADING STRATEGIES
continuedTo capture the end of strong trends, the system was modi-fied to also enter trades when the %C indicator drops below 36 while remaining above 15. The modified system’s net profit climbed to $19,631.50 from $5,170, the profit factor rose to 1.37, and the average profit increased to $55.61.
TABLE 3 — FURTHER IMPROVEMENTS
Total net profit $19,631.50
Gross profit $73,189.00
Gross loss $53,557.50
Profit factor 1.37
Total number of trades 353
Percent profitable 44.76%
Avg. profit $55.61
Avg. winner $463.22
Avg. loser $274.65
Ratio avg. win / avg. loss 1.69
Largest winning trade $1,075.50
Largest losing trade $514.50
Max. consec. winning trades 6
Max. consecutive losing trades 9
Avg. bars in total trades 10.11
Avg. bars in winning trades 11.64
Avg. bars in losing trades 8.87
Return on initial capital 19.63%
Account size required $6,265.50
Percent of time in market 9.39%
Annual rate of return 2.99%
Max. drawdown (intraday peak to valley) -$6,645.50
Net profit as percentage of drawdown 295.41%
The system’s net profit rose to $47,601 and its average profit jumped to $147.83 after a slightly longer look-back period was used for long trades (among other changes).
TABLE 4 — MORE TWEAKS BOOST PERFORMANCE
Total net profit $47,601.00
Gross profit $145,857.50
Gross loss $98,246.50
Profit factor 1.48
Total number of trades 322
Percent profitable 45.03%
Avg. profit $147.83
Avg. winner $1,005.84
Avg. loser $555.05
Ratio avg. win / avg. loss 1.81
Largest winning trade $1,695.50
Largest losing trade $1,314.50
Max. consec. winning trades 6
Max. consecutive losing trades 11
Avg. bars in total trades 35.19
Avg. bars in winning trades 39.84
Avg. bars in losing trades 31.93
Return on initial capital 238.01
Account size required 20,000.00
Percent of time in market 29.31%
Annual rate of return -31.50%
Max. drawdown (intraday peak to valley) -7,955.50
Net profit as percentage of drawdown 595.01%
Source: TradeStation
Source: TradeStation
Related reading
“Trading volatility breakouts”
Futures & Options Trader, May 2008.
This breakout approach enters calm markets in hopes that volatility will pick up.
“Trading System Lab:
Bollinger Band breakout-anticipation system”
Active Trader, March 2008.
A low BandWidth reading reflects a temporary balance of buyers and sellers. When the bands tighten significantly, sharp volatility expansions — and trends — are possible. The follow-ing system attempts to capitalize on this idea.
“Filtering Bollinger Band breakouts”
Active Trader, December 2007.
Does volatility make or break your strategy? Avoiding choppy market conditions strengthens this system.
“Opening shots,” Active Trader, April 2003.
Narrow-range bars and inside bars represent short-term volatility lows out of which price can move sharply. This strategy uses a simple volatility measurement to determine where to enter trades to capitalize on this behavior.
“Futures Trading System Lab: Volatility breakout system”
Active Trader, October 2002.
This trading strategy is based on identifying situations when a market is about to burst out of a congestion area and potential-ly establish a long-term trend.
You can purchase and download past articles at http://store.activetradermag.com/.
Short-term calendar spreads
C
alendar spreads are best known as strategies that exploit the time decayof options, but like all options positions, they are also affected by moves in the underlying market and implied volatility(IV) changes.Making money with calendar spreads requires an under-standing of how each of these three factors influences the position’s value. Calendar spreads are flexible, which means you can make money even in a very short time peri-od, assuming you can profit from either changes in the underlying’s price or implied volatility.
Calendar spreads are created by selling an option in one month and buying an option with the same strike price that expires later. The spread typically profits from the differ-ence in the rate of time decay of the two options. The short-er-term option you sell will lose value faster than the longer-term option you buy.
However, the position can also profit from an IV increase or even compensate for a move in the underlying, assuming you adjust it correctly. It’s possible to earn modest profits with calendar spreads in a short period of time; the trick is to be sure IV won’t drop and to add a second position if the underlying makes a definitive move.
Calendar spread example
Figure 1 shows a daily chart of Google Inc. (GOOG) from Jan. 16, 2007 to July 31, 2007.
Google dropped 7.1 percent on July 20 after its second-quarter earnings were announced. After falling so sharply, GOOG was likely to trade sideways for a few days before picking a direction — a good time to enter a short-term cal-endar spread.
Figure 2 shows Google’s 30-day historical volatilityand its IV over the past 12 months (blue and yellow lines, respectively). In early July, IV jumped to 35 percent from 25 percent before dropping to roughly 24 percent after Google’s earnings announcement. At this point IV was near the low end of its 12-month range, so it was unlikely to drop further and had the potential to bounce back slightly.
With GOOG trading at $518 on July 31, a calendar spread was entered by selling 10 August 520-strike calls and buying 10 September 520 calls for a net cost of 8.80 ($8,800). Table 1 shows the calendar spread’s details. The IV of the September calls is slightly lower than August calls’ IV (23.9 percent vs. 24.84 percent, respec-tively).
Figure 3 shows the calendar spread’s potential gains and loss-es on three datloss-es: trade entry
Calendar spreads are versatile positions that can make money quickly if market conditions
are right. Implied volatility and the market’s direction play a pivotal role.
Strategy snapshot Strategy: Short-term calendar spread. Market bias: Neutral.
Components: One short front-month option and one long same-strike option
with more time until expiration. Use at-the-money (ATM) options for a neutral outlook (calls or puts).
Logic: To benefit from short option’s time decay as it approaches
expiration. Underlying will trade sideways, implied volatility may increase, and time value will decrease.
Looking for a 5-percent gain in less than a week.
Criteria: Use front-month options. You must believe that IV will hold or
increase.
Max. gain: The underlying closes at the strike price when the short option expires
and you keep its premium.
Max. risk: The price paid for the spread.
Adjustments: If the underlying starts to move in one direction, exit half of original
spread and add a second calendar spread with the proceeds. If market drops, use lower-strike puts. If market rallies, use higher-strike calls.
BY JONATHAN MAHER
TRADING STRATEGIES
TRADING STRATEGIES
continued(July 31, blue line), halfway to August expiration (Aug. 8, green line), and August expiration (Aug. 18, red line). The position is prof-itable only in a narrow range between $502 and $539, with a maximum profit of roughly $7,000 at the 520 strike price.
You have to be careful with such a narrow profit range, espe-cially because Google is such a volatile stock. This spread is delta neutral, which means the position will lose ground if GOOG moves either up or down.
Implied volatility is important…
Figure 3 shows how the calendar spread is affected by underlying price moves and time decay, but it doesn’t show the effect of IV changes. Also, it only shows potential gains and losses up to the August expiration. At that point, you still own the September 520 call that hasn’t expired yet.
You can’t afford to ignore IV when trading calendar spreads, because it can dramatically impact their value. The value of the September 520 calls will fluctuate along with changes in implied volatility.
Short-term calendar spreads are as influenced by IV as by time. You shouldn’t enter a calendar spread if you think implied volatility will drop. On the other hand, the position will be helped immensely if IV increases. …but time decay still matters Calendar spreads take time to make money, but you can often find short-term calendar spreads that offer an attractive balance between reward and risk and last only a few days. Calendars work especially well if you anticipate a rise in implied volatility.
Let’s take another look at the August-September Google calendar
After dropping sharply on earnings news, Google was likely to trade sideways — a good time to enter a calendar spread.
FIGURE 1 — GOOGLE INC.
Source: eSignal
Google’s implied volatility (yellow line) neared a 12-month low after dropping to 24 percent.
FIGURE 2 — VOLATILITY VIEW
spread. Because the spread sells August calls, there are only 14 trading days left before these options expire. Therefore, these calls’ time value
should decay rapidly.
Figure 4 is similar to Figure 3, but it shows the spread’s percentage yield, which peaks at roughly 80 percent. Given the trade’s narrow upper and lower breakeven points, it wouldn’t take much of an underlying move for the trade to become a loser. But there are a couple of ways to adjust the trade to help neutral-ize that risk.
The trade can last up to 14 trading days, but you don’t have to hold it that long. Instead, you can exit after it posts a small profit. Although an 80-percent gain is possible, this strategy waits for a 5-percent profit with-in a few days and get out before something happens.
Double your fun
Google fell to $510 after we entered the August-September calendar at $518 at 10:15 a.m. on July 31. Luckily, however, implied volatility jumped as GOOG dropped, and we man-aged to sell half the position (5 contracts) at $8.80 per contract — their original cost.
The next adjustment was to add a lower-strike calendar spread to help reduce the overall
position’s delta. Table 2 shows that five August-September 500-strike put calendar spreads were bought for $6.20 each.
You can use calls or puts when entering calendar spreads. In general, it makes sense to use puts when adjusting the spread downward and to use calls when adjusting the spread upward, because these options are out of the money
(OTM) and could expire worthless.
The position was now a double calendar spreadthat con-tains four different options with a cost of $15 ($8.80 + $6.20). The overall position includes only five contracts for a total value of $7,500 ($15 cost * 5 contracts * 100 options multi-plier).
Figure 5 compares the risk profiles of the original and adjusted calendar spreads. The adjustment neutralized the position’s delta and stretched its range of profitability. The upper and lower breakeven points widened to $491 and $531.
The tradeoff is the potential profit drops to about 50 per-cent of the spread’s cost. But remember you only need a gain of 5 percent, so this isn’t a problem.
Waiting to adjust the spread
Why not just enter a double calendar spread in the first
Buying this August-September 520 call calendar spread on Google cost $8.80, which represents its maximum risk. The spread could earn 5 percent within a few days if GOOG traded sideways and IV didn’t drop.
TABLE 1 — CALENDAR SPREAD DETAILS
Google traded at $518 on July 31, 2007. Aug./Sept. 520 calendar spread
Dollar amount (price * no. Position Long/ Implied of contracts *
short volatility Price 100 multiplier)
10 August 520 calls Short 24.84% $11.30 $11,300
10 Sept. 520 calls Long 23.91% -$20.10 -$20,100
Total debit (max. loss): -$8.80 -$8,800
This calendar spread was profitable only in a narrow range between $502 and $539 with its maximum profit of roughly $7,000 at the 520 strike price.
FIGURE 3 — RISK PROFILE: CALENDAR SPREAD
Source: MarketGear Inc.
TRADING STRATEGIES
continuedplace? One reason is to see which direction Google may move before you decide which way to adjust. You may have to adjust multiple times if the underlying keeps mov-ing.
Figure 6 shows a daily chart of Google through Aug. 2, 2007. Fortunately, the stock cooperated by trading sideways within the spread’s profitable range. The dou-ble calendar’s bid price was $15.50 and its ask price was $16.50, which means you could have sold the spread for $16.00 the next morning — a $1 profit per contract ($500 overall). This represents a yield of 6.7 percent ($500/$7,500) in less than four days. The key to small and consistent gains is not to get greedy.
If you waited another day, you could have earned an additional 10 percent. By Aug. 6, the adjusted spread’s value climbed to $17.50 as the bid-ask spread rose to $17.40-$18.40. However, these gains can be fleeting, which is one reason to limit your risk by limiting the time you hold a trade. For instance, the trade’s bid-ask spread fell to $14.80-$15.80 by Aug. 8 as Google climbed 1.8 percent to $519 and IV crashed. Picking the right market Short-term calendar spreads can be profitable if conditions are right. Ideally, the underlying should be stable and implied volatility should be likely to rise. These trades are an attempt to capture changes in implied volatility as much as cap-turing time value. If IV drops, the strategy probably won’t work.
Finally, be ready to add addition-al caddition-alendar spreads if the underly-ing starts to move in one direction. This adjustment lowers the spread’s maximum profit and increases the profit zone. Remember you’re just trying to earn small gains in a few days.
For information on the authorsee p. 5.
After Google fell to $510, we made two adjustments. First, half the original trade was sold at the same price. Then, a second calendar was bought using 500-strike puts. The adjusted position became a double calendar spread that contained four options with a cost of $15.
TABLE 2 — ADJUSTMENTS
Google fell to $510 on July 31, 2007. Double calendar spread
Dollar amount (price * Position Long/ no. of contracts *
short Price 100 multiplier) Original spread:
10 August 520 calls Short $11.30 $11,300
10 Sept. 520 calls Long -$20.10 -$20,100
Debit (max. loss): -$8.80 -$8,800
Adjustment:
1. Sell half the original position
at same price. $8.80 $4,400
2. Add a second spread with a 500 strike.
5 August 500 puts Short $6.43 $6,430
5 Sept. 500 puts Long -$12.63 -$12,630
Adjusted debit: -$6.20 -$3,100
Final cost: -$15.00 -$7,500
Although an 80-percent gain is possible, it’s easier to wait for a 5-percent profit and exit the trade before the underlying moves sharply or IV drops.
FIGURE 4 — PROFITS AND LOSSES BY YIELD
Related reading
“Calendar spreads surrounding earnings news”
Options Trader, March 2007.
More versatile than you might think, these calendar spreads profit from changes in volatility rather than the time decay.
“Directional calendars on the S&P 500”
Futures & Options Trader, May 2007.
This lab compares two strategies with similar profiles: a horizontal cal-endar spread and a butterfly spread. Both positions try to collect premium from short options and protect them with long options, but they protect against large losses differently.
“Calendar spreads:
Taking time out of the market”
Options Trader, February 2005.
Trading time spreads offers a way to take advantage of time decay and volatility changes while limiting risk.
“Combining calendar spreads with stock”
Options Trader, October 2006.
Adding a calendar spread to an underlying position instead of simply creating a covered call offers some surprising benefits. The combined strategy helps you lock in profits with-out sacrificing further upside gains.
“Calendar spreads after earnings releases”
Options Trader, September 2006.
The system placed an at-the-money (ATM) horizontal debit (calendar) spread on stocks one day after quar-terly earnings were announced.
“Calendar spreads on the S&P 500”
Options Trader, August 2006.
This system tested an at-the-money (ATM) horizontal (calendar) debit spread strategy on the cash-settled options of the S&P 500. The goal of the calendar spread is to profit from the near-term short options time decay while partially protecting it with a longer-term long option.
You can purchase past articles at http://store.activetradermag.com/
The adjusted double calendar spread has a lower potential profit, but the position becomes delta-neutral and its breakeven points are widened to $491 and $531.
FIGURE 5 — SINGLE VS. DOUBLE CALENDAR SPREADS
Source: MarketGear Inc.
After the calendar spread was adjusted, Google traded in a range over the next couple of days, allowing us to sell the spread on Aug. 3, 2007 for $16.00 — a 6.7 percent profit.
FIGURE 6 — GOOGLE IN A TRADING RANGE
Backspreads and ratio spreads
A
ratio backspread is an options strategy that can produce profits in uncertain markets. The goal is to benefit from an explosive move in one direction while limiting risk. A backspread can be created with either puts or calls. In either case, you short options while buying a larger number of options (in a ratio such as 1:2 or 2:3) with strikes that are further from the market’s current value.If you enter the spread at a credit (which means the pre-mium you receive from the short options is larger than the cost of the long options), you keep the premium if the underlying trades in a range. However, a backspread can earn much larger profits if the underlying moves substan-tially in the right direction, especially if you expect implied volatilityto climb.
One disadvantage of backspreads is they tend to show losses before becoming profitable, which is why profession-al traders often prefer the opposite trade — the ratio spread. To create a ratio spread, you buy options and sell a larger number of options with more distant strikes — again, typi-cally in a 1:2 or 2:3 ratio. Instead of profiting the most when an explosive move occurs, a ratio spread earns the largest profit if the underlying doesn’t
move too far.
Which strategy is better? The answer depends on your directional forecast, risk toler-ance, and margin limits. The following examples focus on strategies that use calls, but you can create similar posi-tions with puts. For more details, see “Backspreads vs. ratio spreads.”
Backspread ratios and strikes
To enter a call backspread,
Which options spread is preferable when you’re expecting an explosive underlying move?
TRADING STRATEGIES
The SPDR Gold Trust (GLD) has been quite volatile lately, dropping 14 percent from July 14 to Aug. 8. If you expect gold to rally substantially in the next few months, entering a call backspread might make sense.
FIGURE 1 — AFTER THE GOLD RUSH
Source: eSignal
This trade can be entered at no cost because the premium received from selling 85-strike calls equals the cost of buying 89-strike calls.
TABLE 1 — BACKSPREAD COMPONENTS
BY FREDERIC RUFFY
SPDR Gold Trust (GLD) traded at $84.43 on Aug. 8. January 2009 85-89 backspread
Dollar amount (price * No. of Long/ no. of contracts * contracts Month Type Strike short Price 100 multiplier)
20 January 2009 Calls 85 Short $6.00 $12,000
30 January 2009 Calls 89 Long -$4.00 -$12,000
short one or more calls and buy two or more calls with a higher strike price but the same expiration month. Common ratios are one short call and two long calls (1:2) or two short calls and three long calls (2:3). Ratio values are normally
0.667 or less (2:3 = 0.667); you can use any combination of long and short calls (e.g., 3:5) that yield a ratio less than 0.667.
Backspreads typically consist of short calls with near- or at-the-money (ATM) strikes and long calls with out-of-the-money(OTM) strikes. Selling ATM calls generates premium that covers the cost of part, or all, of the long OTM calls. Favorable market conditions The call backspread doesn’t work well in every type of market environment. It yields the best results in an explosive market with high implied volatility. For example, a backspread might make sense on a biotechnology stock when you have a bullish outlook ahead of an important event, such as the upcoming FDA approval of a key product.
If your forecast is correct and the stock rallies dramatically, the backspread will gain ground quickly because it includes more long calls than short ones. In options parlance, this means it quickly becomes deltapositive.
Let’s look at gold, which has been a volatile market. Price hit a high of 1,033.90 an ounce on March 17 before dropping more than 25 percent; the October futures contract (GCV08) traded as low as 736.40 on Sept. 11 before shooting $920 a week later. The SPDR Gold Trust (GLD) is an exchange-traded fund that holds gold; the ETF also has an active option series. If you expect gold to rally substantially in the fourth quarter of 2008 and into 2009, a call backspread might make sense.
Options on GLD are listed in one-point strike-price intervals (84, 85, 86, etc.), which is great for option-spread traders. Most options contracts have
strike prices in five-point increments; GLD has more choices. On Aug. 8, the SPDR Gold Trust traded at $84.43, so let’s build a call backspread with January 2009 calls, which expire roughly five
months later.
You could enter a 2:3 ratio backspread by shorting 20 January 2009 calls with an 85 strike for 6.00 per contract and buying 30 calls with an 89 strike in the same month for 4.00 per contract. As Table 1 shows, the backspread didn’t cost money to enter, because the premium from the sale of 20 calls at 6.00 each ($12,000) completely offset the cost of buying 30 contracts at 4.00 each ($12,000).
The position has no downside risk. If GLD fails to climb above $85 by expiration Friday on Jan. 16, 2009, the spread’s calls will simply expire worthless. If you had entered this spread with a credit and gold went nowhere, you would simply keep the pre-mium.
However, the trade will per-form better if the underlying jumps higher. Figure 1 shows a daily chart of GLD from June 1 to Aug. 8. Price fell 12.5 percent from July 15 to Aug. 8. A rebound is possible over the next five months, but remember if gold keeps falling, the spread won’t lose money.
Figure 2 shows the back-spread’s potential gains and loss-es on three datloss-es: trade entry (Aug. 8, dotted line), halfway until expiration (Oct. 28, dashed line), and expiration (Jan. 17, solid line). The sooner GLD climbs, the more profitable the spread will be. For example, if gold rose suddenly in the next few weeks, the trade will quickly become profitable. On the other
TRADING STRATEGIES
continuedA ratio spread’s potential gains and losses are the opposite of a backspread’s risk pro-file. The January 85-89 ratio spread’s maximum gain occurs at the long strike and losses mount above $97.
FIGURE 3 — RISK PROFILE: RATIO SPREAD
Source: OptionVue
The sooner GLD climbs, the more profitable this spread will be. Time decay will kill this trade if GLD’s rally is gradual rather than dramatic. However, the trade has no downside risk.
FIGURE 2 — RISK PROFILE: BACKSPREAD
hand, if the ETF rallies briefly and then stalls, the backspread will start to lose money. Time decay
will kill this trade if GLD’s rally is gradual rather than dramatic.
In the worst-case scenario, the SPDR Gold Trust settles at $89.00 at expiration Friday on Jan. 16 expiration and the 89-strike long calls expire worthless. The 85-strike short calls will be worth their intrinsic value, 4.00. Although the short side of the trade earned 2.00 per contract, that gain isn’t large enough to cover the long calls’ losses of 4.00 per contract.
Therefore, if GLD closes at $89 at expiration, the backspread’s maximum loss is $8,000 ($12,000 long call loss - $4,000 short call gain).
The backspread’s maximum loss won’t occur until expiration. If the underlying doesn’t jump as high as expected, it makes sense to exit the trade well before expiration rather than waiting for the underlying to drop toward the long calls’ strike price.
The ratio-spread alternative Entering a ratio spread can reverse the back-spread’s components by purchasing 20 January 85-strike calls for 6.00 each and selling 30 January 89-strike calls for 4.00 each. Table 2 shows this ratio spread’s details. Again, the spread is entered at no cost and has no downside risk.
The risk profile of a ratio spread is the exact opposite of a backspread. Figure 3 shows the ratio spread’s profit zone at expiration is between $85 and $97, with a maximum gain of $8,000 if GLD climbs to $89 at Jan. 17 expiration. The trade begins to turn sour above $97.
Ratio spreads are not suitable for many indi-vidual traders because they have more risk and higher margin requirements. With call back-spreads, you are buying more calls than you are selling. Therefore, the position is covered because the long calls protect the short calls.
In the ratio spread, however, more options are sold than bought. These uncovered or “naked”
calls dramatically increase the trade’s risk profile, and most brokers require more margin to trade them. Figure 3’s January 85-89 ratio spread faces unlimited losses above $97.
Backspreads do not have the margin requirements associated with selling naked options. The margin is the same as for vertical spreads such as bull-call or bear-put spreads, plus the cost of buy-ing additional options. In the
TRADING STRATEGIES
continuedBackspreads and ratio spreads are leveraged positions that involve buying and selling options in different propor-tions, usually in 1:2 or 2:3 ratios. Backspreads contain more long options than short ones, so the potential profits are unlimited and losses are capped. By contrast, ratio spreads have more short options than long ones and have the opposite risk profile. Table A lists the basic differences among these spreads using call and put options.
Backspreads
Traders typically enter backspreads when they believe a large underlying move is possible (in either direction), but they want to limit risk if they’re wrong. For example, if you’re extremely bullish, sell one near-the-money or ITM call and buy two higher-strike calls. Here, you’ll be protected if price drops drastically, and you’ll gain if it jumps well above the long strike. The strategy loses a limited amount around the long strike.
If you’re extremely bearish, enter a put backspread by selling one near-the-money put and buying two lower-strike OTM puts. You’ll profit if price sells off sharply, and an unexpected rally won’t hurt the position. Again, put backspreads post capped losses if the underlying is near the long strike.
Ratio spreads
Ratio spreads may be appropriate when such a large underlying price move is unlikely. A ratio call spread con-tains a long call and two (or more) short calls at a higher strike. The position is a vertical bull call spread with addi-tional calls at the higher strike. The trade’s maximum profit occurs at the short strike, while unlimited losses are possi-ble if the underlying rallies significantly above this level. However, the trade typically protects against sharp sell-offs. Ratio put spreads have the opposite outlook — neutral to slightly bearish. These positions combine one long put with two (or more) short lower-strike OTM puts, which is a bull put spread with an additional short put. While the ratio put spread’s largest possible gain occurs at the short strike, it will post massive losses if the underlying sells off dramatically. However, potential losses are capped if price unexpectedly surges above the long strike.
TABLE A
Backspreads Components Market outlook Profit/loss
Using calls Short call + long multiple Extremely bullish Unlimited upside gains;
higher-strike calls maximum loss at long strike.
Using puts Short put + long multiple Extremely bearish Unlimited downside gains;
lower-strike puts maximum loss at long strike.
Ratio spreads
Using calls Long call + short multiple Neutral to bearish Maximum profit at short strike;
higher-strike calls unlimited upside losses.
Using puts Long put + short multiple Neutral to bullish Maximum profit at short strike;
lower-strike puts unlimited downside losses.
Backspreads and ratio spreads
A ratio spread simply reverses the components of a backspread. Here, you buy close-to-the-money calls and sell higher-strike calls.
TABLE 2 — RATIO SPREAD COMPONENTS
SPDR Gold Trust (GLD) traded at $84.43 on Aug. 8. January 2009 85-89 ratio spread
Dollar amount (price * No. of Long/ of contracts * contracts Month Type Strike short Price no. 100 multiplier)
20 January 2009 Calls 85 Long -$6.00 -$12,000
30 January 2009 Calls 89 Short $4.00 $12,000
GLD example, the backspread’s margin would be the same as buy-ing 20 January 85-89 bull call spreads plus 10 long January 89 calls.
Weighing the options
The backspread is not for everyone and certainly is not the right strategy for every market. In fact, the ratio spread, which is essentially the opposite position, is often preferable when you have a directional forecast for the underlying market. However, the backspread can deliver profits when you expect a big move but are uncertain about direction.
As with most options strategies, risk management is important. If the
underly-ing doesn’t move sufficiently within a reasonable amount of time, it is better to close the trade rather than risk the maximum loss, which happens if the spread’s long side expires worthless.
For information on the authorsee p. 5.
Related reading
“Managing profitable trades”
Options Trader, August 2006.
Handling a profitable options trade may seem easy, but it can be difficult to decide whether to cash out or hold on for further gains.
“A closer look at put backspreads”
Options Trader, July 2006.
Perfect on paper but still a trade you may want to avoid.
“Ratio call spreads:
Leverage profits and reduce risk”
Options Trader, June 2006.
Ratio call spreads can enhance an underlying position’s potential gains at no extra cost, or in many cases, for a net credit.
“Put ratio spreads:
Selling volatility to buy an option”
Options Trader, June 2006.
Put ratio spreads profit from slightly bearish moves, but the trick is to understand how implied volatility affects these positions. We explore several trade scenarios and discover the best time to place these spreads.
You can purchase past articles at http://store.activetradermag.com/
