FOT200811

November 2008 • Volume 2, No.
11
OPTIONS TRADER STUDY

offers strategy clues p. 18
FUTURES:
Trading multiple
systems p. 10
OIL’S
slippery slope p. 39
SPREAD TRADING
with the A-D line p. 22
PROFITABLE
delta-neutral trading p. 14
BASICS:
The put-call ratio p. 24
CONTENTS
Options Trading System Lab

Spread trading with the
advance-decline line . . . . . . . . . . . . . . . . . .22
This credit-spread system takes directional cues
from a market-breadth indicator.
By Steve Lentz and Jim Graham
Trading Basics
Put-call ratio . . . . . . . . . . . . . . . . . . . . . . . . .24
This widely watched indicator compares the
activity in put options to call options.
Learn about its variations and uses.
By Chris Peters
News
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .5 More exchanges move toward
electronic platforms . . . . . . . . . . . . . . . . . . .26
Market Movers . . . . . . . . . . . . . . . . . . . . . . . .6 The CBOE and the MGEX move toward
Futures markets are down across the board all-electronic platforms as open outcry gets even
as traders and investors divest themselves quieter.
of holdings.
CME Group offerings expand with
Trading Strategies plastics, swaps contracts . . . . . . . . . . . . . .27
Two systems are better than one . . . . . . .10 Merc keeps the new-contract spigot open.
Combining multiple trading systems can
improve the performance of your portfolio.
continued on p. 4
By Richard Weissman
Gamma scalping . . . . . . . . . . . . . . . . . . . . . .14

Find out how to build delta-neutral positions
and trade them profitability, regardless of
which way the market moves.
By Dan Passarelli
Who trades options? . . . . . . . . . . . . . . . . . .18

A recent academic paper analyzing who trades
different types of options strategies offers clues
for successful trading.
By George Hoekstra
2 November 2008 • FUTURES & OPTIONS TRADER

“I don’t need advice on what to trade.
I need tools so I can decide for myself.”
You don’t react to headlines, fads or the latest financial guru’s

hunches. You make your own trading decisions, based on your
experience, knowledge and discipline. You need a brokerage that offers
sophisticated tools and comprehensive data to back-test your ideas
before you trade. You don’t need advice, you need TradeStation.
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IMPORTANT INFORMATION: No offer or solicitation to buy or sell securities, securities derivative or futures products of any kind, or any type of trading or investment advice,
recommendation or strategy, is made, given or in any manner endorsed by TradeStation Securities, Inc. or any of its affiliates. • Past performance, whether actual or indicated by
historical tests of strategies, is no guarantee of future performance or success. • Active trading is generally not appropriate for someone of limited resources, limited investment
or trading experience, or low-risk tolerance. • There is a risk of loss in futures trading. Options and Security Futures trading is not suitable for all investors. Please visit our Web site
for relevant risk disclosures. • System access and trade placement and execution may be delayed or fail due to market volatility and volume, quote delays, system and software
errors, Internet traffic, outages and other factors. • All proprietary technology in TradeStation is owned by TradeStation Technologies, Inc., an affiliate of TradeStation Securities,
Inc. • Trading foreign exchange carries a high level of risk and may not be suitable for all investors. There is a possibility that you may sustain a loss equal to or greater than
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CONTENTS
Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .28

Momentum, volatility, and volume
statistics for futures.
Option Radar . . . . . . . . . . . . . . . . . . . . . . . . . .29

Notable volatility and volume
in the options market.
Futures & Options Watch

COT extremes . . . . . . . . . . . . . . . . . . . . . . . .30
A look at the relationship between commercials
and large speculators in all 45 futures markets. Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36
Options Watch: New Products and Services . . . . . . . . . . . . .38

Consumer Staples ETF components . . . . . . . .30
Futures Trade Journal . . . . . . . . . . . . . . .39
Futures & Options Calendar . . . . . . . . . . . .31 Adventures in the crude market.
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .32 Options Trade Journal . . . . . . . . . . . . . . .40

References and definitions. Buying puts on IBM as the stock
market crashes.
Have a question about something you’ve seen

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

Click on the company name below for a direct link to the ad
in this month’s issue of Futures & Options Trader.
Ablesys PFGBEST.com
eSignal RS of Houston
Mark 2 Market TradeStation
OptionsMentoring

CONTRIBUTORS
CONTRIBUTORS
George Hoekstra is a research engineer in the

petroleum refining business. He started trading options 30
A publication of Active Trader ®

years ago while studying under Myron Scholes who was
his professor at the University of Chicago. Hoekstra holds
For all subscriber services: degrees in chemical engineering from Purdue University and an MBA
www.futuresandoptionstrader.com
from the University of Chicago. He can be contacted via his Web site,
Editor-in-chief: Mark Etzkorn http://hoekstratrading.com/default.aspx.
metzkorn@futuresandoptionstrader.com
Richard L. Weissman is the author of Mechanical

Managing editor: Molly Goad
mgoad@futuresandoptionstrader.com Trading Systems: Pairing Trader Psychology with Technical
Analysis. He has more than 20 years experience as a deriv-
Senior editor: David Bukey
dbukey@futuresandoptionstrader.com atives trader and has provided training and consultation
services on technical analysis, risk management, and
Contributing editor:
derivatives trading to traders and risk managers for 15 years. Currently,
Keith Schap
he provides training for the Energy Management Institute
Associate editor: Chris Peters
(http://www.energyinstitution.org), a training solution provider to the
cpeters@futuresandoptionstrader.com
CME Group and IntercontinentalExchange, and can be reached at
Editorial assistant and rweissman@emimail.org.
Webmaster: Kesha Green
kgreen@futuresandoptionstrader.com
Dan Passarelli is the author of Trading Option Greeks
Art director: Laura Coyle
lcoyle@futuresandoptionstrader.com (Bloomberg, 2008) and the founder of Market Taker
Mentoring. For more information and a free excerpt from
President: Phil Dorman
pdorman@futuresandoptionstrader.com
his book, please visit http://markettaker.com. Passarelli
can be reached at dan@markettaker.com.
Publisher,
Ad sales East Coast and Midwest:
Bob Dorman Steve Lentz (advisor@optionvue.com) is a well-
bdorman@futuresandoptionstrader.com
established options educator and trader and has spoken all
Ad sales over the U.S., Asia, and Australia on behalf of the CBOE’s
West Coast and Southwest only: Options Institute, the Options Industry Council, and
Allison Chee
achee@futuresandoptionstrader.com
the Australian Stock Exchange. As a mentor for
DsicoverOptions.com, he teaches select students how to use complex
Classified ad sales: Mark Seger
options strategies and develop a consistent trading plan. Lentz is con-
seger@futuresandoptionstrader.com
stantly developing new strategies on the use of options as part of a com-
Volume 2, Issue 11. Futures & Options Trader is pub- prehensive profitable trading approach. He regularly speaks at special
lished monthly by TechInfo, Inc., 161 N. Clark Street,
Suite 4915, Chicago, IL 60601. Copyright © 2008
TechInfo, Inc. All rights reserved. Information in this
events, trade shows, and trading group organizations.
publication may not be stored or reproduced in any
form without written permission from the publisher.
The information in Futures & Options Trader magazine Jim Graham (advisor@optionvue.com) is the product
is intended for educational purposes only. It is not
meant to recommend, promote, or in any way imply manager for OptionVue Systems and a registered invest-
the effectiveness of any trading system, strategy, or
approach. Traders are advised to do their own ment advisor for OptionVue Research.
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.
FUTURES & OPTIONS TRADER • November 2008 5

MARKET MOVERS
The Great Sell-off continues

October expanded on September’s liquidation theme, with the financial crisis triggering selling across the board.
Instead of directing money into different markets as they took it out of the crumbling stock market, money managers
put it in cash (the U.S. dollar has been one of the few beneficiaries of the market panic).
Two wit: the lack of bullish activity in U.S. Treasuries and gold — two markets that conventional wisdom dictates
should rally in “flight-to-quality” situations. Apparently, traders and investors perceived little quality anywhere.
Preliminary data showed volume dropping significantly in both the futures and equity markets.
One interesting note: Futures of all kinds were up across the board on election day in the U.S. (Nov. 4).
Energy
Last month
crude oil fell well
below half its
July all-time high,
with the December futures
(CLZ08) hitting $61.30 on Oct. 27.
After a small bounce that took
the market up to $70, crude
opened November on a weak
note, turning back below $65 Source for all: TradeStation
before leaping back above $70 on
election day, Nov. 4.
The selling was imitated in the other major energy futures — gasoline
(RB), natural gas (NG), and heating oil.
Metals
The big story in
precious metal
futures has been Grains
the lack of story:
Gold refused to budge as the
Grains, like all com-
stock market disintegrated. It
modities, were down
looked like it might make a run
across the board, with
on Oct. 10 when the December
wheat (W) showing the
contract (GCZ08) pushed above
most signs of life — attempting to
$935 (topping the September
spike higher on a few days in late
high), but the move turned out to
October and early November — as the
be a feint: The contract closed down and over the next three weeks dropped
markets stabilized.
as low as 681. Silver and copper also wallowed near long-term lows as
November trading began.
The rationalization for gold’s weakness has been lack of inflationary pres-
sures in the market. However, this argument handily sidesteps the lack of the
expected “safe-haven” move into gold as stocks collapsed — something gold
bugs had been anticipating.

MARKET MOVERS continued
Softs and fibers

Coffee, sugar, and cocoa all sold off sharply in October, with
December coffee (KCZ08) and March 2009 sugar (SBH09)
rallying a little toward the end of the month while cocoa con-
tinued to trade sideways to lower.
Treasuries
Like gold, T-
notes failed to
produce the
perhaps-antici-
pated rally in October. However,
as discussed in “The flight-to-
quality trade” (Active Trader,
October 2008), the sell-stocks,
buy-treasuries phenomenon does-
n’t occur as often as people think.
December 10-year T-note
futures (TYZ08) fell from a high above 119 in mid-September to a low of 111-
12.5/32 in mid-October. By Nov. 4, the market had rebounded to around 115.
Stock
indices
Stock index futures
went on a wild ride in
October, posting huge intraday swings
and lurching higher and (mostly) lower
from day to day. After the spike low on
Oct. 10, the E-Mini S&P 500 futures zig-
zagged crazily before slightly exceeding
Meats that low on Oct. 27 and 28. The market
rallied the next few days, closing strong-
Toward the end of
ly on Nov. 4.
October, live cattle
Detailed coverage of the stock market
(LC) managed to
and the financial crisis can be found
stage a small rally off
in the current issue of Active Trader
its lows while lean hogs
(http://www.activetradermag.com).
(LH) continued to push to new lows.
December live cattle (LCZ08) traded as
high as 93.80 on Nov. 3 — the highest
level in nearly three weeks.
Currencies
The big story in the forex world was the dollar’s renewed
strength as the financial panic deepened. The buck gained
against all major currencies except the Japanese yen.
The dollar index (DXY) pushed to its highest level since 2006. (For currency
strategies, news, and analysis, go to http://www.currencytradermag.com).
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These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results shown in an actual performance record, these
results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under-or over-compensated for the impact, if any, of
certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of
hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to these being shown. The testimonial may not be representative of
the experience of other clients and the testimonial is no guarantee of future performance or success CTA Firm
TRADING STRATEGIES
Two systems
are better than one
Taking trade signals from multiple systems can help smooth out a portfolio’s equity curve.
The trick is to pick the right strategies.
BY RICHARD WEISSMAN
M ost investors understand the logic behind

diversifying their assets. One asset class or
industry may perform well as another one
loses ground, so if you place capital in dif-
ferent areas you can smooth your overall returns.
The same logic applies to diversifying trading systems.
Instead of focusing on only one system, traders can use two
ate-term approaches — a trend-following system and a
mean-reverting system with a trend filter. The systems are
then combined to show how total performance can be
improved when they are traded simultaneously.
Bollinger Band breakout system

The first system enters long trades when price closes above
or more systems that aren’t highly correlated to offset weak- the upper Bollinger Band and enters short trades when
nesses and improve a portfolio’s reward-risk profile. The price closes below the lower Bollinger Band. The system
idea is to mix trading styles to make sure the systems will exits when price reaches the 20-day simple moving average
complement each other: trend-following vs. countertrend, (SMA).
short-term vs. long-term, and so on.
The following strategy examines two different intermedi- Trade rules:
1. Go long if price closes above the

FIGURE 1 — TRADE EXAMPLE IN NATURAL GAS upper Bollinger Band (using a 20-day
The trend-following Bollinger Band strategy caught a major down move in SMA and two-standard-deviation
October natural gas futures from July 8 to Aug. 27. The system sold short bands).
when price closed below the lower Band and exited after it reached a 20-day
simple moving average. 2. Sell short if price closes below the
lower Bollinger Band.
3. Exit all trades with a stop-loss

order when price reaches the
20-day SMA.
Figure 1 shows a daily chart of the

October natural gas contract (NGV08) and
highlights a profitable short trade. The sys-
tem sold short when natural gas closed
below the lower Bollinger Band on July 8,
and closed the trade when price hit the 20-
day SMA on Aug. 27.
Table 1 shows back-test results for a
diversified portfolio of futures contracts
from Sept. 1, 1998 to Sept. 1, 2008 (including
$50 round-trip commission and slippage
fees). First, the average trade lasted just 12
Source: CQG, Inc. days, significantly shorter than many trend-

TABLE 1 — BOLLINGER BAND SYSTEM
The overall system’s profit-to-maximum-drawdown ratio (4.2) is larger than in any individual market, which is typical of a
diversified portfolio.
Avg. Percentage
trade Avg. Max. time
Total No. of Trades length Avg. annual Max. consecutive P:MD Winning in the
Market net profit trades per year (days) trade profit drawdown* losers ratio percentage market
British pound futures (BP) $5,267 98 9.8 12 $53.74 $526.70 -$14,862 9 0.35 35.71 44.46
Euro futures (EC) $30,328 96 9.6 14 $315.92 $3,032.80 -$18,250 8 1.66 32.29 48.83
Japanese yen futures (JY) $18,736 93 9.3 14 $201.46 $1,873.60 -$16,300 5 1.15 37.63 47.89
Natural gas futures (NG) $108,770 94 9.4 14 $1,157.13 $10,877.00 -$50,990 7 2.13 36.17 47.28
Crude oil futures (CL) $25,890 93 9.3 13 $279.35 $2,589.00 -$23,030 12 1.12 39.78 45.44
Gold futures (GC) -$11,510 106 10.6 13 -$108.58 -$1,151.00 -$23,300 10 -0.5 31.13 49.22
Sugar futures (SB) $872 94 9.4 14 $9.28 $87.20 -$8,341 10 0.1 31.91 47.75
Soybean futures (S) $43,324 84 8.4 15 $515.76 $4,332.40 -$11,062 6 3.92 46.99 46.89
Wheat futures (W) -$7,985 106 10.6 12 -$75.33 -$798.50 -$19,837 10 -0.4 26.42 46.86
10-year T-note futures (TY) $14,196 88 8.8 15 $161.32 $1,419.60 -$9,406 7 1.51 43.18 49.08
E-Mini S&P 500 futures (ES) -$33,724 98 9.8 12 -$344.12 -$3,372.40 -$38,362 9 -0.88 27.55 41.1
Portfolio $194,164 1,050 105 12 $184.92 $19,416.40 -$46,261 18 4.2 35.14 NA

*17 months — beginning of drawdown to new equity high (10/06-3/08)
Longest drawdown was 26 months (10/98-12/00), but drawdown was -$45,566
Source: CQG, Inc.
FIGURE 2 — TRADE EXAMPLE IN EURO FUTURES

following systems, and therefore more
The countertrend RSI system bought Euro futures after the RSI closed below 35
psychologically palatable to most
on May 2 and exited after the RSI climbed above 65 on May 22.
traders. One of the biggest advantages
of shorter trades is per-trade losses are
often smaller.
Table 1 shows that gains from indi-
vidual markets add to the portfolio’s
profits, while the individual maximum
drawdowns don’t add to the portfo-
lio’s overall drawdown. For example,
the profit-to-maximum-drawdown
ratio (P:MD) for the portfolio is 4.2 —
larger than the P:MD ratio of any single
market. This is typical of a diversified
portfolio and suggests profits in one
market offset drawdowns in others.
Like most trend-following systems,
the portfolio’s percentage of winning
trades is well below 50 percent. The
system is still profitable overall, how-
ever, because its average wins are sig-
Source: CQG, Inc.
nificantly larger than its average losses.
System developers understand these
differences, and some simply choose to omit certain mar- Countertrend RSI system
kets from trend-following system portfolios and others A straightforward way to complement the Bollinger Band
from mean-reversion, or countertrend, portfolios. If we system is to add a countertrend system with no bias toward
traded the Bollinger Band breakout strategy, for example, the dominant market trend. Instead, let’s test a coun-
we would likely not use it to trade stock-index futures. That tertrend system that uses the relative strength index (RSI)
said, there is no guarantee trending markets of the past 10 with a 200-day SMA to prevent taking trade signals that are
years will continue to trend in the future, and previously against the long-term trend.
choppy markets could become trending markets in the
future, which is why the E-Mini S&P 500 was included. continued on p. 12

TRADING STRATEGIES continued
TABLE 2 — COUNTERTREND RSI SYSTEM

This countertrend RSI system had a winning percentage of 67.65 percent and only 6 consecutive losses. On the other hand,
it took 43 months to recover from its largest drawdown.
Avg. Percentage
trade Avg. Max. time
Total No. of Trades length Avg. annual Max. consecutive P:MD Winning in the
Market net profit trades per year (days) trade profit drawdown* losers ratio percentage market
British pound futures (BP) $33,466 34 3.4 25 $984.29 $3,346.60 -$11,631 2 2.88 82.35 32.63
Euro futures (EC) $20,410 23 2.3 25 $887.39 $2,041.00 -$15,212 2 1.34 69.57 22.41
Japanese yen futures (JY) -$527 27 2.7 28 -$19.52 -$52.70 -$20,625 2 -0.03 59.26 28.87
Natural gas futures (NG) -$10,800 40 4 20 -$270.00 -$1,080.00 -$57,560 4 -0.19 45 29.87
Crude oil futures (CL) $22,430 28 2.8 25 $801.07 $2,243.00 -$15,800 1 1.42 71.43 26.87
Gold futures (GC) $14,810 27 2.7 29 $548.52 $1,481.00 -$10,350 2 1.43 74.07 30.58
Sugar futures (SB) -$118 25 2.5 32 -$4.72 -$11.80 -$5,958 2 -0.02 72 31.15
Soybean futures (S) -$27,900 24 2.4 39 -$1,162.50 -$2,790.00 -$32,350 2 -0.86 56.52 34.59
Wheat futures (W) $11,417 30 3 25 $380.57 $1,141.70 -$12,625 2 0.9 76.67 28.74
10-year T-note futures (TY) $6,541 27 2.7 30 $242.26 $654.10 -$12,350 2 0.53 66.67 30.89
E-Mini S&P 500 futures (ES) $7,252 21 2.1 32 $345.33 $725.20 -$11,212 1 0.65 71.43 26.03
Portfolio $76,981 306 30.6 25 $251.57 $7,698.10 -$43,203 6 1.78 67.65 NA

Source: CQG, Inc.
Trade rules: volume is less than yesterday’s volume.
1. Go long if the nine-day RSI is below 35, price 4. Exit short trade if the RSI closes below 35 or with
closes above its 200-day SMA, and today’s volume a $7,500 stop-loss.
is less than yesterday’s volume.
Figure 2 shows a daily chart of Eurocurrency futures (EC)
2. Exit long trade if RSI closes above 65, or with a with a profitable long trade. On May 2 the RSI fell below 35
$7,500 stop-loss. and price remained above its 200-day SMA, triggering a
long trade. The RSI closed above 65 on May 22 and the
3. Sell short if the nine-day RSI is above 65, price trade was exited the next day.
closes below the 200-day SMA, and today’s Table 2 shows back-test results for the same futures mar-
kets over the past 10 years. Unlike the Bollinger Band
breakout system, the countertrend RSI system had a high
Related reading winning percentage — 67.65 percent. In addition, the E-
Mini S&P 500 futures, which was the trend-following strat-
“Multi-system testing” egy’s poorest performer, was profitable and had a 0.65
Active Trader, December 2008. P:MD ratio ($7,252 net profit/$11,212 maximum draw-
This Trading System Lab shows there is more to trading down). Finally, the countertrend system had only six con-
multiple systems than first meets the eye. secutive losing trades compared to 18 for the Bollinger
Band system.
“Allocating capital to multiple trading signals” Of course, the RSI strategy had its own weaknesses, espe-
Active Trader, November 2006. cially a lengthy 43-month drawdown before hitting a new
Find out how a multi-signal system performed using equity high and a mediocre 1.78 P:MD ratio. If traded alone,
three different capital-allocation techniques.
these weaknesses would be troublesome, but the goal is to
combine it with the Bollinger Band system. Therefore, the
You can purchase and download past articles at
strengths of the latter system will offset the weaknesses of
http://store.activetradermag.com.
the former.

TABLE 3 — COMBINING THE SYSTEMS
The combined system performed better than either standalone system. It had a profit-to-maximum-drawdown ratio of 5.39,
which is superior to either strategy.
Avg.
trade Avg. Max.
Total No. of Trades length Avg. annual Max. consecutive P:MD Winning
Market net profit trades per year (days) trade profit drawdown* losers ratio percentage
British pound futures (BP) $38,733 132 13.2 15.35 $293.43 $3,873.30 -$13,100 7 2.96 47.73
Euro futures (EC) $50,738 119 11.9 16.13 $426.37 $5,073.80 -$17,362 7 2.92 41.18
Japanese yen futures (JY) $18,209 120 12 17.15 $151.74 $1,820.90 -$16,901 5 1.08 41.67
Natural gas futures (NG) $97,970 134 13.4 15.79 $731.12 $9,797.00 -$56,520 7 1.73 38.06
Crude oil futures (CL) $48,320 121 12.1 15.78 $399.34 $4,832.00 -$17,390 12 2.78 47.11
Gold futures (GC) $3,300 133 13.3 16.25 $24.81 $330.00 -$16,090 9 0.21 39.85
Sugar futures (SB) $754 119 11.9 17.78 $6.34 $75.40 -$5,946 6 0.13 40.34
Soybean futures (S) $15,424 108 10.8 20.33 $142.81 $1,542.40 -$14,314 4 1.08 50
Wheat futures (W) $3,432 136 13.6 14.87 $25.24 $343.20 -$11,188 7 0.31 37.5
10-year T-note futures (TY) $20,737 115 11.5 18.52 $180.32 $2,073.70 -$11,732 7 1.77 48.7
E-Mini S&P 500 futures (ES) -$26,472 119 11.9 15.53 -$222.45 -$2,647.20 -$33,492 10 -0.79 35.29
Portfolio $271,145 1,356 135.6 14.93 $199.96 $27,114.50 -$50,351 16 5.39 42.33
Source: CQG, Inc.
Combining low-correlation countertrend RSI system (24 months your broker to prevent one strategy’s
systems vs. 43 months). More importantly, the long positions from offsetting anoth-
Table 3 shows the results of combining combined system had a 5.39 P:MD er’s short positions.
the systems. The combined portfolio ratio, which is superior to either of the
had a higher winning percentage than component strategies. For information on the author see p. 5.
the Bollinger Band strategy (42.33 per- One disadvantage to trading mul-
cent vs. 35.14 percent) and a shorter tiple systems is you might have to
peak-to-valley drawdown than the open additional subaccounts with
CQG programming code

Bollinger Band system:
Long Entry: Close(@)[-1] > BHI(@,Sim,20,2.00)[-1]
Short Entry: Close(@)[-1]< BLO(@,Sim,20,2.00)[-1]
Long & Short Exit (set price field to): BMA(@,Sim,20)[-1]
Counter-trend RSI system:
Long Entry: RSI(@,9)[-1] < 35 AND Close(@)[-1] > MA(@,Sim,200)[-1] AND

Vol(@)[-2] > Vol(@)[-1]
Long Exit: RSI(@,9)[-1] > 65 OR

OpenPositionAverageEntryPrice(@,ThisTradeOnly) - Dollar2Price(@,7500)
/ OpenPositionSize(@,ThisTradeOnly)
Short Entry: RSI(@,9)[-1] > 65 AND Close(@)[-1] < MA(@,Sim,200)[-1]

AND Vol(@)[-2] > Vol(@)[-1]
Short Exit:
RSI(@,9)[-1] > 65 OR OpenPositionAverageEntryPrice(@,ThisTradeOnly) -
Dollar2Price(@,7500) / OpenPositionSize(@,ThisTradeOnly)

TRADING STRATEGIES
Gamma scalping
In uncertain times smart traders focus on volatility, not market direction.
BY DAN PASSARELLI
G iven the recent stock-market rout, volatility

seems like a dirty word. But it doesn’t have
to be. Volatility simply means opportunity in
the options markets.
Every opportunity to make money includes the potential
for risk. In highly volatile markets, you really need skills to
have a fighting chance.
decay — a strategy known as “gamma scalping.”
Understanding the Greeks

Before trading this strategy, you need to understand the
Greeks, which measure different components of an option’s
price — delta, gamma, theta, and vega.
Delta is the rate of change of an option’s value relative to
The problem is many traders focus solely on predicting a change in the underlying’s price. Delta is also considered
the market’s direction, a foolish task in such an uncertain the equivalent to shares held in the underlying. Gamma is
environment. Instead, sophisticated traders try to take
advantage of rising volatility regardless of which direction TABLE 1 — NASDAQ 100 TRACKING STOCK
the markets are headed. (QQQQ) PRICES
One way to exploit a jump in volatility is to buy an
options straddle (long call, long same-strike put). Straddle In August, QQQQ’s close-to-close price change (up or
buyers make money if the underlying market moves far down) was $0.50. If you think its daily price moves could
rise to $0.90 in six weeks, you could buy an October
enough in one direction to offset the position’s cost.
options straddle to take advantage of increased volatility.
Another way to make money with a long straddle is to
buy or sell the underlying market each time it moves a cer-
tain amount. The idea is that if you buy stock after it drops Date Closing price Daily change
and sell after it climbs, you can offset the straddle’s time 8/1/08 44.88
8/4/08 44.43 -0.45
Strategy Snapshot 8/5/08 45.93 1.5
8/6/08 46.63 0.7
Strategy: Gamma scalping with straddles
8/7/08 46.27 -0.36
Components: Long at-the-money (ATM) calls 8/8/08 47.32 1.05
+ 8/11/08 47.75 0.43
Long same-strike puts 8/12/08 47.8 0.05
Logic: Create a delta-neutral position by buying 8/13/08 47.7 -0.1
options and offsetting their deltas by 8/14/08 48.25 0.55
trading an appropriate number of shares. 8/15/08 48.16 -0.09
To keep the trade direction neutral, buy 8/18/08 47.6 -0.56
when position delta gets negative and sell 8/19/08 47.01 -0.59
when position delta gets positive.
8/20/08 47.09 0.08
Criteria: Use options that expire within one or 8/21/08 46.87 -0.22
two months. 8/22/08 47.49 0.62
Best-case The profits from buying low and selling 8/25/08 46.49 -1
scenario: high exceed any time decay from the long 8/26/08 46.43 -0.06
options. Implied volatility spikes. 8/27/08 46.73 0.3
8/28/08 47.11 0.38
Worst-case Time decay from the long options exceed
scenario: any gains from buying low and selling 8/29/08 46.12 -0.99
high. Implied volatility tanks. Transaction
costs add to losses. Avg. daily change (up or down): 0.50

FIGURE 1 — RISK PROFILE – LONG STRADDLE
Long straddles make money if the underlying moves far enough in either direction
to offset the negative effect of time decay. On Sept. 4, this long 43-strike straddle
the rate of change of an option’s delta will become profitable if QQQQ either drops to $41.42 or climbs to $44.06.
relative to a change in the underlying’s
price. Theta is the rate of change of an
option’s value relative to the passage
of time. And vega is the rate of change
of an option’s value relative to a
change in implied volatility (IV).
If these terms are new to you, that’s
okay. But keep in mind strategies that
rely heavily on the Greeks are often
more complex. Let’s examine a long
straddle example to see how these con-
cepts work together.
Buying volatility
with straddles
Table 1 lists the daily closing prices of
the Nasdaq 100 tracking stock (QQQQ)
in August. Disregarding direction, the
average close-to-close price change
was $0.50. Let’s assume you thought Source: OptionVue
daily change could climb to $0.90 in
the next six weeks. TABLE 2 — OPTION GREEKS
On Sept. 4, QQQQ closed at $43.66, and you could have
When QQQQ closed at $43.66 on Sept. 4, you could have
bought 10 October 43-strike calls for 2.05 each and 10
bought Oct. 43-strike calls for 2.05 each and Oct. 43-strike
October 43 puts for 1.33 each — a total of 3.38 ($338) each.
puts for 1.33 each — a total cost of 3.38. The position is vul-
When you buy this straddle, you acquire Greeks risk, nerable to changes in the underlying’s price (delta), delta’s
meaning the position is vulnerable to changes in the under- value (gamma), time (theta), and implied volatility (vega).
lying’s price (delta), delta’s value (gamma), time (theta),
and implied volatility (vega). Table 2 lists the long strad- 10 Oct. 10 Oct. 10 Oct.
dle’s cost and Greeks values. 43 calls 43 puts 43 straddles
Figure 1 shows the long straddle’s potential gains and Value (per contract) 2.05 1.33 3.38
losses on three dates: trade entry (Sept. 4, dotted line), Delta 5.88 -4.15 1.73
halfway until expiration (Sept. 26, dashed line), and expira- Gamma 0.93 0.94 1.87
tion (Oct. 18, solid line). The position will typically make Theta -0.2 -0.18 -0.38
money if QQQQ either rallies or falls, but it must move Vega 0.58 0.58 1.16
enough to offset the negative effect of time decay. As time
passes, the straddle’s value drops, and the Nasdaq 100
tracking stock must move further in either direction to be of the Nasdaq 100 tracking stock. And as QQQQ rallies
profitable. higher, the delta will rise further.
However, the goal here isn’t simply to hold the straddle On the other hand, if QQQQ falls, the straddle’s delta
and wait for the underlying to make a large move. Instead, will drop by gamma’s value. So if the Nasdaq 100 tracking
we plan to capture small profits as QQQQ fluctuates each stock drops $1 to $42.66, the straddle’s delta slips from 1.73
day, which requires monitoring the position’s Greeks to -0.14 by the gamma value of 1.87. Now, the straddle’s
closely. delta resembles 14 short shares. And as QQQQ falls lower,
the delta will become more negative. If the underlying
Tracking delta and gamma drops $1 further to $41.66, the straddle’s gamma (1.87) will
The straddle has a delta of 1.73, meaning its directional risk cause the delta to change to -2.01 from -0.14. As QQQQ’s
is similar to 173 QQQQ shares. If the Nasdaq 100 tracking decline intensifies, the more the straddle will earn for each
stock climbs by $1, the straddle will gain $1.73 ($173). But $1 drop.
considering you are holding 20 contracts, representing 2,000
underlying shares, this is a fairly flat position at this point. Creating a delta-neutral position
Gamma tracks delta’s rate of change as the underlying Ideally, the long straddle will have a delta of zero, but the
moves. Therefore, if QQQQ rises $1 from $43.66 to $44.66, October 43 straddle has a long delta bias (1.73). If QQQQ
the straddle’s delta will climb by 1.87 — gamma’s value — fell from $43.66, the only benefit positive gamma offers is to
to 3.60. At that point, the straddle will resemble 360 shares continued on p. 16

TABLE 3 — DELTA-NEUTRAL STRADDLE
Related reading At first, the straddle had a delta of 1.73, but it fell to zero after
we sold short 173 shares. Notice that delta is the only Greek
Dan Passarelli articles: value that changes when you trade the underlying stock.
“Fighting the options battle with the Greeks” 10 Oct. 10 Oct. 10 Oct. 10 straddles,
Futures & Options Trader, February 2008. 43 43 43 short
Paying attention to options Greeks is vital for nearly any calls puts straddles 173 shares
options trader. Tracking an option’s delta, gamma, theta, Value (per contract) 2.05 1.33 3.38 3.38
and vega might save your neck in today’s volatile market. Delta 5.88 -4.15 1.73 0
“Trading against the pros” Gamma 0.93 0.94 1.87 1.87
Options Trader, November 2006. Theta -0.2 -0.18 -0.38 -0.38
Understanding how market makers manage risk may Vega 0.58 0.58 1.16 1.16
help you get better fills.
“Calendar spreads: Taking time out of the market” reduce delta’s value, meaning the position loses less as the
Options Trader, February 2006. underlying falls.
Trading time spreads offers a way to take advantage of
To trade volatility instead of direction, the first step is to
time decay and volatility changes while limiting risk.
eliminate the straddle’s directional (delta) bias by selling
Other articles: short 173 shares of QQQQ. Table 3 shows the position is now
“Shifting into neutral” delta neutral. After this adjustment, all the Greek values
Futures & Options Trader, June 2008. remain unchanged except for delta, because 100 underlying
You don’t always have to forecast market direction cor- shares have a delta of 1.0, but a gamma, theta, and vega of
rectly to make money-trading options. This non-direction- zero.
al approach will gain ground if you buy options before Now that the straddle’s directional bias has been eliminat-
volatility picks up or sell them before it declines. ed, you can begin to trade based solely on the underlying’s
“Valuing options with ‘gamma rent’” volatility — the more volatile QQQQ becomes, the more
Active Trader, August 2007. chances you’ll have to make money. After the Nasdaq 100
Deciding whether an option is cheap enough to buy or tracking stock rises or falls, you can neutralize its delta by
expensive enough to sell can be tough. This simple for- buying or selling underlying shares, locking in profits with
mula uses implied volatility to find out what the markets each trade. This process is called gamma scalping, because
think. positive gamma creates the opportunity to trade stock favor-
“Swing with the market: Vega and rho” ably.
Options Trader, February 2007. If, for example, QQQQ climbs $1 to $44.66, the position’s
Vega and rho are lesser-known “Greeks,” but they meas- delta rises to 1.87 from zero, and you can sell short 187 shares
ure the effect of two critical option-pricing components: to lower its delta back to zero. Then if QQQQ drops back
implied volatility and interest rates. down to $43.66, you can buy back the short 187 shares, lock-
“Know your theta”
ing in a $187 profit. Again, as volatility climbs, the strategy’s
Options Trader, January 2007. potential profit increases.
Time eats away at every options position, so it pays to In theory, this technique sounds good, and it works well if
know time decay affects option prices. the underlying is volatile enough. But when volatility wanes,
the position is punished by the passage of time.
“Get on the fast track with gamma”
Options Trader, November 2006.
Gamma digs digger into explaining how underlying price The trade-off between gamma and theta
moves affect an option’s price. The success of a long straddle depends on the trade-off
between gamma, which drives the strategy, and theta, which
“Delta for the rest of us” erodes the position’s value. Time decay, or theta, takes its toll
Options Trader, October 2006.
on the straddle’s value as time passes; the October 43 straddle
A few simple concepts shed light on delta and how option
loses $38 each day, including weekends. Therefore, you must
prices change.
earn $266 in gamma scalps each week to cover the position’s
Several of these articles are included in “Options carrying costs.
Basics Collection, Volume 1,” a set of nine past If the Nasdaq 100 tracking stock moves roughly $1 each
Options Trader and Active Trader articles. The collection day, this isn’t a problem, but remember it was only moving
encompasses options terminology, fundamental trading
$0.50 each day when we entered the position on Sept. 4. If
concepts and simple strategies, as well as practical con-
QQQQ rises $0.50 to $44.16, delta will climb to 0.94, similar to
siderations such as margin. This is a series designed for
those new to options trading, whether in stock or futures, 94 long shares. At that point, you can sell 94 shares to neu-
available now for a 30-percent discount. tralize delta. And if QQQQ drops $0.50 the next day, you can
buy back 94 shares to neutralize delta again. This trade earns
You can purchase and download past articles at just $47 in two days, which isn’t enough to cover theta’s cost.

Don’t forget IV (vega)
If trading volatility is so easy, then why
don’t clever traders just buy straddles on
the most volatile stocks? They do, and the
price of straddles rises because of this buy-
ing pressure, posing two problems for
straddle buyers. First, because a straddle
costs more, theta is higher, inflating the
position’s daily carrying cost. Also, the IV of
the options increases.
Implied volatility is the relative price of
an option based on the market’s expecta-
tions of future volatility. When the market
thinks volatility will climb in the future,
which benefits long straddles, options
prices rise and vice versa.
How IV affects your trade depends on
the difference between your view of future
volatility compared to the market’s assess-
ment. Is the straddle’s cost worth it? The
problem appears when the market adjusts
its view of future volatility, causing IV to
fall and your straddle to be worth less.
You can track IV’s effect on your position
using vega: In the October 43 straddle
example, IV is 28 percent. However, if
traders suddenly felt volatility in QQQQ is
poised to rise and bought more options, IV
could climb, boosting the straddle’s value
by its vega. For example, if IV advances one
percentage point to 29, the straddle’s cost
will jump 1.16 ($116). By contrast, if the
market’s opinion of volatility fell by one
percentage point to 27, the straddle will lose
the same amount. Note that this vega’s
value is based on a 10-contract straddle; the
straddle’s per-contract vega value is 0.116
($11.60).
The realities of gamma scalping

In the past, only market makers and other
professional traders could make money
scalping gamma on delta-neutral positions,
because commissions took a big chunk of
any profits. These days, low commissions
and portfolio margining allow retail traders
to use this technique too.
However, trading based on the Greeks is
complex, and this example should be
viewed as only the first step in learning the
nuances of this approach.
For information on the author see p. 5.
FUTURES & OPTIONS TRADER • November 2008

TRADING STRATEGIES
Who trades options?

An academic study of who trades what in the options markets finds that traders
prefer to keep their strategies simple.
BY GEORGE HOEKSTRA
W henever you trade an option, someone

takes the other side of your trade. Have
you ever wondered who that person is?
Professional market makers, whose job is
to provide a market in the options on that stock, often do.
But who else trades options and how can you use this infor-
mation?
some myths about how options markets work and offer
clues about how to trade options more effectively.
Call options are big business

First, the researchers broke down the CBOE data into four
different groups of non market makers: firm proprietary
traders, discount customers, full-service customers, and
A recent academic study of option market activity ana- other public customers. These four investor groups trade
lyzed 12 years of trading data for options listed at the many more calls than puts. Figure 1 breaks down their
Chicago Board Options Exchange (CBOE) to see who trades trades according to open interest during the 12-year period.
options and why they do it. The conclusions are summa- Open interest in calls was four times as large as open
rized in a paper titled Option Market Activity by professors interest in puts (80 percent vs. 20 percent). The most popu-
Josef Lakonishok, Inmoo Lee, Neil Pearson, and Allen lar trade among non market makers was to sell calls, main-
Poteshman of the University of Illinois. ly as part of popular covered call positions (long stock,
These researchers uncovered some interesting details short call).
about option market activity from 1990 to 2001 that debunk
FIGURE 1 — TYPES OF POSITIONS FIGURE 2 — WHO SELLS CALLS?

Non market makers traded calls almost exclusively from Full-service customers — hedge funds and retail
1990 to 2001. By contrast, only 20 percent of all trades traders — held 70 percent of the short-call open inter-
used puts (short or long). est, meaning they often sold covered calls.
Source: Option Market Activity Source: Option Market Activity

FIGURE 3 — CALL-BUYING VOLUME SURROUNDING TECH BUBBLE
Discount customers bought more calls as the technology bubble inflated in the
late 1990s.
Who sells calls?
Figure 2 shows who sold calls from
1990 to 2001. Customers of full-service
brokerage firms held 70 percent of the
short-call open interest. These cus-
tomers include hedge funds and retail
investors who often use more sophisti-
cated investment strategies. Most of
their positions hedge long stock posi-
tions — i.e., covered calls.
Another interesting conclusion is
some advanced strategies that get a
great deal of attention in trading litera-
ture and textbooks weren’t used
much.
The following strategies weren’t as
popular as you might think:
Straddles, strangles, and butterfly
spreads. Options educators often focus
on ways options can be used to specu- Source: Option Market Activity
late on changes in stock volatility.
Straddles, strangles, and butterflies FIGURE 4 — SHERWIN WILLIAMS SEPTEMBER 60 CALL
are volatility-based strategies. But
Trading volume tends to pick up as interest grows and the contract moves closer
the study’s data reveals “volatility
to expiration.
trading through straddles, stran-
gles, and butterflies — whether for
speculative or hedging purposes —
explains at most a small fraction of
option trading.” Traders may enjoy
discussing these positions, but few
use them in real-world situations.
Protective puts. Another high-pro-
file strategy is buying puts to hedge
long stock positions. This is a sensi-
ble strategy that resembles buying
insurance on the underlying stock.
However, the study shows that
very few traders use protective
puts. Indeed, traders rarely bought
puts for any reason; Figure 1 shows
only 9 percent of total open interest
was long puts.
Source: OptionsXpress
Dot-com bubble fueled call
buying
The study also found discount customers bought more calls bubble (1990-1994), early-bubble (1994-1997), peak-bubble
as the technology bubble inflated in the late 1990s. Before (1998-March 2000), and post-bubble (April 2000-2001).
reaching this conclusion, researchers analyzed the average Figure 3 shows that call buying by discount customers
volume of opening purchases in four time periods: pre- continued on p. 20

doubled from the initial pre-bubble period to the early-bub- For example, Figure 4 shows a daily chart of a Sherwin
ble period (1990-1994 vs. 1994-1997). Then, as the bubble Williams (SHW) September 2008 60 call. Charts of individ-
peaked from 1998 to March 2000, discount customers ual options are available on most brokers’ Web sites. The
bought nearly 2.5 times as many calls than before the bub- SHW September 60 call began trading in February 2008.
ble began. After the bubble, discount customers bought
only one-third as many calls as they did during the peak. TABLE 1 — TIME AND SALES DATA
Clearly, the technology boom attracted discount cus-
tomers who speculated that stocks would continue to rise. The more an option contract trades, the more likely you
will be able to get a better filled price on a limit order.
And many of them were probably new options traders.
Volume was concentrated in long calls on large growth Date Time Exchange Size Price
stocks. By contrast, the study didn’t find increased call buy- 9/4/08 9:31:12 10 2.3
ing among other types of investors. 9/4/08 9:45:45 CBOE 5 2.39
(Click here to download the full Option Market Activity 9/4/08 11:09:25 48 2.15
article.) 9/4/08 11:09:25 46 2.15
9/4/08 11:09:25 53 2.15
Lessons from this study
9/4/08 11:09:25 84 2.15
First, most options traders use simple strategies such as
9/4/08 11:09:25 19 2.15
buying calls and selling covered calls. It makes sense to
keep things simple. Don’t get caught up in the idea that you 9/4/08 11:11:35 2 2.15
should trade complex strategies, which usually require a 9/4/08 11:11:36 9 2.15
great deal of capital to execute consistently and add to 9/4/08 11:11:37 5 2.15
transaction costs. 9/4/08 11:11:43 123 2.15
Also, the study contradicts a common myth that most 9/4/08 11:11:44 CBOE 2 2.15
retail option traders are wide-eyed, unsophisticated gam- 9/4/08 11:11:44 111 2.15
blers who buy calls to make short-term, high-leverage bets
9/4/08 11:13:29 47 2.25
on stocks. To some extent, this caricature was likely accu-
9/4/08 11:13:29 PSE 15 2.25
rate during the dot-com bubble, but even then, call buying
was only a small part of the total picture, and it has dried 9/4/08 11:13:29 PSE 11 2.25
up since 2000. 9/4/08 11:13:29 CBOE 78 2.25
A corollary to this myth is that selling covered calls is a 9/4/08 11:13:29 30 2.25
smart way to take advantage of the overabundance of call 9/4/08 11:13:29 PSE 6 2.25
buyers who bid up option prices to excessive levels to pay 9/4/08 11:13:29 10 2.25
for high-leverage bets. However, the study’s data suggests 9/4/08 11:13:40 CBOE 9 2.25
the supply-demand balance among non market-makers is
9/4/08 11:14:23 21 2.2
tilted toward an oversupply of call sellers. If more traders
9/4/08 11:14:23 9 2.2
want to sell calls than buy them, prices will tend to be driv-
en down. Therefore, that bias may work to call buyers’ 9/4/08 11:59:43 10 2
advantage. 9/4/08 15:07:08 4 1.6
9/4/08 15:07:41 11 1.6
Dig into trading data 9/4/08 15:28:26 CBOE 10 1.6
Can you benefit from studying trading data on options that 9/4/08 15:28:26 10 1.6
seem attractive? The Options Market Activity authors used 9/4/08 15:37:14 12 1.6
some clever analysis, along with available data, to learn
9/4/08 15:37:17 4 1.6
when and how options trades took place. This kind of data
9/4/08 15:37:18 8 1.6
is increasingly available to anyone.
Many options are thinly traded, meaning only a few 9/4/08 15:37:22 4 1.6
trades are executed each day. These contracts usually have 9/4/08 15:37:23 4 1.6
wide bid-ask spreads. Today, it is possible to study how a 9/4/08 15:39:10 6 1.6
day’s trading unfolds, tick-by-tick. If you are considering 9/4/08 15:39:10 54 1.6
buying or selling options on a stock, it makes sense to dig Source: OptionsXpress
into that data and see what you can learn.

Related reading: George Hoekstra articles
“The quest for cheap options” “The option pricing edge,” Options Trader, October 2005.
Futures & Options Trader, August 2008. Buying options at a 10- to 20-percent discount can be the dif-
This option-buying strategy builds on a recent academic study ference between making and losing money over time. A pop-
that found a compelling edge in the options market from 1996 ular trading approach is to buy options on a stock you expect
to 2005. to have more volatility than the level implied by the price of its
options. Higher volatility translates into higher option prices,
“Getting a handle on volatility” so if your assessment of future volatility is correct, such
Options Trader, September 2006. options give you an advantage in that higher actual volatility
Want to understand volatility? Before you dive into option-pric- increases the chance of a profitable trade.
ing models and complex math, do some basic price compari-
son. You’ll be surprised how much you can learn. “Bargain hunting options,” Active Trader, January 2005.
If you get the willies every time you read “standard deviation,”
“Focusing on volatility,” Options Trader, August 2005. take heart: This volatility analysis approach and option trading
To hone in on options with the most favorable odds, structure strategy takes the mathematical sting out of finding inexpen-
a search that focuses on a certain stock price, exercise price, sive options.
and expiration date, and then use a simple analysis approach
to identify options that are the most underpriced. You can purchase and download past articles at
Price and volume data is shown from Sept. 4. There were a couple of small
its initial offering in February to Sept. trades at 9:31 a.m. and 9:45 a.m., but
5, two weeks before it expired on Sept. then no trades occurred until the five-
19. minute interval from 11:09 a.m. to
Trading volume was sparse in 11:14 a.m. when volume exceeded the
February and March as the call didn’t total number of contracts traded so far.
trade at all on most days. But volume What does this mean? One clue is
picked up in July and August as expi- whether the trades are filled at the bid
ration drew closer. The first time its price, ask price, or in between. You can
daily volume exceeded 100 contracts find other clues by examining other
was July 18. By August the contract Sherwin Williams options. For exam-
traded nearly every day, and in ple, did volume climb in same-strike
September, its expiration month, vol- puts or calls with different strikes or
ume increased considerably, including expirations?
one day with 900 contracts traded. The idea is to study the trades in
This pattern of gradually increasing attractive options to find patterns. If,
trading volume is typical as interest for example, you see volume spurts
grows and the contract moves closer to occasionally either at the bid or ask
expiration. price, you might be able to enter a
limit order and wait for it to get filled
Gleaning insight from at a more attractive price. If a contract
time and sales data never trades, you probably won’t be
Another way to examine an option’s able to buy it much below the ask
trading activity is to use its time and price. But if a contract trades more fre-
sales data available in the quotes sec- quently, you might get a better fill on a
tion of most brokers’ Web sites. limit order if you are patient.
Table 1 shows the time and sales
data for the SHW September 60 call on For information on the author see p. 5.

OPTIONS STRATEGY
OPTIONS TRADING SYSTEM
LAB LAB
Spread trading with

the advance-decline line
Market: Options on the S&P 500 index (SPX). Trade rules:
System concept: This system trades credit spreads Bullish signal

based on signals generated by the advance-decline (A-D) The S&P 500 forms a lower low than yesterday, but
line, which is a day-to-day running total of the number of the A-D line doesn’t.
stocks that have closed higher on the day (advancing) Enter the trade at the close on the first day the S&P
minus the number of stocks that have closed lower on the 500 posts a gain.
day (declining). The indicator is applied to the S&P 500
index, but it can be calculated on any market index for Entering bull put spreads
which daily advancing and declining issues are reported. 1. Sell 10 puts with a strike located one standard
Trade signals are triggered when the underlying’s price deviation out-of-the-money (OTM).
diverges from the A-D line. For example, a bullish signal is 2. Buy 10 puts at a strike 10 points below the short
triggered when the S&P 500 forms a lower low but the A-D put.
line doesn’t. A bearish signal occurs when the S&P 500 3. Use the first expiration month with more than 21
makes a higher high but the A-D line doesn’t. days left until expiration.
Depending on the type of signal, the system enters a bull 4. The spread’s minimum yield must be at least 5
put spread or a bear call spread. Each spread is held either percent (premium received / net margin
until it expires worthless or an opposite signal appears. The required).
system isn’t always in the market, so there are long periods
of inactivity. Bearish signal
To enter a vertical credit spread, you sell an option with 1. The S&P 500 forms a higher high than yesterday,
a strike that is closer to the money than the one bought to but the A-D line doesn’t.
protect it. The spread tries to
exploit the short option’s time
FIGURE 1 — RISK PROFILE: BULL PUT SPREAD
decay and collects the most
profit if the underlying doesn’t This 1135-1145 bull put spread has an 88-percent probability of profit and will make
reverse beyond the short strike money if the S&P 500 index closes above 1143.94 at Oct. 17 expiration.
price by expiration. Both
options share the same expira-
tion month, and when strikes
are 10 points apart, a 10-contract
position requires a $10,000 mar-
gin. The spread is entered at a
net credit, which you keep if
both options expire worthless.
Figure 1 shows the potential
gains and losses of an October
1135/1145 bull put spread
entered on Sept. 5 when the S&P
500 closed at 1242.30. The trade
would be profitable if the S&P
500 closes above 1143.94 on Oct.
17 (expiration). The spread’s
maximum gain is $1,070, a 12-
percent potential yield (104 per-
cent annualized). The position
can lose up to $8,960 if the S&P
500 drops to 1135 or below at
expiration.
Source: OptionVue

2. Enter the trade at the close on FIGURE 2 — SYSTEM PERFORMANCE
the first day the Trading credit spreads with the A-D line gained 29 percent since July 2001.
S&P 500 posts a loss.
Entering bear call spreads

1. Sell 10 calls with a strike
located one standard deviation
OTM.
2. Buy 10 calls at a strike price 10
points above the short call.
3. Use the first expiration month
with more than 21 days left
until expiration.
4. The spread’s minimum yield
must be at least 5 percent
(premium received / net
margin required).
Exit Source: OptionVue

Close either spread if the S&P 500
touches the short strike. STRATEGY SUMMARY
Otherwise, allow the position to expire worthless.
Net gain: $4,350.00
Starting capital: $15,000.
Percentage return: 29.0%
Execution: When possible, option trades were executed at Annualized return: 4.0%
the average of the bid and ask prices at the daily close; oth- No. of trades: 20
erwise, theoretical prices were used. Standard deviation was Winning/losing trades: 15/5
calculated using the implied volatility (IV) of the at-the- Win/loss: 75%
money (ATM) call. Each spread held 10 contracts per “leg.”
Avg. trade: $192.50
Commissions were $1.50 per contract.
Largest winning trade: $1,870.00
Test data: The system was tested using options on the Largest losing trade: $3,060.00
S&P 500 index (SPX). Avg. profit (winners): $1,003.33
Avg. loss (losers): -$2,240.00
Test period: July 8, 2001 to Sept. 18, 2008. Avg. hold time (winners): 38
Avg. hold time (losers): 2
Test results: Figure 2 shows the system’s performance,
Max consec. win/loss: 13/2
which gained $4,350 (29 percent) since July 2001. The strate-
gy’s average winning trade ($1,003.33) is lower than its aver-
age losing trade (-$2,240), but it also
has a high percentage of winning
LEGEND:
trades (75 percent). However, the
Net gain – Gain at end of test period.
annual return of 4 percent is less than
Percentage return – Gain or loss on a percentage basis.
ideal.
Annualized return – Gain or loss on a annualized percentage basis.
No. of trades – Number of trades generated by the system.
—Steve Lentz and Jim Graham
Winning/losing trades – Number of winners and losers generated by the system.
of OptionVue Win/loss – The percentage of trades that were profitable.
Avg. trade – The average profit for all trades.
Option System Analysis strategies are
Largest winning trade – Biggest individual profit generated by the system.
tested using OptionVue’s BackTrader
Largest losing trade – Biggest individual loss generated by the system.
module (unless otherwise noted).
Avg. profit (winners) – The average profit for winning trades.
Avg. loss (losers) – The average loss for losing trades.
If you have a trading idea or strategy that Avg. hold time (winners) – The average holding period for winning trades (in days).
you’d like to see tested, please send the Avg. hold time (losers) – The average holding period for losing trades (in days).
trading and money-management rules to Max consec. win/loss – The maximum number of consecutive winning and losing trades.
Advisor@OptionVue.com.

TRADING BASICS
Put-call ratio
Tracking the volume and open interest of put options vs. call options
can highlight investor sentiment extremes.
BY CHRIS PETERS
T here are two types of options: calls and puts.

Call options give the owner the right to buy a
stock or futures contract at a predetermined
price for a set amount of time. Put options give
the owner the right to sell a stock or futures contract at a
predetermined price for a set amount of time. Investors
generally buy puts when they feel the price of a particular
market might be nearing a bearish sentiment extreme and is
poised for a reversal. The opposite is true for very high call
activity relative to put activity.
Put-call ratios can be calculated for any single stock or
group of stocks. Two of the largest options exchanges —
Chicago Board Options Exchange (CBOE) and the
International Securities Exchange (ISE) — publish compre-
instrument will decline. The opposite is true for calls. hensive put-call ratios for stocks and indices. Unlike the
The put-call ratio compares the volume of put and call CBOE ratios, the ISE ratios distinguish between market
options and is often used to determine market sentiment. makers and broker/dealers and include only opening long
The indicator is traditionally used in contrarian fashion: trades, which is meant to show the direction in which retail
Typically, a high level of put-option volume relative to call- investors are leaning.
option volume is considered potentially bullish, while the These examples use daily values, but put-call ratios can
opposite condition is considered potentially bearish. be calculated on any time interval from intraday (tick and
An important aspect of interpreting put-call ratios is that minute) to weekly periods or longer.
the public is more likely to buy options while professionals
are more likely to sell them. Thus, high put volume is taken Calculation
as a sign of bearishness on the part of the uninformed and Put-call ratios are usually calculated by dividing total put-
reactionary public as opposed to the more-sophisticated option volume by total call-option volume:
professionals. When put volume reaches a certain high
level relative to call volume, the typical interpretation is the Put-call ratio = put-option volume/call-option volume
Although a 1.00 put-call ratio value might seem to

FIGURE 1 — CBOE PUT-CALL RATIOS
suggest neutral market sentiment, historically call
Relative peaks and troughs in the CBOE’s equity and index put- activity in stocks has outweighed put activity on
call ratios sometimes accompany market reversals. For example, stocks because of the overall bullish trend in the equi-
the equity put-call ratio fell below 0.50 in October 2007 as retail ty market. As a result, the equity put-call ratio’s “neu-
investors traded more than twice as many calls than puts, bullish
tral” level is actually closer to about 0.70. For example,
sentiment that suggested a market top.
the CBOE’s total equity put-call ratio’s five-year aver-
age (as of Oct. 17) is roughly 0.66.
However, the CBOE’s total index put-call ratio
reflects a different dynamic. The index ratio’s average
is about 1.62 over the past five years, which indicates
put volume has outnumbered call volume in these
markets by more than 50 percent. One reason is insti-
tutional investors, such as hedge funds, in addition to
retail investors, tend to buy index put options as a
way to hedge against price drops in their portfolios.
For comprehensive put-call ratios on stocks, how-
ever, readings of less than 0.50 or more than 1.0 tend
to be considered bearish and bullish extremes,
although such thresholds aren’t set in stone; traders
typically look for relative spikes and dips in the ratio.
Figure 1 compares the S&P 500’s monthly closing
prices to the CBOE index and equity put-call ratios
from November 2003 to October 2008. Notice how the
equity put-call ratio dips below 0.5 in October 2007,
indicating a peak in bullish sentiment just before the
Source: CBOE
market begins to drop.

FIGURE 2 — VOLUME PUT-CALL RATIO
The put-call ratio’s daily calculations are fairly Put-call ratios based on daily volume can produce choppy results if
volatile, so a moving average is often used to smooth not smoothed by a moving average.
the indicator’s readings.
A recent Active Trader Market Pulse article exam-
ined how the S&P 500 tracking stock (SPY) behaved
after a 10-day exponential moving average (EMA) of
the CBOE equity and index put-call ratios hit bullish
and bearish extremes, defined as 120-day lows and
highs, respectively (see “Related reading”).
Overall, the market behaved more predictably
after high/low extremes in the equity ratio than it
did following its index-ratio counterparts. SPY
climbed an average 1.57 percent in the 10 days after
the equity put-call ratio hit bearish extremes.
However, the market was basically flat in the 10 days
after the equity put-call ratio hit bullish extremes.
Volume vs. open interest

Source: Schaeffers Research
Traditionally put-call ratios have been calculated
using option volume, but you can also use option
FIGURE 3 — OPEN INTEREST PUT-CALL RATIO
open interest, which represents the number of open
positions (unclosed trades). The number of outstand- A put-call ratio based on open interest tends to show clearer trends
ing contracts can also indicate market sentiment, in market sentiment than the traditional volume ratio
depending on option type (puts or calls). A daily put-
call volume ratio offers a snapshot of a single day’s
activity, but the open-interest ratio can show chang-
ing sentiment over time, because it builds upon pre-
vious days as open contracts are held into the next
day.
Figures 2 and 3 show put-call ratios for SPY based
on volume and open interest, respectively. As with
Figure 1’s CBOE index ratio, both put-call calcula-
tions show significantly more puts than calls in the
market.
Overall, both put-call ratios moved lower in the
past couple of years, but the volume ratio was much
choppier than the open-interest ratio. While still
prone to a few wild swings, the put-call open-interest
ratio provides a much smoother representation of the Source: Schaeffers Research
market sentiment (bearish to less bearish).
Related reading
“Getting sentimental about options” “The put-call ratio as a contrarian indicator”
Active Trader, March 2002. Active Trader, March 2006.
Successful option trading depends on a number of variables, but Many traders believe the put-call ratio’s extremes signal market
one many traders overlook is sentiment analysis. Find out what turning points, but interpreting this indicator isn’t that simple.
different sentiment tools represent and how they can round out The following analysis shows how the S&P 500 tracking stock
your trading. (SPY) behaved in the two weeks after extreme daily highs and
lows in both OEX and equity put/call ratios since 1997.
“Put-call inversions: Separating the smart money
from the dumb,” Active Trader, June 2002. “Going against the crowd,” Active Trader, November 2000.
Contrary to popular belief, there’s more than one put-call ratio, The put-call ratio has long been used as a measure of market
and looking at the wrong one at the wrong time can give you a sentiment. Here’s a new twist on an old approach that can help
misleading picture of the market. you catch turning points based on short-term put-call extremes.
“CBOE put-call ratio,” Active Trader, October 2007. You can purchase and download past articles at
This Trading System Lab tests extreme put-call ratio readings as http://store.activetradermag.com.
mechanical buy and sell signals on individual stocks and index-
based exchange-traded funds.

INDUSTRY NEWS
More exchanges move toward electronic platforms

CBOE develops electronic alter ego and Minneapolis does away with its pits.
FIGURE 1 — EQUITY OPTIONS VOLUME
T he Chicago Board Options Exchange (CBOE)

announced an initiative to open an all-electronic
options exchange sometime in 2009. Currently
dubbed “C2,” the new exchange would operate under a sepa-
rate exchange license than the CBOE and have a separate
The CBOE and ISE have dominated the equity options
market in the U.S., with the ISE holding a slight lead for
the past few years.
access structure and fee schedule.

According to information released by the exchange, the new
exchange will have its own Board of Directors, rules, connec-
tivity, and systems architecture, with its primary data center in
the New York metropolitan area.
The exchange expects the endeavor’s initial capital invest-
ment will be approximately $25 million with the in-house sys-
tem development expected to be completed this year.
The CBOE currently operates what it calls a “hybrid” system
that consists of both open-outcry and electronic trading, allow-
ing investors to choose where to rout their orders.
In 2000 the International Securities Exchange (ISE) opened
the first all-electronic options exchange in the U.S. While the ume. The gap has been closing in recent months, however.
CBOE has ruled the roost when it comes to index options, Figure 1 displays each exchange’s equity options volume as
accounting for 88 percent of total index options trading in a percentage of all equity options traded on U.S. exchanges, as
September alone, the ISE took the lead in equity options vol- recorded by the Options Clearing Corporation. While the two
exchanges’ equity option market share has
remained fairly close, the ISE’s lead has dwindled.
MANAGED MONEY Overall, total equity options volume has increased
Top 10 option strategy traders ranked by September 2008 return. by nearly 300 percent since 2005, and was up 33
(Managing at least $1 million as of Sept. 30, 2008.) percent year-to-date through August 2008 vs. the
same period last year.
September YTD $ under Also in October, the Minneapolis Grain
Rank Trading advisor return return mgmt.
Exchange (MGEX) announced it will close its trad-
1. Elk River Trading 12.08% 28.61% 54.0 ing pits and switch to an electronic platform on
2. Reynoso Asset Mgmt. (Options Arb.) 10.68% 11.76% 1.6
Dec. 19. Beginning on Nov. 1 and running through
3. Harbor Assets 2.56% 19.44% 2.6
the final date of the transition, the exchange will
4. Chicago Capital Mgmt (Strat Option) 2.10% 27.95% 2.4
waive all open outcry transaction fees for floor
5. Hyman Beck (Volatility) 1.38% 3.32% 106.2
traders initiating trades on their own behalf as well
6. Conservative Concept (Athena Inst) 0.62% 9.73% 271.5
as fees for electronic trading permit (ETP) holders
7. Zenith Resources II LP - A 0.56% 8.86% 78.4
as an incentive to continue trading the MGEX mar-
8. Conservative Concept (Athena Ret) 0.49% 9.74% 271.5
9. K4 Capital Management (MVS) 0.43% 9.77% 18.0 ket. Formed in 1881, the MGEX futures and
10. Diamond Capital Management 0.42% -7.83% 16.6 options exchange is known primarily for its hard
red spring and winter wheat futures contracts.
Source: Barclay Hedge (http://www.barclayhedge.com) For more information about the ongoing shift to
Based on estimates of the composite of all accounts or the fully funded subset method. electronic exchanges, see “The shrinking trading
Does not reflect the performance of any single account.
floor” in the November 2008 issue of Active
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.
Trader.

CME Group offerings expand with plastics, swaps contracts
CME Group unleashes new contracts through their newly acquired ClearPort platform.
T he CME Group announced the

launch of two plastics futures
contracts for trade on NYMEX’s
ClearPort platform in November.
Polypropylene (P1) and polyethylene
index, and swing swaps futures
began trading on Oct. 20, includ-
ing the Algonquin Citygate natu-
ral gas basis swap (B4) and the
Tennessee Zone 0 natural gas
FIGURE 1 — POLYPROPYLENE FUTURES
Although new to the CME, plastics futures
have traded for a few years on the LME.
Polypropylene (PP) prices peaked in July,
but have significantly fallen off since.
(P6) contracts will initially be listed for index swap (Q4). Seventeen petro-
24 consecutive months beginning with leum based swaps began trading
January 2009 contracts. on the platform on Oct. 27, and
The London Metals Exchange (LME) five natural gas liquid swaps con-
has offered contracts for both polypropy- tracts began trading on Nov. 3.
lene and polyethylene since 2005, includ- Swaps contracts are quoted as
ing global and regional contracts. Figure differentials between two different
1 shows the continuous closing price pricing points. In the case of the
action in the polypropylene (PP) futures natural gas contracts, different
denominated in U.S. dollars. Price rose market centers are priced against
throughout much of 2008, but the market the Henry Hub pricing point. The
was not immune to the bursting of the contracts are used to hedge
commodity bubble. In October alone the against specific price risks in their
contract dropped nearly 40 percent. respective markets.
The Dubai Gold and Commodities Through these contracts, which
Exchange (DGCX) also plans to launch are usually traded on an over-the-
similar contracts. counter (OTC) basis, the CME
The CME Group launched a slew of hopes to lure OTC traders seeking
new swaps contracts on the ClearPort a safer exchange haven for their Source: eSignal
platform. Eighteen natural gas basis, transactions.
FUTURES SNAPSHOT (as of Oct. 30)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute
trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility.
See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and
may not reflect total volume for all contract months.
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures
is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
10-day move/ 20-day move/ 60-day move/ Volatility
Market Symbol Exchange Volume OI rank rank rank ratio/rank
E-Mini S&P 500 ES CME 3.62 M 2.74 M 2.18% / 50% -14.50% / 59% -25.33% / 89% .33 / 42%
10-yr. T-note TY CBOT 735.4 1.45 M 0.94% / 22% -1.75% / 65% -0.88% / 29% .67 / 62%
E-Mini Nasdaq 100 NQ CME 516.7 357.0 2.19% / 50% -9.32% / 14% -28.96% / 89% .27 / 7%
5-yr. T-note FV CBOT 509.9 1.39 M 0.87% / 25% -0.02% / 0% 1.90% / 63% .35 / 45%
Mini Dow YM CBOT 305.0 96.0 2.90% / 50% -12.61% / 59% -20.68% / 90% .38 / 56%
2-yr. T-note TU CBOT 263.9 726.7 0.06% / 20% 0.05% / 10% 1.79% / 83% .18 / 32%
30-yr. T-bond US CBOT 262.2 778.0 -0.03% / 0% -4.22% / 81% -0.10% / 9% .66 / 67%
Crude oil CL NYMEX 260.1 236.1 -5.57% / 5% -29.81% / 85% -44.38% / 92% .16 / 0%
Eurodollar* ED CME 229.4 989.56 0.03% / 13% 0.46% / 67% 1.09% / 70% .22 / 40%
E-Mini Russell 2000 TF CME 214.5 489.3 -2.88% / 10% -19.39% / 57% -28.78% / 84% .38 / 12%
Eurocurrency EC CME 198.0 154.3 -3.54% / 20% -6.38% / 72% -15.82% / 91% .31 / 32%
Japanese yen JY CME 131.7 139.7 2.27% / 17% 6.22% / 75% 11.23% / 91% .78 / 78%
Corn C CBOT 124.6 486.2 6.50% / 0% -9.82% / 36% -19.41% / 43% .14 / 7%
Soybeans S CBOT 95.8 143.4 7.73% / 50% -6.97% / 23% -23.47% / 57% .11 / 8%
Gold 100 oz. GC NYMEX 89.9 147.3 -8.20% / 56% -12.53% / 63% -15.96% / 92% .36 / 28%
British pound BP CME 68.1 103.2 -4.93% / 45% -6.92% / 63% -15.48% / 94% .47 / 58%
S&P 500 index SP CME 67.8 594.3 2.18% / 50% -14.49% / 64% -24.17% / 88% .33 / 39%
Natural gas NG NYMEX 63.8 81.8 -4.06% / 18% -14.04% / 61% -26.70% / 31% .11 / 43%
Swiss franc SF CME 48.3 39.3 -0.14% / 0% -0.29% / 2% -6.74% / 67% .21 / 28%
Sugar SB ICE 45.2 315.2 6.18% / 0% -9.40% / 47% -16.49% / 59% .39 / 58%
E-Mini S&P MidCap 400 ME CME 38.0 102.8 1.60% / 100% -17.71% / 59% -30.85% / 87% .31 / 35%
Canadian dollar CD CME 35.7 92.8 -2.22% / 5% -11.18% / 82% -13.65% / 87% .43 / 38%
Australian dollar AD CME 35.5 54.7 0.24% / 100% -12.22% / 73% -25.16% / 72% .29 / 30%
Wheat W CBOT 35.3 161.4 -3.10% / 0% -15.41% / 51% -29.73% / 78% .17 / 2%
RBOB gasoline RB NYMEX 28.5 39.2 -9.56% / 5% -34.94% / 87% -50.26% / 95% .15 / 2%
Heating oil HO NYMEX 25.7 30.6 -4.94% / 5% -26.77% / 87% -38.72% / 79% .16 / 5%
Silver 5,000 oz. SI NYMEX 25.5 59.6 1.56% / 100% -12.01% / 32% -39.81% / 83% .11 / 2%
Soybean oil BO CBOT 24.9 64.0 -2.74% / 0% -19.27% / 72% -33.02% / 72% .18 / 3%
Nikkei 225 index NK CME 22.8 62.5 3.35% / 100% -17.72% / 68% -31.73% / 85% .37 / 38%
Soybean meal SM CBOT 19.9 47.8 12.42% / 83% 5.16% / 86% -15.18% / 40% .15 / 2%
Crude oil e-miNY QM NYMEX 15.3 6.9 -5.57% / 10% -29.81% / 88% -44.65% / 92% .17 / 0%
Copper HG NYMEX 13.6 47.2 -9.35% / 5% -28.05% / 83% -44.78% / 95% .25 / 10%
Mexican peso MP CME 12.5 47.7 3.46% / 100% -12.26% / 67% -22.23% / 78% .27 / 15%
Fed Funds FF CBOT 12.2 70.5 0.43% / 60% 0.81% / 97% 1.69% / 100% .27 / 60%
Coffee KC ICE 10.2 81.1 -1.73% / 11% -11.52% / 53% -19.51% / 84% .23 / 7%
Lean hogs LH CME 9.3 52.3 0.04% / 100% -15.09% / 73% -33.65% / 100% .12 / 2%
Live cattle LC CME 9.1 32.6 2.24% / 100% -4.44% / 31% -10.65% / 90% .27 / 48%
Cocoa CC ICE 7.3 56.3 -1.88% / 0% -14.97% / 83% -24.38% / 88% .20 / 3%
U.S. dollar index DX ICE 6.3 43.4 3.77% / 35% 6.52% / 81% 14.95% / 93% .38 / 45%
Mini-sized gold YG CBOT 6.2 2.9 -8.32% / 56% -12.91% / 65% -16.06% / 93% .36 / 25%
Nasdaq 100 ND CME 5.7 25.7 1.66% / 0% -10.96% / 24% -29.07% / 90% .26 / 2%
Dow Jones Ind. Avg. DJ CBOT 4.5 25.9 2.90% / 50% -12.61% / 59% -20.68% / 90% .38 / 57%
E-Mini eurocurrency ZE CME 4.1 2.0 -3.54% / 20% -6.38% / 72% -15.82% / 91% .31 / 32%
New Zealand dollar NE CME 2.2 19.2 -2.80% / 11% -9.68% / 87% -17.25% / 88% .46 / 77%
Natural gas e-miNY QG NYMEX 2.1 2.8 -4.06% / 18% -14.04% / 63% -26.70% / 31% .11 / 37%
Soybeans E-mini YK CBOT 1.6 12.0 8.77% / 50% -6.08% / 21% -22.28% / 51% .12 / 8%
Feeder cattle FC CME 1.0 4.5 0.23% / 50% -2.04% / 8% -13.54% / 80% .22 / 41%
*Average volume and open interest based on highest-volume contract (February 2009).
Legend day moves, 20-day moves, etc.) show the percent means the current reading is larger than
Volume: 30-day average daily volume, in centile rank of the most recent move to a cer- all the past readings, while a reading of 0 per-
thousands (unless otherwise indicated). tain number of the previous moves of the cent means the current reading is smaller than
same size and in the same direction. For the previous readings. These figures provide
OI: Open interest, in thousands (unless other-
example, the rank for 10-day move shows perspective for determining how relatively
wise indicated).
how the most recent 10-day move compares 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 most Volatility ratio/rank: The ratio is the short-
20-day move: The percentage price move recent 20-day move compares to the past term volatility (10-day standard deviation of
from the close 20 days ago to today’s close. sixty 20-day moves; for the 60-day move, the prices) divided by the long-term volatility (100-
60-day move: The percentage price move rank field shows how the most recent 60-day day standard deviation of prices). The rank is
from the close 60 days ago to today’s close. move compares to the past one-hundred- the percentile rank of the volatility ratio over
The “rank” fields for each time window (10- twenty 60-day moves. A reading of 100 per- the past 60 days.
This information is for educational purposes only. Futures & Options Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Futures & Options
Trader assumes no responsibility for the use of this information. Futures & Options Trader does not recommend buying or selling any market, nor does it solicit orders to buy
or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.

OPTIONS RADAR (as of Oct. 30)
MOST-LIQUID OPTIONS*
Indices Symbol Exchange Options Open 10-day move / 20-day move / IV / IV / SV ratio —
volume interest rank rank SV ratio 20 days ago
S&P 500 index SPX CBOE 277.4 1.13 M 0.81% / 0% -14.38% / 0% 55.4% / 91.9% 41.4% / 36.2%
Russell 2000 index RUT CBOE 123.9 471.2 -4.17% / 0% -19.37% / 0% 61.8% / 87.7% 47.3% / 37.3%
S&P 500 volatility index VIX CBOE 86.2 501.9 -6.97% / 0% 38.97% / 0% 229.5% / 310.5% 250% / 136.6%
Mini Nasdaq 100 index MNX CBOE 35.5 288.8 1.59% / 0% -10.54% / 0% 57.2% / 93.6% 46.8% / 40%
Nasdaq 100 index NDX CBOE 33.5 163.4 1.60% / 0% -10.54% / 0% 57.9% / 86.7% 47.8% / 38.1%
Stocks
Apple Inc AAPL 281.4 983.0 8.98% / 0% 10.93% / 0% 66% / 118% 92.6% / 73.5%
Citigroup C 250.9 3.64 M -17.55% / 0% -41.73% / 0% 100.2% / 159% 92.9% / 117.8%
Bank of America BAC 188.3 2.41 M -6.06% / 0% -37.37% / 0% 83.7% / 159.9% 77% / 110.6%
Microsoft MSFT 187.5 2.12 M -6.45% / 0% -13.79% / 0% 56.6% / 98.4% 47.9% / 47.2%
General Electric GE 161.4 1.54 M -2.71% / 0% -12.64% / 0% 75.5% / 105.9% 68.8% / 83.6%
Futures
Eurodollar ED-GE CME 594.6 7.91 M 0.44% / 0% 1.06% / 0% 69.2% / 73.6% 63.7% / 47.1%
Crude oil CL NYMEX 47.8 317.5 -6.01% / 0% -30.14% / 0% 76.9% / 87.1% 56.5% / 60.3%
Corn C-ZC CME 40.4 426.0 6.50% / 0% -9.82% / 0% 51.3% / 56.5% 39.3% / 39%
10-year T-notes TY-ZN CME 35.6 348.7 0.97% / 0% -1.72% / 0% 10.2% / 11.2% 11% / 10.6%
E-mini S&P 500 futures ES CME 24.6 106.1 2.02% / 0% -14.63% / 0% 56.4% / 99.5% 43.6% / 40.6%
VOLATILITY EXTREMES**
Indices - High IV/SV ratio
Swiss franc index XDS PHLX 1.7 12.6 0.11% / 0% -0.19% / 0% 21.4% / 13.4% 14.8% / 14%
Euro index XDE PHLX 1.7 13.3 -3.72% / 0% 3.72% / 0% 28% / 18.7% 14.5% / 14%
Indices - Low IV/SV ratio

Oil service index OSX PHLX 1.8 10.1 6.54% / 0% -24.41% / 0% 87.3% / 161.9% 74.1% / 65.6%
S&P 500 Index SPX CBOE 277.4 1.13 M 0.81% / 0% -14.38% / 0% 55.4% / 91.9% 41.4% / 36.2%
Mini SPX index XSP CBOE 3.3 81.2 0.81% / 0% -14.38% / 0% 56.8% / 93.2% 42.6% / 36.5%
Mini Nasdaq 100 index MNX CBOE 35.5 288.8 1.59% / 0% -10.54% / 0% 57.2% / 93.6% 46.8% / 40%
Stocks - High IV/SV ratio

Savient Pharma SVNT 3.0 146.6 -65.53% / 0% -69.69% / 0% 197.9% / 133.4% 109.5% / 90.7%
HSBC Holdings HBC 10.5 320.9 -11.27% / 0% -23.46% / 0% 86.9% / 69.4% 47.1% / 51.6%
General Motors GM 66.1 1.28 M -5.16% / 0% -32.78% / 0% 193.4% / 180.5% 139.2% / 132.6%
Stocks - Low IV/SV ratio

National City NCC 52.8 617.8 -21.57% / 0% -23.57% / 0% 90% / 323.6% 245.1% / 200.5%
Wachovia WB 56.0 845.7 -8.37% / 0% 51.15% / 0% 71% / 211.5% 202.3% / 273.1%
Sovereign Bancorp SOV 7.0 140.4 -10.39% / 0% -47.43% / 0% 93.7% / 276.2% 216% / 150.7%
Rohm & Haas ROH 1.6 21.7 -0.24% / 0% 2.14% / 0% 32.4% / 88.4% 31.6% / 26%
SLM Corp SLM 12.6 297.3 -9.17% / 0% 9.68% / 0% 112.4% / 299% 139% / 110.3%
Futures - High IV/SV ratio

Milk DA CME 1.8 12.8 -8.40% / 0% -7.31% / 0% 23.6% / 14.9% 8.8% / 13.8%
Wheat W-ZW CME 8.2 72.1 -3.10% / 0% -15.41% / 0% 50.7% / 47% 43.6% / 38.4%
30-year T-bond US CME 20.6 223.1 0.20% / 0% -5.00% / 0% 17.5% / 16.6% 14% / 14.4%
Lean hogs LH CME 3.6 36.6 0.04% / 0% -15.09% / 0% 27.5% / 27.2% 28.2% / 22.9%
Futures - Low IV/SV ratio

Cotton CT ICE 4.7 57.0 -9.04% / 0% -22.84% / 0% 48.7% / 80.4% 37.5% / 49.8%
Sugar SB ICE 12.8 402.9 6.18% / 0% -9.40% / 0% 40.7% / 58.6% 33.5% / 55%
Gold GC NYMEX 8.1 60.4 -8.20% / 0% -12.53% / 0% 49% / 68.8% 41.9% / 51%
Silver SI NYMEX 3.8 18.4 1.56% / 0% -12.01% / 0% 76.5% / 100% 58.5% / 77.9%
* Ranked by volume ** Ranked by 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 example,
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 WATCH
FIGURE 1 — COT REPORT EXTREMES
COT extremes The largest positive readings represent markets in which net commer-
The Commitment of Traders (COT) report is published cial positions (longs - shorts) exceed net fund holdings in October. By
contrast, the largest negative values represent markets in which net
weekly by the Commodity Futures Trading Commission
fund holdings surpass net commercial positions.
(CFTC). The report divides the open positions in futures
markets into three categories: commercials, non-commeri-
cals, and non-reportable.
Commercial traders, or hedgers, tend to operate in the
cash market (e.g., grain merchants and oil companies that
either produce or consume the underlying commodity).
Non-commercial traders are large speculators (“large
specs”) such as commodity trading advisors and hedge
funds — professional money managers who do not deal in
the underlying cash markets but speculate in futures on a
large-scale basis. Many of these traders are trend-followers.
The non-reportable category represents small traders, or the For a list of contract names, see “Futures Snapshot.” Source: http://www.upperman.com
general public.
Figure 1 shows the relationship between commercials Legend: Figure 1 shows the difference between net commer-
cial and net large spec positions (longs - shorts) for all 45 futures
and large speculators on Oct. 21. Positive values mean net commercial positions markets, in descending order. It is calculated by subtracting the
(longs - shorts) are larger than net speculator holdings, based on their five-year current net large spec position from the net commercial position
historical relationship. Negative values mean large speculators have bigger posi- and then comparing this value to its five-year range. The formu-
la is:
tions than the commercials.
a1 = (net commercial 5-year high - net commercial current)
In Japanese yen (JY) and U.S. dollar index futures (DX), the difference between b1 = (net commercial 5-year high - net commercial 5-year low)
commercials and large speculators is ranked lowest among all futures markets, c1 = ((b1 - a1)/ b1 ) * 100
which is a bearish sign. But in oats (O) and lumber futures (LB), this relationship a2 = (net large spec 5-year high - net large spec current)
is near a five-year high, a bullish indication. These extremes aren’t trade signals, b2 = (net large spec 5-year high - net large spec 5-year low)
but they sometimes appear before price reversals. c2 = ((b2 - a2)/ b2 ) * 100
– Compiled by Floyd Upperman x = (c1 - c2)
Options Watch: Consumer Staples ETF components (as of Oct. 29) Compiled by Tristan Yates
The following table summarizes the expiration months available for the top components of the Consumer Staples exchange-traded fund (XLP).
It also shows each stock’s average bid-ask spread for at-the-money (ATM) October options. The information does NOT constitute trade signals.
It is intended only to provide a brief synopsis of potential slippage in each option market.
Option contracts traded
2008 2009 2010 2011 Bid-ask spreads
Bid-ask
spread as %
June
Dec.
Nov.
Feb.
Jan.
Mar.
Jan.
Jan.
Apr.
May
Closing of underlying
Stock Ticker price Call Put price
Altria Group Inc MO X X X X X X 19.14 0.03 0.04 0.18%
Wal-Mart Stores Inc WMT X X X X X X 55.02 0.10 0.11 0.19%
Coca-Cola Co KO X X X X X X X 43.85 0.15 0.18 0.37%
General Mills Inc GIS X X X X X X 66.81 0.26 0.30 0.42%
HJ Heinz Co HNZ X X X X X X 42.59 0.19 0.23 0.48%
Kimberly-Clark Corporation KMB X X X X X X 59.09 0.30 0.29 0.50%
Costco Wholesale Corp COST X X X X X X 56.88 0.28 0.30 0.51%
Kellogg Co K X X X X X X 50.02 0.25 0.28 0.52%
Colgate-Palmolive CL X X X X X X X 60.00 0.38 0.29 0.55%
Pepsico Inc PEP X X X X X X 55.00 0.38 0.24 0.56%
Kraft Foods Inc KFT X X X X X X 28.47 0.16 0.16 0.57%
Philip Morris Intl Inc PM X X X X X X 41.55 0.26 0.23 0.59%
Walgreen Co WAG X X X X X X 23.74 0.15 0.14 0.61%
Archer-Daniels-Midland ADM X X X X X X X 21.42 0.13 0.15 0.64%
Kroger Co KR X X X X X X 26.50 0.18 0.18 0.66%
CVS Caremark Corp CVS X X X X X X X 26.31 0.18 0.18 0.67%
Sysco Corp SYY X X X X X X X 24.86 0.18 0.16 0.68%
Proctor & Gamble Co PG X X X X X X 61.33 0.55 0.46 0.83%
UST Inc UST X X X X X 67.74 0.66 0.48 0.84%
Anheuser-Busch Companies BUD X X X X X X 59.83 0.48 0.60 0.90%
Select Sector SPDR Consumer Staples XLP X X X X X X 23.29 0.31 0.25 1.21%
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.

FUTURES
GLOBAL & OPTIONS
ECONOMIC CALENDAR
CALENDAR NOVEMBER/DECEMBER
MONTH
November 21 LTD: November single stock futures
Legend (OCX); November T-bond options
1 FDD: November crude oil and natural (CME); November equity options;
FDD (first delivery day): gas futures (CME) December corn, oats, rice, wheat,
The first day on which deliv-
ery of a commodity in fulfill-
2 soybeans, soybean products, and
natural gas options (CME); December
ment of a futures contract 3 FND: November orange juice futures orange juice options (ICE)
can take place. (ICE) Cattle on feed report
FND (first notice day): Also FDD: November soybeans, gold, silver,
known as first intent day, this
copper, platinum, aluminum, and 22
palladium futures (CME) 23
is the first day a clearing-
Crop progress report
house can give notice to a
buyer of a futures contract 4 FND: November heating oil, propane,
24 FND: December crude oil futures
(CME)
that it intends to deliver a and RBOB gasoline (CME) LTD: December natural gas futures
commodity in fulfillment of a
futures contract. The clear-
5 Petroleum status report (CME); December copper futures
(CME); December gasoline and heating
inghouse also informs the 6 LTD: November orange juice futures oil options (CME)
seller. (ICE) Crop progress report
LTD (last trading day): The FDD: November propane futures (ICE)
first day a contract may EIA natural gas storage report 25 LTD: November gold, silver, copper,
trade or be closed out before platinum, aluminum, and palladium
7 LTD: November live cattle options futures (CME)
the delivery of the underlying (CME); December cocoa and cotton
asset may occur. options (ICE) 26 FND: December natural gas futures
(CME)
8 FDD: November gasoline and heating Petroleum status report
CPI: Consumer price index oil futures (CME) EIA natural gas storage report
ECI: Employment cost index
9 27
FOMC: Federal Open
Market Committee 10 FDD: November orange juice futures 28 FND: December T-bonds, corn, oats,
(ICE) wheat, soybean products, gold, silver,
GDP: Gross domestic Crop production report
product copper, aluminum, platinum, and
Crop progress report palladium futures (CME); December
ISM: Institute for supply World agricultural production wheat futures (MGX); December wheat
management futures (KCBOT)
11 LTD: December coffee (ICE)
PPI: Producer price index LTD: December heating oil and RBOB
Quadruple witching Friday:
12 gasoline futures (CME); December
A day where equity options, 13 FND: December cocoa futures (ICE) lumber options (CME)
Petroleum status report U.S. agricultural prices
equity futures, index options,
and index futures all expire.
14 LTD: November lumber, rice, and 29
soybeans futures (CME) 30
NOVEMBER 2008 EIA natural gas storage report
26 27 28 29 30 31 1 NOPA soy crush
2 3 4 5 6 7 8 15 December
9 10 11 12 13 14 15 16 1 FDD: December T-bonds, corn,
16 17 18 19 20 21 22 soybean products, gold, silver, copper,
17 FND: November lumber futures (CME) palladium, aluminum, platinum, crude
23 24 25 26 27 28 29 LTD: December crude oil options oil, and natural gas futures (CME);
30 1 2 3 4 5 6 (CME); December sugar options (ICE) December cocoa and coffee
FDD: November lumber futures (CME)
Crop progress report 2 FND: December heating oil and RBOB
DECEMBER 2008 gasoline
30 1 2 3 4 5 6
18 FND: December coffee futures (ICE)
3 Petroleum status report
7 8 9 10 11 12 13 19 LTD: December platinum options
(CME) 4 EIA natural gas report
14 15 16 17 18 19 20
Petroleum status report 5 LTD: December live cattle options
21 22 23 24 25 26 27 (CME); January cocoa options (ICE)
20 FND: November feeder cattle futures
28 29 30 31 1 2 3 (CME); December cotton futures (ICE)
LTD: December feeder cattle and crude
The information on this page is oil futures (CME); December feeder
subject to change. Futures & cattle, gold, silver, and copper options
Options Trader is not responsible
for the accuracy of calendar dates (CME)
beyond press time. EIA natural gas storage report
November 2008 • FUTURES & OPTIONS TRADER 31

KEY CONCEPTS
The option “Greeks”

Advance-decline line: A breadth indicator that meas- Delta: The ratio of the movement in the option price for
ures aspects of supply and demand not always reflected every point move in the underlying. An option with a
directly in price. The indicator is a day-to-day running total delta of 0.5 would move a half-point for every 1-point
move in the underlying stock; an option with a delta of
of the number of stocks that have closed higher on the day 1.00 would move 1 point for every 1-point move in the
(advancing) minus the number of stocks that have closed underlying stock.
lower on the day (declining). A version using the week-to-
week figures can also be used as a longer-term indicator. Gamma: The change in delta relative to a change in the
underlying market. Unlike delta, which is highest for
The most commonly referenced A-D line is the one calcu- deep ITM options, gamma is highest for ATM options
lated on New York Stock Exchange (NYSE) stocks, but the and lowest for deep ITM and OTM options.
indicator can be calculated on any index or exchange.
Rho: The change in option price relative to the change
Calculation
in the interest rate.
A-D line = [AS(today) – DS(today)] + AD(prev)
Theta: The rate at which an option loses value each day
where (the rate of time decay). Theta is relatively larger for
OTM than ITM options, and increases as the option gets
AS(today) = the number of advancing stocks (those that
closer to its expiration date.
closed higher than the previous day’s close)
DS(today) = the number of declining stocks (those that Vega: How much an option’s price changes per a one-
closed lower than the previous day’s close) percent change in volatility.
AD(prev) = previous day’s A-D line value
You buy the higher-strike put, which costs more, and sell
That is, add the difference between the number of the cheaper, lower-strike put.
advancing stocks and declining stocks today to yesterday’s
A-D number, which is the running total of all previous Bollinger Bands: Bollinger Bands are a type of trading
days. A nominal value is often used to begin the A-D “envelope” consisting of lines plotted above and below a
calculation. moving average, which are designed to capture a market’s
typical price fluctuations.
American style: An option that can be exercised at any The indicator is similar in concept to the moving average
time until expiration. envelope, with an important difference: While moving
average envelopes plot lines a fixed percentage above and
Assign(ment): When an option seller (or “writer”) is below the average (typically three percent above and below
obligated to assume a long position (if he or she sold a put) a 21-day simple moving average), Bollinger Bands use stan-
or short position (if he or she sold a call) in the underlying dard deviation to determine how far above and below the
stock or futures contract because an option buyer exercised moving average the lines are placed. As a result, while the
the same option. upper and lower lines of a moving average envelope move
in tandem, Bollinger Bands expand during periods of rising
At the money (ATM): An option whose strike price is market volatility and contract during periods of decreasing
identical (or very close) to the current underlying stock (or market volatility.
futures) price. Bollinger Bands were created by John Bollinger, CFA,
CMT, the president and founder of Bollinger Capital
Bear call spread: A vertical credit spread that consists Management (see Active Trader, April 2003, p. 60). By
of a short call and a higher-strike, further OTM long call in default, the upper and lower Bollinger Bands are placed
the same expiration month. The spread’s largest potential two standard deviations above and below a 20-period sim-
gain is the premium collected, and its maximum loss is lim- ple moving average.
ited to the point difference between the strikes minus that
premium. Upper band = 20-period simple moving average + 2 stan-
dard deviations
Bear put spread: A bear debit spread that contains puts Middle line = 20-period simple moving average of closing
with the same expiration date but different strike prices. prices

Lower band = 20-period simple moving average - 2 stan- and foreign brokers are required to report daily the futures
dard deviations and options positions of their customers that are above spe-
cific reporting levels set by the CFTC.
Bollinger Bands highlight when price has become high or For each futures contract, report data is divided into three
low on a relative basis, which is signaled through the touch “reporting” categories: commercial, non-commercial, and
(or minor penetration) of the upper or lower line. non-reportable positions. The first two groups are those
However, Bollinger stresses that price touching the lower who hold positions above specific reporting levels.
or upper band does not constitute an automatic buy or sell The “commercials” are often referred to as the large
signal. For example, a close (or multiple closes) above the hedgers. Commercial hedgers are typically those who actu-
upper band or below the lower band reflects stronger ally deal in the cash market (e.g., grain merchants and oil
upside or downside momentum that is more likely to be a companies, who either produce or consume the underlying
breakout (or trend) signal, rather than a reversal signal. commodity) and can have access to supply and demand
Accordingly, Bollinger suggests using the bands in conjunc- information other market players do not.
tion with other trading tools that can supply context and Non-commercial large traders include large speculators
signal confirmation. (“large specs”) such as commodity trading advisors (CTAs)
and hedge funds. This group consists mostly of institution-
Bull call spread: A bull debit spread that contains calls al and quasi-institutional money managers who do not deal
with the same expiration date but different strike prices. in the underlying cash markets, but speculate in futures on
You buy the lower-strike call, which has more value, and a large-scale basis for their clients.
sell the less-expensive, higher-strike call. The final COT category is called the non-reportable posi-
continued on p. 34
Bull put spread (put credit spread):
A bull credit spread that contains puts with
the same expiration date, but different
strike prices. You sell an OTM put and buy
a less-expensive, lower-strike put.
Calendar spread: A position with one

short-term short option and one long
same-strike option with more time until
expiration. If the spread uses ATM options,
it is market-neutral and tries to profit from
time decay. However, OTM options can be
used to profit from both a directional move
and time decay.
Call option: An option that gives the

owner the right, but not the obligation, to
buy a stock (or futures contract) at a fixed
price.
The Commitments of Traders

report: Published weekly by the
Commodity Futures Trading Commission
(CFTC), the Commitments of Traders
(COT) report breaks down the open inter-
est in major futures markets. Clearing
members, futures commission merchants,

KEY CONCEPTS continued
tion category — otherwise known as small traders — i.e., Double calendar spread: A calendar spread involves
the general public. purchasing an option and selling a shorter-term, same-
strike option of the same type (call or put) against it. Double
Covered call: Shorting an out-of-the-money call option calendars have two strikes: one put calendar spread below
against a long position in the underlying market. An exam- the current underlying price and one call calendar spread
ple would be purchasing a stock for $50 and selling a call above it. The goal is to collect premium and capture theta
option with a strike price of $55. The goal is for the market from the shorter-term sold options as expiration approach-
to move sideways or slightly higher and for the call option es. Single calendars only profit in a fairly narrow range of
to expire worthless, in which case you keep the premium. underlying prices, so the double calendar widens this range
and increases its chances of success.
Credit spread: A position that collects more premium
from short options than you pay for long options. A credit European style: An option that can only be exercised at
spread using calls is bearish, while a credit spread using expiration, not before.
puts is bullish.
Exercise: To exchange an option for the underlying
Debit: A cost you must pay to enter any position if the instrument.
components you buy are more expensive than the ones you
sell. For instance, you must pay a debit to buy any option, Expiration: The last day on which an option can be exer-
and a spread (long one option, short another) requires a cised and exchanged for the underlying instrument (usual-
debit if the premium you collect from the short option does- ly the last trading day or one day after).
n’t offset the long option’s cost.
Intermonth (futures) spread: A trade consisting of
Debit spread: An options spread that costs money to long and short positions in different contract months in the
enter, because the long side is more expensive that the short same market — e.g., July and November soybeans or
side. These spreads can be verticals, calendars, or diagonals. September and December crude oil. Also referred to as a
futures “calendar spread.”
Deep (e.g., deep in-the-money option or deep
out-of-the-money option): Call options with strike In the money (ITM): A call option with a strike price
prices that are very far above the current price of the under- below the price of the underlying instrument, or a put
lying asset and put options with strike prices that are very option with a strike price above the underlying instru-
far below the current price of the underlying asset. ment’s price.
Delivery period (delivery dates): The specific time Intrinsic value: The difference between the strike price
period during which a delivery can occur for a futures con- of an in-the-money option and the underlying asset price. A
tract. These dates vary from market to market and are deter- call option with a strike price of 22 has 2 points of intrinsic
mined by the exchange. They typically fall during the value if the underlying market is trading at 24.
month designated by a specific contract - e.g. the delivery
period for March T-notes will be a specific period in March. Iron condor: A market-neutral position that enters a bear
call spread (OTM call + higher-strike call) above the market
Delta-neutral: An options position that has an overall and a bull put spread (OTM put + lower-strike put) below
delta of zero, which means it’s unaffected by underlying the market. Both spreads collect premium, and profit when
price movement. However, delta will change as the under- the market trades between the short strikes by expiration.
lying moves up or down, so you must buy or sell All options share the same expiration month.
shares/contracts to adjust delta back to zero.
Logarithm: The exponent by which a certain base, such as
Diagonal spread: A position consisting of options with 10, is raised to produce another number. For example, the
different expiration dates and different strike prices — e.g., logarithm of 10,000 is 4 because 10 to the 4th power equals
a December 50 call and a January 60 call. 10,000.

Premium: The price of an option.
Naked option: A position that involves selling an unpro-
tected call or put that has a large or unlimited amount of Put option: An option that gives the owner the right, but
risk. If you sell a call, for example, you are obligated to sell not the obligation, to sell a stock (or futures contract) at a
the underlying instrument at the call’s strike price, which fixed price.
might be below the market’s value, triggering a loss. If you
sell a put, for example, you are obligated to buy the under- Put ratio backspread: A bearish ratio spread that con-
lying instrument at the put’s strike price, which may be well tains more long puts than short ones. The short strikes are
above the market, also causing a loss. closer to the money and the long strikes are further from the
Given its risk, selling naked options is only for advanced money.
options traders, and newer traders aren’t usually allowed For example, if a stock trades at $50, you could sell one
by their brokers to trade such strategies. $45 put and buy two $40 puts in the same expiration month.
If the stock drops, the short $45 put might move into the
Naked (uncovered) puts: Selling put options to collect money, but the long lower-strike puts will hedge some (or
premium that contains risk. If the market drops below the all) of those losses. If the stock drops well below $40, poten-
short put’s strike price, the holder may exercise it, requiring tial gains are unlimited until it reaches zero.
you to buy stock at the strike price (i.e., above the market).
Put spreads: Vertical spreads with puts sharing the same
Near the money: An option whose strike price is close expiration date but different strike prices. A bull put spread
to the underlying market’s price. continued on p. 36
Open interest: The number of options

that have not been exercised in a specific
contract that has not yet expired.
Out of the money (OTM): A call option

with a strike price above the price of the
underlying instrument, or a put option
with a strike price below the underlying
instrument’s price.
Parity: An option trading at its intrinsic

value.
Physical delivery: The process of

exchanging a physical commodity (and
making and taking payment) as a result of
the execution of a futures contract.
Although 98 percent of all futures contracts
are not delivered, there are market partici-
pants who do take delivery of physically
settled contracts such as wheat, crude oil,
and T-notes. Commodities generally are
delivered to a designated warehouse; T-
note delivery is taken by a book-entry
transfer of ownership, although no certifi-
cates change hands.

KEY CONCEPTS continued
contains short, higher-strike puts and long, lower-strike Relative strength index (RSI): Developed by Welles
puts. A bear put spread is structured differently: Its long Wilder, the relative strength index (RSI) is an indicator in
puts have higher strikes than the short puts. the “oscillator” family designed to reflect shorter-term
momentum. It ranges from zero to 100, with higher read-
Ratio spread: A ratio spread can contain calls or puts and ings supposedly corresponding to overbought levels and
includes a long option and multiple short options of the low readings reflecting the opposite. The formula is:
same type that are further out-of-the-money, usually in a RSI = 100 – (100/[1+RS])
ratio of 1:2 or 1:3 (long to short options). For example, if a where
stock trades at $60, you could buy one $60 call and sell two RS = relative strength = the average of the up closes over
same-month $65 calls. Basically, the trade is a bull call the calculation period (e.g., 10 bars, 14 bars) divided by the
spread (long call, short higher-strike call) with the sale of average of the down closes over the calculation period.
additional calls at the short strike.
Overall, these positions are neutral, but they can have a For example, when calculating a 10-day RSI, if six of the
directional bias, depending on the strike prices you select. days closed higher than the previous day’s close, subtract
Because you sell more options than you buy, the short the previous close from the current close for these days, add
options usually cover the cost of the long one or provide a up the differences, and divide the result by 10 to get the up-
net credit. However, the spread contains uncovered, or close average. (Note that the sum is divided by the total
“naked” options, which add upside or downside risk. number of days in the look-back period and not the number
of up-closing days.)
EVENTS
Event: SIFMA’s OFAC Compliance Symposium Event: TradeStation ETF Symposium

Date: Nov. 6 Date: Dec. 4-6
Location: AXA Equitable Conference Center, NYC Location: Delray Beach Marriott, Delray, Fla.
For more information: http://www.sifma.org/events For more information:
http://www.TradeStation.com/Strategy
Event: 23rd Annual Futures & Options Expo
Date: Nov. 10-12 Event: Dynamic Hedging of Long Volatility Strategies
Location: Hyatt Regency Chicago Date: Dec. 4-5
For more information: Go to Location: Sheraton Suites on the Hudson, New York
http://www.futuresindustry.org and click on “Conferences” For more information: http://www.marcusevans.com
Event: Traders Expo Las Vegas Event: The Options Intensive Two-day Seminars
Date: Nov. 19-22 Dates: Dec. 4
Location: Mandalay Bay Resort & Casino, Las Vegas Location: CBOE Options Institute, Chicago
For more information: http://www.tradersexpo.com For more information: http://www.cboe.com
Event: Middle East Investor Conference Event: TradeTech Foreign Exchange 2009
Date: Nov. 20 Date: Feb. 9-11
Location: The Monarch Dubai Hotel, Dubai, U.A.E. Location: Bridgewaters, NYC
For more information: For more information:
http://dubai.nasdaqinvestorprogram.com
http://www.TradeTechForeignExchange.com
Event: The Options Initiative Two-day Seminars

Date: Nov. 20
Location: CBOE Options Institute, Chicago
For more information: http://www.cboe.com

For the four days that closed lower than the previous share a strike price (calendar spread) or have different
day’s close, subtract the current close from the previous strikes (diagonal spread).
low, add these differences, and divide by 10 to get the
down-close average. If the up-close average was 0.8 and the Time value (premium): The amount of an option’s
down close average was 0.4, the relative strength over this value that is a function of the time remaining until expira-
period would be 2. The resulting RSI would be 100 - tion. As expiration approaches, time value decreases at an
(100/[1+2]) = 100 - 33.3 = 66.67. accelerated rate, a phenomenon known as “time decay.”
Simple moving average: A simple moving average Vertical spread: A position consisting of options with
(SMA) is the average price of a stock, future, or other mar- the same expiration date but different strike prices (e.g., a
ket over a certain time period. A five-day SMA is the sum of September 40 call option and a September 50 call option).
the five most recent closing prices divided by five, which
means each day’s price is equally weighted in the calcula- Volatility: The level of price movement in a market.
tion. Historical (“statistical”) volatility measures the price fluctu-
ations (usually calculated as the standard deviation of clos-
Straddle: A non-directional option spread that typically ing prices) over a certain time period — e.g., the past 20
consists of an at-the-money call and at-the-money put with days. Implied volatility is the current market estimate of
the same expiration. For example, with the underlying future volatility as reflected in the level of option premi-
instrument trading at 25, a standard long straddle would ums. The higher the implied volatility, the higher the option
consist of buying a 25 call and a 25 put. Long straddles are premium.
designed to profit from an increase in volatility; short strad-
dles are intended to capitalize on declin-
ing volatility. The strangle is a related
strategy.
Strangle: A non-directional option

spread that consists of an out-of-the-
money call and out-of-the-money put
with the same expiration. For example,
with the underlying instrument trading at
25, a long strangle could consist of buying
a 27.5 call and a 22.5 put. Long strangles
are designed to profit from an increase in
volatility; short strangles are intended to
capitalize on declining volatility. The
straddle is a related strategy.
Strike (“exercise”) price: The price

at which an underlying instrument is
exchanged upon exercise of an option.
Time decay: The tendency of time

value to decrease at an accelerated rate as
an option approaches expiration.
Time spread: Any type of spread that

contains short near-term options and long
options that expire later. Both options can

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FUTURES TRADE JOURNAL
Blown stop is oldest story

in the trading world.
TRADE
Date: Tuesday, Oct. 14, 2008.
Entry: Long December mini crude oil

futures (QMZ08) at 80.875.
Reasons for trade/setup: Crude

futures have been cut nearly in half
since their July high around $150.
Source: TradeStation
Having flushed most of the longs who
expected strong support at $100, the
market is showing signs of stabilizing after the recent push Trade executed according to plan? No.
below the round-number price of $80, and the time appears
right for an attempt at a long position. Outcome: Rarely have we been so satisfied with a trade
We actually captured a small (approximately $1) profit entry — holding back from chasing the market and buying
during yesterday’s uptrend, then turned around and went as the market tested the day’s low — and had such imme-
short for what we expected to be a small scalp. However, diately disastrous results.
the market turned higher once again and we scratched the No point in dressing up this one. It was simply a case of
short and reverted to our long position. not being able to take a loss. Adhering to the initial stop
would have resulted in this trade essentially giving back
Initial stop: $79.125. the previous day’s profit instead of turning into the disaster
it was. The fact the market was so volatile and had tended
Initial target: $82.125. Take partial profits and raise stop. to bounce back from its drops led us to believe it would do
it one more time … as the market sank and sank. The fact
Second target: 85.125. the market never really rebounded and eventually traded
as low as 61.30 by Oct. 27 was small comfort.
Note: Initial targets for trades are typically based on things such as the
RESULT
historical performance of a price pattern or trading system signal.
However, individual trades are a function of immediate market behav-
Exit: $74.20 (first trade). ior; initial price targets are flexible and are most often used as points at
which a portion of the trade is liquidated to reduce the position’s open
Profit/loss: -6.675 (8.2 percent). risk. As a result, the initial (pre-trade) reward-risk ratios are conjec-
tural by nature.
TRADE SUMMARY
Initial Initial
Date Contract Entry stop target IRR Exit Date P/L LOP LOL Length
10/14/08 QMZ08 80.875 79.125 82.125 0.71 $74.20 10/15/08 -6.675 (8.2%) +0.10 -6.675 1 day
Legend: IRR — initial reward/risk ratio (initial target amount/initial stop amount); LOP — largest open profit (maximum available profit
during lifetime of trade); LOL — largest open loss (maximum potential loss during life of trade).

FOREX DIARY
OPTIONS TRADE JOURNAL
Profits on this bearish position are limited by a hasty exit.
FIGURE 1 — RISK PROFILE — LONG PUT

This in-the-money October 105 put is poised to make money if IBM drops by the close.
TRADE
Date: Tuesday, Oct. 7.
Market: Options on IBM Corp.

(IBM).
Entry: Buy one October 105 put

for $8.50.
Reasons for trade/setup:

IBM Corp. was downgraded from
“overweight” to “equal weight”
by Barclays Capital before the
stock market opened on Oct. 7.
Historically, downgraded Dow
stocks fall an average 1.40 percent
overnight, so we were surprised
when IBM opened flat that morn-
ing. Downgraded stocks also tend
to drop an additional 0.45 percent Source: OptionVue
by the close, suggesting that IBM
was likely to drop, at least briefly (see “Playing the ratings month, climbing from 22.6 percent on Aug. 29 to 50 percent
game,” Active Trader, September 2007). Moreover, the S&P by Oct. 7. For instance, the 105 put had a $3.50 extrinsic
500 slid 3.8 percent on Oct. 6 as traders continued to panic, value, reflecting skyrocketing volatility estimates. In short,
so further weakness in the broader market also seemed this trade could backfire quickly if IBM began to rally and
likely. IVs fell. But because this was such a short-term trade, we
The easiest way to benefit from a market decline is to buy were prepared to take this risk.
puts. As a result, we bought October 105 puts for 8.50 when Figure 1 shows the trade’s potential gains and losses on
IBM traded at $100 at 10 a.m. on Oct. 7. We entered just after Oct. 7. The risk profile resembles an outright short trade —
IBM dropped roughly 1 percent within two or three
minutes, and the goal was to ride this quick down move TRADE SUMMARY
and exit by the close.
From a directional standpoint, the 105 put seemed Entry date: Oct. 7, 2008
ideal. It was in-the-money by roughly 5 points with a Underlying security: IBM Corp. (IBM)
-71 delta. Position: 1 long Oct. 105 put
However, IBM’s implied volatility doubled in the past
Initial capital required: $850
Initial stop: Exit if put loses one-third of its value.
TRADE STATISTICS
Initial target: Hold until close.
Oct. 7 10 a.m. 10:08 a.m. Initial daily time decay: $22.61
Delta: -71.20 -72.03 Trade length (in days): 1
Gamma: 2.49 2.86 P/L: $0.40 (4.7%)
Theta: -22.61 -18.35 LOP: $0.40
Vega: 6.60 6.10 LOL: $0
Probability of profit: 34% 40%
LOP — largest open profit (maximum available profit during life of trade).
Breakeven point: 98.36 99.21
LOL — largest open loss (maximum potential loss during life of trade).

FIGURE 2 — EXITING TOO SOON
profits will accumulate if IBM
drops below $99 and losses IBM fell 1.25 percent to $98.76 within 10 minutes and we sold the puts for a $0.40 (4.7
percent) profit. However, if we had simply followed our plan, we could have cashed in as
will mount if the stock jumps,
IBM dropped another 2.8 percent by the close.
although the trade can’t lose
more than $850. Again, we
plan to hold this bearish posi-
tion until the close, but we’ll
exit if the put loses a third of
its value.
Initial stop: Exit if position

loses one-third of its value.
Initial target: Hold until

close.
RESULT
Outcome: Figure 2 shows

IBM continued to decline after
we entered the trade. Within Source: eSignal
10 minutes, IBM fell 1.2 per-
cent to 98.76, and we sold the October 105 puts for $8.90 — We managed to exit near a short-term low, and IBM
a $0.40 (4.7 percent) profit. Exiting the trade at a decent bounced back above $101 within 20 minutes. However, IBM
price wasn’t easy because the put’s bid-ask spread widened dropped another 2.8 percent by the close, and we gave up
to $0.70 as the stock tanked. another $200 in profits by not sticking to the original plan.

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November 2008 • Volume 2, No.

OPTIONS TRADER STUDY

Options Trading System Lab

Gamma scalping . . . . . . . . . . . . . . . . . . . . . .14

Who trades options? . . . . . . . . . . . . . . . . . .18

2 November 2008 • FUTURES & OPTIONS TRADER

You don’t react to headlines, fads or the latest financial guru’s

Find out about our special offer for new accounts

Call Now - Limited Time Offer

Futures Snapshot . . . . . . . . . . . . . . . . . . . . . .28

Option Radar . . . . . . . . . . . . . . . . . . . . . . . . . .29

Futures & Options Watch

Options Watch: New Products and Services . . . . . . . . . . . . .38

Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . .32 Options Trade Journal . . . . . . . . . . . . . . .40

Have a question about something you’ve seen

Looking for an advertiser?

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

Mark 2 Market TradeStation

4 November 2008 • FUTURES & OPTIONS TRADER

George Hoekstra is a research engineer in the

A publication of Active Trader ®

Richard L. Weissman is the author of Mechanical

FUTURES & OPTIONS TRADER • November 2008 5

The Great Sell-off continues

6 November 2008 • FUTURES & OPTIONS TRADER

Softs and fibers

Getting Specific Buy/Sell/Stop Signals “ I have found that the most

M ost investors understand the logic behind

Bollinger Band breakout system

1. Go long if price closes above the

3. Exit all trades with a stop-loss

Figure 1 shows a daily chart of the

10 November 2008 • FUTURES & OPTIONS TRADER

Portfolio $194,164 1,050 105 12 $184.92 $19,416.40 -$46,261 18 4.2 35.14 NA

FIGURE 2 — TRADE EXAMPLE IN EURO FUTURES

FUTURES & OPTIONS TRADER • November 2008 11

TABLE 2 — COUNTERTREND RSI SYSTEM

Portfolio $76,981 306 30.6 25 $251.57 $7,698.10 -$43,203 6 1.78 67.65 NA

Source: CQG, Inc.

Trade rules: volume is less than yesterday’s volume.

12 November 2008 • FUTURES & OPTIONS TRADER

Source: CQG, Inc.

CQG programming code

Long Entry: Close(@)[-1] > BHI(@,Sim,20,2.00)[-1]

Short Entry: Close(@)[-1]< BLO(@,Sim,20,2.00)[-1]

Long & Short Exit (set price field to): BMA(@,Sim,20)[-1]

Counter-trend RSI system:

Long Entry: RSI(@,9)[-1] < 35 AND Close(@)[-1] > MA(@,Sim,200)[-1] AND

Long Exit: RSI(@,9)[-1] > 65 OR

Short Entry: RSI(@,9)[-1] > 65 AND Close(@)[-1] < MA(@,Sim,200)[-1]

FUTURES & OPTIONS TRADER • November 2008 13

G iven the recent stock-market rout, volatility

Understanding the Greeks

14 November 2008 • FUTURES & OPTIONS TRADER

FUTURES & OPTIONS TRADER • November 2008 15

16 November 2008 • FUTURES & OPTIONS TRADER

The realities of gamma scalping

For information on the author see p. 5.

FUTURES & OPTIONS TRADER • November 2008

Who trades options?

W henever you trade an option, someone

Call options are big business

FIGURE 1 — TYPES OF POSITIONS FIGURE 2 — WHO SELLS CALLS?