Option Trader

5/27/2018 Option Trader

1/43

STEP-BY-STEP

trade planning

THE SLINGSHOT

STRANGLE:

Catching reversalsthe options way

OPTION BASICS:

Understandingthe option "Greeks"

INTERVIEW:

Don Fishback

ONLINE OPTIONPAPER TRADING

OPTION REPAIR STRATEGIES

Dont kill that trade when you can fix itOPTION REPAIR STRATEGIES

Dont kill that trade when you can fix it

MAY 2005Volume 1, No. 2


2/432 May 2005 OPTIONS TRADER

Contributors . . . . . . . . . . . . . . . . . . . . . . . . 4

In this Issue . . . . . . . . . . . . . . . . . . . . . . . . 6

Options Resources . . . . . . . . . . . . . . . . .8Software, Web sites, and new products and

services.

Options NewsBy Carlise Peterson

No slowing equity options volume . . . . .10Volume in the options market continues to grow.

After a record-breaking year in 2004, the U.S.

options industry is poised to set a new milestone

in 2005.

CBOE gets SEC go-ahead . . . . . . . . . . . .10The Chicago Board Options Exchange will begin

buying exercise rights from Chicago Board of

Trade members.

Options Strategies

Easing the pain:

Option repair strategies . . . . . . . . . . . . . .12This technique is designed to reduce risk and

improve potential profit when an options trade

is under water.

By John Summa

The slingshot strangle . . . . . . . . . . . . . . .20How to use a different kind of strangle to trade

turning points with less risk.

By Kevin Lund

Approaching options through

volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24Purchasing options merely because you expect

the underlying stock to make a significant move is

short-sighted. This volatility-based technique is

designed to make it easier to find options appropri-

ate to your trading strategy.

By Jay Kaeppel

Options Expiration Calendar and

Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

Options Trader Interview . . . . . . . .30Don Fishback

Option trading advisor Don Fishback talks

about the probabilities of option trading.

By Options Traderstaff

Options BasicsThe put/call ratio . . . . . . . . . . . . . . . . . . . . 36By Options Traderstaff

The option Greeks . . . . . . . . . . . . . . . . . . .38How much and how fast will your option movewhen the underlying stock or futures market

moves? The option Greeks are key.

By Guy Bower

Key concepts and definitions. . . . .43

CONTENTS

Have a question about something youve seen in Options Trader?

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Click on the company name below for a direct link to the ad in this months issue of Options Trader.

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Editor-in-chief: Mark Etzkorn

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Managing editor: Molly Flynn

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Associate editor: Carlise Peterson

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Contributing editor: Jeff Ponczak

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Volume 1, Issue 2. Options Traderis published monthly by TechInfo, Inc.,150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2005TechInfo, Inc. All rights reserved. Information in this publication may not bestored or reproduced in any form without written permission from the publisher.

The information in Options Tradermagazine is intended for educational pur-poses only. It is not meant to recommend, promote or in any way imply theeffectiveness of any trading system, strategy or approach. Traders are advisedto do their own research and testing to determine the validity of a trading idea.Trading and investing carry a high level of risk. Past performance does notguarantee future results.

For all subscriber services:www.optionstradermag.com

A publication ofActive Trader

CONTRIBUTORS

4 May 2005 OPTIONS TRADER

CONTRIBUTORS

John Summa is an economist, author and profes-sional options trader. In 1997 he foundedOptionsNerd.com, where he teaches traders how tobecome successful option sellers. He also publishes anoption trading advisory. He is the author of TradingAgainst The Crowd: Profiting From Fear and Greed in Stock,Futures and Options Markets (John Wiley & Sons, 2004)and the co-author of Options on Futures: New TradingStrategies (John Wiley & Sons, 2001). He currently oper-ates a portfolio of managed account programs thatemploy his philosophy of selling options on stock indexfutures.

Australian-based Guy Bower

(www.guybower.com) is the founderand director of Option1, an option advi-sory service for index and commodityoption markets. He is also a director ofCDM Trading, a Commodity TradingAdviser (CTA) specializing in optionmarkets. Bower is the author of two

books: Options: A Complete Guide and Hedging: SimpleStrategies.

Jay Kaeppel is director ofresearch at Essex Trading Co. Ltd.(www.essextrading.com), a developerof trading software for futures andoptions traders. He is also an activecommodity trading advisor. Kaeppel isthe author of The Option Traders Guideto Probability, Volatility and Timing (Wiley, August 2002), as

well as The Four Biggest Mistakes inOption Trading and The Four BiggestMistakes in Futures Trading.

Kevin Lund is a private trader and

writer.
mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]://www.optionstradermag.com/http://www.optionsnerd.com/http://www.guybower.com/http://www.guybower.com/http://www.guybower.com/http://www.essextrading.com/http://www.essextrading.com/http://www.essextrading.com/http://www.optionsnerd.com/http://www.essextrading.com/http://www.guybower.com/http://www.optionstradermag.com/mailto:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]:[email protected]


5/43
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Trading Strategies

Easing the pain: Option repair strategies highlights theflexibility of trading with options. When youre in a losingtrade, you typically have a choice between two unattractivecourses of action: Wait for your trade to get stopped out (orstop yourself out prematurely) or risk ruin by cancelingyour stop and hoping the market goes in your favor. Thisarticle shows how adding new legs to an existing optionposition can change its risk profile into something more intune with current market conditions.

The slingshot strangle describes how to use options tobottom pick markets you think can make big up moves.Although bottom picking is typically an exercise in futility its impossible to know precisely when a market willreverse options can buy you a larger time window andthus a better chance of catching the turnaround.

Approaching options through volatility describes anapproach for identifying quality trades based on volatilityanalysis, among other things. It provides a good model forapproaching any trade, using any technique: a step-by-stepmethodology that addresses the factors that could impactthe position.

Trader Interview

Don Fishback discusses his understanding of optionspricing and volatility analysis, and how he uses it to con-struct high-probability trades. Fishback makes many of thearcane aspects of options more intuitive and shows how ahandful of principles can be channeled to create bettertrades.

Option Basics

For those just getting their feet wet in options, we havein-depth features on two subjects youll want to get a han-dle on as soon as possible the option Greeks (delta,gamma, et al.) and the put-call ratio.

Resources, Expiration Calendar, and more

Options Resources takes a look at a Web site that allowsyou to paper trade your option strategies without risking

real money.

As always, the Options Expiration calendar will keepyou on top of this months important trading dates, and youcan check out upcoming industry conferences and seminarsin the Events section. Finally, Industry News has a story onthe continued strength in options trade volume.

IN THIS ISSUEIN THIS ISSUE
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8/43

A lthough its not foolproof, paper trading is a goodway to prepare for the real thing. It allows you toimprove your skills without risking actual money.However, paper trading has its obstacles and complications.

For example, you have to perform a lot of manual paper-work and calculations, not to mention the need to be com-pletely accurate and honest to obtain realistic results.

Paper trading while someone else keeps track of the resultsis the better situation. This way, you can concentrate on theprocess of trading without concerning yourself with account-ing worries. And the possibility of cheating fudging onentry/exit prices or not recording a trade because if I was trad-ing real money, I wouldnt have entered it is eliminated.

Some brokerages offer paper trading through simulatedaccounts, but only after youve opened an account withthem and deposited thousands of dollars. However, there isa Web site where would-be traders or even experiencedtraders looking to try a new system can focus on tradingwithout spending thousands of dollars.

The Equity Options Paper Trading System (www.e-opts.com)isnt free there are three different subscriptionlevels depending on how many accounts you want to openand how many orders you plan to place. However, it offersa good way to practice for real-world options trading by

allowing users to paper trade stocks.The data is the least reliable part of e-opts options

chains and stock prices are provided, but they are not auto-matically updated in real time (you have to refresh thequotes yourself). So you might want to refer to another dataanother source while using e-opts.

Everything else, though, is on par with a regular broker-age. Users can enter positions such as spreads, straddles,strangles, covered calls, etc., as well as simple calls and puts,through a standard order screen resembling that of anyoptions system.

E-opts also has a screen that keeps track of open orders

(Figure 1) and another that shows profit/loss and other

information for trades that have been entered. The pageallows you to click a close position button and be trans-ferred to the order page, where a closing order can be trig-gered with one more click.

Users of e-opts are allowed to trade on margin, and theprogram has a screen showing exactly how much money isleft in each account. Plus, there is a virtual commission($9.99 plus $1.75 per contract) assessed for each trade.

Theres also a History page, which provides a record ofall transactions for a specified time period. This is a helpfultool for traders who track their trades in an effort to identi-fy certain patterns (e.g., all put trades were profitable, allcall trades were profitable, etc.).

Subscription levels run $9.95, $14.95, and $24.95 permonth. To some, that may seem like a lot to pay whentheres no chance of making the money back when youtrade, but its far better than losing thousands of real dollarsbecause youre not ready to enter the market.

OPTIONS RESOURCES


www.e-opts.com

FIGURE 1 OPEN ORDERS

Just as a broker would, e-opts.com allows users to keep track of all open orders on a single screen.

Source:www.e-opts.com

Options Trading for the Conservative Investor:Increasing Profits Without Increasing Your Risk

By Michael C. Thomsett

Financial Times Prentice Hall, 2005Hardback, 288 pages

$34.95

Thomsett targets all investors,

especially those with no previous

options experience. He explains how

to trade options in a way that can limit

surprises. He presents five underly-

ing assumptions of a conservative

investor, outlines basic aspects of

options, and then delves into possible

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OPTIONS NEWS BY CARLISE PETERSON

The six U.S. options exchanges theInternational Securities Exchange, theChicago Board Options Exchange, theAmerican Stock Exchange, the

Philadelphia Stock Exchange, the Pacific Exchange, andthe Boston Options Exchange combined to tradealmost 1.1 billion equity option contracts in 2004, mark-ing the first time the industry had gone over the 1 billionmark and besting the 2003 volume record by more than30 percent.

However, if the first quarter of 2005 is any indication,the record will be short-lived. The Options IndustryCouncil (OIC) reported record volume of more than 112million contracts for March 2005, marking the second

time in three months a monthly record had been set (theprevious record was set in January 2005). Through theend of March, average daily volume for 2005 was abouta million contracts a day better than 2004.

Volume didnt slow down in April, as April 15 volumeof more than 11 million contracts set a daily record andgave 2005 four of the top five highest-volume days in OIC his-tory. As of April 15, the month was on pace to trade more than11.7 million contracts, which would set another record.

The volume trend is continuing due to several factors,says Gina McFadden, Executive Director of the OIC. A keycomponent is the ongoing education initiative showing more

and more investors how options can be used in any type ofmarket environment.

Options volume has been on the increase for almost adecade. Since 1995, when a then-record 174.4 million con-tracts were traded, a new volume record has been set everyyear except one. That came in 2002, when the annual totalof just more than 700 million fell short of the more than 722million that traded in 2001. However, volume picked up

again in 2003 when more than 830 million contractschanged hands.

Numb

erofcontracts(inmillions)

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005*

Year *projected

1,400

1,200

1,000

800

600

400

200

0

Overall volume in equity contracts has steadily increased since

1995 and is on pace to set another record in 2005.

FIGURE 1 OPTIONS VOLUME

Source: Options Industry Council

A

fter denying a request by a Chicago BoardOptions Exchange member to reconsider itsapproval, the Securities and Exchange

Commission gave the CBOE the go-ahead to pur-chase exercise rights held by Chicago Board of Trade members.CBOE member Marshall Spiegel has long opposed the

plan and asked the SEC to deny approval on the groundsthat not enough of the CBOE membership approved thepurchase (about 54 percent voted in favor of it). However,the SEC was not swayed by Spiegels argument.

We are gratified by the commissions decision andpleased to have the purchase offer back on track, saidWilliam J. Brodsky, CBOE Chairman and CEO. The exerciseright has been embedded in the CBOT membership for 32years, and the purchase offer represents CBOEs first oppor-

tunity to begin to buy back any portion of those rights.

Since 1973, when the CBOE was created as an arm of theCBOT, the exercise rights have given CBOT members theability to become CBOE members without purchasing a

separate membership. Purchasing the rights gives theCBOE a greater deal of independence from the CBOT,which would make it easier to convert to a stockholder-owned company and sell shares to the public, if it choses totake that route.

Rights will be priced between $60,000 and $100,000, andCBOT members willing to sell their rights can offer them atany price in that range. Through a modified Dutch Auctionprocess, the price where the most selling interest lies will bethe price paid for all rights, although the CBOE is under noobligation to purchase a minimum number of rights.

The purchasing was expected to begin in late April and

last for 30 days.

Gaining independence

CBOE gets SEC go-ahead

Another record?

No slowing equity options volume


11/43
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Most option tradersaccept that not alltrades turn out to bewinners, but dealing

with sudden, unexpected losses justafter entering a position presents a

dilemma. Youre faced with two choices:Exit the trade at a loss, or implement arepair strategy that adjusts to the newmarket conditions and has the potentialto restore the trades profitability.

It is essential to analyze a number ofwhat-if scenarios (i.e., what could gowrong) before placing any trade especially if you sell options, becauseof the risk of unlimited losses.However, repair strategies should bepart of your trading plan regardless of

whether youre a buyer or seller.

Two options repair trades a bearput spread and a butterfly spread can reduce the risk of an unprofitablelong put position and increase theprobability of a winning trade.Options strategy briefing reviews

the put strategies discussed here.The following examples use S&P

500 stock index puts. However, youcan adapt these repair strategies tocalls if you have a bullish outlook, andthey can be applied to individualstocks as well.

Your long put goes south

With the current outlook for stockssomewhat rocky in late March, youmight have considered buying S&P

500 puts, especially since they were

trading with low levels of impliedvolatility the ideal time to buythem.

Figure 1 shows that by March 29, theS&P 500 had already declined 4.89 per-cent from its March 7 high of 1225.31 to

1165.36, and some analysts were pre-dicting another 5-percent drop waslikely before the end of the year.

December 2005 put options, whichexpire on Dec. 16, 2005, would provideenough time to catch such a movebetween April and the end of the year.An out-of-the-money December 1150put cost $41 on April 4, or a premiumof $4,100.

Now lets see what you can do if theS&P rises back above 1200 to 1211 just

OPTIONS STRATEGIES

EASING THE PAIN:

Option repair strategies

continued on p. 14

It can be frustrating when the market

doesnt go your way,

but it doesnt have to be painful.

Two option repair strategies

a bear put spread and a butterfly spread

can reduce an unprofitable

long puts risk and preserve potential profitability.

BY JOHN SUMMA


13/43OPTIONS TRADER May 2005 13



after buying the December 1150 put.Figure 2 shows the puts potentialprofit and loss based on the S&P500sprice. The solid line is the potentialprofit at expiration, while the upper

blue dashed line shows its profitabili-ty on April 4; the other lines representinterim periods.

If instead of falling as expected, theindex rallies from 1176 (the close onApril 4) to 1211, the long put will suf-fer an immediate, unrealized loss ofabout $1,000. This assumes no time

value decay, which would add to theloss.

However, many things can happenbefore the puts Dec. 16 expirationdate. Your maximum loss ($4,100) isfixed, so you dont have to worryabout unlimited losses in a runaway

bull market. Meanwhile, the S&P 500could eventually head lower so youmight want to remain in your long putposition and ride out the bounce. Butrisking the entire premium may stillbe too much for you.

OPTIONS STRATEGIES continued

Options strategy briefing

Spreads, which are positions consisting of both long and short

options, can be effective tools for reducing the risk of an exist-

ing option trade. They can be organized according to three

general characteristics: Linear vs. ratio, credit vs. debit, and vertical vs.

calendar.

Linear vs. ratio. A linear spread has an equal number of long and

short options; ratio spreads contain more long options than short ones (or

vice versa). For example, the bear put and butterfly spreads shown in

Figures 3and 4 are linear, but the bull put spread discussed in Other

repair strategies has more short puts than long ones, making it a ratio

spread.

Credit or debit. When you place a credit spread, you receive morepremium for the short options than you pay for the long options. A debit

spread has the opposite characteristic i.e., it costs you money to put

on the position.

Vertical vs. horizontal.All options used in vertical spreads have the

same expiration month, but different strike prices. Vertical bear spreads

have risk profiles that typically resemble the one in Figure 3; a bull

spreads risk profile is similar, but it reaches its maximum profit if the

underlying moves higher instead of lower.

Once youve bought a put, you can change it into a put butterfly spread

similar to Figure 4 by selling two same-month puts at the money and then

buying a second same-month put deep in the money. The strike prices of

all three legs must be equidistant from each other.In contrast, horizontal (or calendar) spreads consist of options with dif-

ferent expirations. For example, you could sell an S&P 500 index

September 1175 call and buy a same-strike December call. Here, youll

profit if the market trades near 1200 at the Sept. 16 expiration date.

Calendar spreads can also be diagonal using different strikes across

time.

Sources: Lawrence G. McMillan, McMillian on Options (John Wiley and

Sons, 2004, second edition). Guy Cohen, The Bible of Options

Strategies: The Definitive Guide for Practical Trading Strategies

(Financial Times Prentice Hall, 2005).

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Repairing the damage with a

bear put spread

Lets consider the choices for this posi-tion. If you simply wait for the down-trend to resume, you could possiblylose the entire investment whichyou know you dont want to do. Youcould take the loss now, which means

youre out $1,000.

One possible fix is to buy anotherput option at a higher strike price toraise the breakeven level for this trade.However, this would add additionalrisk to the trade if the S&P headshigher, youll lose even more.

An acceptable middle-gro u n d adjustment is to transform the long

put into a bear put spread by purchas-

ing another put with a higher strikeprice while also selling twoDecember 1150 puts, which can raise

the long puts breakeven point andincrease its probability of profitwithout increasing risk.

Again, lets assume the S&P 500has climbed to 1211 from its April4 close of 1176. To create a bear putspread out of the long put posi-tion, place two orders: Sell twoDecember 1150 puts and buy one

December 1200 put.Because you are long one

December 1150 alre a d y, sellingtwo 1150 puts converts the originalposition to a short December put.When this is combined with thenew long December 1200 put, youare left with a bear put spread.

Table 1 shows how the originalDecember 1150 puts value dropsto $31 from $41 as the S&P climbs.Table 2 shows how the original

positions cost is reduced whenyou sell two December 1150 putsat $31 each and buy a December

1200 put at $48.F i g u re 3 shows the total risk

dropped to $2,700 from $4,100 (exclud-ing commissions). More importantly,the breakeven point climbs to 1173from 1109 a 5.8-percent rise.

At this point, the new positionsbreakeven point is just 3.15 percentbelow the S&Ps current level of 1211

continued on p. 16

Buying a December 1150 put for $4,100 on April 4 could be a good strategy ifyou thought the S&P 500 may sell off further. If the market suddenly rallies,however, youd face hefty unrealized losses.

FIGURE 1 S&P 500 DAILY CHART

Source: OptionVue 5 Option Analysis Software (www.optionvue.com)

If the S&P rallies to 1211 (from 1176), your long put will drop by $1,000 (top bluedashed line). However, Figures 3 and 4 show how two clever adjustments canimprove this risk profile.

FIGURE 2 DEALING WITH UNEXPECTED LOSSES


S&P 500 (SPX), daily

Profit/loss by change in SPX Index price

?

April May June July Aug. Sept. Oct. Nov. Dec. 2005 Feb. March April

1,127 1,134 1,141 1,148 1,155 1,162 1,169 1,176 1,183 1,190 1,197 1,204 1,211 1,218 1,225

1,2401,2301,2201,2101,2001,1901,1801,1701,1601,1501,1401,1301,1201,1101,1001,0901,0801,070

1,0601,050

3,000

2,400

1,800

1,200

600

0

-600

-1,200

-1,800

-2,400

-3,000

-3,600

-4,200

TABLE 1 LONG PUT BEFORE

AND AFTER S&P 500 RALLY

When the S&P 500 rallies nearly 3percent instead of falling, the longput position loses 24 percent. At this

point, you can make adjustmentsthat will reduce the trades risk andpreserve some profit potential.

S&P December

price 1,150 put price

1,176 41.00

1,211 31.00
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much better than the original longputs breakeven point, which was 8.42percent lower.

If the S&P 500 rally fails and theindex declines to the support levelaround 1164, the bear put spread willprofit below 1173, which is above thestarting point of the original trade.

The tradeoff

The bear put spreads drawback is it

limits potential profit in exchange for

the higher breakeven level and greaterprobability of profit. However, it sub-stantially lowers the total risk in theprocess.

Profit is now limited by the short1150 put in the new spread trade.Figure 3 shows if the S&P settles at1150, maximum profit on this positionis $2,300, or $5,000 (the spreads value)- $2,700 (the debit for the trade). Thecost of the bear put spread, though,

appears to be far outweighed by the

potential benefits i.e., lifting the

breakeven level without addingrisk.

Other repair possibilities

Depending on your outlook, thereare other ways to adjust the origi-nal long put position. Many ofthese choices will be limited byyour risk tolerance. If you believethe market has good upsidepotential after the market success-fully tests support and turns high-

er, you could convert the originallong put into a bull put spread,which is a net-selling strategywith a long put leg.

To create a bull put spread, youwould sell another put above the

December 1150 put to bring in enoughpremium to pay for the cost of the ini-tial December long put.

More aggressive traders might rollinto a bull put ratio spread by sellingtwo further out-of the-money puts

(e.g., December 1125) below the origi-nal December 1150 long put. Thismethod would collect enough premi-um to easily pay for the original longput, and generate a credit offering apotential profit if the S&P 500 staysabove the short strike prices by theDec. 16 expiration date.

Having the December long putabove the short strikes lets the strategypick up additional profit if the S&P500closes between 1125 (the short puts

strike price) and 1150 (the original longputs strike price) by expiration.However, the bull put spread has oneuncovered put that poses substantialrisk if the index heads sharply lower.This would require additional adjust-ments to reduce risk.

The butterfly spread

If your S&P outlook has changed frombearish to neutral, a more conservativeapproach is to adjust the position into

OPTIONS STRATEGIEScontinued

Transforming a losing long put into a bear put spread by following the steps outlinedin Table 2 raises your breakeven point without adding risk, but it limits the originaltrades potential profit to $2,300.

FIGURE 3 BEAR PUT SPREAD



1,130 1,140 1,150 1,160 1,170 1,180 1,190 1,200 1,210 1,220 1,230 1,240 1,250 1,260 1,270

2,700

2,250

1,800

1,350

900

450

0

-450

-900

-1,350

-1,800-2,250

-2,700

TABLE 2 REPAIR #1: BEAR PUT SPREAD

If your long put takes a hit, you can sell two identical puts (at a lower price) andbuy a put that is closer to the money; this step reduces your risk and raisesyour breakeven point.

Transactions Debits/credits Cumulative net

debits/creditsOriginal trade:

Bought 1 December -$4,100 -$4,100

1,150 Put at $41

Repair trade:

Sell 2 December +$6,200 +$2,100

1,150 Puts at $31

Buy 1 December -$4,800 -$2,700

1,200 Put at $48

continued on p. 18

Breakeven at 1173
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17/43

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OPTIONS STRATEGIEScontinued

a put butterfly spread, whichinvolves buying an in-the-moneyDecember 1250 put and sellingtwo at-the-money December 1200puts when the S&P 500 passes the

1200 level on the way back up.Figure 4 shows how these three

new legs can reduce risk, whichdecreases to $1,400 the newmaximum loss. With this positionyoull make money if the S&Pstays between 1164 and 1236, witha profit of $3,600 if the S&P 500settles right at 1200 at expiration.

In this butterfly spread, maxi-mum profit exists at the strike ofthe two short calls (December

1200), but big moves up or downmay lead to losses. Moving pastthe breakeven points, maximumlosses would be $1,400 (upside)and $1,400 (downside).

Because this is a market-neutralstrategy, a comprehensive repair strat-egy for the original December 1150long put might be to combine adjust-ments. For example, you could mix a

butterfly spread with a bear putspread by having multiple lot posi-

tions. If you were long two puts fromthe start, you could adjust to one but-terfly spread and one bear put spread.This would keep some potential prof-itability intact if the market moveslower, and offer a higher breakevenpoint.

Taking advantage

of flexibilityOptions offer traders flexibility out-right positions the underlying instru-

ment cannot match. You can managepotential losing trades with re p a i rstrategies that may reduce risk andincrease the probability of success.

So when you do your homeworkand place an options trade but youranalysis turns out to be wrong lookinto the possibility of adapting to thenew market conditions with a repairstrategy that can ease the pain.

For information on the author see p. 4.

Questions or comments? Click here.

Related reading

John SummaActive Traderarticles

Diagonal put spreads: Beyond the basic credit spread,Active Trader, March

2005. How diagonal put spreads can improve on standard vertical spreads by

taking advantage of increasing volatility.

OtherActive Traderarticles

Option spreads: The reinsurance approach,Active Trader, July 2004.

An analysis of option credit spreads from the perspective of playing the odds

the way insurers and casinos do.

Timing events with the calendar spread,Active Trader, October 2003.

The calendar spread offers a way to capitalize on aspects of time, market

direction and volatility.

Controlling risk with spreads, Active Trader, March 2003. Trading the bull

call-option spread.

Extra credit (spreads),Active Trader, February 2002. Another look at trad-

ing credit spreads.

Spreading your charting options, Active Trader, July 2000. How to know

what strategies are appropriate for different market conditions.

You can purchase past articles at www.activetradermag.com/purchase_arti-

cles.htm and download them to your computer.

This butterfly spread caps your risk at $1,400, and youll make money if the S&Ptrades between 1164 and 1236 at expiration (Dec. 16). Here, youll gain $3,600 ifthe S&P settles at 1200.

FIGURE 4 BUTTERFLY SPREAD



1,130 1,140 1,150 1,160 1,170 1,180 1,190 1,200 1,210 1,220 1,230 1,240 1,250 1,260 1,270

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0

-500

-1,000

-1,500
mailto:[email protected]?subject=Summa%20Repair%20Strategyhttp://www.activetradermag.com/purchase_articles.htmhttp://www.activetradermag.com/purchase_articles.htmhttp://www.optionvue.com/mailto:[email protected]?subject=Summa%20Repair%20Strategyhttp://www.activetradermag.com/purchase_articles.htmhttp://www.activetradermag.com/purchase_articles.htmhttp://www.optionvue.com/


19/43

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BY KEVIN LUND

Its one thing to believe a mar-

ket reversal is coming, but itssomething else predictingexactly when it will occur.

Most of the time, trying to catch topsand bottoms results in getting caughton the wrong side of the market. Unfor-tunately, although phrases such asDont catch a falling knife aremantras in the trading world, sometraders stubbornly continue to try tooutsmart the market.

There is a useful technique, however,

for bottom-fishers with a little patienceand market insight: the slingshotstrangle (slingshot for short), a rever-sal strategy using options that can beentered with minimal risk even whenextreme pessimism is rampant in themarket. It is an often-neglected optionstrategy that is worth dusting off thenext time you find yourself close to amarket rebound.

Strangle basics

A traditional strangle is nothing morethan the simultaneous purchase of acall option and a put option with thesame expiration date but differentstrike prices. Typically, the call and putare both out-of-the-money (OTM). Anexample would be to buy a 45 call anda 35 put on a stock trading at 40.

Traders use strangles when theyexpect an imminent breakout in theunderlying issue but are unsure inwhich direction it will occur. When the

breakout occurs, either the call or the

put profits on the move, while theother side loses. If the move is largeenough, the winning side will gain

much more than the losing side loses.There is really no hard-and-fast rule

about the options being out-of-the-money. Strangles can contain optionsthat are both in the money (ITM), or onein and one out, depending on a tradersdegree of bullishness or bearishness.The slingshot strangle consists of a calland a put that are both in the money.

Setting the stage:

Panic at market bottoms

Just before a broad market sell-off bot-toms out, the selling is largely indis-criminate and driven by panickyinvestors throwing in the towel. Theselling pressure becomes so extremethe market typically becomes over-sold, like a rubber band that has beenstretched too far.

At some point a positive catalystemerges to release this pressure,replacing pessimism with optimism.

What follows is a high-volume rally astraders cover the short positions theyestablished when the market was sell-

ing off. The momentum of this reversalis analogous to the catapult action of aslingshot.

During such heavy selling periods and prior to the appearance of thecatalyst some aggressive tradersattempt to pick up stocks at cheap lev-els. Not surprisingly, they wind up los-ing large sums of money when, asweve seen many times in the last cou-ple of years, a rebound never occurs.

Making the trade:Finding the right stocks

The slingshot strangle allows you toenter a trade without confirmation ofan upside reversal, while limiting riskto only a couple hundred dollars. Inaddition, you also can profit if the mar-ket continues to drop, provided youfollow a few simple rules:

1. Look for stocks that have been

beaten down severely. Find solid

OPTIONS STRATEGIES

Catching market bottoms is a great approach for traders with crystal balls. If youre like most

traders, though, the odds are youll miss the reversal point while waiting for confirmation of the trend

change. A variation of the option strangle trade gives you more time to fish for a market

turnaround while simultaneously capping your risk level.

The greatest advantage the slingshot strangle

has over other reversal strategies is that it retains most

of its value until a major move occurs in the underlying

market. Its drawback is that profits initially come more

slowly compared to other short-term strategies.

The slingshot strangle


21/43

stocks that have declined as a result ofa broader market sell-off, rather thanthose that have tumbled because oftheir own specific problems. When the

broader market rebounds, usually itsthe beaten down darlings that arethe first to bounce back.

2. Choose stocks that have high his-

torical volatility. In other words, focuson the big movers. A stock with a histo-ry of going from 20 to 40 and back to 20over a six-month period is a much bet-ter candidate for a slingshot stranglethan a stock that moves only $5 in eitherdirection over the same time frame.

3. Establish appropriate risk

parameters: Trade options that are nomore than two strike prices in themoney, while keeping the combinedtime value (also known as extrinsicvalue) of the put and call under $2 to$3, depending on how far out you buythe options. (Tip: Although this rulewill generally preclude you from buy-ing options with more than 30 daysuntil expiration, youll increase youredge if you can buy options that aretwo or more months out for less than

$3 combined time value. This willallow you to get out of the trade withminimal time decay if the stock fails tomake a significant move.)

Because you are simultaneouslybuying an ITM put and call, theoptions intrinsic values are never injeopardy. If the stock price wafflesback and forth a little, one option willgain as much as the other loses (asidefrom the time decay present in bothoptions). When the upside reversal

occurs, the calls profit will be greaterthan the puts loss: As the stock moveshigher, the calls delta remains highwhile the puts delta shrinks. In otherwords, as long as the stock continuesto rally, the puts delta will eventuallyreach 0 while the calls (nearly) 1.00delta will produce dollar-for-dollargains relative to the stock. If the stockcontinues to sell off, the same phenom-enon would occur because the putwould gain on a nearly one-to-one

basis with the stock.

Exiting the trade: Taking your

time and your profits

To exit slingshot strangle trades, useeither a profit stop or a time stop.A profit stop consists of taking profits

when the open profit is 25 percent ofthe cost of the trade. For example, ifyou entered a slingshot strangle at acost of $10, take profits when thepositions value is $12.50. Profits willsometimes exceed this level, so if youchoose to let them run, trail your stop i.e., move your stop up as the trademoves in your direction. Your firststop level (at the 25 percent profit-tak-ing level) should be at the breakevenpoint; at the 50-percent profit-taking

level, move the stop up to the former25-percent profit-taking level, and soon.

The time stop is designed to holdon to some of the options time premi-um in the event the stock goesnowhere. Exit the trade within twoweeks if no upside reversal or down-side continuation move occurs. Thiscan help salvage some of the timevalue of the options. If you placed thetrade with options that expire in less

than two weeks, your time decay will

be minimal, and you can exit at anytime.

Trade example

During most of January and February2002, Qualcomm (QCOM) was in asolid downtrend (see Figure 1, topright). It had traded from approximate-

OPTIONS TRADER May 2005 21

continued on p. 22

Qualcomm Inc. (QCOM), daily

October November December January February March

60.00

55.00

50.00

45.00

40.00

35.00

30.003.00

1.00

-1.00

-3.00

MACD

MACD at low, oversold level

Slingshot straddle established

By March 8, the trade hadincreased in value by 50 percent

A relatively oversold market sets up for a slingshot strangle: Buying a March

(2002) 25 call and a March 35 put produced a 50-percent return by March 8.

Source: TradeStation Platform by TradeStation Group

FIGURE 1 SLINGSHOT: CAPTURING A BOUNCE

Date Stock Quote Profit

2/21/02 32.50 12.12 -.18

2/22/02 32.70 12.26 -.44

2/25/02 35.91 13.08 .78

2/26/02 34.77 12.44 .14

2/27/02 33.57 11.65 -.66

2/28/02 33.25 11.38 -.92

3/1/02 35.97 12.38 .08

3/4/02 38.87 14.38 2.08

3/5/02 38.86 14.34 2.04

3/6/02 39.95 15.22 2.92

3/7/02 41.44 16.57 4.27

3/8/02 43.80 18.87 6.57

Day-by-day profit and loss figures for

the slingshot strangle trade.

Source:Optionetics.comPlatinum

TABLE 1 QCOM PROFIT PROGRESS
http://optionetics.com/http://optionetics.com/


22/43

ly 40 in October 2001 to 62 byDecember 2001, and back to32.50 on Feb. 21, 2002. Assumethat your analysis indicated areversal was imminent

because the current downmove had already lasted sig-nificantly longer than the pre-vious August-September 2001sell-off, and various indicators,including the moving averageconvergence-divergence(MACD) indicator, were sug-gesting the market was over-sold and due for a bounce.

On the Feb. 21 close, aMarch 25/35 slingshot

strangle could have beenplaced by buying a 25 call anda 35 put for 12.30, or $1,230.With the stock trading around32.50, the call and the put arein the money 7.50 and 2.50,respectively. The remaining2.30 is time value, which is

also your total risk on the trade(2.30*100 shares per contract = $230).Because the call is more in the moneythan the put, it will have the higherdelta of the two options.

The risk curve in Figure 2 showsthat just a $5 up move will produce anice profit on the position. For a stocklike QCOM, which has a history ofmoving $20 every few weeks, a $5move in either direction is a relativelyhigh-probability proposition.

A continuation of the downtrendalso would generate a profit, butbecause the puts delta is smaller thanthe calls, it would take a larger move(about $7 to $8) to get in the black.

Regardless of the direction the stockmoves, though, your risk is very mini-mal while you wait.

The stock staged a sharp upsidereversal in early March. As Table 1shows, by March 7, the trade had prof-ited 25 percent; one day later, it hadgained 50 percent. Notice, though, theposition incurred a small loss in thefirst five days of the trade, until thereversal occurred on March 1.

Use the advantages,but remember the risks

The greatest advantage the slingshotstrangle may have over other reversalstrategies is that it retains most of itsvalue until a major move occurs in theunderlying market. This allows you toenter the trade with minimal risk, andlittle in the way of technical confirma-tion that a reversal or continuation isunderway.

One of the drawbacks of the sling-

shot strangle is that profits initiallycome more slowly compared to othershort-term strategies. But if you con-sider how many times youve proba-bly been hurt trying to catch a fallingknife, this strategy can help you holdon to a few fingers in turbulent marketconditions.

For more information on the author see p. 4.

Questions or comments? Click here. Aversion of this article previously appeared

in Active Trader magazine.



Today: 22 days left

14 days left7 days left

Expiration

10 20 30 40Stock price

Profit

$1,000

0

Close= 32.50

This profile shows the straddles profit at differentpoints in time.

Source: Optionetics.com Platinum

FIGURE 2 SLINGSHOT PROFILE

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23/43

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24/43

Option traders understand volatility provides an edge in the market. This method is designed to help

you find high-probability options based on their volatility characteristics.

Approaching optionsthrough volatility


Losses in the options mar-ket often occur becausetraders fail to fully recog-nize options are a wast-

ing asset within a certain time win-dow. Yes, you pay the premium forunlimited profit potential with limitedrisk, but the fact is most long option

trades are unprofitable because of thetime decay factor.

However, by adhering to a fewguidelines, you can increase the proba-bility of making profitable trades.First, you need to know the keys totrading options successfully:

Understand the different optionstrategies available.

Know the appropriate strategy fora given set of circumstances.

Understand the difference between

historical volatility and implied volatil-ity.

Use a strategy to take advantageof disparities in the implied volatilitiesof different options.

Know when to buy premium andwhen to sell premium.

Buy undervalued options and sellovervalued options.

Have a strategy to cut losses. Have a strategy to take a profit.

Well illustrate these points in thecontext of the vertical spread trade.Before detailing this approach, letsreview the most important componentto trading options: implied volatility.

Historical vs. implied volatility

Traders who know at a glance ifoptions are cheap or expensive ona historical basis have a distinct advan-tage. The best traders buy premiumwhen volatility is low and sell premi-

um when volatility is high, and estab-

lish spread positions in which theybuy undervalued options and sellovervalued options. Using spreadstrategies gives the trader the best ofboth worlds.

There are two basic categories ofvolatility: historical volatility and im-

plied volatility. Historical volatility isthe standard deviation of the price fluc-tuations of the underlying security overa specific period of time, such as 90days. For example, we can calculate thestandard deviation of the Nasdaq 100Index tracking stock (QQQs) over thelast 90 days to determine the 90-dayhistorical volatility.

While this statistic can be of somevalue for traders desiring the day-to-day risk of holding a position, implied

volatility is more important for optionstraders. The difference between histor-ical and implied volatility is that theformer looks at the past while the latterreveals the marketplaces currentexpectations of future volatility. Inoptions, value is determined byimplied volatility.

The price of an option is composedof the following elements: The strikeprice, the price of the underlyinginstrument, days to expiration, interest

rates and volatility.

If you had to calculate the price ofan option, you would have to estimatethe volatility variable to use becauseyou dont care what the volatility hasbeen in the past (the historical volatili-ty). You are concerned about what thevolatility is going to be in the future

(the implied volatility). That will affectthe value of the option going forward.

The implied volatility value for agiven option is the value that isbacked out of an option pricingmodel when you plug in all of theother known variables and is therebythe volatility implied by the currentmarket price.

(For a detailed discussion of histori-cal and implied volatility, see Puttingvolatility to work, Active Trader, April

2001, p. 42.)

Ranking volatility

Relative volatility (RV) ranking is atechnique that allows traders to deter-mine whether the current impliedvolatility for the options of a givenstock is high or low on a historicalbasis.

With RV you can determine the bestoption trading strategies to employ fora given security. To calculate RV, take

all the implied volatility readings for a

OPTIONS STRATEGIES

BYJAYK

AEPP

EL



given stocks option over the last oneto three years and divide them into 10groups, or deciles. As a simplifiedexample, if you divide 120 observa-tions of implied volatility into 10 equalgroups (deciles) of 12, the first 10observations might range from 9 per-cent to 15 percent, the second 10 mightrange from 16 percent to 22 percent,the third might range from 23 percentto 35 percent and so on.

If the current implied volatility is inthe highest decile, the RV is 10 (i.e., it isin the highest 10 percent of volatilityreadings over the period you arereviewing). If the current impliedvolatility is in the lowest decile, thenRV is 1 (i.e., it is in the lowest 10 per-cent of volatility readings over the

period you are reviewing).With this information, you can objec-

tively determine whether impliedoption volatility is currently high orlow for a given security. This informa-tion is used to select the appropriatetrading strategy.

Current implied volatility

and relative volatility rank

Using relative volatility is based on asimple premise: Relatively low-volatil-

ity options result in relatively lowoption premiums, which present buy-ing opportunities. The opposite is truefor high relative volatility.

If RV is low (on a scale of 1 to 10) fora given security, traders should gener-ally focus on buy premium strategiesand avoid writing options. Conversely,when RV is high, traders should gen-erally focus on sell premium strategiesand avoid buying options.

This simple filtering method is a crit-

ical first step in making money inoptions. The best way to find goodtrades is to first filter out the badtrades. Buying premium when volatilityis high and selling premium whenvolatility is low is a low probabilityapproach, as it puts the odds immedi-ately against you. Proper trade selectionis the most important factor in tradingoptions profitably in the long run.

Volatility skew

Determining the exact strategy to

employ can be fine-tuned by examin-ing the differences in the impliedvolatilities of various options for agiven stock. Often out-of-the money(OTM) options trade at a much higheror lower implied volatility than at-the-money (ATM) options. These situa-tions create great profit opportunities.

The pattern of the differences betweenimplied volatilities of various options isreferred to as the skew, or smile. OTMoptions are more expensive if the pat-tern of the skew is upward sloping inother words, they trade at a highervolatility than ATM options. If the skewis downward sloping, the OTM calloptions are cheaper than ATM options they trade at a lower volatility.Monitoring the skew provides opportu-

nities for traders to buy cheap optionsand sell expensive options.

Next, lets combine this volatilityinformation with market timing.

Market timing

Many traders will purchase optionsbased solely on their outlook for theprice of the underlying stock.However, there are potential problemsif you buy options just because you arebullish or bearish on a stock:

No matter how accurate youbelieve your market timing is, theprobability is just 50/50 that theunderlying stock will move in the pre-dicted direction between the time anoption is purchased and the expirationdate.

A purchased option will lose itsentire time premium by expiration andwill expire worthless if it is out of themoney at expiration.

If implied option volatility is high

at the time the option is purchased, theamount the underlying stock mustmove in order for the option positionto generate a profit increases.

Traders rarely consider the slip-page from getting filled at a higherprice than anticipated and commis-sions, which constantly eat into a trad-ers capital, even on profitable trades.

This list of factors lowers the proba-bility of making money on any out-

right option purchase. Its not that you

should never buy naked calls or puts;you simply need to pick your spotscarefully and take advantage of anom-alies in implied option volatilities.

Different option strategies are appro-priate for overbought and oversoldconditions. Traders can use a numberof indicators to determine when agiven underlying stock is overboughtor oversold. Two well-known oscilla-tors are the relative strength index(RSI) and stochastics. These indicatorsrange from 0 to 100, with 50 represent-ing neutral momentum or marketmovement. The higher the reading, themore overbought the market; the lowerthe reading, the more oversold themarket. (See Active Trader, August 2000,p. 82 for detailed information on sto-

chastics, and Active Trader, August2001, p. 88 for detailed information onthe RSI.)

Another indicator you can use foroptions on market indices is the 10-dayTRIN (see Active Trader, December2000, p. 88).

The PRO-VEST method

The PRO-VEST option trading methodwas developed to determine precisecriteria in the following key areas:

probability, volatility, time to expira-tion, the skew of implied volatilitiesand market movement.

PRO is for Probability: The PRO-VEST method uses option deltas tomeasure the probability that a givenoption will expire in-the-money.(Delta is the amount an option movesrelative to a 1-point move in the under-lying market. For example, a calloption that rises 50 cents for a 1-pointmove in the underlying stock has a

delta of .50, or 50 percent. A delta of 50implies there is approximately a 50-percent chance the option will expirein-the-money.)

Always ask the question: Should Ibuy or sell in-the-money or out-of-the-money options?

V is for Volatility: Look at RV todetermine if implied option volatility ishigh or low on a historical basis. A RVof 1 to 5 suggests options are cheap andpremium should be bought. A RV of 6

continued on p. 26



to 10 suggests that options are expen-sive and premium should be sold.

E is for Expiration: How muchtime is left until expiration of theoption (and will the position be helpedor hurt by time decay)?

S is for Skew: Is there an edgeavailable by spreading (i.e. simultane-ously buying cheap options and sell-ing expensive options)? If so, the high-er the implied volatility of the optionsold vs. the implied volatility of theoption bought, the better.

T is for Timing: Is the marketoverbought or oversold? What marketconditions should you look for beforeimplementing a given strategy?

Defining appropriate PRO-VEST

factors for options trading strategiescreates a structured approach foroptions trading. We can zero in ontrades that generate the highest proba-bility of making money, rather thanrelying on gut feel or luck. Lets look atone example of the PRO-VEST methodto selling a vertical spread.

The short vertical spread

For this position you sell slightly to farout-of-the-money options and buy far-

ther out-of-the-money options. Selling avertical spread is appropriate if youdont expect the market to move quicklyagainst you. The RV ranking should begreater than 5 the higher the better.

There are a number of advantages toselling a vertical spread. Time decayworks in your favor when you sellOTM options and you can take advan-tage of volatility disparities betweendifferent options. In addition, you canenter a trade with limited risk, rather

than the unlimited risk you face whenselling options outright. Finally, if RVis extremely high, you can profit froman approach that helps identify over-bought and oversold points.

The disadvantage is that profitpotential is limited to the differencebetween the premium received for theoption sold and the premium paid forthe option bought. In fact, the profitpotential is often less than the maxi-mum risk. As a result, you need to

monitor this trade closely and cut yourloss if the need arises.

The PRO-VEST parameters for avertical spread are:

Probability: Only sell call optionswith a delta of 35 (35 percent) or less.Only sell put options with a delta of-35 or more. Sell options at least onestrike out-of-the-money. Do not sell in-the-money options.

Volatility: RV is greater than 5 (pre-cluding outright call or put buying).

Expiration: Sell options with lessthan 45 days until expiration.

Skew: The higher the impliedvolatility of the option sold vs. theimplied volatility of the option bought,the better.

Timing: If the 14-day RSI is greaterthan 50, sell vertical calls only. If the 14-day RSI is less than 50, sell vertical putsonly.

Exiting with a loss

Because short vertical spreads general-


The breakeven point for this vertical spread on the QQQs is 39.58.

Source: Option Pro by Essex Trading Co.

33.30 36.63 39.94 43.31 46.63 49.94 53.31

624

-208

-1,040

-1,873

Date: 4/20/01Profit/loss: 3

Underlying: 39.58Above: 76%Below: 24%

% move reg.: -8.9%

The TradeFinder software allows you to construct hypothetical option trade sce-

narios. Here, the most favorable vertical spread would return 28.2 percent.


FIGURE 1 EXPECTED RETURNS

FIGURE 2 VERTICAL SPREAD PROFILE



ly have greater risk than potentialreward, you must be prepared to cutlosses. Ideally, you should risk no morethan the maximum profit potential forthe trade to keep your reward-riskratio at about 1:1. As we will see, this

can vary based on market conditions.

Exiting with a profit

When selling a vertical spread youshould not hold out for the last dollar.Once your open profit reaches 80 per-cent or more of your maximum profitpotential, you should generally takeyour profit rather than risk allowingthe market to reverse against you priorto expiration.

Trading the QQQsLets look at a recent example of sell-ing a vertical spread (a bull putspread) in the QQQs. Our data is fromMarch 20, 2001. Analysis of the QQQsdetermined the following was theappropriate strategy: Buy 12 April 38puts @ 1.30, and sell 12 April 40 puts @1.90. This trade has a profit potential of$720 (before commissions).

Figure 1 shows the expected returnsover the time to expiration, while

Figure 2 shows the breakeven point onthe expiration day is approximately39.58 below the recent low of 40.56.Based on the historical volatility of theQQQs, the probability of this indextrading above 39.58 at option expira-tion is 76 percent. Thus, at the time thistrade is entered, there is a 76-percentprobability of profit. Figure 3 showsthat the implied volatility is very high,with a relative rank of 10. We enter intothis position as a credit spread to sell at

a credit of 60 cents or better (Figure 4).Generally you should risk no more

than your maximum profit potentialwhen selling a vertical spread.However, there may be good reason to

give this trade more room to move.The 10-day TRIN indicator offers

some insight into market behavior thatwe can use to determine the marketscourse. The 10-day moving average ofTRIN pierced the significant 1.50 levelfor just the eighth time in the last 35years on March 20, 2001. Looking backat the previous seven signals whichoccurred in 1966, 1970, 1974, 1980,1982, 1987 and 1997 the S&P 500index never closed more than 6 percent

below the closing price on the day afterthe signal before beginning a rally. Inaddition, the previous seven signalswere all followed by higher stockprices 12 months later.

As a result, we will exit this trade ifthe S&P falls more than 6 percentbelow its close on March 21, 2001(1,122.14 minus 6 percent yields a stop-loss point of 1,054.81 on the S&P 500index). This illustrates how the markettiming aspect of the PRO-VEST

method can influence an individualoption trade.

Profits will be taken if the spreadnarrows to 12 cents or lower. Therequired capital for a 12-lot trade:

$1,872. The expected profit beforecommission if the trade is exited witha 12-cent spread: $576. The after-com-mission profit will vary depending onhow much you pay your broker to exe-cute option trades.

Trade options with an edge

The PRO-VEST method provides aframework for you to evaluate anyoptions strategy, from buying outrightcalls to selling credit spreads.

The key is to track and determinethe relative volatility rankings andselect the appropriate strategy to raisethe probability of success. Avoid themistake of paying too high a price foran option solely as a leverage opportu-nity based on your market in-dicators.

For more information on the author see p. 4.Questions or comments? Click here.

A version of this article previouslyappeared in Active Trader magazine.

The trade is entered as credit spread, at a price of .60.

Source: www.mrstock.com

The high relative volatility at the time of the trade suggests these options are

expensive and should be sold.


3/19/99 7/19/99 11/17/99 3/17/00 7/18/00 11/16/00 3/19/01

71.00

66.80

62.60

58.40

54.20

50.00

45.80

41.60

37.40

33.20

29.00

24-month relative volatility

FIGURE 3 RELATIVE VOLATILITY

FIGURE 4 ORDER ENTRY
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MONTH

17PPI for April

LTD: June crude oiloptions (NYMEX)

19 20LTD: All May equity options; May S&P options (CME);

May Nasdaq options (CME); May Dow Jones options

(CBOT); June T-bond options (CBOT); June corn,wheat, rice, oats, soybean products, and soybean

options (CBOT); June orange juice options (NYBOT)

GLOBAL ECONOMIC CALENDAR

3FOMC meeting

2

9 10 11 12 13LTD: May currencies

options (CME); May

lean hog futures and

options (CME); June

sugar and coffee

options (NYBOT)

26GDP (prelim) for Q1

2005

LTD: May feedercattle futures and

options (CME)

27LTD: May T-bond options(CBOT); May corn, wheat,

rice, oats, soybean, and

soybean products options

(CBOT)

2824

30Markets closed Memorial Day

312008 LEAPS added

25LTD: June natural gas,gasoline and heatingoil options (NYMEX);

June aluminum, cop-

per, silver and gold

options (NYMEX)

The information on this page is subject to change.Options Traderis not responsible for the accuracyof calendar dates beyond press time.

Monday Tuesday Wednesday Thursday Friday Saturday

OPTIONS EXPIRATION CALENDAR & EVENTS MAY

23

Event: The 17th Annual Las VegasMoney Show.Date: May 9-12Location: Paris & Bally's Resorts;Las VegasFor more information: Log on towww.intershow.com

Event: Linda Raschke's 9th AnnualTrading Seminar

Date: June 10-12

Location: Orlando World CenterMarriott Resort & Convention Center

For more information: Contact

Laura Meek at [email protected] or(888) 546-4836.

Event: Expo Trader Brazil InternationalAsset Managers and TradersConference.Speakers include John Bollinger, LarryWilliams, and Frank Tirado.Date: June 23-24Location: Sofitel Hotel, Rio de Janeiro,BrazilFor more information:

www.expotrader.com.br/

Event: The Traders Expo Chicago.

Date: July 13-16Location: Hyatt Regency ChicagoFor more information:

www.tradersexpo.com or call (800) 970-4355

Event: Fibonacci Trader workshops

Date: July 16-18 (Orlando) and Sept.11-13 (Denver)

Presenters: Dennis Bolze and YuriShramenko.

For more information: Visitwww.fibonaccitrader.com.

5LTD: May CME U.S.

dollar index options

(CME)

4 76LTD: May pork belly

options (CME); June

cocoa options

(NYBOT)

Employment for April

162006 LEAPS conver-

sion

LTD: May GoldmanSachs Commodity

Index options (CME)

18CPI for April

LTD: June platinumoptions (NYMEX)

14

CBOT: Chicago Board of Trade

CME: Chicago Mercantile Exchange

CPI: Consumer Price Index

FOMC: Federal Open Market

Committee

GDP: Gross Domestic Product

NYBOT: New York Board of Trade

NYMEX: New York Mercantile

Exchange

PPI: Producer Price Index

Legend
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Don Fishback is president ofLexington, Ky.-based FishbackManage-ment & Research,Inc., an advisory firm that

offers several services and softwareproducts for option traders.

Before entering the trading indus-try, Fishback worked as a land survey-or for a civil engineering firm in thelate 70s, working mostly on largeindustrial and public works projects.But when the hyper-inflation of thelate 70s and early 80s submerged theconstruction industry, he was com-pelled to look for another line of work.

He landed a position at a commodi-ties brokerage, where he worked forseveral years. Although it wasnt a

dream job, the position did provide avaluable education albeit in aroundabout way.

I didnt really enjoy it because itconsisted of a lot of sales, and I wasmore into analysis, Fishback explains.It was a very small firm, and theresearch department was basically thecommodities section of The Wall StreetJournal. Every day [the firm] wouldpass out the commodities section to thebrokers and say, TheJournal has five

guys saying gold is going up, so tellyour customers to buy gold. Based onthat experience, I developed a realsense of contrary opinion, because Isaw what was going on. First, thefirms commissions were outrageouslyhigh, which was part of the reason cus-tomers were having a hard time mak-ing money, but also, the analysts thereporters repeatedly quoted werehardly ever right.

His next stop in the business

brought him into the world of optiontrading. In late 1987 he interviewedwith Bernie Schaeffer, head ofSchaeffer Investment ResearchInstitute, a firm that focused almostexclusively on option strategies. Hejoined the company in 1988 andworked there for five years, eventual-ly becoming head of research.

Fishbacks ideas about the marketsthat had begun to form during hisbrokerage days really took form in his

new environment.

OPTIONS TRADER INTERVIEW

DON FISHBACKFrom theoretical

option models

to historical trade

simulations,

Don Fishback

focuses on the odds.

BY OPTIONS TRADER

STAFF

2004 David Stephenson



Working with Bernie was a veryvaluable educational experience,Fishback says. I had a really contrarianmindset by the time I hooked up with[Schaeffer], and he and I developed aneven greater [sense of] contrary opin-

ion.

For whom the bell curve tolls

In 1993 Fishback decided to launch hisown career as a trading advisor. A con-versation with a broker friend helpedinitiate a new phase in his research, theone that would dominate his work foryears.

Id been working with a broker inChicago by the name of Pete Stolcers,whom Id met while I was still with

Schaeffer Investment Research Insti-tute, he says. Pete had an idea for aservice that involved selling high-probability OEX (S&P 100 index) creditspreads that were three strike pricesout of the money. The service had agreat track record when I was withSchaeffer.

The thing was, although Fishbacksaw the positive end results of thecredit-spread trade, he wasnt exactlysure why the strategy worked the way

it did. His broker friend helped cluehim in.

Pete said and Ill never forgetthese words Don, it has somethingto do with that bell-curve thing,Fishback says, laughing a little.

Fishback promptly began investi-gating the bell-curve thing, diggingdeep into financial journals and his oldcollege math and statistics textbooks.This was the beginning of his journeyto rediscovering the ideas that were

part of the Black-Scholes optionmodel, particularly the concept ofnormal distribution.

If a distribution of values (such asprices or price changes over a period oftime) is normal, it takes the shape of abell curve, and one standard deviationcontains approximately two-thirds ofall the values in the data set, Fishbackexplains. Two standard deviationscontains 95 percent of all the numbersin the set. Standard deviation relates

directly to probability, which is impor-

tant because, by definition, historicalvolatility is one standard deviation ofan assets price returns. Quite simply,because of that bell-curve thing,volatility produces a standard devia-tion, which in turn produces a proba-

bility. I had no idea the Black-Scholesmodel directly implied probability.(For more information on standard devia-tion, see Variance and standard devia-

tion, above.)

Fishback says his work essentiallyamounted to translating the mathbehind an option-pricing model intomore understandable and practicableconcepts.

Basically, I took everything thatwas in the Black-Scholes model and

made it relatively easy to access anddecipher, he says. So, although Ioriginally thought in 1994 I had foundthe keys to the kingdom, what I reallyhad done was find out about somemathematical formulas that werealready there, but were buried [in themodel].

Realizing if he didnt know aboutthe probability implications of Black-Scholes there were probably other peo-ple who didnt, Fishback put together

a video course explaining the probabil-ity and trading implications he hadlearned. The video became a hot sellerand Fishbacks new advisory careerwas well on its way.

Fishback also eventually developedand sold a number of products and serv-ices reflecting these ideas, including theODDS TradeMaster software. His com-panys main product is www.oddson-line.com, an online option analysissoftware package. Fishback also wrote

the book Options for Beginners and hasproduced a number of instructionalvideo series.

However, he notes, early on he ranafoul of the Commodity FuturesTrading Commission (CFTC) regard-ing the marketing of some of his prod-ucts.

The advertising [that was done] forthose products got me into trouble, hesays. The CFTC did not like it at all.

There were two issues, Fishback

explains. The performance statistics

for the trading system sold to cus-tomers were based on hypotheticalback-testing rather than real trades,which the ads did not adequately dis-close. I saw the advertising beforehandand did nothing to stop it from being

distributed, so I have to take the rap,but I didnt realize you had to use thedisclaimer on back-tested results.

The second thing was the advertis-ing gave the false impression I actuallytraded the system, and, because of thatwas one of the great traders that everlived. I did the analysis, but I didntactually trade [the system]. But any-way, because of advertising that wasdone in the mid-90s, [theres informa-tion about me] on the CFTC Web site.

Fishback has since settled with theCFTC and moved on.

Fishback spoke with us about theprobability concepts he originallylearned and how they evolved overthe years. He also discussed a newservice called Option Mine, which issomething of a departure in that itidentifies option trades based on asimulated test of actual option pricedata going back to 1999 a processthat essentially throws theoretical

option models out the window andinstead reflects past performance.

OT: What are the trading implica-

tions and ideas that came out of the

original probability research you

did?

DF: You can use the probability impli-cations in the Black-Scholes model tocalculate the probability of profit on anoption trade. Lets say you want to buya straddle (a position consisting of a call

option and a put option with the samestrike price and expiration). You can cal-culate the breakeven points, calculatethe volatility and then ask, OK,whats the chance this thing will beprofitable? 60 percent? 40 percent?

What I did was reverse the process.Say I want to [find trade opportunitiesthat] win 90 percent of the time. Whattrades should I take to achieve thatprobability?

One of the things I found was if you

continued on p. 32
http://www.oddsonline.com/http://www.oddsonline.com/http://www.oddsonline.com/http://www.oddsonline.com/



sold OEX credit spreads a certain num-ber of strike prices away from the cur-rent underlying price, you couldachieve that probability. Basically, youcould start with the idea of a 90-percentprobability trade, plug in the volatility,and the formula would determine theprice range the index would trade with-in with 90-percent accuracy. As a result,

you could sell a credit spread outsidethat price range and the spread auto-matically has a 90-percent probabilityof profit. That was the first practicaltrading application of my research.

OT: That sounds a little too easy.

DF: Youre right. You get the probabili-ty, but theres another issue the prof-it-loss. We can find a trade that has acertain probability of profit, but thatsall it does.

OT: Do you mean it doesnt tell you

the potential size of that potential

profit or loss?

DF: Right. The next step is combiningprobability with risk and reward. Backin 1994, the trading world was risk-reward this and risk-reward that. Butif only risk and reward matter, every-body should be buying lottery ticketsfor a living because thats the best risk-reward relationship youre going to

get. But that doesnt work, of course,

because the probability is so awful.But just as you cant look at risk and

reward in a vacuum, you cant look atprobability in a vacuum. If probabilityof profit was the most important thing,then we all should be buying T-bills,because thats as close to 100-percentcertainty as youll get.

Combining risk and reward with

probability gives you the notion ofexpected return. First, I use the proba-bility formulas to find a trade with a 90-percent probability of profit. Then Ihave to determine the expected return,or risk and reward, and how to balanceit with probability.

Ill give you a quick little game as anexample. Say you have a 90-percentprobability of winning, and when youwin, you win $1 and when you lose,you lose $4. If you play 10 times, you

win $9 and lose $4 that leaves youwith a profit of $5. Your expected prof-it-loss is the profit divided by 10,which gives you 50 cents in this case.

If you have another game with thesame 90-percent probability but a $1win and a $20 loss, after playing 10times you would have won $9 and lost$20. Youre $11 in the hole, whichcomes out to an expected profit-loss of-$1.10 on a game that wins 90 per-cent of the time.

OT: So what kind of strategies do

these concepts naturally lend them-

selves to?

DF: The easy example is, you usevolatility to calculate your probabilityof profit and then you look at the risk

and reward, and you can easily evalu-ate the mathematical expectation ofany trade.

OT: Lets go over volatility, then, if

thats whats determining probabili-

ty of profit.

DF: In terms of volatility, it doesntmatter if its high or low, as long as itsone or the other. If its low, we do onething; if its high, we do somethingelse.

Volatility does something calledrevert to the mean, which basicallymeans if its high its going to drop andif its low its going to rise. If its highand you expect it to drop, the beststrategies to use will involve sellingoptions. There are many [kinds ofstrategies], but the one I prefer is thecredit spread.

A credit spread position we recentlydid was in CV Therapeutics (CVTX).The volatility on CVTX was extremely

high and our forecast was for it to drop(see Figure 1). The stock was at $16.52.We put together a strategy of selling the$12.50 put and buying the January $10put for a $.50 net credit. We came upwith that particular trade because Itook the price, $16, and the one-yearhistorical volatility of the stock and cal-culated the price levels that had a 90-percent probability of containing priceaction. The breakeven price for thetrade at expiration was $12 (see Figure

2).The probability formula gives us the

price range for the 90-percent proba-bility threshold, so then we look forthe option strikes that coincide withthat. We sell the option with the strikeprice that is close to that [90-percentthreshold], and then we simply buyanother option of the same kind onestrike price further out of the money.In this case, $12.50 wasnt exactly 90percent, but it was pretty close. The

position had an 86.8-percent probabili-

OPTIONS TRADER INTERVIEW continued

Variance and standard deviation

Variance measures how spread out a group of values are in other words, howmuch they vary. Mathematically, variance is the average squared deviation (ordifference) of each number in the group from the groups mean value, divided bythe number of elements in the group. For example, for the numbers 8, 9 and 10,

the mean is 9 and the variance is:

{(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = .667

Now look at the variance of a more widely distributed set of numbers, 2, 9, 16:

{(2-9)2 + (9-9)2 + (16-9)2 }/3 = (49 + 0 + 49)/3 = 32.67

The more varied prices, the higher their variance the more widely distrib-uted they will be. The more varied a markets price changes from day to day (orweek to week, etc.), the more volatile that market is.

A common application of variance in trading is standard deviation, which isthe square root of variance. The standard deviation of 8, 9, and 10 is: .667 =

.82; the standard deviation of 2, 9 and 16 is: 32.67 = 5.72.



ty of making money.We look at the size of the credit,

which is the profit potential, and themargin requirement, which is the max-imum risk, and then we compare thatprobability to the risk and reward, get

an expected return, and if thats allOK, we do the trade.

Overall, you can apply the expect-ed-return principles to two types oftrading strategies what I call high-profit strategies and high-probabilitystrategies. The high-probability strate-gy is essentially what weve just talkedabout you look for a stock that hasreasonably high volatility.

OT: Why do you prefer the credit

spread in a high-volatility situation?DF: As opposed to selling a straddleor strangle, a credit spread is a simpleway to sell volatility with limited risk.It has limited reward, but it has limit-ed risk, too.

There are more complicated strate-gies, but theyre inappropriate for indi-viduals because of margin require-ments or risk exposure, or, quitefrankly, too-high transaction costs every time you trade youre giving up

the bid or the ask.Its easier for individual traders to

be able to put a position on withouthaving to worry about the trade blow-ing up because the risk is controlledand you havent given all the potentialprofit to the market maker and the bro-ker. There are a lot of great strategiesout there, but for people to trade offthe floor, its really difficult [to tradethem effectively].

OT: So what kind of trade would beappropriate for a low-volatility situa-

tion?

DF: In a high-volatility situation, ifyou sell naked options you exposeyourself to unli

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