February 2008

Volume 2, No. 2

STOCKS VS.
LEAPS p. 28
FIBONACCI
PIVOT POINTS: OPTIONS
A twist on the STRATEGY
floor-trader technique p. 8 comparison p. 16

MANAGING OPTION RISK

with the Greeks p. 30

COMMITMENTS
OF TRADERS:
COT extremes
strategy test p. 22
Large specs vs.
hedgers p. 44
 CONTENTS

Options Trading System Lab

The stock vs. LEAPS showdown . . . . . .29
By Steve Lentz and Jim Graham

Trading Basics
Fighting the options battle
with the Greeks . . . . . . . . . . . . . . . . . . . . . .30
The major options Greeks (delta, gamma,
theta, and vega) can help you anticipate
Contributors . . . . . . . . . . . . . . . . . . . . . . . . . . .6 market risk and manage trades better.
By Dan Passarelli
Trading Strategies
Fibonacci pivot points . . . . . . . . . . . . . . . . .8 Deciphering stock
This intraday system tweaks the standard option symbols . . . . . . . . . . . . . . . . . . . . . .34
pivot-point formulas with Fibonacci ratios Learn how to interpret stock-option symbols.
to improve its odds of success. By Chris Peters
By Lee Leibfarth
continued on p. 4
Exploiting the fear factor . . . . . . . . . . . . .16
What’s the best way to profit from a
high-volatility forecast? Comparing the
performance of covered calls, different
option spreads, and LEAPS shines some
light on the subject.
By Tristan Yates

Futures Trading System Lab

COT extreme-position system . . . . . . . . .22
By Volker Knapp

2 February 2008 • FUTURES & OPTIONS TRADER

 CONTENTS

Futures Snapshot . . . . . . . . . . . . . . . . . . . .38

Momentum, volatility, and volume
statistics for futures.

Options Radar . . . . . . . . . . . . . . . . . . . . . . .39

Notable volatility and volume in the
options market.
News
CME not content to stand pat . . . . . . . . .40
The Chicago Mercantile Exchange has
admitted to negotiations with the New York
Mercantile Exchange about a possible
acquisition.
SEC agrees with CBOE
in rights battle . . . . . . . . . . . . . . . . . . . . . . .40
The Securities and Exchange Commission
agreed with the Chicago Board Options
Exchange that the Chicago Board of
Trade’s purchase by the Chicago Mercantile
Exchange eliminated the existence of CBOE
rights holders at the CBOT.
CBOT integration of electronic
products complete . . . . . . . . . . . . . . . . . . .41
The Chicago Board of Trade’s electronically
traded products have moved to the Chicago
Mercantile Exchange’s Globex platform.
Options Watch:
Top Nasdaq 100 components . . . . . . . . . . .42
Tracking bid-ask spreads on the top
15 Nasdaq 100 stock options.
Futures & Options Calendar . . . . . . . . . . . .43
Futures Fundamentals . . . . . . . . . . . . . .44
This list highlights extremes in sentiment
from the weekly Commitment of Traders
(COT) report.
Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44
New Products and Services . . . . . . . . . . . . .45
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . .46
References and definitions.
Options Trade Journal . . . . . . . . . . . . . . .50
Trading the Fed’s rate cut with a put spread.

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

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OptionsMentoring Zecco

4 February 2008 • FUTURES & OPTIONS TRADER


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6 February 2008 • FUTURES & OPTIONS TRADER
CONTRIBUTORS
CONTRIBUTORS

Lee Leibfarth (lee@powerzonetrading.com) is an independ-
ent futures trader, trading system researcher, and programmer. He
is president and founder of PowerZone Trading, a company that
provides a range of services for traders. His articles on technical
analysis and market technology have been featured in a variety of
publications. He is the author of the recently published Make Money Trading —
How to Build a Winning Trading Business (Marketplace Books, 2007).

Dan Passarelli, author of the book Trading Option Greeks
(Bloomberg, 2008), started his trading career on the floor of the
Chicago Board Options Exchange (CBOE) as an equity options
market maker. He also traded agricultural options and futures on
the floor of the Chicago Board of Trade (CBOT). In 2005, Passarelli
joined CBOE Options Institute and began teaching both basic and advanced
trading concepts to retail traders, brokers, institutional traders, financial plan-
ners and advisors, money managers, and market makers. In addition to his work
with the CBOE, he taught options strategies at the Options Industry Council
(OIC). Passarelli has been featured on television and radio and has written
numerous articles in the financial press.

Tristan Yates researches and writes about enhanced indexing strategies
using derivatives for publications including Futures & Options Trader,
SeekingAlpha, Investopedia, and Trader’s Journal. His articles are distributed
through Yahoo! Finance, Forbes, Kiplinger, and MSN Money. He received his
MBA from INSEAD in Singapore, lives in Bethesda, MD, and is working on a
book on enhanced indexing for the Wiley Trading Series.

Volker Knapp has been a trader, system developer, and
researcher for more than 20 years. His diverse background
encompasses positions such as German National Hockey team
player, coach of the Malaysian National Hockey team, and presi-
dent of VTAD (the German branch of the International
Federation of Technical Analysts). In 2001 he became a partner in
Wealth-Lab Inc. (http://www.wealth-lab.com), which he is still running.

Jim Graham (advisor@optionvue.com) is the product man-
ager for OptionVue Systems and a registered investment advisor
for OptionVue Research.

Steve Lentz (advisor@optionvue.com) is executive vice president of
OptionVue Research, a risk-management consulting company. He also heads
education and research programs for OptionVue Systems, including one-on-one
mentoring for intermediate and advanced traders.
 TRADING STRATEGIES

Fibonacci pivot points

Countertrend and breakout rules complement a Fibonacci pivot-point technique.

Strategy snapshot
BY LEE LEIBFARTH
Strategy: Fibonacci pivot points.
Market: E-Mini S&P 500 (ES).
Logic: Combining Fibonacci numbers and pivot points in an intraday
system. Exploit countertrend moves when price is near the
central pivot, and capture trending markets on a breakout above
resistance (R2) or below support (S2).
Money Profit targets and stop-losses defined by Fibonacci ratios reduce
management: risk and increase profit potential.
Timing: Enter trades between 9:30 a.m. and 1:00 p.m. ET. Exit the
position at 4:00 p.m. if a stop has not been reached.
Only triggers one trade per day.
S upport and resistance is
one of the most basic
technical analysis con-
cepts: When price drops
to support, buyers tend to enter the
market as sellers exit; when price
climbs to resistance, sellers tend to
appear as buyers exit. But when
price moves beyond either level, it
FIGURE 1 — FIBONACCI PIVOT POINTS
may continue trending higher or
Pivot points are a series of horizontal lines intended to represent different lower.
levels of support (S1 and S2) and resistance (R1 and R2). Although the idea is fairly sim-
ple, support and resistance levels
can be difficult to find and often
become clear only in hindsight.
One way around this dilemma is to
calculate pivot points — supposed
support and resistance levels based
on yesterday’s daily range and
closing price.
The idea behind pivot points is
compelling. Standard pivot points
use yesterday’s trading activity to
help define today’s market direc-
tion. Who wouldn’t want to identi-
fy today’s potential support and
resistance levels before the markets
open? Despite their popularity,
however, pivot points are some-
what arbitrary, and few analysts
focus on their performance or why
these specific values are so impor-
Source: TradeStation
tant.

8 February 2008 • FUTURES & OPTIONS TRADER

 Pivot points
Pivot points are calculations some traders use to determine supposed support
and resistance levels derived from the high, low, and closing prices of the previ-
ous price bar. The pivot point value is added to and subtracted from the previous
bars’ reference points to determine support and resistance levels for future trad-
ing. The pivot point (PP) formula is:

The following discussion compares
two different types of intraday pivot-
point strategies designed to capture
both countertrend and breakout
moves. The first strategy uses stan-
dard pivot points, while the second
strategy uses pivot points based on
Fibonacci levels with the goal of
defining more accurate support and
resistance levels and boosting the
technique’s reward-to-risk ratio.
The system is tested on the E-Mini
S&P 500 futures (ES) but it can be
applied to other stock-index futures.
1. PP = (H + L + C)/3
2. First resistance level (R1) = (PP*2) - L
3. Second resistance level (R2) = PP + (H - L)
4. First support level (S1) = (PP*2) - H
5. Second support level (S2) = PP - (H + L)
A typical pivot point application is to cover any short positions and go long at
either of the two support levels, or sell any long positions and go short at the pro-
jected resistance levels. Pivot points are often attributed to a tradition passed
down among floor traders. Like any tool, pivot points should be tested to verify
their potential before trading.
TABLE 1 — FIBONACCI PIVOT POINT FORMULAS
Tweaking the standard formulas shortens the distance between the two support
and resistance levels, a technique that boosts the system’s reward-to-risk ratio.
R2 = pivot + ((yesterday’s high – yesterday’s low) * 0.618)
R1 = pivot + ((yesterday’s high – yesterday’s low) * 0.382)
Pivot = (yesterday’s high + yesterday’s low + yesterday’s close) / 3
S1 = pivot - ((yesterday’s high – yesterday’s low) * 0.382)

Standard vs. Fibonacci S2 = pivot - ((yesterday’s high – yesterday’s low) * 0.618)

pivot points
To calculate pivot points, start with
the central pivot, which is the average
of yesterday’s high, low, and close. In
theory, price should trade around the
central pivot. The next step is to iden-
tify two resistance levels above it (R1
and R2) and two support levels below
it (S1 and S2). For more details, see
“Pivot points.”
Figure 1 shows Fibonacci pivot
points as a series of horizontal lines
applied to an E-Mini S&P 500 chart.
Fibonacci pivot points calculate sup-
port and resistance levels based on
Fibonacci ratios, a technique that typ-
ically shortens the distance between
each point. Because 24-hour markets
tend to have large price swings,
Fibonacci pivots tighten entry and
exit points.
The first Fibonacci ratio divides a
number from the Fibonacci series by
the next consecutive number to form
0.618, often referred to in mathematics
as the “golden ratio conjugate.” The
second ratio divides a number in the
continued on p. 10

FUTURES & OPTIONS TRADER • February 2008 9

 TRADING STRATEGIES continued

FIGURE 2 — COUNTERTREND TRADE EXAMPLE

After the E-Mini S&P 500 climbed to R1, the system sold short around 10 a.m. ET
on Dec. 19, 2007. The market then fell to the pivot (1,462.00) and the system series by the second consecutive
captured gains. number, equaling 0.382. (For more
details about the Fibonacci series,
see “Key concepts.”)
Fibonacci traders measure the
distance between two extremes
and then divide it by Fibonacci
ratios (0.618 or 0.382) to find
retracement levels, or points where
the market could reverse. For
example, if price fell sharply from
a recent high of 100, it may
rebound after it drops near 61.8; or
if price rallied from a recent low of
100, it may lose momentum
around 138.2.
Table 1 shows the revised formu-
las for Fibonacci pivot points,
which are based on the same con-
cept. The central pivot doesn’t
change, but the support and resist-
ance formulas multiply yesterday’s
Source: TradeStation range by Fibonacci retracement
values (0.618 or 0.382).
FIGURE 3 — STANDARD PIVOTS MISS A TRADE
The distance between the standard pivot points was larger on Dec. 19, so Defining session times
Figure 2’s short trade wasn’t triggered. Pivot points are attributed to a floor-
trader tradition that evolved before
stocks and futures traded electronical-
ly. Back then markets had well-
defined trading hours, so identifying
daily ranges was easy. Today, howev-
er, traders can access markets virtual-
ly around the clock, which makes it
more difficult to select the beginning
and ending times that define the ses-
sion’s range and the resulting pivot-
point values.
Although U.S. stock index futures
tend to be most volatile when the cash
market is open (9:30 a.m. to 4 p.m.
ET), trading during off-peak hours is
now more important than ever.
Picking specific time periods is subjec-
tive, so to eliminate any ambiguity
this system uses both the pit and elec-
Source: eSignal
tronic sessions in a 24-hour trading

10 February 2008 • FUTURES & OPTIONS TRADER

 FIGURE 4 — BREAKOUT TRADE EXAMPLE
The system went long after the E-Mini S&P 500 rose above R2 on Nov. 23, 2007
and exited at the 4 p.m. close.

day. The beginning and end of the

day varies in 24-hour markets such
as the E-Mini S&P 500, depending
on your location. Therefore, the
day’s range will likely change, and
pivot-point values may differ even
though U.S. and Australian traders
apply the same formulas.
A session’s highs and lows must
reflect realistic turning points from
yesterday. In this case the daily
range will begin at 12 a.m. and end
at 11:59 p.m. ET, a period chosen
because the price action between
midnight and 9:30 a.m., when the
U.S. stock market opens, can tell
you more about the market’s tone
than yesterday’s price action. Source: TradeStation
In addition, the system enters
trades only between 9:30 a.m. to 1
p.m. ET (when the futures are most
active) and any open positions are
closed at 4 p.m. The system enters
only one trade per day and doesn’t
trade unless certain rules are met.

Countertrend rules:
From S1 to R1
The strategy triggers trades two ways
based on price’s proximity to the cen-
tral pivot. In general, the closer price
is to the central pivot, the more likely
it is to revert back to that level, while
as price climbs above resistance or
below support, it is more likely to
trend in that direction and away from
the central pivot.
Both patterns stem from the basic
tenets of support and resistance:
Resistance acts as a price “ceiling”
and support acts as a price “floor,”
unless the market breaks beyond
either level.
The first set of trade rules tries to
exploit price moves between S1 and
R1. In this range, price will often trade
continued on p. 12

FUTURES & OPTIONS TRADER • February 2008 11

 TRADING STRATEGIES continued

around the central pivot, creating a zone

bordered by R1 (top) and S1 (bottom). To
TradeStation Code
capture gains if price returns to the central
This code can be copied from http://www.activetradermag.com/code.htm pivot point, go long if price drops to S1 or
sell short if price rises to R1. A protective
// ================================
// FibPivot Strategy (Version 1.0) stop-loss is placed at the outer support or
// By: Lee Leibfarth resistance levels (S2 or R2), while the system
// 12-30-07 exits at the central pivot point.
//
// TARGET: 5-Minute ES Fibonacci pivot points provide better exits
// ================================ than the standard formulas because profit
targets will always be larger than stop-loss
variables:
amounts. In other words, the distance from
TradeSwitch(false),
Pivot(0), P to S1 or R1 is bigger than the distance
R1(0), between the first and second support or
R2(0),
resistance levels, which isn’t true with stan-
S1(0),
S2(0), dard pivots. This means you always risk less
PrevHigh(0), than you could earn — a positive risk-to-
PrevLow(0), reward ratio. The countertrend rules are:
PrevClosed(0);
If date <> date[1] then begin
TradeSwitch = true; 1. Enter long if price drops
PrevHigh = highd(1); to S1.
PrevLow = lowd(1);
2. Enter short if price rises to R1.
PrevClosed = closed(1);
Pivot = (PrevHigh + PrevLow + PrevClosed )/3; 3. Exit position with a limit
R1 = Pivot + (PrevHigh - PrevLow) * .382; when price returns to the
S1 = Pivot - (PrevHigh - PrevLow) * .382;
central pivot.
R2 = Pivot + (PrevHigh - PrevLow) * .618;
S2 = Pivot - (PrevHigh - PrevLow) * .618; 4. Exit position with a stop
end; when price falls to S2 (long
if TradeSwitch and time > 930 and time < 1300 and marketposition = 0 then begin trades) or climbs to R2 (short
if c < R1 then sellshort ("SellShort_R1") next bar at R1 limit;
if c > S1 then buy ("Buy_S1") next bar at S1 limit; trades).
if c > R1 and c < R2 then buy ("Buy_R2") next bar at R2 stop;
if c < S1 and c > S2 then sellshort ("SellShort_S2") next bar at S2 stop; Figure 2 shows the Fibonacci pivot system
end;
sold short when price climbed from the cen-
if marketposition = 1 then begin
sell from entry ("Buy_S1") next bar at Pivot limit; tral pivot to R1 (1,472.25) around 10 a.m. ET
sell from entry ("Buy_S1") next bar at S2 stop; on Dec. 19, 2007. The E-Mini S&P 500 fell to
sell from entry ("Buy_R2") next bar at Pivot stop;
the pivot (1,462.00) and the system captured
TradeSwitch = false;
end; gains, although a protective stop-loss order
if marketposition = -1 then begin was placed at R2 (1,478.25).
buytocover from entry ("SellShort_R1") next bar at Pivot limit; Figure 3 shows standard pivot points on
buytocover from entry ("SellShort_R1") next bar at R2 stop;
buytocover from entry ("SellShort_S2") next bar at Pivot stop; the same day. By contrast, no trades were
TradeSwitch = false; triggered, because price failed to hit R1
end; (1,477.08) before dropping again. When
if time >= 1600 then begin
comparing Figures 2 and 3, notice the dis-
sell next bar at market;
buytocover next bar at market; tance between the first and second support
end; and resistance levels is bigger with standard
setexitonclose;
pivots, which means the standard system
risks more than its Fibonacci counterpart.

12 February 2008 • FUTURES & OPTIONS TRADER

TABLE 2 — BACK-TEST RESULTS
The Fibonacci pivots outperformed the standard formulas. The return on capital is twice as large, the average profit is
58 percent bigger, and the profit factor is higher.
Standard Fibonacci Standard Fibonacci
Total net profit $6,060.00 $12,902.50 Profit factor 1.28 1.57
Gross profit $27,567.50 $35,600.00 Gross loss $21,507.50 $22,697.50
Total number of trades 149 201 Percent profitable 51.68% 47.26%
Winning trades 77 95 Losing trades 72 106
Avg. profit $40.67 $64.19 Ratio avg. win / avg. loss 1.2 1.75
Avg. winner $358.02 $374.74 Avg. loser $298.72 $214.13
Largest winning trade $1,502.50 $1,852.50 Largest losing trade $1,097.50 $947.50
Largest winning trade as Largest losing trade as
percentage of gross profit 5.45% 5.20% percentage of gross loss 5.10% 4.17%
Max. consecutive Max. consecutive
winning trades 5 6 losing trades 7 6
Avg. bars in winning trades 46.06 37.75 Avg. bars in losing trades 36.5 23.41
Avg. bars in total trades 41.44 30.18 Account size required $4,080.00 $2,952.50
Total commission $1,490.00 $2,010.00 Percent of time in market 6.09% 6.20%
Return on initial capital 6.06% 12.90% Annual rate of return 5.97% 12.32%
Buy-and-hold return 3.54% 3.32% Return on account 148.53% 437.00%
Standard deviation
Avg. monthly return $505.00 $1,075.21 of monthly return $1,631 $1,409
6 days, 23 hrs, 7 days,
Longest flat period 30 min. 20 min.
Source: TradeStation

Breakout rules:
Above R2 and below S2
The second set of rules tries to capture
breakouts beyond initial support and
resistance levels (S1 and R1). The goal
is to catch a significant trend as price
breaks above R2 or below S2. These
trades are typically triggered after a
small-range or consolidation day
when the current pivot points are
close together.
The breakout rules are:

1. Enter long if price climbs to R2.

2. Enter short if price drops to S2.
3. Exit position with a stop if price
falls back to R1 (long trades) or
advances to S1 (short trades).
4. Or exit position at 4 p.m.

Figure 4 shows a long breakout

trade example of the E-Mini S&P 500
rallying above R2 on Nov. 23, 2007.
Note that price traded below the R2
level at 9:30 a.m. to trigger a long sig-
continued on p. 14

FUTURES & OPTIONS TRADER • February 2008 13

 TRADING STRATEGIES continued
nal. The system exited with a profit at 4
p.m. ET.
Test results
The system was tested on five-minute
bars in the E-Mini S&P 500 futures
from Jan. 2, 2007 to Dec. 27, 2007. (The
bar interval isn’t important, because
the strategy’s signals are based on yes-
terday’s range and closing price.) The
system tested one contract and includ-
ed $10 round-trip commissions.
Table 2 compares back-tested results
of the standard-pivot and Fibonacci-
pivot systems (blue text represents
improved performance). The Fibonacci
pivots beat the standard formulas: The
return on capital was twice as large
(12.9 percent vs. 6.06 percent), the aver-
age profit was 58 percent bigger ($64.19
vs. $40.67), and the profit factor was
higher (1.57 vs. 1.28). The Fibonacci
strategy improved most of the other
performance statistics, including the
average winner and average loser, and
it also increased the number of trades
without increasing the system’s expo-
sure.
Other considerations
This strategy probably benefited from
the increased market volatility in the
last half of 2007. Volatile markets
widen the pivot point levels, so you
can expect larger net profits under
these conditions. Additional volatility
will increase both average winning and
losing trades. On the other hand, less
volatile markets will hurt this strate-
gy’s overall profitability. Its average
profit may drop because smaller daily
ranges lead to smaller profit and loss targets, even though have a smaller profit expectancy than a longer-term system,
the percentage of profitable trades and profit factor may but it will compensate by generating more trades.

change.
Finally, because this is an intraday strategy, it will likely For information on the author see p. 6.
14
Related reading
Lee Leibfarth articles
“Sharpening a countertrend strategy,” Active Trader, October 2007.
Designing a trading system involves more than just creating profitable signals.
You also need to consider how to size your trades.
“Intraday hybrid strategy,” Active Trader, July 2007.
Because simple trend-following methods can fall flat during choppy markets,
this breakout system adjusts its exits to fit different market environments.
“Forecasting techniques,” Active Trader, October 2006.
Predicting probable market action is a challenging task, but a handful of calcula-
tions make it possible to measure the reliability — and improve the accuracy —
of price forecasts.
Other articles
“Trader Interview: Tom DeMark,” Futures & Options Trader, April 2007.
Market legend Tom Demark explains why the tools he created with a calculator
and printed charts more than 30 years ago are still valid today.
“Tom DeMark: Market immersion,” Active Trader, July 2007.
In this second installment, DeMark discusses volume tools, Fibonacci, and
following your nose in the markets.
“Tom DeMark,” Active Trader, August 2007.
Continuing our discussion with Tom DeMark, the analyst, author, and strategy
designer discusses retracements, price projections, and enhancements to his
signature trend reversal techniques.
“The Fibonacci swing filter,” Active Trader, February 2005.
One way to filter market noise and focus on tradable price moves is to gauge
price swings in terms of retracement percentages. This approach creates an
adaptive trading system that adjusts to the market’s behavior.
“Pivot points and candlesticks,” Currency Trader, February 2005.
Augmenting pivot point analysis with candlestick formations helps determine
potential turning points in the forex market.
You can purchase and download past articles at
http://www.activetradermag.com/purchase_articles.htm
February 2008 • FUTURES & OPTIONS TRADER
ads0308 1/11/08 9:54 AM Page 11
 TRADING STRATEGIES

Exploiting the fear factor

Testing shows comparable option strategies can fare much differently depending
on the market environment.
BY TRISTAN YATES

I t’s difficult to recall a new year with so much pes-

simism. In the first week of January, the S&P 500 fell
5.45 percent, wiping out all of 2007’s meager returns.
For option sellers, though, fear is good for business
— it often prompts traders to hedge their positions, increas-
ing potential profits. But selling uncovered, or naked,
options is too risky for many traders, so they prefer to cre-
ate an options spread or enter a covered call.
Successful option traders build positions to exploit cur-
rent market conditions. For example, if you have a slightly
bullish forecast, you could put on a debit spread by pur-
chasing a call and selling a cheaper call to offset its cost. Or,
you could buy the underlying and sell a call against it (a
covered call). But which strategy should you choose?
Comparing four types of option spreads that consist of a
short call and a long call (or its equivalent) for protection
will help answer this question. If you can gauge which posi-
tions tend to perform best in bearish, high-volatility mar-
kets, you can profit while others panic.
Neutral to bullish strategies
Table 1 compares four similar strategies: covered call, bull
call spread, calendar call spread, and a diagonal spread that
uses Long-term AnticiPation Securities, or LEAPS (see

TABLE 1 — COMPARING OPTIONS STRATEGIES

These four options strategies have a neutral or slightly bullish market bias and all sell a front-month ATM call.

Covered call futures
Components Long future + short
front-month, ATM call.
Criteria: Futures contract is
unhedged with
5-percent margin.
Worst-case Market drops to
scenario*: zero.
Best-case Market closes at short
scenario*: strike and call expires
worthless.
Max. gain*: Call strike – underlying
price (at entry) + call
premium collected.
Max loss*: Underyling price
(at entry) - call’s cost.
Note: All positions include: 1) long-term neutral or bullish market bias, and 2) the same short, front-month ATM call.
* At first expiration
Bull call spread
Long front-month ITM
call + short same-month,
ATM call.
Long call is ITM
by 5 percent.
Market drops below
long strike.
Market closes at
short strike.
Strike-price difference –
spread’s cost.
Spread’s cost.
Calendar call spread
Long next-month ATM
call + short front-month,
ATM call.
When the short call
expires, sell the long
call to exit.
Market drops to
zero.
Market closes at
shared strike.
Long call’s cost –
spread’s cost.
Spread’s cost.
Diagonal LEAPS spread
Long 12-month ITM call +
short front-month, ATM call.
Long LEAPS call is ITM by
5 percent. Buy back short
call and sell more calls in
successive months.
Market drops below
long strike.
Market closes at
short strike.
Long call’s cost –
spread’s cost.
Spread’s cost.

16 February 2008 • FUTURES & OPTIONS TRADER

 TABLE 2 — PERFORMANCE ESTIMATES

If the S&P 500 goes nowhere between Nov. 16 and Dec. 21, the calendar call
spread could double in value. But the diagonal LEAPS spread is a good bet for
more conservative traders.

The S&P 500 closed at 1,458.74 on Nov. 16, and the VIX closed at 25.49.
“What are LEAPS?”). Each position Strategy Covered Bull Calendar Diagonal
sells a front-month, at-the-money call futures call spread call spread LEAPS spread
(ATM) call to profit from time decay.
Long S&P 500 Dec. Jan. Dec. 2008
The difference lies in the long compo-
futures 1,350 call 1,450 call 1,400 call
nents that are intended to limit losses.
Covered calls use a long position in Short Dec. Dec. Dec. Dec.
1,450 call 1,450 call 1,450 call 1,450 call
the underlying, while the three
spreads use long calls with different Initial cost
strike prices or expirations. Long 72.94 128.60 73.50 242.88
All four strategies are either neutral Short -53.94 -53.94 -53.94 -53.94
Debit 72.94 74.66 19.56 188.94
or bullish. They will lose value if the
underlying drops sharply, but they 5% gain
may perform well otherwise. The Long 192.52 181.68 100.54 273.75
short call offsets short-term downside Short -81.68 -81.68 -81.68 -81.68
Payoff 110.84 100.00 18.87 192.07
losses somewhat, while (with the
% return 52.0% 33.9% -3.5% 1.7%
exception of the covered call) the long
component is also long volatility. Flat
Despite their similarities, the Long 119.58 108.74 50.05 221.73
Short -8.74 -8.74 -8.74 -8.74
spreads aren’t identical because their
Payoff 110.84 100.00 41.31 212.99
long components hedge risk different-
% return 52.0% 33.9% 111.2% 12.7%
ly and have different leverage. To
compare the strategies, the following 5% drop
Long 46.65 35.80 18.49 174.53
study uses historical data from the
Short 0.00 0.00 0.00 0.00
S&P 500 index (SPX) and the CBOE
Payoff 46.65 35.80 18.49 174.53
volatility index (VIX) from January % return -36.0% -52.0% -74.8% -28.1%
1990 to December 2007. The analysis
Notes: 5% cost of capital used. DITM call for BCS has +4.5% vol. skew. LEAP
excludes slippage and commissions. vol. is fixed at 27%.
(To gauge S&P 500 futures perform- For futures covered call, short call premium may not be immediately applied to
ance, the test used 5-percent initial initial margin to create debit spread.
margin.)

Performance estimates
November index options expired on
Nov. 16, 2007 when the S&P 500 trad-
ed at 1,458.74 and the VIX at 25.49.
Given these numbers, you could have
sold an ATM December call for $53.94
— about 3.7 percent of the index’s
value.
Table 2 shows the four strategies’
initial costs on Nov. 16, 2007 and esti-
mates each position’s performance if
the S&P 500 index gains 5 percent,
drops 5 percent, or stays flat by Dec.
21 expiration.
Covered call futures and the bull
call spread should outperform diago-
nals and calendars. The first two
strategies will gain the most ground if
continued on p. 18
What are LEAPS?
Long-term AnticiPation Securities, or LEAPS, are longer-term options contracts
that expire up to two years and eight months in the future. They are no different
from regular puts and calls, and give the owner the right to buy or sell 100 shares
of stock at any time. But instead of expiration months, they have expiration years
(e.g., January 2008 LEAPS expire on Jan. 19, 2008).
All LEAPS are divided into three cycles that determine when they are listed.
Cycle 1 LEAPS are listed after May equity options expire, cycle 2 are listed after
the June expiration period, and cycle 3 are listed after the July period, three cal-
endar years in advance (i.e., 2010 LEAPS begin listing in 2007, 2011 LEAPS in
2008, etc.) As of Aug. 14, you can buy LEAPS on the S&P 500 index that expire
on Jan. 16, 2010 — 24 months from now.
In theory, LEAPS behave the same as regular options. In practice, however,
new LEAPS have low thetas and deltas in the first few months. This means time
decay is reduced, but changes in the underlying market don’t affect the option’s
price as much, at least initially.

FUTURES & OPTIONS TRADER • February 2008 17

 TRADING STRATEGIES continued

FIGURE 1 — S&P 500 BETWEEN EXPIRATIONS

The S&P 500 climbed 1.7 percent from Nov. 16 to Dec. 21
when the short 1,450 call expired at a profit of 19.48. All
four strategies gained ground during this period.
the underlying closes above the short strike at expiration.
The covered call should gain 52 percent regardless of
whether the market climbs or goes nowhere. And the bull
call spread should gain 33.9 percent in either scenario.
One difference is that a futures contract can lose more
than its initial margin requirement. Therefore, the bull call
spread risks less (at the expense of profitability). However,
both positions are highly leveraged and can lose a great
deal even if the underlying falls slightly.
By contrast, the calendar call spread will gain the most
ground if the S&P remains flat (111.2 percent), while it
should lose only 3.5 percent if the S&P 500 climbs 5 percent.
If, however, volatility drops, the calendar could lose value,
because it has additional vega risk.
Table 2’s estimates show the diagonal LEAPS spread
should be the most stable position, but it is also the most
expensive. For instance, the diagonal may gain modestly in
flat and rallying markets, and it should lose less than the
others if the S&P 500 drops. However, the diagonal LEAPS
spread costs more than twice as much as the bull call
spread (188.94 vs. 74.66, respectively).
LEAPS are less vulnerable to changes in price and
volatility, but their cost reduces leverage and capital effi-
ciency. For example, if the S&P 500 goes nowhere, the diag-
onal LEAPS spread will likely gain just 12 percent.

Actual performance
Figure 1 shows a daily S&P 500 chart and highlights the
December 1,450 strike. The S&P 500 climbed 1.7 percent to
1,484.46 from Nov. 16 to Dec. 21 expiration. The short
December 1,450 call moved in-the-money (ITM) and was
Source: eSignal
exercised.
Table 3 lists each strategy’s actual
TABLE 3 — RESULTS: NOVEMBER TO DECEMBER 2007 returns; all four positions posted gains
Covered call futures and the bull call spread gained at least 33.9 percent, match- during this period. Covered call
ing Table 2’s flat-market estimates. The diagonal LEAPS spread climbed 8.6 per- futures gained 52 percent and the bull
cent, while the calendar call spread gained just 6.2 percent because IV dropped. call spread gained 33.9 percent, respec-
tively, matching Table 2’s flat-market
S&P 500 index traded at 1484.46 on Dec. 21, 2007, estimates.
when SPX options expired. The calendar call spread should
have gained at least 60 percent, but it
Strategy Covered Bull Calendar Diagonal
climbed just 6.2 percent. The reason:
call futures call spread call spread LEAPS spread
Implied volatility fell 7 points from
Long S&P 500 Dec. Jan. Dec. 2008
25.49 percent to 18.47 percent. But if IV
futures 1,350 call 1,450 call 1,400 call
had risen, the calendar’s vega expo-
Short Dec. Dec. Dec. Dec.
sure would have boosted perform-
1,450 call 1,450 call 1,450 call 1,450 call
ance.
Actual result
The LEAPS diagonal spread
Long 145.30 134.46 55.24 239.56
climbed 8.6 percent from Nov. 16 to
Short -34.46 -34.46 -34.46 -34.46
Dec. 21 expiration. But most traders
Payoff 110.84 100.00 20.78 205.10
would buy back the ITM short call just
% return 52.0% 33.9% 6.2% 8.6%
before it expired and then sell another
one.

18 February 2008 • FUTURES & OPTIONS TRADER

Historical results
Table 4 lists the four positions’ month-
TABLE 4 — HISTORICAL RESULTS
ly statistics since January 1990. Like
Tables 2 and 3, the methodology does- The calendar call spread gained an average 21.1 percent per month and
n’t use actual options prices, but posted the largest risk-adjusted returns.
derives them from the S&P 500’s and Average Median StDev Min Max Return/risk
VIX’s daily historical values. Covered
The calendar call spread gained an call futures 17.2% 28.3% 45.3% -236.7% 98.2% 0.38
average 21.1 percent per month, rep- Bull
resenting Table 4’s highest risk-adjust- call spread 11.5% 31.6% 45.5% -100.0% 53.4% 0.25
ed returns. Its standard deviation is Calendar
slightly higher than the bull call call spread 21.1% 17.6% 52.2% -68.6% 162.8% 0.40
spread’s and covered call futures’ Diagonal
(52.2 percent vs. 45 percent, respec- LEAPS spread 4.1% 4.9% 10.4% -48.8% 31.0% 0.40
tively). However, the calendar spread Note: 3.5% cost of capital used to incorporate dividends, 10% volatility premium
has much larger potential profits, for bull call spread, 25% average long-term volatility for 365 day + 1 month LEAP
assumed for all environments.
which compensates for its vega risk.
The diagonal LEAPS spread has
one of the best return-risk ratios
(average/standard deviation), TABLE 5 — COVERED CALLS VS. BULL CALL SPREADS
although its average gain (4.1 per-
Covered call futures and the bull call spread were extremely volatile. The covered
cent) is the lowest. LEAPS spreads
call lost more than its initial margin in at least one month during six of the 18 years
offer plenty of stability, because
analyzed.
short-term losses can be erased by
the market’s long-term uptrend. Covered call futures Bull call spread
However, LEAPS aren’t the most
Average Worst Best StDev Average Worst Best StDev
effective way to use capital.
The bull call spread and covered 1990 14.6% -142.3% 65.8% 60.5% 5.7% -100.0% 50.4% 57.5%
call futures are risky. Although both 1991 21.0% -62.2% 58.5% 40.5% 14.8% -94.2% 48.6% 51.4%
positions posted the biggest median 1992 18.4% -20.1% 36.2% 20.2% 16.5% -31.4% 38.8% 27.6%
gains in Table 4, they sometimes suf-
1993 17.0% -25.0% 29.3% 16.8% 18.5% -36.0% 33.0% 21.4%
fer large losses of 100 percent or
more. 1994 1.3% -59.7% 43.9% 38.3% -4.3% -88.5% 43.1% 49.3%
Also, the bull call spread’s ITM 1995 25.1% 16.9% 28.8% 3.3% 28.9% 17.9% 32.8% 4.0%
call is expensive. ITM calls on the 1996 23.5% -62.4% 42.5% 29.9% 22.0% -88.7% 42.2% 38.8%
S&P 500 tend to have bigger IVs than
1997 27.7% -67.8% 77.3% 44.4% 14.5% -100.0% 52.2% 56.6%
their ATM counterparts, a phenome-
non called volatility skew. The 1998 28.1% -236.7% 98.2% 87.1% 27.2% -100.0% 53.4% 44.4%
added expense reduces the spread’s 1999 32.9% -17.8% 62.0% 29.9% 16.7% -48.3% 49.5% 42.3%
long-term profitability. 2000 3.8% -109.0% 66.1% 54.6% -13.4% -100.0% 50.4% 60.2%
2001 0.3% -139.0% 73.8% 77.9% -9.9% -100.0% 51.8% 70.3%
Year-by-year performance
Tables 5 and 6 break down the four 2002 -14.0% -148.4% 89.4% 81.2% -24.7% -100.0% 53.1% 69.6%
strategies’ monthly performance by 2003 39.9% 8.9% 66.0% 16.7% 30.5% -32.3% 50.4% 25.5%
year. Table 5 compares covered call 2004 21.8% -38.0% 39.8% 23.0% 20.9% -57.8% 40.7% 30.4%
futures to bull call spreads and Table
2005 11.4% -22.4% 32.8% 20.7% 10.6% -34.7% 36.0% 26.8%
6 compares calendar calls to diago-
nal LEAPS. The tables’ last row lists 2006 21.1% -37.6% 34.7% 18.8% 23.5% -51.1% 37.6% 23.7%
each strategy’s average monthly 2007 15.3% -48.6% 51.9% 33.6% 8.9% -83.2% 46.4% 43.1%
gains or losses. Avg: 17.2% -67.3% 55.4% 38.7% 11.5% -68.2% 45.0% 41.3%
The calendar call spread gained
an average 21.1 percent per month, Note: 1990 is a partial year as only 11 months of SPX/VIX data were available.
continued on p. 20

FUTURES & OPTIONS TRADER • February 2008 19

 TRADING STRATEGIES continued

TABLE 6 — CALENDARS VS. DIAGONAL LEAPS

The calendar call spread is the clear winner, gaining an average 21.1 percent
and outperformed the others in seven
per month and beating other positions in seven of the last eight years.
of the last eight years. The calendar
even gained ground during the 2000-
Calendar call spread Diagonal LEAPS spread 2002 downturn when the bull call
Average Worst Best Average Worst Best spread lost an average 25 percent per
month. Table 7 shows calendars beat
1990 31.2% -66.2% 162.8% 5.3% -30.1% 22.7%
the others during 11 of the past 18
1991 2.2% -68.6% 134.7% 2.6% -12.8% 12.8% years.
1992 34.1% -28.6% 132.6% 4.6% -3.4% 10.9% The diagonal LEAPS call risked less.
1993 37.2% -25.5% 79.9% 3.4% -4.7% 8.8% Although it gained just 4.2 percent on
average, it lost less than 10 percent a
1994 -2.6% -37.8% 44.5% -0.5% -12.5% 13.1%
month in the past five years. These
1995 7.1% -44.9% 97.9% 2.2% -1.6% 8.9% types of lower-risk strategies allow you
1996 32.2% -56.4% 139.0% 4.1% -13.4% 11.0% to reinvest capital at a quicker pace, so
1997 4.6% -48.0% 110.8% 5.0% -12.8% 22.2% they can often compound just as quick-
ly as higher-risk ones.
1998 12.2% -56.1% 125.3% 7.2% -48.8% 31.0%
By contrast, covered call futures and
1999 24.3% -37.2% 102.5% 8.7% -0.3% 17.5% the bull call spread were extremely
2000 18.4% -55.8% 134.4% 3.3% -22.1% 26.3% volatile. Covered call futures gained an
2001 10.1% -60.8% 101.2% 3.1% -29.1% 25.4% average 17.2 percent per month, but the
strategy lost more than 100 percent of
2002 0.8% -46.8% 123.2% 0.3% -29.3% 29.2%
its initial margin in at least one month
2003 37.4% -63.3% 109.7% 10.3% 0.6% 25.0% during six of the 18 years analyzed.
2004 34.2% -38.1% 107.5% 5.1% -7.4% 10.3% A bull call spread can’t lose more
2005 27.1% -38.4% 107.0% 2.2% -3.9% 8.7% than it costs, but its returns are also sig-
nificantly lower than the covered call’s.
2006 36.0% -26.1% 114.6% 3.8% -8.0% 11.9%
It gained an average 11.5 percent, but
2007 33.6% -32.5% 88.3% 4.0% -8.9% 16.4% its average worst monthly move was -
Avg: 21.1% -46.2% 112.0% 4.2% -13.8% 17.3% 68.2 percent.
Note: 1990 is a partial year as only 11 months of SPX/VIX data were available.
The volatility effect
All 215 months were then divided into
three levels of volatility: high, medium,
TABLE 7 — BEST STRATEGY, 1990-2007 and low. The categories were as follows:

Trading calendar call spreads beat the other strategies High volatility = VIX >= 22
during 11 of the past 18 years. Medium volatility = VIX < 22 and VIX > 14
Low volatility = VIX <= 14
1990 Calendar 1999 Future
1991 Future 2000 Calendar Overall, the strategies’ average monthly performances
1992 Calendar 2001 Calendar weren’t affected by implied volatility. All positions gained
1993 Calendar 2002 Calendar 0.75 percent to 0.80 percent per month (not shown) regard-
1994 Future 2003 Future less of VIX levels. But important trends appear when you
1995 Bull call 2004 Calendar examine each strategy.
Table 8 lists each strategy’s monthly statistics according
1996 Calendar 2005 Calendar
to VIX levels. Fear-driven strategies such as options selling
1997 Future 2006 Calendar should be more profitable in high-VIX markets, because
1998 Future 2007 Calendar option premiums tend to spike. However, the strategies’
Note: 1990 is a partial year as only 11 months of SPX/VIX return-risk ratios drop as volatility increases. For example,
data were available. calendar call spread’s return/risk ratio is 0.38 when volatil-
ity was normal, but the ratio fell to 0.291 when volatility

20 February 2008 • FUTURES & OPTIONS TRADER

 TABLE 8 — VOLATILITY VIEW

When volatility spikes, the futures covered call and bull call spread become
extremely dangerous, while the LEAPS diagonal is probably the most
profitable strategy.

Average Worst Best StDev Return/risk

Covered call futures
High vol 23.2% -236.7% 98.2% 65.9% 0.35
was high. The same trend appeared in Med vol 15.4% -142.3% 48.3% 39.8% 0.39
two of the three other positions. Low vol 13.7% -62.4% 29.3% 22.0% 0.62
When volatility spiked, the bull call
Bull call spread
spread gained 10 percent, but 100-per-
High vol 10.1% -100.0% 53.4% 56.9% 0.18
cent losses were more common. And
Med vol 10.6% -100.0% 45.0% 46.7% 0.23
covered call futures lost 237 percent
Low vol 14.2% -88.7% 33.1% 28.5% 0.50
when the S&P 500 index dropped 14
percent in the summer of 1998. Calendar call spread
By contrast, the calendar call was High vol 16.2% -63.3% 123.2% 55.5% 0.29
still relatively profitable in highly Med vol 20.8% -68.6% 162.8% 54.8% 0.38
volatile markets. Admittedly, its Low vol 26.3% -44.9% 139.0% 44.5% 0.59
worst monthly move was -63 percent, Diagonal LEAPS spread
about four times larger than its aver- High vol 8.0% -48.8% 31.0% 15.0% 0.53
age gain (16.2 percent). But calendars Med vol 3.1% -30.1% 13.7% 8.6% 0.37
still might earn up to 100 percent (or Low vol 1.0% -3.4% 6.9% 4.3% 0.24
more) if the S&P 500 trades sideways
and volatility remains high.
The LEAPS diagonal spread is
probably the most profitable strategy
Related reading
for high-volatility markets. LEAPS Tristan Yates articles
diagonals are riskier when the VIX “Long-term diagonal call spreads,” Futures & Options Trader, November 2007.
climbs, but its return/risk ratio (0.53) This detailed look at diagonal spreads shows how to trade them with a long-term
is the largest. The LEAPS’ time value perspective.
and ITM strike helps you hedge
against market drops. “Rolling leaps calls,” Futures & Options Trader, September 2007.
Holding LEAPS calls instead of the underlying shares can pay off — but only if you
Finding the right strategy know when to roll them forward.
It’s a good idea to avoid bull call
spreads and covered call futures in Other articles
highly volatile markets. When the
VIX is high, calendar call spreads tend “Managing covered calls,” Active Trader, February 2008.
to gain more ground with less risk. In Roll out, roll down, roll up, or do nothing? You have several options when trading
covered calls.
addition, diagonal LEAPS spreads
may be appropriate if you prefer
“Another look at double diagonal spreads,” Options Trader, March 2007.
lower leverage. The bottom line is you
This position combines bullish and bearish diagonal spreads and is quite flexible if
should sell fewer calls to keep risk at you’re willing to adjust its components.
a tolerable level.
However, there is one important “Calendar spreads surrounding earnings news,” Options Trader, March 2007.
caveat. Historically, the best time to More versatile than you might think, these calendar spreads profit from changes in
sell options was in January 2003 — volatility rather than the time decay.
the best-performing year since 1990.
But the S&P 500 didn’t rebound until “Death, Taxes, and time decay,” Options Trader, March 2006.
April 2003, and the VIX did not Markets that go nowhere can be frustrating, but call calendar and diagonal spreads
decline significantly until 2004.
can generate respectable profits in these situations by taking advantage of time
decay.
For information on the author see p. 6.
“Controlling risk with spreads,” Options Trader, July 2005.
Tired of fighting time decay and volatility fluctuations? Here’s a look at an option
For a spreadsheet containing the
spread trade that was a much lower-risk alternative to an outright purchase.
formulas used here, visit
http://www.futuresandoptionstrader.com You can purchase and download past articles at
between Feb. 5 and Feb. 29. http://www.activetradermag.com/purchase_articles.htm

FUTURES & OPTIONS TRADER • February 2008 21

 FUTURES TRADING SYSTEM LAB

COT extreme-position system

FIGURE 1 — SAMPLE TRADES
Market: Futures.
The exits, which were based exclusively on the COT data, were more timely than the entries.

System concept: The Com-

mitment of Traders (COT) re-
port released every Friday by
the Commodity Futures Trading
Commission (CFTC) details the
positions of different types of
traders in all traded futures con-
tracts.
The COT data measures open
interest — the outstanding
(unclosed) positions in any mar-
ket — that meets the CFTC’s
minimum reporting limits, bro-
ken down into the following cat-
egories of traders:

Commercial traders (those

involved in the production or
consumption of the commodi-
ties in which they trade, such
as oil refineries or agribusi-
nesses).
Source: Wealth-Lab Pro 5.0
FIGURE 2 — EQUITY CURVE
The system was profitable, but its equity growth was rather jagged.

Large non-commercials (commodity

trading advisors, hedge funds and
other professional large specula-
tors), also referred to as “large
specs.”

Non-reportable positions (small

speculators), also referred to as
“small specs” (i.e., the public).

The report shows the overall (net)

long or short position for each group
in each market, as well as the individ-
ual long and short position numbers.
For example, the commercial trader
short open interest in crude oil would
be subtracted from the long open inter-
est to determine the net long or short
commercial trader position in crude
oil. (For more information on the COT
report and related trading techniques, Source: Wealth-Lab Pro 5.0
see “Related reading.”)
One popular idea about the COT report is the positions market or locking in prices. As a result, they are mostly
of the commercial traders are especially worth watching countertrend traders, buying as prices fall and selling into
because these traders are believed to be the most “in the rallies.
know” about the supply and demand situation in their This system is based on the idea that an extreme long or
markets. However, rather than taking positions to profit short commercial position indicates a market reversal. To
from price fluctuations, commercial traders are typically determine what qualifies as “extreme,” the current COT
involved in hedging their exposure in the cash commodity reading is compared to a certain number of past readings.

22 February 2008 • FUTURES & OPTIONS TRADER

 PERIODIC RETURNS

Percentage Max Max

Avg. Sharpe Best Worst profitable consec. consec.
return ratio return return periods profitable unprofitable
Monthly 0.56% 0.10 20.72% -10.45% 44.17 4 4
Quarterly 1.58% 0.09 24.64% -11.35% 55.00 3 3
Annually 6.13% 0.10 23.18% -9.57% 50.00 2 2

These extremes are used only to exit STRATEGY SUMMARY

positions.
To enter trades the system relies Profitability Trade statistics
mostly on price-based indicators, Net profit: $712,460.50 No. trades: 334
resulting in a trend-following system Net profit: 71.25% Win/loss: 49.40%
with a countertrend exit technique
Profit factor: 1.25 Avg. profit/loss: 1.10%
based on the COT data. However,
Payoff ratio: 1.54 Avg. hold time (days): 32.60
COT data is also used to filter entry
signals: the commercial traders should Recovery factor: 3.32 Avg. profit (winners): 6.67%
be net short (below zero) for long Exposure: 8.33% Avg. hold time (winners): 43.98
trades and net long (above zero) for Total commission $5,288
short trades. Drawdown Avg. loss (losers): -4.33%
Max. DD: -20.17% Avg. hold time (losers): 21.48
Strategy rules: Longest flat period: 591 days Max consec. win/loss: 8/7
Buy tomorrow at the market when:
1. Today’s net commercial
position is below zero. LEGEND
2. The 13-day exponential Avg. hold time — The average holding period for all
secutive unprofitable periods.
moving average (EMA) of trades. Max consec. win/loss — The maximum number of con-
secutive winning and losing trades.
closing prices crosses above Avg. hold time (losers) — The average holding time for
losing trades. Max. DD — Largest percentage decline in equity.
the 39-day EMA of closing Avg. hold time (winners) — The average holding time for Net profit — Profit at end of test period, less commission.
prices. winning trades.
No. trades — Number of trades generated by the system.
3. The 14-day average Avg. loss (losers) — The average loss for losing trades.
Payoff ratio — Average profit of winning trades divided by
directional movement index Avg. profit/loss — The average profit/loss for all trades. average loss of losing trades.

(ADX) is above 15.
Short tomorrow at the market when:
1. Today's net commercial
position is above zero.
2. The 13-day EMA of closing
prices crosses below the
39-day EMA of closing prices.
3. The 14-day ADX is above 15.
Avg. profit (winners) — The average profit for winning
trades.
Avg. return — The average percentage for the period.
Best return — Best return for the period.
Exposure — The area of the equity curve exposed to long
or short positions, as opposed to cash.
Longest flat period — Longest period (in days) between
two equity highs.
Max consec. profitable — The largest number of consecu-
tive profitable periods.
Max consec. unprofitable — The largest number of con-
Percentage profitable periods — The percentage of peri-
ods that were profitable.
Profit factor — Gross profit divided by gross loss.
Recovery factor — Net profit divided by max. drawdown.
Reward/risk — The ratio of the net profit to maximum
drawdown.
Sharpe ratio — Average return divided by standard devia-
tion of returns (annualized).
Win/loss — The percentage of trades that were profitable.
Worst return — Worst return for the period.

Exit long position tomorrow at the market when the net Alternately, exit long or short position with a protective
commercial position is less than or equal to the 100-day 5-percent stop-loss order.
lowest net commercial position.
Cover short position tomorrow at the market when the (See “Key concepts” for information about EMAs and the
net commercial position is greater than or equal to the 100- ADX.)
day highest net commercial position. continued on p. 24

FUTURES & OPTIONS TRADER • February 2008 23

 FUTURES TRADING SYSTEM LAB continued

FIGURE 3 — DRAWDOWN
The deepest drawdown was just a little more than -20 percent.

Figure 1 shows examples of extreme

commercial positions in the Japanese
yen (top pane). In both cases, price bot-
toms very near the system’s exit
points.

Money management: Risk 1 per-

cent of account equity per position.

Starting equity: $1,000,000. Deduct

$8 commission and one tick of slippage
per trade.

Test data: The system was tested on

the Futures & Options Trader Standard
Futures Portfolio, which contains the
following 20 futures contracts: British
pound (BP), soybean oil (BO), corn (C),
Source: Wealth-Lab Pro 5.0 crude oil (CL), cotton #2 (CT), E-Mini
Nasdaq 100 (NQ), E-Mini S&P 500
FIGURE 4 — ANNUAL RETURNS (ES), 5-year T-note (FV), euro (EC), gold
(GC), Japanese yen (JY), coffee (KC),
The system was inconsistent from year to year.
wheat (W), live cattle (LC), lean hogs
(LH), natural gas (NG), sugar #11 (SB),
silver (SI), Swiss franc (SF), and T-
Bonds (US). Data source: ratio-adjusted
data from Pinnacle Data Corp.
(http://www.pinnacledata.com).

Test period: January 1998 through

December 2007.

Test results: The system was prof-

itable (71.3 percent total return), but the
Source: Wealth-Lab Pro 5.0 equity curve (Figure 2) is not very
appealing. The system was inconsis-
TABLE 1: PARAMETER OPTIMIZATION RESULTS tent, with winning streaks abruptly interrupted by losing
periods.
Look-back Net Reward/ The system’s long and short sides ended up more or less
(days) profit Max DD Trades risk equally profitable, but short trades were the real profit gen-
100 71.25% -20.17% 334 3.53 erator for most of the test period. Because of renewed
125 64.29% -22.50% 322 2.86 upswings in the commodity market (especially precious
150 114.01% -27.66% 311 4.12 metals and some of the grains), the long side began driving
profits more recently.
175 117.89% -28.89% 304 4.08
Drawdowns (Figure 3) were neither excessive (-20.2 per-
200 124.56% -30.31% 294 4.11 cent) nor too prolonged (591 days), at least for a long-term
continued on p. 26

24 February 2008 • FUTURES & OPTIONS TRADER

 Las Vegas - February 29th, 2008

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trader who has lectured all over the United States, Asia and
Australia on behalf of the CBOE’s Options Institute, the
Options Industry Council and the ASX. Steve is constantly
developing new strategies and ways to use options as part
of a comprehensive and profitable trading approach.

For more information or to register for this event, please contact your
OptionVue representative at 1-800-733-6610.

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to Futures & Options Trader.
 FUTURES TRADING SYSTEM LAB continued
FIGURE 5 — PROFIT DISTRIBUTION
Five markets (out of 20 in the portfolio) were responsible
for three quarters of the system’s profit.
Source: Proprietary calculations
trend-following system. The system has a solid “gain-to-
pain” ratio, as reflected by ratio net profit to maximum
drawdown.
Of the 334 trades, almost half (49.4 percent) were winners
— a slightly higher-than-expected win rate for a trend-fol-
lowing system. The average profit of 1.1 percent certainly
could have been larger, but the system’s market exposure
was low at 8.3 percent (along with an average holding peri-
od of 33 days). The system is not particularly active, mak-
ing a little more than 30 trades per year on average.
The annual returns (Figure 4) were inconsistent: a prof-
itable year or two was followed by a losing year or two,
although all the annual losses (except for the first) were
smaller than the smallest annual gain.
Finally, Figure 5 shows 75 percent of profits were gener-
ated by just five markets — an unhealthy concentration that
should be taken into consideration.
Optimization: What happens if the look-back period exit
parameter is altered? For example, trader Larry Williams
suggests referencing even longer-term COT readings. Table
1 shows the performance results look progressively better
as the look-back period increases. After doubling the look-
back period, the net profit percent jumped 75 percent and
the reward-to-risk ratio rose from 3.5 to 4.1.
Bottom line: Although the test shows trading based on
the positions of commercial traders is a viable idea, this
strategy had much room for improvement.
COT data can be used several ways. Trader Steve Briese
developed the COT Index — a stochastic-like formula that
26
Related reading
“Interview: Larry Williams looks inside futures”
Active Trader, January 2006.
Larry Williams discusses the twists he puts on the COT
report in his latest book.
Interview: “Floyd Upperman: Digging into COT data”
Active Trader, February 2006.
It’s not just a matter of hedgers vs. speculators. An
engineer turned trader discusses ways to make sense of
the futures Commitment of Traders report.
“Straddling the COT report”
Futures & Options Trader, September 2007.
Tracking shifts in large-trader sentiment can signal trade
opportunities. This long straddle was triggered by an
extreme reading in the S&P 500 futures.
“Cracking the COT code”
Futures & Options Trader, July 2007.
While data from the COT report has been used in conjunc-
tion with other indicators, this strategy relies exclusively on
the numbers found in the COT.
“All traders, big and small: The Commitment of
Traders report”
Active Trader, March 2003.
A COT primer for beginning traders or those unfamiliar
with the report.
Note: The Larry Williams and Floyd Upperman interviews
are also part of the discounted article collection, “The
Active Trader Interviews Vol. 3”
You can purchase and download past articles at
http://www.activetradermag.com/purchase_articles.htm.
measures the current net position of a group to the range of
past values over a given look-back period. Trader Floyd
Upperman uses a proprietary method for calculating the
normal distribution of COT values for each group.
Larry Williams also combines standard open interest
with COT values. These are all potential ideas for further
research.

— Volker Knapp of Wealth-Lab
For information on the author see p. 6.
Futures Lab strategies are tested on a portfolio basis (unless otherwise noted)
using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see
tested, please send the trading and money-management rules to
editorial@activetradermag.com.
Disclaimer: The Futures Lab is intended for educational purposes only to
provide a perspective on different market concepts. It is not meant to rec-
ommend or promote any trading system or approach. Traders are advised
to do their own research and testing to determine the validity of a trading
idea. Past performance does not guarantee future results; historical testing
may not reflect a system’s behavior in real-time trading.
February 2008 • FUTURES & OPTIONS TRADER
 OPTIONS TRADING SYSTEM LAB

The stock vs. LEAPS showdown

FIGURE 1 — LEAPS VS. MARGINED STOCK
Market: Options on large-cap stocks. The LEAPS position (blue line) outperforms margined stock only if the
This technique could also be applied to underlying stock is quite volatile in the following year.
exchange-traded funds (ETFs) with liq-
uid options contracts.

System concept: A stock option con-

trols 100 shares of stock with less capital
than buying stock outright. This type of
leverage is typically associated with the
options, futures, and currency markets,
but stock traders can also use leverage by
buying stock on margin and borrowing
up to half its initial cost.
This system compares buying large-
cap stock on margin to buying calls.
Which strategy offers the best combina-
tion of leverage and expected profit?
Instead of testing regular calls, the sys-
tem uses Long-term Equity AnticiPation
Securities (LEAPS), which don’t expire
for at least 12 months. Some LEAPS
don’t expire for up to three years, behave
like underlying stock, and don’t initially Source: OptionVue
lose much time value. Ideally, LEAPS
calls can lower cost, reduce risk, and per-
form roughly the same as stock. The main difference is that Figure 1 compares the potential gains and losses of one of
LEAPS don’t pay dividends and lack voting rights. Also, the long stock positions (red line) to the equivalent LEAPS
LEAPS expire, stocks don’t. call position — long 8 Intel January 2009 calls at a $20 strike
Previous Option Labs have analyzed how specific options (blue line). Both positions are represented as if they were
positions (vertical spreads, covered calls, butterflies, etc.) both entered on Sept. 1, 2006. The different lines represent
have performed in the last few years. By contrast, this each strategy’s performance at various stock prices by Sept.
Options Lab measures the same long-term bullish strategy, 4, 2007. Notice the underlying stocks’ risk line is straight,
but focuses on these two different ways to use leverage. while the LEAPS calls’ risk line is curved.
Buying stocks on margin is pretty straightforward. The The LEAPS position outperforms margined stock only if
system started with roughly $20,000 for each of the seven the stock is quite volatile in the following year. For example,
stocks tested on Sept. 4, 2001, bought
multiples of 100 shares of seven large- FIGURE 2 — PERFORMANCE — STOCK VS. LEAPS
cap stocks, and held them until Dec. 31, Although the LEAPS calls (red line) gained the most ground, the margined stock
2007. The total account began with method (blue line) outperformed for long stretches, which underscores the
$75,610 in capital, and since the shares LEAPS calls’ need for increased volatility.
were bought with 50-percent initial mar-
gin, the system initially controlled
$151,220 of stock.
The LEAPS position contains one at-
the-money (ATM) LEAPS call for each
100 shares of stock. If, for example, the
system buys 800 shares of Intel Corp.
(INTC), it also purchases 8 LEAPS calls
simultaneously. To minimize time decay,
all LEAPS calls were sold every year in
the first week of September when they
are converted to standard options. At
that point, the system buys a new LEAPS
call in the furthest expiration month.

28 February 2008 • FUTURES & OPTIONS TRADER

 STRATEGY SUMMARY LEGEND:
Net gain – Gain at end of test period, less commission.
Stock LEAPS
Percentage return – Gain or loss on a percentage basis.
margin (50%) strategy
Annualized return – Gain or loss on an annualized percentage
Starting capital ($) 75,610 43,000
basis.
Net gain ($): 201,036 132,796
No. of trades – Number of trades generated by the system.
Percentage return (%): 266 309
Winning/losing trades – Number of winners/losers generated
Annualized return (%): 42.0 48.8 by the system.
No. of trades: 7 49 Win/loss (%) – The percentage of trades that were profitable.
Winning/losing trades: 2/5 20/29
Avg. trade – The average profit for all trades.
Win/loss (%): 29 41
Largest winning trade – Biggest individual profit generated
Avg. trade ($): 28,719.43 2,710.12 by the system.
Largest winning trade ($): 215,984.00 74,354.00 Largest losing trade – Biggest individual loss generated by
Largest losing trade ($): -8,436.00 -6,226.00 the system.
Avg. profit (winners): 110,094.00 9,640.35 Avg. profit (winners) – The average profit for winning trades.
Avg. profit (losers): 3,830.40 -2,069.34 Avg. loss (losers) – The average loss for losing trades.
Avg. hold time (winners): 2,309 304 Avg. hold time (winners) – The average holding time for winning
Avg. hold time (losers): 2,309 348 trades.
Max. consec. win/loss : 2/5 6/9 Avg. hold time (losers) – The average holding time for losing trades.
Max consec. win/loss – The maximum number of consecutive
winning and losing trades.
Intel traded at $19.88 on Sept. 1, 2006, and buying INTC on
margin leads to larger gains and smaller losses if Intel trades Option System Analysis strategies are tested using OptionVue’s
between $10 and $24 during this period. But if the underly- BackTrader module (unless otherwise noted).
ing drops below $10 or jumps above $24, the LEAPS If you have a trading idea or strategy that you’d like to see tested,
approach will perform better. please send the trading and money-management rules to
Advisor@OptionVue.com.
Trade rules:
Margined stock: ance in the last six and a half years. The margined stock
1. Buy as many shares of each stock with $20,000, approach gained $201,036 (266 percent), while the LEAPS
rounded to the nearest 100 shares, on Sept. 4, 2001. strategy earned $132,796 (306 percent). In dollar terms, buy-
Use 50-percent initial margin. ing stock beat the LEAPS method, but it lagged the LEAPS
calls in percentage terms, because LEAPS required less capi-
LEAPS calls: tal.
1. Buy one ATM LEAPS call in the furthest available If you study Figure 2, however, you will notice that buy-
expiration month for each 100 shares of underlying ing stock outperformed the LEAPS calls for long stretches,
stock held. which underscores the LEAPS calls’ need for increased
2. Sell the LEAPS calls one year later in the first week of volatility. Despite these differences, a large portion of the
September. Then replace those ATM LEAPS by gains from both systems was because of a single stock —
buying one call in the furthest available expiration Apple Inc., which rallied 133.5 percent in 2007.
month for each 100 shares of underlying stock held.
Bottom line: LEAPS calls have a clear advantage only if
Test details: the underlying moves sharply (up or down). If the markets
• Dividends were not included. plummet, you will lose less with a LEAPS call than with
• Margin interest expense was ignored. margined stock, and there are no margin calls to worry
• Daily closing prices were used. Trades were executed about. Also, if the markets spike, the LEAPS approach will
at the bid and ask, when possible. Otherwise, beat margined stock. But if your forecast lies in between
theoretical prices were used. these extremes, buying stock on margin is prudent.
• Commissions were $5 plus $1 per option trade, For stocks, margin interest expense was not included, but
$8 per stock trade. could be $4,000 to $6,000 per year. The system assumed a
30-percent maintenance margin, and there would have been
Test data: The system was tested on the following stocks no margin calls during this test period. For LEAPS, the test
and their options: Apple Inc. (AAPL), Citigroup (C), General required an additional $13,000 in capital at one point, but
Electric (GE), Intel (INTC), Johnson and Johnson (JNJ), would also have been able to reinvest excess capital at the
Microsoft (MSFT), and Wal-Mart (WMT). risk-free interest rate during most other portions of the test
period. Finally, minimal commissions were included, but
Test period: Aug. 31, 2001 to Dec. 31, 2007. larger fees and bad fills will likely affect performance.

Test results: Figure 2 compares both strategies’ perform- — Steve Lentz and Jim Graham of OptionVue

FUTURES & OPTIONS TRADER • February 2008 29

 TRADING BASICS

Fighting the options battle

with the Greeks
Paying attention to options “Greeks” is vital for nearly any options trader. Tracking an option’s delta,
gamma, theta, and vega might save your neck in today’s volatile market.
BY DAN PASSARELLI

FIGURE 1 — LONG CALL RISK PROFILE

This chart shows only the ATM call’s absolute risk and
reward at expiration — the effects of time (theta) and implied

O ptions trading is a battle few people sur- volatility (vega) are ignored.
vive. If you don’t understand the risks
(and there are several), you’ll run into
trouble — fast. Successful traders deter-
mine the risks of every trade with precision. They under-
stand not only the markets’ intricacies, but also the best
way to profit from a forecast with the least amount of
risk.
This may sound obvious, but understanding option
risk is more difficult than it seems. Options are complex
instruments that are influenced by several variables.
When measuring option risk and reward, some traders
focus on the options’ potential values at expiration.
Although this is an important consideration, prior to
expiration three main factors govern the price of an
option: the direction of the underlying instrument, the lose more than its premium ($2), but if the underlying stock
time to expiration, and volatility. rises the call gains value.
It is essential to understand how each of these variables Figure 1 only tells part of the story, however. Although
can affect an option’s price. And the best way to measure the distance between the underlying instrument and an
these risks is to study the major option
“Greeks” — delta, gamma, theta, and
FIGURE 2 — OPTION GREEKS
vega.
When a stock traded at $36.95 on Jan. 7, its February 35 call had a delta of
Absolute risk and reward 0.72. If the stock gains $1, the call’s value will rise by $0.72, but if the stock
First, it is helpful to consider an drops $1, the call’s value will drop by $0.72.
option’s “absolute risk.” When you
buy an option your risk is limited to
the premium you paid for it, while
your potential reward can be unlimit-
ed. When you sell an option, risk and
reward are reversed: Your potential
reward is limited to the premium you
received, while your risk can be unlim-
ited.
Suppose a stock trades at $50 and
you buy an at-the-money (ATM) call
option with a strike price of 50. Figure
1 shows the call’s possible gains and
Source: OptionsHouse
losses at expiration. The long call can’t

30 February 2008 • FUTURES & OPTIONS TRADER

FIGURE 3 — INDIVIDUAL AND TOTAL GREEKS
To measure the Greeks for a multi-option position, simply add the same-type Greeks together.
Source: OptionsHouse
option’s strike is important, absolute
risk tends to be relevant only if the
option is held until expiration.
Meanwhile, two other variables are
critical: an option’s time to expiration
and implied volatility (IV).
Meet the Greeks
The option Greeks are measures that
describe aspects of an option’s behav-
ior. The four most common Greeks are:
Delta: The rate of change of
an option’s value relative to a
change in the underlying
instrument’s price.
Gamma: The rate of change
of an option’s delta relative
to a change in the underlying
instrument’s price.
Theta: The rate of change of
an option’s value relative to time.
Vega: The rate of change of an
option’s value relative to a
change in IV.
Figure 2 shows call option prices
with Greeks (highlighted in yellow) on
FUTURES & OPTIONS TRADER • February 2008
a stock trading at $36.95 on Jan. 7.
Delta is in the first Greeks column.
Call options have positive deltas and
put options have negative deltas. Let’s
examine delta by measuring how
Figure 2’s near-the-money February 35
call might move if the stock climbs or
drops $1.
The 35-strike call has a delta of 0.72,
meaning that if the underlying rises
$1, the call’s value will rise $0.72. That
means, all else held constant, you can
expect the call’s bid and offer prices
(2.49 and 2.53) to each climb 0.72. If,
conversely, the stock falls $1, the
February 35 call’s price will decline
$0.72.
Figure 2’s next column shows
gamma, which represents the delta’s
change as the stock price changes (i.e.,
delta’s acceleration or deceleration).
Again, with all other factors remaining
constant, if the stock climbs $1 the 35-
strike call’s delta would rise from 0.72
to 0.814 — an increase of 0.094, which
is the gamma value. If, however, the
stock falls $1, the February 35 call’s
continued on p. 32
31
 TRADING BASICS continued
FIGURE 4 — DIRECTIONAL RISK — PORTFOLIO
When these stocks rally, the total options position should gain ground (and vice versa). But gains accumulate faster than losses.
Source: OptionsHouse
delta would decrease by the gamma (0.094), falling from
0.72 to 0.626.
The third Greeks column in Figure 2 lists theta, or “time
decay.” Theta measures how much an option’s value will
decrease as each day passes. The February 35 call’s theta is
0.014, which means the call will lose $0.14 as one day pass-
es, assuming price and volatility remain constant.
Figure 2’s last Greeks column is vega, which is the
option’s response to IV changes. The February 35 call has an
IV of 28 percent and a vega of 0.043. If IV rises one percent-
age point to 29, the call’s value will increase by $0.043, all
else equal; if IV falls one percentage point to 27, the call’s
value will drop by $0.043 as a result of vega.
The Greeks go to battle
Each Greek helps you fight a different market foe. For
instance, delta measures your option position’s directional
exposure. If you are strongly bullish, you would likely want
an option position with a larger delta than you would if you
are only moderately bullish, because the value of higher-
delta calls will increase more if the underlying rallies. The
trade-off is they also face greater losses if the stock falls.
In short, delta is a measure of how aggressive a position
is from a directional perspective. Calls have positive deltas
because they benefit from underlying price increases, while
32
puts have negative deltas because they benefit from under-
lying price declines.
Gamma can help or hurt you depending on whether an
option position is long or short. Buying options yields pos-
itive gamma, which creates more favorable deltas as the
underlying price moves. As the stock price rises, a long
call’s delta will increase, racking up profits faster. As the
stock price drops, a long call’s delta will decrease, easing
the pain of loss.
Short options, however, have negative gamma working
against them. For example, if the underlying’s price rises, a
short call’s delta becomes increasingly negative and losses
can mount; if the underlying falls, a short call’s delta
shrinks, so profits accumulate at a slower pace.
Traders who buy options are hurt by the passage of time
as the value of their options decreases. By contrast, traders
who sell options benefit from time decay because their short
options decrease in value as time passes. Theta helps
traders estimate how much time is helping or hurting their
position.
Vega measures a position’s exposure to positive or nega-
tive IV. Long options have positive vega. Conversely, short
options have negative vega. When implied volatility rises,
option holders benefit and option sellers are hurt. The
reverse is true when IV falls.
February 2008 • FUTURES & OPTIONS TRADER

Calculating position Greeks
In addition to tracking the Greeks on individual options,
you should calculate their totals on a portfolio basis.
Measuring Greeks for a position with multiple options is
fairly easy — simply add the values of each type of Greek.
Figure 3 shows a sample stock portfolio — Bed Bath and
Beyond (BBBY), Baidu.com Inc., (BIDU), Crocs Inc. (CROX),
and Dryships Inc. (DRYS), among other symbols. The figure
shows the corresponding risk in terms of delta, gamma,
theta, and vega. Here, the individual options’ Greeks are
broken down so you can see how underlying direction,
time, and volatility might affect these trades.
Each Greek’s total portfolio value is shown in Figure 3’s
first row, which indicates how the overall position might be
affected if direction, time, or volatility rise or fall across the
board. These total Greeks values represent the portfolio’s
market risk.
For example, Figure 3’s position delta shows its direc-
tional exposure, which has the biggest effect on most trades.
Its total delta (-257) shows how much this hypothetical posi-
tion will lose as the underlying securities move higher in
unison. The portfolio loses $257 if the underlying stocks all
rise by $1 and gains $257 if they all fall by $1. (Because of
gamma, however, deltas will change as the underlying
stock prices move.)
Figure 4 shows how the same options portfolio would
fare if all its underlying stocks gain or lose 5, 10, 20, or 50
percent (i.e., directional risk). In this portfolio, some options
are bullish and some are bearish, but the overall position is
bullish. For instance, if the stocks rise 5 percent, the overall
position could gain $5,496. The higher the stocks rise, the
greater the profit.
If all stocks in the portfolio fall significantly by equal
amounts, the overall position loses ground. The more the
underlying prices decline, the greater the loss (although
gains accumulate faster than losses).
Living to trade another day
Risk is unavoidable, but recognizing and understanding the
risks you face as an options trader can help make this
enemy easier to fight. Studying Greeks can help you see
what is at risk and to what degree. Once you know the var-
ious risks associated with delta, gamma, theta, and vega,
you can react to threats as markets change.
Delta is helpful in assessing directional risk, but deltas
change. To gain a clearer picture of directional risk, study a
portfolio’s total delta, especially for big moves. This gives
you a sense of how much a stock needs to move to reach a
profit target. It also reveals how much a stock can move
against you before you must take a loss. Knowing your risk
helps you live to trade another day.

For information on the author see p. 6.
FUTURES & OPTIONS TRADER • February 2008
Related reading
Dan Passarelli articles
“Trading against the pros”
Options Trader, November 2006.
Understanding how market makers manage risk may help
you get better fills.
“Calendar spreads: Taking time out of the market”
Options Trader, February 2006.
Trading time spreads offers a way to take advantage of
time decay and volatility changes while limiting risk.
Other articles
“The theta-vega relationship”
Futures and Options Trader, January 2008.
Focusing on these option “Greeks” can help you avoid
missteps when trading calendar spreads.
“Swing with the market: Vega and rho”
Options Trader, February 2007.
Vega and rho are lesser-known “Greeks,” but they measure
the effect of two critical option-pricing components: implied
volatility and interest rates.
“Know your theta”
Options Trader, January 2007.
Time eats away at every options position, so it pays to
know how time decay affects option prices.
“Get on the fast track with gamma”
Options Trader, November 2006.
Gamma digs deeper into explaining how underlying price
moves affect an option’s price.
“Delta for the rest of us”
Options Trader, October 2006.
A few simple concepts shed light on delta and how option
prices change.
“Meet the Greeks: Delta and gamma”
Active Trader, February 2003.
Knowing what these calculations represent and how they
affect an option’s price will give you a better handle on how
options behave — as well as a deeper understanding of
risk.
Many of these articles are included in “Options Basics
Collection, Volume 1,” a set of nine past Options Trader
and Active Trader articles. Designed for those new to
options trading, this discounted collection encompasses
options terminology, fundamental trading concepts and
simple strategies, as well as practical considerations such
as margin.
You can purchase and download past articles at
http://www.activetradermag.com/purchase_articles.htm
33
 TRADING BASICS

Deciphering
stock options symbols
Options symbols can seem as impenetrable as the Cyrillic alphabet, but learning how
to interpret these codes is simple. This primer explains the logic behind the labeling process.

BY CHRIS PETERS

O
BV?
ptions symbols often seem cryptic to new
traders. If, for instance, you wanted to buy a
front-month, at-the-money (ATM) put on
the Dow Jones tracking stock (DIA) when it
traded at $124 on Jan. 29, should you buy DAW BT or DAW

Although these symbols seem strange, they reveal

important details such as the underlying stock, option type
(put or call), strike price, and expiration month. Admittedly,
the labeling process isn’t obvious, but the code is fairly easy
to crack.
This guide explains how to interpret stock options’ five-
letter symbols so they won’t slow you down before placing
a trade. The following example focuses on stock options;
the symbol-naming process is slightly different for other
option types such as Long-term AnticiPation Securities
(LEAPS), index options, and options on futures.
Lost in translation
To find a stock option’s symbol, start with the underlying
stock. Many online brokerage firms and the Options
Clearing Corp. (http://www.theocc.com) let you look up
quotes for a stock’s listed options by entering the underly-
ing’s symbol.
The first few characters of an option’s symbol represent
the underlying and usually share one or two letters with
that stock’s symbol. Figure 1 shows the symbol (DLQ BE)
for a February Dell call with a strike price of 25.
The fourth letter (B) reveals two critical details: expira-
tion date and option type (put or call). Table 1 shows how
expiration months are represented. Letters A through L cor-
respond to calls from January to December, and M through
X represent puts. Figure 1 shows a February call, as indicat-
ed by the B in the month spot. Because an options contract
always expires after the third Friday of the month, you now
have all the required information to find the exact expira-
tion date (Feb. 16).
An option symbol’s last letter represents its strike price
and uses the entire alphabet. Table 2 shows how this label-
ing process works. A represents strike prices ending in 5
such as 5, 105, 205, etc. B represents strikes ending in 10, C
corresponds to prices ending in 15, and so on. This

TABLE 1 — EXPIRATION MONTH CODES

Options symbols contain a great deal of information. These expiration month codes represent both the option’s type (put
or call) and the expiration date with a single letter.

Jan. Feb. Mar. Apr. May June July Aug. Sept. Oct. Nov. Dec.
Calls A B C D E F G H I J K L
Puts M N O P Q R S T U V W X

34 February 2008 • FUTURES & OPTIONS TRADER

 FIGURE 1 — OPTION SYMBOL –
DELL
sequence continues through T, always contracts that expire in the same month.
An option’s symbol isn’t pretty,
by increments of five. but it reveals key information For example, Dell traded at $20.62 on
But not all strike prices are labeled in such as underlying stock, type, Jan. 29, but if it spiked to $120.62 before
multiples of five. The letters U to Z sig- strike price, and expiration Feb. 16 expiration, the exchanges may
nify strikes in intervals of 2.5. This gets month. This symbol represents list a 125 strike with the same symbol as
tricky because the number-to-letter pro- a February 25-strike call on Dell Dell’s 25 strike (DLQ BE). At this point, a
Inc.
gression changes. For example, U repre- new symbol must be created to distin-
sents 7.5, V represents 12.5, and the guish between options whose strike
series continues to move in five-point prices share the same two digits.
intervals until Z, after which the process
starts over at U. Table 2’s last row The long and short of it
shows strike prices up to $182.5. Figure 1 shows an option’s “short form”
Some contracts’ strike prices are listed symbol. Some option-analysis programs,
in $1 increments. Although the labeling however, offer “long form” symbols,
process is similar, they require more which are more explicit and easier to
tables to decode and sometimes involve adding an extra let- understand. Long symbols include four sections (instead of
ter to the symbol. three), but they provide essentially the same information.
Figure 1’s February Dell call has a 25 strike, although E (The terms “long” and “short” simply refer to the symbol’s
could also represent 125 or 525. But it’s easy to figure out length, not its directional outlook.)
what strike the last letter represents, because you should The long symbol for Figure 1’s February Dell 25 call is
know the underlying stock’s current price. DELL FEB25C. The first few letters represent the stock’s
If Dell moves up or down significantly within a few days, entire symbol, while the second section reveals expiration
the same letter might represent multiple strikes for different continued on p. 36
 TRADING BASICS continued

month with a three-letter abbreviation (JAN, FEB, MAR,
etc.). The last two components describe the strike price and
option type. The strike price includes as many digits as
needed. The final letter is either P for a put or C for a call.
Some quote screens also list the exchange where the con-
tract is traded. Although this code is often listed in a sepa-
rate column, it may be added at the symbol’s end. And pro-
grams don’t always use the same exchange codes, so it’s a
good idea to check how your software handles this issue.
Other types of options symbols
Symbols for index options follow these basic rules too.
However, the rules for LEAPS and options on futures are
slightly more complex.
LEAPS options alter the root, or underlying, symbol to
distinguish among contracts expiring in the same month,
but in different years. Symbols for options on futures repre-
sent expiration months in an entirely different way, which
mimics futures contract month symbols with an added
strike price code. (For specific symbols, ask your broker or
visit the exchange’s Web site.) However, plans are under-
way to standardize symbols across all instruments. The
Options Symbology Initiative, which is set to complete in
July 2009, will more than triple the size of option symbols,
removing the need for complicated tables.
Picking the right options strategy can seem daunting, but
interpreting their symbols shouldn’t be. The rules in Tables
1 and 2 should help you quickly identify a stock option by
its symbol and focus on entering trades.

TABLE 2 — STRIKE PRICE CODES

An option symbol’s last letter represents its strike price and uses the entire Related reading
alphabet.
“Options 101”
Strike prices
Options Trader, April 2005.
A 5 105 205 305 405 505
Options can seem complex, but
B 10 110 210 310 410 510 learning a few basic concepts will
C 15 115 215 315 415 515 remove much of the mystery and
D 20 120 220 320 420 520 intimidation. Here’s what you need
to know to get started in the world
E 25 125 225 325 425 525
of puts and calls.
F 30 130 230 330 430 530
G 35 135 235 335 435 535 “Options exercise
H 40 140 240 340 440 540 and assignment”
I 45 145 245 345 445 545 Futures & Options Trader,
December 2007.
J 50 150 250 350 450 550
If you are new to options, you need
K 55 155 255 355 455 555 to learn the rules behind exercise
L 60 160 260 360 460 560 and assignment. This guide explains
M 65 165 265 365 465 565 how to avoid mistakes on expiration
N 70 170 270 370 470 570 day.

O 75 175 275 375 475 575

“Making the options LEAP”
P 80 180 280 380 480 580 Options Trader, December 2005.
Q 85 185 285 385 485 585 Long-Term Equity AnticiPation
R 90 190 290 390 490 590 Securities can have expiration dates
S 95 195 295 395 495 595 more than two years away. Find out
the difference between these
T 100 200 300 400 500 600
options and standard options and
U 7.5 37.5 67.5 97.5 127.5 157.5 how you can use them to your
V 12.5 42.5 72.5 102.5 132.5 162.5 advantage.
W 17.5 47.5 77.5 107.5 137.5 167.5
You can purchase and download
X 22.5 52.5 82.5 112.5 142.5 172.5
past articles at http://www.activetra-
Y 27.5 57.5 87.5 117.5 147.5 177.5
dermag.com/purchase_articles.htm.
Z 32.5 62.5 92.5 122.5 152.5 182.5

36 February 2008 • FUTURES & OPTIONS TRADER

 FUTURES SNAPSHOT (as of Jan. 29)
The following table summarizes the trading activity in the most actively traded futures contracts. The information does NOT constitute
trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility.
See the legend for explanations of the different fields. Volume figures are for the most active contract month in a particular market and
may not reflect total volume for all contract months.
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures
is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
E- Pit 10-day move/ 20-day move/ 60-day move/ Volatility
Market symbol symbol Exchange Volume OI rank rank rank ratio/rank
E-Mini S&P 500 ES CME 2.08 M 1.90 M -4.10% / 37% -8.31% / 82% -12.41% / 96% .36 / 2%
10-yr. T-note ZN TY CBOT 1.09 M 2.30 M 0.88% / 5% 3.46% / 79% 5.36% / 85% .26 / 35%
5-yr. T-note ZF FV CBOT 577.8 1.86 M 0.23% / 5% 2.70% / 79% 4.63% / 91% .27 / 50%
E-Mini Nasdaq 100 NQ CME 447.6 300.7 -7.31% / 38% -14.79% / 92% -19.56% / 100% .33 / 36%
Eurodollar* GE ED CME 402.7 1.50 M 0.52% / 40% 1.30% / 88% 1.80% / 98% .45 / 68%
30-yr. T-bond ZB US CBOT 366.2 980.1 0.80% / 5% 3.37% / 54% 6.16% / 87% .25 / 23%
2-yr. T-note ZT TU CBOT 289.4 1.04 M 0.10% / 5% 1.75% / 83% 2.78% / 96% .22 / 43%
E-Mini Russell 2000 ER CME 277.6 572.8 -0.84% / 6% -8.61% / 72% -15.09% / 92% .26 / 0%
Crude oil CL NYMEX 239.6 281.1 -2.72% / 25% -4.54% / 33% -3.06% / 67% .22 / 25%
Mini Dow YM CBOT 186.5 69.4 -2.56% / 25% -7.12% / 73% -10.51% / 93% .33 / 0%
Eurocurrency 6E EC CME 153.8 166.9 -0.73% / 57% 0.23% / 0% 1.72% / 19% .26 / 50%
Gold 100 oz. GC NYMEX 118.2 256.4 2.40% / 20% 9.78% / 76% 16.32% / 73% .30 / 63%
Japanese yen 6J JY CME 117.5 163.1 0.99% / 0% 4.97% / 71% 7.62% / 93% .15 / 7%
Corn ZC C CBOT 102.7 586.4 1.21% / 5% 10.21% / 43% 33.46% / 86% .22 / 28%
Sugar SB ICE 77.2 480.2 6.36% / 80% 11.52% / 67% 21.15% / 99% .47 / 67%
Soybeans ZS S CBOT 65.4 147.9 -1.51% / 50% 4.47% / 5% 25.41% / 75% .26 / 73%
British pound 6B BP CME 62.7 80.4 1.68% / 100% -0.22% / 7% -4.54% / 95% .30 / 25%
S&P 500 index SP CME 57.2 520.0 -4.10% / 37% -8.31% / 82% -12.40% / 96% .36 / 2%
Natural gas NG NYMEX 51.6 74.0 -4.91% / 100% 7.54% / 28% -8.04% / 27% .30 / 62%
Wheat ZW W CBOT 47.3 195.8 2.94% / 25% 6.67% / 31% 21.31% / 48% .30 / 58%
Swiss franc 6S SF CME 45.4 64.8 -0.22% / 100% 2.73% / 38% 5.63% / 71% .16 / 3%
Australian dollar 6A AD CME 42.9 65.1 -1.21% / 71% 1.67% / 44% -5.09% / 100% .30 / 57%
Canadian dollar 6C CD CME 39.3 76.7 1.64% / 75% -2.13% / 33% -5.56% / 88% .36 / 80%
E-Mini S&P MidCap 400 ME CME 32.1 98.8 -1.32% / 17% -8.23% / 72% -12.63% / 90% .35 / 8%
Heating oil HO NYMEX 31.0 51.6 -1.83% / 25% -3.61% / 52% 1.17% / 2% .20 / 22%
RBOB gasoline RB NYMEX 28.8 42.2 -1.82% / 9% -5.29% / 61% -0.58% / 2% .16 / 2%
Soybean oil ZL BO CBOT 28.1 86.5 0.47% / 0% 9.40% / 47% 26.98% / 84% .23 / 47%
Soybean meal ZM SM CBOT 25.5 56.1 -3.66% / 67% 4.17% / 18% 24.81% / 76% .29 / 82%
Silver 5,000 oz. SI NYMEX 25.3 78.5 2.28% / 10% 12.79% / 84% 16.36% / 72% .30 / 35%
Gold 100 oz. ZG CBOT 23.3 12.4 2.41% / 20% 9.78% / 76% 16.24% / 72% .30 / 63%
Mexican peso 6M MP CME 21.0 86.7 0.58% / 75% 0.55% / 38% -1.66% / 57% .25 / 50%
Cotton CT ICE 18.8 138.8 -4.16% / 100% 0.52% / 7% 6.84% / 36% .57 / 82%
Fed Funds ZQ FF CBOT 14.2 130.6 0.18% / 80% 0.34% / 93% 0.58% / 59% .36 / 92%
Crude oil e-miNY QM NYMEX 13.9 5.3 -2.72% / 25% -4.54% / 36% -3.06% / 67% .22 / 18%
Nikkei 225 index NK CME 13.8 67.4 -4.64% / 30% -11.64% / 83% -19.61% / 97% .19 / 3%
Live cattle LE LC CME 12.4 58.9 0.28% / 0% -5.10% / 95% -3.98% / 65% .20 / 15%
Lean hogs HE LH CME 11.7 71.3 7.21% / 100% 1.22% / 12% 7.66% / 100% .29 / 83%
Coffee KC ICE 11.2 109.3 -2.80% / 75% 0.45% / 8% 9.28% / 60% .27 / 77%
Cocoa CC ICE 9.3 103.0 1.50% / 13% 8.65% / 82% 14.91% / 77% .29 / 47%
Copper HG NYMEX 9.2 42.9 -1.20% / 20% 7.39% / 71% -1.89% / 16% .22 / 8%
Nasdaq 100 ND CME 6.4 37.4 -7.31% / 38% -14.73% / 92% -19.56% / 100% .33 / 37%
Mini-sized gold YG CBOT 6.2 4.6 2.41% / 20% 9.78% / 73% 16.24% / 72% .30 / 62%
Dow Jones Ind. Avg. ZD DJ CBOT 5.1 26.6 -2.56% / 25% -7.12% / 73% -10.51% / 93% .33 / 0%
U.S. dollar index DX ICE 3.8 29.7 0.01% / 13% -1.35% / 36% -0.83% / 7% .33 / 88%
Silver 5,000 oz. ZI CBOT 3.4 3.8 2.62% / 15% 12.82% / 84% 16.16% / 73% .29 / 29%
Natural gas e-miNY QG NYMEX 3.2 3.3 -4.91% / 100% 7.54% / 25% -4.65% / 14% .32 / 62%
Russell 2000 index RL CME 3.0 36.1 -0.84% / 6% -8.61% / 72% -15.09% / 92% .26 / 0%
*Average volume and open interest based on highest-volume contract (December 2008).
Legend day moves, 20-day moves, etc.) show the per- cent 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.

38 February 2008 • FUTURES & OPTIONS TRADER

 OPTIONS RADAR (as of Jan. 28)
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 252.3 1.26 M -3.36% / 28% -8.29% / 84% 25.9% / 30.3% 19.5% / 16.8%
Russell 2000 index RUT CBOE 105.5 591.0 -0.32% / 0% -9.19% / 79% 31.9% / 36.4% 26% / 24.9%
S&P 500 volatility Index VIX CBOE 91.2 647.2 17.31% / 60% 37.12% / 67% 95.6% / 146.6% 161.3% / 96.2%
S&P 100 index OEX CBOE 42.5 95.7 -3.70% / 35% -8.46% / 89% 25.5% / 29.9% 18.8% / 16.7%
Nasdaq 100 index NDX CBOE 42.5 174.4 -5.63% / 13% -14.29% / 95% 31.4% / 37.1% 21.6% / 19.9%

Stocks
Apple Inc AAPL 374.5 1.17 M -24.71% / 93% -34.53% / 97% 50.6% / 69.9% 50% / 40%
Citigroup C 290.2 2.51 M -3.19% / 15% -6.46% / 13% 41.6% / 75.4% 40.8% / 44.1%
AT&T Inc T 185.8 674.7 -4.71% / 0% -13.37% / 95% 31.3% / 54.9% 26.5% / 28.1%
Intel INTC 151.9 1.90 M -7.73% / 21% -24.38% / 86% 38.5% / 58.6% 32.5% / 28.3%
Microsoft MSFT 151.8 2.65 M -3.51% / 20% -9.04% / 68% 30.7% / 36.4% 27% / 26.4%

Futures
Eurodollar GE-ED CME 615.3 8.62 M 0.59% / 58% 1.40% / 98% 44.7% / 59.2% 22.8% / 11.3%
Sugar SB NYBOT 77.4 934.6 8.13% / 90% 11.58% / 69% 33.5% / 53.9% 26% / 23.7%
10-yr T-notes ZN-TY CBOT 53.8 435.5 1.62% / 16% 4.40% / 96% 10.5% / 6.7% 7.5% / 7.8%
Crude oil CL NYMEX 53.5 465.9 -1.83% / 0% -5.83% / 67% 30.9% / 34.2% 30.4% / 34.9%
Corn ZC-C CBOT 33.3 374.9 1.45% / 0% 10.47% / 47% 28.7% / 28.7% 27.2% / 19.8%

VOLATILITY EXTREMES**
Indices — High IV/SV ratio
British pound index XDB PHLX 1.5 28.5 1.42% / 100% -0.57% / 5% 9% / 7.3% 8.9% / 6.6%
Eurodollar index XDE PHLX 4.8 82.1 0.05% / 0% 1.09% / 23% 9.9% / 8.5% 8.7% / 6.7%
Japanese yen index YUK ISE 2.7 48.0 -1.79% / 11% -6.01% / 89% 13.9% / 13.3% 7.6% / 8.3%

Indices — Low IV/SV ratio

S&P 500 volatility index VIX CBOE 91.2 647.2 17.31% / 60% 37.12% / 67% 95.6% / 146.6% 161.3% / 96.2%
Morgan Stanley retail index MVR CBOE 6.3 55.8 14.12% / 100% -0.93% / 2% 36.6% / 50.2% 33.6% / 27.9%
Oil Service index OSX PHLX 4.2 24.3 -8.50% / 46% -12.37% / 89% 41.5% / 55.1% 29.4% / 27.7%
Banking index BKX PHLX 2.0 98.4 6.60% / 33% 0.99% / 20% 37.6% / 49.5% 36.4% / 32.5%
Semiconductor index SOX PHLX 1.3 8.4 1.65% / 100% -12.45% / 70% 33% / 41% 24.4% / 20.8%

Stocks — High IV/SV ratio

Keryx Pharmas KERX 3.8 59.0 -24.79% / 95% -25.41% / 98% 178.6% / 86.5% 172% / 67.4%
Huntsman HUN 1.5 50.5 -0.16% / 0% -3.27% / 42% 63.4% / 33.4% 41.4% / 24.1%
Clear Channel Comm CCU 45.3 577.0 -8.85% / 100% -9.16% / 87% 76.2% / 41% 49.3% / 27.6%
Align Technology ALGN 1.2 26.2 -12.05% / 45% -24.21% / 58% 95.8% / 62.5% 61.3% / 46.7%
Medarex MEDX 7.2 805.0 -7.97% / 82% -10.71% / 45% 60.9% / 45.9% 60.3% / 52.8%

Stocks — Low IV/SV ratio

Ventana Medical System VMSI 4.3 32.0 1.25% / 20% 3.49% / 76% 7.8% / 22.4% 36.1% / 23.5%
Regions Financial RF 5.2 67.8 16.22% / 100% -1.25% / 2% 43.1% / 86.1% 56.2% / 42.6%
National City NCC 7.8 133.4 10.71% / 50% 1.94% / 100% 53.3% / 102.6% 54.6% / 57.7%
Jefferies Group JEF 1.0 21.6 2.13% / 0% -17.53% / 65% 49.3% / 94.6% 46.2% / 48.7%
First Horizon National FHN 2.8 38.6 21.68% / 80% 15.98% / 100% 62.1% / 117.8% 65.1% / 67.7%

Futures — High IV/SV ratio

10-yr T-notes ZN-TY CBOT 53.8 435.5 1.62% / 16% 4.40% / 96% 10.5% / 6.7% 7.5% / 7.8%
5-yr T-notes ZF-FV CBOT 16.4 126.2 1.55% / 37% 3.58% / 96% 6.8% / 4.9% 5.9% / 5.9%
30-yr T-bonds US-ZB CBOT 19.1 226.7 1.04% / 16% 4.53% / 94% 13.4% / 9.8% 11.4% / 12.6%
Canadian dollar 6C-CD CME 1.6 14.5 1.48% / 38% -2.53% / 46% 12.1% / 9.8% 11.7% / 8.3%
British pound 6B-BP CME 2.5 17.4 1.32% / 100% -0.69% / 8% 9.3% / 8% 8.8% / 6.6%

Futures — Low IV/SV ratio

Sugar SB NYBOT 77.4 934.6 8.13% / 90% 11.58% / 69% 33.5% / 53.9% 26% / 23.7%
Cotton CT NYBOT 21.7 262.5 -2.37% / 67% 0.77% / 7% 21.8% / 31% 19.8% / 15.3%
Eurodollar GE-ED CME 615.3 8.62 M 0.59% / 58% 1.40% / 98% 44.7% / 59.2% 22.8% / 11.3%
S&P 500 futures SP CME 11.0 62.9 -3.78% / 32% -9.08% / 89% 24.7% / 32% 18.3% / 16.5%
Cocoa CC NYBOT 1.7 30.9 2.36% / 43% 7.12% / 82% 24.8% / 31.2% 22.7% / 22.6%
* Ranked by volume ** Ranked based on high or low IV/SV values.
LEGEND:
Options volume: 20-day average daily options volume (in thousands unless otherwise indicated).
Open interest: 20-day average daily options open interest (in thousands unless otherwise indicated).
IV/SV ratio: Overall average implied volatility of all options divided by statistical volatility of underlying instrument.
10-day move: The underlying’s percentage price move from the close 10 days ago to today’s close.
20-day move: The underlying’s percentage price move from the close 20 days ago to today’s close. The “% rank” fields for each time window (10-day moves,
20-day moves) show the percentile rank of the most recent move to a certain number of previous moves of the same size and in the same direction. For exam-
ple, the “% rank” for 10-day moves shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “% rank”
field shows how the most recent 20-day move compares to the past sixty 20-day moves.

FUTURES & OPTIONS TRADER • February 2008 39

 INDUSTRY NEWS
Another year, another deal
CME not content to stand pat
T he CME Group has once again been bitten by the
acquisition bug.
Already the world’s largest exchange after its takeover of
the Chicago Board of Trade last year, the CME Group con-
firmed in late January it was discussing a deal with the
New York Mercantile Exchange (NYMEX).
The deal, worth about $11 billion, would give NYMEX
shareholders an 11-percent premium on the price of
NYMEX stock and the CME Group control of about 98 per-
cent of all U.S.-traded futures contracts.
The big appeal of the NYMEX — and the reason it has
continually shattered volume records the last few years —
is its energy contracts, particularly crude oil. The CME
Group does not trade any energy futures, and adding the
NYMEX, which also trades metal products, would com-
plete its product base, which already includes equity
indices, foreign currencies, interest rates, grains, and live-
stock.
A combined CME-NYMEX could also end the dilemma
the CME will face regarding gold and silver. The CME’s
Globex electronic trading platform already hosts the
NYMEX’s gold and silver contract, but the CBOT began
trading gold and silver in 2006.
CBOE 1, CME 0
SEC agrees with CBOE in rights battle
T
issue.
he Chicago Board Options Exchange (CBOE) won
a huge battle against the CME Group in mid-
January when the Securities and Exchange
Commission (SEC) ruled in the CBOE’s favor over a rights
The CBOE was created by the Chicago Board of Trade
(CBOT) in 1973 in a deal that gave CBOT members the right
to trade on the CBOE floor. As the CBOE has demutualized
in the past few years and planned an IPO, the rights issue
became a sticking point.
The point of contention was how much a trading right
was worth to a CBOT member if and when the CBOE went
public. As the two sides could not agree on a value, the
CBOE postponed its IPO, and the case wound up in court,
where it is still pending.
Last year’s merger of the Chicago Mercantile Exchange
and the CBOT created one entity — the CME Group. The
CBOE contended that since the merger essentially eliminat-
ed the CBOT, it also eliminated the trading rights of any for-
40
While CBOT volume totals have been respectable, it is
rumored the exchange has not made any money in precious
metals, mainly because it has cut fees to the bare minimum
in an attempt to gain volume.
The CME and the NYMEX have a no-compete clause,
essentially stating the CME cannot begin trading precious
metals on its own or provide support to entities that do.
The CME-CBOT hookup seems to violate that clause,
and the belief was the CME would simply end the trading
of precious metals once it completely took over the CBOT.
An acquisition of the NYMEX would make that decision
easier.
Neither the CME nor the NYMEX would comment on the
deal except to confirm that talks took place. The two sides
have a 30-day exclusivity agreement (meaning they can
only negotiate with each other) that expires Feb. 28.
If the two sides do agree to a deal, it would put the
IntercontinentalExchange on notice. The ICE has estab-
lished itself as a major player in the energy markets since
being established less than eight years ago. It lost out to the
CME Group in an attempt to buy the CBOT, and remaining
independent against a conglomerate such as a combined
CME-NYMEX could prove problematic.

mer CBOT member — a position the CME obviously dis-
agreed with.
The SEC agreed with the CBOE, approving the rule inter-
pretation that nobody remains eligible for CBOE rights after
the merger.
Nonetheless, the SEC’s ruling is not legally binding. The
ultimate fate of the dispute will be decided in a Delaware
court. However, the court is expected to consider the SEC’s
ruling in making its final decision, and the CBOE says it will
ask the courts to drop the suit.
“We are extremely pleased by the SEC’s approval of
CBOE's position regarding exercise right eligibility, which
should dispose of the claims in the class action in Delaware
court,” says CBOE Chairman and CEO Bill Brodsky. “CBOE
applauds the Commission for addressing the exercise right
issues with certainty, clarity, and specificity. We are espe-
cially gratified that the order specifically confirms our legal
position regarding the impact on exercise right eligibility of
the acquisition of CBOT by CME. We believe this places us
February 2008 • FUTURES & OPTIONS TRADER
 MANAGED MONEY
Top 10 option strategy traders ranked by December 2007 return.
(Managing at least $1 million as of Dec. 30, 2007.)
in a very strong position to achieve a favor-
able resolution, once and for all, in Delaware 2007
December YTD $ under
court.” Rank Trading advisor return return mgmt.
While the ruling leaves the status of some 1. ACE Investment Strategists (DPC) 13.90 -13.89 5.0M
temporary CBOE members who formerly
2. ACE Investment Strategists (ASIPC) 13.33 -2.64 8.7M
exercised their rights in limbo, the CBOE
3. Parrot Trading Partners 12.48 62.42 15.5M
says it is working on a plan to address their
4. ACE Investment Strategists (SIPC) 12.01 -0.34 99.9M
situation.
5. Solaris Market Neutral Fund LP 7.26 49.73 1.9M
Meanwhile, the ruling could cost the
6. LJM Partners (Neutral S&P Option) 6.80 21.34 141.9M
CME Group a significant amount of money.
7. Aksel Capital Mgmt (Growth & Income) 6.48 -10.67 5.1M
The CME won a hotly contested battle for
8. CKP Finance Associates (LOMAX) 6.24 19.94 5.7M
the CBOT last year, beating out the
9. Censura Futures Mgmt. 5.20 17.31 55.3M
IntercontinentalExchange in a multi-billion
10. Singleton Fund 4.79 64.41 23.0M
dollar deal. As part of the deal, the CME
promised CBOT members $250,000 for an Source: Barclay Hedge (http://www.barclayhedge.com)
individual right and another $250,000 when Based on estimates of the composite of all accounts or the fully funded subset method.
the lawsuit concluded if the court ruling did Does not reflect the performance of any single account.
not favor the CME. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.

With more than 600 trading rights still in

question, the CME might be on the hook for more than $300 the exchange said in a statement. “The ruling clearly
million. Considering the CME has a market cap of more emphasizes that the state court's decision takes precedent in
than $30 billion, it shouldn’t have any problem absorbing preserving the exercise and property rights of CBOT mem-
the debt. bers. We will continue our efforts to preserve the rights of
As for the ruling, the CME typically put a positive spin CBOT members to become or remain exercise members of
on it. The SEC could have usurped the court’s ability to the CBOE pursuant to the exercise right and to share equal-
make a final decision and make one itself, but it chose not ly in any CBOE demutualization.”
to. Neither side would comment on the likelihood of an out-
“We are pleased that the SEC agrees with CME Group of-court settlement, but third-party lawyers have raised the
that the merits of our claims reside in the Delaware courts,” possibility.

Globex now bigger, faster

CBOT integration of electronic products complete

T he CME Group took a big step toward total inte-

gration of the Chicago Board of Trade (CBOT) in
mid-January when the CBOT began transferring
its electronically traded futures and options contracts from
its e-CBOT platform to the CME’s Globex system.
The CBOT’s equity index products and agricultural prod-
ucts switched over to Globex on Jan. 13. Interest-rate prod-
ucts were transferred over on Jan. 27.
With all the electronic trading now in place at the CME,
the next step is to move the CME’s trading floors to the
CBOT building. This is expected to occur in the second
quarter of 2008.
The CME began mock trading sessions on Saturdays in
December to give traders and firms a chance to become
familiar with the new system.
“Throughout the integration process, we have worked
closely with both customers and independent software ven-
dors to make the transition to a single, and in some cases
new, platform as seamless and efficient as possible,” said
CME Group Chief Operating Officer Bryan Durkin in a
statement. “ Now each product group has one set of rules
and policies and standardized trading hours. Our cus-
tomers will also have access to improved risk-management
tools and faster, more timely market data.”
With the transition, the CME Group now has control of
all four major index providers (S&P, Nasdaq, Dow Jones,
and Russell), livestock and grain futures, and both ends of
the interest-rate yield curve.
“We have reached a key milestone in our merger,” says
continued on p. 42

FUTURES & OPTIONS TRADER • February 2008 41

 INDUSTRY NEWS continued

CBOT continued from p. 41

CME CEO Craig Donohue. “Our customers who trade both
CME and CBOT products electronically will now benefit
from reduced front-end development and system costs as
well as from new trading opportunities across every major
asset class.”
Donohue added the CME Group plans to launch cross-
product and cross-exchange spread functionality later in
the year.
The CME further expanded its product group by adding
electronically traded contracts at the Kansas City Board of
Trade (KCBOT) and the Minneapolis Grain Exchange
(MGEX). The KCBOT’s main product is hard red winter
wheat, while the MGEX offers a spring wheat contract.
In addition to the increased product base, the CME also
announced technology upgrades that will reduce response
time from an average of 31 milliseconds to 16.5 milliseconds.
The CME will also, for the first time, allow block trades in
certain interest-rate products. This coincides with CME’s
plan to change the minimum tick size for the 30-year T-
bond futures and the 5-year T-bond options.
The minimum tick for 30-year futures will be reduced
from 1/32 to one-half of 1/32 (from $31.25 to $15.625),
while 5-year futures will drop from one-half of 1/32 to one-
fourth of 1/32 (from $15.625 to $7.8125). Options on the 5-
year will drop from 1/64 to one-half of 1/64 ($15.625 to
$7.8125).
The tick reductions are expected to take effect March 3,
pending CFTC approval.
“[The reduced tick sizes] will decrease our customers’
total transaction costs, and new block trading facilities will
further expand our customers’ execution choices while
reducing market impact costs for very large orders,” Duffy
says.

Options Watch: Top Nasdaq 100 components (as of Jan. 28)

Compiled by Tristan Yates
The following table summarizes the expiration months available for options on the top 15 Nasdaq 100 stocks. It also shows each index's average bid-ask
spread for at-the-money (ATM) February 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
Sept.
June

Aug.
Feb.

Mar.

July

Jan.

Jan.
Apr.

May

Bid-ask spreads

Bid-ask
spread as %
Closing of underlying
Stock Symbol Exchange price Call Put price
Nasdaq 100* QQQQ N/A X X X X X X X 44.33 0.02 0.02 0.05%
Microsoft* MSFT N/A X X X X X X 32.72 0.02 0.03 0.07%
Qualcomm* QCOM N/A X X X X X X 40.5 0.05 0.02 0.08%
Google GOOG N/A X X X X 555.98 0.50 0.48 0.09%
Intel* INTC N/A X X X X X X 20.29 0.02 0.02 0.10%
Apple* AAPL N/A X X X X X X 130.01 0.15 0.11 0.10%
Research in Motion* RIMM N/A X X X X X X 92.07 0.11 0.08 0.10%
Cisco Systems* CSCO N/A X X X X X X 24.1 0.03 0.03 0.11%
Amgen* AMGN N/A X X X X X X 47.86 0.08 0.07 0.15%
Amazon* AMZN N/A X X X X X X 75.82 0.13 0.15 0.18%
Gilead Sciences GILD N/A X X X X X X 43 0.10 0.14 0.28%
Genzyme GENZ N/A X X X X X X 75.12 0.23 0.20 0.28%
Adobe ADBE N/A X X X X X X 35.15 0.10 0.11 0.30%
Teva Pharmaceutical TEVA N/A X X X X X X 43.99 0.14 0.15 0.33%
eBay EBAY N/A X X X X X X 26.87 0.11 0.10 0.40%
Oracle ORCL N/A X X X X X X 20.26 0.10 0.06 0.40%
Starbucks SBUX N/A X X X X X X 19.66 0.09 0.08 0.41%
Dell DELL N/A X X X X X X 20.35 0.09 0.09 0.43%
Paccar PCAR N/A X X X X X X 48.17 0.26 0.24 0.52%
Comcast CMCSA N/A X X X X X X 17.69 0.10 0.10 0.57%

*Penny pilot program participant

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.

42 February 2008 • FUTURES & OPTIONS TRADER

 FUTURES & OPTIONS CALENDAR
Legend
CPI: Consumer Price Index
ECI: Employment cost index
First delivery day (FDD):
The first day on which deliv-
ery of a commodity in fulfill-
ment of a futures contract can
take place.
First notice day (FND): Also
known as first intent day, this
is the first day a clearing-
house can give notice to a
buyer of a futures contract
that it intends to deliver a
commodity in fulfillment of a
futures contract. The clearing-
house also informs the seller.
FOMC: Federal Open Market
Committee
GDP: Gross domestic
product
ISM: Institute for supply man-
agement
LTD: Last trading day; the
first day a contract may trade
or be closed out before the
delivery of the underlying
asset may occur.
PPI: Producer price index
Quadruple witching Friday:
A day where equity options,
equity futures, index options,
and index futures all expire.
FEBRUARY 2008
27 28 29 30 31 1 2
3 4 5 6 7 8
10 11 12 13 14 15 16
17 18 19 20 21 22 23
24 25 26 27 28 29
MARCH 2008
24 25 26 27 28 29
2 3 4 5 6 7
9 10 11 12 13 14 15
16 17 18 19 20 21 22
23 24 25 26 27 28 29
30 31 1 2 3 4
The information on this page is
subject to change. Futures &
Options Trader is not responsible
for the accuracy of calendar dates
beyond press time.
FUTURES & OPTIONS TRADER • February 2008
February
1 Employment
ISM index
LTD: March cocoa options (ICE);
February pork belly and live cattle
options (CME)
FND: March T-bond futures (CBOT)
FDD: February natural gas, gasoline,
and crude oil futures (NYMEX);
February aluminum, palladium, copper,
platinum, silver, and gold futures
(NYMEX)
2 LTD: March natural gas, gasoline, and
3 heating oil options (NYMEX); March
4 FND: February propane and heating oil
futures (NYMEX); February pork belly
and live cattle futures (CME)
5 FDD: February pork belly futures
(CME)
6 Productivity and costs
FDD: February propane futures
(NYMEX)
7 FDD: February live cattle futures
(CME)
8 LTD: February currency options
(CME); March sugar and coffee options
(ICE); March cotton options (ICE)
FDD: February heating oil options
(NYMEX)
9 futures (NYMEX); March oats, rice,
10
11
12 Federal budget
9 13 Retail sales
14 LTD: March crude oil options
(NYMEX); February lean hog futures
1 and options (CME)
15 LTD: All February equity options;
February S&P options (CME);
February Nasdaq options (CME);
1 February Dow Jones options (CBOT);
8 February Russell options (CME);
March orange juice options (ICE)
FND: March coffee futures (ICE)
16
5 17
18 Markets closed — President’s Day
19
20 CPI
LTD: March crude oil futures (NYMEX);
March platinum options (NYMEX)
FEBRUARY/MARCH
MONTH
21 Leading indicators
FND: March coffee futures (ICE)
22 LTD: March T-bond options (CBOT);
March corn, wheat, rice, oats, soy-
bean, and soybean products options
(CBOT)
FND: March crude oil futures (NYMEX)
23
24
25 FND: March cotton futures (ICE)
26 PPI
aluminum, copper, silver, and gold
options (NYMEX); February pork belly
futures (CME)
27 LTD: March natural gas and gasoline
futures (NYMEX); February aluminum,
palladium, copper, platinum, silver, and
gold futures (NYMEX)
28 GDP
FND: March natural gas and gasoline
futures (NYMEX)
29 LTD: March propane and heating oil
futures (NYMEX); February live cattle
futures (CME); March sugar futures
(ICE); March lumber options (CME)
FND: March aluminum, palladium,
copper, platinum, silver, and gold
wheat, corn, soybean, and soybean
product futures (CBOT)
March
1 FDD: March natural gas, gasoline, and
crude oil futures (NYMEX); March
sugar futures (ICE)
2
3 ISM
FND: March orange juice and sugar
futures (ICE)
FDD: March T-bond futures (CBOT);
March aluminum, copper, palladium,
platinum, silver, and gold futures
(NYMEX); March oats, wheat, rice,
corn, soybean, and soybean product
futures (CBOT); March cocoa and
coffee futures (ICE); March cotton
futures (ICE)
4 FND: March propane and heating oil
futures (NYMEX)
5 Productivity and costs
43
 FUTURES FUNDAMENTALS

What’s new FIGURE 1 — COT REPORT EXTREMES

Extreme differences between commercials and speculators might lead to price

in the COT report reversals as speculators unwind their positions.*
The weekly Commitment of Traders
(COT) report lists the positions of two
main groups that are the primary driv-
ers of a futures contract’s price. Large
speculators represent the funds that
often follow trends, while commercials
tend to hedge and usually take the
other side of a position. (For a more
detailed explanation about the COT
report, see “Key concepts.”)
Figure 1’s values aren’t related to
price, though. Instead, they highlight
the relationship between these two
large players. Commercials either need * For a list of contract names, see “Futures Snapshot.”
or use commodities such as soybeans,
Source: www.upperman.com
crude oil, or gold, and speculators try
to profit from underlying price moves.
Figure 1 shows how far apart these players were
Legend: Figure 1 shows the difference between net commercial and net fund
on Jan. 15. For instance, there has been a great deal of positions (longs - shorts) for all 45 futures markets, in descending order. It is
speculation in gold futures (GC), and funds held a calculated by subtracting the current net-fund position from the net-commer-
large amount of long positions. At the same time, cial position and then comparing this value to its five-year range. The basic for-
gold producers were hedging (i.e. selling) to lock in mula is:
recent high prices. a1 = (Net commercials’ 5-year high - net commercials’ current)
At some point, all of the speculators will have bought b1 = (Net commercials’ 5-year high - net commercials’ 5-year low)
and the commercials will be fully hedged.
Historically, if both groups are opposing each other c1 = ((b1 - a1)/ b1 ) * 100
by a certain degree, it could signal some type of mar-
a2 = (Net funds’ 5-year high - net funds’ current)
ket reversal. However, COT data isn’t a standalone b2 = (Net funds’ 5-year high - net funds’ 5-year low)
trade signal, although it can be combined with price-
based indicators.
c2 = ((b2 - a2)/ b2 ) * 100

x = (c1 - c2)
Compiled by Floyd Upperman

EVENTS
Event: Options Seminar hosted by Steve Lentz
Date: Feb. 28
Location: Las Vegas, Nev.
For more information: Call (800) 733-6610
Event: 24th Annual Risk Management Conference
Date: March 9-11
Location: Hyatt Regency Coconut Point Resort and Spa,
Bonita Springs, Fla.
For more information: http://www.cboe.com/rmc
Event: Real Trading with Dan Sheridan
Date: March 13 Location: Hilton, Atlanta, Ga.
Date: April 24 Location: Hilton, Scottsdale, Ariz.
Date: July 24 Location: CBOE Options Institute,
Chicago
For more information: Call (877) THE-CBOE
Event: The Options Initiative Two-day Seminars
Dates: April 10, July 17, Nov. 20
Location: CBOE Options Institute, Chicago, Ill.
For more information: Call (877) THE-CBOE
Event: 17th Annual FIA Futures Services Division
OpTech Conference
Date: April 17
Location: New York City
For more information: Call (202) 466-5460
Event: 30th Annual Law & Compliance Division
Workshop
Date: May 7-9
Location: Renaissance Harborplace Hotel, Baltimore
For more information: Call (202) 466-5460
Event: The Options Intensive Two-day Seminars
Dates: May 22, Aug. 21, Oct. 23, Dec. 4
Location: CBOE Options Institute, Chicago, Ill.
For more information: Call (877) THE-CBOE

44 February 2008 • FUTURES & OPTIONS TRADER

 NEW PRODUCTS AND SERVICES

TradingEducation.com has
launched TraderQuotes.com, part of
the TraderWeb.com network of Web
sites offering education, chat, blogs,
quotes, news, quizzes, and more.
TraderQuotes.com delivers free
quotes, charts, and data for stock,
futures, and forex traders. Users can
set up portfolios, apply indicators, and
access and analyze historical perform-
ance data for a wide variety of finan-
cial instruments. Traders can see the
latest readings for pivot points,
retracement levels, moving averages,
and a number of other technical indi-
cators. For more information, visit
http://www.traderquotes.com.

Calyon Financial
(http://www.calyonfinancial.com)
and CQG (http://www.cqg.com) have
partnered to provide trading access to
nine Asian futures exchanges.
Customers can use CQG’s platforms to
trade futures on the Hong Kong Ex-
change, Korea Exchange, Korea Stock
Exchange, Osaka Stock Exchange,
Singapore Exchange, Taiwan Futures
Exchange, Tokyo Financial Exchange,
TOCOM, and Tokyo Stock Exchange.
CQG’s Integrated Client offers
advanced trading tools, including
exclusive TradeFlowTM charts and
studies, DOMTrader and Order Ticket
trading interfaces, and smart order
functionality.

Forex, futures, equities, and
options broker MB Trading
(http://www.mbtrading.com) has up-
graded its MBT Navigator Platform.
The new version of MBT Navigator
11.0 includes upgraded basket trading
and advanced order control features
via the Market Depth screen. Also
included are advanced features such
as the new Managed Account Trading
FUTURES & OPTIONS TRADER • February 2008
(MAT) tool, designed for traders man- the corresponding value of BSE’s
aging multiple accounts with one or futures contract. The contract will have
multiple strategies. The new Java- a notional value of 40,000 and a tick
based charting platform has advanced size of $5. Expected market partici-
features such as Fibonacci tools and pants include hedge funds and institu-
Ichimoku charts as well as data from tions, international mutual funds, and
more than 15 years ago to the latest individuals seeking investments in
tick chart. Indian markets.

ETF-provider PowerShares Note: The New Products and Services sec-
Capital Manage-ment has listed tion is a forum for industry businesses to
the PowerShares S&P 500 BuyWrite announce new products and upgrades.
Portfolio (PBP). PBP is based on the Listings are adapted from press releases and
CBOE S&P 500 BuyWrite Index, which are not endorsements or recommendations
from the Active Trader Magazine Group. E-
measures the total rate of return of an
mail press releases to editorial@futuresan-
S&P 500 covered call strategy. The
doptionstrader.com. Publication is not guar-
strategy consists of holding a portfolio anteed.
indexed to the S&P 500, and selling a
succession of one-month at-the-money
S&P 500 call options. The CBOE S&P
500 BuyWrite Index assumes call
options are written on the third Friday
of each month, held until expiration,
and exercised options are settled in
cash. For more information, visit
http://www.powershares.com.

U.S. Futures Exchange
(USFE) will exclusively license the
Bombay Stock Exchange’s (BSE)
benchmark SENSEX Index for U.S.
dollar-denominated futures trading
beginning Feb. 22. USFE’s SENSEX
contract will allow eligible U.S.
investors to directly participate in
India’s equity markets for the first
time, without requiring American
Depository Receipt (ADR) authoriza-
tion. The SENSEX Index is composed
of 30 major Indian stocks and regarded
as the country’s premier stock market
index. BSE currently offers rupee-
denominated SENSEX futures to qual-
ified Indian market participants.
USFE’s U.S. dollar-denominated SEN-
SEX futures contract will trade 23
hours per day and settle monthly to
45
 KEY CONCEPTS
American style: An option that can be exercised at any
time until expiration.
Assign(ment): When an option seller (or “writer”) is
obligated to assume a long position (if he or she sold a put)
or short position (if he or she sold a call) in the underlying
stock or futures contract because an option buyer exercised
the same option.
At the money (ATM): An option whose strike price is
identical (or very close) to the current underlying stock (or
futures) price.
Average directional movement index (ADX):
Measures trend strength, regardless of direction. The high-
er the ADX value, the stronger the trend, whether the mar-
ket is going up or down. The indicator can be applied to any
time frame, although it is typically used on daily charts.
Although the ADX concept is straightforward, its calcu-
lation is rather lengthy. The indicator was designed by
Welles Wilder and is described in detail in his book New
Concepts in Technical Trading Systems (Trend Research 1978).
Calculation:
1. Calculate the positive or negative directional move-
ment (+DM and -DM) for each bar in the desired look-
back period. Bars that make higher highs and higher
lows than the previous bar have positive directional
movement. Bars that make lower highs and lower lows
than the previous bar have negative directional move-
ment.
If a bar has both a higher high and a lower low than
the previous bar, it has positive directional
movement if its high is above the previous high more
than its low is below the previous low. Reverse this
criterion for negative directional movement. An inside
bar (a bar that trades within the range of the
previous bar) has no directional movement, and nei-
ther does a bar whose high is above the previous high
by the same amount its low is below the previous low.
2. If a bar has positive (negative) directional move-
ment, the absolute value of the distance between
today’s high (low) and yesterday’s high (low) is added
to the running totals of +DM (-DM) calculated over a
given lookback period (i.e., 20 bars, 30 bars, etc.). The
absolute value is used so both +DM and -DM are pos-
itive values.
3. Calculate the sum of the true ranges for all bars in
the lookback period.
4. Calculate the Directional Indicator (+DI and -DI) by
dividing the running totals of +DM and -DM by the
sum of the true ranges.
5. Calculate the directional index (DX) by taking the
absolute value of the difference between the +DI value
46
The option “Greeks”
Delta: The ratio of the movement in the option price for
every point move in the underlying. An option with a
delta of 0.5 would move a half-point for every 1-point
move in the underlying stock; an option with a delta of
1.00 would move 1 point for every 1-point move in the
underlying stock.
Gamma: The change in delta relative to a change in the
underlying market. Unlike delta, which is highest for
deep ITM options, gamma is highest for ATM options
and lowest for deep ITM and OTM options.
Rho: The change in option price relative to the change
in the interest rate.
Theta: The rate at which an option loses value each day
(the rate of time decay). Theta is relatively larger for
OTM than ITM options, and increases as the option gets
closer to its expiration date.
Vega: How much an option’s price changes per a one-
percent change in volatility.
and the -DI value, dividing that by the sum of the +DI
and -DI values, and multiplying by 100.
6. To create the ADX, calculate a moving average of the
DX over the same period as the lookback period used
throughout the other calculations.
Bear call spread: A vertical credit spread that consists
of a short call and a higher-strike, further OTM long call in
the same expiration month. The spread’s largest potential
gain is the premium collected, and its maximum loss is lim-
ited to the point difference between the strikes minus that
premium.
Bear put spread: A bear debit spread that contains puts
with the same expiration date but different strike prices.
You buy the higher-strike put, which costs more, and sell
the cheaper, lower-strike put.
Beta: Measures the volatility of an investment compared
to the overall market. Instruments with a beta of one move
in line with the market. A beta value below one means the
instrument is less affected by market moves and a beta
value greater than one means it is more volatile than the
overall market. A beta of zero implies no market risk.
Bull call spread: A bull debit spread that contains calls
with the same expiration date but different strike prices.
You buy the lower-strike call, which has more value, and
sell the less-expensive, higher-strike call.
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.
February 2008 • FUTURES & OPTIONS TRADER
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 mar-
ket-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.
Carrying costs: The costs associated with holding an
investment that include interest, dividends, and the oppor-
tunity costs of entering the trade.
The Commitments of Traders report: Published
weekly by the Commodity Futures Trading Commission
(CFTC), the Commitments of Traders (COT) report breaks
down the open interest in major futures markets. Clearing
members, futures commission merchants, and foreign bro-
kers are required to report daily the futures and options
positions of their customers that are above specific report-
ing levels set by the CFTC.
For each futures contract, report data is divided into three
“reporting” categories: commercial, non-commercial, and
non-reportable positions. The first two groups are those
who hold positions above specific reporting levels.
The “commercials” are often referred to as the large
hedgers. Commercial hedgers are typically those who actu-
ally deal in the cash market (e.g., grain merchants and oil
companies, who either produce or consume the underlying
commodity) and can have access to supply and demand
information other market players do not.
Non-commercial large traders include large speculators
(“large specs”) such as commodity trading advisors (CTAs)
and hedge funds. This group consists mostly of institution-
al and quasi-institutional money managers who do not deal
in the underlying cash markets, but speculate in futures on
a large-scale basis for their clients.
The final COT category is called the non-reportable posi-
tion category — otherwise known as small traders — i.e.,
the general public.
Covered call: Shorting an out-of-the-money call option
against a long position in the underlying market. An exam-
ple would be purchasing a stock for $50 and selling a call
option with a strike price of $55. The goal is for the market
to move sideways or slightly higher and for the call option
to expire worthless, in which case you keep the premium.
Credit spread: A position that collects more premium
from short options than you pay for long options. A credit
spread using calls is bearish, while a credit spread using
puts is bullish.
Debit: A cost you must pay to enter any position if the
components you buy are more expensive than the ones you
sell. For instance, you must pay a debit to buy any option,
and a spread (long one option, short another) requires a
FUTURES & OPTIONS TRADER • February 2008
debit if the premium you collect from the short option does-
n’t offset the long option’s cost.
Debit spread: An options spread that costs money to
enter, because the long side is more expensive that the short
side. These spreads can be verticals, calendars, or diagonals.
Deep (e.g., deep in-the-money option or deep
out-of-the-money option): Call options with strike
prices that are very far above the current price of the under-
lying asset and put options with strike prices that are very
far below the current price of the underlying asset.
Delta-neutral: An options position that has an overall
delta of zero, which means it’s unaffected by underlying
price movement. However, delta will change as the under-
lying moves up or down, so you must buy or sell
shares/contracts to adjust delta back to zero.
Diagonal spread: A position consisting of options with
different expiration dates and different strike prices — e.g.,
a December 50 call and a January 60 call.
Exponential moving average (EMA): The simple
moving average (SMA) is the standard moving average cal-
culation that gives every price point in the average equal
emphasis, or weight. For example, a five-day SMA is the
sum of the most recent five closing prices divided by five.
Weighted moving averages give extra emphasis to more
recent price action. Exponential moving average (EMA)
weights prices using the following formula:
EMA = SC * Price + (1 - SC) * EMA(yesterday)
where
SC is a “smoothing constant” between 0 and 1, and
EMA(yesterday) is the previous day’s EMA value.
You can approximate a particular SMA length for an
EMA by using the following formula to calculate the equiv-
alent smoothing constant:
SC = 2/(n + 1)
where
n = the number of days in a simple moving average of
approximately equivalent length.
For example, a smoothing constant of 0.095 creates an
exponential moving average equivalent to a 20-day SMA
(2/(20 + 1) = 0.095). The larger n is, the smaller the constant,
and the smaller the constant, the less impact the most recent
price action will have on the EMA. In practice, most soft-
ware programs allow you to simply choose how many days
you want in your moving average and select either simple,
weighted, or exponential calculations.
European style: An option that can only be exercised at
expiration, not before.
continued on p. 48
47
 KEY CONCEPTS continued
Exercise: To exchange an option for the underlying
instrument.
Expiration: The last day on which an option can be exer-
cised and exchanged for the underlying instrument (usual-
ly the last trading day or one day after).
Fibonacci series: A number progression in which each
successive number is the sum of the two immediately pre-
ceding it: 1, 2, 3, 5, 8, 13, 21, 34, 55, and so on.
As the series progresses, the ratio of a number in the
series divided by the immediately preceding number
approaches 1.618, a number that is attributed significance
by many traders because of its appearance in natural phe-
nomena (the progression of a shell’s spiral, for example), as
well as in art and architecture (including the dimensions of
the Parthenon and the Great Pyramid). The inverse, 0.618
(0.62), has a similar significance.
Some traders use fairly complex variations of Fibonacci
numbers to generate price forecasts, but a basic approach is
to use ratios derived from the series to calculate likely price
targets.
For example, if a stock broke out of a trading range and
rallied from 25 to 55, potential retracement levels could be
calculated by multiplying the distance of the move (30
points) by Fibonacci ratios –– say, 0.382, 0.50, and 0.618 ––
and then subtracting the results from the high of the price
move. In this case, retracement levels of 43.60 [55 - (30*.38)],
40 [55 - (30*.50)], and 36.40 [55 - (30*.62)] would result.
Similarly, after a trading range breakout and an up move
of 10 points, a Fibonacci follower might project the size of
the next leg up in terms of a Fibonacci ratio –– e.g., 1.382
times the first move, or 13.82 points in this case.
The most commonly used ratios are 0.382, 0.50, 0.618,
0.786, 1.00, 1.382, and 1.618. Depending on circumstances,
other ratios, such as 0.236 and 2.618, are used.
Float: The number of tradable shares in a public company.
Intermonth (futures) spread: A trade consisting of
long and short positions in different contract months in the
same market — e.g., July and November soybeans or
September and December crude oil. Also referred to as a
futures “calendar spread.”
In the money (ITM): A call option with a strike price
below the price of the underlying instrument, or a put
option with a strike price above the underlying instru-
ment’s price.
Intrinsic value: The difference between the strike price
of an in-the-money option and the underlying asset price. A
call option with a strike price of 22 has 2 points of intrinsic
value if the underlying market is trading at 24.
Leverage: An amount of “buying power” that increases
48
exposure to underlying market moves. For example, if you
buy 100 shares of stock, that investment will gain or lose
$100 for each $1 (one-point) move in the stock.
But if you invest half as much and borrow the other half
from your broker as margin, then you control those 100
shares with half as much capital (i.e., 2-to-1 buying power).
At that point, if the stock moves $1, you will gain or lose
$100 even though you only invested $50 — a double-edged
sword.
Limit up (down): The maximum amount that a futures
contract is allowed to move up (down) in one trading ses-
sion.
Lock-limit: The maximum amount that a futures contract
is allowed to move (up or down) in one trading session.
Long call condor: A market-neutral position structured
with calls only. It combines a bear call spread (short call,
long higher-strike further OTM call) above the market and
a bull call spread (long call, short higher-strike call). Unlike
an iron condor, which contains two credit spreads, a call
condor includes two types of spreads: debit and credit.
Long-Term Equity AnticiPation Securities
(LEAPS): Options contracts with much more distant expi-
ration dates — in some cases as far as two years and eight
months away — than regular options.
Market makers: Provide liquidity by attempting to prof-
it from trading their own accounts. They supply bids when
there may be no other buyers and supply offers when there
are no other sellers. In return, they have an edge in buying
and selling at more favorable prices.
Naked (uncovered) puts: Selling put options to collect
premium that contains risk. If the market drops below the
short put’s strike price, the holder may exercise it, requiring
you to buy stock at the strike price (i.e., above the market).
Near the money: An option whose strike price is close
to the underlying market’s price.
Open interest: The number of options that have not
been exercised in a specific contract that has not yet expired.
Opportunity cost: The value of any other investment
you might have made if your capital wasn’t already in the
markets
Outlier: An anomalous data point or reading that is not
representative of the majority of a data set.
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
February 2008 • FUTURES & OPTIONS TRADER
instrument’s price.
Parity: An option trading at its intrinsic value.
Premium: The price of an option.
Put option: An option that gives the owner the right, but
not the obligation, to sell a stock (or futures contract) at a
fixed price.
Put ratio backspread: A bearish ratio spread that con-
tains more long puts than short ones. The short strikes are
closer to the money and the long strikes are further from the
money.
For example if a stock trades at $50, you could sell one
$45 put and buy two $40 puts in the same expiration month.
If the stock drops, the short $45 put might move into the
money, but the long lower-strike puts will hedge some (or
all) of those losses. If the stock drops well below $40, poten-
tial gains are unlimited until it reaches zero.
Put spreads: Vertical spreads with puts sharing the same
expiration date but different strike prices. A bull put spread
contains short, higher-strike puts and long, lower-strike
puts. A bear put spread is structured differently: Its long
puts have higher strikes than the short puts.
Ratio spread: A ratio spread can contain calls or puts and
includes a long option and multiple short options of the
same type that are further out-of-the-money, usually in a
ratio of 1:2 or 1:3 (long to short options). For example, if a
stock trades at $60, you could buy one $60 call and sell two
same-month $65 calls. Basically, the trade is a bull call
spread (long call, short higher-strike call) with the sale of
additional calls at the short strike.
Overall, these positions are neutral, but they can have a
directional bias, depending on the strike prices you select.
Because you sell more options than you buy, the short
options usually cover the cost of the long one or provide a
net credit. However, the spread contains uncovered, or
“naked” options, which add upside or downside risk.
Simple moving average: A simple moving average
(SMA) is the average price of a stock, future, or other market
over a certain time period. A five-day SMA is the sum of the
five most recent closing prices divided by five, which means
each day’s price is equally weighted in the calculation.
Strike (“exercise”) price: The price at which an under-
lying instrument is exchanged upon exercise of an option.
Support and resistance: Support is a price level that
acts as a “floor,” preventing prices from dropping below
that level. Resistance is the opposite: a price level that acts
as a “ceiling;” a barrier that prevents prices from rising
higher.
FUTURES & OPTIONS TRADER • February 2008
Support and resistance levels are a natural outgrowth of
the interaction of supply and demand in any market. For
example, increased demand for a stock will cause its price
to rise, creating an uptrend. But when price has risen to a
certain level, traders and investors will take profits and
short sellers will come into the market, creating “resistance”
to further price increases. Price may retreat from and
advance to this resistance level many times, sometimes
eventually breaking through it and continuing the previous
trend, other times reversing completely.
Support and resistance should be thought of more as gen-
eral price levels rather than precise prices. For example, if a
stock makes a low of 52.15, rallies slightly, then declines
again to 52.15, then rallies again, a subsequent move down
to 52 does not violate the “support level” of 52.15. In this
case, the fact that the stock retraced once to the exact price
level it had established before is more of a coincidence than
anything else.
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 share a strike price (calendar spread) or have
different strikes (diagonal spread).
Time value (premium): The amount of an option’s
value that is a function of the time remaining until expira-
tion. As expiration approaches, time value decreases at an
accelerated rate, a phenomenon known as “time decay.”
Vertical spread: A position consisting of options with
the same expiration date but different strike prices (e.g., a
September 40 call option and a September 50 call option).
Volatility: The level of price movement in a market.
Historical (“statistical”) volatility measures the price fluctu-
ations (usually calculated as the standard deviation of clos-
ing prices) over a certain time period — e.g., the past 20
days. Implied volatility is the current market estimate of
future volatility as reflected in the level of option premi-
ums. The higher the implied volatility, the higher the option
premium.
Volatility skew: The tendency of implied option volatil-
ity to vary by strike price. Although, it might seem logical
that all options on the same underlying instrument with the
same expiration would have identical (or nearly identical)
implied volatilities. For example, deeper in-the-money and
out-of-the-money options often have higher volatilities than
at-the-money options. This type of skew is often referred to
as the “volatility smile” because a chart of these implied
volatilities would resemble a line curving upward at both
ends. Volatility skews can take other forms than the volatil-
ity smile, though.
49
 OPTIONS TRADE JOURNAL

This bear put spread takes a wild ride in the wake of the Fed’s surprise rate cut.

TRADE
Trader, March 2008). This bearish bias isn’t reliable, though,
Date: Wednesday, Jan. 22. because it’s based on just 8 past examples. In mid-January,
however, the market was clearly in a downtrend since all
Market: Options on the S&P 500 tracking stock (SPY). major U.S. indices had dropped at least 6 percent in 2008 so
far.
Entry: Buy 1 February 135 put at $6.35. To exploit further market weakness, we entered a bear
Sell 1 February 130 put at $3.85. put spread on the S&P 500 tracking stock when it traded at
$130 at 10:30 a.m. CT on Jan. 22. Earlier that morning, the
Reasons for trade/setup: The S&P 500 tracking stock Federal Reserve cut its fed funds target rate unexpectedly
(SPY) gapped down on Jan. 4 as it opened 1 percent lower 0.75 percent to 3.5 percent. Although the S&P 500 index
that day and fell another 1.4 percent by the close. Seven opened 0.9 percent lower in reaction to recent sharp
days later, SPY still traded below Jan. 4’s high as it gapped declines in Asian and European markets, stocks were
down again, forming a second daily down gap on Jan. 15. rebounding on the news as the debit spread was entered.
Historical testing showed SPY continued to fall in the 10 Vertical spreads are attractive because the short option
days after these types of patterns (see “Double gaps,” Active helps offset the long option’s cost, and they limit exposure
to changes in implied volatility (IV)
and time decay. To enter a bear put
FIGURE 1 — RISK PROFILE — BEAR PUT SPREAD
spread, we bought February 135 puts
This February 135/130 bear put spread risks $2.50 to gain $2.50 if SPY trades for $6.35 and sold same-month 130
at (or below) 130 by Feb. 16 expiration.
puts for $3.85 — a total debit of $2.50.
The long 135 puts were in-the-money
(ITM) by roughly $5 and the short 130
puts were at-the-money (ATM).
Figure 1 shows the spread’s poten-
tial gains and losses on four dates: Jan.
22 (trade entry, dotted line), Feb. 16
expiration (solid line), and two interim
dates. The spread’s gains and losses
are capped at $2.50 at expiration, and
the trade will make money if SPY
doesn’t climb above $132.50 by that
point.
We plan to hold the spread three
days and exit at the close on Jan. 25.
Because the maximum loss is limited
to $2.50, this trade doesn’t use a stop.
Source: OptionVue

50 February 2008 • FUTURES & OPTIONS TRADER

 FIGURE 2 — EYE OF THE STORM

The vertical spread was entered after the Fed cut interest rates 0.75 percent
on Jan. 22. SPY fell 2.78 percent the next morning, so we exited early to cap-
ture an overall profit of $0.60.

Initial stop: None.

Initial target: Hold spread for three

days and exit at Jan. 25’s close.

Outcome: Figure 2 shows SPY trad-

ed sideways after entering the
135/130 spread. The trade lost only
$0.10 by Jan. 22’s close. But the market
opened 2.78 percent lower the next
morning, and the spread gained
ground.
After the drop, we decided to exit
early to capture a gain of $0.65. But
exiting the trade was awkward,
because we bought back the short 130
Source: eSignal
put before selling the long 135 put.
Figure 2 shows SPY traded at $127.50
TRADE SUMMARY
at 8:45 a.m. when the short 130 put was bought back at a
loss ($1.45). And SPY spiked 2.75 percent before we could Entry date: Jan. 22, 2008
sell the long put at a profit ($2.05). Underlying security: S&P 500 tracking stock (SPY)
We finally sold the 135 put when SPY weakened
Position: Bear put spread
around lunchtime, so the spread gained $0.60 overall.
1 long Feb. 135 put: -$6.35
And given the markets’ extreme volatility on Jan. 23 —
SPY bounced 5 percent off its lows that afternoon — the 1 short Feb. 130 put: $3.85
spread’s meager profits were probably pure luck.
Initial capital required: $1,020
Initial stop: None

TRADE STATISTICS Initial target: Hold three days

Initial daily time decay: $1.45
Date: Jan. 22 Jan. 23
Trade length (in days): 2
Delta: -19.61 -20.16
P/L: $60 (5.9 percent)
Gamma: -0.34 -1.32
Theta: 1.45 3.17 LOP: $65
Vega: -1.31 -2.37 LOL: -$10
Probability of profit: 59% 67% LOP — largest open profit (maximum available profit during life of trade).
Breakeven point: 130.78 131.25 LOL — largest open loss (maximum potential loss during life of trade).

FUTURES & OPTIONS TRADER • February 2008 51

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