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SELECTIVE TRADING:
Can you identify your
strategy’s best signals?
p. 6
INTERMARKET
SOYBEAN
system p. 12
TRADING
golden butterflies p. 16
THE GAIN/LOSS
SPREAD:
Trading options with
a new volatility
measure p. 22
ADJUSTING OPTIONS
for stock splits
and dividends p. 30
Applying a simpler
volatility measure . . . . . . . . . . . . . . . . . . . .22
This new calculation demystifies volatility and
provides an easy way to compare the details of
two (or more) stocks. It also helps you uncover
opportunities that other options traders ignore.
By George Hoekstra
Events . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34
Options Watch:
Large-cap stocks . . . . . . . . . . . . . . . . . . . . . . .38
eSignal RS of Houston
PFGBEST.com
BY LEE LEIBFARTH
Trade rules
The strategy uses a 14-period fast sto-
chastic oscillator to generate entry sig-
nals. Instead of buying the market
when the fast %K line crosses below 25
— a classic oversold signal — the sys-
tem sells the market to exploit further
weakness. And instead of selling short
when the fast %K line crosses above 75 Source: TradeStation
— a traditional overbought signal —
the approach goes long to benefit from the market’s poten- Trade rules
tial strength. These signals are sometimes referred to as a 1. Go long if the 14-period fast %K line crosses
stochastic “pop” and trade in the direction of the intraday above 75.
trend. 2. Sell short if the 14-period fast %K line crosses
The system trades from 8:30 a.m. to 3:00 p.m. ET and below 25.
holds each trade until one of the exit conditions are met, 3. Exit the trade if it earns $800 (profit target),
even if a signal triggers in the opposite direction (i.e., trades loses $800 (stop loss), or at the stock market’s close
are not reversed). at 4 p.m. ET.
continued on p. 8
Figure 1 shows five short trades on Jan. 22, three of which drawdowns. The system’s winning percentage doesn’t
were profitable. The approach earned $1,600 as the Mini change, but it could earn significantly more money than if
Russell 2000 futures dropped roughly 4 percent in the you simply traded one contract.
morning. It gave back profits in the early afternoon before However, the Martingale rule magnifies risk. By trading
moving back into the black as it sold short when the market increasingly larger positions, you could easily go broke
fell apart again in the final two hours of trading. before you have the chance to bounce back. Figure 2’s equi-
Because the strategy’s profit target and stop loss amounts ty curve shows how the Martingale rule can ruin a strategy:
are identical, performance depends entirely on the percent- Drawdowns are steep as just one or two trades can wipe
age of winning trades. In other words, the system earns you out. When the Martingale rule was applied to this sys-
money if more than half of all trades are winners, and it tem, equity fell from a $22,000-profit to a loss of more than
loses money if more than half of all trades are losers. Thus, $46,000 within 90 trades. You must have very deep pockets
the strategy is basically a coin toss with the entry rules pro- to succeed with a Martingale system.
viding the only hope of positive expectancy and potential Clearly, this approach is too risky to trade, but you can
profit. add elements of the Martingale rule to a system and still
Table 1 lists the system’s back-tested results, which were trade responsibly. One idea is to double the trade’s size a
modestly profitable when trading one contract (commis- certain number of times before the system stops trading or
sions are excluded). The strategy traded 146 times in the 60- resets, even if it hasn’t recovered. The goal, of course, is to
day test period and gained ground 54 percent of the time recoup any losses before this limit is reached. This method
with a 1.19-profit factor (gross profit/gross loss). Its maxi- relies on a system’s favorable winning percentage to keep it
mum drawdown was $6,310, and it posted losses up to four from shutting down.
times in a row (more in a moment). Remember that the intraday stochastic system posted up
So far the strategy isn’t very impressive, as a good chunk to four consecutive losses. Instead of trading just one con-
of its average profit ($61.10) will likely be eroded by com- tract, let’s apply the Martingale rule and double the next
missions and slippage. Let’s try to improve performance by trade’s size after a loss up to four times in a row. After four
adjusting each trade’s size based on whether previous consecutive losses, the fifth trade should pull the system
trades gained or lost money. out of its hole. If the strategy starts with one contract and
posts a loss, the next trade will be two contracts; and if loss-
Sizing positions the Martingale way es continue, the system will then trade four, eight, and final-
In theory, you can sharpen a system’s performance by trad- ly 16 contracts. Ideally, a single 16-contract winning trade
ing larger positions after each losing trade, a tactic known will overcome the losses of the previous four trades — a
as Martingale betting. The idea is to successively double the total of 15 contracts (1 + 2 + 4 + 8 = 15).
size of a previous losing trade until a single winner recoups Table 2 shows the back-test results of applying the
your losses. The upside is you could quickly overcome any Martingale rule up to four times on the intraday stochastic
percent) profit is relatively low because it traded only 11 exploring the role of probability is an important step in
times during the 60-day test period. designing a trading system and can be beneficial if done
Adding risk to a trading strategy shouldn’t be taken properly.
lightly. These adjustments were proposed to inspire creativ-
ity — not to be traded without further research. That said, For information on the author see p. 5.
BY MARKOS KATSANOS
Market selection
To design an intermarket system
based on this analysis, we need to
decide which market has the best
predictive correlation for soybeans.
However, the main purpose of a
predictive model is not to select a
commodity with the highest correla-
tion value from a contemporaneous
correlation analysis but to find a
predictive market that produces dis-
parities between forecasted and
observed values that warn you of
dangers and opportunities well
— CONTACT —
Bob Dorman Allison Chee Mark Seger
Ad sales East Coast and Midwest Ad sales West Coast and Southwest Account Executive
bdorman@activetradermag.com achee@activetradermag.com seger@activetradermag.com
(312) 775-5421 (415) 272-0999 (312) 377-9435
I
long call’s value.
n times of economic uncertainty and market volatil-
Criteria: Calls are spaced at equidistant strike ity, investors have fewer places to turn. The Dow
prices. Short strike is placed at the Jones Industrial Average was down roughly 44 per-
underlying’s target price. Use options
cent year-to-date at its Nov. 21 nadir with daily
that expire in fewer than 45 days.
ranges around 5 to 6 percent. Mutual funds are getting
Best-case Underlying closes at the short strike hammered and, in October, stock funds lost more than $1
scenario: at expiration. All short calls expire trillion, or 20 percent of their assets, according to the
worthless.
Investment Company Institute.
Worst-case Underlying moves beyond one of the Crude oil and other commodities have been in freefall.
scenario: long protective wings. The maximum Bonds are performing well, but with the yield on 10-year
loss is the spread’s cost. Treasuries at 2.4 percent on Dec. 16 and corporate bonds’
Possible Create a condor instead by selling two default risk still high, the bond market also looks dicey.
modifications: strike prices instead of just one. Fortunately, investors can turn to the options market to
Chances of earning maximum profit create a variety of pre-defined risk-reward opportunities.
are increased. Directional butterflies and condors are two option spreads
Quantity Symbol Expiration month Strike Type Price Bid/ask side Exchange Time
278 GLD December 78 Calls $2.41 Bid side ISE 9:45:26
139 GLD December 81 Calls $1.64 Ask side ISE 9:45:26
139 GLD December 75 Calls $3.58 Ask side ISE 9:45:26
Source: Trade Alert
BY GEORGE HOEKSTRA
Comparing volatilities
of different stocks
Let’s use weekly gain-loss charts to
compare the volatility of Flowers
Foods with Raytheon (RTN), which
has a one-year standard deviation of
30 percent (similar to FLO). Figure 3
shows RTN’s weekly gain-loss chart,
and Figure 4 shows its weekly bar
chart.
If you compare Figures 2 and 4, you
will notice Raytheon has a much dif-
Option adjustments
The option you traded last week might be a different creature altogether
after a special dividend, stock split, or merger occurs.
BY FOT STAFF
T
he House Committee on Agriculture, which over- “divert trading in highly regulated commodity and energy
sees the Commodity Futures Trading Commission futures markets to less-regulated OTC and foreign markets
(CFTC), approved the “Derivatives Markets accessible to U.S. investors but beyond the reach or
Transparency and Accountability Act of 2009” on Feb. 12, jurisdiction of the U.S. government,” while forcing OTC
after holding two days of congressional hearings that derivatives onto regulated exchanges would drive trade
brought more than 20 witnesses before the committee. It overseas.
will soon be heading for a vote in the House. The Chicago Board Options Exhange (CBOE) also issued
The bill, sponsored by Minnesota Democrat and chair- a statement saying that while they support the need for
man of the House Committee on Agriculture Collin revamped regulation, it should be through “a collaborative
Peterson, would broaden the authority of the Commodity process that includes the Obama administration, all
Futures Trading Commission to include oversight of OTC Congressional Committees with relevant jurisdiction, the
derivatives, set stringent trading limits on deliverable com- members of the President’s Working Group on Financial
modities, and would require OTC derivatives to be cleared Markets, and the private sector.”
on a CFTC- or (for financial derivatives) a Securities Democratic Representative Barney Frank, chairman of
Exchange Commission (SEC)-regulated exchange. Among the House Financial Services Committee, has also voiced
further provisions, the bill would also require greater infor- opposition to the bill. His committee oversees the SEC and
mation sharing between international regulatory bodies, the Federal Reserve, organizations that have also vied for
increased data reporting requirements, and would grant regulatory authority in this area. Frank had proposed a
the CFTC the ability to criminally prosecute violators of the Systemic Risk Regulator charged with assessing risk across
act’s provisions. all financial markets, along with a strengthening of the
Exchanges raised some opposition following the bill’s CFTC and SEC’s regulatory power. The proposed Systemic
approval for a House vote. The CME Group issued a Risk Regulator would most likely be part of the Federal
statement which claimed that increased trade limits would Reserve.
O
n Feb. 13, The Commodity Futures Trading ber of instruments that can be held by a non-commercial
Commission (CFTC) approved limits proposed firm in line with the spot month speculative limits already
by the Chicago Board of Trade (CBOT) on the in place.
number of delivery instruments, such as warehouse “We will monitor the effectiveness of this and other grain
receipts and shipping certificates, that can be held by a non- contract changes to see if convergence remains an issue
commercial entity in the grain markets. The move is the lat- requiring further action,” said acting CFTC chairman
est effort to improve the convergence of grain futures and Michael Dunn in the committee’s statement announcing the
spot cash prices, a problem which first arose in early 2008 as approval. The commission believes this new rule will also
commodity prices skyrocketed. reduce the grain market’s susceptibility to manipulation.
The limit applies to corn, mini-sized corn, wheat, mini- Non-commercial entities will have until May 31 to com-
sized wheat, oats, rough rice, soybean, mini-sized soybean, ply with the new rules, while soybean oil certificate holders
soybean oil, and soybean meal contracts. It brings the num- will have until Sept. 25.
T
he Chicago Futures Exchange tracks the implied volatility of S&P 500 to a range between 40 and 50.
(CFE), which is owned by the index options. The contract will be
Chicago Board Options Ex- priced off the VIX using a $100 multi-
change (CBOE), announced mini-sized plier, as opposed to the $1,000 multi-
versions of their VIX futures contracts plier used for the larger VIX futures
to begin trading in March. contracts (VX).
The new contracts, which will trade This cash-settled contract will ini-
under the symbol “VM,” will track the tially be available for March, April,
CBOE’s volatility index (VIX), which and May serial months, with a mini-
MANAGED MONEY
Top 10 option strategy traders ranked by January 2009 return.
(Managing at least $1 million as of Jan. 31, 2009.)
EVENTS
Event: The World Money Show Event: Securities Operations World 2009
Date: March 17-19 Location: Hong Kong Date: May 27
Date: May 11-14 Location: Las Vegas Location: New York City
For more information: Go to For more information: http://www.fmwonline.com
http://www.moneyshow.com and click on “Events”
Event: The 15th Forbes Cruise for Investors
Event: 10th Free Annual Technical Analysis Expo Date: June 2-14
Date: March 20-21 Location: Lisbon to Venice
Location: Paris, France For more information: Go to
For more information: http://www.salonAT.com http://www.moneyshow.com and click on “Events”
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.
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 217.1 1.63 M -11.99% / 93% -13.02% / 93% 40.9% / 39.3% 37.2% / 36.2%
Russell 2000 Index RUT CBOE 71.0 514.1 -13.63% / 93% -14.17% / 88% 47.3% / 41.3% 47.1% / 45.1%
S&P 500 volatility index VIX CBOE 55.4 748.4 12.36% / 67% 8.73% / 58% 84.4% / 124.7% 105.5% / 118.9%
E-Mini S&P 500 futures ES CME 24.6 107.1 -12.12% / 93% -12.87% / 93% 41.8% / 25.7% 37.7% / 26.6%
S&P 100 Index OEX CBOE 19.1 68.4 -11.52% / 94% -12.84% / 96% 37.1% / 37.7% 36.5% / 33.9%
Stocks
Bank of America BAC 398.7 1.72 M -32.71% / 89% -41.74% / 62% 194.4% / 205.1% 136.4% / 157%
General Electric GE 296.0 2.19 M -27.14% / 95% -33.10% / 98% 104.1% / 82.7% 64.7% / 73.4%
Citigroup C 244.0 2.59 M -58.45% / 100% -61.54% / 98% 153.6% / 165.4% 131.7% / 172.4%
Wells Fargo WFC 190.9 1.03 M -27.98% / 54% -35.57% / 76% 140.7% / 148% 106.6% / 119.9%
Apple Inc. AAPL 165.1 844.0 -10.03% / 67% -3.97% / 19% 50.6% / 45.3% 43.5% / 49.4%
Futures
Eurodollar ED CME 397.5 6.48 M -0.09% / 29% -0.21% / 67% 77.5% / 72.6% 90.5% / 99.4%
10-year T-notes TY CME 58.0 247.8 -3.26% / 92% -1.85% / 55% 11.1% / 10.6% 10.7% / 11%
Corn C CME 44.0 512.4 -1.97% / 12% -5.92% / 39% 41.1% / 33.7% 41.6% / 46.4%
Crude oil CL NYMEX 31.8 264.4 31.72% / 100% 8.01% / 46% 69.6% / 74.1% 81% / 92.5%
30-yr T-bonds US CME 28.7 138.8 -4.63% / 71% -3.10% / 32% 21.2% / 16.9% 19.4% / 17.8%
VOLATILITY EXTREMES**
Indices - High IV/SV ratio
E-Mini S&P 500 futures ES CME 24.6 107.1 -12.12% / 93% -12.87% / 93% 41.8% / 25.7% 37.7% / 26.6%
Japanese Yen index YUK ISE 1.2 17.0 7.36% / 88% 8.45% / 85% 17.8% / 13.6% 20.4% / 15.4%
S&P 500 futures SP CBOE 12.6 78.9 -12.11% / 93% -12.89% / 93% 36.6% / 31.9% 34.1% / 31.4%
Russell 2000 Index RUT CBOE 71.0 514.1 -13.63% / 93% -14.17% / 88% 47.3% / 41.3% 47.1% / 45.1%
Gold/Silver Index XAU PHLX 1.0 14.4 -10.39% / 100% -5.08% / 80% 61.1% / 53.6% 59.7% / 70%
Options Watch: Large-cap stocks (as of Feb. 26) Compiled by Tristan Yates
The following table summarizes the expiration months available for the 20 largest U.S. stocks, the large-cap S&P 100 index (OEX), and the S&P
100 tracking stock (OEF). It also shows each ETF’s average bid-ask spread for at-the-money (ATM) March 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
2009 2010 2011 Bid-ask spreads
Bid-ask
spread as %
Sept.
June
Aug.
Dec.
Dec.
Dec.
Mar.
July
Jan.
Jan.
Apr.
May
Oct.
Closing of underlying
Stock Ticker price Call Put price
Wal Mart Stores WMT X X X X X X 48.25 0.03 0.02 0.05%
AT&T Inc T X X X X X X 24.09 0.02 0.02 0.08%
Exxon Mobil Corp XOM X X X X X X 70.95 0.07 0.04 0.08%
Microsoft Corp MSFT X X X X X X 16.42 0.01 0.02 0.08%
Verizon Communications VZ X X X X X X 28.48 0.03 0.02 0.09%
Google Inc GOOG X X X X X X 337.18 0.30 0.30 0.09%
Cisco Sys Inc CSCO X X X X X X 14.49 0.01 0.02 0.10%
Pfizer Inc PFE X X X X X X 12.7 0.02 0.01 0.12%
JP Morgan Chase & Co JPM X X X X X X 23.05 0.04 0.03 0.14%
S&P 100 index OEX X X X X X X X X 357.22 0.58 0.50 0.15%
Apple Inc AAPL X X X X X X 89.18 0.19 0.09 0.15%
IBM IBM X X X X X X 88.97 0.13 0.15 0.15%
Hewlett Packard HPQ X X X X X X 30.24 0.05 0.05 0.17%
Proctor & Gamble PG X X X X X X 48.97 0.09 0.10 0.19%
Abbot Labs ABT X X X X X X 50.58 0.10 0.10 0.20%
Pepsico Inc PEP X X X X X X 49.42 0.10 0.10 0.20%
Chevron Corp CVX X X X X X X 63.17 0.10 0.18 0.22%
Philip Morris PM X X X X X X 34.21 0.08 0.08 0.22%
General Electric Co GE X X X X X X 9.1 0.02 0.02 0.22%
Coca Cola Co KO X X X X X X 41.07 0.10 0.09 0.23%
Johnson & Johnson JNJ X X X X X X 52.44 0.11 0.31 0.41%
S&P 100 tracking stock OEF X X X X X X X X 35.95 0.84 0.94 2.47%
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.
38 March 2009 • FUTURES & OPTIONS TRADER
NEW PRODUCTS AND SERVICES
The New York Institute of Finance (NYIF) has dedicated to beginning traders; a series of intelligence reports; a
formed a strategic partnership with the Chicago Board Options weekly and monthly online Webinar series; a strategies func-
Exchange (CBOE) that allows registered CBOE.com users tion, which allows traders to sort choices by skill level and mar-
access to NYIF’s entire curriculum of instructor-led virtual ket outlook; and 35 hours of educational video content on stock,
classes. Users can access more than 175 hours of online learning, options, and fixed-income investing.
covering more than 25 financial-area topics, including back
office operations, derivatives, equities, credit, risk management, Lightspeed Financial launched Lightspeed Spotlight,
and corporate finance. In addition, the entire instructor-led an online social networking community enabling its customers
public courses curriculum is available both in New York and in to interact with other Lightspeed customers and participate in
Chicago. All courses earn professional continuing education online educational courses and seminars. Members can partici-
credits. Registered users receive a discount on NYIF courses, pate in group discussions; create groups and personal blogs;
and can register directly through the CBOE site gain access to educational information and resources including
(http://www.theoptionsinstitute.com) or through NYIF’s Web discussions and online Webinars from Lightspeed Trading,
site for virtual, “e-learning,” and public instructor-led courses Options Industry Council, and the Chicago Mercantile
(http://www.nyif.com/cboe). Exchange; view and post videos, articles and events on
Spotlight’s message boards, blogs, and calendar; and access
optionsXpress announced three additions to its broker- research and analyst Webinars from StreetBrains.com and chart-
age platform. The new myOX portal allows users to customize pattern recognition techniques provided by Recognia, Inc.
the http://www.optionsXpress site to their specific interests
and preferences. myOX users design their own “control cen- Wolters Kluwer Financial Services’s GainsKeeper
ters” on the site by using the adaptable modular interface to (http://www.gainskeeper.com) tax-lot accounting technology
select the information they want to see, its location on the has been integrated with Firstrade Securities’
screen, and even how it is displayed. Users can select from 16 (http://www.firstrade.com) online trading platform, offering
different preset myOX modules including account balances, Firstrade customers new functionality and helping Firstrade
watch lists, charts, positions, futures and options chains, and prepare for requirements of the recently enacted cost-basis
even RSS feeds from financial news sites or blogs. Similarly, the reporting law (http://www.costbasisreporting.com).
new Research Center provides a single access point for research GainsKeeper assists Firstrade customers with portfolio track-
reports, breaking news, market commentary, quotes, and other ing, adjusting cost basis, and gain/loss reports for wash sales
information. The Research Center allows users to read any full and corporate actions, while its tax-trading tools help investors
report or news item without ever leaving the page. The new manage their portfolios in a tax-efficient manner and identify
Education Center offers investors access to progressive invest- the tax impact on their investment returns. Firstrade customers
ment education courses, hundreds of free online learning are also able to easily generate a Schedule D for tax filing using
events, as well as a library of general investing information. GainsKeeper.
CME Group announced 10 new natural gas basis swap Patsystems announced it is now a Certified ISV for
futures contracts, trading on the CME ClearPort electronic BM&F, the derivatives segment of BM&FBOVESPA. Patsystems
clearing and trading system. The new contracts and their com- will provide direct market access to the exchange for both local
modity codes are: Columbia Gulf Mainline (5Z); Florida Zone 2 and international participants. As well as direct access,
(8A); OneOk, Oklahoma (8X); Southern Star, Texas, Oklahoma, Patsystems also offers access to BM&F products via CME
Kansas (8Z); Tennessee 800 (6Z); Texas Eastern West LA (8B); Globex, which allows existing CME customers to trade the main
Texas Gas Zone 1 (9F); Transco Zone 1 (8E); Transco Zone 2 (8F); BM&F derivatives contracts listed on the Globex platform. All
and SoCal Citygate (9A). The contracts are 2,500 MMBtus in BM&F segment products will be available through Patsystems’
size with a minimum price fluctuation of $0.0025 per MMBtu. front-ends, J-Trader and Pro-Mark, and risked by Patsystems’
Trading began with the April 2009 contract and is listed for the pre-trade System and Risk Administration (SARA) module.
current year plus the next five years. The CME Group also
announced the dual listing of Henry Hub natural gas financial RTS Realtime Systems Group is offering connectivity
last day options, trading on CME ClearPort and the New York to Nasdaq Dubai. Users are able to trade all of Nasdaq Dubai’s
trading floor. The new contract (commodity code: E7) is a listed products, including equities, derivatives, and structured
European-style option that is 10,000 MMBtus in size with a min- products. RTS will offer direct market access through its entire
imum price fluctuation of $0.0001 per MMBtu. It began trading trading solutions portfolio, including its RTD-API, the front-
with the March 2009 contract and is listed for the balance of the end trading systems RTD and eRTD, as well as RTD Tango, its
current year, plus consecutive months for the next five years automated algorithmic trading solution. With the connectivity
through 2014. These contracts are listed with, and subject to, the to Nasdaq Dubai, RTS now offers access to all three Dubai-
rules and regulations of the New York Mercantile Exchange. based exchanges.
Note: The New Products and Services section is a forum for industry
TradeKing (http://www.tradeking.com) has launched an businesses to announce new products and upgrades. Listings are adapted
education offering that is free to any TradeKing client and from press releases and are not endorsements or recommendations from
accessible through its new Online Learning Center. TradeKing’s the Active Trader Magazine Group. E-mail press releases to
new learning center features the “Rookies Corner” with content editorial@futuresandoptionstrader.com. Publication is not guaranteed.
Exercise: To exchange an option for the underlying Put option: An option that gives the owner the right, but
instrument. not the obligation, to sell a stock (or futures contract) at a
fixed price.
Expiration: The last day on which an option can be exer-
cised and exchanged for the underlying instrument (usual- Put ratio backspread: A bearish ratio spread that con-
ly the last trading day or one day after). tains more long puts than short ones. The short strikes are
closer to the money and the long strikes are further from the
In the money (ITM): A call option with a strike price money.
below the price of the underlying instrument, or a put For example, if a stock trades at $50, you could sell one
option with a strike price above the underlying instru- $45 put and buy two $40 puts in the same expiration month.
ment’s price. If the stock drops, the short $45 put might move into the
money, but the long lower-strike puts will hedge some (or
Intrinsic value: The difference between the strike price all) of those losses. If the stock drops well below $40, poten-
of an in-the-money option and the underlying asset price. A tial gains are unlimited until it reaches zero.
call option with a strike price of 22 has 2 points of intrinsic
value if the underlying market is trading at 24. Put spreads: Vertical spreads with puts sharing the same
expiration date but different strike prices. A bull put spread
Naked option: A position that involves selling an unpro- contains short, higher-strike puts and long, lower-strike
tected call or put that has a large or unlimited amount of puts. A bear put spread is structured differently: Its long
risk. If you sell a call, for example, you are obligated to sell puts have higher strikes than the short puts.
the underlying instrument at the call’s strike price, which
might be below the market’s value, triggering a loss. If you Simple moving average: A simple moving average
sell a put, for example, you are obligated to buy the under- (SMA) is the average price of a stock, future, or other mar-
lying instrument at the put’s strike price, which may be well ket over a certain time period. A five-day SMA is the sum of
above the market, also causing a loss. the five most recent closing prices divided by five, which
Given its risk, selling naked options is only for advanced means each day’s price is equally weighted in the calcula-
options traders, and newer traders aren’t usually allowed tion.
by their brokers to trade such strategies.
Stochastic oscillator: A technical tool designed to
Naked (uncovered) puts: Selling put options to collect highlight shorter-term momentum and “overbought” and
premium that contains risk. If the market drops below the “oversold” levels (points at which a price move has, theo-
short put’s strike price, the holder may exercise it, requiring retically at least, temporarily exhausted itself and is ripe for
you to buy stock at the strike price (i.e., above the market). a correction or reversal).
Calculation: The stochastic oscillator consists of two
Near the money: An option whose strike price is close lines: %K and a moving average of %K called %D. The basic
to the underlying market’s price. stochastic calculation compares the most recent close to the
price range (high of the range - low of the range) over a par-
Open interest: The number of options that have not ticular period.
been exercised in a specific contract that has not yet expired. For example, a 10-day stochastic calculation (%K) would
be the difference between today’s close and the lowest low
Out of the money (OTM): A call option with a strike of the last 10 days divided by the difference between the
price above the price of the underlying instrument, or a put highest high and the lowest low of the last 10 days; the
option with a strike price below the underlying instru- result is multiplied by 100. The formula is:
ment’s price. %K = 100*{(Ct-Ln)/(Hn-Ln)}
where
Parity: An option trading at its intrinsic value. Ct is today’s closing price
Hn is the highest price of the most recent n days (the
Physical delivery: The process of exchanging a physical default value is five days)
commodity (and making and taking payment) as a result of Ln is the lowest price of the most recent n days
the execution of a futures contract. Although 98 percent of
all futures contracts are not delivered, there are market par- The second line, %D, is a three-period simple moving
ticipants who do take delivery of physically settled con- continued on p. 42
average of %K. The resulting indicator fluctuates between 0 eral price levels rather than precise prices. For example, if a
and 100. stock makes a low of 52.15, rallies slightly, then declines
Fast vs. slow: This formula is sometimes referred to as again to 52.15, then rallies again, a subsequent move down
“fast” stochastics. Because it is very volatile, an additional- to 52 does not violate the “support level” of 52.15. In this
ly smoothed version of the indicator –– where the original case, the fact that the stock retraced once to the exact price
%D line becomes a new %K line and a three-period average level it had established before is more of a coincidence than
of this line becomes the new %D line –– is more commonly anything else.
used (and referred to as “slow” stochastics, or simply “sto-
chastics”). Time decay: The tendency of time value to decrease at an
Any of the parameters –– either the number of periods accelerated rate as an option approaches expiration.
used in the basic calculation or the length of the moving
averages used to smooth the %K and %D lines –– can be Time spread: Any type of spread that contains short
adjusted to make the indicator more or less sensitive to near-term options and long options that expire later. Both
price action. options can share a strike price (calendar spread) or have
Horizontal lines are used to mark overbought and over- different strikes (diagonal spread).
sold stochastic readings. These levels are discretionary;
readings of 80 and 20 or 70 and 30 are common, but differ- Time value (premium): The amount of an option’s
ent market conditions and indicator lengths will dictate dif- value that is a function of the time remaining until expira-
ferent levels. tion. As expiration approaches, time value decreases at an
accelerated rate, a phenomenon known as “time decay.”
Straddle: A non-directional option spread that typically
consists of an at-the-money call and at-the-money put with Vertical spread: A position consisting of options with
the same expiration. For example, with the underlying the same expiration date but different strike prices (e.g., a
instrument trading at 25, a standard long straddle would September 40 call option and a September 50 call option).
consist of buying a 25 call and a 25 put. Long straddles are
designed to profit from an increase in volatility; short strad- VIX: The Volatility Index (VIX) measures the implied
dles are intended to capitalize on declining volatility. The volatility of S&P 500 index options traded on the Chicago
strangle is a related strategy. Board Option Exchange (CBOE). The VIX is designed to
reflect the market expectation of near-term (in this case, 30-
Strangle: A non-directional option spread that consists of day) volatility and is a commonly referenced gauge of the
an out-of-the-money call and out-of-the-money put with stock market’s “fear level.”
the same expiration. For example, with the underlying The original VIX, launched in 1990, was derived from
instrument trading at 25, a long strangle could consist of eight near-term at-the-money S&P 100 (OEX) options (calls
buying a 27.5 call and a 22.5 put. Long strangles are and puts) using the Black-Scholes options pricing model.
designed to profit from an increase in volatility; short stran- The VIX underwent a major transformation in late 2003.
gles are intended to capitalize on declining volatility. The The current index is derived from both at-the-money and
straddle is a related strategy. out-of-the-money S&P 500 (SPX) calls and puts to make the
index better represent the full range of volatility. At the
Strike (“exercise”) price: The price at which an under- same time the CBOE applied the new calculation method to
lying instrument is exchanged upon exercise of an option. the CBOE NDX Volatility Index (VXN), which reflects the
volatility of the Nasdaq 100 index.
Support and resistance: Support is a price level that The exchange still publishes the original VIX calculation,
acts as a “floor,” preventing prices from dropping below which can be found under the ticker symbol VXO. Figure 1
that level. Resistance is the opposite: a price level that acts shows both indices: the VXO from May 19, 1993 to Sept 19,
as a “ceiling;” a barrier that prevents prices from rising 2003 and the new VIX over the next four years.
higher. For more information about the VIX and its calculation,
Support and resistance levels are a natural outgrowth of visit http://www.cboe.com/vix.
the interaction of supply and demand in any market. For
example, increased demand for a stock will cause its price Volatility: The level of price movement in a market.
to rise, creating an uptrend. But when price has risen to a Historical (“statistical”) volatility measures the price fluctu-
certain level, traders and investors will take profits and ations (usually calculated as the standard deviation of clos-
short sellers will come into the market, creating “resistance” ing prices) over a certain time period — e.g., the past 20
to further price increases. Price may retreat from and days. Implied volatility is the current market estimate of
advance to this resistance level many times, sometimes future volatility as reflected in the level of option premi-
eventually breaking through it and continuing the previous ums. The higher the implied volatility, the higher the option
trend, other times reversing completely. premium.
Support and resistance should be thought of more as gen-
TRADE
RESULT