TA vs. Modern Portfolio Theory Live it UP!

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VOLUME 10, NO. 3 | MARCH 2011
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Let’s Celebrate!
turns 10 this year, and March is the one-year
anniversary of our all-electronic magazine!

In thanks >> SFO’s success would not be possible

without our readers.
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a free e-book to each of you!

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 CONTENTS
OPTIONS SPOTLIGHT
42 TIME FOR A NEW INDICATOR: 23 CLOSET HEDGING
OPTION PRICE VARIANCE By Matt Blackman
By Jeff Augen

32
Room for Improvement INTERVIEW
Adjusting the Butterfly
19 ALTERNATIVE APPROACH PAYS
OFF FOR BOX AND TRADERS
By Mark By Heather Larson-Blakestad
Sebastian

FEATURES
60 BREAK OUT

The Big Picture:
WITH OPTIONS
By Dan Passarelli THE MAIN EVENT:
Big Green Should T.A. vs. Modern 77
HIGHWiden Its View
52 STRUGGLING WITH Portfolio Theory
VOLATILITY?
By Phil Flynn
38 By Michael Kahn, CMT
By Paul Kavanaugh

DEPARTMENTS 69 TRADE THE PATH LESS TRAVELED

6 EDITOR’S NOTE
8 BOOK REVIEW
11 ASK DR. DUKE
12 EYE ON FUTURES
14 TECHNICAL STRATEGY
16 TRADE OF THE MONTH
98 THE LAST WORD
By Clem Chambers
85 RATES OF INTEREST
By Howard L. Simons
93 BOOK EXCERPT: LIVE IT UP! BUT
DON’T OUTLIVE YOUR INCOME
By Scott Harstad
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500 stock or options trades (plus 75¢ per options contract). Account must be funded within 60 days of account open. Credits for cash or securities will be made based on deposits of new funds
or securities from external accounts made within 45 days of account open, as follows: $250,000 or more will receive $500; $100,000-$249,999 will receive $250; $50,000-$99,999 will receive
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discussed therein or to engage in any specific investment activity.
Securities products and services are offered by E*TRADE Securities LLC, Member FINRA/SIPC.
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EDITOR’S NOTE
A GOOD YEAR
I know this is cliché, but boy,
does time fly! Can it really be a
year since SFO converted to an
all-digital publication?
I have to admit that with the
first digital edition, everyone on
our team was still adjusting to
the new format, trying to reframe
how we think about content that
is not static but dynamic and
limited only by our imaginations.
We have definitely come a long
way since last March.
I am proud of the SFO team’s
ability to embrace the new
medium and go for the gusto,
trying something new with each
edition, improving readability,
enhancing subscriber engage-
ment and expanding coverage.
This month, I am happy to
announce the launch of SFO’s
mobile-friendly website—anoth-
er tweak to make SFO easier for
you to access on the go.
THANK YOU
Also, I am grateful for our loyal
readers who have hung with
us after the conversion. It is not
easy to see a favorite periodical
change so drastically.
6 MARCH 2011
And I am thankful for our new
subscribers, several of whom
have joined us because SFO
is electronic. Many of you live
outside of the United States. One
of the greatest benefits to SFO’s
digital format is that we can dis-
tribute to anyone with an e-mail
address, no matter where he or
she is physically located. The
high cost of international post-
age prohibited us from reaching
such a wide audience before.
OUR GIFT TO YOU
In celebration of SFO’s first
electronic year and in thanks
for your continued support, we
are giving you the e-book SFO
Personal Investor Series: Psy-
chology of Trading. Enjoy!
Heather Larson-Blakestad,
executive editor
PUBLISHER
Wasendorf & Associates Inc.
Russell R. Wasendorf Sr., Chairman and CEO
Karris Golden, President and COO
P.O. Box 849 • Cedar Falls, IA 50613
EDITORIAL
EXECUTIVE EDITOR: Heather Larson-Blakestad
MANAGING EDITOR: Kira McCaffrey Brecht
ASSOCIATE EDITOR: Meghan Pedersen
EDITORIAL ASSISTANT: Erin Holmes
CONTRIBUTING WRITERS
PRODUCTION
CREATIVE DIRECTOR: Sara Kies
DESIGNER: Sarah Judisch
DESIGNER: Samantha Schmiesing
WEB DEVELOPER: Jeff Kennedy
CONTACT SFO
Customer Service: 800.590.0919
SUBSCRIBE TO SFO
ADVERTISE WITH SFO
Stephanie Rottinghaus: 319.553.2100
Copyright 2011 by Wasendorf & Associates Inc. All rights reserved.
No part of this publication may be reproduced or transmitted in any
form by any means, electronic or mechanical including photocopying,
recording or by any informative storage and retrieval system without the
written permission of Wasendorf & Associates Inc.’s president.
This publication is strictly the opinion and conjecture of its writers
and is intended solely for informative and educational purposes and
is not to be construed, under any circumstances, by implication or
otherwise, as an offer to sell or a solicitation to buy or trade in any
commodities or securities herein named. This publication is not meant
to recommend, promote or in any way imply the effectiveness of any
trading system, strategy or approach. Information is obtained from
sources believed to be reliable, but is in no way guaranteed. Further,
there is no guarantee of any kind that is implied or possible
where projections of future conditions are attempted.
The publisher is not liable for typographical errors.
Commodity futures, securities, options and forex trading involve risk
and are not suitable investments for everyone. Any investment should
be carefully considered in light of an investor’s personal financial
objectives and risk tolerance.
Articles and/or advertisements contained herein may provide
hypothetical or simulated performance results. Hypothetical or
simulated performance results have certain inherent limitations. Unlike
an actual performance record, simulated results do not represent
actual trading. Also, because the trades have not actually been executed,
the results may have over- or undercompensated for the impact, if any,
of certain market factors such as the lack of liquidity. Simulated trading
programs are also subject to the fact that they are designed with the benefit
of hindsight. No representation is being made that any account
will or is likely to achieve profits or losses similar to those shown.
Further, past performance does not guarantee future results.
Traders shoul d uTi l i z e o n ly Th e
very B es T in Te c h n o l o g y.
I built PFGBEST to be a different type of trading company. Traders should utilize only the very
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T h e r e i s a s u b s t a n t i a l r i s k o f l o s s i n t r a d i n g c o m m o d i t y f u t u r e s , o p t i ons and off-exchange
f o r e i g n c u r r e n c y p r o d u c t s . P a s t p e r f o r m a n c e i s n o t i n d i c ative of future results.
 BOOK REVIEW
KNOW market direction. To arrive at
such forecasts, traders require
SOMETHING the technical analysis tools
$5500
BUY NOW!
By John A. Sarkett Fullman provides in the book.
In the 1840s the Know Nothing The chapters cover topics such
political party emerged.Today’s as reasons for technical analysis,
options markets include parti- TA basics, trends, patterns, oscil-
sans that could go by the same lators, and when to invest and
name—the delta-neutral crowd. trade. Such information is crucial prices, or if that does not occur,
Because they “know nothing” for the options trader, whatever to boost returns accordingly.
about the direction of the market, his or her political stripe. Even This is not a secret strategy. It is
they routinely use strategies some of the most stalwart op- widely presented but less widely
counting on no movement, such tions know-nothings gravitate to employed than it should be.
as condors, butterflies and cal- technical analysis in time. The book is not get-rich-quick
endars, and make money from I appreciate Fullman’s dis- material. It presents the reader
options decay. cussion of combos: buy quarter with basic blocking and tack-
In Increasing Alpha with Op- allotments of stock (e.g., if you ling skills and proper tech-
tions, Scott H. Fullman takes a ultimately want 400 shares, niques so traders do not hurt
different approach that harks buy 100) and sell a quarter themselves or their capital.
back to when an options strate- allotment of puts to acquire This is how Super Bowl
gist needed an opinion about the same stock at even lower games are won. The winning
team does the basics better
TURBULENT REVIEW —By John A. Sarkett than anyone else, shows up
ready to play and especially
Larry Shover’s Trading Options in Turbulent Markets offers stays off the injured reserve.
useful insights on:
• A quick way to measure the market’s view of a stock’s likely
John A. Sarkett is creator of
trading range between now and expiration.
Option Wizard® and author of
• The reset collar and using additional put credit spreads to
Extraordinary Comebacks: 201
finance it. (This alone may be worth the price of the book.)
Inspiring Stories of Courage,
• The inconstancy of volatility. As a friend and expert in the
Triumph, and Success.
options business puts it, “Theta is not linear!”
However, the book did have room for improvement. For one,
I would have liked to see more actionable strategies for vola-
tile markets, especially those of the low-risk, high-return variety.
Perhaps the author will treat us to these in a second volume.
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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.
 ASK DR. DUKE
DEAR DR. DUKE,
Do you agree that opening
a credit spread 45 days prior
to expiration increases the
risk in the trade as compared
to entering it 20 to 30 days
before expiration?
I realize that risk management
is important. I always use a con-
tingency order to close my short
leg position when the stock
price rises above the strike price
in a bear call spread. I control
risk by selecting a premium as
far out of the money as I can
go that will return 7% to 10%. I
trade for monthly income out of
my IRA account. Year to date, I
am in the black.
—Dan, Dayton, Ohio
FREE WEBINAR!
Want more from Given? Sign
up for his webinar on March
8 at 3:30 p.m. CT.
REGISTER NOW!
DEAR DAN,
The answer depends on the
criteria I use to choose the
strike prices. If I position my
credit spread one standard
deviation out of the money
at 45 days and compare that
position to a credit spread
positioned at one standard de-
viation out of the money at 30
days, I will see that the 45-day
spread and the 30-day spread
will have nearly identical prob-
abilities of success (or nearly
identical levels of risk).
The credits received for the
two spreads will be similar, so
the maximum profitability will
also be comparable.
The spreads positioned at 45
days may be farther OTM in an
absolute dollar sense, but the
probability of the index or stock
price reaching the spread is the
same as for the 30-day spread,
even though the 30-day spread
is positioned closer to the price
of the underlying stock.
If I use probability distribu-
tion calculations to position my
spreads, then the risk will be
identical regardless of the time
remaining to expiration.
The Official Advocate for Personal Investing
Q&A
If I always position my credit
spread a fixed dollar amount
OTM (e.g., if I sell the call
spread $10 above the stock
price), then I will observe two
principal differences if I initiate
the position 45 days versus 30
days to expiration.
First, the credit will be larger
for the 45-day spread, so the
maximum potential return will
also be larger.
Second, the probability of
success will be smaller for the
45-day spread, or put another
way, the risk of the 45-day
spread will be higher.
You point this out in your
note, and you are absolutely
correct. It sounds like you are
managing risk well and have
been achieving good results.
Keep up the good work.
Kerry W. Given,
Ph.D. (a.k.a. Dr.
Duke), is the
founder and
managing direc-
tor of Parkwood Capital LLC and the
author of No Hype Options Trading.
11
EYE ON FUTURES
KNOW YOUR
MARGIN
By Curt Wagaman
Defining “margin” depends on its
context—profit margin, margin of
error, a document’s margin—but
here I focus on how it relates to a
futures contract.
MARGIN OF DIFFERENCE
A distinct difference exists be-
tween margin in securities and
margin in futures trading.
In securities, margin is money
borrowed to purchase shares:
buying on margin.
With futures, margin sim-
ply represents the amount of
capital or acceptable collateral
required to initiate and main-
tain a trade. Once you offset a
position, the margin is available
again for trading.
Exchanges set the minimum
margin levels for their futures
contracts. Futures commis-
sion merchants (brokers)
require margin from traders;
clearing members require
margin from brokers, and
clearinghouses require mar-
gin from clearing members.
12 MARCH 2011
Margin breaks down further.
Exchanges set two types: initial
and maintenance.
Initial margin is the amount
needed to initiate a position.
Maintenance margin denotes
how much must be preserved
in an account to hold the posi-
tion each day thereafter.
For example, initial margin
for trading one corn contract is
$2,025, and the maintenance
margin is $1,500. If you do not
meet these conditions, your
broker must take action (more
about that later).
BACK TO LEVERAGE
Within the futures markets,
margin inextricably relates
to leverage. But leverage is a
double-edged sword, allowing
you to control a large contract
value with a relatively small
amount of money.
The total value of a corn
contract (5,000 bushels) is
$32,500 if corn trades at
$6.50 per bushel. By taking
the margin required and divid-
ing it into the total contract
value, you find the percent
margin required: approximately
The Official Advocate for Personal Investing
6%. The leverage offered in
corn futures in this example is
roughly 17-to-1 (100 ÷ 6).
ON CALL
If you do not meet your margin
requirements, you will receive
what is known as a margin call.
Should this happen, you have
three choices:
1. Liquidate your position.
2. Lighten your position to
alleviate the call if your are
trading multiple contracts.
3. Deposit additional funds to
your trading account to re-
turn the balance to the initial
margin level or higher.
If the market were to move
drastically against you, a broker-
age has the right to liquidate your
position at its discretion.
Therefore, being aware of your
margin requirements, account
balance and worst-case scenario
are key to staying in the game.
Curt Wagaman is an instructor
and professional trading mentor
for the Futures Training Division
of PFGBEST.
 LIVE WEBINARS!
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There is a substantial risk of loss in trading commodity futures, options and off-ex-
change foreign currency products. Past performance is not indicative of future results.
Dates and times are subject to change—Please visit www.pfgbest.com/webseminar for
further details and up-to-date information!
 TECHNICAL STRATEGY
BREAKOUT
CONFIRMATION
FILTER
By James A. Hyerczyk
Two of the most powerful
day-trading strategies are
the “opening price breakout”
and the “first hour break-
out.” Because of uncertainty
about the market’s direction,
traders often wait until the
first hour’s range is created
before committing to either
side of the market.
The occasional false break-
out when using either entry
methodology makes it neces-
sary to combine the two sepa-
rate techniques into one more
powerful indicator.
If you notice how many
times a market crosses above
and below the opening price
FREE
Learn more about this strategy
during James Hyerczyk’s SFO
Author Series webinar, March 29
WEBINAR at 3:30 p.m. Register now!
14 MARCH 2011
before finally settling on a di-
rection, you realize the neces-
sity of a breakout confirmation
filter. In this case, it is the high
for the first hour.
SETUP
This strategy combines key
features of these two tradi-
tional breakout methods.
If the main trend is up, then
the strategy will be to enter a
long position in the direction
of the trend when the market
breaks out above both the
opening price and the first
hour’s high.
Experience has shown that
the narrower the spread be-
tween the opening price and
the first hour’s high, the better.
If the spread between the
opening and the high is too
wide, then scalpers will likely
exit on the first test of the high
price because they will read
this level as resistance. This can
cause a whipsaw swing.
The initial analysis for this
trading strategy is to compile a
list of markets that are trad-
ing below the open and have
narrow spreads between the
opening price and the first
hour’s high. Also because of
24-hour trading, you have to
hone in on the opening price
you prefer to use.
GETTING IN
Breakout strategies are usu-
ally entered on stop orders in
the direction of the move.
When trying to catch an
intraday trend trade, you may
have to allow for a retracement
to the breakout level in accor-
dance with the old saying,
“Old tops tend to become
new bottoms.”
Watch for markets that may
be gaining upside momentum
shortly before the turn of the
first hour. These candidates
may allow you to hit the
ground running.
I also suggest that you
watch volume. Markets trad-
 FIGURE 1: 5-minute March 2011 E-mini S&P 500 Prices

[1,235.25] [1,235.25]

1st Hour High

[1,233.25] [1,233.25]
[1,232]

[1,231]

Opening Price
1,231.25

[1,229]

[1,227.25]

12/10 9:00 9:30 10:00 10:30 11:00 11:30 12:00 12:30 13:00 13:30 14:00 14:30 15:00 12/13

Source: TradeStation

ing under compressed vol-
ume may be getting ready to
expand on the breakout.
GETTING OUT
Remember that when apply-
ing this entry strategy, some
traders will be in for a short
scalp and others will be trad-
ing for a continuation move
under the assumption that the
day will be a trend day. If you
are treating the breakout as a
momentum trade, then move
stops to the breakeven point
as soon as possible.
Other possible exit strate-
gies include setting specific
price targets or using swing
chart theory to stop out the
position when the intraday
trend has changed.
James A. Hyerczyk is an educa-
tor and publisher of The Forex
Pattern Price & Time Report
and The Futures Pattern Price &
Time Report.

The Official Advocate for Personal Investing 15

TRADE OF THE MONTH
DIVIDENDS FIGURE 1: A Lost Decade for Bristol-Myers Squibb

SHINE
By Charles Lewis Sizemore, CFA Stock Dividend
$45 0.33
BMY trades for barely half the price of the late 1990s
0.32
$40 while dividends have increased 35%
It may sound a little counterin- $35
0.31

0.30
tuitive, but I find it much easier
$30 0.29
to make money in a crisis than
$25 0.28
in a stable market. 0.27
$20
As a contrarian investor, I love 0.26
a good panic. If you are able to $15
0.25

keep a cool head—which is far $10 0.24

from easy when everyone around
you is in a state of panic—you
can bet against the crowd and
make an absolute killing.
It is during those boring,
business-as-usual markets that
it is harder to stand apart.
That is where we are today.
The market is not expensive, per
se, but it is far from cheap. And
though the average investor
is not euphoric, as in the late
1990s, there is no sign of the
fear that prevailed in late 2008.
This is very much a boring,
complacent market with few
wildly compelling buys.
DIVIDENDS MATTER
In this kind of market—in
which stocks are likely to go
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
sideways—income is your
best bet. In a trendless market,
you can manufacture decent
returns by investing for yield
and reinvesting the dividends.
Should fear and volatility
return, the dividend yield acts
as a backstop. And should the
market rally, you are likely to
participate in at least most of
the upside.
THE TRADE
Buy shares of Bristol-Myers
Squibb (BMY), the pharma-
ceutical giant. BMY’s shares
have been dead money for
the past decade, but over
Source: Yahoo! Finance
that period, the dividend has
risen by 35%.
Should the market go flat
for the next one to two years,
BMY’s cheap valuation and
high dividend should make it
an outperformer. Enjoy a fat
5.1% dividend and the pos-
sibility of 10% to 20% capital
gains as investors look for
return in an otherwise lacklus-
ter market.
Charles Sizemore is editor of
The Sizemore Investment Letter.

16 MARCH 2011
 ThE DATA
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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.
BOX Options is Going Green!
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Alternative
Approach
Pays Off for
BOX & Traders
By Heather Larson-Blakestad

Tony McCormick,
CEO of BOX
Options Exchange
 In seven years, Boston Options Exchange
Group LLC has delivered $337 million of
savings to its customers through its price
improvement auction (PIP) versus the
prevailing national best bid and offer for
contracts. In January 2011 alone, the sav-
ings equaled $8.7 million for an average
$1.12 price improvement per contract.
With numbers like that, it is no wonder
that BOX’s overall average daily trading
volume increased 85% in January from
a year ago. And it is a testament to the
exchange’s novel market model:
THE INTERVIEW
1. What are the key characteristics
that set BOX apart from other options
exchanges, and why are they important
to the retail trader?
2. What are the major issues facing
options exchanges this year, and how is
BOX prepared to handle them?
3. As partially owned by TMX Group, how
would the merger with LSE affect BOX?
What does BOX bring to the merger?
• Competing market makers (no desig-
nated specialists)
• Price-time order matching (rewards the
liquidity taker)
• Price improvement period auction
• Low access and operating costs
• Transparency and anonymity
• Equal access
This alternative to traditional options
exchanges is clearly gaining momentum.
As such, SFO turns to Tony McCormick,
BOX CEO, to learn more about what is in
store for the options markets in 2011.
4a. Where do you see growth potential
for retail options trading? How do you
plan to tap into that?
4b. Do you think this is being driven
by the advisers themselves or their
customers?
5. What other areas is BOX courting to
grow its volume? Why?
6. BOX is working on setting up its own
self-regulatory organization. Why is that
important, and when do you think it will
launch?
 GET TO KNOW MCCORMICK
Tony McCormick has been on the job as chief executive officer at Boston
Options Exchange since October 2009. In that time, he has led the ex-
change through a change of its business model and realignment of its
strategy, which included technological improvements.
Prior to joining BOX, McCormick managed Charles Schwab & Co.’s trade
execution quality group and extensive business relationships. While there,
he also was a member of the Options Steering Committee and chaired the
company’s Order Routing Committee.
For 12 years before working at Schwab, McCormick served Harris Futures
Corporation in several leadership positions, including CEO from 1993-’97.

7. Speed of trade execution seems 10. BOX is part of a group of exchanges

almost unbelievable now—less than one
millisecond for BOX. Have exchanges
exhausted the amount of edge that can
be gained by speed?
developing a test (Series 56) that
proprietary traders would be required to
pass before they could execute trades.
What are the exchanges’ objectives for
the test?

8. Where is the next area where

exchanges and traders can find an 11. Would you recommend that individual
advantage? retail traders take the test? Why?

9. In the U.S., options exchanges seem 12. Where will the options market find its
to be popping up like spring flowers. next great innovation?
Why do you think this is, and are there
enough participants to support so many
of them?
 EASIER than you think.

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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.
 FIGURE 1: Weekly U.S. Dollar Value Priced in Gold Like Icarus, gold took flight
over the last decade and
has reached new heights.
0.44
0.42
0.40
Its meteoric 450% rise
0.38
0.36
since 2001 has prompted
pundits to declare the
0.34
0.32
0.30
0.28 metal in bubble territory.
0.26
0.24
0.22
This is in stark contrast to
0.20
0.18
the Dow Jones Industrial
Average, which had been
0.16
0.14
0.12
0.10 essentially flat, and the
0.08
-87 0.06
0.04
S&P 500 Index’s 18% drop
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
since 2000 (to Dec. 31,
2010) in dollar terms.
A deadly cocktail of loose monetary policy and aggressive dollar creation
efforts in response to tough economic times have taken their toll on the buying
power of the dollar. CRASH AHEAD?
Source: GenesisFT.com
Has gold flown too far,
too fast, and like Icarus,
now doomed to crash
FIGURE 2: Weekly Relative Strength of Gold to Copper
back to earth?
Any gold discussion
7.0 demands a closer look at
6.5 the U.S. dollar because it
6.0
is the flip side of the story.
Gold Overvalued versus Copper 5.5

During the past 10 years,

5.0

4.5
the dollar has experi-
4.0 enced a punishing bear
3.5
market when priced in
gold, dropping more than
3.0

2.5
Gold Undervalued versus Copper
2.0
87% since 2000 (see Fig-
1.5 ure 1). This compares to
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2003 2003 2004 2005 2006 2007 2008 2009 2010 2011

a real drop of nearly 85%

When it is high, gold is expensive relative to copper and when it is low, copper for the Dow and 84% for
is expensive relative to gold. Currently, gold is certainly not expensive relative to the S&P 500 when priced
copper. When the ratio is falling, gold is dropping relative to copper.
in gold, adding strength to
Source: GenesisFT.com
the gold bubble argument.

24 MARCH 2011
 So is a weakening dollar
the power behind gold?
To answer that, we must
consider gold from a non-
dollar perspective.
GOLDEN PERSPECTIVES
Copper has often been re-
ferred to as “Doctor Cop-
per” due to its history as a
useful measure of relative
economic strength. Ris-
ing prices show increas-
ing economic demand for
copper-based components
used in construction and
other growth industries.
Much of the current de-
mand for copper comes
from China and other
emerging markets. Gold
and copper also have an
interesting relationship.
As Figure 2 shows, at
a current gold-to-copper
ratio of 3.18, gold is well
below its historical long-
term average of 3.8 rela-
tive to copper. So what-
ever force is driving gold
is also driving copper.
However, an even more
important economic com-
modity is oil. The key
takeaway is that as Fig-
ure 3 shows, at 15.54, the
FIGURE 3: Gold-to-Crude Oil Ratio
1989 1990 1991 1992 1993
Gold is not expensive when compared to the price of oil. When the ratio is
rising, gold is strengthening relative to oil.
ratio of gold to oil is below
its 27-year average (15.86)
and below the mid-point
(horizontal blue line).
Gold is certainly not soar-
ing when priced in oil.
ELSEWHERE
Other precious and in-
dustrial metals, as well
as raw materials such as
rubber and cotton, have
also gained in recent
years. Between Decem-
ber 2008 when the com-
modity rally began and
Dec. 31, 2010, the basket
of futures represented by
the Commodity Research
26
24
22
20
18
16
14
12
10
8
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Source: GenesisFT.com
Bureau Index (CRB) has
soared more than 90%.
U.S. food prices are at five-
year highs and food infla-
tion in China has become a
real problem. The U.N. Food
Price Index hit a record
level in December surpass-
ing its previous high in June
2008, which sparked riots in
Haiti and elsewhere.
Notable exceptions to
this trend include feeder
cattle, lean hogs, lumber
and natural gas, which
are priced near or below
where they were in 2000.
If any metals are in bub-
ble territory, they are pal-
The Official Advocate for Personal Investing 25
 IT’S TIME TO GO
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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products.

Precious metals markets are highly volatile and have wide swings on a daily basis and should be considered a high risk investment.
 FIGURE 4: Gold Futures January 1990-December 2009
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
-0.5%
-1.0%
-1.5% Jan Feb Mar Apr
ladium and silver, which
have become downright
expensive relative to oil.
But despite strong de-
mand, gold has remained
fairly valued compared to
oil and other metals and
key commodities.
GLITTER SEASON
A carefully planned gold
currency hedge strat-
egy is not foolproof and,
therefore, is no guarantee
against gold price cor-
rections. During the first
week of January, gold and
silver prices suffered their
most serious daily drops in
a number of months. Not
only had some metals be-
May Jun Jul Aug Sep Oct Nov
Source: EquityClock.com
come expensive, but prices
had become overbought, so
a correction was overdue.
All commodities expe-
rience seasonal cycles,
and gold is no exception.
As Figure 4 shows, gold
has exhibited seasonal
fluctuations during the
past two decades. Gold is
typically weak during the
first two weeks of Janu-
ary, peaks in mid-Febru-
ary, then see-saws lower
to mid-September. The
fourth quarter is typi-
cally the strongest for the
precious metal thanks
in large part to seasonal
year-end jewelry demand
around the world.
Last year was good to
gold even after the signifi-
cant correction from early
December to the begin-
ning of February. With the
exception of another cor-
rection in July, gold rallied
for the rest of 2010, gaining
more than 29% on the year.
FIAT-PAPER PUT
For many, gold has become
a safe haven in the face of
Dec
unprecedented govern-
ment spending, loose mon-
etary policy and record
debt levels. Certainly, it is
a better option than Trea-
sury bonds if yields (inter-
est rates) continue to rise.
Taking a cue from Wall
Street, governments have
come up with novel poli-
cies in an attempt to solve
their debt dilemmas. But in
the final analysis, they are
simply doing more of what
got the economy into trou-
ble in the first place: creat-
ing more debt to solve debt
problems. These actions to
kick vthe debt can down
Main Street are both short-
term and unsustainable.
Never before has a civi-
lization printed its way to
The Official Advocate for Personal Investing 27
economic prosperity. Debt HISTORY SHOWS been kind to economies
levels continue to soar, and Since the dawn of fiat employing currencies
rising commodity inflation paper money during the backed only by the faith
is just one unpleasant side Song Dynasty China (11th and credit of governments.
effect of this strategy. century), history has not It is not a matter of if but
when hyperinflation takes
hold. Economic collapse

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GOLDEN CAVEATS
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Futures trading involves risk of loss. Only risk capital should be used.
Two situations could stop
the gold rally dead in its

28 MARCH 2011
tracks. The first would be
a concerted effort to cut
government spending and
money creation, followed
by a return to some form
of gold or finite commodi-
ty standard. It would push
currency values higher.
But this approach would
be neither politically nor
economically popular,
especially given current
debt, unemployment and
export levels.
Second, a deflationary
spiral triggering a real
money supply decline
could put a big crimp in the
gold rally. So far, Ameri-
cans have only experi-
enced stagflation (rising
costs of living combined
with slow economic growth
and high unemployment).
Serious deflation has
so far been limited to a
nightmare scenario in the
minds of central bankers.
But if it were to become
reality, it would con-
demn the U.S. to a new
and more severe round
of economic contractions,
possibly driving com-
modity prices, including
gold, lower.
UNLIKELY SCENARIOS
Neither situation seems
realistic any time soon
given the current political
sentiment and helicopter
monetary policies. If there
is any long-term politi-
cal plan in effect, it is the
hope that the latest $600
billion stimulus plan will
succeed where past plans
have failed and the econ-
omy will eventually mend.
Central banks will then
be able to curtail quanti-
tative easing and reduce
money supply to contain
inflation. We could then
all live happily ever after.
But this Goldilocks
scenario also assumes
that interest rates remain
stable and total credit
market debt in the U.S.,
currently moving higher
than $55.5 trillion (more
than $680,000 per U.S.
family according to US-
DebtClock.org) miracu-
lously declines.
SEASONAL SETBACKS
Unfortunately, like all
good fairy tales found in
optimistic central bank
forecasts, it may allow
The Official Advocate for Personal Investing
policymakers to sleep bet-
ter but has a snowball’s
chance on the floor of the
NYSE of becoming real-
ity. In the meantime, gold
will undoubtedly suffer
setbacks that based on
seasonality are likely to
come between January
and September.
Between 1975 (four years
after the U.S. officially quit
the gold standard) and
2010, gold has averaged
a gain of 9.4% per year;
certainly not a ringing
endorsement of the abil-
ity of the government and
central bank to safeguard
the dollar. And based on
recent performance, this
stewardship has become
even less stalwart.
So unless there is a dra-
matic change in monetary
policy and political will
combined with a sus-
tained strengthening of
the dollar, the longer-term
outlook for gold should
continue to be bright.
Matt Blackman is a full-time
financial writer and trader.
29
 Better answers.
Longer hours.
Richer experience.

More Personal.

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 PFGBEST knows that people can definitely tell the difference between quality customer service and
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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.
 Room for Improvement

Adjusting the Butterf

One of my favorite income trades is the but-
terfly options spread. It can make money over
a short period in calm markets, while limiting
market exposure. It is one of the most com-
mon trades for income traders and a strategy I
strongly focus on when teaching my students
at Option Pit.

By Mark Sebastian

32 MARCH 2011
fly

The Official Advocate for Personal Investing 33

 Despite the frequency with which it is
used, the butterfly is often traded ineffi-
ciently. The most common reason for this
is that the trader does not truly under-
stand how the spread alters as conditions
in the market change and time passes.
Among most traders, there is also an

Investors & Traders almost universal misunderstanding of

Subscribe FREE to this newsletter series!
theta. One common misconception is that
the exponential decay model applies to
all options; it does not. It only applies to
at-the-money options. Out-of-the money
options actually experience decay closer
to a linear than an exponential rate.

HARVEY’S BUTTERFLY STRATEGY

This knowledge is what got my attention
as I was discussing the merits of con-
verting a butterfly into a condor with my
friend Dr. Dan Harvey. He was explain-
ing a butterfly management strategy that
lets you stay in a butterfly trade over a
longer period than most management
strategies allow—and with less risk.
Because you are in the trade longer,
you are, in theory, able to collect more
time decay, potentially making the trade
and management strategy more profit-
able. Here is an extremely oversimpli-
fied explanation of Harvey’s proposed
management strategy:
Suppose that on Dec. 10, 2010, you sell
a $120-$125-$130 iron butterfly using
options on the SPDR S&P 500 exchange-
traded fund (SPY). Figure 1 shows the
trade at its onset.

34 MARCH 2011
FIGURE 1: Butterfly Position at Onset

Profit/Loss by Change in SPY Common Price

$3,500

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0

$-500

$-1,000

$-1,500

$-2,000
114.90 116.50 118.10 119.70 121.30 122.90 124.50 126.10 127.70 129.30 130.90 132.50 134.10

Source: OV6

FIGURE 2: Butterfly Position after Several Days of Decay

Profit/Loss by Change in SPY Common Price

$3,500

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0

$-500

$-1,000

$-1,500

$-2,000
116.10 117.50 118.90 120.30 121.70 123.10 124.50 125.90 127.30 128.70 130.10 131.50 132.90

Source: OV6

The Official Advocate for Personal Investing 35

More from
SEBASTIAN
Every other week, Mark Sebastian writes
for SFO Daily, taking a look at current
option market conditions and noting a
trade opportunity for the day.
Sign up for the RSS feed or follow
SFO on Twitter or Facebook to receive
alerts when SFO Daily is updated.
By Dec. 20, the position is up more than
10%, or about $330. However, something
else is happening to the position as it
makes money: risk is changing.
The butterfly has experienced a large
increase in gamma. Part of this is caused
because the ATM options are closer to
expiration. However, an even larger
contributor to the gamma spike is the
decreasing price sensitivity of OTM op-
tions—the wings of the iron butterfly—as
they decay toward worthlessness.
By the end of Dec. 20, the $120 puts and
$130 calls are little more than protection
against a massive move in the market.
The combination of less sensitive wings
and a more sensitive “thorax” causes the
profit curve to steepen significantly. The
profit curve in Figure 2 shows how the
position has become more sensitive to
changes in price.
To smooth the profit curve, Harvey
suggests kicking out the body of the but-
36 MARCH 2011
terfly. In this case, you could buy back
the $125 straddle and sell a $122-$128
strangle. This produces a wider profit
and loss area and reduces gamma at a
cost of about two-thirds of the total pre-
mium in the butterfly.
Figure 3 shows that while the current
P&L curve is smoother, the total premi-
um remaining has been slashed.
Two positive points to this manage-
ment strategy are that as time passes,
instead of gamma increasing, it will ac-
tually begin to decline; and the landing
area for SPY is larger.
IMPROVEMENTS
But despite these benefits, I could not
help thinking that there had to be a way
to smooth the curve without giving up
two-thirds of the premium in decay. I
also did not like that if SPY gapped or
ran hard in one direction, I could poten-
tially lose significant capital in the trade.
As I examined the strategy, I realized
that my major issue with the approach
was that the management strategy in-
volves unwinding the ATM options with
exponential decay while selling OTM
options with more linear decay.
I asked Harvey if he had ever consid-
ered kicking in the outer wings and leav-
ing the ATM options alone. As we exam-
ined the trade together, we realized this
approach reduced gamma and flattened
the P&L curve while hanging on to those
options with high exponential decay.
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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. Past performance is not indicative of future results.
 FIGURE 3: Butterfly Converted to a Condor

Profit/Loss by Change in SPY Common Price

$3,500

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0

$-500

$-1,000

$-1,500

$-2,000
116.10 117.50 118.90 120.30 121.70 123.10 124.50 125.90 127.30 128.70 130.10 131.50 132.90

Source: OV6

FIGURE 4: A Reverse Harvey Butterfly Adjustment

Profit/Loss by Change in SPY Common Price

$3,500

$3,000

$2,500

$2,000

$1,500

$1,000

$500

$0

$-500

$-1,000

$-1,500

$-2,000

116.10 117.50 118.90 120.30 121.70 123.10 124.50 125.90 127.30 128.70 130.10 131.50 132.90

Source: OV6

38 MARCH 2011
 To implement this strategy, rather than
buying back the $125 straddle and selling
a wider strangle, you would do the reverse:
Sell out of the $120-$130 strangle and buy
a strangle that was closer to the money—in
this case the $123-$127 strangle.
BENEFITS OF THE ADJUSTMENT
As I stated earlier, one of the major
causes of the profit-and-loss curve’s
steepening is that the out-of-the-money
options lose their Greeks along with
their value. By selling the cheap op-
tions and buying ones that were closer
to the money, you get out of options that
have no true Greeks to them (I call these
cheap insurance options “units”) and
into long options that have true Greek
value. The new position produces a flat-
ter profit and loss curve.
Other advantages also come with the
flatter profit and loss curve. The wing
kick in Figure 4 is extremely aggressive,
but it still retains more premium than
converting a butterfly into an iron con-
dor. The position cuts the Greeks down
aggressively, but most significantly, it
slices the margin to near zero.
This frees up capital, practically en-
sures a profit and allows the trader to
stay in the ‘fly for as long as the SPY
price oscillates around $125. If SPY does
begin to run, there is little chance that
the trade will blow all of the profit.
The Official Advocate for Personal Investing 39
 We were both impressed with this strat-
egy’s performance in various market con-
ditions. Because he is a great sport and the
trade was inspired by doing the reverse
of what Harvey proposed, we decided to
name the adjustment strategy after him.
Thus was born the “reverse Harvey.”
STEP BY STEP
Although it might seem a little com-
plex, the strategy is not that difficult to
employ and can be used by all levels of
traders. Here is the process:
1. Enter the trade.
2. Once the trade has made at least 10%
net of commissions, look at the price
of the winged options. For an underly-
ing such as SPY, if either wing is trad-
ing less than 0.25, the position is prob-
ably able to be “reverse Harveyed.”
3. Sell out of the cheap option and buy
something closer to being at the money.
Try to buy something worth at least
0.5. (The trading price considered to be
a worthless option should be adjusted
based on the value of the underlying se-
curity. For instance, for an options con-
tract on the S&P 500 Index (SPX), which
is 10 times the size of SPY, I would con-
sider 2.5 to be a worthless option.)
4. When determining how far to kick in
the wings, weigh how much premium
you want to keep in the trade versus
how much risk you want to take out
of it. For most traders, it makes more
sense to lean toward reducing risk.
40 MARCH 2011
5. If the trade stays within the butterfly’s
tent, feel free to stay in the trade.
6. If you took a less aggressive approach
when initiating the reverse Harvey,
you may end up making this adjust-
ment more than once.
7. If at any point the trade moves out-
side the tent, it is time to exit the trade.
There is no reason to lose money on a
profitable trade while you hope a stock
will move up or down back into the tent.
8. If the trade hits your profit target, you can
exit, tighten up more (another reverse
Harvey) or some combination of both.
KNOW YOUR OPTIONS
There are many other ways of managing
butterflies, condors, calendars and other
income and nonincome strategies. It is
not through some stroke of brilliance that
this adjustment occurred to me; it was
studying and understanding how options
truly function that led me to it.
By taking the time to learn options
inside and out, you can become a better
manager of your positions. This is the
way I try to teach my students. It is also
why I fully expect one of my pupils to
develop the “reverse Sebastian” some day.
Mark Sebastian is the COO and director of education
for Option Pit and the director of risk for Argyle Man-
agement Group LLC. He also writes the Option Pit Blog.
 something
Big is coming.
can you guess?

here’s a few hints:

1. this new trade expresses simple
yes/no propositions.

2. the contract size is always $100.

3. your maximum risk on a trade is always

known in advance.

4. you can never be called upon for extra

funds or margin.

think you know? tell us.

there is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products.Past performance
is not indicative of future results.
Time for a New Indicator:
OPTION PRICE VARIANCE
Demand for volatility investment products has exploded in recent years. The Chi-
cago Board Options Exchange has responded with a portfolio of indexes that track
volatility of the broad market, gold, currencies and crude oil. The Volatility Index
(VIX) is perhaps the best-known member of this rapidly expanding family that also

By Jeff Augen
includes a variety of fu- Professional traders have tors to buy or sell the S&P
tures and option contracts. focused on this difference 500’s realized volatility
Stock investors who are for several years. over a period of three
unaware of these prod- Their interest stems months (CBOE S&P 500
ucts are blind to the most from the observation that Three-Month Variance
important set of indicators options’ implied volatility Futures were introduced
and trading vehicles in tends to be consistently in June 2004).
the market. larger than the actual More recently, the CBOE
An increasingly popular volatility of the market. decided to extend this
approach to quantify- Not surprisingly, the gap theme with a benchmark
ing market uncertainty tends to widen when the that tracks the perfor-
involves tracking the market becomes unstable. mance of a hypothetical
difference between ac- Activity in this area was volatility arbitrage trading
tual volatility of the S&P strong enough to prompt strategy that capitalizes
500 Index and implied the CBOE Futures Ex- on the difference between
volatility of the options change to introduce a implied volatility of S&P
as represented by VIX. product that allows inves- 500 Index options and
the actual volatility of the
index (CBOE S&P 500
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There is a substantial risk of loss in trading commodity futures, options and off-exchange foreign currency products. volatility indexes pro-
Past performance is not indicative of future results.
vides a valuable set of

44 MARCH 2011
indicators that everyone FIGURE 1: VIX/True and S&P 500 Index
can learn to use.
1,300 4.0
Apr 2010

PREDICTING MARKET 1,200

VIX = 17/true = 6.7%

CORRECTIONS
Investors who follow VIX
often make the mistake of
believing that a relatively
low value indicates that the
market is stable. Unfortu-
nately, this misconception
tends to be compounded by
the financial news media.
A much more relevant
indicator is the ratio be-
tween VIX and the true
historic volatility of the
market (VIX/true).
This distinction came
sharply into focus in early
April 2010 when VIX had
fallen as low as 17, but the
VIX-to-true ratio peaked
above 2.5. The market fell
sharply, correcting 13% in
eight weeks. The market
stabilized, and the decline
ended when the ratio fell
below 1.
Conversely, in February
2009 with VIX hover-
ing above 50, the mar-
ket entered a sustained
rally—exactly opposite
the expectations of most
investors who interpret
1,100
1,000
900
800
700
Feb 2009
VIX = 50/true = 40%
600
a high VIX as a signal of
instability. During this
timeframe, however,
true volatility remained
relatively high, peaking
above 40%.
These dynamics are ap-
parent in Figure 1, which
displays the VIX-to-true
ratio (right Y-axis), the
S&P 500 (left Y-axis) and
notes regarding the value
of VIX at key points dur-
ing this period.
The upward sloping
line that connects peaks
in VIX/true reveals a
steadily rising series of
peaks that signal the
market’s increasing re-
luctance to price risk at
3.5
3.0
Jun 2010
VIX = 30/true = 32%
2.5
2.0
1.5
Source: Jeff Augen
levels corresponding to
the actual volatility.
These dynamics have
been true for some time.
Over the past 3,000 trad-
ing days, the ratio has
averaged 1.3. That is, VIX
averaged 1.3 times the un-
derlying volatility of the
S&P 500 Index calculated
in a 20-day window.
Since the beginning of
1999, it has risen sharply
and peaked higher than
2.3 times the volatility of
the underlying index on
four occasions.
The April to June 2010
correction was one of
those instances. In early
April, VIX posted a value

The Official Advocate for Personal Investing 45

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 FIGURE 2: S&P 500 Index September 2000-March 2003 waves of the NASDAQ
collapse. A fourth fol-
1,600 lowed closely after, at the
09/05/2000 VIX/true > 2.3
1,500 beginning of the recov-
1,400 ery in September 2003.
Following the fourth
1,300
01/14/2002 VIX/true > 2.3 distortion, the market
1,200
experienced four large
1,100 oscillations over a nine-
10/28/2002 VIX/true < 1
1,000 month timeframe.
900 During these oscilla-
800
tions, the S&P climbed as
high as 1,150 and fell as
700
low as 1,060—a volatile
Source: Jeff Augen
time to say the least.
More important, each
FIGURE 3: Implied Volatility of Apple Inc. large spike in the VIX-
to-true ratio was eventu-
$326 27.0 ally followed by a reversal
where the ratio fell below 1.
$325
26.8 In each case, the low
$324 ratio signaled that the
Apple 26.6 market had stabilized and
$323 the drawdown ended. The
26.4 recent January correction,
$322
for example, began with a
26.2
$321 ratio of 2.12 and ended in
February when the ratio
$320 26.0
Implied volatility $320 put
again fell below 1.
Figure 2 illustrates this
$319 25.8
concept by tracing the S&P
Source: Jeff Augen
500 through the NASDAQ
meltdown. The first two
of 17, while 20-day his- Three occurrences of a arrows mark spikes above
torical volatility had fallen highly distorted VIX were 2.3 in VIX/true; the third
to just 6.7%. associated with various arrow marks a downward

The Official Advocate for Personal Investing 47

ASK
AUGEN
SFO invites you to a free we-
binar presented by options
expert and top-selling author
Jeff Augen March 23 at 10:30
a.m. CT. This is your chance
to ask him questions and to
learn more tips about using
option price variance as a
technical indicator.
REGISTER NOW!
MORE
FROM AUGEN
Catch additional trade
ideas from Jeff Augen in SFO
Weekly, a free e-newsletter.
Sign up now!
NAME
E-MAIL
SUBMIT
spike that occurred as the
market began to stabi-
lize. The chart begins on
Sept. 5, 2000, and ends on
March 13, 2003.
BRIEF TIMEFRAMES
These dynamics are also
valid in short timeframes.
Figure 3 traces implied
volatility for Apple Inc.
$320 puts between 1 p.m.
and 3:10 p.m. Dec. 13 when
the stock suddenly fell $5
to just below the strike
price. The trading price of
the stock is displayed on
the left Y-axis, and implied
volatility for the put is
measured on the right Y-
axis. Individual points on
the chart are calculated us-
ing five-minute intervals.
Implied volatility of the
near-the-money put was a
perfect leading indicator.
In this regard, it is im-
portant to choose an op-
tion with a high delta that
is sensitive to small moves
in the underlying stock.
In-the-money options,
however, can yield mis-
leading results. This
phenomenon is related to
actual trading behavior.
A long investor will often
accept a slightly discount-
ed price to close a highly
profitable in-the-money
trade, while a short inves-
tor might overpay to close
a losing position quickly.
These dynamics create
noise in the form of rising
and falling volatility.
Conversely, far out-of-
the-money options are
relatively insensitive to
the behavior of the under-
lying stock.
The example depicted
in Figure 3 represents an
ideal situation because
the stock moved from $5
out-of-the-money to just a
few cents below the strike.
Market participants who
were short the $320 put
responded urgently when
the stock began to fall.
Generally speaking,
charts that display im-
plied volatility for near-
the-money options are
one of the best indicators
for day trading.
The options market of-
ten responds to news and
events that have not yet
surfaced at the retail in-
vestor level by pricing in
corrections several min- indicators will always lose their attention on analyz-
utes before they occur. money to sophisticated trad- ing subtle distortions in
This behavior is most ers armed with more pow- volatility and identifying
apparent in heavily traded erful tools. The days of buy- anomalies in derivative
stocks, such as Apple, ing and selling stocks when prices. The popularity of
where institutional inves- moving averages cross or an complex products such as
tors hold option positions oscillator reaches one side VARB-X Strategy Bench-
involving several strikes. of a channel are gone. mark represents a natural
Their behavior represents Moreover, investors evolution of this trend.
a level of efficiency that did who fool themselves into
not exist a few years ago. believing that they can Jeff Augen is a private investor
exploit combinations of and author of five investment
A NEW WAY TO WIN these indicators are mak- books, most recently Trading
Because the market is a ing a huge mistake. Times Realities: The Truth, the Lies, and
zero-sum game, individuals have changed. the Hype In-between.
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The Official Advocate for Personal Investing 49

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 Struggling
with
High VolatilitY?
By Paul Kavanaugh
In the futures market, FX options provide one of
the best opportunities for individual speculators.
They offer traders significant advantages over fu-
tures contracts, including the ability to:
• Trade directional moves in the currency markets
with specific and limited risk.
• Use multiple units to diversify one’s entry and
exits over both price and time.
• Make adjustments to one’s position and exposure
during a move.
• Have freedom from using stop loss orders (the
placement of these can be difficult, especially in
times of high volatility).
 FIGURE 1: Bear (Vertical) Put Spread on the Euro/USD Contract, March 11, 2010

O = 13156 1.425
H = 13272 Sold 1 unit, $300 gain
L = 13091
L = 13114
∆ = -52 1.400

1.375

1.350

1.325

1.300
Entered Jan. euro 1.31/1.33 put spread
Sold 2nd unit, $750 gain
1.275

100
75
50
25

20 27 01 11 18 25 01 08 15 22 29 01 06 13 20 27

Source: CQG Inc.

The buyer of an option has limited risk,
which is equal to the cost of the option (or
premium paid). The option’s value is based
on the time remaining until its expiration
and its intrinsic value, or how far the op-
tion is in the money. Herein lies a signifi-
cant disadvantage for options buyers: With
each passing day, time premium works
against them.
DEBIT SPREADS
In times of high volatility, the strategy
I find effective to mitigate the effects of
time decay is a debit spread, i.e., a bear put
spread or a bull call spread. I like to de-
scribe these techniques as “selling half at
double” when explaining them to clients.
A bear put spread (also known as a
vertical put spread) involves purchasing
put options at a specific strike price while
selling the same number of contracts on
the same futures contract but at a lower
strike price. Because the put one buys
is at a higher strike price, it is more ex-
pensive. The premium, or cost the trader
pays to enter this spread, is known as the
net debit (see Figure 1 for an example of
a bear put spread).

54 MARCH 2011
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THERE IS A SUBSTANTIAL RISK OF LOSS IN TRADING COMMODITY FUTURES, OPTIONS AND OFF-EXCHANGE FOREIGN CURRENCY PRODUCTS. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.
EQUITIES AND EQUITIES OPTIONS ARE OFFERED BY BEST DIRECT SECURITIES, LLC. MEMBER FINRA & SIPC

In a bull call spread (also known as a
vertical call spread), a trader purchases
a call option with a low strike price while
selling one with a higher strike price.
The maximum risk in a bull call spread
or bear put spread is the net debit plus
commissions and fees. The maximum
gain is limited to the difference between
the strike prices, less the premium paid to
enter the spread, commissions and fees.
Another advantage of these debit spreads
is that no margin above the amount of
the net debit is required, so one can trade
high-margin commodities without having
the initial margin of the futures contract in
his or her account, so the risk of receiving a
margin call can be avoided completely.
In contrast, a trader entering a credit
spread where he or she buys a less ex-
pensive put or call and sells the more
valuable put or call will bring in a credit,
but this involves higher risk and does not
offer favorable profit-to-loss ratios such
as debit spreads.
I use debit spreads when I anticipate
a directional move, whereas I often best
employ credit spreads to trade nondirec-
tional moves or consolidations.
Using debit spreads is my favorite ap-
proach for traders new to the forex fu-
tures markets because it enables them
to benefit from the leverage the markets
offer but without the high risk futures
contracts involve. The benefits of using
56 MARCH 2011
debit spreads instead of outright futures
contracts are significant.
PROFIT FROM VOLATILITY
Debit spreads allow traders to partici-
pate in the extreme price fluctuations
many of the currency markets are
experiencing with specific and limited
risk, which can be a key factor in sus-
tainable speculation.
For instance, a trader could enter a
bearish position on the euro versus the
dollar by entering a debit options spread
based on the CME Group’s EUR/USD fu-
tures contract. He or she would buy a 1.20
put for 160 points while selling a 1.18 put
for 120 points. The point or tick value for
the euro is $12.50, so the 1.20 put would
cost $2,000 (160 points x $12.50), and the
1.18 put would bring in $1,500 (120 points
x $12.50). Thus, the trader is effectively
buying the right to sell the euro at 1.20
while selling or giving up the ability to
benefit from any moves below 1.18.
So at expiration if the euro is below 1.18,
the short 1.18 put would lose what the long
1.20 put made at a 1-to-1 ratio. The trader in
this example has the potential to make the
difference between the strike prices minus
the premium paid. In this scenario, the
premium is 40 points and the difference
between the strikes is 200 points, so the
trader has the potential to make a maxi-
mum of 160 points, or $2,000. This repre-
sents a profit-to-loss ratio of 4-to-1—a criti-
cal factor in choosing strike price locations.
ADDED FLEXIBILITY

OptiOns
The limited risk of a debit spread lends
itself to trading multiple units, which can

traders!
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the position to cover the original cost of
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ELIMINATE STOP LOSS HEADACHES millions and taught many individuals to become suc-
Debit spreads do not require the use of cessful options traders. Today, strategy and trading
stop-loss orders, which are necessary to analysis are part of his many active roles.
limit potential losses when trading the
underlying futures contract outright.
In times of high volatility, stop loss place-
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For these reasons, when volatility is
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Paul Kavanaugh is the senior currency market ana-

lyst at PFGBEST Research. There is a substantial risk of loss in trading commodity
futures, options and off-exchange foreign currency products.
Past performance is not indicative of future results.

The Official Advocate for Personal Investing 57

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60 MARCH 2011
Break Out
WITH OPTIONS
One of the classic trading techniques is play-
ing breakouts. A breakout is when a stock is in
a range and moves through either support or
resistance with anticipation of continuing in that
trajectory. Given the leverage feature of options,
one would think they would lend themselves
quite well to playing breakouts—and they do—if
the trader plays it right.

By Dan Passarelli

The Official Advocate for Personal Investing 61

 I have seen plenty of
traders mess up an oth-
erwise good breakout
play by using options.
Even though options are
perfect instruments for
playing breakouts, trad-
ers sometimes neglect to
consider all that goes into
such a trade.
THE SETUP
First, there are sev-
eral types of breakouts
that can materialize.
But there are two main
breakout setups:
• Flag pattern setups
• High-volatility stocks
that settle into a chan-
nel with the expectation
of a violent breakout
With both of these set-
ups, traders need to strat-
egize the option-centric
influences that come into
play, mainly leverage/
direction, time, volatility
and the exit plan.
PLAYING BREAKOUTS
A classic flag pattern is
when there is a day or two
of upward (or downward)
thrusting price action
(creating the flagpole), fol-
lowed by a few low-volume
days with small ranges
trending in the opposite di-
rection (creating the flag).
Figure 1 shows a typical
upward flag pattern.
A channel breakout is
when a stock is oscillating
up and down in a “chan-
nel,” bouncing up when
it hits support and down
when it hits resistance.
When the stock per-
meates either support
or resistance, the trader

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looks for a continuation FIGURE 1: Flag Breakout
in that direction. Fig-
ure 2 shows a stock in a
channel and then break-
ing through resistance.
Given the setups in Fig-
ures 1 and 2, traders would
take a bullish position in
anticipation of a follow-up
breakout to the upside.
Breakouts such as these
are typically short-term
trades. One would expect
to close the trade after a
few days, either taking a
profit or loss. Volatility is
not a major consideration.

LEVERAGE
Source: LiveVol
The breakout setup is
perfect for exploiting the
leverage provided by op- FIGURE 2: Range Breakout
tions. Option leverage is
largely measured by delta
and capital at risk.
Instead of buying the
underlying stock, trad-
ers can buy calls for a
fraction of the price of
the stock and use delta
to determine how many
calls to buy. For the same
risk, instead of buying
100 shares of a $50 stock,
a trader may buy two 0.5
Source: LiveVol
delta calls. That means

The Official Advocate for Personal Investing 63

 More From
Passarelli
Each Monday, Dan Passarelli offers a
tip on improving your options trading
in SFO Weekly, a free e-newsletter.
the trader has the expo-
sure of 100 shares. Why?
Each of the two calls
changes in value 50 per-
cent as much as the stock.
So, together the two calls
act like 100 percent of a
100-share position.
If each call costs, say, $2,
a position with the expo-
sure of 100 shares costs
just $4 instead of the $50
that the stock would cost.
Therefore, a trader can
leverage a position simi-
lar to a 200-share position
for just $8 by buying four
calls, and so on.
As a rule of thumb, op-
tions with a delta of 0.25 to
0.3 are best for breakout
plays in which a sizable
follow through is anticipat-
ed. Because their deltas get
bigger as the stock price
increases, they provide
the best leverage and are
64 MARCH 2011
NAME
E-MAIL
cheaper (i.e., less risk) than
their at-the-money or in-
the-money counterparts.
TICK TOCK
Time is an important con-
sideration in options trad-
ing because they lose value
as time passes—a concept
called time decay. But in
this case, it is a small con-
sideration because of the
expected short-term na-
ture of the trade.
As theta does not have
such a strong effect on
short-term breakout plays,
a trader should buy the
front-month, higher-lever-
aged options.
UNDERSTAND VOLATILITY
Volatility is an impor-
tant consideration when
trading options both in
terms of historical and
implied volatility.
SUBSCRIBE!
Historical volatility is a
measure of how volatile
the underlying market
has been in the recent
past. Usually when a flag
pattern is developing, the
large move that created
the flag pole contributes
to historical volatility ris-
ing and remaining high
for 30 days. This renders
historical volatility a less
useful tool than usual.
But with a channel break-
out, often historical vola-
tility is low as the stock’s
price volatility wanes. This
can cause implied volatility
to become cheaper, creat-
ing a prime opportunity for
option buying.
Implied volatility indicates
the relative expense of the
volatility premium embed-
ded in the option. In short,
the more volatile the op-
tions market thinks a stock
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will be, the more expensive
its options will be.
GET IT RIGHT
Understanding volatility
is where breakout option
plays can be made or
broken.
Sometimes implied
volatility can be unusu-
ally high, making options
extremely expensive.
Further, implied volatil-
ity can change—moving
higher or lower. If options
are relatively expensive
as a result of overpriced
implied volatility, they
can lose on the volatil-
ity portion of their value
when implied volatility
revaluates downward.
Sometimes, the loss
on implied volatility can
be so great that it more
than offsets any gains
on directional move-
ment, even leading to a
loss on the call when the
stock increases.
But when implied vola-
tility is low, the trader
arguably has an edge
because the options are
relatively cheap and risk
of vega losses is low.
66 MARCH 2011
THE RULES
1. Look for the setup. It
could be a flag pattern or
breakout of a channel.
2. Select a 0.25 to 0.3 delta
option to get the best
leverage.
3. Analyze volatility.
Ensure that implied
volatility is low to gain
volatility edge and
avoid overpaying.
4. Set a stop loss and have
a plan for profit taking.
THE TAKEAWAY
Breakouts either work or
they do not. Traders can
see whether the breakout
will happen rather quickly
after the trade is initiated.
If the breakout fails, trad-
ers need to get out quickly
for a small loss.
But options are lever-
aged, thus, traders need
to accept a higher per-
centage loss than they
would if they were trad-
ing the stock. Usually,
25% to 30% of the call
value must be forfeited if
the trade is stopped out.
If it works, though, trad-
ers need to let their prof-
its run.
I recommend two tech-
niques: Either use a trailing
stop once the trade is prof-
itable, or if a big enough
favorable move occurs that
the option has doubled in
value, sell half and play
with the “house’s money.”
GETTING OUT
To plan exits, traders
should use an options
modeling tool to test how
changes in any of the
above stated inputs can
affect the value of the call.
Though the isolated
impact of delta, theta and
vega are easy to mea-
sure, when the three
Greeks influence the op-
tion value all at the same
time, the results can get
a little convoluted.
It helps to use a tool
to show the effects as
direction, time and vola-
tility all change at once.
This helps traders better
plan their exit strategies.
Dan Passarelli is the author of
Trading Option Greeks and options
educator at Market Taker Mentoring.
 hat is a

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Trade the Path
LESS TRAVELED
“It’s tough to make predictions, especially about the
future,” claimed Yogi Berra. This is, of course, our
calling as traders—the tricky job of predicting the
future. It is much easier to predict the past.

BY CLEM CHAMBERS
 Technical analysis (TA),
in essence, is an attempt
to use the past to predict
the future. The trouble is
that thousands of people
use the same sets of num-
bers to try to do so, mak-
ing success for any one
person extremely difficult.
NO HOLY GRAIL
Anyone who sits down
with a time series and
backtesting software soon
learns that there is no
obvious or easy techni-
cal analysis method to
make money robotically.
Traders also quickly find
thousands of earlier at-
tempts leading down the
obvious pathways they
are exploring.
Moving average cross-
overs and trend-following
ideas do not pan out, and it
usually is not until imprac-
tical methods are applied
that anything at all inter-
esting starts to appear.
Often the strategies that
seem promising, looking
backward, do not work in
practice going forward.
They simply do not have
any profit in them tomor-
70 MARCH 2011
row, no matter how reward-
ing they were yesterday.
Market
INEFFICIENCIES
are where
traders make
their money.
BE WARY OF
CURVE FITTING
Curve fitting always fits
a strategy to the past, but
sadly it does not work in
the future any more than a
randomly selected one will.
A curve-fitted strategy does
not work going forward; it
only works for the history
to which it was molded.
It is not so difficult to
understand why these
studies are fruitless. We
have to realize that the
gleaming towers of Wall
Street and the City of
London with their armies
of financial profession-
als are all looking at the
same column of numbers,
trying to find the magic
indicators to win in the
markets. And so is anoth-
er army: global amateurs.
They are all pawing over
the same old time series,
using the same old math.
It would be a funny
market if obvious prof-
its were lying around for
anybody to pick up with
everybody’s analysis
being focused on a few
megabytes of data. It is
not surprising, then, that
real opportunities are
hard to find.
THE SWEET SPOT
A hint of where there is
opportunity comes from
the British spread bet-
ting companies. The life
of a novice trader is often
short and not particularly
sweet. Although I will not
address this failure, it is
interesting to know where
they do see success.
According to spread
betting companies, profit-
able traders look at a time
horizon of seven to 90
days, or put another way,
medium-term trading.
This period is too short
for investing and too long
for day trading. It is too
dangerous for staid inves-
FIGURE 1: Daily Nasdaq Composite Index

5,000

4,000

3,000

2,000

1,000

1998 1999 2000 2001 2002 2003

Source: ADVFN.com

FIGURE 2: Daily Nasdaq Composite Index and Apple Inc. Price

Nasdaq Composite Index Apple Inc.

5,000
$300

4,000

$200

3,000

$100

2,000

$0
1,000

1998 1999 2000 2001 2002 2003 2002 2004 2006 2008 2010 2012

Source: ADVFN.com

The Official Advocate for Personal Investing 71

 SFO is proud to host a free webinar presented by

LIVE WEBINAR Clem Chambers March 16 at 10:30 a.m. CT. This

is your opportunity to learn more about using
WITH CHAMBERS geometry to find a trading edge and to ask
Chambers your questions. Register now!
d

tors and too boring for and are not obvious when its glory. It is the explo-
day traders. This window they collapse. Everyone sive vertical phase that
may be a sweet spot with claims to have seen them reveals you are dealing
enough inefficiency to after the fact. with a bubble. Figure 2
make returns for the dili- Few traders and inves- shows Apple Inc. side-
gent trader. tors currently see the by-side with the Nasdaq
Inefficiencies are where China bubble or the relat- Composite Index; looks
you make your money. ed raw material bubble. kind of familiar.
As the market tends to- No one has yet real- The trouble is identify-
ward perfect efficiency, ized that we have been ing how far the bubble
the market becomes more through a governmental will inflate. The rise can
random; therefore, trad- bubble that has seen the look impressive, but a
ing an efficient market countries of the West large amount of rise may
is a game of chance. You gorge on their artificially still come.
cannot trade an efficient inflated gross domestic You can follow the logic
market for profit, but you product figures through with Apple. This stock has
can take money from an overtaxation. run and run. Who would
inefficient one. However, when it is all want to fight this bubble?
over, everyone will pre- Oh, sorry Apple holders, did
BUBBLES ARE INEFFICIENT tend to have been wise to I say Apple was a bubble?
You are searching for the process. As a bubble goes up like
inefficiencies, and these In my latest book, 101 a rocket and down like a
come in many forms. The Ways to Pick Stock Mar- stick, you first might think
best are bubbles, and ket Winners, I cover some about riding the take off.
some are not so long term. techniques to trade bubbles.
Bubbles go up beyond BOXES OFFER SIGNALS
all sense and come crash- BUBBLE SPOTTING The best way to do this is
ing down with violence. First you need to identify to use what I call the box
Bubbles are invisible to a bubble. Figure 1 reveals technique. After each stage
most while they inflate the dot-com bubble in all of an increase, the price

72 MARCH 2011
will hit equilibrium, rest FIGURE 3: Daily Apple Inc. Prices with Boxes
and even explode again
or crash. By putting a box
around the volatility, you
$300
give yourself a guide to
which way it is going next.
Through this tech-
nique you can identify a $200

stop-loss or a double-up
point on the chart. You
can use this to trade the
boom, and you can use Split 1/2
$100

the breakdown through

the box to trade the crash
(see Figure 3).
$0
Trading the crash is
2002 2004 2006 2008 2010 2012
tricky via purely techni-
Source: ADVFN.com
cal methods. A simple
way to back up the chart
is to look at the numbers. FIGURE 4: Daily Apple Inc. Prices with Fractals
If a company with little to
show for itself promises
that it is worth hundreds $300

of millions—perhaps bil-
lions—gravity begins to
become inevitable. If the
$200
financial numbers make
no sense and appear too
lunatic, the bubble may
be nearing its end. Split 1/2
$100
It is too easy to use
an old example for this
piece, a bubble that has
already burst, so I use $0

Apple as a real-time il- 2002 2004 2006 2008 2010 2012

Source: ADVFN.com
lustration. At some point,

The Official Advocate for Personal Investing 73

it will deflate, so it is a of symmetry with half- FOLLOW THE SIGNALS
good test for this article. way trend breaks, quarter There is never any rush
So with that in mind, can breaks, eighth breaks, etc.— to trade a crash. The ini-
a company such as Apple everywhere to be seen if tial period is volatile, but
sustain its position as the you go looking. after a month or two, the
second most valuable com- A boom-bust cycle is of- inevitable fall sets in and
pany in the U.S.? Do the ten full of such symmetry, grinds to a slow but prof-
numbers make sense? and these can be a good itable death. Hope springs
aid. The “halfway” shows eternal for most people.
THE HALFWAY RULE either a halfway point or Whatever your opinion
A final guide is my “half- an end point, so combined of Apple, these simple
way” rule. Through the with the box, it can give rules give strong trading
strange law of probability, you a good basis for plan- signals. This, after all, is
halfway is a particularly ning entries and exits. what a trader wants.
powerful point. Self-affine, Figure 4 reveals these Classical technical analy-
self-similar fractal sequenc- symmetries, which look sis uses a small set of tools
es, make for a great deal particularly interesting. to analyze time series, and
consequently its insights
have been traded away.
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74 MARCH 2011
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THE MAIN EVENT:
T.A. vs. Modern Portfolio Theory
BY MICHAEL KAHN, CMT

If I had to guess, I would say that most trad-

ers have heard of Modern Portfolio Theory
(MPT) and either do not know much about
it or do not agree with it. As a certified chart
head, I am in the latter camp.
 But that does not mean most of us
should ignore it.
HOW IT WORKS
Basically, MPT is a theory of invest-
ment that attempts to maximize a
portfolio’s expected return for a given
amount of total risk by choosing the
proper proportions of various assets.
Immediately, the reader should note
that it is a theory of portfolios and not
individual stocks or bonds, or even
stocks and bonds as solo assets.
If you are a short-term trader, then
you only care about a few stocks or fu-
tures at a time. But if you manage client
money or the family fortune, then you
probably should know a little bit about
MPT. And when I say a little, I mean it,
because it is a big theory. It does its best
work with the financial adviser commu-
nity, where they can tell clients a good
story and back it up with high-level
math and a Nobel laureate.
THE DEBATE
Recently, I addressed a group of advisers
as part of a debate on technical analysis
(T.A.) versus modern portfolio theory.
My “adversary” was himself a financial
adviser and a big, big fan of MPT.
Much to the chagrin of those who
enjoy a good Jerry Springer-style smack
down, the debate was quite friendly,
and we concluded that there were mer-
its for both styles of analysis.
78 MARCH 2011
What I would like to do here is lay out
the basic concepts of both styles and
show that both have their place. However,
when all is said and done, I will not be
trading my CMT (chartered market tech-
nician) designation for a CFA (chartered
financial analyst) any time soon.
MULTIPLE VIEWS
I learned a long time ago that relying on
one type of analysis exclusively can lead
to problems. Even a hard-core technician
such as myself looks at other styles if only
to know what others are watching.
Most SFO readers are likely familiar
with T.A., so let’s start there.
STUDYING CHARTS
Technical analysis is a horrible name for
the study of the action of people in the mar-
ketplace. The basic idea is that people tend
to take similar actions when faced with
similar conditions, so mass market psychol-
ogy seems to be a better term than T.A.
While fundamental analysts delve into
the inner workings of companies, econo-
mies and demographics, technical analysts
assume all of this is embedded within the
price of the security in question. It as-
sumes the public has done its homework
and made its decision to buy, sell or hold.
That is a bit simplistic. Charts show what
people are doing with their money right
now, but we can all agree that informa-
tion flow is far from perfect. You would be
kidding yourself to think that a major Wall
Street firm gets the news from company X
at the same time the little guy gets if from
watching financial television. Similarly,
international oil companies have a better
handle on new regulations, new explora-
tions and new technology than you do.
Imperfect flow of information is re-
sponsible for the very trends we analyze.
If everyone knew everything at the same
time and could assimilate with the same
speed, then prices would jump from one
level to the next immediately.
But quantum leaps are not what hap-
pen, and that is why technical analysis
is such a vital part of the investment and
trading process.
Although we may not know when a bio-
tech company is ready to announce its cure
for cancer to the world, we can indeed watch
the footprints of those who are in the know
and ride the trend as it happens. Picking the
exact bottom is fantasy for most of us and
probably involves an element of guessing.

THE OTHER SIDE OF THE STREET

On the other end of the spectrum, MPT
is based on the idea that managing asset
proportions in a portfolio produces the
maximum risk-adjusted returns. Stock
picking and even understanding of the
market’s trend are irrelevant.
MPT relies on several assumptions,
many of which have been challenged
over the years. One of the most impor-
tant is that returns are normally distrib-
uted, and we can see how the concept of

The Official Advocate for Personal Investing 79

normal distributions forces linear order
on a nonlinear, illogical marketplace.
The second major assumption is that
correlations among assets are constant,
forever. We know that correlations do
change, and in times of crisis, they
sometimes move to unity—everything
moves together.
In 2008, there seemed to be no place to
hide from the carnage in the marketplace.
Stocks, corporate bonds, gold, oil and
even soybeans and rubber all collapsed,
so the idea that uncorrelated assets pro-
vide diversification got quite a jolt.
But there was one asset that did do well
in 2008: U.S. Treasury bonds. A portfo-
lio containing Treasuries may not have
thrived, but it survived. And that is a
pretty good argument for MPT.
There is one more assumption that
comes with modern portfolio theory. It
assumes that investors cannot time the
market, something with which I can
agree to a point. It also harps on the idea
that missing the best rally days in his-
tory severely affects returns.
IS IT A BULL?
In preparing for my debate, I dug into
my sources for the counterargument that
missing the worst days made an even
bigger—and positive—impact on re-
turns. In other words, there is a benefit
to knowing if it is a bull market or bear
market. Numerous studies prove this
point, so I will not dwell on it here.
80 MARCH 2011
Suffice to say that the ability to move
in and out of the market at major turn-
ing points is quite important. However, I
will stipulate to the inability of the pub-
lic to time every wiggle. Further, I will
agree that the public is generally wrong
at major turning points, lending cre-
dence to MPT’s assumption.
This lack of timing ability is the basis
for sentiment analysis within T.A., but I
will not agree with the public’s inability
to get it right most of the time, i.e., ride
the trend.
Although sentiment analysis looks for
extremes of bullishness or bearishness
as major trends near their ends, it also
believes that the public moves to the
correct side—bull or bear—in the middle
of that trend. If it did not, then no trend
would exist at all. Who would sustain a
bull market if not the public?
THE CYCLE UNFOLDS
As major trends unfold, the public does
not know the proper information in the
beginning (Elliott wave analysis might
call this wave one). It gets it right dur-
ing the bulk of the trend (Elliott wave
three). And then it gets it wrong in the
end (wave five). MPT does not distin-
guish among which stage of a bull or
bear market is in effect. It does not
know where the market is within any
bull or bear cycle.
The models on which MPT was built
also seem to view all stages of an inves-
 tor’s lifetime with the same fixed lens.
Today’s investment goal is not the same
as it will be in 10 or 20 years; therefore,
asset allocation must change.
2 KEY PRINCIPLES
However, MPT forces investors to
recognize two principles: diversifi-
cation is better, and more risk comes
with more return. This is why modern
portfolio theory has value even for ac-
tive money managers who have shorter
time horizons.
Everyone would likely benefit from
proper asset allocation, too, even if their
focus is on quick strikes. Just as know-

MANAGING RISKS
When bean counters talk about risk, they
refer to the variation of returns from the
expected. However, when investors talk
about risk, they want to know how
much money they can lose. Greg
Morris, chief technical analyst at
Stadion Money Management,
provided this explanation to me to
counter any argument I might have gotten
during my T.A. vs. MPT debate:
“In the ‘world of finance,’ which includes academia
and their social science, their focus is on nonsystemat-
ic risk or diversifiable risk. Their theories do a fair job in
that arena, even with the horrible assumptions that
they make to develop the theory (efficient markets
and rational investors). However, the large piece of
the risk pie is the systematic or market risk, and only tech-
nical analysis deals with that portion. I have read academic
white papers that even admit that systematic risk is probably 60%
to 70% of all risk.
“Or said in technical analysis terms: Technical analysis deals with draw-
down, which I believe is true risk. I don’t know anyone who gets their
brokerage statement and sees a standard deviation of 0.63 along with a
40% loss for the year and then focuses on the reported portfolio sigma.”
81
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RATES OF
INTEREST
By Howard L. Simons

If you wish to get seated at a crowded

restaurant, start talking in a loud voice
about real interest rates. The place will
clear out in no time, and you will have
your choice of tables, unless the Ameri-
can Economics Association is in town. If
so, they will invite you to sit and share
a few thoughts (notice how nothing was
said about them buying you dinner).
The subject should be anything but
dry and unimportant. The mix between
inflation expectations and real interest
rates affects what exposure investors
should have to risky assets, including
corporate bonds and stocks.

IT IS OF INTEREST
The simple fact of the matter is that few
subjects are as important to the allocation
of resources within an economy and are as
difficult to assess in practice as real interest
rates. Interest rates are the price of money;
that much is quick and simple. But in their
economic sense, interest rates equilibrate
future and present consumption.

The Official Advocate for Personal Investing 85

 If real interest rates rise, consum-
ers have an incentive to save and defer
consumption until later. If they fall,
consumers lose some of their incentive
to save. Notice this is “some,” not “all.” As
interest income falls, people have to save
an ever-greater percentage of their pay-
checks to meet retirement or other goals
(see To Save or Not to Save?).
Now inflation expectations must be
brought into the mix. It is one thing to
recite Fisher’s Law robotically—nominal
interest rates are the sum of real interest
rates plus expected inflation—but it is
another to obtain some hard numbers.
Economists had hoped to use the
breakeven rates of inflation from the
Treasury Inflation-Protected Securi-
ties (TIPS) market, but those can be
distorted by flights to quality, financial
crashes, investment flows, changing
expectations of tax rates and skepticism
regarding the government’s reports on
consumer inflation.
It has not been difficult at all to write
why the TIPS market is flawed (see The
Illusion of TIPS Protection and Are You
Throwing Your Money Away?).
If Fisher’s Law worked in this market,
you should be able to run it backward
by taking known nominal interest rates
and known contemporaneous TIPS
breakevens and derive known short-
term interest rates. That you cannot do
so shows that other factors enter into
the equation, including the volatility of
86 MARCH 2011
both interest rate and currency markets,
the shape of the yield curve and swap
spreads, or the willingness of floating-
rate borrowers to fix their payments.
Let’s not allow the best to be the enemy of
the good. All relationships in finance, even
the imperfect ones, are information rich.
If we subtract TIPS breakeven rates of
inflation from nominal interest rates to
proxy for a real interest rate and track
the ratio of this real rate to the nominal
rate over time, we should learn some-
thing about the supply and demand bal-
ance for credit and, therefore, about the
balance between economic activity and
the state of the financial markets.
NORMALIZED REAL INTEREST RATES
As interest rates have varied wildly over
most of our lifetimes, from near 20%
short-term levels in the early 1980s to
near 0% short-term levels starting in
2008, we should focus on relative mea-
sures to normalize real interest rates.
Let’s create a measure called normal-
ized real interest rates—(nominal rates -
TIPS breakevens) ÷ nominal rates—to do
this. These are displayed in Figure 1 for
the five-, 10- and 30-year maturities.
Normalized real rates declined be-
tween early 2002 and March 2003, then
rose to September 2007, fell again in
March 2008, exploded higher during the
financial crisis and declined sharply be-
tween when the Federal Reserve cut the
target Federal funds rate in December
 FIGURE 1: The Real-to-Nominal Rate Ratio

105% 160%
Norm. 30
95%
Norm. 10
Norm. 5
85% 110%

75%
10- & 30-year Treasuries

65% 60%

5-year Treasuries
55%

45% 10%

35%

25% -40%

15%

5% -90%
Aug-98
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Nov-03
May-04
Nov-04
May-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Aug-10
Source: Bloomberg data; Simons Research calculations

2008 and when it began its second round
of money printing (quantitative easing)
in November 2010.
Because the three measures move to-
gether closely and as the weighted aver-
age maturity of most broad corporate
bond indexes is close to 10 years, we can
isolate the normalized real 10-year rate
in the remainder of the discussion.
TAKING STOCK
What does a period of declining real rates
relative to nominal rates indicate? By def-
inition, a falling level of real interest rates
signals increased availability of credit
relative to its demand. A falling ratio also
can signal rising inflation expectations.
We saw this combination during the
later stages of the 2002 bear market and
for six months bracketed by the October
2007 all-time high and the March 2008
Bear Stearns panic low.
Falling credit demand and rising infla-
tion expectations sound like a bad com-
bination. Is it? Plotting the normalized
10-year real rate in Figure 2 inversely
against U.S. large- and small-capitaliza-
tion issues as measured by the Russell
1000 and Russell 2000 indexes shows it
led the stock indexes by three months on

The Official Advocate for Personal Investing 87

 FIGURE 2: Normalized Real Rates’ Stock Market Impact

5%
Norm. 10 200%
15%
Russell 1000

Russell Indexes Led 3 Months, Aug. 3, 1998 = 100%

Russell 2000
25% 180%
Normalized 10-year Real Rate, Inverse Scale

35%
160%
45%
140%
55%

65% 120%

75%
100%
85%
80%
95%

105% 60%
Aug-98
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Nov-03
May-04
Nov-04
May-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Aug-10
Source: Bloomberg data; Simons Research calculations

average during each of the three market March 9, 2009, and investors in high-yield
environments noted previously. bonds outperformed almost all classes
This is consistent, incidentally, with of American stocks for the 2009 calendar
the argument that the corporate bond year and through November 2010.
and stock market rallies of 2009 were Corporate bonds lost their Rodney
propelled by liquidity: Low interest Dangerfield status during this period;
rates and rising inflation expectations they got respect, maybe even a little too
lower the real cost of capital and en- much respect.
courage risk taking. Regardless, if we map the normalized
real rates for 10-year notes and plot them
WHAT ABOUT CORPORATE BONDS? inversely in Figure 3 against the option-
Corporate bonds led stocks out of the adjusted spreads for investment-grade and
2008 market panic. Indeed, investment- high-yield corporate bonds, a clear answer
grade and high-yield bonds hit their bot- emerges: The rise and fall of corporate
toms Nov. 20 and Dec. 16, 2008, respec- credit spreads is matched directly to real
tively. Stocks did not hit their low until interest rates and inflation expectations.

88 MARCH 2011
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I can state a rather definitive conclusion:
The risk of such a direct connection be-
tween normalized real rates and the health
of the corporate bond market is obvious.
Once private credit demands increase rela-
tive to government credit demand, a more
normal price of money should re-emerge.
If coupled with an end to excessively
loose monetary policies, the best-of-all-
worlds market of 2009-’10 will start to
disappear, just as a similar market in
2003 dissipated.
There will be a higher normalized real
interest rate, and that should end the
contraction of corporate bond spreads
as seen in Figure 3. In addition, as the
three-month lead time shown in Figure
2 indicates, an end to the corporate bond
rally should cause an end to the stock
market rally about three months later.
THE END OF (RECENT) HISTORY
One of the enduring legacies of the Great
Recession has been and will be a break
in the pact between Wall Street and
Main Street (see Wall Street Armaged-
don). This distinction can be lost to those
who live on both.
Social compacts had arisen after World
War II: Your home was your best invest-
ment; long-term investors were rewarded
for their patience; and if you played by the
rules, this was the greatest place on earth.
Those assumptions were shattered over
the past decade as housing prices fell, two
bear markets punished long-term and
 FIGURE 3: Normalized Real Rates’ Corporate Bond Market Impact

105% 970%
Norm. 10
95% High-Yield 870%
Inv.-Grade

Corporate Bonds, Aug. 3, 1998 = 100%

85% 770%
Normalized 10-year Real Rate

75%
670%
65%
570%
55%
470%
45%
370%
35%

25% 270%

15% 170%

5% 70%
Aug-98
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jun-01
Dec-01
Jun-02
Dec-02
Jun-03
Nov-03
May-04
Nov-04
May-05
Oct-05
Apr-06
Oct-06
Apr-07
Oct-07
Mar-08
Sep-08
Mar-09
Sep-09
Mar-10
Aug-10
Source: Bloomberg data; Simons Research calculations

stock-heavy investors, and the government
moved to bail out those who had perpetrat-
ed the distress at the cost of the innocent.
The rising federal debt load started
to crowd out private credit demands in
2008, and the bailed-out banks began to
gorge on the steep yield curve to finance
the government’s deficits at the expense
of job-creating private borrowers.
This is what pushed real interest rates
lower and inflation expectations higher.
The final irony was the chief beneficia-
ries of this twist in policy results dur-
ing 2009 were those very same financial
institutions seen at the fire with a book
of matches and a can of gasoline.
Once this strange mixture of economic
distortions ends—if it ends—the real
economy will recover at the expense of
investors and financial games. This will be
a time of mixed emotions for those used
to gorging on government malfeasance.
Investors—a class likely to include you—
should be careful for what they wish.
Howard L. Simons is president of Simons Research,
which provides economic and financial analyses
and commodity trading advisories for firms, traders
and exchanges.

The Official Advocate for Personal Investing 91

 RESEARCH

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The Official Advocate for Personal Investing 93

From Chapter 30:
Oil & Gas Development and Exploration
We already explored oil and gas royalties
as a means to generate long-term retire-
ment income. Now we will review using
oil and gas development and exploration
investment to reduce conventional and
AMT [alternative minimum tax] liability.
These are direct investments and are
typically best suited to high net worth/
high income accredited investors. To
encourage the search for oil and gas
resources, the federal government has
set up special tax rules to accelerate the
tax shelter benefits associated with pros-
pecting for oil/gas.
There are two general programs: de-
velopmental drilling and exploration.
Developmental drilling is done near
existing, producing basins and involves a
lower level of risk.
On the other hand, exploratory drilling
involves drilling wells in areas identified
as having high potential but untapped
potential. This activity also is called
wildcatting. Exploratory drilling has a
higher degree of risk than development
and a higher potential of producing a
“dry hole,” which does not produce any
oil or gas.
These special tax rules are called
intangible drilling costs (IDC). Drill-
ing is capital-intensive, and the major-
94 MARCH 2011
ity of expenses are incurred up front;
the IDC costs are written off in the first
year of the investment. The IDC tax
deduction is between 80% and 90% of
the investment amount in the year the
investment is made. If you are in the
federal maximum marginal tax [brack-
et] of 35% or are ensnared in AMT,
paying 28%, oil and gas development or
exploration may be a great option.
To curb abuses in the tax shelter are-
na, the federal government has placed
special active vs. passive rules in place.
When you invest, you can choose to be
either a limited or a general partner. If
limited, your total potential loss is lim-
ited to your initial investment. If you
choose to be a general partner, your
potential loss is unlimited. To encour-
age investors to become general part-
ners, you can use your IDC to offset
earned income and offset up to 40% of
your AMT income. If you choose to be a
limited partner, your IDC deduction can
only be used to offset passive income
and portfolio income.
Do not do a limited partner oil and gas
exploration or development investments
if you do not have sufficient passive
income or portfolio income. If your pas-
sive income is composed of primarily
qualified dividends (taxed at a federal
maximum of 15%), this investment may
not be appropriate.
The best fit is a person who is comfort-
able signing on as a general partner and
has high income subject to conventional
taxes or AMT. Many oil and gas invest-
ments take advantage of the IDC rules by
converting your investment status from
general partner in the first year and to a
limited partner status in ensuing years.
The second benefit of oil and gas de-
velopment and exploration investment is
income distributions. As new wells are
put into production, income is distributed
to the investors.
Some investments distribute the in-
come for a fixed number of years (usu-
ally seven to 10) or are open-ended. In
an open-ended investment, the income
stream continues until the oil or gas pro-
duction ceases. Oil and gas prices vary
widely in the marketplace. As such, the
income stream can also increase and de-
crease considerably. The income does not
always correlate with the overall market.
The price for oil and gas may go up while
the general market declines.
Therefore, this is a non-correlated
return and adds a desirable level of di-
versification to a portfolio. Most oil and
gas investments are in the United States
and subject to domestic demand charac-
teristics. OPEC and other oil producing
organizations can influence the supply
of world oil supplies. Supply can greatly
impact the market price for oil. Natural
gas is less subject to supply manipula-
tions because it is not transferred around
the world like oil is.
Production volumes, operating ex-
penses and market price affect the roy-
alty income produced by oil and gas
investments. Your oil and gas income
is partially sheltered due to the federal
depletion allowance. As the pool of oil or
gas is depleted, the production gradually
decreases. To encourage the continued
recovery of the resource; a portion of the
income is made exempt from taxation.
Otherwise, as soon as the income got
close to the cost of production, the well
would be shut down until a more cost-ef-
ficient means of recovery was developed.
If you are a general partner, you may
use the oil depletion allowance to make
up to 65% of your income tax exemp-
tion. If you are a limited partner, the
passive rules kick in and your 65% ex-
emption will only apply to passive and
portfolio income. In either case, any
amount exempted from conventional
taxation will be added back into the
AMT income total. The tax treatment is
the pivotal element of the financial vi-
ability of this investment. It is an abso-
lute necessity you engage qualified tax
and financial resources to determine
your particular tax situation before
making this investment.
If the oil exploration does not gener-
ate producing wells, it is possible the tax
The Official Advocate for Personal Investing 95
 shelter effects of IDC may be the only
return produced by the investment.
There is no guarantee the investor will
receive back the original investment.
The investments are not publicly traded.
Liquidity is limited but does exist.
There is a secondary market supply-
ing limited liquidity using online auc-
tion sites, such as energynet.com or
Ogclearinghouse.com. Again, there is
typically no market for investments
producing nominal ongoing income.
At some point the oil or natural gas
ceases to spring forth and the invest-
ment ceases to exist. Oil and gas invest-
ments track with the worldwide demand
and keep pace with inflation. The price
changes do not directly correlate with
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the stock market because they’re invest-
ed in hard assets.
In recessions, oil and natural gas con-
sumption tends to decrease, thereby
depressing market prices and income
distributions. It is a good hedge against
inflation but not entirely recession proof.
Scott Harstad is a financial consultant with 25 years
of experience and does fee-based financial plan-
ning, investment strategy and project management
for businesses and families.
Reprinted with permission.
Copyright 2011 W&A Publishing | Traders Press Inc.® All rights reserved.
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THE

YOUR FAVORITES OF THE PAST YEAR

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Please tell us what your favorites have been during the past year. Check The Last Word online through-
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APRIL PREVIEW
Green investing in the U.S. had
never been hotter than it was just
following Barack Obama’s election,
but where is it today, given the
sluggish economy and Republican
takeover of the House of Represen-
tatives? SFO examines this segment
of the market in April, covering so-
lar stocks, green exchange-traded
funds, compressed natural gas
and new agri-technologies.
Check out Sneak Peek for a pre-
view of these and other April articles
after March 25.